New Year brings new US Reporting requirement introducing Form 8938 Statement of Specified Foreign Financial Assets

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1 New Year brings new US Reporting requirement introducing Form 8938 Statement of Specified Foreign Financial Assets Arthur J. Dichter Cantor & Webb P.A., Miami FL The following article gives an overview of new reporting requirements for US taxpayers who own specified foreign financial assets as introduced by the FATCA provisions of the Hiring Incentives to Restore Employment (HIRE) Act. Arthur J. Dichter is a Partner with Cantor & Webb P.A., Miami FL I. Introduction The Hiring Incentives to Restore Employment (HIRE) Act added a new information reporting requirement for US taxpayers who own certain types of assets outside the United States (called specified foreign financial assets ). The new reporting requirement is to be met by attaching a reporting form to a US tax return, by any individual who is required to file an income tax return. (Most nonresident aliens and people with income below the filing thresholds are therefore excused.) The filing requirement applies to tax years beginning after March 18, 2010, which for most individual taxpayers means that 2011 tax returns being filed in 2012 will be the first returns filed under the new rules. The Internal Revenue Service ( IRS ) recently released its final version of Form 8938, Statement of Specified Foreign Financial Assets, and the instructions thereto. On the same day that the final form was released, the Treasury Department issued temporary regulations providing additional guidance on the new reporting requirements. There is little reason for taxpayers to be excited about this new reporting requirement, as it will add significant complexity and cost to the tax return preparation process. If there is any good news, it is that information being reported on other forms, such as 3520, 3520-A, 5471, 8621, 8865 and 8891 need not be reported again on Form The Form 8938 must still be filed, however, but only the number of those other reporting forms being filed must be stated on the form. The bad news is that there is no relief from duplicative filing for individuals who are required to file Form TD F , Report of Foreign Bank and Financial Accounts (the FBAR ). 01/12 Tax Planning International Review BNA ISSN

2 The new form must be filed by any US citizen or US resident required to file a United States income tax return who owns an interest in specified foreign financial assets ( SFFA ) and the value of those assets is more than the annual reporting threshold in the box below. For now, the filing obligation only applies to individuals; domestic entities (corporations, partnerships, trusts, and estates) are not subject to these rules, but they will be subject to them in the future, likely next year, and they may be required to report their 2011 information along with their 2012 information at that time. Further, there is no attribution of ownership from a corporation, partnership, trust, or estate to its shareholder, partner, or beneficiary (except in the case of disregarded entities and grantor trusts). Filing Thresholds Filing Status Living in the US Living Abroad Single SFFAs valued at more SFFAs valued at more than $50,000 on the last than $200,000 on the day of the year or more than $75,000 at any time more than $300,000 at during the Married filing jointly SFFAs valued at more than $100,000 on the more than $150,000 at Married filing separately SFFAs valued at more than $50,000 on the last day of the year or more than $75,000 at any time during the SFFAs valued at more than $400,000 on the more than $600,000 at SFFAs valued at more than $200,000 on the more than $300,000 at In order to qualify as living abroad an individual must be able to satisfy the same requirements that are imposed when claiming the foreign earned income exclusion on Form 2555 (i.e., a tax home in a foreign country and either (i) bona fide residence in a foreign country for an uninterrupted period that includes the entire tax year, or (ii) physical presence in a foreign country or countries for 330 days during a 12-month period). II. What is a Specified Foreign Financial Asset? SFFAs include financial accounts maintained by foreign financial institutions, as well as certain other foreign financial assets or instruments. In addition to foreign bank and securities accounts, SFFAs also include investments in foreign corporations or partnerships (i.e., shares and partnership interests), notes, bonds, debentures, or other forms of indebtedness that are issued by a foreign person that are not held in an account. SFFAs also include more exotic classes of foreign assets such as interest rate, currency, basis, commodity, equity, equity index, and credit default swaps, interest rate caps and floors, or similar agreements with a foreign counterparty or an option or other derivative instrument with respect to any of these investments or with respect to currency or commodity that is entered into with a foreign counterparty or issuer. Certain other foreign assets not specifically listed in the temporary regulations, such as physical commodities (gold in a foreign safe deposit box) and life insurance, may or may not be considered as SFFAs. A life insurance policy maintained with a foreign insurer that has a cash surrender value or that includes an investment component likely would be a SFFA. The form does not, however, appear to require reporting of an investment in foreign real estate held directly in the taxpayer s name. One class of SFFA seems likely to present some rude surprises for citizens and resident aliens who live or work abroad. While an interest in social security, social insurance, or other similar program of a foreign government is excepted from the SFFA definition, other foreign pension or deferred compensation plans are considered foreign financial assets that are SFFAs. Thus, private retirement arrangements, equivalent to the US IRA or perhaps 401(k) plan, must be reported as SFFAs. Many US taxpayers who have lived abroad are unaware that these arrangements not being qualified retirement plans under US rules are not (or at best are not necessarily) tax-deferred for US purposes. The income from them therefore may have been taxable, but unreported in the past due to ignorance of their US status. New Form 8938 may therefore put evidence of a possibly significant unreported income item directly in front of the IRS. [Income tax treaties may provide deferral for some arrangements, at least with respect to those in the country that is party to the treaty, but this is something that must be reviewed as a return containing one of these filings is assembled.] An interest in a foreign trust or estate may be considered a SFFA, but only if the US person knows or has reason to know of the existence of the trust or 01/12 Tax Planning International Review BNA ISSN

3 estate based on readily accessible information. For example, a distribution from a foreign trust or estate constitutes actual knowledge for this purpose. Unlike the rules for FBARs, for purposes of Form 8938, a financial account maintained by a financial institution organised in a possession of the United States (American Samoa, Guan, the Northern Mariana Islands, Puerto Rico, or the US Virgin Islands) will be considered a SFFA. Accounts maintained in these jurisdictions are not considered foreign under the FBAR reporting rules, which are based on banking law and not tax law. Once the filing threshold is met, every SFFA owned by the taxpayer must be reported (or otherwise accounted for) on Form 8938, even if it has little or no value. Certain assets are specifically excluded from reporting. These include assets for which mark-to-market accounting (under section 475) is used, a financial account maintained by a foreign financial institution for which the US person uses mark-to-market accounting for all of the holdings in the account, and Assets used in a trade or business may also be excluded, but an interest in a foreign entity may not be considered as used in a trade or business even if the only activity of that entity is the business of investing. III. What must be reported on Form 8938? In addition to general information about the taxpayer (name, address, taxpayer identification number, tax year, and type of filer), the information required to be reported on Form 8938 varies depending on the type of SFFA being reported. For foreign bank or securities accounts, the information required to be reported is similar to what is reported on the FBAR: type of account, account number, maximum value during the year, and the name and address of the foreign financial institution. The form also asks whether the account was opened and/or closed during the year, whether the account was jointly owned with a spouse, whether income was generated by the account, and certain information regarding foreign currency held in the account. For SFFAs other than foreign financial accounts, the information required to be reported includes: s a description of the asset, the date the asset was acquired or disposed of (if during the current year); s whether the account was jointly owned with a spouse; s whether income was generated by the account; s the maximum value of the asset during the year; and s certain information regarding the asset if denominated in a foreign currency. In addition, if the asset is an interest in a foreign entity, the following additional information must be reported: s The name and address of the entity; s The type of entity (partnership, corporation, trust, or estate); and s owhether the entity is a Passive Foreign Investment Company (PFIC). If the asset is other than an interest in a foreign entity, the following additional information must be reported: s Name and address of the issuer or counterparty; and s Type of issuer or counterparty (partnership, corporation, trust, or estate. For each SFFA reported, the amount of income, gain, deduction, or credit being included on the taxpayer s tax return, as well as the specific schedule or form and line number, must be provided. If the interest in the SFFA is reported on one of the following forms: s Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, s Form 3520-A, Annual Information Return of Foreign Trust With a US Owner, s Form 5471, Information Return of US Persons With Respect To Certain Foreign Corporations, s Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, or s Form 8865, Return of US Persons With Respect to Certain Foreign Partnerships, the taxpayer is not required to report the SFFA on Form Rather, the taxpayer reports on Form 8938 the number of each of the above forms he or she is filing for the tax Importantly, and deliberately, there is no similar reporting exception for financial account information reported on an FBAR (Form TD F ). Taxpayers who file FBARs and who meet the minimum reporting threshold for Form 8938 must file Form 8938 for each account reported on the FBAR in which they have a direct financial interest. Unlike FBAR reporting, however, there is no indirect ownership for purposes of Form If a US person owns 100 percent of the stock in a foreign corporation or is the sole beneficiary of a foreign nongrantor trust which owns a bank account, that account constitutes a financial interest reportable on an FBAR. The bank account need not be reported on Form 8938, although the shares of stock or the interest in the trust are SFFAs, that must be reported on Form 8938, if their value is high enough to cross the reporting threshold.. IV. How do I determine the value of my SFFAs? The value of a SFFA for purposes of determining the aggregate value of SFFAs and the maximum value of a SFFA is its fair market value stated in US dollars. The maximum value is a reasonable estimate of the asset s maximum fair market value during the tax For assets denominated in foreign currency, the highest value is determined based on the highest value during the year in foreign currency converted into US dollars using the appropriate exchange rate as of the last day of the tax For assets with no positive value, the maximum value is zero. For certain assets, the determination of value is a relatively simple exercise. For assets held in a financial account, the value reported on account statements may be relied on unless the US person has actual knowledge or reason to know based on readily accessible information that the statements do not reflect a reasonable estimate of the maximum value during the taxable Assets that are not held in a foreign financial account but that are publicly traded 3 01/12 Copyright 2012 by The Bureau of National Affairs, Inc. TPIR ISSN

4 will also be relatively easy to value as pricing information is readily available. For other SFFAs, such as stock in closely held companies and unlisted debt obligations, valuation will not be so easy. The regulations merely provide that the maximum value of such assets may be determined as of the last day of the tax Beyond requiring that the value reflect a reasonable estimate of the maximum value of the asset, the regulations do not provide any further guidance with regard to determining the fair market value. The Preamble to the regulations (the Treasury Department s introduction to the regulations) provided that fair market value may be determined based on information publicly available from reliable financial information sources or from other verifiable sources. Even if there is no information from reliable financial information sources regarding the fair market value of a reported asset, the regulations do not require a specified person to obtain an appraisal by a third party in order to reasonably estimate the asset s fair market value. Given the government s lack of additional guidance for determining the value of foreign assets in the recent Offshore Voluntary Disclosure Initiative process, we do not expect any clarifications. The regulations include some very interesting rules on valuing assets owned jointly by multiple taxpayers that ensure that the value of certain foreign assets will be reported multiple times. Except in the case of assets owned jointly by spouses, each joint owner of a SFFA is required to report the full fair market value of the asset, not the value of their individual interests. Married joint owners filing a joint income tax return are only required to report the asset once on a single Form 8938 filed with their return. Another troublesome issue with respect to valuation is the value of an interest in a foreign trust. As stated above, an interest in a foreign trust is considered to be a SFFA only if the US person knows or has reason to know of the existence of the trust or estate based on readily accessible information. The regulations provide that the maximum value of a person s interest in a trust is the sum of: s The fair market value, determined as of the last day of the tax year, of all distributions received from the trust; and s The value as of the last day of the tax year of the person s right to receive mandatory distributions from the foreign trust. In other words, if the trust is a wholly discretionary trust and the US person did not receive any distributions during the tax year, the maximum value of the US person s interest in that trust is zero. What if a US person received a distribution from the discretionary trust this year, but does not receive one next year, is the interest in the trust a SFFA that must be reported on Form 8938 next year? Assuming that the filing threshold was otherwise met, we believe that the answer is, yes. The distribution in the first year caused the US beneficiary to know of the existence of the trust. Further, since no distribution was received in the second year, Form 3520 would not be required to be filed. Once the US person is aware of their interest in the trust, however, the interest in the trust becomes a SFFA. The value of the interest in the trust reported on Form 8938 in the second year, however, would be zero since the US person did not receive a distribution and the trust is a discretionary trust. The maximum value of an interest in a foreign estate, pension plan or deferred compensation plan is the fair market value of the US person s beneficial interest in the assets of the estate or plan determined on the last day of the tax If, based on readily accessible information, the US person does not know or have reason to know the fair market value of their beneficial interest in the asset, the maximum value to be reported is the fair market value of the currency and other property actually distributed during the tax year to the US beneficiary or participant. V. What penalties apply for failure to comply? As with other information reporting requirements with respect to foreign assets, there is a USD$10,000 penalty for failure to file Form If a correct and complete Form 8938 is not filed within 90 days after the IRS mails the taxpayer a notice of the failure to file, an additional USD$10,000 penalty may be charged for each 30-day period (or part of a period) during which the failure continues up to a maximum additional penalty of USD$50,000. Since a taxpayer is required to file only one Form 8938 (with multiple copies as attachments), these penalties do not apply on a per asset basis. It would appear that the maximum penalty per year would be USD$60,000 (USD$10,000 for failure to file and an additional USD$50,000 for failure to file after receiving notice of failure to file). This is in contrast to the penalties that apply for failure to file Forms 5471 and 8865 (USD$10,000 per foreign corporation or foreign partnership) and the FBAR (USD$10,000 per account for the negligence penalty). Fraud and/or criminal penalties may also apply, if appropriate. If the IRS determines that a taxpayer owns an interest in a SFFA and asks the taxpayer for information about the value of any SFFA, unless he or she provides sufficient information to document the value of the SFFA, the taxpayer will be presumed to exceed the filing threshold. If income from an unreported SFFA results in an underpayment of income tax, a 40% penalty may be imposed on the tax underpayment. If Form 8938 is not filed, the statute of limitations for that tax year may remain open for the tax return for that year until 3 years after the date on which Form 8938 is filed. Further, it is the IRS s position that the statute remains open for all purposes, not just with respect to the SFFA. If the SFFA is reported but the gross income from the SFFA is omitted from the income tax return, the statute of limitations is open until 6 years after the return was filed. VI. Conclusion This article is not intended to cover all of the rules applicable to SFFA reporting provided in the Internal Revenue Code, the temporary regulations, or the instructions to Form It is intended to raise awareness of the new requirements and the new information that needs to be reported. The IRS has estimated that the time required to complete the Form 8938 is one hour and five minutes. As can be seen 01/12 Tax Planning International Review BNA ISSN

5 from this article, these rules are quite complex and will apply to a great number of taxpayers. Tax preparers will be required to gather additional information from taxpayers and that will significantly increase the amount of time required to prepare returns. The services of an experienced international tax attorney may be helpful in determining whether an asset is a SFFA and in reporting the information on Form 8938 properly. Arthur J. Dichter is a Partner at Cantor & Webb P.A., in Miami FL. He may be contacted by at: art@cantorwebb.com 5 01/12 Copyright 2012 by The Bureau of National Affairs, Inc. TPIR ISSN