UK: Labuan, the USA and the UK - New Trust Legislation

Last Updated: 24 October 1996
The Labuan Offshore Trust Bill was tabled in Parliament on 24th July this year. This bill is expected to stimulate trust business by providing a clear understanding of the legal framework of trusts in the Labuan OIFC.

This will allow creation of offshore trusts in Labuan by non-residents of Malaysia. This is part of the drive by Labuan to develop an offshore Islamic financial centre.

The bill contains provisions that trusts for non-residents can have a maximum life span of 100 years. Asset protection trusts will be recognised providing they are not used to defraud creditors.

Trustees will have a duty to report any trusts created from illegal money.

There will be an option by which trusts may be registered; migration of trusts will be permitted as will purpose trusts. Protectors may be appointed. One trustee must be a licensed trust company registered with the Labuan authorities. Apart from this there are no limits to the number of trustees permitted.

United Kingdom

CREST: Trustees should examine their trust deeds
The settlement procedure on the London Stock Exchange based upon paper transactions, known as Talisman, adopted a fortnightly accounting period. This was replaced by a ten-day rolling settlement which was then reduced to a five-day rolling settlement last year in preparation for a paperless electronic system of settlements.

This new system, known as CREST, is to due to take over from the Talisman system in April 1997. This system, which has been described as Certificateless Registrar of Electronic and Share Transfers, will become the normal means of settling stock exchange debts.

Initially only Talisman securities are eligible to take part in CREST. These will be introduced under a phased period of nine months. The system will then be extended to include other securities, such as gilts and unit trusts, not within the previous Talisman system.

To use CREST the investor must become a sponsored member or use a stockbroker's or bank's nominee which has become a member.

As a sponsored member the investor, or trustee, remains as the registered shareholder but not all brokers are offering a sponsored membership service. Using the stockbroker or bank's nominee service appears to be the most suitable and troublefree route to CREST. If a trustee's stockbroker is providing the benefits of this new service little further action is required by the trustee as the broker's nominee company will undertake the process of dematerialisation. Trustees, however, should review the number of certificates held for any one shareholding and consider consolidating them into large blocks ready for the abandonment of the paper-based holding. A cost may be agreed with the registrars companies if a large number of certificates are held. This is frequently done by the trustees' brokers.

Trustees should also scrutinise the trust deed. The older trust deeds may not allow trustees to use computer systems or allow investment decisions to be delegated. The trust deed should grant to the trustees appropriate powers to allow the use of CREST and to be able to appoint nominees.

Trustee Investment Powers

The Government continue to consider the repeal of the Trustee Investment Act 1961 and to replace it by a new piece of legislation aimed at allowing trustees a greater power to invest. The intention will be to improve the return on assets of trust funds.

This proposed revision has been brought about by pressure from trustees for greater freedom to take advantage of new markets and by the abnormally low interest rates on traditional conservative investments.

The intention is to introduce new legislation which will allow a reduction in the cost of making investments and to cut the borrowing.

The consultative paper, issued in May this year, points out that the safeguarding of trust assets will in future rely upon the Financial Services Act measures and provisions relating to trustees' duties found in general trust law. These will be amplified to require the addition to the duty of trustees to show reasonable care that trustees in adopting a greater spread in investment take into account the suitability of the investments for each particular trust. The circumstances vary from trust to trust. Trustees will be required to obtain appropriate investment advice and to act upon it.

United States of America

Overview of Foreign Trust Tax Law Changes under the U.S. Tax Code

Sweeping changes to the United States' 1986 Internal Revenue Code ("hereinafter "Code") were recently signed into law by President Clinton. Among the various enactments is the Small Business Job Protection Act of 1996 (hereinafter "the Act"). Included in the Act are numerous changes that affect the taxation and reporting obligations of foreign trusts. Ignoring the logical question of just what foreign trusts have to do with business, the following major areas of change are highlighted for the reader.

1. Definition of a "Foreign Trust" - The definition of a foreign trust has been changed to any trust, unless "(i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States fiduciaries have the authority to control all substantial decisions of the trust."

This change is effective for tax years beginning after 31st December 1996. However, a trustee of a trust may irrevocably elect to have the change effective for tax years ending after the enactment date of 20th August 1996.

The House Committee Report states
'the Committee expects that part (i) of the new definition generally will be satisfied by any trust instrument that specifies that it is to be governed by the laws of any State.' Further:

The Committee expects that part (ii) of the new definition will be satisfied in any case where fiduciaries that are U.S. persons hold a majority of the fiduciary powers (whether by veto or otherwise), and where no foreign fiduciary, such as a 'trust protector' or other trust advisor, has the power to veto important decisions of the U.S. fiduciaries. The Committee further expects that, in applying this test, a reasonable period of time will be allowed for a trust to replace a US fiduciary that resigns or dies before the trust is treated as foreign'.

If a domestic trust becomes a foreign trust, the Act clarifies that the 35 per cent excise tax of Code Section 1491 applies unless one of the exceptions to its application is otherwise available.

2. Increased Reporting Obligations - The reporting requirements which relate to a foreign trust, and the penalties for non compliance, are increased. Note that for this purpose, a domestic trust with substantial foreign activities or foreign assets shall be treated as a foreign trust.

On or before the 90th day following any "reportable event," the "responsible party" must provide "written notice" of the event to the Service. A "responsible party" includes a grantor of an inter vivos trust, a transferor to a foreign trust (except by reason of death), and the executor of a decedent's estate. A "reportable event" includes the creation of a foreign trust by any US person, any transfer to a foreign trust (whether during life or by reason of death), and the death of a US citizen or resident who was treated as the grantor of a foreign trust under the grantor trust rules or whose gross estate includes the value of any portion of a foreign trust. A "reportable event" does not include either a transfer at fair market value, or a transfer to certain charitable or pension trusts.

The "written notice" must include a description and value of the property transferred, and the identity of the trustee, each trustee and each beneficiary (or class of beneficiaries). The Service is authorised to expand the information which must appear in the written notice.

Concern existed (and likely continues to exist) at the Internal Revenue Service (hereinafter "the Service") over how the secrecy laws of certain offshore financial centres would impact the ability of an individual treated as the grantor of a foreign trust under the grantor trust rules to fully and properly declare income and gain of the foreign grantor trust attributable to the grantor. Accordingly, there is now a requirement that the foreign trust designate is a US person who as agent of the trust is authorised by the foreign trust to accept service of process. The agent must be authorised to act with respect to any request by the Service to examine records or to give testimony concerning the trust. The appearance of the agent or the production of records is not to subject that person or the records to legal process other than in connection with determining the amount of tax due and owing. The agent's activities are not to be imputed to the foreign trust so that the foreign trust would be deemed to be doing business in the US or be deemed to have an office in the US. If no agent is appointed, then the Service may on its own assess a tax to the grantor based on what it determines to be the amount of income taxable to the grantor.

Additionally, under the Act the grantor of a foreign trust is to each year ensure that the trust files a report which, among other items, sets forth an accounting of the foreign trust's financial activities for the year.

Beneficiaries of a foreign trust will also have reporting obligations under the Act. A beneficiary who receives a distribution from a foreign trust, whether directly or indirectly, will be required to report the details thereof to the Service. The Service is expected to take into account information provided by a foreign trust under other reporting requirements.

Failure to properly report transfers to, or distributions from, a foreign trust may result in a penalty equal to 35 per cent of the value of the transferred or distributed property (hereinafter the "gross reportable amount"). This penalty also applies if there is a failure to provide information in connection with transfers subject to the 35 per cent excise tax under Code Section 1491.

Subject to a ceiling equal to the gross reportable amount, an additional penalty of US$10,000.00 shall be imposed for each period of 30 days (or fraction thereof) beginning 90 days after the Service notifies the responsible party of the failure to file. A reasonable cause exception will be available. However, reasonable cause will not include the fact that a foreign jurisdiction may impose civil or criminal penalties on the tax payer or any other person for disclosure.

Failure of the grantor to ensure that the foreign trust each year files the required annual report may result in a penalty equal to 5 per cent of the value of the trust which is considered as owned by the grantor under the grantor trust rules.

The reportable events provisions and the US beneficiary reporting requirements apply to subject events after the enactment date. The grantor trust reporting provision applies to tax years of U.S persons which begin after 31st December 1996.

3. Outbound Foreign Grantor Trusts - These provisions amend Code Section 679 as to all transfers after 6th February 1995. Code Section 679 (a) (1) generally provides that a US person who transfers property to a foreign trust shall be treated as the owner of the transferred property for so long as there is a US beneficiary. An exception applies under Code Section 679(a) (2) (B). Under the Act, this exception has been changed from a transfer in which gains is recognised to a transfer at fair market value. For this purpose, notes or other obligations issued by the trust, the grantor or a beneficiary, or by any person related to the grantor or a beneficiary, are generally not taken into account. Per the House Ways and Means Committee Report, however, any obligation bearing arm's-length terms would qualify for the exception.

A non-resident alien will be deemed to make an outbound transfer if the NRA has a US "residency starting date" within five years after the date of a transfer to a foreign trust. A transfer to a domestic trust will be deemed to be a transfer to a foreign trust if the domestic trust later changes its domicile to a foreign jurisdiction. The transfer will be deemed to have taken place on the date of the change of domicile. If a foreign person who is a beneficiary of a foreign trust becomes a US person more than five years after the date of a transfer to a foreign trust, such person will not be considered a US beneficiary of the foreign trust.

Under the attribution rules, a payment which is either made or accumulated for the benefit of a controlled foreign corporation (hereinafter "CFC") will be deemed to be paid or accumulated for the benefit of a US person.

4. Inbound Foreign Grantor Trusts - Generally, but subject to certain exceptions, the grantor trust rules are now to be applied only when they result in amounts being taken into account in computing the income of a citizen or resident. In other words, the grantor trust rules will not apply if they result in a foreign person being considered the grantor for purposes of the US grantor trust rules. The grantor trust rules will still apply, however, if the grantor is a CFC under US tax law.

The rule that treats a US beneficiary who transfers property to a foreign trust as the grantor of the trust with respect to the property so transferred now applies without regard to whether the foreign grantor is treated as the owner under the US grantor rules. The Conference Committee Report provides that this rule does not apply to a family member who makes such a transfer.

Of the certain exceptions referred to above in this section., the principal exceptions are when the trust is revocable, and when distributions may only be made during the grantor's life time to the grantor or the grantor's spouse.

These provisions are generally effective on the enactment date. The Secretary may prescribe regulation by which taxes imposed on a foreign grantor by a foreign country or US possession are taken into account, and may accordingly allow a credit for foreign taxes actually paid on the income.

5. Foreign nongrantor trust rules - The Act amends the rules relating to foreign nongrantor trusts as well. Commencing on 1st January 1996, the interest rate applicable to accumulation distributions from foreign nongrantor trusts will be the underpayment rate under Internal Revenue Code Section 6621(a)(2), on a compounded basis. Regulations may be issued by the Secretary for purposes of carrying out rules that apply to estates, trusts and beneficiaries, including rules to prevent abusive transactions.
All loans of cash or marketable securities by a foreign nongrantor trust to a US person made after 19th September 1995 will be treated as a distribution to the US person if the US person is the grantor or a beneficiary. This will be the rule even if there is an adequate interest rate charged, and the loan is later repaid. However, under the Committee Reports, Congress intends that a loan that is pursuant to arm's-length terms be excepted from this rule. If a loan is treated as a distribution pursuant to the foregoing, then later payments of interest or principal will be disregarded.

6. Reporting the recipient of a gift or bequest from a foreign source - The Act also imposes a reporting obligation when one receives a gift or bequest from a foreign source of US$10,000 (subject to cost of living adjustment) in any one year, which are received after the effective date of the Act. Failure to comply can result in the recharacterization of the amounts received as income, and a penalty of up to 25 per cent of the amount received.

As the term "foreign gift" means any amount received from a non- US person which the donee is required to treat as a gift or bequest, it is unlikely that the reporting obligation will be imposed on US persons who receive distributions from a foreign trust.

By Barry Engel, Esq
Principal, Engel & Rudman, P.C
President, The Offshore Institute
The Quadrant
5445 DTC Parkway, Suite 1025
Englewood, Colorado 80111
Telephone: +00 303 741 1111
Facsimile +00 303 694 4028

The views expressed in this article are the personal views of the author concerned and should not be taken to be the views or opinion of any other person, firm or company whose name or work appears on this web site and should not without further professional advice form the basis on which any action is taken.

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