A trust is established in a U.S. jurisdiction such as South Dakota and a South Dakota trustee is appointed. How could this trust be considered a non-U.S. trust? The short answer is the U.S. Internal Revenue Service (IRS) allows trusts to be created with a U.S. situs which the IRS will then treat as a foreign trust.
There is no magic wand to achieve the foreign trust status. Instead, it requires that the trust satisfy certain IRS requirements in addition to any local state trust laws. Local state trust laws vary among the states with some states such as South Dakota having a more flexible approach to trust establishment, maintenance and taxation.
In general, a trust is a relationship in which one person holds title to property, subject to an obligation to keep or use the property for the benefit of another. In the U.S., a trust is formed under state law.
The grantor is the person who establishes the trust and may also be known as the settlor or creator.
A Non-U.S. Person (also known as a Non-Resident Alien (NRA)) is a non-U.S. citizen or a foreign national who does not pass the green card test or the substantial presence test.
South Dakota is the Mount Rushmore State and “Dakota” means friend in the Sioux language. (Fun facts but not necessary for establishing a foreign grantor trust).
Foreign or Domestic Trust?
Generally speaking, if a non-US person makes substantial decisions for the trust, the trust will be classified as a foreign trust under U.S. tax law. The non-U.S. person may be, for example, the trust protector, investment adviser or grantor.
The specific basis for differentiating a foreign from a domestic trust is the application of the Court Test and the Control Test. A trust is considered a domestic trust if it satisfies both the Court and Control Tests.
A trust meets the Court Test if a court within the United States is able to exercise primary supervision over the administration of the trust. More specifically, a trust satisfies the Court Test if:
The trust instrument does not direct that the trust be administered outside of the U.S.;
The trust is administered exclusively in the U.S.; and
The trust is not subject to an automatic migration provision.
A trust meets the Control Test if one or more U.S. persons have the authority to control all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions.
If the trust fails either the Control Test or the Court Test, the trust is treated by the IRS as a foreign trust.
Grantor or Non-Grantor Trust?
Once a decision is made as to whether the entity is a foreign trust or a domestic trust, the next step is to determine whether the trust is a:
Foreign Grantor Trust (FGT) or a
Foreign Non-Grantor Trust
To qualify as an FGT:
The trust must be revocable solely by the foreign grantor without the approval of any other person. If consent is required to revoke the trust, then the consent must be by a person who is related or subordinate and subservient to the foreign grantor (e.g., certain relatives and employees).
The only amounts distributable from the trust are distributable to the foreign grantor or to the foreign grantor’s spouse.
If the trust does not meet the above requirements, then it is a foreign non-grantor trust.
US Tax Treatment
A grantor trust is a flow-through entity for U.S. tax purposes and all assets of the trust and income earned on those assets are attributed to the grantor.
To be considered a “foreign” grantor, the grantor must be a Non-Resident Alien (NRA) under U.S. income tax rules. This means that the foreign grantor will only pay U.S. taxes on a limited category of income.
Assuming the FGT is professionally administered, it will be considered a Foreign Financial Institution (FFI) under the Foreign Account Tax Compliance Act (FATCA). [For a discussion of FGT FATCA classification, see my September 7, 2017 blog: FATCA: Foreign Grantor Trust Classification Strategy.]
As a result of being an FFI, the trust must establish a FATCA compliance program and submit a FATCA report to the IRS for payments made to U.S. beneficiaries. If the FGT makes payments to a U.S. Person, it will be required to submit a FATCA report to the IRS.
The U.S. is not participating in the OECD’s Common Reporting Standard (CRS). As a result, the FGT is not required under CRS to report payments made to non-U.S. Persons.
If the professionally managed / administered FGT creates an investment vehicle outside of the U.S., it is likely that this vehicle will be established in a CRS jurisdiction. Whether the FGT downstream investment vehicle must undertake local CRS reporting depends on the structure of the investment vehicle:
If the FGT has an account with a reporting financial institution (FI) in a CRS jurisdiction, then the reporting FI will treat the FGT as a Passive Non-Financial Entity (NFE) and look through the FGT to identify and report Controlling Persons.
If the FGT’s downstream investment vehicle is located in a CRS jurisdiction and is classified as a Passive NFE, then the reporting FI will look through the FGT to identify Controlling Persons. This will require the reporting FI look to through the Passive NFE and look through the FGT to identify and report Controlling Persons.
If the FGT’s downstream investment vehicle is located in a CRS jurisdiction and is classified as an Active NFE, then the reporting FI will not be required to look through the Active NFE to identify and report Controlling Persons.
The Controlling Person of the trust is anyone who exercises control over the trust, which can include a settlor, protector, investment adviser and beneficiary.
Check with an Expert
This is a simplistic review of a foreign grantor trust. Thus, it is necessary to speak with a U.S. trust specialist and a FATCA/CRS attorney to ensure that you understand the requirements and tax implications for your specific situation.
It is also necessary to understand both FATCA’s and CRS’ anti-abuse/anti-avoidance rules which prohibit individuals from engaging in certain activities to avoid due diligence and reporting.
For additional blog posts see: December 26, 2017: New Filing Requirement for LLCs & U.S. Foreign Grantor Trusts.