International Law – Trust ‘Substitutes’

Take-Away: Foreign trusts frequently have annual FinCEN reporting requirements, which carry stiff penalties for their failure to report. The challenge is to determine when a trust actually exists under the laws of foreign nations, and in particular, civil law jurisdictions.

Background: Civil law countries often do not recognize what we call a  trust. The Hague Conference on Private International Law adopted a Convention on the Law Applicable to Trusts and Their Recognition (the Hague Trust Convention) which provides that a trust should be governed by the law chosen by the settlor as evidenced in the trust instrument. The Hague Trust Convention further provides that its provisions will not prevent the application of some mandatory laws, such as marital rights, succession rights and creditor rights. Consequently, U.S. law may treat an arrangement as a trust which will be respected, even when the word trust is not used to describe the arrangement.

Trust Substitutes: Civil law countries often provide different vehicles to hold property that allow the owners to achieve results similar to holding property through a trust.   If such devices are treated by the IRS as a trust then these foreign asset-holding vehicles may be subject to file annual reports with the Department of Treasury.  However, these foreign alternatives to a trust are often less flexible and generally are of limited duration. A few of the more commonly encountered examples of these international trust  ‘alternatives’ are summarized below.

Anstalt: A Liechtenstein anstalt is a type of incorporated organization that is established when the founder transfers assets to a board of directors, which manages the assets as directed by the articles of incorporation. The anstalt is a  legal entity separate from its founder. Under default Liechtenstein law, the founder reserves the right to amend the articles of incorporation. The anstalt may be treated as a trust or a corporation, depending upon its operations or the purposes for which it is established. Accordingly, the particular facts and circumstances must be scrutinized to determine the anstalt’s classification for United States property and tax reporting purposes.

Stiftung: A stiftung is a civil law device. It is a statutory entity with a separate legal identity from its founder. A stiftung is established to pursue a purpose identified by its founder. Assets are irrevocably transferred to the stifung, which functions often like a foundation, and its assets are managed by a council for that specific purpose. A stiftung can have a charitable or non-charitable purpose. Generally, the IRS will look to the actual purpose of the stiftung, to determine if it should be treated as a trust or business entity.

Usufruct:  A usufruct is a civil law construct which is a limited in rem right that divides property between the usufructary and the ‘bare’ titleholder to the property. The usufructary: (i) possesses the right to use the property for a term of years or a ‘measuring life;’ (ii) has a duty to maintain the property; and (iii) is entitled to the income from the property. The ‘bare owner’ holds legal ownership and may transfer title but may not disturb the usufructary’s interest. Because there is no separate fiduciary, the usufruct generally should be viewed and treated as a life estate under U.S. law. However, in one IRS Private Letter Ruling, a German usufruct was treated as a trust where the usufructary served as the executor for the duration of the usufruct. Again, the particular facts and circumstances will determine the proper classification of a usufruct for U.S. reporting purposes. Note that if the usufruct is treated as a gift of the remainder interest and the gift is by a foreign person (the usufructary) to a U.S. individual, the U.S. individual will need to file an Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts [Form 3520] if the value of the gifts exceeds $100,000. [Private Letter Ruling 201032021.] In addition, if the usufruct is treated as a trust, a Form 3520 and an Annual Information Return with a U.S. Owner of a Foreign Trust [Form 3520-A] will also be required, and possibly a Report of Foreign Bank and Financial Accounts (FinCEN Report 114.)

Fideicomiso:  A Mexican fideicomiso, or trust, is required to be used by non-Mexican nationals in order to acquire and hold land in the ‘restricted zone.’ The ‘restricted zone’ includes 50 kilometers from all Mexican borders. Under the Mexican Constitution, real property that is located within the ‘restricted zone’ that will be used for residential purposes may only be owned by Mexican nationals (through birth or naturalization) and Mexican entities, but such entities cannot be owned by non-Mexican persons. If, however, the real property is used for nonresidential purposes, the property may be owned by a Mexican entity, which in turn may be owned by non-Mexican individuals.  For real property that is located within the ‘restricted zone’ and which is used for residential purposes, title to that property must be held in a fideicomiso. By law, only a Mexican bank or financial institution may serve as trustee of the fideicomiso. Although title to the real property is held in the name of the trustee, the beneficiary retains all of the corresponding rights to use, lease, or sell the rights that are derived from the trust. The Mexican government must grant a special permit to establish this fideicomiso-like trust; the permit is granted for a 50-year renewable term. An individual or legal entity may be the beneficiary under a fideicomiso, including a U.S. individual, U.S. LLC or a U.S. trust. If an entity is not named as the beneficiary, then it is important to identify successor beneficiaries. If a fideicomiso is considered a trust for US tax purposes, a Form 3520 and Form 3520-A must be filed, along with a Statement of Specified Foreign Financial Assets (Form 8938) and possibly a Report of Foreign Bank and Financial Accounts (Form FinCEN Report 114.) In 2013, a fideicomiso was determined by the IRS to not to be a trust,  based upon the terms of the fideicomiso; key to that conclusion was the fact that the trustee did not engage in any activity other than holding title to the land. [Revenue Ruling 2013-14.]

U.S. Reporting- What is a Trust?: With a foreign entity, it is often difficult to determine how the entity will be classified for U.S. tax and reporting purposes. Treasury Regulations provide that the classification of organizations that are recognized as separate entities will be made under Regulation 301.7701-2, 3, and 4, unless a provision of the Tax Code provides for special treatment of that organization. An arrangement will be treated as a trust if it can be demonstrated that the purpose of the arrangement is to vest in trustees the responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of these responsibilities and, therefore, they are not ‘associates in a joint enterprise’ for the conduct of business for profit. If an entity has both associates and a business purpose, it cannot be classified as a trust for federal income tax purposes. [Treasury Regulation 301.7701-1(b) and 301.7701-4(a).] Thus, in general, if an entity exists to carry on a trade or business and has associates, it will be taxed as a business entity. Conversely, if the entity exists in order to hold and invest property, but not to conduct a business and does not have associates, it will be classified as a trust.

Conclusion: FinCEN reporting requirements are sometimes overlooked. Making matters even more confusing is when a foreign trust is involved, especially when the foreign trust is not called a ‘’trust” when it is formed in a civil law country, but it in fact functions like a trust.