CONSEQUENCES OF THE FNGT BEING A NON-RESIDENT ALIEN

 

If the FNGT qualifies as a non-resident alien, it’s gains derived from the disposition of foreign-source assets, current income generated from foreign sources, U.S. portfolio income, and U.S. capital gains can all be earned free from U.S. taxation under the FNGT structure.

FNGTs are not subject to tax on income from foreign sources not effectively connected with a U.S. business, but are taxed on income (not distributed or required to be distributed) (1) from U.S. sources, or (2) effectively connected with a U.S. trade or business.²⁷

1. U.S. Activities. The FNGT will be taxed on it's U.S. source income, which includes income from all sources worldwide which is effectively connected with the conduct of a U.S. trade or business,²⁸ and this is particularly the case if the FNGT has an office or other fixed place of business in the U.S. during the tax year.²⁹

Note that:

a. If the FNGT trades in stocks and securities for its own account through a U.S. resident broker, commission agent, custodian or other independent agent, the FNGT is not considered as engaging in or conducting a "trade or business within the U.S.".³⁰ This rule does not apply if at any time during the year the FNGT has an office or other fixed place of business in the U.S. through which or by the direction of which the various stocks and shares transaction are effected.³¹ The volume of the transaction during the tax year is not taken into account in determining whether the FNGT is engaged in a trade or business within the U.S.

b. If the FNGT is engaged in a U.S. trade or business, then the Beneficiaries are also to be treated as carrying on such trade or business within the U.S.³²

c. If the FNGT does not engage in a U.S. trade or business, but does have U.S. source FDAP Income, then such FDAP Income will be subject to thirty per cent (30%) withholding (or lower applicable treaty rate).

d. Deductions are allowed from the gross income which is subject to U.S. taxation, but such deductions are only allowed to the extent that they are effectively connected with a trade or business within the U.S.³³

The advantage of having the FNGT (which has no present U.S, Beneficiaries) own shares of a foreign corporation is that the foreign corporation is not a CFC, a PFIC", or a FPHC during the lifetimes of the Settlor and spouse. Therefore the profits of the foreign corporation from its non-U.S. activities are not taxable to the U.S. Settlor or future beneficiaries. When the FNGT acquires a U.S. Beneficiary the ownership of the corporation’s shares will be attributable to those U.S. Beneficiaries in proportion to their actuarial interests in the FNGT, and the foreign corporation could become a CFC, PFIC, FIC, or FPHC for U.S. tax purposes.³⁴ If this happens future tax savings could be lost.

2. Income and Capital Gains Tax. See page 2, footnotes 4-8, above.

3. Portfolio Interest. Portfolio interest is not subject to the 30% tax that applies to other U.S. source interest income received by NRAs.³⁵ The exemption for portfolio interest applies only to the tax that otherwise would apply under IRC §§871(a)(1)(A) or (C), 881(a)(1), or (a)(3). Those sections tax only income that is not effectively connected with a U.S. trade or business. If the portfolio income is effectively connected with a U.S. trade or business, it remains subject to U.S. tax.

a. Interest on Unregistered Obligations.³⁶ Portfolio interest includes interest on unregistered (bearer) obligations issued after July 18, 1984, that meet the requirements of IRC §163(f)(2)(B).³⁷ An obligation meets those requirements if:

i. it is sold under procedures reasonably designed to prevent sale or resale to U.S. persons;³⁸

ii. interest on the obligation is payable only outside the U.S. or its possessions;³⁹ and

iii. the obligation states on its face that any U.S. person who holds it will be subject to limitations under U.S. tax laws.⁴⁰

b. Interest on registered obligations.⁴¹ Portfolio interest includes interest paid on registered obligations issued after July 18, 1984, if the U.S. person (including a foreign paying agent of an issuer who is a U.S. person) who would otherwise be required to deduct and withhold tax from the interest receives a statement from the beneficial owner of the obligation or from a securities clearing organization, a bank, or other financial institution that holds customer securities in the ordinary course of its trade or business that the beneficial owner of the obligation is not a U.S. person.⁴² However, a statement won't satisfy the requirement if at least one month before payment IRS has published a determination that a statement from such a person isn't acceptable.⁴³

4. Estate Tax. If the U.S. Settlor has retained any power to replace the Trustees, that power may bring the trust assets back into the estate of the U.S. Settlor, See Estate of Beckwith v. Commissioner.⁴⁴

5. Taxation of U.S. Beneficiaries. During the lifetime of the U.S. Settlor(s) and of any spouse(s), no part of the income or corpus of the FNGT may be paid or accumulated to or for the benefit of a "U.S. person".⁴⁵ This requirement must be clearly stated in the FNGT, and must be strictly complied with.

It is absolutely critical to avoid running afoul of this rule, as it will cause IRC §679(b) to apply with the result that probably: (i) All of the income of the FNGT will be subject to U.S. taxation not only for the tax year in question, but for all previous years since the creation of the FNGT; and (ii) An interest charge for any deferral in distributions will be payable.46 In some cases the tax and interest can be near confiscatory.

All distributable net income ("DNI") of the FNGT after it acquires a U.S. Beneficiary should be distributed currently to avoid the interest charge. If the DNI is accumulated, then the interest charge period is calculated over the period during which accumulation of the DNI occurred (excepting the year in which the distribution is made), with an adjustment. The formula is complex.47

The FNGT will most likely own shares in a foreign corporation. When the FNGT acquires a U.S. Beneficiary the ownership of such shares will be attributable to that U.S. Beneficiaries. At that point it will be necessary to determine whether such foreign corporation is (i) A Controlled Foreign Corporation ("CFC"), resulting in inclusion in the U.S. income of the U.S. Beneficiary of his or her ratable share of the earnings and profits of the CFC, whether or not distributed;48, (ii) A Foreign Personal Holding Company ("FPHC") resulting in constructive dividend treatment of the ratable share of the U.S. Beneficiary of undistributed personal holding company income;49, (iii) A personal holding company ("PHC") which will result in a tax of fifty per cent (50%) on the ratable share of the U.S. Beneficiary of the undistributed PHC income of the PHC;50 or (iv) A Foreign Investment Company “FIC”51 or a Passive Foreign Investment Company (“PFIC”).52 In the case of an FIC or PFIC it is even more difficult to determine the ownership and characterization of stock of such corporations.

The FNGT is a discretionary trust. The trustees can decide who amongst the beneficiaries is to receive principal or income or both from the FNGT. It is difficult for the ratable share of a beneficiary (or even the actuarial share) to be calculated. This means that when the FNGT acquires U.S. Beneficiaries, their interests may be such that no foreign corporation owned by the FNGT meets with the above requirements. However, this inability to establish an actuarial interest is a critical issue.

 

  

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