The news media have been full of reports over the last year about money and assets being held in offshore accounts, and this has brought on a new push for the government to make sure people are reporting all their foreign income at tax time. The IRS announced a new compliance program in March aimed at people and companies with foreign investments, and agency officials have said they will hire as many as 700 new revenue agents and officers to deal with international issues.
Although the focus is on bringing in more U.S. tax revenue from assets and accounts held in low-tax jurisdictions, the compliance effort is sure to affect many people with holdings in countries that are not thought of as tax havens. This article reviews tax and reporting obligations of people who invest abroad. (For information about U.S. taxpayers living and working abroad, see the previous article, Living Abroad: Expat Tax Rules.)
Under the Bank Secrecy Act, anyone with more than $10,000 in foreign accounts is required to file a foreign bank account report (FBAR) with the Treasury Department by June 30 the following year. This obligation extends to any foreign accounts or investments over which an individual has signing authority, regardless of whether that person also has an ownership interest in the account. FBARs are filed on Form TD F 90-22.1, and while they are not part of a tax return, they are used by the IRS in tax compliance programs.
This information collection is clearly aimed at finding out who owns the account and who owes taxes on it. The form asks about the type of account, financial institution, account number, and maximum value during the calendar year. For joint accounts, it asks for the number of owners and identifying information for the “principal joint owner.” For accounts on which the filer has signing authority but no financial interest, it asks for information about the account owner.
The penalties for not filing are very high. For “willful failure” to file the information, the civil penalty can be as high as $100,000 or 50 percent of the total balance in the account, whichever is higher. In cases of “non-willful failure” to file, the civil penalties can range up to $10,000 per violation.
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According to the form’s instructions, individual investments in foreign bonds, stocks, or notes do not count as foreign accounts for purposes of this reporting obligation. Neither do accounts in U.S. possessions (including Puerto Rico and the U.S. Virgin Islands). Specifically exempt from the filing requirement are accounts at U.S. military facilities.
Taxation of foreign investment income
U.S. citizens with investment income from sources outside the United States must report that income on their U.S. tax returns unless it is exempt under U.S. law. The IRS notes in Publication 550, Investment Income and Expenses, that this is true even if you do not receive a Form 1099 covering the income.
Dividends on investments in some foreign corporations may be taxed at the lower tax rate (0 to 15 percent) applied to “qualified” dividends from U.S. corporations, particularly if the company is in a country with a tax treaty and exchange-of-information agreement with the United States. Those that do not qualify are taxed at the investor’s ordinary income tax rate.
Foreign investments are taxed under a complicated set of rules that have evolved through the years as Congress has tried to thwart investors’ efforts to move money overseas to avoid paying taxes on passive income, according to Nick Hodges, president of NCH Wealth Advisors in Fullerton, Calif. One set of laws applies to foreign operating companies controlled by U.S. taxpayers, allowing their profits to be taxed only when the cash is brought back into the United States. Passive income generally will be subject to U.S. tax in the year earned, whether held directly by the U.S. taxpayer, through a controlled foreign corporation, or through a personal holding company established under the rules of another country, he said.
When an individual or group of investors set up a foreign personal holding company, each taxpayer must declare his/her share of its earnings each year, even if no earnings were distributed. A controlled foreign corporation is considered a foreign personal holding company if five or fewer U.S. individuals hold more than half the stock or voting power.
Max Koss, director of International Tax Services for Frost, PLLC, in Raleigh, N.C., gave this example: If an investor sets up a company in the another country to invest in European stocks or the company holds assets in an interest-bearing account, the company’s assets are considered passive and the income is taxed at the shareholder level. However, if the company primarily invests in and actively manages real estate or other foreign ventures, any rents or royalties it receives are not considered passive income, he said.
Koss noted that investors in passive foreign investment companies (PFICs) can choose whether to declare their portion of its earnings each year or to defer paying taxes on it until money is distributed or the investment is sold. However, once the income is declared, it is prorated over the five years ending with the year of distribution. Taxes must be paid at the highest rate in effect in each of those years, plus interest, he said.
Tax reporting on investments with no profit
Nick Hodges cautioned that foreign companies, including foreign personal holding companies, must be identified to the IRS each year on Form 5471, filed with the investor’s tax return, regardless of whether there are profits or a “taxable event” to declare. This filing requirement generally applies to any foreign company in which the investor owns at least 10 percent of the company’s stock.
Foreign investments can be very rewarding and reap benefits for the investor through portfolio diversification, but looking at them as a means of avoiding paying taxes can be risky. Penalties for failure to file Form 5471 are $10,000, and the new “voluntary compliance” program announced in March makes it clear that the IRS is on the lookout for people who are not reporting all their income. Foreign investors who are uncertain about their obligations would be well advised to consult with an experienced international tax practitioner.
This is the second article in a series on tax issues faced by U.S. citizens and resident aliens with offshore interests.