We have heard a lot about large, publicly-traded U.S. corporations that have parked trillions of dollars overseas to avoid the payment of U.S. income tax. We have heard how the tax system must be seriously broken to have so incentivized so many of these corporations to “relocate” overseas.
What is usually overlooked or omitted in these reports is the number of smaller, closely-held U.S. corporations and partnerships that have established operations overseas in pursuit of legitimate business goals, including the opening of new markets, among others.
Equally absent from these reports is any mention of the number of U.S. citizens living outside the U.S. who own companies that are engaged in business overseas.
Quite often, these closely-held companies are unaware of their U.S. income tax reporting obligations as regards their foreign operations and income. The owner of one of these companies will naturally be focused on the business opportunities, and challenges, presented by establishing an overseas presence and, unless the company’s tax advisers are well-versed in so-called “outbound” transactions, the company may unwittingly fail to satisfy its filing obligations.
This may result in the imposition of steep penalties on the business, as one taxpayer recently discovered to its detriment.
A Taxpayer Can Get Burned
Taxpayer was a U.S. citizen residing in Country. During the years in issue, he operated a business in Country through a foreign corporation (“FC”). At some point during this period, he sold the majority of his stock to a non-U.S. resident of Country. The issue for decision was whether Taxpayer was liable for the penalties assessed against him for his failure to declare, on IRS Form 5471, his ownership interest in FC.
Taxpayer timely filed his Forms 1040, U.S. Individual Income Tax Return, for the years in issue but did not attach IRS Forms 5471 to any of his returns. Although Taxpayer hired a tax preparation firm in Country to prepare his U.S. tax returns during the years in issue, he did not inform this firm until years later that he held an interest in FC.
Thereafter, the IRS began an examination of Taxpayer’s ownership of FC. Taxpayer then submitted delinquent Forms 5471 regarding his interest in FC, after his tax counsel advised him of his obligation to do so. The Forms 5471 submitted were incomplete.
The IRS assessed penalties for Taxpayer’s failure to timely file completed Forms 5471 declaring his ownership interest in FC.
The Tax Court explained that the Code imposes information reporting requirements on any U.S. person who controls a foreign corporation. A person controls a foreign corporation (a “controlled foreign corporation,” or “CFC”), the Court stated, if he owns (directly or constructively):
- Stock that that represents more than 50% of the total combined voting power of all classes of voting stock of the corporation, or
- More than 50% of the total value of shares of all classes of stock of the corporation.
Under the Code, a U.S. person must furnish, with respect to any foreign corporation which that person controls, such information as the IRS may prescribe. Form 5471 is used to satisfy these reporting requirements, and it must be filed with the U.S. person’s timely-filed Federal income tax return. Moreover, a U.S. person who disposes of sufficient stock in a CFC to reduce his interest to less than the above stock ownership threshold is required to provide certain information with respect to the foreign corporation.
Additionally, information reporting requirements are also imposed on any U.S. person treated as a “U.S. shareholder” of a corporation that was a CFC for an uninterrupted period of 30 days during its annual accounting period and who owned stock in the CFC on the last day of the CFC’s annual accounting period. A U.S. shareholder, with respect to any foreign corporation, is a U.S. person who owns, or is considered as owning, 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.
To avoid a penalty, a taxpayer must make an affirmative showing that the failure to furnish the appropriate information with his return was due to reasonable cause.
To establish reasonable cause through reliance on a tax adviser’s advice, the taxpayer must prove: (i) the adviser was a competent professional with sufficient expertise, (ii) the taxpayer provided necessary and accurate information to the adviser, and (iii) the taxpayer relied in good faith on the adviser’s judgment.
The Taxpayer could not satisfy these requirements. Thus, the Court found that he failed to show reasonable cause for his failure to file Forms 5471, and the imposition of the penalties was sustained.
But Wait, There’s More
The penalties imposed upon the taxpayer in the decision described above are bad enough, but there are other issues of which such a taxpayer needs to be aware.
Indeed, Congress recognizes that the IRS may not be able to “timely” identify all U.S. persons who conduct business overseas and fail to report their foreign activities and income.
Thus, another consequence of failing to file the requisite returns may be the additional tax for the year in which the event(s) to be reported occurred – meaning that the IRS can impose a tax upon a delinquent taxpayer whenever the IRS discovers the existence of the foreign business activities or transactions.
In other words, these reporting obligations cannot be ignored; they must be taken seriously.
However, these failures, and the resulting consequences, can be avoided relatively easily if the company’s tax adviser or tax compliance officer is familiar with the IRS’s many reporting requirements for U.S. businesses that operate overseas, and understands the underlying purpose for the required filings.
Common Filing Obligations
The following summarizes some of the more common reporting requirements imposed upon a U.S business that operates or holds assets overseas, as well its U.S. owners.
A basic principle of U.S. tax law is that U.S. persons – which includes, for example, U.S. citizens and resident individuals, domestic corporations, and domestic trusts – must file an annual tax return with the IRS to report their worldwide income, regardless of the source or the type of income. This income is taxable in the U.S., notwithstanding that it may also have been taxed by the foreign country in which it was sourced or generated. Of course, the U.S. person may be able to claim a tax credit for any foreign taxes withheld and/or paid on such income in the foreign country; such credit may offset any U.S. income tax that would otherwise be imposed on such income.
If a U.S. person transfers property to a foreign corporation or partnership in what purports to be a tax-free exchange, the U.S. person may have to report the transfer on IRS Form 926. This filing provides a means by which the IRS confirms the taxable or tax-free nature of the transfer of property by a U.S. person to a foreign jurisdiction, and perhaps beyond the reach of the IRS.
If a U.S. person owns an interest in a foreign corporation, the U.S. person may have to file IRS Form 5471 (as we saw above). The rules for CFCs may require the inclusion of CFC income (so-called “Subpart F” income) in the gross income of a U.S. person even where such income has not been distributed to the U.S. person (i.e., repatriated). In general, this reporting is aimed at situations in which the U.S. person, the CFC, and/or certain other related persons, engage in intercompany transactions of a nature that tends to shift the resulting tax liability to a lower tax jurisdiction.
If a U.S. person owns or acquires an interest in a foreign partnership, IRS Form 8865 may have to be filed. This form is similar to Form 5471 and to the partnership tax return on Form 1065. It is intended to assist the IRS in monitoring the overseas business and investment activities of U.S. taxpayers through foreign flow-through entities, the income from which must be reported on the U.S. person’s tax return in the same way that a U.S. person’s distributive share of a domestic partnership’s taxable income must be reported.
If a U.S. person owns an interest in a passive foreign investment company (a “PFIC”; e.g., a foreign mutual fund), and receives certain distributions from the PFIC, or recognizes gain on the disposition of PFIC stock, the U.S. person may have to file IRS Form 8621 and pay a tax, along with a special interest charge that is intended to offset the tax deferral benefit that the U.S. person enjoyed as to the distributed funds and the recognized gain. The purpose of these rules is to help ensure that U.S. investors in such foreign investment vehicles are taxed on an equal footing with similar investments in domestic investment vehicles.
If a U.S. person has an interest in certain foreign accounts or other foreign financial assets, including accounts in foreign financial institutions and interests in a foreign corporation or partnership, those assets may have to be reported on Form 8938. This filing is intended to assist the IRS in cracking down on unreported investment income from overseas.
The U.S. person may also have to file FinCEN Form 114 (the well-known “FBAR”) to report accounts held in foreign financial institutions. The FBAR reporting requirement is aimed at establishing a U.S. taxpayer’s connection to such an account for the purpose of ensuring that the funds deposited therein, as well as the investment income earned thereon, were properly reported and taxed.
Don’t Be Overwhelmed
Granted, this is a daunting litany of reporting obligations, and it may appear overwhelming – “overkill,” some taxpayers may say. From the perspective of the IRS, however, they are necessary if the tax statutes in effect today are to be enforced and their underlying goals accomplished.
The best way to avoid any issues and surprises is, first and foremost, to find a tax adviser who is familiar with the rules and can explain them. The next step is to establish internal procedures to ensure that the necessary information will be collected in a usable form. Finally, the taxpayer must prepare and timely file the proper returns.
Yes, it may be a chore today, but it certainly beats the alternative down the road. Just witness those “poor” taxpayers who failed to timely file their FBARs and are now walking through the OVDP gauntlet.