A trust is a fiduciary arrangement that allows a third party, or trustee, to hold properties on behalf of a beneficiary or beneficiaries.  Trusts allow for the ownership of certain assets to be transferred from the grantor (one who creates the trust and funds it with assets) and controlled by a trustee for the benefit of a beneficiary. Whether a grantor, a trust beneficiary or the trust is subject to any US income tax is determined by

• whether the trust is a US domestic or foreign trust; and
• whether the grantor and the beneficiary are US “persons”; and
• how the assets will be treated in the deed of the trust.

US Domestic Trust versus Foreign Trust

Whether the trust is considered a US domestic or foreign trust for us tax purpose will determine what income, if any, is subject to US tax. Domestic trusts are generally subject to US tax on their worldwide income while foreign trusts are only subject to US tax on their US-source income.

A trust will be consideredUSdomestic trust only if

1. A US court can exercise primary supervision over the administration of the trust (the “court test”), and
2. one or more US persons have the authority to control all substantial decisions of the trust (the “control test”).

Any trust that fails of one of these tests is a foreign trust.

For purpose of the court test, the regulations provide that a US court includes any federal, state, or local court located in the 50 states plus the District of Columbia; a court within a US territory or possession is not a US court. A US court is considered to have primary supervision if the court has or would have the authority to determine substantially all issues concerning administration of the entire trust.

The regulations contain a “safe harbor” test under which a trust is considered as meet the court test if:

• The trust deed does not direct that the trust be administered outside the untied states;
• The trust is, in fact, administered exclusively in the untied states; and
• The trust is not subject to an automatic “flee clause” pursuant to which the trust migrates form the untied state in the event that a US court attempts to asset jurisdiction over the trust’s administration.

The control test will be considered to be satisfied if US persons control all substantial decisions affecting the trust and no foreign person acting in any capacity can overcome the decisions of the controlling US persons. Substantial decisions generally include the amount and timing of distributions and whether to make them form income or corpus, the selection of beneficiary, investment decisions, whether to terminate the trust, and decisions regarding trustee changes.

Foreign grantor trust versus Foreign Non-grantor trust

Whether a trust is considered a “grantor” or “non-grantor” trust for US tax purpose will determine who is potentially liable for any US income tax. To determine whether a foreign trust will be classified as a grantor trust, it is necessary to first identify if the grantor and beneficiaries are US persons. The trust can be put into one of the following 4 categories:

1. A foreign trust created by a non-US grantor that does benefit foreign persons only (no US beneficiaries);
2. A foreign trust created by a non-US grantor that has (or could ever have) US beneficiaries;
3. A foreign trust created by a US grantor that does benefit foreign persons only (no US beneficiaries);
4. A foreign trust created by a US grantor that has (or could ever have) US beneficiaries;

There are different grantor-trust rules for separate categories.

For a trust of which the grantor is a foreigner as in categories (1) and (2), to be treated as a grantor trust only if:

• The grantor reserves the right to revoke the rust solely or with the consent of a related or subordinate party and revisit the title assets to himself; or
• The amounts distributable during the life of grantor are distributable only to the grant and/or the spouse of the grantor

For a foreign trust created by a US grantor that does not have US beneficiaries as in category (3) to be treated as a grantor trust, the US grantor must retain certain controls over the trust property.

For a foreign trust created by a US person that has, or may have, US beneficiaries as in category (4) will be considered a grantor trust even if the grantor has not retained interest or powers over the trust. In addition, a foreign trust established by a non-US person who becomes a US  person within five years of transferring property to the trust, directly or indirectly, will be grantor trust if, at the grantor’s residency starting date, the trust has a US beneficiary.

Any foreign trust that is not treated as a grantor trust will be treated as a foreign non-grantor trust.

US Taxation of Foreign Trust

Foreign grantor trust: ForUS income tax purpose, a grant trust is disregarded entity. The grantor/owner of the trust must include the trust’s income on his income tax return and pay tax on that income as income is realized each year regardless of whether or not such income is actually distributed. The beneficiaries of a grantor trust are not subject toUS income tax on distribution from the grantor trust. However, US beneficiaries may have information reporting obligations.

Foreign non-grantor trust: A non-grantor trust is treated as a separate entity from its grantor. Non-grantor trust is taxed on its taxable income, and the beneficiaries are taxed on their share of the trust’s distributable net income (DNI) that is distributed to them. Any DNI that is not distributed in the year in which it is realized will be accumulated within the trust and will carry forward as undistributed net income (“UNI”) into the next year. In a year when a non-grantor trust makes distribution to the beneficiaries, the trust is allowed to deduct its net income for such distribution in the extent of DNI in the current year. Distribution to beneficiaries are consider first to carry out the DNI of the current year and will be taxed to recipient beneficiaries. Any distribution from the trust in exceed of the DNI for the current year, will be then considered to come from the accumulated UNI and the excess amount, if any, is considered finally from the principal of the trust. Distribution of UNI to US beneficiaries is subject to the throwback tax on the recipients. Any capital gains accumulated by a foreign trust will be taxed as ordinary income. Distribution from the principal is not taxable income to the beneficiary. In order to avoid characterization as an accumulation distribution, a beneficiary must obtain and provide a statement from the trustees in a form required by the IRS. This might be a “foreign non-grantor trust beneficiary statement” or a “foreign grantor trust beneficiary statement”.

Foreign grantor and Foreign beneficiaries: The grantor of a foreign grantor-trust is taxed individually as a nonresident alien. To the extent that a nonresident alien beneficiary of a foreign trust receives US sourced taxable distributions of distributable net income, the beneficiary is required to file a US individual income tax return. The taxable US income includes:

• US-source fixed or determinable, annual or periodic pains, profit and income (“FDAP” income);
• Income effectively connected with the conduct of  a US trade or business; and
• Gains from the disposition of US real property interest (treated as income effectively connected with the conduct of a US trade or business).

There are certain designated US-sourced incomes that are deemed to be exempt from taxation to a nonresident alien. These incomes consist of certain interest on a United States bank deposit, interest from qualifying portfolio indebtedness, and a percentage of any dividend paid by a United States corporation which is in conformity with an eighty percent foreign business requirement test. In addition,US-sourced, non-real estate capital gains income is not taxable if not effectively connected to a US trade or business.

Reporting requirement

Form 3520 Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. The US grantor or beneficiary of a foreign trust is required to file this form who:

1. The formation of a foreign trust
2. The transfer of cash or other assets by the settlor/grantor to a foreign trust
3. The receipt of any distributions by US beneficiaries from the foreign trust
4. The receipt by any US person of a bequest from a foreign person in excess of $100,000
5. The receipt by any US person of a gift from a foreign partnership or corporation in excess of  $13,000 (for 2009)
6. Loan transactions between the trust and any beneficiary

U.S.persons must file Form 3520 at the time their individual income tax returns are due.  A US person failing to file Form 3520 is subject to an initial penalty of the greater of (1) $10,000 or (2) (a) 35% of the gross value of the property transferred to a foreign trust, (b) 35% of the gross value of the distributions received from a foreign trust, or (c) 5% of the gross value of the trust. IRC § 6677. Additional penalties for subsequent filing failures may follow.

Form 3520-A. Annual information return of foreign trust with a US owner. For purposes of Form 3520-A, a reportable event includes the following: (1) the creation of any foreign trust, (2) the transfer of any money or property (directly or indirectly) to a foreign trust, and (3) the death of a citizen or resident of the United States who was either the owner of the trust for U.S. federal tax purposes or all or a portion of the foreign trust was includable in the person’s gross estate. IRC § 6048(a)(3)(A).

This form is due the 15^th day of thee third month after the end of the trust’s tax year. For any failure to file Form 3520-A, the US owner is subject to an initial penalty of the greater of $10,000 or 5% of the gross value of the trust. IRS § 6048(b)(1). For continued failure to file past 90 days after the IRS mails notice of such filing failure, the US owner is subject to an additional $10,000 penalty for each 30-day period during which the failure continues

Form 4970, Tax on Accumulation Distribution of Trusts. AU.S. beneficiary who receives a distribution that consists of UNI from a foreign trust must calculate the throwback tax on such distribution on Form 4970 and attach it to the beneficiary’s Form 3520.

 Form 1040, US Individual Income Tax Return, Schedule B. Any taxpayer who received a distribution form a foreign non-grantor trust must report such receipt on schedule of their IRS form 1040. Any individual required to report an interest in or signatory authority over a foreign ban (or other type of financial) account on TD F 90-22.1 must also disclose this on Schedule B of their Form 1040.

Form 1040NR, US. Non-Resident Alien Income Tax Return. Generally, a foreign non-grantor trust that receives US source income must report such income on Form 1040NR.

Form 1040NR must be filed by the 15th day of the 4th month after the tax year ends if the foreign trust that has an office in the United States, or by the 15th day of the 6th month after the tax year ends if the foreign trust have does not have an office in the United States. If Form 1040NR is not timely filed, the penalty is 5% of the amount due for each month the return is late, up to a maximum of 25%. If the failure to timely fie is fraudulent, the penalty is 15% per month, up to a maximum of 75% of the amount due. Interest and late payment penalties of up to 25% also apply. Other penalties may be imposed for the filing of a frivolous return, negligence, substantial understatement of tax and fraud.

Form 1041,US income tax return for estates and trust. A foreign grantor trust that receives US source income must report such income on Form 1041. A schedule is attached to form 1041 that shows the amount that are taxable directly to the grantor.

If Form 1041 is not timely filed, the penalty is 5% of the amount due for each month the return is late, up to a maximum of 25%, unless the taxpayer has a reasonable explanation. If the failure to timely file is fraudulent, the penalty is 15%  per month, up to a maximum of 75% of the amount due. Interest and late payment penalties of up to 25% also apply. Other penalties may be imposed of the filing of a frivolous return, negligence, substantial understatement of tax and fraud.

TDF 90-22.1: Report of Foreign Bank and Financial Accounts – You might have to file this form if you have a financial interest in or signature authority over an account associated with a foreign trust The FBAR is required to be filed by a U.S. person who has a financial interest in, or signature or other authority over, any foreign financial account (including bank, securities or other types of financial accounts), if the aggregate value of the financial account(s) exceeds $10,000 at any time during the calendar year. Grantors of foreign asset protection trusts are deemed to be the owners of all trust assets for tax purposes. Thus, the FBAR filing requirement applies to such grantors, whether or not they actually control trust assets and whether or not they receive distributions from the trust.

Form 8938 A foreign trust that invests (directly or indirectly) in securities and other financial interests may, under certain circumstances, be treated as a foreign financial institutions if the trustee is a trust company or if an entity, such as a bank or other financial institution, is acting as the investment advisor. FATCA Individual Reporting: AU.S. person who holds an interest in a specified foreign financial asset must disclose such interest on Form 8938 if the aggregate value of all such assets exceeds certain threshold amounts. A foreign financial asset includes an interest in a foreign trust, although special valuation rules may apply. Typically, assets are reported only when and as a trust makes a distribution to a US beneficiary, the amount of the distribution being the reportable asset. This disclosure requirement is in addition to the FBAR requirement described above.

Form 709 Gift Tax Return. AU.S. person who transfers money or property to a foreign trust may be required to file Form 709 United States Gift tax return.