ARTICLE WRITTEN BY UHY MESA HODSON AND MERIL MARKLEY
The last few years have seen increased emphasis on individuals reporting about their foreign investments and penalizing those who fail to do so. While we have written about these rules in prior Tidbits, this article covers some key changes about reporting with respect to the 2013 tax year with particular importance for anyone with investments in foreign mutual funds or other foreign corporations that might be considered “passive foreign investment companies” or “PFICs.” Individuals should consult their tax advisors about complying with these requirements.
THE TRIO OF REPORTING REGIMES FBAR, FATCA, AND PFIC
A new form for FBAR has been issued (FinCEN Form 114 – Report of Foreign Bank and Financial Accounts) along with a revised form for FATCA (Form 8938 – Statement of Specified Foreign Financial Assets). Owing to regulations issued by Treasury on December 30, 2013, there are new reporting requirements related to PFICs for the 2013 tax year (Form 8621 – Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund).
Ownership of a foreign investment, whether directly or indirectly, can involve reporting about a PFIC on Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) and about foreign financial assets on Form 8938 (Statement of Specified Foreign Financial Assets), both as part of a 2013 federal income tax return. In addition, separate reporting to the U.S. Treasury Department may be required about a foreign financial account using the electronic FinCEN Form 114 (Report of Foreign Bank and Financial Accounts). Each of these forms involves penalties for failure to file.
The form known as the FBAR or Foreign Bank Account Report has been around for decades and is used to report to the U.S. Treasury Department an interest in, or signature authority over, a foreign financial account. What was TD F 90-22.1 (Report of Foreign Bank and Financial Accounts), and used for calendar years through 2012 is now called FinCEN Form 114 and can only be filed online. The report for calendar 2013 is due on or before June 30, 2014. No extensions are available. However, reports by certain persons with signature authority but no ownership interest may not be due until June 30, 2015.
For some time there was uncertainty about the extent to which mutual funds organized outside the U.S. might be foreign financial accounts reportable on the FBAR. The regulations finalized by the Financial Crimes Enforcement Network (“FinCEN”) of the U.S. Treasury Department on February 23, 2011 provide that “a mutual fund or similar pooled fund which issues shares available to the general public that have a regular net asset value determination and regular redemptions” is included in the definition of a reportable account.
The FBAR is not a tax form and is not included in a federal income tax return. Individuals can register online and file the form but it is also possible for tax preparers to file the form online on behalf of their clients. Persons required to file an FBAR include U.S. citizens and tax residents, U.S. corporations, limited liability companies (including those disregarded for U.S. federal income tax purposes), partnerships, estates, and trusts having an ownership interest in a foreign financial account as well as individuals with signature authority but no ownership interest in the account. Generally, the threshold for filing is based on a total aggregate value of accounts exceeding $10,000 at any time during 2013 and regardless of whether any income was earned.
FATCA or the Foreign Account Tax Compliance Act was part of the Hiring Incentives to Restore Employment Act of 2010 and added section 6038D to the Internal Revenue Code. Beginning with the 2011 tax year, individual taxpayers whose specified foreign financial assets exceed the applicable thresholds have been required to include Form 8938 in their U.S. federal income tax returns. This is to report their interests in foreign financial accounts and in foreign financial assets held for investment, such as interests in foreign corporations and partnerships not held through an account maintained with a financial institution.
In the case of a foreign mutual fund, a U.S. individual who owns shares directly in the fund, rather than through a brokerage account, would report the investment among his or her foreign financial assets. If instead, the investment is held through a brokerage account at a foreign financial institution, the brokerage account would be reported as a foreign financial account but the investment in the foreign mutual fund would not be reported separately. If the brokerage account through which the investment is made is at a U.S. financial institution, then neither the brokerage account nor the investment in the foreign mutual fund is reported on Form 8938.
Definitions and reporting requirements for FBAR and FATCA differ, with the result that a person whose accounts or assets exceed the threshold for Form 8938 may not have to file an FBAR, and vice versa, or may have to file both Form 8938 and the FBAR. For a summary comparing FBAR and FATCA, see the table on the IRS website, reproduced (as of February 10, 2014 update by the IRS), below. It is not, however, a substitute for reviewing in detail the rules on reporting of specified foreign financial assets.
PFIC rounds out the trio of foreign filing requirements covered in this Tidbit. Rules covering a PFIC have been around since the Tax Reform Act of 1986 and are found in IRC sections 1291 through 1298. The legislative history indicates that the PFIC rules were enacted to target U.S. investors in foreign mutual funds who were taxed at preferential capital gains rates when disposing of an interest in a fund organized as a foreign corporation but not a “controlled foreign corporation” or “CFC.”
A CFC is a corporation created or organized in a foreign country and having more than 50% of voting power or value of the corporation held by persons who are “U.S. Shareholders.” A U.S. Shareholder is a U.S. person having at least a 10% interest in the voting power of a foreign corporation. When a U.S. Shareholder disposes of shares in a CFC, capital gain is recharacterized as ordinary income under IRC section 1248 to the extent of earnings of the CFC not previously subjected to U.S. tax and attributable to the shares transferred.
The PFIC rules were an attempt to put U.S. owners of shares in foreign mutual funds on a footing roughly equal to that of U.S. Shareholders in CFCs. However, the reach of these provisions goes far beyond foreign mutual funds to any foreign corporation whose passive income or assets exceed the thresholds in IRC section 1297: 75% or more of gross income is passive or the average percentage of assets, held by the corporation for the year and considered to produce passive income, is at least 50%. It is likely that a foreign mutual fund or other investment vehicle organized as a corporation under the laws of a foreign country could be a PFIC because of the nature of its income being passive (e.g., dividends, capital gains) or its assets (e.g., shares in other companies) being of a type that generates passive income. However, a foreign corporation conducting an active business can also fall into the PFIC classification if, for example, it has a net operating loss but its only income, interest earned from a bank account, is passive. Once it becomes a PFIC, it will remain one unless certain elections are made.
Owing to an amendment enacted by the Tax Reform Act of 1997, a foreign corporation that is a CFC will not be considered a PFIC, but only with respect to persons who are U.S. Shareholders. U.S. persons who do not own shares representing at least 10% of the voting power of a CFC, and so would not be U.S. Shareholders, should be concerned about whether the foreign corporation is or may become a PFIC and the consequences of receiving an excess distribution or disposing of shares.
The PFIC rules do not tax income of a PFIC currently unless the shareholder so elects. If in the absence of an election the PFIC shareholder received an excess distribution (such as certain dividends) or sold the shares of the PFIC in 2013, the excess distribution or gain is allocated to each day in the shareholder’s entire holding period for the stock. Gross income taxable at ordinary income rates for 2013 would include the amount allocated to 2013 and amounts allocated to years prior to 2013 when the shareholder owned the shares. In addition to tax on the income so allocated, the shareholder’s tax for 2013 would be increased by a deferred tax amount designed to take into account the taxes that the shareholder would have paid, had the PFIC distributed its earnings each year, and interest on those taxes. While elections are available and involve alternative methods of taxing shareholders of a PFIC, these elections should be considered carefully with a tax advisor.
Determining whether a foreign corporation is a PFIC has taken on greater importance for the 2013 tax year. This is because of regulations issued on December 30, 2013 amending provisions covering the filing of Form 5471 and requiring shareholders of a PFIC to report information about the PFIC on Form 8621 annually. The regulations contain some exceptions from reporting on Form 8621, for example, if the value of all PFICs owned directly by the U.S. person is $25,000 or less. In that case, however, the investment in the PFIC might still need to be reported on Form 8938 as well as the FBAR if the value of the taxpayer’s foreign financial assets exceeds the filing thresholds for those forms..