Foreign Trusts and Foreign Grantors—Special Issues

Foreign grantors establishing trusts for the benefit of their kin must navigate a myriad of issues when forming a trust. While grantor wishes remain paramount, it is important to understand the grantor’s unique fact pattern, carefully evaluate the type of trust, jurisdiction, and intended beneficiaries to ensure that the will of the grantor is not perverted by outside, unanticipated forces.

The Hague Convention and Jurisdictional Recognition of Trusts

Civil law jurisdictions can be particularly harsh to trusts, as these jurisdictions generally do not have legal frameworks which recognize trusts. Examples of such jurisdictions include Liechtenstein, Luxembourg, the Netherlands, and Switzerland.

The Hague Convention of 1982 (Convention) attempted to mitigate this issue. The Convention was a global initiative with the goal of harmonizing tax and legal treatment over a number of issues including banking law, family law, and notably, trust law. The impetus was to unify the codified set of rules to consistently adjudicate interjurisdictional disputes. There are 83 member states from around the world, and the organization continues to attract nonmember nations as parties to the Convention.

With respect to trusts, the Convention instituted a common framework for civil law countries, thus avoiding the question of how the trust will be characterized under local law, often a difficult and convoluted issue. This framework allows the party jurisdictions to recognize the trust and settle disputes in ways local laws often cannot.

However, settlors should be aware that not all jurisdictions are parties to the Convention. Sweden is one such jurisdiction. Swedish law does not contain any precedent or appropriate constructs to enable courts to address and properly adjudicate trusts. Moreover, trusts are not recognized by any Swedish legislation to date.

This lack of recognition often leads to adverse tax results. Of the rare case law in Sweden involving Swedish trusts (given many settlors opt not to form trusts there), the trusts have generally been deemed by the courts to be a foundation, or, “stiftelse” under Swedish law. This forced recharacterization subjects the trust to unfavorable tax effects, such as current income taxation and loss of creditor protection.

There are other practical reasons dissuading settlors from forming trusts in Sweden. Where settlors attempt to mortgage real property of the trust, Swedish lawyers and banks have difficulty effectuating the transaction due to lack of precedent.

Getting Cash Out of the Trust

Another jurisdictional issue to be considered in trust formation is the ability to distribute proceeds. China is an acute example of a jurisdiction notoriously difficult from which to withdraw funds. The Chinese government policy, specifically its strict regulations on cash outflows, is intended to prevent significant sums of money from leaving the country for fear of adverse economic impact. China’s State Administration of Foreign Exchange (SAFE) is the authorized institution that controls foreign exchange, including the amounts of money entering and leaving the country. To take funds out of China, through SAFE, a trust must use a bank as a conduit and show proof of proper income taxes paid in China. This can be a burdensome and arduous process.

Dominion and Control of Foreign Trusts—IRS Reporting

Another key issue arises where certain trust arrangements can inadvertently trigger IRS foreign trust reporting requirements. Given the significant penalty exposure at play ($10,000 or 10% of unreported amount), it is critical that these agreements be scrutinized to mitigate this risk.

Generally, foreign grantor trusts governed under tax code Section 679 are subject to foreign bank account and trust reporting requirements (i.e., forms FBAR, 3520, and 3520-A). By contrast, foreign non-grantor trusts are not typically subject to these requirements. However, where the beneficiary has expanded rights in the trust, even when not entitled to cash or in-kind distributions, there is a risk of an imputed reporting requirement.

Rights in the trust such as signing authority, distribution discretion, or control over investment decisions on the trust all create this risk. The decision hinges on whether these rights—depending upon how bestowed in the trust agreement—convey “dominion and control” to the beneficiary over the trust assets. What constitutes dominion and control is a question of facts and circumstances in each individual instance.

It should be noted that the IRS in making these initial assessments is not a trier of fact, but rather an advocate of their position. The IRS has recently been more assertive in the foreign trust arena in terms of issuing notices and flagging missed reporting. As a result, caution and a sobering assessment of the documents is recommended to ensure that all beneficiaries have only the rights intended to be conveyed by the agreement. Should such additional rights be desired, proper tax and legal advice is recommended to ensure all reporting is accurately and timely filed.

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.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.