On Feb. 22, the Internal Revenue Service issued final regulations (T.D. 9752) to further implement Internal Revenue Code Section 6038D, which imposes on certain U.S. taxpayers a requirement to report “specified foreign financial assets” if the aggregate value of such assets exceeds applicable thresholds. The regulations specifically address the reporting requirement for domestic entities. The regulations took effect Feb. 23 and impose the reporting requirement on domestic entities for tax years beginning after Dec. 31, 2015.
Please note that the IRC Section 6038D reporting requirement is in addition to the Report of Foreign Bank and Financial Accounts reporting requirement that takes place on FinCen Form 114.
IRC Section 6038D
The Hiring Incentives to Restore Employment Act enacted IRC Section 6038D in 2010, which imposed a new reporting requirement on U.S. taxpayers with respect to foreign financial assets.
In general, IRC Section 6038D requires any individual holding specified foreign financial assets (SFFAs) to report with their income tax return information about such assets. Although the terms of the statute only apply to individuals, the provision authorized the issuance of regulations under which entities would also be subject to the reporting requirement. The filing obligation only applies when the taxpayer’s SFFAs have an aggregate value that exceeds an applicable threshold.
SFFAs generally include two categories of assets:
- Any “financial account” maintained by a “foreign financial institution.” For these purposes, both financial account and foreign financial institution are specially defined terms.
- Any of the following foreign financial assets not held in an account maintained by a financial institution: stock or securities issued by non-U.S. persons, any financial instrument or contract held for investment having an issuer or counterparty that isn’t a U.S. person, and any interest in a foreign entity.
IRC Section 6038D was effective for tax years beginning after March 18, 2010.
With respect to individuals, the IRS issued temporary regulations on Dec. 19, 2011 (TD 9567) addressing the reporting requirements under IRC Section 6038D. In addition, the IRS issued a version of Form 8938 (Statement of Specified Foreign Financial Assets) in December 2011. Form 8938 is designed to implement the IRC Section 6038D reporting requirements. The 2011 temporary regulations were issued as final regulations on Dec. 12, 2014 (TD 9706).
With respect to domestic entities, the IRS published proposed regulations under IRC Section 6038D on Dec. 19, 2011 (REG-130302-10). These proposed regulations weren’t adopted in the 2014 final regulations. Accordingly, until the final regulations discussed here were issued, domestic entities had no reporting requirement under IRC Section 6038D.
However, the 2014 final regulations did address the applicable threshold for domestic entities. Under these rules, the IRC Section 6038D requirement would only apply to domestic entities if the aggregate value of a domestic entity’s SFFAs exceeds: (1) $50,000 on the last day of the taxable year, or (2) $75,000 at any time during the taxable year.
The final regulations extend the Form 8938 reporting requirement to “specified domestic entities” under the conditions described below.
Section 1.6038D-6(a). This section defines a “specified domestic entity” to mean a domestic corporation, domestic partnership or a domestic trust (as defined for U.S. tax purposes), if such entity is “formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets.” Whether an entity is a “specified domestic entity” is determined annually.
Section 1.6038D-6(b). This section provides an objective test for making the “formed or availed of” determination (the proposed regulations had provided for an objective test or a test with a subjective component). Under the objective test, a corporation or partnership meets the “formed or availed of” threshold if and only if two conditions are satisfied:
First, the entity must be closely held. For corporations, this means that a specified individual owns directly, indirectly or constructively, at least 80 percent (by vote or value) of the corporation, on the last day of the corporation’s taxable year. For partnerships, this means that a specified individual holds directly, indirectly or constructively, at least 80 percent of the capital or profits interest on the last day of the partnership’s taxable year. Specified individuals are defined elsewhere in the regulations and include resident aliens of the United States for any portion of the taxable year and U.S. citizens.
Second, at least 50 percent of the entity’s gross income for the taxable year is passive income, or at least 50 percent of the entity’s assets produce or are held for the production of passive income.
This section includes rules for making the 50 percent determination, a definition of passive income (which matches the passive income definition contained in regulations under IRC Section 1472), an exception from passive income treatment for dealers and rules to apply the passive income and asset test to related entities.
Section 1.6038D-6(c). This section addresses the “formed or availed of” test as applied to domestic trusts (as defined for U.S. tax purposes). A domestic trust meets the “formed or availed of” threshold if and only if the trust has one or more specified persons as a current beneficiary. A specified person is defined elsewhere to mean a specified individual or a specified domestic entity. Current beneficiary means, with respect to the taxable year, any person who at any time during the 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). 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 doesn’t include any holder of a general power of appointment that’s exercisable only on the death of the holder.
Section 1.6038D-6(d). This section excludes certain entities from being specified domestic entities. Among these exclusions is one for trusts that are treated as grantor trusts for U.S. tax purposes. The regulations elsewhere make clear that the grantor of the grantor trust is treated as the owner of the trust’s assets for IRC Section 6038D reporting purposes. Also excluded are domestic trusts if the trustee: (1) has supervisory authority over or fiduciary obligations with respect to the SFFA of the trust, (2) timely files annual returns for the trust, and (3) is (A) a bank subject to U.S. bank regulatory oversight; (B) a financial institution registered with and regulated or examined by the SEC; or (C) a domestic corporation that’s regularly traded on an established securities market or an affiliate of a domestic corporation that’s so traded.
Section 1.6038D-6(e). This section provides that the above rules apply to taxable years beginning after Dec. 31, 2015.
Form 8938 and the instructions thereto will presumably be modified prior to the 2016 tax filing season to address these final regulations.