Overview of Fideicomisos
If you own a home or a vacation home in Mexico, chances are that your property is held in a fideicomiso. A fideicomiso is a contractual arrangement that is arguably something in between a trust and a custodial agreement. Under Mexican law, a fideicomiso is a written contract whereby the trustee receives funds or property for the purpose of carrying out a lawful objective.
Fideicomisos are required by the Mexican Government for many U.S. persons for development and acquisition of real property in areas of Mexico where foreign investment is either restricted or limited. In such instances, a transaction may be planned whereby a foreigner may acquire an interest in the fideicomiso itself rather than taking title to the underlying property.
A trustee must be appointed to oversee the fideicomiso. Under Mexican law, the trustee of a fideicomiso is obligated to act in a fiduciary capacity with respect to both the grantor and the beneficiary and must be an approved bank or credit institution. The trustee holds legal title to the property, while beneficial ownership remains vested in the grantor. The grantor retains the sole power to make decisions regarding the sale or transfer of property. Upon the termination of the fideicomiso agreement, the grantor receives legal title except where the grantor is a foreigner and the property held in trust consists of residential real property located in a zone where foreign ownership is prohibited.
Introduction to the Hiring Incentive Restoration Employment Tax and the New Law’s Implications on U.S. Persons that Have an Interest in a Fideicomiso
The Hiring Incentive Restoration Employment (HIRE) Act was signed into law on March 18, 2010. The HIRE Act contains several provisions that change the rules applicable to foreign trusts and their beneficiaries, causing the use of trust property to be treated as a deemed distribution. The HIRE Act broadens the grantor trust rules which treat U.S. settlors of foreign trusts as owners of trust property for federal income tax purposes. The new law was intended to target individuals who utilized foreign trusts to avoid U.S. taxes. However, the HIRE Act has some serious unintended consequences to U.S. Persons or U.S. investors who have an interest in a Mexican fideicomiso. This article will discuss the U.S. implications tax and reporting to U.S. persons that hold an interest in a fideicomiso.
The Implication of the Grantor Trust Rule to Foreign Trusts with a U.S. Beneficiary
Sections 671 to 679 of the Internal Revenue Code contain the so-called 'grantor trust rules,' which treat certain trust settlors (and sometimes persons other than the settlor) as the owner of a portion or all of a trust's income, deductions and credits for U.S. tax purposes. A trust where the settlor (or other person) is treated as the owner of the trust assets for U.S. tax purposes is referred to as a 'grantor trust.' The grantor trust rules apply to both foreign and domestic trusts, but in different ways.
Under the grantor trust rules, a U.S. person who transfers property to a foreign trust is generally treated for income tax purposes as the owner of that portion of the trust attributable to the transferred property, even if the trust would not have been a grantor trust had it been domestic. This is the result for any tax year in which any portion of the foreign trust has a U.S. beneficiary. A foreign trust is treated as having a U.S. beneficiary for a tax year unless (i) under the terms of the trust, no part of the trust's income or corpus may be paid or accumulated during the tax year to or for the benefit of a U.S. person, and (ii) if the trust is terminated at any time during the tax year, no part of the income or corpus could be paid to or for the benefit of a U.S. person. The Treasury Regulations under Section 679 of the Internal Revenue Code generally treat a foreign trust as having a U.S. beneficiary if any current, future or contingent beneficiary of the trust is a U.S. person.
Informational Return Filing Requirements of U.S. Persons Having a Financial Interest in a Fideicomisos
Section 6048 of the Internal Revenue Code imposes reporting obligations on foreign trusts and persons creating, making transfers to or receiving distributions from such trusts. For example, a U.S. person who transfers property to a foreign trust must report the transfer to the Internal Revenue Service (IRS), and a U.S. beneficiary who receives a distribution from a foreign trust must report the distribution. Both reports are made on IRS Form 3520 and the failure to file the form in a timely manner results in a penalty generally equal to 35 percent of the gross value of the transfer or distribution per year. In addition, if a U.S. person is treated as the owner of any portion of a foreign trust under the grantor trust rules, the U.S. person is responsible for ensuring that the trust files an annual information return on Form 3520-A and provides information to each U.S. person who is treated as the owner of any portion of the trust, or receives (directly or indirectly) any distribution from the trust.
The Combination of the Grantor Trust Rules and the New HIRE Combine to Produce a Perfect Storm for U.S. Beneficiaries of Fideicomisos
The HIRE Act broadens Section 643(i) of the Internal Revenue Code to provide that any use of foreign trust property after March 18, 2010 by a US grantor, a U.S. beneficiary or any U.S. person related to a U.S. grantor or U.S. beneficiary will be treated as a distribution for federal income tax purposes to such U.S. grantor or U.S. beneficiary of the fair market value of the potential to use the property where it is actually used or not. As discussed above, the recipient of the deemed distribution will be required to file Form 3520 to report the distribution from the foreign trust. Not only will a beneficiary of a fideicomiso have to report the fair market value of the use of the property held in the fideicomiso on a Form 3520, a U.S. person holding an interest in a fideicomiso may have to report the fair market value of the use of the property held in the fideicomiso on his or her federal income tax return, whether it is used or not. This deemed distribution rule will not apply to the extent that the foreign trust is paid fair market value for the use of the property within a reasonable period of time. There is no indication as to what period of time will be considered 'reasonable' and the IRS is likely to provide guidance on this issue.
On June 24, 2011, dated November 17, 2010 and released on June 24, 2011, the IRS Office of the Chief Counsel took the position that as “general information only,” any U.S. person who transfers property to or who has an interest in a Mexican fideicomiso must treat the entity as a foreign trust for purpose of filing Forms 3520 and 3520-A. The new tax laws promulgated by the HIRE Act took elevated this matter. Under the HIRE Act, the United States has moved beyond collecting information on fideicomisos and now seeks to impose tax on a U.S. taxpayer’s interest on a fideicomiso. Clearly, U.S. taxpayers who hold an interest in a fideicomiso must file applicable Form 3520s reporting the fair market value of the use of the property held by the entity. In addition, the new HIRE Act imposes unforeseen federal income tax on U.S. persons who established a fideicomiso or have a beneficial interest in a fideicomiso. Whether the IRS can impose a federal income tax liability against the grantor or beneficiary is unclear, however, please refer to Section C. of our client update regarding foreign trusts for potential tax filing obligations.
Under Article 27 of the Constitution of Mexico, only Mexicans by birth or naturalization or Mexican companies may “acquire direct ownership of lands or waters within a zone of hundred kilometers along the frontiers and of fifty kilometers along the shores of the country.” A fideicomiso is a property-ownership arrangement to comply with Article 27 of the Mexican Constitution under which a Mexican Bank Trust obtains legal title to a piece of real estate within a prohibited zone, and a foreigner, as the beneficiary of the trust, enjoys the beneficial interest in the property, including all the usual rights of ownership.
Section 643(i)(3) of the Internal Revenue Code, as amended by the HIRE Act, provides that the U.S. grantor, or U.S. beneficiary, must report the fair market value rental value of the use of any property placed in a trust. Article 27 of the Mexican Constitution clearly defines a fideicomiso as a trust. Since a fideicomiso is classified as a trust under Mexican law, the IRS will take the position that a U.S. grantor or U.S. beneficiary of a fideicomiso will take the position that the fair market value of the potential use of the property placed in the trust will be taxable on an annual basis, whether it is actually used or not. Currently, U.S. persons who hold an interest in fideicomisos have the use of property that is located in some very expensive and desirable coastal areas. Given the new HIRE Act imposes a duty to recognize a tax liability on the fair market value of the value of real estate placed in a foreign trust, the beneficiaries of fideicomisos may be subject to a very unwelcome new annual federal income tax, unless the person takes effective steps to avoid it.
Unless the grantors or beneficiaries of fideicomisos can distinguish it from a foreign trust, it seems that the realization of a new federal income tax will simply become an enormous cost of having an interest in a fideicomiso. In other words, an argument must be made that a fideicomiso cannot legally be classified as a trust. Given the current state of Mexican law and the wording of most fideicomiso agreements, arguing that a fideicomiso is not tantamount to a trust does seem realistic. Under Mexican law, most fideicomiso agreements will never permit the Mexican property held in the fideicomiso to revert to the U.S. grantor. Fideicomiso agreements are typically limited to a term of years, typically 50 years. Given the very nature of the fact that the usage of the land held by the fideicomiso is limited to a term of years, and title to the property held by the fideicomiso can never pass to the beneficiary or his or her heirs, a compelling position can be taken that a true trust agreement has not been established. Instead, the U.S. person acquiring a property interest in the fideicomiso holds a long term lease on property where foreign ownership is prohibited.
Since the time period which a U.S. person and his or her heirs can enjoy the property is limited by a term of years and title to the property can never revert to the U.S. beneficiary of the fideicomiso, a strong argument can be made that a fideicomiso should not be characterizes as a foreign trust for U.S. tax purposes. Instead, a fideicomiso should be treated as a custodial, nominee arrangement or even a lease agreement in which a U.S. person leases land in Mexico for term of years. And, a Mexican Bank is appointed to hold title to the property at issue.
At this time the rules governing the U.S. taxation of an interest in a Mexican fideicomiso remains in flux. Given the uncertainty in this area, U.S. taxpayers with an interest in a fideicomiso should consider obtaining a private letter ruling to determine the IRS position on the U.S. tax consequences of that particular entity.
Please do not hesitate to contact us to learn more.