Foreign Grantor Trusts: Planning Non-U.S. Family Trusts – Corporate / Commercial Law
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Trusts are often used by successful families for long-term estate planning and centralized asset management. However, US tax rules can negatively impact US citizens, green card holders, and tax residents who benefit or may even benefit from income and capital gains in non-US trusts (and their holding companies under -jacent). Non-American patriarchs and matriarchs with American family members, however, can significantly improve the situation of their American family members through the establishment of a “Foreign Grantor Trust” (hereinafter “FGT”).
Benefits of an FGT
A properly structured and administered FGT offers very favorable U.S. federal tax treatment to U.S. family members, including:
- No annual tax or declaration of income or earnings of the trust (unless from US sources) during the settlor’s lifetime;
- No annual tax or declaration regarding investments classified as passive foreign investment companies (“PFIC”) and / or entities that might otherwise be classified as controlled foreign companies (“SEC”) during the grantor’s lifetime;
- Non-taxable distributions to U.S. family members during the grantor’s lifetime (although a payee disclosure requirement applies); and
- Elimination of future US gift and inheritance taxes on trust assets (provided that the assets located in the US, if any, are held through a non-US holding company classified as a corporation for U.S. tax purposes).
Disadvantages of outright gifts and non-ceding foreign trusts
These advantages are particularly attractive compared to the outright transfer of assets to US family members or the current investment of assets in a trust that does not qualify for FGT status. Assets currently transferred to:
- U.S. family members would be subject to tax on future income and gains generated by those assets and would become subject to the U.S. gift and inheritance tax system which currently imposes a tax rate of 40% on the estate. value of assets of future donations or bequests made by American family members.
- Any non-US trust other than one qualifying for “foreign grantor trust” status would be classified as a “non-grant foreign trust” and would generally subject US family members to current year income tax and income tax. gains distributed to them and unfavorable tax rates and compound interest charges on undistributed trust income and gains in the year of realization and could result in tax and / or reporting obligations for US family members in respect of any PFIC or CFC assets held by the trust.
Structuring Trust for Other American Considerations
While in many circumstances it should be relatively straightforward to structure a trust to achieve FGT status, there are a number of related but additional considerations relating to the drafting and structuring of the trust that must be taken into account. :
- If U.S. family members are granted certain powers or rights under the trust, this could subject them to U.S. income or gift or estate tax either during the settlor’s lifetime or after the settlor’s death. .
- If the trust directly holds assets located in the United States, those assets will generally be subject to U.S. estate tax upon the death of the settlor (and to gift tax if transferred to family members of the settlor. living of the constituent).
- If the settlor directly owns assets located in the United States and transfers those assets to the trust, then on the death of the settlor there will generally be US inheritance tax on the trust even if those assets had been sold there long and that the trust did not directly or indirectly own any assets located in the United States at the time of the settlor’s death.
- Such exposure to inheritance and gift tax can generally be avoided through the use of a non-US holding company to hold assets located in the United States.
- In most cases, it will be desirable to structure the FGT such that the assets directly held by the trust automatically receive a “base increase” to the current market value upon the death of the settlor. On a subsequent sale of these directly held assets, the amount of the gain realized by the trust will be reduced, thereby reducing the amount of tax payable on distributions to US family members.
Following the death of the settlor
Following the death of the settlor, the FGT will automatically switch to the status of “non-granting foreign trust” (hereinafter “FNGT”). At that point, leaving aside additional considerations regarding fiduciary assets classified as PFIC or CFC, in a very general way,
- Income and distributed earnings during the year made to American family members would generally be taxed to them as if those amounts had accrued directly to those individuals; and
- Income and gains made but not distributed until a later year to U.S. family members would generally be subject to tax under the so-called “retroversion” rules as “undistributed net income” (“UNI”), these amounts are generally taxable on ordinary income. even though they were originally capital gains, and generally subject to additional interest charges compounded over the period in which those amounts accumulated in the trust.
Rather than directly owning investment assets, non-US trusts will frequently choose to use a non-US holding company to hold those assets. In addition, as noted above, with respect to assets located in the United States, it is generally true that these assets should be held through a non-US holding company in order to eliminate exposure to US inheritance tax that would generally apply to those assets located in the United States. . Using a holding company, however, can create tax complications for recipient US family members with respect to the grantor’s death.
Based on all the facts and circumstances at the time of the settlor’s death, if more than half of the ownership of the holding company is attributed through the trust to members of the United States family, that holding company would generally be classified as a CFC, creating a U.S. tax and return. considerations for U.S. family members with respect to income and earnings generated within the holding company after the settlor’s death.
Prior to 2018, it was generally true that (after the grantor’s death) continued CFC tax exposure for U.S. family members could be eliminated by filing an election called a ‘tick the box’ to deal with the corporation. holding as liquidated / ignored for the United States. for tax purposes in a manner that does not create SEC tax exposure for U.S. family member beneficiaries while protecting U.S.-based assets held by the holding company from tax exposure US estate in connection with the grantor’s death.
However, under current legislation, this choice to ‘tick the box’ could now itself generate a CFC tax for U.S. family members (typically measured by reference to the amount of earnings embedded in family assets. holding company and at the time of the year when the settlor passed). Thus, if the holding company has a mix of assets located in the United States and not in the United States, in the absence of additional planning, the tax cost of protecting the assets located in the United States from exposure to Inheritance tax will generally be a one-time CFC tax exposure for US family members following the death of the settlor.
In cases where the holding company does not own any assets located in the United States, it should generally be possible to make a checkbox choice in a manner that does not expose members to CFC tax for members. family in the United States.
Assuming that it is not possible to eliminate the assets located in the United States, several strategies can then be considered, all of which would improve the position in different ways, including:
- sell and repurchase assets annually in order to “enhance” the holding company’s base in those assets;
- isolate the assets located in the United States in a separate non-US holding company (which holding does not itself hold any non-US assets); and
- create certain types of multi-level holding structures to allow the implementation of the checkbox choices in a way that should itself allow most, but not necessarily all, of the appreciation of the assets to escape taxation under CFC rules.
Where the trust holds (directly or indirectly) substantial interests in “trading companies” or “operating companies”, other CFC considerations may apply.
Depending on all the facts and circumstances following the death of the settlor, if the trust holds PFICs (directly or through or in respect of holding companies), the beneficiary members of the U.S. family could be subject to taxes and compound interest when these PFICs are transferred or these PFICs themselves make distributions (potentially even though these amounts are not even currently distributed to beneficiary US family members). In fgeneral:
- holding companies through which trusts indirectly hold investments may themselves be classified as PFICs. For example, an investment asset holding company that is not classified as an SEC may be classified as a PFIC.
- Most non-US mutual funds such as non-US mutual funds, non-US ETFs, non-US hedge funds, and some non-US private equity funds will be classified as PFICs.
How best to deal with PFICs will depend on a number of factors, including the makeup and needs of US and non-US family members, whether the trust has been structured to qualify for a base increase, how the PFICs were held (for example, if through a holding company, also owned donkeys located in the United States) and how the checkbox planning is implemented in connection with the settlor’s death.
We would be delighted to discuss how best to tailor a “foreign transferor trust” structure to the particular facts and circumstances of each family.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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