Tax Global Client Alert IRS Issues Proposed Regulations Addressing Taxation of US Citizens or Residents Receiving Gifts or Bequests from Expatriates The Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act”) is well-known for imposing an exit tax on US citizens and long-term green card holders who expatriate from the United States. The HEART Act also imposes a tax on US citizens or residents who receive gifts or bequests from certain expatriates. This tax on US recipients of gifts or bequests is codified in Internal Revenue Code (“IRC”) section 2801 (the “section 2801 tax”). Like the exit tax, the section 2801 tax is applicable to persons who expatriate on or after June 17, 2008. Guidance regarding the section 2801 tax has been long-awaited since Notice 2009-85, released on October 15, 2009, announced that satisfaction of the reporting and tax obligations for certain gifts and bequests made since June 17, 2008 is deferred pending issuance of separate guidance. On September 9, 2015, the US Internal Revenue Service (“IRS”) issued proposed regulations addressing section 2801 (the “proposed regulations”). This alert provides an overview of the proposed regulations and highlights some of the practical issues for taxpayers who are affected by section 2801. The proposed regulations are divided into seven sections, in addition to some administrative regulations: (1) general rules of liability for the section 2801 tax; (2) definitions of key terms; (3) rules and exceptions applicable to the definitions of “covered gift” and “covered bequest”; (4) liability and computation of the section 2801 tax; (5) treatment of foreign trusts under section 2801; (6) special rules and crossreferences; and (7) determining responsibility for the section 2801 tax. The further administrative regulations address filing and payment due dates as well as returns, extension requests, and recordkeeping matters relating to section 2801. This alert follows the outline of the proposed regulations. Section 1: General Rules of Liability under Section 2801 Section 2801 imposes a tax on US citizens and residents who receive certain gifts or bequests (known as “covered gifts” and “covered bequests”), directly or indirectly, from a so-called “covered expatriate.” As explained in greater detail below, for purposes of section 2801, US domestic trusts as well as foreign trusts electing to be treated as US domestic trusts for purposes of section 2801 will be treated in the same manner as US citizens. Tax is paid by the recipient of the covered gift or bequest. Section 2: Definitions The following key definitions apply solely for purposes of section 2801 and the corresponding regulations. October 2015 In This Issue: Section 1: General Rules of Liability under Section 2801 Section 2: Definitions Section 3: Rules and Exceptions Applicable to the Definitions of Covered Gift and Covered Bequest Section 4: Liability and Computation of Section 2801 tax Section 5: Treatment of Foreign Trusts under Section 2801 Section 6: Special Rules and Cross-References Section 7: Determining Responsibility under Section 2801 Administrative Regulations Conclusion 2 “Citizen or resident of the United States” – particularly noteworthy, the IRS clarifies that this definition is not based on the US income tax definition of “resident” but relies on the definition under the US estate and gift tax rules. Thus, a “resident” in this context is determined by “domicile” for US gift and estate tax purposes. Domicile is a subjective intent test based on facts and circumstances. For purposes of section 2801, citizenship or residence in the United States is to be determined as of the time of receipt of the covered gift or covered bequest. “Covered gift” and “covered bequest” – “Covered gift” means any property acquired by gift directly or indirectly from an individual who is a covered expatriate at the time the property is received by the US citizen or residence. “Covered bequest” refers to any property acquired directly or indirectly by reason of the death of a covered expatriate. The IRS clarified that a gift or bequest will be a covered gift or bequest regardless of its situs and regardless of whether such property was acquired by the covered expatriate before or after expatriation from the United States. “US recipient” – A “US recipient” is a US citizen or resident, a US domestic trust, or an electing foreign trust, that receives a covered gift/bequest, directly or indirectly, during the calendar year. This term includes US citizens or residents receiving a distribution from a foreign trust not electing to be treated as a US domestic trust for purposes of section 2801 if the distributions are attributable (in whole or in part) to one or more covered gifts or covered bequests received by the foreign trust. This term also includes the US citizen or resident shareholders, partners, members, or other interest-holders, as the case may be (if any), of a US domestic entity that receives a covered gift or covered bequest. “Expatriate” and “covered expatriate” – For purposes of section 2801, the term “expatriate” has the same meaning as in section 877A(g)(2), and the term “covered expatriate” has the same meaning as in section 877A(g)(1). The determination of whether an individual is a covered expatriate is made as of the expatriation date as defined in section 877A(g)(3). If an expatriate meets the definition of a covered expatriate, the expatriate is considered a covered expatriate for purposes of section 2801 at all times after the expatriation date. Nevertheless, an expatriate is clearly not treated as a covered expatriate for purposes of section 2801 during any period beginning after the expatriation date during which such individual is subject to US estate or gift tax as a US citizen or resident, since the transfer will be subject to tax in the hands of the expatriate in such a case. In the case of an individual who has expatriated more than once, his status as a covered expatriate will be determined as of the date of the most recent expatriation. “Indirect acquisition of property” – The IRS broadly expanded on the meaning of an "indirect" covered gift or bequest. In such case, an indirect acquisition of property includes the following: (i) Property acquired as a result of a transfer that is a covered gift or covered bequest to a corporation or other entity other than a trust or estate (based on the US recipient’s interest in the corporation or other entity); (ii) Property acquired by or on behalf of a US recipient, either from a covered expatriate or from a foreign trust that received a covered gift or Contacts: Caracas Centro Bancaribe, Intersección Avenida Principal de Las Mercedes Caracas 1060 Venezuela Ron Evans +58 212 276 5093 email@example.com Chicago 300 East Randolph, Suite 5000 Chicago, IL 60601 United States Robert Kent, Jr. +1 312 861 8077 firstname.lastname@example.org Richard M. Lipton +1 312 861 7590 email@example.com Dallas 2300 Trammell Crow Center 2001 Ross Avenue Dallas, TX 75201 United States Robert H. Albaral +1 214 978 3044 firstname.lastname@example.org Geneva Rue Pedro-Meylan 5 1208 Geneva Switzerland Stephanie Jarrett +41 (0)22 707 98 21 email@example.com Elliott Murray +41 (0)22 707 98 39 firstname.lastname@example.org Jennifer O’Brien +41 (22) 707 98 41 email@example.com Danilo Santucci +41 (22) 707 98 28 firstname.lastname@example.org Hong Kong 14th Floor, Hutchison House 10 Harcourt, Hong Kong Hong Kong SAR Richard L. Weisman +852 2846 1969 email@example.com 3 covered bequest, through one or more other foreign trusts, other entities, or from a person not subject to the section 2801 tax; (iii) Property paid by a covered expatriate, or distributed from a foreign trust that received a covered gift or covered bequest, in satisfaction of a debt or liability of a US citizen or resident (regardless of the payee of that payment or distribution); (iv) Property acquired by or on behalf of a US citizen or resident pursuant to a non-covered expatriate’s power of appointment granted by a covered expatriate over property not in trust, unless the property previously was subjected to section 2801 tax upon the grant of the power or the covered expatriate had no more than a non-general power of appointment over that property; and (v) Property acquired by or on behalf of a US citizen or resident in other transfers not made directly by the covered expatriate to the US citizen or resident. This broad definition of indirect acquisition of property brings much needed clarity to the question of the reach of the section 2801 tax. Section 3: Rules and Exceptions Applicable to the Definitions of Covered Gift and Covered Bequest After a detailed explanation of the definition of covered gifts and covered bequests, several exceptions to these definitions are explained. Next, the proposed regulations address the applicability of covered gifts and bequests in the context of trusts and powers of appointment. Finally, several examples are provided which illustrate these rules and exceptions. Rules and Exceptions The term "gift" in “covered gift” has the same meaning as it does for US gift tax purposes, but disregarding certain exceptions provided in sections 2501 and 2503. With respect to the term "bequest", the proposed regulations provide that property acquired "by reason of the death of a covered expatriate" includes any property that would have been included in the gross estate of the covered expatriate had they been a US citizen at the time of their death. To supplement this general explanation, several instances are noted where property is treated as a covered bequest when acquired by reason of a covered expatriate's death including, among others, instances with respect to QTIPs, property rights passing under a right of survivorship, annuity payments, property subject to a general power of appointment, and life insurance proceeds. There are no real surprises with these definitions. They are fairly allencompassing as was expected. There are several exceptions to the definition of covered gift and covered bequest: Transfers from covered expatriates that are included on a timely filed Form 709, with any resulting US gift tax being timely paid, are not covered gifts. Transfers from covered expatriates that are included on a timely filed Form 706 (or Form 706-NA), with any resulting US estate tax being timely paid, are Houston 700 Louisiana, Suite 3000 Houston, TX 77002 United States Rodney Read +1 713 427 5053 firstname.lastname@example.org London 100 New Bridge Street London EC4V 6JA United Kingdom Ashley Crossley +44 (0)20 7919 1424 email@example.com Miami Sabadell Financial Center 1111 Brickell Avenue Miami, FL 33131 United States James Barrett +1 305 789 8957 firstname.lastname@example.org Simon Beck +1 305 789 8929 email@example.com Michael Bruno +1 305 789 8923 firstname.lastname@example.org Steven Hadjilogiou +1 305 789 8909 email@example.com Cecilia Hassan +1 305 789 8939 firstname.lastname@example.org Bob Hudson +1 305 789 8906 email@example.com Daniel Hudson +1 305 789 8986 firstname.lastname@example.org Stewart Kasner +1 305 789 8940 email@example.com Michael Melrose +1 305 789 8926 firstname.lastname@example.org Bobby Moore +1 305 789 8995 email@example.com 4 not covered bequests. In instances where a Form 706 is not otherwise required to be filed, it must nevertheless be filed for the property passing from that covered expatriate to be excluded from the definition of covered bequest. Importantly, only property included on the form is eligible for the exclusion. Qualifying transfers to US charities and transfers pursuant to the covered expatriate's qualified disclaimer are not covered gifts or bequests. Transfers to a covered expatriate's spouse or trust are excepted from the definitions of covered gift and covered bequest to the extent a marital deduction would have been allowed had the covered expatriate been a US citizen at the time of the transfer. An important item to note in these exceptions is that a transfer excluded from the definition of a taxable gift is not excluded from the definition of a covered gift even if the transfer is reported on the donor's Form 709. This is different than the covered bequest which suggests that bequests not subject to US estate tax (e.g., non US-situs property passing to a US person), but nevertheless included on the Form 706 (or Form 706-NA) is excluded from the definition of covered bequest. As an example, please suppose Mr. A expatriated in 2012 and at that time was properly classified as a covered expatriate. In 2015, Mr. A died at a time where he owned no US situs property and had no obligation to file a US estate tax return. Mr. A left his US citizen daughter securities worth US$ 1 million in a Liechtenstein bank account. Unless Mr. A's estate files a Form 706 with the IRS, and includes the existence of the Liechtenstein bank account, the US$ 1 million should be treated as a covered bequest. Trusts and Powers of Appointment When a covered expatriate transfers a covered gift or bequest to a trust the transfer is treated as a covered gift or covered bequest to the trust, without regard to the beneficial interests in the trust or whether any person has a general power of appointment or a power of withdrawal over trust property. Generally, the exercise, release, or lapse of a general power of appointment held by a covered expatriate over property for the benefit of a US citizen or resident is a covered gift or covered bequest. If a covered expatriate exercises a power of appointment that creates a power of appointment for the benefit of a US citizen or resident it is a covered gift or covered bequest. It is not surprising that covered gift or bequest status of a transfer to a trust does not hinge on the beneficial interests in a recipient trust but on whether the transfer itself qualifies as a covered gift or bequest under the terms of section 2801. As an example, the proposed regulations address for situations: (i) a transfer to a US spouse, (ii) the reporting of property as subject to the US estate tax, (iii) a covered gift in trust with a grant of a general power of appointment over the trust property, and (iv) a lapse of a power of appointment held by a covered expatriate. As another example, the IRS addressed property passed from covered expatriate to a US citizen by right of survivorship and reached a concerning result. In this example, the executor of the covered expatriate's estate timely filed an extension to file a Form 706-NA and pay the US estate tax. The executor does file the Form 706-NA but only after the time allotted under the extension. The example concludes that the US citizen must pay the section 2801 tax because the estate Pratiksha Patel +1 305 789 8 984 firstname.lastname@example.org Abrahm Smith +1 305 789 8972 email@example.com Sean Tevel +1 305 789 8965 firstname.lastname@example.org Jennifer Wioncek +1 305 789 8985 email@example.com New York 452 Fifth Ave New York, NY 10018 United States Marc Levey +1 212 891 3944 firstname.lastname@example.org Douglas M. Tween +1 212 626 4355 email@example.com Glenn Fox +1 212 626 4689 firstname.lastname@example.org Paul DePasquale +1 212 626 4230 email@example.com Palo Alto 660 Hansen Way Palo Alto, CA 94304 United States Scott H. Frewing +1 650 251 5917 firstname.lastname@example.org Singapore 8 Marina Boulevard #05-01 Marina Bay Financial Center Tower 1 Singapore 018961 Singapore Dawn Quek +65 6434 2599 email@example.com Washington, DC 815 Connecticut Avenue, N.W. Washington, DC 20006 United States Kathleen A. Agbayani +1 202 835 4242 firstname.lastname@example.org A. Duane Webber +1 202 452 7040 email@example.com Mary C. Bennett +1 202 452 7045 firstname.lastname@example.org Joshua D. Odintz +1 202 835 6164 email@example.com Peter M. Daub +1 202 452 7081 firstname.lastname@example.org 5 did not timely file the Form 706-NA. Does this mean that the property is subject to both the US estate tax and section 2801 tax? The example is clear that the missed filing deadline caused the section 2801 tax to be applicable, however it does not address whether either taxpayer may receive a credit/refund for the payment of tax by the other. Section 4: Liability and Computation of Section 2801 tax Liability for Section 2801 tax As previously noted, the US citizen or resident who receives a covered gift or bequest is liable for the section 2801 tax. Because a US domestic trust is treated as a US citizen for this purpose, a US domestic trust is liable for the section 2801 tax when the trust receives a covered gift or bequest. A trust's payment of the section 2801 tax does not trigger a deemed taxable distribution to the trust beneficiary for generation-skipping transfer tax purposes if the trust is liable for the section 2801 tax (i.e., if the trust is a US domestic trust or a foreign trust electing to be taxed as a US domestic trust for purposes of section 2801). A charitable remainder trust is subject to the section 2801 tax when the trust receives a covered gift or bequest. The amount of any covered gift or bequest excludes the charitable remainder interest. A foreign trust may elect to be treated as a US domestic trust solely for purposes of section 2801. A foreign trust making this election is liable for the section 2801 tax when it receives a covered gift or bequest. In the case of a foreign trust that does not make this election, a US citizen or resident beneficiary will be liable for the section 2801 tax when the beneficiary receives (directly or indirectly) a distribution from the foreign trust to the extent that the distribution is attributable to a covered gift or bequest. A foreign trust that does not make the election is subject to the section 2801 tax if the trust migrates to the US in a subsequent year. A US recipient of a distribution from a foreign trust may qualify for a limited deduction for the section 2801 tax to the extent that the distribution is included in the recipient's gross income for US income tax purposes. Trustees of foreign non-electing trusts will need to determine the amount of a distribution that is attributable to a covered gift or bequest and pass that information to the US recipient for the US recipient to determine the amount of the distribution subject to the section 2801 tax and to determine the amount of any deduction that can be taken for the section 2801 tax. Computation of Section 2801 tax To compute the section 2801 tax, a US citizen or resident (or a trust liable for the section 2801 tax) must determine the total value of all covered gifts and bequests received during the calendar year and subtract the per-donee annual exclusion amount for the year (the annual exclusion for 2015 is US$ 14,000) and then multiply that amount by the highest rate of US gift tax (for a covered gift) and US estate tax (for a covered bequest). Currently, the maximum US gift and estate tax rates are unified at 40%. The amount of the section 2801 tax can be reduced by non-US gift or estate taxes that apply to the covered gift or bequest. Zurich Holbeinstrasse 30 8034 Zurich Switzerland Marnin Michaels +41 (0)44 384 12 08 email@example.com Lyubomir Georgiev +41 (0)44 384 14 90 firstname.lastname@example.org Marie-Thérèse Yates +41 (0)44 384 14 87 email@example.com Thomas Salmon +41 (0)44 384 13 72 firstname.lastname@example.org Gregory Walsh +41 (0)44 384 12 91 email@example.com Jacopo Crivellaro +41 (0)44 384 12 90 firstname.lastname@example.org Devan Patrick +41 (0)44 384 12 94 email@example.com David Gershel +41 (0)44 384 14 93 firstname.lastname@example.org 6 The value of a covered bequest or covered gift is the fair market value of the property on the date of its receipt by the US recipient using US gift and estate tax valuation principles. This would allow the application of valuation discounts to the extent applicable. As an example, to illustrate the liability and computational rules of section 2801, please assume Mr. A from the above example bequeaths US$ 1 million to his son (who is a US person) and US$ 1 million to each of three trusts. Trust 1 is a US domestic trust. Trust 2 is a non-US electing trust, and Trust 3 is a non-US nonelecting trust. Mr. A's son, Trust 1, and Trust 2, are liable for the section 2801 tax upon receipt of the bequest each receives. Trust 3 is not subject to the section 2801 tax. Five years after Mr. A's death, Trust 3 distributes the US$ 1 million to Mr. A's son at a time when Mr. A's son is a US person. When he receives the distribution from Trust 3, Mr. A's son is liable for the section 2801 tax on the distribution. To compute the son's tax on his receipt of the distribution at Mr. A's death, first take the total value of all covered gifts and bequests during the year (US$ 1 million) and reduce that amount by the annual exclusion (US$ 14,000, assuming the full annual exclusion is available for application against the covered bequest). The resulting US$ 986,000 is multiplied by the highest rate of estate tax, which is currently 40%. In this example, Mr. A's son would owe US$ 394,400 in section 2801 tax. Section 5: Treatment of Foreign Trusts under Section 2801 The proposed regulations provide guidance also on the treatment of foreign trusts. If a covered gift or covered bequest is made to a foreign trust, the section 2801 tax applies to any distribution from that trust, whether of income or corpus, to a recipient that is a US citizen or resident, unless the foreign trust elects to be treated as a US domestic trust for purposes of section 2801. The proposed regulations define the term “distribution” broadly to include any direct, indirect, or constructive transfer from a foreign trust, including each disbursement from such a trust pursuant to the exercise, release, or lapse of a power of appointment. This determination is made without regard to whether any portion of the trust is treated as owned by the US recipient or any other person under grantor trust rules (pertaining to grantors and others treated as substantial owners). Whether the US recipient of the transfer is designated as a beneficiary by the terms of the trust is also irrelevant. The section 2801 tax applies only to the portion of a distribution from a non-electing foreign trust that is attributable to covered gifts and covered bequests contributed to the foreign trust. The proposed regulations provide that the amount of the distribution attributable to covered gifts and covered bequests, is determined by multiplying the total distribution by a ratio, as in effect at the time of the distribution, that is redetermined after each contribution to the trust. The proposed regulations explain how to compute that ratio and provide that each distribution from the foreign trust is considered to be made proportionally from the covered and non-covered portions of the trust, without any tracing with regard to particular assets. One effect of this rule is that the portion of a distribution from a foreign trust that is attributable to covered gifts and covered bequests contributed to the foreign trust includes the ratable portion of any appreciation and income that has accrued on the foreign trust’s assets since the contribution of the covered gifts and covered bequests to the foreign trust. As an example, the proposed regulations illustrate the computations in case of contributions of US$ 100,000 each to a trust by a person who is a covered expatriate (and thus the contribution is a covered gift) and another person who is not. The section 2801 ratio is computed by comparing the pre-contribution value of the trust (e.g. US$ 0) times the pre-contribution section 2801 ratio (zero), plus the current covered gift (e.g. US$ 100,000), divided by the post-contribution fair market value of the trust (e.g. US$ 200,000). Therefore, 50% of each distribution from the trust is subject to the section 2801 tax (until the next contribution is made to the trust). If the trustee distributes US$ 40,000 to a U.S. citizen, then US$ 20,000 is a covered gift. 7 As another example, the proposed regulations go into the details of computing the ratio when multiple contributions are made to a foreign trust by a person (“grantor”) prior to June 17, 2007 (the effective date of section 2801) and after that date when the grantor became a covered expatriate. In that case, the aggregate contributions to the trust, both before and after expatriation, are taken into account separately. The portion of the distribution from the foreign trust attributable to a covered gift is calculated as made proportionally from the covered and non-covered portions of the trust. The non-covered portions are the ones prior to the grantor becoming a covered expatriate. Each year, the trustee of the foreign trust should provide the US citizen beneficiary with an accounting of the trust showing each receipt and disbursement of the trust during that year, including the date and amount of each contribution by the grantor. In any case, it is critical to keep proper records to which the US recipient has access. Otherwise, the proposed regulations treat the distributions very harshly if the trustee of a foreign trust does not have sufficient books and records to make the calculation, or if the US recipient is unable to obtain the necessary information, the US recipient must assume that the entire distribution is attributable to a covered gift or covered bequest. Once a section 2801 tax has been timely paid on property that thereafter remains in a foreign trust, that property is no longer considered to be, or to be attributable to, a covered gift or covered bequest to the foreign trust for purposes of the computation. Shifting the Section 2801 Tax Burden from US Beneficiaries to Foreign Trusts: Electing Foreign Trusts Treated as US Domestic Trusts for Section 2801 Purposes Although a US recipient of an amount received from a foreign trust, which is attributable to a covered gift or covered bequest, must normally pay the section 2801 tax on such amount, the foreign trust can make an election to shift such obligation for the tax to itself. Depending on the timing and distribution amounts, this election could benefit US beneficiaries in administrative matters, although in many circumstances such an election would likely result in an acceleration of tax and would reduce somewhat the application of annual exemption amounts. The likelihood of foreign trustees making this election will remain to be seen as such a decision will require an assessment of whether such duty is owed to the beneficiaries and the risks associated if the applicable laws (i.e., foreign laws as they relate to the trustee) are not properly adhered to. A foreign trust may elect to be treated as a US domestic trust solely for purposes of section 2801. A trust making such an election, known as an “electing foreign trust”, will be subject to the section 2801 tax when it receives covered gifts or covered bequests from a covered expatriate, rather than the US beneficiaries becoming subject to the tax when distributions are made out of the electing foreign trust. A foreign trust may make this election for a calendar year without regard to whether the foreign trust received a covered gift or covered bequest during that calendar year. Election as an electing foreign trust imposes the following requirements on the trustee: The election must be made on a timely filed Form 708; Payment of the section 2801 tax for the calendar year in which the election is made; Reporting of covered gifts and covered bequests received in years prior to the election; Payment of section 2801 tax on the fair market value of the trust attributable to such prior covered gifts and covered bequests (determined as of the last day of the calendar year immediately before the election is made); 8 Designation and authorization of a US agent for purposes of section 2801; Agreement to file Form 708 annually to certify that no covered gifts or covered bequests were made, or else to report and pay the section 2801 tax; Reporting of the amount attributable to covered gifts and covered bequests that was distributed to US recipients in years prior to the election; and Notification of “permissible distributees” that the trustee is making the election, and providing the IRS with the name, address and TIN of all such “permissible distributees.” The permissible distributees include any US citizen or resident who: Currently may or must receive distributions from the trust, whether of income or principal; May withdraw income or principal from the trust, regardless of whether the right arises or lapses upon the occurrence of a future event; or Would have been a permissible distributee if the interests of all the permissible distributees had just terminated or the trust had just terminated. The election is valid as of the beginning of the calendar year for which Form 708 is filed until the election is terminated. Termination may occur in the event of failure to make the required annual Form 708 filing or pay the required section 2801 tax. During this time, US citizens and residents receiving a distribution from the foreign electing trust will not be subject to section 2801 tax on such distributions. The electing foreign trust is instead liable for reporting and paying the section 2801 tax, just as a US domestic trust would be. After termination of an election, a foreign trust may make the election again by fulfilling the election requirements. US recipients remain, however, liable for section 2801 tax on distributions from prior years, which will be reported by the electing foreign trust. Additionally, in the event that the IRS disputes the valuation of a covered gift or covered bequest contributed to a foreign electing trust and the section 2801 tax remains unpaid on any overage ultimately determined by the IRS, the election is deemed “imperfect” and the US recipients are then liable for the section 2801 tax on the amount proportional to such overage for subsequent distributions received from the electing foreign trust. This election has no impact on taxation or reporting of foreign trust distributions outside the scope of section 2801. As an example, please suppose that Mr. A is a covered expatriate who expatriated in 2012. In 2013, he transfers a 20% limited partnership interest in a closely held business to a foreign trust created for Mr. A’s child, Ms. B, who is a US citizen. This limited partnership interest is a covered gift. The trustee of the foreign trust make a valid election to have the trust treated as a domestic trust for purposes of section 2801, the trustee timely files a Form 708 and timely pays the section 2801 tax on the reported fair market value of the covered gift (US$ 500,000). Later during 2013, the trustee distributes US$ 100,000 to Ms. B. In 2015, the IRS disputes the reported value of the partnership interest transferred in 2013 and determines that the correct valuation of the limited partnership on interest on the date of the transfer to the foreign trust was US$ 800,000. Soon after, the IRS issues a letter to the trustee of the foreign trust explaining its finding regarding the actual value of the limited partnership interest, and noting the resulting increase in section 2801 tax, plus accrued interest. If the trustee does not pay the additional section 2801 tax and interest by 9 the due date stated in the IRS’ letter, the foreign trust’s election for 2013 will be an imperfect election which means that its election will be deemed to have terminated on January 1, 2013. As an example, the proposed regulations assume that the trustee of a foreign trust that received a covered gift makes a valid election to be treated as a domestic trust. However, the trustee fails to file timely IRS Form 708 for the next year. The foreign trust election is terminated as of January 1 of that year. Thus, any distributions made to US recipients during the first year of the election have a section 2801 ratio of zero and are not subject to the section 2801 tax. However, any such distributions made during the second year of failed filing are subject to the section 2801 tax to the extent the distributions are attributable to a covered gift or covered bequest received by the trust during that second year. Unless the trustee makes a new election, beginning in the second year, the foreign trust’s section 2801 ratio must be recomputed each time the foreign trust receives a contribution. As another example, the proposed regulations suggest making a subsequent election after termination of the foreign trust election. The facts are the same as in the example immediately above with the failed timely filing and election termination. In the third year, the foreign trust does not receive a covered gift or covered bequest. However, the trustee decides that making another election to be treated as a domestic trust would be in the best interests of the trust’s beneficiaries. Accordingly, by the due date for IRS Form 708 for the third year, the trustee timely files the return and pays the section 2801 tax on the portion of the trust attributable to covered gifts and covered bequests. The trustee calculates the portion of the trust attributable to covered gifts and covered bequests received by the trust in prior calendar years by multiplying the fair market value of the trust on December 31 of the second year by the section 2801 ratio in effect on that date. Then the foreign trust is an electing foreign trust in the third year. Section 6: Special Rules and Cross-References The proposed regulations discuss the interaction with other provisions of the Code that are not addressed in section 2801. Specifically, to the following (1) basis determination rules, (2) application of GST tax, (3) reporting of large foreign gifts or bequests and distributions from foreign trusts, and (4) application of penalties for underpayments, failure to file and failure to pay, and substantial and gross valuation misstatements attributable to incorrect appraisals. A US recipient’s basis in property received as a covered gift or covered bequest is determined under the normal basis provisions of the Code (i.e., sections 1014 and 1015 or 1022 if the property is a bequest from an expatriate who died during 2010). The general basis determination rules are modified for covered gifts, however, by denying the increase for US gift tax paid under section 1015(d). The IRS does not provide any reasoning for denying such adjustment to basis which would otherwise be available if the gift was made by a US citizen or resident. The generation-skipping transfer tax will apply normally regardless of “a covered expatriate’s failure to timely file and pay the section 2801 tax, if applicable.” We note a minor typo: the phrase should read “…because of a US recipient’s failure to timely file and pay the section 2801 tax… (emphasis added).” The proposed regulations extend a US citizen's or resident’s information reporting requirements under section 6039F (receipt of gifts or bequests from a foreign person (other than a foreign trust) and section 6048(c) (receipt of distributions from foreign trusts) to US domestic trusts by virtue of the definition of US citizen and resident.. Thus, US domestic trusts receiving covered gifts or covered bequest (including distributions from foreign trusts that qualify for this definition) must report such gifts or bequests on IRS Form 3520. Foreign trusts electing treatment as US domestic trusts are not subject to these information reporting requirements. Additionally, the penalties owed for failure to timely file Form 3520 apply equally to US domestic trusts receiving distributions from foreign trusts that qualify as covered gifts or covered bequests. 10 Lastly the proposed regulations institute new penalties and extend the imposition of already existing penalties to the reporting or payment of tax due to the receipt a covered gift or covered bequest. Specifically, US recipients may be subject to: penalties imposed upon an underpayment of tax due to (i) a substantial valuation understatement under section 6662(g), or (ii) a gross valuation misstatement under section 6662(h); penalties attributable to substantial and gross valuation misstatements arising from incorrect appraisals; and penalties for failure to file new IRS Form 708 or pay the tax owed. Section 7: Determining Responsibility under Section 2801 US recipients are responsible for determining their obligations upon receiving any gifts or bequests originating from an expatriate or distributions from foreign trusts funded (at least in part) by an expatriate. The responsibility extends to both the determination of whether an expatriate is a covered expatriate and whether a gift or bequest is a covered gift or covered bequest. Despite the IRS' and the Treasury Department's acknowledgment of the difficulties imposed on US recipients, the introduction to the proposed regulations reminds taxpayers that the same standard of due diligence applies to US recipients as apply to "any other taxpayer." To assist US recipients with their determinations, the proposed regulations authorize the IRS to disclose, upon request of the US recipient, an expatriate’s US federal income tax return or information from such return, from which US recipients can determine covered expatriate or covered gift or covered bequest status. A US recipient is not permitted to rely on information disclosed by the IRS where the US recipient knows, or has reason to know, that the information is incorrect. The IRS will publish details regarding when and how a US recipient can request this information in the Internal Revenue Bulletin. In the case of living expatriates, the proposed regulations create a rebuttable presumption that a living expatriate is a covered expatriate if he or she does not authorize the disclosure of the tax return or other information by the IRS. This presumption can be rebutted by the US recipient’s filing of a protective Form 708, but US recipient must have “reasonably concluded” that the gift or bequest was not a covered gift or covered bequest. Administrative Regulations The proposed regulations also include administrative regulations under separate provisions of the Code that address filing of IRS Form 708 and payment due dates, extension requests, recordkeeping requirements with respect to the section 2801 tax, and the application of these provisions to the tax return preparer rules. Recordkeeping Matters US recipients will be required to retain information and records used to determine the total amount of covered gifts or bequests and to prepare Form 708. Any documents or vouchers used by the US recipient to complete Form 708 also must be retained “so as to be available for inspection whenever required” by the IRS. US recipients must furnish to the IRS information that it believes is necessary to determine the correct tax owed under section 2801. A US recipient will be required to provide to the IRS upon request the following: 11 all documents related to the covered gift or bequest; any appraisals of items included in the aggregate amount of covered gifts and covered bequests; any balance sheets or financial statements related to stock or other property constituting a covered gift or covered bequest; and any other information obtainable by the US recipient that may be necessary for the IRS to determine the tax owed. With respect to life insurance policies received as covered gifts or covered bequests, a US recipient must request that the insurance company completes Form 712, which provides detailed information regarding the policy, decedent, and policyholder. The US recipient must file Form 712 with the IRS office where Form 708 is filed. The proposed regulations also authorize the IRS to request that the insurance company file Form 712 directly. Returns Any tax owed under section 2801 must be reported on new IRS Form 708. US recipients must use Form 708 to report each covered gift and covered bequest received during the calendar year and to provide the information required by the proposed regulations. Form 708 is due each year that a US recipient receives a covered gift or a covered bequest and must be filed by the US recipient. A US recipient does not have to file Form 708 if the value of all covered gifts and covered bequests received during a calendar year does not exceed the amount of the annual exclusion from gift tax applicable on a per-donee basis under section 2503(b) (i.e., currently US$ 14,000). In addition to the filing requirement imposed upon US recipients, the proposed regulations authorize the filing of protective Forms 708. A US citizen or resident (which includes a US trust) can file a “protective” Form 708 to start the assessment period after receiving a gift or bequest from a foreign person where the US recipient “reasonably concludes” that the gift or bequest was not a covered gift or a covered bequest. In such cases, the US citizen or resident filing a protective Form 708 must include (i) all of the information required by the form, and (ii) an affidavit signed under penalties of perjury that provides the information on which the filer relied to determine that the gift or bequest was not a covered gift or covered bequest or that the donor or decedent was not a covered expatriate. The protective filing must also (i) detail the efforts undertaken by the filer to obtain information that might be relevant these determinations, (ii) include a copy of any information obtained from the IRS under the regulations, and (iii) include a copy of the relevant portions of IRS Form 3520, if applicable. If a Form 708 is filed that meets these requirements and the IRS does not asses a tax under section 2801 within the limitations period, then the IRS is barred from later assessing any tax. The preamble to the proposed regulations notes that the “mere absence” of information regarding the expatriate’s status as a covered expatriate or regarding the qualification of the gift or bequest as a covered gift or covered bequest is not a sufficient basis for filing a protective Form 708. Absent fraud or other “special factors,” late filing and late payment penalties will not apply even if the gift or bequest is later determined to be a covered gift or covered bequest within the limitations period. However, if the US citizen or resident filer knows or has reason to know that the information provided by the IRS (or any other source) is incorrect or incomplete, then the filer may not rely upon such information and may be subject to the general rules applicable to the assessment and collection of taxes and penalties. 12 The IRS intends to issue Form 708 once these regulations are published as final regulations. Time For Filing IRS Form 708 A US recipient who receives a covered gift or bequest generally will be required to timey file Form 708 on or before the 15th day of the 18th calendar month following the close of the calendar year in which the covered gift or covered bequest was received. However, in the case of covered bequests that are treated as being received on the covered expatriate's date of death but received later by the US recipient will be allowed to timely file Form 708 as of the later of (i) the 15th day of the 18th calendar month following the close of the calendar year in which the covered expatriate died; or (ii) the 15th day of the 6th month of the calendar year following the close of the calendar year in which the covered bequest was received. As mentioned above, the regulations account for the migration of a non-electing foreign trust that has previously received a covered gift or covered bequest and that subsequently becomes a US domestic trust. In such case, the migrated non-electing foreign trust must file a Form 708 by the 15th day of the 6th month of the calendar year following the close of the calendar year in which the non-electing foreign trust becomes a US domestic trust. It is noted that the regulations do not address whether a migration includes assets that are appointed, or decanted, from a non-electing foreign trust to a US domestic trust. The regulations also provide the time requirements for filing Form 708 in the case of a foreign trust electing to be treated as a US domestic trust for 2801 purposes, and the time for reporting covered gifts or covered bequests to the foreign trust elected to be treated as a US domestic trust. Extension Requests US recipients will be permitted to file for an automatic 6 month extension to file Form 708 before the applicable due date. US recipients will be required to file IRS Form 7004 to request such extension on or before the applicable due date for filing Form 708. The automatic extension does not extend the time to pay the 2801 tax and, thus, it would be prudent for US recipients to make an estimated 2801 tax payment to avoid applicable filing penalties and interest. Consistent with Announcement 2009-57, US recipients will be given a reasonable period of time after the date the final regulations are published in the Federal Register to file the Form 708 and to pay the section 2801 tax on covered gifts and covered bequests received on or after June 17, 2008, and before the date of publication of the final regulations in the Federal Register. Interest will not accrue on the section 2801 tax liability for any taxable years until the due date for payment, as specified in the final regulations, has passed. The failure to timely file Form 708 or pay the 2801 tax will be subject to the penalties specified under section 6651, unless it is shown that such failure is due to reasonable cause and not due to willful neglect. Conclusion The proposed regulations under section 2801 provide clear guidance on a number of matters. These include addressing the treatment of spousal and charitable transfers in trust by a covered expatriate, the treatment of powers of appointment exercised by a covered expatriate or granted to a US person by a covered expatriate, and the manner in which the section 2801 tax is to be calculated, paid and reported. The proposed regulations do not provide US recipients who receive transfers from covered expatriates any exemption that is similar to the US$5.34 million exemption available when a US citizen or resident makes a taxable gift or bequest. This is probably warranted, since section 2801 leaves no room for the IRS to include such a provision in the regulations. Consequently, the proposed regulations do not make the decision to 13 expatriate any easier for a US person who has children or other intended beneficiaries who will remain US persons and who will consequently be subject to the section 2801 tax. On the other hand, where an entire family is living outside the US, it may be appealing for descendants of covered expatriates also to consider renouncing US citizenship or permanent residency themselves. Of particular interest is the obligation of the US recipient to determine whether a gift or bequest received was a covered gift or bequest, with an opportunity to file a protective return claiming no tax is due under section 2801 to start the statute of limitations running. A Treasury official noted on September 11, 2015 at a Practicing Law Institute seminar in New York that a revenue procedure is being prepared which will explain the procedure for taxpayers to get information from the IRS regarding an expatriate’s tax returns in order to determine whether the transferor of the gift or bequest was a covered expatriate. There are some issues that the comments to the proposed regulations specifically leave open to comment. These include how to calculate the amount of a distribution from a foreign trust attributable to a covered gift or bequest when the US recipient does not have sufficient information about the distribution, how to minimize the burden with respect to making an election to be treated as a US domestic trust while accounting for the government's interest in collecting tax from the trust, and how contributions to and distributions from a foreign trust to a US spouse can qualify for the marital deduction. In light of these open issues, it is important to note that these proposed regulations are open to comment and, therefore, will apply as from the date of the official publication of the final regulations. A public hearing on these proposed regulations is scheduled for January 6, 2016 and it is expected that final regulations will follow sometime during the first half of 2016. Until final regulations are published, taxpayers may not rely upon them for planning purposes. However, taxpayers should exercise caution in planning as proposed regulations give us insight as to the IRS position on particular issues that could be later challenged and accepted by a court. . For planning purposes, the IRS has broadly interpreted the meaning of a covered gift and covered bequest potentially limiting certain techniques that could be used to prevent application of the 2801 tax. On the other hand, legitimate planning techniques still remain viable, including sales to a grantor trust and planning that reduces the value of the covered gift or bequest through the use of discounts. This alert was prepared by Paul DePasquale (New York), Glenn Fox (New York), Lyubomir Georgiev (Zurich), Elliott Murray (Geneva), Rodney Read (Houston), Gregory Walsh (Zurich), Jennifer Wioncek (Miami) and Marie-Thérèse Yates (Zurich). For further contacts and information, please refer to the worldwide contacts in the left margin of the client alert.