By Anthony Diosdi
In order to effectively audit the transfer prices used by a U.S. subsidiary of a foreign corporation, the Internal Revenue Service (“IRS”) often must examine the books and records of the foreign parent corporation. Historically, foreign parties have resisted making their records available to the IRS, or have not maintained records sufficient to determine arm’s length transfer prices. In response, Congress enacted the requirement that each year certain reporting corporations must file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, and maintain certain records. See IRC Sections 6038A and 6038C. A domestic corporation is a reporting corporation if, at any time during the taxable year, 25 percent or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. A foreign corporation is a reporting corporation if, at any time during the taxable year, it is engaged in a U.S. trade or business, and 25 percent or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. See Treas. Reg. Section 1.6038A-1(c). In filing a Form 5472, the reporting corporation must provide information regarding its foreign shareholder, certain other related parties, and the dollar amounts of the transactions that it entered into during the taxable year with foreign related parties. See Treas. Reg. Section 1.6038A-2(b). A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation engaged in reportable transactions during the year. See Treas. Reg. Section 1.6038A-2(a). Anyone completing a Form 5472 must understand the importance of this form and the fact that the IRS often uses the Form 5472 as a starting point for conducting a transfer pricing examination.
The information required to prepare a Form 5472 is as follows:
1. The name and address of the reporting corporation, and its employer identification number.
2. Identification of the foreign stockholder of the reporting corporation, including the country of organization, the countries where it conducts business, and countries where it files its income tax returns.
3. Identification of the related party with which the reporting corporation is conducting reportable transactions, including its name and address, principle business activity, the countries in which it conducts business, and the countries in which it files income tax returns.
4. Information about non-monetary transactions between the reporting corporation and the related party, describing the substance and the size of the transaction or group of transactions, with an estimate of the fair market value, or nature or importance of any non-monetary value transferred.
We will next review the Form 5472 line-by line.
Part 1 Reporting Corporation
Line 1a. Name of Reporting Corporation
For Line 1a, the preparer should state the name of the reporting corporation and its address.
Line 1c. Total Gross Assets
For Line 1c, the domestic reporting corporation should enter its total assets from item D, page 1, Form 1120. Foreign reporting corporations enter the amount from line 17, column (d), Schedule L, Form 1120-F.
Lines 1d and 1e. Principal Business Activity and Principal Business Activity Code
For Lines 1d and 1e, the preparer should enter a description of the principal business activity and enter the principal business activity code. A list of business activity codes can be found in the instructions for Form 1120 or Form 1120-F instructions.
Line 1f. Total Value
For Line 1f, the preparer must enter the total value in U.S. dollars of all foreign related party transactions reported in Parts IV and VI of this Form 5472. This is the total of the amounts entered on lines 13 and 26 of Part IV plus the fair market value of the nonmonetary transactions reported in Part VI. For purposes of Form 5472, related parties include the 25 percent foreign owner and any party related to the reporting corporation or the 25 percent foreign owner, using the affiliation rules of Internal Revenue Code Sections 318, 267(b), 707(b)(1), and 482.
Line 1g. Total Number of Form 5472 Filed for the Tax Year
For Line 1g, the preparer must state the number of Form 5472s being filed for the year on behalf of the reporting corporation.
Line 1h. Total Value of Gross Payments Made or Received
For Line 1h, the preparer must enter the total value in U.S. dollars of all foreign-related party transactions reported in Part IV and VI of all Form 5472 filed for the tax year.
Line 1j. Countries Under Whose Laws the Reporting Corporation Files an Income Tax Return as a Resident
For Line 1j, the preparer should check the box if this is the initial year for which the U.S. reporting corporation is filing a Form 5472.
Line 1k. Country of Incorporation
For Line 1k, the preparer should state the country the reporting corporation is incorporated.
Line 1l. Country Under Whose Laws the Reporting Corporation Files an Income Tax Return as a Resident
For Line 1l, the preparer must state the country or countries whose laws the reporting corporation files an income tax return as a resident.
Line 1m. Principal Countries Where Business is Conducted
For Line 1m, the preparer must provide the principal countries where business is conducted. The preparer should not list any countries in which business is conducted solely through a subsidiary.
For Line 2, the preparer should check the box if at any time during the tax year the reporting corporation if a “foreign person” had a 50 percent direct or indirect ownership (applying the constructive ownership rules of Section 318) in the reporting corporation.
For Line 3, the preparer should check the box if the reporting corporation is a disregarded entity for U.S. tax purposes.
Part II. 25 Percent Foreign Shareholder
Lines 1a through 1e. Information About 25 Percent Direct Foreign Shareholders
For Lines 1a through 1e, the preparer should provide basic information regarding the direct 25 percent foreign shareholders of the reporting corporation.
Lines 2a through 2e. Information About 25 Percent Direct Foreign Shareholders
For Lines 2a through 2e, the preparer should provide basic information regarding the direct 25 percent foreign shareholders of the reporting corporation.
Lines 3a through 3e. Information About 25 Percent Indirect Foreign Shareholders
For Lines 3a through 3e, the preparer should provide basic information regarding the ultimate indirect foreign shareholders of the reporting corporation.
Lines 4a through 4e. Information About Ultimate Indirect 25 Percent Foreign Shareholders
For Lines lines 4a through 4e, the preparer should provide basic information regarding the ultimate indirect foreign shareholder of the reporting corporation.
Part III. Related Party
All reporting corporations must complete Part III of Form 5472. The preparer must also check the boxes next to “Part III” to notify the IRS if the subsection of the form is being prepared for a “foreign person” or a “U.S. person.”
Line 1a. Name and Address of Related Party
For Line 1a, the related parties name and address must be stated.
Line 1b(1). U.S. Identifying Number
For line 1b(1), the preparer must enter the related party’s U.S. identifying number, if any.
Line 1b(2). Reference ID Number
For Line 1b(2), the preparer should enter the related party’s U.S. reference number, if required. A reference ID number is required only in cases where no U.S. identifying number was entered for the foreign related party on line 1b(1).
Line 1b(3). Foreign Taxpayer Identification Number
For Line 1b(3), the preparer should enter the Foreign Tax Identification Number (“FTIN”) of the reporting corporation.
Line 1c. Principal Business Activity
For Line 1c, the preparer should state the principal business activity of the reporting corporation.
Line 1d. Principal Business Activity Code
For Line 1d, the preparer should enter the principal business activity code of the reporting corporation.
Line 1e. Relationship
For Line 1e, the preparer should check the boxes that apply.
Line 1f. Principal Country(ies) Where Business is Conducted
For Line 1f, the preparer should enter the principal country(ies) where business is conducted.
Line 1g. Country (ies) Under Whose Laws the Related Party Files an Income Tax Return as a Resident
For Line 1g, the preparer should enter the country(ies) whose laws the related party files an income tax return as a resident.
Part IV Monetary Transactions Between the Reporting Corporations and Foreign Related Party
Part IV must be completed if the “foreign person” box is checked in the heading for Part III. If estimates are used, the preparer should check the box next to “Part IV” of the form.
For Line 1, the preparer must report the payments received and paid from the sale of stock in trade (inventory) between the reporting corporation and a foreign related party.
For Line 2, the preparer must report the payments received and paid from the sale of tangible property other than stock in trade between the reporting corporation and a foreign related party.
Lines 3 and 16.
For Lines 3 and 16, the preparer must report platform contribution transaction payments received and paid by the reporting corporation (without giving effect to any netting of payments due and owed. The questions for Lines 3 and 16 ask the preparer to report platform contribution payments received from a foreign related party and platform contribution payments made to a foreign related party. Platform contribution transactions almost always involve cost sharing arrangements. In the context of a cost sharing arrangement, Treasury Regulation Section 1.482-7(c)(1) defines a platform contribution to be “any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to an intangible development activity that is reasonably anticipated to contribute to developing cost shared intangibles.”
Lines 4 and 17.
For lines 4 and 17, the preparer is required to report cost-sharing transaction payments received and paid by the reporting corporation (without giving effect to any netting of payments due and owed). The corporation is required to complete line 4 only if the corporation itself incurred intangible development costs. If the corporation does not itself incur intangible development costs, then it should only report cost-sharing transaction payments made on line 17.
Line 9. Amounts Borrowed
For line 9, the preparer should report amounts borrowed using either the outstanding balance method or the monthly average method. If the outstanding balance method is used, the preparer should enter the beginning and ending outstanding balance for the tax year on lines 9a and 9b. If the monthly average method is used, skip line 9a and enter the monthly average for the tax year on line 9b.
Line 12. Other Amounts Received
For line 12, the preparer should enter amounts received that are not specifically reported on lines 1 through 11. The preparer should include amounts on line 12 to the extent that these amounts are taken into account in determining the taxable income of the reporting corporation.
Line 23. Interest Paid
For line 23, the preparer must report the amount of interest paid or accrued. If the amount of interest paid or accrued is subject to the limitation of Section 163(j), the preparer should report only the amount allowed as a deduction under that section.
The preparer should keep in mind that controlled entities generally must charge each other an arm’s length rate of interest on any intercompany loans or advances. See Treas. Reg. Section 1.482-2(a)(1)(i). There is an exception, however, for intercompany trade receivables, which are debts that arise in the ordinary course of business and are not evidenced by a written agreement requiring the payment of interest. See Treas. Reg. Section 1.482-2(a)(1)(iii)(A).If the controlled borrower is located outside the United States, it is not necessary to charge interest on an intercompany trade receivable until the first day of the fourth month following the month in which the receivable arises. See Treas. Reg. Section 1.482-2(a)(1)(iii)(C). If the controlled borrower is located within the United States, the interest free period extends to the first day of the third month following the month in which the receivable arises. See Treas. Reg. Section 1.482-2(a)(1)(iii)(B).
Longer inter free periods are possible if the controlled lender ordinarily allows unrelated parties a longer interest-free period or if a controlled borrower purchases the goods for resale in a foreign country and the average collection period for its sales is longer than the interest free period. See Treas. Reg. Section 1.482-2(a)(1)(iii)(D). Intercompany debt other than a trade receivable generally must bear an arm’s length interest charge. See Treas. Reg. Section 1.482-2(a)(1)(i). To determine the arm’s length rate, the reporting corporation must consider all relevant factors, including the amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender for comparable loans between the uncontrolled parties. See Treas. Reg. Section 1.482-2(a)(20(i). If an arm’s length rate is not readily determinable, the reporting corporation can still protect itself against an IRS adjustment by satisfying the requirement of a safe-harbor provision. Under this safe harbor, an interest rate is deemed to be an arm’s length if it is between 100 percent and 130 percent of the applicable federal rate. See Treas. Reg. Section 1.482-2(a)(2)(iii)(B). The applicable federal rate is the average interest rate (redetermined monthly) on obligations of the federal government with maturities similar to the term on the intercompany loan. See IRC Section 1274.
Line 24. Premiums for Insurance or Reinsurance
For line 24, the preparer should enter the amounts paid between the reporting corporation and a foreign related party for insurance or reinsurance.
Line 25. Other Amounts Paid
For line 25, the preparer should enter the amounts paid that are not specifically reported on lines 14 through 24. The preparer should include the amounts taken into account in determining taxable income of the reporting corporation.
Part V. Reportable Transactions of a Reporting Corporation
For Part V, the preparer must check the box if the reporting reporting corporation
Is a foreign-owned disregarded entity that had any other transactions as defined by Treasury Regulation Section 1.482-1(i)(7) not already entered on Part IV. 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. These transactions must be described on an attachment to the Form 5472.
Part VI. Nonmonetary and Less-Than Full Consideration Transactions Between the Reporting Corporation and the Foreign Related Party
The preparer must check the box for Part VI and attach a description to Form 5472 if the related party is a foreign person or foreign corporation. If there are transaction(s) between the reporting corporation and a foreign related party that is non monetary or less-than full consideration, the attachment must include the following description:
1. A description of all property (including monetary consideration), rights, or obligations transferred to the foreign-related party and from the foreign-related party to the reporting corporation.
2. A description of all services performed by the reporting corporation for the foreign-related party and by the foreign-related party for the reporting corporation; and
3. A reasonable estimate of the fair market value of all properties and services exchanged, if possible, or some other reasonable indicator or value.
Part VII. Additional Information
Line 1. Does the reporting corporation import goods from a foreign related party?
Line 1 calls for a “Yes” or “No” answer. In order to answer this question, the term “foreign related party” must be defined. A related party is any party that is related to the reporting corporation or the 25 percent foreign owner, using the affiliation rules of Internal Revenue Code Sections 318, 267(b), 707(b)(1), and 482.
If the preparer answered “Yes” to Line 1 of Part VII, the preparer must state “Yes” or “No” if the basis or inventory cost of the goods are valued greater than the customs value of the imported goods.
If the preparer answered “Yes” to Line 2b, the preparer must attach a statement to the Form 5472 explaining the difference. When preparing this attachment, the preparer must keep in mind Section 1059A of the Internal Revenue Code. Section 1059A provides that property imported into the United States in a transaction that is, directly or indirectly, between related persons will have a cost or inventory basis not greater than the “custom value” of the property. The customs value is the amount used to determine customs and other duties imposed on the import of the property. Section 1059A effectively establishes the maximum cost that the related party may use for tax purposes. Note that the reporting corporation may use a tax cost that is less than the customs value if it satisfies the requirements of Section 482. See Treas. Reg. Section 1.1059A-1(c)(1).
If the preparer answered “Yes” to questions 1 and 2a, the preparer must answer “Yes” or “No” if documents were used to support the treatment of the imported goods and if the documents are available for inspection by the IRS.
Line 3 asks if during the tax year was the foreign parent corporation a participant in any cost-sharing arrangement? The question calls for a “Yes” or “No” answer. The question calls for a “Yes” or “No” answer.
In order to answer Line 3, the preparer must know the definition of a “cost sharing arrangement” for U.S. tax purposes. In general, a cost sharing arrangement is an agreement between two or more persons to share the costs and risks of research and development as they are incurred in exchange for a specified interest in any intangible property that is developed. The preparer should keep in mind that that although the IRS permits cost sharing arrangements, it expects them to produce results consistent with the purpose of the commensurate-with-income standards in Section 482- i.e., that the “income allocated among the parties reasonably reflect the actual economic activity undertaken by each.” See H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-638 (1986).
The regulations provide that no reallocation under Section 482 will generally be made with respect to a “qualified cost sharing arrangement” except for assuring that the parties to the arrangement bear shares of the costs of developing the intangible property equal to their shares of reasonably anticipated benefits. See Treas. Reg. Section 1.482-7(a)(2). Certain requirements must be met if the cost sharing agreement is to be treated as “qualified.” The agreement must be in writing and must reflect a sharing of the costs of developing intangibles based upon the participants’ respective shares of anticipated benefits from exploiting them. It must provide for adjustments to account for changes in economic conditions, business operations and practices and the ongoing developments of intangibles.
Line 4 asks if during the tax year, did the foreign parent corporation become a participant in any cost-sharing arrangements. This question calls for a “Yes” or “No” answer.
Line 5a asks if during the tax year, did the reporting corporation pay or accrue any interest or royalty, to the related party, for which the deduction is not allowed under Section 267A? This question calls for a “Yes” or “No” answer. In order to answer this question, Internal Revenue Code Section 267A must be defined. Section 267A disallows deductions for “disregarded payment” of interest or royalties to a related person. Under the proposed regulations, “disregarded payments” are interest and royalty payments that are not taxable income to the recipient. Specifically, Section 267A includes payments that: 1) are not considered received by the recipient under the tax law of the recipient’s home country; and 2) that would be deductible to the recipient.
When Section 267A applies, the deduction generally is disallowed to the extent the related party does not include the amount in income or is allowed a deduction with respect to the amount. However, the deduction is not disallowed to the extent the amount is included in the gross income of a U.S. shareholder under Section 951(a).
If question 5a was answered “Yes,” the preparer must state the amount of the disallowed deduction.
Line 6a asks the preparer to state whether or not the reporting corporation claimed a foreign-derived intangible income (“FDII”) deduction (under Section 250) with respect to the amounts listed in Part IV?
FDII is determined as follows: First, a corporation’s gross income is determined and then reduced by certain items of income, including subpart F income, dividends received from controlled foreign corporations, and income earned from foreign branches. This amount is reduced by deductions allocable to such income. After applicable deductions are utilized, the deduction eligible income (FDDEI”) is determined. Second, the foreign portion of such income is determined. This amount includes any income derived from the sale of property to any foreign person for foreign use. Third, the corporation’s deemed intangible income is determined. This is the excess of the corporation’s deduction eligible income over 10 percent of its qualified business asset investment (“QBAI”). A corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation.
The FDII calculation is expressed by the following formula:
FDII=Deemed Intangible Income x Foreign-Derived Deduction Eligible Income Deduction Eligible Income
Domestic corporations are allowed to deduct 37.5 percent of its FDII under Internal Revenue Code Section 250. The preparer is required to state in Line 6a, the Section 250 deduction of FDII income.
Line 6b asks the preparer to enter the FDDI gross income derived from sales, leases, exchanges, or other dispositions (but not licenses) of property to the foreign related party that the reporting corporation included in its computation of FDDEI is discussed in the explanation for Line 6a.
Line 6c asks the preparer to list any FDDEI income derived from a license of property to a related foreign party.
Line 6d asks the preparer to list any FDDEI income derived from services provided to a foreign related party.
Part VIII. Base Erosion Payments and Base Erosion Tax Benefits Under Section 59A
Line 1. Amounts defined as base erosion payments under Section 59A(d).
Line 1 asks the preparer to enter the amount of base erosion payments made by the reporting corporation (if any). The 2017 Tax Cuts and Jobs Act introduced Internal Revenue Code Section 59A otherwise known as base erosion and anti-abuse tax (“BEAT”). This code section was designed to prevent base erosion in the crossborder context by imposing a type of alternative minimum tax, which is applied by adding back to taxable income certain deductible payments, such as interest and royalties, made to related foreign persons. Section 59A applies to C corporations with gross receipts of at least $500 million over a three-year testing period and a “base erosion percentage” of at least 3 percent. See IRC Section 59A(C)(4)(A). (A 2 percent threshold applies to banks and registered securities dealers). The base erosion minimum tax is the excess of 10 percent of the corporation’s modified taxable income over its regular tax liability. (The percentage is one percent higher for banks and registered securities dealers).
For purposes of completing Line 1, the term base erosion payment generally means any amount paid or accrued by the reporting corporation or a foreign person, which is related party and with respect to which a U.S. deduction is allowed. Base erosion payments also include amounts paid or accrued by the reporting corporation to the foreign related party in connection with the acquisition of depreciable or amortizable property, certain reinsurance payments, and certain payments to expatriated entities. If applicable, for Line 1, The preparer should enter any base erosion payments.
Line 2. Amount of base erosion tax benefits under Section 59A(c)(2).
For Line 2, the preparer must enter the amount of the base erosion tax benefits under Section 59A(c)(2). The term base erosion tax benefit generally means any permissible U.S. deduction. The term base erosion tax benefit also includes certain reductions in gross premiums with respect to certain reinsurance payments. If applicable, the preparer should enter on Line 2 any base erosion tax benefits.
Line 3. Amount of total qualified derivative payments as described in Section 59A(h) made by the reporting corporation.
For Line 3, the preparer must enter the total qualified derivative payments. The term qualified derivative payment generally means any payment made by a taxpayer according to a derivative with respect to which the taxpayer: 1) recognizes gain or loss as such derivative were sold for its fair market value on the last business day of the taxable year; 2) treats any gain or loss so recognized as ordinary; and 3) treats the character of all items of income, deduction, gain, or loss with respect to a payment according to the derivative as ordinary. If applicable, on Line 3, the preparer should enter the total qualified derivative payments discussed above.
Completing Form 5472 is extraordinarily complex. In addition, the Internal Revenue Code requires a reporting corporation to keep extensive records of the related parties and all transactions (including those with unrelated parties). The type of records that must be maintained include not only all the usual accounting records, but also records concerning pricing of transactions with related parties. The failure to file a Form 5472 or to maintain records is $25,000. If such failure continues for more than 90 days after notification by the IRS, an additional $25,000 penalty may be assessed for each 30-day period or fraction thereof.
If you or your company is required to file a Form 5472 or the Form 5472 that you filed is being audited by the IRS, you should consult with an attorney well versed in international tax planning and compliance. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.