Volume 18, Number 2
REAL ESTATE LAW
International Estate Planning
By Barbara R. Hauser and Joseph M. Erwin
Asset protection trusts (APTs) are trusts established in offshore jurisdictions for the purpose of thwarting claims of creditors. They are usually created without incurring gift tax, which means that they are fully taxed by the United States at the death of the U.S. settlor. They are also fully subject to U.S. income tax. The hallmark of APTs has been the purported legal inability of the settlor to have access to trust assets in the event of a claim by a creditor.
This assumption was severely undermined in Federal Trade Commission v. Affordable Media, LLC, in which the Court of Appeals for the Ninth Circuit affirmed an injunction against the settlors of an APT that required the defendants to repatriate any assets held for their benefit outside of the United States. The Affordable Media case seriously undermines the working assumption of practitioners in this area that impossibility is a defense to an order to repatriate assets. Though the Affordable Media court relied chiefly on the status of the defendants as protectors in finding that they had effective control over the trust, the possibility that other factors not addressed there could result in a similar conclusion was left open.Foreign trust rules. The classification of a trust as either foreign or domestic has significant consequences for income tax purposes. If a trust that has previously been treated as a U.S. person becomes a foreign trust, a taxable transfer will be deemed to have occurred. Section 684 of the Internal Revenue Code (I.R.C.) treats a transfer from a U.S. trust to a foreign trust as a sale or exchange for an amount equal to the fair market value of the trust assets, and any gain realized would be recognized by the transferring trust in the year of transfer. Also, the status as "owner" of a grantor trust causes income of the trust to be taxed to that person.
New treasury regulations provide a two-part test that must be satisfied in order for a trust to be considered a U.S. person for income tax purposes, including the tax on the change from a domestic trust to a foreign trust. The two-part test to determine a trust’s residence status is made up of the control test and the court test. The terms of the trust and the state law applicable to the trust are applied to determine whether these tests are met. To satisfy the control test, one or more U.S. persons must "have the authority to control all substantial decisions of the trust." The court test requires that a " court within the United States is  able to exercise  primary supervision over the  administration of the trust...."
The IRS issued final, temporary, and proposed regulations regarding trusts with foreign grantors, covering distributions through intermediaries, the definition of the term "grantor," foreign persons not treated as owners, and recharacterization of purported gifts. Final regulations treat any property transferred to a U.S. person by an "intermediary" as property transferred directly by the foreign trust, if done pursuant to a plan in which one of the principal purposes was the avoidance of U.S. tax. Final regulations provide that the grantor trust rules other than I.R.C. § 672(f) are first applied to determine whether any portion of a trust is treated as owned by someone other than a U.S. person. If such is the case, that person will be treated as an owner only if the person is a foreign corporation or meets an exception. Gifts from foreign donors can be recharacterized under the new final regulations. Gratuitous transfers to U.S. donees from trusts created by foreign partnerships or foreign corporations that are treated as owners of the trusts are treated as a gift from the partnership or corporation.Estate and gift tax treaties. On November 5, 1999, the Senate approved a new Protocol for the 1980 U.S.-Germany Estate Tax Treaty. The amendments made by the Protocol are effective for decedents dying and gifts made after the date ratifying instruments are exchanged.
Amending article 4, paragraph 3(c) of the Treaty, the Protocol extends from five to ten years the period during which an individual, who otherwise meets the domicile requirements, may be treated as not meeting the domicile requirement. In determining the taxability of transfers on certain types of assets situated in a state, only specified deductions and exemptions are allowed. The Protocol amends article 10, paragraph 4 to provide that these mandated deductions and exemptions do not apply to a U.S. citizen or former long-term resident domiciled in Germany at the time of the transfer. The Protocol adds paragraphs 5 and 6 to article 10 of the Treaty. Paragraph 5 grants a pro rata unified credit to the estate of a decedent domiciled in Germany for purposes of computing the U.S. estate tax. New paragraph 6 allows a marital deduction for estates meeting certain conditions, with the intent to effectively limit the deduction to smaller estates. Finally, the "savings clause," by which each country reserves the right to tax certain estates or donors under the country’s internal laws, without regard to the Treaty, was amended to expand the savings clause on behalf of the United States. The amended savings clause covers two new classes of individuals: the estate of a decedent or a donor who was domiciled in the United States, and the estate of a decedent or donor who was a former long-term resident.Charitable contributions. In Technical Advice Memorandum 99-25-043, the IRS construed a decedent’s will to provide a charitable bequest to a U.S. affiliate of a foreign charity rather than to the foreign charity itself, thus allowing an estate tax deduction under I.R.C. § 2106. The decedent, a citizen and resident of the country where the foreign charity was organized and operated, made a bequest of $1 million to be used to fund the expansion of a hospital operated by the foreign charity. The original of the will and the English translation of the will did not clarify whether the foreign charity or its U.S. affiliate was the intended beneficiary. A court in the foreign country held the bequest to be to the U.S. affiliate. The IRS said that it was reasonable to construe the bequest as being to the U.S. affiliate because the full bequest would be available to the hospital only if it passed free from U.S. estate taxes.Passive foreign investment companies. Regulations were proposed to implement changes made by the Taxpayer Relief Act of 1997, amending I.R.C. § 1296, by which a U.S. shareholder of a Passive Foreign Investment Company (PFIC) may make a mark-to-market election with respect to the stock of the PFIC if the stock is "marketable stock." These proposed regulations were made final shortly after year end. If stock in a PFIC is marketable stock, the U.S. person who owns the stock may elect to include in gross income the excess of the fair market value of the stock over such person’s adjusted basis. The new regulations refine the concept of what is a marketable stock by explaining the meaning of "regularly traded," a term that is not as easily applied to foreign markets as in the United States. Generally, the new regulations apply concepts familiar to U.S. investors for regulated securities markets.Qualified domestic trust. In IRS Private Letter Ruling 99-18-039, the IRS ruled that the classification of the trust as a foreign trust under § 7701(a)(31)(B) did not cause it to fail to qualify as a qualified domestic trust (QDOT) under § 2056A. Because the surviving spouse was not a U.S. citizen, in order to qualify for a marital deduction, the trustee had to elect to invoke the rules for a QDOT under I.R.C. § 2056A. In IRS Private Letter Ruling 99-17-045, the IRS ruled that the distribution of assets from a QDOT will not result in the imposition of additional estate tax under § 2056A when none of the asset had been includable in the decedent’s estate for U.S. estate tax purposes.
Barbara R. Hauser is special counsel at Cadwalader, Wickersham & Taft, and adjunct professor at the University of Minnesota Law School. Joseph M. Erwin is senior manager at KPMG LLP, Dallas, Texas.
- This article is an abridged and edited version of one that originally appeared on page 591 of The International Lawyer, Summer 2000 (34:2).