To begin with, an arrangement is a trust if its purpose is to invest its trustees with responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this obligation. A trust is the presence of a business purpose and associates that courts have typically found to distinguish an association taxable as a corporation from a trust.
According to the 1996 Small Business Act, a trust is considered domestic if U.S. courts can exercise primary supervision over its administration and U.S. persons are in control of all substantial trust decisions.
If a foreign or domestic trust has a grantor who is not a U.S. citizen, more limited rules apply in determining whether the trust will be considered a grantor trust. A non-grantor trust, on the other hand, is a separate taxpayer for U.S. federal income tax purposes. For purposes of calculating taxable income, a trust receives a deduction for distributions to its beneficiaries to the extent these distributions carry out the trusts distributable net income, or DNI, for the taxable year.
The “throwback rule” is one of the most important parts of the tax code dealing with taxing provisions which apply to foreign trusts. This regulation applies to distributions of accumulated income from foreign trusts.
Foreign trusts which do not distribute all its DNI in the current year will see their after-tax portion of the undistributed DNI become “undistributed net income,” or UNI. Any distributions for subsequent tax years in excess of the DNI of the current taxable year will be considered to come next from UNI.
Another major provision applying to transfers of foreign trusts is in section 684 which provides that any transfer of property by a U.S. citizen to a foreign trust is considered a taxable exchange of the properly.
Cash loans, except as provided in regulations, are now treated as a trust distribution which is generally taxable under the normal trust rules. However, if the loan within the ambit of section 643(i) of the tax code is made to a person other than a grantor or beneficiary it will be treated as a distribution to the grantor or beneficiary to whom the person is related.
Rules regarding how foreign trusts are taxed are complicated and there are many issues which are not specifically addressed by the statutory provisions and for which there is no further public guidance and little applicable precedent.