Reporting common foreign transactions of U.S. clients.
U.S. persons with international transactions or investments need to file a winery of special tax forms. (1) Noncompliance can be costly. Besides any tax due, not filing some information returns can result in the loss of a benefit or a monetary penalty. Some reporting failures may result in criminal sentences. No tax adviser wants to have a current or previous client receive a notice demanding penalties.
This article highlights common client activities (2) that give rise to an international reporting obligation, offers a number of examples and identifies the tax forms that need to be filed ha each case. Some common international reporting forms are listed in Exhibit 1 on p. 735. It will be helpful for tax advisers who do not specialize in international tax, but whose clients have international transactions, investments or business activities.
The International Reporting Minefield
While it is a cliche to say the world is getting smaller, it is true that national borders are becoming less of an obstacle to cross-border transactions. Small businesses create websites and soon receive orders from all over the globe. Investors look for investments all over the world using the Internet. Employees of U.S. multinational companies work abroad, get married and raise a family outside the U.S.
Below are some examples of the many ways in which U.S. clients get involved (or entangled) in various offshore or cross-border arrangements with tax ramifications different from similar transactions in the U.S.
Example 1: P, a small specialty publisher, advertises on the Internet; potential customers from around the world respond and submit orders via credit card. Dealers in other countries inquire about discounts and shipping terms. Reporters and editors worldwide call for background on a "hot" new book or request review copies. An acquaintance suggests that P could save taxes with a company in a tax haven and defer income taxes on all of his sales to foreign buyers. A lawyer in the Bahamas creates an International Business Company (IBC) and P begins to route orders from foreign countries to the Bahamas IBC. The lawyer also suggests that P establish a foreign trust to own the IBC, for asset protection from potential litigation. The lawyer agrees to serve as the trustee of the foreign trust, but P continues to serve as the IBC's chief executive officer.
Had P consulted with an attorney who specializes in international tax, it would have learned that its activities give rise to a number of return and reporting requirements:
1. P should be declaring all of the profits from the IBC as current taxable income on Form 5471, Return of U.S. Persons with Respect to Certain Foreign Corporations, because the IBC is a controlled foreign corporation (CFC) and the IBC's income is currently taxable to its shareholders.
2. P is the grantor of a foreign trust and is required to file Forms 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, and 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner.
3. Form 926, Return by U.S. Transferor of Property to a Foreign Corporation, should have been filed in the year the IBC was funded.
4. Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, should be filed to disclose foreign account information.
U.S. Persons Working and Living Outside The U.S.
Example 2: J was sent to England to manage a branch office of a U.S. distributor of medical equipment. He was single and looked forward to the opportunity to live in another country. The earned income exclusion (3) (Form 2555, Foreign Earned Income) appeared beneficial. He began to invest some of his income in foreign mutual funds.
England imposes higher taxes on earnings than does the U.S. J could take a tax credit under Secs. 901-906, using Form 1116, Foreign Tax Credit--Individual, Estate or Trust, for the U.K. taxes paid on income subject to tax in both countries. However, under Sec. 904, the tax credit is limited to the tax he would have paid on the same income in the U.S. The excess taxes paid to England cannot be offset against J's U.S. taxes.
The foreign mutual funds J invested in are not treated the same way as U.S. mutual funds. J would cither have to endure a punitive tax on the sale or liquidation of the foreign mutual fund shares or file an election under Secs. 1292-1295 to report the fund's income each year on Form 8621, Return by U.S. Shareholder of Passive Foreign Investment Company or Qualified Electing Fund.
Investors Seeking High Yields Offshore
Example 3: A and B are retired and frustrated with the low interest rates being paid on their investments. C, a member of their church, told them about an investment opportunity with a bank in Grenada and assured them the bank was guaranteed by the International Deposit Indemnity Corporation. (4) According to C, the investment was paying as much as 5% a month on certificates of deposit (CDs). C also assured them that the income was tax deferred as long it was outside the U.S.
A and B contacted the bank and were told they would have to make the investment through a trust or corporation in a country other than the U.S. and Grenada. A bank employee referred them to a per son in the British Virgin Islands (BVI) who would set up a corporation for them for about $1,000. They then invested $31,000 in their foreign corporation, which purchased $30,000 of CDs. For a couple of years, they were ecstatic over the huge returns being compounded in their account statement.
However, when they attempted to recover some of their profits to pay for the annual corporation fees, the bank informed them it was having computer problems. These problems persisted for nearly six months; the Government of Grenada froze the bank's accounts and hired a liquidator to find bank assets. A and B were victims of one of the biggest Ponzi (5) schemes of the late 20th century.
A and B were required to file back tax returns for their BVI corporation, a CFC. They have to file Forms 5471, 926 and TD F 90-22.1, and amend their personal returns to disclose the foreign account on Form 1040, Schedule B, Part III, Information Regarding Foreign Accounts or Trusts. These returns are required even though no income was ever earned or realized.
Protection from Litigation
A lifetime of diligent work and frugal savings can be eliminated because of a single mistake or a predatory litigant. In many cases, insurance coverage is inadequate mad the defendant's personal assets are at risk. In a growing number of cases (particularly with medical professionals), malpractice insurance is not available. The business and personal assets of those who operate a business or real estate venture as a sole proprietor or general partner are also at risk. Assets held jointly (6) with a spouse, children or even parents, are likewise at risk.
There are a variety of legal ways to mitigate such risks, including a trust located in a foreign country with pro defendant laws. (7) However, the use of a foreign trust generally involves filing some tax forms that differ greatly from those commonly used by U.S. tax advisers:
1. The transfer of assets to a foreign trust (and some other transactions) requires the filing of Form 3520. Once the trust is established, an annual Form 3520-A is required to disclose the trust's income and financial position. Because the trust is a grantor trust, Form 1041, U.S. Income Tax Return for Estates and Trusts, may also be required.
2. If the foreign trust forms a foreign corporation, Form 5471 is required-unless the trust and the grantor elect to have the entity taxed as a "disregarded entity." That election requires Form 8832, Entity Classification Election.
3. If the foreign trust invests in any foreign mutual funds, Form 8621 may have to be prepared for each such fund.
4. The trust grantor will have to file Form TD F 90-22.1 each year to disclose the ownership (albeit indirectly) of one or more foreign financial accounts.
Foreign Partnerships and Joint Ventures
Example 4: R is a retired business owner who wanted a promoter to help Iron create a foreign limited liability company (LLC), so he could retain some control over his assets. (8) He bought a package service to form a Nevis LLC, then gave his son a small ownership interest, so that he would be a co owner. R elected on Form 8832 to have the LLC treated as a disregarded entity.
The entity classification election for a foreign entity with multiple owners results in a foreign partnership, which requires filing Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships. Form 8865 is also required whenever a joint venture is based outside the U.S. Thus, a U.S. company engaged in a cooperative effort with a foreign person or company must file this form.
Offshore Annuities and Life Insurance
Example 5: C does not want to risk his assets with a foreign trustee he does not know. He has no appetite for tax evasion and knows that the U.S. imposes taxes on the income of a foreign trust or foreign corporation funded by a U.S. person. (9) In addition, he cannot risk investing more than $100,000. He is considering Swiss annuity policies.
Foreign annuity contracts are treated the same as domestic annuity contracts (for tax purposes), as long as the policy is an immediate annuity or a variable policy. (10) Swiss annuity policies are attractive if the Swiss franc gains in value vis-a-vis the U.S. dollar. However, under the U.S.-Switzerland tax treaty, there is no U.S. excise tax on premiums paid to foreign insurance companies. (11) To avoid filing Form 720, Quarterly Federal Excise Tax Return, arm paying the excise tax, C has to annually file Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701 (b), to disclose his treaty-based return position. In addition, he has to file form TD F 90-22.1 to disclose his interest in a foreign financial account.
The Expatriate Who Returned Home
Example 6: P is a computer programmer who came to the U.S. from Australia in 1987 to work for Hewlett-Packard. When he applied for a permanent work visa ("green card"), he became a long-term resident of the U.S. and subject to the same tax laws as U.S. citizens. In late 2002, he met Z, another Australian who was working in the U.S. on a temporary teacher's visa. They soon decided to get married. They returned home to Australia in 2003 when Z's visa expired. At that time, P's assets exceeded $580,000.
Under Sec. 877, P might be required to continue paying U.S. taxes for up to 10 years after leaving the U.S. He filed Form 8854, Expatriation Initial Information Statement, (12) to report his net worth prior to expatriation. Because his assets exceeded $580,000 in 2003, P has to apply for a ruling request to waive filling Form 1040-NR, U.S. Nonresident Alien Income Tax Return, for 10 years after expatriating. In addition to Form 1040-NR, P and Z have to file Form I040-C, U.S. Departing Alien Income Tax Return. (13)
In spite of the fact that P is a citizen of Australia, married an Australian citizen and his family is in Australia, his request for a waiver was rejected; he is required to file an annual Form 1040-NR to report his U.S.-source income each year.
U.S. Corporations with Foreign Subsidiaries
When a U.S.-based corporation decides to open an unincorporated branch in another country, the branch income is subject to income taxes in the country where the branch is located. The same income will be included in the U.S. corporation's total income. The U.S. corporation can claim a tax credit on Form 1118, Foreign Tax Credit--Corporations, for the foreign tax paid, but there are significant limits on the credit. First, the credit cannot exceed the tax that would be paid to the U.S. on the same income, if the foreign tax is greater than the U.S. tax. Second, the credit is only available for taxes in the nature of income taxes. Many foreign countries impose a value-added tax as a substitute for income tax.
If the foreign operations become significant, a U.S. company will usually establish a foreign subsidiary to limit potential liability to the amount of the foreign operation's assets. The U.S. corporation then has to file Form 5471 for a CFC. While the foreign corporation cannot file as part of a consolidated return under Sec. 1504(b)(3) with the U.S. parent, some of its income may be subject to current taxation under tire subpart F rules in Sees. 951-964.
Even tax advisers who do not specialize in international tax should be aware of reporting obligations for clients engaging in international transactions, investments and business activities. This article discussed how clients often become involved in such activity and the tax forms required in each case.
Exhibit 1: Common cross-border tax forms Form number Title 56 Notice Concerning Fiduciary Relationship 709 United States Gift (and Generation-Skipping Transfer) Tax Return 720 Quarterly Federal Excise Tax Return 926 Return by U.S. Transferor of Property to a Foreign Corporation 1040-B, Part III Information Regarding Foreign Accounts or Trusts 1040-NR U.S. Nonresident Alien Income Tax Return 1116 Foreign Tax Credit--Individual, Estate or Trust 1118 Foreign Tax Credit--Corporations 1120-F U.S. Income Tax Return for a foreign Corporation 2555 Foreign Earned Income Exclusion 3520 Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts 3520-A Annual Information Return of Foreign Trust with a U.S. Owner 5471 Return of U.S. Persons with Respect to Certain Foreign Corporations 5472 Information Return of a Foreign-Owned U.S. or a foreign Corporation Engaged in a U.S. Trade or Business 8621 Return by U.S. Shareholder of Passive Foreign Investment Company or a Qualified Electing Fund 8804, 8805 Annual Return for Partnership Withholding Tax (Section 1446) and Foreign Partner's Information Statement of Section 1446 Withholding Tax 8832 Entity Classification Election 8833 Treaty-Based Return Position Disclosure Under Section 6114 or 7701 (b) 8865 Return of U.S. Persons with Respect to Certain Foreign Partnerships 8873 Extraterritorial Income Exclusion TO F 90-22.1 Report of Foreign Bank and Financial Accounts Note: Details about each form are online at www.offshorepress.com/AICPA/taxforms.htm.
* U.S. taxpayers are commonly involved in offshore or cross-border arrangements that involve setting up foreign corporations, trusts and joint ventures, as wed as investments in foreign bank, annuity and life insurance accounts.
* Offshore activities trigger tax ramifications and reporting requirements that differ from similar U.S. transactions.
* U.S. persons working and living abroad are subject to possible U.S. taxation and are required to file special forms.
For more information about this article, contact Mr. Jacobs at firstname.lastname@example.org.
Editor's note: Mr. Jacobs is a member of the AICPA Tax Division's International Tax Technical Resource Panel's (TRP's) International Tax Reporting Requirements Task Force. Other Task Force members who assisted in the preparation of this article include Ben Vernazza, Howard Godfrey, Neil Sullivan, Olaf Barthelmai and Eileen Sherr (AICPA Technical Manager). Andrew Mattson, chair of the AICPA Tax Division's International Tax TRP, also assisted with technical editing.
(1) The author's website (www.offshorepress.com/AICPA/) includes a list of these forms and links to numerous international tax resouces.
(2) A more extensive discussion of 21 of the most commonly used international tax forms is available for AICPA members at www.offshorepress.com/AICPA/ taxforms.htm. For each of the forms listed, there is a discussion of who is required to file, the information required, when the form is due, how long it takes to prepare, the nonfiling penalties and other comments.
(3) See Secs. 911 and 912. Section 350 of S. 1054, the Jobs and Growth Tax Relief Reconciliation Act of 2003, as introduced and passed in the Senate, would have repealed the foreign-earned-income and housing-expense exclusions. However, the House and final versions of the bill &d not include the provision. The defeat may have been in large part due to the AICPA's efforts; see www.cpa2biz.com/Resource Centers/Tax/International/section911.htm. It does not appear likely that tiffs issue will surface again in the near future.
(4) The International Deposit Indemnity Corporation is not a government-supported insurance program.
(5) Investment schemes that purport to offer very high returns and distribute them to early participants--using money from later participant--are called Ponzi schemes, because they resemble a scheme developed by Charles K. Ponzi; see www.mark-knutson.com/. The Grenada Bank scheme has been estimated to have generated over $12a million in deposits; see www.taxnews.com/ asp/story/story_print.asp?storyname=4810.
(6) Property held as joint tenants with right of survivorship can be subject to the claims of creditors of either joint owner; see Rosen and Rothschild, Asset Protection Planning, 810-2d T.M.
(7) See www.offshorepress.com/protection/ap9401.htm.
(8) Foreign trust are at risk if the grantor retains control over the trustee or the assets; see Jacobs and Duke, The Offshore Tax Manual (Offshore Press, Inc., 2d ed. 2002), Part 6, at www.offshorepress.com/offshoretaxmanual.htm.
(9) The income of a foreign trust is not taxable to the grantor if the trust does not have any living U.S. beneficiaries; the income of a foreign corporation is not taxable to the U.S. shareholders unless it is a CFC under Sees. 951-964 and it has "subpart F income" as defined in Sec. 952
(10) See Jacobs, Your Guide to Offshore Variable Annuities (Offshore Press, Inc., 2001) at www.offshorepress.com/osva-info.htm.
(11) See id.
(12) See www.irs.gov/pub/irs-pdf/f8854.pdf.
(13) See www.irs.gov/pub/irs-pdf/f1040c03.pdf.
Vernon K. Jacobs, CPA, CLU
Prairie Village, KS
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|Author:||Jacobs, Vernon K.|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 2003|
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