Unofficial Transcript of IRS Hearing on Proposed Regs on Transfers to Foreign Trusts

Dooley expressed concern that the regs disregard "longstanding prudent-wise policy" and lack clarity because they don't follow the "main theme" of existing tax law. The general practitioner, he said, wouldn't really understand what they needed to do by looking at the regs. Dooley suggested outlining the requirements for information reporting and adding additional, simplified examples to the regs. He also recommended that the regs clarify when a section 684 transaction has occurred and explain that gain has to be reported.

Bruce suggested simplifying the method for dealing with a nonsection 679 trust that later acquires a U.S. beneficiary. He questioned the direct authority of the regs for the throwback and interest charge rules in section 1.679-2(c)(1). Bruce said the regs' method of treating the U.S. grantor as having additional income in the first taxable year in which the trust has a beneficiary, and not only taxing the grantor on the trust's undistributed net income, but also applying the throwback and interest charge rules, "appears to go beyond the statute." As an alternative, he suggested that the IRS "just tax them."

[10:02 a.m.]

[1] MR. YATES: Good morning, welcome to the hearings on the proposed regulations under section 679 and 684. Thank you all very much for coming.

[2] My name is Bill Yates. I'm with the office of the subject chief counsel, International, Branch 1. I am the principle drafter of the proposed regulations under section 679.

[3] We have five panelists today, including myself. Karen Rennie-Quarrie, is the principle drafter of the 684 regulations. She's also a chief counsel Branch 1 member. The reviewer of the 679 regulations is Grace Fleeman, who is an Assistant to the Branch Chief of branch 1. To her right we have Michael Kirsch, who is with the Office of International Tax Counsel at Treasury. He is the Treasury reviewer of both regulations under section 679 and 684. Lastly, we have Elizabeth Karzon, who is the Branch Chief of Branch 1. She is the reviewer of the 684 regulations.

[4] We have two speakers today, Charles M. Bruce of Moore & Bruce, which is a Washington law firm; and also, Brian Dooley, who is a California sole practitioner.

[5] Gentlemen, we usually allow ten minutes per speaker. Today, as you may recall, yesterday I asked both of you if you would be more comfortable speaking for 20 minutes and including both regulations during your speech. Both of you agreed to that. We're very comfortable with that. So we will allow 20 minutes per speaker.

[6] We ask only if you can do it, try to avoid jumping back and forth between regulations. But if it works out that the issues are so interrelated that it's better to do it by mentioning both regulations, or discussing them both at the same time, that's fine with us.

[7] We do like to stick to our time limits, but we would like you to understand two things: if we have a question from a panel member, which most likely will be in the form of asking for an elaboration of a particular point that you're making, we won't count that against your time limit. And also please understand that this is not your last chance to comment on these regulations. We want you only to understand that we consider these regulations, both of them, to be very important and they will be finalized. We anticipate that they will be on the business plan for next year's regulation projects, and therefore, if you do have additional comments, we would like to receive them sooner rather than later.

[8] So at this point, I would like to begin the hearing with Charlie Bruce. He has asked that he be allowed to remain where he is, and I said, that's fine. With that I would like to begin the hearing.

[9] MR. BRUCE: Thank you very much for affording me the opportunity to speak on these subjects. Let me say in responding to the point that there may be an opportunity for additional input.

[10] The American Bar Association Section of Taxation outgoing committee, the Committee on Foreign Activities of U.S. Taxpayers has not commented on these regulations. I'm going to suggest that they give a -- the members look at them and consider whether they want to do so or not. If so, we'll bring forward those comments and present those.

[11] Today I'm not speaking in any shape, form or fashion for that subcommittee on international trusts. My comments today are on behalf of a Valmet Group, which is part of a larger group, the Risk Management Group, which is actually a Bermuda company, listed on the New York Stock Exchange, and also MTI Services. Valmet is a corporate and trust services company. Over the years, it has occasionally come and commented on prior sets of regulations in this area.

[12] I'm going to -- I presented a number of points and some of them I'm going to touch on very lightly or skip over, because I think they almost speak for themselves.

[13] The first point is really Roman numeral two in my outline. You asked for thoughts on how to handle transfers by spouses of jointly held or community property. There may be issues that I'm not seeing there, but we've not had particular problems in the area of dividing interest, making transfers over -- of the divided interest, and then making transfers out. There are many occasions when people need to reorganize -- the family needs to reorganize and needs to transfer something that belongs to both people, or may belong to both people. They want to clarify that, so will just divide interest or transfer over, if just one person wants to be the transferee -- transferor, and proceed on that basis.

[14] The next point is that -- we suggest that some place it be noted, perhaps in the preamble, but some place, that a U.S. person that uses trust assets, but this is not treated as a constructive distribution. There was a -- in the 1996 legislation, in various versions of it, there was consideration of how to handle constructive ownership.

[15] If memory serves me, there was a draft or perhaps a proposal that would have actually treated constructive use as a constructive distribution. This was not -- and, sometimes it's difficult to nail down things that are not in the statute, and I suggest that some clarification be given to that.

[16] MR. KIRSCH: Let me ask, was that -- the '96 legislation -- was that in the 679 context, or was that dealing with some of the other inbound rules?

[17] MR. BRUCE: I don't recall whether it was pegged just for the inbound part or to the whole package. And it can probably be researched as to where the proposal was.

[18] But in addition to the proposal there were discussions across the board as to what to do with the use of assets. It would have also cropped up in the reporting, because a big problem that would have arisen was how to police the fact that there was use of, for instance, an apartment owned by a trust.

[19] So I would think it would be more than one section of the -- one aspect of the 1996 package.

[20] MR. KIRSCH: I mean, you're right. I think we can go back and check that, but I seem to recall that was dealing with whether there should be taxation to the beneficiary upon one of those transactions.

[21] Is this a different question, which is -- you know, is there a beneficiary to begin with? Isn't that the question that 679 is asking?

[22] MR. BRUCE: That's -- yes, that's one place where it crops up. That's one manifestation of what I think is the same issue.

[23] I couldn't -- I'll think about it some more, because this is an area where things off the top of the head may not be the right thing, but off hand, I can't think of having a -- giving effect to use of an asset in one area like 672(f), I guess, or the reporting rules and not giving effect to it under some other area.

[24] The item five on my outline, a clarity that a valid insurance policy -- and I would cross reference the insurance policy definitions in the code. I think that would be the 7702. I would suggest some sort of cross referencing, and that point be made.

[25] The next point really hits around example 13 under 679-2. Perhaps it's -- I know that it's a tiny point, and I know that it's one that may sound like dwelling upon nuances, but because of the fact that people's residence and citizenship can jump around, it is - - people look for ways to draft trusts to meet the 679 test, that they not be the possibility of any U.S. beneficiary.

[26] I'm suggesting that you add an example that somehow works to give clarity on what works as well as what doesn't work. I think what works is to say that no beneficiary can be a U.S. person -- a U.S. citizen or a U.S. resident. If someone who is, let's say, a U.S. resident later ceases to be a U.S. resident, and for example, then becomes qualified, perhaps, then gets added to a list of beneficiaries. It seems to me that ought to be okay.

[27] MR. KIRSCH: Are you saying that you don't think that the examples in the regulation made clear what the result is in that case? Because I think it was our intention to say that someone in that situation would be covered by 679, if they're currently a U.S. citizen, and income is being accumulated, even though the trust might say that they can't get their hands on the money until after they're no longer a U.S. citizen.

[28] MR. BRUCE: This example -- and I realize you haven't had a chance to read Roman six, but it is that -- it would track the language of the statute to say that there could be no income accumulated for or future distributions to a U.S. person.

[29] If an individual, who is a U.S. person -- say, a U.S. resident, later ceases being a U.S. person and then is added, because they come into now a category that would qualify, then it seems to me that they should be -- 679 should not apply in that situation.

[30] There are instances where because of nationality rules, someone has to make a choice by age something or another, and I forget whether it's 18 or 21, that person may choose that they're just going to remain English or French or something else.

[31] A trust could be created where they could not be a beneficiary, and would not be a beneficiary. However, at a later date when they make the choice not to be U.S., then it seems to me that they should fall in a category where they could qualify as being added.

[32] Having been U.S. at one time should not taint them forever from being added to that class of beneficiaries, I don't think. That situation is not quite the situation in your example 13.

[33] Roman seven deals with that part of the 679-2 regulations where a trust might be treated as having a U.S. beneficiary by reference to written and oral agreements and understandings not contained in the trust document, an actual reasonably expected disregard of the terms of the trust instrument by the parties to the trust.

[34] I note that this is really new drafting in my experience. I've not seen this type of drafting before. Secondly, I think that there's a -- to me, it's a fine line in drafting as to how much you put in regulations and how much you really want to leave to case law.

[35] In my own view of it, this may go a little too far towards drafting and to regulations case law. If I were you, I would recommend going back a little and putting some clear language in there, which actually is not in there, that not all things that are called trusts are trust, and that to be a trust, you have to do a number of things, including but not limited to, you have to make a transfer where you give something up or you let go of it.

[36] Secondly, after you've set the thing up, you've got to behave like it was a trust. Those are the two major prongs that I can think of, and you can -- I think it's a perfectly good idea to then cite a string of cases. The string for the first line, and that is, you've got to give it up, I think is Bixby Samuels, the old Dead Sea Scroll case. I would cite that line; and the second line is, I think, the Marcocian -- there's another Marcocian case that's actually a foreign trust. I think Marcocian was a domestic trust.

[37] I would state the big proposition that you've got to be a trust, and that means among other things, giving it up and behaving like it's a trust. And then I'd cite the case law. I would go more in that direction than creating an actual or reasonably expected disregard test, which I have no idea how that would play out.

[38] So, it's a hard job, I understand, but that would be my suggestion. I say that because I think that a lot of trusts that are out there that are giving people problems are really not trusts, and need not to be getting into this business. They should even be looking at these regulations. They should be flunked out. They should not be in these regulations.

[39] Roman nine is addressing 679-2 provisions dealing with a situation where a non-679 trust, at least not a 679 trust in the beginning, subsequently acquires a U.S. beneficiary and what the fallout of that is, and the regulations say that one of the aspects of fallout is not only are you taxed on the undistributed net income, but you're hit with throw-back and interest charge.

[40] I looked to see if there was clear authority for the application of throw-back and interest charge and I don't see a direct tie to those, but I could see how one could get there. So, my real point is that, as a practical matter, this will often happen I think by accident.

[41] Well, you certainly are going to have cases where people accidentally get hit with 679. It was not a planned transaction. Note that this is tax, and in many cases there isn't going to be any real cash in hand, it's just that you're getting hit with a sort of phantom situation.

[42] So, my own feeling is that throw-back and interest charge which jumps all over the place, according to the history of the trust. It could be not a big problem or it could be an enormous problem, and it's also a record-keeping problem because you can't run those numbers unless you've got a complete set of records. If you don't have a complete set of records, you have sort of default rules against you, which are killer default rules.

[43] So, with that big and bad enough consequence, I would slow down before I automatically went to the interest charge and throw- back. Maybe just tax them. And I don't think that creates something that people would plan to get within.

[44] The item eleven deals with exception for transfers to a foreign charity that came in in '96. This issue I've pondered and thought about probably more than any of the other provisions as to what might be a good idea. My first point is that I think you should allow some time after the transfer for the transferor to catch up with his determination letter.

[45] We typically create a foreign entity, frequently a foreign trust as the vehicle for the non-U.S. charitable organization. Then we go get a determination letter, because frequently a reason for all of this is the estate tax deduction. So you want to go get your determination letter.

[46] Those determination letters, first of all -- maybe this is a wrong generality, but not-for-profit may not move quite as quickly in a transaction as a for-profit group. It's not always the case, but -- so, blazing speed, I'd hate to see a rule that required six months or something.

[47] Secondly, it doesn't come back that fast from the Service. I started to put in here, let's say, 24 months. Then I thought, boy, those flat rules are not smart. So if there could be some reasonableness test, to permit people to go get their determination letter, I highly recommend that. I don't see any reason -- otherwise, you're going to have to transfer $100 and then keep track of it, the rest just being a portion of the trust and all that stuff; and I just think that's not a good way to go.

[48] Then on the idea of whether it should apply at all, I think you probably should have a rule that the foreign trust has got to sooner or later have a good housekeeping seal of approval of some sort. I think it would be a mistake not to.

[49] Then, since that sounded a little tight to me I thought, well, maybe not here, but remarks for the good of the order, perhaps, in the treaty program. There is more language, more provisions about exempt organization -- exempt charities -- in these treaties. It's creeping in and in, and I think that's good. It's an important -- very important area.

[50] So I think treaty-by-treaty, in appropriate circumstances -- and hopefully most treaties would be appropriate -- that you make it clear that a trust resident, understanding that's a big term, and covered by that treaty, that was okay under the law of the contracting state, the other contracting state would be treated as okay under these rules. I'd recommend that.

[51] Really those -- I'll leave my 684 regulations --

[52] MR. YATES: You're down to 2:46, two minutes and 46 seconds.

[53] MR. BRUCE: That's okay, I'll -- as they say -- yield the rest of my time. But I do appreciate very much your attention to these subjects.

[54] MR. YATES: Okay, thank you very much.

[55] Brian, you're next. You want to come up here?

[56] MR. DOOLEY: Sure.

[57] MR. YATES: Our next speaker is Brian Dooley, who is a sole practitioner in California.

[58] MR. DOOLEY: Hi, I'm Brian Dooley. I'm a CPA and I practice in Newport Beach, California. I thank you all for allowing me to come here today and talk about these important regulations.

[59] I appreciate the fact that there's really a need to get proper reporting on foreign transactions. I know that these regulations have an important goal in obtaining that need.

[60] As a practitioner, I'm a pretty old timer practitioner. I started back in 1968. When I come across a set of regulations or a ruling that's not the same as long- standing general income tax law, whether it be case law, other IRS rulings, or regulations. It's very hard for me, as a practitioner, to know that I'm in compliance with the concept now of substantial authority.

[61] So, if I have more than one substantial authority, what do I do when I'm preparing a tax return or trying to advise a client, and that's a real concern. To avoid malpractice, my writing -- my advice should always be in writing, because clients tend to want to make up what you said, if things go bad. So, I like to put it in writing, just to outline items and put in these substantial authorities; and as I read through these regulations, I could see that a goal is to capture all types of transfers, so that they can be reported on a form 5520, form 5528, a form 5471, reporting on this section 684.

[62] One of my concerns is that to achieve that transparency in a transfer is that the proposed regulations had to ignore long- standing law. The example I talked about most in my written testimony is the ignoring of the existence of a corporation as a separate entity.

[63] We have Supreme Court cases, Moline Property, a court holding doctrine. In my written testimony I do a footnote of cases that popped up when I put in Moline Property into my CD to see how many times that case was used since 1986, that's how far back my cases go on that CD, and it was hundreds of times. I talked about it a lot in my written testimony, so I won't recite all the cases again.

[64] At the same time, there's really a need for the government to be able to track what funds are going off shore, may it be through a loan, through a private annuity transaction, which is used a lot for estate planning, especially on the west coast, because we have two cases in the Ninth Court of Appeals that uphold that as proper estate planning; but installment sales, re-insurance proceeds -- so many methods that are hard to easily categorize in today's reporting requirement as a need to be reported.

[65] So what I suggest is that in those examples where the corporation's being disregarded that the examples go on to explain that the disregarding is for reporting requirements, only, and I suggest that for two reasons.

[66] One, when I read the example, it was real hard for me to pick up on that desire of the IRS, that the example was trying to get to that place. So, if I read it and if I don't know that's what's being said, then it's real hard. Most of these regulations are read by general practitioner CPAs or general practitioner attorneys, and where I spend quite a lot of time reading laws regarding international taxes, they do not. So, they could easily miss that.

[67] It kind of reminds me of being a parent. I really have to tell my kids what I meant, you know, they'd find the loophole somehow; and not that every -- I don't mean to say that every CPA or attorney would find loopholes, but they just won't know often unless you tell them that's what you mean.

[68] And at the same time, I believe that would salvage the integrity of judicial law, other IRS regulations that recognize appropriations as a separate entity. And my other concern is that the examples could create a whole new layer of loophole planning.

[69] Because under our tax laws, we don't really differentiate between a domestic corporation and a foreign corporation, except for like the controlled foreign corporation rules, section 367, rules that are designed to avoid tax-saving type transactions.

[70] The same with a trust. Other than section 679, we don't differentiate between a trust, maybe domestic or foreign. So if one were to take the examples and just change the domestic -- the foreign trust to a domestic trust and change the foreign corp to a domestic corp and use these examples as a way to disregard the domestic corp, that would give the creative tax planner an opportunity to use that to his or her advantage when the case may come up.

[71] Or, if the corporation is disregarded because the trust is a grantor trust, there's a lot of domestic grantor trusts, and it just makes it too easy. So, what's occurring is that there's a disregard for what I believe is long- standing, prudent, wise policy that's been reviewed by the Supreme Court many, many times, and followed by the IRS, and doesn't really let me know what's going on.

[72] So, as I read the examples, that would be one of my main suggestions in the examples. I want to talk first about the examples, and then about the text of the regs.

[73] As I read the examples, and read the regs, first under section 679, and I really -- there would be a statement in a few of the examples referring over to section 684. Then I read section 684 and it said see the regulations under 1.679-3, which is this long set of regulations, but they didn't tell me where.

[74] What I really was supposed to see are those examples that the transaction is looking through the corporation going after the trust -- at least, this is what I believe, and if I'm wrong, then that shows that the examples were not explained to me what they wanted, but no where did it really say that I have a section 684 transaction that needs to be reported and is treated as a sale to the extent that there's a gain.

[75] So once again, going back to the general practitioner who doesn't understand all this, there's a good chance he won't really know or she won't really know what is supposed to take place.

[76] So I thought, really you know, a real clear statement that is a section 684 transaction, and that means that the transferor reports gain on the transferors -- I'm sorry, reports the transaction as a sale to the extent there's gain on the transferor's income tax return.

[77] As I get to the text, there are quite a few places where I see that the text varies slightly from the law, and then the example somehow take that variation to go a little bit farther with it.

[78] I think section 679 is a difficult section because it doesn't fit neatly into the other provisions in the tax code regarding trusts, starting maybe 641 and going forward. It uses a different term. It doesn't use the concept of distributable net income or accumulative net income.

[79] The form 3528 talks about having to use -- it doesn't use those terms either, but it says that the accounting that a beneficiary gets from the trustee when he receives the distribution alone has to be under U.S. tax accounting theory, and those theories would be the theory of distributable net income, which is called DNI, distributable net income.

[80] So when these -- when the drafted section 679 used the term "accumulated" income, it's a different term. It doesn't fit into the long history of the tax code. Actually, I think these terms came up in the tax code of 1939 and carried over to '54.

[81] I note -- I read the reports by the Senate Finance Committee and the House Ways and Means for quite some time, but I noted that in the Senate Finance Committee Report, it actually states that a trust can have a U.S. beneficiary in the trust. What it states is that the trustee can add a trust beneficiary, it may be a U.S. person or not, and the trust would still not be a section 679 trust as long as the language on the prohibition of accumulation of income and distribution was in the trust agreement. I think that's very, very important.

[82] One of the examples talks about after the death of the transfer, or the trust then transfers assets to a new trust and the example was very good. The first time I read the example, I thought it was wrong. I'm sorry. But the example was very good.

[83] The example pointed out that in the trust agreement it did not prohibit the distribution of corpus during the lifetime of the transferor. So I was thrown off. I thought the issue was the transfer to the other trust was the issue, but the issue really was that the existing trust did not have this prohibition in it.

[84] I think what's -- I think the examples do a good job eluding to it, but once again, trying to get it to be really telling the practitioner, the attorney or the CPA, exactly what they have to do, they have to have that language from section 679 in the trust agreement, and if there is a distribution to a trust after the death of the transferor, no income that was accumulated during the lifetime of the transfer, or it would be paid over to that trust.

[85] To make it real clear, just like the language says in the Senate Finance Report that the most important item is that you have these terms in the trust agreement.

[86] I kind of want to spend part of my time talking about having the regs address, I think, one of the important concerns, is the reporting, because it's very hard for the IRS to track transactions that, say, are abusive without knowing that they take place. And having the regs maybe emphasize more on that, and have the regs emphasize all the tools the IRS at its disposal under current law to curtail or stop the use of the abusive transaction.

[87] What I hear people talk about is they form a trust, $100 corpus, $1,000 corpus, the trust forms a foreign corporation with $100, then the corporation buys property for $1 million, or $5 million, and gets a loan from a related entity.

[88] We've had the long-standing judicial doctrine, in capitalization. Back I think in the '76 Act, section 385 was enacted laying the guidelines as to what would be a thinly capitalization transaction, but the general judicial doctrine is that, if the ratio of corporate net worth to related party debt exceeds three to one, then that loan is no longer a loan, that loan is preferred stock.

[89] So, if the IRS wanted to recast the transaction in a way that would stop the abuse by treating that thinly capitalized corporation with a big loan, by treating that loan as preferred stock, the IRS then would have turned that foreign corporation into a controlled foreign corporation so that preferred stock could be more than 50 percent of the value of the outstanding stock, even if the trust somehow avoided the controlled foreign corporation rules.

[90] The other place where I see practitioners talk about transactions is the same scenario, a corporate trust with a $1,000 corpus or less, the trust forms a corporation and they sell assets in for a private annuity, the sales price may be $1 million, $2 million, $3 million. The IRS issues regulations back about 1990, 1991 on section 7520 and most people think that's the section for interest rates for related party transaction -- and it is.

[91] In the regulations, the IRS talks about the amount of capital needed in a limited liability entity, so a trust is one in which the debts of the trust do not exceed over to the beneficiaries of the trustee. A corporation's the same type, and LLC would be the same type. A general partnership would not be that type. An individual would not be that type.

[92] My experience is, depending upon the interest rate factor for the AFR in account for any one month, if the annuitant, the transferor or the one that's putting the money into the foreign corporation, is someplace around age 60, the amount of capital required is about 30 to 40 percent.

[93] So, if the amount that's going into the foreign corporation is $10 million, and the required capital then should be about $3.5 million. That means that the trust would have to be created with a gift at $3.5. Assuming it's a gift by a U.S. person, there would be gift tax due, and that would be the capital into the foreign corporation.

[94] If that capital is not there, what the regulations state is that there is a gift. There is a gift of that 35 percent, and there's gift tax due. If the gift tax return was not filed, of course, there's a fine. And if it was a gift of appreciated -- I'm sorry, if it was an annuity of appreciated property, to the extent there was a gift, there would be a gratuitous transfer to it. Section 684 would apply.

[95] There are a lot of tools like that that can be used to curb the abusive transactions without trying to have the regulations push section 679 to a position that I think loses the integrity of the regulations by ignoring, like I said, pre-existing law, may it be judicial cases, IRS regulations, even some other code sections. I think it's important that there's at least integration within the concepts.

[96] Along that same line is the concept of indirect -- and that's used a lot throughout these regulations; and indirect means, at least I believe it means, based upon the research I did with case law and going through IRS regulations -- it means generally a nominee arrangement. It doesn't mean a constructive arrangement.

[97] To the extent that the regulations tend to use it in a different way, then that once again leaves the integrity of existing case law, existing regulations -- and we don't have this continuity, which then make the regulations complex where they lack clarity, because they're not following the main theme of existing tax law.

[98] So I would like to see the use of that term be somewhat in the general use of existing law; and once again not be used -- changing the use of that term as a way to try to pull in transactions, other than report. But saying for reporting purposes, this is an indirect transfer, but not to give it a recognition for tax law. By that, it doesn't mean that it gets to be reported on a return as an event, because I'm afraid it will end up being used against the IRS by creative tax planners.

[99] And, that's it.

[100] MR. YATES: Thank you.

[101] MR. DOOLEY: Thank you very much.

[102] MR. YATES: I didn't know it did that [referring to timer].

[103] [Laughter.]

[104] MR. YATES: I don't think we -- any more comments from our panelists or questions?

[105] [No verbal response.]

[106] MR. YATES: Again, thank you all for coming, and at this point, I declare the hearing to be closed.

[107] [Whereupon, at 10:55 a.m., the proceedings were adjourned.]