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Trust Distributions to Foreign Beneficiaries:

Mastering Complex Planning and Calculation Challenges Navigating the Complicated Interplay of Foreign Withholdings, Treaty Benefits, DNI Calculations, and Trust Compliance

THURSDAY, JANUARY 5, 2017, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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FOR LIVE PROGRAM ONLY

Jan. 5, 2017

Trust Distributions to Foreign Beneficiaries

Cynthia Brittain, Vice President and Senior Fiduciary Officer

Northern Trust, Santa Barbara, Calif.

Cdb11@ntrs.com

Dianne C. Mehany, Member

Caplin & Drysdale, Washington, D.C.

dmehany@capdale.com

John R. Strohmeyer

Crady Jewett & McCulley, Houston

jstrohmeyer@cjmlaw.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

5

Strafford Continuing Education

Webinars – January 5, 2017

A presentation for

U.S. Taxation of Foreign Trusts

Cynthia D. Brittain, J.D., LL.M., TEP Senior Vice President Regional Wealth Advisor, Northern Trust

© 2017 Northern Trust

6

Overview

Introduction: Why understanding trusts in the global context is important: And the moral of the story is….

Definition of a Trust – in the world of global relationships

Definition of a Foreign Trust (Foreign Grantor/Foreign Nongrantor)

Definition of U.S. Person versus Foreign Person

Israeli tax on Israeli Resident Beneficiaries who are U.S. Persons;

Case Study

7

And the Moral of the Story…why do you need to understand this stuff?

Outbound

• The California Revocable Trust Migration Story.

• Gifting to U.K.-based children through U.S. gift trusts.

• Gifting to Israeli-based children through U.S. gift trusts.

• Trust planning with California community property.

Inbound

• The California Revocable Trust for the Non-Resident, Non-Domiciled

individual’s inbound activities. (Inbound)

United Kingdom individuals

Canadian residents

Scenarios to demonstrate the difference between Inbound and Outbound Planning

and the treatment of trusts in different jurisdictions: The “why” of understanding trusts

in the cross border context.

Definition of a Trust – in the world of global relationships

9

Trust Classification

What is a Trust for U.S. Tax Purposes? And Why Does it Matter…

Lichtenstein Foundations?

Stiftungs? Usufructs?

Treuhand? Establishments?

Investment or Business Trusts?

10

Classifications (continued)

Ordinary Trusts -- 301.7701-4(a)

In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement

created either by a will or by an inter vivos declaration whereby trustees take title to property

for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules

applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more

than accept the benefits thereof and are not the voluntary planners or creators of the trust

arrangement. However, the beneficiaries of such a trust may be the persons who create it and

it will be recognized as a trust under the Internal Revenue Code if it was created for the

purpose of protecting or conserving the trust property for beneficiaries who stand in the same

relation to the trust as they would if the trust had been created by others for them. Generally

speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can

be shown that the purpose of the arrangement is to vest in trustees responsibility for the

protection and conservation of property for beneficiaries who cannot share in the discharge of

this responsibility and, therefore, are not associates in a joint enterprise for the conduct of

business for profit.

11

Classifications (continued)

Business Trusts -- 301.7701-4(b)

There are other arrangements which are known as trusts because the legal title to property is

conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for

purposes of the Internal Revenue Code because they are not simply arrangements to protect

or conserve the property for the beneficiaries. These trusts, which are often known as

business or commercial trusts, generally are created by the beneficiaries simply as a device to

carry on a profit-making business which normally would have been carried on through

business organizations that are classified as corporations or partnerships under the Internal

Revenue Code. However, the fact that the corpus of the trust is not supplied by the

beneficiaries is not sufficient reason in itself for classifying the arrangement as an ordinary

trust rather than as an association or partnership. The fact that any organization is technically

cast in the trust form, by conveying title to property to trustees for the benefit of persons

designated as beneficiaries, will not change the real character of the organization if the

organization is more properly classified as a business entity under Section 301.7701-2.

12

Classifications (continued)

Investment Trusts -- 301.7701-4(c)(1)

An “investment” trust will not be classified as a trust if there is a power under the trust

agreement to vary the investment of the certificate holders. See Commissioner v. North

American Bond Trust, 122 F. 2d 545 (2d Cir. 1941), cert. denied, 314 U.S. 701 (1942). An

investment trust with a single class of ownership interests, representing undivided beneficial

interests in the assets of the trust, will be classified as a trust if there is no power under the

trust agreement to vary the investment of the certificate holders. An investment trust with

multiple classes of ownership interests ordinarily will be classified as a business entity under

Section 301.7701-2; however, an investment trust with multiple classes of ownership interests,

in which there is no power under the trust agreement to vary the investment of the certificate

holders, will be classified as a trust if the trust is formed to facilitate direct investment in the

assets of the trust and the existence of multiple classes of ownership interests is incidental to

that purpose.

13

Classifications (continued)

301.7701-4(c)(2), Example 4. Business Interest versus Trust Classification.

Corporation N purchases a portfolio of bonds and transfers the bonds to a bank under a trust

agreement. At the same time, the trustee delivers to N certificates evidencing interests in the

bonds. These certificates are sold to public investors. Each certificate represents the right to

receive a particular payment with respect to a specific bond. Under section 1286, stripped

coupons and stripped bonds are treated as separate bonds for federal income tax purposes.

Although the interest of each certificate holder is different from that of each other certificate

holder, and the trust thus has multiple classes of ownership, the multiple classes simply

provide each certificate holder with a direct interest in what is treated under section 1286 as a

separate bond. Given the similarity of the interests acquired by the certificate holders to the

interests that could be acquired by direct investment, the multiple classes of trust interests

merely facilitate direct investment in the assets held by the trust. Accordingly, the trust is

classified as a trust.

14

Why is Trust Classification Important?

Usufruct --

In Public Letter Ruling – 9121035 (91 TNT 116-47 (February

25, 1991), the IRS characterized a usufruct under German law (a Civil

Law country) as a foreign non-grantor trust.

Stiftung -- Great Analysis of trust factors…

In Estate of O.T. Swan, 24 T.C. 803 (1981, acq. 1981-2 C.B.

1., the Tax Court determined that stiftungs should be treated as trusts

for U.S. tax purposes.

The family wanted the stiftung to be treated as a trust

because U.S. children were inheriting German assets.

Liechtenstein Anstalt

A trust analysis provided that the anstalt was a trust. (AM

2009-012).

Foreign Trusts -- To Satisfy the Unique Needs of Nonresident, Non-domiciled Individuals and Their Families

16

NRAs Have Unique Needs

Political uncertainty in the client’s home

country may be causing currency instability.

Institutions in the home country may lack

sufficient financial strength.

Home country conditions may increase client

desire for privacy.

Home country market may not offer sufficient

asset diversification.

Desire access to U.S. markets directly.

NRA needs may include:

Stability:

Safety:

Privacy:

Diversification:

Access:

17

Common Reporting Standard – Broader than FATCA

• G20 Leaders at their meeting in September 2013 fully endorsed the OECD proposal for a truly global

model for automatic exchange of information and invited the OECD, working with G20 countries, to

develop such a new single standard for automatic exchange of information, including the technical

modalities, to better fight tax evasion and ensure tax compliance.

• The Standard, developed in response to the G20 request and approved by the OECD Council on 15

July 2014, calls on jurisdictions to obtain information from their financial institutions and automatically

exchange that information with other jurisdictions on an annual basis. It sets out the financial account

information to be exchanged, the financial institutions required to report, the different types of accounts

and taxpayers covered, as well as common due diligence procedures to be followed by financial

institutions.

• To fight tax evasion, 99 countries have agreed to automatically exchange information, including most

western nations (except the USA), BRICS and tax havens. Accounts include banking, custodial,

securities and investment funds. These may be held by individuals or entities, including companies,

partnerships, trusts and foundations. Politically motivated and flawed legislation has been rushed

through with no cost-benefit analysis invading individual privacy and national sovereignty, resulting in

global data theft, blackmail and political oppression. At least two countries may become major

beneficiaries as havens for global capital.

Foreign Trusts -- Defined

19

When is a Trust a Foreign Trust?

• A Trust is deemed to be foreign unless both of the following

are satisfied:

Court Test

Control Test

• Curing an inadvertent change

• Beware IRC §684(c)

Definitions found in IRC §7701(a)(30)(E), (a)(31)

20

Is the Foreign Trust a Nongrantor or Grantor Trust?

Grantor Trust: Definition

• U.S. Settlor – IRC §§ 671-679

Grantor trust status generally limited to U.S. citizens,

resident individuals, and domestic corporations

Foreign Grantor Trust: Definition

• Non-Citizen, non-resident settlor – IRC §672(f)

Foreign grantor trust status available only if:

Foreign settlor retains right to revest assets (i.e., a

revocable trust), OR

The Trust must distribute only to settlor or settlor’s

spouse during his or her lifetime.

• Foreign intermediaries may be disregarded (IRC §672(f)(5))

21

Is the Foreign Trust a Nongrantor or Grantor Trust?

Foreign Grantor Trust : Definition (cont.)

• U.S. Grantor Treated as Owner - IRC § 679

Trust is a foreign trust

Transferor is a U.S. Person (IRC § 7701(a)(30))

NRA transferor who becomes a U.S. resident within

5 years of the transfer

Trust has one or more U.S. beneficiaries; AND

Transferor makes a direct or indirect transfer of assets

to the trust

Exceptions for testamentary transfers, transfers for

FMV and transfers to charitable or employee trusts

Presumption that every foreign trust has a U.S.

Beneficiary…

Taxation and Reporting --

23

Federal Taxation and Reporting of Foreign Nongrantor Trust

Foreign Nongrantor Trust: Taxation and Reporting

Calendar Year End (IRC § 644)

Taxed as an NRA individual with modifications (IRC § 641(b))

Reports only U.S.-source FDAP income (30% withholding

or treaty rate) and ECI (at graduated rates)

Income taxed to trust, beneficiaries, or partly to each:

DNI includes worldwide income

DNI includes capital gains (net of losses) (IRC §

643(a)(6)(C))

Deductions for distributions to beneficiaries

Simple or Complex

24

Federal Taxation and Reporting of Foreign Nongrantor Trust

Foreign Nongrantor Trust: Taxation and Reporting (cont)

• File Form 1040NR, U.S. Non-resident Alien Income Tax Return

U.S.-source FDAP not properly withheld upon or if deemed

to be ETB in the U.S.

Due June 15 (if no office in the U.S.), 6 month extension

• EIN

• Pass-through of U.S. withholding taxes

• Form W-8 and U.S. withholding considerations

• Throwback rules for distribution to U.S. beneficiaries of

accumulated income (IRC §§ 666 and 667)

25

Federal Taxation and Reporting of Foreign Nongrantor Trust

Foreign Nongrantor Trust: Taxation and Reporting (cont)

• Provide Foreign Nongrantor Trust Beneficiary Statement

for distributions to U.S. Beneficiaries

• Appoint a U.S. Agent?

• Form W-8 and U.S. withholding considerations

• Form 8805, Foreign Partner’s Information Statement of

Section 1446 Withholding Tax, for a trust that is a

partner in a partnership that withheld tax under IRC §

1446 (ECI)

Provide to U.S. beneficiary a copy of Form 8805

from partnership and prepare Schedule T Form

8805.

26

Federal Taxation and Reporting -- U.S. Beneficiary of Foreign Nongrantor Trust

Foreign Nongrantor Trust – U.S. Beneficiary: Taxation and

Reporting

• Report taxable trust distributions on Form 1040

• Form 3520, Annual Return to Report Transactions with

Foreign Trusts and Receipt of Certain Foreign Gifts

Receives a distribution from a foreign trust

Direct or indirect loan of cash or marketable

securities of the uncompensated use of trust

property (exception for qualified obligations)

Attach Foreign Nongrantor Trust Beneficiary Statement

• Form 4970, Tax on Accumulation Distribution of Trusts

UNI distribution

27

Federal Taxation and Reporting -- U.S. Beneficiary of Foreign Nongrantor Trust

Foreign Nongrantor Trust – U.S. Beneficiary: Taxation and

Reporting (cont)

• FinCen Form 114, Report of Foreign Bank and Financial

Accounts

U.S. beneficiary with a greater than 50% present beneficial

interest n the trust’s assets or income

• Form 8938, Statement of Specified Foreign Financial Assets

An interest in a foreign trust or estate is a SFFA

• Consider need for Forms 5471, 8865, 8858, 8621, 926 (foreign

entities)

28

Federal Taxation and Reporting -- Foreign Beneficiary of Foreign Nongrantor Trust

Foreign Nongrantor Trust – Foreign Beneficiary: Taxation

and Reporting

• U.S. reporting may be required if distribution carries out a

portion of DNI that is U.S.-source FDAP or ECI

• File Form 1040NR, U.S. Nonresident Alien Income Tax

Return

U.S.-sourced FDAP income not properly withheld upon

or if deemed to be ETB in the U.S.

29

Federal Taxation and Reporting -- Foreign Grantor of Foreign Grantor Trust

Foreign Grantor Trust – Foreign Grantor: Taxation and Reporting

• Trust Files Form 1040NR, U.S. Nonresident Alien Income Tax

Return

Include “grantor trust language” and detail of income, gains,

and losses

Due June 15 (if no office in the U.S.), 6 month extension

• Foreign grantor files Form 1040NR to report trust’s U.S.-source

FDAP income (if not properly withheld upon) or if deemed to be

ETB in the U.S.

• Form W-8 and U.S. withholding considerations

31

Federal Taxation and Reporting -- U.S. Grantor of Foreign Grantor Trust

Foreign Grantor Trust – U.S. Grantor: Trust Taxation and

Reporting

• Trust Files Form 1040NR, U.S. Nonresident Alien Income Tax

Return

Include “grantor trust language” and detail of income, gains,

and losses

Due June 15 (if no office in the U.S.), 6 month extension

• Trust Files Form 3520-A Annual Information Return of Foreign

Trust with a U.S. Owner

Trustee must file an annual Form 3520-A to report U.S.

owner

• Foreign Grantor Trust Owner Statement

• Foreign Grantor Trust Beneficiary Statement

• Appoint a U.S. agent?

• Form W-8 and withholding considerations

32

Federal Taxation and Reporting -- U.S. Grantor of Foreign Grantor Trust

Foreign Grantor Trust - U.S. Grantor: Grantor Taxation and Reporting

• U.S. grantor includes trust income, gain and losses on Form 1040

• Form 3520, Annual Return to Report Transactions with Foreign

Trusts and Receipt of Certain Foreign Gifts

Attach Foreign Grantor Trust Owner Statement

• U.S. grantor is responsible for Trustee filing Form 3520-A and

providing owner and beneficiary statements

33

Federal Taxation and Reporting -- U.S. Grantor of Foreign Grantor Trust

Foreign Grantor Trust - U.S. Grantor: Grantor Taxation and

Reporting (cont)

• FinCen Form 114, Report of Foreign Bank and Financial

Accounts

U.S. grantor reports foreign accounts held by trust

• Form 8938, Statement of Specified Foreign Financial Assets

U.S. grantor considered to own an interest in any SFFA

held by the trust

• Consider need for Forms 5471, 8865, 8858, 8621, 926 (foreign

entities)

• U.S. withholding tax considerations

34

Federal Taxation and Reporting – U.S. Beneficiary of Foreign Grantor Trust

Foreign Grantor Trust –U.S. Beneficiary: Taxation and

Reporting

• Form 3520, Annual Return to Report Transactions

with Foreign Trusts and Receipt of Certain Foreign

Gifts U.S. beneficiary receives a distribution from a foreign

trust Direct or indirect loan of cash or marketable securities or

the uncompensated use of trust property (exception for

qualified obligations)

Attach Foreign Grantor Trust Beneficiary Statement

35

Federal Taxation and Reporting -- Foreign Beneficiary of Foreign Grantor Trust

Foreign Grantor Trust –Foreign Beneficiary: Taxation and

Reporting

• No U.S. taxation or reporting

36

California Taxation -- Grantor/Nongrantor Trusts

Grantor Trust Treatment in California

• Federal grantor trust status generally respected

• Except if only a grantor trust under § 679

Cal. Rev. & Tax Code § 17024.5(b)

Nongrantor Trust Treatment in California

• Subject to California tax if:

One or more of the fiduciaries is a California resident;

One or more of the “noncontingent beneficiaries” is a

California resident; or,

The trust has California sourced income.

Settlor residence is irrelevant

37

Current Client Issues with trusts…

What are the issues? Trusts are not always the panacea…

Israel taxes income distributions from foreign trusts made to Israeli resident beneficiaries

If relative trusts – choose 25% currently or 30% deferred;

This income already taxed in the US as a grantor trust;

What is income?

Can we get a foreign tax credit?

Israel, the UK, Canada – pose particular issues with trusts

These require special considerations

Mom, U.S., and Dad, NRA (US taxation)

Children (U.S. and Israel)

(Israel taxation)

38

Allocate

GST $5,430,000

$23,570,000 $12,800,000

This value passes free of estate tax

and GST Tax. We presume

$67,000,000 at death of Surviving

spouse. $67,000,000 estate tax free

to children.

This value at SS death is

$213MM. Subject to U.S.

Estate Tax=$85,200,000

(40,45,50) (40,45,50)

Recommendation – GST Planning and

Loan to NRA Spouse under § 7672.

(35,40,45,50) (25,30,35)

$31,800,000

All become subject to US Estate Tax at Child’s Level

At Mom’s passing, this

amount can be double.

Taxed in children’s

estates

At Mom’s passing, this

amount can be double.

Taxed in children’s

estates.

Cross Border Scenario --- Mom is U.S. and Dad is NRA/Non-

Domiciled

The Mother’s SP Trust

Family Trust –

Unified Credit Amount

Outright to children in stages.

QDOT--

Outright to children in

stages.

Mom’s Gift Trust –

From her parents.

To GC in stages.

Mom’s Gift Trust –

From her parents.

To GC in stages.

39

Family Trust –

GST-Exempt

(Delaware Dynasty

Recommended)

QDOT –

Outright to children in

stages, or in trust for

asset protection

Mom’s Gift Trust -

- To children in

stages.

$12,800,000

$179MM outright.

(Only $13,570,000 invested

with $10MM note freeze)

US Est. Tax = $71,600,000

Versus

$23,570,000—invested

U.S. Est. Tax= $85,200,000

Keep in Trust for asset

protection.

The real savings shows in

the FGT planning.

These amounts stay in trust.

Wealth transfer grows estate tax

free; Ultimate distribution to

great-grandchildren estate tax

free.

Foreign Grantor Trust –

This is GST Exempt.

Use with estate freeze.

Dad should also consider.

1980 Children’s Trust

To children in stages

$31,800,000

Separate children’s

Trusts GST Exempt

(Delaware

Dynasty Trust)

$10mm invested US

estate tax free. During

Dad’s life, U.S. income

tax free. Provides greater

investment yield, except

to extent taxed in Israel.

After Mom’s passing,

this amount can more

than double.

Taxed in children’s

estate.

After Mom’s passing,

this amount can more

than double.

Taxed in children’s

estate

$23,570,000

• GST from Parents to Children --

$124MM

• GST from Children to

grandchildren - $7,270,000,000.

• Options with drop-off trust and

foreign grantor trust. Two

strategies in tandem.

1. GST from Parents to children --

$67,000,000

2. GST from Children to

grandchildren -- $318,363,602;

3. GST from Grandchildren to

GGC -- $1,918,571,243

4. GGC pass away --

$23,716,699,973 – planning

dynastically

Cross Border Recommendations (continued) Planning

$10mm Intra-spousal loan

The Mother’s SP Trust

$12,800,000 $31,800,000

Beware Foreign

Intermediary rules

Dianne C. Mehany

Citizenship – the “accidental citizen.” Consider the following scenario:

• Jack is born in the US in the 1930s. Moves to Canada at 25 and becomes a naturalized citizen.

• Jack and his Canadian wife Mary give birth to Anna in 1962 in Canada and Matthew in 1968 in

Canada.

• Anna is sent to boarding school in Vermont for two years. Then, trying to “find herself,” she

waitresses in New York City while trying to make it on Broadway. One year later she gives up and

moves back to Canada.

• Matthew spends four years in boarding school in Vermont, but attends university in Canada. After

graduation, he works for a hedge fund in New York City for three years before returning again to

Canada.

• Anna (unmarried) gives birth to Joe in 1995 in Canada.

• Jack and his (Canadian) wife, Susan, give birth to Kathryn in 1998 in Canada.

• Who is an American Citizen?

41

Residency – is your non-US citizen actually a US resident?

• Green card – does not matter whether “reside” in US or whether expired.

• Substantial Presence test (IRC 7701(b)(3))

• Spends 183 days, or more, in the US in any year.

• Spends 183 days under the “multiplier” in a three year period.

• 31 days in current year.

• Count entire day in current year, 1/3 day in immediately preceding

year, 1/6 day in second preceding year.

• Day count

• Any portion of a day in the US counts.

• Transit time does not count.

• Illness after enter US and unable to return home does not count.

What if enter US for medical treatment?

42

Exceptions to the substantial presence test

• Exempt Individuals (7701(b)(5)) • Closer connection and foreign tax home (7701(b)(3)(B))

• Must be in the US less than 183 days during the current year

• Must maintain a tax home in a foreign country • Cannot have taken affirmative action to become a lawful

permanent U.S. resident • Requirement to timely claim exception

• Treaty tie-breaker

43

• Generally, trust treated as taxable entity, but may pass through items of income

and deductions to beneficiaries

• Domestic Trusts

• The worldwide income of a US trust is taxable

• US trust has the deductions and credits available to a US individual (plus no AGI

limit on charitable deductions). Also receives distribution deduction for

beneficiary distributions.

• Foreign Trust

• Only US source income taxable in US. This includes FDAP, ECI, and FIRPTA.

(Interest under 871(h) and (i) excluded.)

• Foreign trust may only receive deductions to the extent they serve to offset ECI.

Also receives distribution deduction for beneficiary distributions.

44

• Basically, trust taxed like an individual, with certain exceptions

• Basic exception is that trust allowed a deduction for certain distributions

it makes to beneficiaries.

• DNI (distributable net income) is a unique income tax concept.

• It functions as an accounting methodology by which worldwide

income and gains are carried out to U.S. beneficiaries.

• DNI not completely taxable to foreign beneficiaries. One must look

through to the character and source of income to determine taxability

for foreign beneficiaries.

45

• DNI (distributable net income) is a unique income tax concept.

• It is essentially fiduciary accounting income that is distributable to

beneficiaries, net of trust expenses and deductions.

• Fiduciary Accounting Income (Section 643(b)) is the amount of income

of the trust under the terms of the governing instrument and

applicable local law. Items of gross income constituting extraordinary

dividends or taxable stock dividends which the fiduciary, acting in good

faith, determines to be allocable to corpus under the terms of the

governing income and applicable local law shall not be considered

income.

46

• US Trust DNI is taxable income plus tax exempt income; however, it

excludes capital gains and losses.

• Special rule for capital gains under 1.643(a)-3, if discretion permitted

by trust document. Treatment of distributions to foreign beneficiaries

in this case?

• Foreign trust DNI is taxable income including capital gains and losses.

• If Foreign trust distributes DNI to US beneficiary, the US beneficiary

must pay US tax on share of DNI that represents foreign source income

(even though foreign trust only remitted tax on portion of DNI that

was US source income).

47

• To calculate DNI

• First identify items of gross income (by type)

• Apply deductions to specific gross income items

• Allocate DNI between beneficiaries

Division depends on whether trust is simple or complex

o Simple = attribute ratably amongst beneficiary distributions,

regardless of whether foreign or domestic

o Complex = allocate according to the terms of the trust document

48

• Tier System

• Permits separate classes of beneficiaries

• Some receive mandatory distributions (typically all consisting of DNI)

• Some are discretionary beneficiaries

If the amount of distribution required for Tier 1beneficiaries exceeds DNI,

then all DNI is allocated to the Tier 1 beneficiaries.

If, however, there remains DNI after Tier 1 beneficiaries receive their full

distributions, the remaining DNI is allocated proportionately among the

Tier 2 beneficiaries, based upon the amount of trust property received

by each

49

Benefit of tier system for foreign beneficiaries? To trust entity itself?

• Consider type of income generated by trust

Treatment of capital gains deduction

• Consider type of assets distributed to beneficiaries

Consequences of FIRPTA withholding

50

• Whereas US persons are expected to file Form 1040 to report distributions and

remit tax, foreign persons are not (unless requesting a refund).

• Trusts are required to withhold tax on DNI distributions to foreign beneficiaries;

therefore, the net distributable amount differs between US beneficiaries and

foreign beneficiaries

• Withhold on DNI, to the extent it represents

FDAP income

Distributions of ECI from publicly traded partnership

Certain contingent payments

• Certain classes of income are exempt from 1441 withholding, but still

reportable on Form 1042-S

• Distributions of corpus not taxed (nor reported on Form 1042-S).

51

Exemptions from Withholding

• Distributions of corpus not taxed (nor reported on Form 1042-S).

• Certain classes of income are exempt from 1441 withholding, but still

reportable on Form 1042-S

Interest on bank deposits (to the extent not ECI)

Accrued interest

Interest income not taxable pursuant to 871(h)(1) and (2)

o Isidro Martin-Montis Trust

o Relatively new reporting requirements for trust

52

Total withholding reported annually to foreign beneficiary on (copy of) Form

1042-S, due by March 15 of the following calendar year.

• Form denotes type of DNI, whether interest, dividends, capital gains

• Separate form required for each type of DNI if statutory withholding rate

varies (even if rate does not actually vary due to application of treaty

rates)

E.g., Trust distributes DNI consisting of dividends and interest to three

different foreign beneficiaries. How many Forms 1042-S required?

• Trusts files corresponding Form 1042-S with IRS, along with Forms 1042

and 1042-T

Penalties apply for not withholding as well as for non-filing of required

Forms

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• Withholding occurs at time of distribution to foreign beneficiaries

• “Entity” (i.e., the actual trust) bears responsibility for withholding. Reg.

1.1441-5.

• Withholding rate generally 30% of the beneficiary’s allocable portion of

DNI

• Contrast with rate of tax available to US person – i.e., US person carries

forward character of income for purposes of calculating tax rate.

• Treaties may apply to reduce amount of withholding. Foreign

beneficiaries must submit Form W-8BEN to the trust.

• Gross amount of income subject to withholding may not be reduced

by any individual deductions.

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• The trust need not withhold if a foreign person obtains classification as a

qualified intermediary or authorized foreign agent

• Form W-8IMY required.

• Trust must retain copy

For qualification as a foreign agent

• Written agreement required

• Notification procedures adhered to

• Foreign agent makes books and records available to IRS for

examination

• Trust remains liable for tax in case of default by foreign agent

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______________________________________________

Disclaimer This communication does not provide legal advice, nor does it create an attorney-client relationship with you or any other reader. If you require legal guidance in any specific situation, you should engage a qualified lawyer for that purpose. Prior results do not guarantee a similar outcome. Attorney Advertising It is possible that under the laws, rules, or regulations of certain jurisdictions, this may be construed as an advertisement or solicitation. © 2016 Caplin & Drysdale, Chartered

All Rights Reserved.

Dianne C. Mehany Member Caplin & Drysdale, Chartered 202-862-5068 dmehany@capdale.com

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Trust Distributions to Foreign Beneficiaries

John R. Strohmeyer

Distributions from Estates

Specific Bequest Exception

Separate Share Rule

Interest on Funding Pecuniary Bequests

Distribution of Property In Satisfaction of Pecuniary Bequest

Distribution of IRD to Satisfy Pecuniary Bequest

In-Kind Distributions are typically not taxable under Rev. Rule 69-486.

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U.S. Income Tax Treaty System

The U.S.A. is a party to 58 bilateral income tax treaties with 68 countries. The U.S.–U.S.S.R. income tax treaty remains in effect for

members of the Commonwealth of Independent States that have not negotiated and ratified new treaties.

The U.S.–China income tax treaty does not apply to Hong Kong.

Three additional treaties (Chile, Hungary, & Poland) and four protocols (Japan, Luxembourg, Spain, & Switzerland) have been signed but not approved by the Senate.

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U.S. Income Tax Treaties

Available at http://ow.ly/TGSdp

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U.S. Income Tax Treaty Partners

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Recent Tax Treaty Cases

Cole v. Comm’r., T.C. Summ. Op. 2016-22.

U.S. citizen caught by the U.S.-Israel Savings Clause.

Topsnik v. Comm’r., 146 T.C. No. 1 (2016).

You must be a resident to claim treaty benefits.

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Income Taxation of Nonresident Aliens

Effectively Connected Income (“ECI”) Net-basis taxation for business income

Gains from the Sale of Real Property—FIRPTA Subject to mandatory 15% withholding, and taxed as ECI

Certain taxpayers are subject to 10% withholding

Fixed, Determinable, Annual, or Periodical Income (“FDAP”) All income other than gains from sale of property or income excluded

from gross income

Dividends

Interest

Pensions and annuities

Alimony

Rent and Royalties

Gross-basis taxation subject to mandatory 30% withholding

Gains from the Sale of Non-Real Property—Not Taxed 64

Selected Treaty Articles

Article 2—Taxes Covered

Article 3—General Definitions

Article 4—Resident

Article 5—Permanent Establishment

Article 6—Income From Real Property

Article 7—Business Profits

Article 12—Royalties

Article 13—Gains

Article 22—Limitation on Benefits

Article 23—Relief From Double Taxation

Article 25—Mutual Agreement Procedure 65

2016 U.S. Model Treaty Updates

On February 17, 2016, Treasury released a new U.S. Model Income Tax Treaty. New Article 1 Paragraph 7—Exempt Permanent Establishments

New Article 3 Paragraph 1(l)—“Special Tax Regime”

Changes in Articles 10, 11, & 12—Payments to Expatriated Entities

Changes to Article 22—Limitation on Benefits

New Article 28—Subsequent Changes in Law

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Tax Treaty Comparison

Australia (effective Dec. 1, 1983, Protocol Jan. 1, 2004 )

Canada (effective Jan. 1, 1985, Protocols Jan. 1, 1996, Dec. 16, 1997, and Jan. 1, 2009)

Japan (effective Jan. 1, 2005)

Kazakhstan (effective Jan. 1,1996)

Mexico (effective Jan. 1, 1994, Protocols Oct. 26, 1995 and Jan. 1, 2004)

New Zealand (effective Nov. 2, 1983, Protocol Jan. 1, 2011)

South Africa (effective Jan. 1, 1998)

Tajikistan (U.S.-U.S.S.R. Income Tax Treaty) (effective Jan. 1, 1976)

Tunisia (effective Jan. 1, 1990)

United Kingdom (effective Jan. 1, 2004) 67

U.S. Income Tax Treaty Comparison

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Dividends (Article 10)

Tax Rate on Dividends Paid by U.S. Corporations No Treaty—30%

Model Treaty—5% if owner has 10% ownership, 15% otherwise

Australia—15%

Canada—15%

Japan—10%

Kazakhstan—10%

Mexico—10%

New Zealand—15%

South Africa—15%

Tajikistan—30%

Tunisia—15%

United Kingdom—15% 69

Interest (Article 11)

Tax Rate on Interest Income Paid by U.S. Obligors No Treaty—30%

Model Treaty—15%

Australia—10%

Canada—0%

Japan—10%

Kazakhstan—10%

Mexico—15%

New Zealand—10%

South Africa—0%

Tajikistan—0%

Tunisia—15%

United Kingdom—0%

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Pensions & Annuities (Article 17)

Tax rate on non-governmental pensions & annuities No Treaty—30%

Model Treaty—15%

Australia—0%

Canada—15%

Japan—0%

Kazakhstan—0%

Mexico—0%

New Zealand—0%

South Africa—15%

Tajikistan—30%

Tunisia—0%

United Kingdom—0%

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U.S. Estate & Gift Tax Treaties

Available at http://ow.ly/TLGKH

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Estate & Gift Tax Treaties

7 Situs-Type Treaties

Allocation taxation of assets to jurisdictions based on the situs of the assets.

Treaties with Australia, Finland, Greece, Ireland, Italy, Japan, Norway, South Africa, & Switzerland.

6 Domicile-Type Treaties

Allocate taxation of assets to jurisdictions based on the domicile of the taxpayer.

Treaties with Austria, Denmark, France, Germany, Netherlands, Sweden, & the United Kingdom.

Protocol Amending United States-Canada Income Tax Treaty.

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U.S. Estate & Gift Tax Treaty Partners

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Expatriation

U.S. citizens and long-term U.S. residents who cease to be permanent U.S. residents may be “Covered Expatriates.”

Three-prong test to not be a Covered Expatriate

Average annual net income tax bill for the five prior years ending before expatriation under $162,000 in 2017 (adjusted for inflation)

Net worth under $2,000,000 on date of expatriation (not adjusted for inflation)

Certify on Form 8854 that you’ve complied with all U.S. federal tax filing obligations for 5 years preceding date of expatriation

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Expatriation

Income tax on mark-to-market valuation of assets on the day before expatriation ($699,000 exemption in 2017)

Must report for 10 years. Topsnik v. Comm’r., 143 T.C. No. 12 (2014)—

If you fail to properly surrender your Green Card, then you haven’t left the U.S. tax system.

Special rules apply to distributions from applies only to nongrantor trusts only if the covered expatriate was a beneficiary of the trust on the day before the expatriation date.

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Nongrantor Trusts After Expatriation

Special rules for distribution of any property from a nongrantor trust to a covered expatriate under Code § 877A(f)

The trustee must withhold 30%of the taxable portion of the distribution.

Gain will be recognized on the distribution as if the distributed property were sold to the expatriate at its fair market value if the fair market value of the distributed property exceeds its adjusted basis in the hands of the trust.

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Nongrantor Trusts After Expatriation

The “taxable portion” of a distribution is that portion of the distribution that would be includible in the gross income of the covered expatriate if such expatriate continued to be subject to tax as a citizen or resident of the United States.

A “nongrantor trust” means the portion of any trust that the individual is not considered the owner of under subpart E of part I of subchapter J, with the determination made immediately before the expatriation date.

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Nongrantor Trusts After Expatriation

Special Rules apply to withholding

Any item subject to the withholding is subject to tax under Code § 871.

Any item subject to withholding is subject to withholding under Code § 1441.

Rules similar to the rules for withholding liability under Code §§ 1461—1464 .

Treaty Issues: The covered expatriate is treated as having waived any right to claim any reduction under any treaty with the United States.

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Crady, Jewett & McCulley, LLP 2727 Allen Parkway, Suite 1700

Houston, Texas 77019-2125 (713) 739-7007 telephone (713) 739-8403 facsimile

Tax Disclosure: Please note that this outline was written as support for a presentation for Strafford Webinar on January 5, 2017, and any statement in this outline (including attachments) is not written or intended to be used, and cannot be used, for the purpose of avoiding tax penalties. Any recipient should seek advice based on the recipient’s particular circumstances from an independent tax advisor.

Crady, Jewett & McCulley, LLP

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