New U.S. Reporting Obligations Imposed on Foreign-Owned Disregarded Entities
In December 2016, the U.S. Department of the Treasury and Internal Revenue Service (IRS) issued final regulations regarding foreign-owned domestic disregarded entities. Under these regulations, the IRS will treat foreign-owned domestic disregarded entities as domestic corporations for the record-keeping and reporting requirements of Internal Revenue Code § 6038A.
These regulations come after many countries assert that the U.S. is one of the largest tax havens in the world due to relaxed reporting requirements for disregarded entities. The use of U.S. disregarded entities by foreign persons has increased exponentially due to several planning opportunities. One potential benefit of using a U.S. disregarded entity is that it can provide limited liability protection. Additionally, it can provide a U.S. holding vehicle while business is conducted entirely outside of the U.S. However, the primary use of U.S. disregarded entities by foreign owners (under the old reporting environment) was to purposely shield certain activities and owners from disclosure, whether in the U.S. or abroad.
Prior to the new regulations, foreign-owned disregarded entities were, in most cases, not subject to the requirement to obtain a Taxpayer Identification Number (TIN) in the U.S., thus keeping their existence and ownership information essentially hidden from both the IRS and foreign tax agencies. Additionally, foreign owners did not have to report transactions between themselves and the disregarded entity.
The new regulations treat a U.S. disregarded entity owned by a foreign person as a separate corporation for information reporting and record-keeping purposes. Specifically, § 6038A requires U.S. corporations that are 25 percent foreign-owned to report information about its foreign owners. Also, the corporation’s transactions with such owners will now apply to foreign-owned U.S. disregarded entities.
Under the new regulations, any transaction described in Treasury Regulation § 1.482-1(i)(7) is now a reportable transaction. This includes sales and purchases, borrowings and loans, rents, interest, royalties, service fees, commissions or other amounts paid or received in transactions between the corporation and a foreign related party. A related party is any direct or indirect 25 percent shareholder, any person related to the corporation or a 25 percent shareholder as defined by § 267(b) or § 707(b)(1), and any other person related to the corporation as defined in § 482.
The regulations also amend Treasury Regulation § 301.7701-2 to treat a U.S. disregarded entity owned by a foreign person as a U.S. corporation for the information reporting and record-keeping requirements of § 6038A. The new rules, however, do not otherwise affect the entity classification or the entity’s general treatment for U.S. tax purposes. Because a foreign-owned U.S. disregarded entity is now treated as a U.S. corporation for information reporting purposes, it is required to file Form 5472 for reportable transactions between the entity and foreign related parties. The entity is also required to maintain adequate records to establish the accuracy of this information return.
As a result of this new filing obligation, the entity would have to obtain an Employer Identification Number (EIN) by filing Form SS-4. This can be a potentially expensive and time-consuming process but it is necessary to identify its responsible party including the responsible party’s identifying number (i.e., Social Security Number (SSN), Individual Tax Identification Number (ITIN) or EIN).
Entity owners would be subject to a $10,000 penalty for every unfiled Form 5472 that should have been filed. For companies that have multiple foreign-owned disregarded entities the penalty impact could be considerable.
The regulations go into effect for all tax years beginning on or after Jan. 1, 2017 and ending on or after Dec. 31, 2017. If you or your company are involved with foreign-owned U.S. disregarded entities and would like to learn more about these new regulations please contact a KSM advisor.
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