FBAR Headaches Spawn FATCA Migraine

When President Obama took office in January, 2009, international tax reform was a key policy objective. The President's 2009 and 2010 budget proposals stalled until a clever bureaucrat employed at a Bank in Switzerland thought it would be a good idea to open a Florida office for UBS (the Swiss-based global financial services company) so that Americans interested in offshore investing would not have to fly overseas to Geneva. The result of this administrative foot foul was "Match point - America." That Florida office rendered UBS and its executives open to being sued in U.S. courts. The resulting litigation pierced the veil of Swiss bank secrecy and provided U.S. government lawyers with unprecedented access to information on offshore accounts held by Americans.

On March 18, 2010, Congress enacted the Hiring Incentives to Restore Employment Act (the HIRE Act). The HIRE Act was aimed primarily at providing U.S. businesses with tax incentives to help finance the hiring and retention of new employees. To offset the projected revenue loss from these incentives, the Foreign Account Tax Compliance Act (FATCA) was added to the bill.

The purpose of FATCA is the establishment of a new regulatory structure wherein foreign (non-U.S.) institutions are "deputized" to track the identities of their account holders and thereby "detect, deter, and discourage offshore tax evasion" by Americans using financial institutions outside of the U.S.¹ Of more significant and immediate concern are the FATCA provisions aimed at closing certain information reporting loopholes for those Americans using foreign trusts.² The U.S. Senate Subcommittee on Investigations, in its 2006 Report on Tax Haven Abuses, identified gaps in reporting that allowed U.S. persons to avoid disclosure of offshore assets and income held in trust for the benefit of U.S. persons.

The FATCA rules are complex and far-reaching,³ and the penalties are onerous. Non-compliance can result in penalties of up to 40% of the value of trust property. Although certain provisions will become effective in 2013, the reporting rules relating to foreign trusts are effective in 2011. The purpose of this article is to focus on the areas of FATCA that expanded the reporting for foreign trusts:

1. the specified foreign financial asset;
2. the presumption of U.S. beneficiary in a foreign trust; and
3. the uncompensated use of property of a foreign trust.

The "Specified Foreign Financial Asset" and new Form 8938

Present US Reporting Rules

Under the present foreign bank account reporting (FBAR) rules, certain grantors and beneficiaries of trusts are required to file the FBAR forms (TDF.90-22.1) reporting foreign financial accounts exceeding $10,000 held in trust, and to report certain transactions with foreign trusts.⁴

FATCA Reform under HIRE Act

In addition to the FBAR reporting, new section 6038D of FATCA provides that an individual who holds any interest in a "specified foreign financial asset" (SFFA) shall attach to his/her U.S. tax return certain information with respect to each SFFA if the aggregate value of all such SFFAs exceeds $50,000.

The definition of SFFA includes any interest in a foreign entity as defined in section 1473 of the Internal Revenue Code (IRC). Section 1473(5) provides that the term "foreign entity" means any entity that is not a U.S. person. The Technical Explanation to the HIRE Act contemplates that a foreign trust is an SFFA; it states that a beneficiary of a foreign trust who is not within the scope of the FBAR reporting requirements may nonetheless be required to disclose the interest in the trust in his/ her U.S. tax return if the value of that beneficiary's interest in the trust, together with the value of other SFFAs exceeds the aggregate value threshold.

The information required under these rules includes "such information as is necessary to identify the trust, the maximum value of the trust during the taxation year." It is not clear whether a copy of the trust document must be filed with the tax return to satisfy this requirement. Also unclear is how a beneficiary of a trust is to value his/her interest in such a trust for purposes of determining whether the $50,000 reporting threshold is met.

Although the reporting applies to the 2011 taxation year, the Internal Revenue Service (IRS) has not yet issued the regulations or finalized the form meant to capture the information to ensure proper compliance with these rules. The IRS thus issued Notice 2011-55 on June 21, 2011, which suspended only the requirement to attach Form 8938 to income tax returns that are filed before the release of Form 8938. Following the release of Form 8938, individuals for which the filing of Form 8938 has been suspended under Notice 2011-55 for a taxable year ("suspended taxable year"), will be required to attach Form 8938 for the suspended taxable year to their next income tax or information return.

The presumption of U.S. beneficiary rules

As noted above, the U.S. Senate Subcommittee on Investigations, in its 2006 Report on Tax Haven Abuses, identified gaps in reporting that that allowed U.S. persons to avoid disclosure of offshore assets and income held in trust for the benefit of U.S. persons.

Present Rules

Subject to certain exceptions, under IRC section 679(a), a U.S. person who directly or indirectly transfers property to a foreign trust is treated as the owner of the portion of the trust attributable to the transferred property for any year in which there is a U.S. beneficiary of any portion of the trust. Under these rules, a trust is treated as having a U.S. beneficiary for this purpose unless no part of the income or corpus of the trust may be paid or accumulated during the taxable year to or for the benefit of a U.S. person, and if the trust were terminated at any time during the taxable year, no part of the income or corpus of such trust could be paid to or for the benefit of a U.S. person.

Consider the following common Canadian situations:

1. A U.S. citizen living in Canada contributes to an RESP for the benefit of a non-U.S. child's future education.
2. A Canadian resident citizen establishes an inter vivos Canadian resident discretionary trust for family tax planning and contributes property to such trust for the benefit of the parent's five children. Two of the children are U.S. citizens, having been born in the United States. No distributions have yet been made to any beneficiary.

Under the present rules, the RESP contribution would require reporting on Form 3520 and Form 3520A, and possibly reporting under the FBAR rules if the dollar threshold is met.

Under the inter vivos trust arrangement, there is presently no requirement to report the contribution to the trust nor is there any FBAR reporting since (a) the contributor is not a U.S. person, (b) the trust is discretionary, and (c) no distributions were made to a U.S. beneficiary.

Presumption of U.S. beneficiaries

Sections 531 and 532 of the HIRE Act amended the IRC to expand the scope of foreign trusts treated as having U.S. beneficiaries, even if the contributor is a non-U.S. person, to include situations in which:

• a U.S. beneficiary's interest in the trust is contingent on a future event;
• any person has the discretion to make distributions from the trust (including by power of appointment), unless the terms of the trust specifically identify the class of persons to whom such distributions may be made and none of those persons are U.S. persons during the taxable year;
• agreements or understandings regarding the accumulation or payment of income or corpus to a U.S. person exist between the foreign trust and a U.S. person who transferred property directly or indirectly to the foreign trust; and
• the foreign trust received transfers from a U.S. person (directly or indirectly), unless such person demonstrates to the IRS that the trust does not have any U.S. beneficiaries.

These expanded rules are creating concern for Canadian tax advisors because no guidance has yet been provided as to what constitutes an "interest in a foreign trust" for FATCA purposes. Can the FBAR definitions be used for FATCA? The New York City Bar Committee on Estate and Gift Taxation has recommended that, although the information required by FATCA rules may not be within the scope of the FBAR legislation, the "Final Rule" issued by the Financial Crimes Enforcement Network (FinCEN) on February 24, 2011, on FBAR could be used as guidance regarding what constitutes an interest in a foreign trust for the purposes of FATCA. The Final Rule provides that, for FBAR filings, only a U.S. settlor who is treated as the owner of the trust under the grantor trust rules, and a U.S. person who has either a present beneficial interest in more than 50% of the trust assets or who receives more than 50% of the trust's current income are considered to have a financial interest in foreign financial accounts held by a trust. The Final Rule clarified that a remainder interest in a trust is not within the scope of the term "present beneficial interest" for the purposes of filing an FBAR. It further clarified that it is not intended for a beneficiary of a discretionary trust to be treated as having a financial interest in a foreign account simply because of his/her status as a discretionary beneficiary. Under these FBAR rules, at least until such time as a discretionary beneficiary receives a distribution from the trust, or the interest of a remainder beneficiary becomes vested, the beneficiary may never realize any direct or indirect benefit in respect of the value or the income of the trust.

FinCEN took a very practical approach to the discretionary trust scenario because the existence of the trust may be unknown to discretionary or remainder beneficiaries until they receive a distribution from the trust. Both U.S. and Canadian practitioners have requested the IRS or the U.S. Treasury to clarify that FATCA reporting does not apply to either a person who has a remainder interest in a foreign trust or a discretionary beneficiary who did not receive any trust distributions in a given year.

Presumably, the filing requirements should apply to:

• a settlor of the foreign trust who is treated as the owner under the grantor trust rules (or an individual treated as the owner of the foreign trust under section 678 of the IRC);
• a beneficiary who has a present fixed - rather than a contingent - interest, in the foreign trust; and
• a discretionary beneficiary who receives distributions from a foreign trust in the year in question.

The significance of the expanded scope means that more foreign trusts may become subject to the SFFA reporting and thereby increase exposure to the FATCA penalties.

The uncompensated foreign trust property rules

Background

Prior to the amendments by the HIRE Act, the U.S. rules provided that, if a foreign trust made a loan to a U.S. grantor or a U.S. beneficiary of that foreign trust, or a person related to such grantor or beneficiary, then the amount of the loan was treated as a distribution by the trust to the grantor or beneficiary. One could envision the application of this rule (intended or otherwise) where a Canadian family trust (or RESP) directly pays the tuition of a Canadian university student who is a U.S. beneficiary of that trust.

Under the HIRE Act

Section 533 of the HIRE Act amended IRC section 643(i) to add new provisions treating uncompensated use of trust property by a U.S. grantor or a U.S. beneficiary of the foreign trust, or a person related to such U.S. grantor or U.S. beneficiary, as a distribution to the grantor or beneficiary. Under these amendments, if a trustee permits a U.S. person to use trust property (like, for example, a vacation home) without payment to the trust for the fair market value of the use of such property, the value of such use will be treated as a distribution.

The use of a Canadian resident trust⁵ to hold U.S. real estate has been a common estate tax planning tool given that nonresident decedents of the United States remain subject to U.S. estate and gift tax in connection with ownership of U.S. real estate. A foreign trust settled by a Canadian parent that purchases U.S. vacation property and allows a U.S. person or U.S. beneficiary to use the property without compensation will result in a deemed distribution to that user measured as the fair value of such use. If a real estate market exists for the use value of the property, then the fair rental value could constitute the amount of the deemed distribution. What remains unclear is how "use" is to be quantified.⁶ Many tax practitioners have requested guidance and have suggested a safe harbor that fair rental value, as determined in the community, would suffice for purposes of determining use value in these examples.

These FATCA rules have created tremendous uncertainty in an area that demands exactly the opposite. The slippery slope of overreaching U.S. tax policy started in 2001, when U.S. legislation enlisted foreign financial institutions through the Qualified Intermediary program to assist in enforcing U.S. tax laws. The FATCA provisions now have turned to the foreign capital markets to expand enforcement of the U.S. tax net. Unfortunately, the end to such tax policy is not in sight.

Joseph E Sardella, CA, CPA, is a Tax Partner in the Toronto office of Collins Barrow.

¹ The RBC Financial Group, in a letter dated June 30, 2010, to the U.S. Department of the Treasury outlined its concerns and recommendations; this was followed by submissions by other interest groups in the hedge fund, insurance and estate and trust industries.

² These rules are of more immediate concern because Canadian financial institutions, most of which are already participants in the IRS Qualifying Intermediary (QI) program, are well-equipped to recalibrate their reporting systems. Professional advisors who recommend non-commercial trusts in Canadian tax planning are unprepared to advise on the U.S. tax consequences.

³ New complex reporting rules for Passive Foreign Investment Corporations were also introduced.

⁴ Forms 3520 and 3520A are used to report transactions with foreign trusts, such as RESPs, TFSAs and receipts from non-commercial trusts.

⁵ Although structured as Canadian resident trusts, they may be referred to as "U.S. Residential Trusts."

⁶ Is it based on the number of days actually used, as compared to the total number of days in the year? Or is the calculation based on the number of days that the property is actually available to the beneficiary? (i.e. Is a summer home that has no heating considered unavailable in the winter?) It might be considered inappropriate to treat a beneficiary as using the property when the beneficiary is not actually there. On the other hand, if the beneficiary retains his or her furnishings in the property year-round, even if the beneficiary only uses the property in the summer, does this constitute a "use" by the beneficiary of the property year-round?