INSIGHT: Foreign Trust Jurisdictional Considerations

In the process of forming a trust, the choice of jurisdiction and its associated tax or legal regime may play a significant role impacting the decision. The purpose of this piece is to provide a high-level snapshot of several noteworthy regimes and jurisdictions. Each of these regimes requires a different approach to planning and to structuring the resulting trusts. Practitioners should always keep in mind that there is no “one size fits all” method when it comes to establishing foreign trusts. Depending upon the unique circumstances and goals of both the trust instrument and the affected trust individuals, certain items below may play a role in guiding the ultimate decision.

Civil Law Jurisdictions (e.g., Germany, France, Liechtenstein)

Civil law jurisdictions differ from their common law counterparts in that they rely primarily on written statutes to govern, as opposed to common law nations which utilize precedential case law. This reliance on codified statute by civil law entities creates uncertainty due to the evolution of trust planning. Oftentimes, no statutes exist to govern complex trust planning. Accordingly, civil law jurisdictions are forced to wrestle with novel trust concepts without statutory precedent upon which to rely. This causes significant unpredictability in dispute resolution outcomes, which can often run counter to the wishes of the trust creator. Such variability has led to the somewhat deserved perception that civil law jurisdictions are hostile to trusts.

One major issue, to highlight this point specifically, is recognition by civil law jurisdictions of the trust itself. Because, as mentioned, trusts may not be grounded in statutes in certain civil law countries, courts there may not regard the trust instruments and will instead look exclusively to local law to govern factual disputes. When trust terms conflict with local statute, they may be invalidated. For example, in Germany, if assets in dispute are deemed to be property of a trust, the court must apply mandatory provisions of German property law to apply to the factual issue, rather than the trust terms themselves.

The Hague Convention of 1992 was introduced as an attempt to eliminate such inconsistencies by forcing civil law jurisdictions to recognize trusts and setting up a universal set of guidelines under which to govern disputes. However, to this day, it has only been ratified by 14 nations and its overall effectiveness is open to debate. The view that civil law jurisdictions pose additional legal challenges for trusts remains valid.

Nevertheless, trust-like results can be obtained in civil law jurisdictions through the formation of a different kind of entity, such as a family foundation. Entities like family foundations are typically better supported by the existing statutes of civil law regimes, avoiding the stability issues inherent to trusts under civil law. Although different from trusts in the legal personality they are invested with and the broader powers their governing boards may be invested with in comparison to a trustee, family foundations are well-equipped to meet much the same ends as trusts in civil law jurisdictions.

Usufruct Interest

An additional planning opportunity found in many European countries, including civil law countries, is the granting of a usufruct interest. Similar to a common law life estate, ownership of the property is split between title ownership (“bare” ownership) and ownership of the right to use and enjoyment of the property (the “usufruct interest”). Gifting bare ownership to one’s beneficiaries while maintaining a usufruct interest for oneself allows the title to the property to pass with lessened exposure to European gift tax due to the reduced value of bare ownership, without triggering a greater European inheritance tax when the usufruct right expires.

Care should be taken when attempting to make use of this strategy when there is still U.S. tax exposure, however, as additional reporting requirements may be triggered. Furthermore, the possibility of U.S. gift or estate tax exposure will need to be mitigated by further planning or by utilizing provisions against double taxation in U.S. tax treaties.

Tax Havens (e.g, Cayman Islands, Cook Islands, Nevis)

Another item to consider when forming a trust is whether to establish the trust in a tax favorable jurisdiction. Several jurisdictions, noted in the tagline above, have long been friendly to the establishment of trusts. In addition to essentially nil tax rates, these nations provide significant legal creditor protections and privacy regulations. The Cook Islands, for instance, do not recognize foreign judgments against the trust, forcing creditors to file in country claims in order to simply penetrate the trust (to say nothing of the merits of the claim). Nevis provides similar provisions, and further flexibilities to allow trusts to be combined, split, hold multiple asset forms and exist indefinitely. These Nevis advantages will typically be combined with a Nevis LLC for the trust to hold, as the Nevis LLC statute creates additional layers of asset protection even for single-member entities without creating additional Nevis taxes or reporting requirements.

Because of their highly favorable trust laws, these “tax haven” jurisdictions are often subject to heightened monitoring. Cook Islands and Nevis are designated as “On Watch” by the European Union and other international bodies, while the Cayman Islands are listed as a non-cooperative third country jurisdiction by the European Union, affecting the reporting obligations and income tax treatment of the trust in relation to European Union contacts. Trust formation in these haven jurisdictions should be weighed in light of the goals of the trust and the level of reporting obligations and income tax modifications acceptable to involved individuals.

Evolution of Laws (e.g., New Zealand)

In the trust creation process, prudence should be exercised when considering whether the instrument relies on favorable laws of a jurisdiction. Where those laws change, the impact on the trust can be dramatic. Consider New Zealand as a cautionary example. Under prior New Zealand rules, trusts enjoyed high levels of privacy and autonomy from scrutiny and regulation.

As of January 2021, the recently enacted Trusts Act takes effect to change this status. Greatly increased reporting, both to trust beneficiaries and the government, will reduce the privacy of the parties and create new administrative hurdles for the trustees. The expanded transparency is also expected to create additional future disputes in the trust arena as a consequence of the increased reporting to more parties. For these reasons, most practitioners expect the number of instruments to utilize New Zealand as a trust jurisdiction going forward will decline.

Though impossible to predict with absolute certainty, individuals seeking to create trusts should discerningly analyze the anticipated jurisdiction’s tax and legal landscape, understanding the impacts of potential law changes on the trust.

Malta Foreign Grantor Trust Planning

Lastly, Malta itself begs particular attention due to a unique tax planning opportunity there. It should be noted this planning is limited to a particular interpretation of the U.S.-Malta Double Tax Treaty around pensions, an interpretation not necessarily agreed upon by all practitioners.

Under such a reading, U.S. individuals may establish, under U.S. tax principles, a foreign grantor trust in Malta. Malta treats this trust locally as a pension plan. The initial contributions to the plan (e.g., cash, real estate, etc.) are tax-free from both a U.S. and Maltese perspective. Subsequent sales of appreciated property, because they are in a Maltese retirement account, are also not subject to taxation. Additionally, Maltese rules allow for a tax-free lump-sum distribution of up to 30% of the proceeds of the account once the beneficiary reaches the age of 50. Additional distributions can also be made free of tax four years following the opening of the account, subject to certain restrictions.

Because this planning relies on an interpretation of complex rules involving cross-border jurisdiction, such formations should be undertaken with great care and professional tax/legal guidance is critical.

A Final Word—Community Property

Unlike the U.S., where separate property regimes predominate amongst the states, many countries around the world have either universal or elective community property. This is typical in Latin American countries like Brazil and Argentina, as well as certain European countries such as France, Italy, and Switzerland. When crafting a tax plan that touches on a country with community property law, care must be taken to avoid commingling of assets that would otherwise be treated as separate property. If commingled, such property runs the risk of being deemed community property. Careful drafting of trust instruments and other agreements, however, will ensure that the separate character of any such property is maintained.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jack C. Millhouse is an international tax manager at FGMK LLC in Chicago. Charles F. Schultz IV is an associate in Chicago.