A trust is a three-way fiduciary relationship in the form of an agreement that allows the first party, often referred to as the trust founder or settlor, to transfer assets to a legal entity, the trust, for the benefit of a third party, the trust beneficiary. In the case of an offshore trust, the trust settlor will have created a trust in a jurisdiction that is different from where they reside. In the past, this used to provide numerous additional benefits such as hiding assets and business operations away from the local tax revenue services, ultimately allowing for massive tax evasion. However, offshore trust reporting is now more onerous and, before setting up an offshore trust, it is worth understanding one’s reporting obligations.
Through the Foreign Account Tax Compliance Act which was passed in March 2010 and which became effective in July 2014, the United States has been trying to combat tax avoidance by their own citizens through offshore entities. It was through the Organisation for Economic Co-operation and Development (OECD) that the Common Reporting Standard was developed at the request of the G20, and which was approved in July 2014 and effected in March 2016.
The Common Reporting Standard (CRS) calls on jurisdictions to gather information from their respective financial institutions and to automatically exchange that information on an annual basis. Further, the CRS set out the financial account information to be exchanged, which financial institutions are required to report, the various types of accounts and taxpayers covered, together with common due diligence procedures to be followed by the financial institutions. The premise of this was to help tax authorities tackle offshore tax evasion by shedding a light on their residents’ detailed information of assets and wealth held abroad.
That said, the world was not fully aware of the extent to which this standard of reporting would shine a light until the Panama Papers of 2016. The Panama Papers refers to the 11.5 million leaked, encrypted documents that were the property of Panama-based law firm, Mossack Fonseca. These documents were released on 3 April 2016 by Süddeutsche Zeitung, a German newspaper, who dubbed them the ‘Panama Papers’. These documents exposed a network of more than 214 000 tax havens involving individuals and entities spread across 200 different countries. Süddeutsche Zeitung and the International Consortium of Investigative Journalists embarked on a year-long investigation to decipher the encrypted files, after which their findings were made public.
The Panama Papers include personal financial information of a number of wealthy individuals and public officials that have previously been kept private. Among those named in the leak were a dozen current and former world leaders, 128 public officials, politicians, celebrities, numerous business people, and other wealthy individuals. While the majority of the documents showed no inappropriate or illegal behaviour, there were a number of shell corporations and entities set up by Mossack Fonseca that were revealed by reporters to have been used for illegal purposes, including fraud, tax evasion, and the avoidance of international sanctions.
So, how exactly does the CRS affect those with offshore trusts and what type of requirements does CRS place on those with offshore trusts? The framework of the CRS is such that an obligation to provide and report account holder information to the various tax administration offices in the participating jurisdictions is placed on financial institutions. This includes a number of steps to identify exactly who and what needs to be reported.
While all trusts are considered entities in the eyes of the CRS, bear in mind that a trust may be a Financial Institution or a Non-Financial Entity. The most likely scenario in which a trust will be a Financial Institution is where it falls within the definition of Investment Entity as described in Section VIII, paragraph A(6)(b) of the Common Reporting Standard. These would typically include banks, brokers, custodian banks, funds, portfolio managers and life insurance companies that would ordinarily have an obligation for financial reporting.
However, when it comes to reporting in respect of trusts that are Non-Financial Entities, the CRS has five steps:
Step 1: Determine who the reporting financial institution is
A reporting financial institution could include depository institutions, custodial institutions, investment entities, or specified insurance companies. While the trust might not itself be a reporting financial institution, it is commonly found that the assets held within the trust are themselves held by a financial institution that has an obligation to report, such as where a trust has a bank account held in a financial institution in Guernsey.
Step 2: Review financial accounts
A financial account is an account maintained by a financial institution. Specifically, the term ‘financial account’ includes five categories of accounts, namely depository accounts, custodial accounts, equity and debt interests, cash value insurance contracts and annuity contracts.
Step 3: Identify reportable accounts
The account held by a trust that is a NFE is a reportable account if:
a) the trust is a reportable person; or
b) the trust is a passive NFE with one or more controlling persons that are reportable persons.
Step 4: Apply due diligence rules
The reporting financial institution must apply the due diligence rules to determine if the account held by the trust is a reportable account.
Step 5: Reporting the relevant information
Where a trust is a reportable person, the reporting financial institution will report the account information and the financial activity for the year with respect to the account of the trust. The account information will include the identifying information of the trust – such as the name of the trust, address, residence, taxpayer identification number, and account number – and the identifying information of the reporting financial institution, being the name and identifying number.
In the past, offshore trusts had very few reporting requirements and were commonly used to hide assets from local authorities and tax administration services. However, the CRS has resulted in many jurisdictions collaborating to exchange global economic cooperation and the exchanging of information which helps to pierce the veil on such entities.
From a South African perspective, the CRS means that, while a South Africa tax resident might not disclose their assets to Sars, there remains a good chance that through global cooperation their activities will be reported to our tax authorities. Naturally, there are still some jurisdictions that do not comply with the CRS, but it is becoming more difficult to transact and do business in jurisdictions where this is the case.