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By Kimberly S. Blanchard, Esq.
What is a foreign pension trust? Is it a true trust within the meaning of the entity classification rules? Or is it a business entity that may be treated as a partnership or corporation? What turns on the question?
The entity classification regulations make clear that only a "business entity" can elect to be treated as a partnership or corporation for U.S. tax purposes.1 An entity properly classified as a trust is not a business entity; conversely, an entity not properly classified as a trust is a business entity.2 The label given to the entity is not dispositive; one must seek its correct classification by divining the meaning of the entity classification regulations.
Regs. §301.7701-4 attempts to define what is, and is not, a true trust. The regulations begin by defining what a trust is, and then proceed to tell us what types of entities will not be treated as trusts. According to subsection (a), a true or "ordinary" trust is:… an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
The foregoing definition of a true or "ordinary" trust begins with the statement that a trust is ordinarily created by will or inter vivos declaration, thus suggesting that to be a trust under this definition, the entity must be created by a natural person. The language suggests that what the drafter was aiming at was a trust described in Subchapter J of the Code.3 Although the last sentence of this definition is not so limited, and could be read in isolation to cover a pension trust, the last sentence is not an addition to the earlier sentences but simply an extension of them. Because this portion of the regulations nowhere mentions pension trusts, one might conclude that pension trusts are not true or "ordinary" trusts. In that event, a pension trust would be treated as a trust only if it were so treated under some other subsection of Regs. §301.7701-4. Unfortunately, none of the other subsections clearly covers pension trusts, either. In that case, taking the regulations literally, a pension trust would be a business entity classified as either a partnership or a corporation.
Notwithstanding the foregoing, few would disagree that a domestic pension trust (as commonly understood) is, in fact, a trust and not a business entity. Regs. §301.7701-7 applies only to trusts and addresses whether a trust is foreign or domestic. That regulation includes domestic pension trusts in a list of trusts that are able to take advantage of a safe harbor from the control test applicable to determine whether a trust is foreign or domestic.4
The regulation simply assumes, without stating it, that these entities are classified for tax purposes as trusts.
One would think that if a domestic pension trust is, for whatever reason, classified as a trust, the same would be true of a foreign pension trust. However, it is hard to get comfortable without more. Put simply, it seems possible that the lack of any bright-line entity classification rule for pension trusts is due to the fact that the taxation of domestic pension trusts is exhaustively covered elsewhere in the Code.5 Nothing in the Code, of course, has anything to say about foreign pension trusts. So the question of how to classify a foreign pension trust may simply be unresolved.
As noted above, the regulations describe other types of entities that can be treated as trusts. The only possibly relevant portion of the regulations is at Regs. §301.7701-4(c), entitled "Certain investment trusts." It states:An "investment" trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. SeeCommissioner v. North American Bond Trust, 122 F.2d 545 (2d Cir. 1941), cert. denied, 314 U.S. 701 (1942). An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate holders. An investment trust with multiple classes of ownership interests ordinarily will be classified as a business entity under §301.7701-2; however, an investment trust with multiple classes of ownership interests, in which there is no power under the trust agreement to vary the investment of the certificate holders, will be classified as a trust if the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interests is incidental to that purpose.6
The investment trust rule, which nowhere defines what is meant by an "investment trust," seems peculiarly ill-suited to pension trusts. Essentially, this rule provides that a trust that issues interests to investors will not be treated as a trust unless all of the units confer identical rights that cannot change over the course of the entity's existence; a true unit investment trust would normally be treated as a trust under this rule, while most other investment trusts would not. Pension trusts do not issue certificates to investors; they are trusts formed to hold assets on behalf of workers. It is thus difficult to get comfortable that a foreign pension trust would be treated as a trust under this subsection of the regulations.
There is very little law that addresses the classification of a foreign pension trust. PLR 200035027 involved a Canadian investment fund organized as a common-law trust, all of the beneficiaries of which were (or at least claimed to be) Canadian pension trusts. The ruling was addressed solely to the question of whether the investment trust qualified to claim treaty benefits under Article XXI of the U.S.-Canada Income Tax Treaty. Because Article XXI confers an exemption from tax on dividends and interest paid to a trust, company, or other entity formed to benefit only pension trusts, it made no difference to the ruling whether the investment trust itself was properly classified as a trust. All that was required was that all of its members be Canadian pension trusts.
Unfortunately, the ruling simply assumed without discussion that the Canadian pension trust beneficiaries were, in fact, trusts. (The ruling did the same in respect of the investment trust, simply assuming it would be treated as a trust for U.S. tax purposes.) It is possible that the IRS erroneously believed that, for treaty purposes, the entity's classification was only a matter of Canadian law. It is also possible that the issue was addressed internally but assumed away in the ruling. Finally, it is possible that the entity classification issue simply did not occur to the IRS.
Regulations issued under §892, applicable to foreign governments, contain a special rule for foreign governmental pension trusts.7 Although these regulations distinguish between pension trusts, which are entities of some kind, and pension funds, which are not, they do not address the entity classification of pension trusts for other purposes of the Code. Once again, the regulations appear to have been drafted by someone who simply assumed that a pension trust is properly classified as a trust. In the same way, many U.S. tax treaties refer to foreign pension trusts and simply assume that they are classified as trusts.
Given the seemingly universal assumption that a foreign pension trust is a trust, notwithstanding the utter absence of any rule in the entity classification regulations that can be relied upon to prove that proposition, one might suppose that nothing much turns on the question of proper entity classification. In fact, very much turns on it. For example, if a foreign pension trust were classified as a partnership, it would be unable to claim treaty benefits in its own right and its beneficiaries would likely be denied treaty benefits under the §894 regulations, as the income of a pension trust does not pass through automatically to its beneficiaries. If a foreign pension trust were classified as a business entity and not as a trust, the first question would be whether it defaults to corporate status, or should make a check-the-box election to be treated as either a corporation or a partnership. Here, too, the application of the default rules to foreign trusts is completely unclear.8
The moral of this story is that the IRS should issue definitive guidance stating that a foreign pension trust is in fact classified as a trust and is not a business entity.
This commentary also will appear in the November 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and in Tax Practice Series, see ¶7110, U.S. International Taxation — General Principles.
* I thank Joan Arnold for renewing my interest in this topic, and for confirming that I am not the only one who worries about it.
1 Regs. §301.7701-3(a).
2 Regs. §301.7701-2(a).
3 One thing seems fairly clear: A domestic pension trust is not a trust described in Subchapter J, relating to the taxation of family trusts and their beneficiaries. See Regs. §1.641(a)-0(a). For a confusing description of the interrelationship between this rule and the tax rates applicable to the unrelated business income of trusts, see Sherwin-Williams Company v. U.S., 403 F.3d 793 (6th Cir. 2005).
4 Regs. §301.7701-7(d)(1)(iv).
5 See, e.g., §401, et seq.
6 This provision is generally referred to as the "Sears" regulation because it was adopted in response to instruments marketed on behalf of Sears and other issuers in the 1980s that sought to use trusts to divide stock between growth and dividend rights. For a summary of the problem that was the intended target of these rules, see Butch & Conlon, "Should Transfers of Subordinated Interests in Investment Trusts Be Restricted?" 50 Tax Notes 1009 (3/4/91).
7 Regs. §1.892-2T(c).
8 See Blanchard, "The Uncertain Withholding Tax Status of Foreign Investment Funds," 90 Tax Notes 251 (1/8/01), which described other adverse tax consequences of not knowing the status of a foreign entity.
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