When consulting with international clients one of the most common miscommunications involves discussing a “foreign trust.” For most people, a foreign trust would intuitively be a trust of a foreign country. However, under U.S. law it is not that simple.
For tax purposes, there is not a definition of a foreign trust. Instead, there is a definition of a U.S. trust and any trust that does not meet that definition is by default foreign. To be a U.S. trust both the court test and the control test must be met. The court test requires a court within the U.S. to be able to exercise primary supervision over the administration of the trust. The control test requires one or more U.S. persons to have the authority to control all substantial decisions of the trust. If either of these tests are failed the trust will be considered foreign. While these are the general rules, there are many unique situations which require more detailed analysis of the rules and safe harbors.
Therefore, because both tests have to be met, it is possible to have a trust formed under U.S. law that is considered “foreign” for U.S. tax purposes if a foreign person has the authority to control the trust. This is where the confusion can happen. Foreign trusts are very often a key tool for international tax planning. When discussing this with people not familiar with the U.S. rules, it is important to be clear that this does not necessarily mean the trust must be formed in a foreign jurisdiction.
The tax laws of the U.S. are not always intuitive. However, they are usually well defined and detailed, which makes it very important to get reliable advice and have all the information to make an informed decision.