Inbound Grantor Trusts With Foreign Grantors

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

[REG-252487-96]

RIN 1545-AU90

Inbound Grantor Trusts With Foreign Grantors

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations implementing

section 672(f) of the Internal Revenue Code, as amended by the Small

Business Job Protection Act of 1996, which relates to the application

of the grantor trust rules to certain trusts established by foreign

persons. The proposed regulations affect primarily United States

persons who are beneficiaries of trusts established by foreign persons.

This document also provides notice of a public hearing on these

proposed regulations.

DATES: Written comments must be received by August 4, 1997. Requests to

speak (with outlines of oral comments) to be discussed at the public

hearing scheduled for August 27, 1997, at 10 a.m. must be submitted by

August 6, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-252487-96), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

[[Page 30786]]

Washington, DC 20044. Submissions may be hand delivered between the

hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-252487-96), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,

Washington, DC. Alternatively, taxpayers may submit comments

electronically via the Internet by selecting the ``Tax Regs'' option on

the IRS Home Page, or by submitting comments directly to the IRS

Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html.

The public hearing will be held in room 3313, Internal Revenue

Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning Sec. 1.671-2(e), James

Quinn (202) 622-3060; concerning the remainder of these regulations, M.

Grace Fleeman (202) 622-3850; concerning submissions and the hearing,

Michael Slaughter (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 1904 of the Small Business Job Protection Act of 1996 (the

Act), Public Law 104-188, 110 Stat. 1755 (August 20, 1996), amended

section 672(f) and certain other sections of the Internal Revenue Code

(Code). The amendments affect the application of sections 671 through

679 of the Code (the grantor trust rules) to certain trusts created by

foreign persons.

1. Prior Law

Under prior law, a grantor of a trust generally was treated as the

owner of any portion of the trust over which he retained any of the

powers or interests described in sections 673 through 677 without

regard to whether he was a domestic or foreign person. A special rule

contained in prior section 672(f) generally provided that, if a U.S.

beneficiary of a trust created by a foreign person transferred property

to the foreign person by gift, the U.S. beneficiary was treated as the

grantor of the trust to the extent of the transfer.

Under the prior rules, if a foreign person created a trust with one

or more U.S. beneficiaries that was treated as a grantor trust with the

foreign person as the grantor, a distribution of income from the trust

to a U.S. beneficiary was treated as a gift and was not subject to U.S.

income tax in the hands of the beneficiary. See Rev. Rul. 69-70 (1969-1

C.B. 182). If the income of the trust was not taxable to the foreign

grantor under section 871 and also not taxable to either the grantor or

the trust by either the grantor's country of residence or another

foreign country, the income of the trust was, thus, not subject to tax

by any jurisdiction.

A special rule contained in section 665(c) provided generally that

intermediaries or nominees interposed between certain foreign trusts

and their U.S. beneficiaries could be disregarded. However, that rule

applied only to trusts created by U.S. persons.

2. Overview of Changes

The changes made by section 1904 of the Act are designed to ensure

that U.S. persons who benefit from offshore trusts created by foreign

persons (inbound trusts) pay an appropriate amount of U.S. tax.

Generally, the grantor trust rules now cause a person to be treated as

the owner of a trust only to the extent such application results,

directly or indirectly, in an amount being currently taken into account

in computing the income of a U.S. citizen or resident or a domestic

corporation. Exceptions are provided for certain revocable trusts, for

trusts from which the only amounts distributable during the lifetime of

the grantor are to the grantor or the grantor's spouse, and for certain

compensatory trusts. There also are grandfather rules for certain

trusts that were in existence on September 19, 1995.

As a result of the changes, many inbound trusts that were grantor

trusts under prior law are now nongrantor trusts. Distributions of

trust income to the U.S. beneficiaries of such trusts are now taxable

to U.S. beneficiaries and may be subject to an interest charge on

accumulation distributions.

Section 1904 of the Act also includes some special rules. Section

643(h), which replaces former section 665(c), treats any amount paid to

a U.S. person that is derived directly or indirectly from a foreign

trust of which the payor is not the grantor as if the amount is paid by

the foreign trust directly to the U.S. person. Section 672(f)(4) allows

the IRS to recharacterize a purported gift or bequest from a

partnership or foreign corporation when necessary to prevent the

avoidance of the purpose of section 672(f). Section 672(f)(5), which is

an expansion of prior section 672(f), generally provides that if a U.S.

beneficiary of a trust created by a foreign person transfers property

to the foreign person, the U.S. beneficiary is treated as the grantor

of the trust to the extent of the transfer.

Explanation of Provisions

1. Section 1.643(h)-1: Distributions by Certain Foreign Trusts Through

Intermediaries

The proposed regulations describe the circumstances under which an

amount of property that is derived, directly or indirectly, by a U.S.

person from a foreign trust through an intermediary will be deemed to

have been paid directly by the foreign trust to the U.S. person. This

rule does not apply if the intermediary is the grantor of the portion

of the trust from which the amount is distributed. The amount will be

deemed to have been paid directly by the foreign trust if any one of

the following conditions is satisfied: (1) The intermediary is related

(as defined in the regulations) to either the U.S. person or the

foreign trust and the intermediary transfers to the U.S. person either

property that the intermediary received from the trust or proceeds from

the property that the intermediary received from the trust; (2) the

intermediary would not have transferred the property to the U.S. person

(or would not have transferred the property on substantially the same

terms) but for the fact the intermediary received property from the

foreign trust; or (3) the intermediary received the property from the

foreign trust pursuant to a plan one of the principal purposes of which

was the avoidance of U.S. tax.

The proposed regulations describe the effect of disregarding the

intermediary. If the intermediary is an agent of either the foreign

trust or the U.S. person under generally applicable agency principles

(under the standards set forth in Commissioner v. Bollinger, 485 U.S.

340 (1988)), the amount is treated as paid by the foreign trust to the

U.S. person in the year it would be so treated under the general

principles. Thus, if the intermediary is an agent of the foreign trust,

the amount is treated as paid to the U.S. person in the year it is paid

by the intermediary to the U.S. person. If, however, the intermediary

is an agent of the U.S. person, the amount is treated as paid to the

U.S. person in the year it is paid by the foreign trust to the

intermediary.

If the intermediary is not an agent of either the foreign trust or

the U.S. person under generally applicable agency principles, the

intermediary generally will be treated as an agent of the foreign

trust, and the amount will be treated as paid by the foreign trust to

the U.S. person in the year the amount is paid by the intermediary to

the U.S. person. However, the district director may determine, based on

all the relevant facts and circumstances, that the

[[Page 30787]]

intermediary should be treated as the agent of the U.S. person.

The regulations provide a de minimis rule for distributions that do

not exceed in the aggregate $10,000.

2. Section 1.671-2(e): Definition of Grantor

The proposed regulations provide a definition of grantor that

applies for purposes of the grantor trust rules generally. A grantor is

any individual, corporation, or other person to the extent such person

(i) creates a trust or (ii) directly or indirectly makes a gratuitous

transfer to a trust. For purposes of the proposed regulations, a

gratuitous transfer is any transfer other than a transfer for fair

market value, or a corporate or partnership distribution. Treasury and

the IRS request comments regarding the appropriate scope of gratuitous

transfers.

A grantor includes a person who acquires an interest in a trust in

a nongratuitous transfer from a person who is a grantor of the trust. A

grantor also includes an investor who acquires an interest in a fixed

investment trust from a person who had acquired his interest through a

direct investment in the trust. Treasury and the IRS request comments

on the appropriate scope of these rules as they affect fixed investment

trusts.

If a person creates or funds any portion of a trust primarily as an

accommodation for another person, the other person will be treated as a

grantor with respect to such portion of the trust. See, e.g., Stern v.

Commissioner, 77 T.C. 614 (1981), rev'd on other grounds, 747 F.2d 555

(9th Cir. 1984).

These regulations are not intended to change the result of existing

law with respect to trusts used for business purposes. See

Sec. 301.7701-4(e) (environmental remediation trusts); Rev. Rul. 87-

127, 1987-2 C.B. 156 (pre-need funeral trusts); Rev. Proc. 92-64, 1992-

2 C.B. 422 (rabbi trusts). Treasury and the IRS request comments on the

application of these new rules to trusts used for business purposes.

A grantor of a trust may or may not be treated as an owner of the

trust under sections 671 through 677 and 679. A person other than a

grantor of a trust may be treated as an owner of the trust under

section 678.

3. Section 1.672(f)-1: Foreign Persons Not Treated as Owners

The proposed regulations prescribe a two-step analysis for

implementing the general rule of section 672(f). First, the grantor

trust rules other than section 672(f) (the basic grantor trust rules)

are applied to determine the worldwide amount and the U.S. amount.

Then, the trust is treated as partially or wholly owned by a foreign

person based on an annual year-end comparison of the worldwide amount

and the U.S. amount.

The worldwide amount is defined as the net amount of income, gains,

deductions, and losses that would be taken into account for the current

year under the basic grantor trust rules in computing the worldwide

taxable income of any person, whether or not such person is a U.S.

taxpayer (as defined in the regulation). The worldwide amount is

determined in accordance with U.S. principles of income taxation, and

includes amounts that would be attributable to foreign persons, without

regard to whether such amounts are subject to U.S. income taxation.

The U.S. amount is defined as the net amount of income, gains,

deductions, and losses that would be taken into account for the current

year under the basic grantor trust rules (directly or through one or

more entities) in computing the taxable income of a U.S. taxpayer. The

U.S. amount includes amounts such as interest on state or local bonds

that are not includible in gross income.

A U.S. taxpayer is defined as any person who is a U.S. citizen, a

resident alien individual, a domestic corporation, a U.S. person who is

treated as the owner of a trust under section 679, or a domestic trust

to the extent such trust actually pays U.S. tax with respect to the

income, gains, deductions, and losses.

If the worldwide amount and the U.S. amount are the same, the basic

grantor trust rules continue to apply without the limitation of section

672(f). If the worldwide amount is greater than the U.S. amount,

section 672(f) prevents the basic grantor trust rules from treating a

person as the owner of that portion of the trust attributable to the

excess of the worldwide amount over the U.S. amount.

4. Section 1.672(f)-2: Trusts Created by Certain Foreign Corporations

Section 672(f)(3) provides in part that, except as otherwise

provided in regulations, a controlled foreign corporation (CFC) shall

be treated as a domestic corporation for purposes of section 672(f)(1).

Under the proposed regulations, a CFC that creates and funds a trust

will be treated as a domestic corporation to the extent that, if the

basic grantor trust rules were applied, income earned by the trust for

the taxable year would be subpart F income to the CFC that would be

currently taken into account in computing the gross income of a U.S.

citizen or resident or a domestic corporation. However, the CFC will

not be treated as a domestic corporation to the extent the income of

the trust would not be subpart F income or to the extent it would be

subpart F income but would not be taken into account in computing the

gross income of a U.S. citizen or resident or a domestic corporation

(e.g., the CFC had no overall earnings and profits).

The proposed regulations include similar rules for trusts created

by passive foreign investment companies (PFICs) or foreign personal

holding companies.

Section 672(f)(3) also provides that the general rule of section

672(f)(1) shall not apply for purposes of section 1296. The proposed

regulations implement this rule by providing that, for purposes of

determining whether a foreign corporation is a PFIC, the grantor trust

rules shall be applied as if section 672(f) had not come into effect.

Consequently, a foreign corporation cannot avoid PFIC status by

transferring passive assets to a trust that would be treated as a

nongrantor trust if section 672(f) were applied.

5. Section 1.672(f)-3: Exceptions to General Rule

A. Certain Revocable Trusts

The proposed regulations provide that the general rule of

Sec. 1.672(f)-1 does not apply to any portion of a trust if the power

to revest in the grantor title to such portion is exercisable solely by

the grantor without the approval or consent of any other person. If the

grantor can exercise the power only with the approval of a related or

subordinate party who is subservient to the grantor, such power will be

treated as exercisable solely by the grantor.

The exception will not apply unless the power to revest is

exercisable for a period or periods aggregating 183 days or more during

the taxable year of the trust. This rule is intended to provide a

bright line rule for the benefit of both taxpayers and IRS examiners

that addresses potentially abusive situations in which a power to

revest is so limited that it is not likely to be exercised. The 183

days need not be consecutive; thus, a power to revest that is

exercisable each year from January 1 through May 31 and again from

September 1 through December 31 would be eligible for the exception.

Consistent with the statute, the proposed regulations provide a

grandfather rule for a trust that was treated as owned by the grantor

under

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section 676 on September 19, 1995. As long as such a trust would

continue to be so treated under the basic grantor trust rules, the

trust will be exempt from the general rule of section 672(f), except

with respect to any portion of the trust attributable to transfers to

the trust after September 19, 1995. Under the proposed regulations,

separate accounting is required for amounts transferred to the trust

after September 19, 1995, together with all income and gains thereof,

as well as losses and distributions therefrom.

B. Certain Other Trusts

The proposed regulations provide that the general rule does not

apply to any trust (or portion of a trust) if the only amounts

distributable (whether income or corpus) from such trust (or portion of

a trust) during the lifetime of the grantor are amounts distributable

to the grantor or the grantor's spouse. For this purpose, payments of

reasonable nongratuitous amounts, such as reasonable administrative

expenses, are not considered to be amounts distributable from the

trust.

The proposed regulations clarify that amounts distributable in

discharge of a legal obligation of the grantor or the grantor's spouse

will generally be treated as amounts distributable to the grantor or

the grantor's spouse. Thus, it is expected that a reinsurance trust

that would have been a grantor trust under prior law generally will

continue to be a grantor trust. (No inference is intended as to whether

a reinsurance trust constitutes a trust under regulation Sec. 301.7701-

4.) However, a legal obligation will not include an obligation to a

person who is related (as defined in the regulations) to the grantor or

the grantor's spouse, unless the obligation was entered into for

adequate and full consideration in money or money's worth. Trusts from

which distributions are taxable as compensation for services rendered

generally will be covered by the exception for compensatory trusts,

described below.

Amounts distributable to support a family member will be treated as

amounts distributable to the grantor or the grantor's spouse only if

certain requirements are satisfied. Although different jurisdictions

have different requirements for support obligations, administrative

simplicity is served by providing one uniform rule on this point. Under

the proposed regulations, the family member must be an individual who

would be treated as a dependent of the grantor or the grantor's spouse

under sections 152(a)(1) through (8), without regard to the requirement

that half of the individual's support be received from the grantor or

the grantor's spouse. In addition, the family member must be either

permanently and totally disabled (within the meaning of section

22(e)(3)) or, in the case of a son, daughter, stepson, or stepdaughter,

less than 24 years old.

Consistent with the statute, the proposed regulations provide a

grandfather rule for a trust that was treated as owned by the grantor

under section 677 (other than subsection (a)(3) thereof) on September

19, 1995. As long as such a trust would continue to be so treated under

the basic grantor trust rules, the trust will be exempt from the

general rule, except with respect to any portion of the trust

attributable to transfers to the trust after September 19, 1995. Under

the proposed regulations, separate accounting is required for amounts

transferred to the trust after September 19, 1995, together with all

income and gains thereof, as well as losses and distributions

therefrom.

C. Compensatory Trusts

The proposed regulations implement section 672(f)(2)(B), which

provides that, except as provided in regulations, the general rule

shall not apply to any portion of a trust from which distributions are

taxable as compensation for services rendered. Tracking the language of

the statute, the proposed regulations list categories of trusts that

constitute compensatory trusts, without regard to whether they could be

treated as grantor trusts under the basic grantor trust rules. This

list is intended to be an exclusive list. However, the proposed

regulations also provide that additional categories of compensatory

trusts may be designated later in guidance published in the Internal

Revenue Bulletin.

The following categories of trusts are classified as compensatory

trusts: (i) qualified trusts described in section 401(a), (ii) trusts

described in section 457(g), (iii) nonexempt employees' trusts

described in section 402(b), (iv) individual retirement account (IRA)

trusts that are either simplified employee pensions described in

section 408(k) or simple retirement accounts described in section

408(p), (v) IRA trusts to which the only contributions are rollover

contributions listed in section 408(a)(1), (vi) certain so-called rabbi

trusts (see Rev. Proc. 92-64 (1992-2 C.B. 422)), and (vii) trusts that

are welfare benefit funds described in section 419(e) (without regard

to whether they provide taxable benefits).

The IRS and Treasury contemplate that the nonexempt employees'

trusts listed in category (iii) above will be treated as grantor trusts

only to the extent provided in proposed regulations Sec. 1.671-1(g) and

Sec. 1.671-1(h), which were published in the Federal Register (61 FR

50778) on September 27, 1996.

IRAs that are excluded from the list of compensatory trusts because

they are funded by individuals, rather than employers, are expected to

be covered by one or both of the exceptions for revocable trusts or for

trusts from which the only amounts distributable during the lifetime of

the grantor are to the grantor or the grantor's spouse.

6. Section 1.672(f)-4: Recharacterization of Purported Gifts

The proposed regulations implement the purported gift rule of

section 672(f)(4), which was enacted as a backstop to section 672(f).

See Staff of the Joint Committee on Taxation, 104th Cong., 2nd Sess.,

General Explanation of the Tax Legislation Enacted in the 104th

Congress, at 271 (1996). The purported gift rule prevents taxpayers

from avoiding the general rule of section 672(f) by using a partnership

or a foreign corporation as a substitute for a trust.

As a general rule, if a U.S. donee receives a purported gift or

bequest directly or indirectly from a partnership, the purported gift

or bequest must be included in the U.S. donee's income as ordinary

income. If a U.S. donee receives a purported gift or bequest directly

or indirectly from a foreign corporation, the purported gift or bequest

generally must be included in the U.S. donee's gross income as a

distribution from the foreign corporation. In the latter case, the U.S.

donee will not be treated as having basis in the foreign corporation,

and the U.S. donee will be treated as having a holding period in the

foreign corporation equal to the average holding period (using a

weighted average) of the actual interest holders.

However, the gift or bequest will not be recharacterized if the

donee can establish that a U.S. citizen or resident alien who directly

or indirectly holds an interest in the partnership or foreign

corporation treated the purported gift as a distribution from the

partnership or foreign corporation and a subsequent gift to the donee.

There also is an exception for charitable contributions to donees

described in section 170(c).

The proposed regulations provide rules for gratuitous transfers to

U.S. donees from trusts created by partnerships or foreign

corporations. As a result, a partnership or foreign corporation cannot

avoid the purported gift rule by creating a nongrantor trust that makes

an immediate nontaxable distribution of trust corpus to a U.S.

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donee. Under the proposed regulations, if the partnership or foreign

corporation is not treated under the grantor trust rules as the owner

of the portion of the trust from which property is distributed to a

U.S. donee in a gratuitous transfer, the distribution will be

characterized as a distribution from the partnership or foreign

corporation if such characterization results in a higher U.S. tax

liability.

Notwithstanding any other provision, the proposed regulations

provide that the district director may recharacterize a transfer that

is subject to the rules of section 672(f)(4) to prevent the avoidance

of U.S. tax or clearly to reflect income. For example, the district

director may determine, based upon the facts and circumstances, that a

distribution from a partnership or foreign corporation is more properly

treated as a distribution from a trust.

The proposed regulations provide a de minimis rule for purported

gifts or bequests that do not exceed in the aggregate $10,000.

7. Section 1.672(f)-5: Special Rules

A. Transfers by Certain Beneficiaries to Foreign Settlor

The proposed regulations provide that if, but for section

672(f)(5), a foreign person would be treated as the owner of any

portion of a trust, any U.S. beneficiary of the trust will be treated

as the owner of a portion of the trust to the extent the U.S.

beneficiary directly or indirectly made transfers of property to such

foreign person in excess of transfers to the U.S. beneficiary from the

foreign person. (Such a transfer may also constitute an indirect

transfer from a U.S. person to a foreign trust for purposes of section

679.) The U.S. beneficiary need not have been a U.S. person at the time

of the transfer.

The proposed regulations do not specify a time period within which

a transfer must have been made to trigger this rule. However, they do

provide that the rule will not apply to the extent the U.S. beneficiary

can demonstrate that the transfer was wholly unrelated to any

transaction involving the trust. In addition, consistent with the

statute, the proposed regulations provide that a transfer of property

does not include either a nongratuitous transfer or a gift that would

be excluded from taxable gifts under section 2503(b).

B. Different Taxable Years

The proposed regulations provide that if a person has a different

taxable year from the taxable year of the trust, an amount is currently

taken into account in computing the income of such person for purposes

of the general rule if the amount is taken into account for the taxable

year of such person that includes the last day of the taxable year of

the trust.

C. Entity Characterization

The proposed regulations provide that entities generally will be

characterized under U.S. income tax principles. See regulations

Secs. 301.7701-1 through 301.7701-4. However, an entity having a single

owner could avoid the purported gift rule if it could elect to be

disregarded as a separate entity, because the purported gift or bequest

would then be received from the owner of the entity, rather than from

the entity itself. Therefore, the proposed regulations provide that,

for purposes of section 672(f)(4), a wholly owned business entity must

be treated as a corporation, separate from its single owner.

8. Section 301.7701-2(c)(2)(iii): Special Rule for Business Entities

That Make Purported Gifts

As explained above, an entity having a single owner could avoid the

purported gift rule if it elected to be disregarded as a separate

entity under the existing entity classification regulations. Therefore,

the proposed regulations add a new sentence to the existing regulations

to provide that, for purposes of section 672(f)(4), a wholly owned

business entity must be treated as a corporation, separate from its

owner.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) does not apply to these regulations, and, because the

regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Code, these regulations will

be submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (preferably a

signed original and eight (8) copies) that are submitted timely to the

IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled for August 27, 1997, at 10

a.m., in room 3313, Internal Revenue Building, 1111 Constitution

Avenue, NW., Washington DC. Because of access restrictions, visitors

will not be admitted beyond the Internal Revenue Building lobby more

than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by August 4, 1997, and submit an outline of the

topics to be discussed and the time to be devoted to each topic

(preferably a signed original and eight (8) copies) by August 6, 1997.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is M. Grace Fleeman of

the Office of Associate Chief Counsel (International). However, other

personnel from the IRS and Treasury Department participated in their

development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

Employment taxes, Estate taxes, Excise taxes, Gift taxes, ncome

taxes, Penalties, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as

follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.643(h)-1 also issued under 26 U.S.C. 643(a)(7).

Section 1.671-2(e) also issued under 26 U.S.C. 643(a)(7) and

672(f)(6).

Section 1.672(f)-1 also issued under 26 U.S.C. 643(a)(7) and

672(f)(6).

Section 1.672(f)-2 also issued under 26 U.S.C. 643(a)(7), 72(f)

(3) and (6).

Section 1.672(f)-3 also issued under 26 U.S.C. 643(a)(7), 72(f)

(2) and (6).

[[Page 30790]]

Section 1.672(f)-4 also issued under 26 U.S.C. 643(a)(7),

72(f)(4) and (6).

Section 1.672(f)-5 also issued under 26 U.S.C. 643(a)(7) and

672(f)(6). * * *

Par. 2. Section 1.643(h)-1 is added to read as follows:

Sec. 1.643(h)-1 Distributions by certain foreign trusts through

intermediaries.

(a) In general. For purposes of sections 641 through 683, any

amount of property that is derived, directly or indirectly, by a United

States person from a foreign trust through another person (an

intermediary) shall be deemed to have been paid directly by the foreign

trust to the United States person if any one of the following

conditions is satisfied--

(1) The intermediary is related (within the meaning of paragraph

(e) of this section) to either the United States person or the foreign

trust and the intermediary transfers to the United States person either

property that the intermediary received from the foreign trust or

proceeds from the property that the intermediary received from the

foreign trust;

(2) The intermediary would not have transferred the property to the

United States person (or would not have transferred the property to the

United States person on substantially the same terms) but for the fact

that the intermediary received property from the foreign trust; or

(3) The intermediary received the property from the foreign trust

pursuant to a plan one of the principal purposes of which was the

avoidance of U.S. tax.

(b) Exception for grantor as intermediary. Paragraph (a) of this

section shall not apply if the intermediary is the grantor of the

portion of the trust from which the amount is derived. For the

definition of grantor, see Sec. 1.671-2(e).

(c) Effect of disregarding intermediary. If an amount is treated as

paid directly by the foreign trust to a United States person pursuant

to this section, one of the following rules shall apply:

(1) Intermediary is agent under general principles. If the

intermediary is an agent of the foreign trust or the United States

person under generally applicable agency principles, the payment shall

be treated as paid by the foreign trust to the United States person in

the year it would be so treated under such principles. Thus, if the

intermediary is an agent of the foreign trust, the payment shall be

treated as paid to the United States person in the year the amount is

paid by the intermediary to the United States person. If, however, the

intermediary is an agent of the United States person, the payment shall

be treated as paid to the United States person in the year the amount

is paid by the foreign trust to the intermediary.

(2) Intermediary is not agent under general principles--(i) Agent

of foreign trust. Except as provided in paragraph (c)(2)(ii) of this

section, if the intermediary is not an agent of the foreign trust or

the United States person under generally applicable agency principles--

(A) The intermediary shall be treated as an agent of the foreign

trust; and

(B) The payment shall be treated as paid by the foreign trust to

the United States person in the year the amount is paid by the

intermediary to the United States person.

(ii) Agent of United States person. The district director may

determine, based on all the relevant facts and circumstances, that the

intermediary should be treated as the agent of the United States

person. If the intermediary is treated as the agent of the United

States person pursuant to this paragraph (c)(2)(ii), the payment shall

be treated as paid to the United States person in the year the

intermediary receives the payment from the foreign trust.

(d) De minimis exception. This section shall not apply if, during

the taxable year of the United States person, the aggregate amount that

is transferred to such person from all foreign trusts through one or

more intermediaries does not exceed $10,000.

(e) Related parties. For purposes of this section, an intermediary

shall be treated as related to a United States person or foreign trust

if the intermediary and the United States person or foreign trust are

related within the meaning of section 643(i)(2)(B), with the following

modifications:

(1) For purposes of applying section 267 (other than section

267(f)) and section 707(b)(1), ``at least 10 percent'' shall be

substituted for ``more than 50 percent'' each place it appears;

(2) The principles of section 267(b)(10), substituting ``at least

10 percent'' for ``more than 50 percent,'' shall apply to determine

whether two corporations are related; and

(3) The principles applicable to trusts shall apply to determine

whether an estate is related to another person.

(f) Examples. The following examples illustrate the rules of this

section. In each example, FT is an irrevocable foreign trust that is

not treated as owned by any other person. The examples follow:

Example 1. Related intermediary. I, a nonresident alien who is

not the grantor of FT, receives a distribution of stock from FT in

the year 2001. In the year 2002, I sells the stock to an unrelated

party for its fair market value of 100X and gives the 100X to his

daughter, B, who is a U.S. resident. I is not an agent of either FT

or B under generally applicable agency principles. Under paragraphs

(a)(1) and (c)(2)(i) of this section, FT is deemed to have

distributed 100X directly to B in the year 2002.

Example 2. ``But for'' condition. I, a foreign bank that is

unrelated to any of the parties in these transactions, received a

deposit of 500X from FT in the year 2001. In the year 2002, I

transfers 400X to B, a United States person, in a transfer that it

would not have made but for the fact that I had received 500X from

FT. I is not an agent of either FT or B under generally applicable

agency principles. Under paragraphs (a)(2) and (c)(2)(i) of this

section, FT is deemed to have distributed 400X directly to B in the

year 2002.

Example 3. Tax avoidance purpose. FT was created in 1980 by A, a

nonresident alien. In the year 2001, FT's trustee, T, determines

that 1000X of accumulated income should be distributed to A's U.S.

granddaughter, B. Pursuant to a plan with a principal purpose of

avoiding the interest charge that would be imposed by section 668, T

causes FT to distribute 1000X to I, an unrelated foreign person. I

subsequently transfers 1000X to B in the year 2001. Under paragraph

(a)(3) of this section, B is deemed to have received an accumulation

distribution from FT in the year 2001.

Example 4. Amount not derived from foreign trust. W and her

husband, H, are both nonresident aliens. W's son, S, is a U.S.

resident. W receives annual income of 5000X from her own

investments. Several years ago, H created and funded FT using his

separate property. At the beginning of the year 2001, W receives a

distribution of 100X from FT. There is no plan with a principal

purpose of avoiding U.S. tax. At the end of the year 2001, W gives

100X of her investment income to S. None of the conditions in

paragraph (a) of this section is satisfied. The transfer to S is

treated as a nontaxable gift from W and not as an amount derived

directly or indirectly from FT.

(g) Effective date. The rules of this section are applicable for

transfers made by foreign trusts on or after August 20, 1996.

Par. 3. In Sec. 1.671-2, paragraph (e) is revised to read as

follows:

Sec. 1.671-2 Applicable principles.

* * * * *

(e)(1) For purposes of subchapter J of the Internal Revenue Code, a

grantor includes any person to the extent such person either creates a

trust, or directly or indirectly makes a gratuitous transfer (within

the meaning of paragraph (e)(4)(i) of this section) of property to a

trust.

(2) A grantor includes a person who acquires an interest in a trust

from a grantor of the trust if either--

[[Page 30791]]

(i) The transfer is nongratuitous (within the meaning of paragraph

(e)(4)(ii) of this section); or

(ii) The transfer is of an interest in a fixed investment trust.

(3) If one person creates or funds a trust (or portion of a trust)

primarily as an accommodation for another person, the other person

shall be treated as a grantor of the trust (or portion of the trust).

(4)(i) A gratuitous transfer is any transfer other than a transfer

for fair market value, or a corporate or partnership distribution. A

transfer of property to a trust may be considered a gratuitous transfer

without regard to whether the transfer is a gift for gift tax purposes

(see chapter 12 of subtitle B of the Internal Revenue Code).

(A) For purposes of this paragraph (e), a transfer for fair market

value includes only transfers in consideration for property received

from the trust, services rendered by the trust, or the right to use

property of the trust. A transfer is for fair market value only to the

extent that the value of the property received, services rendered, or

the right to use property is equal to at least the fair market value of

the property transferred. For example, rents, royalties, and

compensation paid to a trust are transfers for fair market value only

if the payments reflect an arm's length price for the use of the

property of, or services rendered by, the trust. For purposes of this

determination, if a person contributes property to a trust (or to

another entity that subsequently transfers the property (or proceeds

therefrom) to a trust) in exchange for any type of interest in the

trust (or other entity), such interest in the trust (or other entity)

shall be disregarded in determining whether fair market value has been

received. In addition, a person shall not be treated as making a

transfer for fair market value merely because the transferor recognizes

gain on the transaction. For example, if a taxpayer elects to treat a

transfer of appreciated property to a foreign trust as a deemed sale

under section 1057, such a transfer will not be treated as a transfer

for fair market value because the transferor did not receive actual

fair market value consideration pursuant to the deemed sale.

(B) For purposes of this paragraph (e), a transfer to a trust is a

corporate distribution, and therefore not a gratuitous transfer, only

if it is a distribution described in section 301, 302, 305, 355 or 356.

Similarly, for purposes of this paragraph (e), a transfer to a trust is

a partnership distribution, and therefore not a gratuitous transfer,

only if it is described in section 731. A distribution from one trust

to another trust that is a beneficiary of the first trust is a

gratuitous transfer.

(C) Notwithstanding any other provision of this paragraph (e), the

district director may determine, based upon the facts and

circumstances, that a direct or indirect transfer to a trust is more

properly characterized as a gratuitous transfer if the transfer was

structured with a principal purpose of avoiding U.S. tax. See, e.g.,

sections 643(a)(7) and 679(d).

(ii) For purposes of this paragraph (e), any transfer other than a

gratuitous transfer is a nongratuitous transfer.

(5) The following examples illustrate the rules of this paragraph

(e):

Example 1. A creates and funds a trust, T, for the benefit of

her children. Under paragraph (e)(1) of the section, A is a grantor

of T.

Example 2. A makes an investment in a fixed investment trust, T,

that is classified as a trust under Sec. 301.7701-4(c)(1) of this

chapter. B subsequently acquires A's entire interest in T for fair

market value. Under paragraph (e)(2) of this section, B is a grantor

of T with respect to such interest.

Example 3. A, an attorney, creates a trust, T, for the benefit

of his client, B, and B's children. The trust instrument names A as

the grantor. A funds T with a nominal contribution out of his own

funds. A views the contribution as an investment in the generation

of fees for future legal services. Under paragraph (e)(3) of this

section, B is a grantor of T.

Example 4. A, a U.S. citizen, creates and funds a trust, T, for

the benefit of B. B holds an unrestricted power to withdraw any

amount contributed to the trust for a period of 60 days after the

contribution is made. B is treated as an owner of T under section

678 as a result of the withdrawal power. However, B is not a grantor

of T under paragraph (e)(1) of this section as a result of the

withdrawal power, because B neither created T nor made a gratuitous

transfer to T.

Example 5. A contributes cash to a trust, T, through a broker,

in exchange for units in T. The value of the units in T is

disregarded in determining whether A has received fair market value

under paragraph (e)(4)(i)(A) of this section. Therefore, A has made

a gratuitous transfer to T, and, under paragraph (e)(1) of this

section, A is a grantor of T.

Example 6. A borrows cash from T, an unrelated trust. Arm's-

length interest payments by A to T will not be treated as gratuitous

transfers under paragraph (e)(4)(i)(A) of this section. Therefore,

under paragraph (e)(1) of this section, A is not a grantor of T with

respect to the interest payments.

Example 7. A creates and funds a domestic trust, DT. After A's

death, DT distributes cash to a foreign trust, FT, that is a

beneficiary of DT. Under paragraph (e)(4)(i)(B) of this section, the

trust distribution by DT is a gratuitous transfer. Therefore, under

paragraph (e)(1) of this section, DT is a grantor of FT with respect

to such transfer.

Example 8. A creates and funds a trust, T. T owns stock of C, a

publicly traded company, that pays a dividend to its shareholders,

including T. The dividend paid by C is a nongratuitous transfer

under paragraph (e)(4)(i)(B) of this section. Therefore, C is not a

grantor under paragraph (e)(1) of this section with respect to the

dividend.

Example 9. A, a nonresident alien, creates a trust, T, for the

benefit of her spouse, B, who is a U.S. citizen. T is not treated as

owned by any other person. A sells property worth $1,000,000 to T in

exchange for $100,000 in cash. Under paragraph (e)(4)(i)(A) of this

section, the $900,000 excess is a gratuitous transfer by A.

Therefore, A is a grantor of T under paragraph (e)(1) of this

section with respect to such transfer.

(6) The rules of this paragraph (e) are applicable as of August 20,

1996.

Par. 4. Sections 1.672(f)-1, 1.672(f)-2, 1.672(f)-3, 1.672(f)-4,

and 1.672(f)-5 are added to read as follows:

Sec. 1.672(f)-1 Foreign persons not treated as owners.

(a) General rule. Section 672(f)(1) provides that sections 671

through 679 (the grantor trust rules) shall cause a person to be

treated as the owner of any portion of a trust only to the extent such

application results in an amount (if any) being currently taken into

account (directly or through one or more entities) in computing the

income of a citizen or resident of the United States or a domestic

corporation. Section 672(f)(1) may apply only to a trust that would be

treated as owned, in whole or in part, by a foreign person under the

grantor trust rules without regard to section 672(f). For rules

describing the application of this section, see paragraph (b) of this

section. For definitions regarding the rules of this section, see

paragraph (c) of this section. For examples illustrating the

application of this section, see paragraph (d) of this section. For the

effective date of the rules of this section, see paragraph (e) of this

section.

(b) Application of general rule--(1) Initial determination. To

determine whether a trust is treated as owned by a foreign person, the

taxpayer should first apply the grantor trust rules without regard to

section 672(f) (the basic grantor trust rules) to determine the

worldwide amount (as defined in paragraph (c)(1) of this section) and

the U.S. amount (as defined in paragraph (c)(2) of this section).

(2) Result. The trust is treated as owned by a foreign person based

on an annual comparison at the end of the trust's taxable year of the

worldwide amount and the U.S. amount. If there is a worldwide amount

and such amount is greater than the U.S. amount, under

[[Page 30792]]

section 672(f) the foreign person shall not be treated as the owner of

the portion of the trust attributable to the excess of the worldwide

amount over the U.S. amount. Otherwise, the basic grantor trust rules

shall apply without the limitation of section 672(f). For examples, see

paragraph (d) of this section.

(c) Definitions--(1) Worldwide amount. The worldwide amount is the

net amount of income, gains, deductions, and losses that would be taken

into account for the current year under the basic grantor trust rules

in computing the worldwide taxable income of any person, whether or not

such person is a U.S. taxpayer (as defined in paragraph (c)(3) of this

section). The worldwide amount is computed in accordance with U.S.

principles of income taxation and includes amounts that would be

attributable to foreign persons, without regard to whether such amounts

are subject to U.S. income tax.

(2) U.S. amount. The U.S. amount is the net amount of income,

gains, deductions, and losses that would be taken into account for the

current year under the basic grantor trust rules (directly or through

one or more entities) in computing the taxable income of a U.S.

taxpayer (as defined in paragraph (c)(3) of this section). The U.S.

amount includes amounts that would be attributable to the U.S. taxpayer

even if the amount would not be includible in gross income (e.g., tax-

exempt interest described in section 103(a)).

(3) U.S. taxpayer. A U.S. taxpayer is any person who is a U.S.

citizen, a resident alien individual, a domestic corporation, a U.S.

person who is treated as the owner of a trust under section 679, or a

domestic trust to the extent such trust actually pays U.S. tax with

respect to its income, gains, deductions, and losses.

(d) Examples. The following examples illustrate the rules of this

section:

Example 1. U.S. amount equals worldwide amount. A, a citizen of

the United States, creates and funds an irrevocable foreign trust,

FT, for the benefit of his U.S. son, B. Under the basic grantor

trust rules (see section 679), A would be treated as the owner of

FT. For the taxable year ending December 31, 1999, FT has ordinary

income of 100X, long-term capital gain of 200X, deductions of 20X,

and short-term capital losses of 15X. Under paragraph (c)(1) of this

section, the worldwide amount is 265X (100X+200X-20X-15X). Under

paragraph (c)(2) of this section, the U.S. amount also is 265X.

Consequently, under paragraph (b)(2) of this section, because the

worldwide amount is equal to the U.S. amount, the basic grantor

trust rules apply without the limitation of section 672(f) to treat

A as the owner of FT.

Example 2. No U.S. amount. A, a nonresident alien, funds an

irrevocable domestic trust, DT, for the benefit of his U.S. son, B.A

has a reversionary interest within the meaning of section 673. If

the basic grantor trust rules were applied, A would be treated as

the owner of DT, and any distributions to B would be considered

nontaxable gifts from A to B. Under paragraph (c)(2) of this

section, there is no U.S. amount, because no amount is taken into

account for the current year under the basic grantor trust rules in

computing the taxable income of a U.S. taxpayer. Under paragraph

(c)(1) of this section, the worldwide amount is equal to DT's net

income. Under paragraph (b)(2) of this section, A is not treated as

the owner of any portion of DT. Consequently, DT is a separate

taxable entity, and distributions from DT to B must be taken into

account in computing B's income.

Example 3. U.S. amount less than worldwide amount. FP is a

foreign partnership for U.S. income tax purposes. FP has two

partners: C, a nonresident alien, and D, a U.S. citizen. The

partnership agreement provides that all income, gains, losses,

deductions, and credits are allocated 50 percent to each partner. FP

contributed cash to an irrevocable foreign trust, FT, primarily for

the benefit of E, D's U.S. brother. FP can control the beneficial

enjoyment of the trust assets within the meaning of section 674. If

the basic grantor trust rules were applied, FT would be treated as

the owner of FP. Because D's 50 percent distributive share of FP's

income would be currently taken into account in computing the income

of a U.S. citizen, the U.S. amount computed under paragraph (c)(2)

of this section is equal to one half of the worldwide amount

computed under paragraph (c)(1) of this section. Therefore, under

paragraph (b)(2) of this section, FP is not treated as the owner of

the portion of FT attributable to C's interest in FP. Such portion

of FT will be treated as a separate taxable entity, and

distributions by FT to E with respect to that portion of the trust

will be considered distributions to E under section 662 and may be

subject to the section 668 interest charge on accumulation

distributions. (In addition, distributions from FP to E may be

subject to recharacterization as purported gifts under

Sec. 1.672(f)-4.)

Example 4. No worldwide amount. USC is a U.S. corporation with a

wholly owned foreign subsidiary, FC. USC funds an irrevocable

foreign trust, FT, that cannot benefit any U.S. person. USC retains

no power or interest that would cause it to be treated as the owner

of FT under the basic grantor trust rules. However, FC is given a

power of appointment such that FC would be treated as the owner of

FT under section 678. FT acquires a note issued by FC. FT has no

items of income, deduction, losses, or credit other than income from

the note. Under U.S. income tax principles, if the basic grantor

trust rules were applied, FC would be treated as the owner of FT.

Thus, FC would be treated as both the debtor and the creditor with

respect to the note, and the note would be disregarded. Under

paragraph (c)(1) of this section, there is no worldwide amount.

Under paragraph (c)(2) of this section, there is no U.S. amount.

Consequently, under paragraph (b)(2) of this section, the basic

grantor trust rules apply without the limitation of section 672(f)

to treat FC as the owner of FT.

Example 5. Deemed contribution on effective date. Assume the

same facts as in Example 2. DT was created in 1990. On August 20,

1996, DT held accumulated income. Prior to August 20, 1996, A was

treated as the owner of DT. A is deemed to have contributed the

assets that were held in DT on August 20, 1996 to a new trust on

that date.

(e) Effective date. The rules of this section are applicable as of

August 20, 1996.

Sec. 1.672(f)-2 Trusts created by certain foreign corporations.

(a) Controlled foreign corporations. A controlled foreign

corporation (as defined in section 957) that creates and funds a trust

shall be treated as a domestic corporation for purposes of

Secs. 1.672(f)-1 through 1.672(f)-5 to the extent that, if the grantor

trust rules without regard to section 672(f) (the basic grantor trust

rules) were applied, income earned by the trust for the taxable year

would be currently taken into account pursuant to section 951 in

computing the gross income of a citizen or resident of the United

States or a domestic corporation.

(b) Passive foreign investment companies--(1) In general. A passive

foreign investment company (as defined in section 1296) that creates

and funds a trust shall be treated as a domestic corporation for

purposes of Secs. 1.672(f)-1 through 1.672(f)-5 to the extent that, if

the basic grantor trust rules were applied, income earned by the trust

for the taxable year would be currently taken into account pursuant to

section 1293 in computing the gross income of a citizen or resident of

the United States or a domestic corporation.

(2) Application of section 1296. For purposes of determining

whether a foreign corporation is a passive foreign investment company

as defined in section 1296, the grantor trust rules shall be applied as

if section 672(f) had not come into effect.

(c) Foreign personal holding companies. A foreign personal holding

company (as defined in section 552) that creates and funds a trust

shall be treated as a domestic corporation for purposes of

Secs. 1.672(f)-1 through 1.672(f)-5 to the extent that, if the basic

grantor trust rules were applied, income earned by the trust for the

taxable year would be currently taken into account pursuant to section

551 in computing the gross

[[Page 30793]]

income of a citizen or resident of the United States or a domestic

corporation.

(d) Examples. The following examples illustrate the rules of this

section. In each example, FT is an irrevocable foreign trust, and CFC

is a controlled foreign corporation. The examples follow:

Example 1. Controlled foreign corporation without ultimate U.S.

ownership. Two nonresident aliens, A and B, create a domestic

partnership, DP. DP's only asset is all the stock of CFC. CFC

creates and funds FT to benefit A's U.S. daughter, C. CFC retains an

administrative power over the trust as described in section 675.

Thus, if the basic grantor trust rules were applied, CFC would be

treated as the owner of FT, and distributions from FT to C would not

be taxed as distributions under section 662. However, under

paragraph (a) of this section, CFC is not treated as a domestic

corporation for purposes of Sec. 1.672(f)-1. Although CFC is a

controlled foreign corporation (because CFC is owned by DP, a

domestic person), no income earned by CFC will be included in the

income of a U.S. taxpayer. Consequently, there is no U.S. amount

under Sec. 1.672(f)-1(c)(2). Under Sec. 1.672(f)-1(b)(2), the basic

grantor trust rules do not apply to treat CFC as the owner of FT.

Transfers from FT to C are considered to be distributions to C under

section 662 and may be subject to the section 668 interest charge on

accumulation distributions. (In addition, distributions to C from

DP, CFC, or FT may be subject to recharacterization as purported

gifts under Sec. 1.672(f)-4.)

Example 2. Trust income is all subpart F income. CFC is wholly

owned by USC, a domestic corporation. CFC creates and funds FT for

the benefit of USC. CFC can control the beneficial enjoyment of the

trust assets within the meaning of section 674. All of FT's income

is of the type that is subpart F income (as defined in section 952).

FT does not distribute any income. Without regard to income earned

by FT, CFC has a significant amount of earnings and profits. If the

basic grantor trust rules were applied, CFC would be treated as the

owner of FT, and all items of income of FT would be currently taken

into account in computing the income of USC, a domestic corporation.

Consequently, under paragraph (a) of this section, CFC is treated as

a domestic corporation for purposes of Sec. 1.672(f)-1. Under

Sec. 1.672(f)-1(b)(2), the basic grantor trust rules apply without

the limitation of section 672(f) to treat CFC as the owner of FT.

Distributions from FT to USC are treated as distributions from CFC

to USC.

Example 3. Portion of trust income is subpart F income. Assume

the same facts as in Example 2, except that FT also owns all of the

stock of S, a corporation that is incorporated in the same country

as CFC and that uses a substantial part of its assets in a trade or

business in such country. Thus, dividends from S are not subpart F

income. In the taxable year ending December 31, 1999, FT's only

income is subpart F income of 200X and dividends from S of 50X. FT

has no deductions or losses for 199X. Under paragraph (a) of this

section, CFC is treated as a domestic corporation for purposes of

computing the U.S. amount under Sec. 1.672(f)-1(c)(2) only to the

extent FT's income is of the type that is subpart F income.

Consequently, the U.S. amount is 200X. Under Sec. 1.672(f)-1(c)(1),

the worldwide amount is 250X. Under Sec. 1.672(f)-1(b)(2), CFC is

not treated as the owner of the portion of FT attributable to the

excess of the worldwide amount over the U.S. amount. Such portion of

FT will be treated as a separate taxable entity. Distributions to

USP with respect to such portion of FT will be included in USP's

income under section 662 and may be subject to the section 668

interest charge on accumulation distributions.

Example 4. Reduction in portion of trust treated as nongrantor

trust. Assume the same facts as in Example 3. For each of the years

2001 through 2010, FT receives dividend income of 2X from S, none of

which is distributed. In the year 2011, at a time when FT's basis in

the stock of S is 80X, S sells its business and invests the proceeds

in assets that generate subpart F income. CFC will now be treated as

the owner of the portion of FT that had previously been treated as a

separate taxable entity. FT will be deemed to have distributed 80X

(the stock of S) to CFC. CFC will be required to include 20X of

undistributed net income (2X a year for 10 years) in its income.

(d) Effective date. The rules of this section are applicable as of

August 20, 1996.

Sec. 1.672(f)-3 Exceptions to general rule.

(a) Certain revocable trusts--(1) In general. The general rule of

Sec. 1.672(f)-1(a) shall not apply to any portion of a trust if the

power to revest absolutely in the grantor title to such portion is

exercisable solely by the grantor without the approval or consent of

any other person. If the grantor can exercise such power only with the

approval of a related or subordinate party who is subservient to the

grantor, such power will be treated as exercisable solely by the

grantor. The grantor will be treated as having a power to revest only

if the grantor has such power for a period or periods aggregating 183

days or more during the taxable year of the trust. See section

643(a)(7). For the definition of grantor, see Sec. 1.671-2(e). For the

definition of related or subordinate party, see Sec. 1.672(c)-1. For

purposes of this paragraph (a), a related or subordinate party is

subservient to the grantor unless the presumption in the last sentence

of Sec. 1.672(c)-1 is rebutted by a preponderance of the evidence.

(2) Grandfather rule--(i) In general. The general rule of

Sec. 1.672(f)-1 shall not apply to a trust that was treated as owned by

the grantor under section 676 on September 19, 1995, as long as the

trust would continue to be so treated under the basic grantor trust

rules. However, such a trust will be subject to the general rule of

Sec. 1.672(f)-1 with respect to any portion of the trust attributable

to transfers to the trust after September 19, 1995.

(ii) Separate accounting for transfers after September 19, 1995. In

the case of a revocable trust that contains both amounts held in the

trust on September 19, 1995, and amounts that were transferred to the

trust after September 19, 1995, paragraph (a)(2)(i) of this section

shall apply only if the amounts that were held in the trust on

September 19, 1995, together with all income, gains, and losses derived

therefrom (less all post-September 19, 1995, distributions therefrom)

are separately accounted for from the amounts that were transferred to

the trust after September 19, 1995, together with all income, gains,

and losses derived therefrom (less all distributions therefrom). If

there is no separate accounting, the general rule of Sec. 1.672(f)-1

shall apply to the trust. If there is separate accounting, the general

rule of Sec. 1.672(f)-1 shall not apply to the portion of the trust

that is attributable to amounts that were held in the trust on

September 19, 1995.

(3) Examples. The following examples illustrate the rules of this

paragraph (a):

Example 1. Owner is grantor. After September 19, 1995, FP1, a

foreign person, creates and funds a revocable trust, T, for the

benefit of FP1's children, who are U.S. residents. The trustee is a

foreign bank, FB, that is owned and controlled by FP1 and FP2, who

is FP1's brother. The power to revoke T and revest absolutely in FP1

title to the trust property is exercisable by FP1, but only with the

approval or consent of FB. There are no facts that would suggest

that FB is not subservient to FP1. Therefore, under paragraph (a)(1)

of this section, T is not subject to the general rule of

Sec. 1.672(f)-1. FP1 is treated as the owner of T.

Example 2. Owner not grantor. Assume the same facts as in

Example 1, except that FP1 dies. After FP1's death, FP2 has the

power to withdraw the assets of T, but only with the approval of FB.

There are no facts that would suggest that FB is not subservient to

FP2. However, under paragraph (a)(1) of this section, T is now

subject to the general rule of Sec. 1.672(f)-1, because FP2 is not a

grantor of T. FP2 is not treated as the owner of T.

Example 3. Trustee not related or subordinate party. Assume the

same facts as in Example 1, except that neither FP1 nor any member

of his family has any substantial ownership interest or other

connection with FB. FP1 can remove and replace FB at any time for

any reason. Although FP1 can replace FB if FB refuses to approve or

consent to FP1's decision to revest the trust property in himself,

FB is not a related or subordinate party. Therefore, under paragraph

(a)(1) of this section, T is subject to the general rule of

Sec. 1.672(f)-1. FP1 will not be treated as the owner of T.

Example 4. Unrelated trustee will consent to revocation. FP, a

foreign person, creates

[[Page 30794]]

and funds an irrevocable trust, T. The trustee is a foreign bank,

FB, that is not a related or subordinate party within the meaning of

Sec. 1.672(c)-1. FB has the discretion to distribute trust income or

corpus to any person, including FP. Even if FB would in fact

distribute all the trust property to FP if requested to do so by FP,

under paragraph (a)(1) of this section, T is subject to the general

rule of Sec. 1.672(f)-1, because FP does not have the power to

revoke T. FP will not be treated as the owner of T.

Example 5. Husband treated as holding power held by wife. H and

his wife, W, both nonresident aliens, create and fund a trust, T,

using community property. The power to revoke T and revest

absolutely in H and W title to the trust property is exercisable

either by W acting alone or by H with the consent of W. W has

advised H that she will not consent to any decision by H to revoke

T. Although W is a related or subordinate party to H within the

meaning of Sec. 1.672(c)-1, the presumption that W is subservient to

H is rebutted by a preponderance of the evidence. However, pursuant

to section 672(e), H is treated as holding the power to revest that

is held by W. Therefore, under paragraph (a)(1) of this section, T

is not subject to the general rule of Sec. 1.672(f)-1. H and W are

treated as the owners of T.

Example 6. U.S. grantor of trust revocable by foreign person. A,

a nonresident alien, creates a revocable foreign trust, FT, and

funds FT with $5,000 cash. The only possible beneficiary of FT is a

foreign person. B, a U.S. citizen, contributes $1,000,000 of

appreciated property to FT. B retains no powers that would cause B

to be treated as an owner of any portion of FT under the grantor

trust rules. Although A has the power to revest absolutely in itself

title to the appreciated property, A is not a grantor of FT with

respect to the appreciated property. See Sec. 1.671-2(e). Therefore,

under paragraph (a)(1) of this section, the portion of FT that is

attributable to the appreciated property is subject to the general

rule of Sec. 1.672(f)-1. A is not treated as the owner of such

portion.

(b) Certain other trusts--(1) In general. The general rule of

Sec. 1.672(f)-1(a) shall not apply to any trust (or portion of a trust)

during the lifetime of the grantor if the only amounts distributable

(whether income or corpus) from such trust (or portion of a trust)

during the lifetime of the grantor are amounts distributable to the

grantor or the spouse of the grantor. This paragraph (b) shall not

apply to that portion of a trust from which, at any time after October

20, 1996, any amounts are distributable to any person other than the

grantor or the spouse of the grantor. For purposes of this paragraph

(b), payments of nongratuitous amounts (within the meaning of

Sec. 1.671-2(e)(4)(ii)) will not be considered amounts distributable.

For the definition of grantor, see Sec. 1.671-2(e).

(2) Amounts distributable in discharge of legal obligation--(i) In

general. Subject to the provisions of paragraph (b)(2)(ii) of this

section, amounts that are distributable from a portion of a trust in

discharge of a legal obligation of the grantor or the spouse of the

grantor shall be treated as amounts distributable to the grantor or the

spouse of the grantor for purposes of paragraph (b)(1) of this section.

For this purpose, an obligation is considered a legal obligation if it

is enforceable under the local law of the jurisdiction in which the

grantor (or the spouse of the grantor) resides.

(ii) Legal obligation to related person. For purposes of paragraph

(b)(2)(i) of this section, the term legal obligation does not include

an obligation to a related person except to the extent the obligation

was contracted bona fide and for adequate and full consideration in

money or money's worth (see Sec. 20.2043-1 of this chapter). For this

purpose, a related person is a person described in Sec. 1.643(h)-1(e).

(3) Amounts distributable in discharge of support obligation.

Amounts that are distributable from a portion of a trust in discharge

of the grantor's or the grantor's spouse's obligation to support a

family member shall be treated as amounts distributable to the grantor

or the spouse of the grantor only if the family member is an individual

who would be treated as a dependent of the grantor or the grantor's

spouse under sections 152(a) (1) through (8), without regard to the

requirement that half of the individual's support be received from the

grantor or the grantor's spouse, and the family member is either--

(i) Permanently and totally disabled (within the meaning of section

22(e)(3)); or

(ii) In the case of a son, daughter, stepson, or stepdaughter, less

than 24 years old.

(4) Grandfather rule--(i) In general. The general rule of

Sec. 1.672(f)-1 shall not apply to a trust that was treated as owned by

the grantor under section 677 (other than section 677(a)(3)) on

September 19, 1995, as long as the trust would continue to be so

treated under the basic grantor trust rules. However, such a trust will

be subject to the general rule of Sec. 1.672(f)-1 with respect to any

portion of the trust attributable to transfers to the trust after

September 19, 1995.

(ii) Separate accounting for transfers after September 19, 1995. In

the case of a trust that contains both amounts held in the trust on

September 19, 1995, and amounts that were transferred to the trust

after September 19, 1995, paragraph (b)(4)(i) of this section shall

apply only if the amounts that were held in the trust on September 19,

1995, together with all income, gains, and losses derived therefrom

(less all post-September 19, 1995, distributions therefrom) are

separately accounted for from the amounts that were transferred to the

trust after September 19, 1995, together with all income, gains, and

losses derived therefrom (less all distributions therefrom). If there

is no separate accounting, the general rule of Sec. 1.672(f)-1 shall

apply to the trust. If there is separate accounting, the general rule

of Sec. 1.672(f)-1 shall not apply to the portion of the trust that is

attributable to amounts that were held in the trust on September 19,

1995.

(5) Examples. The following examples illustrate the rules of this

paragraph (b):

Example 1. Amounts distributable only to grantor or grantor's

spouse. H and his wife, W, are both nonresident aliens. H and W have

a child, C, who is a U.S. resident. H creates and funds an

irrevocable trust, FT, using only his separate property. The only

amounts distributable (whether income or corpus) from FT as long as

either H or W are alive are amounts distributable to H or W. Upon

the death of both H and W, C may receive distributions from FT.

Under paragraph (b)(1) of this section, FT is not subject to the

general rule of Sec. 1.672(f)-1 during H's lifetime. H is treated as

the owner of FT.

Example 2. Amounts temporarily distributable to person other

than grantor or grantor's spouse. Assume the same facts as in

Example 1, except that C is a 30-year old law student at the time FT

is created, FT is created after October 20, 1996, and the trust

instrument provides that as long as C is in law school amounts may

be distributed from FT to pay C's expenses. Thereafter, the only

amounts distributable from FT as long as either H or W are alive

will be amounts distributable to H or W. C's expenses are not

treated as legal obligations of H or W under paragraph (b)(2)(ii) of

this section or as support obligations under paragraph (b)(3) of

this section. Therefore, under paragraph (b)(1) of this section, FT

is subject to the general rule of Sec. 1.672(f)-1(a). H is not

treated as the owner of FT. After C graduates from law school, the

general rule of Sec. 1.672(f)-1 still will be applicable, and H

still will not be treated as the owner of FT.

Example 3. Grantor predeceases spouse. Assume the same facts as

in Example 1. H predeceases W. Under paragraph (b)(1) of this

section, FT will become subject to the general rule of

Sec. 1.672(f)-1 upon H's death, because W is not a grantor.

Accordingly, FT will be treated as a separate taxable entity upon

H's death.

Example 4. Effect of divorce. H creates and funds a trust, FT,

from which the only amounts distributable are amounts distributable

to himself and A. At the time FT is created, A is H's wife. However,

the trust document refers to A only by her name. H and A divorce.

Under paragraph (b)(1) of this section, FT will be subject to the

general rule of Sec. 1.672(f)-1 after the divorce, because amounts

will still be distributable to A, and

[[Page 30795]]

A will no longer be the spouse of the grantor. After the divorce, FT

will be treated as a separate taxable entity.

Example 5. Fixed investment trust. FC, a foreign corporation,

invests in a domestic fixed investment trust, DT, that is classified

as a trust under Sec. 301.7701-4(c)(1) of this chapter. The only

amounts that are distributable from the portion of DT that is owned

by FC are amounts distributable to FC. Under paragraph (b)(1) of

this section, such portion of DT is exempt from the general rule of

Sec. 1.672(f)-1. FC is treated as the owner of its portion of DT.

Example 6. Reinsurance trust. A domestic insurance company, I,

reinsures a portion of its business with a foreign insurance

company, FI. FI creates and funds an irrevocable domestic trust, DT,

in the United States as security for its obligations under the

reinsurance agreement. The trust funds are held by a U.S. bank and

may be used only to pay claims arising out of the reinsurance

policies. On the termination of DT, any assets remaining will revert

to FI. The only amounts that are distributable from DT are

distributable in discharge of FI's legal obligation. Therefore,

under paragraph (b)(1) of this section, DT is exempt from the

general rule of Sec. 1.672(f)-1. FI is treated as the owner of DT.

Example 7. Asset securitization trust. A foreign corporation,

FC, borrows money from a bank, B, to finance the purchase of an

airplane. FC creates a foreign trust, FT, to hold the airplane as

security for the loan from B. The only amounts that are

distributable from FT are amounts distributable to B in the event

that FC defaults on its loan from B. Thus, the only amounts

distributable from FT are in discharge of FC's legal obligation to

B. When FC repays the loan, the trust assets will revert to FC.

Under paragraph (b)(1) of this section, FT is exempt from the

general rule of Sec. 1.672(f)-1. FC is treated as the owner of FT.

(c) Compensatory trusts--(1) In general. Except as provided in

paragraph (c)(4) of this section, Sec. 1.672(f)-1 does not apply to any

portion of a trust distributions from which are taxable as compensation

for services rendered. A trust described in this paragraph (c)(1) is

referred to in this section as a compensatory trust.

(2) Trusts classified as compensatory trusts. The following types

of trusts are the only types of trusts that shall be classified as

compensatory trusts within the meaning of paragraph (c)(1) of this

section--

(i) A qualified trust described in section 401(a) (but see

Sec. 1.641(a)-0(a));

(ii) A trust described in section 457(g);

(iii) A nonexempt employees' trust described in section 402(b) (see

Sec. 1.671-1(g) and (h));

(iv) A trust that is an individual retirement account described in

section 408(k) or 408(p);

(v) A trust that is an individual retirement account the only

contributions to which are rollover contributions listed in section

408(a)(1);

(vi) A trust that would be a nonexempt employees' trust described

in section 402(b) but for the fact that the trust's assets are not set

aside from the claims of creditors of the actual or deemed transferor

within the meaning of Sec. 1.83-3(e); and

(vii) A trust that is a welfare benefit fund described in section

419(e).

(3) Other individual retirement accounts. For rules that apply to

individual retirement accounts (within the meaning of section 408(a))

that are not compensatory trusts within the meaning of paragraph (c)(1)

of this section, see paragraphs (a) and (b) of this section.

(4) Exceptions. The Commissioner may, in revenue rulings, notices,

or other guidance published in the Internal Revenue Bulletin (see

Sec. 601.601(d)(2)(ii)(b)), designate categories of compensatory trusts

to which the general rule of paragraph (c)(1) of this section does not

apply.

(d) Effective date. Except as provided in paragraph (b)(1) of this

section, the rules of this section are applicable as of August 20,

1996.

Sec. 1.672(f)-4 Recharacterization of purported gifts.

(a) In general--(1) Purported gifts from partnerships.

Except as provided in paragraphs (b) and (f) of this section, and

without regard to the existence of any trust, if a United States person

(U.S. donee) directly or indirectly receives a purported gift or

bequest (as defined in paragraph (d) of this section) from a

partnership, the purported gift or bequest must be included in the U.S.

donee's gross income as ordinary income.

(2) Purported gifts from foreign corporations. Except as provided

in paragraphs (b) and (f) of this section, and without regard to the

existence of any trust, if a U.S. donee directly or indirectly receives

a purported gift or bequest (as defined in paragraph (d) of this

section) from a foreign corporation, the purported gift or bequest must

be included in the U.S. donee's gross income as if it were a

distribution from the foreign corporation. For purposes of section

1012, the U.S. donee will not be treated as having basis in the foreign

corporation. However, for purposes of section 1223, the U.S. donee will

be treated as having a holding period in the foreign corporation on the

date of the deemed distribution equal to the weighted average of the

holding periods of the actual interest holders.

(b) Exceptions--(1) U.S. partner or shareholder treats transfer as

distribution and gift. Paragraph (a) of this section shall not apply if

the U.S. donee can establish that a U.S. citizen or resident alien who

directly or indirectly holds an interest in the partnership or foreign

corporation treated the purported gift as a distribution to the U.S.

partner or shareholder and a subsequent gift to the U.S. donee.

(2) Charitable contributions. Paragraph (a) of this section shall

not apply to U.S. donees that are described in section 170(c).

(c) Certain distributions from trusts created by partnerships or

foreign corporations. If a partnership or foreign corporation is

treated as the owner, under sections 671 through 679, of a portion of a

trust from which property is distributed to a U.S. donee in a

gratuitous transfer, the U.S. donee must treat the amount as a

distribution from the partnership or foreign corporation. If a

partnership or foreign corporation is not treated as the owner, under

sections 671 through 679, of the portion of a trust from which property

is distributed to a U.S. donee in a gratuitous transfer, the U.S. donee

shall be taxable in the manner provided in paragraph (a) of this

section only if the U.S. tax computed under that section exceeds the

U.S. tax that would be due if the U.S. donee treats the amount as a

distribution from the trust.

(d) Definition of purported gift or bequest. For purposes of this

section, a purported gift or bequest is any transfer by a partnership

or foreign corporation (other than a transfer for fair market value) to

a person who is not a partner in the partnership or shareholder of the

foreign corporation.

(e) Effect on U.S. partner or shareholder. This section applies

only to computations of the U.S. donee's gross income. This section

does not affect the U.S. tax treatment of a U.S. partner in the

partnership or a U.S. shareholder of the foreign corporation.

(f) Recharacterization by district director. Notwithstanding any

other provision in this section, if a U.S. donee receives a transfer

that is subject to the rules of this section, the district director may

recharacterize such transfer to prevent the avoidance of U.S. tax or

clearly to reflect income. For example, the district director may

determine, based upon the facts and circumstances, that a distribution

from a partnership or foreign corporation is more properly

characterized as a distribution from a trust.

(g) De minimis exception. This section shall not apply if, during

the taxable year of a U.S. donee, the aggregate amount of purported

gifts or bequests that is transferred to such U.S. donee

[[Page 30796]]

directly or indirectly from a partnership or foreign corporation does

not exceed $10,000. The aggregate amount must include gifts or bequests

from persons that the U.S. donee knows or has reason to know are

related to the partnership or foreign corporation (within the meaning

of section 643(i)).

(h) Examples. The following examples illustrate the rules of this

section:

Example 1. FC is a foreign corporation that is wholly owned by

A, a nonresident alien. FC distributes property directly to A's U.S.

daughter, B, purportedly as a gift. Under paragraph (a)(2) of this

section, B must treat the distribution as a dividend from FC.

(However, if B can establish that the distribution exceeded FC's

earnings and profits, B must treat such excess as an amount received

in excess of basis under section 301(c)(3).) If FC is a passive

foreign investment company, B must treat the amount as a

distribution under section 1291. B will be treated as having the

same holding period as A.

Example 2. FC is a foreign corporation that is wholly owned by

A, a nonresident alien. FC creates and funds a revocable foreign

trust, FT, from which a gratuitous transfer is made immediately to

A's U.S. daughter, B. Thus, the transfer is out of trust corpus. FC

is not treated as the owner of FT under sections 671 through 679.

Under paragraph (c) of this section, B must treat the transfer as a

dividend from FC, rather than a distribution from FT, if such

treatment results in a higher U.S. tax liability.

(i) Effective date. The rules of this section are applicable for

any transfer by a partnership or foreign corporation on or after August

20, 1996.

Sec. 1.672(f)-5 Special rules.

(a) Transfers by certain beneficiaries to foreign settlor--(1) In

general. If, but for section 672(f)(5), a foreign person would be

treated as the owner of any portion of a trust, any U.S. beneficiary of

such trust shall be treated as the owner of a portion of the trust to

the extent the U.S. beneficiary directly or indirectly made transfers

of property to such foreign person (without regard to whether the U.S.

beneficiary was a U.S. beneficiary at the time of any transfer) in

excess of transfers to the U.S. beneficiary from the foreign person.

The rule of this paragraph will not apply to the extent the U.S.

beneficiary can demonstrate to the satisfaction of the district

director that the transfer by the U.S. beneficiary to the foreign

person was wholly unrelated to any transaction involving the trust. For

purposes of this paragraph, a transfer of property does not include a

nongratuitous transfer. See Sec. 671-2(e)(4)(ii). In addition, a gift

shall not be taken into account to the extent such gift would not be

characterized as a taxable gift under section 2503(b). For a definition

of U.S. beneficiary, see section 679.

(2) Examples. The following examples illustrate the rules of this

section:

Example 1. A, a nonresident alien, contributes property to FC, a

foreign corporation that is wholly owned by A. FC creates a foreign

trust, FT, for the benefit of A and his children. FT is revocable by

FC without the approval or consent of any other person. FC funds FT

with the property received from A. A and his family move to the

United States. Under paragraph (a)(1) of this section, A is treated

as the owner of FT.

Example 2. B, a U.S. citizen, makes a gratuitous transfer of $1

million to his uncle, C, a nonresident alien. C creates a foreign

trust, FT, for the benefit of B and his children. FT is revocable by

C without the approval or consent of any other person. C funds FT

with the property received from B. Under paragraph (a)(1) of this

section, B is treated as the owner of FT. (B also would be treated

as the owner of FT as a result of section 679.)

(b) Different taxable years. If a person has a different taxable

year (as defined in section 7701(a)(23)) from the taxable year of the

trust, an amount is currently taken into account in computing the

income of such person for purposes of Sec. 1.672(f)-1 if the amount is

taken into account for the taxable year of such person that includes

the last day of the taxable year of the trust.

(c) Entity characterization. Entities generally shall be

characterized under U.S. income tax principles. See Secs. 301.7701-1

through 301.7701-4 of this chapter. However, for purposes of

Sec. 1.672(f)-4, a transferor that is a wholly owned business entity

shall be treated as a corporation, separate from its single owner. See

Sec. 301.7701-2(c)(2)(iii) of this chapter.

(d) Effective date. The rules of this section are generally

applicable as of August 20, 1996. However, the rules in paragraph (c)

of this section shall not be applicable until [date of publication as a

final regulation in the Federal Register].

PART 301--PROCEDURE AND ADMINISTRATION

Par. 5. The authority citation for part 301 is amended by adding an

entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 301.7701-2(c)(2)(iii) also issued under 26 U.S.C.

643(a)(7), 672(f)(4) and (6).

Par. 6. Section 301.7701-2 is amended by adding paragraph

(c)(2)(iii) to read as follows:

Sec. 301.7701-2 Business entities; definitions.

* * * * *

(c) * * *

(2) * * *

(iii) Special rule for foreign business entities that make

purported gifts. For the purposes of applying the rules of section

672(f)(4), a wholly owned business entity shall be treated as a

corporation, separate from its single owner.

* * * * *

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

[FR Doc. 97-14735 Filed 6-4-97; 8:45 am]

BILLING CODE 4830-01-U