Trojan transparency

As the world came to terms with the credit crunch in 2007/08, the United States became intent on putting an end to banking secrecy. This culminated in the enactment of the Foreign Accounts Tax Compliance Act (FATCA). This seeks to eradicate tax evasion through an information reporting system enforced, through a 30 per cent withholding tax on US-source income for non-compliance.

In order to avoid the 30 per cent withholding tax, foreign financial institutions must register with the Internal Revenue Service (IRS) and undertake to report any financial account held both directly and through 'foreign entities' (such as companies, partnerships or trusts) by a US taxpayer.

The U.S. tax rules are very complex, but the key point is that there is a direct correlation between reporting under FATCA and a settlor's or beneficiary's U.S. tax liability. All that FATCA seeks to do is prevent the evasion of tax by imposing automatic exchange of information.

The link between exchange of information and tax liability was also at the heart of article 26 of the Organisation for Economic Cooperation and Development (OECD) model, which provides the standard for exchange of information, that is 'foreseeably relevant for carrying out the provisions of this convention or to the administration or enforcement of the domestic laws concerning taxes'.

However, the Common Reporting Standard (CRS) championed by the OECD turns this principle on its head.

FATCA, IGAs and the CRS

Although FATCA is aimed at 'foreign financial institutions', it remains a domestic piece of legislation, albeit
with extraterritorial reach. In order to give effect to FATCA abroad, a number of foreign countries have entered into
so called 'intergovernmental agreements' (or IGAs) with the U.S.

What the IGAs do, however, is much more than enabling the extension of FATCA to foreign financial institutions. Instead, they incorporate terminology that appears to be borrowed from the CRS which, while being developed on the back of FATCA, makes use of anti-money laundering definitions derived from the work of the Financial Action Task Force (FATF).

Therefore, most of the IGAs concluded with the U.S. do away with the term 'substantial US owners' and instead use the term 'controlling persons', which is a term used in the CRS to define 'beneficial owners' in accordance with the recommendations made by the FATF. The wider definitions used under CRS are likely to generate more information than under the domestic FATCA rules and have partially modified the nature of FATCA.

The problem with the OECD's approach

Few people would disagree that information relating to an account held by an individual is likely to be relevant for that individual's tax liability. The same applies to an account held indirectly through an offshore company or partnership.

However, when it comes to trusts, the wide definition of 'controlling person' contained in the CRS (as well as the IGAs) is indicative of a degree of ignorance and suspicion which is reminiscent of the statements made by policymakers in France and Belgium.

Thus, in an appalling example of tautology, the CRS commentary states: 'The settlor(s), the trustee(s), the protector(s) (if any) and the beneficiary(ies) or class(es) of beneficiary(ies) must always be treated as controlling persons of a trust, regardless of whether or not any of them exercise control over the trust.'

This raises a number of fundamental issues:

• Where does the reference to protectors originate from? In most jurisdictions, the existence of a protector is irrelevant for the tax treatment of the trust.

• Why are settlors and beneficiaries 'controlling persons' in all circumstances, i.e. regardless of their tax profile?

This is a far cry from FATCA, which does not contain any mention to protectors, as they are generally irrelevant for the tax treatment of a trust - although they may determine whether a trust is a 'U.S. trust' or a 'foreign trust' under the control test contained in the U.S. tax legislation.

Unfortunately, most uninformed readers may be led to think that CRS and FATCA are effectively the same thing because CRS borrows heavily
from FATCA and is, to a large extent,
a copy-cat of FATCA. However, the use of almost identical terms and an almost identical structure masks the fact that FATCA and the CRS are also very different in various respects.

In particular, the introduction of anti-money laundering concepts into the CRS means that CRS is not concerned with information that is directly relevant for the tax position of a taxpayer of one country with financial assets in a different country.

Instead (unlike FATCA), the CRS and IGAs provide for an indiscriminate collection and dissemination of information concerning taxpayers, which is potentially irrelevant for their tax position under the domestic laws of their country of residence.

The OECD's draft commentary appears to suggest that, in the case of discretionary trusts, information exchange is only necessary in the event of distributions, but there is nothing in its model automatic exchange agreement to suggest such limitation. Indeed, (unlike the FATCA legislation) the model automatic exchange agreement does not contain any reference to trust beneficiaries.

Instead, the CRS contains a very wide definition of 'equity interest'.
It states: 'In the case of a trust that is a financial institution, an 'equity interest' is considered to be held by any person treated as a settlor or beneficiary of all or a portion of the trust, or any other natural person exercising ultimate effective control over the trust.

A reportable person will be treated as being a beneficiary of a trust if such reportable person has the right to receive directly or indirectly (for example through a nominee) a mandatory distribution or may receive, directly or indirectly, a discretionary distribution from the trust.'

Therefore, the CRS:

• defines a term that is not used in the model automatic information exchange agreement (which the CRS is supposed to supplement);

• does not explain the context in which the defined term is to be used (unless 'equity interest' has the same meaning of 'debt or equity interest in the financial institution'); and

• although the commentary to the model automatic information exchange agreement and the CRS contains a discussion concerning the difference between settlor-interested trusts and fixed interest/discretionary trusts, it is not clear how that discussion relates to the main agreement itself, leading to potential confusion in practice and enabling 'trust-adverse' countries to demand unlimited exchange of information.

In the case of trusts, the need for a balanced approach that takes into account different (and potentially opposing) interests has become abundantly evident during the debate, concerning the introduction of national registers on beneficial ownership in the EU.

After intense lobbying, the final version of the new rules (contained in the fourth anti-money laundering directive) provide a more balanced solution. According to the compromise version of article 30(4): 'Member states shall require that the information in paragraph 1 is held in a central register when the trust generates tax consequences'.

Trusts under attack in Europe

Once upon a time, even France recognised trusts, with over 20 reported cases dating from the 19th century. Nevertheless, in 2005 the French Supreme Court held that a settlor of a US revocable trust had not departed from his assets at the time of the creation of the trust (so that French succession tax was due when the trust assets came to be distributed to his family on his death).

Overall, the Italian and Swiss tax rules reflected a relatively benign approach towards the tax treatment of trusts, which was largely echoed in Belgium, where the local tax authorities issued a widely reported ruling confirming that a trust distribution to a Belgian-resident discretionary beneficiary was not subject to tax.

The legislative backlash

The advent of the credit crunch in 2007/8 brought widespread recrimination against the perceived failings of Anglo-Saxon capitalism.
Here we sketch out how this impacted on the treatment of trusts in Europe.

France - In 2011, the French parliament introduced harsh rules on the tax treatment of trusts. In practice, the new French rules disregard trusts completely as far as gift and succession taxes are concerned, and treat the trust assets as belonging to the beneficiaries, regardless as to whether or not they have any vested interest in the trust property.

Belgium - Belgium recently announced a draft bill on the transparent tax treatment of 'wealth structures'. The state explained: 'The new system will allow the taxman to levy tax where tax would otherwise be avoided because of the interposition of the chosen legal structure; on the other hand, the system of transparency should not catch persons who are not the beneficial owners [of the structure] and also avoid that certain items of income become subject to (economic) double taxation.'

Italy - Italy does not have a domestic trust law, but its case law is awash with judgments upholding the validity of such 'domestic' trusts. In 2006, the government announced the introduction of statutory rules dealing with the tax treatment of trusts, and the 2007 Finance Act introduced the novel idea of taxing trusts as akin to companies and thus, as separate tax subjects.

In 2010, the Italian tax authorities abruptly pulled the hand-break by outlining scenarios under which they would seek to treat a trust as a 'fictitious interposition'. In practice, any trust under which the settlor or a beneficiary has a say is likely to be treated as interposed for tax purposes, with devastating effects in tax compliance terms.

Switzerland - When the Swiss government considered the formal recognition of trusts, thought was given to the potential ramifications for Swiss taxpayers. An early version of a memorandum on the Hague Trust Convention contained the following statement: 'In Switzerland, the trust concept is often… perceived as a means to hide the real ownership position and as a tool for tax evasion, money laundering and the violation of succession law provisions.'

Spain - Trusts have attracted less debate in Spain than in other countries. However, in one occasion, the Spanish Supreme Court had to consider the validity of a testamentary trust and its interaction with the Spanish 'forced heirship' rules. It confirmed that the look-through approach would extend to succession taxes.

A practitioner's call to arms

FATCA and the CRS are here to stay. However, an appreciation of the differences between FATCA and CRS, and the lessons learnt from the fourth EU anti-money laundering directive, suggest that it is not too late to fine tune the CRS's approach to trusts to obtain a balanced solution that takes into account the different interests.

What trust law jurisdictions
can do

Most offshore jurisdictions have signed up to the OECD standard of information exchange and entered into a number of tax information exchange agreements (TIEAs). In addition, they committed to adopting CRS, some as early as 2017, with others following suit in 2018.

In light of this, policy statements such as those underpinning the tax rules in several continental European countries no longer have any justification. When negotiating access to information to treaty countries, trust law jurisdictions should therefore ensure that the other country has a coherent approach to the tax treatment of trusts, which is based on a sound legal analysis.

Trust law jurisdictions should also be aware of the perils of providing indiscriminate information to countries that do not intend to recognise the effects of trusts, whether as a matter of civil law (e.g. Spain), or by imposing a prohibitive tax burden on any family wishing to use trusts as part of their legitimate estate planning (e.g. France).

Furthermore, trust law jurisdictions should insist on applying a restrictive definition of 'equity interest' when it comes to trusts, so as to exchange information only in the case of settlor interested trusts and fixed interest trusts, but not discretionary trusts (or trusts under which the settlor has not retained any interest). This approach is in line with the solution contained under FATCA which (in the case of trusts) has found its way into the OECD commentary.

Experience of TIEAs in practice has shown that trust law jurisdictions - especially small ones with little bargaining power - should approach negotiations with bigger continental European counterparts with a degree of caution, ensuring that a bilateral IGA would bolster, rather than undermine, their trust industry.

Conclusions

These are unprecedented times for private clients and unfortunately, the complexity of the CRS rules represent
a huge obstacle to an open debate,
as policy-makers and professionals alike struggle to come to terms with the exact meaning of what is being proposed.

Nevertheless, private client practitioners and interested governments must act now to ensure the adoption of a balanced approach. This must take into account the legitimate concerns of sovereign states faced with historic tax evasion and the global fight against terrorism, and the legitimate concerns of families seeking to organise their affairs efficiently and privately. 

Filippo Noseda is a partner at Withers