Posts By: Stephane Cossettini

The U.S. Repatriation Tax – IRS issues further guidance

On June 4, 2018 the IRS issued News Release IR-2018-131.  In this release the IRS address some concerns in regards to penalties associated with the late payment of the first instalment of the transition tax.

New IRC §965, enacted on December 22, 2017 as part of the Tax Cuts and Jobs Act (P.L. 115-97),  imposes a one-time tax on untaxed foreign earnings and profits (E&P) of foreign corporations owned by “United States shareholders”, as defined under the Internal Revenue Code,  by deeming those earnings to be repatriated as a subpart F income.

Earnings and profits held in the form of cash and cash equivalents are taxed at an effective rate of 15.5 percent, for corporations, and up to 17.5 percent for individuals. The remaining earnings and profits are taxed at an effective 8 percent rate, for corporations,  and up to 9 percent  for individuals.

The transition tax generally may be paid in installments over an eight-year period when a taxpayer files a timely election under section 965(h).

Many taxpayers have struggled with understanding these new rules especially given the fact that the IRS continues to issue guidance.  Much of this guidance has been issued AFTER the filer’s original due date.  Though extensions can be filed, the first instalment payments were due by the original due date.

The Release states:

“In some instances, the IRS will waive the estimated tax penalty for taxpayers subject to the transition tax who improperly attempted to apply a 2017 calculated overpayment to their 2018 estimated tax, as long as they make all required estimated tax payments by June 15, 2018.

  • For individual taxpayers who missed the April 18, 2018, deadline for making the first of the eight annual installment payments, the IRS will waive the late-payment penalty if the installment is paid in full by April 15, 2019. Absent this relief, a taxpayer’s remaining installments over the eight-year period would have become due immediately. This relief is only available if the individual’s total transition tax liability is less than $1 million. Interest will still be due. Later deadlines apply to certain individuals who live and work outside the U.S.
  • Individuals who have already filed a 2017 return without electing to pay the transition tax in eight annual installments can still make the election by filing a 2017 Form 1040X with the IRS.”

For individual taxpayers who reside outside the United States, the IRS has previously announced that they would allow the first instalment payment to be made by June 15th, 2018, the “normal” due date for these taxpayers.  This is evident in the last sentence of the first bullet point.  It is not clear, however, if the IRS would also allow nonresident taxpayers to defer their first instalment payment to April 15, 2019.

While providing penalty relief is a step in the right direction, we would hope that the IRS and/or Congress would see fit to exclude United States expatriates from the provisions altogether.  It is clear that the intent of this legislation was to encourage (force?) large U.S. based multi-national enterprises to bring the offshore money back “home” and re-invest in the U.S. to create U.S. jobs.  For individual United States shareholders abroad, it is doubtful that any of these “repatriated” funds would actually be re-invested in the U.S.  In many cases the foreign countries would be the beneficiaries as planning is being undertaken to accelerate foreign tax to eliminate any potential double taxation.   We are hopeful that further IRS guidance will be forth coming.

What is my U.S. taxable year (as it relates to certain Canadian corporations)?

The recently enacted U.S. Tax Cuts and Jobs Act introduced new IRC §965, “Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation.” This onetime tax imposes a “repatriation or transitional tax” on United States shareholders of “specified foreign corporations”.

The term “specified foreign corporation” is defined to mean “(A) any controlled foreign corporation, and (B) any foreign corporation with respect to which one or more domestic corporations is a United States shareholder.”

Many U.S. persons (U.S. citizens or lawful permanent residents) who are resident in Canada own interests in Canadian companies.  If that U.S. person owns 10% or more of the votes or value (the value test being new as of January 1, 2018) then that person is defined to be a “United States shareholder”.  If “United States shareholders,” in aggregate, own more than 50% of the votes or value of the Canadian company that company is a controlled foreign corporation (CFC) and hence a specified foreign corporation for purposes of the repatriation or transitional tax.

The timing of the income inclusion to the shareholder, which then determines when the transitional tax is due, is based on the year end of the specified foreign corporation (i.e., Canadian company).  If the company follows a calendar year the income inclusion is December 31, 2017.  If the company follows a fiscal period, the income inclusion is the year end of the last fiscal period that began before January 1, 2018. For example, if the fiscal year was October 1, 2017 to September 30, 2018, the income inclusion occurs on September 30, 2018.

Many Canadian companies select a fiscal period other than that of the calendar year.  This could be for natural business reasons. For example retailers may select a January 31 year end instead of December 31 to account for the Christmas season. Others may choose a non-calendar year end to defer the taxation of income as long as possible.  In many cases it is not an issue for Canadian tax purposes. For U.S. tax purposes, however, the company may not have a choice.

IRC §898 outlines what the taxable year should be of certain foreign corporations.  In general, the determination of the “required year” is

  1. the majority U.S. shareholder year, or
  2. if there is no majority U.S. shareholder year, the taxable year prescribed under regulations.

Let’s look at a typical situation in Canada, a U.S. citizen resident in Canada who owns 100% of the shares of a Canadian operating company.  The Canadian company is a CFC for U.S. tax purposes since the U.S. citizen Canadian resident owns 100% of the votes and value of the company.  As he is the majority U.S. shareholder, the year of the company should be the same year as he has.

IRC §441(a) states “Taxable income should be computed on the basis of the taxpayer’s taxable year.”  The provision then goes on to define the term “taxable year” to mean the calendar year if certain conditions are not met.

In general, a calendar year is mandatory for an individual who keeps no books, does not have an annual accounting period, or has an annual accounting period that does not qualify as a fiscal year. It is possible for an individual to have a fiscal year but in the vast majority of cases the conditions are not met meaning that they would default to a calendar year filer.

What this means, in our example, is that the reporting period for U.S. tax purposes, of the Canadian company, should be the calendar year NOT a fiscal year since the majority U.S. shareholder’s taxable year is the calendar year.

In our experience the IRS has not addressed the issue of fiscal reporting periods of Canadian CFCs. This could be for many reasons including (i) there is no loss to the U.S. treasury (since non subpart F income is only taxed when distributed); (ii) the taxpayers may to be too small to warrant IRS examination; (iii) the IRS may not be aware of this issue or possibly; (iv) Congress simply does not understand the issues of U.S. citizens living abroad (as evidenced by many of these new rules).

With respect to the IRC §965 income inclusion it raises a potential issue – do fiscal specified foreign corporations need to adjust to a December 31st, 2017 year end to be in compliance with the Internal Revenue Code?  To date, the IRS has not issued any guidance on this point.  Taxpayers, however, need to be aware that they may not be technically in compliance.

IRS Provides Some Relief For U.S. Taxpayers Abroad in Meeting the Repatriation Tax Payment Deadlines

Yesterday, April 2, 2018, the IRS released Notice 2018-26, the long-awaited additional guidance related to the one-time repatriation tax under new IRC section 965, “Treatment of deferred foreign income upon transition to participation exemption system of taxation.” This tax impacts those United States persons who own interests in specified foreign corporations, which includes an interest in a Controlled Foreign Corporation (CFC).  While we are still reviewing the Notice to assess its impact on our clients, we want to timely share one item of relief that the IRS has provided.

As we have mentioned in previous U.S. Tax Tips, an election is available under new IRC Section 965(h)(1) to pay the one-time repatriation tax in instalments over an eight-year period with a payment of 8% of the tax being due this year. Section 965(h)(2) then states that in order for the election to be valid the first payment is required by the due date of the tax return without regard to any extension of time for filing the return.  As such many taxpayers were struggling to come up with a realistic estimate of their cumulative E&P in order to make the required payment.

In the Notice the IRS has provided some relief for a subset of taxpayers.  In Section 2.18 of Notice 2018-26 the IRS recognizes that United States citizens or residents whose tax homes and abodes, in a real and substantial sense, are outside the United States and Puerto Rico are granted an extension of time for filing income tax returns and for paying any tax shown on the return until the fifteenth day of the sixth month following the close of the taxable year under Reg. 1.6081-(5)(a).  For individual taxpayers on a calendar year, this extends the due date of Form 1040 until June 15.

In Section 3.05(e) the IRS addresses the question as to whether the timely payment rule under Section 965(h)(2) negates the extension of time to pay that is available under Regulation 1.6081-5(a).  In its response, the IRS states that, “The Treasury Department and the IRS intend to issue regulations providing that, if a specified individual receives an extension of time to file and pay under §1.6081-5(a), then the individual’s due date for an installment payment under section 965(h) is also the fifteenth day of the sixth month following the close of a taxable year.”

Therefore, it appears that those U.S. persons who own shares in a U.S. Controlled Foreign Corporation, and who live outside the United States, will automatically receive a two-month extension for the payment of the Section 965 repatriation tax.  Extensions granted under Reg. 1.6081-5(a) do not have to be filed in advance, but instead require a statement attached to the tax return stating that the individual is qualified for an extension under Section 1.6081-5(a)..

We will continue to review the IRS guidance on the repatriation tax and will release U.S. Tax Tips as the information becomes available.

Understanding U.S. Due Dates, Extensions and Payment Dates

The due date for a U.S. personal income tax return will depend on both the residence of the taxpayer, the category of the taxpayer and the type of return filed.

Filing Form 1040, “U.S. Individual Income Tax Return”

The regular due date for the filing of a U.S. personal income tax return is generally April 15th of the following year.  If the 15th falls on a Saturday, Sunday or legal holiday, the due date is extended to the next business day.  Since April 15th, 2018 falls on a Sunday, the due date would be extended to the next business day. Monday, April, 16th.  However in Washington D.C., Monday April 16th is Emancipation Day, a legal holiday.  As such, the due date is Tuesday, April 17th, 2018.

If the taxpayer is a U.S. citizen or resident whose tax home and abode, in a real or substantial sense, is outside the United States, the Regulations allow for an automatic extension until June 15th, 2018.  The two-month extension is obtained by attaching an explanation to the taxpayer’s return when it is filed.

If the taxpayer is a U.S. citizen or resident whose tax home and abode are within the United States but is “out of the country” on the regular due date, the taxpayer is allowed the extra two month extension to June 15th, 2018.

Both U.S. resident taxpayers and U.S. taxpayers abroad, however, can file Form 4868, “Application for Automatic Extension of Time to File U.S. Individual Income Tax Return” for additional time to file.  The filing of this form extends the due date for an additional six months in the case of a U.S. domestic filer, to October 15th, 2018.  For U.S. taxpayers abroad, however, the additional extension is only 4 months to October 15th, 2018 as the extension request runs concurrent with the additional 2 month extension allowed per the Regulations.  The IRS cannot refuse this extension request.  The extension must be timely filed, by the regular due date, for the extension to be allowed.

Extensions can be electronically or paper filed. A paper extension will be considered timely filed if it is postmarked by the due date and mailed in an envelope that is properly addressed and has enough postage.

In addition to the six-month extension, taxpayers who are out of the country may request an additional two month extension to December 15th, 2018.  This extension, however, is not automatic and at the discretion of the IRS.  To request this extension, taxpayers must send a letter to the IRS (before October 15th, 2018) explaining why the additional two months is needed. If the extension is allowed the IRS will NOT respond to your request. They will only respond if they deny the request. When this extension request is denied, taxpayers have an additional 10 days to file before the return will be considered late.

Filing Form 1040NR, “U.S. Nonresident Alien Income Tax Return

The due date for non-resident aliens, who do not earn wages subject to U.S. income tax withholding, is June 15th, 2018.  Filing Form 4868 extends the due date to December 15th, 2018.

If the nonresident alien has wages, subject to U.S. withholding, the due date is April 18th, 2018.  Again an extension to October 15, 2018 is available.

Form 8840, “Closer Connection Exception Statement for Aliens

If you are filing a Form 1040NR, because you have U.S. source income, Form 8840 should be attached to Form 1040NR and filed by the due date (including extensions).    If you do not have to file Form 1040NR, then Form 8840 should be filed, independently, by the due date (including extensions) for filing Form 1040NR.

Payment dates

The filing of an extension does not, however, extend the payment due date.

For U.S. resident taxpayers or non-resident aliens with wages subject to U.S. income tax withholding, the payment due date is April 18th, 2018.

For other non-residents aliens and for U.S. citizens and residents abroad, the payment due date is June 15th, 2018.

If a return is not timely filed, including extensions, the IRS will impose a failure-to-file penalty of 5% for each month or part of a month up to a maximum of 25%.  The penalty is based on the amount of unpaid taxes, if any, owed by the filing due date.

If at least 90% of the ultimate balance due has not been paid by the original due date, the IRS will impose a failure-to-pay penalty of 0.5% per month up to a maximum of 25%.  If the failure-to-file penalty and the failure-to-pay penalty both apply in any month, the combined maximum penalty for that month will be 5%.

The IRS will also impose interest on any unpaid balance until paid (this includes tax and any penalties).  The interest rate is determined quarterly and is the federal short-term rate (known as the applicable federal rate or AFR) plus 3%. The short-term AFR for April 2018 is 2.12%.

Understanding the U.S. Days Counting Test and U.S. Tax Residency

In most countries an individual’s tax residency is determined by their residential ties, which considers one’s own unique “facts and circumstances”.  In Canada, for example, there is no statutory definition of “residency” contained in the Canadian Income Tax Act.

In the United States, however, tax residency is a more rigid process.  If you are not a U.S. citizen nor a lawful permanent resident (i.e. green card holder) residency is determined by the number of days an individual is physically present in the country.  For this purpose, each part of a day in the U.S. is counted as a day, whether for business or pleasure (or both).  An individual who spends “too many days” in the U.S. may unintentionally become a U.S. tax resident.

Substantial Presence Test

How does the U.S. determine what is “too many days”?  This is computed under the “Substantial Presence Test” or “SPT”.  First the individual must have at least 31 days of physical presence in the current year.  If the individual has less than 31 days in the current year, the SPT does not apply. If the individual has 31 days or more then the SPT applies the following formula:

All of the days in the current year +
1/3 of the days in the preceding year +
1/6 of the days in the second preceding year

If the result is 183 days or more, then the individual meets the SPT and will be considered a U.S. tax resident, under US domestic tax law, unless an exception applies.

Exceptions to the Substantial Presence Test

There are a few exceptions to the Substantial Presence Test.  These include:

  • Closer Connection to Another Country – An individual who meets the SPT but who spends less than 183 days in the U.S. in the current year and who has a closer connection to another country can claim a Closer Connection Exception. To claim this exception, an individual must file Form 8840, “Closer Connection Exception Statement for Aliens”,  each year along with their U.S. tax return, or by June 15 if no U.S. tax return is required.  An individual who spends more than 183 day or more in the current year cannot use the Closer Connection Exception.  Those wishing to file as a U.S. nonresident, in determining any potential U.S. tax exposure, must then file under a tax treaty (see below).
  • Exempt Individuals – Individuals do not have to count the days that they are in the United States as an “exempt individual”. These are defined as:
    • An individual temporarily present in the U.S. as a foreign government-related individual under an “A” or “G” visa, other than individuals holding “A-3” or “G-5” class visas;
    • A teacher or trainee temporarily present in the U.S. under a “J” or “Q” visa, who substantially complies with the requirements of the visa;
    • A student temporarily present in the U.S. under an “F,” “J,” “M,” or “Q” visa, who substantially complies with the requirements of the visa;
    • A professional athlete temporarily in the U.S. to compete in a charitable sports event.

    Exempt individuals must file a Form 8843, “Statement for Exempt Individuals and Individuals with a Medical Condition” along with their U.S. tax return, or if no tax return is required by June 15, in order to claim the exemption.

  • Medical Condition – Individuals who are unable to leave the United States because of a medical condition that arose while in the U.S. can exempt some of these days. To claim this exemption, the individual must file a Form 8843 along with their U.S. tax return, or by June 15 if no U.S. tax return is required.

If a Form 8840 or 8843 is not filed on time, an individual cannot claim an exemption from the Substantial Presence Test.  This will not apply if the individual can prove that he took reasonable action to become aware of the filing requirements and significant steps to comply with those requirements.

Canada-United States Tax Convention (1980) aka the “Treaty”

If an individual meets the SPT and does not meet one of the exceptions listed above, he is a U.S. tax resident under U.S. domestic law. What happens, however, if the individual spends more than 183 days in the current year alone?

Individuals who are also Canadian tax residents and who maintain residential ties closer to Canada, than the U.S., can use the residency tie breaker rules, contained in Article IV, to override U.S. domestic law.  This is done by filing a U.S. Form 1040NR, “U.S. Nonresident Alien Income Tax Return, by the due date along with a Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b)” claiming an exception from U.S. taxes under the Treaty.  If there is no U.S.-source income to report, then there is no U.S. tax to pay.

The downside of this is that the Treaty only reduces or eliminates any potential U.S. tax. It does not eliminate any filing obligations the nonresident may have.  Individuals who are considered U.S. nonresidents, by way of a Treaty, are still subject to the foreign reporting requirements of a U.S. resident.  Keep in mind that anything Canadian is considered “foreign” in this context.  Some of these additional filings may include:

Foreign bank accounts – FinCEN 114, “Report of Foreign Bank and Financial Accounts

Foreign corporations – Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations

Foreign partnerships – Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships

Foreign trusts – Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts

Foreign trusts – Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner

Foreign mutual funds – Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund

If an individual becomes a tax resident and is unable to claim an exception or use the Treaty, then he will be required to report his worldwide income to the U.S. and comply with all foreign reporting required of U.S. persons.  While foreign tax credits may offset some or all of the U.S. tax payable, it can still be a timely and expensive process.

It’s important to keep in mind that the Substantial Presence Test, the exceptions, and the Treaty override are all related to U.S. federal tax residency rules.  Each individual state has its own residency rules as well.  These should be reviewed as well.

Cadesky U.S. Tax can analyze your unique situation and help you keep onside with the U.S. tax residency rules.  Please contact us for an appointment to discuss your situation.

IRS Announces the end of the Offshore Voluntary Disclosure Program though Streamlined is still around – for now

On March 13, 2018 the Internal Revenue Service announced (IR-2018-52) that it will close the 2014 Offshore Voluntary Disclosure Program (OVDP) on Sept. 28, 2018.  Acting IRS Commissioner David Kauffer states

“Taxpayers have had several years to come into compliance with US Tax Laws under this program. All along, we have been clear that we would close the program at the appropriate time, and we have reached that point. Those who still wish to come forward have time to do so.”

Beginning in 2009, the IRS initiated a series of offshore voluntary disclosure (OVD) programs to settle with taxpayers who had failed to report offshore income and file any related information return such as the FBAR.  According to the IRS more than 56,000 taxpayers have used one of the programs to comply voluntarily. All told, those taxpayers have paid a total of US $11.1 billion in back taxes, interest and penalties.

The planned end of the current OVDP also reflects advances in third-party reporting and increased awareness of U.S. taxpayers of their offshore tax and reporting obligations.  With respect to U.S. persons living in Canada, the enactment of the U.S. Foreign Account Tax Compliance Act (FATCA) and the signing of the Intergovernmental Agreement (the “IGA”), between the Government of Canada and the Government of the United States of America, required Canadian financial institutions to report information about their U.S. customers to the IRS (indirectly via the Canada Revenue Agency).

The number of taxpayer disclosures has decreased substantially over the years with only 600 disclosures in 2017. Unlike Canada, the IRS does not have an on-going voluntary disclosure program.  All programs have a specific beginning and end date.

Tax Enforcement

The IRS notes that it will continue to use tools besides voluntary disclosure to combat offshore tax avoidance, including taxpayer education, Whistleblower leads, civil examination and criminal prosecution. Since 2009, IRS Criminal Investigation has indicted 1,545 taxpayers on criminal violations related to international activities, of which 671 taxpayers were indicted on international criminal tax violations.

“The IRS remains actively engaged in ferreting out the identities of those with undisclosed foreign accounts with the use of information resources and increased data analytics,” said Don Fort, Chief, IRS Criminal Investigation. “Stopping offshore tax noncompliance remains a top priority of the IRS.”

Streamlined Procedures and Other Options

Effective September 1, 2012, the IRS introduced the Streamlined Filing Compliance Procedures.  These procedures were introduced  for taxpayers who might not have been aware of their filing obligations.

The Streamlined Filing Compliance Procedures will remain in place and available to eligible taxpayers. Similar to OVDP, the IRS has said it may end the Streamlined Filing Compliance Procedures at some point.

Because the circumstances of taxpayers with foreign financial assets vary widely, the IRS will continue offering the following options for addressing  previous failures to comply with U.S. tax and information return obligations with respect to those assets:

  • IRS-Criminal Investigation Voluntary Disclosure Program;
  • Streamlined Filing Compliance Procedures;
  • Delinquent FBAR submission procedures; and
  • Delinquent international information return submission procedures.

What you need to do

If you are a US person and you have not brought your past filings into compliance time is running out.  If you do not file under one of the IRS programs you may be subject to significant penalties for non-compliance.  Cadesky US Tax has a long history of assisting clients with bringing their past filings up to date.  We can also assist with renunciation should that be an option you wish to examine.

Please do not hesitate to reach out to any member of the Cadesky US Tax team if you have any questions.

The importance of E&P – Will you be paying the right amount of tax to the IRS?

An accurate determination of “earnings and profits” (E&P) of a foreign (i.e., Canadian) corporation is often an overlooked step in U.S. tax reporting for controlled foreign corporations (CFC).  In many cases book retained earnings was or is used as a proxy and no adjustments were made to convert book retained earnings to E&P.  To the extent that distributions were significantly less than book retained earnings the inaccuracy of the accumulated E&P balance was not a current tax issue assuming there was sufficient “cushion” in the retained earnings balance.

That changed on December 22, 2017 when President Trump signed into law sweeping changes to U.S. tax legislation.  The legislation provides for a one time transitional tax, for specified foreign corporations (which includes controlled foreign corporations) and subjects all undistributed post-1986 earnings and profits (E&P), for these entities, to a deemed repatriation. Since all E&P will be distributed the inaccuracy of book retained earnings will now be an issue. This deemed repatriation will result in a potential U.S. tax of 15.5% or 8% (depending on the characterization of the accumulated E&P).

Calculating your E&P accurately

Given the importance of E&P it is not, however, defined in the Internal Revenue Code (IRC).  E&P measures a corporation’s overall ability to pay dividends.  It is an economic concept based upon and related to (U.S.) taxable income.  When determining E&P all facts must be considered. E&P is used to determine whether any distributions are a taxable dividend, a tax free return of capital or a capital gain.

Due to the lack of a statutory definition, one needs to look at the regulations, administrative guidance and other sources to determine it accurately.

IRC Sec. 964 and Regulation. Sec. 1.964-1(a) provides guidance on the three main steps in determining E&P for foreign entities.

  1. Prepare a profit and loss statement with respect to a year from the books of accounts regularly maintained in the local country. This may be in a foreign currency.
  2. Make the necessary adjustments to conform such statement to the accounting principles generally accepted in the United States (GAAP).
  3. Make further adjustments to conform to tax accounting standards of the United States.

Important to note: although retained earnings per foreign country books and GAAP are a good estimate of E&P, they do not include the necessary adjustments to compute E&P.

Current year income per foreign books of accounts in foreign currency are reconciled to current year E&P (per US financial and tax accounting standards) in USD.  Some common items that may require adjustment are as follows (the list is not comprehensive):

  • Tax-free reorganizations and/or liquidations in the foreign country that are not tax-free for US tax purposes.
  • Depreciation, depletion, and amortization allowances must be based on the historical cost of the underlying asset, and depreciation must be computed according to US tax law.
  • Inventories must be taken into account according to US tax rules dealing with valuation and capitalization and the related regulations.
  • An adjustment needs to be made for meals and entertainment which are non-deductible or only 50% deductible for US tax purposes.
  • Income Taxes must be adjusted for temporary and permanent differences between book provisions vs. amounts deductible for tax purposes. The impact of refundable taxes must also be considered.
  • Nondeductible fines/penalties are deductible in computing E&P as they represent a cash outlay.
  • Foreign Currency Adjustments
  • Accrued Bonus, Deferred Compensation and other salary expenses which maybe deductible for book but not tax purposes.

 

Un-booked adjustments can cause a material variance between book retained earnings and E&P for purposes of US tax reporting of a foreign corporation.

Is the E&P of your foreign corporation accurately stated? If not, please do not hesitate to contact us. At Cadesky U.S. Tax we can help in determining the E&P for a corporation owned by you or related to you.

IRS Form 5472 : An easy but expensive filing obligation to overlook?

Recent media coverage, as it relates to U.S. tax in Canada, has almost entirely focused on the U.S. Tax Cuts and Jobs Act, in particular the deemed repatriation of foreign earnings provision.  An important issue, that did not receive significant coverage, was that the U.S. Senate version of the tax reform legislation, had proposed increasing the penalty for a late, improperly filed, or incompletely filed, Form 5472, “Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business”.  The penalty was to increase to $25,000 (per form; per year).

While the proposal was not included in the final legislation, it clearly highlights the importance of this form to U.S. legislators. Now maybe a good time to “play catch -up” as the proposed increase may be considered again in the future. The current penalty for non-compliance is $10,000 (per form; per year) which, while it is a high penalty, is significantly lower than what was proposed.  In certain instances the IRS may abate penalties if the taxpayer has a reasonable cause for the infraction. Unlike Canada, many of the U.S. information returns do NOT have a     de minimis level.

Form 5472 reports information that is required when reportable transactions occur during the tax year of a reporting corporation with a foreign or domestic related party. It is important that the Form (exceptions apply) needs to be filed for each reportable transaction with each related party.

Important change for tax year 2017: The definition of a reporting corporation was expanded to include 100% foreign- owned disregarded entities. This applies to tax years of entities beginning on or after 1 January 2017.

Who needs to file i.e. the Reporting Corporation?

There are three types of reporting corporations

a. New to 2017 tax year – 100% Foreign-Owned Domestic Disregarded Entities (including US LLCs)

These entities are disregarded for U.S. income tax purposes (unless they make an election to be taxed as a corporation). The LLC does not file a U.S. return at the entity level (as the income is reported by the 100% foreign owner on their U.S. return). These entities will now need to apply for an employer identification number (EIN) in order to complete the form. The owner of the LLC must now complete Form 5472 by the due date.

For example: Mr. X is a Canadian resident individual taxpayer who owns U.S. real estate in Orlando through a Florida LLC.  He owns 100% of the LLC. Since Mr. X owns the LLC 100% (and assuming that he did not make an election for the LLC to be taxed as a corporation), Mr. X will report the gross income and expenses, from the U.S. real estate, on his U.S. personal income tax return,  Form 1040NR, “U.S. Nonresident Alien Income Tax Return”.  He was not required to file Form 5472 (as the LLC was a disregarded entity for tax purposes).

New rules: While Mr. X can continue to file Form 1040NR, to report the income and expenses from the U.S. real estate (the LLC still being a disregarding entity for income tax purposes), the LLC is no longer disregarded for purposes of Form 5472. The LLC now meets the definition of a reportable corporation. Mr. X will now be responsible to complete and file Form 5472 on behalf of the U.S. LLC.  He will also be required to obtain an Employer Identification Number (EIN) for the LLC.

b. 25% Foreign-Owned Domestic Corporation (Form 1120 Filers)

A foreign corporation that is at least 25% foreign- owned (measured by votes or value of all classes of stock) that has a “reportable transaction during the year”. Attribution and constructive ownership rules will apply in determining the 25% threshold. While certain exceptions do apply, the IRS has in the past disregarded formal arrangements to shift voting-control, and takes a substance over form approach.

c. Foreign Corporations with U.S. Trade or Business (1120-F filers)

A foreign corporation engaged in a trade or business in the United States at any time during the year including foreign corporations that are partners in a partnership engaged in a U.S. trade or business. Certain exceptions apply to corporations that do not have permanent establishment in the U.S. (under applicable treaty).

What is a reportable transaction?

A reportable transaction is any monetary and certain non-monetary transactions that occur between the reporting corporation, the 25% foreign owner and any foreign or domestic party related to the owner. These transactions include, but are not limited, to sales of inventory, sale of property, cost sharing arrangements, rents, royalties, management fees, commissions, loans, capital contributions, distributions, services provided etc.

When is the form due?

Form 5472 should be attached to the reporting corporation’s income tax return and is due at the same date as the return itself (including extensions). A $10,000 penalty maybe assessed to the reporting corporation for non-compliance. The penalty applies to late, improperly filed and incomplete filings.  In certain cases criminal penalties may also apply. Disregarded entities with no current filing obligation will need file a pro-forma Form 1120 and attach Form 5472 to it, by the due date of Form 1120 (15th day of the 4th month after the year end or April 15th, 2018)

How we can help?

At Cadesky U.S. Tax we understand what these rules are and how they may impact you or your clients. To determine whether this form applies to a corporation owned by or related to you please do not hesitate to contact us.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

Understanding Constructive Share Ownership

The Tax Cut and Jobs Act (TCJA) has significant implications for United States persons who own shares in a Controlled Foreign Corporation (“CFC”), which is a non-U.S. corporation that is more than 50% owned (votes or value)  by “United States”  shareholders.  In determining whether a corporation is a CFC, for U.S. tax purposes, it is necessary to review the corporation’s share register to determine who the ultimate U.S. shareholders are.

One, however, does not only look at shares directly held by a United States person.   One must also look at shares indirectly owned and shares constructively owned.  This is true in a U.S. domestic context but even more so in the case of a foreign corporation.

The constructive ownership rules, however, do NOT attribute income.  These rules are only used to determine the status of the foreign corporation for U.S. tax purposes.

Internal Revenue Code (IRC) section 318 provides the basic rules in determining constructive ownership.  The provisions address ownership to or from family members, to or from partnerships, estates, trusts and corporations and where a person holds options.  In context of foreign corporations, IRC section 958 modifies section 318 as required.

Members of family

In general, an individual shall be considered as owning the stock owned directly or indirectly by his spouse, children, grandchildren and parents.  A legally adopted child is treated as a child.  Note that the definition does not include siblings, nieces or nephews.  The general provision is modified such that an individual is NOT considered as owning stock if the family member is a nonresident alien.  Constructive ownership only applies from a U.S. person to another U.S. person.

From an estate

Property of a decedent shall be considered as owned by his or her estate if such property is subject to administration by the executor or administrator.  The term “beneficiary” includes any person entitled to receive property of a decedent pursuant to a will or pursuant to laws of descent and distribution.

From a trust

Any stock owned directly, or indirectly, by or for a non-grantor trust will be considered as being owned by its beneficiaries only to the extent of the interest of such beneficiaries in the trust.  Accordingly, the interest of income beneficiaries, remainder beneficiaries, and other beneficiaries will be computed on an actuarial interest.  In computing a beneficiary’s actuarial interest the “factors and methods” prescribed in the Estate Tax regulations shall be used in determining a beneficiary’s actuarial interest for these purposes.

Any stock owned directly, or indirectly, by a grantor trust are treated as being owned by the grantor or owner of the trust.

From a corporation

If 50 % or more in value of stock in a corporation is owned, directly or indirectly, by or for a person, such person shall be considered as owning the stock owned by or for such corporation, in that proportion which the value of the stock which such person owns bears to the value of all the stock in such corporation.

For example assume Albert owns 70% of Holdco and Robert owns the remaining 30%. Holdco owns 50% of Opco while Albert owns, directly, the remaining 50% of Opco.  Since Holdco owns 50% or more in Opco it will be deemed to own 100% of Opco . In addition, Albert will be considered as owning  85% in Opco – 50% directly and 35% indirectly (70% x 50%).

Conclusion

The U.S. constructive ownership rules can be complicated, especially in a foreign corporation context.  Cadesky U.S. Tax can assist in determining the status of your foreign corporation for U.S. tax purposes.  If you require our assistance please do not hesitate to reach out to us.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

Changes to U.S. “Kiddie Tax” Rules

With both the increases in Canadian personal tax rates, over the last few years, and the new changes to the tax on split income (TOSI) rules, many Canadians are reviewing ways to effectively split income between family members in order to lower the family’s combined taxes.  With Canadian prescribed rates slated to increase from 1% to 2% on April 1, 2018, many Canadians are rushing to set up loans to family trusts at the 1% prescribed rate. If you’re an American who is resident in Canada, you may want to slow down. If you already have a prescribed rate loan in place you may want to consider repaying it. If either the contributor or beneficiaries of the trust are U.S. persons, recent changes in the U.S. may reduce the overall impact of this strategy.

Since January 1, 1987, the United States has imposed a “kiddie tax” on the unearned income of certain children. The Tax Cut and Jobs Act has changed, effective January 1, 2018, how this tax is computed.

In general, unearned income is defined as the excess of the portion of the adjusted gross income (“AGI”) for the taxable year which is not attributable to earned income.  The term “earned income” means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered including self-employment income.  Unearned income is meant to capture investment income such as interest, dividends, rents, royalties, annuities and capital gains, etc.

The kiddie tax applies to a (U.S.) child if either of the following two conditions are true:

  • the child has not reached age 18 by the end of the taxable year; or
  • the child has not reached age 24, their earned income is not more than one-half of their support, and they must be a full-time student;

U.S. kiddie tax applies unless all three of the following conditions are true:

  1. the child is required to file a return for the year;
  2. the child has at least one parent alive at the close of the taxable year; and
  3. the child will not file a joint return for the taxable year.

Under the previous legislation there were two possible methods to compute this additional tax liability.  With either method, essentially, the tax on the unearned income was computed at the parent’s marginal tax rate.

The first method allowed the parents to include the net unearned income, of all affected children, on the parent’s U.S. personal income tax return.

The second method determined an “allocable parental tax” which was then included on the child’s tax return.  In general, the “allocable parental tax” represented the child’s portion of the additional tax that would have been paid by the parents if the child’s, and other effected children’s, unearned income was taxed on the parent’s U.S. personal tax return.  This would have represented the marginal tax increase.

The IRS had issued temporary regulations which outlined various family scenarios to assist in determining which parent’s tax return would be used as the base in computing the “allocable parental tax”.  One scenario, that the Regulations do not address, is the situation where there is a U.S. child but both parents are non-resident aliens.  This would happen, for example, if the parents were in the U.S. on a temporary basis (work assignment, attending school, etc.) and had the child while there were temporarily resident in the United States.  It does not appear that the IRS has provided any guidance as to whether the U.S. kiddie tax rules would apply to the U.S. child and, if it does, any guidance as to how it would apply.

Effective January 1, 2018 that is a moot point.  The computation of the U.S. kiddie tax no longer refers to the taxable income nor the actual U.S. tax of the parents.  Instead the kiddie tax must now be computed under the estate and trust tax table.    These tables provide for very compressed brackets where by the top marginal rate of 37% is reached for taxable income in excess of US $12,500.  Qualified dividends and long term capital gains (LTCG) still qualify for the lower marginal tax rates but the 15% rate is maxed out at US $12,700.  Any LTCG and qualified dividends would then be taxed at the maximum 20% rate.

Given that Canadian personal marginal tax rates may exceed 50%, there are instances where planning may still result in overall tax savings.  Cadesky U.S. Tax can assist in helping you understand the impacts of these rules and to assist in any required planning.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.