Here is Your International Tax Compliance Checklist
With the end of compliance season rapidly approaching, now is the time to review common pitfalls in international tax compliance and how to avoid them. Overlooking some of these details exposes you to significant penalties and potential for future risk. Consider these areas to avoid unnecessary penalties and maximize your tax position before you file. Here is your international tax compliance checklist:
- Form 5471
- Subpart F
- Dual Consolidated Losses
- Disallowance of Foreign Taxes
- Foreign Source Expense Apportionment
- Miscellaneous International Tax Compliance Opportunities
The Ambiguity around Form 5471
The passing of the Hiring Incentives to Restore Employment (HIRE) Act of 2010 has increased the emphasis taxpayers place on filing Form 5471 correctly, since incorrect filings now potentially incur a $10,000 penalty and require filing an amended form. Adjustments to earnings and profits (E&P) will be discussed first.
When preparing or reviewing E&P adjustments, taxpayers commonly err both by not making adjustments when they need to be made and by making adjustments beyond what is required. Internal Revenue Code Section (“§”) 964 states that “…no adjustment shall be required … unless it is material;” however, it sets forth no clear standard for materiality. Secondary sources in the international tax arena presume that the threshold is anywhere from 5% to 10% of gross income. This standard is not always easy to apply because an item that is material in one year may not be material in the following year. Usually, the past few years are first examined to determine if an item is material and then an adjustment in the following year is made to be consistent.
Turning to cash vs. accrued taxes, many taxpayers inappropriately apply the accounting rule from §901 which allows for an election on Form 1118 to calculate foreign tax credits using either cash or accrued taxes. This election is not available to most taxpayers because the accounting consistency rule states that taxes must be accrued using the same method used for federal income tax purposes. Most companies need to use an accrual method and do not have the choice to use the cash method to take foreign credits.
Subpart F is not a Curse Word
§956 inclusions are another frequently missed area. We have noted that taxpayers fail to timely clear intercompany trade accounts that could potentially result in §956 balances. From the perspective of receivables arising from inventory sales, CFC receivables with the U.S. must be settled consistent with industry standards in order to avoid a §956 inclusion. For example, given a CFC that sells a product to the U.S. on accounts payable, failure to settle the payable within the industry standards results in §956 income inclusion. For services, the §956 regulations have a 60-day safe harbor on CFC receivables with the U.S. I have seen, in both instances, where taxpayers left payables outstanding for months or sometimes even years with the attendant §956 exposure.
For this purpose, I have seen several taxpayers taking the approach of netting the intercompany accounts receivable with intercompany accounts payable. Unfortunately, the IRS has taken a contrary view in Field Service Advice 003312. It is still possible to net accounts receivable with accounts payable — but it must be done by making the actual offsetting entries before the financial statements are closed for the year and backing it up by either legal documentation or an existing policy to allow the netting of the accounts.
For General Subpart F, many taxpayers are not apportioning all required expenses or are apportioning too many expenses. When calculating foreign based company sales income and foreign based company services income, for example, taxpayers generally remember to include sales and cost of goods sold but forget indirect expenses and thereby miss an opportunity to reduce their Subpart F. I have also seen the reverse, where the Subpart F has been reduced by including indirect expenses in the apportionment base, as in the case of passive income. Under §861 regulations, expenses must first be allocated to a class of gross income and then apportioned between the statutory grouping (e.g., Subpart F and non-Subpart F in this specific example). The expense must be apportioned based on the factual relationship between the deductions to the income. I have seen tax software automatically apportion expenses based on gross income for all items but that does not necessarily mean that those methods are correct for each item of inclusion. On several occasions, I have seen for example SG&A apportioned to passive Subpart F interest income from banks. However, there was not a factual relationship between the SG&A expense and the passive interest income resulting in an underestimate of the Subpart F income on the tax return.
On the application of Subpart F look-thru, be aware that a transaction that may appear to qualify for Subpart F look-thru may not actually qualify, because it reduces Subpart F income. For example, loan interest from a CFC to a CFC is not Subpart F income if the CFCs are related. However, if the intercompany interest reduces another item of Subpart F income, then the intercompany interest income would not be subject to look-thru and would be part Subpart F income.
The Skinny on Dual Consolidated Losses (DCLs)
Since the issuance of final regulations under IRC §1503 in 2007, certain statements previously attached to the tax returns made under the 1992 regulations no longer apply to DCLs. These statements only apply to DCLs created in tax years beginning on or before April 17,2007 and cannot be simply rolled forward for DCLs created at a later date. The certification period under the 2007 regulations was reduced to five years so there should be no current filings under the 1992 regulations and the new statements should apply.
Acquiring the Right to Disallow Foreign Taxes
Foreign tax credits are disallowed for a portion of foreign income tax attributable to income from covered asset acquisitions generated after December 31, 2010.
The covered asset acquisitions (CAAs) are:
- Qualified stock purchases as defined under section §338(a)
- Transactions that are treated as acquisitions of assets for U.S. tax purposes and as acquisitions of stock (or are disregarded) for foreign tax purposes
- Acquisitions of partnership interests when a §754 election is made
- Any other similar transactions that result in the creation of additional asset basis for U.S. tax purposes without a corresponding increase in asset basis for foreign tax purposes
The disqualified portion of taxes for a taxable year is the ratio of:
- Aggregate basis differences for relevant foreign assets allocable to taxable year, over
- Foreign taxable income on which foreign income tax has been calculated
- Relevant foreign assets include all assets with respect to a CAA if income, deduction, gain or loss attributable to such assets is taken into account to determine foreign income tax
- Aggregate basis difference equals the difference between:
- Adjusted U.S. tax basis immediately after a CAA, and
- Adjusted U.S. tax basis immediately before a CAA
Taxpayers should be looking at what the tax basis is before the acquisition, albeit a labor-intensive calculation. This amount could be a very different answer than just looking at just the §197 amortization Your Interest in Foreign Source
Your Interest in Foreign Source Expense Apportionment
When apportioning interest expense to a foreign source, assets without identifiable yields are sometimes not considered in the calculation. For the purposes of characterizing assets by the source and type of income they generate, §861-9T defines a type of asset without directly identifiable yield which should be excluded from U.S., foreign, and total assets. These are assets that do not generate any type of income – U.S. or foreign source income. The regulations are not specific as to type of assets without identifiable yield but they provide an example that land and buildings for the headquarters of a company could be characterized as such assets.
Some taxpayers do not apportion sufficient headquarter expenses under the justification that their foreign offices are self-sufficient and/or that they have an existing management fee that is being charged out. However, two types of expenses still need to be apportioned to foreign source income:
- Expenses that remotely benefit foreign expense are not charged out but still need to be apportioned
- Even though they are only remote and not charged out, the regulations under 861 still view them as needing to be apportioned to foreign source
- Expenses that do not generate any type of income must be apportioned to all classes of gross income
When apportioning research and development (R&D) expenses under the sales method, remember to account for sales that include §863(b) sales, CFC sales benefiting from U.S. R&D, and royalties translated in sales (royalty divided by royalty rate). Under the gross income method, include only gross income benefiting from R&D (e.g. gross profit, royalties, dividends, etc. but not interest income, capital gain, etc.).
Miscellaneous International Tax Compliance Opportunities
Be aware of these additional, often-missed, areas:
- Gain recognition agreements
- Instances where the fair market value that needs to be included on the gain recognition is either not provided, “available on request,” or a guess that is far from reality. There are instances where the IRS has denied the gain recognition agreement in such situations and assessed that the transaction is taxable.
- Restructuring statements
- If §351, §332, §368, and A, B, C, D reorganizations are present, ensure that all appropriate disclosure statements are included, including their counterpart §367(a) or §367(b) statements. This is a very complex topic so be aware of what needs to be included.
- §904(d) baskets
- Most taxpayers are using just the general limitation basket and it is important to keep track of your passive basket as well.
- §909 splitter
- There are instances where foreign taxes are paid by one foreign company. However, under U.S. tax regulations, they need to be pro-rated among several CFCs.§863(b) sales to disregarded entity
- Products manufactured in the U.S. and sold to a foreign disregarded entity underneath the U.S. can be treated as §863(b) sales if certain requirements are met. I have seen many companies incorrectly treating the U.S. manufacturing profit on these sales as U.S. source income and the foreign distribution income as foreign source income. Under §863(b), both the U.S manufacturing and foreign distribution profits are split 50% U.S. source and 50% foreign source under the administrative rules. More often than not, this would result in a larger amount of foreign source income since the manufacturing income should be larger than the distribution income, but facts and circumstances may differ from case to case.
Have a Happy Compliance Season
As we enter the tail-end of compliance season, I hope the contents of this blog have given you some unique ideas that will make it a smooth one. Remember if you need help, feel free to reach out to me at firstname.lastname@example.org, and I will be happy to get you over any hurdles. International tax compliance can be tricky, but making the right considerations, and asking for help when needed can make your compliance season a happy one.
 Treas. Reg. § 1.964-1(a)(2)
 Treas. Reg. § 1.861-9T(g)(3)(iii). For an example, see Treas. Reg. § 1.861-12T(j).