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By Thomas St.G. Bissell
The IRS finalized its new Form 8938 ("Statement of Specified Foreign Financial Assets") in December and issued supporting temporary and proposed regulations, giving thousands of U.S. individuals who must file the form ample time to comply with the 2010 HIRE Act's §6038D reporting requirements.1 Unfortunately, neither the form's instructions nor the regulations clarify some of the basic rules underlying §6038D, and as a result it is likely that substantial underreporting will result on the part of many individuals with foreign financial accounts and that substantial overreporting will result on the part of many individuals with U.S. financial accounts.
Section 6038D was part of Congress' response to a highly publicized series of events in which several foreign financial institutions assisted U.S. owners of U.S. securities to reduce or avoid U.S. federal income tax on income from those securities by holding them in offshore custodial accounts. Congress chose to deal with this problem from two directions - first, by imposing a potential new 30% U.S. withholding tax on income from U.S. securities (including gross proceeds from the sale of those securities) held by a "foreign financial institution" for the benefit of either U.S. or foreign customers,2 and second, by imposing under §6038D an annual information reporting requirement (backed up by severe penalties) on certain U.S. individuals who own either U.S. or foreign securities through a foreign brokerage account or similar foreign custodial account.3
The new §6038D reporting rules took effect for most individuals starting with the 2011 taxable year. A U.S. individual (generally, a U.S. citizen or a §7701(b) "resident alien") must file Form 8938 as an attachment to his 2011 federal income tax return (Form 1040) if he owns "specified foreign financial assets" (SFFAs) whose value exceeds certain threshold amounts on the last day of the year or at any time during the year. An unmarried U.S. individual living in the United States must file Form 8938 if the value of his SFFAs is more than $50,000 on the last day of the year or more than $75,000 at any time during the year, but higher thresholds apply for other categories of individuals (based on marital status, and whether the individual lives in the United States or abroad). Severe penalties can be imposed for failure to file the form (or for failure to file an accurate form), in addition to an extension of the statute of limitations for the IRS to audit the return and impose income taxes.4
To understand the scope of §6038D - and the confusion that the Instructions to Form 8938 are likely to cause - it is helpful to consider three different categories of investments by U.S. individuals. Reporting is required for two of these categories, provided that the dollar thresholds are met, but not for the third category. As noted above, information reporting is required if the U.S. individual owns SFFAs that exceed certain dollar thresholds, but not if the value of his SFFAs falls below those thresholds.
The three relevant categories are:
1. Any "financial account" that is "maintained by" a foreign financial institution (FFI) is classified as an SFFA under §6038D(b)(1). It is unfortunate that the statute uses the term "maintained by," when what is really meant is "maintained by the U.S. individual at" (or "in" or "with") an FFI. The Joint Committee Report is much clearer, stating that SFFAs include "depository or custodial accounts at foreign financial institutions …" (emphasis added). This first category includes all assets that are held for the benefit of the U.S. individual in a depository or custodial account at an FFI, whether the assets in the account are U.S. securities, foreign securities, or a combination of the two.
2. Section 6038D(b)(2) describes three kinds of investments that are also classified as SFFAs, to the extent that the particular assets are "not held in an account maintained by a financial institution." In effect, therefore, to the extent that any of these investments are owned directly by the U.S. individual and not held in a depository or custodial account at either a U.S. financial institution or a foreign financial institution (i.e., an FFI), they are SFFAs and are potentially required to be reported. The three kinds of investments that are described in §6038D(b)(2) are: (A) any stock or security issued by a non-U.S. person; (B) certain financial instruments held for investment where the issuer or counterparty is not a U.S. person; and (C) any interest in a "foreign entity" as described in §1473(5) (a category that includes direct investments by the individual in foreign partnerships - such as foreign hedge funds and foreign private equity partnerships - and other kinds of investments in foreign entities that are not classified as foreign-issued stock or securities within the meaning of (A)). It is noteworthy that while the thrust of the HIRE Act was to enable the IRS to obtain information about securities held by U.S. individuals in offshore financial accounts, i.e., securities described in the "first category" described above, Congress decided that the new reporting requirement should include not only securities held in a U.S. individual's custodial accounts at an FFI, but also foreign investment assets owned directly by U.S. individuals without any involvement by an FFI.
3. The third category - those investment assets that are not SFFAs, and thus not reportable - are not specifically mentioned in either §6038D or in the Joint Committee Report, but because they are not included within the statutory definition of the term "SFFA," they are clearly excluded from the definition. By reading §6038D(b)(1) and (2) together, it is clear that this category of non-reportable assets includes all investment assets that are "held in an account maintained by a financial institution" that is not a foreign financial institution. Thus, to the extent that a U.S. individual owns either U.S. or foreign investment assets in a depository or custodial account with a U.S. financial institution, those assets are not required to be reported on Form 8938. Accordingly, if a U.S. individual owns foreign securities whose value exceeds the relevant dollar thresholds and holds those securities in a custodial account with a U.S. financial institution, neither the securities nor the account itself is required to be reported on Form 8938.5
The Instructions to Form 8938 and the regulations are very explicit that potential reporting (subject to the dollar thresholds) is required for the second category - foreign investment assets that are owned directly and not held in a depository or custodial account at either a U.S. or foreign financial institution. They are not at all clear, however, concerning the rules that apply in the first and third categories, primarily because they retain the very convoluted structure of the statutory language in §6038D itself. Thus, the instructions do not expressly state that a U.S.
individual who owns U.S. securities that are held in a custodial account with a foreign financial institution (FFI) is potentially required to report information about the account on Form 8938, even though the individual may be reporting all of the income from those securities on his U.S. individual income tax return (Form 1040). This result is certainly implicit in the instructions and the regulations, but they require a very careful reading of several different paragraphs in combination with one another.
Similarly, the instructions do not expressly state that a U.S. individual who owns foreign securities in a custodial account with a U.S. financial institution is not required to report those securities, or information about the account. Again, this result is certainly implicit in the instructions and the regulations, but they also require a careful reading of several different paragraphs in combination.
This oversight on the part of the IRS would not be so important were it not for the fact that failure to file an accurate Form 8938 carries with it a potential $10,000 penalty, increasing by as much as $50,000 more in certain circumstances.6 The penalty may be imposed even though all income from the unreported securities is reported as gross income on the individual's tax return. The risk of incurring the penalty is particularly high for those U.S. individuals who mistakenly assume - in the absence of explicit IRS instructions - that a custodial account with an FFI need not be reported if it holds only U.S. securities, or that the value of the account (if it is reported) should only reflect the non-U.S. securities in the account.
In the reverse situation - erroneous filing of Form 8938 by a U.S. individual to report an account with a U.S. financial institution that holds foreign securities - there is no penalty risk because the form need not be filed at all. If the individual prepares his own Form 8938, however, he will waste a good deal of time in preparing it, and if his tax return preparer completes the form, in most cases the taxpayer will also incur an unnecessary out-of-pocket expense.
How serious is the risk that underreporting of "category 1" SFFAs will occur and that unnecessary reporting of "category 3" accounts will occur? Given the complexity of the Instructions - the "Who Must File" section alone takes up almost three pages - it can be expected that both errors will occur with significant frequency if a U.S. individual prepares his own return, or if his tax return preparer is not a firm that specializes in international taxpayers and investments.
What would reduce these two risks? Certainly a clear set of concrete examples, in the form of "Frequently Asked Questions" (a format that the IRS has been using quite effectively in recent years to clarify complex tax rules), but also incorporation of those examples into the instructions themselves.
There are additional points of criticism that can be leveled at the drafters of the instructions and the regulations - particularly the requirement that certain accrued foreign pension plan participation and deferred compensation benefits be reported on Form 8938. Those issues will be discussed in one or more subsequent commentaries.
Although information that is also being reported on other IRS forms for the same taxable year is generally not required to be reported on Form 8938,7 both the instructions and the regulations make clear that any information that is reported on the Treasury Department's "FBAR" form (Form TD F 90-22.1, "Report of Foreign Bank and Financial Accounts") may also be required to be reported on Form 8938, if it falls within the scope and definitions of §6038D. For example, if the applicable rules require that a taxpayer's particular foreign securities account be reported on an FBAR and also on Form 8938, both forms must be filed.8
This commentary also will appear in the March 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Blum, Canale, Hester, and O'Connor, 947 T.M., Reporting Requirements Under the Code for International Transactions, and in Tax Practice Series, see ¶7170, International Withholding and Reporting Requirements.
1 Section 6038D was enacted by §511(a) of the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147. The temporary and proposed regulations were published in T.D. 9567 and REG-130302-10.
2 §§1471-1474, enacted by §501(a) of the HIRE Act. For a detailed discussion of these rules, see Tello, 915 T.M., Payments Directed Outside the United States - Withholding and Reporting Provisions Under Chapters 3 and 4, XXIX.
3 These new rules were intended to reduce the possibility that U.S. individuals could reduce or avoid paying the correct amount of federal income tax on their U.S. and/or foreign securities in the future. With respect to U.S. individuals who had neglected to report the correct amount of income from their U.S. and/or foreign securities in the past, the IRS initiated an "offshore voluntary disclosure initiative" (OVDI) to encourage U.S. taxpayers with unreported income to voluntarily apply to the IRS so as to potentially reduce the penalties that otherwise applied to their situation. The IRS's third OVDI program was announced on Jan. 9, 2012. See IR-2012-5.
4 Sections 6229(c) and 6501(e)(1), as amended by §513 of the HIRE Act.
5 The three categories just described do not include all securities that might be owned by a U.S. individual. A "fourth category" would include "everything else" - i.e., U.S. securities owned directly by the individual. Thus, categories 1 and 3 include all securities (both U.S. and foreign) that are held in a custodial account (with either a foreign or a U.S. financial institution), category 2 includes all foreign securities owned directly, and "category 4" includes all U.S. securities owned directly. A "matrix" with these four categories would include all securities worldwide that a U.S. individual might own. Because it is extremely unlikely that a U.S. individual or his tax return preparer would mistakenly assume that securities in "category 4," i.e., U.S. securities owned directly, might have to be reported on Form 8938, this category is not discussed further in this commentary.
7 Form 8938 expressly states that if information is being provided to the IRS on Forms 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts), 3520-A, 5471 (Information Return of U.S. Persons With Respect To Certain Foreign Corporations), 8621 (Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund), 8865 (Return of U.S. Persons With Respect To Certain Foreign Partnerships), or Form 8891 (U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans), it is not also required to be reported on Form 8938. See also Regs. §1.6038D-7T.
8 See Bruce, "FBAR and FATCA Foreign Financial Assets Reporting: Seeing Double? Not Really," 246 Bloomberg BNA Daily Tax Rpt., J-1 (12/22/11).
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