On October 22, 2008, the IRS announced on its Web site that it would begin automatically to assess penalties on certain officers, directors and shareholders who fail to timely file required information returns regarding their interests in foreign corporations starting January 1, 2009.
Every U.S. person must furnish information annually with respect to any foreign corporation which that person controls. Additionally, every U.S. citizen or resident must file an information return if he or she becomes a 10 percent shareholder in a foreign corporation during the year, and/or if he or she becomes an officer or director of a foreign corporation in which a U.S. person is a 10 percent shareholder. The form the IRS has prescribed for such returns is Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations.
In the fund context, this most often occurs when a manager creates an offshore fund that is formed as a corporation in the Cayman Islands or British Virgin Islands, or some other non-U.S. offshore jurisdiction, and is named as an officer or director of that fund. The U.S. manager may even become a seed investor and so his or her investment may also trigger a filing.
Note that if a foreign limited partnership or limited duration company has “checked the box” to be taxed as a corporation for U.S. tax purposed, such an entity is considered to be a “foreign corporation” for the purposes of Form 5471 compliance.
Who is Required to File These Reports?
In general, a Form 5471 is an information statement provided to the IRS as an attachment to income tax returns of businesses and individuals. The form reports the results of foreign operations and amounts gained or lost due to transactions with foreign parties that are related to the taxpayer.
Every U.S. person must furnish information on Form 5471 with respect to any foreign corporation which that person controls. A person has “control” if:
Additionally, U.S. persons must file a Form 5471 if:
The percentage stock ownership requirements described above are measured by both the taxpayer’s direct ownership of stock and the taxpayer’s indirect ownership by attribution. The attribution rules can cause a taxpayer to be considered the constructive owner of stock held by his family members, or of stock held by entities.
Applicability to Fund Managers
It is common for hedge funds to include an offshore corporate investment vehicle – either a separate fund or a foreign feeder into a domestic or foreign “master.” The offshore corporation blocks UBTI (on which U.S. tax-exempt organizations are taxable) relating to debt financed investments, and also keeps foreign investors off the U.S. tax rolls. If a hedge fund manager who is a U.S. person serves as a director or officer of such offshore corporation, or if the manager owns, directly, indirectly or constructively, 10 percent of the voting power of the foreign corporation, the manager will have an annual reporting obligation.
These reporting obligations may apply as well to private equity or venture capital fund managers who serve as officers or directors in foreign portfolio companies (or holding companies or UBTI blocker corporations formed to make investments in the U.S. or abroad).
The obligation to file Forms 5471 is in addition to a manager’s obligation to file Treasury Forms TD F 90-22.1, Report of Foreign Bank and Financial Authority, in connection with foreign bank accounts in which the individual has an ownership interest or signing authority. See Schneidman and Nowak, “ Possible Offshore Financial Account Filing Obligation” (April 13, 2007).
Late Filing and Reporting Penalties are Significant
This new automatic penalty program was born out of an audit conducted by the Treasury Inspector General for Tax Administration (TIGTA) that was finished and release in May 2006. The audit focused on the Service’s assessment and enforcement of the penalties for late filing informational returns, including Form 5471.
The monetary penalty for the late filing of a Form 5471 is substantial. Every incidence of late filing can bear a $10,000 fine, unless the taxpayer can show “reasonable cause” for the late filing.
One item of particular focus in the TIGTA audit was that 76 percent of the late filers reviewed in their small sample of 50 taxpayers could offer no reasonable cause for their lack of timely filing.
Under the new automatic penalty system, it appears that all untimely filers would be immediately assessed. While the new assessment procedure cannot override the Code’s provision staying the penalty for reasonable cause, it does appear that taxpayers will now be forced to make their case for reasonable cause post-assessment, and thus potentially be required to go through the full IRS administrative appeal process.
In its audit report, TIGTA took the position that the Form 5471 and its attendant penalties play “an important role in promoting compliance in the international tax arena,” as evidenced by the severity of the penalties for untimely filing. Yet the audit came to the conclusion that by using a manual penalty assessment system the IRS was “missing opportunities to promote better compliance.” As evidence, TIGTA identified nearly $80 million in potential late filing penalties that could have been asserted in 2002, but were not. Based on the information collected in its audit, TIGTA recommended that the IRS convene a study group to explore developing an automated penalty system, which has apparently resulted in the system being rolled out on January 1, 2009.
There Appears to be a Compliance Window that Closes on December 31, 2008
In its Web site announcement, the IRS strongly encourages taxpayers to submit delinquent Forms 5471 before the first of the year (thus implying, though not specifically stating, that it will not automatically impose penalties for late filed Forms 5471 filed by December 31, 2008). The IRS began sending letters in August 2008 to taxpayers to alert them to this change in the penalty procedure. Certain taxpayers may not have received such a letter or it may have been delivered to an offshore address; moreover, if a taxpayer has never filed such a form, it is unclear how the IRS would have even known to send the taxpayer a letter in the first place!
Because of the attribution rules mentioned above, taxpayers that hold no direct interest in a foreign corporation, but who are related to parties that do hold significant interests in foreign corporations may be required to file nevertheless. Taxpayers should carefully inspect their holdings so that they are not hit with an unexpected penalty in January. This is especially important given that ignorance of the law generally does not constitute “reasonable cause.”
The 2006 TIGTA audit and the Web site notice seem to indicate that the automatic penalty program covers only the monetary lateness penalties that attach to untimely filed Forms 5471. The monetary penalty for late filing is not the only arrow in the IRS’ quiver. The IRS also can assess penalties for inaccuracy or for incomplete reporting; it also can reduce available foreign tax credits for late filers by up to 10 percent of the available credit.
The automation of the administration of late filing penalties will free up agents to apply greater scrutiny to Forms 5471, and perhaps increase the taxpayer’s exposure to all of the other penalties. Therefore, on a going-forward basis, taxpayers that regularly and timely report should continue to place strong emphasis on ensuring the accuracy and completeness of their reporting.
Steven D. Bortnick, Gregory J. Nowak and Marc D. Nickel