Why You Should Hire a Tax Professional to Review Your Foreign Legal Structure
U.S. parented corporations that have foreign operations conducted through a foreign legal structure have significant U.S. tax filing and reporting obligations. The U.S. international tax rules and regulations that apply to U.S. parented structures are voluminous and complicated. Whether the parent corporation is a start-up company establishing offshore operations for the first time or a mature business with pre-existing offshore operations that is considering certain international tax planning, the parent corporation’s foreign legal structure may be able to be optimized for tax efficiency. In addition to the abundance of sticks in the tax code, it also contains many tax benefits that uncounseled taxpayers may not be fully utilizing. A thorough review and analysis of a parent corporation’s organizational structure may uncover unutilized tax benefits that coupled with international tax planning could increase the foreign legal structure’s tax efficiency.
Additionally, reviewing the organizational structure ensures that the parent corporation and each of the entities in its foreign legal structure are complying with U.S. tax reporting obligations and are filing required information returns. Failing to comply with these U.S. tax reporting obligations and information returns may result in significant tax penalties, keeping the statute of limitations open indefinitely, and even criminal tax penalties in extreme cases. Early identification of any deficiencies in the parent corporation’s U.S. tax reporting obligations or information returns is critical to mitigating issues and limiting any tax and penalty exposure. Thus, reviewing a parent corporation’s organizational structure serves dual purposes: (1) it can ensure that the parent corporation and its foreign legal structure are benefiting from the available tax benefit provisions of the Code and (2) it can identify any deficiencies in its tax reporting to avoid costly and significant tax penalties.
As a corporation grows and evolves, a tax professional should be consulted prior to executing an international tax planning transaction to identify and consider any unforeseen tax impacts. However, at the very least, a tax professional should be consulted to periodically review its organizational structure and tax reporting with these dual purposes in mind. Below, are some of the benefits to having a tax professional review a parent corporation’s organizational structure and offshore operations as well as some of the commonly overlooked U.S. tax reporting obligations and filings.
Tax Benefits under the Code and U.S. Tax Treaties
A U.S. parent corporation may not be taking full advantage of the various tax benefits provided for in the Code and under the United States’ extensive tax treaty network. Some of these benefits could include (i) eliminated or reduced rate of withholding tax on payments from a foreign jurisdiction to the United States, (ii) a dividends received deduction under section 245A,[1] on distributions received by a domestic corporation shareholder from a 10 percent owned foreign corporation, of which the domestic corporation is a U.S. shareholder (as defined in section 951(b)), (iii) under section 250(a)(1)(A), a 37.5 percent deduction for a domestic corporation’s foreign-derived intangible income (income from property that is sold by the taxpayer for foreign use, or services provided by the taxpayer to any person (or with respect to property) not located within the United States, (iv) a foreign entity’s eligibility for certain exceptions from the subpart F and GILTI tax regimes, and, (v) treating the sale or deemed sale of foreign corporation stock as a deemed dividend that is eligible for the section 245A dividends received deduction.[2]
The non-exclusive list above is only for illustration purposes; however, it demonstrates the breadth of tax benefits that may be available to a U.S. parented corporation that conducts foreign operations through a foreign legal structure. Well advised taxpayers of all types and sizes can utilize these tax benefits with certain international tax planning. The specific requirements of the various Code and tax treaty provisions must be satisfied to obtain a specific tax benefit and qualification for a tax benefit often requires an in-depth analysis of the taxpayer’s facts, the foreign legal structure and foreign operations, entity classifications for U.S. tax purposes, and an analysis of the taxpayer’s tax attributes. This review and analysis should be done on both a prospective basis before a U.S. parent corporation makes changes to its offshore operations or foreign legal structure or implements international tax planning and on a retrospective basis to ensure that no tax benefits are unused and that all required tax and filing obligations have been (or will be) satisfied after the new organizational structure for the foreign operations is in place.
International Information Returns that May Apply to Foreign Legal Structures
Taxpayers may not be aware that they may have an obligation to file certain information return forms with the IRS if they have foreign operations or have (i) financial assets in a foreign country, (ii) ownership in a foreign business, or (iii) financial activity from a foreign source. Failure to file these information returns can result in significant tax penalties. A determination of whether a taxpayer that has foreign operations is required to file an information return requires an analysis of the Code provision, relevant Treasury regulations, and the often detailed instructions to the information return form itself.
Form 5471 – Reporting an Interest in Foreign Corporations in a Foreign Legal Structure
For instance, a taxpayer is required to file a Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, if it falls within one or more of several categories of filers as described in the detailed instructions to the Form 5471. A taxpayer required to file a Form 5471 can include a shareholder who has no direct or indirect interest in a foreign corporation and only has a constructive ownership interest in the foreign corporation through attribution of the taxpayer’s parent that holds a direct or interest in the relevant foreign corporation. That result and the requirement for the taxpayer to file the information return might be unintuitive. However, if a taxpayer that is required to file a Form 5471 fails to do so, the penalties can be significant. The failure to file a Form 5471 is generally subject to a $10,000 penalty per information return, plus an additional $10,000 for each month the failure continues, beginning 90 days after the IRS notifies the taxpayer of the failure, up to a maximum of $60,000 per return.
Form 8938 and FBAR – Reporting an Interest in Foreign Financial Assets in an Organizational Structure
Other information return items that are related to the Form 5471, include filing a Form 8938, Statement of Specified Foreign Financial Assets, and a Report of Foreign Bank and Financial Accounts (“FBAR”). Unless an exception applies, a Form 8938 is required for certain specified persons (generally, a U.S. citizen or resident) or a specified domestic entity (generally, a closely held domestic corporation or domestic partnership that has at least 50 percent of its gross income from passive sources, or at least 50 percent of its assets produce passive income) that have an interest in specified foreign financial assets and the value of those assets is greater than the reporting threshold. The reporting threshold for individual unmarried taxpayers and specified domestic entities is if the total value of the specified foreign financial assets is more than $50,000 on the last day of the year or more than $75,000 at any time during the tax year. For married taxpayers filing a joint return these thresholds increase to $100,000 on the last day of the year or more than $150,000 at any time during the tax year. The penalty for the failure to file a Form 8938 is the same as the Form 5471 described above.
As we have discussed in a prior post, a taxpayer must file an FBAR if the taxpayer has a financial interest in or signature authority over foreign financial accounts with an aggregate value of over $10,000 at any time during the calendar year.[3] The IRS imposes civil penalties for failure to file an FBAR in the amount of $10,000 for each non-willful violation or for willful violations, a penalty that is the greater of $100,000 or 50 percent of the balance in the account at the time of the violation. The FBAR penalty may apply to each violation.[4] The willful failure to file an FBAR is a crime that is punishable by a prison term of up to 10 years and a fine of up to $500,000.
Form 8865 and Form 8858 – Reporting an Interest in Foreign Partnerships and Foreign Disregarded Entities in a Foreign Legal Structure
If a taxpayer’s offshore operations or foreign legal structure include foreign partnerships or entities that are treated as disregarded as an entity separate from their owners for U.S. federal tax purposes (a “disregarded entity”) other information returns may be required. A U.S. person that qualifies under one or more categories of filers must file a Form 8865, Information Return of U.S. Persons with Respect to Certain Foreign Partnerships, with respect to its ownership in the foreign partnership. Additionally, a U.S. person that is a tax owner of a foreign disregarded entity or operates a foreign branch (or own interests in tax owners of foreign disregarded entities or foreign branches) must file a Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs) and Schedule M. The instructions to both forms contained detailed directions as to who must file, what portions of the forms must be completed, and certain exceptions to filing. The penalty for the failure to file a Form 8865, or a Form 8858 is the same as described above for the Form 5471.
Consider a fact pattern where a U.S. parent corporation owns 100 percent of the stock of a foreign corporation (CFC), and the foreign corporation owns a disregarded entity (FDE). Further consider that CFC has a single foreign bank account with an aggregate balance of $100,000. If the U.S. parent corporation failed to file (i) a Form 5471 for CFC, (ii) a Form 8858 for the FDE, and (iii) non-willful FBAR for CFC’s foreign bank account, and (iv) a Form 8938, the total initial penalties could total $40,000 per month and the total maximum penalty could be $240,000 with the FBAR penalty and the monthly continuation penalties. These penalties could significantly increase if a U.S. parent corporation has a large foreign legal structure and failed to file information returns for many foreign entities.
Form 926 and Section 6038B – Reporting an Outbound Transfer of Property for use in Offshore Operations
In addition to the international information forms discussed above, certain outbound transfers of property by a U.S. person may be subject to significant penalties if not reported or if incorrectly reported. If a U.S. person transfers property to a foreign corporation in a transaction described in sections 6038B(a)(1)(A), 367(d), or 367(e), that U.S. person must file a Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. The failure to file a Form 926, is a failure to comply with section 6038B. Under section 6038B(c), the penalty for failure to furnish information at the time and in the manner required by the regulations is 10 percent of the fair market value of the property at the time of the exchange but not greater than $100,000 unless the failure was due to intentional disregard. Additionally, a U.S. person that transfers property to a foreign corporation must file a Treas. Reg. § 1.6038B-1 statement. The failure to file this statement is also a failure to comply with section 6038B and subject to the same penalty under section 6038B(c) described above.
Gain Recognition Agreements – Reporting an Outbound Transfer of Stock for use in a Foreign Legal Structure
Finally, as described in detail in a prior post, a U.S. person that transfers stock of a corporation to a foreign corporation in an exchange described in section 351, 354, 356, or 361 must recognize gain on the transaction under section 367(a)(1) unless the U.S. person owns 5 percent or more of the stock of the transferee foreign corporation immediately after the transfer and enters into a gain recognition agreement (“GRA”). A failure to comply with the GRA rules, including a failure to file an annual certification or new GRA, as required, is a failure to comply with section 6038B and can result in concurrent penalties of (i) the immediate recognition of the built-in gain of the foreign corporation stock that is subject to the GRA and (ii) the penalty in section 6038B(c). Thus, the consequences of failing to comply with a U.S. transferor’s ongoing GRA obligations can be significant, especially when the stock of the first-tier subsidiary that was transferred outbound has a large built-in gain.
It is particularly important for U.S. parent companies that have foreign operations or foreign legal structures with GRAs in place to consult with a tax advisor as to the impacts of a transaction on an entity that has relevance to the GRA. A transaction as simple as a name-change F reorganization or a foreign law legal migration of an entity subject to a GRA can be a reportable triggering event and a failure to do so could trigger the GRA.
Documents that Taxpayers Should Provide to their Tax Professional to Review a Foreign Legal Structure
As discussed above, a U.S. parent corporation with offshore operations or a foreign legal structure should consult with a tax professional prior to undertaking a transaction or international tax planning to understand any potentially available tax benefits, tax consequences, and filing obligations of the transaction. The tax professional may be able to suggest an alternative that is more tax efficient or provides a tax benefit while furthering the transaction’s underlying business purpose. In any case, prior to the taxpayer’s tax year-end, it should consult with a tax professional and disclose all of the transactions that it executed during the year (i.e., internal and external acquisitions, dispositions, reorganizations, liquidations, entity classification elections etc.) to create a list of required information returns and compliance obligations.
To that end, the taxpayer should provide the tax professional with any transaction slide decks or tax opinions/memos reflecting transactions or international tax planning executed during the calendar year, organizational structure charts from the beginning and end of the year, and the tax returns for the immediately preceding tax year. An ongoing dialogue between the taxpayer and the tax professional regarding the U.S. parent corporation’s foreign operations and foreign legal structure, and any contemplated international tax planning will help ensure that all available tax benefits are used and that all information returns and compliance obligations are properly completed and timely filed.
International and Offshore Tax Compliance Attorneys
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[1] In a prior post we discussed, in detail, the requirements of the section 245A dividends received deduction.
[2] In a prior post we discussed certain tax planning strategies to treat a sale or deemed sale of foreign corporation stock as a deemed dividend eligible for the section 245A dividends received deduction.
[3] 31 U.S.C. § 5314.
[4] It is remains unclear whether the FBAR penalty is determined on a per form or per account basis. That issue is presently before the U.S. Supreme Court which recently heard oral arguments in U.S. v. Bittner, No. 21-1195.
