Foreign trust

Foreign trust commonly refers to a trust that is governed by the laws of a jurisdiction other than the United States. These trusts may be used for investment, estate planning and succession planning purposes, but are most commonly used for asset protection.

Here are some reason why foreign trusts may be used for asset protection.

The commonly understood meaning of the term “foreign trust” is a trust governed by the laws of a foreign jurisdiction. However, as discussed below, the term “foreign trust” has a very specific meaning under the Code. Whenever the term “foreign trust” appears in this text, it refers simply to a trust governed by the laws of a foreign jurisdiction.

A foreign trust, per se, does not have any asset protection benefits. The benefits come from the jurisdiction which governs the trust. To understand more fully the benefits of foreign trusts and the reasons why they are so commonly used in asset protection planning the reader must return briefly to (i) domestic trusts, and (ii) fraudulent transfer laws.

A domestic discretionary trust, set up for a beneficiary by a third party, has great asset protection benefit. A domestic spendthrift trust also has certain asset protection benefits. In some states, including California, there are statutory limitations placed on the protective benefits of these trusts.

The most important statutory limitation is the prohibition against self-settled trusts. That one factor severely limits the use of domestic trusts for asset protection purposes, as most asset protection trusts are self-settled. Several states have now passed legislation allowing self-settled trusts as a protective shield. But questions remain, as these jurisdictions are a part of the United States and are subject to the constitutional restrictions, such as the full faith and credit clause, requiring one state to recognize a judgment from a sister state, and are further hampered by the choice of law analysis.

Even assuming that these domestic asset protection trusts manage to overcome such issues, or a debtor establishes a California discretionary trust for the benefit of a third party, there is always a potential of a fraudulent transfer challenge. No matter how protective a domestic trust is, even if it is fully discretional, in the case of a fraudulent transfer the trustee will have to distribute the trust assets to the creditor.

It is in light of these challenges that the efficacy of foreign trusts becomes obvious. Foreign jurisdictions are not subject to the constitutional restrictions placed on U. S. states. Some jurisdictions do not recognize foreign judgments against trusts and have very debtor friendly fraudulent transfer laws. For example, St.Vincent (in the West Indies) requires creditors to establish a fraudulent transfer beyond a reasonable doubt and has a one-year statute of limitations on fraudulent transfers that begins running from the date of the transfer.

Foreign trusts are truly efficient for asset protection purposes only if liquid assets are used to fund the trust, and such assets are, at some point, transferred offshore. While a foreign asset protection trust can hold any property, including personal and real property in the U. S., the ability of a U. S. court to reach U. S. property suggests the benefits of holding offshore assets in the foreign trust.

Foreign trusts are usually treated as “foreign trusts” for the purposes of the Internal Revenue Code. This means that transfers of assets to the trust will be treated as a sale for tax purposes. To avoid the sale treatment on the funding of the trust, most foreign trusts are drafted as grantor trusts. Being grantor trusts, they avoid sale treatment on funding, and remain tax neutral during their existence. Foreign asset protection trusts are usually established solely for asset protection purposes, and almost never for tax purposes.

Generally, when contrasted with a domestic trust, a foreign trust offers the following benefits:

1. Increased ability of the settlor to retain benefit and control;2. Less likely to be pursued by a creditor;3. Foreign jurisdictions usually have more beneficial to the debtor statute of limitations, burden of proof, and other important provisions;4. No full faith and credit, comity or supremacy clause issues;5. Favorable to the debtor spendthrift provision laws;6. Confidentiality and privacy; and7. Flexibility.

It is very important to pick the right jurisdiction as the trust’s situs. Over the past decade, certain foreign jurisdictions have implemented trust legislation specifically designed to provide added asset protection to settlers and beneficiaries. Other jurisdictions, while not focusing on asset protection per se, have made their trust laws more flexible in other respects.

The following factors should be considered when evaluating a foreign trust situs jurisdiction:

1. Nonrecognition of foreign judgments,2. Recognition of self-settled trusts,3. No local taxation,4. Debtor friendly fraudulent transfer laws, including short statute of limitations and high burden of proof,5. Availability of competent and reliable trustees,6. Availability of competent local attorneys and banks,7. British Commonwealth based culture and legal system, 8. Trust assets are not reachable by creditors, include for alimony or child support, and9. Stable political environment.

Also, in some cases secrecy may be an important consideration, but it is not a factor in most asset protection cases.

From an asset protection standpoint three jurisdictions stand out from the rest of the pack: (i) the Cook Islands (in the South Pacific), (ii) St. Vincent and the Grenadines (in the West Indies), and (iii) Nevis (in the West Indies). Certain other offshore jurisdictions also offer asset protection benefits to trusts, but not to the same extent. These jurisdictions include the Cayman Islands, Bermuda, Bahamas, the Channel Islands (Isle of Man, Jersey and Guernsey) and Gibraltar.

For example, Cook Islands, St. Vincent and the Grenadines and Nevis have the following favorable to the debtor provisions: (i) nonrecognition of foreign judgments with respect to trusts; (ii) “beyond a reasonable doubt” standard for fraudulent transfers; (iii) a short statute of limitations for fraudulent transfers; (iv) requirement of showing actual fraud and constructive fraud to prove a fraudulent transfer; (v) allowance of self-settled trusts; and (vi) ability by the settlor/beneficiary to retain some control. All three, particularly St. Vincent, have a long established financial services industry and legal system.

Bahamas lacks clauses (i), (ii) and (iii). Bermuda and Cayman Islands lack clauses (i), (ii), (iv), (v) and (vi). Mauritius lacks clause (i).

Interestingly, New Zealand has been recently gaining popularity as an asset protection destination. New Zealand is closely tied to the Cook Islands (which were a former New Zealand protectorate) and its trust laws are at the forefront of other developed nations. New Zealand does not tax trusts that generate their income elsewhere, but it does recognize self-settled trusts. In eyes of some practitioners, New Zealand is not a “notorious” asset protection jurisdiction, and makes planning easier.

There are several disadvantages to using New Zealand for asset protection purposes. New Zealand has a relatively long statute of limitations on fraudulent transfers (four years), it will recognize a U. S. judgment, and there is no established history of protecting trust settlors and beneficiaries from creditors. (At least not to the same extent as in St. Vincent, the Cook Islands and Nevis.) Because foreign asset protection trusts should be used openly, and they are extremely effective if established in the right jurisdiction, perceptions by creditors (and even judges) are not very important.