STEP Submission to HM Treasury and HMRC regarding FATCA and the implications for UK resident trusts

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1 STEP Submission to HM Treasury and HMRC regarding FATCA and the implications for UK resident trusts 1. Introduction UK tax legislation in relation to trusts is complex. We understand why the US authorities wish to prevent tax evasion by US citizens, but UK resident trusts do not pose a tax avoidance risk. This paper is written on the basis that the UK and the US will enter into an intergovernmental agreement on the lines of the joint statement issued on 8 February 2012, pursuant to which FFIs established in the UK: (i) (ii) (iii) (v) will not be subject to withholding under FATCA; will not be required to enter into separate FFI Agreements with the IRS provided that they are registered with the IRS or excepted from doing so; will not be required to withhold on passthru payments to other FFIs organized in the UK; and will not be required to close the accounts of recalcitrant accountholders. We note that the joint statement indicates that the intergovernmental agreement may identify specific categories of FFIs established in the UK that would be treated as deemed compliant or as presenting a low risk of tax evasion. As indicated above, UK resident trusts do not represent a tax risk to the US. Our comments in this paper are restricted to UK resident family trusts.

2 2. Recommendations 2.1 The intergovernmental agreement should make it clear that UK resident trusts are to be treated as NFFEs and not FFIs. 2.2 There should be no requirement for trustees of UK resident trusts to register with or enter into an agreement with the IRS as long as they provide the required information to HMRC. 2.3 The intergovernmental agreement should explain in clear language the rules for trustees. The US legislation is so complex that most UK resident trustees and UK advisers cannot establish what the obligations under it are and this will lead to noncompliance unless addressed. 2.4 The proposed approach in the regulations for deciding whether a trust is substantially US owned could be adopted but should be set out in the intergovernmental agreement. 2.5 Trustees of UK-resident trusts should not be required to identify whether the trust is a grantor trust for US purposes. 2.6 As part of their UK tax compliance trustees of UK-resident trusts should disclose to HMRC whether the settlor is a US person and whether any beneficiary who has received a distribution in the prior UK tax year is a US person. 2.7 It needs to be clear what the status of estates in administration and personal representatives is. As part of their UK tax compliance, personal representatives could disclose whether the deceased was a US person and whether a legatee/residuary beneficiary to whom a distribution has been made is a US person or not. 2.8 The obligation on the trustees should be to ask the settlor or recipient beneficiary whether he/she is a US person. Further investigation should not be required unless the answer given is inconsistent with other information known to the trustees.

3 2.9 HMRC will be in a position to pass details of any disclosed US settlor or beneficiary to the IRS On the basis that the above information is being supplied, FFIs will not need to report or otherwise concern themselves with UK resident trusts The US authorities will be given information on a UK fiscal year basis. This will save both UK resident trusts and HMRC the need to invest in new systems to collect data on a calendar year basis We suggest that there should be a specific exemption for UK resident charitable trusts. 3. Details of the different types of trust used 3.1 This paper is concerned with UK resident family trusts. A family trust is one where the beneficiaries are members of the settlor s family, usually his children and remoter issue, and sometimes including the settlor himself. 3.2 There are two main types of trust namely: The fixed interest family trust. Here a beneficiary is entitled to the trust income as of right for his life or for some shorter period. At the end of the fixed interest period, the capital either passes to one or more beneficiaries absolutely or is held on further trusts The discretionary trust, where the trustees have discretion as to whether to distribute income and, if so, to which beneficiaries These two types of trust are not mutually exclusive, in that a fixed-interest trust can become discretionary on termination of the fixed interest. So too a fixed interest can be appointed under a discretionary trust. 3.3 The general rule is that a trust is UK resident for tax purposes if one or more of the trustees is UK resident. But if the settlor was neither resident nor domiciled in the

4 3.4 UK when he made the settlement the trust is only UK resident if all the trustees are UK resident. 3.5 In general, a UK resident trust is subject to: Income tax on trust income. The normal rate is currently 50% but will be 45% from 6 April Capital gains tax ( CGT ) on realised capital gains at the rate of 28% Inheritance Tax ( IHT ) at 6% of the value of the trust capital every 10 years. 3.6 These general rules are subject to exceptions of which the following four are the most significant: If the settlor is an actual or potential beneficiary the trust income and assets are taxed for income tax and IHT purposes as if they were his. The trustees do however have compliance obligations and trust capital gains are taxed as theirs The income of a fixed-interest trust is taxed as that of the beneficiary. But the trustee remains accountable for basic-rate tax Where the settlor was non-uk domiciled the foreign situs assets of the trust are not subject to IHT The assets in certain fixed-interest trusts are treated for IHT purposes as belonging to the income beneficiary. But the trustee is still accountable for any IHT due. 3.7 Discharging the above obligations means the trustees of UK resident trusts have regular and ongoing contact with HMRC, including the filing of annual tax returns.

5 3.8 Tax, both UK and foreign, is also of concern to trustees when making distributions as they have a common-law duty to understand what the tax implications of a distribution are. This extends to foreign as well as UK tax. 3.9 Trusts of the kind discussed above must be distinguished from bare trusts, which are simply situations where the trustee holds property as nominee for another person. Here the bare trustee or nominee is ignored for tax purposes Family trusts must also be distinguished from charitable trusts and trusts used in business. An example of the latter is employee benefit trusts. There should be a specific exemption for UK resident charitable trusts Perhaps the most frequently encountered form of family trust occurs where the first of a married couple to die leaves his or her assets to the surviving spouse for life with a gift over to the children. This is a fixed-interest trust, the spouse being entitled to the income for his/her life and the capital going to the children absolutely on his/her death The trustees of many if not most family trusts are family, not professional. This is particularly true of the surviving spouse trusts just described. 4. Differences between US and UK trusts There are indubitably differences between US and UK trusts, both in use and in terminology. It would therefore be quite wrong to apply US concepts to a UK context. As STEP UK we are not in a position to comment comprehensively on these differences. We would be happy, however, to convene a meeting with US colleagues where an attempt could be made to tease out the differences. Some of the more obvious differences are brought out in the next section of this paper.

6 5. Comments from a UK perspective on some of the provisions in the draft regulation For UK trustees and their UK advisers the regulation is very difficult to follow and understand, not least because it requires a knowledge of the provisions of the US tax code and other regulations. In this section the extracts from the draft regulation and other US provisions are set out in bold (b) Definitions (b) (11) Complex trust. A complex trust is a trust that is not a simple trust or a grantor trust. For UK tax purposes the fact that a settlement is settlor-interested does not affect the type of trust that it is although it does affect who is taxable on the income of the trust (see above). We understand that for US tax purposes, the distributable net income of a foreign non-grantor trust includes capital gains as well as income which is not the case with a UK resident trust where capital gains are generally subject to capital gains tax and then form part of trust capital which can only be distributed to capital beneficiaries. The way in which trust income is calculated is therefore different. The intergovernmental agreement needs to deal with the differences in the way which trusts are taxed in setting out the reporting requirements (b) (17) Entity. The term entity means any person other than an individual. As a matter of general law, a trust is not a person. The trustees are treated for UK income and capital gains tax purposes as is there were a single person distinct from the persons who are trustees from time to time.

7 (b) (23) FFI The term FFI or foreign financial institution has the meaning set forth in (d). See below (b) (28) Flow-through entity. The term flow-through entity means a partnership, simple trust, or grantor trust, as determined under U.S. tax principles For UK tax purposes an interest in possession trust is not a flow-through entity as the life tenant is entitled to the income net of income expenses and is not entitled to the gains. The trustees are assessable to basic rate tax (b) (31) Grantor trust. A grantor trust is a trust with respect to which one or more persons are treated as owners of all or a portion of the trust under sections 671 through 679. If only a portion of the trust is treated as owned by a person, that portion is a grantor trust with respect to that person. Briefly our understanding is that IRC sections (which relate to US income tax) provide that If a US grantor makes a gratuitous transfer to a trust and retains/has at least one of the following grantor powers, the trust will be classified as a grantor trust: reversionary interest in grantor or spouse power to control beneficial enjoyment administrative powers power to revoke income and/or capital gains may be paid to grantor non-grantor beneficiary with general power of appointment.

8 Also if a US Person makes a gratuitous transfer to a foreign trust that has US beneficiaries, the US transferor will be treated as the grantor of the portion of the trust attributable to the property transferred. If a non-us person transfers property to a trust such a person will not be considered to be the owner of the trust but there are two exceptions: A revocable trust if the grantor has the power to revest the trust s assets in himself either alone or with the consent of a related or subordinate party who is subservient to the grantor. An irrevocable trust if, during the lifetime of the grantor, income or capital may be distributed only to the grantor or the grantor s spouse. In many cases, when examined from a UK perspective, grantor trusts are not classified as trusts at all but as bare trust or nominee arrangements. The complexity of the US rules means that it will not be possible for UK resident trustees to decide whether a trust is a grantor trust for US purposes without seeking US legal advice. This will impose an unacceptable burden and cost on trustees particularly where there were no US advisers involved when the settlement was established. For UK income tax purposes a settlement is settlor-interested if (under section 625(1) ITTOIA 2005) there are any circumstances in which the property or any related property (a) (b) (c) is payable to the settlor or the settlor's spouse or civil partner, is applicable for the benefit of the settlor or the settlor's spouse [ or civil partner], or will, or may, become so payable or applicable.

9 As will be apparent this is not the same test as those which apply in determining whether a trust is a grantor trust (b) (36) NFFE. The term NFFE or non-financial foreign entity means a foreign entity that is not a financial institution, including a territory NFFE (b) (46) Person. The term person has the meaning set forth in section 7701(a) (1) and the regulations thereunder. The term person does not include a wholly owned entity that is disregarded for federal tax purposes as an entity separate from its owner. Notwithstanding the previous sentence, the term person includes, with respect to a withholdable payment, a foreign branch of a U.S. person that furnishes an intermediary withholding certificate indicating that it is a QI IRC Section 7701(a) (1) provides that The term person shall be construed to mean and include an individual, a trust, estate, partnership, association, company or corporation (b) (54) Simple trust. The term simple trust means a trust that meets the requirements of section 651(a) (1) and (2). Section 651 provides that the trust is required to distribute all income annually and does not distribute capital or make charitable contributions. In English law a bare trust or nomineeship can be described as a simple trust 1. This is a trust where a bare trustee holds property in trust for a single beneficiary who is absolutely and indefeasibly entitled. However, the type of trust envisaged by IRC section 651 is not a bare trust but is similar to an interest in possession settlement for UK purposes, in that the income must be paid as of right to the life tenant. However, for UK purposes the trustees of an interest in possession trust may have a separate power to pay or apply capital (either under an express provision in the 1 Para1-21 Lewin on Trusts 18 th Edition

10 trust deed or section 32 Trustee Act 1925) to or for the benefit of the life tenant or some other beneficiary. It is understood that for some US tax purposes trust gains may be treated in the same way as income. For UK tax purposes capital gains realised on the disposal of assets from part of capital. 5.9 FFI definition (d). (d) Definition of FFI. The term FFI means any financial institution (as defined in paragraph (e) of this section) that is a foreign entity. A territory financial institution is not an FFI under this paragraph (d). (e) Definition of a financial institution (1) In general. Except as otherwise provided in paragraph (e) (5), the term financial institution means any entity that (i) Accepts deposits in the ordinary course of a banking or similar business (as defined in paragraph (e) (2) of this section); (ii) Holds, as a substantial portion of its business (as defined in paragraph (e) (3) of this section), financial assets for the account of others; (iii) Is engaged (or holding itself out as being engaged) primarily (as defined in paragraph (e)(4) of this section) in the business of investing, reinvesting, or trading in securities (as defined in section 475(c)(2) without regard to the last sentence thereof), partnership interests, commodities (as defined in section 475(e)(2)), notional principal contracts (as defined in (c)), insurance or annuity contracts, or any interest (including a futures or forward contract or option) in such security, partnership interest, commodity, notional principal contract, insurance contract, or annuity contract; or

11 (iv) Is an insurance company (or the holding company of an insurance company) that issues or is obligated to make payments with respect to a financial account under paragraph (b) (1) of this section. (2) Banking or similar business (i) In general. An entity is considered to be engaged in a banking or similar business if, in the ordinary course of its business with customers, the entity engages in one or more of the following activities (A) Accepts deposits of funds; (B) Makes personal, mortgage, industrial, or other loans; (C) Purchases, sells, discounts, or negotiates accounts receivable, installment obligations, notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness; (D) Issues letters of credit and negotiates drafts drawn thereunder; (E) Provides trust or fiduciary services; (F) Finances foreign exchange transactions; (G) Enters into, purchases, or disposes of finance leases or leased assets; or (H) Provides charge and credit card services. (ii) Application of section 581. Entities engaged in a banking or similar business include, but are not limited to, entities that would

12 qualify as banks under section 585(a)(2) (including banks as defined in section 581 and any corporation to which section 581 would apply except for the fact that it is a foreign corporation). (iii) Effect of local regulation. Whether an entity is subject to the banking and credit laws of a foreign country, the United States, a State, a possession of the United States, or a subdivision thereof, or is subject to supervision and examination by agencies having regulatory oversight of banking or similar institutions, is relevant to but not necessarily determinative of whether that entity qualifies as a financial institution under section 1471(d)(5)(A). Whether an entity conducts a banking or similar business is determined based upon the character of the actual activities of such entity. (3) Holding financial assets as a substantial portion of its business--(i) Substantial portion. An entity holds financial assets for the account of others as a substantial portion of its business if the entity s gross income attributable to the holding of financial assets and related financial services equals or exceeds 20 percent of the entity s gross income during the shorter of (A) The three-year period ending on December 31 of the year in which the determination is made; or (B) The period during which the entity has been in existence. (ii) Effect of local regulation. Whether an entity is subject to the banking and credit, broker-dealer, fiduciary or other similar laws and regulations of the United States, a State, a possession of the United States, a political subdivision thereof, or a foreign country, or to supervision and examination by agencies having regulatory oversight of

13 banking or other financial institutions, is relevant to but not necessarily determinative of whether that entity holds financial assets for the account of others as a substantial portion of its business. (4) In the business of investing, reinvesting, and trading. An entity is engaged primarily in the business of investing, reinvesting, or trading if the entity s gross income attributable to such activities equals or exceeds 50 percent of the entity s gross income during the shorter of (A) The three-year period ending on December 31 of the year in which the determination is made, or (B) The period during which the entity has been in existence. (5) Exclusions. Entities described in any of paragraphs (e)(5)(i) through (v) of this section are excluded from the definition of a financial institution under paragraph (e)(1) of this section and are excepted NFFEs under (c)(1)(v). We do not feel that merely providing trust and fiduciary services without more should cause a corporate trustee to be treated as being engaged in a banking business. Trustees, (if professional or corporate) may be charging fees in relation to their own business of acting as trustees, but generally when acting in their role as trustees of a specific trust they do not carry on a business. Whilst they may as trustees of a given trust hold financial assets as part of the trust portfolio of investments in accordance with the terms of trust for the benefit of the beneficiaries, our view is that this does not constitute a business. For UK purposes trustees of UK resident private trusts holding investments in order to generate income or capital returns for the benefit of the beneficiaries are not

14 taxed as if they were undertaking a trade. The income from such investments is taxable as investment income in the hands of the trustees rather than business income and gains are subject to capital gains tax. Most trustees hold financial assets through asset managers or nominees. Trustees are not in the business of investing or reinvesting and trading. In the UK trust cash is mostly deposited in banks and securities (other than some private company shares or the shares of wholly owned underlying companies) are held through nominees or asset managers. Most trustees holding a portfolio of shares, securities and other investments delegate the investment management function to an investment manager or adviser. In addition, for UK tax purposes any gain generated when investments are realised in the process of investing, reinvesting or trading is not generally treated as income for UK tax purposes. The trustees will be liable to capital gains tax on any such gains and the proceeds of the disposal then form part of the capital of the trust. It is not clear how the requirements as to gross income in (3) and (4) above would operate in the context of UK resident trusts IRC 1473(2) SUBSTANTIAL UNITED STATES OWNER. (A) IN GENERAL. The term substantial United States owner means (i) with respect to any corporation, any specified United States person which owns, directly or indirectly, more than 10 percent of the stock of such corporation (by vote or value), (ii) with respect to any partnership, any specified United States person which owns, directly or indirectly, more than 10 percent of the profits interests or capital interests in such partnership, and (iii) in the case of a trust

15 (I) any specified United States person treated as an owner of any portion of such trust under subpart E of part I of subchapter J of chapter 1, and (II) to the extent provided by the Secretary in regulations or other guidance, any specified United States person which holds, directly or indirectly, more than 10 percent of the beneficial interests of such trust. (B) SPECIAL RULE FOR INVESTMENT VEHICLES. In the case of any financial institution described in section 1471(d)(5)(C), clauses (i), (ii), and (iii) of subparagraph (A) shall be applied by substituting 0 percent for 10 percent. One additional problem with their being considered to be FFIs by reason of section 1471(d)(5)(C) (entities engaged primarily in the business of investing, reinvesting or trading in securities ) is that the 10% US ownership threshold will not apply and it appears that the trustees of a trust which does not have a US grantor would have to provides details of every potential beneficiary who is a US person whether or not they have ever received a benefit. This is excessive particularly in the context of UK resident discretionary trusts. 6. Classification as FFIs 6.1 Trust companies as FFIs It is not clear to us whether a trust company which acts as trustee of one or more settlements would be a financial institution. Most trust companies provide primarily trustee and fiduciary services and generate most of their income from the fees for those services. Generally custodial and asset management services are delegated to third parties although the trustees need to carry out their duties with regard to oversight of investment performance. In any case, we do not feel that the trust company should be an FFI solely on the basis that banking is defined as including entities which in the ordinary course of their business provide trust or

16 fiduciary services, if it does not qualify under any of the other requirements. The intergovernmental agreement should set out in clear terms whether UK resident trust companies are FFIs. 6.2 Individual trustees as FFIs It is clear that individuals who are acting as trustees cannot be FFIs in relation to acting in that capacity as they are not entities ( (b) (17)). 6.3 Trusts as FFIs It is not clear whether trusts themselves will be FFIs, and in our opinion, it should be made clear in the intergovernmental agreement that UK resident trusts are not to be treated as FFIs. Trustees do not generally (i) accept deposits in the ordinary course of a banking or similar business, (ii) hold, as a substantial portion, of its business financial assets for the account of others; and (iii) are not engaged (or hold themselves out as being engaged) primarily in the business of investing, reinvesting, or trading in securities. UK resident trusts are taxable in the UK and the trustees have UK compliance obligations and trust income suffers tax at UK rates. We therefore feel that they are low risk in this context. Most UK resident trusts do not have US beneficiaries/grantors but even where this is the case they will still be subject to the onerous FFI reporting requirements and when faced with this prospect, they are likely to choose simply not to invest in the US. 6.4 Trusts as NFFEs We consider that UK resident trusts should be treated as NFFEs any therefore either have to report information to the relevant FFI through which trust assets are held or directly to HMRC in the annual trust tax return (and therefore on a UK fiscal

17 year basis) in accordance with the provisions of the intergovernmental agreement rather than the US legislation. This would allow the requirements to be set out in UK terms which UK resident trustees could readily access and understand. We feel that this would reduce the risks of inadvertent non-compliance. It would need to be made clear the extent to which trustees (and in particular lay trustees) have to make enquiries in relation to the US status of the settlor or any particular beneficiary to whom a payment is made. Submitted by STEP UK Technical Committee on 11 May 2012