Asset Protection BLOG - Mark Nestmann: U.S. Taxpayers: Beware Holding Offshore Funds in an Offshore Trust

One of the most unfair and insidious parts of the U.S. Tax Code is Section 1291-1297, which deals with the taxation of offshore mutual funds.

Naturally, the Treasury doesn't call offshore funds "offshore funds." That would be too simple. Instead, it calls them "passive foreign investment companies" (PFICs).

For purchases of U.S. mutual funds, the IRS receives a report of income or gain on Form 1099. Since offshore funds don't file Form 1099, the IRS requires investors to determine their share of the income and pay tax on it.

That's often impossible for an investor to do. And if you can't make the necessary calculations, using IRS-approved methods, the IRS imposes punitive taxes and interest payments on whatever taxes you defer. The details of the calculations are complex, but the result is that for offshore funds held for many years, the tax and interest due can easily exceed the total gain. However, the law provides that the tax and interest charge shall not exceed the amount of the distribution. (Gee, thanks IRS!)

Some U.S. investors have tried to avoid these rules by purchasing offshore funds through an offshore trust. I recommend to my clients that they NOT do so, unless they receive enough information from the fund to use the IRS-approved methods to calculate their gains.

This recommendation stems from the fact that under the U.S. grantor trust rules (I.R.C. 691-697), income or gain received by a foreign trust is treated as if was received by the grantor (the person who funded the trust). Since most offshore trusts funded by U.S. persons are taxed as grantor trusts, most of the time, they shouldn't own offshore funds.

Now, the IRS has published an even more extreme interpretation of the PFIC rules. In a recently released Technical Advice Memorandum (TAM #200733024), it declared that U.S. beneficiaries of a foreign trust are subject to the PFIC rules as well, even when non-U.S. persons established and funded the trust.

In this case, the foreign trust, established in 1981, five years before the PFIC rules came into effect, owned a foreign corporation (holding company). The holding company in turn owned the stock of some other foreign corporations.

The IRS held that the holding company was a PFIC. When it was liquidated and its assets transferred to the foreign trust, the IRS ruled that it was a taxable event under the PFIC "excess distribution" rules. This subjected the U.S. beneficiaries not only to tax on the excess distribution, but to interest charges going back 12 years.

This result doesn't seem to be fair—or in accordance with the rules for this type of trust (called a foreign non-grantor trust). The beneficiaries may well appeal the ruling. But it illustrates the extreme dangers of holding offshore funds in an offshore trust without a thorough analysis of the possible tax consequences.

In my next blog entry, I'll describe a few ways U.S. taxpayers can purchase offshore funds, without worrying about the PFIC rules.

(Thanks to CPA Vern Jacobs for bringing this Technical Advice Memorandum to my attention in the International Wealth Protection Monitor. Link: http://www.offshorepress.com.)