Upcoming Free Events. Monthly Journal of Tax Controversy THE PFIC REGIME AND FORM 8621 A PRIMER FOR TAX PRO- Contents FESSIONALS.

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1 Monthly Journal of Tax Controversy Contents The PFIC Regime and Form 8621 A Primer for Tax Professionals 1 Foreign Retirement Plans 11 Tax Court Calendar 18, 21 Upcoming Events 19 Upcoming Free Events The Ninth Annual Federal and New Jersey Criminal Tax Enforcement Update January 31 RSVP: conta.cc/2dwdkk5 Paramus, NJ Tax Practice, Part II - Filing Status, Credits, and Due Dilligence February 6 RSVP: conta.cc/2ossleb Hackensack, NJ Tax Practice, Part III - Gross Income, Exclusions, Penalties, etc. May 8 RSVP: conta.cc/2otnggt Hackensack, NJ Preparation for the US Tax Court Admission Exam Practice Exam June 2 RSVP: conta.cc/2zgktco Hackensack, NJ Practice Before the US Tax Court Practice & Procedure Part I July 10 RSVP: conta.cc/2a03vyr Hackensack, NJ Practice Before the US Tax Court Practice & Procedure Part II August 7 RSVP: conta.cc/2oxkdd4 Hackensack, NJ THE PFIC REGIME AND FORM 8621 A PRIMER FOR TAX PRO- FESSIONALS By Frank Agostino, Esq. Michael Wallace, EA. 1 The term Passive Foreign Investment Company ( PFIC ) is a mystery to many tax professionals. Uninformed tax professionals who prepare returns erroneously assume their clients do not have such foreign investments. Knowledgeable investors thoroughly sensitized to the tax ramifications of interests in foreign corporations can easily forget that foreign mutual funds, hedge funds, foreign exchange-traded funds ( ETFs ), insurance products, and offshore pension plans all have the potential to trigger the PFIC regime. Investors or tax professionals unfamiliar with the PFIC rules can easily be blindsided, with potentially severe consequences. Whenever a taxpayer has any kind of investment outside of the United States ( U.S. ), the tax professional should ascertain whether PFIC rules are applicable. For instance, a foreign bank account is a PFIC if the account is a money-market fund because money market accounts are generally considered short-maturity fixed-income mutual funds. 2 The PFIC rules also apply to investments held in foreign pension funds unless those pension plans are recognized as qualified under the terms of a double-taxation treaty. 3 The PFIC regime imposes rigid reporting requirements and has the potential to alter the timing, character, and computation of income and tax, sometimes leading to harsh and unexpected tax results. Furthermore, PFIC classification can materially influence after-tax investment performance. For example, a U.S. taxpayer holding shares in a U.S. (Continued on page 2) (201) Hackensack, NJ

2 mutual fund invested in foreign stocks pays tax at capital gains rates on qualified dividends and any appreciation. The same taxpayer holding a foreign mutual fund invested in identical stocks is subject to the PFIC regime, and may find all income (including long term capital gains) taxed as ordinary income. 4 Although some find PFIC rules inordinately complicated, they are the law. This article reviews the key PFIC tax rules and exceptions, important elections, and information professionals need to know about completing Internal Revenue Service ( I.R.S. ) Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. I. Introduction The PFIC regime was introduced as a part of the Tax Reform Act of 1986 to neutralize tax benefits received by U.S. persons 5 who shifted passive investments into offshore companies. Before the PFIC rules, passive income on a foreign company's holdings was typically not exposed to U.S. tax until the foreign company made distributions or liquidated, enabling indefinite tax-deferral and enhanced compound returns. PFIC treatment was designed to put foreign company passive holdings on the same level as domestic passive holdings for U.S. persons. To achieve this equalization, the PFIC default procedure 6 requires that all income realized from a PFIC is pro rated among all years in a shareholder holding period. 7 The amount allocated to the current year and any previous year the investment was not a PFIC is taxed as ordinary income; the amount allocated to the other years (prior PFIC years) is taxed at that year's maximum ordinary tax rate. 8 An interest surcharge is then added proportionally to the value of the deferral. 9 Alternatively, a PFIC investor can opt out of the default procedure by electing Qualified Election Fund 10 ( QEF ) or Mark to Market 11 ( MTM ) treatment, realizing phantom income annually, coupled with adjustments to basis. II. Does my client own a PFIC? I.R.C. 1297(a) defines a foreign corporation as a "passive foreign investment company" if either: (1) 75 percent or more of its gross income in a given taxable year is passive; or (2) at least 50 percent of its average assets during a year produce passive income (or are held for that purpose). The balance of I.R.C refines what is meant by "passive income" and "average assets" for the purposes of that section, and enumerates various exceptions. At a conceptual level, however, any foreign corporation that either produces, or has the potential to produce, passive income, should be evaluated to determine if it is a PFIC. For hierarchical foreign corporate structures this determination is complicated by provisions requiring lookthrough into the holdings of subsidiaries. A parent corporation directly or indirectly owning 25 percent or more of the stock of another corporation is treated as if it directly held its proportional share of that corporation's assets and directly received its share of that corporation's income of all characters (even if undistributed). 12 This provision can cause a foreign company that would not otherwise qualify as a PFIC to become a PFIC. III. Annual Reporting Requirements Form 8621 In general, a U.S. person that is a direct or indirect shareholder of a PFIC must file Form 8621 if that person: 13 Receives certain direct or indirect distributions from a PFIC; Recognizes gain on a direct or indirect disposition of PFIC stock; 2

3 Is reporting information with respect to an I.R.C qualified electing fund or I.R.C mark-to-market election; Is making any election reportable in Part II of the form; or Is required to file an annual report pursuant to I.R.C. 1298(f). Form 8621 is a four-page annual report. It should be attached to a PFIC stockholder's income tax return. 14 A. Exceptions to Filing from There are few broad exceptions to Form 8621 filing requirements, the most significant of which include: Exempt organizations and persons who own PFIC stock through taxexempt organizations or accounts. 16 Domestic partnerships, if their direct and indirect partners are themselves exempt from filing under I.R.C. 1298(f). 17 Certain foreign pension funds covered by a tax treaty. 18 Holdings by some dual resident taxpayers and residents of U.S. territories. 19 Final regulations released on December 27, 2016, 20 provide other exceptions for certain foreign pension funds covered by a U.S. Tax treaty, dual-resident taxpayers, and residents of U.S. territories for at least 183 days. 21 The regulations further state U.S. shareholders are exempt from Form 8621 reporting if the value of the PFIC stock is $25,000 or less for single taxpayers, or $50,000 or less for joint filers. 22 If the value of the stock in an I.R.C fund is $5,000 or less and the stock is owned indirectly the taxpayer will not be required to file Form Lastly, PFIC shares held less than 30 days are also exempt from the filing requirement, provided a distribution was not received and the shares were not sold. 24 B. Consequences for Failure to File Form 8621 There is an encompassing penalty under I.R.C. 6038D for not disclosing certain foreign financial assets. If the shareholder does not disclose a PFIC on Form 8398, Statement of Specified Foreign Financial Assets, or Form 8621, the penalty for failure to disclose is $10, Also, the failure to furnish Form 8621 for a taxable year extends the statute of limitations until three years after the required form is submitted to the I.R.S. 26 IV. PFIC Regimes A. Excess Distribution Unless a QEF or MTM election is made, the default provisions of I.R.C permit shareholders of PFICs to defer tax on the earnings until they are distributed, or the stock is sold. These provisions subject investors to special rules when they receive "excess distributions" from I.R.C funds or recognize gain on the sale or disposition of the stock of such funds. A distribution may be partly or wholly an excess distribution. An excess distribution is the part of a distribution received by a shareholder from an I.R.C fund in 3

4 any taxable year that is greater than 125 percent of the average distributions received in respect of such stock by the shareholder during the three preceding taxable years. 27 The entire amount of gain from the disposition of an I.R.C fund is always treated as an excess distribution. 28 However, no part of a distribution received, or deemed received, during the first taxable year of the shareholder's holding period of the stock is treated as an excess distribution. 29 An excess distribution is determined on a per share basis and is allocated to each day in the shareholder's holding period for the stock. 30 The tax treatment of each day's allocation is determined by the period and taxable year into which it falls. Allocations to days in the current taxable year and to days in any period before the foreign corporation qualified as a PFIC ("pre-pfic years") are included in Adjusted Gross Income ( AGI ) in the current taxable year and taxed as ordinary income. 31 Allocations to days in prior years when the foreign corporation was a PFIC are not included in any year's AGI, but are subject to the separate tax and interest charge set forth in I.R.C. 1291(c). 32 The tax is computed at the maximum ordinary rate for each prior year to which an excess distribution is allocated. The interest charge is computed from the due date of each prior taxable year return through the current taxable year return due date. 33 The following example will illustrate the application of I.R.C and the tax effects of the default rule: Example: An individual taxpayer purchases 100 shares of PFIC stock on March 1, 2014, for $30,000 and sells the shares on October 31, 2017, for $40,200. No QEF or MTM election is made. The taxpayer's marginal tax rate in 2017 is 25 percent. Form 1040 is being prepared for calendar year Tax Year Days Excess Distribution (daily) Excess Distribution (annual) Highest marginal tax rate Increase in tax Interest on tax $2, $920 $ $2, $1,101 $ $2, $1,104 $ $2,308 Total 1,339 $10,200 $3,125 $191 A. The entire $10,200 gain is subject to the punitive tax treatment of the default treatment under I.R.C since all gain from disposition of a I.R.C PFIC is an excess distribution." 34 B. The excess distribution is allocated pro-rata to each day in the taxpayer's holding period: $10,200 divided by 1,339 days is $ per day. C. The $2,307 allocated to days in 2017 (the current taxable year) is reported on line 16b of Form 8621 and line 21 of the taxpayer's Form 1040, included in AGI, and taxed at the taxpayer's current year marginal rate (which was assumed to be 25 percent). D. The excess distributions of $2,324, $2,780, and $2,788 allocated to 2014, 2015, and 2016, respectively, are taxed at the highest marginal rate for each of those years (which happens to have been the same, 39.6 percent, for each year). The total, $3,125, shows up on line 4

5 16c of Form 8621 and as an increase in tax on line E. Interest is assessed on each of the prior year's increase in tax. The total $191 appears on line 16f of Form 8621 and on Form 1040, line B. Qualified Election Fund A U.S. PFIC investor wishing to avoid the arduous default I.R.C regime can elect the QEF methodology described in I.R.C Affected shareholders can make the election for any taxable year in which an investment meets the definition of a PFIC. 37 Tax professionals must review the PFIC Annual Income Information Statement 38 to determine if the investment qualifies as a PFIC. Once made, the election applies to all years until the disposition of the investment. 39 A separate election must be made for each PFIC the shareholder wishes to be taxed as a QEF. 40 A QEF's owner recognizes a pro rata share when the QEF earns income, 41 regardless of the amount or form of any distributions. 42 Since this process results in no deferral of tax, there is no need to allocate income among days and years, no need for an interest surcharge, and no need to protectively apply top bracket rates. Moreover, long term capital gain ( LTCG ) earned by the PFIC retains its character. 43 For example, a PFIC earning $80 in ordinary income and $200 in net LTCG would distribute a statement to a 25 percent shareholder showing $20 in ordinary income and $50 of LTCG, each reported appropriately on the shareholder's return, regardless of whether the PFIC distributed any cash. Basis adjustments mirror events each year. Basis in QEF stock increases with amounts the shareholder takes into income, and decreases for any distributions received. 44 The disposition of PFIC shares with a QEF election is then taxed as a capital transaction. If the election is not made in the first year, the I.R.C gain can be purged in the year of election or deferred until disposition and the disposition will be taxed under I.R.C rules. Example: On January 1 of 2015, a U.S. person invests in 100 shares of PFIC stock at a $30 per share, for a total of $3,000. A QEF election in made on Form 8621 for the first year of ownership. In 2017, the investor sells the 100 shares of stock for $25 a share or $2,500. The PFIC's earnings and distributions with respect to the 100 shares during the period of ownership are as follows: Tax Year Ordinary Income Distributions $ $100 $ $20 $90 Total $120 $330 The investor reports $100 of ordinary income in 2016 and $20 in The basis in the stock is increased by the income and decreased by distributions. 46 In this case, when the stock is sold the shareholder's basis is $2,790 ($3, ). The shareholder recognizes a long-term capital loss of $290. 5

6 C. Mark-to-Market Another alternative to the default I.R.C regime is an election to adopt the MTM rules of I.R.C The provisions of I.R.C require annual redetermination of the fair market value ( FMV ) of an investor's holdings in a PFIC. Consequently, the election is only available to a PFIC shareholder if the PFIC's shares meet I.R.C. 1296(e) definition of "marketable stock." In general, stock regularly traded on an established exchange will meet that criterion. 47 An MTM election can be made at any time for PFIC stock that meets the marketable stock requirement at the time of the election. 48 If the election is not made timely (in the first year) then the I.R.C 1291 excess distribution rules will apply. The election is made on Form 8621 and filed with the U.S. shareholder's annual return. Once made, the election governs the taxable year for which it is made and remains in force until the shareholder disposes of the holding (or the PFIC's stock ceases to be marketable). 49 An election for qualified PFIC holdings of Controlled Foreign Corporations ( CFC ) can be made on Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. 50 Like the I.R.C QEF regime, a separate election must be made for each PFIC that the shareholder wishes to report under MTM rules. Once the MTM election is made, the owner of the PFIC stock recognizes ordinary income annually equal to amount by which the FMV of the MTM stock exceeds the owner s adjusted basis. 51 Conversely, the investor in the PFIC recognizes an ordinary loss to the extent adjusted basis exceeds the FMV. 52 This loss, however, is limited to the investor's "unreserved inclusion" applicable to the holding, corresponding to the cumulative mark-to-market gain included in income in prior years. 53 Any gains on the sale of MTM stock are included in gross income in the year of sale and taxed at ordinary rates. Losses are ordinary up to the net amount of previously recognized gains; any further loss on sale of MTM shares is capital in character. Example: A U.S. person purchases PFIC stock in 2014 for $500, makes a timely MTM election for 2014, and sells the holding in 2017 for $470. Initial FMV Ending FMV Distributions MTM Income/(Loss) Adjusted Basis 2014 $500 $515 - $15 $515 $ $515 $520 $5 $5 $520 $ $520 $480 $10 ($20) $ $ $500 - Unreversed Inclusion Distributions are included in income when received. 54 The taxpayer also reports $15 and $5 in MTM income in 2014 and 2015, respectively. Only $20 of the $40 decline in FMV value in 2016 is allowed as an MTM loss since losses cannot be claimed in excess of the unreversed inclusion (prior to disposition). 55 The $30 loss on disposition in 2017 is capital, since the net amount of previously recognized gain (unreversed inclusion) is $0. The gain or loss and un-reversed inclusion cannot be aggregated and must be tracked on a per share basis. 6

7 V. Late Elections 8621-A Shareholders and tax professionals often do not detect that a foreign investment meets the definition of a PFIC immediately, if at all. Taxpayers who do not make timely elections pursuant to I.R.C or 1296 can still escape the default regime of I.R.C by making a deemed sale election or a deemed dividend election. Such an election recognizes all previously accumulated deferred income in the current year. The election is made on the shareholder's original or amended return for the taxable year to which the election applies by including Form 8621-A, Return by a Shareholder Making Certain Late Elections To End Treatment as a Passive Foreign Investment Company. If the election is made on an amended return, the return must be filed within three years of the due date, as extended under I.R.C. 6081, of the original return for the election year. 56 There are four check the box late elections available on Form 8621-A. The first is a Late Deemed Dividend Election With Respect to a Former PFIC. This election can be made by a U.S. person that is a shareholder of a foreign corporation that no longer qualifies as a PFIC under either the income or asset test of I.R.C. 1297(a) or a U.S. shareholder (as defined in I.R.C. 951(b)) that owns stock in a foreign corporation that is a CFC and a PFIC, but that is not treated as a PFIC with respect to the U.S. shareholder under I.R.C. 1297(d). 57 The effect of this election is that the dividend is taxed as an excess distribution for the portion of the shareholder's holding period in which the foreign corporation qualified as a PFIC. 58 The second check-the-box late election is the Late Deemed Sale Election With Respect to a Former PFIC. The effect of the deemed sale election is that the shareholder is deemed to have sold the former PFIC stock for its fair market value on the date PFIC status terminated. The gain from the deemed sale is taxed as an excess distribution received on the termination date. After the deemed sale election, the shareholder's stock is not treated as stock in a PFIC unless the foreign corporation thereafter qualifies as a PFIC. 59 The third check-the-box late election is the Late Deemed Dividend Election With Respect to a Section 1297 (e) PFIC. With this election, the shareholder is treated as having received a dividend of its pro rata share of the post-1986 earnings and profits of the I.R.C. 1297(e) PFIC on the CFC qualification date. The deemed dividend is taxed as an excess distribution, allocated only to the days in the shareholder's holding period during which the foreign corporation qualified as a PFIC. For this purpose, the shareholder's holding period ends on the day before the CFC qualification date. 60 The fourth, and final, check-the-box late election is the Late Deemed Sale Election With Respect to a Section 1297(e) PFIC. A shareholder making this election is deemed to have sold the I.R.C. 1297(e) PFIC stock on the CFC qualification date for its FMV. Any gain from the deemed sale is taxed as an excess distribution received on the CFC qualification date. 61 After any of these four elections, the shareholder's stock is no longer treated as stock in a PFIC until such a time as the foreign corporation later qualifies as a PFIC. 62 VI Reporting Shareholder with an equal or greater share of the PFIC stock can furnish a statement attached to Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, identifying the other shareholders and declaring the reporting requirement has been satisfied for ownership in certain for- 7

8 eign corporations that meet the definition of a PFIC. In some cases, this can reduce redundant reporting. VII. PFIC s and Offshore Voluntary Disclosures Practitioners can easily overlook or misreport PFICs when preparing returns for Offshore Voluntary Disclosures due to inadequate or erroneous information on cost basis or holding periods. The I.R.S. has a remedial method of reporting statutory PFIC computations that resolves PFIC issues in a manner consistent with the MTM methodology authorized in I.R.C This method simplifies reconstruction of historical data and provides some protection for the professional. 63 The I.R.S. lists seven terms the taxpayer must accept to use the methodology. 64 One term states that, when elected, the basis computation for gains and losses using the MTM method will apply to the first year of the voluntary disclosure application and to all PFIC s owned in the voluntary disclosure period. This process requires a determination of the basis for every PFIC investment, which should be agreed between the taxpayer and the I.R.S. based on the best available evidence. 65 One important point about selecting this alternative solution is that a tax rate of 20 percent will be applied to the MTM gain(s), MTM net gain(s), and gains from all PFIC dispositions during the voluntary disclosure period under the OVDP, in lieu of the rate contained in I.R.C. 1291(a)(1)(B) for the amount allocable to the current year, and I.R.C. 1291(c)(2) for the deferred tax amount(s) allocable to any other taxable year. 66 Secondly, a rate of seven percent of the tax computed for PFIC investments marked to market in the first year of the OVDP application will be added to the tax for that year, in lieu of the interest charge mechanism described in I.R.C. 1291(c) and 1296(j). 67 Before electing the alternative PFIC resolution, the I.R.S. recommends that the practitioner and the taxpayer reach consensus as to which alternative method is the best approach for the taxpayer s case. If the remedial method is not used, then the taxpayer will be subject to the normal excess distribution regime. VIII. PFICs and Net Investment Income Tax In preparation and planning, tax professionals should not overlook the 3.8 percent Net Investment Income ( NII ) tax. NII tax also applies to shareholder of PFICs and CFCs. A U.S. person can make an election under 26 C.F.R (g) to include undistributed income from CFC or QEF PFICs in NII, and exclude distributions from the stock of the CFC or QEF in the year the U.S. person pays tax on undistributed income. This election, which cannot be revoked, applies to the tax year for which it is made and to all later taxable years, and applies to all interests in the CFC or QEF that are later acquired. 68 The effect of the election is that it prevents the U.S. person from paying NII tax twice on the current distribution from the CFC or QEF and the previously taxed undistributed income. IX. Conclusion The calculations, rules, and options for PFICs can be quite complex. 69 If not managed properly, these complexities can have costly consequences. Professionals should perform due diligence on each of taxpayer's investments in foreign entities to determine whether PFIC rules apply. This diligence must be revisited annually, as corporations can easily shift from PFIC to non-pfic designation and back. Professionals must also be alert to the consequences when non-citizens become U.S. residents. An investment that was simple to report outside the U.S. might become a PFIC upon becoming a U.S. person. A good starting point for analysis is determining whether a foreign investment qualifies as a foreign entity under the U.S. entity classification rules. 8

9 For tax professionals who encounter PFICs and are struggling with the calculations after reading all the applicable code sections and treasury regulations, there is a great Form 8621 Calculator resource that can help navigate through the complex and tedious calculations faster and more accurately than using spreadsheets. The tool is developed by Expat Tax Tools and can be accessed at Endnotes: 1. Frank Agostino is Principal of, and Michael Wallace is an Enrolled Agent at, Agostino and Associates, P.C. 2. See I.R.C. 1297; See also I.R.C Thun Financial Advisors, Why Americans Should Never Own Shares in a Non-US Mutual Fund (PFIC), 2016, available at thunfinancial.com/pdf/why-americans-should-never-own-foreign-mutual-funds-2017.pdf. 4. I.R.C. 1291(a)(2). 5. For a definition of a U.S. Person see I.R.S., Classification of Taxpayers for U.S. Tax Purposes, international- taxpayers/classification-of-taxpayers-for-us-tax-purposes (last updated Aug. 17, 2017). 6. I.R.C I.R.C 1291(a)(3)(A). 8. I.R.S., Instructions for Form 8621 (July 2017), available at [hereinafter, Form 8621 Instructions]. 9. I.R.C. 1291(c)(1)(B). 10. I.R.C I.R.C I.R.C. 1297(c). 13. Form 8621 Instructions, supra. 14. Note, however, that PFIC filing requirements are not contingent on the requirement to file an income tax return. If a taxpayer is not required to file an income tax return or other return for the tax year, Form 8621 can be filed directly with the Internal Revenue Service Center, Ogden, UT Treas. Reg (c). 16. Treas. Reg (c)(1). 17. Treas. Reg (c)(6). 18. Treas. Reg (c)(4). 19. Treas. Reg (c)(5) and (8). 20. T.D. 9806, available at [heireinafter T.D. 9806]. 21. Id. 22. Id. 23. Provided the shareholder does not otherwise meet a requirement to file e.g. sale, received distribution, making or made an election. 24. T.D. 9806, supra. 25. Treas. Reg D-8-(a). 26. I.R.C. 6501(c)(8). (The whole return generally remains open, not just the parts directly affected by the omitted foreign reporting (though a showing of reasonable cause can limit scope). 27. Or, if shorter, the portion of the shareholder's holding period before the current taxable year. 28. I.R.C. 1291(a)(2). 29. I.R.C. 1291(b)(2)(B). 30. See I.R.C. 1291(b)(3) for adjustments that are made when determining if a distribution is an excess distribution. 31. Reported on I.R.S. Form 8621 and line 21 of I.R.S. Form Appearing on I.R.S. Form 8621 and line 44 of I.R.S. Form 1040 (for prior year tax) and line 62 (for interest on the deferred tax amount). 33. The amount is calculated using the rates and method applicable under I.R.C for underpayments of tax. See also I.R.C. 1291(c)(3)(A). 34. I.R.C. 1291(b)(2)(A)(ii). 35. Check box C and enter 1291 tax as a marginal entry. 36. Check box C and enter 1291 Int as a marginal entry. 37. Treas. Reg (d). 38. Treas. Reg (g)(1) 39. I.R.C. 1295(b)(1). Note that a PFIC is considered "unpedigreed" when an election is made after the first applicable taxable year until a second election is made under 1291(d)(2) to "purge" any income from taxable years prior to the year of the QEF election. Unpedigreed QEFs are taxed annually like pedigreed QEFs until disposition, at which point taxation reverts to the harsh 26 U.S.C regime. See Treas. Reg Form 8621 Instructions, supra. 41. I.R.C 1293(a) and (b). 42. I.R.C 1293(c). 9

10 43. I.R.C 1293(a). 44. I.R.C 1293(d). These basis adjustments can create problems if the taxpayer and PFIC don't use the same taxable year. See for a detailed analysis of the issues, which can necessitate estimating and then amending returns every year a U.S. taxpayer owns a QEF. 45. I.R.C 1293(a) (1) (A). 46. I.R.C 1293(d). 47. I.R.C (e) (1)(A). 48. Treas. Reg (h)(1)(i). 49. I.R.C (k). 50. Treas. Reg (h)(1)(ii). 51. Treas. Reg (c)(1). Note: In the case in which a U. S. person purchased or acquired shares of stock in a PFIC at different prices, the rules of this section shall be applied in a manner consistent with the rules of Treas. Reg Treas. Reg (c)(5). 52. Treas. Reg (c)(3) 53. I.R.C (d). 54. I.R.C (a) 55. The amount of MTM income included in gross income over the amount allowed as a deduction for prior taxable years. 56. Treas. Reg (b)(3) and (c)(4). 57. Form 8621 Instructions, supra. 58. I.R.S., Instructions for Form 8621-A (Rev. November 2017), available at Id. 60. Id. 61. Id. 62. Id. 63. I.R.S., Offshore Voluntary Disclosure Initiative: Passive Foreign Income Company Investment Computations, newsroom/offshore-voluntary-disclosure-initiative-passive-foreign-income-company-investment-computations (last updated Oct. 2, 2017). 64. Id. 65. I.R.S., Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers 2014, international-taxpayers/offshore-voluntary-disclosure-program-frequently-asked-questions-and-answers-2012-revised (last updated Dec. 20, 2017). 66. Id. 67. Id. 68. I.R.S., Instructions for Form 8960 (2017), available at C.F.R

11 FOREIGN RETIREMENT PLANS By Frank Agostino, Esq. Caren Zahn, EA. 1 I. Introduction Recently there has been an increase in Internal Revenue Service ( I.R.S. ) audits related to foreign trusts and assets. Preparers often overlook taxpayers interest in foreign retirement plans. Pension, annuity, and other retirement account distributions from sources outside of the United States as well as employer contributions to foreign retirement plans may be fully or partially taxable. Given the potential tax exposure and onerous penalties, it is important to understand the tax treatment and reporting requirements of such plans. This article will discuss: (1) how to determine which country has the authority to tax the retirement plan, (2) I.R.S. forms most often associated with foreign retirement plans, and (3) how to correct noncompliance with reporting requirements. II. Distributions From and Contribution To Foreign Retirement Accounts May Be Taxable Citizens of the United States who have worked abroad are likely to have a tax liability stemming from foreign retirement plans, such as pensions, annuities, and foreign social security. Taxpayers should be mindful of the additional reporting requirements for income received from a: Foreign employer, Trust established by a foreign employer, Foreign government or one of its agencies (including foreign social security pension), Foreign insurance company, or Foreign trust or other foreign entity designated to pay an annuity. 2 United States citizens working abroad and making contributions to foreign retirement plans may also have unexpected reporting requirements and tax liabilities. Employer contributions to foreign retirement plans may be considered taxable income because they are not qualified plans within the purview of I.R.C Additionally, while employee contributions to certain retirement plans created or organized in the United States may receive favorable tax treatment, contributions to foreign retirement plans are almost never deductible. 3 Additionally, a foreign retirement account can not be rolled over to a United States retirement account. III. Taxability of a Foreign Retirement Plans is Determined by Treaties Whether a foreign retirement account is taxable in the United States depends on the tax treaty between the country where the retirement plan originated and the taxpayer s country of residence. The taxpayer should determine if a tax treaty between the two countries exists, and carefully examine the articles related to pensions, annuities, and social security payments. Each treaty is unique and should be reviewed diligently. Most treaties permit the country of taxpayer s residence to tax the retirement account under its domestic laws. 4 In the United States, for example, residents and citizens of other countries are often taxed at a reduced rate or are exempt from paying tax on certain income from sources within the United States. 5 Moreover, some treaties prohibit the country of residence from taxing income that would not have been taxable by the country where the income is earned if the taxpayer were a resident of that country. 6 Most income tax treaties have special rules for government social security payments. Foreign social security payments are generally taxable by the country making the payments, but there may be special rules for 11

12 lump sum withdrawals. 7 Pensions and annuities paid by foreign governments to their residents who are temporarily present in the United States as nonresident aliens are generally exempt from United States income tax. Employees of foreign governments and international organization that do not qualify for an exemption under a treaty should check if they are exempt pursuant to United States tax law. 8 If the applicable tax treaty does not cover foreign retirement plans, or if there is no treaty between the country where the plan originated and the United States, income received by a United States resident or citizen from a foreign retirement plan will taxed in accordance with the instructions for the applicable United States tax return. 9 Additionally, treaties generally prohibit United States residents and citizens from using provisions of a tax treaty in order to avoid taxation of income sourced from the United States. 10 Many issues related to foreign retirement income have been addressed in private letter rulings. Taxpayers and tax professionals unsure of reporting requirements should search private letter rulings concerning similar plans from the relevant country. Taxpayers should also be aware that some states do not honor provisions of tax treaties and should consult with appropriate state tax authorities about reporting requirements. 11 IV. Determining Residency To determine whether a tax treaty applies, the taxpayer should look at the domestic laws of each country to determine residency. 12 A United States taxpayer who is not citizen, is considered a resident if he or she is (1) lawfully admitted for permanent residence, (2) meets the substantial presence test, and (3) makes an election provided in I.R.C. 7701(b)(4). 13 Substantial presence for purposes of I.R.C. 7701(b) means that the taxpayer is present in the United States on at least 31 days of the calendar year, and the sum of the number of the number of days on which such an individual was present in the united States during the current year and the 2 preceding calendar years (when multiplied by the applicable multiplier ) 14 equals or exceeds 183 days. 15 If the taxpayer is a resident of the United States and the other country, the taxpayer should ask the following tiebreaker questions: In which country do you have a Permanent Home available to you? With which country do you have closer personal and economic relations? In which country do you have a Habitual Abode? Of which country are you a National? A taxpayer claiming entitlement to tax treaty benefits may be required by foreign taxing authorities to submit a certification from the United States Government that the taxpayer had filed an income tax return as a United States citizen or resident. In such a case, the taxpayer should request Form 6166, Certification of U.S. Tax Residency, by submitting Form 8802, Application for United States Residency Certification, to the I.R.S. V. I.R.S. Forms Related to Foreign Retirement Accounts Participants in foreign retirement plans may be responsible for filing one or more of the forms below. A. Form 8833, Treaty-Based Return Position Disclosure under Section 6114 or 7701(b) 12

13 A taxpayer taking a position that any United States tax is overruled or reduced by a tax treaty, should disclose that position on Form 8833 and attach the same to the United States tax return. A return must be filed along with Form 8833 to report the taxpayer s position even if the taxpayer concludes that there is no requirement to file a tax return in the United States as a result of the treaty. 16 For individuals, failure to file Form 8833 may result in a $1,000 penalty per form required but not filed. 17 B. Financial Crimes Enforcement Network Form 114, Report of Foreign Bank and Financial Accounts Taxpayers who have a financial interest in, or signature authority over, a foreign financial account with a balance exceeding $10,000 at any point in the year, are required to report the account yearly by filing a Financial Crimes Enforcement Network Form 114, Report of Foreign Bank and Financial Accounts ( FBAR ). 18 The due date for the annual filing is on or before April 15, with a maximum extension for a 6- month period ending on October The FBAR must be filed electronically through FinCEN s BSA E- Filing System. 20 Failure to file the required FBAR may result in a civil penalty of $10,000 for each violation, unless the violation was due to reasonable cause and the amount of the transaction or the balance in the account at the time of the transaction was properly reported. 21 If the violation is found to be willful, the penalty is the greater of $100,000 or 50 percent of the amount in the account for each violation. 22 C. Form 8938, Statement of Specific Foreign Financial Assets A taxpayer that holds an interest in foreign assets, such as foreign accounts, stock, securities, financial instruments, or contracts issued by foreign entities must file Form 8938 if the aggregate value of foreign assets meets or exceeds the prescribed filing threshold. 23 The Form 8938 reporting threshold varies depending on the marital status of the taxpayer. For an unmarried taxpayer, Form 8938 must be filed if the value of the foreign financial assets exceeds $50,000 on the last day of the tax year or $75,000 at any time during the tax year. For a married taxpayer, reporting is required if the value of the foreign financial assets exceeds $100,000 on the last day of the tax year or $150,000 at any time during the tax year. 24 Failure to file Form 8938 may result in a $10,000 civil penalty. Further, failure to file Form 8938 within 90 days after the I.R.S. mails a notice of failure to file, will result in a penalty of $10,000 for each 30 day period that the form is not filed, up to $50,000. Moreover, underpayment of tax due to undisclosed specified foreign financial assets will result in a 40 percent accuracy-related penalty. 25 Underpayment due to fraud will be subject to a penalty of 75 percent. 26 Taxpayers who file Form 1040, Form 1040NR, Form 1041, Form 1065, Form 1120, and Form 1120S must attach Form 8938 to their annual Federal return and file by the due date of that return. Form 8938 does not relieve taxpayers of the FBAR requirement to report any financial interest or signatory authority over a foreign account. 27 Foreign social security, social insurance, or other similar programs of a foreign government, however, are not specified foreign financial asset, and are not reportable on Form D. Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner If a foreign pension plan is considered a trust, the employee receiving distributions may be considered an 13

14 owner of the trust and, thus, may have a reporting requirement under I.R.C. 6048(b). 29 A foreign trust with at least one United States owner must file a Form 3520-A, 30 which provides information about the foreign trust, its United States beneficiaries, and any United States person who is treated as an owner of any portion of the foreign trust under the grantor trust rules. 31 A taxpayer treated as an owner of any portion of the foreign trust must also deliver the annual form to its United States owners and beneficiaries. 32 Failure to file Form 3520-A or to furnish the required information to the appropriate parties may result in an initial penalty equal to the greater of $10,000 or 5 percent of the gross value of the portion of the trust s assets treated as owned by the United States person at the close of that tax year. 33 Penalties are also imposed if noncompliance continues for more than 90 days after the I.R.S. notifies the taxpayer of the failure to file, 34 and undisclosed foreign financial asset may be subject to accuracy-related penalties under I.R.C. 6662(j). Lastly, criminal penalties may be imposed under I.R.C. 7203, 7206, and E. Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund A beneficiary considered to be an owner of a foreign trust may also have a reporting requirement under I.R.C if the trust owns an interest in passive foreign investment company ( PFIC ). A taxpayer is required to report interest in a PFIC using Form 8621 if the taxpayer: Receives certain direct or indirect distributions from a PFIC; Recognizes gain on a direct or indirect disposition of PFIC stock; Is reporting information with respect to a Qualified Electronic Fund or mark-to-market election; Is making an election reportable in Part II of Form 8621; or Is required to file an annual report pursuant to I.R.C. 1298(f). 35 However, [a] shareholder who is a member or beneficiary of, or participant in, a plan, trust, scheme, or other arrangement that is treated as a foreign pension fund (or equivalent) under an income tax treaty to which the United States is a party and that owns, directly or indirectly, an interest in a PFIC is not required under section 1298(f) and these regulations to file Form 8621 (or successor form) with respect to the PFIC interest if, pursuant to the applicable income tax treaty, the income earned by the foreign pension fund may be taxed as the income of the shareholder only when and to the extent the income is paid to, or for the benefit of, the shareholder. 36 Additionally, beneficiary of a foreign non-grantor trust or foreign estate is not required to complete Part I with respect to the stock of the PFIC that is owned by the trust or estate unless it has made a [Qualified Electronic Fund] or section 1296 mark-to-market election, received an excess distribution, or recognized gain treated as an excess distribution with respect to the stock of the PFIC. 37 VI. Correcting Noncompliance A. Delinquent International Information Return Submission Procedures In most instances, a taxpayer who fails to report a foreign pension may seek relief from penalties under the Delinquent International Information Return Submission Procedures ( DIIRSP ). 38 This program is available to taxpayers who do not need to use the Offshore Voluntary Disclosure Procedures or the Streamlined Fil- 14

15 ing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax, but who: have not filed one or more required international information returns, have reasonable cause for not timely filing the information returns, are not under a civil examination or a criminal investigation by the I.R.S., and have not already been contacted by the I.R.S. about the delinquent information returns. 39 Taxpayers should file the delinquent international information with a statement establishing reasonable cause for failure to file and a certification that the taxpayer was not engaged in tax evasion. 40 Under this program, if there is no tax due and reasonable cause for failure to file exists, there should be no penalty. B. Delinquent FBAR Submissions Taxpayers who have not filed the required FBAR, are not under a civil examination or a criminal investigation by the I.R.S., and have not already been contacted by the I.R.S. about the delinquent FBAR, should electronically file the delinquent FBAR, along with a statement explaining why the FBAR is late, and pay any additional tax owed. 41 Similarly to DIIRSP, the taxpayer should attach a reasonable cause statement to seek relief from civil penalties. C. Abatement of Civil Penalties in Delinquent Filings Due to Reasonable Cause A civil penalty may be imposed on a taxpayer who fails to report foreign monetary transactions. 42 However, no penalty will apply if the violation was due to reasonable cause, and the amount the transaction or the balance in the account at the time of the transaction as property reported. 43 Reasonable cause, however, carries a high standard of proof because [t]axpayers who conduct business or transactions offshore or in foreign countries have a responsibility to exercise ordinary business care and prudence in determining their filing obligations and other requirements. 44 Further, [i]t is not reasonable or prudent for taxpayers to have no knowledge of, or to solely rely on others for, the tax treatment of international transactions. 45 When considering reasonable cause, examiners will use discretion, taking into account the facts and circumstances of each case, in determining whether penalties that are less than the total amounts provided for in the mitigation guidelines are appropriate. 46 VII. Conclusion Taxpayers should beware of hefty penalties for failure to timely file complete and accurate international information returns. With the growing number of taxpayers with foreign retirement plans, tax professionals should ask their clients if they participate in any foreign retirement plans to ensure compliance with United States tax laws and avoid substantial penalties. 15

16 Endnotes: 1. Frank Agostino is the President of, and Caren Zahn is an Enrolled Agent at, Agostino & Associates, P.C., in Hackensack, New Jersey. 2. I.R.S., The Taxation of Foreign Pension and Annuity Distributions, (last updated Sep. 30, 2017) [hereinafter Taxation of Pensions]. 3. See I.R.C Taxation of Pensions, supra. 5. I.R.S., Publication 901: U.S. Treaties, Sept. 2016, available at [hereinafter U.S. Treaties]. 6. Taxation of Pensions, supra. 7. Taxation of Pensions, supra. 8. U.S. Treaties, supra, at U.S. Treaties, supra, at Taxation of Pensions, supra. 11. I.R.S., United States Income Treaties A to Z, (last updated Aug. 17, 2017) [hereinafter Income Treaties]. 12. Taxation of Pensions, supra. 13. I.R.C. 7701(b). 14. The multipliers are as follows: 1 for the current year, 1/3 for the first preceding year, and 1/6 for the second preceding year. I.R.C. 7701(b)(3)(A)(ii). 15. I.R.C. 7701(b)(3). 16. U.S. Treaties, supra, at Id. 18. See 31 U.S.C. 5314; Treas. Reg ; I.R.M (Nov. 6, 2015). 19. Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, Pub. L. No , 2006(b)(11), 129 Stat. 443, Treas. Reg (c) U.S.C. 5321(a)(5). 22. Id. 23. See I.R.C. 6038D. 24. I.R.S., Instructions for Form 8938 (2017), available at [hereinafter From 8938 Instructions]. 25. I.R.C. 6662(j). 26. I.R.C From 8938 Instructions, supra. 28. Id. 29. Foreign trusts are defined by I.R.C I.R.S., Instructions for Form 3520-A (2017), available at [hereinafter Form A Instruction]. 31. See I.R.C. 671 to 679 for grantor rules. 32. Form 3520-A Instructions, supra. 33. I.R.C. 6677(a) through (c). 34. I.R.C I.R.S.., Instructions for Form 8621 (2017), available at Treas. Reg (c)(4) 37. Treas. Reg (b)(3)(iii). 38. I.R.S., Delinquent International Information Return Submission Procedures, (last updated Aug. 3, 2017). 39. Id. 40. Id. 41. I.R.S., Delinquent FBAR Submission Procedures, (last updated Aug. 7, 2017). 42. I.R.C. 5321(a)(5)(A) U.S.C. 5321(a)(5)(B)(ii). 44. I.R.M (Oct. 24, 2013). 45. I.R.M (Oct. 24, 2013). 46. See I.R.M (Nov. 6, 2015). 16

17 AGOSTINO & ASSOCIATES, P.C. CONTACT INFORMATION TAXPAYERS ASSISTANCE CORPORATION - OF COUNSEL (201) Desa Lazar, Esq. Lazar@tac-nj.org Frank Agostino, Esq. Ext. 107 Fagostino@agostinolaw.com Phillip Colasanto, Esq. Ext. 105 Pcolasanto@agostinolaw.com Jeffrey Dirmann, Esq. Ext. 119 Jdirmann@agostinolaw.com Eugene Kirman, Esq. Ext. 142 Ekirman@agostinolaw.com Nicholas Karp, EA Ext. 118 Nkarp@agostinolaw.com Dolores Knuckles, Esq. Ext. 109 Dknuckles@agostinolaw.com Edward Mazlish, Esq. Ext. 120 EMazlish@agostinolaw.com Nache Patoir, Esq. Ext. 130 Npatoir@agostinolaw.com *Admitted Only in New York* Alec Schwartz, Esq. Ext. 123 Aschwartz@agostinolaw.com Malinda Sederquist, Esq. Ext. 131 MSederquist@agostinolaw.com Valerie Vlasenko, Esq. Ext. 112 Vvlasenko@agostinolaw.com Michael Wallace, EA Ext. 143 Mwallace@agostinolaw.com Caren Zahn, EA Ext. 103 Czahn@agostinolaw.com TAC TIP Expanded criteria for accelerated processing of installment agreements. The I.R.S. is continuing to test expanded criteria for streamlined processing for installment agreements. The test has been extended to run through September 30, One criterion being tested immediately is individual taxpayers with an assessed balance of tax, penalty and interest between $50,000 and $100,000 may experience accelerated or streamlined processing of their installment agreement request. Streamlined processing criteria currently does not apply to assessed balances of tax between $50,001 and $100,000. Taxpayers will have up to 84 months to pay, or the number of months necessary to satisfy the liability in full by the Collection Statute Expiration date, whichever is less. If the taxpayer agrees to make payment by direct debit or payroll deduction a collection information statement is not required. A determination is required for filing of a Federal Tax Lien. There are additional changes to lien determinations for balances less than $50,000. Test criteria will apply to installment agreement requests submitted through SB/SE Campus Collection Operations, including the Automated Collection System (ACS), Automated Collection System Support (ACSS) and Compliance Services Collection Operations (CSCO). This test will not be applied to accounts worked by Field Collection revenue officers or Taxpayer Assistance Center employees. There is information and additional changes to test criteria that can be reviewed at 17

18 (Continued from page 17) During the test period, I.R.S. will solicit Practitioner feedback, evaluate the results, and determine if any permanent changes are appropriate. UPCOMING UNITED STATES TAX COURT CALENDAR CALLS All Calendar Calls Are Held at: Jacob K. Javits Federal Building 26 Federal Plaza Rooms 206, 208 New York, NY January 29, 2018 February 5, 2018 March 5, 2018 April 9, 2018 May 14, 2018 June 11,

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