U.S. Taxation of Foreign Trusts, Trusts with Non-U.S. Gran.

U.S. Taxation of Foreign Trusts, Trusts with Non-U.S. Grantors and Their U.S. Beneficiaries* by Ellen K. Harrison, Elyse G. Kirschner and Carlyn S. McCaffrey

* Copyright August 2003, Ellen K. Harrison and Carlyn S. McCaffrey

TABLE OF CONTENTS

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I. HOW TO CREATE A FOREIGN TRUST ........................................................... 1 A. How to Determine Whether a Trust is a Foreign Trust ............................. 1 1. Before the 1996 Act ....................................................................... 1 2. After the 1996 Act ......................................................................... 2 a. The Treasury Regulations .................................................. 4 b. The Court Test ................................................................... 4 c. The Control Test ................................................................ 6 d. Reversing an Unintended Loss of U.S. Status ................... 7 e. Election Available for Trusts in Existence on August 20, 1996 ................................................................. 7 B. Creation of and Transfer of Property to a Foreign Trust by a U.S. Person......................................................................................................... 8 1. Tax Consequences of Creation and Transfer ................................. 8 2. Tax Treatment During the Life of a U.S. Creator or Transferor....................................................................................... 9 3. Tax Treatment at the Death of U.S. "Owner" of a Foreign Trust ............................................................................................. 11 4. Tax Treatment After Death of U.S. Person.................................. 12 5. Reporting Requirements .............................................................. 12 6. Treatment of Trusts That Become Foreign Trusts....................... 13 a. In General......................................................................... 13 b. Reporting Requirements .................................................. 14 C. Creation of a Foreign Trust by a Non-U.S. Person.................................. 14

II. TAX TREATMENT OF FOREIGN NONGRANTOR TRUSTS....................... 15 A. In General................................................................................................. 15 B. Gross Income ........................................................................................... 15 C. Imposition of U.S. Income Tax................................................................ 16 1. Income Effectively Connected With U.S. Trade or Business...... 16 2. Election With Respect to Income From Real Property................ 16 3. Disposition of U.S. Real Property Interests ................................. 16

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4. Fixed or Determinable Annual or Periodic Income..................... 17 5. Other Gains .................................................................................. 18 6. Exceptions.................................................................................... 18 D. Deductions ............................................................................................... 18 1. Income Effectively Connected With U.S. Trade or Business...... 18 2. Other Income ............................................................................... 19 3. Foreign Tax Credit....................................................................... 19 E. Tax Rates ................................................................................................. 20 1. Income Effectively Connected to a U.S. Trade or Business........ 20 2. Other Income ............................................................................... 20 F. Withholding ............................................................................................. 21 1. Income Effectively Connected With U.S. Trade or Business...... 21 2. U.S. Real Property Interests......................................................... 21 3. Fixed or Determinable Annual or Periodic Income..................... 21 G. Effect of Tax Treaties .............................................................................. 22 H. Taxable Year; Reporting.......................................................................... 22 1. Taxable Year and Estimated Tax Payments ................................ 22 2. U.S. Nonresident Alien Income Tax Return ? Form

1040NR ........................................................................................ 22 3. Report of Foreign Bank and Financial Accounts ? Form TD

F 90-22.1 ...................................................................................... 22 4. Taxpayer Identification Numbers ................................................ 23 III. TAX TREATMENT OF U.S. BENEFICIARIES OF FOREIGN NONGRANTOR TRUSTS.................................................................................. 23 A. In General................................................................................................. 23 B. Distributions of Income in the Year Earned ............................................ 24 1. General Rules............................................................................... 24

a. Distributable Net Income................................................. 24 b. Determining a Beneficiary's Share of DNI ..................... 24 c. Meaning of "Income" ...................................................... 25 d. Sixty-Five Day Election................................................... 26 e. Specific Gifts ................................................................... 26

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f. Distributions of Property Other Than Cash ..................... 26 2. Special Rules Applicable to Nongrantor Trusts That Are

Foreign ......................................................................................... 27 a. Different Definition of Distributable Net Income ........... 27 b. Tax Character of Distributions......................................... 28 c. Credit for U.S. Withholding Tax ..................................... 28 d. Credit for Foreign Income Taxes Paid by Trust .............. 29 C. Distribution of Income Accumulated in a Prior Year ? the "Throwback Rules".................................................................................. 30 1. In General..................................................................................... 30 2. Accumulation Distributions ......................................................... 30 a. In General......................................................................... 30 b. Exceptions........................................................................ 30

(1) Specific Gifts ....................................................... 30 (2) Distributions Not in Excess of Trust

Accounting Income.............................................. 31 (3) Default Method of Calculating an

Accumulation Distribution................................... 31 (4) Undistributed Net Income.................................... 33

(a) In General................................................. 33 (b) Addition of Taxes .................................... 33 (c) Reduction of UNI..................................... 33 (d) Default Method of Calculating UNI ........ 34 (5) Calculation of Throwback Tax on an Accumulation Distribution................................... 34 (a) In General................................................. 34 (b) The Steps.................................................. 34 (c) Use of the Steps With the Default

Method ..................................................... 37 (6) Calculation of the Interest Charge ....................... 37

(a) In General................................................. 37 (b) Before the 1996 Act ................................. 37 (c) After the 1996 Act ................................... 38

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(d) The Default Method................................. 41 (e) Observation .............................................. 41 D. Loans Treated as Distributions ................................................................ 41 1. In General..................................................................................... 41 2. Repayment of Loans .................................................................... 43 3. Amount of the Distribution.......................................................... 43 E. Indirect Transfers From Foreign Trusts................................................... 43 1. Distributions Through "Intermediaries" ...................................... 43 2. The Grantor Is Not an "Intermediary" ......................................... 46 3. Agency Principles Control Issue of Timing and Amount of Income.......................................................................................... 46 F. Treatment of Income of Controlled Foreign Corporations, Foreign Personal Holding Companies and Passive Foreign Investment Companies................................................................................................ 47 1. In General..................................................................................... 47 2. The Anti-Deferral Regimes.......................................................... 48 a. Controlled Foreign Corporations ..................................... 48 b. Foreign Personal Holding Companies ............................. 48 c. Passive Foreign Investment Companies .......................... 49 3. The Attribution, Indirect, and Constructive Ownership Rules ............................................................................................ 50 4. Planning Techniques.................................................................... 52 IV. TAX TREATMENT OF U.S. BENEFICIARIES OF GRANTOR TRUSTS WITH FOREIGN GRANTORS .......................................................... 53 A. Background .............................................................................................. 53 B. Limitation on Grantor Trusts ................................................................... 54 C. Definition of "Grantor"............................................................................ 54 1. Accommodation Grantor ............................................................. 54 2. "Gratuitous Transfer"................................................................... 54 3. "Grantor" Includes Purchasers..................................................... 55 4. Grantors Who Are Corporations or Partnerships......................... 55 5. Trusts Established by Other Trusts .............................................. 55 6. Code ? 678 Powers ...................................................................... 56

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