The IRS and Treasury issued final regulations on Feb. 22 (T.D. 9752
) under Section 6038D that require certain domestic entities to report specified foreign financial assets. The regulations provide conditions under which a domestic entity will be considered a “specified domestic entity” required to satisfy certain information reporting requirements. Taxpayers that may be considered a specified domestic entity should carefully evaluate these rules to determine if they will be required to comply with the new information reporting requirement (i.e., Form 8938, Statement of Specified Foreign Financial Assets
Enacted as part of the Foreign Account Tax Compliance Act (FATCA) in 2010, Section 6038D requires individuals to report interests in certain specified foreign financial assets on Form 8938 if the aggregate value of such assets is greater than $50,000 on the last day of the year, or $75,000 at any time during the year. Congress provided authority to the IRS and Treasury to issue regulations requiring certain domestic entities to comply in the same manner as individuals.
In 2011, the IRS issued proposed regulations (REG-130302-10
) that directed that certain domestic entities must report interests in specified foreign financial assets. The proposed regulations were largely adopted in the final regulations.
Final regulations at a glance
The final regulations define “specified domestic entity” as a domestic corporation, a domestic partnership or a domestic trust formed or availed of for purposes of directly or indirectly holding specified foreign financial assets. The determination of whether a domestic entity is a specified domestic entity is made annually. The final regulations provide that a corporation or partnership is treated as “formed or availed of” for purposes of directly or indirectly holding specified foreign financial assets if (1) the corporation or partnership is closely held by a specified individual (i.e., greater than 80% of the total vote or value of a corporation or 80% of the total capital or profit interest of a partnership is held by a specified individual); and (2) at least 50% of the corporation or partnership’s gross income is passive or at least 50% of the assets produce or are held for the production of passive income.
This is a departure from the proposed regulations, which also included a principal purpose test. Under the proposed regulations, all facts and circumstances were taken into account to determine if the specified individual had a principal purpose of avoiding Section 6038D. The government believes, however, that the 50% passive assets and income threshold sufficiently satisfied the intended objective of Section 6038D and that taxpayers should be able to determine their reporting requirements under an objective requirement rather than a subjective principal purpose test.
The IRS and Treasury believe that the weighted average test for active non-financial foreign entities in the regulations under Section 1472 provides an “administrable way to determine the passive asset percentage.” Accordingly, the final regulations provide that the passive asset percentage is determined based on a weighted average approach, which is similar to the rule provided in Treas. Reg. Sec. 1.1472-1(c)(1)(iv). Under the weighted average test, corporations or partnerships may use either fair market value or book value (as reflected on the entity’s balance sheet and as determined under either a U.S. or an international financial accounting standard) to determine the value of their assets.
The final regulations also include other notable changes from the proposed regulations, several of which are summarized below.
Organizational changes regarding application of the reporting threshold
Under the proposed regulations, a domestic entity would apply the reporting threshold (i.e., $50,000 on the last day of the year or $75,000 at any time during the year) when determining whether it was a specified domestic entity and again when determining whether it had a reporting requirement. The final regulations now apply this threshold only when determining whether a specified domestic entity has a reporting requirement.
Modifications to the definition of passive income
The final regulations include several modifications to the definition of passive income to conform Sections 1472 and 6038D. Specifically, these modifications clarify that the term “dividends” includes substitute dividends, and “interest” includes income equivalent to interest, including substitute interest. The final regulations also add a new exception for certain active business gains or losses from the sale of commodities and define notional principal contracts by adding a reference to Treas. Reg. Sec. 1.446-3(c)(1). In addition, the final regulations provide that rents and royalties derived in the active conduct of a trade or business conducted “at least in part” by employees of a corporation or partnership will not be considered passive income.
Clarification to aggregation rules
The final regulations simplify the aggregation rules by eliminating the reference to treating all domestic corporations and partnerships as a single entity. When applying the aggregation rule, the final regulations attribute the assets or income of members of the group to an entity for purposes of determining the aggregate value of specified foreign financial assets.
The final regulations clarify that the term “current beneficiary” also includes any holder of a general power of appointment, whether or not exercised, that was exercisable at any time during the taxable year, but does not include any holder of a general power of appointment that is exercisable only on the death of the holder.
The final regulations are generally effective for taxable years beginning after Dec. 31, 2015.
There are significant consequences associated with failure to furnish information required under Section 6038D. Failure to file a complete and accurate Form 8938 by the due date (including extension) may result in a penalty of $10,000. Additionally, such failure may extend the statute of limitations for assessment of taxes indefinitely under Section 6501(c)(8) or until three years after the information return is filed.
An objective test may capture closely held active entities that happen to exceed the passive assets or income threshold, which otherwise may have been excluded under a more subjective test. Taxpayers should carefully evaluate these rules to identify any potential reporting requirements, particularly given the consequences associated with failure to furnish information required under Section 6038D.
For more information, please contact Douglas Wood, David Sites or Cory Perry.
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