In his bestseller, 1984, George Orwell explores a society where, Big Brother, the head of the only political party, sees all and controls everything from the daily news to the rewriting of history. The party applies the concept of “doublethink,” which Orwell describes as:
The power of holding two contradictory beliefs in one’s mind simultaneously, and accepting both of them… To tell deliberate lies while genuinely believing in them, to forget any fact that has become inconvenient.
In 2014, the Organisation for Economic Cooperation and Development (OECD) published the Standard for Automatic Exchange of Financial Account Information in Tax Matters (CRS) with the aim to eliminate tax evasion globally. Often referred to as global FATCA, the CRS consists of due diligence and reporting requirements and provides for the exchange of financial account information between participating jurisdictions.
The CRS has had impact on the offshore trust industry. Trust settlors and beneficiaries are clearly exposed to the possibility of being reported. However, trust protectors often don’t have any economic entitlements under the terms of a trust. Should protectors resident in reportable jurisdictions be reported irrespective of the nature of the trust or their powers?
Under the CRS, an account holder is reportable if resident in a participating jurisdiction, of which there are presently more than 100. Contrary to what’s expressed in the CRS itself and to the approach under FATCA and the FATCA intergovernmental agreements (IGAs), the OECD in its CRS FAQ of June 2016 (OECD FAQ) stated that, “a protector must be treated as an Account Holder irrespective of whether it has effective control over the trust.” Let’s consider whether the OECD FAQ position on protectors is doublethink or otherwise flawed.
How the CRS Works
Under the CRS, when a person tax resident in jurisdiction A is deemed reportable in respect of a financial account held with a reporting financial institution (RFI) in jurisdiction B:
The RFI will report details to the competent authority in jurisdiction B in respect of the financial account, including, the identity of account holders who are tax resident in a reportable jurisdiction (each a reportable person) and their deemed account balances; and
The competent authority of jurisdiction B will exchange details reported in respect of the financial account to the competent authority of jurisdiction A.
Concerns Regarding the CRS
Perhaps unsurprisingly, with a notable exception of the United States (which implemented FATCA), most major economic jurisdictions are participating jurisdictions, and many have incorporated the CRS into their domestic law. Jurisdictions with histories of misuse of personal information are among the participating jurisdictions. Almost 50 participating jurisdictions agreed to exchange information under the CRS by September 2017 with others agreeing to commence exchanges during 2018.
Questions remain about what’s reportable under the CRS. Notwithstanding requirements in the CRS for safe‐keeping of information, regular media reports of large scale cyberattacks on institutions ensure the concerns of persons who may be reported under the CRS remain. Given the aims of the CRS relate to taxation, protectors may have reason to question why they ought to be reported.
The OECD FAQ
The OECD FAQ’s approach may stem from the OECD not fully understanding what a protector is. The OECD’s CRS Implementation Handbook (Handbook) states that a “protector enforces and monitors the trustee’s actions, such as overseeing investment decisions or authorising a payment to a beneficiary.”
However, a protector is a person who’s granted one or more powers under the terms of the trust. The terms of one trust may provide a protector very limited powers and may not require any of the powers mentioned in the Handbook. Other trusts may provide protectors extensive powers.
Neither the OECD FAQ, nor the Handbook, form part of the CRS and, in most participating jurisdictions, haven’t been incorporated into domestic laws implementing the CRS.
Jurisdiction Specific Guidance
Many participating jurisdictions have released guidance to assist RFIs to fulfill their CRS obligations. However, many guidance notes have treated the approach of the OECD FAQ in respect of protectors (notably of trusts classified as financial institutions (FI trust)) as the elephant in the room. Few, if any, participating jurisdictions have expressed a view on this issue. Many RFIs have felt compelled to follow the OECD FAQ. However, disclosing more information than is required places RFIs at risk of breaching legal and contractual obligations.
When are Protectors Reportable?
Bermuda’s CRS laws and guidance are considered here for the purpose of the analysis. However, the analysis will likely be relevant for most participating jurisdictions.
Under the CRS, all entities, including trusts, are classified as either financial institutions or non‐reporting financial institutions. In circumstances in which a non‐reporting financial institution can be further classified as a passive non‐financial entity (NFE) and holds a financial account with an RFI (and is therefore an account holder), the RFI is required to report with respect to controlling persons of that account holder who are resident in reportable jurisdictions.
The CRS provides that:
The term “Controlling Persons” … [i]n the case of a trust … means the settlor(s), the trustee(s), the protector(s) (if any), the beneficiary(ies) or class(es) of beneficiaries, and any other natural person(s) exercising ultimate effective control over the trust…. The term “Controlling Persons” must be interpreted in a manner consistent with the Financial Action Task Force Recommendations.
Accordingly, provided such protectors are resident in a reportable jurisdiction, protectors of trusts that are classified as passive NFEs clearly are reportable by RFIs with which the trust (acting by its trustee) opens financial accounts.
However, for FI trusts to be reportable under the CRS, a person must be:
An account holder;
A controlling person of a passive NFE that’s an account holder; and resident in a reportable jurisdiction.
The following CRS definitions are relevant for the purposes of determining whether protectors of FI trusts are account holders:
“The term ”Account Holder” means the person listed or identified as the holder of a Financial Account by the Financial Institution that maintains the account. A person, other than a Financial Institution, holding a Financial Account for the benefit or account of another person as agent, custodian, nominee, signatory, investment advisor or intermediary, is not treated as holding the account for the purposes of the [CRS], and such other person is treated as holding the account.”
“The term “Financial Account” means an account maintained by a Financial Institution… and, in the case of an Investment Entity, any equity or debt interest in the Financial Institution.”
“The term “Equity Interest” means, in the case of a partnership that is a Financial Institution, either a capital or profits interest in the partnership. In the case of a trust that is a Financial Institution, an Equity Interest is considered to be held by any person treated as a settlor or a beneficiary of all or a portion of the trust, or any other natural person exercising ultimate effective control over the trust.”
CRS Rules of Interpretation
The expression “exercising ultimate effective control” appears in the definitions of equity interest and controlling person.
The Multilateral Competent Authority Agreement that many jurisdictions have signed to participate in the CRS forms part of the CRS and provides that any term not defined in the CRS:
will, unless the context otherwise requires … have the meaning that it has at that time under the law of the Jurisdiction applying this Agreement, any meaning under the applicable tax laws of that Jurisdiction prevailing over a meaning given to that term under the other laws of that Jurisdiction.
Many offshore financial centers’ laws don’t have a definition of “control” for tax purposes. The laws of these jurisdictions contain definitions of “control” for use in other contexts, including in connection with preventing money laundering.
However, the context of those definitions may mean that they are irrelevant to the application of the expression “a natural person exercising ultimate effective control” as it appears in the CRS definition of “equity interest.”
The term “controlling persons” doesn’t appear in the definition of “equity interest” or “account holders” and is irrelevant for determining whether a protector (who’s a natural person) is an account holder of an FI trust.
As is the case with a number of participating jurisdictions, Bermuda’s CRS legislation incorporates the CRS definition of “controlling persons.” Consistent with the CRS, Bermuda’s guidance includes a list of controlling persons of trusts (that is, of passive NFE trusts), which includes protectors who are natural persons.
The differences between the definitions of “equity interest” and “controlling persons” and their evolution demonstrate that the definition of “equity interest” targets persons who have taxable economic interest in trusts. This purpose is more clearly reflected in the definition of “equity interest” in respect of partnerships, in which only persons who have a “capital or profits interest” in the partnership hold an equity interest.
Equity Interest Under General Law
Under equitable principles, a person wouldn’t have a beneficial or equitable interest in a trust property unless the person has a vested interest. However, legislation can provide a meaning to terms that differs from general law. However, to include persons that don’t have an entitlement to distributions of trust property within the definition of “equity interest” may be counterintuitive.
Discretionary beneficiaries have a mere hope that the trustee will make distributions to them. In many jurisdictions, beneficiaries who receive discretionary distributions incur a tax liability on receipt. Consequently, the Commentary (which forms part of the CRS) provides that, notwithstanding that discretionary beneficiaries fall within the definition of persons who have an equity interest in trusts, they’re only reportable for periods when distribution are actually made to them.
In some jurisdictions, settlors may incur tax liabilities in connection with trusts they establish irrespective of whether the settlor is a beneficiary. This is likely why the definition of “equity interest” expressly includes settlors.
With the exception of remuneration that they may charge for services, trustees and protectors who aren’t settlors or beneficiaries of trusts don’t ordinarily receive benefits from trusts. This may be why trustees and protectors weren’t expressly identified in the definition of “equity interest.” On this analysis alone, a person wouldn’t hold an equity interest and, therefore, be an account holder, merely because that person has been appointed as a protector of an FI trust.
Bermuda’s guidance, while not being law, provides that a “trust company and service provider” (TCSP) acting as trustee of an FI trust shouldn’t be treated as holding an equity interest in the trust, “as TCSPs don’t have any economic entitlement over the assets of the underlying trust.”
Applying this approach, protectors of FI trusts who act in a fiduciary capacity and don’t have any economic interest over the trust assets shouldn’t be account holders.
FATCA Recommendations and Controlling Persons
The above analysis is consistent with the approach taken in the FATCA regulations and the IGAs. The FATCA regulations were designed to prevent U.S. citizens from avoiding U.S. income tax and don’t require the disclosure of protectors in circumstances in which the protector is neither a settlor nor a beneficiary.
The IGAs introduced the concept of reporting controlling persons in connection with FATCA. The controlling persons concept expands the idea of beneficial ownership for the purposes of combatting money laundering and terrorist financing. Consequently, it expanded the scope of persons who may be reportable under the IGAs.
The definition of “controlling persons” under the IGAs is only relevant in respect of entities that are classified under the IGAs as “passive non‐ financial foreign institutions,” being the substantial equivalent of passive NFEs under the CRS. The definition of “equity interest” in the IGAs is similar to that in the CRS. If it’s accepted in respect of the IGAs that the term “equity interest” means a person with a beneficial interest (that is, economic entitlement) in an entity, why would a definition of “equity interest” in the CRS be construed differently?
In contrast to the definition of “equity interest,” the definition of “controlling persons” in the CRS and the IGAs provides that it be interpreted in a manner consistent with the FATF recommendations.
The FATF recommendations include a wide definition of “beneficial owner.” The glossary of the FATF recommendations provides that:
Beneficial owner refers to the natural person(s) who ultimately owns or controls a customer and/or the natural person on whose behalf a transaction is being conducted. It also includes those persons who exercise ultimate effective control over a legal person or arrangement.
Reference to “ultimately owns or controls” and “ultimate effective control” refer to situations in which ownership/control is exercised through a chain of ownership or by means of control other than direct control.
This approach to beneficial ownership reflected in the FATF recommendations is reflected in Bermuda’s Proceeds of Crime Regulations 2008 (PoC regulations) and similar regulations in the United Kingdom and other jurisdictions.
However, the PoC regulations, like the FATF recommendations, are designed for the purpose of combatting money laundering and have a wider focus than, and are irrelevant to, the definition of equity interest under the CRS.
Trust Law and “Control”
In the Matter of Esteem Settlement (Esteem) considered what may constitute “substantial or effective control” in the context of whether it was possible to “pierce the veil” of a valid Jersey law trust. It’s likely the Jersey Court’s approach will be applied in other offshore jurisdictions.
In Esteem, the settlor was a beneficiary of a discretionary trust but didn’t have extensive powers expressly granted to him under the trust’s terms. The settlor exerted considerable influence over the trustee (a licensed trust company) in connection with several investment transactions and discretionary distributions. The trustee complied with almost all of the settlor’s requests.
The court rejected the argument that the doctrine of piercing the corporate veil could apply in the same way to trusts. The court nevertheless considered the plaintiffs’ submission that, if the doctrine were recognized, the plaintiffs would need to demonstrate that the settlor had “substantial or effective control” over the trust. The court noted the difficulty the plaintiffs had formulating a test for “substantial or effective control.” The plaintiffs’ submitted that the test should determine “who in practice determines what happens to the trust assets?” and that the degree of control was relevant. The plaintiffs maintained that something less than complete control was required, but that the test could be satisfied on the evidence by the number and nature of the requests made by the settlor and the trustee’s compliance with them.
The court disagreed with the plaintiffs’ test and “before determining the issue of control stood back and looked at the picture as a whole” before holding that for the purposes of a substantive hearing:
The question in this context is whether the trustees acted in good faith, consciously put their mind to the discretion vested in them, arrived at a decision and implemented that decision. Such persons cannot be regarded as being under another’s substantial or effective control.
STEP Guidance
The Society of Trust and Estate Practitioners CRS guidance of March 8, 2017 notes the approach in the OECD FAQ and states that:
This [i.e., FAQ] response does not address the clear distinction in the Standard [i.e., CRS] itself between the holders of Equity Interests in a trust which is an RFI … which only includes Protectors if they actually exercise ultimate effective control, when contrasted with the Controlling Persons definition of a trust that is a Passive NFE… which includes Protectors regardless of the powers they hold… In this context, we note that the OECD’s guidance does not constitute a legally binding interpretation of the Standard ….. Until the legal basis for this is made clear in the CRS treaty, it is considered that there is a reasonable basis for forming the opposite conclusion.
What Happens Next?
An interpretation of the definition of “equity interest” under the CRS to automatically include protectors may suggest there’s no meaningful distinction between holders of equity interests and controlling persons of trusts. If this were correct, it may call into question why there’s a definition of equity interest for the purposes of trusts in CRS at all. However, the definitions have a different purpose, and focus and should be construed in that context.
But, “[w]hat can you do against the lunatic … who gives your arguments a fair hearing and then simply persists in his lunacy?”
It’s possible that, for the purpose of considering enforcement action, a competent authority may adopt the view contained in the OECD FAQ in relation to protectors of FI trusts. However, that position may be contrary to applicable CRS legislation.
The OECD might amend the CRS to expressly provide that protectors of FI trusts are always reportable irrespective of whether they have an economic interest in the FI trust. The OECD hasn’t expressed any plans to do so. In many participating jurisdictions, such amendment to the CRS would automatically be incorporated into applicable CRS legislation.
