Business or personal requirements sometimes necessitate the formation of a foreign corporation, but the ownership of such an entity is rarely simple. In addition to local country tax and operational concerns, US tax considerations also must be addressed.
Deferral of Foreign Corporate Earnings
Many taxpayers assume that earnings in a foreign corporation are not subject to US tax until those earnings are brought back to the US as a dividend. While that is often the case, a number of IRS rules can cause the earnings in the foreign corporation to be taxed currently or otherwise subjected to negative US tax treatment. These rules include the Controlled Foreign Corporation (CFC) and Passive Foreign Investment Corporation (PFIC) regimes. Under both sets of rules, the ownership of the foreign corporation and the type of income earned must be monitored to avoid unexpected tax consequences such as current income inclusion.
Contributions to a Foreign Corporation
A contribution of property, such as cash or equipment, to a foreign corporation may trigger a US reporting requirement. Form 926, Return by a US Transferor of Property to a Foreign Corporation, is filed by US citizens, residents, domestic corporations, or domestic estates or trusts to report certain transfers of property to a foreign corporation. While several exceptions to filing exist, most capital contributions to a wholly owned corporation will be reportable. The penalty for failing to file is 10% of the value of the property contributed, generally limited to $100,000.
Ownership Transactions and Control
Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations, is an annual filing requirement for many shareholders of foreign corporations. The form is somewhat unusual in that it requires the completion of certain schedules based on the category of filer. Four categories of filers are specified, depending on ownership transactions during the year, control of the entity, and specific ownership thresholds. A US taxpayer that wholly owns a foreign corporation will file this form annually. In addition, certain ownership transactions, including the formation of the entity, require the filing of Schedule O. Failure to file Form 5471 can result in a $10,000 penalty annually. Failure to file Schedule O carries a separate $10,000 penalty.
Form 5471 reports income statement and balance sheet information for the foreign entity. It also includes disclosures relating to earnings and profits, as well as related party transactions. Summary filing is allowed for certain corporations that are considered “dormant” by IRS definition.
Another common filing requirement for the owner of a foreign corporation is FinCEN 114, Report of Foreign Bank and Financial Accounts (FBAR). A US Owner with a greater than 50% interest in the foreign corporation must file FinCEN 114 if the aggregate value of the corporation’s non-US accounts exceeds $10,000. This filing requirement sometimes arises in unexpected ways. For example, assume the US owner of a vacation property in Canada owns the property through a Canadian corporation. The corporation maintains a Canadian bank account to pay day to day expenses related to the property, but the owner is careful to keep the bank balance under $10,000. However, renovations on the property in a given year require more funds in the account and the bank balance goes to $15,000 for a brief period. This spike in the account balance triggers the FBAR filing requirement and the potential for a $10,000 penalty if the form is missed.
A foreign corporation may make sense for business or personal reasons and is becoming far more common. However, ownership carries certain risks that need to be considered and evaluated. The best time to discuss the benefits and costs of a foreign corporation with your tax advisor is prior to incorporation. Making sure the structure and reporting requirements are addressed in detail and up-front can minimize both surprises and tax penalties in the future.