On May 8, 2024, the Treasury Department issued proposed regulations regarding the classification, taxation, and reporting of foreign trusts. The proposed regulations were issued for sections 643(i), 679, 6039F, 6048, and 6677 of the Internal Revenue Code. The proposed regulations would largely incorporate guidance that the IRS provided in Notice 97-34, with some modifications.[1]
In this post, we’ll take a look at the proposed regulations for section 643(i).
Background
Original Enactment
As first enacted in 1996, section 643(i) of the Internal Revenue Code provides that if a nongrantor foreign trust directly or indirectly makes a loan of cash or marketable securities to a United States person who is a grantor or beneficiary or who is related to a grantor or beneficiary of the foreign trust, then that loan is treated as a distribution by the foreign trust to that grantor or beneficiary (a “Section 643(i) distribution”).[2]
A Section 643(i) distribution is treated as having been made by a trust that doesn’t distribute only current income.[3] If adequate records are not provided to determine the proper treatment of a distribution from a foreign trust, then the distribution is treated as an accumulation distribution subject to taxation under subpart D of the trust provisions.[4]
Section 643(i) allows the Treasury Department to make exceptions to this treatment by regulation.[5] The legislative history for Section 643(i) indicates that Congress intended that the Treasury Department issue regulations providing an exception for loans of money or marketable securities with arm’s length terms.[6]
Notice 97-34
On June 23, 1997, the IRS issued Notice 97-34, which provided guidelines an exception to section 643(i) for loans of cash or marketable securities in the case of a “qualified obligation.” [7] The notice defined a “qualified obligation” and provided rules for additional loans between the same parties as well as for the distribution that would result when an obligation ceased to be a qualified obligation.[8] The notice also provided guidance on how to determine the tax consequences of a Section 643(i) distribution.[9]
2010 Amendment
On March 18, 2010, Congress amended section 643(i) to treat the uncompensated use of trust property by a United States person who is a grantor or beneficiary or who is related to a grantor or beneficiary of the foreign trust as a distribution from the foreign trust to the grantor or beneficiary.[10] An exception applies if the trust is paid the fair market value of the use of trust property within a reasonable period of time.[11]
Proposed Regulations
Tax Consequences of Section 643(i) Distribution
The proposed regulations generally would require a foreign trust to treat a section 643(i) distribution as an amount paid, credited, or required to be distributed under section 661(a)(2) for which the trust may be allowed a distribution deduction in computing its taxable income.[12] If the foreign trust makes a section 643(i) distribution of marketable securities, the trust would be deemed to have made section 643(e) election to recognize gain or loss on the distribution.[13]
In order for the U.S. grantor or beneficiary to determine the tax consequences of a section 643(i) distribution, the foreign trust may issue a Foreign Nongrantor Trust Beneficiary Statement with the relevant information.[14] The proposed regulations call this the actual calculation method.[15]
If the foreign trust doesn’t issue a Foreign Nongrantor Trust Beneficiary Statement, then the U.S. grantor or beneficiary would be required determine the tax consequences of a section 643(i) distribution using the default calculation method.[16]
Under the default calculation method, a U.S. grantor or beneficiary would treat that portion of a section 643(i) distribution that exceeds 125 percent of the average amount of the distributions that the foreign trust made to the grantor or beneficiary during the prior three taxable years as an accumulation distribution of the foreign trust’s undistributed net income trust.[17] The U.S. grantor or beneficiary must presume the foreign trust has been in existence for ten years and that no taxes have been imposed on the trust in any previous year.[18]
These rules are similar to the treatment of foreign trust distributions set out in Notice 97-34 and the Instructions for Form 3520.[19]
Qualified Obligations
The proposed regulations’ definition of a “qualified obligation” is largely consistent with that provided in Notice 97-34:
- The obligation must be in writing;
- The term of the obligation must not exceed five years;
- All payments on the obligation must be in cash in U.S. dollars;
- The obligation must be issued at par and must provide for stated interest at a fixed rate or a qualified floating rate;
- The yield to maturity must be not less than 100 percent and not greater than 130 percent of the applicable Federal rate in effect on the day on which the obligation is issued;
- All stated interest on the obligation must be qualified stated interest.;
- The U.S. grantor or beneficiary must extend the period for assessment of any income tax attributable to the loan for each year that the obligation issued in consideration for the loan is outstanding for at least three years after the maturity date of the obligation;
- The U.S. grantor must report the status of the obligation on a Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gift; and
- The obligor must make all payments of principal and interest on the obligation according to the terms of the obligation.[20]
As in Notice 97-34, the proposed regulations provide that if, while a qualified obligation is outstanding, the U.S. obligor directly or indirectly issues another obligation to the foreign trust in exchange for cash, the outstanding obligation is deemed to have the maturity date of the new obligation for purposes of determining whether the term of the outstanding obligation exceeds five years.[21] The outstanding obligation must be retested as of the issue date of the new obligation to determine whether the outstanding obligation continues to be a qualified obligation.[22] The new obligation also must be separately tested to see if it satisfies the requirements to be a qualified obligation.[23]
If a qualified obligation ceases to be a qualified obligation (for example, because a modification causes the term of the obligation to exceed five years), the U.S. grantor or beneficiary would be treated as receiving a section 643(i) distribution from the foreign trust.[24] The amount of the section 643(i) distribution would be the obligation’s outstanding stated principal amount plus any accrued but unpaid qualified stated interest (within the meaning of § 1.1273–1(c)) as of the date of the event that causes the obligation to no longer be a qualified obligation.[25]
The IRS may treat two or more obligations issued by a U.S. obligor as a single obligation that is not a qualified obligation if they are structured with a principal purpose of avoiding the application of section 643(i).[26] If the IRS treats two or more obligations as a single obligation that is not a qualified obligation, then the amount of the section 643(i) distribution will not exceed the sum of the outstanding stated principal amounts of the obligations plus any accrued but unpaid qualified stated interest as of the date determined by the IRS.[27]
Other Exceptions
If a foreign trust allows a U.S. grantor or beneficiary or person related to a U.S. grantor or beneficiary the use of trust property, this use won’t be treated as a section 643(i) distribution to the to the extent that the foreign trust receives the fair market value of this use within a reasonable period (60 days or less) from the start of this use.[28] The fair market value of the use is based on all the facts and circumstances, including the type of property and the period of use.
De minimis use of trust property other than a loan of cash or marketable securities also won’t be considered a section 643(i) distribution.[29] De minimis use is defined as aggregate use by members of a group consisting of the U.S. grantors and beneficiaries and U.S. persons related to them for a total of 14 days or less during a taxable year.[30]
Finally, a loan of cash that is made by a foreign corporation to a U.S. beneficiary of the foreign trust won’t be treated as a section 643(i) distribution to the extent that the aggregate amount of all such loans to the beneficiary does not exceed the foreign corporation’s undistributed earnings and profits attributable to amounts included in the beneficiary’s gross income under section 951, 951A, or 1293.[31] The Treasury Department explains that:
[T]his exception is intended to prevent double taxation that could result by reason of the application of section 643(i) to an amount that has already been included in the U.S. beneficiary’s gross income as a subpart F income inclusion [section 951], a global intangible low-taxed income inclusion [section 951A], an inclusion by reason of a controlled foreign corporation’s investment of earnings in United States property [sections 951 and 956], or a qualified electing fund inclusion [section 1293].[32]
Comments
The Treasury Department seeks comments on these proposed regulations before they are adopted. A public hearing will be held on August 21, 2024.[33]
To schedule a consultation, please contact Freeman Law at 214.984.3000.
[1] 89 Fed. Reg. 39444, 39449, 39451, 39454, 39457 (May 8, 2024).
[2] 89 Fed. Reg. 39441; The Small Business Job Protection Act of 1996, Pub. L. 104-188, § 1906(c)(1), 110 Stat. 1755, 1915 (1996).
[3] I.R.C. § 643(i)(2)(D).
[4] I.R.C. § 6048(c)(2)(A).
[5] Id.
[6] 89 Fed. Reg. 39441 (citing H.R. Conf. Rep. No. 737, 104th Cong., 2d Sess., at 334 (1996)).
[7] Notice 97-34, V. A, 1997-25 I.R.B. 22, 28-29.
[8] Id.
[9] Id. at 29.
[10] 89 Fed. Reg. 39441; The Hiring Incentives to Restore Employment (“HIRE”) Act, Pub. L. 111-147, § 533, 124 Stat. 71, 114 (2010).
[11] I.R.C. § 643(i)(2)(E).
[12] 89 Fed. Reg. 39446, 39463 (Prop. Reg. § 1.643(i)-3(c)(2)(i)).
[13] 89 Fed. Reg. 39446, 39463 (Prop. Reg. § 1.643(i)-3(c)(2)(ii)).
[14] 89 Fed. Reg. 39446, 39463 (Prop. Reg. § 1.643(i)-3(c)(1)(iii))
[15] 89 Fed. Reg. 39446, 39463 (Prop. Reg. § 1.643(i)-3(c)(1)(iii)).
[16] 89 Fed. Reg. 39446, 39453, 39463, 39478 (Prop. Reg. §§ 1.643(i)-3(c)(1)(iii), 1.6048-4(d)(1)(iii)).
[17] 89 Fed. Reg. 39447, 39453, 39463, 39478 (Prop. Reg. §§ 1.,643(i)-3(c)(3), 1.6048-4(d)(3)).
[18] Id.
[19] See Notice 97-34, V. B, 1997-25 I.R.B. 22, 29; Instructions for Form 3520, Schedule A.
[20] 89 Fed. Reg. 39446, 39461 (Prop. Reg. § 1.643(i)–2(b)(4)).
[21] Id.
[22] Id.
[23] 89 Fed. Reg. 39446, 39460 (Prop. Reg. § 1.643(i)–2(a)(2)).
[24] 89 Fed. Reg. 39446, 39460 (Prop. Reg. § 1.643(i)-2(a)(2)).
[25] 89 Fed. Reg. 39446, 39461 (Prop. Reg. § 1.643(i)-2(b)(6)).
[26] 89 Fed. Reg. 39446, 39461 (Prop. Reg. § 1.643(i)–2(b)(5)).
[27] 89 Fed. Reg. 39446, 39461 (Prop. Reg. § 1.643(i)-2(b)(6)).
[28] 89 Fed. Reg. 39446, 39460 (Prop. Reg. § 1.643(i)-2(b)(6)).
[29] 89 Fed. Reg. 39446, 39460 (Prop. Reg. § 1.643(i)-2(a)(3)).
[30] 89 Fed. Reg. 39446, 39460 (Prop. Reg. § 1.643(i)-2(a)(3)).
[31] 89 Fed. Reg. 39446, 39460 (Prop. Reg. § 1.643(i)-2(a)(4)).
[32] 89 Fed. Reg. 39446.
[33] 89 Fed. Reg. 39458.
