By Jennifer Becker Harris, CPA
New international tax developments over the last six months will affect U.S. charities and provide welcomed relief in some areas and added compliance in others. The following is a summary.
Passive Foreign Investment Companies (PFICs)
What is a PFIC?
A foreign corporation is a PFIC if:
- 75% or more of its gross income is from passive sources, or
- the average FMV of assets which produce or are held to produce passive income is 50% or more.
Once a foreign corporation is classified as a PFIC, it remains a PFIC to those shareholders, even if in later years it no longer meets either the income or asset tests.
What if the charity doesn’t meet the exceptions for filing a PFIC return? Form 8621 would need be filed with the U.S. charity’s Form 990-T. We recommend discussing this with your tax advisor to determine if any elections may be made and the related tax consequences.
Much needed clarity and relief from overly burdensome and unclear reporting rules came at the end of 2013 when new PFIC regulations were issued. Prior to this, if a charity was a shareholder in a PFIC, then potential filing requirements existed if the fund had distributions, sales or was debt-financed (and therefore subject to unrelated business taxable income or UBTI). Now, exempt organizations, including Sec 501(c), pension and IRA plans, colleges and universities and qualified tuition programs, are not subject to any PFIC filing requirement if there is no UBTI involved. Even if there is UBTI there are special exceptions if the aggregate value of the PFIC stock owned by the charity is less than $25,000 and $5,000 for direct and indirect ownership, respectively. That is great news for U.S. charitable organizations, because it simplifies their PFIC reporting. The reporting rules are in effect for tax years ending on or after December 31, 2013.
Foreign Account Tax Compliance Act (FATCA)
FATCA requires identifying and reporting assets held abroad by U.S. persons as well as substantial U.S. owners. The goal is to establish transparency within entities and the U.S. Treasury to limit U.S. persons hiding their assets. Many of these changes went into effect on July 1, 2014 and apply to payments made after June 30, 2014.
There are three main classifications under FATCA: U.S. Withholding Agent (USWA), Foreign Financial Institution (FFI), and non-financial foreign entity (NFFE). In general, U.S. charitable organizations are not considered FFIs or NFFEs; however, they could be considered a USWA. The foreign affiliates of a U.S. charity may be considered an FFI or NFFE. A USWA is any U.S. or foreign person that controls, holds, disposes, or makes payment of any item of a foreign person that is subject to withholding. For these purposes, a U.S. charity needs to be concerned about withholdable payments.
Unless the payee qualifies for an exception, there is a 30% withholding tax on such payments. The IRS may collect any un-withheld FATCA withholding tax from the USWA as well as impose penalties and interest upon the USWA. FATCA withholding should be reported annually on a Form 1042 and Form 1042-S with respect to each payee. FATCA withholding payments made during 2013 and 2014 must be reported by March 15, 2015 and then annually thereafter.
If your organization is a USWA that makes a withholdable payment, then you must perform due diligence. First, determine the payee. Generally the payee is the person to whom the payment is made, regardless of beneficial ownership of the payment (exceptions may apply in the cases involving agents or intermediaries). Second, obtain the documentation and other information to verify the payees FATCA classification, such as a W-8 for foreign payees or a W-9 for US payees.
Documentation is key under the FATCA regulations. Again, failure to comply could result in your charity paying a 30% withholding tax. The new FATCA policies allow electronic copies and electronic retention policies which makes documentation easier. Whether paper or electronic, it is important to have a procedure in place to note the date the documentation was received and reviewed. Although other forms of documentation can be used to establish FATCA status the most straightforward documentation is a Form W-8. This article does not discuss the various versions of Form W-8 or the required documentation if a W-8 is not available, but if unsure please consult your tax advisor.
The Forms W-8 generally expire on December 31st of the third year following the year they were signed. In addition, the form becomes invalid when the withholding agent becomes aware of a change in circumstances affecting the form. Existing forms that expired at the end of 2013 have been extended until January 1, 2015. The forms are being revised throughout 2014. Therefore before requesting updated forms please be sure to check the IRS website for the most recent version. Due to the regulation changes with regard to FATCA we highly recommend US charities and NGOs update their certificates on file by January 1, 2015 to include the most recent version that has been released by the IRS.
Offshore Voluntary Disclosure Program (OVDP) and other delinquent international filing procedures
The Offshore Voluntary Disclosure Program allows taxpayers to voluntarily come forward with delinquent foreign filings and receive a reduction in penalties. Severe civil and criminal penalties associated with not timely filing foreign tax forms usually begin at $10,000 per missed filing. Thus a reduction in these penalties can be quite a savings.
On June 18th, the Service announced significant changes to the existing 2012 OVDP starting on July 1, 2014. It is not a mere coincidence that these new changes went into effect the same day many of the new FATCA rules began. One of the purposes of FATCA is to highlight foreign assets and income for the IRS to properly tax their share of that income. On the other hand, the U.S. tax system is based on voluntary taxation. Therefore, self-reporting is key to effective compliance and it is in the IRS’s best interest to help all taxpayers with that compliance.
While ODVP is geared toward individuals that have not disclosed foreign assets to the IRS in the past, it also sweeps in entities that have not disclosed foreign bank account filings or other international filings. If a charity identifies they have missed foreign filings there are now two recommended options. These options are only available if the charity is not under investigation or audit by the IRS or if the IRS has not contacted it regarding the delinquent filings. In addition, both options should be reviewed with your tax advisor to fully understand the organization’s risks and requirements.
The first option is to go through the ODVP program, which includes an eligibility assessment, pre-clearance process, submitting substantial paperwork and paying the associated penalties under the program. The program allows an individual or entity (including a charity) to mitigate its future civil and criminal risks by paying a mixture of penalties and interest.
Alternatively, a charity could amend its prior year Forms 990, 990-EZ, 990-PF, or 990-T and attach the missing foreign filings along with a reasonable cause statement for the missing filings. (Please note that Form FinCEN 114 for foreign accounts and Forms 3520/3520-A for foreign trusts will need to be filed separately from the Form 990 series.) The reasonable cause statement is crucial because the IRS will use this information to determine if the organization should pay the penalties or not.
It is unclear at this time if the charity files the returns and requests for the penalties to be abated, if the penalties will be automatically assessed thereby requiring the organization to explain to the assigned agent the facts and circumstances surrounding the delinquency.
Are foreign filings open to public disclosure?
The only IRS guidance stating that if you file an international filing with a Form 990, 990EZ or 990-PF that it will not be considered open to public disclosure is from the Internal Revenue Manual. However, Notice 2008-49 provides that if the filings are included with a Form 990-T that they will not be open to public disclosure.
Therefore, the authors recommend using the Form 990-T as the mechanism for filing the international returns, even if there is no unrelated business income for the charity in that particular year.
What is reasonable cause?
In order for the IRS to abate certain penalties, it must determine that the charity had a rational reason for not being in compliance. The test is known as “reasonable cause” and it is based on the facts and circumstances surrounding the missing filings. The most common example of reasonable cause is the charity relied on its tax advisor to identify and file all applicable U.S. filings. Another example would be that the charity had circumstances outside the charity’s control and therefore it was unable to comply with filing requirements.
It is helpful when the organization establishes that it has no history of noncompliance and it has created procedures to avoid missing international filings in the future.
With these new changes, now is a good time for U.S charities with operations, investments and other activities abroad to identify their compliance obligations. More information can be found on the IRS’s international programs and tax requirements website page.
Co-author: Tiffany Kawasaki, tax senior
© Clark Nuber PS, 2014. All Rights Reserved