Topic: U.S. Tax Tip

CARES Act – Changes to Net Operating Loss Carry Forwards

In prior U.S. Tax Tips we looked at who is eligible for the Economic Impact Payment (also known as the COVID-19 Stimulus Check), under the CARES Act.  This US $1,200 payment is for eligible individuals which includes U.S. persons who live abroad.  The CARES Act also has a number of provisions that are aimed primarily at businesses based in the United States and would provide little benefit to U.S. persons abroad.  There are, however, other potential provisions that may be relevant for U.S. persons abroad.  One such provision relates to the utilization of net operating losses (NOLs).

In general, the 2017 Tax Cuts and Jobs Act (TCJA) limited the amount of losses from the trades or businesses of noncorporate taxpayers that the taxpayer could claim each year. Taxpayers could no longer deduct overall net business losses that are more than a threshold amount in the current year, the threshold being 80% of taxable income (determined without any NOL deduction). The amount of the excess business loss is treated as an NOL carryover in the subsequent year. The ability to carry back an NOL to a prior year was eliminated.

The IRS has now issued guidance (IR 2020-67 and Rev. Proc. 2020-24) outlining changes under the CARES Act which have relaxed or suspended a number of the TCJA restrictions.  NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021 may now be carried back to each of the five tax years preceding the tax year of such loss.  The CARES Act also temporarily removes the 80% limitation, reinstating it for tax years beginning after 2020.

As a result of changes under the CARES Act, taxpayers with eligible NOLs may now be able to claim a refund for tax returns from prior tax years. The CARES Act did not modify IRC Section 172(b)(3), meaning that a taxpayer can still waive the carryback and elect to carry NOLs forward to subsequent tax years.

Taxpayers that own a controlled foreign corporation (CFC) need to consider the interaction of an NOL carryback with other IRC provisions such as IRC §965 (known as the “transition tax”).  IRC §965 dealt with the (forced) repatriation of a deferred corporation’s earnings and profits as at November 2 or December 31, 2017 (whichever E&P was higher).   The CARES Act does not generally prohibit taxpayers from using an NOL from a tax year with a lower corporate tax rate (e.g., 2020) to offset taxable income that was subject to a higher corporate tax rate in an earlier tax year (e.g., 2017).

Taxpayers may also want to consider how a carry back of an NOL will affect any foreign tax credits claimed or AMT paid in the prior year.  We at Cadesky U.S. Tax can assist with any required computations.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.

Stranded in the United States? IRS provides COVID-19 guidance

As we have discussed in prior U.S. Tax Tips, the determination of residency in the United States is a question of fact.  If you are not a U.S. citizen nor a lawful permanent resident (i.e. a green card holder) you will be a U.S. tax resident under U.S. domestic law if you satisfy the substantial presence test.   Under this test, a nonresident alien will become a U.S. resident if they are physically present, and those days are not statutorily excluded, in the United States (i) over 182 days in the current year or (ii) over 182 days under the three year rolling average test.  The total number of days, as computed under the three year rolling average test, equals

The number of days in the current year
+
(the number of days in the first prior year x 1/3)
+
(the number of days on the second prior year x 1/6).

If a nonresident alien becomes a U.S. resident under U.S. domestic law they would be required to file a U.S. income tax return and, potentially, pay U.S. taxes.  When a person is considered a U.S. resident it may also be possible, however, to rely on the residency tie-breaker rules of a bilateral tax convention.

Because of the current COVID-19 pandemic many nonresidents are stuck in the U.S. This may be due to border closures or airlines suspending international flights, etc.  Absent any statutory relief this unexpected time in the United States would count towards meeting the substantial presence test as the nonresident alien is physically present in the United States.

On Tuesday, April 21st, the IRS issued Rev. Proc. 2020-20 and Rev. Proc. 2020-27 and a list of FAQs.  Under this guidance the IRS stated that travelers who meet certain requirements won’t be subject to taxes if they are stuck in the U.S. because of virus-related restrictions.

Under Rev. Proc, 2020-20, a nonresident alien can choose a 60 consecutive day period beginning on or after February 1, 2020, and on or before April 1, 2020, while they were “stuck” in the United States.  This period is defined as the COVID-19 Emergency Period.

A nonresident alien, who intended to leave the United States during the individual’s COVID-19 Emergency Period, but was unable to do so due to COVID-19 Emergency Travel Disruptions, may exclude the individual’s COVID-19 Emergency Period for purposes of applying the substantial presence test.  These days will be considered to be a Medical Condition Travel Exception.  Such days are statutorily excluded (not counted) when determining the days of physical presence under the substantial presence test.

In addition, an individual’s eligibility for treaty benefits with respect to income from employment or the performance of other dependent personal services within the United States, any days of presence during the individual’s COVID-19 Emergency Period on which the individual was unable to leave the United States due to COVID-19 Emergency Travel Disruptions, will not be counted.   .

Similarly U.S. persons, who live abroad (their tax home is bona-fide outside of the United States), may temporarily be stuck in the United States.  To qualify for the foreign earned income (FEI) exclusion, under IRC §911, the taxpayer must be resident in the foreign country for a certain number of days each year.

Rev. Proc. 2020-27 states that qualification for gross income exclusions won’t be impacted by days spent away from a foreign country due to travel restrictions. The relief applies to foreign individuals who had reasonably expected to meet the threshold requirements during 2019 or 2020, and is valid through July 15, 2020, unless further extended by Treasury.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.

Rules Regarding Certain Hybrid Arrangement

On April 7, 2020 the United States Treasury and the Internal Revenue Service released final and proposed regulations aimed at curbing hybrid mismatch arrangements.  A hybrid mismatch occurs when a transaction is treated differently between countries and one of the main reasons of the transaction is to avoid taxes both in the foreign country and in the United States.

Rules preventing hybrid mismatch arrangements were part of the Organization for Economic Cooperation and Development’s (OECD) project to curb base erosion and profit shifting (BEPS). The 2017 Tax Cuts and Jobs Act (TCJA) implemented some of the OECD’s anti-hybrid guidance into the U.S. Internal Revenue Code.

Previous proposed regulations (REG-104352-18) were issued on December 28, 2018.  These regulations, (at 217 pages) as amended by comments received, are now final effective as of the date of their publication in the Federal Register.  These regulations provide guidance for IRC§§ 245A(e), 267A, 1503(d), 6038, 6038A, 6038C and 7701.

New proposed regulations (REG-106013-19) were also issued.  These regulations are intended to provide “Guidance Involving Hybrid Arrangements and the Allocation of Deductions Attributable to Certain Disqualified Payments under Section 951A (Global Intangible Low-Taxed Income)”.  These proposed Regulations encompass 59 pages of guidance.

What is a hybrid mismatch?

Entities may be classified differently in different countries.  In addition, under U.S. tax law it may be possible to choose an entity classification under the U.S. “check-the-box” rules.  For example, under U.S. tax law (absent an election under the “check-the-box” rules) a Limited Liability Company (LLC) is treated as disregarded entity for U.S. tax purposes.  If the LLC is a single member entity it is taxed as a sole proprietorship.  If it is a multi-member LLC, it is treated as a partnership for U.S. tax purposes.  In the U.S., an LLC does not pay tax, the LLC members do.

Many foreign countries, however, treat an LLC as a corporation and the corporation would pay the tax.  As such, we have a hybrid mismatch, a taxable entity in the foreign country and a disregarded entity in the U.S.  Ultimately we have different taxpayers responsible for paying the tax.

Sophisticated tax planning has been undertaken to take advantage of this mismatch.  Such planning would lead, for example, to deducting expenses twice (once in the foreign country and again in the United States) or the non-recognition of income.  It is this type of planning that led to the OECD BEPS initiative, changes to the Internal Revenue Code, and the issuance of the Regulations.  In general, the main rationale for these provisions, is that income needs to be taxed somewhere (either in the foreign country or in the United States).

An example

Assume that we have a U.S. domestic corporation that owns a controlled foreign corporation (CFC 1) in a high tax jurisdiction.  As a “United States shareholder” (a defined term under the IRC), the U.S. domestic corporation would be subject to the U.S. subpart F provisions, GILTI and the deduction under IRC §245A (Deduction For Foreign Source-Portion Of Dividends Received By Domestic Corporations From Specified 10-Percent Owned Foreign Corporations).  

Further assume that CFC1 creates a subsidiary, CFC 2, in another low tax jurisdiction.  CFC 1 funds CFC 2 with 100% equity.   CFC 1 then borrows the entire amount of funds which capitalized CFC 2.  CFC 1 then pays interest to CFC 2 and deducts the interest expense in computing its taxable income under the laws of the country in which CFC 1 is resident.  CFC 2 may or may not have taxable income depending on the laws of country 2.

If CFC 2 is or has elected to be a disregarded entity (under U.S. tax law), for U.S. tax purposes, this transaction is completed ignored as CFC2 would be considered to be a branch of CFC 1.  If properly structured minimal or no foreign taxes may have been paid.

When CFC 1 then repatriates funds back to the U.S. parent (as a dividend), absent any anti-avoidance provisions, in general the dividend would not be taxable in computing U.S. taxable income.

The changes to the IRC and the Regulations aim to prevent this type of abuse.  Such a dividend may be classified as a “hybrid dividend” or “tiered hybrid dividend” and would not be deductible in computing U.S. taxable income.

The above example is not meant to be definitive but is just meant to give the reader an idea of one area of potential abuse.

Why should I care?

When structuring U.S. inbound or outbound investments, it is important to understand the potential U.S. tax implications if entities are, are can be, treated differently in the foreign country and the United States.  Failure to understand and plan accordingly can lead to unexpected and undesirable tax outcomes.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.

Update on IRS Filing Guidance and 2020 Recovery Rebate

2019 Filing Due Dates

In previous U.S. Tax Tips we have reported that the U.S. Congress has extended the tax payment and filing deadline for those with an April 15, 2020 due date to July 15, 2020.  Relief is automatic; affected taxpayers do not have to call the IRS or file any extension forms, or send letters or other documents to receive this relief. However, not all taxpayers (i.e., June 15th filers) were accorded this automatic extension. 

On April 9th, the IRS released IR-2020-66 and IRS Notice 2020-23.  The IRS now states that all payments and filings due on or after April 1st, 2020 and before July 15th, 2020 will now receive an automatic extension to July 15th, 2020.  This extension applies to nonresident aliens filing Form 1040NR, “U.S. Nonresident Alien Income Tax Return,” to U.S. citizens living abroad, and other filers.

Taxpayers can still request an additional time to file by filing the appropriate extension form.  For individuals that is Form 4868, “Application for Automatic Extension of Time to File U.S. Individual Income Tax Return.”  The IRS guidance indicates that at this time, these “normal” extension deadlines are not, themselves, extended.

As a result of the postponement of the due date for filing, the period beginning on April 1, 2020, and ending on July 15, 2020, in general, will be disregarded in the calculation of any interest, penalty, or addition to tax for failure to file or to pay payments postponed by this notice. Interest, penalties, and additions to tax with respect to such postponed payments will begin to accrue on July 16, 2020.

Should I e-file or paper file my U.S. tax return?

The IRS recommends that all taxpayers file their returns electronically through their tax preparer, tax software provider or IRS Free File if possible.

The IRS is not currently able to process individual paper tax returns. The IRS also advises that if you have already filed your return via paper filing but it has not yet been processed, do not file a second tax return or write to the IRS to inquire about the status of your return. Paper returns will be processed once the processing centers are able to reopen.

At Cadesky U.S. Tax, we routinely e-file our clients’ U.S. tax returns whenever possible.  However, some U.S. tax returns do no qualify for electronic filing and must still be paper filed.

2020 Economic Impact Payment Update

In a prior U.S. Tax Tip we provided information regarding the US $1,200 cash rebate (the 2020 Recovery Rebate advance payment) as provided for in the CARES Act. However, many eligible taxpayers were not able to receive the payment since they were not required to file a 2018 nor 2019 U.S. individual income tax return (for example, those whose income was below the filing threshold). 

To address this issue, the IRS launched a new web tool allowing for quick registration for those who don’t normally file a tax return, to qualify for the Economic Impact Payments.  The feature is available only on IRS.gov, and users should look for Non-filers: Enter Payment Info Here.

Taxpayers who use this tool will need to provide basic information including their Social Security Number, name, address, and dependents. The IRS will use this information to confirm eligibility, calculate and send an Economic Impact Payment. Entering bank or financial account information will allow the IRS to deposit your payment directly into your U.S. bank account. The IRS does not make deposits to foreign bank accounts, instead the IRS will mail a check to the last address they have on file.

The IRS is reviewing their procedures with respect to Social Security recipients who may have not been required to file a U.S. individual income tax return.  They hope to provide guidance for these individuals in the near future.

We will continue to monitor IRS guidance as it is released and provide relevant information in future U.S. Tax Tips.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.  If you require our assistance please do not hesitate to reach out to us.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act What does it mean for Americans Abroad?

On March 27th, 2020 President Trump, signed into law, the largest stimulus package in U.S. history, estimated at some US $2.2 trillion. The CARES Act is the U.S. federal government’s response to the COVID-19 pandemic and its impact on the U.S. economy.  The CARES Act passed the United States Senate on March 25th, 2020, by a vote of 96-0 and passed the House by a voice vote on March 27th, 2020. It is estimated that out of those funds, in addition to individual rebates, that some $510 billion will go towards loans and grants to large companies, $377 billion towards smaller businesses, and $260 billion for expanded and extended unemployment benefits.

An estimated $290 billion will be used for individual tax rebates, known as the 2020 Recovery Rebate. The rebate will be claimed as a credit against the taxpayer’s income tax liability for the first taxable year beginning in 2020.  The payments represent an advance on that credit.

The United States State Department has estimated that at any one time up to 7 million Americans may be living abroad.  In our mind, there are two immediate questions:

  1. How are Americans abroad impacted by the CARES Act?
  2. What happens if you claim the foreign earned income exclusion (“FEIE”)?

What happens now?

The U.S. government has stated that they will try and get the cash into taxpayer’s hands as soon as possible.  Under the legislation, the cash advance will be equal to U.S. $1,200 per “eligible individual” (U.S. $2,400 on a married filing joint basis). There is an additional US $500 credit per eligible child, as defined under the Internal Revenue Code (“IRC”). 

The term “eligible individual” means any individual other than: (A) any nonresident alien individual; (B) any individual with respect to whom a personal exemption (a deduction allowed under IRC §151) is allowable to another taxpayer for a taxable year beginning in the calendar year in which the individual’s taxable year begins, and (C) an estate or trust.  It should be noted, however, that the exemption amount under IRC §151 means zero until December 31, 2025 under the 2017 Tax Cuts and Jobs Act (TCJA).

The amount of the credit allowed, however, shall be reduced (but not below zero) by 5 percent of so much of the taxpayer’s adjusted gross income as exceeds $75,000 for an individual,  $112,500 in the case of a head of household return or $150,000 in the case of a joint return.  In general, payments will be based on the taxpayer’s 2019 tax return information (if already filed) or the taxpayer’s 2018 tax return (if the 2019 return has not yet been filed). 

The rebates will be eliminated when adjusted gross income exceeds $99,000 for single taxpayers (with no children) and $198,000 for married taxpayers (with no children).

There is no requirement that the “eligible individual” be a resident of the United States in order to qualify for the credit. 

What happens if I never filed a U.S. individual income tax return?

The CARES Act states that recipients must have filed a tax return in 2018 or 2019 in order to receive the Rebate.  The Act gives Treasury flexibility in establishing eligibility for the Rebate.  Treasury has not yet, however, indicated how they will proceed to deliver Rebates to those who have not yet filed prior year tax returns.

There is no mechanism for registering for nor applying for the Recovery Rebate.  Whether Treasury will implement any such procedure remains to be seen.

The Foreign Earned Income Exclusion (FEIE)

Eligible taxpayers whose tax home is outside of the United States may have reduced their adjusted gross income (AGI) by claiming the foreign earned income exclusion.  For 2020 the maximum FEIE deduction is US $107,600 (2019 – $105,900, 2018 – $104,100 ).  The Act does not define AGI for purpose of the Rebate.  As such, until such time as additional guidance is (if) provided it is assumed that the definition of AGI will remain unchanged.

What happens when I file my 2020 individual income tax return?

Technically, the cash that will be received is treated as an advance credit against the taxes imposed on an “eligible individual” for the first tax year beginning in 2020.   The allowed credit will be equal to the lesser of:

  1. net income tax liability, or
  2. $1,200 ($2,400 in the case of a joint return).

An eligible individual’s “net income tax liability” means the excess of the sum of the taxpayer’s “regular” tax liability and alternative minimum tax, if applicable, over credits allowed pursuant to Part IV, Subchapter A, Chapter 1 of the IRC.  Part IV, “Credits against tax”, encompasses IRC §21 though IRC §54AA.  Credits not to be taken into account, for the computation, include the child tax credit (under IRC §24) and refundable credits under IRC §31 through IRC §37. 

Foreign tax credits are allowed pursuant to IRC §27 (as provided under IRC §901) and fall with Part IV. As such the “net income tax liability” appears to be after foreign tax credits are claimed.  In other words, an actual net U.S. income tax liability.

As such it is entirely possible that the actual credit that will be allowed, on the “eligible individual’s” 2020 tax return will be less than the cash payments received. There will be a true-up for the amount for which one is eligible on the filing of their 2020 individual income tax return.

At this point in time, it appears that any overpayment, associated with the Rebate, will be forgiven.  There is no requirement to repay the overpayment.

We await further guidance from the IRS on the CARES Act and will provide updates as they are available.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.  If you require our assistance please do not hesitate to reach out to us.

IRS moves filing due date to July 15th, 2020

In our last U.S. Tax Tip we advised that the United States Treasury Secretary Steven Mnuchin had announced that the United States would defer the 2019 tax payment date, April 15th, 2020, by 90 days to July 15th, 2020.  On March 18th, 2020 the IRS issued IRS Notice 2020-17 providing guidance on the deferral.  The IRS will not charge any late payment penalties nor interest on payments which were originally due on April 15th, 2020.  Consolidated groups could defer up to US $10,000,000 of tax payments while all other taxpayers, including individuals, could defer up to US $1,000,000 of tax payments.

At the time of this announcement, the Treasury’s position was that the original FILING due date of April 15th was still in place and that taxpayers would need to file Form 4868, “Application for Automatic Extension of Time to File U.S. Individual Income Tax Return” to receive an extension of their due date, to October 15th, 2020.

Today, however, Secretary Mnuchin announced that the filing deadline of April 15th, 2020 has also been extended to July 15th, 2020.  Mnuchin said “All taxpayers and businesses will have this additional time to file and make payments without interest or penalties.”

While taxpayers now have additional time to file, those taxpayers who anticipate receiving a refund may still wish to file as soon as possible.  In addition, those taxpayers who are waiting for various tax forms, such as a Schedule K-1, may still wish to file an extension.  These extensions are automatic and cannot be denied by the Internal Revenue Service.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.

Treasury Announces Extension of Payment Due Date

On March 17, 2020, U.S. Secretary of the Treasury Steven Mnuchin announced that the Department of the Treasury will be deferring the April 15th deadline to pay taxes owed. Individuals and many businesses will have an additional 90 days to make their payments to the IRS.

Individual taxpayers will be able to defer up to $1 million of tax liability. Corporations will receive an extension on up to $10 million of tax liability.

For individuals whose tax home is in the United States, both the tax filing and tax payment due date is normally April 15th.   For those United States persons whose tax home, in a real and economic sense is outside of the United States, under the Regulations their normal filing due date is June 15th.

Taxpayers have always been able to obtain additional time to file their U.S. individual income tax return by timely filing Form 4868, “Application for Automatic Extension of Time to File U.S. Individual Income Tax Return”.  The timely filing of this form extends the due date until October 15th, 2020.

Payments, however, are due by the original filing date.  If taxpayers have not paid at least 90% of their ultimate tax liability by the original due date they would be subject to a late payment penalty equal to ½ percent per month (until paid) up to a maximum of 25% plus interest.  The announced extension will eliminate any potential late payment penalties and interest for an additional 90 days.

At this point in time, Treasury has not announced any changes in the filing deadline.  Also it is not clear, whether it is necessary to timely file an extension in order to receive a deferral of any payments.  Hopefully, Treasury will provide additional guidance shortly.

This payment extension is part of the Administration’s effort to curb the economic effects of the coronavirus pandemic.  Treasury estimates the extension will add up to US $300 billion of liquidity in the economy as individuals and businesses have more time to pay their taxes.

 “This is a commonsense step to afford individual Americans and businesses access to financial resources they need during this time of economic and social disruption,” Senate Finance Committee Chairman Chuck Grassley said in a statement.

The IRS routinely extends the filing deadline for victims of natural disasters. On March 6th, 2020 the IRS granted victims of recent tornadoes in Tennessee until July 15 to file various individual and business tax returns and to make tax payments.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.

Forms 3520 and 3520-A Filing Relief – Finally!

On March 2, 2020, the IRS released an advanced version of Revenue Procedure (Rec. Proc.) 2020-17.   It is expected that the final regulations will be issued on March 16, 2020 and will be effective as of the date of publication in the Internal Revenue Bulletin. To summarize, Rev. Proc. 2020-17 states that the U.S. Treasury and the IRS intend to issue proposed regulations that will impact the U.S. information reporting requirements with respect to the reporting of certain “foreign trusts”.

IRC §6048, in general, requires certain U.S. citizens and resident individuals (in the U.S.) to file Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” and/or Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner”, depending on whether the taxpayer made a transfer to/from a foreign trust or whether the taxpayer was considered to own all or a portion of the foreign trust (as determined under U.S. tax law).  The filing of these forms was a costly and time consuming exercise.  Failure to accurately and timely file these forms, if required, can lead to substantial penalties. 

What does this mean?

Canada has five tax favored/deferred accounts being: (1) a Registered Retirement Savings Plan (RRSP); (2) a Registered Retirement Income Fund (RRIF); (3) a Registered Education Savings Plan (RESP); (4) a Registered Disability Saving Plan (RDSP); and (5) a Tax Free Savings Account (TFSA).

In Notice 2003-75, issued on December 15, 2003, the IRS provided guidance which specifically eliminated the need to file Form 3520 and Form 3520-A with respect to Canadian RRSPs and RRIFs.  The IRS, however, had never issued any guidance as to the “correct” characterization of the remaining plans for U.S. tax purposes and whether, as a result, the above forms were required to be filed.  Given the potential penalties many taxpayers choose to file these forms as a protective measure.

Why now?

As part of their crackdown on potential off-shore tax abuse, the IRS Large Business and International (LB&I) division launched a number of international compliance campaigns.   One such program, entitled Forms 3520/3520-A Non-Compliance and Campus Assessed Penalties, was launched on May 21, 2018.

According to the IRS website

“This campaign will take a multifaceted approach to improving compliance with respect to the timely and accurate filing of information returns reporting ownership of and transactions with foreign trusts. The Service will address noncompliance through a variety of treatment streams (PDF) including, but not limited to, examinations and penalties assessed by the campus when the forms are received late or are incomplete.”

It has been our experience that the IRS had begun to routinely issue US $10,000 penalties against many taxpayers for filing “incomplete” forms.  This caused many taxpayers a significant amount of anguish and resulted in additional compliance costs in challenging these assessments.  In many cases, these was a long and drawn out process.

In our opinion (and our opinion only) the LB&I division was becoming overwhelmed with requests for penalty abatements and had the common sense to actually determine what information they actually needed to enforce U.S. tax laws. 

What still needs to be reported

Rev. Proc. 2020-17, when enacted appears to eliminate the need to file either Form 3520 or Form 3520-A (to be confirmed once the final guidance has been issued).  Relevant information that was disclosed on those forms was, in many ways, also reported on other disclosures.  These other disclosures will not be eliminated and, as such, the IRS feels that there is unnecessary duplication that can be eliminated.

If applicable, the following forms will still need to be filed to report the taxpayer’s interest in these “foreign trusts”.

  • FinCEN Form 114, “Report of Foreign Bank and Financial Accounts” and
  • Form 8938, “Statement of Specified Foreign Financial Assets

Income earned in an RESP, RDSP and/ or a TFSA is not exempt from U.S. taxation.  There are no provisions in the U.S. Internal Revenue Code to exempt income earned in any of these plans from current U.S. taxation nor are there any provisions in the Canada-United States Tax Convention (1980) to exempt the income.

Tax-Free Savings Account

We do not believe, at this time, that the Rev. Proc. 2020-17 applies to a Tax-Free Savings Account.

Rev. Proc. 2020-17 discusses a “Tax-Favored Foreign Retirement Trust”, which should include an RRSP and a RRIF, and a “Tax-Favored Foreign Non-Retirement Savings Account”. These latter plans are defined “… exclusively to provide, or to earn income for the provision of medical, disability, or educational benefits,…”.  As such, it would appear that Canadian RESPs and RDSPs would also be exempt from the requirement to file Form 3520 or Form 3520-A.

It is hoped that the IRS could provide some guidance and certainty with respect to TFSAs. 

Abatement of penalties

As mentioned above, the IRS has already assessed penalties.  Rev. Proc. 2020-17 provides guidance on how to request an abatement of assessed penalties that the IRS imposed on a “tax-favored foreign trust”.  Form 843, “Claim for Refund and Request for Abatement” must be filed pursuant to the Rev. Proc.  The Rev. Proc., once published, applies to all open taxable years subject to the limitations of IRC §6511.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.

Investing in the U.S. via partnerships or limited liability companies (LLCs) – Part 3

This Cadesky U.S. Tax Tip is the third of three that deal with non-residents investing in the United States via partnerships or limited liability companies (LLCs).  Part 1 looked at the U.S. implications of the partnership or LLC not timely filing a U.S. partnership return nor timely filing Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.”  Part 2 looked at the withholding obligations the partnership has with respect to distributions to non-resident partners.  In part 3 we will look at how the U.S. treats the sale or redemption of a non-resident partner’s partnership interest.

In general, under IRC §865(a)(2), when a non-resident sold shares of a U.S. corporation (which are considered as personal property), the gain was sourced “outside the United States”.  As such, the U.S. did not tax the gain.  There are exceptions, however, where the underlying value is attributable to U.S. real property.   In the case of a sale of redemption of a U.S. partnership interest (whose value was not related to U.S. real property), the case was not clear.

The question was whether to apply an “aggregate” or an “entity” approach.  Under the “aggregate” approach a partnership is considered as an aggregate of individual co-owners who have bound themselves together with the intent to share gains and losses.  Under this approach the partnership has no existence separate and apart from its partners.  As such, each partner is viewed as directly owning an undivided interest in the partnerships’ assets and operations. 

Under the “entity” approach a partnership is treated as a separate and distinct entity to which each partner has a piece of ownership.  In this aspect a partnership interest in similar to a share of a corporation.  The partnership interest would be an intangible personal property.

The IRS had issued Rev. Rul. 91-32, 1991-1 C.B. 107 where they applied the aggregate approach to a non-resident’s disposition of a United States partnership interest.  Rev. Rul. 91-32 reflects the IRS position that a non-U.S. investor selling an interest in a partnership will, for U.S. federal tax purposes, be treated as realizing income that is effectively connected with a U.S. trade or business (ECI) to the extent the gain on the sale of the interest is attributable to a U.S. trade or business of the partnership operated through a fixed place of business. In that situation, rather than characterizing gain from the sale of the partnership interest as non-US-source gain from the sale of property (which is generally not subject to US federal income tax), the 1991 ruling treats the non-US investor’s gain on a sale of the partnership interest as ECI to the extent attributable to the partnership’s assets that would generate ECI if sold by the partnership. Accordingly, the ruling characterizes any such gain as ECI to the extent such gain is attributable to the non-US investor’s share of the partnership’s property used to generate ECI.

Many in the tax community, however, strongly disagreed with the IRS as they felt that the IRS position had no basis in law.

The matter was not resolved until July 13th, 2017 when the United States Tax Court heard the case of Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner of Internal Revenue (149 T.C. No. 3). The Court held that a non-US partner is not subject to U.S. tax on gain arising from the sale of a partnership interest which conducts business in the United States.  It applied the entity approach and rejected the aggregate theory espoused in IRS Rev. Rul. 91-32.  The IRS appealed and lost.

What happens when a taxing authority loses a court case?  The government changes the law.  The 2017 Tax Cuts and Jobs Act repealed the result in the Grecian Magnesite decision and codified Rev. Rul. 91-32 into law.

What’s the law now?

Two new code sections were introduced, IRC §864(c) and IRC §1446(f) which are effective for dispositions occurring on or after November 27, 2017.

Under IRC §864(c), a foreign partner’s disposition of a partnership interest is subject to U.S. taxation as effectively connected income (ECI) to the extent that the foreign partner would have had ECI had the partnership hypothetically sold all of its assets at fair market value on the date of disposition.

IRC §1146(f) imposes a withholding obligation, on the buyer, equal to 10% of the amount realized by the (non-resident) seller if any portion of the seller’s gain would be ECI under these new rules.  This is not a final tax, the seller will receive credit any amounts withheld when they file their U.S. non-resident income tax return.

The take-away

Non-residents who sell or redeem a partnership interest may now be subject to U.S. federal taxation to the extent that a portion (or all) of the gain is considered to be ECI.  Much of the information required to make these determinations has to come from the partnership itself and extra work will be required to accurately perform the necessary computations.

The gain, though ECI, will still be considered a capital gain and, depending on the holding period, may qualify as a long-term capital gain.  The maximum U.S. federal tax rate on a long-term capital gain is 20% (for individuals and trust).  State taxes may also arise.

The U.S. tax may, however, be eligible as a foreign tax credit in the non-resident’s country of residence.  If a full FTC is granted in the country of residence then the taxpayer is, globally, no worse off paying the U.S. tax as his overall global tax will not have changed.  As such, when looking at investing in the U.S. via a partnership it is imperative that the taxpayer’s global tax position be reviewed, not just the fact that there is now a U.S. tax liability.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.

Investing in the U.S. via partnerships or limited liability companies (LLCs) – Part 2

This Cadesky U.S. Tax Tip is the second of three that deal with non-residents investing in the United States via partnerships or limited liability companies (LLCs).  Part 1 looked at the U.S. implications of the partnership or LLC not timely filing a U.S. partnership return nor timely filing Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.”  In this U.S. Tax Tip we look at the withholding obligations the partnership has with respect to distributions to non-resident partners.

As discussed in Part 1, a partner is deemed to be doing business in the U.S. via their interest in the partnership.  Partnerships, in general, do not pay tax, the partners do.   As such, with respect to a foreign partner the U.S. Congress was (and still is) concerned that once funds leave the United States that the U.S. Internal Revenue Service (IRS) may be unable to enforce payment of the non-resident’s U.S. tax liability.  As such, the Internal Revenue Code imposes a withholding obligation on the partnership itself.  IRC §1446 states

SEC. 1446. WITHHOLDING OF TAX ON FOREIGN PARTNER’S SHARE OF EFFECTIVELY CONNECTED INCOME.

  • GENERAL RULE – If
  • A partnership has effectively connected taxable income for any taxable year, and
  • Any portion of such income is allocable…to a foreign partner,

such partnership shall pay a withholding tax under this section at such time and in such manner as the Secretary shall by regulations prescribe.”

Some observations; remember effectively connected income is NOT subject to a flat U.S. non-resident withholding tax.  A U.S. income tax return must be filed, by the partner, to report any ECI (per the partner’s Schedule K-1 (Form 1065)) and the foreign partner is liable for any U.S. tax if their U.S tax return reflects net taxable income.  In addition, the partnership may have earned and distributed non-ECI investment income such as interest, dividends, etc. (also known as FDAP – fixed, determinable, annual or periodical). These too may be reported on the K-1.  These amounts, however, would not be subject to withholding under IRC §1446 as they would be subject to a final U.S. non-resident withholding tax.  In many instances, where the partner is a foreign person, they may have also received Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding”.

IRC §1446, however, imposes a withholding obligation on the partnership where the partnership has effectively connected taxable income (ECTI) and where any portion is allocable to a foreign partner.  Note that the withholding is on effectively connected income ALLOCATED to a foreign partner.  That income does not necessarily have to be distributed to the foreign partner.  As such there could be cash flow implications where income is allocated but not distributed.

The amount that is required to be withheld depends on the type of taxpayer the partner is.  In general, the tax required to be withheld is equal to the taxpayer’s top marginal tax rate for the year.  For individual and trusts, the rate is 37% on ordinary income and 20% on long term capital gains.  For corporations, the rate is 21%. This is NOT a final tax, only a withholding obligation on the payor partnership.  The foreign partner receives credit on their U.S. tax return for any amounts withheld and remitted on their behalf.  Since individuals and trusts are taxed at graduated rates in many instances they would be entitled to a refund when they actually file their U.S. non-resident income tax return.

Reporting of withholdings

The partnership is required to file Form 8804, “Annual Information for Partnership Withholding Tax (Section 1446)” with the IRS.  Each foreign partner would receive Form 8805, “Foreign Partner’s Information Statement of Section 1446 Withholding Tax” indicating the amount of U.S. federal tax withheld and remitted on their behalf. These returns are due to be filed with the IRS on or before the 15th day of the third month following the close of the partnerships’ tax year.  For partnerships that keep their books and records out of the United States and Puerto Rico, the due date is the 15th day of the sixth month following the close of the partnerships’ tax year.  The partnership may also file an extension, Form 7004, “Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns” to request more time to file the information returns.  An extension, however, does not extend the time for the payment of the withheld tax.

If these information returns are not timely filed (including extensions), the IRS will impose late filing penalties.  A partnership that fails to file Form 8804 on a timely basis will be subject to a late filing penalty of 5% (0.05) of the unpaid tax for each month (including a part month) the return is late.  The maximum late filing penalty is 25%.  If, however, Form 8804 is filed more than 60 days late, the minimum penalty will be $330, or the amount of any tax owed, whichever is smaller.  The IRS can also impose late payment penalties.  This penalty is imposed at the rate of ½ of 1% (0.005) of the unpaid tax per month.  The maximum late payment penalty if 25%. 

The late filing of Form 8805 could result in a penalty of $270 for each Form 8805.  It may be possible to have penalties abated, but that usually requires additional time and fees.

Instalments

Where partnerships have foreign partners, not only must the partnership (ultimately) withhold and remit (per above) but the partnership will also be required to make quarterly estimated instalment payments in anticipation of those final withholdings. These quarterly payments are reported on Form 8813, “Partnership Withholding Tax Payment Voucher (Section 1446)”. These must be filed, and payments made, by the 15th day of the 4th, 6th, 9th and 12th months of the partnership’s tax year.  Failure to timely make the required payments will result in interest costs and late under instalment penalties.

Waivers

Where a foreign partner has losses that have been carried forward, there may not be a cumulative taxable position even though the partnership may have generated current year ECTI.  The partnership is still required to withhold and remit based on current year ECTI.  The foreign partner, however, may request a reduction in the current year withholding by filing, with the IRS, Form 8804-C, “Certificate of Partner-Level Items to Reduce Section 1446 Withholding”. Once approved this form should be submitted to the partnership to allow them to reduce the required withholding.

Summary

Whenever a foreign partner invests in the United States, numerous and varying filing obligations will arise.  The partnership (or its agent) needs to review the types of income the partnership earned (ECTI or FDAP), the type of partner involved (individual, trust or corporation), the tax residence of the partners (U.S. or foreign), etc. as these will impact what and when different information returns needs to be filed.  Failure to consider these differences will result in penalties to the partnership.  Cadesky U.S. Tax Ltd. is well versed in assisting clients with the preparation of all required partnership filings.

Who we are

Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm.  We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.   

If you require our assistance please do not hesitate to reach out to us.