Foreign Tax Reporting

Knowing the room, on October 24^th, at the UCLA Extension Tax Controversy Conference, IRS Commissioner Danny Werfel announced the IRS would cease automatically assessing penalties for late-filed Forms 3520 and would review the reasonable-cause statements attached to the forms before making a penalty determination. The resultant applause at the Beverly Hills Hotel (“such a lovely place”) was described by one attendee as “resounding.”

Required by I.R.C. § 6039F, the Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” is an information return, in part, as to foreign gifts and inheritances of more than $100,000, even where no tax is in fact due. But as has been candidly admitted by the IRS in its instructions to examiners: “Many taxpayers and representatives know that basic tenant of tax law [the non-taxable nature of gifts and inheritances] but are not aware of the requirement to report large foreign gifts and inheritances under I.R.C. § 6039F.” Voluntary Disclosure Practice Examiner Guide Paper, p. 44 (Rev:1/26/22) (Tax Notes Document Service, Doc. 2022-23495). Hence, unsophisticated taxpayers without advisors practiced in the foreign realm frequently incur the penalty, which can amount to twenty-five percent of the amount to be reported. I.R.C. § 6039F(c)(1)(B).

The harshness of the penalty structure has been a matter of distinct concern for some time with the IRS Taxpayer Advocate explaining in 2023 that her office was “aware of situations in which a foreign grandparent provided a gift to cover the cost of a U.S. grandchild’s living expenses while attending college. In this example, if the amount exceeded the $100,000 threshold, the grandchild has a filing obligation and could be penalized for up to 25 percent even though no U.S. tax liabilities may result from the gift. Similarly, if a U.S. person receives an inheritance from a foreign individual, the recipient is penalized if they do not file a Form 3520, even though the foreign individual may never have had a U.S. filing obligation or tax due.” See NTA Blog: International Information Return Penalties Impact a Broad Range of Taxpayers (August 22, 2023).

Congress likely authorized the penalty perhaps imagining it would catch nefarious high net-worth individuals with international connections. (Picture Dr. Evil.) But as noted by Ms. Collins’s office, such players typically have the legal assistance to easily sidestep the penalty or successfully obtain abatements. Instead, it is lower-income individuals, immigrants, and small businesses who receive a once-in-a-lifetime tax-free gift or inheritance and are unaware of their reporting requirement. But now at least, they have some respite, thanks to Ms. Collins’s diligent argumentation.

In today’s interconnected world, a country’s borders are just political concepts. It is often necessary for investors to invest internationally to diversify portfolios and maximize returns. However, investing internationally means dealing with the intricate world of international taxation. An example of this complexity is the taxation of Passive Foreign Investment Companies (PFICs). Fully grasping the tax implications of PFIC investments is essential for making informed decisions and navigating the regulatory landscape.

What are PFICs?

A foreign corporation is a PFIC if either, (1) 75% or more of its gross income is passive income, or (2) 50% or more of its assets produce passive income or are held for the production of passive income. Entities like foreign mutual funds, certain holding companies, foreign insurance companies, and offshore investment funds can be PFICs. Passive income, includes interest, dividends, rents, royalties, and capital gains.

Taxation of PFICs

In order to prevent U.S. taxpayers from deferring taxes by investing in PFICs, the Internal Revenue Code (IRC) imposes punitive tax rules under IRC §§ 1291 through 1297. Furthermore, the PFIC rules can seem like they were designed to confuse and discourage investors from getting involved with PFICs.

Investors can inadvertently be subject to PFIC rules for various reasons. A foreign fund can change its investment strategy or portfolio composition causing previously non-PFIC investments to be classified as PFICs. PFIC status may not readily be apparent to an investor, since PFIC status depends on a company’s income and asset composition. Compounding this challenge is the lack of disclosure or transparency from these foreign entities regarding the requisite PFIC information. Moreover, if a company undergoes a transition from domestic to foreign status, whether through relocation or restructuring, investors and employees who previously exercised stock options may unknowingly find themselves subject to PFIC rules.

PFIC Taxation Methods

There are three main ways for taxing PFIC investments: the Excess Distribution Method, the QEF Election, and the Mark-to-Market Election. Under the Excess Distribution Method, distributions exceeding 125% of the average in the preceding three years are taxed as ordinary income at the highest marginal tax rate. Additionally, any gains from the sale of PFIC shares are treated as excess distributions, thus, no favorable capital gains treatment, while losses are disallowed.

The QEF Election allows taxpayers to include in their taxable income each year their share of the PFIC’s ordinary earnings and net capital gain. This election allows taxpayers to circumvent the punitive tax consequences of the Excess Distribution Method. However, for this election to be viable, the PFIC must furnish sufficient information to enable shareholders to accurately compute their taxable income.

The Mark-to-Market Election allows taxpayers holding marketable stock to include in their income each year the increased value of PFIC shares. PFIC shares are treated as if they were sold at the end of each tax year. Any gain recognized is taxed at ordinary income tax rates, while losses are subject to capital loss limitations.

Annual Information Reporting

U.S. taxpayers owning PFIC shares must file an annual report using Form 8621. This form provides details on income, distributions, and tax computations under different PFIC taxation methods, ensuring adherence to tax requirements and facilitating accurate tax reporting.

Other Relevant Rules and Requirements

In addition to PFIC rules, investors should be aware of other relevant IRC provisions, such as those concerning controlled foreign corporations (CFCs), foreign tax credits, foreign earned income exclusion, and taxation of foreign trusts and estates. Knowing how PFIC rules interact with other IRC provisions is important for taxpayers involved in foreign investments to ensure compliance with U.S. tax laws.

Investors may have additional reporting requirements, including disclosing foreign financial accounts through the Foreign Bank Account Reporting (FBAR) regime via Form 114 and complying with the Foreign Account Tax Compliance Act (FATCA) via Form 8938. PFIC investments may trigger reporting requirements under the FBAR regime if the investor’s foreign financial accounts exceed a certain threshold. FATCA compels foreign financial institutions to report U.S. account holders and imposes reporting duties on U.S. taxpayers regarding specified foreign financial assets, such as PFIC investments.

Conclusion

There are several challenges when navigating PFIC rules, including but not limited to compliance burdens, the risk of potential double taxation, the interaction with other tax rules and regimes, and the complexities of strategic tax planning. It is important to have an effective tax plan to mitigate the potential adverse tax consequences of PFIC investments. While investing in PFICs may be essential for diversifying portfolios and having access to global markets, the tax implications require careful consideration. Our firm can help navigate these complex tax rules, ensuring compliance with annual reporting requirements, and devising plans to minimize adverse tax consequences. Get in touch now.

Overview

The Foreign Account Tax Compliance Act (FATCA) has been a cornerstone of the U.S. government’s efforts to combat tax evasion involving foreign financial accounts. By imposing obligations on Foreign Financial Institutions (FFIs) to report information about financial accounts held by U.S. taxpayers, FATCA has largely eliminated overseas tax havens.

However, the reciprocal exchange of information is not as robust in the opposite direction. While the U.S. has entered into a number of Intergovernmental Agreements with other jurisdictions to facilitate the exchange of information under FATCA, the level of information the U.S. provides to other countries about their citizens’ financial accounts in the U.S. is not always equivalent. The U.S. has not committed to adopting the Common Reporting Standard, which is the global standard for the automatic exchange of financial account information, developed by the Organization for Economic Cooperation and Development.

This asymmetry in information exchange has raised concerns that the U.S. could be seen as a tax haven for non-U.S. persons. For instance, certain trusts, limited liability companies, and other investment vehicles in the U.S. can offer non-U.S. persons a degree of confidentiality about their ownership interests and assets. This is particularly true in states with favorable trust and corporate laws that do not require the disclosure of beneficial ownership information.

It is important to note that the U.S. has taken steps to address some of these concerns. The Corporate Transparency Act requires U.S. and foreign persons to report their beneficial ownership information of certain U.S. entities to the Financial Crimes Enforcement Network. This legislation is aimed at preventing and combating the misuse of legal entities for purposes of money laundering, tax evasion, and other illicit activities.

But the Corporate Transparency Act has significant limitations. It only applies to entities that are formed or registered by the filing of a document with a secretary of state or similar office. This means that certain entities, such as trusts that are not registered with a secretary of state or similar office, are still not required to disclose beneficial ownership information. This continuing lack of transparency, combined with the potentially favorable tax treatment of foreign persons, means that the U.S. has emerged as a major international tax haven.

FATCA: Legislation Passed by the U.S. in 2010 to Combat Offshore Tax Evasion by U.S. Taxpayers

• Requires foreign financial institutions (FFIs) like banks and investment companies to report information about financial accounts held by U.S. taxpayers to the IRS.
• Includes requirements for US taxpayers to report foreign assets and offshore accounts.
• Imposes a 30% withholding tax on certain payments from U.S. sources made to FFIs that do not comply with FATCA reporting requirements.

U.S. Implementation of FATCA

• The U.S. has signed intergovernmental agreements (IGAs) with many countries to facilitate implementation of FATCA and information sharing.
• Partner countries entering into IGAs agree to share that information with the IRS.
• These IGAs require the partner countries to share information with the IRS, but help to protect the financial institutions of partner countries from FATCA penalties.
• More than 100 countries have entered into IGAs with the U.S., requiring FATCA compliance.
• This effectively breaks secrecy laws in tax havens and forces disclosure of information about accounts held by US taxpayers.
• FATCA has resulted in the disclosure of billions in previously unreported offshore assets and income, helping the IRS crack down on offshore tax evasion.

The U.S. Also Used Its Criminal Laws to Target Institutions in Foreign Tax Havens

The enforcement of FATCA went hand-in-hand with the U.S. government’s broader efforts to pursue tax compliance and combat offshore tax evasion. The aggressive enforcement actions that began around 2009, prior to FATCA’s enactment, were a clear signal of the government’s intent to crack down on noncompliance with tax obligations related to foreign accounts.

The Department of Justice, in collaboration with the IRS, targeted FFIs that they believed were complicit in helping U.S. taxpayers hide assets and income offshore. High-profile cases against Swiss banks, in particular, led to numerous deferred prosecution agreements and non-prosecution agreements. Under these agreements, FFIs were required to admit to wrongdoing, pay fines, and provide detailed information about U.S. customers who had held undisclosed accounts. These enforcement actions resulted in billions of dollars in fines and the disclosure of thousands of account holders to the IRS.

Following these disclosures, the IRS pursued U.S. taxpayers who had not reported their foreign accounts and income. The IRS offered several Offshore Voluntary Disclosure Programs and the Streamlined Filing Compliance Procedures as a way for U.S. taxpayers to come into compliance voluntarily. Taxpayers who did not take advantage of these programs and were subsequently identified faced significant penalties and potential criminal prosecution.

The International Community Seeks to Implement Financial Account Information Sharing

The larger international community has sought to implement FATCA’s information-sharing provisions on a broader scale. The Common Reporting Standard (CRS) is a global standard for the automatic exchange of financial account information between tax authorities. It was developed by the Organization for Economic Cooperation and Development (OECD) in 2014 and has been adopted by over 100 countries and jurisdictions.

• CRS requires financial institutions like banks, brokers, and funds in participating countries to identify foreign account holders and report information on their accounts to their domestic tax authority. This includes account balances, interest/dividend payments, sale proceeds from financial assets, and other income.
• The domestic tax authority then automatically exchanges that information with the tax authorities in the account holder’s country of tax residence. This enables tax authorities to verify if their tax residents have properly reported their offshore financial accounts and income.
• Reciprocal exchange is a key component of CRS. If country A exchanges information about country B’s tax residents, then country B will also provide the same information about country A’s tax residents.
• Over 100 countries and jurisdictions participate in CRS information exchange, including major economies like the UK, Germany, France, China, India, and Japan.
• The U.S. does not participate in CRS.

The U.S. Has Not Joined CRS Due to Opposition from Congress and the Financial Industry:

• The U.S. already unilaterally receives financial account information from other countries through FATCA. CRS is therefore seen as providing little benefit for the U.S.
• There are concerns about the costs to U.S. financial institutions of implementing CRS due diligence and reporting systems.
• Powerful voices in Congress oppose adopting legislation that facilitates information sharing with foreign governments to assist their tax enforcement.
• In summary, CRS is a widely adopted global standard for reciprocal exchange of financial account information between tax authorities, but the U.S. is a notable non-participant due to political and industry opposition.

The U.S.’s Emergence as a Tax Haven

The OECD defines a tax haven as a jurisdiction that (1) has no obligation to exchange information, (2) lacks transparency, (3) does not require a local presence, and (4) has zero or nominal tax rates. For non-U.S. persons, the U.S. meets these four requirements.

• The U.S. does not provide meaningful reciprocal reporting of financial accounts to other countries.
  • The U.S. has not adopted CRS or implement fully reciprocal information exchange under FATCA.
• entities still can lack transparency.
  • The U.S. has taken significant steps to increase transparency of entity ownership. Prior to this year, there was no U.S. requirement to identify the beneficial owners of U.S. entities. But the Corporate Transparency Act (CTA), effective in 2024, now requires the disclosure of the beneficial owners of certain U.S. entities.
  • But the CTA only applies to entities that are formed or registered through a filing with a secretary of state or similar office. This means that certain types of legal entities, including many trusts, are not subject to the beneficial ownership reporting requirements of the CTA. The U.S. Treasury Department has been tasked with developing regulations to implement the CTA, which may in the future seek to expand its application to trusts and other entities. It is also possible that future legislation or regulatory action could expand the reporting requirements to include additional types of legal arrangements, including trusts.
  • But, at this time, there is still the potential for foreigners to shield their ownership of entities and assets in the U.S.
• Foreigners do not need a U.S. presence to hold U.S. financial assets, entities, or trusts.
• Foreigners can generally pay little or no U.S. tax when they invest in U.S. assets.
  • Generally, foreign taxpayers are subject to U.S. tax on (1) fixed, determinable, annual or period (known as FDAP) income and (2) income from a U.S. trade or business.
  • Foreign taxpayers generally pay no tax when selling U.S. assets other than real estate.

The Sunset of International Tax Havens

The enactment of the CTA signals a commitment by the U.S. to enhance financial transparency and combat the misuse of entities for illicit purposes, including tax evasion. The CTA, along with the aggressive enforcement of its tax laws as seen in the past decade, suggests that the U.S. is taking steps to shed any perception of being a tax haven.

As the U.S. aligns with global trends towards financial transparency, it is possible that the characteristics which have made the U.S. attractive for foreign persons seeking confidentiality may change. The playbook used by the U.S. to dismantle secrecy in offshore jurisdictions—compelling information sharing and enforcing domestic laws—could be adopted by other nations looking to protect their tax bases. This international effort is further supported by initiatives like the OECD’s CRS and the automatic exchange of information agreements.

For advisors and financial institutions in the U.S. that assist foreign persons, it is crucial to operate within the bounds of both U.S. law and international legal frameworks. The Department of Justice has the authority to prosecute U.S. persons for crimes such as aiding and abetting tax evasion, even if the tax evasion occurs under another nation’s laws. Additionally, engaging in activities that facilitate the evasion of another country’s taxes can expose U.S. persons to legal action by that foreign jurisdiction. As the Department of Justice pursued the Swiss, foreign nations can pursue U.S. institutions and persons.

Conclusion

At Kim & Rosado, our partners’ background as tax attorneys with the Department of Treasury provides us with unique insights into the government’s enforcement strategies. We understand the serious nature of these matters and the importance of proactive compliance. We offer our clients expert guidance on navigating the complex web of U.S. tax laws, including the intricacies of reporting foreign financial assets and income. Our goal is to ensure that our clients are not only compliant but also protected from the severe consequences that can arise from noncompliance.

For individuals and institutions that may already be facing scrutiny or enforcement actions, we leverage our extensive experience to advocate on their behalf, seeking resolutions that minimize exposure and penalties. Our direct partner involvement means that clients benefit from the highest level of expertise and representation in these serious and high-stakes matters.