On December 11, 2014, the Internal Revenue Service (“IRS”) released final regulations providing guidance relating to the provisions of the Hiring Incentives to Restore Employment Act that require certain interests in foreign assets to be reported by U.S. taxpayers to the IRS (the “Final Regulations”). Such reporting requirements are codified under Section 6038D of the Internal Revenue Code of 1986, as amended (the “Code”).
By way of background, for tax years beginning after March 18, 2010, Code Section 6038D generally provides that individuals with one or more interests in “specified foreign financial assets” during the tax year must attach a disclosure statement to their income tax return for any year in which the aggregate value of all such assets is greater than $50,000 (or a dollar amount higher than $50,000 as IRS may prescribe). Further, to the extent provided by IRS in regulations or in other guidance, this reporting requirement applies to any domestic entity formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets, in the same manner as if the entity were an individual. For this purpose, “specified foreign financial assets” generally include: (1) depository or custodial accounts at foreign financial institutions, and (2) to the extent not held in an account at a financial institution, (a) stocks or securities issued by foreign persons, (b) any other financial instrument or contract held for investment that is issued by or has a counterparty that is not a U.S. person, and (c) any interest in a foreign entity.
The Code Section 6038D reporting requirement is significant because implementing the requirement may prove challenging for financial institutions (including hedge funds and other alternative investment vehicles) that are already straining to comply with the Foreign Account Tax Compliance Act, or “FATCA”. Further, it can be onerous for taxpayers generally to have what seems to be a duplicative reporting requirement between the Code Section 6038D requirement and a similar reporting requirement under the FinCEN Form 114, Report of Foreign Bank and Financial Accounts (or “FBAR”) rules. The Final Regulations provide no relief from these — at times overlapping reporting obligations.
On December 19, 2011, the IRS published temporary regulations (the “2011 Temporary Regulations”) addressing the reporting requirements under Code Section 6038D, as well as a notice regarding the proposed rulemaking. The notice of proposed rulemaking included Proposed Regulation Section 1.6038D-6, which set out the conditions under which a domestic entity will be considered a specified domestic entity and, therefore, required to report specified foreign financial assets in which it holds an interest. Certain corrections were subsequently made to the regulations by the IRS. The IRS then accepted comments on the regulations. After reviewing such comments, the IRS has adopted the 2011 Temporary Regulations as final regulations with the following notable modifications:
- The Final Regulations provide an exemption from the Code Section 6038D reporting requirements for a dual resident taxpayer who determines his U.S. tax liability as if he were a nonresident alien and claims a treaty benefit as a U.S. nonresident by timely filing a Form 1040NR, Nonresident Alien Income Tax Return (or such other appropriate form), and attaching a Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b). This is a welcome result for many dual resident taxpayers and reduces the Code Section 6038D compliance burden for such taxpayers.
- The Final Regulations clarify that a specified person that is transferred property in connection with the performance of personal services is first considered to have an interest in the property for purposes of Code Section 6038D on the first date that the property is substantially vested or, in the case of property with respect to which a specified person makes a valid election under Code Section 83(b), on the date of transfer of the property. Because many alternative investment funds transfer interests in their offshore investment vehicles to their service providers as part of an overall compensation package, this is a helpful clarification.
- The Final Regulations provide that a specified person that owns a foreign or domestic entity that is a disregarded entity is treated as having an interest in any specified foreign financial assets held by the disregarded entity. As a result, a specified person that owns a disregarded entity (whether domestic or foreign) that, in turn, owns specified foreign financial assets, must include the value of those assets in determining whether the specified person is subject to the Code Section 6038D reporting requirements. This result is consistent with prior IRS guidance on this issue and is a helpful confirmation.
- The Final Regulations clarify that each of the joint owners of a specified foreign financial asset who are not married to each other must include the full value of the asset (rather than only the value of the specified person’s interest in the asset) in determining whether the aggregate value of such specified individual’s specified foreign financial assets exceeds the applicable reporting thresholds, and each joint owner must report the full value of the asset. In addition, the Final Regulations clarify that, in the case of joint owners who are married to each other and file separate returns, each joint owner of a specified foreign financial asset must report the full value of the asset (rather than only the value of the specified person’s interest in the asset), even if both spouses are specified individuals and only one-half of the value of the asset is considered in determining the applicable reporting thresholds under Code Section 6038D.
The IRS is not currently adopting Proposed Regulation Section 1.6038D-6, but intends to adopt it at a later date. This is a welcome development, as this proposed regulation would increase the reporting obligations for a number of domestic entity taxpayers.
The penalties for failure to comply with the Code Section 6038D reporting requirements have not changed. An applicable taxpayer who during a tax year holds any interest in a specified foreign financial asset and fails to provide required information for any tax year is subject to a $10,000 penalty. A failure continuing for more than 90 days after the day on which IRS mails a notice of the failure to such a specified person subjects the specified person to an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure continues after the 90-day period has expired, up to a maximum penalty of $50,000 for each such failure. No penalty applies if the failure was due to reasonable cause and not willful neglect.
The full text of the Final Regulations may be found here [https://s3.amazonaws.com/public inspection.federalregister.gov/2014-29125.pdf].