Comments Regarding Notice of Proposed Rulemaking Regarding Transactions With Foreign Trusts and Large Foreign Gifts (Reg-124850-08, May 8, 2024)
This is my written testimony on the 2024 proposed regulations regarding foreign trusts, specifically as they apply to U.S. individuals who own tax-favored employer or foreign government sponsored accounts that provide pension, retirement, or other savings benefits. I also presented oral testimony at the public hearing on the proposed regulations on August 21, 2024. Final regulations have not yet been issued.
These comments were originally printed in Tax Notes Federal. See CPA Firm Criticizes Foreign Trust Reporting Requirements.
Introduction
I am Gary W. Carter, owner GW Carter, Ltd., a certified public accounting firm in Edina, Minnesota. I am grateful for the opportunity to offer comments on the proposed regulations regarding the reporting of transactions with foreign trusts.
My Background
I received a BA in accounting from Eastern Washington University in 1977, a Master of Taxation degree from the University of Denver in 1980, and a PhD in taxation from the University of Texas at Austin in 1985. I am licensed to practice as a CPA in Minnesota.
GW Carter, Ltd. is a niche tax practice serving about 1,500 clients annually. The firm specializes in international tax, with a focus on the tax needs of foreign nationals and U.S. individuals living outside the United States. Many of our clients are immigrants to the United States who, prior to their immigration, contributed to employer- or government-sponsored, tax-favored accounts in their home countries. Others are U.S. citizens living outside the United States and contributing to the same types of accounts. For that reason, I have been very involved with the filing requirements of Internal Revenue Code (IRC) section 6048 involving foreign trusts.
Purpose
My comments relate specifically to the proposed filing exemptions, under Proposed Regulation section 1.6048-5, for U.S. individuals who own tax-favored employer or foreign government sponsored accounts, classified as foreign trusts, that provide pension, retirement, or other savings benefits.
General Rules for Form 3520 and Form 3520-A Filing Requirements
IRC section 6048 requires a United States person to report certain transactions with foreign trusts and ownership of foreign trusts (file Form 3520). Additionally, IRC section 6048(b)(1)(A) makes the owner of a foreign trust responsible for ensuring that the trust submits a return setting forth all trust activities (file Form 3520-A). The owner must file a Substitute Form 3520-A if the foreign trust fails to file Form 3520-A.
Generally, under IRC section 6677, failure to timely file Form 3520 results in a penalty of $10,000. An additional $10,000 penalty is imposed for failure to timely file Form 3520-A or Substitute Form 3520-A. These penalties are not afforded the rights of the deficiency procedures for income, estate, gift, and certain excise taxes in IRC sections 6211-6216 (IRC Section 6677(e)). That means taxpayer claims of aggrievance can be denied by the IRS, and penalties can be assessed without the taxpayer receiving the opportunity of a hearing in the United States Tax Court.
Recap of IRC Section 6048 Rational
The Background of the proposed regulations recounts the purpose of the enhanced foreign trust reporting and penalty provisions under IRC section 6048:
During the mid- to late 1990s, abusive tax schemes, including offshore schemes involving foreign trusts, reemerged in the United States after last peaking in the 1980s. [Citing a 2002 GAO report]. In these schemes, foreign trusts were used to transfer large amounts of assets offshore, where it was much more difficult for the IRS to identify whether U.S. persons owned an interest in such trusts, and whether such persons were reporting and paying the required taxes on their income from such trusts. Many of the foreign trusts were established in tax haven jurisdictions with bank secrecy laws. . . . 1Background II. “Purpose of Foreign Trust and Gift Provisions”
The Background then explains why tax-favored foreign retirement trusts, tax-favored foreign non-retirement savings trusts, and a tax-favored foreign de minimis savings trust should be exempt from reporting:
First, these foreign trusts generally are subject to written restrictions, such as contribution limitations, conditions for withdrawal, and information reporting, under the laws of the country in which they are established that are broadly consistent with the eligibility requirements under the Code for U.S. trusts serving similar policy goals. Second, U.S. individuals with an interest in these trusts may be required under section 6038D to separately report information about their interests in accounts held by, or through, these trusts 2Background IV. D. 2. “Additional Exceptions to Reporting Transactions with Foreign Trusts”
IRS Application Of Section 6048 Filing Requirements Have Failed The Sound Tax Policy Standard Of Certainty
Taxpayer Certainty is Imperative for Sound Tax Administration
Taxpayer certainty in knowing what tax filings are expected of them and when they are due is a core principle of a fair and sound tax regime. Adam Smith, in Part II of his iconic treatise An Inquiry into the Nature and Causes of the Wealth of Nations (1776, p. 676), describes the importance of certainty as his second of four maxims of sound tax administration.
The tax which each individual is bound to pay, ought to be certain and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person. Where it is otherwise, every person subject to the tax is put more or less in the power of the tax-gatherer, who can either aggravate the tax upon any obnoxious contributor, or extort, by the terror of such aggravation, some present or perquisite to himself. . . .
IRC section 6048 does not involve the payment of a tax. However, the penalties under IRC section 6677 for failure to file, or to file late or improperly completed Forms 3520/Substitute 3520-A are unusually harsh for what might be a naive and mild infraction. This enhances the proposition that U.S. taxpayers deserve certainty in knowing if they are subject to these filing requirements.
What is a Foreign Trust?
Although IRC section 6048 imposes filing requirements on any United States person who owns a foreign trust, the definition of "foreign trust” for this purpose is far from certain. This is because the term “trust” is not defined in the Internal Revenue Code.
A foreign trust is defined in IRC section 7701(a)(31)(B): "The term 'foreign trust' means any trust other than a trust described in subparagraph (E) of paragraph (30)." Subparagraph (E) of paragraph (30) describes as a United States Person "any trust if (i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States persons have the authority to control all substantial decisions of the trust.” Therefore, a foreign trust is not a United States person, but what is a “trust”?
Proposed Treasury Regulation section 1.6048-1 defines a “foreign trust” as a trust within the meaning of Treasury Regulation section 301.7701-7. This regulation provides safe harbors and examples distinguishing foreign trusts from domestic trusts, but it does not offer a definition of the term “trust.”
An interpretive regulation under IRC section 7701 (not cited by the proposed regulations) defines the term “Ordinary Trust” as follows:
In general, the term 'trust' as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually, the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and
conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit. 3 Treasury Reg. section 301.7701-4(a) last amended by T.D. 9961, 87 FR 166-182 (Jan. 4, 2022)
It is presumed that the proposed regulations do not intend to abandon this technical regulatory definition of a “trust”, even though Proposed Regulation section 1.6048-5(b)(2), (3), and (4) refer to tax-favored foreign retirement trusts, tax-favored foreign non-retirement savings trusts, and tax-favored foreign de minimis savings trusts as including “a trust, plan, fund, scheme, or other arrangement (collectively, a trust) . . ."
Therefore, if a trust, defined in Treasury Reg. section 301.7701-4(a), is also defined as a “foreign trust” in Treasury Regulation section 301.7701-7, it is subject to the filing requirements of IRC section 6048.
The Trustee Must Be a Fiduciary
According to the regulatory definition, there must be a trustee who has responsibility for the protection and conservation of property for the beneficiaries "under the ordinary rules applied in chancery or probate courts." The general duties of a trustee include a fiduciary responsibility (defined in IRC section 7701(a)(6)) to the beneficiaries.
The nature of fiduciary obligations differs from country to country, which could raise the question of whether laws in a particular country even allow for the protection contemplated by the regulation. In fact, most of the “foreign trusts” owned by my clients are merely accounts authorized by the governments of the host countries to provide tax benefits. They are not arrangements, as described in Regulation section 301.7701-4(a), “whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under ordinary rules applied in chancery or probate courts.” It is therefore uncertain whether the fiduciary requirement of the regulation is present with respect to any of these government-sponsored plans.
The Mexican fideicomiso (Mexican Land Trust) is an example of a “foreign trust" that fails the fiduciary test. If you are not Mexican, you cannot own real estate in Mexico too close to the coast or border. These areas are known as the "restricted zone." If you wish to buy real estate in the restricted zone, you must buy it through a Mexican Land Trust with a Mexican bank as trustee. The Mexican bank holds title and collects a fee, but disclaims all responsibility for the property, including obtaining a clear title. Trust owners can buy and sell the property, make improvements, lease the property, and do everything a legal owner can typically do, without permission from the bank trustee.
For several decades, the IRS position was that a fideicomiso was a foreign grantor trust for which Forms 3520/3520-A were required to be filed. In a reverse course in 2012, the IRS issued Private Letter Ruling (PLR) 201245003 (followed by Rev. Rul. 2013-14, 2013-26 IRB 1267), conceding a fideicomiso is not a trust as defined in Regulation section 301.7701-4(a) because the trustee was not a fiduciary, but merely an agent for holding the property.
Free Choice of Investment Options
Another critical point of the regulatory definition is that the beneficiaries "cannot share in the discharge of this responsibility." This implies that the trustee must have full control of trust assets, but most of the tax-favored government-sponsored accounts that might be considered “foreign trusts” have options to allow the owner to choose or even control investments.
Are Foreign Government-Sponsored Tax-Favored Investment Accounts "Foreign Trusts?"
As mentioned above, many of my clients own tax-favored accounts in their home country or
current country of residence, most of which are commonly referred to as trusts. A few examples of such accounts are Canadian Registered Education Savings Plans (RESP), Canadian Tax-Free Savings Accounts (TFSA), UK Individual Savings Accounts (ISA), UK Self-Invested Pension Plans (SIPP), Australian superannuation plans, New Zealand Kiwi-Saver plans, and Indian Public Provident Fund (PPF) plans or Senior Citizen Savings Schemes (SCSS).
A Dearth of Guidance From the IRS
The attributes of a “trust” described above suggest that many, if not most, of these accounts are not subject to the filing requirements of IRC section 6048. Yet, there has been virtually no guidance from the IRS on whether any of these accounts are considered foreign trusts in the Service’s view, for which IRC section 6048 filings are required. The IRS has refused to rule on this issue. The last ruling that defines a foreign trust for the filing requirements of IRC section 6048 (to my knowledge) was Rev. Rul. 2013-14 (described above), issued over ten years ago.
In spite of this uncertainty, responsible tax advisors, even if they are not well versed in the technical requirements of IRC section 6048, are compelled to alert their clients about the requirements to file Forms 3520/Substitute 3520-A for accounts that appear to be foreign trusts, and to inform them that not filing these forms could result in devastating penalties. U.S. taxpayers, for the most part, desire to do the right thing when it comes to abiding by their tax filing requirements, whether actual or perceived.
Yet IRS Penalty Policies Are Harsh and Unrestrained
While refusing to clarify the filing requirements under IRC section 6048, the IRS has leveraged the good intent of tax advisors and their clients into an IRC section 6677 penalty bonanza. A late-filed Form 3520 and attached Substitute Form 3520-A are answered with a CP15 notice charging a $10,000 penalty for the late Form 3520 and a second CP15 notice charging a $10,000 penalty for the late Substitute Form 3520-A. The penalty notices are issued even if the forms are one day late, and a compelling, reasonable cause statement is attached. Even if many of the penalties are eventually abated, this is a huge resource drain for IRS Appellate personnel, practitioners, and taxpayers.
I am currently dealing with the precise case as mentioned above, involving a UK cash ISA. My client, while living in the UK, attempted to meet the extended due date, but was one day late, due to her preparer’s delay in preparing the forms. She received the maximum penalties, in spite of a compelling, reasonable cause statement attached to the forms. We have asked for an Appellate hearing.
Appellate Hearing Regarding a Canadian TFSA
I represented a client in a similar situation in 2023. This client was a young immigrant from Canada, filing as a resident for the first time for 2018. He employed a professional tax return preparer for his first resident tax return because he wanted to make sure it was done properly. After completing the return, the preparer mentioned to my client that he should file Forms 3520 and 3520-A because my client still owned a TFSA in Canada, which, according to the preparer, was a foreign trust. The preparer's firm, however, refused to prepare the foreign trust forms.
This news was given to my client a day before the April 15, 2019, filing deadline for his 2018 tax return. An extension was not submitted or suggested by the preparer. Since the preparer was unwilling to complete the foreign trust forms, my client obtained the forms and instructions and completed them himself. He was intent on filing the forms he thought were required. He mailed the forms to the IRS in late April 2019, completely unaware of the likely consequences. He received CP15 notices imposing the maximum late filing penalties about 2 years later and came to me for help.
I suggested that we argue on appeal that the forms were not required in the first place because a TFSA is not a trust for which the forms are required. A TFSA is not a separate entity, has no trustee, and consequently does not meet the definition of a foreign trust. Penalties cannot be imposed under IRC section 6677 based on a filing requirement that does not exist.
When the issue was finally taken up by Appeals in 2023, the Appellate Officer agreed with my argument almost immediately. He informed us that this was an Appeals Coordinated Issue (ACI) for which he must seek approval for his decision. A couple of weeks later, the Appellate Officer confirmed that the penalties would be removed.
Still, an untold number of Forms 3520/3520-A are prepared annually by cautious practitioners and well-intentioned clients who own Canadian TFSAs. I intend to make the same argument regarding my current client's cash ISA.
The Uncertainty of When Substitute Form 3520-A Must Be Filed
I must recount a systemic initiative by the IRS of issuing erroneous late filing penalty notices for Substitute Form 3520-A. This largely took place in 2019. It was an egregious example of an administrative failure when certainty in tax administration was absent, and IRS personnel were allowed free rein.
History of Substitute Form 3520-A Filing Requirements
Prior to the Small Business and Job Protection Act of 1996 (the Act), a U.S. person who transferred property to a foreign trust was required to report the transfer on Form 3520 (a prior version of today's), within 90 days of the transfer. Also, U.S. owners of foreign trusts were required to annually file a prior version of Form 3520-A. No reporting was required by foreign trusts or by U.S. beneficiaries of foreign trusts or by U.S. persons who received gifts from foreign persons.
The Act changed the reporting requirements, so U.S. owners of foreign trusts are no longer required to file Form 3520-A but are required to ensure the form is filed by the trust (See IRC section 6048(b)(1)), and trust beneficiaries and U.S. persons receiving gifts from foreign persons are subject to reporting requirements.
In response to the new reporting requirements of the Act, and to reduce duplicative reporting requirements, the IRS revised Form 3520, “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts”. The goal was to allow U.S. persons to use a single form to comply with all the new reporting requirements of the Act pertaining to transactions with foreign trusts and the receipt of foreign gifts.
Also, Form 3520-A, “Annual Information Return of Foreign Trust with a U.S. Owner,” was revised so that trustees of foreign trusts would be able to use that form to meet the added information reporting requirements of IRC section 6048(b). Again, U.S. owners of foreign trusts are no longer required to file Form 3520-A but are required to ensure the form is filed by the trust. (See IRS Notice 97-34, 1997-1 CB 422.)
A foreign trust with a U.S. owner must file Form 3520-A to provide information about the foreign trust, its U.S. beneficiaries, and any United States person who is treated as an owner of any portion of the foreign trust. Form 3520-A is required to be filed by the trust with the IRS by the 15th day of the third month after the end of the trust’s tax year (March 15 for a calendar year). An extension can be requested to file by September 15 using Form 7004.
Foreign trusts often do not fulfill this reporting requirement. In fact, they rarely do. (I have never seen it happen.) Congress recognized that it is tough to make a foreign trust obey U.S. tax law, so it is the owner of a foreign trust who gets penalized if the owner fails to “ensure” that the foreign trust files a timely Form 3520-A. See IRC section 6048(b)(1).
The statute does not explain how an owner is to ensure that Form 3520-A is filed by the trust. However, the instructions to Form 3520 instruct a U.S. owner of a foreign trust who has not received a Foreign Grantor Trust Owner Statement from the foreign trust to complete a Substitute Form 3520-A, to the best of the owner's ability, and attach it to the owner’s Form 3520. (See also CCA 201150029 – “Information with Respect to Certain Foreign Trusts.”)
There is no special form provided for this – it is the same Form 3520-A filed by the trust. However, the instructions (prior to 2020) required a statement in the header of Substitute Form 3520-A stating: “Substitute - No Information Received from the Trust.” In 2020, a check box was added to the form for this purpose.
The due date to file Form 3520 is the 15th day of the fourth month following the end of the U.S. person’s tax year. The instructions to Form 3520 explain that if the U.S. person is granted an extension of time to file Form 1040, the due date for filing Form 3520 is the 15th day of the tenth month following the end of the U.S. person’s tax year. In other words, Form 4868 extends the time to file Form 3520 along with Form 1040.
Prior to 2020, neither the instructions for Form 3520 nor the instructions for Form 3520-A specified a due date for Substitute Form 3520-A. To recap, the due date for Form 3520-A is generally March 15, with an extension available by filing Form 7004. The due date for Form 3520, to which Substitute Form 3520-A (if required) must be attached, is April 15, with an extension available by filing Form 4868.
Although the instructions were silent, the Internal Revenue Manual (IRM) recognized the unfeasibility of different due dates for a form (Form 3520) and another form required to be attached to it (Substitute Form 3520-A). IRM section 21.8.2.19.7 said: “If the foreign trust does not file Form 3520-A, but the U.S. owner completes and attaches a Substitute Form 3520-A for the foreign trust to the U.S. owner’s timely filed Form 3520 in accordance with the instructions for Form 3520, the U.S. owner will not be subject to the penalty for failure to file Form 3520-A.”
Our filing procedures were to carefully mark “Substitute - No Information Received from the Trust” in the header of our Substitute Forms 3520-A and attach them by staple to timely filed Forms 3520. In response to the question in Form 3520 asking if the owner had received a Foreign Grantor Trust Owner Statement from the foreign trust, we attached a statement stating “No Information Received from the Trust.”
Taxpayer Nightmares Begin Because of IRS Confusion
Our clients began to receive CP15 Notices beginning in early 2019, charging them $10,000 for late-filed Forms 3520-A. Each of our clients had attached Substitute Form 3520-A to a properly extended Form 3520. In each case, the due date for Form 1040 had been properly extended by filing Form 4868, and Forms 3520/Substitute Form 3520-A were filed after March 15 but prior to the extended due date for Form 1040.
Calls to the IRS in attempts to argue that the notices were issued in error were not successful. We were told that Form 3520-A was due March 15, and an extension on Form 7004 was not filed. When we responded that Substitute Form 3520-A, not Form 3520-A, had been attached to a timely filed Form 3520, IRS phone personnel had no programmed response. We were told to follow the instructions in the letters and file a request for an appellate hearing within 30 days, which we did in each case.
I believe every one of our clients in that filing circumstance eventually received a penalty notice. Each case involved a tax-favored foreign government-sponsored or foreign employer account. The owners were either foreign nationals who had become U.S. persons after establishing the accounts or U.S. citizens living overseas. In communicating with other practitioners and taxpayers, it became clear that this problem was systemic and pervasive.
On November 15, 2019, the AICPA Trust, Estate, and Gift Tax Technical Resource Panel met with IRS representatives from the Office of Associate Chief Counsel and described the issue. The IRS attorneys then had a call with the IRS processing and penalty groups responsible for these penalty notices and relayed our concerns to them. The processing and penalty groups agreed to a follow-up call with AICPA representatives in January of 2020 to address the issue, but first wanted to get details about individuals affected.
I asked each of my clients who received an erroneous Form 3520-A penalty notice to write an impact statement. Here is an excerpt from the statement written by one of my clients:
On the 29th of November 2019, my husband received a notice from the IRS claiming we had not filed Form 5320-A for the tax year 2018 which was due on March 15, 2019. It then asserted that we owed a penalty of $10,000 for the failure to file the form!!
We have always filed this form when due. Our CPA always completes the form and we sign it and post it. The above notice is the only documentation that we have received from the IRS on this matter. It’s seems highly unjust to be given such a fine when you have done everything to comply- it seems that the IRS has all the cards in their hands. The whole process is very onerous on the taxpayer and it could be made much easier to file and receive acknowledgement from the IRS at the very least.
Our family has faced a very stressful time over the last couple of years and having this burden placed before us is enough to put us at breaking point. . . . I am a 46- year-old female with 2 beautiful daughters and loving husband. Sadly in 2016 I was diagnosed with cancer, . . .
When I was given my “terminal” diagnosis back in May I was told that I had 6-12 months to live. Based on current health issues, scan results etc. it seems that the time frame is likely. If you could try and imagine for a minute being placed in our shoes!
We are having to deal with so much emotionally and financially. These sort of unfair fees could easily result in some far-reaching consequences for many families let alone families who are having to deal with other circumstances as well. It has caused us a massive deal of stress and worry. My head tumors and treatment cause me fatigue and writing and spelling is much more difficult than it was. I need to be spending quality time with my family, not staying up until 10:30 pm writing to the IRS. I really hope that this situation changes.
The penalty imposed on this client’s husband was eventually removed several months later, but the client died on January 9, 2020, a few weeks after submitting her statement, still very worried about her family’s fate.
A phone call took place on January 10, 2020, involving IRS examination personnel, AICPA trust committee chairs, representatives of the Office of Associate Chief Counsel, and several affected practitioners. During the call, IRS examination personnel admitted that mistakes had been made and promised to correct their procedures. They also stated that the instructions for Form 3520 and Form 3520-A were amended to clarify the due date for Substitute Form 3520-A. This would hopefully serve to educate IRS examination personnel, since practitioners already assumed the due date of a form attached to another form was the same as the form to which it was attached.
There has never been a public apology from the IRS for the tragic and monumental blunder of issuing erroneous penalty notices in the amount of $10,000 each to an untold number of U.S. taxpayers. There has never been a public accounting of how many bogus penalty notices were issued, or how many bogus penalties were simply paid by taxpayer victims, either because they assumed the IRS was right, or they simply did not want a conflict with the world’s most powerful tax collection agency.
The incident described above did great damage to the faith in our tax system and trust in the Internal Revenue Service among the countless taxpayer victims and practitioners involved. Among my clients, in every case, the bogus penalty notice issued involved a foreign government-created or employer-provided tax-favored account.
Good Faith And Trust In The Internal Revenue Service Can Be Repaired Through A Revised Proposed Regulation Section 1.6048-5
Rev. Proc. 2020-17 Is Largely Ineffective
Rev. Proc. 2020-17 was issued a few weeks after the January 10, 2020, phone call referred to above, and expressed sound rationale:
The Treasury Department and the IRS have determined that, because applicable tax-favored foreign trusts generally are subject to written restrictions, such as contribution limitations, conditions for withdrawal, and information reporting, which are imposed under the laws of the country in which the trust is established, and because U.S. individuals with an interest in these trusts may be required under section 6038D to separately report information about their interests in accounts held by, or through, these trusts, it would be appropriate to exempt U.S. individuals from the requirement to provide information about these trusts under section 6048. 4 Rev. Proc. 2020-17, Section 3
This ruling, a preliminary view of Proposed Regulation section 1.6048-5, may have been a well-meaning attempt to mitigate the ill will created by the fallacious IRS penalty campaign targeting Substitute Forms 3520-A filers. However, some of the qualifications and limitations, which have been carried forward to the proposed regulation, seriously weaken its usefulness in exempting most of the foreign government and employer-sponsored tax-favored trusts around the globe.
Slightly Relaxed Rev. Proc. 2020-17 Standards Are Extended in Proposed Regulation Section 1.6048-5
Rather than simply accepting the written restrictions, conditions for withdrawal, and information reporting that are imposed under the laws of the country in which the trusts are established as adequate safeguards for abuse, Proposed Regulation section 1.6048-5 contains conditions and limitations that require in-depth research and data analysis that have no implications for potential abuse.
Example 1
For a tax-favored foreign retirement trust, Proposed Regulation section 1.6048- 5(b)(2)(iii) requires the following:
Generally, only contributions with respect to income earned from the performance of personal services are permitted (with allowances made for limited contributions made by unemployed individuals).
This is not to require contributions to be measured by a percentage of earned income. That requirement is shown in Proposed Regulation section 1.6048-5(b)(2)(iv)(2)(i). Although I have not done a thorough search, I am not aware that this provision is a factor in popular foreign retirement plans. Why is it required? If a practitioner searches for this language in a foreign retirement trust and fails to find it, the plan will be disqualified. Even though this attribute's absence does not indicate a potential for abuse or create any purpose for obtaining information by requiring IRC section 6048 reporting, Form 3520 and Form 3520-A still would be required.
Example 2
For a tax-favored foreign retirement trust, Proposed Regulation section 1.6048- 5(b)(2)(vi) requires the following:
In the case of an employer-maintained trust: (A) The trust is nondiscriminatory insofar as a wide range of employees, including rank and file employees, must be eligible to make or receive contributions or accrue benefits under the terms of the trust (alone or in combination with other comparable plans); (B) the trust (alone or in combination with other comparable plans) actually provides significant benefits for a substantial majority of eligible employees; and (C) the benefits actually provided under the trust to eligible employees are not discriminatory.
How is a U.S. tax practitioner able to research this requirement? Where is the available data from the myriad of potential countries and plans within those countries, and how would a U.S. practitioner find access to it? How will an IRS agent confirm that this condition was met? And if the condition is not met, how does that put this retirement plan into the category of abusive tax schemes for which the GAO recommended the enactment of IRC section 6048? Even though this attribute's absence does not indicate potential for abuse or create any purpose for obtaining information by requiring IRC section 6048 reporting, Form 3520 and Form 3520-A still would be required.
How To Vet Eligible Tax-Favored Foreign Trusts
The IRS seeks to exempt applicable tax-favored foreign trusts under the authority of IRC section 6048(d)(4), and this is an excellent start. The IRS recognizes its requirement to screen trusts that might be eligible for this exemption. However, the IRS vetting process in Proposed Regulation section 1.6048-5 destroys the effectiveness of the potential exemption. Vague and unverifiable standards applied universally are not helpful. For fear of potential liability, tax 14 practitioners will simply recommend that their clients file Forms 3520 and 3520-A rather than attempting to research and verify nebulous standards. Easily identifiable, verifiable, and country-specific criteria would create certainty for tax practitioners, taxpayers, and IRS personnel.
The Vetting Has Been Done Already in FATCA IGAs
The Foreign Account Tax Compliance Act (FATCA), signed into law on March 18, 2010, as part of the Hiring Incentives to Restore Employment (HIRE) Act (P.L. 111-147), introduced sections 1471 to 1474 into the IRC. The Act was intended to combat offshore tax evasion by certain U.S. persons with offshore financial accounts. FATCA requires foreign financial institutions (FFIs) to report to the IRS information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. Refusal by an FFI to report the accounts of U.S. taxpayers incurs a substantial penalty on payments to the FFI.
One problem with FATCA's sweeping mandate is that the laws of numerous countries do not permit financial institutions in such countries to provide information about their account holders to a foreign government, and may not permit financial institutions to close such accounts. As a result, the potential exists that FFIs are faced with the choice of suffering a punitive withholding tax (or divesting from U.S. investments) or breaking the law in their countries of organization and operation. For this reason, Treasury developed an alternative approach to FATCA compliance through bilateral intergovernmental FATCA agreements (IGAs).
IGAs are negotiated between the United States and the partner country and follow two models. Under a Model 1 IGA, the FATCA partner agrees to collect the information required by the United States from its financial institutions and to automatically provide such information to the IRS. Under a Model 2 IGA, the FATCA partner agrees to require its FFIs to enter into FFI agreements with the IRS and to provide the IRS with the requisite information regarding U.S. accounts, as well as pooled information regarding recalcitrant accounts (supplemented by information exchange between the FATCA partners). There are now 113 Model 1 and 2 IGA agreements in effect. An IGA does not require the existence of an income tax treaty with the IGA partner country, so the United States has many more IGA partners than income tax treaties.
Tax-Favored Retirement and Savings Accounts Are Not Treated as Financial Accounts Requiring
FATCA Reporting
In Annex II of each IGA, there is a section titled “Accounts Excluded from Financial Accounts” or “Exempt Accounts.” This section lists the country-specific tax-favored retirement and savings accounts that are excluded from the definition of “financial account” for purposes of defining a “United States Account” for which FATCA reporting is required.
IRC section 1471(d)(2), in defining “financial account", defers to the Treasury the authority to define the types of accounts that are excluded from this definition. Legislative Regulation section 1.1471-5(b)(2) provides the exceptions, which include tax-favored retirement accounts and tax-favored non-retirement savings accounts.
The Model IGA
Model 1 IGA, Annex II, part V is a nearly exact recital of Regulation section 1.1471-5(b)(2), and describes excluded financial accounts generically as follows:
Accounts Excluded from Financial Accounts - The following accounts are excluded from the definition of Financial Accounts and therefore shall not be treated as U.S. Reportable Accounts:
- A. Certain Savings Accounts
- Retirement And Pension Accounts. — A retirement or pension account maintained in [FATCA Partner] that satisfies the following requirements under the laws of the laws of [FATCA Partner].
- The account is subject to regulation as a personal retirement account or is part of a registered or regulated retirement or pension plan for the provision of retirement or pension benefits (including disability or death benefits);
- The account is tax-favored (i.e., contributions to the account that would otherwise be subject to tax under the laws of [FATCA Partner] are deductible or excluded from the gross income of the account holder or taxed at a reduced rate, or taxation of investment income from the account is deferred or taxed at a reduced rate)
- Annual information reporting is required to the tax authorities in [FATCA Partner] with respect to the account;
- Withdrawals are conditioned on reaching a specified retirement age, disability, or death, or penalties apply to withdrawals made before such specified events; and
- Either (i) annual contributions are limited to $50,000 or less, or (ii) there is a maximum lifetime contribution limit to the account of $1,000,000 or less, in each case applying the rules set forth in Annex I for account aggregation and currency translation.
- Non-Retirement Savings Accounts: An account maintained in [FATCA Partner] (other than an insurance or Annuity Contract) that satisfies the following requirements under the laws of [FATCA Partner].
- The account is subject to regulation as a savings vehicle for purposes other than for retirement;
- The account is tax-favored (i.e., contributions to the account that would otherwise be subject to tax under the laws of [FATCA Partner] are deductible or excluded from the gross income of the account holder or taxed at a reduced rate, or taxation of investment income from the account is deferred or taxed at a reduced rate);
- Withdrawals are conditioned on meeting specific criteria related to the purpose of the savings account (for example, the provision of educational or medical benefits), or penalties apply to withdrawals made before such criteria are met; and 12 Model 1 IGA Annex II November 30, 2014
- Annual contributions are limited to $50,000 or less, applying the rules set forth in Annex I for account aggregation and currency translation.
These are verifiable standards, all of which are contained in the current Proposed Regulation section 1.6048-5, and which meet the legislative purpose for excluding certain retirement and savings trusts from IRC section 6048 reporting requirements.
Based on the standards of the Model IGA, each FATCA partner has provided the specific retirement and savings accounts in its jurisdiction that meet the requirements. Since the Act was intended to combat offshore tax evasion by certain U.S. persons with offshore financial accounts, the excluded accounts are deemed not to be in that category because they pose no threat of tax evasion.
Canadian Example
Here is Annex II, Part IV of the Canadian IGA:
Accounts Excluded from Financial Accounts - The following accounts and products established in Canada and maintained by a Canadian Financial Institution shall be treated as excluded from the definition of Financial Accounts, and therefore shall not be treated as U.S. Reportable Accounts under the Agreement:
- Registered Retirement Savings Plans (RRSPs) – as defined in subsection 146(1) of the Income Tax Act.
- Registered Retirement Income Funds (RRIFs) – as defined in subsection 146.3(1) of the Income Tax Act.
- Pooled Registered Pension Plans (PRPPs) – as defined in subsection 147.5(1) of the Income Tax Act. 17.
- Registered Pension Plans (RPPs) – as defined in subsection 248(1) of the Income Tax Act.
- Tax-Free Savings Accounts (TFSAs) – as defined in subsection 146.2(1) of the Income Tax Act.
- Registered Disability Savings Plans (RDSPs) – as defined in subsection 146.4(1) of the Income Tax Act.
- Registered Education Savings Plans (RESPs) – as defined in subsection 146.1(1) of the Income Tax Act.
If this IGA could serve as a reference for U.S. residents owning Canadian tax-favored retirement or savings accounts to understand their reporting requirements under IRC section 6048, it would provide tax certainty and eliminate the filing burden for thousands of taxpayers. The same would apply to taxpayers owning accounts in every IGA partner country. For accounts not within the authority of an IGA partner, Annex II, Part V. of the model 1 IGA provides verifiable standards for exemption eligibility.
My Recommended Changes to Proposed Regulation Section 1.6048-5(b)
First, the definition of an “eligible individual” in Proposed regulation 1.6048-5(b)(1) should be retained, with the added requirement that the individual be in full compliance with FinCEN Form 114 reporting requirements under the Bank Secrecy Act.
Next, section –5(b)(2), (3) and (4) should be replaced by describing any “tax favored foreign retirement trust”, “tax-favored foreign non-retirement savings trust” or “tax-favored foreign de minimis savings trust” as any account or product described in Annex II of the specific country's IGA currently in effect, under the section labeled “Accounts Excluded from Financial Accounts” or “Exempt Accounts."
Lastly, section –5(b) should also specify that tax-favored foreign retirement and nonretirement savings trusts not under the jurisdiction of an IGA currently in effect must meet the definition of an account excluded from financial accounts in Model 1 IGA, Annex II Part V, or Regulation section 1.1471-5(b)(2)(i).
Thank you for your consideration. For any inquiries:
Email: gary@gwcarter.com
Phone: 952-960-2255