In the second of a two part commentary, global advisory firm Maitland Group, considers a family trust as a financial institution or a non-financial entity.
No one likes to be a square peg in a round hole. It doesn’t feel right. However, for protectors of family trusts with an eye on the new Common Reporting Standard (CRS) requirements, it can often be better for the trust to wear the incongruous name of “financial institution” than the alternative of “passive non-financial entity”.
In part one of this article we discussed what the CRS might mean in general terms for protectorsIn part two, we look in more detail at the different consequences for protectors depending on whether the trust is a financial institution or a non-financial entity.
A trust that is a financial institution is deemed to maintain financial accounts and it is the financial account that is potentially the subject of reporting. So what is a financial account in the context of a trust? This is where the square peg has to be hammered particularly hard as, of course, a trust is very different from a bank or an investment fund where the concept of an account is easily understood.
The CRS rules specify that a financial account in the context of a trust is a debt or equity interest in the trust. At this point, protectors reading this article would, understandably, be saying to themselves that they certainly do not hold a debt or equity interest in the normal sense of the word.
However, the CRS deems the following people to hold an equity interest:
It is the third category that potentially affects a protector. Can it be said that a protector is “exercising ultimate effective control” over a trust? We pointed out in part one of this article that the OECD FAQs state that any protector should always be treated as an account holder irrespective of whether they exercise effective control over the trust. We also pointed out that in most countries this is not an accurate statement of the law and it would not be correct to follow it. But it shows us what we are up against. Many institutions may find it easier to follow the advice of the OECD in the FAQ rather than to perform the legal analysis required to determine whether the advice is correct.
Do protectors exercise ultimate effective control?
This is a question that needs to be considered carefully as, if it is the case, then the protector is potentially the subject of reporting and there may be circumstances in which the entire value of the trust would be reported to the protector’s tax authorities.
Fortunately, there will be many instances where a protector’s powers will be such that they do not place ultimate effective control in the hands of the protector and, even if they do, there is still the question as to whether the protector actually exercises those powers. But the position can only be clarified in each case by an examination of the terms of the trust deed and of the other factual circumstances surrounding the role actually played by the protector.
Where there is doubt as to the impact of the current powers of a protector, as set out in the trust deed, or the implications of the interaction between the protector and the trust, steps should be taken to create greater certainty by removing or modifying certain powers. Consideration could also be given to whether the circumstances of the trust are such that a protector is still needed. However, in many cases, it may be possible to retain a protector without adverse reporting consequences.
When are protectors treated as controlling persons?
A trust is not a financial institution where, for example, its trustees are individuals or the financial situation of the trust does not meet the requirements for financial institution status.
In most cases the trust will instead be classed as a “passive non-financial entity”. In such a situation, the trustee has no reporting obligations. Instead, the obligations shift to other financial institutions (for example banks or investment funds) with whom the trust holds an account. If the trust has a wholly owned subsidiary with a managed investment portfolio, that entity is also likely to be a financial institution with reporting obligations. In such cases the bank, fund or underlying company is required to identify the controlling persons of the trust and file any necessary reports.
In the case of a non-financial entity trust, protectors are treated as a controlling persons regardless of whether or not they exercise any control. This follows directly from the wording of the CRS rules, which specifically require reporting of protectors of trusts that are passive non-financial entities. Thus, the bank will report the protector as someone with control over the trust bank account and this information (which will include the account balance and movements on the account) is likely to end up with the tax authorities in the country of the protector’s residence.
It can readily be seen that the protector of a financial institution trust is in a better position with regard to CRS reporting compared with where the trust is a passive non-financial entity. In the former situation, legitimate measures can be taken to ensure that unnecessary reporting does not happen (and, even if reporting is required, it may be possible to report a zero value rather than the full value of the trust). In the latter situation, abolition of the protector role may be the only remedy. Lucky for those who are the square pegs.
Next steps for protectors
Reporting in many countries will start to be made by financial institutions imminently. Protectors would be well advised to verify whether their trusts are financial institutions and, if so, whether their powers under the trust deed are such as to render them potentially reportable. It should not be too late to take remedial action, but that will to some extent depend on the status of the due diligence carried out to date by the trustees or by the trust’s bank.