2016-Issue 16 – The United States enacted the Foreign Account Tax Compliance Act (FATCA) to uncover U.S. persons who were hiding money in offshore financial institutions and similar investment vehicles. To incentivize these foreign institutions to cooperate, the IRS threatened them with a stiff withholding tax on most payments generated from the United States. As a result, these institutions spent millions of dollars in a massive compliance effort to set up the infrastructure to capture and report the information to the U.S. government. While many business organizations and governments were not happy with FATCA, it is now accepted as just another piece of a much wider regulatory net in the global push for tax transparency and compliance. Nonetheless, tax authorities and non-governmental organizations abroad have questioned and criticized the United States for imposing FATCA on the rest of the world while not doing enough to curb the use of the United States as a tax haven.
The U.S. government is responding to those comments and has several rules in the pipeline to address various aspects of the U.S. banking, tax and legal system that may facilitate foreign persons in not fully complying with their tax obligations abroad. One of the rules being proposed would require the disclosure of key ownership and transactional information of any U.S. disregarded entity that is owned by a single foreign person.
Most U.S. states allow for the formation of a limited liability company (generally in a day or two) with very little information about its owners and for as little as a few hundred dollars. Several states maintain websites (i.e., “sunbiz.org” in Florida) that may list information about the managers or other representatives of the LLC, but the LLC’s ownership information is not public and the persons forming or managing the company may be outside advisors. These factors make such vehicles very attractive to persons who do not want to deal with the extensive know your customer (KYC) due diligence that most countries require to form a company. The U.S. tax rules provide an added benefit: most of these LLCs are treated as disregarded entities for U.S. tax purposes and, therefore, are not required to pay U.S. taxes or report information about their ownership or transactions to the U.S. tax authority.
As a result of these favorable rules, U.S. LLCs became a vehicle of choice for many foreign persons who needed a fast, inexpensive holding company for non-U.S. investments that offered tax neutrality and confidentiality. A typical structure involves a foreign individual or a foreign holding company owning all of the units of a U.S. LLC that in turn owns shares or other assets located outside the United States. These disregarded entities receive dividends, rents, interest, royalties or proceeds from the sale of assets without any U.S. tax or any U.S. reporting obligation. The monies would flow completely tax-free through the U.S. LLC without any need to report anything to the U.S. tax authority. Unfortunately for many, the game appears to be over.
Treasury is proposing regulations that will treat domestic disregarded entities wholly owned by foreign persons as domestic corporations separate from the owners for limited reporting and record-keeping purposes under Section 6038A of the Internal Revenue Code. Section 6038A, through the filing of Form 5472, entitled Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, imposes a reporting and record-keeping requirement on domestic corporations that are 25 percent foreign-owned. The purpose of these proposed regulations is to gather information for the IRS to share with foreign governments in order to fulfill U.S. obligations under tax treaties and information exchange agreements, as well as to enhance U.S. tax enforcement efforts.
Under the proposed regulations, Section 6038A will require that any disregarded entity owned by a foreign person file a Form 5472 to report transactions with the owner and other related parties. In general, the form requires the following transactions to be reported:
- Purchases and sales of property, including inventory
- Cost sharing and platform contribution payments
- Other intangible property payments
- Technical, managerial and other service payments
- Loans or interest payments
However, the proposed regulations expand the types of transactions to be reported by including also those that would fall within the definition of “transactions” under Treasury Regulation Section 1.482-1(i)(7): “Transaction means any sale, assignment, lease, license, loan, advance, contribution, or any other transfer of any interest in or a right to use any property (whether tangible or intangible, real or personal) or money, however such transaction is effected, and whether or not the terms of such transaction are formally documented. A transaction also includes the performance of any services for the benefit of, or on behalf of, another taxpayer.”
It doesn’t end there. In addition to the onerous reporting requirements, the LLC will have to maintain records regarding these transactions that are sufficient to establish the accuracy of the form. The general exceptions to the record-keeping requirements that exist under Section 6038A are also not applicable. Specifically, the proposed regulations exclude the small corporation and de minimis transaction exceptions. In other words, no matter how small or infrequent the transactions, any foreign-owned disregarded entity with a reportable transaction will be subject to Section 6038A and its record-keeping requirements.
To the extent there are no reportable transactions in any given year, the form should not be required. Likewise, the form is to disclose transactions affecting the LLC and not necessarily to report all of the assets of the LLC.
Finally, all LLCs filing a Form 5472 will be required to obtain a U.S. employer identification number (EIN) to file properly. To obtain a U.S. EIN, the LLCs will need to file a Form SS-4, disclose who the responsible party for the LLC is and include the responsible party’s information and his or her U.S. identification number. The “responsible party” is the person who “has a level of control over, or entitlement to, the funds or assets in the entity that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the entity and the disposition of its funds and assets.”
What You Need to Know:
- Failure to comply with Section 6038A carries significant penalties.
- Failure to file a complete Form 5472 comes with a penalty of $10,000.
- The cost to comply with the proposed regulations will include increased accounting and tax preparation fees.
- The proposed regulations will apply to tax years ending on or after the date that is 12 months after the date of publication of the final regulations.
- Information from the form may be shared with foreign jurisdictions.
Alvarez & Marsal Taxand Says:
Foreign persons who have these structures should study the implications that the proposed regulations will have on their overall tax structure. Even those persons willing to register, obtain the necessary U.S. identification number and report all of their information need to weigh the cost of compliance along with the other benefits of the structure. Therefore, affected persons should take a proactive approach and evaluate alternatives before the regulations are finalized. Ultimate owners should be aware that these new rules may force them to obtain a U.S. tax identification number and become known to the U.S. tax authority.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.
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