A trust which has a foreign situs for United States income taxation may have both US and foreign (non-US) persons as beneficiaries. The result may give rise to divergent objectives between the two beneficiary categories. This is especially so in terms of potential ultimate trust domestication considerations.
In general, domestication refers to the process of shifting the situs of a trust for United States income taxation from foreign to domestic – from a foreign jurisdiction to the United States. Typically domestication considerations arise on the demise of the settlor with transformation of the trust from a grantor to a nongrantor trust. In this event, the US beneficiaries, to avoid untoward United States income tax consequences (e.g., interest charge and loss of income character on accumulation distributions) and onerous reporting requirements (e.g., the filing of Form 3520), may highly prefer a domestic situs shift. By contrast, as these concerns typically do not exist for the foreign beneficiaries, their view would correspondingly be that the trust retain its foreign situs.
These divergent objectives should be addressed but at the very outset with initial drafting and contemplated inception of the trust rather than after the fact. Delay may limit the alternatives available potentially precluding a situs shift or even if not precluded, substantially enhancing ultimate tax exposure.
Indeed, duly addressing domestication at the outset enhances the likelihood of a seamless subsequent situs transition. The notion is to draft the trust with foresight in a manner to minimise the discontinuity in the situs transition to the fullest practicable extent. Otherwise, serious adverse United States income, estate, gift, and/or generation-skipping transfer (GST) tax consequences may arise as a result of the situs shift. As a general principle, discontinuity for this purpose is diminished where the trust retains its identity as part of the situs shift, i.e., the trust as domesticated remains the same basic trust as that initially created.
Duly addressing domestication at the outset enhances the likelihood of a seamless subsequent situs transition
Rights and powers
Pertinent rights and powers bearing on domestication, which should be considered at the outset in drafting a trust include the following:
- Authorisation to remove a trustee, including an initial trustee, and to appoint a successor trustee,
- The power, as extended to the trustee, to appoint new or other trusts, and
- The power, again as extended to the trustee, to transfer income and/or capital to new or other trusts.
Notably, the above provisions should ordinarily be directed not merely to the initial jurisdiction of trust creation but to new or other jurisdictions as well. These provisions should also be coupled with one authorising a change in trust situs for United States income taxation from one jurisdiction to another. Moreover, a separate provision authorising the subsequent exclusion of a person as a trust beneficiary, whether as extended to the trustee or to the trust beneficiaries themselves, should likewise be included. Further, the initial foreign situs jurisdiction selected should provide sufficient flexibility under its own internal law to affect the desired method of situs transition.
Since in this context it would be the US beneficiaries who desire domestication, the tentative initial perception may be conceptually to exercise the above rights and powers in a manner to create a new domestic (US) trust for their immediate and direct benefit. To illustrate, the trustee of an extant foreign trust could, on duly taking into account the court and control tests for attainment of United States situs, appoint a new domestic trust within the US. The US beneficiaries of the foreign trust could correspondingly be expressly designated as beneficiaries of the new domestic trust. Concurrently, the income and/or capital in respect of assets attributable to the US beneficiaries of the foreign trust could likewise be transferred to the new trust. Simultaneously, the US beneficiaries could then be excluded from being continuing beneficiaries of the foreign trust. The original foreign trust would remain and continue in its initial jurisdiction of formation with the balance of the trust assets and the foreign persons as its sole beneficiaries. This approach commonly is referred to as decanting.
It is submitted that, at least in this context, decanting should be avoided. The rationale again rests on diminishing the discontinuity and the potential adverse United States tax consequences that may otherwise arise in connection with the situs shift. Specifically, to what extent would the collective actions taken, e.g., formation and funding of a new domestic trust, insertion of the US persons as its beneficiaries, and removal of the US persons as beneficiaries of the foreign trust, etc., present adverse United States income, estate, gift, and/or GST tax consequences? To illustrate, issues which may arise include:
- Whether the US beneficiaries could be treated as having transferred assets to the new domestic trust with the transferred assets not being insulated from the US estate tax.
- Assuming multiple US beneficiaries, whether the respective beneficiaries could be considered as making taxable gifts from one to another.
- Whether GST tax may likewise be activated, i.e., whether a trust previously not exposed may as a result of domestication thereby become subject to the tax.
While with thoughtful and careful analysis, the above and potentially other issues may be defused, results depending on the facts presented may nevertheless be problematic and lack the requisite degree of certitude which may otherwise exist if the trust as domesticated retains its identity with the situs shift.
Specifically, rather than a domestic trust, a new foreign trust could be created with the extant foreign beneficiaries designated as beneficiaries of the new trust. Correspondingly, the new trust could be funded but in this instance by the transfer of the assets of the initial foreign trust attributable to the foreign beneficiaries. Likewise, the foreign beneficiaries could concurrently be excluded as beneficiaries of the initial foreign trust.
This would leave the US beneficiaries as the sole beneficiaries of the initial foreign trust. It is that trust, i.e., the trust as literally created at the outset, which would then be domesticated. The foreign trustee would merely be removed and replaced through appointment of a successor domestic trustee, with the court and control tests again being duly taken into account. As the US beneficiaries would under this scenario at all times remain beneficiaries of the extant trust, without being removed and inserted as beneficiaries of a new separate trust, the level of discontinuity and the associated potentially negative US tax consequences should thereby be diminished.
This approach is analogous to that addressed in Priv. Ltr. Rul. 200338015 (the “Ruling”). See also Priv. Ltr. Ruls. 7917037 and 7917063 (addressing same approach in context of domestication prior to adoption of court and control tests for determining situs). The Ruling, in connection with domestication of a foreign trust, stated:
‘The trust’s advisors have determined that it would be in the best interest of the beneficiaries of the trust to convert the trust to a domestic trust. The Trustee Selection Committee plans to change the trustee from foreign trustee to an institution organised and established under the laws of the United States or one of the several states in the United States (US resident trustee). The perpetuity date will be changed, if necessary, to comply with the applicable law.’
Though the methodology by which the court and control tests were to be satisfied was not addressed, the approach discussed is consistent with the trust’s having retained its identity with the situs shift.
Moreover, the Ruling expressly concluded the gift tax would not apply as a result of domestication. First, it reasoned that a completed gift, in the factual context of the Ruling, had occurred at the time the settlor transferred property to the initial foreign trust. Secondly, consistent with Treas. Reg. §25.2511-1(g)(1) which delimits the gift tax to the transfer of a beneficial interest and not ‘… to a transfer of bare legal title to a trustee’, the Ruling emphasised that that the transfer of title from the foreign to the US resident trustee would not result in a taxable gift.
Additionally, the Ruling specifically held the trust would not as a result of domestication become exposed to the GST tax. It emphasised:
‘… no aspect of domestication, including the trust’s change of status from a foreign grantor trust to a domestic nongrantor trust and the change of fiduciary from foreign trustee to US resident trustee, will cause the GST tax to apply to an otherwise taxable termination or taxable distribution from the trust and the dynasty trusts under section 2601.’
In reaching this result the Ruling likewise concluded that because the original completed transfer in trust by the foreign settlor was subject neither to gift nor estate tax, the GST tax was at the outset inapplicable as well. Insulation against the GST tax continued with domestication even though the Perpetuity Date (defined therein as the day preceding the one hundred fiftieth anniversary of the date of the Trust Deed) was to be changed, “if necessary, to comply with the applicable law”. See Page 3 of Ruling. As the period of duration on domestication under the applicable law was undefined by the Ruling, use of the terminology if necessary presents the implication that this holding would have been reached irrespective of whether the period of trust duration was shortened or lengthened as a result of domestication.
In conclusion, trust domestication considerations where both US and foreign (non-US) beneficiaries are present should be duly addressed at the outset with initial inception of a foreign trust rather than after the fact. For this purpose the objective is to be in position to affect a subsequent situs transition with the trust retaining its identity as part of the situs shift. Doing so should minimise the discontinuity which may otherwise exist and assist in ensuring insulation from taxation.
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