U.S. International Income Tax Considerations and the Tax Traps for Family Offices
October 16, 2017
By Harold Adrion, Angela Chen and Karen Goldberg
Family offices both in the U.S. and outside the U.S. have a myriad of international tax considerations to contend with. A typical family office may be organized as a trust, partnership, corporation, or a combination of all and have family members who are U.S. citizens, residents or non-residents. In addition, many family offices make cross border investments that may impact the family members, depending on their status as citizens or residents.
(Another aspect that must be considered for any family office is estate and gift tax issues. This article does not address estate and gift tax issues.)
The U.S. Anti-Deferral Regimes
a. Controlled Foreign Corporations ("CFC")
A foreign corporation is a CFC if over 50% (by vote or value) of its stock is owned by "United States shareholders." For purposes of this definition, a United States shareholder is a United States person who owns directly, through one or more foreign entities, or through the application of certain constructive ownership rules, at least 10% of the total combined voting power of all classes of stock entitled to vote.
A U.S. person who owns directly or through a foreign entity shares of a CFC must include in gross income for each year her pro rata share of the CFC's "Subpart F" income. A shareholder's pro rata share of a CFC's Subpart F income is that amount which would have been distributed with respect to the stock which such shareholder directly or indirectly (but not constructively) owns if, on the last day of the taxable year, the CFC had distributed all of its Subpart F income pro rata to its shareholders. Subpart F income includes insurance income, "foreign-base company income," international boycott income and foreign bribe-produced income. Generally, foreign-base company income includes, among other things, dividends, interest, royalties, rents, annuities, gains from the sale or exchange of certain types of property, gains from commodities, foreign currency gains, profits from the certain purchases and sales of certain types of personal property, and income from the performance of certain services for or on behalf of a related person outside the CFC's country of incorporation.
b. Passive Foreign Investment Companies (PFIC)
A U.S. shareholder who is not subject to current tax under the CFC regime may still be subject to the so-called PFIC regime. A foreign corporation is a PFIC if (1) 75% or more of its gross income for the taxable year is "passive income" or (2) the average percentage of assets (by value) held by the corporation for the production of passive income is at least 50%. Passive income generally means income which would be foreign personal holding company income under Subpart F. Generally, a U.S. person who owns any interest in a PFIC will be subject to ordinary income tax on gain from disposing of PFIC stock and will be subject to an interest charge on the income tax imposed on such gain and on distributions from the PFIC. For purposes of this provision, a disposition of shares in a PFIC by a foreign non-grantor trust may be treated as a disposition of PFIC stock by the trust's U.S. beneficiaries. Similarly, a distribution of property from a PFIC to a non-grantor trust may be treated as a distribution to its U.S. beneficiaries.
Trusts and Their Classification
Trusts with a U.S. connection can be classified under three separate categories. First, is the trust a U.S. resident or foreign resident? Second, is it a "grantor" trust or "non-grantor" trust? Third, for purposes of U.S. withholding tax rules and the U.S. domestic taxation of U.S. grantors and beneficiaries, a non-grantor trust may be either "simple" or "complex."
There is a two-part test for determining whether a trust is foreign or domestic for U.S. income tax purposes. The trust satisfying both parts of the test is a domestic trust; failing either or both parts of the test results in the trust being considered a foreign trust. The first part is known as the "court test," which requires that a court within the United States be able to exercise primary supervision over the administration of the trust. Administration for these purposes includes those duties imposed upon a trustee under both the trust instrument and applicable law. The second part of the test, referred to as the "control test," is satisfied as long as one or more U.S. fiduciaries have the authority to control, in effect, almost all decisions of the trust.
A "grantor" trust for U.S. income tax purposes simply refers to trusts under which all of the income earned by the trust is attributed to the settlor of the trust (also known as the grantor, which under U.S. rules is really the contributor to the trust). Grantor trust status may, therefore, only apply during the grantor's lifetime. Examples of trusts that will be treated as grantor trusts, regardless of whether the grantor is a U.S. person or a non-resident alien, include the following:
- A foreign grantor of a revocable trust;
- A foreign grantor of an irrevocable trust that may only benefit a grantor or her or his spouse, or both;
- A U.S. grantor of almost every foreign trust (provided that the foreign trust may benefit a U.S. income taxpayer);
- A U.S. grantor of a revocable trust or an irrevocable trust of which the grantor and/or his or her spouse is a beneficiary; and
- A U.S. grantor of an irrevocable trust over which the individual retains certain administrative powers.
A simple trust is one that requires that all income be distributed to a specific beneficiary. Thus, for example, a qualified spousal trust would be treated as a simple trust. All other non-grantor trusts would be complex trusts. This distinction is only significant for U.S. resident trusts and for foreign trusts that have U.S. source income (where the issue involves U.S. withholding taxes).
The taxation rules for each category of trusts are summarized below.
All trust income and expenses and other tax deductions for all purposes are attributed to the grantor. For U.S. domestic estate planning, this is quite advantageous because an individual may settle an irrevocable grantor trust, the value of which would be excluded from his or her estate, and allow the trust to grow tax-free during his or her lifetime.
All of the net ordinary income of a simple trust (one which requires the payment of income to a specific beneficiary) results in the trust getting a full deduction for the net ordinary income and the beneficiary including all of such income in his or her income for the year in question, regardless of whether the income is paid.
U.S. non-grantor, discretionary trusts are taxed on a conduit principle. That is to say, if there are no distributions to beneficiaries, all of the ordinary income (as well as the net realized capital gains) are taxed to the trust. The trust rates are individual income tax rates but they rise much more quickly to the maximum rate. Dividends, however, have a maximum rate of only 23.8% under 2017 U.S. federal tax law.
A foreign grantor trust is not recognized as a taxable entity for U.S. tax purposes because the foreign grantor may retain the ownership of the trust assets and income. If the grantor is not a U.S. person for U.S. income tax purposes, he or she is not required to report the trust income to the U.S. tax authority (unless the trust earns U.S. source income).
Whenever grantor trust status ceases (such as the death of the grantor), or if a foreign trust does not meet grantor trust criteria, the trust is a foreign non-grantor trust. Under this regime, there are U.S. income tax consequences and additional reporting requirements with respect to any distribution to beneficiaries who are U.S. income taxpayers.
Each beneficiary of a foreign non-resident grantor trust is taxed on the trust's current net income to the extent that such income is distributed to the beneficiary pursuant to the governing instrument.
Each U.S. beneficiary must report any distribution received from the foreign non-grantor trust to the IRS using Form 3520 for each year that a distribution occurs and must be able to prove the character of the distribution as reported on the Forms 2520 and 1040 (current ordinary income, current capital gain, accumulation distribution, or tax-free principal distributions).
Who is the Actual Grantor?
Often members of a foreign family hold assets for each other. If the person who has the power to revoke the trust or is (or their spouse is) the beneficiary of the trust is not the real contributor of assets, the trust will not qualify as a foreign grantor trust. If a foreign trust is not a grantor trust, U.S. beneficiaries can't report distributions properly for U.S. tax purposes.
Unanticipated U.S. Resident
For U.S. income tax purposes, a U.S. "resident" is any person who (1) is a "green card holder," (2) is physically present in the United States for at least 183 days in the current year or (3) meets a test of a rolling, weighted three-year average of at least 183 days in the United States, known as the "substantial presence test."
There are exceptions to the substantial presence test if an individual was present in the United States for less than half of a year and if she can establish a closer connection to a foreign country. Other exceptions apply to certain categories of individuals such as students.
In the context of foreign families, they often send their children to the U.S. for college. When the children graduate, they cease being considered exempt from resident status. As U.S. resident beneficiaries of a foreign trust, they will have U.S. reporting obligations.
CFC and PFIC Trap
If a CFC or a PFIC is owned by a foreign non-grantor trust, U.S. tax laws may attribute ownership of shares of the foreign corporation to a U.S. beneficiary. The result may be that the U.S. beneficiary is subject to U.S. tax based upon activity occurring at the level of the foreign corporation or the trust, even if she did not receive a distribution from the trust.
U.S. Family Offices Investing in Foreign Mutual Funds or Unit Trusts
From a U.S. tax perspective, foreign mutual funds and unit investment trusts are generally characterized as corporations under the U.S. entity classification rules. As a result, foreign mutual funds and unit investment trust are likely to be considered PFICs. Although there are certain elections available, they are often hard to implement in practice.
Dual Resident Trust
It is possible for a U.S. trust to be considered a "dual resident." In the case of a U.S. trust with foreign beneficiaries, the use of a grantor trust may result in the trust income being subject to U.S. and foreign tax, with the trust unable to claim a foreign tax credit and uncertainty as to relying on "competent authority" or obtaining competent authority relief.
For example, until recently, Israel did not tax trusts whose settlors were all nonresidents of Israel on foreign-source income. Under recently passed Israeli legislation (Israeli tax reform), for any trust with beneficiaries that are Israeli residents, either:
- The trust itself will be required to pay Israeli income tax; or
- The beneficiaries who reside in Israel will be subjected to Israeli income tax on distributions. These taxes will apply to Israeli – and foreign-source income will apply to Israeli – and foreign-sourced income.
This means that a U.S. trust with beneficiaries who are dual Israel and U.S. residents (including U.S. citizens who are residents of Israel) could face Israeli income tax at a rate of at least 25%, or else the Israeli resident beneficiaries will incur Israeli tax on distributions at a rate of 30%. Also, there will be U.S. tax imposed on either the trust, the beneficiaries, or (in the case of an entity classified as a grantor trust) the grantor. Large numbers of trusts exist that have been established by U.S. citizen grantors with beneficiaries who are both U.S. citizens and residents of Israel.
The potential for double taxation – and the application of the Israeli-U.S. tax treaty to avoid this result – raises interesting questions of treaty interpretation.
Accumulation Distributions from Foreign Non-Grantor Trust
If the trust makes any distributions in excess of its current income in any year, there are no U.S. tax implications to the extent of the capital portion so distributed, provided that all prior year's net income was fully distributed. Accumulation distributions are treated as ordinary income (that is, the special character of tax-favored items of income, such as qualified dividends and long-term capital gains, is lost), subject to income tax and interest. The amount of income tax plus compounded interest represents an estimate of the taxes that the beneficiary would have paid if the trust had distributed the UNI as earned. The interest charge is intended to compensate the U.S. government for the delay in payment of the tax.
In summary, family offices both U.S. and foreign need to be aware of the U.S. tax ramifications that impact both their beneficiaries and the investment they make as well as issues involving dual resident trusts, accumulation distributions and family members who become U.S. residents.
Asset Management Intelligence – Q4 2017
- The Rise of Cryptocurrencies: Considerations from an Audit, Tax, and Regulatory Perspective
- The Expanding Role of Family Offices in the Private Investment Fund Arena
- What U.S. Fund Managers Need To Know About Year-End Financial Reporting for Their Irish Domiciled Funds
- Alternative Investment Industry Outlook for Q4 and Early 2018
- U.S. International Income Tax Considerations and the Tax Traps for Family Offices