The IRS issued final regulations requiring specified domestic entities to report specified foreign financial assets in which they have interests (T.D. 9752). The rules generally apply to tax years beginning after December 31, 2015.
Until now, the requirement to report “Specified Foreign Financial Asset” (SFFA) applied only to individuals, but the IRS is also authorized to apply the reporting requirement to any domestic entity that is formed or availed of principally to avoid reporting.
These regulations set forth the conditions under which a domestic entity will be considered a specified domestic entity required to undertake such reporting. These regulations affect certain domestic corporations, partnerships, and trusts.
Elimination of Principal Purpose Test
Proposed Sec. 1.6038D-6(b)(1)(iii) provides that a corporation or partnership is treated as formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets if either:
- At least 50 percent of the corporation or partnership's gross income or assets is passive; or
- at least 10 percent of the corporation or partnership's gross income or assets is passive and the corporation or partnership is formed or availed of by a specified individual with a principal purpose of avoiding section 6038D (the principal purpose test).
Under proposed Sec. 1.6038D-6(b)(1)(iii), all facts and circumstances are taken into account to determine whether a specified individual has a principal purpose of avoiding section 6038D.
The Treasury Department and the IRS believe that a 50-percent passive assets or income threshold appropriately captures situations in which specified individuals may use a domestic corporation or partnership to circumvent the reporting requirements of section 6038D.
Furthermore, the Treasury Department and the IRS have concluded that taxpayers should be able to determine their reporting requirements under section 6038D based on objective requirements rather than a subjective principal purpose test. Therefore, these final regulations eliminate the principal purpose test for determining whether a corporation or partnership is a specified domestic entity.
However, the Treasury Department and the IRS will continue to monitor whether domestic corporations and partnerships not required to report under these final regulations are being used inappropriately by specified individuals to avoid reporting under section 6038D. If needed, the Treasury Department and the IRS may expand the definition of a specified domestic entity in future guidance.
Definition of Passive Income
Specifically, these modifications: (1) Clarify that ``dividends'' includes substitute dividends and expand ``interest'' to cover income equivalent to interest, including substitute interest, (2) add a new exception for certain active business gains or losses from the sale of commodities, and (3) define notional principal contracts by adding a reference to Sec. 1.446-3(c)(1). In addition, these final regulations add the exception for dealers that is described in Sec. 1.1472-1(c)(1)(iv)(B)(2).
These final regulations provide that the passive asset percentage is determined based on a weighted average approach similar to the rule in Sec. 1.1472-1(c)(1)(iv). Under this test, corporations or partnerships may use either fair market value or book value (as reflected on the entity's balance sheet and as determined under either a U.S. or an international financial accounting standard) to determine the value of their assets. Corporations or partnerships may be required to substantiate their determination of the passive asset percentage upon request by the IRS. See section 6001.
Annual Determination of Specified Person's Interest in a Domestic Partnership
Proposed Sec. 1.6038D-6(a) provides that whether a domestic partnership is a specified domestic entity is determined annually, and proposed Sec. 1.6038D-6(b)(3)(ii) provides that a partnership is closely held if at least 80 percent of the capital or profits interest in the partnership is held directly, indirectly, or constructively by a specified individual on the last day of the partnership's taxable year.
These final regulations retain the rule in the proposed regulations for determining if a domestic partnership is closely held.
Clarification to Aggregation Rules
The proposed regulations provide that, for purposes of applying proposed Sec. 1.6038D-6(b)(1)(i) and the reporting threshold, all domestic corporations and domestic partnerships that have an interest in specified foreign financial assets and are closely held by the same specified individual are treated as a single entity, and each such related corporation or partnership is treated as owning the specified foreign financial assets held by all such related corporations or partnerships.
These final regulations simplify the aggregation rules by eliminating the reference to treating all domestic corporations and partnerships as a single entity.
Domestic Trusts
Proposed Sec. 1.6038D-6(c) provides that a trust described in section 7701(a)(30)(E) is a specified domestic entity if and only if the trust has one or more specified persons as a current beneficiary.
The term current beneficiary means, with respect to the taxable year, any person who at any time during such taxable year is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust (determined without regard to any power of appointment to the extent that such power remains unexercised at the end of the taxable year). The Treasury Department and the IRS intend that a specified domestic entity include a trust whereby a specified person has an immediately exercisable general power of appointment, even if such specified person is not technically a beneficiary.
These final regulations clarify that the term current beneficiary also includes any holder of a general power of appointment, whether or not exercised, that was exercisable at any time during the taxable year, but does not include any holder of a general power of appointment that is exercisable only on the death of the holder.
Expanding the Exceptions for Domestic Entities
The 2014 final regulations provide in Sec. 1.6038D-2(a)(7) that a specified person, including a specified domestic entity, is not required to file Form 8938, ``Statement of Specified Foreign Financial Assets,'' with respect to a taxable year if the specified person is not required to file an annual return with the IRS with respect to that taxable year. In the case of a specified domestic entity, the term ``annual return'' means an annual federal income tax return or information return filed with the IRS, including returns required under section 6012. See Sec. 1.6038D-1(a)(11). A Form 1041 is an annual return for purposes of Sec. 1.6038D-1(a)(11) of the final regulations.
The requirement under proposed Sec. 1.6038D-6(b) that to be a specified domestic entity at least 80 percent of the capital or profits interest in a partnership must be held by a specified individual on the last day of the partnership's taxable year establishes appropriate general criteria that, as a practical matter, should exempt most publicly traded partnerships from being specified domestic entities.
The Treasury Department and the IRS believe the exception under proposed Sec. 1.6038D-6(d)(1) for domestic entities that are not ``specified United States persons'' pursuant to section 1473(3), together with the exception for trusts whose trustees satisfy the supervisory oversight requirements and the income tax and information return filing requirements under proposed Sec. 1.6038D-6(d)(2), are sufficiently broad to except employer trusts that represent a low risk of tax avoidance from characterization as a specified domestic entity.
Special Analyses
These regulations will not have a significant economic impact on a substantial number of small entities within the meaning of section 601(6) of the Regulatory Flexibility Act (5 U.S.C. chapter 6). In the case of domestic corporations and partnerships, these regulations apply only when two separate tests are met.
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The first requires that at least 80 percent of the entity must be owned, directly, indirectly, or constructively, by a specified individual, generally a U.S. citizen or resident.
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The second test compares the entity's business income and assets with its passive income and assets. If more than 50 percent of the entity's annual gross income for the year is active business income and more than 50 percent of its assets for the taxable year are assets that produce or are held for the production of active income, then the entity is not subject to the reporting requirements under section 6038D.
This two-part test reduces the burden imposed by these final regulations on domestic small business entities because closely-held domestic corporations and partnerships that are predominantly engaged in an active business generally will be excluded from reporting.
Furthermore, small not-for-profit organizations that are tax-exempt under section 501(a) of the Internal Revenue Code and small governmental jurisdictions are not subject to these regulations.
For closely-held domestic corporations and partnerships that meet both tests, these final regulations limit the burden imposed.
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First, reporting is required only when the aggregate value of the entity's interests in specified foreign financial assets exceeds the reporting threshold under Sec. 1.6038D-2(a)(1).
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Second, the final regulations exclude the value of specified foreign financial assets reported on one or more of the following forms from being taken into consideration in determining whether the small entity satisfies the reporting threshold under Sec. 1.6038D-2(a)(1): Form 3520, ``Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts``; Form 3520-A, ``Annual Information Return of Foreign Trust With a U.S. Owner''; Form 5471, ``Information Return of U.S. Persons With Respect To Certain Foreign Corporations''; Form 8621, ``Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund''; or Form 8865, ``Return of U.S. Persons With Respect to Certain Foreign Partnerships.''
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Third, small entities that hold specified foreign financial assets generally will be excepted from reporting such assets if the assets are reported on one or more of the these forms, thereby further limiting the burden imposed by the final regulations on small entities.
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