International Tax and Planning

The US Tax Court recently held that a foreign corporation is not subject to US income tax on the sale of a partnership interest where the partnership conducts a US business.  In so holding, the Tax Court rejected a 26 year old Revenue Ruling (Rev Rul 91-32) that reached the opposite conclusion.  For foreign investors in US businesses (that do not own real estate), this is an important decision.

A foreign investor who owns an interest in a partnership that holds US real estate may be subject to US federal income tax on a sale of that partnership interest under the Foreign Investment in Real Property Tax Act (“FIRPTA”).  For real estate, the IRS has indicated that gain derived by a foreign investor from the disposition of an interest in a partnership is subject to US tax only to the extent it is attributable to US real property interests owned by the partnership.  Regs §1.897-7T(a); Notice 88-72.

In Rev Rul 91-32, the IRS set forth its view that taxation on the sale of a partner’s interest in a partnership can go beyond mere real estate investment and apply to a sale of an interest in a partnership if the partnership is engaged in any US trade or business and has effectively connected income (“ECI”).  In this ruling, the IRS applied the “aggregate” theory of partnership taxation to justify looking through the partnership to its underlying assets in determining the source and character of the partner’s gain.

In July, 2017, the Tax Court issued its decision in Grecian Magnesite, Mining, Industrial & Shipping Co, SA v Comm’r, 149 TC 3The court declined to follow the IRS’s long standing position under Rev Rul 91-32, and held that a non-US person’s gain from the sale of its interest in a partnership engaged in a US trade or business is generally not subject to US federal income tax.

Grecian Magnesite Mining was a privately owned corporation organized under the laws of Greece that sells magnesia and magnesite to customers around the world.  From 2001 through 2008, it was a member of a US LLC that was engaged in the business of extracting, producing, and distributing magnesite in the US.  In 2008, Grecian Mining’s interest in the LLC was completely redeemed, resulting in treating the transaction as a sale or exchange of the membership interest.

The IRS asserted that the capital gain was properly treated as ECI since Grecian Mining was engaged in a trade or business as a result of its investment in the LLC.  Grecian Mining’s position was that the assets of the LLC do not control the character of the gain from a disposition of an interest in the LLC.  The gain should not have been treated as US-source gain and generally cannot be taxed in the US as ECI under the proposition that foreign-source income cannot be ECI except in limited instances that arise from the presence of US real estate under FIRPTA, which only applied to a small part of their gain.

Foreign investors should carefully review their US tax exposure on a sale of a partnership interest before they simply pay tax on their realized gain.  Grecian Magnesite calls into question the validity of Rev Rul 91-32 (though an appeal or non-acquiescence is possible).  A foreign investor should be able to rely on this case to avoid paying tax.  Moreover, foreign investors that have already paid income tax based upon Rev Rul 91-32 may wish to file a refund claim based on this decision.

The Supreme Court has recently struck down state bans on same-sex marriage as unconstitutional in Obergefell v. Hodges, 576 US ___ (2015), after previously striking down the federal exclusion of same-sex couples from marriage-related laws in US v. Windsor, 570 US ___ (2013).  The Internal Revenue Service (IRS) has now followed suit to recognize same-sex marriage for all federal tax purposes, including income, estate, gift, generation-skipping, and employment tax.

On October 23, proposed regulations were published in the Federal Register, which redefine the terms “husband” and “wife” under Section 7701(17).  Both terms will now mean an individual lawfully married to another individual, and the term “husband and wife” will mean two individuals lawfully married to each other. These definitions would apply regardless of sex.  Prop Reg § 301.7701-18(a).  The IRS is accepting comments for a limited time.

However, the proposed regulations redefining marriage will not apply to domestic partnerships, civil unions or other relationships. Prop Reg § 301.7701-18(c).  The couples’ choice to remain unmarried is respected by the IRS as deliberate, for example, for purposes of preserving eligibility for government benefits or avoiding the tax marriage penalty.  Preamble to Prop Reg 10/21/2015.  In addition, a marriage conducted in a foreign jurisdiction will be recognized for federal tax purposes only if the marriage would be recognized in at least one state, possession, or territory of the United States.  Preamble to Prop Reg 10/21/2015.

On June 18, 2014, the IRS announced a revamped Offshore Voluntary Disclosure Program.

The existing OVDP has been in place since March 2009.  The program allows a taxpayer to voluntarily come into compliance with US tax reporting obligations and pay a reduced civil penalty rather than facing either greater civil penalty exposure or criminal exposure.  The updated program makes significant changes to the penalty structure, as well as changes to streamline the administration of the program.

Penalty Structure

The penalty structure has been changed significantly.  As part of the voluntary disclosure, the taxpayer must agree to pay a penalty in place of any FBAR penalties that would otherwise apply and in place of any penalties that would apply for the non-filing of various information returns that are also required for international tax compliance.  For the first time, the IRS has implemented a two-tier structure that prescribes a different penalty for those whose violations were willful and those whose violations were not willful.

The OVDP penalty percentage of 27.5% will continue.  The new program introduces a 50% penalty in place of the 27.5% penalty for those taxpayers who had banked with institutions or promoters that the US government has investigated for facilitating evasion activities for its clients, banks or promoters that are cooperating with the US, or banks or promoters who have been publicly identified as having been issued a summons for US taxpayer activity.  The IRS has published a list of such banks.  The higher penalty will be applicable only after August 4, 2014.  It serves as a further incentive for noncompliant taxpayers to come into compliance immediately through the use of the OVDP.

Streamlined Process

The second significant change is the expansion of the streamlined process, which had been in place since 2012, to U.S. residents and to all taxpayers who certify that their non-compliance was not due to willfulness.  The streamlined process allows for taxpayers to submit three years of tax returns and six years of FBARs.  There is no preclearance procedure for the streamlined process and no documentation other than the required returns and certification.  In addition, there is no longer any maximum tax threshold (previously $1,500) and no risk assessment, which in the 2012 program had limited the streamlined program to those considered low risk because of the nature of the offshore account and the amount in the account.  Once the streamlined process is used, the taxpayer can no longer avail himself of the OVDP.

The streamlined process differs slightly between US residents and non-US residents.

  • Non-residents may submit both delinquent original tax returns and amended tax returns.  Residents are only able to submit amended returns and are not eligible if they have not filed returns.
  • There is no FBAR penalty for a non-resident.  A resident must submit a 5% penalty for the FBAR violations.  The 5% penalty only applies to bank accounts that need to be reported on an FBAR and is narrower than the penalty base in the OVDP, which includes other assets that were vehicles for offshore tax evasion.

Transitional Guidance

Because of the reduced penalty available for non-willful taxpayers, the IRS has provided guidance for the transition of OVDP participants to the streamlined process.  Taxpayers who have opted out of the OVDP can also request to be transitioned to the streamlined program.  The important distinction between those who use the streamlined process initially from those who transition in from the OVDP is the requirement for OVDP participants to submit all required OVDP paperwork.  This element of the transition must be considered carefully in situations where the documentation shows possible willfulness.   The new guidance also notes that the streamlined process is available for those who filed amended returns and FBARs as a “quiet disclosure.”

Where no tax is due

In situations where there is no tax due and only FBARs or other information returns were not filed, the IRS has separately issued revised guidance for filing the information returns and FBAR forms without any penalty.

Open Issues

The question of whether an individual was willful is a legal determination that will depend on the facts and circumstances of each case.  The Supreme Court’s definition of willfulness is the “intentional violation of a known legal duty.”  How this standard is applied in the context of FBAR violations is the subject of controversy in several recent court cases and is by no means settled law.  This legal determination should be made by an attorney.

Immediate Action Items

  • For those who have accounts at banks under investigation, apply to the OVDP by August 4, 2014 to avoid the 50% penalty.

If you have any questions regarding the foregoing, please contact Jeffrey Schechter 201-525-6315, Geoffrey Weinstein 201-525-6282, Steven Saraisky 201-525-6259 or Reuben Muller 201-525-6238.

June 30, 2013 is the filing due date for 2012 “FBARs,” also known as Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts.  If there is a non-willful failure to file, the penalties are up to $10,000.  If there is a willful failure to file, the penalties are up to the greater of $100,000 or 50% of account balances per year.  Criminal penalties also may apply.

Anyone who maintained offshore financial accounts with an aggregate value in excess of $10,000 at any time during tax year 2012 is required to file an FBAR.  No extensions are available for this filing deadline and an extension of time to file a federal income tax return does not extend the due date for filing an FBAR.  For 2012, you may file the FBAR by mailing it to the U.S. Department of the Treasury, P.O. Box 32621, Detroit, MI 48232-0621.  Please note that the 2012 FBAR, available here, must be received by the U.S. Department of the Treasury on or before June 30, 2013.

Effective July 1, 2013, taxpayers must electronically file FBARs through the BSA E-File System:

Currently, a third party preparer may not electronically file an FBAR on behalf of a taxpayer.  FinCEN currently is contemplating changes to the FBAR form which would add the capability for a third party preparer to file the FBAR on behalf of a taxpayer.  Whether those changes will take place, or if they do, when they become effective, is uncertain.

If you have questions concerning undeclared foreign assets or bank accounts, please contact us.

In February 2011 the IRS announced the Offshore Voluntary Disclosure Initiative (OVDI) for taxpayers with undisclosed foreign accounts.  This program was a follow up to a program initiated by the IRS in 2009 on the same topic following civil and criminal cases brought by the Department of Justice against Swiss bank UBS AG seeking the release of information concerning secret accounts maintained by U.S. persons with the Swiss bank.  Approximately 15,000 taxpayers came forward under the 2009 program which required the payment of taxes on omitted income going back to 2003, a 20% penalty on those back taxes and a 20% miscellaneous penalty on the high balance of the undisclosed foreign account between 2003 and 2008.

Under the 2011 OVDI, subject to limited circumstances where a reduced penalty may apply, the miscellaneous penalty has been increased by 5% to 25% of the high balance and taxpayers must still pay the taxes on omitted income going back to 2003.  The new program expires August 31, 2011, but can be extended by up to 90 days under certain circumstances.

The February 2011 OVDI is similar to the 2009 program with some exceptions including an increase in the penalty from 20% to 25%, and an eight year lookback rather than a six year lookback on back taxes.  Taxpayers who do not come forward face much more severe penalties including a fraud penalty equal to 75% of the back taxes and a miscellaneous penalty equal to 50% of the high balance each year (potentially 300% in the aggregate) as well as possible criminal prosecution.

Guidance issued in June 2011 expands eligibility for a 5% penalty (in lieu of a 25% penalty) and clarifies the procedure for individuals choosing to “opt out” of the OVDI.  Those who “opt out” are subject to a more detailed audit and penalties will be determined following the completion of that exam. Cole Schotz Partner Jeffrey Schechter was recently quoted on this issue in the following article titled, “IRS Guidance on Offshore Asset Disclosure Program Perceived Beneficial to Taxpayers” published by BNA Daily Tax Report, which provides some insight into the new guidance. Also, all of the updated frequently asked questions pertaining to the OVDI can be found here.