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.

Foreign Corporations And Form 5471 ComplianceInstructions for Form 5471 (Rev

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.

Flott-and-Co-US-Tax-Compliance-And-Planning-For-US-Executives-Entrepreneurs-And-Investors-Living-Outside-The-USA 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.

ENDNOTES

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.