Definition of Foreign Trust
A trust is a “foreign trust” unless both of the following conditions are met: (1) a court within the United States must be able to exercise primary supervision over the administration of the trust (the “Court Test”), and (2) one or more United States persons must have the authority to control all substantial decisions of the trust (the “Control Test”). IRC § 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(1).
The Court Test
A trust can fulfill the Court Test by complying with a safe harbor. Treas. Reg. § 301.7701-7(1)(c). Specifically, the Court Test will be satisfied if: (i) the trust instrument does not direct that the trust be administered outside of the United States [(the trust may simply remain silent on the issue, see Treas. Reg. §301.7701- 7(1)(c)(2), Example A)]; (ii) the trust is in fact administered in the United States; and (iii) the trust is not subject to an automatic migration provision [(i.e.—there is no clause requiring the trust to automatically migrate from the United States if any U.S. court attempts to assert jurisdiction or otherwise supervise administration directly or indirectly, see Treas.Reg. § 301.7701-7(1)(c)(4)(ii))].
The Control Test
The Control Test is met where one or more United States persons has or have the authority to control all substantial decisions of the trust. Treas. Reg. § 301.7701-7(a)(ii). A “United States person” includes a citizen or resident of the United States, a domestic partnership, a domestic corporation, an estate that is not foreign, and a trust that is not foreign. IRC§ 7701(a)(30). “Control” means “having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions.” Treas. Reg. § 301.7701-7(d)(iii). Hence, if a decision by multiple trustees must be unanimous, no co-trustee may be a non-United States person. If a decision may be made by majority, then a majority must be United States persons. No non-United States co-trustee may have veto power. See Treas. Reg. § 301.7701-7(d)(v). A “substantial decision” is one that is not merely ministerial (such as bookkeeping, collection of rents, and execution of investment decisions), which includes, but is not limited to: whether and when to distribute income or corpus; the amount of any distributions; whether a receipt is allocable to income or principal; whether to compromise, arbitrate, or abandon claims of the trust; and investment decisions. See Treas. Reg.301.77-1-7(d)(ii).
Consequences of Foreign Trust Status
A domestic trust that becomes a foreign trust is treated as having made a transfer of its assets to a foreign trust. SeeIRC 684(c). This, in turn, would cause a capital gains tax recognition event. Though there is an exception for any grantor trust, see IRC §684(b), this exception would cease to exist—such as for an Irrevocable Pure Grantor Trust (“iPug™”)—after the death of the grantor(s), once any subtrusts created thereunder come into existence. Another potential downside to foreign trust status involves the additional reporting requirements to which they are subject. See IRC § 6084. Any failure to comply with these reporting requirements can lead to significant penalties. See IRC § 6677.
Conclusion
If a trust fails to meet either the “Court Test” (i.e.—it is not subject to the jurisdiction of a U.S. Court) or the “Control Test” (i.e.—a non-U.S. person has the authority to control all substantial decisions of the trust), then it is a foreign trust. A foreign trust suffers from less favorable tax treatment than a domestic trust, including but not limited to earlier recognition of capital gains, additional reporting requirements, and additional penalties for non-compliance.
