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US GAAP Conversion of Foreign Financials: Most Common Issues | Form 5471 Lawyer

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Form 5471 generally requires US GAAP (Generally Accepted Accounting Practices) conversion of foreign financial statements for the purposes of reporting book income, because foreign accountants usually prepare these statements based on a different foreign standard.  While Treas. Reg. Reg. §1.964-1(a)(2) contains a limited exception to the US GAAP conversion adjustments for “non-material” items (the same exception applies to tested/income loss calculation for GILTI purposes; see Treas. Reg. §1.951A-2(c)(2) (which refers to Treas. Reg. §1.952-2, which, in turn, mention the “materiality” rules of the §964 regulation)), the translation of foreign financial statements to US GAAP is a common problem for tax professionals who deal with Form 5471.

In this article, I will outline the most common issues related to the conversion of foreign financial statements to US GAAP.

US GAAP Conversion Issues: Depreciation

At the top of the US GAAP adjustments are different methods of depreciation and amortization. These differences cover pretty much all types of depreciable assets: fixed assets and intangible assets (including goodwill).

When we at Sherayzen Law Office prepare Forms 5471 for our clients, it is our standard practice to request that foreign accountants provide a detailed depreciation report, including amounts and dates concerning the purchase/sale of assets, the amortization/depreciation conventions used in foreign financial statements and the methods of accounting for increase/decrease in the value of depreciable assets.

US GAAP Conversion Issues: Inventory

Another very common area of US GAAP adjustments involves inventory. Here there could be an array of variations from FIFO/LIFO to expense capitalization methods and valuation of inventory.  Common problems arise when the inventory valuation adjustments result from related-party transactions.

For example, in one of our cases, our client had contracts of sale drafted between the head office in the United States and a foreign branch office (due to the foreign country’s requirements), making it impossible to directly rely on the foreign branch’s financial statements to determine the Cost of Goods Sold (COGS) due to varying mark-ups on tens of thousands of items.

US GAAP Conversion Issues: Valuation of Assets

One highly-problematic area for US GAAP adjustments is the valuation of assets in the foreign financial statements.  Oftentimes and in a large number of tax jurisdictions, historic cost of assets is replaced with another valuation method allowed by a local accounting standard but not by US GAAP.

We see this problem appear often in tax jurisdictions as varied as Czech Republic, Jamaica, Nigeria, Pakistan, Poland, et cetera.

US GAAP Conversion Issues: Mergers, Dissolutions and Acquisitions

Mergers, dissolutions and acquisitions may result in a bewildering array of differences between foreign financial statements and US GAAP requirements: from income recognition to asset valuation, treatment of reserve, E&P calculations and so on. Sometimes, there may be a break in the continuity of financial statements due to a dissolution of one entity and creation of another entity for US GAAP purposes while entities are treated as one entity in a foreign jurisdiction. I remember one case from Pakistan and one case from Poland where we had to make just an enormous amount of changes to bring these financial statements into compliance with US GAAP precisely due to the issues of mergers and acquisitions.

US GAAP Conversion Issues: Hyperinflation

Hyperinflation may present a US international tax attorney with its own challenges. As it is especially common in Latin America, local financials would incorporate inflationary adjustments that are incompatible with US GAAP.  An international tax lawyer has to identify these adjustments, reverse them and, if necessary, replace with adjustments required by GAAP.

US GAAP Conversion Issues: Reserves

Finally, the last most common area of problems has to do with reserves.  The problem usually arises in situations where local accounting rules permit allocation of certain reserves in a manner incompatible with US GAAP rules.

US GAAP Conversion Issues: Special Case of Consolidated Financial Statements

In a situation where a US parent company of a foreign subsidiary prepares consolidated financial statements, problems may arise with respect to whether these statements provide all relevant information needed to create a GAAP-compliant Form 5471. There are four main areas of concern in this type of cases: artificial consolidations through check-the-box rules, foreign currency fluctuations, deductions related to pensions and transfers within the group.  I will discuss these issues in more detail in a future article.

E&P Adjustments

I want to mention here that, in addition to GAAP adjustments to local financial statements, Form 5471 also requires E&P adjustments to GAAP-compliant financial statements. I will explore this topic in a future article.

Contact Sherayzen Law Office For Professional Help with Form 5471 Preparation and Offshore Voluntary Disclosures

If you are a US person who owns (fully or partially) a foreign corporation and you need to prepare a Form 5471 for a current year or any previous years, then you should contact Sherayzen Law Office for professional help.

Our international tax team, led by an international tax attorney and founder of Sherayzen Law office, Mr. Eugene Sherayzen, is a group of highly experienced and creative tax professionals with profound knowledge of US international tax law and US international tax accounting rules. We have filed hundreds of Forms 5471 in the past helping clients around the globe with their current US tax compliance as well as offshore voluntary disclosures related to prior Form 5471 noncompliance. We can help You!

Contact Us Today to Schedule Your Confidential Consultation!

Basic Individual Tax Reporting Requirements for U.S. Citizens Residing Outside of the United States

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If you are a U.S. citizen or a dual citizen of the United States and another country (or countries) the IRS expects you to comply with certain individual tax reporting requirements even you reside outside of the United States. The purpose of this article is to outline some of the most important of these reporting requirements; it should be noted, however, that this article simply provides a broad background information and does not cover all of the requirements that may be applicable to in your situation – you are advised to consult Sherayzen Law Office for a detailed analysis of your particular tax reporting requirements.

A. Tax Return Filing Requirements

The United States has a very complex tax system which is somewhat unique in the world. One of the most singular features of this tax system is the taxation of the worldwide income of its citizens. As a United States citizen, you must file a federal income tax return for any tax year in which your gross income is equal to or greater than the applicable exemption amount and standard deduction. I wish to emphasize here that “gross income” means worldwide income. For example, if you earned $1,000 in the United States and $50,000 outside of the United States, you must file a U.S. tax return (however, if you meet all of its requirements, you may be able to take the foreign earned income exclusion). With exceptions which may or may not apply to your case, you have to report the worldwide income irrespective of what type of income you are receiving – rental, bank interest, dividends, et cetera. Note, however, that certain tax treaties may apply and modify your particular tax reporting requirements.

B. Form TD F 90-22.1: FBAR (Report on Foreign Bank and Financial Accounts)

As a United States citizen, you may be required to report your interest in certain foreign financial accounts on FinCEN Form 114 formerly Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). The form should be filed separately from your tax return by June 30 of each relevant calendar year. Visit our Voluntary Disclosure and FBAR Center for more information.

It is important to emphasize that the combination of failure to file the FBAR with failure to pay U.S. tax can radically complicate your legal situation as the FBAR penalties are more likely to be imposed in this scenario. These FBAR penalties are likely to be much higher than your average failure to file penalty.

Please schedule a consultation with Sherayzen Law Office experienced FBAR tax firm in order to deal with this situation properly.

C. Individual Reporting With Respect to Foreign Business Ownership: Forms 5471, 8865, et cetera.

In some situations, you may be required to file additional forms with respect to foreign business ownership. The most common of these forms are 5471, 8865, 8858, and so on. These are highly complex forms which are usually filed with your tax return.

D. Reporting of Foreign Gifts, Inheritance, and Trust Income: Form 3520

In some situations, you may be required to file Form 3520 in order to report qualifying foreign gifts, inheritance, and trust income.

Keep in mind, additional requirements may apply with respect to domestic gifts, inheritance and trust distributions.

E. Passive Foreign Investment Company Income: Form 8621

In some situations, you may be required to file Form 8621 in order to properly report what is known as “passive foreign investment company” or PFIC income. Despite its deceivingly simple format, this form may require extremely complex accounting calculations and legal determinations. A separate penalty structure applies to Form 8621.

F. New Reporting Requirements of Foreign Financial Assets: Form 8938

A new law (FATCA) requires U.S. taxpayers who have an interest in certain specified foreign financial assets with an aggregate value exceeding the specified threshold amount to report those assets to the IRS. Taxpayers who are required to report must submit Form 8938 with their tax return. See our earlier article with respect to Notice 2011-55 for additional information about this reporting requirement under IRC section 6038D.

This form carries its own elaborate penalty structure which may even affect your ability to take foreign tax credit.

H. Other Reporting Requirements

Obviously, it is beyond the scope of this article to list every tax reporting requirements that may apply to your case. This article merely attempts to sketch some of the most important tax filing requirements that you may need to comply with. There are may be other forms that may apply to your particular situation; you will need to consult Sherayzen Law Office for a particular analysis of your fact pattern.

G. Penalties

1. Penalties and Interest imposed for failure to file income tax returns or to pay tax

Failure to file the income tax return and/or pay tax due may result in substantial IRS penalties unless you show that the failure is due to reasonable cause and not due to willful neglect. Main penalties are listed in Internal Revenue Code (IRC) Section 6651 and include failure to file and failure to pay tax (both of which are limited to 25 percent of your total tax deficiency).

In addition to penalties, pursuant to IRC Sections 6621 and 6622, the IRS will also require you to pay the interest on the tax liability according to underpayment rate (compounded daily) published on a quarterly basis.

2. Reasonable Cause Considerations

Whether a failure to file or failure to pay is due to reasonable cause is based on a consideration of the facts and circumstances. Reasonable cause relief is generally granted by the IRS when you demonstrate that you exercised ordinary business care and prudence in meeting your tax obligations but nevertheless failed to meet them. In determining whether you exercised ordinary business care and prudence, the IRS will consider all available information.

This is why it is important to have an experienced tax attorney advocating your position and presenting the arguments to the IRS. While it is not a guarantee that the IRS will actually abate the penalties, your chances of success are likely to be higher than if you were to present your case without professional assistance.

3. Possible additional penalties that may apply in particular cases

In addition to the failure to file and failure to pay penalties, in some situations, you could be subject to other civil penalties, including the accuracy-related penalty, fraud penalty, and certain information reporting penalties.

Moreover, you may be subject to additional penalties for failure to accurately file other informational reports such as 3520, 8865, 5471, 8621, 8938 and other forms. These penalties can be extremely severe and such cases must be reviewed by a tax professional before presenting the argument to the IRS. FBAR penalties especially stand out due to their potentially draconian severity. For example, the civil penalty for willfully failing to file an FBAR can be up to the greater of $100,000 or 50 percent of the total balance of the foreign account at the time of the violation. See 31 U.S.C. § 5321(a)(5). Since the penalty can be imposed for each year of non-compliance, the FBAR penalties can greatly exceed the current balance on an account.

Finally, criminal penalties may be imposed in extreme cases.

You should visit our Voluntary Disclosure and FBAR Center in order to learn more about the tax reporting requirements as well as the various penalty structures that may apply to you.

Contact Sherayzen Law Office To Determine Your IRS Reporting Requirements

This article merely provides a general background information on U.S. tax reporting requirements and is NOT meant to be treated as a legal advice. If you are U.S. citizen or a dual citizen and you live abroad (or have exposure to international taxes), contact Sherayzen Law Office for legal help with U.S. international tax compliance. Our experienced tax compliance firm will guide you through the complex web of international tax reporting requirements and help you bring your tax affairs into full compliance with U.S. tax laws and regulations.