What Foreign Owners of U.S. Disregarded Entities Need to Know About U.S. Tax Filing Requirements

A number of years ago, the Internal Revenue Service (“IRS”) and the Treasury Department issued final regulations regarding the reporting requirements for domestic disregarded entities held by a nonresident. If a single-member LLC does not elect to be treated as a corporation with the IRS, the LLC is a “disregarded entity.” According to the regulations under Internal Revenue Code Section 6038A, a disregarded entity will be treated as a U.S. corporation. Historically, a foreign-owned disregarded entity was just that- disregarded. As a result, nonresidents were not required to disclose disregarded entities to the IRS on a tax return or informational return. Under the new rules, this is no longer the case.

Under the regulations, a disregarded entity held by a nonresident individual or foreign entity is required to obtain a Employer Identification Number (“EIN”), prepare a pro-forma Form 1120, and potentially file a Form 5472, Information Return of a 25% Foreign Owned US Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. A Form 5472 must be filed with the IRS if the LLC had a “reportable transaction.” We will begin this article with a discussion of the basic terminology regarding the Form 5472.

Form 5472: Basic Terminology

A Form 5472 is required to be filed by a domestic corporation (or a disregarded entity) that can be classified as a reporting corporation. An entity can be classified as a reporting corporation, if, at any time during the taxable year, 25% or more of its stock, by vote or value, is owned directly or indirectly by at least one foreign person.

A foreign person is:

1) An individual who is a citizen or resident of a U.S. possession who is not otherwise a citizen or resident of the United States;

2) Any partnership, association, company, or corporation that is not created or organized in the United States;

3) Any foreign estate or foreign trust; or

4) Any foreign government (or agency or instrumentality thereof) to the extent that the foreign government is engaged in the conduct of a commercial activity.

The Constructive Ownership Rules

The constructive ownership rules of Section 318 apply to determine if a corporation is 25% foreign owned. For purposes of Form 5472, stock in a corporation can be owed in three possible ways. First, the person can own the stock “directly.” For example, owning stock in a brokerage account constitutes direct ownership of the stock. Second, the person can own the stock “indirectly” through an intervening entity, such as a corporation, partnership, or trust. In these cases, the stock owned by the intervening entity is typically considered to be owned proportionately by its shareholders, partners, or beneficiaries, as the case may be. The third way that a person can own stock is by “constructively” owning the stock due to a relationship with another person. This relationship most commonly involves family members. This form of constructive ownership (referred to as downward attribution) arises when an individual or entity parent directly or indirectly owns stock in a corporation and, at the same time, owns an interest in another entity. Under downward attribution, the corporation’s stock that the parent owns is attributed downward from the parent to the second entity. As a result, the second entity is considered to own constructively the same stock owned by the parent. Generally, the stock that is owned constructively by one person due to family or downward attribution cannot be further owned constructively by another.

Section 318 is one of several sets of constructive ownership rules in the Internal Revenue Code and applies when it is expressly made applicable by another provision of the Internal Revenue Code. Its principal role is in the redemption area, where it treats a taxpayer as “owning” stock that is actually owned by various related parties. The attribution rules in Section 318 fall into the following four categories.

1. Family Attribution

An individual is considered as owning stock by his spouse, children, grandparents, and parents. Siblings and inlaws are not part of the “family” for this purpose, and there is no attribution from a grandparent to a grandchild. See IRC Section 318(a)(1).

2. Entity to Beneficiary Attribution

Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in proportion to their beneficiary interests. See IRC Section 318(a)(2)(A). Stock owned by a trust is considered as owned by the beneficiaries in proportion to their actuarial interests in the trust. In the case of grantor trusts, stock is considered owned by the grantor or other person who is taxable on the trust income. See IRC Section 318(a)(2)(C). Stock owned by a corporation is considered owned proportionately (comparing the value of the shareholder’s stock to the value of all stock) by a shareholder who owns, directly or through the attribution rules, 50 percent or more in value of that corporation’s stock. See IRC Section 318(a)(2)(C). For purposes of the Form 5472, Section 318(a)(2)(C) is modified to substitute 10% for 50% in Section 318(a)(2)(C).

3. Beneficiary to Entity Attribution

Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or estate. See IRC Section 318(a)(3)(A). All stock owned by a trust beneficiary is attributed to the trust except where the beneficiary’s interest is “remote” and “contingent.” Grantor trusts are considered to own stock owned by the grantor or other person taxable on the income of the trust. See IRC Section 318(a)(3)(B). All the stock owned by a 50 percent or more shareholder of a corporation is attributable to the corporation. See IRC Section 318(a)(3)(C). The above discussed Sections 318(a)(3)(A), (B), and (C) do not apply to consider a U.S. person as owning stock for purposes of the Form 5472 filing requirements.

4. Option Attribution

A person holding an option to acquire stock is considered as owning that stock. See IRC Section 318(a)(4).

Related Party Rules

A Form 5472 filing requirement applies only to transactions between reporting corporations between foreign persons and related parties.

A related party can be defined as follows:

1) Any direct or indirect 25% foreign shareholder of the reporting corporation.

2) Any person who is related (within the meaning of Section 267(b) or 707(b)(1) to the reporting corporation). The applicable related party rules under Section 267(b) considers two corporations to be related where a parent corporation owns more than 50% of the vote or value of the subsidiary corporation. The applicable related party rules under Section 707(b)(1) considers two partnerships to be related in which the same person owns, directly or indirectly, more than 50 percent of the capital interests or profits interests.

3) Any person who is related (within the meaning of Section 267(b) or 707(b)(1) to the reporting corporation.

4) Any person who is related (within the meaning of Section 267(b) or 707(b)(1)) to a 25% foreign shareholder of the reporting corporation, or

5) Any other person who is related to the reporting corporation within the meaning of Section 482 and the related regulations. Determining whether a party is related within the meaning of Section 482 is no simple task. The vehicle for addressing problems of transfer pricing is set forth in Internal Revenue Code Section 482. Section 482 states that:

In any case of two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests, the IRS may distribute, apportion, or allocate gross income, deductions, credits, or allowances, between or among them, if it determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of them.

The regulations explain that the purpose of the provision is to place “a controlled taxpayer [i.e., a member of a commonly controlled group] on a tax parity with an uncontrolled taxpayer to determine the true taxable income of the controlled taxpayer.” See Treas. Reg. Section 1.482-1(a)(1). The appropriate standard is usually characterized as fair market value or “arm’s length” pricing. See Treas. Reg. Section 1.482-1(b)(1). In general, this standard is met if the results of a transaction are consistent with the results that would obtain if the parties were not related. The definitional reach of Section 482 is broad, covering virtually any conceivable business arrangement between or among any commonly controlled individuals, businesses, arrangement between or among any commonly controlled individuals, business or types of entity. See Treas. Reg. Section 1.482-1(i)(1), (2). The potential reach of the provision is extended further by the broad definition of “control” that is applied. The regulations provide that control means “any kind of control, direct, or indirect, whether legally enforceable, and however exercisable or exercised.” Control might also be found where two or more unrelated taxpayers act in concert or with a common goal or purpose. See Treas. Reg. Section 1.482-1(i)(4).

A careful examination must be made of the facts and circumstances of each case to determine if the related party rules of Section 482 for purposes of the related party rules.

Reportable Transaction

Generally a reporting corporation must file Form 5472 if it had a reportable transaction with a foreign or domestic related party. A reportable transaction is a transaction that is listed on the following parts of the Form 5472:

1) Any type of transaction listed on Part IV of the Form 5472 for which monetary consideration was the sole consideration paid or received during the corporation’s tax year.

2) Any transaction listed on Part V of Form 5472.

3) Any transaction or group of transactions listed in Part VI of Form 5472.

Given the importance of Part VI, V, and VI as to whether or not an entity is required to file a Form 5472, we now discuss extremely important subparts of the Form 5472.

Part IV- Monetary Transactions Between Reporting Corporations and Foreign Related Party

Part IV of Form 5472 is only required to be completed for transactions with foreign related parties. The following transactions with foreign related parties must be disclosed on Part IV of the Form 5472. Section 6038A(c)(2) defines a related party as (i) any 25% foreign shareholder of the reporting corporation, (ii) any person who is related (within the meaning of Section 267(b) or Section 707(b)(1) to the reporting corporation or to a 25% foreign shareholder of the reporting corporation, and (iii) any other person who is related to the reporting corporation within the meaning of Section 482. For purposes of measuring ownership, the attribution rules of Section 318 apply.

Under Section 267(b), two corporations are related if they are members of the same “controlled group.” A controlled group includes two or more corporations if, among certain other tests, five or fewer persons who are individuals own stock possessing (i) at least 50% of the total combined voting power of all classes of stock entitled to vote or at least 50% of the total value of shares of all classes of the stock of each corporation, and (ii) more than 50% of the total combined voting power of all classes of stock entitled to vote or more than 50% of the total value of shares of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation. Sections 267(f)(1) and 1563(a)(2). When determining ownership of stock for purposes of ascertaining whether there is a controlled group, an individual shall be considered as owning the stock owned, directly or indirectly, by his spouse (except under certain circumstances not relevant here) and minor children. Section 1563(e)(5) and (6). An individual who otherwise owns more than 50% of the total stock of a corporation, by vote or value, shall be considered as owning the stock in such corporation owned, directly or indirectly, by or for his parents, grandparents, grandchildren, and children who have attained the age of 21 years. Section 1563(e)(6)(B). Stock constructively owned by a person by reason of this rule shall not be treated as owned by him for the purposes of again applying this rule to make another the constructive owner of such stock. See IRC Section 1563(f)(2)(B).

In addition, under section 267(b)(2), an individual and a corporation are related if more than 50% in value of the outstanding stock of the corporation is owned, directly or indirectly, by or for such individual. For purposes of determining the ownership of stock in applying section 267(b), an individual shall be considered as owning the stock owned, directly or indirectly, by or for his family. Sections 318(a)(1) and 267(c)(2). Under section 318(a)(1), the family of an individual includes his spouse, children, grandchildren and parents. Section 267(c)(4) further includes in an individual’s family his siblings and all other ancestors and lineal descendants. Stock constructively owned by a person by reason of this rule shall not be treated as owned by him for the purposes of again applying this rule to make another the constructive owner of such stock. See IRC Sections 318(a)(5)(B) and 267(c)(5).

1. Platform Contributions

Any amounts received or paid in relation to platform contributions with a foreign related party must be disclosed on Part IV of the Form 5472.  A platform contribution or (“PCT”) is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible developed activity that is reasonably anticipated to contribute to developing cost sharing intangibles. The determination whether a resource, capability, or right is reasonably anticipated to contribute to developing cost shared intangibles is ongoing and based on the best available information.

A platform contribution transaction payment is not the equivalent of a licensing fee. Treasury Regulation Section 1.482-7(c)(4) provides:

“Certain make-or-sell rights excluded- (i) In general. Any right to exploit an existing intangible without further development, such as the right to make, replicate, license or sell existing products, does not constitute a platform contribution to a cost sharing agreement, and the arm’s length compensation for such rights (make-or-sell rights) does not satisfy the compensation obligation under a PCT. By definition, a PCT payment is not the equivalent of a licensing fee for an existing intangible, because a platform contribution transaction requires “further development” of the intangible. If the payment were made solely for the use of the existing intangible, without any further modification, it would not qualify as a PCT. “

Below, please see Illustration 1 through Illustration 3 which demonstrate examples of PCTs.

Illustration 1.

P and S, which are members of the same controlled group, execute a cost sharing agreement. Under the cost sharing agreement, P and S will bear their RAB shares of intangible development cost (“IDCs”) for developing the second generation of ABC, a computer software program. Prior to that arrangement, P had incurred substantial costs and risks to develop ABC. Concurrent with entering into the arrangement, P (as the licensor) executes a license with S (as the licensee) by which S may make and sell copies of the existing ABC. Such make-or-sell rights do not constitute a platform contribution to the cost sharing agreement.

The rules of Treasury Regulations Sections 1.482-1 and 1.482-4 through 1.482-6 must be applied to determine the arm’s length consideration in connection with the make-or-sell licensing arrangement. In certain circumstances, this determination of the arm’s length consideration may be done on an aggregate basis with the evaluation of compensation obligations pursuant to the PCTs entered into by P and S in connection with the cost sharing agreement.

Illustration 2.

P, a software company, has developed and currently exploits software program ABC. P and S enter into a cost sharing agreement to develop future generations of ABC. The ABC source code is the platform on which future generations of ABC will be built and is therefore a platform contribution of P for which compensation is due from S pursuant to a PCT. Concurrent with entering into the cost sharing agreement, P licenses to S the make-or-sell rights for the current version of ABC. P has entered into similar licenses with uncontrolled parties calling for sales-based royalty payments at a rate of 20%. The current version of ABC has an expected product life of three years. P and S enter into a contingent payment agreement to cover both the PCT Payments due from S to P’s platform contribution and payments due from S for the make-or-sell license. Based on the uncontrolled make-or-sell licenses, P and S agree on a sales-based royalty rate of 20% in Year 1 that declines on a straight line basis to 0% over the 3 year product life of ABC.

The make-or sell rights for the current version of ABC are not platform contributions, though paragraph Section 1.482-1(g)(2)(iv) of the regulations provides for the possibility that the most reliable determination of an arm’s length charge for the platform contribution and the make-or-sell license may be one that values the two transactions in the aggregate. A contingent payment schedule based on the uncontrolled make-or-sell licenses may provide an arm’s length charge for the separate make-or-sell license between P and S, provided the royalty rates in the uncontrolled licenses similarly decline, but as a measure of the aggregate PCT and licensing payments it does not account for the arm’s length value of P’s platform contributions which includes the rights in the source code and future development rights in ABC.

Illustration 3.

S is a controlled participant that owns Patent Q, which protects S’s use of a research tool that is helpful in developing and testing new pharmaceutical compounds. The research tool, which is not itself such a compound, is used in the cost sharing agreement activity to develop such compounds. However, the cost sharing activity is not anticipated to result in the further development of the research tool or in patents based on Patent Q. Although the right to use Patent Q is not anticipated to result in the further development of Patent Q or the technology that it protects, that right constitutes a platform contribution (as opposed to make-or-sell rights) because it is anticipated to contribute to the research activity to develop cost shared intangibles relating to pharmaceutical compounds covered by the cost sharing agreement.

2. Cost Sharing Transactions

Cost sharing transaction payments received and paid by a reporting corporation and a foreign related party must be reported on Part IV of the Form 5472. Treas. Reg. Section 1.482-7(a)(1) defines a cost sharing arrangement as an agreement for sharing costs of development of one or more intangibles in proportion to the participants’ shares of reasonably anticipated benefits (or “RAB”) from their exploitation of interests in any intangibles that are developed. If a “qualified cost sharing arrangement” exists, no Section 482 allocation of arm’s length royalties or equivalent payments can be made by the IRS. In other words, a cost sharing arrangement is an arrangement by which controlled participants share the costs and risks of developing cost shared intangibles in proportion to their reasonably RAB shares. An arrangement is a cost sharing agreement if and only if the requirements of Treasury Regulation Section 1.482-7(b)(ii) are satisfied.

3. Amounts Borrowed

The amounts borrowed from the foreign related party using either the outstanding balance method or monthly average method must be disclosed on Part IV of the Form 5472.

4. Amounts Loan

The amounts loaned to a foreign related party using either the outstanding balance method or monthly average method must be disclosed on Part IV of the Form 5472.

5. Interest Paid

The amounts of interest paid or accrued with a foreign related party must be disclosed on Part IV of the Form 5472. If the amount of interest paid or accrued is subject to the limitation of Section 163(i), the amounts reported on the Form 5472 should only reflect the amount of the deduction available. Section 163(j) limits the deductibility of interest expenses paid or accrued on debt properly allocable to a trade or business to the sum of business interest income, and 30% of the “adjusted taxable income.” For these purposes, a rough estimate of what adjusted taxable income will be earnings before interest and taxes (“EBIT”). Any deduction in excess of the limitation is carried forward and may be used in a subsequent year, subject to the limitations of Section 163(j).

6. Any Transactions that Involves the Exchange of Money

Any transaction that involves the exchange of money with a foreign related party must be disclosed on Part IV of the Form 5472.

Part V- Reportable Transactions of a Reporting Corporation That is a Foreign-Owned U.S. Disregarded Entity

Part V should only be completed if the so-called reporting corporation is a foreign owned disregarded entity that had any other transactions, as defined in Treasury Regulation 1.482-1(i)(7) (For purposes of Treasury Regulation Section 1.482-1(i)(7), a transaction means any sale, assignment, lease, license, loan, advance, contribution, or any other transfer in or a right to use any property (whether tangible or intangible, real or personal) or money, however such transaction is effected or not the terms of such transaction are formally documented) not already reported on Part IV of the Form 5472. These transactions include amounts paid or received in connection with the formation, dissolution, acquisition, and disposition of the entity, including contributions to, and distributions from the entity.

Part VI- Nonmonetary and Less-Than-Full Consideration Between the Reporting Corporation and the Foreign Related Party

Part VI should only be completed by a reporting corporation that had transactions with foreign related party that was for less than full consideration. If the related party is a foreign person, the reporting corporation must attach a schedule describing each reportable transaction. The description must include sufficient information so that the nature and approximate value of the transaction can be determined. The schedule should include the following:

1. Property Transferred

The schedule should include a description of all property transferred to the foreign related party (including monetary consideration), rights, or obligations transferred from the reporting corporation to the foreign related party.

2. Services Performed

The schedule should include a description of all services performed by the foreign related corporation for the foreign related party for the foreign related party by the reporting corporation as well as a reasonable estimate of the services performed.

Penalty for Failing to Timely File a Form 5472

A penalty of $25,000 will be assessed for any foreign owned LLC that is a disregarded entity of $25,000 if the Form 5472 filed late. The penalty also applies for failure to maintain records as required by the Regulations of Section 1.6038A-3. The regulations provide that a substantially incomplete Form 5472 constitutes a failure to file Form 5472. However, the IRS gives no guidance on what it considers to be a substantially incomplete form. If a disregarded entity is notified by the IRS of a failure to file a Form 5472 and the failure continues for more than 90 days after the notification by the IRS, an additional penalty of $25,000 can be assessed. There is the possibility of criminal penalties under Section 7203, 7206, and 7207 of the Internal Revenue Code for the failure to submit information or filing false or fraudulent information with the IRS.

Form 5472 Filing Requirements

Nonresidents and foreign entities that hold interests in disregarded entities must file a Form 5472 with the IRS. The Form 5472 must be submitted with a corporate tax return. There is also a need to maintain appropriate records. Treasury Regulation Section 1.6038A-3 provides that:

“Such records must be permanent, accurate, and complete, and must clearly establish income, deductions, and credits. This requirement includes records of the reporting corporation itself, as well as records of any foreign related party that may be relevant to determine the correct U.S. tax treatment of transactions between the reporting corporation and foreign related parties. The relevance of such records with respect to related party transactions shall be determined upon the basis of all the facts and circumstances.”

Among the types of transactions that require disclosure are sales, cost-sharing transactions payments, rents, royalties, leases, commissions, loans, and interest.

The Form 5472 requires an entry for the foreign taxpayer identifying (“FTIN”) of the owner of the disregarded entity. If the foreign-owned disregarded entity has, as a direct owner, a foreign disregarded entity, the direct owner of the foreign disregarded entity should be disclosed to the IRS. If the disregarded entity does not have an FTIN, “None” or “N/A” should be entered in the FTIN block.

Form 1120-F

Nonresidents that hold an interest in a disregarded entity must also firm a Form 1120-F annually. Nonresidents that fail to timely file a Form 1120F may be subject to additional penalties. The Form 1120-F must typically be electronically filed with the IRS. The IRS may however waive the electronic filing rules in certain cases. The IRS can assess an additional penalty for failing to timely file a Form 1120-F or filing an incorrect Form 1120-F with the IRS. The Form 1120–F is used to report income, gains, losses, deductions, credits, and for purposes of calculating U.S. income tax liability.

Conclusion

The Form 5472 is an incredibly difficult return. This article ambitiously attempts to summarize whether a disregarded entity has Form 5472 filing obligation with the IRS. Under certain circumstances the Internal Revenue Code exempts a reporting corporation from filing a Form 5472 if there were no reportable transactions of the types listed in Parts IV and VI, and, in the case of a foreign owned disregarded entity, they also have no reportable transactions of the type listed in Part V of the Form 5472. There are other circumstances in which the Internal Revenue Code may exempt a reporting corporation from filing a Form 5472 such as:

1) A U.S. person who controls the foreign-related corporation files a Form 5471 for the tax year at issue;

2) The related corporation qualifies as a foreign sales corporation for the tax year and files a Form 1120-FSC;

3) The foreign corporation does not have a permanent establishment in the United States under an applicable income tax treaty and timely files a Form 8833;

4) The foreign corporation’s gross income is exempt from taxation under Section 833 of the Internal Revenue Code;

5) Both the reporting corporation and the related party are not U.S. persons under Section 7701(a)(30) of the Internal Revenue Code;

Reporting corporations should consult with a qualified international tax attorney to determine if it has a Form 5472 filing obligation. Any reporting corporation that fails to timely file a correct Form 5472 may be subject to an annual penalty of $25,000. If the failure to file a correct Form 5472 with the IRS continues for more than 90 days after notification by the IRS, an additional $25,000 penalty will apply. This penalty applies with respect to each related party for which a failure occurs for each 30-day period.

Foreign owners of a disregarded entity may also have an obligation to file a Form 1120-F with the IRS. The Form 1120-F is a detailed eight-page return that requires detailed financial information regarding the foreign owned disregarded entity in order to determine its U.S. tax liability. The IRS estimates that it may take over 70 hours to prepare a Form 1120-F. Given the complexity of the Form 1120-F, foreign owners of a disregarded entity should consult with an international tax attorney regarding the preparation of this form.

Anthony Diosdi is an  international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or [email protected].

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.