Foreign Income & Taxpayers
The acronym for the Foreign Account Tax Compliance Act—FATCA—is easy to remember if one thinks of “fat cat.” Unfortunately, this may be the only thing about FATCA that is easy. This item highlights the provisions of FATCA that are most likely to affect U.S. tax practitioners and their clients—the taxpayer reporting provisions of new Sec. 6038D.
FATCA is a provision of the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147, which President Barack Obama signed into law on March 18, 2010. FATCA requires individuals and, to the extent provided in future regulations, domestic entities, to report certain foreign assets and is a response by Congress to the procedural nondisclosure and information-sharing constraints faced by IRS examiners (Joint Committee on Taxation, Technical Explanation of the “Foreign Account Tax Compliance Act of 2009” (JCX-42-09), p. 28 (October 27, 2009).
Since the enactment in 1970 of the Bank Secrecy Act (BSA), P.L. 91-508, U.S. citizens and U.S. residents have been required to report the existence of certain foreign bank and financial accounts. Such reportable accounts are disclosed on Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). The BSA is a part of Title 31, meaning that it is not part of the Internal Revenue Code. The FBAR has received a great deal of attention recently and has been the focus of three amnesty programs by the IRS (see News Notes, “Third Offshore Voluntary Disclosure Program Launched,” 43 The Tax Adviser 149 (March 2012)).
FATCA, on the other hand, is part of Title 26, the Internal Revenue Code. FATCA requires reporting of a much broader range of offshore assets than a person is required to report on the FBAR. Unfortunately, FBAR and FATCA reporting is duplicative in many instances because filing an FBAR does not fulfill the filing obligation under FATCA, and vice versa. This duplicative reporting, along with the associated client education that needs to take place, represents one of the many challenges of FATCA for U.S. tax practitioners.
FATCA became effective for tax years beginning after March 18, 2010. For purposes of FATCA, foreign assets are disclosed on new Form 8938, Statement of Specified Foreign Financial Assets. Form 8938 is due with the income tax return, as extended, of the U.S. person required to file. Because the IRS issued the final Form 8938 only in late December 2011, a transitional rule allows taxpayers to file a Form 8938 in 2012 for tax years that began after March 18, 2010, if the taxpayer had filed timely returns for those tax years before the release of the form. Until final regulations are issued that specify the entities that are subject to the FATCA reporting requirements, only individuals are required to file Form 8938.
In February, the IRS issued proposed regulations regarding the withholding and reporting obligation FATCA imposes on foreign financial institutions. These rules allow time for resolving local law limitations that may affect financial institutions, but they do not affect taxpayer reporting obligations under Sec. 6038D. (See News Notes, p. 209.)
Individuals and entities subject to FATCA are known as “specified persons.” With respect to individuals, this includes U.S. citizens, resident aliens (Green Card holders), and U.S. residents who meet the substantial-presence test of Sec. 7701(b). In addition, individuals making an election to be treated as residents of the U.S. and individuals who would otherwise be U.S. residents under the substantial-presence test but are claiming nonresidency under a U.S. tax treaty are also subject to FATCA reporting. Under proposed regulations that the IRS says it intends to finalize this year, specified persons would include C corporations, S corporations, partnerships, trusts, and other “specified domestic entities” that are “formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets” (Prop. Regs. Sec. 1.6038D-6).
The foreign assets that specified persons must report under FATCA are known as “specified foreign financial assets” (SFFAs). If the reporting threshold is met, foreign bank and financial accounts and other specified foreign financial assets must be reported, including foreign hedge funds and foreign private equity funds; foreign retirement accounts; stock issued by foreign corporations (but see exception below); partnership units issued by foreign partnerships; interests in foreign trusts or foreign estates; notes, bonds, debentures, or other debt issued by a foreign person; and certain foreign derivatives. However, see exceptions below for duplicative reporting.
Notably, specified persons are not required to disclose direct ownership of foreign real property under FATCA. However, any foreign financial accounts maintained for the purpose of servicing the foreign real property may be subject to reporting.
Specified persons are not required to report a single SFFA below the statutory reporting thresholds. However, they must aggregate the fair market value of all SFFAs annually to determine whether they exceed these thresholds:
- Single individuals or married couples filing separately who reside in the U.S.: $50,000 at the end of the year or $75,000 at any time during the year;
- Married couples filing jointly who reside in the U.S.: $100,000 at the end of the year or $150,000 at any time during the year;
- Single individuals or married couples filing separately who reside abroad: $200,000 at the end of the year or $300,000 at any time during the year;
- Married couples filing jointly who are living abroad: $400,000 at the end of the year or $600,000 at any time during the year.
To qualify for the higher “living abroad” thresholds, the individual taxpayer(s) must qualify under either the “bona fide residence test” or the “physical presence test.” These tests already determine eligibility for certain tax benefits under Sec. 911 on Form 2555, Foreign Earned Income. The Form 8938 instructions do not require that Form 2555 be filed with the income tax return. This is significant because the tax liability of a U.S. national living abroad may be lower if he or she only claims a foreign tax credit and does not claim a Sec. 911 earned income or housing cost exclusion on Form 2555.
The value of SFFAs is determined in U.S. dollar terms, converted from the foreign currency or currencies in which the SFFA is denominated. Temp. Regs. Sec. 1.6038D-5T(d) states that periodic statements provided at least annually may be used to determine the maximum value of a specified foreign financial account “unless the specified person has actual knowledge or reason to know based on readily accessible information” that the statements or value does not reflect a reasonable estimate of the maximum account value.
For specified foreign financial assets that are not held in a financial account maintained by a foreign financial institution, a specified person may use the value of the asset as of the last day of the tax year on which the specified person has an interest in the asset as the maximum value of that asset, unless the specified person has actual knowledge or reason to know based on readily accessible information that the value does not reflect a reasonable estimate of the maximum value of the asset (Temp. Regs. Sec. 1.6038D-5T(f)). In an “Explanation of Section 6038D Temporary and Proposed Regulations” published on the IRS website, the IRS states that “a specified person may determine the fair market value of a specified foreign financial asset based on information publicly available from reliable financial information sources or from other verifiable sources” and, even if such information is not available, is not required to obtain “an appraisal by a third party . . . to reasonably estimate the asset’s fair market value” during the tax year.
Temp. Regs. Sec. 1.6038D-5T also provides specific guidance regarding valuation for foreign trusts, interests in foreign estates, foreign pension plans, and foreign deferred compensation plans.
Unfortunately, neither the Form 8938 instructions nor the temporary regulations provide guidance regarding the valuation of foreign partnership interests or of non–publicly traded shares issued by a foreign corporation. A specified person might not be provided any information regarding the value of his or her foreign partnership interests. The only information available to the specified person may be his or her capital account. Similarly, specified persons who own shares issued by private foreign corporations may know only their cost basis in the shares if the private foreign corporation chooses not to have its stock valued. It is uncertain how such specified persons can accurately determine and then report the value of their investments in these other specified foreign assets if no fair market value information is provided or available.
Fortunately, there are reasonable exceptions to FATCA reporting. A specified person is not required to report shares of stock issued by foreign corporations if they are held inside U.S. brokerage or financial accounts. The dividends from such shares are reported on Form 1099-DIV, Dividends and Distributions, and the sale of such securities on Form 1099-B, Proceeds from Broker and Barter Exchange Transactions.
Significantly, indirect ownership of foreign assets is treated favorably under FATCA. The Form 8938 instructions state, “In most cases, you do not own an interest in any specified foreign financial asset held by a partnership, corporation, trust, or estate solely as a result of your status as a partner, shareholder, or beneficiary.”
Unlike the possibility for duplicative FBAR and FATCA reporting, no reporting under FATCA is required when specified foreign assets are already reported on certain other tax forms by the specified person: Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts; Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations; Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund; Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships; and Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans.
Temp. Regs. Sec. 1.6038D-7T, as well as the Form 8938 instructions, specifies that taxpayers must file Form 8938 to qualify for the duplicative reporting exception. Part IV on Form 8938 is used to indicate where SFFAs are disclosed on the above forms. However, there is no separate line in Part IV of Form 8938 for Form 8891, which is important for most Canadian nationals who are in the U.S. The information is included on the Form 3520 line. This could be confusing for practitioners.
Clients may be reluctant to gather information and pay additional professional fees for the complete and accurate filing of a Form 8938. If so, the practitioner might remind the client of the seriousness of not complying with Sec. 6038D by noting that:
- The statute of limitation never starts running on the entire tax return if a specified person is required to file Form 8938 but does not. The statute begins to run only after the specified person files the form.
- A $10,000 failure-to-file penalty is the starting point for monetary civil penalties. A specified person who does not file within 90 days after the IRS mails a notice regarding a failure to file Form 8938 is subject to an additional $10,000 penalty for each 30 days that the person does not file a form after the 90-day grace period. This secondary penalty is capped at $50,000 for each failure to file. A reasonable-cause exception exists for both the initial $10,000 penalty as well as the post-90-day add-on penalties (Temp. Regs. Sec. 1.6038D-8T).
- Both the temporary regulations and the Form 8938 instructions state that criminal penalties may be imposed for a failure to file Form 8938. Most practitioners are aware that the IRS has been working with the Department of Justice to impose criminal penalties in certain FBAR situations.
The FATCA disclosure requirements of Sec. 6038D represent a significant challenge to the practitioner. Engagement letters will need to be updated, tax organizers will need to be expanded, and practitioner due diligence and processes will need to be altered to reduce the possibility of a missed filing.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, TX. Andrew Mattson is a tax partner at Mohler, Nixon & Williams in Campbell, CA. Prof. Chambers and Mr. Mattson are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at email@example.com.