form 5471 substantial compliance rules: irs international...

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Form 5471 Substantial Compliance Rules: IRS

International Practice Unit GuidanceRecognizing When the IRS Will Deem an International Tax Information Filing as Not "Substantially Complete"

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THURSDAY, NOVEMBER 1, 2018

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Minaux LeRoi, CPA, MST, Senior Manager, Marcum, Miami

Michel R. Stein, Principal, Hochman Salkin Rettig Toscher & Perez, Beverly Hills, Calif.

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Hochman Salkin Toscher Perez P.C. and

Marcum LLPfor

Strafford

Form 5471 Substantial Compliance Rules: NewIRS International Practice Unit Guidance

When Will the IRS Deem an International Tax InformationFiling as Not “Substantially Complete”?

Marcum LLP

5

Minaux LeRoi

Senior Manager,

International Tax Services

305.995.9714

[email protected]

November 1, 2018

Hochman Salkin Toscher Perez, P.C.

Taxlitigator.com

9150 Wilshire Blvd, #300

Beverly Hills, CA 90212

Michel Stein, Esq.

310.281.3200

[email protected]

www.taxlitigator.com


The Internal Revenue Service recently issued an International Practice Unit (“IPU”) providing guidance to its examining agents as to when a Foreign Information Reporting Form will be substantially complete and therefore considered adequate.

• If a taxpayer does not submit a substantially complete return, then penalties under IRC 6038, 6038A and 6046 may apply. Substantially complete and substantially incomplete are not defined in the Internal Revenue Code (IRC) or the regulations. International information returns must be substantially complete in order for the filer to have met its filing requirement.

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Meaning of Substantially Complete


The substantial compliance doctrine is a judicial concept that applies to certain tax returns, elections and the substantiation of certain deductions. In some cases, courts require strict compliance with the statutory or regulatory requirements; in other situations, the courts will accept substantial compliance. While the concept of “substantially complete” has not been the subject of judicial review, the body of case law concerning the substantial compliance doctrine provides guide posts for how a court may interpret whether an international information return is substantially complete.

After this exploration of the substantial compliance doctrine, we will discuss the available IRS informal guidance on substantially complete international information returns. This informal guidance, which consists of a Field Service Advice (“FSA”) and two Chief Counsel Advices (“CCA”), relates to Forms 5471 and 5472.

Finally, we present examples that focus on what is required for a substantially complete international information return.

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Substantial Compliance Doctrine


Strict Compliance Versus Substantial Compliance

In determining whether a tax return satisfies a reporting requirement or whether a taxpayer has complied with a statute or regulatory requirement, there are two standards that may apply. The first requires strict compliance with the statute or regulatory requirement; the second requires substantial compliance. In analyzing the statute or regulatory requirement, the first step is to determine which standard applies. When determining which standard applies, courts may consider the following:

• If the particular information or requirement at issue is determined to be related to the “substance or essence” of the statute or regulation, then strict compliance is necessary.

• If, instead, the requirement is seen as “procedural or directory” then substantial compliance can apply.

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Compliance with Respect to the Statutory Requirement of Filing an Income Tax Return

Indiana Rolling Mills Co. v. Commissioner, 13 BTA 1141 (1928) dealt with the required signatures on a domestic corporate tax return. The statute (Section 239 of the Revenue Act of 1918) required that a corporate tax return be sworn to by the president or other principal officer and the treasurer or assistant treasurer. In Indiana Rolling Mills, the taxpayer’s corporate return was sworn to by the vice president and secretary. The Service argued that the return was not a valid return for purposes of starting the statute of limitations.

Although the dual signature requirement was repealed, this 1928 case was the first case to apply the substantial compliance doctrine to tax statutes.

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Compliance with Respect to the Statutory Requirement of Filing an

Income Tax Return (cont’d)

The court stated that a general rule of statutory construction is that those provisions that relate to the essence of the thing to be done are mandatory; those provisions that do not relate to the essence of the thing to be done are directory. Here, the essence of the statute was the making of an honest return by the corporation. If the requisite information is “fairly and honestly given in a return sworn to by officers of the corporation who are familiar with its affairs,” then the court determined that the taxpayer has substantially complied with the statute. The fact that the treasurer or assistant treasurer did not swear to the return did not go to the essence of the statute.

In general, the Tax Court has required strict compliance where the requirement goes to the essence of the statute. The Tax Court has required only substantial compliance where the requirement does not go to the essence of the statute.

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The Beard Test

The Beard Test, 82 T.C. 777 (1984).

In Beard the Tax Court has summarized the requirements for a tax return to be considered valid for purposes of beginning the statute of limitations on assessment:

• It provides sufficient data to calculate tax liability.

• The document must purport to be a return.

• There must be an honest and reasonable attempt to satisfy the requirements of the tax law.

• The taxpayer must sign the return under penalties of perjury.

A return that meets these four requirements will be considered valid and trigger the running of the statute of limitations even if it contains other inaccuracies or omissions.

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Compliance with Respect to the Statutory Requirement of Making an Election

The substantial compliance doctrine is most commonly applied where a taxpayer attempts to make an election, but does not completely comply with the election requirements.

Taylor v. Commissioner, 67 T.C. 1071 (1977) dealt with an election that once was available under IRC 1251(b)(4)(B) in regard to gain from the disposition of property used in farming. Neither the taxpayer nor their advisors had read any of the published guidance concerning the making of the election. The court found that when the taxpayers filed their 1970 tax return, they subjectively believed that compliance with the accounting methods prescribed by IRC 1251(b)(4)(A) and the fact that they reported the gain from the sale of farm recapture property as long-term capital gain was an effective election under IRC 1251(b)(4).

The Tax Court examined the statute at issue and determined that IRC 1251 was designed to prevent taxpayers from utilizing certain farm losses to convert ordinary income into capital gain. Such a recharacterization could be accomplished by requiring a portion of previously deducted farm losses to be characterized as ordinary losses on the sale of farm equipment. In order to avoid this re-characterization, a taxpayer had to follow certain accounting rules specified in IRC 1251(b)(4). The taxpayers in Taylor had followed these rules, but failed to include the statement required by the statute and regulations indicating that they chose this method.

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Compliance with Respect to the Statutory Requirement of Making an Election (cont’d)

The Tax Court concluded that the essence of IRC 1251(b)(4) is to allow a farmer capital gains treatment if the farmer followed the accounting rules specified in IRC 1251(b)(4). The essence of the statute is that taxpayers compute taxable income from farming by using the methods specified. The election requirements assisted the IRS, but were directive. Therefore, the Tax Court concluded that the taxpayers had substantially complied by following the prescribed accounting methods and reporting the gain as long-term capital gain.

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Compliance with the Substantiation Requirements in Treas. Reg. 1.170A-13

An example of an issue that has been the subject of numerous cases is the requirement in Treas. Reg. 1.170A-13(c)(2) that a taxpayer claiming a deduction for a charitable contribution of property worth more than $5,000 obtain a qualified appraisal, attach a fully completed appraisal summary and retain certain information (including the qualified appraisal itself).

Bond v. Commissioner, 100 T.C. 32 (1993) is illustrative of such cases. In Bond, the taxpayers donated some blimps to charity. Taxpayers had an expert value the blimps and complete the Form 8283, Noncash Charitable Contributions, but the expert did not prepare a separate qualified appraisal. After an audit was opened, the expert provided information about his credentials to the IRS. The Tax Court determined that the only required information that was not provided by the taxpayer on the return was the expert’s credentials and this information had been provided, once it was requested by the Service.

The Tax Court examined whether the requirements in the regulations relate to the substance or essence of the statute. The Tax Court found that the purpose of the regulation was to provide information helpful to the Service in the

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Compliance with the Substantiation Requirements in Treas. Reg. 1.170A-13 (cont’d)

processing and auditing of returns on which charitable contributions are made. The regulation did not relate to the substance or essence of whether a charitable contribution was actually made, but instead alerted the IRS to the charitable contribution and required taxpayers to provide certain information. As a result, the regulatory requirement was held to be directory, rather than mandatory, and the taxpayer was held to have substantially complied.

In cases that followed Bond v. Commissioner, there were varying degrees of noncompliance with the same regulation. In most of these other cases, the taxpayers were held not to have substantially complied because a critical element was missing. Examples include:

• Failing to get an appraisal,

• Failing to fill out Section B, Donated Property Over $5,000 (Except Publicly Traded Securities), of Form 8283,

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Compliance with the Substantiation Requirements in Treas. Reg. 1.170A-13 (cont’d)

• Having someone without the relevant expertise complete the appraisal,

• Having an appraisal prepared outside the statutory window (including more than 60 days before the gift or after the return was filed),

• Including insufficient or inappropriate information in the appraisal or appraisal summary.

In Bond v. Commissioner, the court found that the essence of the regulation was to alert the IRS to the charitable contribution. The Court found that the reporting requirements in the regulations were directory, and therefore the applicable standard was substantial compliance.

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Conclusions About Substantial Compliance from Case Law

While the focus of the discussion has been on cases in which substantial compliance applied, the courts have required strict compliance in cases where they determined the requirement related to the essence of the statute or regulation. An example is the requirement in IRC 170(f)(8) that the taxpayer obtain a contemporaneous written acknowledgement of a donation from the donee. Because obtaining this acknowledgement is part of the essence of IRC 170, courts have ruled that taxpayers must strictly comply with this requirement in order to claim the charitable contribution deduction.

Substantial compliance generally applies to regulatory requirements. Strict compliance applies to statutory requirements. The analysis of whether there is compliance in this heavily litigated area is generally based on the facts and circumstances of the specific case.

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Application of Substantial Compliance Doctrine by District Courts

Following a 1990 case, Prussner v. United States, 896 F.2d 218 (7th Cir. 1990) district courts and federal courts of appeals have generally applied the substantial compliance doctrine in a more restrictive way than the Tax Court. The decision in Prussner criticized the tendency of the Tax Court to broaden application of the substantial compliance doctrine wherever the taxpayer was in a sympathetic position. This tendency caused unwanted uncertainty for taxpayers, in the eyes of the Prussner court, and several circuits have followed Prussner in narrowing application of the substantial compliance doctrine.

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Difference Between an Income Tax Return and an Information Return for Substantial

Compliance Purposes

In General Counsel Memorandum (GCM) 36372 – Application of Section 6652(d) Penalty to Incomplete Forms 990-P and 4848, the Service considered whether section 6652(d)(1) would apply where entities required to file Forms 990-P and 4848 failed to provide all of the information required to be provided on those forms.

In reaching the conclusion that the penalty is applicable under such circumstances, the GCM considers how information returns differ from income tax returns. The memo takes the position that cases concerning incomplete income tax returns are distinguishable from those concerning information returns because the goals of the two types of returns are different. Information reported on income tax returns is necessary to determine tax liability. As such, if a taxpayer omits information that is not necessary to determine tax liability, the return may be considered complete notwithstanding the omission.

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Difference Between an Income Tax Return and an Information Return for Substantial

Compliance Purposes (cont’d)

By contrast, information returns are required so that the Service can properly administer the revenue laws. If material information is left off an information return, such omission can impede the Service’s ability to perform the duties placed on it by Congress. Because income tax and information returns serve different functions, the memo concludes that different rules should apply in determining whether or not a return is complete.

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Substantial Compliance with Respect to International Information Returns

Congress’s intent in requiring taxpayers to report the information required to be reported on international information returns was to give the IRS more information about foreign entities with U.S. ties so that the IRS could determine if U.S. tax laws are being properly observed. In that regard, Congress enacted statutes requiring baseline information to be reported and gave the Secretary regulatory authority to determine the additional information required to be reported.

IRC 6038 and 6038A provide penalties, respectively, for the failure to provide information in regard to (a) controlled corporations and partnerships and (b) certain foreign-owned corporations. The regulations under IRC 6038 provide that a taxpayer may be relieved from liability for the penalty if the IRS determines that such taxpayer “substantially complied” with the reporting requirements of IRC 6038. The regulations under IRC 6038A provide that a taxpayer who files a

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Substantial Compliance with Respect to International Information Returns (cont’d)

“substantially incomplete” return is subject to penalty. Those regulations also provide that a taxpayer may be relieved from liability for the IRC 6038A penalty if the IRS determines that such taxpayer “substantially complied” with the reporting requirements of IRC 6038A. The regulations do not define the terms “substantially complied” or “substantially incomplete.” However, the Service has issued an FSA and two CCAs that explore these concepts.

Failure to file complete returns may result in penalties.

Regulations issued pursuant to IRC 6038 and 6038A provide specific rules that allow field examiners to consider whether the forms submitted have substantially complied with the reporting requirements (Forms 5471 and 5472) or are substantially incomplete (Form 5472) for purposes of the penalties imposed in those sections. The non-precedential advice that has been issued (and that is discussed below) applies only to these sections.

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The judicial concept of substantial compliance, as discussed above, may apply to other international information returns (which do not have the same standards as those imposed under IRC 6038 and 6038A). Stated differently, absent a specific regulatory directive, only the judicial concept of substantial compliance would excuse anything less than strict compliance with a reporting requirement.

A 1997 FSA discusses substantial compliance with respect to Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. FSA 33381431 - IRC 6038 Reporting Requirements.

The FSA warns that even though the majority of the information may have been reported accurately and completely, this does not mean that there has been substantial compliance such that a taxpayer is relieved from liability for the IRC 6038 penalty. In the FSA, the U.S. taxpayer (UST) accurately reported the majority of the information, but it failed to accurately report major transactions with related parties. These types of related party transactions are important information for the IRS to evaluate in determining whether U.S. tax laws have been applied correctly. The FSA rejected the “aggregate approach,” under which a taxpayer would be considered to be in substantial compliance if it accurately reported a certain percentage of the information required to be reported on the Form 5471. Instead, it concluded that substantial compliance is measured on the basis of each significant item of information specified in IRC 6038(a)(1) for each individual Controlled Foreign Corporation (CFC).

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Failure to accurately provide the information required by IRC 6038 may result in returns that are considered incomplete, even if most of the information on the form is correct. The taxpayer may be subject to penalties unless it can show reasonable cause or substantial compliance.

CCA 200429007 considered the meaning of the term substantially incomplete in regard to Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, and as that term is used in Treas. Reg. 1.6038A-4(a)(1). The 2004 CCA considered whether a taxpayer’s return would be considered substantially incomplete, and therefore subject to penalty, in a variety of different factual scenarios.

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The CCA identifies two approaches that could be used to determine whether a return is substantially complete. The first is strict compliance, a rigorous interpretation of the rules that would treat virtually any substantive inaccuracy as rendering the return substantially incomplete. The second is a facts and circumstances approach. The CCA provides a list of seven factors that should be considered in a facts and circumstances analysis:

1. The magnitude of the underreporting, or of the over-reporting, of the erroneous reported transaction(s) in relation to the actual total amount of that reported type of transaction(s).

2. Whether the reporting corporation has reportable transactions other than the erroneous reported transaction(s) with the same related party and correctly reported such other transactions.

3. The magnitude of the erroneous reported transaction(s) in relation to all of the other reportable transactions as correctly reported.

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4. The magnitude of the erroneous reported transaction(s) in relation to the reporting corporation’s volume of business and overall financial situation.

5. The significance of the erroneous reported transaction(s) to the reporting corporation’s business in a broad functional sense.

6. Whether the erroneous reported transaction(s) occur(s) in the context of a significant ongoing transactional relationship with the related party.

7. Whether the erroneous reported transaction(s) is (are) reflected in the determination and computation of the reporting corporation’s taxable income.

Overall, these factors give informal guidance on measuring how significant the errors are. Keep in mind that estimates are allowed in completing Form 5472, if actual information is not readily available, but the estimates must be within prescribed limits. (The CCA assumes that the taxpayer did not estimate.) The

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CCA uses a two-prong test in assessing substantial completeness: the magnitude of the errors and the effect of the noncompliance on the IRS’s ability to efficiently audit the information required by the statute and regulations.

The CCA cautions that no factor is necessarily more important than any other factor.

The FSA and CCAs discussed above only provide informal guidance concerning substantial compliance and substantial completeness as those terms are used in the regulations under IRC 6038 and 6038A. As such, they don’t apply to international information returns other than Forms 5471 and 5472.

The substantial compliance defense to penalties described in the regulations under IRC 6038 and 6038A is available only to taxpayers who are subject to penalties under those sections. However, a court might apply the generally applicable substantial compliance doctrine discussed earlier to other international information returns.

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Example 1- FSA 33381431

Facts: UST filed separate Forms 5471 for a large number of Controlled Foreign Corporations (CFCs). Each Form 5471 reported much of the required information and included numerous pages of detailed financial information regarding financial condition, corporate stock structure, shareholders and results of operations.

During exam, the Service identified significant understatements of purchases from and/or sales to some CFCs and related third parties (reported on Schedule M, Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons) and significant inconsistencies in the reported earnings and profits of some CFCs.

UST submitted most of the information required by IRC 6038 and related regulations. Other than the significant understatements, the information reported on the Forms 5471 was accurate and/or uncontested by the Service.

Analysis: The information is mostly complete, but that doesn’t mean that UST has substantially complied. The information that is missing or incorrect (to the tune of millions of dollars) is information that is the essence of the filing requirement. The related party information is a very important reason for requiring the Forms 5471. If a taxpayer is allowed to satisfy its filing requirements by accurately providing most of the information, it would have the opportunity to not provide or provide incorrect information with respect to very important categories.

Conclusion: The FSA concluded that the UST did not substantially comply with the IRC 6038 reporting requirements.

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Example 2 - CCA 200645023

Facts: UST acquired controlling interest of a foreign parent corporation, which wholly owned the stock of multiple foreign corporations, for approximately four months of the tax year. Even though UST did not believe that it was required to file the forms, UST nevertheless timely filed Forms 5471 for certain foreign corporations. However, the forms were incomplete. Specifically, the amounts were not (a) reported in accordance with U.S. generally accepted accounting principles (GAAP) on Schedules C, Income Statement, and F, Balance Sheet, and (b) reported in U.S. currency on Schedules C and E, Income, War Profits, and Excess Profits Taxes Paid or Accrued. In addition, UST did not attach Schedule O, Organization or Reorganization of Foreign Corporations and Acquisitions and Dispositions of Its Stock, to the Forms 5471. Moreover, UST failed to file Forms 5471 for certain inactive or dormant foreign corporations.

Analysis: There were a few issues addressed in the CCA. The first is UST’s belief that it did not have to file the Forms 5471. That fact does not matter in determining substantial compliance, but may bolster the taxpayer’s defense of reasonable cause.

Second, UST failed to file required information, including Schedule O. Similar to Example 1, the information that is not supplied by UST is important. The failure to include Schedule O, by itself, is likely to cause the taxpayer to fail the substantial compliance test. The failure to convert the information into U.S. GAAP and U.S. dollars makes it difficult for the Service to audit. The Service’s ability to audit efficiently is part of the goal of these reporting requirements.

Conclusion: The CCA concluded that UST did not substantially comply with the IRC 6038 and 6046 reporting requirements.

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Example 3 – CCA 200429007

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Facts: UST is a reporting corporation as defined in Treas. Reg. 1.6038A-1(c). UST timely filed Form 5472 for transactions with its parent (Parent) for the tax years at issue. All information required by Treas. Reg. 1.6038A-2(b)(1) and (2) was included on the Form 5472 and estimates were not used. However, some transactions were erroneously reported. The CCA looked at whether the taxpayer had substantially complied with its reporting requirements. The magnitude of each erroneously reported transaction is substantial in relation to all other reportable transactions, as well as substantial in relation to UST’s volume of business and overall financial situation.

The CCA addressed four issues as to whether the Form 5472 was substantially complete:

1. UST over-reported amounts in Part IV of the Form 5472, reporting Purchases of Stock in Trade as $1,000X when the actual number was $500X.

2. UST reported amounts of intercompany accounts receivables not specifically required to be reported on Form 5472 and later corrected the Form 5472 to remove these amounts.


Example 3 – CCA 200429007 (cont’d)

3. The amount reported on Form 5472 as the ending balance of related party loans did not match the opening balance on the next year’s Form 5472. In addition, the opening balance of a loan was incorrectly reported.

4. UST over-reported one amount and under-reports another amount in Part IV of Form 5472 so that there was a relatively small aggregate difference between the correct total and what was reported.

Analysis: As mentioned above, CCA 200429007 lists seven factors which should be considered in determining whether the taxpayer has substantially complied.

1. Over-reporting constitutes inaccurate information and requires the IRS to determine the correct information. The fact that it is an overstatement, rather than an understatement, does not matter. The incorrect information hinders the IRS’s ability to efficiently audit the Form 5472, if the error is material. Here, the 50% overstatement is of sufficient magnitude to violate the first, third and fourth factors.

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Example 3 – CCA 200429007 (cont’d)

2. The question is whether the Form 5472 as originally filed is substantially incomplete. The CCA assumes that $400X of intercompany receivables is erroneously included in Amounts Borrowed from Parent. The magnitude of the over-reporting is substantial because the overstatement is 40% of the transaction type and is substantial in relation to all other reportable transactions. The error violates the first, third and fourth factors.

3. Similar to 2, above, the magnitude of the over-reporting is 40%, which is significant. In addition, the loan has been in effect for at least two years, so it constitutes part of a significant, ongoing relationship between UST and a related party. This means that the first, third, fourth and sixth factors are violated.

4. In this example, we have relatively large offsetting mistakes, which result in a relatively small mistake on an aggregate basis. However, making multiple mistakes requires analyzing each mistake in isolation, as well as in the aggregate. Each mistake is significant in isolation, even if not in the aggregate, violating the first, third and fourth factors. The CCA concludes that the isolated mistakes cause the Form to be substantially incomplete, even if the Form is not substantially incomplete in aggregate.

Conclusion: In each issue presented in the CCA, the magnitude of the incorrect reporting was substantial, the Form 5472 is substantially incomplete and the penalty should apply, unless UST has reasonable cause.

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Overview of Certain P.L. 115- 97 Provisions Impacting Form 5471 Filings

• Repeal of the “30 day” of uninterrupted control for I.R.C. § 951(a) inclusion (i.e., subpart F) purposes.

• Change of the definition of a “U.S. shareholder” to mean 10% ownership by vote or value.

• Repeal of I.R.C. § 958(b)(4) thereby allowing downward attribution from a foreign owner to a U.S. partnership, trust, or corporation under I.R.C. §318(a)(3).

• Enactment of I.R.C. § 965 which imposes a one-time mandatory tax on 10 percent (or more) U.S. shareholders of Specified Foreign Corporations on their pro rata share of unremitted and previously untaxed post-1986 earnings and profits.

• Enactment of I.R.C. § 951A which imposes an additional any-deferral mechanism on income earned by foreign corporations operating in low-tax jurisdictions.

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Repeal of I.R.C § 958(b)(4)

• Scenario 1:

• Likely no U.S. federal income tax consequences.

• Per Notice 2018-13 the IRS will likely issue relief from filing a form 5471.

Foreign Parent

U.S. Sub

Foreign Sub

100%100%

3335


Repeal of I.R.C § 958(b)(4)

• Scenario 2:

• Likely there would be U.S. federal income tax consequences.

• Likely no relief from filing a form 5471.

Foreign Parent

U.S. Sub

Foreign Sub

90%

100%

10%

3436

What happened before 1962?▪ U.S. shareholders of Controlled Foreign Corporations (or “CFCs”) were for the

most part able to defer U.S. taxation indefinitely on income generated by such

CFCs.

▪ U.S. shareholders were able to convert ordinary income earned by CFCs to capital

gain income by retaining profits in the CFCs until disposition of such CFCs’ stock.

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What happened in and post 1962?▪ The Revenue Act of 1962 included provisions to combat a U.S. shareholder’s ability

to defer U.S. taxation on certain types of income generated by a CFC, colloquially

known as subpart F income.

▪ Section 952 defines subpart F income as:

o Foreign Base Company Income (as defined under section 954); and

o Insurance Income (as defined under section 953)

▪ Foreign Base Company Income primarily includes:

o Foreign Personal Holding Company Income;

o Foreign Base Company Sales; and

o Foreign Base Company Services.

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What happened in and post 1962?▪ Section 1248 which in certain cases converts capital gain income to dividend

income to the extent of a CFC’s current and accumulated earnings and profits.

▪ Section 956 to subject an investment in U.S. property to U.S. taxation to the extent

of a CFC’s current and accumulated earnings and profits.

▪ Potential deferral of U.S. taxation became only possible on non-subpart F income.

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Overview of Transition (Repatriation) Tax▪ 2017 Event.

o The Transition Tax is a one-time mandatory tax imposed on 10 percent (or

more) U.S. Shareholders of Specified Foreign Corporations (“SFCs”) on their

pro rata share of unremitted and previously untaxed post-1986 Earnings and

Profits (“E&P”) pursuant to section 965(a).

▪ Section 965(e) defines SFCs as 1) any CFC, and 2) any foreign corporations with

10 percent (or more) U.S. shareholders that are C corporations.

▪ Calendar year taxpayers are required to include their greater pro rata share of

E&P on either:

➢ November 2, 2017; or

➢ December 31, 2017.

▪ Section 965(b) allows U.S. shareholders to net their 965(a) inclusion with deficits

arising from other SFCs.

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Overview of Transition (Repatriation) Tax▪ Effective Tax Rates:

➢ Corporations:

❑ 8% tax on illiquid assets

❑ 15.5% tax on cash positions

➢ Individuals (assuming they are in the top tax bracket):

❑ 9.05% tax on illiquid assets

❑ 17.54% tax on cash positions

▪ Individuals may elect under section 962 to be taxed at corporate rates (15.5% and

8%) and be allowed a deemed foreign tax credit for any corporate taxes paid by the

SFC(s).

➢ This election does have its drawbacks thus a thorough analysis should be

conducted.

▪ Tax rate increases to 35% for U.S. Shareholders that become expatriated entities

within 10 years of 12/22/17.

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Overview of Transition (Repatriation) Tax▪ Section 965(c) provides for a deduction based on the highest rate applicable to C

corporations under section 11, which is currently 35%, in order to arrive at the

reduced rates mentioned in the previous slide.

▪ To illustrate in the case of C corporations, assume $1,000,000 E&P, cash positions

$900,000, and illiquid assets $100,000.

➢ C corporation

E&P Cash Positions E&P Illiquid Assets

E&P Inclusion $900,000 $100,000

Deduction $501,429 $77,143

Net E&P $398,571 $22,857

Tax Rate 35% 35%

Tax Due $139,500 $8,000

Effective Tax Rate 15.5% 8%

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Overview of Transition (Repatriation) Tax▪ To illustrate in the case of individuals, assume $1,000,000 E&P, cash positions

$900,000, and illiquid assets $100,000.

➢ Individual

E&P Cash Positions E&P Illiquid Assets

E&P Inclusion $900,000 $100,000

Deduction $501,429 $77,143

Net E&P $398,571 $22,857

Tax Rate 39.6 percent 39.6 percent

Tax Due $157,834 $9,051

Effective Tax Rate 17.54% 9.05%

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Overview of Transition (Repatriation) Tax▪ Taxpayers, regardless of their entity type, are allowed to claim a direct foreign tax

credit pursuant to section 901 to offset their federal income tax liability attributable

to any section 965 inclusion. However, the amount of the credit will be reduced

proportionately by the deduction allowed pursuant to section 965(c) to arrive at the

lower tax rates.

▪ In addition to the above, C corporations are also allowed to claim a deemed foreign

tax credit pursuant to section 960 for any corporate taxes paid by the SFC(s) to

offset their federal income tax liability attributable to any E&P inclusion, reduced

proportionately by the deduction allowed pursuant to section 965(c) to arrive at the

lower tax rates.

▪ Shareholders of S corporations can elect to defer the imposition of the Transition

Tax on their share of E&P until there is a triggering event.

▪ Special rules apply to Real Estate Investment Trusts (“REITs”) under section

965(m).

44

Overview of Transition (Repatriation) Tax▪ Election to preserve NOLs is available which is an important consideration

assuming NOLs can be utilized in subsequent years.

▪ Upon election, any individual or corporate shareholder subject to the Transition Tax

may elect to pay the tax liability over an 8 year installment plan as follows:

➢ Years 1 through 5: 8% of the tax liability

➢ Year 6: 15% of the tax liability



▪ Election to increase basis in the Deferred Income Foreign Corporation (“DIFC”) by

the section 965(a) inclusion and decrease in basis in the Deficit Foreign Corporation

my amount allocated to DFIC’s earnings and profits pursuant to section 965(b).

45

Overview of Transition (Repatriation) Tax▪ Steps to calculate Transition Tax:

➢ Calculate E&P as of Nov 2, 2017 and December 31, 2017, then choose the

greater amount on a CFC by CFC basis.

➢ Determine the aggregate cash positions as of the last tax year beginning

before 1/1/2018 and one half of the sum for the last tax year ending before

11/02/2017 plus one half of the sum for the tax year preceding to the

aforementioned one, then choose the greater amount.

❑ To illustrate, a calendar year taxpayer has cash positions of $100 as of

December 31 2017, $90 as of December 2016, $80 as of December 31,

2015 would compare the $100 to 50% of $90 + 50% of 80 = $85, then

chooses the greater amount, which is $100 in this case.

➢ Multiply the E&P amount to the extent of cash positions by 0.557 to calculate

the section 965(c) deduction attributable to cash positions.

➢ The excess amount of E&P multiply it by 0.771, to calculate the section

965(c) deduction attributable to illiquid assets.

46

Overview of Transition (Repatriation) Tax➢ Sum the deduction amounts attributable to cash positions and illiquid assets

to arrive at the total section 965(c) deduction amount.

➢ Multiply any foreign tax credits to be utilized by the 965(c) amount divided

by the section 965(a) amount (965(c)/965(a)) to calculate the section 965(g)

limitation

➢ Subtract the foreign tax credits amount by the section 965(g) limitation to

arrive at the foreign tax credit amount eligible as a credit against the net

section 965 inclusion.

➢ Calculate the regular tax liability without considering the section 965

inclusion.

➢ Calculate the tax liability with the section 965 inclusion.

➢ The difference between the regular tax liability and the tax liability with the

section 965 inclusion is the Transition Tax liability.

47

Global Intangible Low-Taxed Income ▪ A U.S. Shareholder of a CFC (or CFCs) must include in gross income the aggregate

share of the CFC’s (or CFCs’) Global Intangible Low-Taxed Income (“GILTI”) for tax

years beginning after December 31, 2017 pursuant to Section 951A.

➢ GILTI excludes:

❑ ECI

❑ Subpart F income (section 952)

❑ Certain high-taxed Subpart F income

❑ Dividends received from a related person

❑ Foreign oil and gas extraction income

▪ Simplified GILTI formula:

Net Income – (10% x Tangible Depreciable Property) = GILTI

➢ To illustrate, assume a U.S. individual shareholder owns 100% of a CFC, net

income is $100, and value of tangible depreciable property is $50.

❑ Individual’s share of GILTI: $100 net income – $5 (i.e., 10% of $50

tangible depreciable property) = $95

48

Global Intangible Low-Taxed Income ▪ GILTI is taxed at ordinary rates, as follows:

▪ 37% (maximum rate) for individuals

▪ 21% for corporations

▪ C corporations are allowed a GILTI deduction equal to 50% (decreased to 37.5% in

2026) of the GILTI inclusion amount pursuant to section 250(a)(1)(B). This deduction

is not available to individuals and S corporations.

➢ Such deduction reduces the effective income tax rate on GILTI to 10.5%.

▪ C Corporations are allowed to offset their federal income tax liability attributable to

GILTI by 80% of the corporate (or equivalent) tax deemed paid or accrued in foreign

jurisdiction(s) pursuant to section 960(d). This offset is not available to individuals

and S corporations.

➢ If the aggregate foreign tax rate deemed paid or accrued in the CFC’s (or

CFCs’) jurisdiction(s) is 13.125% (or higher), the foreign tax credit should

completely offset the federal income tax assessed on GILTI (80% * 13.125% =

10.5%)

49

Global Intangible Low-Taxed Income ▪ After the enactment of section 951A, deferral of U.S. taxation became even more

limited.

▪ Possible planning in connection with GILTI:

o Inserting a domestic C corporation as a holding company (in the case of non-

corporate shareholders) to mitigate GILTI implications

o Making a section 962 election, if the foreign corporate income taxes (or

equivalent) is equal or close to 26.25% (80%*26.25=21%)

50


Evaluation and Planning of Information Presented

• What is the default U.S. classification of the foreign entity?

• Which form(s) should be filed (e.g., 5471, 8865, 8858, 926, 3520-A, etc.)?

• Can an election be made by filing a Form 8832, Entity Classification Election? If yes, what would be the impact of such election?

52


Form 5471 Information Return of U.S. Persons with Respect to

Certain Foreign Corporations

• Examples of when a U.S. international information return filing is not substantially complete

• Errors apparent on the face of the Form 5471 return

• Errors beyond the face of the return

• Examples from the IRS International Practice Unit guidance

53


Errors Apparent on the Face of the Form 5471 Information Return

▪ Form 5471 Schedule F balance sheet does not balance

▪ Form 5471 Schedule C income statement net income does not correspond to change in beginning to ending retained earnings on Schedule F balance sheet

▪ Loans and receivables due from or payables due to related parties are on balance sheet but are not on Schedule M for Form 5471 Category 4 filer

▪ Loans due from or due to related parties are on Schedule M but not reported separately as related party loans on the balance sheet

▪ Schedule M reflects interest, dividend, rents, or royalty income or expense but those items are not reported separately on the balance sheet and there is no Subpart F income reported

▪ Form 5471 is filed for more than one related foreign corporation and Schedule M is not consistent

▪ Category 2 or 3 filer boxes are checked on page one but Schedule O is not attached, not complete, or wrong sections are filled out

▪ Schedule C income statement shows amount for tax provision but Schedule E does not reflect foreign taxes paid or accrued

54


Errors Apparent on the Face of the Form 5471 Information Return

▪ Schedule C income statement reflects passive income such as interest, dividends, rents, or royalties that does not qualify for the de minimis exception, there is current year E&P, and no current year Subpart F income is reported

▪ Schedule F balance sheet reflects loans due from U.S. shareholders, there is positive E&P, and no current year I.R.C. Section 956 inclusion is reported

▪ Form 5471 Schedule J does not reflect current year Subpart F or I.R.C. Section 956 inclusions which are reported on Schedule I

▪ Form 5471 Schedule J does not reflect current year distributions of non-previously taxed earnings and dividends are reflected on Schedule I

▪ Form 5471 Schedule J does not reflect accumulated amounts of prior year Subpart F or I.R.C. Section 956 inclusions

▪ Form 5471 Schedule J reports current year E&P in USD instead of foreign currency

55


Errors Beyond the Face of the Form 5471 Information Return

▪ Foreign corporation’s financial statements are not properly converted into U.S. GAAP to be reported on the Form 5471

▪ Foreign corporation’s financial statements reported on Form 5471 are not properly converted from foreign currency to USD with the divide by convention or correct exchange rate

▪ Adequate books and records are not maintained to keep track of intercompany and related party loans, receivables, payables, and other transactions

▪ Calculations of CEP and AEP are not maintained from year to year

▪ Correct foreign tax pools are not calculated from year to year for U.S. shareholders that are C corporation parent companies of the foreign subsidiary corporation

▪ U.S. parent corporation does not correctly calculate and report the I.R.C. Section 78 gross up on dividends received from the foreign subsidiary corporation

▪ U.S. parent corporation does not correctly calculate and report the I.R.C. Section 902 or 960 deemed paid foreign tax credit for actual and deemed dividend distributions

▪ I.R.C. Section 1248 amounts are not properly calculated or reported for dispositions of CFC stock

56


Form 5471 Example from the IRS International Practice Unit Guidance

▪ Example 1: FSA 33381431 – The taxpayer did not substantially comply with the Form 5471 reporting requirements. ➢ Significant understatements of purchases from and sales to some CFCs and related third

parties reported on Schedule M

➢ Significant inconsistencies in the earnings and profits of some CFCS

➢ Other information reported on Form 5471 was accurate

▪ Example 2: CCA 200645023 – The taxpayer did not substantially comply with the Form 5471 reporting requirements. ➢ Schedule C income statement and Schedule F balance sheet not reported in accordance with

U.S. GAAP

➢ Schedule O was not attached

➢ Forms 5471 not filed for certain inactive or dormant foreign corporations

57


Form 5472 Examples from the IRS International Practice Unit Guidance

▪ Example 3: CCA 200429007 – The taxpayer did not substantially comply with the Form 5472 reporting requirement. ➢ Some transactions were reported erroneously

➢ Magnitude of each erroneously reported transaction was substantial in relation to all other reportable transactions, substantial in relation to the volume of business and overall financial situation

▪ Specific Errors: ➢ Taxpayer over-reported amounts in Part IV purchases of stock in trade as $1,000X when the

actual amount was $500x

➢ Taxpayer incorrectly reported intercompany A/R not required and later corrected Form 5472 to remove them

➢ Ending balance of related party loans did not match the beginning balance on the next year’s Form 5472 and the opening loan balance was incorrectly reported

➢ Taxpayer over-reported one amount and under-reported another amount. There was a relatively small aggregate difference between the correct total and what was reported.

58


Form 5472 Example from the IRS International Practice Unit Guidance

▪ Example 3: CCA 200429007 – The taxpayer did not substantially comply with the Form 5472 reporting requirement.

▪ Seven factors to consider in determining whether taxpayer has substantially complied.

1. The magnitude of the underreporting, or of the over-reporting, of the erroneous reported transactions in relation to the actual total amount of that reported type of transaction.

2. Whether the reporting corporation has reportable transactions other than the erroneous reported transactions with the same related party and correctly reported such other transactions

3. The magnitude of the erroneous reported transactions in relation to all of the other reportable transactions as correctly reported

4. The magnitude of the erroneous reported transactions in relation to the reporting corporation’s volume of business and overall financial situation

5. The significance of the erroneous reported transactions to the reporting corporation’s business in a broad functional sense

6. Whether the erroneous reported transactions occur in the context of a significant ongoing transactional relationship with the related party

7. Whether the erroneous reported transactions are reflected in the determination and computation of the reporting corporation’s taxable income

59


SCHEDULES REQUIRED TO BE ATTACHED TO FORM 5471 BASED ON APPLICABLE U.S. FILER CATEGORY

60


FORM 5471 – Who Must File?• Category 2 Filer =

1. A U.S. citizen or resident who is an officer or a director of a foreign corporation and

2. A U.S. person has acquired 10% or an additional 10% of vote or value of the foreign corporation in one more transactions

• Category 3 Filer = 1. U.S. person who acquires stock which when added to stock

already owned represents 10% of vote or value2. U.S. person who acquires an additional 10% of vote or value3. U.S. person who is a U.S. shareholder of a captive insurance

company per I.R.C. § 953(c) 4. U.S. person who becomes a U.S. person while meeting the

10% stock ownership requirement5. U.S. person who disposes of sufficient stock to reduce

ownership percentage to less than 10%

61


FORM 5471 – Who Must File?

• Category 4 Filer = • U.S. person who had control of a foreign corporation for

an uninterrupted period of at least 30 days during the foreign corporation’s annual accounting period

• Control = • U.S. person owns more than 50% of vote or value of the

foreign corporation at any time during the U.S. person’s tax year

• U.S. person who controls a corporation which owns more than 50% of another corporation is considered to be in control of the other corporation pursuant to I.R.C. § 6038(e)(2).

62


FORM 5471 – Who Must File?

• Category 5 Filer = 1. U.S. shareholder who owns directly, indirectly or

constructively at least 10% of a controlled foreign corporation (CFC)

2. for an uninterrupted period of 30 days or more during any tax year of the foreign corporation (this requirement will likely be eliminated) and

3. who owned the stock on the last day of that year

• Controlled Foreign Corporation = foreign corporation with more than 50% of the total combined vote or value owned directly, indirectly or constructively by U.S. shareholders.

63


FORM 5471 INFORMATION RETURN OF U.S. PERSONS WITH RESPECT TO CERTAIN FOREIGN

CORPORATIONS

64


FORM 5471 SCHEDULES A & B

65


FORM 5471 SCHEDULE C INCOME STATEMENT

66


FORM 5471 SCHEDULE E INCOME TAXES PAID OR ACCRUED

67


FORM 5471 SCHEDULE F BALANCE SHEET

68


FORM 5471 SCHEDULES G, H & I

69


FORM 5471 SCHEDULE J ACCUMULATED EARNINGS & PROFITS (AEP)

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