Business Tax Complaince

Beware of GILTI Basis Adjustments

December 13, 2018 by Frank Vari, JD. MTax, CPA

Much has certainly been written about the recently proposed regulations on IRC §951A known more famously as the Global Intangible Low-Taxed Income (“GILTI”) regime. What has not been widely publicized are the basis adjustment rules for consolidated groups. This may not be the most easily understood topic but it may be one of the most important topics to groups that are active or expect to be active in the merger & acquisition arena. The GILTI basis adjustment rules are a new area of complexity and risk.

Overview

The GILTI basis adjustment rules are rather simple to understand but are very complex in practice. They require basis adjustments for consolidated group members and Controlled Foreign Corporations (“CFC”) that contribute tested losses to the group. They are intended to prevent the “double dipping” of tax benefits where a member’s GILTI tested loss is used to reduce a current year consolidated group GILTI income inclusion and then again when the contributing member’s outside tax basis remains high when that group member is sold. The rule’s required downward basis adjustment which corresponds with the member’s GILTI tested loss ensures the benefit is only taken once.

That all seems simple enough in theory but practice is another matter. Maintaining regular individual member and CFC federal tax basis calculations is sufficiently difficult and cumbersome that most consolidated groups fail to do it at all. The price for this is that there is usually a very time crunched calculation performed to model or calculate gain or loss when a group member becomes involved in a proposed transaction. When you take into account that many states have not decided whether to join GILTI or not, you are left with calculating three separate basis calculations for each group member – US federal tax, state tax, and US GAAP/IFRS – all potentially reflecting differences due to GILTI basis adjustments.

The Basis Adjustment Rules

Let’s take a look at the basis adjustment rules in detail. As noted above, the basis adjustments relate to the use of tested losses by the group. The Proposed Regulations provide a complex set of rules intended to prevent US consolidated groups from receiving dual benefits for a single tested loss that results if a domestic corporation benefiting from the tested losses of a tested loss CFC could also benefit from those same losses upon a direct or indirect taxable disposition of the tested loss CFC.

The rules apply to any domestic corporation – not including any Regulated Investment Company (“RIC”) or Real Estate Investment Trust (“REIT”) – that is a US shareholder of a CFC that has what the Regulations call a “net used tested loss amount”. The US group must reduce the adjusted outside tax basis of the member’s stock immediately before any disposition by the member’s “net used tested loss amount” with respect to the CFC that is attributable to such member’s stock. Please be further aware that if this basis reduction exceeds the adjusted outside tax basis in the stock immediately prior to the disposition then this excess is treated as gain from the sale of the stock and recognized in the year of the disposition.

The term “net used tested loss amount” is the excess of:

the aggregate of the member’s “used tested loss amount” with respect to the CFC for each US group inclusion year, over;
the aggregate of the member’s “offset tested income amount” with respect to the CFC for each US group inclusion year.

The amount of the used tested loss amount and the offset tested income amount vary depending on whether the member has net CFC tested income for the US group inclusion year.

For a very basic example, let’s take a US group member with two CFCs. In year one, CFC1 has a $100 tested loss that offsets $100 of tested income from CFC2. In year two, CFC1 has $20 of tested income that is offset by a $20 tested loss from CFC2. The rules tell us that the $100 used tested loss attributable to the CFC1 stock from year one is reduced by the $20 of CFC1’s tested income from year two that was used to offset CFC2’s tested loss. The result is a net used tested loss amount of $80 to CFC1 at the end of year two. If we changed the facts a bit and assumed that CFC1 and CFC2 were held by separate US consolidated tax group members you can see the true complexity emerge regarding outside tax basis determinations at both the CFC and consolidated group member levels.

The Proposed Regulations provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs. In certain cases, a disposition of an upper-tier CFC may require downward basis adjustments with respect to multiple CFCs that are held directly or indirectly by the upper-tier CFC. Further, the Proposed Regulations provide guidance with respect to tracking and calculating the net used tested loss amount with respect to a US shareholder attributable to stock of a CFC when the CFC’s stock is transferred in a nonrecognition transaction or when the relevant CFC is a party to an IRC §381 transaction.

Conclusion

There is no need to detail any and all adjustments here because the regime is simply too complex to easily summarize. The point is that the outside basis calculation for CFCs and consolidated group members before GILTI has just become much more difficult and complex. Consolidated tax group contemplating current or future transaction activity are well advised to maintain these basis adjustments annually lest they be forced to perform these very difficult – yet meaningful – calculations in the crunch time of a transaction.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Global Tax Authorities Are Sharing Information – What’s Happening and How to Be Ready

November 6, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

It was not that long ago that a multinational taxpayer could report information differently to one taxing authority than to another even within the same country without significant concern. How often did a value reported for customs and duties purposes match the transfer pricing value for income tax purposes? Probably not very often and what difference did it make? Back then, not very much difference. Now, it makes a huge difference.

What’s Changed in Information Sharing?

The road to where we are today has not been difficult to follow for those that have been actively involved in international tax for the last decade or so. Global tax authorities have been becoming considerably more aggressive for years and that is not a trend that shows any signs at all of abating. Tax authorities have long sought complete transparency in the taxpayer’s supply chain taxation both in the home country and elsewhere. It makes their job much easier and it forces multinational taxpayers to full disclosure of their global tax positions.

There have been many governmental bodies actively pushing these efforts for some time now but the three biggest, at least to U.S. taxpayers, have been the Organization for Economic Cooperation and Development (“OECD”), the EU, and the IRS. Our clients feel this most directly with their Base Erosion and Profit Shifting (“BEPS”) and Foreign Account Tax Compliance Act (“FATCA”) filing requirements.

For U.S. taxpayers, this means a sharing of not only information gleaned from their Form 1120, Forms 5471 and 5472, and customs and duty filings but also what they are reporting on similar non-U.S. filings. When you add government filed transfer pricing filings to all of this you can see how quickly a very significant database of highly confidential and valuable business and financial information can be created and shared.

The Impact of Electronic Filing

Most multinational taxpayers are slowly becoming attuned to the fact that what they are reporting to one country has a significant impact in other countries as well. What many are not sufficiently aware of is that their tax and financial information can now be quickly cross-referenced and shared among numerous governmental taxing authorities with the click of a button.

Electronic filings and sophisticated digital data collection methods allow tax authorities to reach deeper than they ever have before into the taxpayer’s supply chain data. Multinational taxpayers must electronically submit a variety of data that goes beyond tax records in formats specified by different tax authorities often within the same country, e.g., customs, duties, income tax, and VAT. All of these authorities now utilize sophisticated data analytics engines to discover filing discrepancies and compare data across jurisdictions and taxpayers. These governments then issue tax and audit assessments based on these analyses.

It is essential that multinational taxpayers understand the shift from a single country filing view to a global filing view. Tax filings simply have to be viewed as being globally transparent in terms of information sharing, comparative risks, and tax controversy strategy and resolution. Very little if anything is hidden and not shared.

The drivers behind this are numerous. Over 100 countries have signed onto the OECD’s Country-by-Country reporting initiative. The OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”) desires to update over 3,000 double tax treaties to incorporate BEPS changes. It went into effect in July 2018 with 75 countries on board. The MLI requires a principal purpose test for a multinational taxpayer’s tax positions and creates a simplified limitation of benefits provision to curb treaty abuse. This means that tax treaty benefits will be denied when procuring a tax benefit was a principal purpose of a business arrangement.

The OECD is offering a new tool aimed at taxpayer certainly in this new environment. The OECD created International Compliance Assurance Program (“ICAP”) is a voluntary pilot program where, in return for transparency of their tax risks, taxpayers receive some assurance that they will not be targeted by governments participating in the program. In theory, a successful ICAP result provides multinational taxpayers more certainty and a reduced overall global tax risk profile. It is a program with promise but it is being rolled out as a pilot program only in the face of an ever more aggressive tax environment that is not a pilot program.

Tax Adviser Rules

One very significant change impacting practitioners both in the U.S. and worldwide is the EU’s recent update of the Directive on Administrative Cooperation (“DAC”). Under the new DAC rules, intermediaries such as tax advisers, accountants and lawyers that design, promote or implement tax planning strategies are required to report any potentially aggressive tax arrangements directly to the tax authorities. Very concerning , mainly due to the broad scope of definitions provided in these rules, is that reportable arrangements may include arrangements that do not necessarily have a main benefit of obtaining a tax advantage. These new mandatory disclosure rules will have material implications for both advisers and their clients.

According to the DAC, a “reportable cross-border arrangement” refers to any cross-border tax planning arrangement which bears one or more enumerated features listed in the DAC and concerns at least one EU Member State. The enumerated features are broadly scoped and represent certain typical features of tax planning arrangements which, according to the DAC, indicate possible tax avoidance. Certain transfer pricing arrangements must be reported even if they do not have a primary purpose or benefit of obtaining a tax advantage. This include arrangements that involve hard-to-value intangibles or a cross-border transfer of functions, risks, or physical property.

Creating A Global Tax Risk Strategy

Multinational taxpayers that are relying on traditional global compliance practices and reporting models will ultimately lose control of their own tax narrative. These antiquated – and now dangerous – practices feature single country income tax reporting that is not coordinated with operational tax reporting like excise taxes and customs reporting.

When one takes into account decentralized management teams, non-integrated mergers and acquisitions, and information systems that are not coordinated or unable to provide required information in a timely manner, one can see the true scale of the problem. Tax risk must be managed on a global basis. Local, or even regional, management is simply not sufficient.

As tax reporting becomes even more digitally interconnected, existing problems will only grow creating more economic and legal risks to international business strategies. What we are now experiencing has been long perceived and is the future of tax and financial reporting. There really is no getting around it.

Practical Strategies

We are often asked by our clients how to best manage this new global environment. We advise that multinational taxpayers strategically address these issues proactively on a global basis. The risk of not doing so is to hand over important financial data to numerous tax authorities without a clear understanding of how they’ll use it or how it will impact the taxpayer’s core business strategies.

There are steps that can be taken to minimize the impact of these new rules. in a consistent and strategic way will be better equipped to manage controversies as they arise. Specific steps businesses can take to adopt a more consistent global approach to tax controversy management include:

Centrally manage global tax filings to ensure consistency and understanding of what is being disclosed and where. This involves enhanced communication and processes between global reporting teams that may not have existed before. This is, in practice, a cultural shift in how global finance teams address tax matters.
Modify, update, or create information reporting systems that can timely comply with global reporting rules while still allowing time for appropriate tax leadership review prior to filing. Never has the need for information systems to be responsive to tax needs been higher. These systems must not only produce data but do so in a coordinated and strategic manner.
Design and implement a global policy relative to tax compliance, reporting, and response to tax authority inquiries. This policy must not only be nimble but it must fully comply with increasingly complex local rules.
Involve senior management, Board leadership, and even internal audit teams to create a corporate governance plan that complies with SOX requirements but also allows swift communication of tax related risks to strategic business plans and financial reports.
As an adviser/intermediary or taxpayer, understand when a transaction qualifies as a “reportable cross-border arrangement” under the DAC. Unless a legal professional privilege applies, disclosure is necessary. If multiple advisers are involved, each adviser must comply with the reporting obligation unless a report was filed by another adviser.

Even the most sophisticated taxpayers are having trouble keeping up with these new rules and requirements. It truly represents a cultural shift that has been long coming and shows no signs of abating. Only by maintaining awareness of new global reporting rules and creating strategies and processes to ensure both conformance and strategic awareness can economic risks be minimized and global business strategies preserved.

New Tax Benefits for Pass-Through Entities – What’s There to Know?

October 25, 2018 by Frank Vari, JD. MTax, CPA

By FJV Tax Staff

There is a great new tax benefit available courtesy of tax reform that our pass-through clients don’t seem to know much about. That great new benefit is IRC Code §199A (“Section 199A”) which provides owners of pass-through businesses, most notably partnerships and S corporations, with an important new tax benefit from a qualified trade or business.

This deduction is for up to 20% of the qualified business income of a U.S. business that is either a sole proprietorship, partnership, S corporation, trust, or estate. For taxpayers with taxable income that exceeds $315,000 for a married couple filing jointly or $157,500 for all other taxpayers, the deduction is subject to limitations such as the type of business, the taxpayer’s taxable income, the total amount of W-2 wages paid by the business or the unadjusted basis of qualified property held by the business.

The motivation for the new deduction is rather simple. It allows pass-through businesses maintain tax benefits commensurate with the significant corporate tax cut also provided by tax reform. Income earned by a C corporation has always been subject to double taxation. The first level of tax is at the entity level and the second is at the shareholder level when the corporation distributes its income as a dividend. Tax reform reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%. Tax reform did retain the top rate on dividend income of 20% but the significant decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.

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In contrast to a C corporation, income earned by sole proprietorships, S corporations, or partnerships is subject to only a single level of tax at the shareholder level. Owners of these businesses report their share of the business’s income directly on their tax return – Form 1040 – and pay the corresponding tax at ordinary individual rates. Tax reform reduced the top rate on ordinary income of individuals from 39.6% to 37% and Section 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.

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What is most important here is that owners of sole proprietorships, S corporations, and partnerships retained a significant federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.

While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear. As a result, Sec. 199A has created ample controversy since its enactment with many tax advisers anticipating that until further guidance is issued the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS. Adding concern is Congress lowered the threshold where any taxpayer claiming the deduction can be subject to a substantial-understatement penalty. What that means is that they’ve introduced an ambiguous new rule and lowered the margin of error for penalties.

One of the areas giving our clients problems is figuring out exactly what types of business activities are excluded from the 20% deduction. Service businesses are the real problem. Section 199A defined specified service business – for which no deduction is allowed once a taxpayer’s taxable income exceed $415,000 for taxpayers filing jointly or $207,500 for all other taxpayers – as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”. That definition cast a pretty wide shadow.

Proposed regulations have come to the rescue at least a little bit. The proposed regulations clarified several questions related to specified service businesses. First, there is a de minimis exception that allows a business that sells products and provides a service to escape classification as a specified service business if gross receipts are less than $25 million for the year and less than 10% of total gross receipts are from the performance of services in one of the specified services business listed above. Next, the proposed regulations provide guidance on the meaning of various trades or businesses described in Section 199A as specified service business. These rules are meant to help define who qualifies for the benefits in businesses where the lines are blurry between qualifying and non-qualifying activities.

Some of the most complicated areas are services related to health, consulting, and real estate businesses. Here are examples of the application of Section 199A from each of these businesses:

Health and Health Care

A qualifying health care business means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient. It excludes the provision of service not directly related to a medical field even though services logically may relate to the health of the service recipient. An example of these non-qualifying activities would be the operation of a health club or health spa that provides exercise or conditioning to customers or payment processing services for health care providers.

Consulting

Section 199A excludes consulting services defined as the provision of professional advice and guidance to clients to assist in achieving goals and solving problems. However, these services do not disqualify larger businesses that only involve small levels of consulting. Disqualified consulting does not include salespeople who provide training or education courses as an auxiliary service to the sale of product. For example, a construction contractor who provides consultation as part of a home remodeling project is not considered a consultant.

Real Estate

Brokerage services are specifically excluded from Section 199A benefits. This includes services provided by stock brokers, investment managers, and other similar professionals but does not include services provided by real estate agents and brokers or insurance agents or brokers. The proposed regulations clarify that the performance of investing and managing real property services are not included in this definition which allows real estate professionals in the trade or business or managing real property to qualify for the deduction.

As one can see, Section 199A provides a tremendous benefit to owners of sole proprietorships, S corporations, and partnerships. As this post makes clear, granting a 20% deduction to pass-through business owners is far easier in concept than it is in execution. Many questions still remain.

Until time evolves and provides everyone with the guidance needed, taxpayers must still move forward and claim the benefits they’re entitled to. To understand and claim the benefits that you’re entitled to please contact us at fjvtax.com and let us guide you to your benefits.

Transfer Pricing for Small & Mid-Size Business – What is Important Now and Why

October 22, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

One of the most common questions we at FJV receive from our small business clients is what is transfer pricing and why must we address it now? Many clients – and some practitioners – seek an answer but are overwhelmed by the complex and conflicting information generally available.

If your company plans to expand business operations into the U.S. or expand their U.S. operations into another country at least a basic understanding of transfer pricing is required. Once there is a basic understanding, one can better comply with the legally mandated transfer pricing rules and then create a strategic pricing plan.

To best explain, let’s discuss transfer pricing basics, pricing methods, and documentation requirements.

Transfer Pricing Basics

A “transfer price” is the price at which related companies located in different countries buy and sell goods and services to each other. This is very important to each country’s taxing authority as each country wants to tax a share of these worldwide profits. “Transfer pricing” is generally defined as the legal mechanism that allocates the profit from that related party sale between the competing tax jurisdictions without creating double taxation. This mechanism, as outlined in a variety of laws around the world, allocates global supply chain profits based upon the functions and risks of the related parties. The party which performs the most important and costly functions, e.g., design and manufacturing, and takes the greatest risk, e.g., capital investment and customer credit risks, is entitled to the greater profit.

For example, let’s assume a U.S. entity manufactures medical equipment and sells it to a related party located in Germany. The German entity then resells the equipment to its customers within Germany. The financial elements here are as follows:

The medical equipment is manufactured in the U.S. at a cost of $10,000.
The parent sells this equipment to its German relative for $17,000 realizing a taxable profit in the U.S. of $7,000.
The German entity then resells this same equipment to an unrelated German customer for $20,000 thus realizing a taxable German profit of $3,000.
The total taxable profit for the entire global supply chain is $10,000.

How can the U.S. entity justify receiving 70% of the taxable profits, while the German entity only 30%? In our example, the U.S. entity has performed the costly research, design, and manufacturing functions for the medical equipment. The German subsidiary is only involved in the local German marketing and distribution of the product which requires little capital or investment. Thus, the U.S. entity has performed the greater functions and taken the greater risk which legally entitles them to the greater profit.

This profit split may be challenged by either the U.S. or German tax authorities using their own local transfer pricing laws. However, almost every country, including the U.S. and Germany, requires that each related taxpayer perform and document a transfer pricing analysis of their taxable profit allocation with related parties. No exceptions.

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Transfer Pricing Methods

The IRS first enacted rules back in 1928 to address intercompany profit allocations that have evolved into present-day IRC Code §482. These rules actually empower the IRS to reallocate income or deductions between related parties to prevent tax evasion. If the taxpayer doesn’t perform a properly documented allocation or get it right the IRS will do it for them. Not a good place to be for sure.

IRC Code §482 requires taxpayers to create and document a transfer pricing policy that chooses the best method to justify the transfer price of goods and services. The IRS allows various methods for various types of transactions. Transfers of heavy equipment, software, and consulting services are all sufficiently different that different pricing methods are required.

One of the most common pricing methods – and the one most preferred by the IRS and other taxing authorities – is the Comparable Uncontrolled Price (“CUP”) methodology. In our example, let’s assume our U.S. entity also sells the same type of medical equipment to unrelated Chinese and Australian customers for more than it sells to the German related party. The IRS may – and probably will – argue that the U.S. entity is not charging Germany enough and a greater U.S. taxable profit should be reported. Alternatively, if the U.S. entity sells the medical equipment to all three customers, both related an unrelated, for the same price it could justify the intercompany transfer price between the related U.S. and German entities as an “arm’s-length” price.

IRC Code §482 provides other methods besides the CUP to be used for transfer pricing of goods and services. These methods include the Cost Plus method, the Resale Price method, the Comparable Profits method, and the Profit Split method. Taxpayers can even use an unspecified method if they can support it. Taxpayers must be careful to analyze each of those methods separately and select the “best method” for that particular transaction in order to comply with IRC Code §482.

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Documentation Requirements & Penalties

One very important and often overlooked rule is that taxpayers are required to prepare and maintain contemporaneous documentation that explains in a very detailed and technical manner their transfer pricing methodologies. “Contemporaneous” means this documentation must be compiled at the same time their U.S. tax return is filed. If the IRS requests this documentation, the taxpayer must produce it within 30 days of an IRS request. If the taxpayer fails to do so, two very bad things can happen. First, as noted above, the IRS will go ahead and allocate the related party profits as they see fit. Second, the taxpayer will be subject to the documentation penalty provisions of IRC Code §6662.

If the IRS makes a transfer pricing adjustment resulting in an underpayment of tax and the documentation requirement was not met, IRC Code §6662 permits IRS to impose a 20% or 40% percent non-deductible penalty. The 20% penalty applies if the transfer price adjustment exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts. If the transfer price adjustment exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts the IRS may impose a 40% penalty on the adjustment.

Besides proper transfer pricing documentation, U.S. taxpayers must comply with other important requirements including:

U.S. taxpayers who have related party transactions with their subsidiaries located outside of the U.S. must report these transactions on Form 5471.
U.S. taxpayers who have related party transactions with their foreign owners and their related parties must report these transactions on Form 5472.
If the related party sale involves a customs or duty filing, the price on the filing must be the same as that reported in the transfer pricing documentation and the Form 5471 or 5572. The failure to “harmonize” these filings can lead to additional penalties.

These are very harsh penalties that are often incurred by U.S. taxpayers who do not perform written transfer pricing studies to properly allocate or report related party profits. The problem is there is really no way around them for small taxpayers. Small taxpayers around the world have long called for exemptions from transfer pricing reporting but there is no significant relief to date.

Conclusion

Transfer pricing is a complicated issue that must be addressed proactively. If properly addressed in a timely manner, transfer pricing can be addressed at a reasonable cost. If not, the penalties kick in and the cost of these penalties coupled with the legal and professional fees of a transfer pricing conflict with any tax authority can be very high.

Our advice to any client with related party transactions that cross a foreign border is to proactively address their transfer pricing issues in a timely manner. Whether they sell tangible property, services, or sell or license intangible property, our advice is the same. At the end of the day, it saves our clients time and money and brings them fully into compliance with the law.

How About VAT!? – Practical VAT Issues for U.S. Based Exporters

July 13, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

One of the most common issues in our international tax practice today is Value Added Tax (VAT). Even with all of the questions around U.S. sales tax in the wake of South Dakota v. Wayfair, at least our U.S. based clients understand the basic U.S. sales tax rules. That’s not always the case with VAT. U.S. based exporters, ranging from software developers to manufacturers, are subject to a VAT. Even those that fully understand compliance don’t often understand how simply complying and not being proactive around the VAT is costing them money and margin.

The most common issue we face with respect to VAT is the U.S. exporter incurring an unexpected VAT liability. It happens a lot and it happens because many smaller U.S. exporters don’t understand, or choose to ignore, foreign VAT rules. When it happens, and the U.S. exporter is charged with a VAT, profits can be reduced or eliminated, and the U.S. exporter can be taken out of the market by having to increase their selling price, or reduce their margins on export sales, due to unrecoverable VAT.

A basic understanding of the VAT is in order here. The VAT is an indirect tax levied on the consumption or use of goods and services. It is charged at each step of the supply chain process. The product’s end consumer bears the costs of VAT while registered businesses collect and account for VAT acting as tax collectors on behalf of the government.

Here’s a basic example of how VAT works within a Euro country with a VAT regime where all of the supply chain members are properly VAT registered and compliant:

A widget manufacturer sells to a wholesaler for €100. Under the VAT, the manufacturer collects a VAT of 5%, or €5, from the wholesaler on behalf of the government. The wholesaler pays the manufacturer a total of €105.

The wholesaler increases the selling price to €200 and sells it to a retailer. The wholesaler collects a VAT of 5%, or €10, from the retailer on behalf of the government whilst receiving a refund of the VAT paid to the manufacturer in the previous step. The retailer pays the wholesaler a total of €210.

The retailer further increases the selling price to €300 and sells it to a consumer. The retailer collects a VAT of 5%, or €15, from the consumer whilst receiving a refund of the VAT paid to the wholesaler in the previous step. The consumer pays the retailer a total amount of €315 and receives no refund of any VAT paid. Thus, the consumer bears the cost of all VAT incurred throughout the supply chain as all others have recovered what they paid.

That example is rather basic but, in practice, it can be very complex when the supply chain crosses multiple borders and VAT regimes, rates, and classifications. Product transformation through the supply chain raises additional issues. That said, it is imperative that U.S. exporters fully understand the VAT rules and their VAT responsibilities. I’ve seen too many U.S. exporters end up with unexpected VAT costs and penalties that eliminate any profits on their foreign sales especially when legal fees are added to the equation.

The most commonly raised question is how do you basically comply with the VAT? In some cases, e.g. the sale of physical goods, the law is rather settled. In the case of other emerging types of business, e.g., online software sales, the law is evolving and is based on each jurisdiction’s rules. With the exception of the European Union (EU), there really is no Uniform Commercial Code (UCC) or uniform rules on this type of activity. That makes it tough to provide general answers that a client can rely on. Only with specific facts can one arrive at specific answers.

As outlined in the example above, the global theme is that the seller is the one who bears the responsibility for paying the VAT. In practice that works in many different ways, depending on the rules of the specific jurisdiction. For a U.S. exporter, some of the most important practices and issues are:

For physical goods, the importer of record usually incurs the VAT. If the U.S. exporter can get the foreign buyer to be the importer of record they can usually pass on VAT issues altogether.
If the foreign buyer is a VAT registered business, they may be responsible for collecting any VAT and remitting it if they know the seller is offshore or not VAT registered. This “reverse charge” mechanism is a rule in the EU and various other jurisdictions as well. In many instances, the U.S. seller need not worry about VAT if they are aware that the foreign customer is VAT registered and they have the foreign customer’s VAT number on file. That’s great from a compliance perspective but the U.S. seller still ends up economically bearing the VAT expense that the buyer is just passing along on their behalf. Also keep in mind that most individuals don’t have a VAT registration.
In the EU, there is a common reporting system where a non-EU company can register in one EU country, e.g., Ireland, and then run all of their EU sales through that single registration. That has merit solely for sales to EU customers where there is common reporting system.
If the seller has a number of clients in one country with “VATable” sales, the seller should strongly consider registering there to properly collect and remit VAT. Many clients do this in places where they have sales and where VAT problems can bring serious criminal charges. They may even set up a shell company (rare) for this purpose because if there is no company than the VAT cannot be used or credited in the future by the seller due to lack of a VAT registration. Otherwise, the unrecoverable VAT paid simply becomes a sunk cost.
A U.S. exporter may try using an intermediary. For example, the U.S. exporter can sell directly to an EU VAT registered intermediary who, in turn, sells to non-EU countries. In this case, the intermediary is the one who bears the burden for the VAT compliance in non-EU countries. Many small U.S. exporters seek out independent foreign distributors for this reason.
Keep in mind that VAT classification is very important as different countries apply VAT at different rates to different products. For example, software for medical imaging or educational purposes may be rated differently than software for gaming. This is very similar to customs classifications. Freight forwarders often fail their clients here. A freight forwarder will make sure the VAT is paid but it is not their job, and nor do they feel it is their job, to make sure the VAT is paid at the lowest available rate. We see that a lot.
Customs & Duties is always an issue as well even though it is out of this article’s scope. You always want to make sure that all foreign exports comply with local customs & duty rules and regulations. Even for online sales, some countries do levy import duties on, for example, imported software licenses.

These practices and issues are the ones we see most often but they are certainly not an exhaustive list or all possible outcomes. The real problem is the lack of global or regional uniformity as well as the ever evolving nature of the rules. When you couple the obvious complexities with aggressive enforcement, especially against non-resident importers, you see that it doesn’t take much for real problems to arise even for very small U.S. exporters.

VAT violations can be very nasty. Goods and inventory can be seized, a company be barred from a market and, in some countries, officers, directors, or employees can face criminal penalties including prison. I’ve been a part of criminal VAT cases and it is not for the faint of heart.

The bottom line is that the cost of upfront VAT compliance is much cheaper than defending a nasty VAT audit or trying to free impounded inventory. Don’t let VAT drag your profits down or be a barrier to profitable export sales. Contact us today to help you with your VAT and international tax questions and issues.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Foreign Asset Tax Compliance and Why It Is Important Right Now

June 29, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

International tax can be a very complex subject but most associate both the topic and the complexity with multinational businesses. That may be true, but the greatest risk if often borne by individuals who do not properly understand their U.S. reporting obligations for foreign income, assets, and investments. With the U.S. Internal Revenue Service (IRS) recently declaring that the IRS Offshore Voluntary Disclosure Program (OVDP), which was started in 2009, will close for good on September 28, 2018, taxpayers with unreported foreign assets should immediately determine if ODVP would benefit them before it is gone for good. At this same time, the IRS has noted that their enhanced enforcement efforts against unreported foreign assets will not end. Thus, the time is now for taxpayers with unreported foreign assets to formulate a plan for compliance or risk what have been, in certain cases, draconian penalties.

Many individual taxpayers, including those from outside the U.S. who are not educated in U.S. tax reporting rules, own assets located in different countries. Some of these assets are as benign as a bank account they hold with an elderly relative to those with a Swiss bank account fully intended for shelter from the U.S. tax and legal system. In practice, most all of these cases lean toward the former, however, they all are covered by pretty much the same rules.

This article is intended to provide a quick overview of the issue and the avenues available to taxpayers to maintain or obtain compliance with the rules.

Reporting Basics

It is probably not news to any practitioner that a U.S. taxpayer has to report all of their income on a global basis. It is also probably not news that many individual clients do not fully disclose, or fully understand the law to disclose, each and every non-U.S. income stream. That, at a minimum, must be done even if it takes some digging to gather all of the appropriate information.

Reporting assets located outside the U.S. is a bit more tricky. Not only from an asset identification perspective but from a where and how to report perspective. For example, a U.S. taxpayer may have a small longtime family home somewhere in Europe that they occasionally rent to friends. It’s simple enough to understand that the income must be reported on Schedule E, but what about the real estate itself? More on that later but you see the issue.

Foreign Bank Account Reporting (FBAR)

U.S. residents or citizens must report a financial interest in, or signature or other authority over, specified bank and other accounts in a foreign country on Financial Crimes Enforcement Network (FinCEN) Form 114 (the successor to the beloved Form TD 90-22.1), i.e., FBAR, if the accounts aggregate maximum values exceed $10,000 at any time during a calendar year. Please note the “aggregate” and “at any time” language.

FBAR requirements apply to individuals, corporations, partnerships, trusts, estates, and LLCs as well as entities disregarded for tax purposes. The regulations under Sec. 6038D require that a specified person look through a disregarded entity for reporting foreign assets on Form 8938 (discussed below). However, the FBAR requirements impose a separate, independent reporting obligation on such entities.

There are plenty of traps for the unwary here. The most simple may be a U.S. taxpayer who has signatory authority to co-sign with an elderly relative located outside the U.S. More difficult to identify is the reporting obligation of a U.S. corporate executive who has signatory authority, likely along with many others, over a long dormant overseas corporate bank account or accounts exceeding $10,000 at some point during a calendar year. It is a very common situation that is difficult to identify and, hence, ensure compliance. Add fiscal years and foreign currency translation to the equation and you see where the simple becomes difficult even for sophisticated taxpayers.

Form 8938

Specified U.S. individuals with foreign financial assets may need to file Form 8938, also known as the Statement of Specified Foreign Financial Assets as part of their annual income tax return. A “specified individual” is a U.S. citizen, a resident alien of the U.S., or anon-resident alien filing a joint U.S. income tax return.

The “financial assets” which must be reported includes foreign bank accounts, assets held for investment by a foreign institution, foreign retirement plans, and jointly owned foreign financial assets. It is not uncommon for a business executive who has moved to the U.S. to have an interest in a foreign pension plan from a former employer. Items like this must be considered.

The Form 8938 reporting thresholds range from $50,000 of foreign financial assets on the last day of the year or $75,000 at any time during the year for unmarried U.S. individuals to $400,000 on the last day of the year and $600,000 at any time during the year for married joint filers living abroad. Be sure to reference the detailed Form 8938 reporting requirements once the assets themselves are identified.

Besides the individual nature of Form 8938, it is important to note one critical difference between Form 8938 reporting and FBAR. Form 8938 does not require reporting of financial accounts held in foreign branches or held in foreign affiliates of a U.S.-based financial institution. However, such accounts are considered financial accounts for purposes of FBAR reporting because they are located in a foreign country.

Other Common Reporting Forms

The FBAR and Form 8938 are the most widely used foreign asset reporting forms but not the only ones. There are a number of others that capture different kinds of foreign asset activity. These are:

Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, for reporting transfers of property to foreign corporations;
Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts;
Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, for reporting affiliations with foreign trusts or the receipt of gifts from non-U.S. persons;
Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations;
Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, for reporting interests in foreign controlled corporations and reporting transactions with foreign corporations; and
Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, for reporting interests in foreign partnerships.

Each of these forms captures different types of investments and may apply to both individuals and businesses in different forms.

Penalties

The IRS has identified unreported foreign assets as a key element of U.S. tax evasion. So too have foreign tax authorities. As such, the IRS has enacted significant penalties which, coupled with aggressive enforcement, creates a perilous environment for individuals and entities who fail to accurately file these forms. The penalties are very severe, especially considering the fact that the IRS has not made it easy for those with foreign assets to clearly understand what must be reported and how.

The penalties can be very high and reach upwards of $10,000 per form per year. If the IRS establishes that the taxpayer willfully decided not to file the form, their can be criminal penalties as well as civil penalties reaching upwards of millions of dollars depending on the value of the overseas assets.

For practitioners who know, or reasonably should know, of these unreported or underreported foreign assets, Circular 230 still stands to require disclosure with its penalty provisions.

Resolution Options

Once the issue is identified, the appropriate course of action must be determined. If the IRS has identified the issue first or the taxpayer has engaged in willful failure to report, the only option is constructing a legal defense. Those that have experienced this know it to be a potentially very costly experience and more so if criminal penalties are involved.

The most reasonable option to those who otherwise have unreported foreign assets is the OVDP program. Taxpayers who voluntarily come forward and provide the IRS with the nature and extent of their undisclosed foreign assets and income are given assurances that the IRS would recommend against criminal prosecution of these taxpayers. In addition, taxpayers are required to pay all outstanding taxes, interest, and a 20% penalty on the amount of previously unpaid taxes for up to 8 years of noncompliance. Other various penalties apply depending on the form and the facts and circumstances of the case.

These OVDP penalties, while still sometimes steep, pale in comparison with potential penalties if the taxpayers do not enter into the OVDP and are identified by the IRS. In addition to potential criminal sanctions, taxpayers could pay up to a 75% fraud penalty for any previously undisclosed income and the greater of $100,000 or up to 100% of the entire foreign bank account balance for each year of willful noncompliance with FBAR requirements.

It is important to note that the OVPD is not the only option available as the Streamlined Procedures Program still exists. The appropriate option for the taxpayer depends again on the facts and circumstances.

What to do Now

As noted above, the IRS fully intends to continue increasing the number of criminal prosecutions of taxpayers involved in failing to report overseas assets. Additional disclosure methods continue arising and include foreign banks, e.g., UBS, continuing to enter into non-prosecution agreements with the U.S. Department of Justice. Additional tools ranging from international tax information sharing agreements to data mining will continue to aggressively identify non-complaint taxpayers.

It is very important for taxpayers who believe they may have issue to immediately determine a plan of compliance and if OVDP is their best option. Failure to fully evaluate their options before OVDP expires this fall could be very costly.

To learn more about FJV’s foreign tax compliance and tax audit and controversy practices which have considerable experience with this important topic and how it impacts your business and tax positions, please contact FJV Tax or visit us at fjvtax.com.

This article was previously published by the Massachusetts Society of Certified Public Accountants (MSCPA).