BACKGROUND
Due to concerns about the potential use of foreign trusts and gifts as a means to access the proceeds of unreported income, the Internal Revenue Code (the "Code") and related regulations issued by the Treasury Department ("Treas. Reg.") impose extensive reporting obligations for U.S. persons who have an interest in or transactions with foreign trusts. New regulations have been proposed to provide clarity on the application of the rules and relief to taxpayers in some cases.
Many of the rules in the proposed regulations are not new, but they describe and consolidate rules gleaned from statutes, I.R.S. notices, I.R.S. rulings, and instructions for I.R.S. forms.
LOANS TO AND USES OF FOREIGN TRUST PROPERTY
Basic Rule
Code §643(i) focuses on foreign trusts lending money to U.S. persons or allowing U.S. persons to use property without adequate compensation. An example of the latter is the free use of a condominium apartment in New York City or a vacation home in Palm Beach. If a foreign trust allows for the uncompensated use of its property by (i) its U.S. grantor or beneficiary or (ii) a U.S. person who is related to the grantor or beneficiary, the trust is deemed to have made a distribution equal to the value of the property to the grantor or the beneficiary. If the user of the property is a related U.S. person, the distribution is deemed to have been made to the U.S. grantor or beneficiary, not the related U.S. person. The U.S. person must report this transaction on Line 25 of Part III of Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts).
Exceptions
This rule does not apply if the trust is compensated for the use of its property. The proposed regulations1 detail the type of compensation that will create an exception. Loans of cash will not create a §643(i) distribution if the trust is compensated through a "qualified obligation." An obligation must meet the following criteria to be a qualified obligation:
- The obligation must be in writing.
- The term of the obligation must not exceed five years.
- All payments must be made in cash in U.S. dollars.
- The obligation must be issued at par and provide for stated interest at a fixed rate or a "qualified floating rate" (broadly, a rate where variations in the rate reasonably track the cost of borrowing U.S. dollars).
- The yield to maturity must be at least 100% of and not greater than 130% of the applicable federal rate as of the date of the obligation's issuance.
- All stated interest must be qualified stated interest (stated interest that is unconditionally payable in cash or property (other than debt instruments of the issuer) at least annually over the term of the debt instrument at a single fixed rate).2
Additionally, the obligation must meet the following requirements throughout the obligation's existence:
- The U.S. grantor or beneficiary must extend the statute of limitations for the I.R.S. to assess the tax on the deemed distribution to three years after the obligation's maturity date.
- The U.S. grantor or beneficiary must report the status of the obligation (including any payments made) on Part III of Form 3520.
- The obligor must pay principal and interest according to the terms of the obligation.3
The I.R.S. has requested comment on whether a similar exception should be made available for loans of marketable securities. Such an exception was left out because the I.R.S. does not believe that this fact pattern is not common.
For loans of property other than cash or marketable property, distribution treatment will not apply if the trust receives compensation equal to the fair market value of the use within reasonable time (defined as 60 days or less) after the U.S. person starts using the property.4 The proposed regulations also provide a de minimis exception under which Code §643(i) will not apply if the loan is for a period of 14 days or less. 5 Lastly, cash loans made by foreign corporations to a U.S. beneficiary are not treated as distributions to the extent they are attributable to the corporation's undistributed earnings that have been included in the U.S. beneficiary's income under either the controlled foreign corporation or qualified electing fund. This exception presumably only applies to an indirect loan where a foreign corporation is a C.F.C. or a P.F.I.C. and the beneficiary is deemed to own the shares of the foreign corporation by attribution from a foreign trust.6
The reporting requirement also does not apply to the extent that the foreign trust is a grantor trust. A foreign trust can become a grantor trust to the extent that a U.S. person transfers property to the trust and Code §679 consequently applies to make at least a portion of the trust a foreign grantor trust. The preamble explains that this means §643(i) will rarely apply to a U.S. grantor of a foreign grantor trust. This is also confirmed by proposed regulations under Code §679.7
Other Information
Indirect loans fall under the purview of this reporting requirement. The proposed regulations provide three examples of indirect loans:
- A loan made by anyone to the U.S. grantor or beneficiary where the trust guarantees the loan.
- A loan made by a person related to the trust to the U.S. grantor or beneficiary.
- A loan made by the trust to a foreign person related to the U.S. grantor or beneficiary (unless the foreign related person is a grantor or beneficiary of the trust).8
However, under the latter two examples, the U.S. grantor or beneficiary can avoid the Code §643(i) distribution treatment if a statement is attached to his or her tax return demonstrating that the loan would have been made even if the U.S. grantor or beneficiary were not related to the trust.9
The proposed regulations also contain an anti-abuse provision. A foreign individual who receives a loan from a foreign trust and becomes a U.S. person within two years will be subject to Code §643(i) to the extent of the outstanding amount of the loan as of the date the borrower becomes a U.S. person.10
Tax Consequences
If a loan is recharacterized as a distribution, there are tax consequences to both the trust and the U.S. grantor or beneficiary. The trust is given a deduction for making a distribution.11 If the deemed distribution involves marketable securities, the trust is further deemed to have elected under Code §643(e)(3) to recognize gain on the distribution.12 Consequently, any capital gain recognized on the securities is included in the trust's distributable net income.
The trust may provide a Foreign Nongrantor Trust Beneficiary Statement to the U.S. grantor or beneficiary, although the proposed regulations imply that this is not necessary.13 The issuance of the statement determines how the U.S. person will treat the deemed distribution. If a U.S. person receives the statement from the trust, the U.S. person can opt for the actual calculation method, under which the U.S. grantor or beneficiary treats the deemed distribution as an amount that is required to be distributed under Code §662(a)(2).
If the U.S. person does not receive a statement, he or she must use the "default calculation method," including for all subsequent distributions from the same trust (even if later distributions are not Code §643(i) distributions). Under the default calculation method, the distribution is treated as current income to the extent of 125% of the average amount of distributions received by the U.S. person in the prior three years. Any amount of the distribution in excess of that is treated as an accumulation distribution, which is generally considered a less taxpayer-friendly form of a distribution.
Footnotes
1. 89 FR 39440; Prop. Reg. §1.643-2.
2. Prop. Reg. §1.643-2(b)(2)(iii)(A).
3. Prop. Reg. §1.643-2(b)(2)(iii)(B).
4. Prop. Reg. §1.643-2(a)(2)(ii).
5. Prop. Reg. §1.643-2(a)(3).
6. Prop. Reg. §1.643-2(a)(4).
7. Prop. Reg. §1.679-2(a)(v)(5).
8. Prop. Reg. §1.643-1(b)(2).
9. Prop. Reg. §1.643-1(b)(2)(ii).
10. Prop. Reg. §1.643-1(b)(3).
11. Prop Reg §1.643(i)-3(a).
12. Prop Reg §1.643(i)-3(c)(2)(ii).
13. Prop Reg §1.643(i)-3(c)(2)(iii).
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