By Thomas St.G. Bissell
This author's most recent commentary outlined the IRS's requirement that participation in most types of foreign-based deferred compensation plans be reported by U.S. individuals on Form 8938, provided that the applicable dollar threshold is otherwise met. Although that commentary questioned the propriety of requiring participation in foreign deferred compensation plans to be reported at all in most situations (on the basis of the statutory language of §6038D), this commentary discusses some of the most common questions that are likely to arise if an individual does participate in such a plan and wishes to comply with the IRS reporting requirement. This commentary will not discuss participation in "foreign pension plans," which may also have to be reported but which are typically maintained by a separate entity apart from the employer (such as a pension trust).
The principal question that will arise is how to report an individual's rights in a foreign deferred compensation plan where those rights do not have a definitely ascertainable value. In some cases, of course, his rights will have a clearly ascertainable value, such as fully vested rights to receive deferred salary or bonuses in fixed amounts in one or more future years - although even in this situation the precise value may be unclear if the amounts are payable in a foreign currency, or if the deferred payments will be increased by an interest factor that is fluctuating and not fixed. In many other situations, however, the present value may be unclear, because of one or more of a number of factors. For example, if the individual's rights are not fully vested and are subject to potential forfeiture based on one or more factors (such as a §83-type of requirement to perform future services, or possible forfeiture based on some kind of hypothetical malfeasance by the individual), it may be almost impossible to value those rights independently. Similarly, whether or not the individual's rights are vested, the value of those rights may also depend on future conditions in the financial markets. For example, the individual may participate in some kind of an equity-based compensation plan sponsored by a foreign corporation (such as a stock option plan, stock appreciation rights, or a restricted stock unit plan) where his future income (if any) will be based in part on the future market value of his employer's or an affiliate's stock, which can obviously fluctuate until the individual's gross income from the item is eventually realized when the cash or property is transferred to him in a later period.
The IRS regulations and instructions attempt to deal with this issue with a rule that is clearly intended to be taxpayer-friendly. The instructions state, "If you received no distributions during the tax year [from a foreign deferred compensation plan] and do not know or have reason to know based on readily ascertainable information the fair market value of your interest as of the last day of the tax year, use a value of zero as the maximum value of the asset." In theory, this rule may provide a safe harbor for many individuals whose rights in a plan are still unvested, as in most cases they would have received no distributions from the plan during the year, except that it may be risky even for an "unvested" individual to take the position that he does not know or have reason to know the value of his interest. Perhaps in response to this concern, an IRS official recently stated at an AICPA webinar that if an individual's rights in a plan are unvested for the entire taxable year, the IRS may accept a zero value for the individual's rights without raising the valuation rule that must also be satisfied. Unfortunately, there is no basis for this position in either the Form 8938 instructions or in the §6038D regulations, and it would be extremely helpful if the IRS were to make this position known in an official publication on which taxpayers could rely.
It should be stressed that if an individual's rights in a particular foreign plan are entitled to be reported as zero under the rule in the IRS instructions, that does not mean that they do not have to be reported on Form 8938 at all. If the individual's other "specified foreign financial assets" (SFFAs) exceed the relevant dollar threshold, all SFFAs must be reported, including those that have a zero value; otherwise the form will be incomplete, and subject to potential penalties.
An important reason why an individual might want to be extremely cautious in relying on the "zero value" rule in the instructions is because of the special rule in §6038D(e), which provides in effect that if the IRS determines that an individual has an interest in an SFFA and the individual "does not provide sufficient information to demonstrate the aggregate value of such assets," then the aggregate value of such assets will be treated as being in excess of $50,000 (or in excess of whatever higher dollar threshold may apply to the particular individual). In the case of an individual who has an interest in a foreign deferred compensation plan and whose other SFFAs (such as foreign stocks and bonds) have a readily ascertainable market value that is clearly less than $50,000, this rule would seem to be intended to prevent the individual from assigning a low value, or a zero value, to his rights in the plan - and thus arguing that he does not have to file Form 8938 at all because the total value of all his SFFAs is below the $50,000 threshold - unless he has some support for the value that he does assign to his rights in the plan.
In applying the §6038D(e) rule, it is not clear from the instructions exactly how, and when, the individual must "provide sufficient information to demonstrate the aggregate value" of an SFFA such as an interest in a foreign plan that does not have a readily ascertainable market value (in contrast with a publicly traded foreign stock or other publicly traded foreign security). The instructions provide, "If the IRS determines that you have an interest in one or more [SFFAs] and asks you for information about the value of any asset, but you do not provide enough information for the IRS to determine the value of the asset, you are presumed to own [SFFAs] with a value of more than the reporting threshold that applies to you. In such case you are subject to the failure-to-file penalties if you do not file Form 8938." This language implies that the presumption in §6038D(e) may apply only if the IRS raises the issue on audit and the taxpayer does not provide a satisfactory response. Although there may be some support for this position in the literal language of §6038D(e), in view of the potentially severe penalties an individual who has rights in a foreign plan as to which there is any doubt as to the correct value may wish to report it on Form 8938 even though on a "worst case" basis the value of those rights and of his other SFFAs (if any) is clearly less than his applicable dollar reporting threshold. The same cautious approach should probably also be taken if the individual owns additional SFFAs (other than rights in a deferred compensation plan) that do not have a readily ascertainable market value - such as an interest in an actuarially based foreign pension plan, stock in a privately held foreign corporation whose stock is not publicly traded, and debt obligations issued by foreign persons that are not publicly traded.
Because it is uncertain exactly how the IRS may apply §6038D(e) to individuals whose only SFFAs are rights in a foreign deferred compensation plan that does not have a readily ascertainable market value, it is believed that many international tax practitioners are advising their individual clients in this position to report their interests in those plans on Form 8938 - even if on a "worst case" basis those rights, plus the value of the individual's other SFFAs (if any), clearly have a combined value of less than $50,000. Thus, this kind of "protective" filing will probably be reduced only if the IRS publishes substantially more guidance, with concrete examples, on exactly how §6038D(e) will and will not be applied to various types of foreign deferred compensation plans.
An additional problem is posed by the fact that an individual must file a separate attachment to Form 8938 for each SFFA that he owns, and in the case of deferred compensation this rule may require multiple attachments to be filed for the same item of deferred compensation for a particular year. For example, if at the beginning of the year an individual has the right to purchase shares in a foreign company pursuant to a stock option plan and then purchases stock during the year (i.e., he exercises some or all of his rights under the plan), he apparently must file Form 8938 to report his participation in the plan, and a separate attachment to report his ownership of stock in the foreign company following the purchase (assuming that he does not hold the stock through a domestic brokerage account). (If he holds the stock through a foreign brokerage account, he would usually not be required to identify the stock, or the other items in the account, but he would be required to give information about the account itself.) If still later in the year he sold the stock and deposited the cash proceeds in a foreign-currency foreign bank account, he could be required to file still another attachment to Form 8938 to report that account. Some practitioners have also suggested that if rights in any kind of foreign deferred compensation plan change from unvested to vested during the year, separate attachments must be filed to report the individual's rights in the plan during the two portions of the year. It must be questioned what tax policy objective is served by these kinds of multiple filing requirements.
The "multiple filing" problem arises in part because §6038D as drafted by Congress covers only actual property rights, but by requiring participation in deferred compensation plans to be reported as well, the IRS has extended the statutory requirement to include potential future property rights - in contravention of the statute itself, as this author has previously contended. The statute does appear to require multiple filings in the case of foreign stock that is actually owned by a U.S. individual and which is then sold during the year and converted into foreign currency that is deposited in a foreign bank account, as suggested immediately above. The statute does not, however, appear to require participation in the underlying stock option plan to be reported, notwithstanding what the IRS regulations and instructions say. Thus, the problems discussed above - multiple filings resulting from rights that change from unvested to vested (or which are "cashed in"), as well as the cautionary overreporting that will occur in order to avoid the presumption of §6038D(e) - could be avoided if the IRS decided to eliminate the reporting requirement for participation in foreign deferred compensation plans. Apart from the question of proper statutory construction, the IRS could certainly justify such a move from the standpoint of federal tax policy, because the tax law both before and after the enactment of §6038D already requires employers in most cases to report this income to the IRS once it becomes taxable under §83 principles.
This commentary also will appear in the July 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, U.S. International Withholding and Reporting Requirements.
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