2024 Year-End Estate Planning: International Developments

It has been back to business as usual for the Internal Revenue Service (IRS) and Department of the Treasury in 2024. US tax authorities are not shaking up the international private client landscape, but instead are providing useful guidance for taxpayers and tax professionals by releasing long-awaited proposed regulations on the reporting of foreign trusts and foreign gifts and publishing a memorandum detailing certain abusive foreign micro-captive insurance arrangements that are likely to come under more scrutiny. The Supreme Court has taken a similar tack in providing a narrow ruling in a case that many opined could lay the foundations for a net-wealth tax in the United States. We have included a summary of these and other material developments from 2024 that will affect the international private client landscape going forward.

Proposed Foreign Trust and Foreign Gift Regulations

In May 2024, the IRS released proposed regulations covering the reporting of foreign gifts and interactions with foreign trusts. These long-awaited regulations provided guidance in respect of both Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. In addition to the guidance normally accompanying regulations on IRS forms (e.g., filing deadlines, procedures for requesting an extension, rules for dual-resident taxpayers and married couples), the proposed regulations also set forth new ideas regarding the taxation of loans from foreign trusts, uncompensated use of trust property and their related reporting which in some cases differs from current reporting requirements.

Under Section 643(i) of the Code, both (i) a loan from a foreign trust to a US person grantor or beneficiary or a US person related party to that US person grantor or beneficiary, and (ii) uncompensated use of trust property by a US person beneficiary or US person related party to that US beneficiary are treated as distributions to that US person grantor or beneficiary equal to the amount loaned or the fair market value of the uncompensated use of trust property. The proposed regulations changed the treatment of loans from a foreign trust by providing a carve-out for certain qualified obligations and changed the treatment of uncompensated use of trust property by attributing uncompensated use of trust property by a non-US person related to a US person grantor or beneficiary to such US person grantor or beneficiary.

Regarding the carve-out for loans from foreign trusts, the proposed regulations provide an exception to the general rule of Section 643(i) of the Code for loans of cash in exchange for a qualified obligation. A loan of cash (not marketable securities or other property) may be in exchange for a qualified obligation if it meets the following requirements: (i) the obligation is in writing; (ii) the term does not exceed five years; (iii) payments are made in cash in US dollars; (iv) the obligation is issued at par and provide for stated interest at a fixed rate or qualified floating rate; (v) the yield to maturity is not less than 100 percent nor greater than 130 percent of the AFR based on the same compounding period (with corresponding rules for qualified floating rates); and (vi) all stated interest must be qualified stated interest.

In addition to the above, for the initial year of the qualified obligation and each subsequent year in which the obligation is outstanding, the US grantor or beneficiary that received or is attributed the loan must (i) agree to extend the period for assessment in respect of the loan; (ii) report the status of the obligation including outstanding principal and interest payments; and (iii) must make all payments of principal and interest in accordance with the terms of the obligation. A reasonable grace period of no more than 30 days may be allowed for late payments. If any of the above requirements are not met, including following modifications to the qualified obligation, the outstanding principal plus any accrued but unpaid interest is treated as distributed to the US person grantor or beneficiary on the date the obligation ceases to be qualified.

Regarding the expansion of uncompensated use of trust property to include use by non-US persons related to a US grantor or beneficiary, the proposed regulations intend to treat such use by a non-US person related party (excluding a non-US person beneficiary) as a distribution to the related US person grantor or beneficiary unless certain filing requirements are met. If the non-US person-related party was related to more than one US person grantor or beneficiary, the distribution would be split equally amongst all related US persons. The IRS provides an exception to this treatment for US taxpayers that meet their normal reporting requirements in respect of such use but also includes an explanatory statement detailing how the non-US person-related party would have used the trust property without regard to the US person grantor or beneficiary's relationship to the foreign trust. The proposed regulations also include a similar rule and exception for US person grantors or beneficiaries that receive a loan from a related party of a foreign trust and provide an explanatory statement showing how the loan may have been made absent their relationship with the foreign trust.

In addition to the explanatory statements discussed above, deemed distribution treatment under Section 643(i) of the Code for use of trust property can be avoided if the foreign trust is paid fair market value for the use of the property within a reasonable period from the beginning of the use. The proposed regulations provide additional guidance on fair market value of the use and the terms and timing of repayment. Fair market value and reasonable period for these purposes are based on all facts and circumstances, including the type of property used and the period of use, and payments may be made on a periodic basis if consistent with arm's length dealings. The IRS helpfully also provides a safe harbor provision to the reasonable period requirement for payment made or periodic payments beginning within 60 days of the start of the use. Additionally, the IRS provides a de minimis safe harbor that mimics the so-called "Masters" or "Augusta" rule allowing for US person grantors or beneficiaries to avoid deemed distribution treatment for uncompensated use of trust property provided that such use by the group of US person grantors and beneficiaries does not in the aggregate exceed 14 days during the calendar year. The period for public comment on the proposed regulations ended in July 2024. Taxpayers and tax professionals now await the final version of these regulations which may not be identical to the proposed rules discussed above.

IRS Details Abusive Foreign Micro-Captive Insurance Company Fact Pattern

Also in May 2024, the IRS published Chief Counsel Advice Memorandum 202422010 detailing a fact pattern used by certain abusive foreign micro-captive insurance companies to help IRS agents in examinations. The fact pattern focuses on a foreign-regarded entity making an election under Section 953(d) of the Code, allowing foreign insurance companies to be treated as domestic corporations. Following this election, an insured domestic entity makes direct payments to the foreign captive company (or indirect payments if the foreign captive is the reinsurer) that are claimed to be deductible insurance premiums. The insured domestic entity does not deduct or withhold tax on the insurance payments made to the foreign captive. The foreign captive files a Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return, and reports the payments received from the insured domestic entity but excludes them from taxable income using the alternative tax for certain small insurance companies provided by Section 831(b) of the Code.

Following examinations of the foreign captive and insured domestic entity, the IRS found that neither entity could establish that payments made under the above fact pattern were insurance premiums. This finding was based on the arrangement lacking "insurance risk, risk distribution, or risk shifting, or was not insurance in its commonly accepted sense." As a result of this finding, more than half of the business of the foreign micro-captive was not insurance business making the captive ineligible for the 953(d) election and unable to use the 831(b) alternative tax. With the foreign captive no longer being treated as a domestic entity, the insured domestic entity should have been withholding 30 percent of the gross amount of Fixed, Determinable, Annual or Periodical (FDAP) payments made to the foreign captive. This Memorandum should serve as a good indication that the IRS is likely paying closer attention to arrangements similar to the fact pattern above going forward.

Supreme Court Upholds Mandatory Repatriation Tax

In June 2024, the Supreme Court delivered its opinion in Moore v. United States. The Moores challenged the constitutionality of the Mandatory Repatriation Tax (MRT), also called the "Transition Tax" under Section 965 of the Code. The MRT subjected US persons owning 10 percent or more of a controlled foreign corporation (a CFC) to US federal income tax on their pro rata share of the post-1986 untaxed foreign earnings of the CFC. By way of background, in 2006, the Moores invested in a friend's CFC in India and received a 13 percent ownership stake. The business was profitable but did not distribute income to the Moores or other American shareholders. When the MRT was introduced, the Moores were forced to include their pro rata share of the untaxed foreign earnings of the Indian CFC in their income and ultimately paid roughly $15,000 in taxes. The Moores's stated that income (and therefore income taxation) requires realization, and they argued the MRT did not tax income that they had realized. Answering the question of whether realization was a prerequisite to income taxation was thought by many to be a potential stepping stone to the introduction of a net-wealth tax. In light of this, many commentators believed that the Supreme Court would issue a narrow ruling limiting their judgment only to the matter at hand.

As expected, the Supreme Court issued a very narrow ruling upholding the MRT. The opinion draws many parallels between the MRT and both "Subpart F" or passive income of a CFC and pass-through taxation of partnerships and S-corporations and notes that both forms of taxation have been long accepted and constitutional in the United States. The Court also limited its ruling to tax on shareholders of an entity in respect of undistributed income realized by that entity, which has been attributed to the shareholders, when the entity has not been subject to US federal income tax on such income. The Supreme Court noted that realization was not a question they needed to answer, as the income had been realized by the CFC. Consequently, they did not rule on this point. As many had hoped, this ruling was relatively uneventful and did not set the precedent for the introduction of a net-wealth tax in the United States.

Tax Treaty Updates

We reported last year on the Senate's approval of the dual tax treaty between the United States and Chile. At that time, President Biden and the Chilean government both needed to give approval and have since done so. The US-Chile Dual Tax Treaty has since gone into effect applying from February 1, 2024, for withholding taxes and from January 1, 2024, for all other taxes. As part of the treaty coming into force, Chile has been added to the list of treaty partner countries in Notice 2024-11 used to determine whether a corporation is a qualified foreign corporation whose individual shareholders may benefit from reduced tax rates on dividends received. Hungary and Russia have both been removed from the list following the suspension of each country's dual tax treaty with the United States last year. The suspension of the US-Hungary Dual Tax Treaty officially went into effect for amounts paid or credited after January 1, 2024.

Ultimately, we saw fewer legal changes in the international private client arena in 2024 than in 2023. Although some of the guidance issued this year may have been surprising to taxpayers and tax professionals, they can appreciate the importance of additional insight into the US government's position on issues relevant to private clients everywhere. Hopefully, the US international developments in 2024 are not an outlier, and we will see more useful guidance affecting the global private client landscape in future years.