Article: Reporting of 'Specified Foreign Financial Assets' by Taxpayers Under the Provisions of the Foreign Account Tax Compliance Act
The Foreign Account Tax Compliance Act ("FATCA") was included as part of the 2010 Hiring Incentives to Restore Employment (“HIRE”) Act. The potential effect on U.S. taxpayers with ownership of certain foreign investments and assets may be very significant, either in terms of obtaining necessary information and related costs to be in compliance or penalties associated with noncompliance.
Beginning on January 1, 2011, certain provisions of FATCA become effective for individuals filing U.S. tax returns. FATCA also allows the Secretary of the Treasury to issue regulations requiring U.S. entities formed or used for the purpose of holding, directly or indirectly, specified foreign financial assets to file disclosures as if they were individuals. Under FATCA, all “specified foreign financial assets" will have to be disclosed to the Internal Revenue Service (“IRS”) with Form 1040 when their aggregate value exceeds $50,000. This reporting is in addition to current disclosure requirements for filing Form 90-22.1 – Report of the Foreign Bank and Financial Accounts (“FBAR”) when foreign financial assets owned equal or exceed an aggregate value of $10,000.
Specified foreign financial assets are defined by the newly created IRC 6038D(b) and include: ownership of any financial account maintained by a foreign financial institution, any stock or security issued by a non-U.S. person/entity, any financial interest or contract held for investment that has a non-U.S. issuer or counterparty, and any interest in a foreign entity. Where foreign real property is held directly, it will not be required to be reported under FATCA as a foreign investment. However, if foreign real property is held through a foreign entity, reporting of the entity would be required. Many of the assets included under the definition of specified foreign financial asset are also included in the FBAR definition of foreign financial account, creating duplicative reporting requirements. Required reporting will include at a minimum, the names and addresses of financial institutions and account numbers for financial accounts, name and address of the issuer of any stock or contract as well as such information necessary to appropriately identify the actual stock or contract owned, and the name, address and type of foreign entity when an interest in the same is owned as well as the value of the related assets.
FATCA also expands the informational reporting that is required for owners of Passive Foreign Investment Companies (“PFICs”). Previously the information return related to PFIC ownership (Form 8621) was only required when a taxpayer made an election (e.g., QEF, mark to market), received certain distributions or disposed of their interest in the investment. Now U.S. investors will be required to report PFIC activity or inactivity annually. PFIC reporting is done by the first U.S. owner. Consequently, U.S. investors in foreign pass-through entities will need to ensure that they are receiving complete information regarding their indirect ownership in entities that meet the definition of a PFIC. The U.S. taxpayer is subject to all non-reporting penalties even if the pass-through entities that they are invested in do not provide the necessary information. The IRS will not provide relief to the taxpayer in the event the pass-through entity does not make the required disclosures to the shareholders in the event that the entity does not have a U.S. filing obligation. Many non-U.S. partnerships (even those with large numbers of U.S. partners) have openly stated that they have no intention of determining whether their investments are considered PFICs under U.S. tax law. Thus U.S. investors must be more vigilant than ever in understanding all components of their foreign investment holdings and evaluating the non-compliance risks where information may not be provided.
Penalties for failure to comply with FATCA are both monetary and administrative. Effective with returns filed after March 18, 2010 and any return for which the statute assessment period has not yet expired (generally three years from the approved filing date of the return), the statute assessment period during which the IRS can review and adjust the tax return will remain open until all required foreign information is reported (e.g. Forms 5471, 8865, 8621, as well as the yet to be determined reporting for specified foreign assets). Specifically, where the taxpayer fails to include or file any of the foreign information forms with their tax return that are required in their situation, the assessment period for that tax return will not start until such forms are filed. During this period, all items on the return are subject to IRS review and adjustment. In situations where the taxpayer can prove reasonable cause for their failure to provide the required information, the suspension of the assessment period will only apply to items related to the failure (i.e. income reporting related to the foreign assets). In these cases the taxpayer must also establish that the failure was objectively reasonable and in good faith – meaning that the taxpayer had in place a reasonable process or policy for keeping up with changes in reporting requirements.
Another portion of the HIRE Act addresses underpayment penalties applicable to undisclosed income from foreign financial assets for tax years beginning after March 18, 2010. As a result of this amendment to IRC 6662 the penalty will be 40% rather than 20% related to undisclosed transactions associated with foreign financial assets. Further, the statute of limitations (for omissions of 25% or more of gross income or for omissions of more than $5,000 of income attributable to one of more assets required to be reported is increased to 6 years from the normal 3 years. This may mean that for tax returns filed after March 18, 2004, that the statutory assessment period may not have even started if the taxpayer failed to fully complete and file any required foreign informational reporting (such as Forms 5471, 8865, 8621, 3520, etc.).
Monetary penalties are significant but can be waived if failure to file was due to reasonable cause. The minimum penalty for failing to provide a required disclosure is $10,000 and it is increased by $10,000 every 30 days after a 90 day grace period is allowed following a request from Treasury for the information. The maximum penalty is $50,000. These penalties are similar to the penalties for failure to file Form 5471 – Information Return of U.S. Persons with Respect to Certain Foreign Corporations and Form 3520 – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. It is important to note that many assets that require disclosure as a specified foreign financial asset also need to be reported on the FBAR. Penalties for failing to file the FBAR are much more significant and the reasonable cause exception to the imposition of penalties may not be available. Further, both FBAR and FATCA penalties can be assessed for the same year and do not offset each other.
Before year end, calendar year taxpayers need to evaluate their foreign investments and consider the potential increased compliance costs and related U.S. compliance risks where they have holdings in foreign investment type assets. Any specified foreign financial assets held during any date in 20ll will be subject to the disclosure requirements.
In summary, the Internal Revenue Service is continuing increased international tax compliance and enforcement activities and FATCA is another tool that it can use where individuals are purposely attempting to evade U.S. tax. Unfortunately, a very large number of honest taxpayers who are trying to comply with increasingly complex tax regulations have even more opportunities to make a mistake and be harshly penalized. If you have foreign investments, now more than ever it is important that you seek the advice of a qualified tax professional to make sure that you are providing all the required information with your annual tax return.
The contents and opinions contained in this article are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals.