Guest Article by Virginia La Torre Jeker J.D.: Virginia is the owner of VLJ US Tax Advisory, FZE in the United Arab Emirates. She blogs weekly on US international tax matters affecting foreign persons as well as US persons. Virginia can be reached at [email protected]
By way of broad overview, Form 5472 must be filed annually by certain companies (referred to as “reporting corporations”) when there is a so-called “reportable transaction” with a “related party” occurring in that particular tax year. Assuming one has such a “reportable transaction”, the Form is required to be filed by (i) any US company that is at least 25% owned by non-US shareholders (single member US LLCs are now included under recent tax rules; discussed separately in this article), and (ii) foreign companies that are engaged in a US trade or business.
What is Form 5472 Used For?
US Internal Revenue Service (IRS) uses the Form 5472 in developing information about the company and its related parties. Information provided on the form helps the IRS identify potential audit issues. Form 5472 is the place the IRS starts when auditing foreign-owned businesses in the US. Generally, the purpose of the form is to disclose the nature and amount of foreign and domestic transactions that occur with related-parties, since these types of transactions can give rise to abuse (for example, in transfer-pricing or in attempts to siphon off taxable earnings and profits in disguised non-taxable forms). I believe that Form 5472 can be used proactively. Proper preparation of this form provides the chance to document tax planning, as well as to make that planning more robust in the event of a possible audit.
The US wishes to reduce frequent international accusations that it is actually one of the world’s best tax havens. Furthermore, with the Foreign Account Tax Compliance Act, (“FATCA”) now in full swing, the IRS is anxious to be gathering information that can be traded with those countries which have agreed to be FATCA-compliant. Form 5472 helps meet all of these goals.
In today’s world of global fiscal transparency, it is very important to keep in mind whether the foreign shareholder or foreign related party has reported the income from the listed transactions in its home jurisdiction. The US has entered into numerous tax treaties and tax exchange information agreements. Based on information provided on the Form 5472, an exchange of information by the US with the foreign country may result in the foreign country learning about possible tax transgressions by one of its citizens or tax residents.
What is a “Reportable Transaction”?
As mentioned, the Form is not required to be filed by the company unless it has a “reportable transaction” with a “related party” during the tax year. Transactions occurring in each and every tax year must be examined.
In general, a “reportable transaction” is any exchange of money or property with the foreign shareholder such as a payment for sales, rents, royalties, interest. A “reportable transaction” does not include the payment of dividends.
Any amounts paid or received in connection with the formation, dissolution, acquisition and disposition of the entity (including contributions to and distributions from the entity) are also captured as “reportable transactions”.
Reportable transactions can easily be overlooked – frequently overlooked are loans by the corporation to foreign shareholders, or loans from foreign shareholders to the corporation. Such loans can have very significant tax consequences and if any loans exist, proper US tax advice should be taken.
“Reportable transactions” are listed in Part IV of the Form and are detailed in the instructions to the Form. Form 5472 is attached to the reporting corporation’s income tax return by the due date (including extensions) of the return. A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation had a reportable transaction during the tax year.
Who is a “Related Party”?
The definition of a related party is very broad and relies on numerous provisions in the US tax code. Due to its complexity, professional tax advice should be taken to see if a “related party” is involved. A related party includes any direct or indirect 25% foreign shareholder of the reporting corporation. It also includes any person related to the reporting corporation or to one of the 25% shareholders.
- Foreign Shareholder Owns 25% or More of US Corporation
As mentioned, Form 5472 must be filed by a US corporation in certain circumstances.
It is required when that corporation has direct or indirect non-US shareholders who own 25% or more of the stock, and has a so-called “reportable transaction” with the foreign shareholder(s). The form is not required when various foreign persons own, in the aggregate, 25% or more of the corporation. It is required only when a single non-US entity or individual owns 25% or more of the corporation.
- A) Separate Form for Each Foreign Shareholder
A separate Form 5472 must be filed by the reporting corporation for each foreign shareholder who is a 25%-or-greater owner. Thus, if two or more foreign shareholders each own 25% or more of a US corporation and each had a “reportable transaction” with the company, then multiple Forms 5472 will have to be filed.
- B) Information Required
Form 5472 generally requires the following information with regard to each 25%-or-greater foreign shareholder: name, address and country of citizenship (or in the case of an entity-shareholder, the country where it was organized or incorporated); the nature and amount of the reportable transaction with the foreign shareholder; names of the countries under whose laws the foreign shareholder files an income tax return as a resident; and names of the principal countries where that shareholder conducts business.
- US Disregarded Entity (Foreign-Owned Single Member US LLC)
Special mention is required for single-member US LLCs as these are frequently used by foreign persons. Since these are treated under the US tax rules as so-called “disregarded entities”, they are technically not “corporations” for US tax purposes. Recent IRS Treasury Regulations now subject foreign-owned single-member US LLC’s to a brand new reporting regime.
Foreign-owned single-member US LLC’s must now file Form 5472 and are subject to the same reporting, record maintenance and other related compliance requirements as those imposed on 25% foreign-owned US corporations.
Details, including the identity of the LLC’s non-US owner, will now be revealed when there is a “reportable transaction” occurring in the tax year. Remember, if there is no “reportable transaction” in the particular tax year, the Form need not be filed.
- A) Reportable Transaction – No Exceptions Available
Notably, the reportable transaction threshold is easier to reach in the case of a foreign owned single-member US LLC when compared to a US corporation that is 25% foreign-owned. This is so because generally, the intent behind the new regulations was to broaden the scope of reporting for such foreign owned US LLCs. The reporting for these entities was intended to go beyond what would be required to be reported on the Form 5472 for a US corporation that is 25% foreign-owned. As such, certain exceptions that might otherwise apply for Form 5472 purposes, will not apply when there is a foreign owned single-member US LLC.
It’s important to understand that not everything will be a “reportable transaction”. For example, if the US LLC is simply maintaining a foreign bank account, this is not a reportable transaction. If, however, the amount in the foreign bank account exceeds USD10,000 at any time in the year, the US LLC entity must still file the FBAR. The two forms reflect completely separate filing requirements!
Typical examples of a “reportable transaction” requiring the foreign owned single-member US LLC to file Form 5472 for the year the transaction occurs would include creation of the LLC and capitalizing it; liquidating the entity; paying expenses on behalf of the LLC (for example, real property taxes or other costs).
- B) Obtaining “Employer Identification Number” (EIN)
An impacted disregarded entity is required to obtain a US taxpayer identification number (an employer identification number, or EIN) to identify itself on its Form 5472. This may be easier said than done due to the need for the entity to file a Form SS-4 to get an EIN. The Form SS-4 requires the applicant to indicate a responsible party of the entity and this can get complicated as SS-4 then asks for an EIN, ITIN or SSN of the responsible party. This has generated confusion among professionals when the LLC is wholly-owned by a nonresident alien individual (NRA) who is the “responsible party”. Apparently, an ITIN is not mandatory when the LLC has a single NRA owner-responsible party. More detail here.
- Foreign Corporation Engaged in US Trade or Business
Form 5472 must also be filed when a foreign corporation that is “engaged in a US trade or business” (USTB) has a “reportable transaction” with either a US or a foreign related party.
- A) US Trade or Business
A new concept is introduced in this second category of filers – that is, when is a foreign corporation “engaged in a US trade or business?”
Neither the US Internal Revenue Code nor Treasury Regulations clearly define what is meant by being engaged in a USTB. The case law indicates that business activity will not constitute a USTB unless the activity is considerable, continuous and carried out on a regular basis. Unfortunately, the cases are old and ambiguous and despite the case law language requiring considerable, continuous and regular activity, some of the cases find that lower levels of activity satisfy the standard, leaving little real guidance. The IRS has taken a very strict position in published rulings that activities beyond mere passive receipt of income, if conducted in the United States, are sufficient to constitute engaging in a USTB.
Penalties – What Happens if You Don’t Comply?
Failure to file a Form 5472 or maintain the supporting records as required could result in a $10,000 civil penalty for each failure. The penalty is not just a one-time assessment of a $10,000 fine; rather it is $10,000 for every year the form was not filed. If multiple filings should have been undertaken in the same year, the penalty amount can easily skyrocket. Criminal penalties could also apply for failure to submit information or filing false or fraudulent information.
Beware Community Property Rules
Many Latin American and European countries have community property regimes. Application of a foreign country’s community property laws raise serious US tax issues for a married couple, this is especially so when only one spouse is a US person.
In the US LLC context, let’s say that we have a non-US husband, Harry and that he is married to Wilma, a US citizen. The couple are domiciled in a country with a community property regime, let’s say, Switzerland (or even China!). Harry uses funds from his solely titled bank account into which he deposits his salary in order to set up a US LLC. Harry believes that he is the sole member and that as such, the LLC is a “single member disregarded entity”. Harry is wondering if he needs to file Form 5472 based on certain transactions he had with the LLC during the year. He comes to me for advice.
Here’s where we tell Harry the bad news. Harry and Wilma are domiciled in Switzerland. Under the Swiss community property regime, Wilma is deemed to own one-half of the LLC (as well as one-half of Harry’s bank account). The LLC cannot be a “single member” disregarded entity since it has two members (Harry and his wife, Wilma).
Instead the LLC will be treated under US tax default rules as a “corporation” for US tax purposes. This means double-taxation can result. The first level of US income tax will be at the corporate level. After the corporation pays its US income tax, and distributes a dividend to its owners, Harry and Wilma, another level of income tax will result at their individual levels. As for Harry, a nonresident alien individual, the corporation will be required to withhold tax at a 30% rate unless the lower Swiss Treaty rate applies and Harry files the proper paperwork. As for Wilma, she will be required to report the dividend as income on her US tax return and pay tax on the amount. And, yes, Form 5472 will still be required since US corporations that are at least 25% owned by non-US shareholders must file the form.
Harry and Wilma can try to take the position that under Rev. Proc. 2002-69 they can still treat the LLC as a “disregarded entity” or a “partnership” (rather than a “corporation”) even though they have not made an entity classification election on Form 8832. However, without making this election, it is unclear the IRS would accept this position. Furthermore, even if the position was accepted, US tax consequences will still result and must be sorted out for Harry, perhaps for Wilma and even for the entity. For example, if treated as a partnership, the entity itself will have withholding obligations with respect to Harry.
About the Author
Virginia La Torre Jeker J.D., BASED IN DUBAI, UAE
Virginia has been quoted in the New York Times, Newsweek and the Wall Street Journal and is regularly quoted in many local news articles and publications. She has been interviewed by CNN and has been invited for local television appearances. She is regularly asked to speak at numerous conferences and seminars and has published a vast array of scholarly works on US tax issues, some of which have been referenced by other attorneys or organizations both to the US courts and US Congress.
Virginia has over 30 years of experience specializing in US and international tax planning. She has been based in Dubai since 2001; prior to that time she worked in Hong Kong for 15 years as a US tax consultant for international law firms, major banks (including HSBC) international accounting firms (Deloitte) and trust companies. Early in her career she worked in New York with the top-tier international law firm, Willkie Farr & Gallagher.
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This communication is for general informational purposes. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the recipient in making a decision.