Reporting Changes for Passive Foreign Investment Companies Force Tax Filing Extensions
posted Apr 2, 2015 by Paul Oliveira, CPA
The tax return filing deadline is quickly approaching and you may be one of millions of Americans who will be filing an extension this year. A common reason that individuals extend their tax returns is because they are awaiting key tax reporting information about their investments. This information is often not available until later in the year, which can be vexing to many taxpayers.
We routinely field questions from clients and non-clients alike about this topic. Unfortunately, it is the layering of disclosure documents that must be compiled and analyzed by the tax return preparer that slows down the preparation process. The layering results in a complex orchestration amongst the different preparers – as one group at the top races to complete the reporting for which they are responsible, they are beholden to other preparers at lower tiers who are in the same position with respect to others at lower tiers.
The layering effect has been exacerbated by the growth of reporting requirements for foreign investments in recent years. In this blog, we touch on changes to required reporting for Passive Foreign Investment Companies (“PFICs”) and the resulting additional work, cost and risk to taxpayers and tax return preparers alike.
Passive Foreign Investment Companies (“PFICs”) & From 8621
PFICs have been a key area of focus of Treasury and the IRS, culminating in the issuance of new regulations on December 30, 2013. These regulations require additional disclosure – perhaps a very significant amount of additional disclosure – by U.S. shareholders of PFICs. If you have foreign investments, this may be one of the reasons that you will file an extension this year and wait even longer to file the tax return itself. Why is this so?
Gathering information and analysis
The number of investors who have diversified their holdings through investments in hedge funds, investment partnerships, and various other vehicles has grown tremendously. These vehicles then invest in others… and so on, and so on. The lowest tier compiles its foreign reporting disclosures and passes them up the chain to the next tier. This process is repeated until, at long last, your portion of each direct and indirect foreign investment – including the PFICs – makes its way onto your personal income tax return. This is the unfortunate and inefficient result of the foreign reporting requirements.
The 2013 regulations added to the existing filing requirements for Form 8621. Prior to the issuance of these regulations, this form was generally only required when a PFIC’s item of income would be included in taxable income or a PFIC-related election was made by the taxpayer. In other words, it was generally applicable when the PFIC had an effect on your taxable income.
The new Form 8621, coupled with the new regulations’ requirements for when the Form should be filed, are expected to result in a significant increase in the overall number of Forms 8621 filed because they are now filed for information purposes only, even when there may be no effect on your taxable income.
Where there are multiple layers of foreign investments, the effect of these new reporting requirements becomes amplified. This makes the process much more time consuming to analyze for the purpose of determining whether a Form 8621 is required for any or all of the PFICs that are identified. Depending upon your investments, this could result in a few, dozens or hundreds of additional Forms 8621 that must be prepared and included with your tax return.
Do you meet an exception?
As part of this process, if you are lucky, it may be determined that you meet an exception to the reporting requirement for some or all of your PFIC interests. This determination takes time, particularly where there are many investments. For example, consider whether:
- Your holding is through a U.S. partnership that did not allocate a portion of PFIC excess distribution or gain to you;
- You hold your PFIC stock indirectly through a foreign partnership and meet the $25,000 de minimis exception for reporting;
- You hold an indirect interest in a Section 1291 Fund and the value of your indirect interest is $5,000 or less.
If there is not an exception applicable to you, there may be material additional work, cost and risk to you and your tax return preparer who is preparing the forms.
What is the “real” risk?
In the end, the risk to the taxpayer as a result of failure to comply is the ultimate concern. Fortunately, the 2013 regulations do not impose a specific monetary penalty for failure to comply. Don’t be fooled by this, however; the teeth of the regulations are well hidden. Consider:
- Failure to file a required Form 8621 can cause the suspension of the statute of limitations for the entire tax return until such time that the required Form is filed. Where reasonable cause for the failure can be established, the suspension is potentially limited only to the relevant, unreported PFIC investment.
- Coordination with Form 8938 filing requirements. Form 8938, which is beyond the scope of this discussion, is used to report foreign financial assets of the taxpayer. Duplicate disclosure is not required if a foreign financial asset is disclosed elsewhere in the tax return – such as on Form 8621. If, however, a Form 8621 is not filed with respect to a PFIC and the PFIC investment was otherwise required to be reported on Form 8938, then the Form 8938 may be considered incomplete… and a $10,000 penalty assessed against the taxpayer.
Either of these outcomes have the potential to be very painful to the taxpayer. In order to mitigate the risk to you in this very complex area, the additional work should be done to ensure that your tax return has all of the required disclosures and Forms 8621.
We would be happy to discuss questions that you may have about the 2013 regulations, the new Form 8621, and how you might approach dealing with these filing requirements. Please contact a member of the KLR Global Tax Services Group if you have any questions or need assistance.