Determining the Category of Filer for Form 5471 With Respect to Ownership of Foreign Corporations
The Tax Cuts and Jobs Act (“TCJA”) that was passed at the end of 2017 was meant to simplify the tax code. However, in the international tax realm, the complexity has only increased. This is certainly true of the revised form and instructions for Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, as of Dec. 12, 2018 for the 2018 tax filing season. These revisions significantly change the form, and the instructions expand the categories of filers for this form.
Determining the Category of Filer
Determining the category of filer is the first step, and will answer the following questions:
- Whether or not a Form 5471 needs to be filed
- Which sections of the form need to be completed
- Whether or not the filer is eligible for an exception
This determination is based on several factors, including ownership amounts (direct, indirect, and constructive), changes in ownership, and control.
Determining the correct category is critical – the penalties associated with incomplete Form 5471s or unfiled Form 5471s are a minimum of $10,000 per entity per year, and the statute of limitations stays open indefinitely on the entire tax return.
Definitions to Know
Before we get into the various categories and how they are classified, it’s important to start with a few general definitions:
- U.S. Person – A citizen or resident of the U.S., a domestic partnership, a domestic corporation, a domestic estate or trust. This can also include nonresident aliens who elect to be treated as a U.S. person for tax purposes, and a person who becomes a citizen of the U.S. during the tax year.
- U.S. Shareholder – A U.S. person that owns, directly, indirectly, or constructively, 10% or more of the total combined voting power of all classes of stock of a foreign corporation or, in the case of a tax year beginning after Dec. 31, 2017, 10% or more of the total combined voting power or value of shares of all classes of a foreign corporation’s stock.
- Controlled Foreign Corporation (“CFC”) – A foreign corporation that has U.S. shareholders that own, directly, indirectly, or constructively, on any day of the tax year, more than 50% of the total combined voting power or value of the stock of a foreign corporation.
- Section 965 Specified Foreign Corporation (“SFC”) – A CFC, or any foreign corporation with one or more 10% domestic corporation shareholders. Passive foreign investment companies are not included in this definition.
- Direct Ownership – A person or an entity has direct ownership in a foreign entity when they are the immediate owner of the shares (not a related party or another entity) of the foreign entity.
- Indirect Ownership – A person or an entity has indirect ownership in a foreign entity when they are deemed to own shares of such foreign entity through another foreign entity that they own.
- Constructive Ownership – A person or entity has constructive ownership when they are deemed to own stock via application of Section 318(a) as modified by Section 958(b). In general, these rules operate as follows:
- Family Members – An individual is deemed to own the stock owned by his spouse, children, grandchildren, and parents.
- “From Entities” – Subject to certain exceptions, stock owned by a partnership, estate, trust, or corporation is deemed to be owned by its partners, beneficiaries or shareholders. With respect to corporations, this only applies to shareholders that own 10% or more in value of such corporation.
- “To Entities” – Stock owned by a partner, beneficiary or shareholder is deemed to be owned by the partnership, trust, estate, or corporation. However, any stock owned by an entity via this type of attribution is not considered when applying the “From Entities” attribution rules.
There are exceptions to the constructive ownership rule if the related person is a foreign individual. However, the TCJA repealed an important provision related to the stock attribution rules from foreign persons to U.S. entities owned by such foreign person. This change can cause unintended consequences when looking at constructive ownership. This is discussed more below.
Five different categories of filers have been defined by the IRS. They are as follows.
The previously “reserved” category 1 filer has been revised to include U.S. shareholders of a foreign corporation that is an SFC at any point during the year, and that owned the foreign corporation’s stock on the last day of the year in which it was an SFC.
This category includes a U.S. individual (citizen or resident) who is an officer or director of a foreign corporation in which a U.S. person has acquired 10% stock ownership (in vote or value) of the foreign corporation or an additional 10% ownership (in vote or value) in any given tax year.
Note that the U.S. person acquiring the ownership of the foreign corporation can be any U.S. person, and does not need to be related to the officer or director. Additionally, a U.S. person is deemed to have acquired stock in a foreign corporation when that person has an unqualified right to receive the stock, even if the stock is not actually issued.
This category includes:
- Any U.S. person that acquires stock in a foreign corporation that would put the person above the 10% ownership threshold (vote or value)
- A U.S. person that acquires 10% or more of the foreign corporation during the tax year in addition to what they already own
- A person treated as a U.S. shareholder in a captive insurance company
- A person that becomes a U.S. person during the year while meeting the 10% ownership threshold
- A U.S. person that disposes of stock and reduces their interest to below the 10% ownership threshold during the tax year
There is some nuance here – the 10% ownership threshold looks at what the U.S. person owns directly, indirectly, and constructively. However, with respect to individuals, the constructive ownership rules are expanded to include brothers and sisters. Thus, for an individual, this category is applied via attribution from spouse, ancestors (parents, grandparents), and lineal descendants (children) as defined above, but it also includes siblings (brothers and sisters) for purposes of Category 3.
This category includes a U.S. person that had control of a foreign corporation during the tax year.
Control is when a U.S. person owns more than 50% of the total combined voting power of all classes of stock of the foreign corporation entitled to vote, or more than 50% of the total value of the shares of all classes of stock of the foreign corporation. Additionally, a person in control of a corporation that in turn owns more than 50% of the combined vote or value of all classes of stock of another corporation is also treated as being in control of such other corporation. The attribution rules here are different than the Category 3 rules when looking at the 50% ownership requirement. For Category 4 purposes, with respect to individuals, siblings are not included, while direct lineal ancestors and descendants are.
This category includes a U.S. shareholder that owns stock in a foreign corporation that is a CFC at any time during the tax year, and that owned that stock on the last day of the foreign corporation’s tax year in which it was a CFC. This category previously required the CFC to be controlled by the U.S. shareholder for at least 30 days; however, this requirement was removed as part of the TCJA.
To determine whether or not U.S. persons meet the ownership threshold in determining if a foreign corporation is a CFC, TCJA has changed the constructive ownership rules with respect to stock owned by foreign persons as it relates to U.S. entities (as noted in the constructive ownership definition above). The attribution rule to U.S. individuals has not changed in that there is no attribution of ownership from a nonresident alien individual to a U.S. taxpayer individual. However, the rule did change for entities such that a U.S. entity can now be deemed to own stock owned by a foreign partner, foreign beneficiary, or foreign shareholder.
For example, if a foreign parent company owns 85% of a foreign subsidiary and 100% of a domestic subsidiary, and the domestic subsidiary owns the remaining 15% of the foreign subsidiary, the foreign subsidiary was previously considered owned only 15% by a U.S. shareholder. Subsequently, it was not a CFC. However, the TCJA revised the constructive ownership rules to treat the foreign parent ownership as constructively owned by the U.S. subsidiary (when, as in our example, the foreign parent owns greater than 50% of the domestic subsidiary) and the foreign subsidiary becomes a CFC.
In addition to expanding the categories of filers, the TCJA provides multiple exceptions from filing Form 5471, including an exception for U.S. persons that are required to file Form 5471 solely because of constructive ownership. Please reach out to your KSM advisor if you need help determining if one of those exceptions would apply to you.
Determining the category of filer is complicated, and the attribution rules related to ownership of a foreign corporation are complex and difficult. Please contact your KSM advisor if you need assistance.
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