The “G” election, provided for under U.S. Treas. Reg. Section 1.1411-10(g), impacts U.S. direct and indirect individual shareholders of controlled foreign corporations (“CFCs”) and passive foreign investment companies (“PFICs”). A U.S. individual shareholder of a CFC or PFIC with a qualified electing fund (“QEF”) election is required to report and pay U.S. federal tax on certain undistributed income from the CFC or PFIC/QEF. This undistributed income is generally treated as a deemed dividend inclusion, which is subject to both regular U.S. federal individual income tax and the net investment income tax.
The G election allows the U.S. individual shareholder of a CFC or PFIC/QEF to report and pay U.S. tax on undistributed income from a CFC or PFIC/QEF in the same year for both regular tax and net investment income tax purposes. Without the election, the shareholder does not recognize CFC or PFIC income for net investment income tax until the year when an actual cash distribution is made. While the opportunity for deferral may seem favorable, the recordkeeping necessary to keep track of the information to substantiate the deferral and later recognition is not practical for many taxpayers and their tax preparers.
U.S. individuals typically may own indirect interests in CFCs and PFICs through investment fund partnerships, which are pass-through entities. For the tax year ending 12/31/2013, many investment funds have reported footnote disclosures in the investor’s annual Schedule K-1 which advise the individual investor to make the G election on their respective Form 1040 individual income tax return. The disclosures typically advise the U.S. investor that the CFC or PFIC/QEF income is already included in the Schedule K-1 amounts and that the fund did not make the G election. A pass-through entity has the option to make the G election for the year 2013 if the fund obtains consent from all of its direct investors. The fund also has the option to make the G election for years after 12/31/2013.
The technical area of PFIC tax compliance already has very impractical reporting consequences for U.S. taxpayers. The G election is another consideration in specialized U.S. foreign reporting that should not be overlooked.
Please consult your Aronson LLC tax advisor or Alison Dougherty of Aronson’s international tax practice at 301.231.6290 for more information.
When does the new FATCA withholding begin?
Effective July 1, 2014, withholdable payments of U.S.-source FDAP income will be subject to 30% FATCA (Foreign Account Tax Compliance Act) withholding. The new requirement applies to payments made to Foreign Financial Institutions (“FFIs”) and Non-Financial Foreign Entities (“NFFEs”). The types of income that are subject to the withholding include interest, dividends, rents, royalties, annuities and compensation. Withholding begins on January 1, 2017 for withholdable payments of gross proceeds from the disposition of property that produces FDAP income. To avoid the 30% FATCA withholding, FFIs and NFFEs must comply with certain information reporting and due diligence requirements. The FATCA withholding regime is designed to compel information reporting and disclosure with respect to the foreign accounts of U.S. persons and foreign entities with U.S. owners.
An FFI is a foreign entity that accepts deposits in the banking business, holds financial assets for the accounts of others as a substantial part of its business, or which is engaged in the business of investing, reinvesting or trading in securities, partnership interests, commodities or derivatives. An FFI may avoid being withheld upon if it enters into an FFI agreement with the U.S. Treasury Department. An FFI agreement requires the FFI to provide information to the U.S. government regarding its U.S. accounts. The FFI has certain obligations under the agreement including compliance with verification and due diligence procedures. The FFI also must agree to impose withholding with respect to recalcitrant account holders and other FFIs that do not participate. The U.S. Treasury Department is in the process of entering into Intergovermental Agreements with other countries to provide for cooperation by financial institutions in the respective foreign country.
An NFFE is any foreign entity that is not an FFI. An NFFE may avoid being withheld upon if it discloses substantial U.S. owners that own a 10% or greater interest in the entity. An NFFE also may avoid withholding if it certifies that it does not have any U.S. owners, if it is a publicly traded entity, or if it is an active NFFE. An NFFE is active if less than 50% of its gross income is passive and less than 50% of its assets produce passive income. The NFFE must provide the appropriate withholding certificate to the withholding agent to avoid the withholding.
The IRS has not yet issued the revised Form W-8BEN withholding certificate for purposes of FATCA, nor have they issued the revised Form 1042-S that will be utilized to report withholdable payments and FATCA withholding.
The Chapter 4 FATCA withholding regime under I.R.C. Sections 1471 to 1474 applies in addition to Chapter 3 U.S. nonresident tax withholding under I.R.C. Sections 1441 to 1446.
Based on the general rule of deferral, a U.S. shareholder of a foreign corporation defers U.S. federal taxation on earnings of the foreign corporation until a dividend distribution is actually repatriated to the U.S. shareholder. There are some important exceptions to this general rule under the anti-deferral tax regime that applies to controlled foreign corporations. A controlled foreign corporation (CFC) is a foreign corporation of which more than 50% of the vote or value is owned by U.S. shareholders who each own at least 10% of the voting stock of the foreign corporation. A U.S. shareholder of a CFC is required to pay U.S. federal tax on deemed distributions of undistributed income from the foreign corporation, even though an actual cash dividend is not received. The U.S. shareholder is considered to have a deemed dividend inclusion subject to U.S. federal tax if the foreign corporation has Subpart F income or if the foreign corporation has earnings invested in U.S. property.
There are several categories of Subpart F income. One main category of Subpart F income is foreign base company income, which includes several subcategories of income: foreign personal holding company income, foreign base company sales income, foreign base company services income and foreign base company oil related income.
There are de minimis and full inclusion rules for Subpart F income. Based on the de minimis rule, the CFC is not considered to have Subpart F income for the year if the total of its gross Subpart F income is less than the lesser of 5% of all gross income or $1 million. Based on the full inclusion rule, the CFC is required to treat 100% of its gross income for the year as Subpart F income if the Subpart F income is greater than 70% of the total gross income.
A CFC is considered to have earnings invested in U.S. property if it has trade or service receivables owed to the CFC by a U.S. person or if the CFC guarantees the obligation of a U.S. person or stock of the CFC is pledged as collateral for the obligation of a U.S. person. A CFC also is considered to have earnings invested in U.S. property based on investments in stock of U.S. corporations, obligations of U.S. persons or rights to utilize intangible property in the United States.
The new 3.8% net investment income tax applies to U.S. individual, trust and estate taxpayers for tax years beginning after December 31, 2012. For U.S. individual taxpayers, the tax is 3.8% of the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. The threshold amount is $250,000 for joint filers, $125,000 for married filing separately and $200,000 for other U.S. taxpayers. For purposes of the tax, investment income includes:
Net investment income is calculated to include the types of income referenced above, decreased by expenses allocable to such income. Modified adjusted gross income is AGI plus foreign earned income excluded under the foreign earned income exclusion.
The calculation of net investment income for the 3.8% tax includes income attributable to investments in foreign corporations. Net investment income takes into account dividends and gains from stock of a controlled foreign corporation (CFC) or passive foreign investment company (PFIC). A CFC is a foreign corporation of which more than 50% of the vote or value is owned by U.S. shareholders who each own at least 10% of the voting stock. A PFIC is a foreign company of which 75% or more of the gross income for the year is passive income or 50% or more of the average assets for the year produce passive income. Proposed Treasury Regulations Section 1.1411-10 provides rules that apply to an individual, estate or trust that is a U.S. shareholder of a CFC or that is a U.S. person who owns directly or indirectly an interest in a PFIC. The proposed rules also apply to an individual, estate or trust that owns an interest in a U.S. partnership or an S corporation that is a U.S. shareholder of a CFC or which has made a Qualified Electing Fund election for a PFIC.
The proposed regulations provide a rule that requires the U.S. taxpayer to include distributed income from a CFC or PFIC in net investment income for the 3.8% tax if such distribution was previously taxed as a deemed distribution of undistributed income. An anti-deferral rule generally requires U.S. shareholders of a CFC or PFIC to pay U.S. federal tax on certain undistributed income of the foreign corporation. When the earnings that were previously taxed are then distributed later, the U.S. taxpayer is allowed to exclude the distribution from taxable income. The U.S. taxpayer is not required to pay U.S. federal tax again on the actual distribution of the earnings that were taxed previously as undistributed income.
The U.S. taxpayer is allowed to make an election under the proposed regulations to include the undistributed income from the CFC or PFIC in net investment income for the 3.8% tax in the year in which the U.S. taxpayer pays U.S. federal tax on the undistributed income. The election enables the U.S. taxpayer to treat the undistributed income from the CFC or PFIC consistently as taxable income for both regular U.S. federal tax and the 3.8% net investment income tax. Unless an election is made to achieve consistency, the U.S. taxpayer is required to pay the 3.8% net investment income tax on the actual distribution from the CFC or PFIC of the previously-taxed undistributed income that is excluded from regular U.S. federal taxable income.
The proposed regulations also provide other technical rules for basis adjustments and the inclusion of gains from the sale of CFC and PFIC interests.
The Offshore Voluntary Disclosure Program offers U.S. taxpayers the opportunity to come into compliance with U.S. federal foreign reporting obligations. The current program does not have a filing deadline, but the IRS may close the program at any time. A U.S. individual or company is required to file a Report of Foreign Bank and Financial Accounts (Form TD F 90-22.1) if the U.S. person owns or has a financial interest in a foreign account and the highest balance or value of all foreign accounts combined is greater than $10,000 during the calendar year. Reportable foreign accounts include: foreign bank deposit accounts; investment, securities or brokerage accounts; retirement plan accounts; and insurance policies with a cash value. A U.S. individual or company could be required to file certain U.S. federal tax forms, such as Forms 5471, 926, 8865 and 8858, if the U.S. person owns an interest in a foreign company. A U.S. taxpayer also must comply with U.S. federal tax reporting requirements to report interests in foreign trusts, estates and gifts received from foreign persons. There are significant penalties for the failure to file these reports, such as $10,000 per form required to be filed per year.
The IRS currently has an amnesty program that allows U.S. taxpayers to file delinquent foreign reporting forms and pay any related U.S. federal income tax. The forms that may be disclosed include the Foreign Bank Account Report (“FBAR”) and the Form 5471 to report an ownership interest in a foreign corporation. The U.S. taxpayer has two options when making a disclosure. The U.S. taxpayer is allowed to file the delinquent foreign reporting forms for prior years without being subject to any penalties at all if the U.S. person did not fail to report any taxable income in the prior years. However, if the U.S. taxpayer does have additional unreported taxable income related to the disclosure of the foreign reporting forms, then the U.S. person must apply to file a disclosure through the formal Offshore Voluntary Disclosure Program (OVDP).
In the Offshore Voluntary Disclosure Program FAQ #6, the IRS explains the criminal charges that a U.S. person could face if they do not make a disclosure within the scope of the program. As stated in FAQ #6, such criminal charges include the following:
Possible criminal charges related to tax returns include tax evasion (26 U.S.C. § 7201), filing a false return (26 U.S.C. § 7206(1)) and failure to file an income tax return (26 U.S.C. § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322. A person convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000.
The U.S. taxpayer may effectively avoid the criminal liability and prosecution referenced above by making a disclosure within the formal Offshore Voluntary Disclosure Program. However, the U.S. taxpayer generally must agree to comply with the penalty framework when making a disclosure within the program. The applicable penalties include the 20% accuracy-related penalty under I.R.C. Section 6662(a); the failure to pay and the failure to file penalties under I.R.C. Section 6651(a); and a 27.5% offshore penalty that applies to the highest year’s aggregate value of offshore assets and accounts during the years covered by the disclosure.
See the IRS Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers on the IRS website at http://www.irs.gov/Individuals/International-Taxpayers/Offshore-Voluntary-Disclosure-Program-Frequently-Asked-Questions-and-Answers.
Please contact your Aronson LLC tax advisor or Alison Dougherty, International Tax Services at 301.231.6290 for more information.