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Rödl & Partner Tax Matters, published May 30, 2023
Filing Requirement Analysis
Each of the forms mentioned above has several filing categories. The filer must determine which category(ies) are applicable with respect to the filer's connection to the foreign entity. The filing category determines which schedule(s) must be completed in addition to the form itself. Certain filing categories are significantly more onerous than others. Here is an overview of possible filing categories for Form 5471 and Form 8865 based on the latest instructions from the Internal Revenue Service ("IRS"):
In addition to the fact that multiple different filing categories exist, there are also different ownership rules under the tax law which apply to the determination of each category. For example, a U.S. person (or entity) may have direct, indirect or constructive ownership of a foreign entity or activity. We usually need the client to provide a complete organizational structure chart which shows all foreign entities and activities to which the U.S. person is connected in order to gain a complete understanding of the possible reporting requirements. If the client does not already have an organizational structure chart, we typically need to create one. To do so, we must understand all of the U.S. person's ownership of, relationship to, and the residence of each foreign entity or activity, as well as whether any foreign entity owns any subsidiary entities. Sometimes, we need to go through all the financial statement details to uncover this information. Many times, after reviewing this detailed information, we have found additional entities of which the client was previously unaware but which require reporting. Last, but not least, we must understand all of the ultimate owners of the foreign entities to determine if the U.S. person is attributed ownership from other family members or entities. This is referred to as the constructive ownership rules which are also very complex.
Record Keeping, U.S. GAAP/Tax Basis Conversion and Schedule Preparation
Each of the foreign informational forms generally begins with a section of required information. This section starts by listing the identity of the U.S. shareholder and details about the formation and status of the foreign entity or activity. Also included are numerous questions regarding specific transactions occurring during the year, activity between the U.S. owner filing the form (or other U.S. persons or entities) and the foreign entity, plus information regarding capital contributions. The required qualitative information alone can range from 4 to 10 pages long.
Aside from the required qualitative information described above, the most time-consuming part of the foreign informational reporting is generally the income statement and balance sheet. These schedules must be reported on a U.S. GAAP basis. Preparing these schedules is essentially like preparing an entity's full U.S. income tax return. The IRS has estimated the average time needed to prepare the main form in the table below. In addition to the main form, numerous additional schedules may be required based on filing category. Such schedules are listed in Appendix A (Form 5471) and Appendix B (Form 8865) at the end of this letter.
Supplemental schedules are frequently revised by the IRS and generally require some level of additional education for the tax practitioner at the beginning of each filing season. The schedules determine the overall time commitment required for complete and accurate preparation of the form. For example, below is the IRS summary of the estimated time needed to prepare the additional schedules of Form 8865. Among the schedules listed, K-2 andK-3 are new in recent years and are by far the most time consuming since they require the partner's distributive share items to be reported on a U.S. tax basis.
Another schedule which often requires significant time to complete is Schedule M for related party transactions. This schedule is essentially equivalent 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. The rules to determine what is considered a reportable related party transaction are complicated. If the client cannot provide a good record of all related party transactions occurring during the year, we must spend time organizing the data and finding such transactions in the financial statements. The IRS estimates the time needed to complete this schedule as follows:
Special Income Inclusion Calculations
If a foreign corporation is more than 50% owned by U.S. persons (individuals or entities determined by direct, indirect, or constructive ownership) at any time during the year, it is then defined as a Controlled Foreign Corporation ("CFC"). U.S. shareholders of CFCs may be subject to current taxation of undistributed income in the form of GILTI and Subpart F income inclusions. This causes such U.S. shareholders to pay tax on that income on their personal U.S. income tax returns regardless of whether any earnings were actually distributed. The rules for computing GILTI and Subpart F income are extremely complex.
For example, Subpart F income may include dividends, interest, rental income, insurance income, offshore shipping income, sales income, manufacturing income and personal service income of the CFC. Computation of a CFC's GILTI requires conversion of the foreign entity's financial information to a U.S. income tax basis, which can be equated to preparing an entire corporate income tax return for each foreign entity each year. This includes preparation of all book-to-tax adjustments including conversion of foreign fixed asset depreciation to U.S. tax depreciation.
Penalties
The penalty for failing to file a report on time, or for filing an inaccurate or incomplete report, was previously $10,000 for each late, inaccurate, or incomplete form. The Tax Court recently held these penalties for Form 5471 could not be assessed; however, this will likely be challenged. Tax practitioners continue to face penalties for inaccurate or incomplete reporting. Due to the potential penalties for noncompliance, it is essential to ensure that appropriate time and resources are given to the completion of these reports.Conclusion
Preparation of foreign informational reports is one of the most complicated and formidable challenges faced by tax preparers. Unfortunately, we have seen many reports that were not completed properly, incurring even additional time and expense to correct. Our team of trained professionals has extensive experience in this area and always strives to approach these reports from the perspective of minimizing cost to the client while ensuring the completion of timely and accurate reports.
If you have questions about any of these forms, please contact your Rödl & Partner representative to find out how we can help.
Appendix A – Schedules Required Based on Form 5471 Filing Category
Appendix B – Schedules Required Based on Form 8865 Filing Category
Please contact your Rödl & Partner representative with any questions regarding your unique situation.
This publication contains general information and is not intended to be comprehensive or to provide legal, tax or other professional advice or services. This publication is not a substitute for such professional advice or services, and it should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business. Consult your advisor.
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Copyright © May 2023 Rödl Langford de Kock LPAll rights reserved.
Elisa Fay
CPA
Partner-in-Charge Rödl National Tax
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