pivotal tax legislation. While the income tax legislation and the effect of terminating one's US citizenship have received significant publicity, the more onerous legislation dealing with foreign trusts have been largely ignored.

Interestingly, the penalties for failing to comply with the new foreign trust legislation are more onerous than those dealing with income tax. We will summarise this legislation in this and next month's columns.

Foreign Nongrantor Trusts Under the old law accumulation distributions were subject to a simple six percent non-deductible interest charge. Accumulated income was taxed on a first in/first out basis, and where inadequate records existed, a distribution was deemed to be distributed from the first year the trust was organised. The tax on accumulation distributions was commonly avoided by treating a distribution as a "loan'', thus avoiding income tax.

Congress felt that the six percent interest was too low and that the deemed distribution to the first year of the trust discouraged distributions.

To encourage accumulation distributions, the new law allocates distributions proportionately to prior trust years, interest is compounded at a floating market rate, and the period for which interest is charged is determined as a weighted average. Loans from the foreign trust to a US grantor or a US beneficiary will now be treated as a distribution of income. The new law is retroactive and applies to accumulation distributions made after August 21, 1996 and to loans made after September 19, 1995.

Constructive Distribution Under the old law, the use of trust property or assets by a US grantor or a US beneficiary was ambiguous. It was not uncommon for a trust to own a villa on the Riviera, a luxury car, yachts, or even an apartment on Central Park and to allow the US grantor or US beneficiary to utilise these assets.

Under current US law, the use of corporate assets by a shareholder is deemed to be a constructive distribution. A loan from a Controlled Foreign Corporation to a US person is treated as a deemed distribution. But current law did not tax a US person on the use of trust assets. While Congress discussed treating the use of trust assets as taxable income to a US person, no action was taken on this perceived inequity.

Inbound Foreign Grantor Trusts Under the old law, a person with certain powers over the trust assets (the "grantor'') was taxed as if he owned the trust assets directly. Hence, where a foreign person was treated as the trust's owner, trust income distributed to a US beneficiary was not subject to US income tax.

Congress felt that the old law allowed foreign persons to affirmatively use the US domestic anti-abuse laws, and to avoid US income tax through the use of a foreign grantor trust. It had been common practice for a foreign person to set up a trust in a tax neutral jurisdiction (thus avoiding income tax in their country of residence), and then distributing the trust income to a US person. The US person would not have to pay income tax on this income and the principal was not included in their estate.

Under the new law, a foreign grantor is not treated as the owner of the trust (with some exceptions), and the US beneficiary is now subject to tax on the trust income. A foreign tax credit may be taken by the US beneficiary if the foreign grantor paid income tax on the trust income. Distributions from a foreign trust to a US beneficiary through a nominee will be disregarded and the distributions will be treated as if they were received directly from the foreign trust. Trustees of Bermuda trusts with US beneficiaries will be required to account for income before and after August 21, 1996, the effective date of this law.

Sale To a Foreign Trusts Under the old law, the sale of property by a US person to a foreign trust at fair market value was not considered to be a transfer of property, thus avoiding the 35 percent excise tax on the transfer of appreciated property to a foreign trust.

Congress felt that this exception was the subject of abuse (some call it sophisticated planning) by US persons who sold the property at fair market value to a foreign trust, but received a note in exchange that they will never collect. Under the new law, notes received by a US person from the sale of property to a foreign trust will be ignored (with a few exceptions) and the sale subject to tax in the year of transfer. The new law applies retroactive to assets transferred after February 6, 1995.

James Paul Sabo is the President of Expatriate Tax Services, PO Box 617, Bernardsville, NJ and is associated with GulfStream Financial Ltd. in Bermuda.

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