ESTATE AND TAX PLANNING FALL 1996 REPORT Expatriate and Foreign Trust Rules Tightened Provisions in the Health Insurance and Small Business Acts of 1996, as signed into law by President Clinton in late August, alter the tax treatment of U.S. citizens or residents who expatriate and transactions involving foreign trusts. This report reviews the pertinent provisions in the two Acts. New Treatment of Persons who Expatriate Under prior law, certain U.S. citizens who were treated by the IRS as having expatriated for tax reasons were subject to special income, estate and gift tax rules for a period of 10 years after expatriating. The new rules (i) expand the class of persons subject to the expatriation rules, (ii) establish a presumption of tax avoidance in certain cases and (iii) broaden the categories of gain and income treated as U.S. source income subject to U.S. income tax. The rules generally would apply to persons who expatriate after February 5, 1995. Persons subject to the new rules. Until these new provisions were enacted in August, the expatriation rules applied only to U.S. citizens who lost or relinquished their citizenship for tax avoidance purposes. The new statute extends the application of the expatriation rules to non-U.S. citizens who have been long-term residents of the U.S. and who change their residence to another country. A "long-term resident" is generally defined as any person who was a U.S. resident for 8 out of the last 15 years. A long-term resident's status as a U.S. resident can be considered terminated when he relinquishes his "green card" status or is treated as a resident of another country for tax treaty purposes. Presumption of tax avoidance. Prior law applied the expatriation rules to a person who terminated his citizenship if the termination had a tax-avoidance motive. The rules were deemed too difficult to enforce by the IRS in large part because of the subjective nature of determining a taxpayer's motive for leaving the country. The new rules eliminate the need for a subjective determination and apply a bright-line presumption. Thus, an individual who terminates his U.S. citizenship or permanent residence is now presumed to have a tax-avoidance motive (and therefore subject to the expatriation rules) if either (i) the individual's average net annual U.S. Federal income tax liability for the five years preceding the termination exceeded $100,000, or (ii) the individual's net worth equals at least $500,000. (Each of these threshold levels will be indexed in future years for inflation.) For non-U.S. citizens who are long-term residents, the presumption is irrefutable unless specific regulations establish an exception. A U.S. citizen, on the other hand, may counter the presumption by filing a ruling request with the Treasury within one year of the termination of his citizenship to establish the existence of one of the following exceptions: (i) the individual was born with dual citizenship and has continued his citizenship in the other country; (ii) the individual has become a citizen of the country in which he, his spouse or either of his parents were born; (iii) the individual was present in the U.S. for less than 30 days each year of the preceding 10-year period; (iv) the individual has terminated his citizenship prior to attaining age 18; or (v) specific regulations establish another exception. Additional items of gain and income treated as U.S. source income of expatriates. Under prior law, persons who terminated their U.S. citizenship would be subject to U.S. income tax for 10 years on U.S. source income at the rates applicable to U.S. citizens, but generally would not be taxed on foreign source income. For this purpose, certain items of income such as gain from the sale or exchange of stocks and securities of a U.S. corporation or government would be treated as U.S. source income. The new rules would include in the definition of "U.S. source income" all income or gain from stock in a foreign corporation to the extent of earnings and profits accumulated before the expatriate's termination of his U.S. citizenship or residency, if the individual owned more than 50% of the corporation within two years before expatriating. Under the prior rules, an expatriate could transfer stock of a U.S. corporation to a foreign corporation controlled by the expatriate (also known as a controlled foreign corporation, or "CFC"). In theory, the CFC could then sell the stock within the 10-year period following expatriation without the expatriate being subject to U.S. tax on the gain. The new rules would prohibit such tax avoidance measures by requiring that any income or gain received from a CFC with respect to property transferred to the CFC by an expatriate within 10 years after expatriating be treated as U.S. source income received by the expatriate, not the CFC. An expatriate who exchanges property which produces U.S. source income for property which produces foreign source income, in a transaction that would otherwise qualify for tax-free treatment, must recognize gain under the new rules as if the expatriate had sold the property for its fair market value. (Under prior law, such an exchange would have resulted in the gain being deemed non- U.S. source income and not subject to U.S. income tax.) The expatriate may avoid immediate recognition of gain by entering into an agreement with the IRS to recognize income received from such property for the 10-year period as U.S. source income. If the expatriate's risk of loss for property subject to the expatriation rules is substantially reduced as a result of his holding a put, option or a short sale, the running of the 10-year period is suspended until such time as the risk of loss is restored. The IRS is authorized to issue regulations adding other transactions to the list specified in the Act, including the removal of appreciated tangible personal property from the U.S., which would result in an immediate recognition of gain unless the expatriate entered into a gain recognition agreement with the IRS. Transfer tax rules expanded. The transfer tax rules in respect of expatriates have been broadened to require that non-U.S. citizens who terminate their long-term residency for tax-motivated reasons be subject to the expatriate estate and gift tax rules for 10 years after expatriating. (U.S. citizens who relinquish their citizenship for tax-motivated reasons were already subject to such rules.) In addition, new provisions include in the taxable estate of an expatriate his stock in a foreign corporation (not only a U.S. corporation, as under prior law) if he owned more than 50% of the voting rights or the value of the corporation at his death. The new rules also apply the gift tax to transfers by an expatriate of intangible property (not only tangible U.S. source property) within 10 years of expatriating. Both decedents and donors would be entitled to a limited credit for estate and gift tax which must be paid to a foreign government because of the application of the expatriation rules. Information reporting requirements. Finally, new reporting rules require an expatriate to file an information return with the State Department or IRS when expatriating. For individuals relinquishing citizenship, the return must be filed with the State Department at the time citizenship is terminated; for non-citizens changing residence, it must be filed with the IRS when the individual files his tax return for the year in which residency is terminated. The new rules specifically require the reporting of the individual's social security number, his former and new addresses and information detailing his assets and liabilities. Tightening of Foreign Trust Rules The Small Business Act contains a series of new foreign trust rules, including increased reporting requirements and penalties and expanded application of the grantor trust rules, designed to discourage the use of foreign trusts by U.S. persons as a method of avoiding U.S. income taxes. Unless otherwise noted in this summary, the provisions become effective after December 31, 1996. Prior law treated the grantor of a foreign trust who retained certain rights or powers over the trust as its owner. Where a foreign grantor was considered the owner of the trust assets for U.S. income tax purposes, no U.S. income tax would be imposed on foreign source income of the trust and any trust distributions to a U.S. beneficiary would be tax-free. The new legislation provides that, with certain important exceptions, the normal grantor trust rules will be applied only when their application results in income being attributed (and taxed) to a U.S. person. Thus, when a foreign grantor creates a foreign trust for the benefit of a U.S. beneficiary, the grantor trust rules will not be applied and the foreign grantor will not be recognized as the owner for U.S. tax purposes. Consequently, any U.S. beneficiaries will be taxed on any amounts distributed or required to be distributed to them. (The new rules do not affect revocable trusts, trusts of which the grantor or his spouse are the sole income beneficiaries, certain grantor trusts in existence on September 19, 1995 and certain foreign corporations). Under current law, a U.S. beneficiary of a foreign trust who makes a gratuitous transfer to the foreign grantor is treated as the grantor of the foreign trust (and taxable on the income thereof) to the extent of the gift; such rule will now apply regardless of whether the foreign grantor would otherwise be treated as the trust owner. Other provisions would permit the IRS, where appropriate, to recharacterize a "gift" from a foreign partnership or corporation to a U.S. person as a distribution of income subject to U.S. income tax in the hands of the U.S. person. These new rules generally took effect upon enactment on August 20, 1996. Beginning retroactively on January 1, 1996, the interest rate applicable to accumulation distributions from foreign trusts has been substantially increased from simple interest at an annual rate of 6% to compound interest determined in the same manner and at the same rates as interest on underpayments of tax. Further, loans from a foreign trust to a U.S. grantor or U.S. beneficiary or related U.S. person after September 19, 1995 will now be treated as having been distributed to the grantor or beneficiary, as the case may be, unless, as stated in the Committee Report to the Bill, the loan is made in an arm's-length transaction and there is a reasonable expectation of repayment. Provision is made, however, for possible exemptions by regulation. The new loan restrictions would prevent a U.S. beneficiary of a foreign trust from avoiding U.S. income tax on accumulated income of a trust by obtaining a loan from the trust rather than a distribution of accumulated income. Certain provisions in the new statute, which were retroactively effective as of February 5, 1995, would adversely affect persons who immigrate to the U.S. after creating a foreign trust. A nonresident alien who becomes a U.S. resident within 5 years after transferring any property to a foreign trust would be treated as if he had made the transfer to the trust on the day his U.S. residency commenced and would thereupon be treated as the owner of a portion of the trust in any year in which it has a U.S. beneficiary. (The grantor would also be subject to the information reporting requirements, discussed below.) For example, if a nonresident alien creates a trust for a U.S. beneficiary more than 5 years before immigrating to the U.S. and, less than 5 years before immigrating, transfers $1 million to the trust (thereby increasing its principal to $2 million) the grantor would annually report one-half of the income received by the trust once he established U.S. residency. New trust residency rules. Under prior law, there was no clear method of determining the residency of a trust. The new statute establishes a two-part test for determining situs. If (i) a U.S. court can exercise jurisdiction over the administration of the trust, and (ii) one or more U.S. fiduciaries have the authority to control all substantial decisions of the trust, then the trust is domestic. All other trusts are foreign. The Committee Report to the Bill stated that the test is "objective." Yet, it remains unclear how a trust with two or more trustees, or with separate advisors or protectors who may exercise certain powers over the trustees, one or more of whom is foreign, would be treated under these rules. In addition, it may be difficult in some instances to determine the actual situs of jurisdiction of a trust if the grantor, beneficiaries, trustees and trust estate are in separate jurisdictions. A determination that a domestic trust became a foreign trust as a result of a trustee resignation or appointment or due to a weak nexus claim could result in disastrous tax consequences. Under the new rules, if a domestic trust subsequently becomes a foreign trust, the trust will be treated as having made a transfer of its assets to a foreign trust as of the date the trust changed its situs, and generally will be subject to a 35% excise tax on unrealized appreciation under section 1491 of the Internal Revenue Code. The section 1491 excise tax is doubly onerous in that the application of the tax will not result in a step-up in basis for the assets of the trust. (Commentators have predicted that there may be clarification of the new rules in the form of a technical memorandum.) Information reporting requirements. The new law requires a "responsible party" (who may be a grantor of an inter vivos trust, the transferor of property to a foreign trust or the executor of a decedent's estate) to file an information return with the IRS within 90 days of a "reportable event," indicating the amount of money or other property contributed to the trust and the identity of the trust, the trustee or trustees and the beneficiary or class of beneficiaries. A "reportable event" includes the creation of any foreign trust by a U.S. person, the direct or indirect transfer of any money or property to a foreign trust by a U.S. person, and the death of a U.S. person if any portion of a foreign trust was includible in the decedent's gross estate. In addition to the initial reporting requirements, a U.S. person who is treated as the owner of any portion of a foreign trust is required to file an annual return providing a full accounting of all the trust activities for the taxable year. Further, any U.S. person who receives a distribution, either directly or indirectly, from a foreign trust is required to report the name of the trust, the aggregate amount of distributions received and any other information the IRS may request. If the U.S. person fails to provide the required notice or return in respect of an initial transfer to or a distribution from a foreign trust, the U.S. person would be subject to an initial penalty equal to 35% of the gross reportable amount. A failure to file an annual report will result in an initial penalty of 5% of the gross reportable amount. Additional penalties may be added for continued failure to report, up to the gross reportable amount. If a U.S. person is recognized as the owner of any portion of a foreign trust, the new rules require the foreign trust to appoint a "limited" U.S. agent to accept service of process with respect to any communications with the IRS in connection with the tax treatment of any trust items. Although the statute declares that the appointment of a U.S. agent will not subject that person to legal process for any other purpose and will not result in the foreign trust engaging in a U.S. trade or business, it is understandable that many trustees and grantors will be hesitant to appoint a U.S. person to such a position if the objective of creating the trust was to keep it outside the jurisdiction of the U.S. However, if no agent is appointed, the IRS would be authorized to determine the tax consequences of amounts to be taken into account with respect to the grantor trust rules. Where appropriate records are not provided to the IRS with respect to a distribution from a foreign trust to a U.S. distributee, the distribution would be includible in the gross income of the distributee and subject to the accumulation distribution rules. Under prior law, there was no requirement that a U.S. donee of a gift made by a non-U.S. person report the gift. The new law, effective for gifts received after enactment on August 20, 1996, requires such reporting if the value of the aggregate foreign gifts received by the U.S. donee exceeds $10,000 during the tax year. The term "foreign gift" is defined as any amounts transferred by a non-U.S. person to a U.S. person as a gift or bequest. Payments made directly to educational or medical institutions on behalf of a U.S. person are not included in the definition. If the U.S person fails, without reasonable cause, to report the gift within the time prescribed by IRS rules, the IRS would be granted authority to determine the tax nature of the gift. In addition, the donee will be subject to a penalty equal to 5% of the amount of the gift for each month that the failure to report continues, up to a total of 25%. The IRS has not yet promulgated any rules or forms which describe the method, timing or extent of any reporting. Presumably, any such forms would be available early next year in time for the 1996 tax filing season. These new rules reflect a legislative intent that the IRS take a much tougher stance against persons who attempt to reduce their U.S. tax liability through expatriation or the use of foreign trusts. Close scrutiny of the rules is essential. The price of noncompliance is severe -- in some instances penalties can be as high as 100% of the amount in question. Although very few U.S. citizens emigrate permanently each year, many non-citizens who have lived in the U.S. for a number of years return to their home countries. Such persons should carefully consider the myriad tax consequences of "expatriation" prior to termination of their U.S. status. In addition, it is expected that the foreign trust rules will prompt a number of trust reformations or trust amendments as trustees and grantors work to ensure that their trusts do not trigger unintended tax consequences. This report is distributed for general information purposes only. No action should be taken solely on the basis of its contents. ©1998 Dunnington, Bartholow & Miller LLP. All Rights Reserved.