The article was first published in Global Tax Weekly, issue 170. Below is the full text of the seventh article in the series on US taxes for US persons living outside the US.
US Tax Compliance And Planning For US Executives, Entrepreneurs And Investors Living Outside The US
by Stephen Flott, Omar Saleh, and Louisa Eleftheriades, Flott & Co.
This is the seventh article in a series of articles on key US tax compliance and planning issues that should be considered by US executives, entrepreneurs and investors living outside the United States. This article will discuss the importance of ﬁling Form 5471, the general requirements of Form 5471, and the category of Form 5471 ﬁlers.
US Persons1 with ownership interests in a foreign corporation2 may be required to ﬁle Form 5471 to report information on and the operations of the foreign corporation. As US Persons have increasingly invested in corporations outside the US or established foreign corporations for their overseas operations, the Internal Revenue Service (“IRS”) discovered it lacks the appropriate information in order to determine whether these US Persons are properly reporting their income from the foreign corporation on their US income tax returns. The issue for the IRS is foreign corporations with US investors are not required to ﬁle US corporate income tax returns. These foreign corporations are also unlikely to be taxed in the US, with the exception of any US source income.
The US legislative solution to this information gap was to require certain US Persons with an interest in foreign corporations to ﬁle an informational return with respect to their ownership interest in the foreign corporation. Depending on the US Person’s percentage of ownership in the foreign corporation, the informational reporting may require the foreign corporation to provide an income statement, balance sheet, statement of current earnings and proﬁts, and accumulated earnings and proﬁts computation. In other words, the informational ﬁling requires extensive ﬁnancial data about the foreign corporation. It is not uncommon for the US Person not to have access to all of this information and the foreign corporation not to be willing to disclose this in- formation to the IRS.
Other complications include foreign corporations operating under diﬀerent reporting standards than the US Generally Accepted Accounting Principles (“GAAP”). It is common for foreign corporations to keep their books under the International Financial Reporting Standards (“IFRS”). For Form 5471, the income statement and balance sheet are required to be reported under GAAP and for the currency to be converted to US dollars. If the books of the foreign corporation are kept under IFRS, then in order to convert the information to GAAP, it will require signiﬁcant work and will need to be completed by a professional who understands the diﬀerences between reporting under the IFRS and GAAP. For a US investor in a small closely held foreign corporation, the compliance cost can be signiﬁcant due to the amount of reporting and the skill involved to correctly report the information on Form 5471.
Compliance with the Form 5471 ﬁling requirement has recently become signiﬁcantly more important as the IRS has placed a much greater emphasis on international tax compliance. In 1997 the penalties for failure to ﬁle Form 5471 increased to a minimum of USD10,000 for each reporting period of the foreign corporation. Also, the IRS changed from infrequently imposing the failure to ﬁle Form 5471 penalties, to starting in 2008, frequenting imposing penalties for late ﬁled Forms 5471. The penalty for continued failure to ﬁle Form 5471 can increase to a maximum of USD60,000 per year. Failure to ﬁle Form 5471 could also result in criminal penalties. Thus, it is important for US Persons with interest in foreign corporations to be aware of and comply with the ﬁling requirements of Form 5471.
The Foreign Account Tax Compliance Act (“FATCA”)3 increased the potential informational reporting penalties. FATCA increased the accuracy related penalty for understatement of income from 20 percent to 40 percent of the understated amount for foreign ﬁnancial assets that were not disclosed on Form 5471. As important, FATCA indeﬁnitely extends the general three year statute of limitations if certain informational returns, including Form 5471, are not ﬁled.
Since most foreign corporations do not have a US employer identiﬁcation number, the IRS in 2012 started requiring US Persons ﬁling Form 5471 to assign the foreign corporation a Unique Reference Identiﬁcation (“URI”) number. The purpose of the URI number is to make it easier to compare informational returns that span multiple years in order to identify inconsistencies on audit.
US Persons face signiﬁcant diﬃculty in complying with the informational reporting requirements of Form 5471. Remember, there is no income tax associated with Form 5471; it is an additional informational form required to be ﬁled with a US Person’s US income tax return. The required information to be reported on Form 5471 has grown over time and requires extensive ﬁnancial data, which may not be easily obtained by the US Person.
Before describing the four diﬀerent ﬁling categories for Form 5471, it is important to understand how ownership interest in a foreign corporation is determined. In determining whether there is a reporting requirement under Form 5471, a US Person can own stock in a foreign corporation directly, indirectly, or constructively. Constructive ownership of stock means that the US Person is deemed to own stock in a foreign corporation, even if it belong to others, principally the US Person’s family members. To make matters more complicated, there are three diﬀerent sets of attribution rules that apply to the four categories of Form 5471 ﬁlers.
A Category 2 Filer includes a US citizen or resident who is an oﬃcer or director of a foreign corporation in which a US Person has acquired 10 percent or more stock ownership by value or vote (“10 percent Stock Ownership Requirement”).4 A Category 2 Filer is required to report the acquisition of ownership interest of another US person regardless of whether the Category 2 Filer has an owner- ship interest in the foreign corporation or not. It is important to understand, a US citizen or resident who is an oﬃcer or director of a foreign corporation can be subject to signiﬁcant penalties for not ﬁling Form 5471 even if the Category 2 Filer has no ownership interest in the foreign corporation.
A Category 3 Filer’s requirement to ﬁle Form 5471 is triggered by acquisition and disposition of stock in a foreign corporation. A Category 3 Filer includes a US Person who:
1. Acquires stock in a foreign corporation which, when added to stock already owned, meets the 10 percent Stock Ownership Requirement;5
2. Acquires stock which meets the 10 percent Stock Ownership Requirement;6
3. Becomes a US Person while meeting the 10 percent Stock Ownership Requirement;7 or
4. Disposes of suﬃcient stock in the foreign corporation to reduce his or her stock ownership in the foreign corporation below the 10 percent Stock Ownership Requirement.8
The same constructive ownership rules that apply to Category 2 Filers also apply to Category 3 Filers.
In determining whether a US Person is a Category 2 or 3 Filer, certain indirect and constructive ownership rules apply. US Persons are considered to own shares of stock owned by their spouses, siblings (whether by the whole or half-blood), ancestors, and lineal descendants. Also, stock owned directly or indirectly by or for a foreign corporation or a foreign partnership is treated as owned proportionately by its shareholders or partners. There is no attribution for Category 2 and 3 Filers from non-grantor trusts and estates.
A Category 4 Filer is a US Person who, for at least an uninterrupted period of 30 days during the annual accounting period of the foreign corporation, owned more than 50 percent of the foreign corporation stock by value or vote.9
Category 4 Filers are subject to extensive reporting requirements including providing an income statement, balance sheet, statement of current earnings and proﬁts, and accumulated earnings and proﬁts computation. Where a US Person has control of a foreign corporation, the US government is concerned the US Person created the foreign corporation to avoid corporate income tax in the US and/ or to defer income tax to the US Person until proﬁts are repatriated through dividend distributions.
Category 4 Filers are subject to diﬀerent constructive ownership rules than other category ﬁlers. In determining whether a US Person meets the 50 percent Stock Ownership Requirement of a Category 4 Filer, certain indirect and constructive ownership rules apply. US Persons are considered to own stock owned by their spouses, children, grandchildren, and parents.10 Stock considered to be owned by a US Person by reason of a family relationship is attributed only once. In other words, the family relationship does not cause each member’s stock to be attributed to all of the others in sequence.11
If stock is attributed by reason of one of the relationships referenced above, say from a wife to her husband, the stock attributed to the husband cannot be attributed to others by reason of their relationship to the husband. In contrast to Category 2 and 3 attribution rules, the Category 4 attribution rules are more limited because there is no attribution from siblings or grandparents.
If a US Person owns 10 percent or more of the value of a corporation, then the US Person is considered to own the same percentage of the stock of any foreign corporation owned by that corporation.12 Stock of a foreign corporation that is owned by a partnership or estate is considered as owned proportionately by its partners and beneﬁciaries.13 Stock of a foreign corporation that is owned by a trust (with certain exceptions) is considered as owned by the beneﬁciaries in proportion to their actuarial interest in the trust.14 Stock of a foreign corporation owned by a grantor trust is considered as owned by the owner of the grantor trust.15
There are certain exceptions to ﬁling under Category 4. If more than one US person is required to ﬁle as a Category 4 Filer with respect to the same foreign corporation, the ﬁling requirement may be satisﬁed by one of the US Persons ﬁling the required form.16
US Persons in control of foreign corporations are not required to ﬁle as Category 4 Filers if:
1. They have no direct interest in the foreign corporations,
2. They are within Category 4 solely by reason of constructive ownership from other US Persons and that one of the other US Persons ﬁles a Form 5471 that includes all information required of a Category 4 Filer.17
Also, a Category 4 Filer is not required to ﬁle Form 5471 with respect to a foreign corporation if such person:
1. Has no direct or indirect interest in the foreign corporation; and
2. Would be required to ﬁle as a Category 4 Filer solely because of constructive ownership from a nonresident alien.18
This provides an exemption for US Persons who are attributed control of a foreign corporation solely through family attribution rules from foreign family members and have no direct or indirect ownership interest in the foreign corporation.
A Category 5 Filer includes US Shareholders who own stock in a foreign corporation that is a Controlled Foreign Corporation (“CFC”) for an uninterrupted period of 30 days or more during any tax year of the foreign corporation, and who owned stock on the last day of the tax year. A US Shareholder is deﬁned as a US Person who owns 10 percent or more of the voting power of the CFC.19 A CFC is a foreign corporation with US Shareholders that own more than 50 percent of the stock of a foreign corporation by value or vote.
If a foreign corporation is a CFC for purposes of US taxation, then certain items of income of the foreign corporation will be deemed to have been received during the year from the foreign corporation even though there was no distribution to the US Person. A foreign corporation’s classiﬁcation as a CFC generally leads to adverse income tax consequences to the US shareholders of the foreign corporation due to the deemed income received rule.
A US corporation with foreign subsidiaries is eligible to claim deemed paid foreign tax credits if it owns 10 percent or more of the voting stock of a foreign corporation and receives a dividend distribution from that foreign corporation. The deemed paid foreign tax credit is allowed to protect US corporations from double taxation and to closer equate the tax treatment of US corporations with foreign subsidiaries with those operating through foreign partnerships or disregarded entities. This allows US corporations to choose to operate through a foreign corporation or foreign partnership/foreign disregarded entity on a legal basis as opposed to US tax consequences. The CFC rules along with deemed foreign tax credits will be discussed in more detail in the next article of this series.
Category 5 Filers are subject to diﬀerent constructive ownership rules than other category ﬁlers. In determining whether a US Person is a Category 5 Filer, US Persons are considered to own stock owned by their spouses, children, grandchildren, and parents. As compared to Category 4 Filers, Category 5 Filers are not attributed ownership from stock owned by nonresident aliens.20 Stock considered to be owned by a US person by reason of a family relationship is attributed only once.
As discussed above with attribution from partnerships, trusts, or estates in connection with Category 4 Filers, stock owned by a partnership or an estate is considered as owned proportionally by the partners and beneﬁciaries. Stock owned by a trust is considered as owned in proportion to the beneﬁciary’s actuarial interest in the trust. Stock owned by a grantor trust is considered as owned by the grantor. If a US Person owns 10 percent or more of the value of a corporation, then the US Person is considered to own the same percentage of the stock of any foreign corporation owned by that corporation.
From a tax planning perspective, the US Person should be alert to the special tax and reporting rules for ownership interest in companies located outside the US. From a starting point, any entity formed outside the US with a US Person as an owner will be classiﬁed as a corporation, partnership, or disregarded entity for purposes of US taxation. For most types of entities formed outside the US, the US Person will have the opportunity to elect the company’s tax classiﬁcation for purposes of US income taxation.
If no election is made, then the default rules provided in the IRC and Treasury Regulations will determine the tax classiﬁcation of the foreign company. There are certain types of foreign entities that are per se corporations and no election can be made to change the classiﬁcation. The opportunity to elect the tax classiﬁcation of a foreign company provides the US Person with many important initial tax planning considerations as there can be complications with changing the initial entity classiﬁcation after the ﬁrst year of US tax reporting.
For purposes of ﬁling Form 5471, if an entity under the default rules is classiﬁed as a foreign corporation instead elects to be taxed in the US as a partnership, then Form 5471 would not be required to be ﬁled. However, a Form 8865 may be required to report the operations of the foreign partnership. More important than the reporting requirements of a partnership or corporation, is the tax advantages that can be obtained through electing taxation as a partnership instead of a corporation or vice versa. In the initial year a foreign entity is formed it is important that the US Person closely considers whether an election should be made to have the foreign entity classiﬁed diﬀerently than provided under the US default rules.
Determining whether a US Person has a Form 5471 ﬁling obligation is complex. The form itself can be a diﬃcult task, too. Remember, even if an individual has no actual or indirect ownership in a foreign corporation, he or she may be required to ﬁle the form. To add to the potential confusion, there are diﬀerent attribution rules depending upon which category of ﬁler a person is, some of which can require reporting extensive data under GAAP. Because failure to ﬁle a Form 5471 can result in substantial civil and criminal penalties, it is best to obtain advice from professionals who are experienced and knowledgeable. This is not an area for tax rookies.
1 US Persons include: (1) US citizens, (2) resident aliens of the US, (3) a nonresident alien who makes an election to be treated as a resident alien for purposes of ﬁling a joint income tax return, and (4) US corporations, partnerships, estates, and trusts. IRC § 7701(a)(30).
2 As used in this article, foreign corporation means any corporation not created or organized in the US or under the law of the US or of any State. IRC § 7701(a)(4), (5).
3 FATCA was enacted on March 18, 2010 by the United States Congress through the Hiring Incentives to Restore Employment Act (P.L. 111-147). FATCA was enacted as a result of the US effort to target offshore tax evasion and recoup offshore tax revenue.
4 IRC § 6046(a)(2); Reg. 1.6046-1(a)(2).
5 IRC § 6046(a)(2).
6 IRC § 6046(a)(2).
7 IRC § 6046(a)(1)(D).
8 Reg. 1.6046-1(c)(1)(ii)(c). Taxpayers could dispute this requirement as it is outside the scope of the statute, due to the improbability of overturning a regulation, the most prudent approach is to comply with the ﬁling requirement.
9 IRC § 6038(a)(1); IRC §6038(e)(2); Reg. 1.6038-2(a), (b).
10 IRC § 318(a)(1).
11 IRC § 318(a)(5)(B).
12 IRC § 318; IRC § 6038(e)(2); Reg. 1.6038-2(c)(3).Instructions for Form 5471 (Rev)
13 IRC § 318(a)(3)(A).
14 IRC § 318(a)(3)(B)(i).
15 IRC § 318(a)(3)(B)(ii).
16 Reg. 1.6038-2( j)(1).
17 Reg. 1.6038-2( j)(2).
18 Reg. 1.6038-2( j)(3).
19 IRC § 951(b).
20 IRC 958.