Foreign Grantor Trusts, U.S. Situs Assets and 'Check the Box' Planning under the U.S. Tax Reform Act


By Timothy Burns, Wei Zhang and George McCormick, Hong Kong-based Registered Foreign Lawyers at Withers

The recently enacted Tax Cuts and Jobs Act repealed an exemption that may affect the way foreign grantor trusts ('FGTs') hold U.S. situs assets potentially benefitting U.S. (and also possibly non-U.S.) family members.  In view of this change, trustees of FGTs should re-visit their strategies for protecting U.S. situs investments from U.S. estate tax on the eventual passing of the trust's non-U.S. grantor.

Under pre-2018 law, trustees of FGTs generally could use non-U.S. holding companies to provide estate tax protection for U.S. situs assets and then, following the grantor's death, effectively eliminate those holding companies (via so-called 'check the box' elections) within 30 days after the grantor's death without triggering adverse income tax consequences for U.S. trust beneficiaries under the CFC tax provisions.   This is because under pre-2018 law, there would not be CFC tax to U.S. trust beneficiaries on appreciation in the value of holding company assets as long as the check the box election was effective within 30 days after the date of the grantor's death. But the Tax Cuts and Jobs Act repealed this 30-day CFC exemption for tax years beginning after 2017. From now on, a post-death check the box election on a trust's non-U.S. holding company, even effective the day after the death of the grantor, could cause U.S. tax and reporting to U.S. beneficiaries of the trust with respect to the historical appreciation in value of the holding company's assets. 

Trustees of FGTs who are holding U.S. situs assets via non-U.S. holding companies should reconsider whether to and how to hold U.S. situs assets and how to manage those assets from year to year and in anticipation of the grantor's death. Considerations would include weighing U.S. estate tax exposure on underlying U.S. investments versus U.S. income tax exposure on historical U.S. asset portfolio appreciation, as well as practical considerations of implementing new investment strategies and structures for U.S. market exposure.

Traditional FGT Planning

FGT Status

Traditional FGT planning typically involves a non-U.S. person settling a non-U.S. trust for the current or eventual benefit of U.S. (and also possibly non-U.S.) family members. The trust is structured in a manner which generally treats the non-U.S. grantor as the tax owner of trust assets for U.S. purposes, so there generally is no U.S. income tax on non-U.S. source income of the trust. Further benefits accrue to the U.S. beneficiaries after the death of the grantor when the trust also may provide an automatic 'basis step-up' on the grantor's death. Favourable grantor trust and step-up classification is frequently achieved by the grantor having the power to revoke the trust and to receive or direct annual income, but there are a number of other options. Upon the grantor's death, the trust's status automatically converts to so-called 'foreign non-grantor trust' status. 

Estate Tax Position

If the trust directly held U.S. investments, U.S. estate tax generally would apply on the grantor's death at the rate of 40% of the assets' actual value. To eliminate this U.S. estate tax exposure, FGTs often make their U.S. investments via a properly managed and administered non-U.S. holding company. This way, the grantor is generally treated as owning a non-U.S. asset (the holding company) rather than the underlying U.S. investments, meaning that no estate tax should apply on the grantor's death.

Income Tax Exposure from Underlying Investments Following Grantor's Death

Following the grantor's death, when the trust ceases to qualify as a grantor trust, the ongoing existence of the holding company would potentially create tax and information reporting issues for the U.S. beneficiaries of the trust. Generally, under complex CFC 'look-through' rules, U.S. beneficiaries who in the aggregate are deemed to have more than a 50% proportionate interest in the trust or the company could be taxed directly on income and gain in the company.

Check the Box Elections and the CFC 30 Day Rule under Prior Law

Under the tax law that applied prior to 2018, to address the CFC tax issue created by the grantor's death, trustees generally could cause a so-called 'check the box' election to be filed for the holding company effective within 30 days after the grantor's death, triggering a deemed liquidation of the holding company for U.S. tax purposes. Under prior law, this worked well from both an estate and income tax perspective. On the estate tax front, as the liquidation takes effect after the grantor's death, there should not be any U.S. estate tax on the underlying U.S. assets (as the non-U.S. situs holding company is treated as existing as of the time of the grantor's death). This estate tax element of the planning is still preserved under the new law. But on the income tax front, under the prior law, the deemed liquidation within the 30 day time frame did not create any CFC 'subpart F' income for those U.S. beneficiaries. This is because, under prior law, a special rule provided that U.S. shareholders of a CFC (including indirect shareholders through a trust) would not be taxable on CFC subpart F income unless the holding company was classified as a CFC for 30 days or more during the year. 

U.S. Tax Reform Act Impact on the 'Check the Box' Elections Going Forward

The Act eliminates the CFC 30 day exception. Going forward, the check the box election could now create potential CFC subpart F income tax liabilities for the U.S. beneficiaries. This subpart F income would generally be measured by reference to the amount of unrealized appreciation inherent in the investments held by the non-U.S. holding company pro-rated over the company's final year (likely the year of the grantor's death and check the box election). U.S. person beneficiaries of the trust who are considered attributed sufficient ownership of the CFC through the trust would be subject to this CFC subpart F tax and reporting.   

How FGTs Can Plan for U.S. Situs Assets in the Future

FGT trustees that desire exposure to U.S. situs assets must now consider that it will not be quite as easy to minimize estate tax, income tax and complication by simply forming and maintaining a non-U.S. holding company and resolving to check the box on it within 30 days after the grantor's death. Some useful but non-exhaustive ideas and planning considerations are outlined below.

The single company estate tax blocker for U.S. situs assets should continue to be effective against the U.S. estate tax, but if there are substantial U.S. beneficiaries of the trust, one will need to plan for the income tax and reporting on historical appreciation of assets that would eventually be recognized subsequent to the grantor's death. A critical consideration here is an examination of the makeup of the beneficiary class after the grantor's death in order to assess the risk of whether indeed the holding company will have sufficient proportionate U.S. person beneficial ownership to even qualify as a CFC. However, if it is likely to qualify as a CFC, then the trustee should consider strategies to possibly minimize taxable appreciation subsequent to the death of the grantor. For example, selling and purchasing back, or 'churning' assets of the holding company periodically while the trust is still an FGT can have the effect of minimizing eventual taxable gain on a check the box deemed liquidation in the year the company becomes a CFC. In such a case there should be less (if any) CFC tax on asset appreciation that occurred prior to the calendar year of the death of the grantor.

Furthermore, with a more complex multiple tier holding company structure, it should be possible to own U.S. situs assets, maintain the corporate estate tax blocker at the grantor's death, and perform successive check the box elections or liquidations during the calendar year of the grantor's death to minimize post death taxable gain to only that appreciation that occurs between the date of death and the day or two after death that the final check the box election is effective. 

The trustee can also consider achieving U.S. asset exposure via other investment vehicle means. For example, it may be possible to replicate the desired U.S. market exposure by investing in non-U.S. publicly available investment funds that invest in U.S. stock and securities. Such funds structured as corporates for U.S. tax classification purposes, should be considered non-U.S. situs assets not subject to U.S. estate tax, but the fact that they are widely held rather than wholly owned by the FGT should prevent them from qualifying as CFCs. Even though these funds would qualify as passive foreign investment companies (PFICs) after the death of the FGT's grantor, a sale of the fund shortly after the grantor's death should not generate taxable gain to the U.S. beneficiaries beyond appreciation from the date of death to date of the sale, as long as the FGT was drafted with basis step-up language.

A trustee can also obtain U.S. asset exposure without the estate tax exposure by investing in certain types of private placement life insurance policies which invest in the U.S. assets. As the investments in a properly structured and qualifying life insurance contract would be the property of the insurance company, the death proceeds would not be considered a U.S. situs asset subject to U.S. estate tax and the proceeds should not be taxable to trust beneficiaries if properly structured.