AICPA Not-for-Profit Conference Blazek & Vetterling, LLP

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1 I. Current Developments and Overview A. Developments B. Benefits C. Tax Risks D. Additional Steps AICPA Not-for-Profit Industry Conference Alternative Investments: Tax Perspective 1:00 p.m. to 2:15 p.m. Gaylord National Resort and Convention Center, Washington DC. Friday, June 20, 2008 Edward J. Jennings, J.D., CPA Tax Manager University of Michigan David Nelson, J.D., CPA Blazek & Vetterling, LLP TABLE OF CONTENTS II. Tax Savings and Conveniences from Blocker Corporations A. General Comments B. Examples C. Specific Comments III. Managing the Filing Requirements for Reportable Transactions and Excise Taxes for Prohibited Tax Shelter Transactions A. Reportable Transactions B. Excise Taxes for Prohibited Tax Shelter Transactions IV. Managing Filing Requirements for Foreign Partnerships and Corporations A. Foreign Taxes, Exemptions, and Filing Requirements B. U.S. Filing Requirements for Foreign Investments I. Current Developments and Overview 1

2 Alternative investments provide essential benefits to non-profit organizations with the promise of high returns that significantly boost revenue sources; however, they include tax risks that require these exempt investors to take additional steps to ensure tax compliance. 1 A. Developments 1. Congressional Concerns Offshore Blocker Corporations and Endowments a. In May 2007, the Senate Finance Committee held a closed-door meeting to determine whether it should disallow nonprofits from using the foreign blocker corporation as a tax planning tool when investing in hedge funds. b. On September 26, 2007, the Senate Finance Committee held a hearing, entitled "Offshore Tax Issues: Reinsurance and Hedge Funds". As an outgrowth to this hearing came proposals to restrict the endowments of educational institutions with respect to the distributions and expenditures. For instance, an employee for Congressional Research Service (CRS) testified that university and college endowments (which are not subject to taxes) are experiencing significant growth that can be used to slow tuition costs by making mandatory pay-outs from these funds to further subsidize student financial aid. c. On October 25 th, House Ways and Means Committee introduced a bill HR 3970, the Tax Reduction and Reform Act of 2007, which included under Section 1203 a provision that will allow a partnership to incur debt to acquire securities or commodities as an exception to acquisition indebtedness under IRC Section 514(c). The rationale is to eliminate the current law incentive for exempt entities to use offshore blocker corporations. d. On October 29 th, Senator Charles Grassley, R Iowa, and ranking member of the Senate Finance Committee, made a statement in his weekly column for Iowa newspapers that he is seeking mandatory 5% payout for University Endowments as part of a package for higher education tax incentives. The rationale is that these pay-outs may be used to slow increasing tuition costs. e. On January 24, 2008, Senators Baucus and Grassley sent letters to 136 colleges and universities with endowments in excess of $500 million that asked a myriad of questions regarding growth of the funds, percent of spending on student aid and compensation arrangements. The purpose is to determine appropriate stewardship of endowments in light of increased tuition rates, presidents salaries and growth of endowments. f. The status regarding the issue of offshore blocker corporations remains in question. 2. Internal Revenue Service (IRS) Pronouncements Prohibited Transactions a. This August, the IRS published final regulations, T.D. 9350, for reportable transactions under IRC Section 6011 that incorporate transactions of interest as a new category of reportable transactions and eliminate the brief asset holding period requirement, among other items. b. It released final, temporary regulations, T.D. 9334, on return requirements and filing due dates for excise tax payments. c. It released temporary regulations, T.D. 9335, to provide guidance on disclosure rules for nonprofits linked to prohibited transactions. 1 This outline is based on an article entitled Jennings, "Managing The Tax Consequences of Alternative Investments," Taxation of Exempts (Jul/Aug & Sept/Oct 2006). 2

3 d. It released proposed regulations, REG ; REG , to provide excise tax guidance for nonprofits linked to prohibited transactions. e. This September, the IRS issued Form 8886-T, Disclosure by Tax-Exempt Entity Regarding Prohibited Tax Shelter Transactions. B. Benefits 1. Recent studies show that these investments such as, hedge funds, private equity, and venture capital opportunities, are popular with the charitable community. 2. A Commonfund Benchmarks Study for 2006 shows that at least one-third of educational endowment assets are allocated to alternative investments An endowment study by the National Association of College and University Business Officers (NACUBO) for the 2007 year indicates that large educational institutions invest approximately 20% of its endowment assets in hedge funds, a common alternative investment, and that institutions on the whole invest assets in excess of 18%, on a dollarweighted average, in hedge funds. 3 C. Tax Risks 1. Alternative investments include complex funding strategies that may trigger federal and state tax liabilities or unrelated business income tax (UBIT) from operations or leveraged debt. 2. They may, in certain circumstances, raise exemption concerns regarding specific partnership arrangements. 3. They may require investors to file certain forms when engaging in reportable transactions and pay excise tax for certain prohibited tax shelter transactions. 4. They may require investors to file certain forms when conducting affairs with foreign entities directly or indirectly. D. Additional Steps 1. These investments are typically managed by third-party fund managers or investment firms that distance the investor from information that is necessary to manage tax liabilities and to meet tax reporting requirements. 2. To meet its reporting obligations, the investor needs to develop a working relationship with the investment manager as a means to minimize these tax risks while maximizing investment preferences and returns. II. Tax Savings and Conveniences from Blocker Corporations A. General Comments 2 Commmonfund Institute News, U.S. Educational Endowments and Foundations Report Average Return of 9.7% in Fiscal Year 2005, Benchmark Leaders report returns of 13.7% and 11.2% according to Commonfund Benchmark Study; Alternative Strategies Allocations rise for the Fifth Consecutive Year; Average Spending Rate Declines to 4.6%, January 12, 2006 at NACUBO Endowment Study (NES), 3

4 1. The exempt investor can use a foreign corporation as a viable planning tool that may provide tax savings greater than that of a limited partnership or LLC; however, this entity must be incorporated in a favorable tax jurisdiction The acid test question is whether the tax benefits derived from this foreign corporation outweigh those benefits provided by the partnership. 3. As mentioned above, the domestic corporation is less tax efficient than the partnership since its income is subject to tax in its entirety and the exempt partner is subject to tax on its UBIT income only, that is, assuming both parties are taxed at the same U.S. tax rates. However, income derived from a foreign corporation, although taxed in its entirety, may pay less in taxes than exempt partners with less taxable income because the foreign corporation s tax rate is significantly lower than the partner s tax rate. B. Examples 1. The traditional example of a foreign blocker corporation is described in a private letter ruling that involves a charitable remainder unitrust (CRUT) which is a split interest trust that is recognized as an exempt entity used to accept donations. The CRUT transferred assets to a wholly owned foreign subsidiary that, in turn, invested the assets in a U.S. partnership that anticipated deriving UBIT. 2. The issue is whether the UBIT income from the partnership is attributable to the CRUT, in which case, due to its special characteristics and the law at the time, the CRUT would lose its exemption The IRS concluded that the foreign corporation blocked the attribution of UBIT to the CRUT, treating the distribution from the corporation to the CRUT as a dividend excluded from taxation. 6 Hence, in this situation form overrides substance since the partner is not subject to tax when it makes this investment indirectly but otherwise would be if it makes the investment directly. 4. A germane example includes a partnership with charitable organizations as limited partners that intends to invest assets in China with the anticipation of high returns on passive income specifically derived from heavily leveraged debt. 5. The exempt partner as a U.S. citizen is subject to tax on its worldwide income, and as a partner must report a significant portion of its income as UBIT under the debt-financed rules. 6. If the partnership, however, establishes a corporation in the Cayman Islands to invest the assets, the partner derives no taxes. This jurisdiction imposes no corporate income taxes and, as discussed, the IRC excludes from taxation dividends paid to exempt investors. 4 Federal Income Taxation of Investments by Nonprofit Organizations: Beyond a Primer, Stephen Schwarz, 2 National Center on Philanthropy and the Law (2000). 5 Previously, under IRC Section 664(c) a CRUT lost its exemption when it derived any UBIT. Confirmed by Leila G. Newhall Unitrust v. Commissioner, 105 F.3d 482 (9 th Cir. 1997). Currently, Tax Relief and Health Care Act of 2006 imposed an excise tax of 100% on the CRT in the amount of UBIT derived. 6 LTR , September 30, Additional private letter rulings include LTR , September 23, 2002; LTR (September 23, 2002); LTR (September 23, 2002); LTR (January 14, 2003). Note that this ruling concludes that this dividend treatment overrides the controlled foreign corporation rules under IRC Sections except when the income is derived from certain insurance activities under IRC Section 512(b)(17). 4

5 C. Specific Comments 1. These windfall opportunities, however, require a given set of facts that are generally curtailed by various factors. 2. Investment managers that minimize UBIT liabilities give little incentive to establish the foreign corporation. 3. Also, countries impose tax and withholding requirements on income derived within their borders by nonresident aliens. For instance, the United States subjects to taxation in general any and all income earned by non-resident aliens that is effectively connected with the conduct of a U.S. trade or business as well as gains from sales of real estate, and imposes a flat tax rate of 30% on certain types of fixed or determinable annual or periodic U.S. source nonbusiness income It is recommended that the exempt investor carefully consider with its tax counsel the advantages of using blocker corporations. 5. Another use for the blocker corporation, either foreign or domestic, is simply to avoid the taint of UBIT regardless of any resulting incremental tax costs. Certain exempt investors are adverse to deriving taxable income and have zero tolerance for UBIT either as a matter of corporate policy or for lack of resources to maintain tax reporting responsibilities. 6. A blocker corporation provides administrative conveniences to exempt investors since it files the annual income tax returns and the investors are relieved of UBIT and other tax reporting obligations. III. Meeting the Filing Requirements for Reportable Transactions and Excise Taxes for Prohibited Tax Shelter Transactions A. Reportable Transactions 1. Background. a. The IRS with the support of Congress continues to increase its scrutiny with respect to possible tax abusive transactions that may impact exempt investors, including partners, members and certain shareholders in foreign corporations. 8 7 IRC Section 897, Disposition of Investment in United States Real Property; IRC Section 871, Tax on Nonresident Alien Individuals; IRC Section 881, Foreign Corporations not connected with United States Business; and, IRC Section 882, Tax on Income of Foreign Corporations Connected with United States Business. Note that certain interest and capital gains are excluded from withholding requirements and income tax treaties may modify these tax and withholding rules. 8 For more information on the topic refer to No Shelter is Safe New IRS rules scrutinize tax shelter transactions. To ensure compliance, colleges and universities must prepare to tell all, Barbara C. Reeder, Mike Repass, Howard Schoenfeld, and Christina Moore, NACUBO Business Officer, August 2003, pages 35-38; Tax Shelter Disclosure and List Maintenance Rules, Wendi L Kotzen and Joseph A. Reiser, Jr. and David B. Bailey, The Practical Tax Lawyer, Spring Treas. Reg. Section (estate taxes); Treas. Reg. Section (gift taxes); Treas. Reg. Section (employment taxes). Treas. Reg. Section (foundation and similar excise taxes); Treas. Reg. Section (public charity excise taxes). The IRS promulgates these identified transactions in notices. Refer to Notice , I.R.B (September 24, 2004) for an updated list. 5

6 b. Historically, the IRS required the investor to report information regarding tax shelters, but in the last few years has substantially broadened this scope to require the investor to report information on transactions that are considered legitimate but may have little or no purpose other than to generate tax or financial statement benefits. c. In 2003, the Treasury Department issued final regulations that defined six types of transactions that require disclosure; i Listed transactions, ii. Confidential transactions, iii. Transactions with contractual protection, iv. Loss transactions, v. Transactions with significant book-tax differences, and vi. Transactions with a brief asset-holding period. 9 Please note that Notice , I.R.B , concluded that significant book-tax differences is no longer a category as of January 6, 2006, and final regulations on reportable transactions, T.D (8/1/07), determined that the brief asset-holding period is no longer a category. These regulations added transactions of interest as a new category. d. The American Jobs Creation Act of 2004 added significant penalties in an effort to ensure compliance and revised the reporting procedures for the material advisors. Accordingly, these rules provide that if the exempt investor s tax return reflects any resulting tax benefits albeit from transactions conducted by investment managers then it is required to meet these reporting obligations Defining the Types of Transactions a. These transactions can be classified simply into two groups, listed transactions and others, based on the emphasis placed on the former. b. Listed transactions apply to a broad range of taxes, including income, estate and gift, employment, and certain excise taxes whereas the other categories are limited to income taxes only. 11 c. The penalties for failure to disclose the information properly are higher for listed transactions, $100,000 for natural persons and $200,000 in any other case, in comparison to the others that are $10,000 and $50,000 respectively. 12 d. Listed transactions carry an additional administrative burden, a look-back provision that requires the investor to report transactions that are identified by the IRS after the investor filed the tax return in which the transaction occurred but before the general statute of limitations expires. 13 e. For taxpayers that fail to disclose a listed transaction, the statute of limitations is extended to one year after the IRS is provided with the requested information Example 9 Treas. Reg. Section Treas. Reg. Section (b)(6)(ii)(E) and (c)(3). With respect to listed transactions, a partner participates in a listed transaction if the return reflects tax benefits or the partner has reason to know that its tax benefits are derived directly or indirectly from a tax strategy from a listed transaction. 11 Refer to footnote IRC Section 6707A(b). 13 Treas. Reg. Section (e)(2)(i). 14 IRC Section 6501(c)(10). 6

7 a. Certain types of alternative investments may trigger these disclosure requirements. b. For instance, a listed transaction includes transactions that involve using a notional principal contract to claim current deductions for periodic payments made by a taxpayer while disregarding the accrual of a right to receive offsetting payments in the future Losses: The threshold with respect to loss transactions may require the exempt investor to file. a. For example, loss transactions include transactions that result from the corporate investor claiming a loss of at least $10 million in any single year or $20 million in any combination of years, however, losses are broadly defined and accumulate over a significant period of years. b. Losses are defined to include losses incurred from the sale of partnership interests, capital losses, worthless security losses and other similar losses. 16 c. Cumulative losses are defined to include losses claimed in the taxable year that the transaction is entered into and the five succeeding taxable years combined without considering any offsetting gains Foreign Corporation a. An investor with significant shares in a foreign corporation may need to file as well. b. In general, a shareholder of a foreign corporation participates in a reportable transaction when, by attribution, that foreign corporation would be considered to participate in the transaction if it were a domestic corporation. 18 c. A reporting shareholder is defined to include a 10% shareholder of a qualifying electing fund, or a shareholder in a controlled foreign corporation. 19 d. A shareholder in a controlled foreign corporation is defined as owning at least 10% of the voting stock when more than 50% of the voting stock or value of the corporation is owned by U.S. persons Reporting Requirements a. The exempt investor must attach the Form 8886, Reportable Transaction Disclosure Statement, to its income or information tax return for each taxable year that it participates in the transaction and must file a copy with the Office of Tax Shelter Analysis when the investor first files this form for the transaction. 21 b. Final regulations, T.D. 9350, conclude that investors are no longer required to file Form 8271 Investor Reporting of Tax Shelter Registration Number otherwise due on or after August 3, Notice , C.B. 992 (May 6, 2002) as summarized in Notice , (9/04). 16 IRC Section 165, Losses. 17 Treas. Reg. Section (b)(5). 18 Treas. Reg. Section (c)(3)(i)(G). 19 Id. Note that IRC Section 552 with respect to foreign personal holding companies was repealed by the American Jobs Creation Act of IRC Sections 951(b), Treas. Reg. Section (e). 7

8 c. In consequence, with the severity of the penalties and the complexity of these transactions, the exempt investor should include provisions in the agreements that require the investment managers to inform the exempt organization of its reporting obligation with respect to these transactions. B. Excise Taxes for Prohibited Tax Shelter Transactions 1. Background a. The Tax Increase Prevention and Reconciliation Act of 2005 subjects the exempt entity to an excise tax for entering into prohibited tax-shelter transactions. b. Definition: A prohibited transaction includes a listed transaction or a prohibited reportable transaction defined to include a confidential transaction and any transaction with contractual protection. c. Scope: Exempt entities include generally those organizations defined in Sections 501(c), 501(d), and 170(c) (other than the United States). d. Entity tax: The tax for prohibited transactions is equal to the highest corporate tax rate (35%) multiplied by the greater of the net income with respect to such transaction or 75% of the proceeds received from the transaction. If the investor had reason to know that it participated in such a plan, then the tax is the greater of (1) 100% of the entity s net income or 75% of the proceeds. e. Insider tax: A tax of $20,000 is imposed on the entity manager if he or she knows or has reason to know that the transaction is a prohibited tax-shelter transaction. 2. Interim Guidance a. In February 2007, IRS published notice to provide interim guidance on when a tax-exempt entity is a party to such a transaction; b. if it facilitates the transaction by reason of its tax-exempt, tax indifferent or tax-favored status, or is identified in a published guidance by type, class or role, as a party to such a transaction. c. It also provides guidance on how the IRS will allocate to various periods the income or proceeds that are attributed to the transaction Temporary and final regulations, T.D a. Released in July 2007, these regulations provide that exempt organizations are required to file a return on Form 4720, "Return of Certain Excise Taxes under Chapters 41 and 42 of the Internal Revenue Code." b. The entity return is due on or before the date the non-plan entity's annual return, the Form 990, Return of Organization Exempt From Income Tax, is due, if the non-plan entity is required to file such a return. In all other cases, the entity return is due on or before the 15th day of the fifth month after the end of the entity's accounting period. In the case of an insider, the entity manager return s is due on or before the 15th day of the fifth month following the close of the manager's taxable year during which the entity entered into a prohibited tax shelter transaction. c. The regulations provide a transition rule that returns are or were due on or before October 4, 2007 will be deemed timely if the return is filed and the tax is paid before that date. 22 Notice I.R.B (February 7, 2007). 8

9 4. Temporary regulations, T.D a. Also released in July were regulations on guidance regarding disclosure requirements for exempt organizations that are parties to prohibited tax shelter transactions. b. Every tax-exempt entity subject to the excise tax should file with the IRS Form 8886-T, "Disclosure by Tax- Exempt Entity Regarding Prohibited Tax Shelter Transaction". c. The instructions include the due dates which can differ based on the reason for filing, e.g. the exempt investor is a party because it facilitating the transaction using its tax-exempt status as opposed to being a participant to a listed party. d. Disclosure is not required with respect to any prohibited tax shelter transaction entered into by a tax-exempt entity on or before May 17, Also, there is a transition rule transactions entered into after May 17, 2006 and before January 1, Proposed regulations and a. The regulations provide guidance on definitions and disclosure requirements. b. Definitions: The regulations adopt much of the language in Notice ( IRB 608) regarding the criteria for an exempt party to a prohibited tax shelter transaction. Also, included are terms regarding entity managers and the standard of knows or has reason to know. c. Disclosure requirements: The regulations discuss the disclosure requirements for exempt entities as well as taxable entities to exempt investors. IV. Managing Filing Requirements for Foreign Partnerships and Corporations Specific tax issues arise with respect to foreign entities that merit consideration. An organization that derives earnings in foreign countries may subject those earnings to taxes in those countries. Also, such investments may generate filing requirements in those countries. Lack of prudence may cause the exempt partners to incur unnecessary taxes or assume foreign filing requirements. Further, the IRC imposes filing responsibilities on certain U.S. taxpayers that invest in foreign partnerships and corporations. A. Foreign Taxes, Exemptions, and Filing Requirements 1. Investment firms may minimize the burden of taxation to its exempt partners by ensuring that the investments qualify for the reduced tax withholding rate as applied under treaty obligations, or in accordance with that country s tax rates. Additionally, the firm may derive tax savings by filing for exemptions or reclaims and ensure compliance by filing returns when necessary. 2. Examples of recommended provisions to include in a partnership agreement are as follows: a. Trade or Business The general partner shall use best efforts to ensure that the partnership will not be treated as being engaged in a trade or business, or having a permanent establishment in any country outside of the United States with the purpose of avoiding the assessment of any direct tax by such country against the limited partner solely by reason of investments or activities of the partnership. 9

10 b. Exemptions, Refund Claims and Tax Withholdings The general partner shall make filings, applications, or elections to reduce the amount of tax withheld on behalf of the limited partner and to receive refunds of tax withheld or paid, to the extent provided by law. The general partner shall use best efforts to assist the limited partner to obtain any available exemption from or refund of any withholding or other tax imposed by any non-united States jurisdiction in which the Partnership invests as provided under this Agreement. c. Foreign Tax Filings The general partner shall use best efforts to operate the partnership in a manner that would not require the limited partner to file an income tax return in such jurisdiction, or cause the limited partner s activities that are otherwise separate and distinct from this partnership s activities and that are conducted in a jurisdiction outside of the United States to be subject to taxation in such jurisdiction solely because of the activities of this partnership. Should the general partner become aware of the occurrence of either event, it will inform and notify the limited partner within 14 days from the date of discovery. B. U.S. Filing Requirements for Foreign Investments General Comments Exempt investors that invest in foreign partnerships or corporations directly or indirectly may trigger U.S. filing requirements. These requirements are confounding at best and require the investor to navigate through a maze of forms and muddle through a morass of categories within these forms. In addition, these forms require the investor, in certain circumstances, to report detailed information that it may obtain only from the investment managers. Hence, much like UBIT, the investor must work closely with these managers to have access to information necessary to ensure compliance. 1. The Need to File for Foreign Partnerships a. Exempt investors that invest in foreign partnerships either directly or indirectly may need to file Form Return of U.S. Persons with respect to Certain Foreign Partnerships, if they meet one of four categories. 23 Each of these categories maintain different criteria with respect to i. the type of information to report, ii. which entity s year-end to use when reporting the information, and iii. the penalties for failure to comply. b. The investor must file a separate form for each partnership but may file a single form for the same partnership that requires reporting for more than one category. The form should be attached to the annual income or information return filed by the investor for the appropriate period. c. Categories 1 and 2 apply to those partners with control over the foreign partnership. 23 The instructions provide that a foreign partnership is a partnership that is not created or organized in the United States or under the law of the United States or of any state. 10

11 i. Category 1 defines control as a partner that at any time during the year owns more than a 50% interest in the partnership, specifically, capital interests, profits interests or an interest in which greater than 50% of the deductions or losses are allocated. 24 ii. Category 2, as a default to Category 1, defines control as two or more persons that own more than 50% of the partnership with each owning at least a 10% interest. 25 Categories 1 and 2 must include information regarding its distributive share of income, deductions and credits as well as a summary of any transactions between the venture and the investor and its affiliates. iii. Category 1 filers must include information with respect to certain other partners and financial information, including an income statement and balance sheet. 26 iv. Both category filers report this information based on the year-end of the partnership. 27 v. The penalty for failure to file is $10,000 and may result in a 10% reduction on the foreign tax credit. 28 d. As a by-product to Categories 1 and 2, Category 4 requires the filing of a reportable event when the partner either by direct acquisition or disposition has crossed the 10% threshold or changed ownership by 10%. i. For example, the investor must file when a purchase of an interest increases ownership from 9% to 11% or from 11% to 21% compared to the last reportable event. 29 ii. Category 4 filers must include information with respect to the acquisitions and dispositions during the year-end of the partner, not the partnership. 30 iii. The penalty for failure to file is $10, e. Category 3 involves transfers of property rather than controlling or varying interests in the venture, and includes a low threshold that may set a trap for the unwary investor. i. Any partner that contributes property or cash to a foreign partnership in exchange for an interest in the partnership must file this form when either: or the partner owns directly or constructively at least a 10% interest in the venture as a result of the contribution, the value of the contribution transferred exceeds $100,000 including any such transfers made within the 12- month period ending on the date of the transfer IRC Section Id. 26 The instructions to Form 8865 include a matrix of information to file for each Category. 27 IRC Section IRC Section 6038(b) and (c); Treas. Reg. Section (k); The instructions to Form 8865 discuss the application of possible criminal penalties for failure to file or for filing false or fraudulent information. 29 IRC Section 6046A. 30 Treas. Reg. Section A IRC Section Treas. Reg. Section A-1(h). which refer to IRC Section IRC Section 6038B(a)(1)(B) and (b); Treas. Reg. Section B-2(a). 11

12 ii. Hence, the initial and subsequent capital contributions that exempt investors make in foreign partnerships require the filing of this form regardless of their nominal ownership interest in the venture since the transferred amount typically exceeds this dollar threshold. iii. Category 3 requires the investor to file this form if the partner contributed appreciated property and the venture disposes of it while the investor is a partner. 33 iv. The partner must report information with respect to the transaction and, if owns at least a 10% interest, must also include information regarding certain other partners which, in most cases, needs to be obtained from the manager. 34 v. The Category 3 filer must report these transfers during the partner s year-end. vi. The penalty for failure to file equal 10% of the fair market value of the property contributed to the venture, up to $100, This $100,000 cap does not apply if the failure is due to intentional disregard. 36 In addition, the contributor must recognize gain on the contribution as if the property had been sold for fair market value. 37 f. The exempt partner must report this information even if the transfer is made indirectly through a domestic partnership unless the domestic partnership properly filed this form on behalf of the exempt partner. 38 g. Note that each category may receive exceptions to these penalties for reasonable cause The Need to File for Foreign Corporations a. Exempt investors that invest in foreign corporations either directly or indirectly may need to file different forms with respect to the transfer of cash and ownership interests in foreign corporations. i. Form 926 Return by a U.S. Transferor of Property to a Foreign Corporation, which reads similar to Category 3 of form 8865, requires the reporting of cash transfers. ii. Form 5471 Information Return of U.S. Persons with respect to Certain Foreign Corporations, which reads similar to Categories 1, 2 and 4, requires the reporting of controlling interests and certain acquisitions and dispositions. iii. Form Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, requests information with respect to taxable income from certain foreign corporations. b. Form 926 i. The IRS provides that an exempt investor is required to file form 926 when it transfers cash to the corporation and either holds at least a 10% ownership interest in the voting power or total value of the corporation immediately after the transfer, or the amount of cash transferred exceeds $100,000 during the 12-month period mentioned above Treas. Reg. Section B-2(a)(4). 34 Treas. Reg. Section (c)(4) 35 Treas. Reg. Section B-2(h). 36 Id. 37 IRC Section 6038B(c); Treas. Reg. Section B-2(h). 38 Treas. Reg. Section B-2(a)(2). 39 IRC Sections 6038B(c) and 6679(a); Treas. Reg. Sections (k)(4)and B-2(h)(3). 40 IRC Section 6038B(a)(1)(A) and pursuant to the instructions to the Form 926. Part of the difficulty in understanding this form is that the instructions fail to adequately address the impact that the pertinent IRC Sections have on exempt organizations. IRC Section 6038B(a)(1)(A), as modified by the Taxpayer Relief Act of 1997, requires a U.S. person to file this form who transfers property to a foreign corporation in an 12

13 ii. Other transfers regarding corporate transactions that involve liquidations and reorganizations must be disclosed, however, they do not generally apply to charitable organizations. The exempt investor is excluded from transactions that involve the exchange of stock in one foreign corporation for another. 41 iii. The instructions provide that partners are required to file such information notwithstanding transfers made on their behalf by partnerships in which they have an interest. iv. This form must be filed with the exempt investor s income tax or information return for the tax year that includes the date of the transfer. 42 v. The investor is subject to a penalty for failure to file equal to 10% of the fair market value of the property at the time of the transfer capped at $100,000, provided; the failure was not due to intentional disregard. The penalty will not apply if the failure is due to reasonable cause and not willful neglect. 43 c. Form 5471 i. The exempt investor is required to file form 5471 when its ownership of stock in a foreign corporation is deemed significant. 44 ii. This form includes categories that match to the categories included in form 8865: Category 4 (similar to Category 1 of form 8865) focuses on control by the shareholder with more than 50% ownership in the voting stock or value of the corporation; Category 5 (similar to Category 2) focuses on control with two or more persons that own more than 50% of the voting power or value of the corporation with each person owning at least 10% of the voting stock; and Category 3 (similar to Category 4) focuses on the acquisition or disposition of stock that changes its ownership in the corporation significantly. 45 iii. These categories also include different criteria with respect to information to report with Category 4 requiring the most information, including an income statement and balance sheet and an earnings and profit statement. 46 iv. In general, the information for each category is based on the tax year for the foreign corporation ending within or with the investor s tax year, however, the Category 3 filer must report acquisitions and dispositions during its own tax year. 47 exchange for an ownership interest described in IRC Sections 332, 351, 354, 355, 356 or 361. These provisions, however, generally relate to income non-recognition transactions which do not affect exempt organizations. In fact, the instructions for the 1998 year excepted exempt organizations from filing this form; provided, it derived no UBIT. Hence, the question arises whether exempt organizations with no UBIT from the respective transaction are expected by statute to file this form. 41 Treas. Reg. Section B-1(b)(2)(i). 42 Treas. Reg. Section B-1(b)(1)(i). 43 IRC Section 6038B(c). 44 IRC Sections 6038 and The first two categories of this form apply to individual shareholders, directors and officers of foreign corporations and are beyond the scope of this outline. Note that category 1 has been repealed by section 413(c)(26) of the Jobs Creation Act which repealed IRC Section The instructions to Form 5471 include a matrix of information to file for each Category. 47 Treas. Reg. Sections (e) and ; and Form 5471 instructions. 13

14 v. The form should be attached to the investor s income tax or information return with a separate copy sent directly to the IRS and each investor must file a separate form for each foreign corporation. 48 vi. Penalties for failure to file for Categories 4 and 5 are similar to filers of category 1 and 2 of form 8865; a penalty of $10,000 and a 10% reduction of foreign tax credit. 49 Category 3, akin to category 4 of form 8865, is subject to a $10,000 penalty. 50 There are, however, exceptions for failure to file due to reasonable cause. 51 vii. Prudence dictates that with the complexity of the form and the penalties associated for failure to file a complete and accurate return the investor take steps to ensure timely receipt of information from the investment manager. d. Form 8621 i. The exempt investor may file form 8621 in addition to the other forms if the foreign corporation qualifies as a passive foreign investment company (PFIC). ii. A PFIC is defined as any foreign corporation that derives 75% or more of its gross income as passive income, or that holds 50% or more of its assets that derive such income. 52 iii. The form, in general, includes sophisticated tax elections and specific methods to report taxable income from certain transactions. The rationale is to prevent the deferral of taxes to a PFIC either by taxing PFIC earnings currently (through an election) or by taxing the excess dividends paid to applicable tax rates from previous years. The instructions do not distinguish clearly the impact that this form may have on exempt organizations except to note that exempt organizations are subject to the tax and interest rules under IRC Section 1291 if the dividends received from the PFIC trigger taxation to the shareholder under Subchapter, and that EOs that are not taxable under section 1291, may not make the qualifying electing fund election. 53 iv. Clearly, the investor should seek guidance from the manager with respect to filing this form Specific Comments a. Form TD F Report of Foreign Banks and Financial Accounts U.S taxpayers must file this form when they have financial interests or signature authority over a financial account in a foreign country that exceeds $10,000. No exceptions apply to non-profit entities. b. Precautionary Steps 48 Instructions to Form IRC Section 6038(b) and (c). The instructions to Form 5471 discuss the application of possible criminal penalties for failure to file or for filing false or fraudulent information. 50 IRC Sections 6679(a). 51 IRC Section 6679; Treas. Reg. Sections (k)(4). 52 IRC Section 1297(a). 53 This language is derived from Treas. Reg. 1295(d)(6). 54 One commentator takes the position that the IRS has provided unofficially that exempt organizations, such as private foundations, are excluded from filing this form. Exempt Organizations Reporting Requirements for Foreign Investments and Accounts, Richard R. Upton, The Exempt Organization Tax Review, Volume 50, Number 1, pages 21-31, page 27, October

15 With the severity of the penalties and the complexity of these transactions, the exempt investor should include provisions in the agreements that require the investment managers to inform the exempt organization of its reporting obligation with respect to these transactions. 15