By Lynn K. Ching
Certain U.S. taxpayers are required to file an annual report with the Internal Revenue Service (IRS) on Form 5471, with respect to specified interests and transactions related to their ownership in foreign corporations. Form 5471 has long been regarded as one of the most difficult and complex U.S. offshore reporting forms to complete. After the passage of the ‘Tax Cuts and Jobs Act’ of 2017, and the addition of new schedules and worksheets, the time, effort, and expertise required to complete Form 5471 multiplied for many taxpayers.
Moreover, the penalty for submitting an incomplete or inaccurate Form 5471 is not insignificant. Under IRC § 6038, 6038A and related regulations, U.S.taxpayers who are required to file the Form 5471 may be subject to a penalty of $10,000 if the form is not ‘substantially complete’. An additional penalty not to exceed $50,000 may also be assessed if the Form 5471 issues are not resolved within the requisite time period after notice from the IRS.
The foregoing begs the question, “What is ‘substantially complete’ for purposes of Form 5471 and avoiding the IRS’ $10,000 + penalty?
Although not binding legal precedent, the IRS’ guidelines to its auditors, as set forth in the IRS’ International Practice Unit (IPU), provide valuable insight as to how the IRS’ views the ‘substantially complete’ issue with respect to Form 5471 (and 5472).
Form 5471 Facial Errors Deemed Substantially Incomplete
Based on the IRS’ IPU of October 2015, a Form 5471 will be deemed substantially incomplete/non-compliant under IRC § 6038 if it contains certain facial errors as set forth below:
- The Category of Filer is incorrect;
- The total percentage of the foreign corporation’s voting stock is incorrect or omitted;
- Failure to attach any required schedules;
- Failure to attach required financial statements; and
- The name and address of the foreign corporation is omitted or other information provided cannot be associated with a specific foreign corporation.
The Form 5471 May Be Substantially Incomplete/Non-Compliant Even if Most of the Form 5471 Information Is Correct
Field Service Advisory (FSA) 3338143 warns that a taxpayer may still be subject to the IRC § 6038 penalty even if the majority of the information is reported accurately and completely on the Form 5471 (or Form 5472).
In this FSA, the U.S. taxpayer accurately reported the majority of the information on the Form 5471, but failed to accurately report certain major transactions with related parties. The FSA concluded that the U.S. taxpayer did not substantially comply with the IRC §6038 reporting requirements.
The Form 5471 May be Substantially Incomplete if Taxpayer Over-Reports Numbers, Reports Inaccurate Data or Provides Data Not Required
In Chief Counsel Advisory (CCA) 200429007, the U.S. taxpayer was a reporting corporation which timely filed Form 5472 for transactions with its Parent Corporation for the tax years at issue. All information required by Treas. Reg. 1.6038A-2(b)(1) and (2) was included on the Form 5472 and estimates were not used. However, some transactions were erroneously reported.
CCA 200429007 examined four situations and concluded all were substantially incomplete/non-compliant:
- Over-reporting: Taxpayer’s over-reporting of Purchases of Stock In Trade (which were reported as $1000X but should have been reported as $500X) will likely result in the Form 5472 being “substantially incomplete” under Treas. Reg. 1.6038A-4(a)(1). The CCA noted that the magnitude of this over-reporting is substantial because the overstatement is 50% of the transaction type ($500X of $1,000X).
- Providing Reporting Data Not Required: In a situation where a taxpayer reports amounts of intercompany trade receivables not specifically required to be reported on Form 5472, and later corrects the Form 5472 to remove these amounts from the Form 5472, the originally filed Form 5472 was rendered ‘substantially incomplete’.
- Mismatched Data: Where the amount reported on Form 5472 as the ending balance of related party loans does not match the opening balance on the next year’s Form 5472 for that party, this mismatch will render the Form 5472 ‘substantially incomplete’.
- Small Net Error: Where a taxpayer’s over-reporting of one amount and underreporting of another amount in Part IV of Form 5472 resulted in a minimal net change, the Form 5472 was still found ‘substantially incomplete’.
Form 5471 Found Substantially Incomplete For Failure to Use ‘Generally Acceptable Accounting Principles’ (GAAP) and Failure to Convert to U.S. Dollars
Chief Counsel Advisory 200645023: In this case, U.S. taxpayer, a corporation, failed to attach Schedule O’s to all but one of the Forms 5471 (several 5471’s were required). The taxpayer also failed to prepare, translate and report the Form 5471 in U.S dollars and in accordance with U.S. Generally Accepted Accounting Principles (GAAP)
The CCA concluded that the taxpayer did not substantially comply with the IRC 6038 reporting requirements.
Conclusion: Based on the foregoing, taxpayers may be subject to the IRC § 6038 penalty for seemingly minor inaccuracies. Whether future litigation on the substantial compliance issue will provide relief to U.S. taxpayers required to file the Form 5471, remains to be seen.
Lynn K. Ching is a partner and attorney at Diosdi Ching & Liu, LLP located in San Francisco, California. Lynn may be reached at (415) 318-3990 or by email: lching@sftaxcounsel.com.
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.