An increasing number of individuals are becoming globally mobile, relocating from country to country. As a result, attorneys providing estate planning and administration services are being asked questions regarding the income and estate and gift tax aspects related to owning property that is located outside the United States. One of the questions most frequently asked of advisors is "Will I be subject to tax on an inheritance or gift from abroad if I bring the asset into the United States?" The short answer is that the United States does not impose inheritance taxes on bequests. Transfers by gift of property not situated in the United States from foreign nationals not domiciled in the United States are also not subject to U.S. gift taxes. However, advisors need to be aware of the many other U.S. tax rules may apply to such a gift or inheritance.

This article describes the U.S. tax rules that apply to transfers by gift or inheritance of property from abroad to U.S. citizens, U.S. lawful permanent residents ("green card" holders), or foreign nationals residing in the United States. This is the first in a series of articles discussing the U.S. tax rules that apply to cross border estate and gift transfers of property.

U.S. Estate Taxes

The estate and gift tax rules of the Internal Revenue Code include two basic structures for transfers by bequest. One structure covers death transfers by U.S. citizens regardless of where they are domiciled at death. This structure, with some exceptions for transfers to non-U.S. citizen spouses, applies to estates of foreign nationals who are domiciled in the United States. Foreign nationals who are green card holders are generally considered domiciled in the United States for both U.S. estate and gift tax purposes. This is consistent with the immigration law definition of a U.S. lawful permanent resident as an individual who intends to reside permanently in the United States.

Depending on the facts and circumstances, foreign nationals who reside in the United States, but who are not green card holders, may be considered domiciled in the United States for purposes of these tax rules as well. Transfers by foreign nationals not domiciled in the United States are covered by a different estate tax structure that imposes taxes on transfers of certain property situated in the United States.


Estate taxes based on the Code rules may be changed by an estate or gift tax treaty. The United States has estate tax treaties with Australia, Austria, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Norway, Sweden, Switzerland, South Africa and the United Kingdom. The Income tax treaty with Canada also includes articles that minimize the double tax previously caused when assets were subject to the Canada's deemed disposition at death tax which is a capital gains tax rather than a death tax.

In answer to the above question, as long as the decedent who transfers the asset by bequest or is neither a U.S. citizen nor a foreign national domiciled in the United States, no U.S. estate tax is imposed on the transfer. The United States does not impose inheritance taxes on the beneficiary's receipt of a bequest, therefore there is no U.S. tax resulting from the death transfer. Also, the United States also does not impose an income tax on inheritances brought into the United States. However, other U.S. reporting and tax rules may apply to the asset as explained below.
U.S. Gift Taxes

The U.S. gift tax rules apply to gratuitous transfers by U.S. citizens and foreign nationals domiciled in the United States regardless of the location of the asset transferred. Certain exemptions apply to gifts regardless of the domicile of the donor or location of the asset. As with the gift tax rules for U.S. citizens, there is an annual exclusion of $10,000 per donor for each donee gift. Gift splitting is not available to foreign nationals not domiciled in the United States. Gifts to U.S. citizen spouses are free of gift tax. Gifts of up to $100,000 per year to a non-U.S. citizens spouse can be given free of tax.

Gifts by foreign nationals not domiciled in the United States are subject to U.S. gift tax rules only if the asset transferred is situated in the United States (referred to as "U.S. situs" property). Whether property is U.S. situs for purposes of these rules is defined by arcane rules found in sections 2104 and 2105 of the Code. In general, U.S. real estate and tangible personal property that is located in the United States is U.S. situs property but intangibles are not. (However, intangibles such as stock in U.S. companies or debt instruments of U.S. entities or governments are situated in the United States for U.S. estate tax purposes.) Special rules apply to treat U.S. bank accounts as situated outside the United States.

Tangible personal property includes cash. The IRS may consider the gift of a check physically transferred to the donee in the United States to be a gift of tangible property situated in the United States. Gifts of cash by foreign nationals not domiciled in the United States can avoid U.S. gift taxes if structured properly. Such gifts should always be transferred outside the United States. For example, a transfer can be made from the donor's foreign bank account to the donee's foreign bank account. Although such transfers may avoid U.S. gift taxes, the transfer may be subject to foreign gift taxes.

The United States has gift tax treaties, either separate or in combination with estate tax treaties with the following countries: Australia, Austria, Denmark, France, Germany, Japan, Sweden and the United Kingdom. These treaties may eliminate the U.S. gift tax on certain transfers that are otherwise subject to U.S. gift taxes under the Code. An exemption from gift tax under a treaty is made on a gift tax return. The applicable treaty must be analyzed for application to the transfer.


In answer to the above question, as long as the gift is from a foreign national not domiciled in the United States and the asset transferred is non-U.S. situs property. If the gift is subject to U.S. gift taxes, a gift tax treaty may avoid gift taxes.

U.S. Income Taxes

U.S. persons are subject to U.S. income taxes on worldwide income. Therefore, U.S. persons who own income producing property located abroad are subject to U.S. income taxes on that income. U.S. persons for purposes of U.S. income tax rules include U.S. citizens and U.S. lawful permanent residents, regardless of where they reside. The definition of U.S. persons also includes foreign nationals who are resident aliens for U.S. tax purposes. Resident aliens are foreign nationals who meet either the "green card" test or the 183-day substantial presence test of section 7701(b) of the Code. The application of U.S. income taxes to property that is transferred or held in trust depends on the status of the grantor or beneficiary, whether U.S. or foreign, under these income tax rules.

Translation into U.S. Dollars

To determine taxable income for U.S. tax purposes when the income producing asset is denominated in a foreign currency, the income and expenses related to the asset must be translated into U.S. dollars using the appropriate exchange rate. If payments are periodic such as monthly interest, the amount are translated into U.S. dollars using the average exchange rate for the year. Non periodic transactions are translated using the spot rate for the day. Historic exchange rates are available from the Federal Reserve Board by free subscription or on their web site at WWW.BOG.FRB.FED.US.

For example, if a U.S. person inherits stock denominated in a foreign currency the beneficiary's basis in the stock is the fair market value in the stock as of the date of death of the decedent. That value in foreign currency is then translated into U.S. dollars using the exchange rate as of the decedent's date of death to obtain the basis in U.S. dollars. When the stock is sold, the proceeds are translated into U.S. dollars using the exchange rate as of the date of sale. Therefore, included in every such transaction is an unrealized exchange gain or loss depending on the change in exchange values between the decedent's date of death and the date of sale. This IRS tax rule, which was recently upheld by the First Circuit in Quijano vs. The United States, presents the beneficiary with some interesting planning opportunities.

If the beneficiary inherits income producing real property such as an apartment, the rents and expenses related to the apartment are translated into U.S. dollars using these same rules. The property is depreciated using the IRS 40-year rule for property located outside the United States. The rental income and expenses are reported on Schedule E of the individual's Form 1040.

For U.S. income tax purposes, the basis of a gift denominated in foreign currency, is the donee's basis. This must be translated into U.S. dollars using the U.S. dollar exchange rate on the date that the donor obtained the property.

Foreign Taxes

Income from property located abroad may be subject to foreign income taxes as well as U.S. taxes. Periodic income such as interest is usually subject to a withholding tax at source. If the income is from a country with which the United States has an income tax treaty, this withholding tax can be reduced or eliminated by submitting the appropriate withholding certificates to the payor of the income. Otherwise, the beneficiary can compute a foreign tax credit on Form 1116 of Form 1040. Foreign tax credits offset U.S. taxes attributable to foreign income in the individual's tax return. If there is no positive income, as in the case of a rental loss, the foreign taxes may be taken as an itemized deduction.

Many U.S. beneficiaries may either be unaware of or tempted to ignore the U.S. reporting and income tax obligations on foreign assets. Understanding this temptation for cross border tax evasion, tax ministers from around the world began meeting in 1988 at the annual meeting of the International Fiscal Association in Amsterdam to share information on how to use computers to minimize such evasion. For example, income, dividends and other fixed income from payors in countries with which the United States has tax treaties have been reported to the IRS for use in the document match program for almost a decade.

Foreign Trusts

A transfer by death or gift into a foreign trust for the benefit of a U.S. person will impose substantial reporting requirements upon the foreign trustee and U.S. beneficiary as well as subject income distributed to the beneficiary to U.S. income taxes. If the bequest or gift is transferred into a foreign trust by a U.S. person, the U.S. income and reporting rules will apply to income to the trust under the foreign grantor trust rules whether or not the income is distributed to a U.S. person. A foreign trust for purposes of these rules is a trust that is not a domestic trust. A domestic trust is a trust that meets two criteria: 1) A court within the U.S. is able to exercise primary jurisdiction over the administration of the trust; and 2) One or more U.S. fiduciaries have the authority to control all substantial decisions of the trust.

1. Distributions to U.S. Beneficiaries of Foreign Trusts

In 1996 and 1997, the U.S. Congress and Treasury introduced provisions targeting certain perceived abuses in the use of foreign trusts by both U.S. persons seeking to avoid U.S. income taxes and foreign persons seeking to provide perpetual tax-free income to U.S. beneficiaries. Under the new rules, a U.S. person who receives a distribution, directly or indirectly, from a foreign trust after August 20, 1996 is required to report a number of matters relevant to the trust on Form 3520, Annual Return to Report Transactions With Foreign Trusts. The form must include the name of the trust and the aggregate distribution received during the calendar year. A U.S. person who receives a distribution from a foreign trust must disclose the receipt of the distribution by checking the appropriate box on Schedule B of Form 1040.

The deadline for reporting distributions is the due date of the 1997 individual tax return, plus applicable extensions of time to file. A Form 3520 is required for each trust with a distribution to a U.S. beneficiary. The trustee must sign two original Forms 3520 verifying the correctness of the information on the form. One is attached to the U.S. beneficiary's Form 1040 tax return. One is submitted to the IRS Center in Philadelphia, PA. A U.S. beneficiary
who fails to report a distribution received from a foreign trust after August 20, 1996 may be subject to a 35 percent penalty on the gross amount of the unreported portion of the distribution.

For U.S. tax purposes, the income that is included in the trust distribution is determined under the complex Code rules defining distributable net income with certain adjustments related to foreign trusts. Capital gains distributed from a foreign trust retain their character as gains if distributed in the year earned. Income that is not distributed currently, regardless of the original character is taxed as ordinary income under complex tax rules for accumulation distributions.

2. Accumulation Distributions Tax

Under the U.S. income tax rules for distributions from foreign trusts, some complex throwback rules apply to tax accumulation distributions to the beneficiary at a rate equal to that which the beneficiary would have paid had the income been distributed to the beneficiary in the year that it was earned. A three out-of-five year averaging method is used to calculate the tax. An interest charge is then applied to the tax. Under the new reporting rules, this accumulation distribution tax now applies in situations where, by the IRS standards, adequate information is not available to the U.S. beneficiary to determine the U.S. tax consequences of the distribution. The accumulation distribution computation is based on a three-year average of trust distributions using distributions for the current and two prior years.

3. Foreign Grantor Trusts

A foreign trust is a foreign grantor trust if any U.S. person created the trust or transferred cash or other property to the trust. A grantor includes any U.S. person treated as the owner of any part of a foreign trust's assets under sections 671 through 679, excluding section 678. A U.S. person who inherits property from abroad that he allows to be held indefinitely by the foreign executor or administrator of the estate rather than allowing the property to be transferred to his possession may be viewed by the IRS to have created a foreign grantor trust. The transfer of appreciated property to a foreign trust is subject to a 35 percent excise tax under section 1491 of the Code. This tax applies when the U.S. grantor of a foreign grantor trust dies and the trust is no longer a grantor trust for U.S. tax purposes.

Income of a foreign grantor trust must be reported on the grantor's U.S. tax returns using U.S. tax principles. If the grantor or a person related to the grantor receives a loan from a related foreign trust, the loan is treated as a distribution unless the loan is issued in exchange for a obligations that meet certain arms length criteria. This is the case even if the loan is later repaid. A grantor of a foreign grantor trust who receives distributions from the trust must also submit Form 3520 as described above.

The trustee of a foreign grantor trust must also submit Form 3520-A, Annual Information Return of a Foreign Trust with a U.S. Owner, by March 15 of each year. Extensions of time to file can be requested on Form 2758. The due date of this form cannot be extended beyond September 15.

4. Appointment of a U.S. Agent

Certain documentation is required with the Form 3520-A such as a summary of written and oral agreements relating to the trust and the trust instrument itself. If the trustee appoints a U.S. agent for the limited purpose of acting as the agent with regard to these reporting rules, the documentation requirement is avoided. If the foreign trust has appointed a U.S. agent, the name, address, and U.S. taxpayer identification number of the U.S. agent must be included on Form 3520-A.

Stock Ownership in a Foreign Corporation

If stock in a foreign corporation is transferred by gift or bequest to a U.S. person, the ownership of that stock may trigger several U.S. anti tax avoidance rules. Generally, these rules are intended to prevent income from certain passive assets from accumulating off-shore free from U.S. taxation. Three main sets of rules comprise this anti-deferral regime: the controlled foreign corporation rules, the foreign personal holding company rules, and the passive foreign investment company rules. These rules that were designed for major multi- national companies apply with equal force to small closely held foreign companies.

Controlled Foreign Corporations

A controlled foreign corporation (CFC) is a foreign corporation in which U.S. persons, each of whom is at least a 10 percent shareholder, own as a group, more than 50 percent of the vote or value. Under the stock attribution rules for determining whether a foreign corporation is a CFC, stock ownership is attributed from an individual's spouse, children, grandchildren and parents who are also shareholders. If a nonresident shareholder is a spouse, child, grandchild, or grandparent of the U.S. person, that person's stock is not attributed to the U.S. person for purposes of determining CFC status.

Generally, 10 percent U.S. shareholders are taxed currently on certain income of the corporation even if no income is distributed. The income, a description of which is beyond the scope of this article, is reported on the individual's U.S. tax returns as a deemed dividend.

10 percent U.S. shareholders of a CFC are required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Form 5471 requires substantial disclosure regarding the income and assets of the foreign company. The information on Form 5471 allows the U.S. shareholder, as well as the IRS, to calculate the shareholders CFC inclusion. In certain circumstances, the U.S. shareholder who is filing the Form 5471 will be required to disclose any other 10 percent U.S. shareholders.

The penalties for failure to file Form 5471 are severe. The shareholder can be assessed a failure to file penalty of up to $10,000 PER Form 5471 not filed. In addition, the shareholder can lose up to 10 percent of the shareholder's foreign tax credits.

Foreign Personal Holding Company

A foreign personal holding company (FPHC) is a foreign corporation is which 5 or fewer U.S. persons own, as a group, more than 50 percent of the vote or value. The scope of the attribution rules for FPHC status is broader than the attribution rules for CFC status. Ownership of stock is attributed to a U.S. person from any lineal descendant or ancestor whether or not the relative is a U.S. person or a nonresident alien. Stock is attributed from siblings regardless of their U.S. tax.

To qualify as FPHC the corporation's gross income must consist of at least 60 percent passive income. Once that threshold is met, the corporation will continue to be treated as a FPHC if at least 50 percent of its gross income is from certain passive sources.

U.S. shareholders of a FPHC are required to file Form 5471. Form 5471 requires disclosure regarding the income and assets of the foreign company. In addition, Form 5471 calculates the shareholders FPHC inclusion for the tax year. The penalties for failure to file the Form 4571 is the same as those under the CFC rules.

Passive Foreign Investment Company

A foreign company is a passive foreign investment company (PFIC) if one of two tests is met: 1) 75 percent of the gross income of the corporation is passive or 2) the corporation's assets consist of 50 percent or more of passive assets. Passive assets are assets that produce passive income. No threshold of stock ownership by U.S. persons is required for a corporation to qualify as a PFIC.

Unlike the CFC and FPHC rules, income of a PFIC is not taxed currently unless the U.S. shareholder elects to treat the foreign corporation as a Qualified Electing Fund (QEF). Under such an election, the U.S. shareholder includes in his U.S. tax returns, as ordinary income, his pro rata share of the foreign corporation's ordinary income, and, as long-term capital gain, his pro rata share of the foreign corporation's net capital gain. A QEF election is made by filing Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, with the shareholder's tax return for the first year in which the corporation was a PFIC. In order for the election to be valid, the Form 8621 must be filed with a timely filed Form 1040.

If no QEF election is made, when a distribution is made from the corporation or when the stock is sold, the distribution or capital gain will be taxed under the punitive tax rules of the excess distribution regime. The excess distribution regime will also apply to the U.S. shareholder's value in the non-electing corporation, should the shareholder become a foreign person at some future time. This would happen to a U.S. person who is a foreign national who meets the substantial presence test one year but fails to meet it in a subsequent year because of time spent outside the United States.

U.S. shareholders of a PFIC are required to file Form 8621 annually. Form 8621 requires the shareholder to report the ordinary and capital gains income from that foreign company that the shareholder is reporting on Form 1040.

Reporting on Bequests and Gifts from Abroad

All bequests and gifts received by U.S. persons from foreign persons that exceed $100,000 in the calendar year are reportable to the IRS on Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. The amount and description of the bequest must be disclosed. However, the IRS does not require disclosure of the identity of the decedent or donor. One Form 3520 must be attached to the
beneficiary's Form 1040, if any. A second signed Form 3520 must be sent to the IRS Center in Philadelphia, PA. The failure to submit the required forms is 25 percent of the bequest or gift unless just cause for the failure is shown.

If the bequest or gift is a foreign bank account and the amount in the account exceeds $10,000 at any time during the calendar year, the beneficiary must disclose the existence of a foreign account on Schedule B of Form 1040 the existence and country where such account is relocated. In addition, the holder of the account must submit a Form TD F 90-22.1, Report of Foreign and Financial Accounts, to the U.S. Treasury by June 30 of the following year. Neither the Schedule B disclosure nor the bank form are required if the individual's total foreign bank account balances combined are less than $10,000 at all times during the calendar year.

All transfers of cash or negotiable instruments to or from the United States must be reported to the U.S. government. Wire transfers through the banking system are reported by financial institutions. Negotiable instruments and cash that are brought into the United States personally must be reported to U.S. customs.

Summary

A bequest from abroad is not subject to U.S. estate taxes if the decedent is neither a U.S. citizen nor a foreign national domiciled in the United states. A gift from abroad from a foreign national is not subject to U.S. gift taxes unless only U.S. situs assets of such donors are subject to U.S. gift tax rules. However, the income from income producing assets located abroad that are owned by U.S. persons are subject to U.S. income taxes. The determination of the reportable income can be very complex when the asset is stock in a foreign corporation that meets one or several of the anti-deferral regime definitions. Likewise, interests in foreign trust create complex reporting rules. In addition, ownership of foreign assets will subject the U.S. beneficiary or donee to a myriad of other reporting obligations required by the IRS.