On March 5, 2020, the Internal Revenue Service chief counsel released a legal opinion (PMTA 2020-006) discussing the availability of federal income tax credits and refunds under Internal Revenue Code Section 1462, in cases in which a foreign (non-U.S.) complex trust makes a distribution of U.S. source income to U.S. beneficiaries.
Although the opinion isn’t binding on the IRS or any court, it’s at a minimum indicative of the IRS’ view of a particular issue at the time of publication of the advice and provides taxpayers with additional support in case of a challenge by the IRS.
The chief counsel’s opinion applies specifically to individuals who are U.S. persons (those U.S. citizens and other persons who are subject to tax in the United States on their worldwide income) and who are beneficiaries of foreign, complex trusts (in other words, foreign trusts in which the trustee decides when, to whom and to what extent trust distributions will or won’t be made) that receive payments of U.S. source income.
There are several reasons why a U.S. person may be a beneficiary of a foreign trust that receives a payment of U.S. source income, including when the U.S. beneficiary is a member of a second or lower generation of a multiple-generation non-U.S. family, the U.S. beneficiary became a U.S. person subsequent to the settlement of the particular trust, the U.S. beneficiary lives outside of the United States or in cases in which a trust was settled by non-U.S. relatives (for example, a foreign parent) of the U.S. person.
U.S. Source Income
U.S. source income includes income earned from a U.S. trade or business as well as dividends paid by a U.S. corporation, interest paid by a U.S. debtor, and rents and royalties paid in connection to property located or used in the United States.
Generally, U.S. source income that isn’t earned in connection with a U.S. trade or business is subject to a flat 30% withholding tax when paid to non-U.S. persons. This means that a foreign complex trust that, for example, receives dividend distributions from a U.S. corporation, will be subject to 30% withholding on that dividend, even if the dividend is later paid to a U.S. person. On the other hand, if the same dividend was paid directly to a U.S. person, the withholding tax wouldn’t apply, and any taxes due would be due on the total net gain of the U.S. person (and not on the gross distribution) and would be potentially subject to a lower tax rate (in other words, as qualified dividends, which are taxed at a maximum marginal rate of 20% plus 3.8% net investment income tax).
Credit and Refund
The recently issued chief counsel’s opinion, in addition to confirming that U.S. beneficiaries are eligible for a withholding tax credit, goes further and confirms that the U.S. beneficiary should be entitled to claim a refund for excess taxes withheld at the trust level that are proportionately attributed to U.S. source income that’s “paid, credited, or required to be distributed” to the particular U.S. beneficiary.
The credit and refund are available only if the foreign trust doesn’t itself claim a credit or refund for the withholding taxes, properly allocates a credit for the withholding taxes in connection to the U.S. source income to the respective individual U.S. beneficiary(ies), and the individual U.S. beneficiary substantiates entitlement to such withholding tax credit.
Although the chief counsel’s opinion refused to address how U.S. beneficiaries may substantiate entitlement to the withholding credit, at a minimum, proper allocation and substantiation would require that the trustee of the foreign trust and the U.S. beneficiary document and file the correct and consistent IRS forms indicating that the U.S. source income was paid to the U.S. beneficiary and the amount of withholding tax credits associated with such income. Proper documentation includes:
1. Issuance and filing of Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, by the payor of U.S. source income to the foreign trust.
2. Filing by the foreign trust of Form 1040NR, U.S. Nonresident Alien Income Tax Return, with a statement attached to the return describing:
(a) that U.S. source income was paid to a specific U.S. beneficiary; and
(b) the details of the allocation of the credit related to the withholding on the U.S. source income to such U.S. beneficiary, as appropriate.
3. The U.S. beneficiary should then report on their U.S. federal income tax return (Form 1040) the entire dividend distribution as income and claim a 30% tax credit. The amount of the 30% tax credit that exceeds the U.S. beneficiary’s actual tax liability should be subsequently refunded to the U.S. beneficiary.
Further, it’s important to note that the facts to which the guidance relates involve receipt of U.S. source income and distribution of such income by the foreign trust to the U.S. beneficiary in the same tax year. Moreover, the particular foreign trust had no other income for the year, apart from the U.S. source income. Thus, trustees of foreign trusts wishing to assist their U.S. beneficiaries in claiming the withholding tax credit on the basis of the chief counsel’s opinion should ensure that the U.S. source income is distributed to the U.S. beneficiary in the same tax year of receipt, and where possible, distribute only the U.S. source income to the exclusion of other current or accumulate income and assets of the foreign trust.
Potential Significant Tax Savings
The chief counsel’s opinion provides valuable insights on the procedures and formalities U.S. beneficiaries and foreign trusts should follow to successfully claim credits and receive refunds with connection to taxes withheld at the foreign trust level on U.S. source income. U.S. citizens and residents who are beneficiaries of foreign trusts and who receive distributions from such trusts should closely review this guidance as it could result in significant tax savings.
*The original article appeared in Baker & McKenzie’s Client alert.