FATCA and the Taxation of Foreign Trusts and Nonresident Aliens by the US

President Obama signed into law on 18 March 2010 the Hiring Incentives to Restore Employment (HIRE) Act of 2010, which included as its Title V the Foreign Account Tax and Compliance Act (FATCA), which had been introduced in 2009. The Act includes significant provisions impacting the reporting of interests held in foreign accounts and withholding on payments by U.S. persons to foreign accounts, the investment by nonresident aliens in interest-bearing U.S. investments, the creation by U.S. persons of foreign trusts, and the taxation to U.S. beneficiaries of foreign trusts owning interests in real property. These provisions will be briefly described in this article.

Reporting of Interests in Foreign Accounts and Withholding of Tax

U.S. tax law has long provided for the withholding of income tax at a flat 30 per cent (or lesser treaty) rate on payments made to foreign accounts. Generally, the U.S. payor of items of income subject to withholding must withhold at the appropriate rate on payments made to a foreign account unless the payor has account information, including a Form W-9, that will allow the payor reliably to associate the payment with a U.S. person and thus not be subject to withholding. Treas. Regs. Sect. 1-1441-1(b), 1.1441-5.

Because of a belief on the part of the United States Treasury that U.S. persons have been using foreign accounts to avoid payment of U.S. income tax, new Internal Revenue Code (IRC) Section 1471 will now require withholding at a 30 per cent rate on payments to all foreign financial institutions with respect to their accounts for the benefit of U.S. persons, unless the financial institution complies with the annual reporting requirements, to be finalised by regulation, which will require identification by name, address, and taxpayer identification number of all U.S. depositors, with their account numbers, balances, and income earned during the year from all sources. These provisions will, in most cases, apply to payments made after 31 December 2012.

Reporting requirements on the account holders are also strengthened.

Interest on Bearer Bonds and Dividend Equivalent Payments

The IRC has long contained provisions which are entitled to encourage investment by nonresident aliens in certain classes of U.S. investments. Thus, Section 871(h) of the IRC has long provided that nonresident aliens owe no U.S. income tax upon interest received from ‘portfolio debt instruments’. In essence, portfolio debt is registered debt of U.S. issuers which is owned by nonresident aliens for investment purposes. Until the passage of FATCA in the HIRE Act, portfolio debt included both registered debt owned by nonresident aliens, and bearer debt described in Section 163(f)(2)(B) of the IRC, which was debt issued only to nonresident aliens, with payments made outside of the U.S., a legend upon the bond stating that it was intended to be held only by nonresident aliens, and ‘arrangements reasonably designed’ to assure that only nonresident aliens would hold the bearer bonds. Because of concern in the United States Treasury that many U.S. taxpayers were investing in such bearer bonds and paying no tax, Section 502 of the HIRE Act eliminates most bearer bonds as qualified ‘portfolio debt.’

Section 541 of the HIRE Act further amends Section 871 of the IRC by adding a new subsection (l) which will subject ‘dividend equivalent’ payments to withholding at a 30 per cent rate. While dividends are taxable at a 30 per cent rate to nonresident aliens, as noted interest on portfolio debt is not taxed. For some years, major brokerage firms have offered nonresident alien customers account arrangements whereby, through securities lending or sale-repurchase transactions, the brokerage firm received the dividend payment upon a U.S. security owned by the nonresident alien, and paid the nonresident alien an equivalent amount as interest, rather than a dividend. Such payments will be subject to 30 per cent tax where these are made on obligations issued after 18 March 2012.

Foreign Trusts Created by United States Persons

Section 679 of the IRC has long taxed foreign trusts created by United States persons as ‘grantor trusts’, whose income and deductions were owned and reportable by the settlor, if the trust had any United States beneficiaries. There is sometimes a doubt as to whether such a foreign trust has or may have a United States beneficiary. Section 531 of the HIRE Act amends Section 679 in order (according to the statute) to clarify whether a foreign trust has U.S. beneficiaries. Section 532 of the HIRE Act inserts a new Section 679(d) to say that all foreign trusts created by U.S. persons are presumed to have U.S. beneficiaries, and thus to be taxable as grantor trusts, unless the settlor submits to the IRS such information as may be required by the Treasury Department to make clear that the trust does not and cannot have U.S. beneficiaries.

Foreign Trusts Created by Foreign Settlors Which Own Real Estate

Section 643(i) of the IRC has long provided that if a foreign trust with U.S. beneficiaries loaned cash or securities to the U.S. beneficiaries, upon any terms, the amount loaned would be taxed as if it had been distributed to the U.S. beneficiary. Section 533 of the HIRE Act amends Section 643(i) of the IRC to provide that if a foreign trust ‘permits the use of any other trust property’ by the U.S. beneficiary or a United States person who is related to the U.S. beneficiary, the trust will be deemed to have made a distribution to the U.S. beneficiary in an amount equal to the fair market rental value of the property, unless the user pays fair market rent to the trust. The charge applies whether the property is owned directly by the trust or indirectly via an underlying structure.

The amended provision is effective from 18 March 2010. As a result, any use of property after that date, including continuing use which had commenced prior to that date, will have US tax consequences unless the use is fully compensated by means of payment of a fair market value of the use within a reasonable time of such use. If the use is uncompensated, an amount equal to the fair market value of the use is treated as distributed to the U.S. person under the rules applicable to this type of trust. A distribution made from current-year income of the trust is taxable as income in the hands of the U.S. beneficiary. If the trust has undistributed net income (UNI) from earlier years and the distribution exceeds the current year income, the excess over current year income is known as an ‘accumulation distribution’ which will be subject to the ‘throwback rules’. Under these rules, the rates of tax and interest can be punitive.

If a foreign trust is caught by the new taxing provision, there are certain steps which can be considered to avoid the charge.

Remedial Action To Be Considered By Foreign Trustees

Since, for many years, it has been possible for U.S. persons to occupy trust-owned real property or use trust-owned personal property (such as paintings or furniture) without any U.S. tax consequences this change in the law is likely to have a significant impact on many existing structures. Foreign trustees will urgently need to consider how the new provisions impact on each individual structure and determine whether it is necessary or appropriate to take remedial action in each case. There is no ‘one size fits all’ solution.

A number of immediate issues arise for structures which are caught by the rules from the date of enactment. This is likely to apply where a property was in use prior to 18 March 2010 and the use simply continued after that date. While the trustees consider the different options open to them, and take the appropriate action, it would be advisable to put in place an interim market rental agreement, effective from the date of enactment, to prevent the tax charge and reporting requirement arising in the meantime.

Due to the worldwide nature of U.S. taxation of its citizens, these rules will apply to the occupation of trust property or use of trust personal property anywhere in the world by a U.S. person who may be resident in another jurisdiction for tax purposes. There may also be tax charges arising from the occupation or use of the property under the laws of the country of residence. If, for example, the US person is resident in the UK then the UK tax rules must also be considered. Even if the property is not in the UK, there may still be UK tax issues if the beneficiary is UK resident and is not claiming the remittance basis. In the situation where two jurisdictions seek to tax the same benefit, the provisions of any applicable double taxation convention will need to be considered to establish how taxing rights will be allocated and how any credit would be applied.

The payment of a market rent may generate a taxable source of income for the trust representing an ongoing tax leakage from the structure which may previously have been relatively tax neutral. The trustees may need to register as taxpayers in the jurisdiction of the source of the income whether or not a rental profit would arise and tax would be payable. The receipt of rent may also give rise to US reporting requirements for the trust.

Although it may be relatively straightforward to obtain a market valuation of real property for rental purposes, in the case of personal property this is likely to be difficult to establish without engaging valuation experts. There may be an issue as to whether a valuation can be obtained sufficiently quickly to enable the U.S. person who is benefiting from the use to pay a fair market rent within a ‘reasonable time’ of the use. In this situation, it may be advisable for the US person to pay an amount on account of rent in the meantime.

For trusts which are within the U.S. throwback rules the new provisions present a particularly urgent problem if the market rental figure would exceed current year income since the effective rate of tax on distributions of UNI can be punitive. If this were the case uncompensated use of the trust’s property would not be recommended and it would be important to put in place interim arrangements to pay a fair market value for use of the property while a longer-term solution is considered and, where appropriate, implemented.

In the longer term, paying a full market rental each year may be the preferred option in some situations, particularly if there would be significant tax consequences of a restructuring. Where a property has a high rental value this will raise issues of funding the U.S. person in order to pay the rent. This funding may, in turn, give rise to further tax charges.

More comprehensive steps may be necessary in order to restructure or dismantle arrangements which no longer confer the advantage of tax-free use of trust property. Depending on the circumstances, it may be possible to resettle the property in a tax-efficient manner onto a new structure which does not generate income or contain historic UNI, although as a result the trust would then have no income-stream and there could be issues with funding ongoing expenses.

Some clients may consider domesticating foreign trusts into the U.S. in order to avoid the new rules. This could be done either by appointing assets to a U.S. domestic trust or by migrating the existing trust into the U.S. Which option will be more suitable will depend on various factors including, in particular, the UNI position of the existing foreign trust. Similarly, an outright distribution or a sale of the trust property to a beneficiary (whether or not a U.S. person), if it can be done tax-efficiently, may be an appropriate option although it will also be necessary to deal with the resulting estate tax consequences.

The Way Forward

The provisions of FATCA have far-reaching consequences for U.S. persons holding assets offshore, foreign trusts and non-resident aliens. Some of the new measures, including the enhanced reporting requirements for interests in foreign accounts, have an effective date which is still in the future and require further regulation to finalise the detail. The measures of FATCA which are applicable to foreign trusts, however, are effective immediately and require foreign trustees to take appropriate advice and action without delay.