International Tax Attorney Minnesota Minneapolis

Limitations to the Non-Recognition Rules for Asset Transfers to Foreign Corporations

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Are you thinking of transferring appreciated property to a foreign corporation in order to utilize the corporate “non-recognition” rules, and to possibly avoid further US taxes? You should be aware that while in certain circumstances it is feasible to transfer such property in order to properly run a business, there are many limitations placed upon the ability of US persons to do so when transfers to foreign corporations are involved. This article will briefly explain these limitations under section 367, and its subsections.

The Corporate Non-Recognition Rules

Under the IRS non-recognition rules, C corporations can generally avoid taxation on certain transfers of appreciated property when a corporation is formed (IRC section 351), reorganized (IRC sections 354, 355, or IRC 361), or liquidated (IRC section 332). These rules thus constitute an exception to the general corporate tax rule that sales or exchanges of property by taxpayers is a taxable event.

However, the corporate non-recognition rules are limited under IRC Section 367 when property is transferred by or to foreign corporations.

IRC Section 367

IRC Section 367 was enacted in order to prevent US taxpayers from avoiding US taxes by transferring assets to controlled foreign corporations when such an entity is formed, reorganized, or liquidated under the corporate non-recognition provisions. The section specifies that a foreign entity will not be considered to be a “corporation” for the purposes of IRC Sections 332, 351, 354, 356, and 361.

The following paragraphs will briefly describe some of the subsections of section 367.

IRC Section 367(a)

Section 367(a) limits the ability of US persons to transfer appreciated property (such as stock, assets, or certain other property) to foreign corporations in a corporate reorganization to avoid US taxes, and then sell the appreciated property outside of the U.S. tax jurisdiction. Unless a transferor qualifies for an exception, section 367(a) generally treats an exchange of certain property (under sections 351, 354, 356 or 361) by a U.S. person to a foreign corporation as a taxable exchange. These exchanges are commonly termed as “outbound transfers”.

The IRC generally grants an exception to outbound transfers of assets (other than stock) if the assets are to be used in the active conduct of a trade or business outside the United States.

IRC Section 367(b)

IRC section 367(b) is primarily intended to monitor the earnings and profits of a controlled foreign corporation. The subsection IRC provides that, “[I]n the case of any exchange described in IRC sections 332, 351, 354, 355, 356 or 361 in connection with which there is no transfer of property described in IRC section 367(a)(1), a foreign corporation shall be considered to be a corporation except to the extent provided in regulations prescribed by the Secretary which are necessary or appropriate to prevent the avoidance of Federal income taxes”. Additionally, there are proposed regulations under this section addressing the carryover of earnings and profits and taxes.

IRC Section 367(d)

Outbound transfers of intangible assets are covered under subsection 367(d), and not the more general subsection 367(a). Under this subsection, if a U.S. person transfers an intangible asset to a foreign corporation (in an exchange described in IRC section 351 or 361), the tax effect is to treat the intangible asset as having been exchanged for contingent (royalty) payments. The contingent payments (for a period of no more than 20 years) must be commensurate with the income attributable to the intangible transferred.

US persons subject to this subsection must report the exchange in accordance with IRC section 6038B, or be subject to penalties, as well as an extended statute of limitations under IRC section 6501(c)(8).

IRC Section 367(e)

Under Section 367(e), if a US corporation distributes the stock of a foreign corporation to a foreign person in a distribution described in IRC section 355 (“Distribution of stock and securities of a controlled corporation”), gain on the distribution will be taxable to the distributing corporation under IRC section 367(e)(1); however, the distribution of the stock of a domestic corporation by a US corporation to a foreign person under section 355 would not generally be taxable under IRC Section 367(e). The tax liability of the foreign person is unaffected by this section.

Furthermore, under IRC section 367(e)(2), if a U.S. corporation is liquidated into a foreign parent corporation under IRC section 332, the U.S. corporation will be treated as if it sold its assets in a taxable transaction (i.e. IRC section 337(a) and (b)(1) will not be applicable), except as provided by regulations.

Additional Related Reporting Requirements

It is important to remember that IRC Section 367 requires various IRS reporting requirements, collectively known as “367 Notices”. Moreover, certain outbound transfers by U.S. persons may require the filing of Form 926. Other IRS reporting requirements may apply depending on your particular fact pattern.

Contact Sherayzen Law Office for Legal Help With Transferring of Appreciated Property to Foreign Corporations

This article provides only a very general overview of the IRC Section 367; however, the subject matter is much more complex and depends on constantly changing IRS regulations. Therefore, this article does not offer legal advice and should NOT be relied upon in determining your particular tax situation.

If you (or the entities that you control or partially-own) are planning on transferring tangible and intangible property to a foreign entity, contact Sherayzen Law Office for professional legal assistance in this obscure and highly complicated international tax matter. Our experienced international tax firm will guide you through the complex web of international tax rules in order to best structure your international business and tax transactions as well as help you comply with the numerous relevant IRS reporting requirements.

Who Must File Form 8858

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If a U.S. person owns or is considered to be the owner of a Foreign Disregarded Entity (“FDE”), then he must file Form 8858. In general, there are three different groups of persons who may be required to file the Form.

1. Direct “Tax Owners” of FDE

The instructions to Form 8858 define a “tax owner” as a “person that is treated as owning assets and liabilities of the FDE for the purposes of U.S. income tax law.” Thus, this group of filers includes U.S. persons who are direct owners of FDEs for U.S. tax purposes. For example, a natural person A owns 100% of FDE; therefore, A is required to file Form 8858.

2. Category 4 and 5 Filers of Form 5471 With Respect to a CFC That Owns the FDE

The second group of filers includes U.S. persons that are either category 4 or 5 filers of Form 5471 with respect to a controlled foreign corporation (“CFC”) if the CFC is the tax owner of the FDE.

3. Category 1 and 2 Filers of Form 8865 With Respect to CFP That Owns the FDE

Finally, the third group of filers includes U.S. persons that are either Category 1 or 2 filers of Form 8865 with respect to a controlled foreign partnership (“CFP”) if the CFP is the tax owner of the FDE.

Multiple Filers Exception

In some cases, a multiple filers exception may apply in order to avoid unnecessary filing of the same information. This exception works in conjunction with Forms 5471 and 8865 instructions for multiple filers of same information.

Contact Sherayzen Law Office To Determine Whether You Must File Form 8858

This article contains only general background information and should not be relied upon to determine whether you are required to file Form 8858.

If you are unsure about whether you must file Form 8858, contact Sherayzen Law Office for legal advice. Our experienced international tax firm will help you comply with your U.S. tax reporting obligations, including the determination of whether you are required to file Form 8858.

Form 5471: General Overview of the Required Information

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The individuals who fall within the four categories of U.S. persons who are required to file Form 5471 find out very fast just how incredibly complex this Form is. In addition to various problems associated with GAAP compliance, tax year adjustments, understanding very complex corporate tax and accounting rules (as well as the difference between them), and the logistical concerns with respect to obtaining the information, the sheer volume and variety of the information that Form 5471 requires the files to supply makes the Form one of the most difficult compliance requirements in the Internal Revenue Code.

In this essay, I intend to provide a very general overview of the information that needs to be disclosed on Form 5471.

1. General Information

Form 5471 generally requires you to disclose your personal information (such as Social Security Number, address, tax year, and so on), corporate information (name of the corporation, when organized, its business and so on), as well as on whose behalf Form 5471 is being filed.

Despite its apparent innocence, there are at least two pernicious issues in this seemingly basic section. First, there are detailed rules on whose behalf Form 5471 may be filed.

Second, the Form requires you to state your ownership share of the corporation at the end of the year. Sounds simple? Not so fast – there are specific attribution rules which may increase your share ownership in the corporation. Failure to apply those rules may result in choosing incorrect filing category and, ultimately, IRS penalties for non-compliance.

2. Category of Filers

There are generally four categories of filers who are required to file Form 5471 (there used to be five, but the first category was repealed by Congress).

From the outset, Form 5471 requires you to choose the category of filers that apply to you. This is not a simple process as each category has specific requirements. Moreover, you may (and most taxpayers actually do) fit into more than one category. If this is the case, then you may have to file additional schedules that require more disclosures to the IRS.

3. Stock of the Foreign Corporation

In this Schedule A of Form 5471, you are required to describe the stock of the corporation – number and class of stocks. Usually, this is one of the most benign sections of Form 5471. Nevertheless, some of my clients have had problems with Schedule A because they never properly documented all of the classes of stocks and their attributes. This resulted in substantial delays and proactive business planning.

4. U.S. Shareholders of the Foreign Corporation

In Schedule B, you will need to provide the name of each shareholder according to Form 5471 instructions. For each listed shareholder, you will need to provide the name, address, identifying number (for example, social security number), number of shares held (at the beginning and the end of the annual accounting period), and the class of shares. Moreover, for each shareholder, you will need to supply the pro rata share of Subpart F income (which, in itself, is a complex matter).

5. Schedule C: Income Statement

Schedule C is one of the most important and time-consuming parts of Form 5471. The complications are numerous.

First, the Income Statement should be prepared and reported on the Form in accordance with U.S. GAAP. If the foreign company used GAAP to prepare the original statements, the task is not very hard. If, however, the foreign company did not initially use GAAP, the conversion of financial statements to the GAAP standard can be incredibly complex, especially in a foreign context.

Second, the Income Statement should be reported in the Functional Currency and US dollars. The currency translation issues (especially according to GAAP) may become very difficult.

Third, the Net Income part of the Income Statement on Form 5471 presents its separate challenges with its separation of net income from current income per books according to the GAAP standard.

Finally, you need to make sure that the Income Statement corresponds to the Balance Sheet, especially given all of the currency translation issues.

Remember, various items on the income statement must be supported by attached schedules.

6. Schedule E: Taxes

The first common challenge in this section is to correctly identify the taxes that need to be reported. The second common issue is that you need to consult the instructions to make sure that the currency translation rate is correctly identified and presented on the form. I have seen even experienced international tax accountants make mistakes in this area.

7. Schedule F: Balance Sheet

Schedule F may be the most difficult part of Form 5471 (although schedules H and I are very close in this dubious contest).

The problems are so numerous that I will not even attempt to list them in this essay. Rather, I want to point out several common themes that you are likely to deal with in preparing Form 5471.

First, the Balance Sheet should be prepared according to GAAP and all amounts should be reported in U.S. dollars.

Do not be surprised if this means using as many as three or four different currency translation rates according to GAAP. The end result will be that your Balance Sheet does not appear to balance out, forcing you to engage in highly complex accounting.

Second, there will be a shortage of available space to properly reflect all of the Balance Sheet issues.

Third, Retained Earnings may become your best friend and your worst enemy. In the hands of a sophisticated tax professional (accountant or attorney), Retained Earnings may be used to resolve outstanding issues. A novice, however, may spend long hours trying to figure out how to use Retained Earnings and still fail in this task.

Finally, remember that certain items on the Balance Sheet must be supported by attached statements.

8. Schedule G Questions

There are various types of questions listed in Schedule G. In some situations, they may easily be answered, whereas other situations will require a more detailed analysis.

9. Schedule H: Current Earnings and Profits

You should be prepared to spend a significant amount of time on this section. This is another highly complex part of Form 5471. Earnings and Profits is an esoteric part of accounting which has a complex relationship with taxation. When it comes to Form 5471, the foreign context and GAAP rules greatly exacerbate the difficulty of the issues involved.

At the end of Schedule H, you will need to translate the amounts into US dollars and provide the translation rate.

10. Schedule I: Subpart F Income

Another challenging section of Form 5471. Treaties have been written on Subpart F income. I will just mention here that this is a highly complex section on which you should prepared to spend some time.

11. Schedule J: Accumulated Earnings and Profits

Although this part of Form 5471 maybe time-consuming, it is not very complex. One common difficulty that I have encountered in my practice is a practical one – lack of properly prepared records. If the foreign corporation has not been subject to 5471 requirements in the prior years or not for all years of its existence, it may not have the records to calculate the accumulated earnings and profits. This may result a “snowball” effect that it is more and more difficult to comply with Schedule J requirements unless one goes back many years to calculated the accumulated Earnings and Profits.

12. Schedule M

This form only applies in the context of a controlled foreign corporation (CFC). This is another time-consuming part of Form 5471 which concentrates on the transactions between the CFC and the shareholders and other related persons. It may take awhile before you figure out just what exactly should go on this form, especially if there are outstanding loans from and/or to shareholders.

13. Schedules O: Parts I and II

This part of Form 5471 allows the IRS to keep track of any corporate re-organizations, acquisition and disposition of the corporation’s stock, and other organization and asset related matters. Relatively speaking, this is not a complex part of the Form, but it has its own issues that may arise during its preparation.

Conclusion: Contact Sherayzen Law Office NOW for Help With Drafting Form 5471

Based on the very general overview of 5471 requirements, it becomes clear that you should not attempt to complete Form 5471 on your own. Nor should you expect any help from the IRS. There is not a single department that you can call to have your questions answered. Form 5471 specialists are limited to examiners to whom you will not have direct telephone access.

Therefore, if you fall within one of the categories of taxpayers who are required to file Form 5471, please contact Sherayzen Law Office. Our experienced international tax firm will help you prepare the necessary documentation, complete Form 5471 and file it on your behalf. If you have not filed your Forms 5471 for prior years, we will help you deal with this situation and guide you through the IRS voluntary disclosure process.

Foreign Tax Credit: General Overview

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US tax residents and citizens are taxed based upon their worldwide income. This can often result in individuals being subject to double taxation. To provide relief from this problem, the Foreign Tax Credit (FTC) provisions were enacted. There are two types of FTC’s, the direct credit and the indirect credit.

Direct Foreign Tax Credit

In general, IRC Section 901 allows for direct credit for foreign taxes paid by US taxpayers. In general, taxpayers must have directly incurred the taxes paid in order to qualify for the credit. US income tax liability is reduced on a dollar-for-dollar basis under this credit.

Indirect Foreign Tax Credit

If a US corporation conducts operations through a foreign subsidiary, the direct FTC is not allowed for foreign taxes paid by the subsidiary. Instead, for US corporate taxpayers with 10% or more US shareholders that receive actual or constructive dividends from foreign corporation that have paid foreign income taxes, an indirect FTC may be taken. The indirect FTC is determined based upon a specified computation. US corporations that elect the FTC for deem- paid for foreign taxes must “gross up”, or add to income, any dividend income by the amount of deem-paid taxes under IRC Section 78.

Contact Sherayzen Law Office NOW for the FTC Legal Help

This article is intended to give a very brief summary of these issues, and should not be construed as legal or tax advice. Reporting foreign-earned income often necessitates an experienced understanding of complex regulations, IRC statutes, and case law, and IRS penalties for failure to comply can be substantial. If you have further questions regarding your own tax circumstances, Sherayzen Law Office offers professional advice for all of your cross-border, international, and other tax needs. Call now at (952) 500-8159 for a consultation today.