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Is an ISA a foreign trust?
Phil Hodgen
Attorney, Principal
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Yesterday and today I have had an interesting email exchange with three tax practitioners about Individual Savings Accounts from the U.K. I will call this type of account an ISA (pronounced "Ice-uh"), because that's how I say it out loud. I won't identify them by name unless they want to be identified. (Email me and I'll give you credit for inspiring this post.)I stated the title of this blog post as a question, fully cognizant of Betteridge's Law of Headlines.witch trust. ((As I was writing that sentence I imagined a very Monty Pythonesque voice shrieking "I am not a witch!"))
Disclaimer
The emails flying back and forth told me: (1) my 2011 post on the topic is DFW ((There is a swear word in that acronym, and the "W" stands for WRONG)); and (2) I should tell the world what I think is the correct answer. So this post is just me looking at the question and coming to a conclusion. The IRS may well come to a contrary conclusion. Them's the risks. The IRS has opinions, keeps them close to its bureaucratic vest, and chooses to brandish them (or not) at the most inopportune of times.That's the disclaimer. Plus the usual disclaimer: don't rely on anything you read, especially on the internet. Go hire a tax advisor and get advice. Especially don't rely on me. It's late afternoon as I'm writing this and I'm hungry.How an ISA Works in the U.K.
Here's the TL;DR on how an ISA works in the U.K. (Go to that website. It's the official HMRC home page for ISAs).You set one up. There are two different types, and there are limits on how many you can set up every year. You put money in. There are limits on that, too.An ISA can hold cash. That's a "cash ISA". An ISA can hold stocks and shares. That is called a "stocks and shares ISA". Your ISA can hold life insurance. A convoluted and confusing (to me) set of rules tells you whether your life insurance policy should be held in a "cash ISA" or a "stocks and shares ISA". I mean really. Why would anyone want to keep things simple and have a "life insurance ISA"?Interest, dividends, and capital gain are tax-free. (Well, interest on cash in one special type of ISA is subject to a 20% charge. Tax rules always have exceptions, right?)But that's the basic idea: save money in the form of cash, stocks and shares, or life insurance, and let it grow tax-free in the U.K.What Happens When an ISA Touches the United States
Bad things happen when an ISA touches the United States, or more precisely when an individual who owns an ISA touches the United States. This can happen because a U.S. taxpayer (citizen or green card holder) qualifies to open an ISA, and does so. Or perhaps a U.K. citizen or resident moves to the United States to live, and becomes a U.S. taxpayer. In either event, we have problems to solve.The first problem is the taxation of the ISA's income. The IRS doesn't care that the U.K. treats all of the ISA's income as tax-free. You'll be taxed on the income in the ISA under Internal Revenue Code rules that I will describe in a while.The second problem is the scary one. Penalties. The question is simple: "Is an ISA a foreign trust?" If it is, the Internal Revenue Code has a set of paperwork requirements (Form 3520 and Form 3520-A) and some "death penalty for parking violations"-level penalties (Section 6677) if you muff up the paperwork.Income Taxation of ISA Income in the United States
The income derived on ISA investments is taxable in the United States. This is true whether or not an ISA is considered to be a foreign trust.If the ISA is not a foreign trust, it is just a regular investment account, owned by you, dear taxpayer. You pay U.S. income tax on all income you received, worldwide, and so if you have an ISA and you are a U.S. taxpayer, you must pay income tax on the ISA income.If the ISA is a foreign trust, it will be a foreign grantor trust. Either the rules of Internal Revenue Code Section 679 will make it so, or the rules of Internal Revenue Code Section 672(f)(2)(A)(i) will apply. In either event, you, dear taxpayer, will be considered to be the owner of the ISA's assets for income tax purposes (see Internal Revenue Code Section 671). Therefore you're the owner of the income derived from them.Here's the problem that we see with ISAs again and again. Stocks and shares ISAs specifically. The classic asset held there is a unit trust. Translation: a mutual fund. Since the mutual fund is issued by a U.K. financial institution of one type or another, the mutual fund will be a Passive Foreign Investment Company in the eyes of the IRS. I'll call this a "PFIC" because that's what everyone calls it. Pronounce that acronym "PEE-fck". And yes.As a result, a U.S. taxpayer who owns a stocks and shares ISA with PFICs inside it will have a PFIC problem. Go look at Form 8621. And as they said in the saloons of the Old West when the outlaws were playing poker, "Read 'em and weep." You are going to pay a lot of U.S. income tax (even though everything is tax-free in the U.K.) and your accountant is going to charge you a lot of money to prepare your tax return.In brief: interest and dividends from your ISAs will go to Schedule B. Capital gain will go to Schedule D. Everything driven by your unit trust shares will go to Form 8621.An ISA is not a Foreign Trust
Jeez. I should be charging the big bucks for this write-up. I'm weeping when I think of what a saint I am for giving this all away for free. I might even break my arm patting myself on the back.But I digress.The income taxation of ISA income is uncontroversial. The bigger issue is whether an ISA is a foreign trust or not. If it is, you, dear taxpayer, have Form 3520 and Form 3520-A to contend with. And massive penalties if you don't do the paperwork.I think an ISA is not a foreign trust. One of the correspondents on our four-way email exchange thought that the IRS would disagree with me, if asked. So fair warning to you. Tread lightly, and carry a clove of garlic.Trust Defined
The definition of an "ordinary trust" -- for tax purposes, anyway -- is in Treasury Regulations Section 301.7701-4(a):In general, the term “trust” as used in the Internal Revenue Code refers to 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. ((Emphasis helpfully added by mygoodself)).There are two other types of trusts defined in the Treasury Regulations. Section 301.7701-4(b) defines "business trusts" and this definition will not apply to an ISA because these are trusts used, well, run an operating business. Hence the name. And Section 301-7701-4(c) defines "investment trusts" which, if you squint at it with the light shining in the right direction, tells you that this is for things like mutual funds. An ISA may contain investments that look like an "investment trust" under this definition, but an ISA itself won't be one. At least, not on a planet with gravity.So we are only looking at the definition of an "ordinary trust" in the Treasury Regulations. It has a few key requirements:
- A trustee takes title to property;
- For the purpose of protecting it or conserving it
- For the beneficiaries
- Under the ordinary rules applied in chancery or probate courts.
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.Our quest is to determine whether--under U.K. law--an ISA manager is charged with the solemn duty to "protect and conserve" property for people "who cannot share in the discharge of this responsibility". If the ISA manager has this responsibility, then the ISA arrangement is a trust in the eyes of the IRS. If the ISA manager does not have this responsibility, then the ISA is not a
An ISA Manager Is Not Responsible
My opinion is that an ISA manager does not have that responsibility. Even without reading anything (stand by, we will do that), you and I know that all financial institutions worldwide are risk-averse in the extreme and will do anything at all to avoid being at fault. Hence, I would be floored if the U.K. financial institutions that act as ISA managers would ever agree to a level of standard of care that is imposed on trustees. Fiduciary responsibilities are taken really %#$%@#^ seriously in the U.K.But let's not make up stuff. Let's look at what HM Revenue & Customs says (I'm using the American custom of treating an entity as singular, so sorry) about ISA Managers. Helpfully there is a massive PDF titled "ISAs: Guidance Notes for ISA Managers" (warning: massive PDF, so don't open that link on your mobile phone) that is authored by someone at HM Revenue & Customs, so presumably we can rely on it.I looked at it and cannot find anything that tells the ISA manager that it will be put in the position of a fiduciary. Maybe you want to look and see what you find.There are all sorts of other rules for the care and feeding of ISAs. But nothing about the ISA manager's responsibility to the account holder. I'm not saying that no such rules exist. I'm just saying I see nothing here that would even hint at any role for an ISA manager that is greater than a custodian and possibly investment advisor ("You opened a stocks and shares ISA, so why don't you buy these shares? The decision is yours, however.")The Account Holder Is In Control
The other part of the definition of an ordinary trust is that a trustee is in place to hold and conserve assets for the beneficiaries because they cannot share in the discharge of this responsibility. In other words, the trustee is there because the beneficiaries are not able to do the job themselves for whatever reason.One thing is abundantly clear with ISAs: the account holder is in full control at all times.Conclusion: It's Not a Trust
The ISA is not a trust for two reasons: the ISA manager (the would-be trustee) does not have a fiduciary duty, and the account holder (the would-be beneficiary) has full control over the assets in the ISA.- Because the ISA manager (who would be the "trustee") does not have a fiduciary duty, an ISA is not a trust. The normal "I gave my bank some money and they promised not to steal it from me" duty is not sufficient. That's a custodian's obligation not to take someone else's stuff. And if the ISA manager gives investment advice ("Buy stock A, not stock B"), this is nonbonding stuff and the ISA manager does not have the power to force the account holder what to do. So the basic trustee's administrative power of management is missing.
- The account holder's ability to designate investments and terminate the ISA at any time defeats the second arm of the IRS's definition of a trust. Not only does the account holder "share" that responsibility of management, in fact the account holder is the only person who can exercise that management power.