Record keeping for U.S. corporations with foreign ownership.by Feinschreiber, Robert
The IRS wants its fair share of tax on international activities and trading. To achieve that end the IRS must know the extent of the transactions between U.S. corporations and related foreign entities. New final requirements for such dealings. The IRS wants to have records available, in English, to enable it to determine the "correct treatment" of transactions.
Foreign-based corporations and their U.S. subsidiaries face extensive new reporting obligations.
New Regs. Secs. 1.6038A-1 through 7, issued in June 1991, indicate the information to be furnished, the records to be maintained, and the new agency relationships to be sustained. These regulations impose new reporting requirements on both U.S. corporations and foreign related parties.
AND FOREIGN RELATED
Certain foreign-owned U.S. corporations are to be termed "reporting corporations." They must furnish information annually and must maintain records relating to their transactions with certain related parties. The "related foreign persons" are required to authorize the reporting corporation to act as their agent in receiving the legal documents that give the IRS access to information about transactions between the entities.
The regulations are divided into seven sections, each with its own section number:
* Definitions of terms used in the statute, Sec 6038A; * Information to be submitted and the filing of the return, Form 5472, on an annual basis; * Maintenance of records; * Monetary penalty for failure to furnish information or maintain records; * Agent authorization; * Failure to furnish information requested by a summons; and * Noncompliance penalty for failure to authorize an agent or for failure to comply with a summons.
In general, a reporting corporation is a U.S. domestic corporation that is 25% foreign-owned. A corporation is 25% foreign-owned if it has at least one "25% foreign shareholder" at any time during the taxable year. A 25% foreign shareholder must meet a voting power or value test. The shareholder of the corporation must own at least 25% of either the total voting power of all classes of stock of the corporation that are entitled to vote, or the total value of all classes of stock of the corporation.
Shifting of voting power may be disregarded. All facts and circumstances are to be taken into account in determining whether a foreign person owns 25% of the total voting power of all classes of stock of the corporation entitled to vote, or whether the person owns 25% of the total value of all classes of stock of the corporation. Subpart F contains a provision under which arrangements to change voting power are disregarded; similar considerations apply here.
A reporting corporation may also be a foreign corporation that is 25% foreign-owned and engaged in trade or business within the U.S. A reporting corporation now includes a foreign corporation engaged in a trade or business within the U.S. at any time during the taxable year. This rule came about as a result of OBRA 90, and it applies after November 4, 1990.
Foreign Related Party
The primary emphasis of the stepped-up reporting requirements is to focus on transactions between the reporting corporation and a "foreign related party." A foreign related party is a "foreign person" that is also a "related party." This dual requirement encompasses the relationship to the reporting corporation and the foreign structure of the entity.
Various types of entities are "foreign persons," including individuals, partnerships, corporations, trusts, estates, and governmental institutions. An individual is a foreign person if the person is not a citizen or resident of the U.S.; an expatriate might be a foreign person for this purpose. A foreign person does not include any individual who has a current joint return election in effect. Any individual who is a citizen of any possession of the U.S. is a foreign person if the individual is not otherwise a citizen or resident in the U.S. A possession of the U.S. is considered a foreign country for the purposes of this provision.
Any partnership, association, company, or corporation is a foreign person if it is not created or organized in the U.S. or under the laws of the U.S. or any state. Any foreign trust or foreign estate is a foreign person, too.
A non-exempt foreign government or foreign controlled commercial entity is considered a foreign person to the extent that the entity is engaged, directly or indirectly, in a U.S. trade or business and receives non-exempt income. However, a foreign government or foreign controlled commercial entity is treated as a foreign person only for this limited purpose, i.e., the filing of Form 5472, but not for record maintenance.
A "related party," the second part of the "foreign related party" requirement, has to have one of three relationships: A related party is a 25% shareholder of a reporting corporation; the vote and value test applies in determining status as a 25% foreign shareholder. A related party includes any person who is "related" to the reporting corporation. Finally, a related party includes any person who is "related" to a 25% foreign shareholder of the reporting corporation. These relationships encompass a myriad of trust, family, and corporate as well as partnership relationships. Attribution rules apply to corporate constructive ownership and partnership interests.
Any other person that is "related to the reporting corporation" within the inter-company pricing provisions of Sec. 482 is a related party. Extensive case law determines this "related to" concept, but the statute does not directly deal with this relationships itself. For this purpose, a related party does not include any corporation filing a consolidated federal income tax return with the reporting corporation.
See Figures 1,2, and 3 for examples of a reporting corporation, a non- reporting corporation, and of a foreign related party.
DE MINIMIS EXCEPTION
Smaller companies can avoid most of the reporting requirements, if the de minimis exception applies to the record retention rules. A safe harbor for reporting corporations is based on a de minimis value of the related party transactions. This small company safe harbor is distinct from both the small amount rule within the tax return reporting requirements and the reasonable cause penalty provisions. Moreover, this de minimis safe harbor has no relationship to a safe harbor for record maintenance that could only apply to larger companies.
Gross Payments and Percentage
If the de minimis value rules are applicable to a corporation, the record maintenance rules and the agency provisions do not apply. However, such a corporation is subject to the information reporting requirements and general record maintenance requirements. The de minimis value rules apply if both a gross payment test and a percentage test are met.
Under the gross payment test, a reporting corporation must have transactional values that are less than $5 million. This $5 million amount is based on gross payments made by a reporting corporation to a related party or to a reporting corporation by a related party. This aggregate value of gross payments encompasses three types of consideration: monetary consideration, nonmonetary consideration, and the value of transactions involving no consideration.
Under the percentage test, the gross payments to or from foreign related parties must be less than 10% of its gross income. The use of gross income in this context is peculiar; this phrase applies only once in the context of the foreign reporting requirement rules. As a practical matter, the percentage test on top of the gross income test would ordinarily make the de minimis safe harbor provisions inoperable.
Netting and Aggregation
In reporting on these matters, amounts are not netted. Threshold amounts are to be applied separately as "amounts paid to foreign related parties" and "amounts received from foreign related parties." The "no netting" rule presumably applies to both the "aggregate value" test and the percentage test.
Although aggregate amounts are not netted, they are totaled. Related party transactions are totaled by aggregating the value of gross payments made to a foreign related party and amounts received from a foreign related party. These gross amounts are totaled by combining the dollar amounts of the related party transactions, including foreign related party transactions for which only monetary consideration is paid and received, and foreign related party transactions involving nonmonetary consideration or no consideration.
Transactions between the reporting corporation and foreign related parties are combined. The aggregate value of gross payments to all foreign related parties and the aggregate value of payments received from all foreign related parties are computed for all related reporting corporations. The aggregate value is determined by totalling all dollar amounts to or from all foreign related parties. In reporting to the IRS, Form 5472 is used for the foregoing purposes by all related reporting corporations.
A separate exclusion applies to corporations with less than $10 million in gross receipts. The extent of the intercompany transactions is irrelevant in this context.
If a U.S. consolidated income tax return is filed, the return requirement may be satisfied for the entire U.S. consolidated group by filing a consolidated Form 5472. This form is filed by the common parent, which must attach Form 851 and a schedule indicating the members of the U.S. consolidated group that would otherwise be separate reporting corporations. The schedule must provide name, address, and taxpayer identification number as basic data for each member of the consolidated group.
A member of the consolidated group can file its own Form 5472 and is not required to join in a filing of a consolidated Form 5472. Other members of the group may choose to file one or more Forms 5472 on a consolidated basis.
Agency provisions provide for authorization by the foreign related party and acceptance by the reporting corporation. The common parent can perform this agency function by serving as the reporting corporation for a group of reporting corporations. The parent may be authorized to act as the agent for foreign related persons engaged in transactions with members of the consolidated return group in situations in which this agency relationship is solely for summons purposes.
The parent corporation can complete the agency authorization procedure by completing the authorization of agent form on Form 5472 or by filing an authorization of agency statement on Form 5472, if amended Form 5472 is not yet available. Each member of the consolidated return group must maintain the required records.
The common parent and each reporting corporation may potentially be subject to monetary penalties. If these corporations file a consolidated Form 5472, each is liable jointly and severally for penalties for failure to file Form 5472 and for failure to maintain records. The U.S. parent is the sole agent for each subsidiary if the consolidated tax return is filed.
Both the reporting corporation and its foreign related parties have obligations to maintain and retain records. This requirement applies to records of the reporting corporation itself, and to foreign related parties with whom the reporting corporation has dealings. Records of any foreign related party may be relevant to determine the correct treatment of transactions between the reporting corporation and foreign related parties. The "correct treatment" standard, coupled with the "may be relevant" criterion, indicates the pervasive scope of these provisions.
The reporting corporation must keep the permanent books of account and records that are normally required under U.S. tax laws and regulations, but the regulations impose higher standards for specified information, documents and records. Under this standard, records must be "sufficient to establish the correctness of the federal income tax return of the corporation."
Sec. 6001 encompasses transactions between the reporting corporation and foreign related parties, but Sec. 6038A provides more detailed guidance. A taxpayer can elect to use a safe harbor for record keeping or reach a record retention agreement with IRS.
The safe harbor provides detailed rules for record maintenance. Under these provisions, a corporation that maintains or causes another person to maintain these records will be deemed to have met the record maintenance requirements. Nearly one hundred specific items are included within the safe harbor provisions.
A reporting corporation and the District Director may negotiate and enter into a record keeping agreement. This agreement may establish three aspects of the record keeping requirements:
* What records the reporting corporation must maintain or cause another to maintain; * How such records must be maintained; and * By whom these records must be maintained in order to satisfy the reporting corporation's obligations.
The statute provide the Treasury with almost totally pervasive authority over records pertaining to transactions between the reporting corporation and the foreign related party. This provision was added by OBRA 89, supplanting the TEFRA 82 provisions, and provides that the reporting corporation:
"Shall maintain (in the location, in the
manner, and to the extent prescribed
in regulations) such records as may
be appropriate to determine the correct
treatment of transactions with related
parties as the Secretary shall by
regulations prescribe (or shall cause
another person to maintain these records)."
The scope of this statutory authority is likely to be a frequent area of dispute between taxpayers and IRS.
Disputes can arise in situations in which:
* One party asserts that the regulations are legislative, not interpretive, and are entitled to more weight than interpretive regulations; * Establishment of the "correct treatment" of these transactions is contested; or * Appropriateness of the records is disputed.
Direct and Indirect Relationship
Records that are directly or indirectly related to transactions between the reporting corporation and any foreign related parties are subject to the maintenance requirements. The indirect relationship standard applies to foreign related parties and their subsidiaries, even in cases in which this subsidiary is not a foreign related party.
Example: A subsidiary of the foreign related party manufactures and assembles products. This product is subsequently sold as finished product by the foreign related party to the reporting corporation. The scope of these transactions includes indirectly related transactions, such as those dealing with raw material and component costs of this product.
When records are requested by IRS, any records or portion thereof not in the English language must be translated, within 30 days upon request of the District Director; this period may be extended under the scheduled production rule.
If transactions are engaged in by a partnership that are attributable to the reporting corporation, the reporting corporation is subject to record maintenance requirements to the extent of the transactions so attributed. A foreign government is not subject to the obligation to maintain records.
The limited agency relationship between the parties contemplated by the IRC and regulations would normally provide that the foreign related party must provide a wide variety of records to the reporting corporation. In this situation, the foreign related party might consider such materials to be confidential and hence not available to the reporting corporation. This situation is likely to arise when the information includes salary data or comparative pricing strategies between the foreign headquarters operations and its subsidiaries in the U.S. and elsewhere, especially in situations where the headquarters may have established predatory pricing that favors its own home country affiliates. In this regard the reporting corporation and IRS might find themselves on the same side in the event of a disagreement with the parent.
Confidentiality may be misplaced in these agency situations, and in fact may be antithetical to Treasury tax objectives. Nevertheless, the Senate Finance Committee Report intends to make reporting corporations legally responsible to make sure that the specified materials are available in the U.S. The regulations do not require that these materials be placed under the control of the reporting corporation.
A foreign related party or third-party may make arrangements with IRS to furnish these requested records directly, rather than through the reporting corporation. This arrangement should be made with the District Director and is applicable to records requested by the IRS.
The onus for the record maintenance is placed on the reporting corporation, which is liable for maintenance of the records if the foreign related party or a third party maintain these records in the ordinary course of business. This liability continues even if the records are not in the possession of the reporting corporation. A reporting corporation may be subject to the monetary penalty if the foreign related party or the third party fails to maintain such records.
Situs of the Records
The Finance Committee had anticipated that the regulations would generally require records to be maintained in the U.S., but the statute gave the Treasury flexibility in prescribing which records must be maintained in the U.S. and which may be maintained elsewhere. Hence, reporting corporations may be able to maintain the records outside the U.S.
An exception to the U.S. situs requirements for these records can be made in situations in which the reporting party maintains the documents outside the U.S.
Delivery and Moving
Instead of maintaining records within the U.S., the reporting corporation can agree to produce them in the U.S. The reporting corporation can select between a "delivery" method or a "moving" method for production of these documents. Original documents need not be submitted, and duplicates can be used.
These materials normally must be submitted within 60 days from the time the request for them is issued by the IRS, but this time period is doubled for material profit and loss statements. This extra time is needed because of the onerous effort that would be required to assemble transactional records and create "material statements" within the confines of the significant industry segment test or the high profit test. Fortunately for the taxpayer, the material statement rules apply only to companies with relatively large transactions on a cumulative basis.
Under the "delivery" alternative, the reporting corporation must deliver to the IRS the original documents or duplicates of the original documents requested by IRS and must do so within 60 days of this request. The reporting corporation must provide translations of these documents within 30 days of a request for such translations.
Under the "moving" alternative, the reporting corporation must move original documents or duplicates of the original documents to the U.S. and must do so within 60 days of the IRS request. Additional information should be provided to IRS in conjunction with the moving of records:
* Index to the requested records; * Name and address of a custodian located within the U.S. having control over the records; and * Address where the records are to be located within 60 days of the IRS's request for the records.
The reporting corporation must agree to continue to maintain these records within the U.S. throughout the record retention period. Expanded summons procedures would apply to records that have been moved to the U.S. Curiously, the record maintenance rules apply only to the "moving" alternative, not to the "delivery" alternative, but the IRS would also benefit from an index to requested records.
The Finance Committee stated that U.S. maintenance requirements could be satisfied by using duplicates as well as original documents. Documents that are required to be maintained in the U.S. must be translated into English, but translation might not be required simultaneously with the appearance of these documents in the U.S. If the material profit and loss statement rules do apply, labels and text pertaining to the statements must be in English.
Extension of Time
Production or translation of documents may have to be extended or scheduled because of the high volume of these documents or for other reasons. "High volume" is not defined by the regulations. It is not certain whether "volume" would be based on the number of pages or files, and whether the repetitive nature of the documents would have an effect in determining volume.
Production of documents may be scheduled over time so that not all of these records must be produced at once. To obtain this extension, the reporting corporation should establish why the extension is needed, based on the volume of records requested. The period for providing these documents is generally 60 days, and 120 days for material profit and loss statements, so that scheduling could be extended beyond this point.
The decision to schedule the providing of these documents may be affected by the statute of limitations or an extension. The IRS may grant an extension of time for the production and translation of the requested documents. This decision is made by the District Director. The reporting corporation must request the extension in writing and must show good cause for the extension. Extension requests should be made within 30 days of the IRS's request for the records.
Records must be retained as long as they may be relevant to determining the correct tax treatment of any transaction between the reporting corporation and the related party. The definition of the relevancy period is almost open-ended because of the "correct treatment" clause. In no case is the retention period less than the applicable statute of limitations. This limitation period applies to assessment and collection for the taxable year in which the transaction or item relates when the transaction affects the U.S. tax liability of the reporting corporation.
Never Less, Always More
The record retention rules will provide the IRS with considerable access to information and data. These provisions will become increasingly burdensome if implementation is delayed.
PHOTO : FIGURE 1 EXAMPLE OF REPORTING CORPORATION
The U.S. partnership engages in U.S. trade or business and these transactions take place solely with FC2 and FC3. These transactions are attributed to FC1 and the U.S. corporation. FC1 and the U.S. corporation are reporting corporations and must report their respective pro rata share of the value of the transactions, 25% to the U.S. corporation
PHOTO : FIGURE 2 EXAMPLE OF FOREIGN RELATED PARTY
The branch engages in transactions with FC1, FC2 is the reporting corporation, and FC3 is a foreign related party.
PHOTO : FIGURE 3 EXAMPLE OF NON-REPORTING CORPORATION
FC1 constructively owns its proportionate share of the stock of the U.S. corporation owned directly by FC2 and FC3. This constructive ownerhsip is 10%, 25% times 20%, or 5% for each chain, FC2 and FC3. The U.S. corporation is not a reporting corporation because no foreign shareholder owns 25% or more of the corporation. The regulations erroneously refer to "25% shareholder" rather than "25% foreign shareholder."
Robert Feinschreiber, LLM, is the Editor of the Interstate Tax Report and U.S. correspondent for Tax News Service, published by the International Bureau of Fiscal Documentation in Amsterdam. He is the author and editor of numerous books and articles on a wide variety of tax topics and has served as tax consultant to several foreign governments. Mr. Feinschreiber has taught accounting and law courses at universities and has lectured at many tax conferences.
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