US persons engaging in transactions with foreign trusts need to be cautious when dealing with the property of a foreign trust for personal advantage. This includes loans from the trust to a US person.
Types of foreign trust
A foreign trust is classified as either a grantor trust or a nongrantor trust.
A grantor trust is looked through for U.S. tax purposes, so that income and gains, expenses and losses are taxed in the hands of the U.S. grantor. A nongrantor trust is recognized as a separate entity for U.S. tax purposes.
Whichever the classification, information reported is required on Forms 3520 Annual Return to Report Transactions with a Foreign Trust and Receipt of Certain Foreign Gifts, and Form 3520-a Information Return of a Foreign Trust with a U.S. Owner.
Rules
Rules relating to the uncompensated use of trust property by a U.S. person were tightened through the IRS’s work on tracking down unreported accounts.
Under the same legislation that enacted the Foreign Account Tax Compliance Act (FATCA), which is the HIRE Act effective after 18 March 2010, the use of trust property, directly or indirectly, by any U.S. person (whether or not a beneficiary under the terms of the trust) will cause a foreign trust to be treated as a grantor trust.
That is unless the U.S. person repays the loan at a market rate of interest or pays the fair market value of the use of such property within a reasonable period of time.
The vast majority of trusts that we see already fall into the category of a grantor trust because they typically state in the terms of the trust that there are beneficiaries who are U.S. persons.
After 18 March 2010, if a U.S. grantor, a U.S. beneficiary, or any U.S. person related to the U.S. grantor or U.S. beneficiary, directly or indirectly uses any property of a foreign nongrantor trust, and the U.S. grantor, U.S. beneficiary, or U.S. person related to the U.S. grantor or the U.S. beneficiary does not compensate such trust at fair market value for the use of such property within a reasonable period of time, the fair market value of such use will be treated as a distribution by the foreign nongrantor trust to the U.S. grantor or the U.S. beneficiary, as the case may be.
Conclusion
The consequences of this are that the distribution is potentially subject to U.S. income tax, being a deemed distribution from a foreign nongrantor trust.
The Internal Revenue Code presumes that a foreign trust into which a U.S. person has transferred, directly or indirectly property, of any type including cash, has a U.S. beneficiary unless a grantor can satisfy the Secretary of the Treasury otherwise.
Furthermore, the uncompensated use of trust property, including the advance of a loan of cash or securities to or by any U.S. person whether or not a beneficiary under the terms of the trust, shall be treated as paid or accumulated for the benefit of a U.S. person.
Any engagement between a U.S. person and a foreign trust should, therefore, be reviewed for U.S. tax implications before the transaction is executed.
US Treasury Department Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
This article has been written for the general interest of our clients and to stimulate further thought and enquiry. It does not contain answers to specific situations and it is, therefore, essential to treat it as a prompt to take specific advice on any real and particular issues. We believe that the facts as summarised in this article are correct as at the time of going to press. If we discover that the article might be read in a way that conveys a misleading impression (whether by tone, content, error or omission) we will make the necessary changes and draw attention to what has been changed once we become aware of the need to do so. We will not be responsible for any action taken by a reader who relies on the article but does not seek further advice to answer any specific query.