Back to International Taxation

In General

  • 951. What is the difference between a resident alien and a nonresident alien?

    • A foreign individual who is not a U.S. citizen is labeled as an “alien” for U.S. tax purposes. An alien is either a nonresident alien or a resident alien. A resident alien is a foreign individual who meets either the green card test or the substantial presence test, discussed below, and a nonresident alien is any other foreign individual unless that individual is otherwise eligible to elect to be treated as a resident alien (see, for example, Q 953). See Q 956 for a discussion of the relief provided during the 2020 tax year.

      A foreign individual meets the “green card test” if given permission to reside in the U.S. on a permanent basis by U.S. Citizenship and Immigration Services (or a predecessor) and such permission has not been revoked or judicially determined to have been abandoned by the individual.1

      A foreign individual meets the “substantial presence test” if physically present in the U.S. for at least (1) 31 days in 2020 and (2) 183 days during the three-year period that includes 2020, 2019 and 2018, counting only a certain number of days that the individual is present in the U.S. per year, based on the following table:2

      Year Days Counted Toward 183 Day Total
      2020 All days present in the U.S.
      2019 1/3 of days present in the U.S.
      2018 1/6 of days present in the U.S.

      In general, an individual is treated as being “physically present” in the U.S. for any day in which he or she is actually present in the U.S. at any time of the day. Despite this, an individual does not count the following as days as being physically present in the U.S.:

      (1)Days that the individual commutes into the U.S. for work from a residence in Canada or Mexico if that individual regularly commutes into the U.S. for work (meaning that the individual commutes on more than 75 percent of workdays during the individual’s working period);

      (2)Days that the individual is in the U.S. for less than 24 hours while in transit between two foreign countries;

      (3)Days that the individual is in the U.S. as a member of a crew of a foreign vessel;

      (4)Days that the individual is only in the U.S. because of a medical condition that arose while in the U.S. and that rendered that individual unable to leave the U.S.; and

      (5)Days that the individual was an exempt individual (including individuals temporarily present in the U.S. as foreign-government related individuals, teachers or trainees on a “J” or “Q” visa, individuals present in the U.S. on a student visa, and certain professional athletes in the U.S. for a charitable sports event).3

      A resident alien will be taxed much in the same way as a U.S. citizen, and thus will be subject to U.S. taxation on all worldwide income. Conversely, a nonresident alien will only become subject to U.S. taxation in the event that he engages in certain activities that create a connection between that individual and the U.S. (see Q 952).


      1 .See IRS Publication 519, available at http://www.irs.gov/publications/p519/index.html (last accessed July 18, 2021).

      2 .IRS Pub. 519, above.

      3 .IRS Pub. 519, above, and IRS Guidance, “Substantial Presence Test,” available at http://www.irs.gov/Individuals/International-Taxpayers/Substantial-Presence-Test (last accessed July 18, 2021).

  • 952. When does a foreign individual become a U.S. taxpayer who is required to file a U.S. tax return?

    • U.S. citizens and resident aliens (see Q 951) are taxed on worldwide income regardless of where they are located and must generally file a return (though a two-month filing extension will apply for U.S. citizens and residents who are residing overseas).1

      A foreign individual who is a nonresident alien may be required to file a U.S. tax return if any of the following occur:

      (1)A nonresident alien engaged in a trade or business in the U.S. during the tax year. If the nonresident alien’s only U.S. source income consists of wages that are less than the personal exemption amount ($4,300 in 2020-2021, $4,200 in 2019),2 noting that the personal exemption itself was suspended for 2018-2025 that alien is not required to file;

      (2)A nonresident alien not engaged in a trade or business in the U.S., but who has U.S. income on which the tax liability was not satisfied by withholding at the source;

      (3)A representative responsible for filing the return of an individual described in (1) or (2);

      (4)A fiduciary for the estate or trust if any beneficiary of the estate or trust is a nonresident alien; or

      (5)A resident or other fiduciary, or other person charged with the care of the nonresident alien or his or her property, unless the nonresident alien files the return himself or makes other arrangements for a representative to file the return and pay the tax.3


      1. See IRS Guidance, “U.S. Citizens and Resident Aliens Abroad,” available at https://www.irs.gov/individuals/international-taxpayers/us-citizens-and-resident-aliens-abroad-filing-requirements (last accessed July 18, 2021).

      2. Rev. Proc. 2018-57, Rev. Proc. 2019-44, Rev. Proc. 2020-45.

      3. Treas. Reg. §1.6012-3. See also IRS Guidance, “Taxation of Nonresident Aliens,” available at http://www.irs.gov/Individuals/International-Taxpayers/Taxation-of-Nonresident-Aliens (last accessed July 18, 2021).

  • 953. What rules apply when a U.S. citizen or resident alien is married to a nonresident alien and the couple wishes to file a joint U.S. tax return?

    • If a U.S. citizen or resident alien (see Q 951) is married to a nonresident alien, the couple may elect to treat the nonresident alien as a U.S. resident for tax purposes. The couple may elect this treatment by attaching a statement to this effect to their U.S. tax return for the relevant tax year. The election may be made at the time of filing, or by filing an amended tax return for up to three previous tax years (though in this case, the couple must also elect such treatment for all tax returns that have been filed since the date of the amended return).

      The couple must file a joint tax return for the year in which the election is originally made, though separate returns may be filed in later years.

      While this election will result in the nonresident alien being treated as a resident alien for income tax purposes, the individual may continue to be treated as a nonresident alien for purposes of Social Security and Medicare taxes.1

      The election will apply until it is suspended or ended. The election is suspended if, during a later tax year, neither spouse is a U.S. citizen or resident alien. The election is ended if (a) it is revoked by either spouse, (b) one spouse dies, (c) the spouses are legally separated or (d) the spouses have failed to keep adequate records to prove their income tax liability.2 If the election is “ended,” neither spouse may apply to make the election in a subsequent tax year.


      1 .IRS Guidance, “US Citizens and Resident Aliens Abroad – Nonresident Alien Spouse,” available at https://www.irs.gov/individuals/international-taxpayers/nonresident-alien-spouse (last accessed July 18, 2021).

      2 .IRS Pub. 519.

  • 954. When a U.S. citizen is a resident of a foreign country and earns income in that foreign country, is that income included in the taxpayer’s gross income for U.S. tax purposes?

    • Yes. If a U.S. citizen is employed in a foreign country and files a tax return in that country, that individual will also be required to file a Form 1040 in the United States. A U.S. citizen is taxed on worldwide income, regardless of whether that taxpayer lives in the U.S. or in a foreign country.1

      Despite this, a U.S. citizen with foreign earned income may be eligible to exclude all or a portion of foreign earnings from calculation of his or her income for U.S. tax purposes (see Q 955).2 “Foreign earned income” includes amounts received by the individual from sources within a foreign country that are attributable to services performed by the individual.3 Pension and annuity income, amounts paid to the individual by the U.S. (or a U.S. agency) as an employee, and amounts paid to the individual under Section 402(b) (taxability of beneficiaries of nonexempt trusts) or Section 403(b) (taxability of beneficiaries under nonqualified annuities) are excluded from foreign earned income.4


      1 .See IRS Guidance on the Foreign Earned Income Exclusion, available at http://www.irs.gov/Businesses/Foreign-Earned-Income-Exclusion-1 (last accessed July 19, 2021).

      2 .IRC Sec. 911(a)(1).

      3 .IRC Sec. 911(b)(1)(A).

      4 .IRC Sec. 911(b)(1)(B).

  • 955. What is the foreign earned income exclusion?

    • The foreign earned income exclusion is available if the following requirements are met:

      (1)The individual has income received for work performed in a foreign country,

      (2)The individual has a tax home in a foreign country, and

      (3)The individual meets either (i) the bona fide residence test or (ii) the physical presence test (see Q 956).

      According to IRS guidance, an individual’s “tax home” is the general area of the individual’s principal place of business or employment. The individual’s principal place of residence is irrelevant for determining the individual’s tax home. However, if the individual is not consistently present in one business location, the location of that individual’s principal residence may be used as a factor in the tax home determination. If the individual has neither a regular principal place of business or residence, the individual is considered itinerant and his or her tax home is wherever he or she works. The individual’s tax home is not considered to be in a foreign country if that taxpayer’s “abode” is in the U.S.1

      Example: Joe is a U.S. citizen who is employed on a fishing enterprise in the waters of a foreign country. His schedule provides that he works one month on and one month off. Joe continues to maintain a residence in the U.S., where his family lives and where he returns on his “off” months. Joe is considered to have a “tax home” in the U.S. because his time is split equally between the U.S. and foreign waters. He is not entitled to take advantage of the foreign earned income exclusion, though he may be entitled to deduct his living expenses while living abroad as business travel expenses.2

      A taxpayer’s election to exclude foreign earnings under the foreign earned income exclusion may be revoked by the taxpayer by filing a statement to that effect with the IRS, but if the taxpayer attempts to claim the exclusion within five tax years after the revocation, he or she must apply for IRS approval.3


      1 .IRS Pub. 54 (2019), p.12

      2 .See IRS Guidance, “Foreign Earned Income Exclusion – Tax Home in Foreign Country,” available at https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion-tax-home-in-foreign-country (last accessed July 18, 2021).

      3 .See IRS Guidance: “Revocation of the Foreign Earned Income Exclusion,” available at http://www.irs.gov/Individuals/International-Taxpayers/Revocation-of-the-Foreign-Earned-Income-Exclusion (last accessed July 18, 2021).

  • 956. What are the bona fide residence and physical presence tests that can allow a U.S. individual to qualify for the foreign earned income exclusion?

    • A U.S. individual with foreign earned income must satisfy either the bona fide residence test or the physical presence test in order to be eligible to exclude all or a portion of foreign earned income from U.S. income (see Q 966).

      Editor’s Note: The IRS relaxed these requirements for 2020 in response to travel restrictions put in place in response to COVID-19.  An otherwise qualified individual may still exclude foreign earned income for the period in which the individual was actually present in the foreign country even if the individual fails to meet the time requirements. To qualify for relief, an individual must establish (1) he or she must have established residency, or have been physically present in either: China on or before December 1, 2019, or any other foreign country on or before February 1, 2020 and (2) the individual must have departed either: China (excluding Hong Kong and Macau) between December 1, 2019, and July 15, 2020, or any other foreign country between February 1, 2020, and July 15, 2020 and (3) individual would have met the requirements of either the bona fide residence test or the physical presence test, but for the COVID-19 emergency.[1]

       An individual may use the “bona fide residence test” to qualify for the exclusion if the individual is either (a) a U.S. citizen or (b) a U.S. resident alien who is a citizen of a country with which the U.S. has an income tax treaty in effect. The bona fide residence test, as the name suggests, is met if the individual has established a residence in a foreign country. The length of the individual’s stay and the nature of employment are factors considered in determining whether the individual has established a residence in a foreign country, but are not determinative—all of the facts and circumstances of the particular situation must be taken into account.

       The IRS has provided bright-line guidance so that the individual must reside in the foreign country for an uninterrupted period that includes an entire tax year, though every individual that resides in a foreign country for at least an entire tax period is not automatically considered to have established a residence.[2]

       Example: Shannon’s domicile (permanent home) is in Brooklyn, New York, but she is assigned to her employer’s London office for an indefinite duration. She rents an apartment in London with a one-year lease, though she intends to eventually return to Brooklyn. Assuming all other factors indicate that Shannon has established a residence in London, she will meet the bona fide residence test even though she plans to return to Brooklyn at some point in the future. If Shannon had, for example, been sent to London for a month-long work assignment with a definite return date, she would not be able to satisfy the bona fide residence test. If Shannon had been assigned to her work post in London for 16 months, she may not be able to meet the bona fide residence test because her presence in London is limited in duration.

       An individual (whether a U.S. citizen or resident alien) meets the physical presence test if physically present in a foreign country (or countries) for at least 330 days during a consecutive twelve-month period. The individual is not required to establish a residence and there are no requirements as to whether or not the individual intends to return to the U.S. at a specified time under the physical presence test. Unlike the tax home requirement, the individual can be in the foreign country during these days for any reason—there is no requirement that the presence abroad be motivated by business or employment reasons.[3]

       

      [1]      Rev. Proc. 2020-27.

      [2].    See IRS Guidance: “Foreign Earned Income Exclusion – Bona Fide Residence Test,” available at https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion-bona-fide-residence-test (last accessed July 18, 2021).

      [3].    See IRS Guidance: “Foreign Earned Income Exclusion – Physical Presence Test,” available at https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion-physical-presence-test (last accessed July 18, 2021).

  • 957. What is the foreign housing exclusion (or deduction)?

    • The foreign housing exclusion applies to housing costs paid for with employer-provided funds (including amounts paid by the employer to the employee as taxable foreign earned income), while the foreign housing deduction applies to an individual who pays for foreign housing with self-employment earnings.

      The foreign housing exclusion (or deduction) allows an individual to exclude (or deduct) amounts spent on housing costs while residing abroad, provided that the individual’s tax home (see Q 954) is found to be in a foreign country and the taxpayer meets either the bona fide residence test or the physical presence test (see Q 956).1

      An individual’s “housing amount” is the total housing costs for the year minus a base amount that is tied to the maximum foreign earned income exclusion (see Q 954) for the year. The amount is 16 percent of the maximum foreign earned income exclusion $108,400 in 2021 ($107,600 in 2020, $105,900 in 2019, $103,900 in 2018, and $102,100 in 2017, as indexed for inflation),2 calculated on a daily basis, and multiplied by the number of days spent abroad in the tax year.3

      Housing expenses that qualify for the exclusion or deduction must be reasonable, and can also include housing expenses for the individual’s spouse and/or dependents if they live with the individual while abroad.4 The cost of purchasing real property, furniture, accessories or other improvements to increase the value of the property are excluded from the definition of housing expenses for purposes of the exclusion (or deduction). Expenses relating to housing, such as the cost of utilities and insurance, are included in the definition of housing expenses for purposes of the exclusion (or deduction).5

      The amount of a taxpayer’s foreign housing exclusion (or deduction) cannot exceed the amount of foreign-earned income for the tax year.


      1 .IRC Sec. 911(a)(2).

      2 .Rev. Proc. 2016-55, Rev. Proc. 2018-18, Rev. Proc. 2018-57, Rev. Proc. 2019-44, Rev. Proc. 2020-45.

      3 .IRC Sec. 911(c)(1).

      4 .IRC Sec. 911(c)(3).

      5 .IRC Sec. 911(c)(3).

  • 958. Can U.S. individuals employed in a foreign country receive U.S. Social Security credit?

    • In some cases, a U.S. individual will continue to earn U.S. Social Security credit if liable for Social Security and Medicare taxes on amounts earned while performing services as an employee in a foreign country. The IRS has issued guidance that provides that Social Security and Medicare taxes continue to apply to wages paid for services performed by a U.S. individual abroad if any of the following are true:

      (1)The individual is working for a U.S. employer,

      (2)The individual performs services in connection with a U.S. aircraft or vessel and the individual has (a) entered into an employment contract in the U.S. or (b) the vessel or aircraft touches down at a U.S. port while the individual is employed on it,

      (3)The individual is working in a country with which the U.S. has entered a Social Security agreement providing that the foreign earned income is subject to U.S. Social Security and Medicare taxes, or

      (4)The individual is working for a foreign affiliate (a foreign entity in which the U.S. employer has at least a 10 percent interest) of a U.S. employer under a voluntary agreement (under IRC Section 3121(l)) entered into by that employer and the U.S. Treasury Department.1

      The IRS guidance further provides that an individual is “working for a U.S. employer” for purposes of (1), above, if the individual is working for (a) the U.S. government (or instrumentality thereof), (b) another individual who is a U.S. resident, (c) a partnership in which at least two-thirds of the partners are U.S. residents, (d) a trust, in which all of the trustees are U.S. residents or (e) a corporation organized in the U.S., or in any U.S. state (including D.C., the Virgin Islands, Guam, American Samoa and the Northern Mariana Islands).2

      A U.S. employer who voluntarily enters into an agreement to extend Social Security coverage to its employees working in a foreign country is liable for the entire amount of the covered employees’ Social Security taxes that would otherwise apply under Sections 3101 and 3111 if those employees were employed domestically.3

      The IRS has advised that U.S. individuals who are working in a country with which the U.S. has entered a Social Security agreement providing that the individual’s income will not be subject to U.S. Social Security taxes obtain a statement from the relevant agency in the foreign country stating that the individual’s income is subject to Social Security coverage in that foreign country.

      The U.S. Social Security Administration (SSA) will issue determinations that a U.S. individual’s income is subject only to U.S. Social Security taxes if the employer contacts the SSA and provides certain basic identifying information about that individual and his or her employment abroad.


      1 .See IRS Guidance: “Social Security Tax Consequences of Working Abroad,” available at http://www.irs.gov/Individuals/International-Taxpayers/Social-Security-Tax-Consequences-of-Working-Abroad (last accessed July 18, 2021).

      2 .IRC Sec. 3121(h).

      3 .IRC Sec. 3121(l)(1)(A).

  • 959. What are some of the considerations that a U.S. citizen or resident should be aware of when participating in a retirement plan while residing in a foreign country?

    • While many U.S. citizens and residents who are transferred abroad by multinational employers may continue to be covered by the multinational’s U.S. retirement plan, in some cases, a U.S. individual may obtain benefits under a foreign plan. Because U.S. citizens and residents are taxed on their worldwide income, benefits accrued under foreign retirement plans may be subject to U.S. taxation absent a treaty provision that provides otherwise. Most treaties provide that a pension or annuity received from a foreign employer is taxed in the country of residence under its domestic laws.1

      Treaties with some countries provide for liberalized treatment of retirement accounts—for example, the treaty between the U.S. and the U.K. provides that U.S. citizens residing in the U.K. can deduct, for U.S. tax purposes, amounts contributed to a pension plan established in the U.K.2

      Further, while a U.S. individual residing abroad may exclude a portion of foreign earned income from U.S. gross income each year, the foreign earned income exclusion does not apply to income received as a pension or annuity while abroad3 (Q 3559).


      Planning Point: The IRS has released long-awaited proposed regulations clarifying the income tax withholding obligations when distributions from employer-sponsored plans (including pension, annuity, profit sharing, stock bonus or deferred compensation plans) are made to destinations outside the U.S.  While U.S. payees can elect to forgo withholding, non-U.S. payees cannot.  In general, the participant cannot elect to forgo withholding with respect to these distributions even if the participant provides a U.S. residential address, but directs funds to be delivered to a destination outside the U.S.  If the participant provides a non-U.S. residential address, withholding obligations cannot be waived even if the participant directs that the funds be distributed to a U.S. financial institution.  When the participant provides no residential address, withholding obligations cannot be waived.


      Technically, a plan established in a foreign country cannot be “qualified” under IRC Section 401, because of the requirement that a qualified trust be organized under U.S. law.4 Therefore, a U.S. individual participating in a foreign retirement plan would not be entitled to defer taxation of contributions to the foreign plan in the same manner as would be available in the U.S., absent a treaty provision to the contrary.

      However, plans established by certain U.S. multinationals that are established under foreign law may achieve the same tax result if the plan is otherwise qualified.5 IRC Section 404(a)(4) provides a special rule that allows for the qualification of a trust established outside of the U.S. if the employer contributing to the plan is a U.S. resident, corporation or other entity and the plan is otherwise qualified.


      1 .See IRS Guidance, “The Taxation of Foreign Pensions and Annuities,” available at http://www.irs.gov/Businesses/The-Taxation-of-Foreign-Pension-and-Annuity-Distributions (last accessed July 18, 2021).

      2 .See the Treasury Department Technical Explanation of the Convention between the U.S. and U.K, Article 17, available at http://www.treasury.gov/resource-center/tax-policy/treaties/Documents/teus-uk.pdf (last accessed July 18, 2021).

      3 .IRC Sec. 911(b)(1)(B).

      4 .IRC Sec. 401(a).

      5 .IRC Sec. 404(a)(4).

  • 960. Are employer contributions to a foreign retirement account on behalf of a U.S. individual exempt from U.S. reporting requirements?

    • U.S. individuals residing abroad may become subject to both the FBAR and FACTA reporting rules, and the corresponding penalties for noncompliance, based upon their participation in foreign retirement plans.

      Generally, a U.S. individual who has an interest in any “foreign account” is required to file an FBAR (Form TD F90-22.1) if the aggregate value of foreign accounts exceeds $10,000 at any time during the calendar year.1 The IRS has issued regulations that specifically exempt certain accounts, including plans that qualify under IRC Section 401 and IRA accounts, but these regulations do not provide a similar exemption for foreign retirement accounts.2 Therefore, whether FBAR reporting will be required for a U.S. individual’s foreign retirement accounts will likely turn upon whether the individual has a “financial interest” or “signature authority” over the foreign account.

      Penalties for failure to file an FBAR can be steep—for willful violations, the civil penalty can equal the greater of $100,000 or 50 percent of the account assets, and the IRS may be entitled to file criminal charges.3 For non-willful violations, the penalty can still equal up to $10,000 per violation unless the taxpayer can show that there was reasonable cause for failure to file, in which case no penalty is imposed.4

      Because of the steep penalties imposed upon taxpayers who do not comply with FBAR reporting obligations, the IRS has issued guidance to allow certain “low risk” nonresident U.S. taxpayers who have resided outside of the U.S. since January 1, 2009 to catch up on filing delinquent U.S. income tax returns and FBARs with respect to their foreign accounts. Whether an individual is “low risk” or not will be determined based on the amount of U.S. income tax owed (less than $1,500 per tax year is low risk), and these delinquent returns will be processed in a streamlined manner absent any other high risk factors.5 The plan is described by the IRS as a method to provide assistance to U.S. citizens residing abroad, including dual citizens, with foreign retirement plan issues.6

      In addition to FBAR filing requirements, a U.S. individual may be required to comply with FATCA and report any foreign financial assets with an aggregate value of over $50,000 (or higher amount, if the Secretary otherwise provides) on Form 8938, Statement of Specified Foreign Financial Assets, attached tohis or her U.S. tax return.7


      1 .See IRS “FAQs Regarding Report of Foreign Bank and Financial Accounts (FBAR) – Financial Accounts,” available at https://www.irs.gov/businesses/small-businesses-self-employed/report-of-foreign-bank-and-financial-accounts-fbar (last accessed July 18, 2021).

      2 .See IRS Guidance: “Report of Foreign Bank and Financial Accounts (FBAR),” available at https://www.irs.gov/businesses/small-businesses-self-employed/report-of-foreign-bank-and-financial-accounts-fbar (last accessed July 18, 2021).

      3 .31 USC 5321(a)(5).

      4 .See IRS FS-2011-13 (December 2011).

      5 .See IRS Instructions for New Streamlined Filing Compliance Procedures for Nonresident, Non-Filer U.S. Taxpayers, available at http://www.irs.gov/Businesses/Corporations/Summary-of-FATCA-Reporting-for-U.S.-Taxpayers (last accessed July 18, 2021).

      6 .IR-2012-65 (June 26, 2012).

      7 .IRC Sec. 6038D(a).

  • 961. What assets of a foreign individual (nonresident alien) are subject to U.S. estate tax?

    • Unlike a U.S. citizen, who is subject to estate taxation on worldwide assets, the gross estate of a nonresident alien (meaning, a foreign individual who is not a U.S. citizen or resident alien) only includes property that is situated in the U.S. at the time of the nonresident alien’s death.1

      For purposes of determining what property is situated in the U.S., any property which the decedent has transferred, by trust or otherwise, which would be taxable within the provisions of IRC Sections 2035 through 2038 (relating to termination of certain property interests within three years of death, transfers with a retained life estate or to take effect at death, and revocable transfers), is deemed situated in the United States if it was so situated either at the time of the transfer or at the time of death.2

      For a decedent who was a nonresident alien at the time of death, property is considered located in the U.S. if it falls into any of the following categories:

      (1)Real property located in the U.S.;

      (2)Tangible personal property located in the U.S., including clothing, jewelry, automobiles, furniture or currency. Works of art imported into the U.S. solely for public exhibition purposes are not included;

      (3)A debt obligation of a citizen or resident of the U.S., a domestic partnership or corporation or other entity, any domestic estate or trust, the U.S., a state or a political subdivision of a state or the District of Columbia; or

      (4)Shares of stock issued by domestic corporations, regardless of the physical location of stock certificates.3

      However, in the case of a nonresident alien who dies while in transit through the U.S., personal effects are not considered located in the U.S. Neither is merchandise that happens to be in transit through the U.S. when a nonresident alien owner dies.

      The IRS has also addressed certain assets and found that they are specifically excludible from a nonresident alien’s gross estate as being “without the U.S.” The following nonexhaustive list of the property owned by a nonresident alien is not considered to be situated within the U.S. for calculating the gross estate:

      (1)A bank account that is not used in connection with a U.S. trade or business;4

      (2)A deposit or withdrawable account with a savings and loan association chartered and supervised under federal or state law or an amount held by an insurance company under an agreement to pay interest on it. But the deposit or amount must not be connected with a U.S. trade or business and must be paid or credited to the decedent’s account;5

      (3)A deposit with a foreign branch of a U.S. bank if the branch is engaged in the commercial banking business;6

      (4)A debt obligation, the interest on which would be exempt from income tax under IRC Section 871(h)(1), relating to tax-exemption for interest earned by nonresident aliens with respect to portfolio debt investments;7

      (5)Stock issued by a corporation that is not a domestic corporation, even if the certificate is physically located in the United States;8

      (6)An amount receivable as insurance on the decedent’s life;9

      (7)Certain original issue discount obligations;10 and

      (8)Certain stock that a nonresident alien owns in a regulated investment company (RIC) at the time of his or her death.11

      If the decedent was a citizen or resident of one of the countries with which the U.S. had an estate tax treaty in place, the provisions of the treaty may override the normally applicable provisions of the Internal Revenue Code that are outlined above.


      1 .IRC Sec. 2103.

      2 .IRC Sec. 2104(b).

      3 .Treas. Reg. § 20.2104-1(a).

      4 .See IRS Guidance: “Some Nonresidents with U.S. Assets Must File Estate Tax Returns,” available at http://www.irs.gov/Individuals/International-Taxpayers/Some-Nonresidents-with-U.S.-Assets-Must-File-Estate-Tax-Returns (last accessed July 18, 2021).

      5 .IRC Secs. 2105(b)(1), 871(i)(3).

      6 .IRC Sec. 2105(b)(2).

      7 .IRC Sec. 2105(b)(3).

      8 .IRC Sec. 2104(a).

      9 .IRC Sec. 2105(a).

      10 .IRC Secs. 2105(b)(5), 871(g)(1).

      11 .IRC Sec. 2105(d).

  • 962. How does the estate of a foreign individual (nonresident alien) calculate the amount of U.S. estate tax owed?

    • The estate tax computation base of a nonresident alien’s estate consists of his or her taxable estate plus any taxable gifts made during his or her lifetime.1 The taxable gifts of a nonresident alien made after 1976 (other than gifts included in the gross estate) also form part of the tax base upon which the estate tax is computed. The adjusted taxable gifts of a nonresident alien are computed in the same manner as for a resident citizen.2

      Once the taxable estate of the nonresident alien decedent is determined, the mechanics of the actual tax calculation and the applicable rate schedule (before the unified credit) are the same for nonresident alien decedents as for citizen-residents. However, a very important difference comes into play in the use of the unified credit, which is greatly reduced for nonresident alien decedents. This, of course, indirectly results in a higher effective tax rate. See Q 964 for a discussion of the unified credit as applied to nonresident aliens


      1 .IRC Sec. 2101(c).

      2 .IRC Sec. 2101(b), (c).

  • 963. Is the estate of a foreign individual entitled to the same deductions as a U.S. individual?

    • A nonresident alien’s taxable estate is determined by deducting the following items from the alien’s gross estate:

      (1)Expenses, indebtedness, taxes and losses. These items may be deducted only in the proportion that the value of the decedent’s gross estate in the U.S. bears to the value of the entire estate, wherever situated.1 Thus, the deductible portion of each item is limited to the amount of each item multiplied by a fraction, the numerator of which is the value of the property located in the U.S., and the denominator of which is the value of the entire gross estate, wherever located.

      (2)Charitable bequests. Charitable bequests are fully deductible if made to organizations meeting the requirements for an estate tax charitable deduction under IRC Section 2055 and are computed in the same manner as similar deductions allowed the estates of U.S. citizens and residents.2

      (3)Marital Deduction. The marital deduction is not available for property passing to a surviving spouse who is an alien (either a resident alien or a nonresident alien) unless the property passes to the spouse in a qualified domestic trust (QDOT) or is placed in a QDOT before the date on which the decedent’s estate tax return is filed.3 The policy behind this limitation is that if the surviving spouse is an alien, there is a considerable likelihood that the marital deduction property will eventually be moved abroad, and not be taxable upon the death of the surviving spouse. This possibility can be eliminated, however, through the QDOT mechanism, which assures that the property in question will remain subject to U.S. estate tax upon the death of the surviving spouse.

      Allowance of Deductions.A deduction is allowed only if the executor discloses in the estate tax return the value of that part of the gross estate not situated in the U.S.4


      1 .IRC Sec. 2106(a)(1).

      2 .IRC Sec. 2106(a)(2).

      3 .IRC Sec. 2056(d).

      4 .IRC Sec. 2106(b).

  • 964. May a nonresident alien’s estate claim an estate tax exemption upon the death of the nonresident alien?

    • The unified transfer tax credit in the case of a nonresident alien decedent is only $13,000.1 This effectively exempts only the first $60,000 of his or her taxable estate from estate tax, a considerably lower threshold than applies to a domestic decedent (see Q 861).

      A special rule applies if the decedent was a nonresident of the United States, but resided in a U.S. possession (e.g., Puerto Rico, Guam) and was a U.S. citizen only because of birth or residence in, or citizenship of, the possession. Under these circumstances, the decedent is considered to be a “nonresident noncitizen,”2 and the estate of a decedent in this category qualifies for a credit that is the greater of:

      (1)$13,000, or

      (2)$46,800 multiplied by the ratio that the value (at death) of that part of the decedent’s gross estate that is located in the U.S. bears to the entire value of the decedent’s gross estate.3

      In either case, the credit may not be more than the amount of the estate tax.4 Further, the amount of the available credit is reduced by the value of any lifetime gifts made by the nonresident alien-decedent.5


      1 .IRC Sec. 2102(b)(1).

      2 .IRC Sec. 2209.

      3 .IRC Sec. 2102(b)(2).

      4 .IRC Sec. 2102(b)(4).

      5 .IRC Sec. 2102(b)(3)(B).

  • 964.13. What is the passive asset test that applies when determining PFIC status?

    • A foreign corporation is a PFIC if at least 50 percent of its assets produce passive income or are held for the production of passive income.[1]  The passive asset test is calculated by determining the value of the foreign corporation’s assets each tax year. Asset valuation is based on fair market value unless the corporation is also a controlled foreign corporation (CFC), in which case assets are valued based on their adjusted bases.[2]

      An asset will be treated as though it is held for the production of income if it is held to produce capital gains and/or foreign currency gains.[3]

      The asset test applies on a gross basis.  In other words, if the corporation’s liabilities are secured by particular assets, that fact does not reduce the value of those assets for purposes of the 50 percent test.

      The 50 percent test is based on the average of the fair market value of the foreign corporation’s assets determined at the end of each quarterly period.  Typically, foreign corporations will not be required to obtain an independent appraisal to apply the 50 percent test.[4]

      The average percentage of a foreign corporation’s assets is determined using the average of the gross values (or adjusted bases) at the end of each quarter of the foreign corporation’s tax year.[5] The foreign corporation can also measure asset value more frequently than quarterly. The quarter (or shorter period) used by a tested foreign corporation is referred to as its “measuring period.” Applying the asset test based on a period that is shorter than a quarter can provide a more accurate measurement of average asset value, but the more frequently recurring time period is not required because of the potential administrative burden that it could impose on shareholders.

      The same measuring period must generally be used for the tested foreign corporation for the initial tax year (including any short year in which the shareholder elects to use the alternative measuring period) and all subsequent years unless the election to use the more frequently recurring measuring period is revoked.[6] In the case of a short tax year, the quarterly measuring dates for purposes of the asset test are the same as for a full tax year, except that the final quarterly measuring date will be the last day of the short tax year.[7]

      A foreign corporation’s income and assets may also include assets and income of lower-tier corporations if the corporation owns at least 25 percent of the stock.[8] This look-through rule means that a foreign corporation cannot use subsidiaries to avoid PFIC status. Indirect stock ownership is determined under the general rules used in determining ownership by value.[9] These rules apply without regard to whether entities are domestic or foreign, meaning that indirect ownership includes corporate ownership through intermediate corporations, partnerships, trusts, and estates, regardless of where the entity is organized. Further, stock treated as owned by application of the indirect ownership rules is generally considered actually owned for purposes of reapplying the indirect ownership rules.[10]

      The foreign corporation is deemed to own its proportionate share of the lower-tier entity’s assets and income.[11] However, when lower-tier entities are operating subsidiaries, the foreign corporation may avoid PFIC treatment because dividends and interest derived from them are not considered passive income. Under the look-through rule, interest and dividends passed from lower-tier entities retain their character as operating income when passed to the parent corporation.[12]

      For purposes of the passive asset test, a foreign corporation that directly or indirectly owns an interest in a partnership is treated as if it held its proportionate share of the assets of a partnership, provided the tested foreign corporation owns, directly or indirectly, at least 25 percent, by value, of the interests in the partnership.[13] A corporation’s proportionate share of a partnership asset is treated as passive to the extent the asset produced, or was held to produce, passive income in the partnership’s hands, taking into account only the partnership’s activities. If a foreign corporation owns less than 25 percent of the value of the partnership, its interest in the partnership is treated as a passive asset.[14]

      The look-through rule does not always apply to a domestic corporation or any subsidiaries of the domestic corporation.  That’s true if the stock of the domestic corporation is treated as a non-passive asset that produces non-passive income.[15]

      A foreign corporation may attempt to avoid PFIC status regardless of direct and indirect ownership of passive assets by ensuring that a sufficient amount of the assets are held indirectly through two tiers of domestic subsidiaries.[16] For example, a foreign corporation might hold stock in another foreign corporation that is PFIC, but use a two-tiered domestic chain holding passive assets to avoid being treated as a PFIC.  In this case, a U.S. person holding stock of the foreign corporation would generally not be treated as a shareholder of the PFIC stock owned by the tested foreign corporation.[17]


      Planning Point: An anti-abuse rule provides that look-through exceptions regarding a foreign corporation subject to the accumulated earnings tax will not apply if the tested foreign corporation would be a PFIC if the qualified stock or any income received or accrued with respect to such stock were disregarded.[18] A second anti-abuse rule provides that the exception will not apply if a principal purpose for the foreign corporation’s formation or acquisition of the 25-percent-owned domestic corporation is to avoid PFIC status.  The law presumes such a principal purpose exists if the 25-percent-owned domestic corporation is not engaged in an active U.S. trade or business.[19]


      An asset is passive for purposes of the asset test if it produces passive income or is held for the production of passive income.  However, if the asset produces both passive income and non-passive income during the same tax year, it is treated as two separate assets (one passive and one non-passive).[20] The asset is treated as partly a passive asset and partly a non-passive asset in proportion to the proportionate amounts of income generated by the asset during the year.[21]  For purposes of the asset test, the fair market value (or adjusted basis) of the asset is allocated between the passive assets and non-passive assets based on the ratio of passive income produced by the asset during the tax year to non-passive income.

      [1] IRC Sec. 1297(a)(2).

      [2] IRC Sec. 1297(e).

      [3] IRC Sec. 954(c).

      [4] Notice 88-22, 1988-11 IRB 1.

      [5] Prop. Treas. Reg. §1.1297-1(d)(1)(i) and (d)(1)(ii)(A).

      [6] Prop. Treas. Reg. §1.1297-1(d)(1)(ii)(B).

      [7] Prop. Treas. Reg. §1.1297-1(d)(1)(ii)(C).

      [8] IRC Sec. 1297(c).

      [9] Prop. Treas. Reg. §1.1297-2(b)(1); IRC Secs. 1297(c) and 958(a).

      [10] Treas. Reg. §1.958-2(f)(1).

      [11] IRC Sec. 1297(c).

      [12] H. Rep. No. 841 at II-644.

      [13] Prop. Treas. Reg. §1.1297-1(d)(3)(i).

      [14] Prop. Treas. Reg. §1.1297-1(d)(3)(ii).

      [15] Prop. Treas. Reg. §1.1297-2(b)(2)(iii) referencing both IRC Secs. 1297(c) and 1298(b)(7).

      [16] Under IRC Sec. 1298(b)(7), qualified stock held by a domestic corporation is treated as an asset that does not produce passive income when the foreign corporation is subject to the IRC Section 531accumulated earnings tax.

      [17] See Prop. Treas. Reg. § 1.1298-4(e); IRC Sec. 1298(a)(2) and Treas. Reg. §1.1291-1(b)(8)(ii)

      [18] Prop. Treas. Reg. §1.1298-4(f)(1).  See also the exception in IRC Sec.1298(b)(7).

      [19] Prop. Treas. Reg. §1.1298-4(f)(2).

      [20] Prop. Treas. Reg.  §1.1297-1(d)(2).

      [21] Notice 88-22.

  • 965. Can a life insurance policy or annuity contract issued to a U.S. person by a foreign life insurance company qualify for the tax benefits traditionally afforded to U.S. life insurance policies?

    • Generally, foreign insurance companies cannot sell insurance products to U.S. persons without becoming subject to U.S. regulation. Despite this, if a U.S. person resides in a foreign country for an extended period of time, it is possible that he or she may choose to purchase a life insurance or annuity product from a foreign insurance company in that country. In order for a foreign-issued life insurance or annuity product to qualify for the same tax preferences given to domestic products, it will be required to comply with the U.S. requirements for these products (including, for example, the definition of “life insurance contract” under Section 7702 or the annuity provisions of Section 72).

      Further, under the IRC, most annuity contracts issued by domestic insurance companies are exempt from the original issue discount (OID) rules (discussed in Q 497 to Q 503).1 An annuity contract issued by a foreign insurance company will be subject to the OID rules, however, unless that insurance company is subject to tax under subchapter L with respect to income earned on the annuity contract. If the insurance company is not subject to tax under subchapter L, the annuity contract will be included in the definition of a debt instrument and the growth on the annuity cash value can be subject to tax as interest income even if payouts under the annuity contract have not yet begun.2

      In the context of variable life insurance contracts, a contract will not qualify as a variable life insurance contract unless it is a “variable contract” for purposes of IRC Section 817(d). Under this provision, the amounts received under the variable contract must be segregated into an account that is separate from the company’s general asset accounts under state law or regulation.3 The question that arises in this context is whether an insurance company that segregates its assets pursuant to foreign law will qualify. The IRS has found that a foreign insurance company that elects to be taxed as a domestic company under IRC Section 953(d) (meaning it will be subject to subchapter L taxation), and that segregates amounts received under life insurance contracts from general company assets under foreign law, can meet the requirements of Section 817(d).4

      This, however, leaves open the possibility that variable contracts issued by a foreign insurance company that has not elected to be taxed as a domestic company will not qualify for treatment as such under the IRC.


      1 .IRC Sec. 1275(a)(1)(B).

      2 .Treas. Reg. §1.1275-1(k).

      3 .IRC Sec. 817(d)(1).

      4 .Let. Rul. 200919025.

  • 966. What considerations should a U.S. citizen or resident alien be aware of when disposing of real property that is located in a foreign country?

    • The general rule that a U.S. citizen or resident alien is taxed on all worldwide income applies in the case of a sale of real property in the same manner as income from any other source.1 Therefore, a U.S. citizen or resident alien who sells real property that is located in a foreign country must report and abide by U.S. tax rules relating to the sale of real property (see Q 7846).

      Thus, for example, a U.S. citizen who sells a principal residence that he or she has used as a principal residence for two of the five preceding tax years is entitled to exclude a portion of the gain from taxation in the U.S. in the same manner as though the property was located within the U.S. (see Q 7846).

      Though the U.S. citizen or resident alien may also be required to pay taxes upon disposition of foreign-located real property both in the U.S. and in the country in which the property is situated, he or she will be entitled to claim a credit for certain foreign taxes paid on his or her U.S. tax return.2

      Further, a U.S. citizen or resident alien may be entitled to deduct any real property taxes that are imposed by a foreign country on his or her U.S. tax return.3


      1 .See IRS Publication 544.

      2 .See IRS Publication 54.

      3 .IRS Pub. 54.

  • 967. What is FBAR?

    • The Foreign Account Tax Compliance Act (FATCA) requires U.S. taxpayers with foreign accounts and assets to report their interests in financial assets held outside of the United States annually to the IRS. Taxpayers report foreign assets on FinCEN Form 114 (Report of Foreign Bank and Financial Accounts or “FBAR”).[1]

      Generally, an FBAR filing will be required if all of the following are true:

      • The taxpayer is a U.S. person
      • The taxpayer has a financial interest in an account or has signature/other authority over the account
      • The account is located in a foreign country
      • At some point during the tax year, the value of all accounts owned or controlled by the taxpayer exceeded $10,000

      These FBAR reporting rules were developed to prevent U.S. taxpayers from escaping tax liability by hiding assets in foreign jurisdictions. Technically, FinCEN has authority for making rules governing FBAR filing. However, the IRS has enforcement power and authority to impose penalties.

      Failure to comply with the FBAR filing requirements can expose a taxpayer to both civil and criminal penalties.

      Importantly, taxpayers should understand that FBAR filing does not necessarily mean that the taxpayer will be subject to additional taxes. FBAR imposes filing and reporting requirements. The taxpayer may or may not owe taxes based on the foreign financial account activity.

      [1].          See 31 U.S.C. 5314.

  • 968. Who is subject to FBAR filing requirements?

    • U.S. persons are required to file an FBAR if they have a financial interest (see Q 964.03) in foreign bank accounts with an aggregate value exceeding $10,000 at any time during the calendar year (the $10,000 limit applies regardless of filing status).[1] Even if no single account ever exceeds the $10,000 threshold, the taxpayer will be required to file an FBAR if the combined value of all accounts exceeds $10,000 at any point during the year.

      An individual FBAR filer is a natural person who owns a reportable foreign financial account or has signature authority but no financial interest in a reportable foreign financial account that requires the filing of an FBAR for the reportable year.

      Certain individual U.S. persons must file even if they do not have a financial interest in a reportable account if they have signature authority over one or more otherwise reportable accounts. For example, an officer or employee of a U.S. entity who has the requisite control over the transfer or withdrawal of funds from foreign financial accounts will typically be required to file the FBAR even if that individual does not have a direct ownership interest. This filing requirement is based on the idea that the individual has authority to control the funds in the account.

      Generally speaking, a “U.S. person” is a U.S. citizen, U.S. resident, corporation, partnership, limited liability entity, trust or estate. Residency status can be based on either the green card test or the substantial presence test (see Q 949 for a more in-depth discussion).

      If all foreign financial accounts are jointly owned between two spouses, one spouse can complete FinCEN Form 114a to authorize the other spouse to file on his or her behalf.[2]

      [1].          31 CFR 1010.350.

      [2].          See https://www.irs.gov/businesses/small-businesses-self-employed/report-of-foreign-bank-and-financial-accounts-fbar.

  • 969. When does a taxpayer have a financial interest in a foreign financial account for FBAR purposes?

    • As noted, a taxpayer does not have to own a foreign financial account to have an FBAR filing requirement. FBAR filing obligations can be triggered if the individual merely has signature authority over the account.

      A U.S. person has a financial interest in a foreign financial account under the following circumstances:

      1. The U.S. person is the owner of record or holder of legal title.
      2. The owner of record or holder of legal title is one of the following:
      3. An agent, nominee, attorney, or a person acting in some other capacity on behalf of the U.S. person with respect to the account,
      4. A corporation in which the U.S. person owns directly or indirectly (i) more than 50 percent of the total value of shares of stock or (ii) more than 50 percent of the voting power of all shares of stock,
      5. A partnership in which the U.S. person owns directly or indirectly (i) an interest in more than 50 percent of the partnership’s profits (e.g., distributive share of partnership income, taking into account any special allocation agreement) or (ii) an interest in more than 50 percent of the partnership capital,
      6. A trust whereby the U.S. person (i) is the trust grantor and (ii) has an ownership interest in the trust,
      7. A trust in which the U.S. person has a greater than 50 percent present beneficial interest in the assets or income of the trust for the calendar year, or
      8. Any other entity in which the U.S. person owns directly or indirectly more than 50 percent of the voting power, total value of equity interest or assets, or interest in profits.

      Note that taxpayers subject to FBAR filing requirements may also be required to file Form 8938, Statement of Specified Foreign Accounts, with respect to the same financial accounts (even if duplicate information is reported).

  • 970. Which accounts must be reported in an FBAR filing?

    • Typically, any account located in a foreign institution outside of the U.S. is considered a foreign financial account. Taxpayers may be subject to FBAR reporting requirements regardless of whether the account generated taxable income during the year.

      For purposes of the FBAR filing rules, a financial account includes, but is not limited to, a securities, brokerage, savings, demand, checking, deposit, time deposit, or other account maintained with a financial institution (or other person performing the services of a financial institution). Cryptocurrency holdings can also trigger FBAR filing requirements if the virtual currency is held with a non-U.S. company, or a non-U.S. company was involved in the process of converting and transferring the currency into another format.


      Planning Point: Taxpayers should check with qualified tax counsel to determine whether their cryptocurrency activity may trigger FBAR filing requirements


      A financial account also includes a commodity futures or options account, an insurance policy with a cash value (such as a whole life insurance policy), an annuity policy with a cash value, and shares in a mutual fund or similar pooled fund (i.e., a fund that is available to the general public with a regular net asset value determination and regular redemptions).

      Certain types of accounts are specifically exempt from the FBAR filing requirements. According to the IRS, those include accounts that are:

      • Held in an individual retirement account (IRA) the taxpayer owns or is beneficiary of,
      • Held in a retirement plan in which the taxpayer a participant or beneficiary,
      • Part of a trust of which the taxpayer a beneficiary, if a U.S. person (such as the trust, trustee of the trust or an agent of the trust) files an FBAR reporting these accounts
      • Owned by a governmental entity,
      • Owned by an international financial institution,
      • Maintained on a U.S. military banking facility, or
      • Correspondent/Nostro accounts.

      Planning Point: Even if the client does not own an account that triggers FBAR filing requirements, it remains possible that the client may have to report interests in foreign assets on Form 8938 (which is filed with the client’s federal income tax return).  Form 8938 and FBAR are completely separate filings—meaning that clients may have an obligation to report foreign assets on both FBAR and Form 8938.


       

  • 971. How does a taxpayer determine the value of an account for FBAR filing purposes?

    • For FBAR purposes, the account value is determined using the account’s highest value at any point during the tax year. In other words, the FBAR doesn’t report the total amount of the assets a taxpayer holds in foreign financial accounts at year-end. Instead, it reports the maximum amount that the taxpayer held at any single point during the tax year.

      The taxpayer reports the amounts using U.S. dollars regardless of where the assets are located. Foreign currencies must be translated into U.S. dollars using the Treasury Department’s year-end exchange rate.[1] Amounts should be rounded up to the next whole dollar.

      [1].          See https://www.fincen.gov/reporting-maximum-account-value.

  • 972. Are there any exceptions to the FBAR filing requirements?

    • It is not always necessary to file a separate FBAR for each and every foreign financial account. If all of the taxpayer’s foreign financial accounts are listed on a consolidated FBAR, additional FBAR filings will not be required.

      Similarly, taxpayers who have authorized a spouse to file FBARs with respect to jointly owned foreign assets will not be required to file an additional FBAR. The spousal exception applies regardless of filing status. However, this spousal exception does not apply if either spouse owns a separate foreign account (regardless of value).[1]

      Note that there is no specified exception for foreign financial accounts that are owned by minor children.

      [1].          See https://www.irs.gov/businesses/small-businesses-self-employed/report-of-foreign-bank-and-financial-accounts-fbar.

  • 973. What is the FBAR filing deadline and how does a taxpayer file an FBAR?

    • Under prior law, taxpayers were required to file FinCEN Form 114 (FBAR) on or before June 30 of the year immediately following the calendar year being reported. There was no extension of time to file.

      The due date for FBARs has been changed for tax years beginning in 2017 (for calendar year 2016) and thereafter from June 30th to April 15 to coincide with the regular Form 1040 tax filing deadline.[1] As with the federal tax filing deadline, a six-month extension is now available so that taxpayers may file on time by October 15. The Treasury Secretary has authority to waive penalties for failure to complete a timely request for extension for any taxpayer required to file Form 114 for the first time.


      Planning Point: The FBAR filing deadline corresponds to the general federal tax filing deadline for individuals. However, FBARs are not submitted and filed along with a taxpayer’s Form 1040. Instead, FBARs are filed electronically using the FinCEN BSA e-filing system.[2]


      Planning Point: Because of the COVID-19 pandemic, required FBAR filers who filed the 2019 calendar year FBAR by October 31, 2020 were deemed to have timely filed. FinCEN also published a notice on October 6, 2020 giving FBAR filers impacted by certain natural disasters until December 31, 2020 to file FBARs.[3]


      Editor’s Note: FinCEN Notice 2020-1 announced an extension of time for FBAR filings due to the notice of proposed rulemaking FinCEN issued on March 10, 2016. One of the proposed FinCEN amendments would expand and clarify exemptions for certain U.S. persons with signature or other authority over foreign financial accounts. This proposed amendment seeks to address questions about the filing requirement and its application to individuals with signature authority over, but no financial interest in, certain types of accounts as outlined in FinCEN Notice 2019-1. FinCEN further extended the filing due date to April 15, 2022 for individuals whose filing due date for reporting signature authority was previously extended by Notice 2019-1. This FBAR extension applies to the reporting of signature authority held during the 2020 calendar year, as well as all reporting deadlines extended by previous Notices.

      For all other individuals with an FBAR filing obligation, the filing due date remained April 15, 2021.

      FBARs must be filed electronically. An individual who jointly owns an account with a spouse may file a single FBAR report as an individual filer for that joint account. However, a spouse included as a joint owner, who does not file a separate FBAR, must also sign the FBAR. This is not possible with FinCEN’s BSA e-filing system capability because it only allows for one digital signature. In this situation, FinCEN allows the spouses to designate, using Form 114a, which spouse will be designated as the FBAR signatory on the behalf of both.

      FinCEN has granted an extension from filing each year since 2011 for signature authority filers who do not have a financial interest in a reportable foreign financial account.

      Persons who qualify for the extension include U.S. persons who are:

      1. an employee or officer of an entity who has signature or other authority over, but no financial interest in, a foreign financial account of a controlled person of the entity,
      2. an employee or officer of a controlled person of an entity who has signature or other authority over, but no financial interest in, a foreign financial account of the entity, the controlled person, or another controlled person of the entity, or

      3.             an employee or officer of an investment adviser registered with the SEC who has signature or other authority over, but no financial interest in, a foreign financial account of persons that are not investment companies registered under the Investment Company Act of 1940.

      [1].          Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, Pub L 114-41 § 2006(b)(11).

      [2].          See https://bsaefiling.fincen.treas.gov/NoRegFBARFiler.html (accessed August 23, 2021).

      [3].          See https://www.fincen.gov/fincen-clarifies-fbar-extensions (accessed August 23, 2021).

  • 974. What are the penalties for failing to comply with the FBAR filing requirements?

    • The maximum civil penalty for non-willful failure to comply with FBAR reporting requirements is $10,000.[1] However, additional penalties may apply for willful violations. Penalties for a willful failure to file can be as much as the greater of $100,000 or 50 percent of the amount in the account at the time of the violation.[2] These penalties can be imposed for failure to file or for failure to maintain the required records (see Q 964.09).

      The statute of limitations for civil or criminal violations is generally six years for FBAR purposes, meaning that the total penalties for failure to file for multiple years could be more than the value in the account.

      These dollar values are adjusted annually for inflation. In 2021, the penalty for a non-willful failure to comply is $12,921 and $129,210 or 50 percent of the amount in the account at the time of violation for a willful failure to comply.[3]


      Planning Point: On multiple occasions, disputes have arisen over whether the $10,000 maximum penalty for non-willful FBAR filing failures is to be imposed on a per-account basis or a per-taxpayer basis.

      Both the Ninth Circuit and a Texas district court have confirmed that the total FBAR penalties that can be imposed on an individual should be limited to $10,000 per year, rather than $10,000 per financial account.[4] However, the IRS has continued to attempt to assess penalties on a $10,000 per account basis. The most recent challenge to that rule is being held in the District Court for the Northern District of Georgia.


      The test for willfulness is generally whether there was a voluntary, intentional violation of a known legal duty. The IRS has the burden of establishing willfulness. Willfulness is shown by the person’s knowledge of the reporting requirements and the person’s conscious choice not to comply with the requirements. In the FBAR situation, individuals should know is that they have a reporting requirement. If a person has that knowledge, the only intent needed to constitute a willful violation of the requirement is a conscious choice not to file the FBAR.

      [1].          31 U.S.C. 5321(a)(5)(B)(i).

      [2].          31 U.S.C. 5321(a)(5)(C).

      [3].          See https://www.irs.gov/businesses/small-businesses-self-employed/report-of-foreign-bank-and-financial-accounts-fbar

      [4].          See U.S. v. Boyd, 991 F.3d 1077 (9th Cir. 2021) and U.S. v. Bittner, 469 F. Supp. 3d 709 (E. D. Tex. 2020).

  • 975. What records are required to be kept by taxpayers subject to FBAR filing requirements?

    • Taxpayers are required to maintain records of foreign financial accounts subject to FBAR filing requirements for at least five years.[1] Those records should include: (1) the name in which the account is held, (2) the account number or other designations, (3) the name and address of the foreign bank or other person with whom such account is maintained, (4) the type of account, and (5) the maximum value of each account during the relevant reporting period.

      [1].          31 CFR 1010.420.

  • 976. Is there any way to correct a failure to file past FBARs?

    • In prior years, U.S. citizens who were not compliant with U.S. filing requirements could consider becoming compliant using the IRS Offshore Voluntary Disclosure Program (OVDP). However, the IRS eliminated this voluntary compliance program on September 28, 2018. The streamlined filing compliance procedures program (available to taxpayers who may not have been aware of their filing obligations) will continue in place, but the IRS has indicated that it may also be winding down in the future.

      The streamlined filing compliance procedures are available to taxpayers who can certify that their failure to report foreign financial assets and pay all tax due with respect to those assets did not result from willful conduct.[1] If the IRS has initiated a civil or criminal examination of the taxpayer’s returns for any tax year, the taxpayer will not be eligible for the streamlined procedures.

      These streamlined returns are treated in the same manner as any other tax return.

      Current procedures exist for taxpayers who do not need to use either the OVDP or the streamlined filing compliance procedures to file delinquent or amended tax returns to report and pay additional tax. Those procedures apply for taxpayers who (1) have not filed a required FBAR, (2) are not under a civil examination or a criminal investigation by the IRS, and (3) have not already been contacted by the IRS about the delinquent FBAR.[2]

      Those taxpayers should file the delinquent FBARs according to the FinCEN FBAR instructions.[3] However, to resolve the filing of delinquent FBARs, the taxpayer should also include a statement explaining the reason for the late FBAR filing, file all FBARs electronically at FinCEN, and select a reason for the late filing on the cover page of the electronic form.

      The IRS will not impose a penalty for the failure to file the delinquent FBARs if the U.S. tax returns properly report all income, and all tax is paid on the income from the foreign financial accounts reported on the delinquent FBARs. FBARs are not automatically subject to audit but, like any other return, may be selected for audit through the existing audit selection processes that are in place for any tax returns.

      [1].          See https://www.irs.gov/individuals/international-taxpayers/streamlined-filing-compliance-procedures (accessed Aug. 23, 2021).

      [2].          See https://www.irs.gov/individuals/international-taxpayers/delinquent-fbar-submission-procedures (accessed Aug. 23, 2021).

      [3].          Those instructions are available at: https://www.fincen.gov/filing-late

  • 977. What is a passive foreign investment company (PFIC)?

    • A passive foreign investment company (PFIC) is a foreign corporation which satisfies either a passive income test (see Q[2]) or a passive asset test (see Q[3]). A foreign corporation is broadly defined to include any corporation organized outside the United States.

      A foreign corporation will be classified as a PFIC if:

      • 75 percent or more of its gross income for a taxable year is passive income (the income test, see Q[2]), and[1]
      • 50% of its average asset value is held for the production of passive income (the asset test, see Q[3]).[2]

      Foreign-based mutual funds are a common type of PFIC.  PFICs are subject to detailed tax rules established to close tax loopholes that allowed U.S. taxpayers to shelter offshore investments from U.S. taxation.  U.S. PFIC shareholders must also file Form 8621, which is extremely complex and will require the assistance of qualified tax counsel.

      See Q[4] for a discussion of exceptions to the PFIC rules.  See Q[5]-Q[6] for a discussion of the tax treatment of U.S. shareholders in a PFIC.

      [1] IRC Sec. 1297(a)(1).

      [2] IRC Sec. 1297(a)(2).

  • 978. What is the passive income test that applies when determining PFIC status?

    • A foreign corporation is a PFIC if 75 percent or more of its gross income for a taxable year is passive income.[1]  Passive income generally includes any income of a kind that would constitute Foreign Personal Holding Company Income (“FPHCI”).[2]

      For this purpose, passive income includes dividends, interest, royalties, rents, and gains from the disposition of assets that generate any one of those types of income or do not generate income at all. Passive income also includes income from commodities transactions, foreign currency gains, income from notional principal contracts, and income or payments which are the equivalent of interest or dividends.[3]

      However, note that for FPHCI purposes, there are several exceptions to what is included in passive income that are not carried over for PFIC determination purposes.  For example, FPHCI does not include dividends and interest received from a related person that is a corporation created or organized under the laws of the same foreign country under the laws of which the controlled foreign corporation (CFC) is organized if a substantial part of its trade or business assets are located in the same country.[4]  Rents and royalties received from a corporation which is a related person for the use of property within the CFC’s situs country are also excluded for FPHCI purposes, but not PFIC purposes.[5]

      The passive income test considers all income of the foreign corporation, without regard to reductions or exclusions that might apply for U.S. federal tax purposes. For example, passive income includes interest income that would be tax-exempt for U.S. tax purposes.[6]

      The income test is calculated based on a tested foreign corporation’s gross income. However, certain types of income are FPHCI only to the extent that gains exceed losses with respect to a certain category of income.[7] For example, only the excess of gains over losses from the sale or exchange of certain property is treated as FPHCI.[8]

      Similar netting rules apply to income from commodities transactions,[9] foreign currency gains,[10] and income from notional principal contracts.[11] For purposes of the income test, income that is determined by netting gains against losses is accounted for on that net basis, so that only net gains in a particular category of FPHCI may be counted.[12]

      However, the net amount of income in each category of FPHCI is determined separately for each relevant corporation, so that net gains or losses of a corporation, at least 25 percent of the value of stock of which is owned, directly or indirectly, by a tested foreign corporation (also called a “look-through subsidiary”) may not be netted against net losses or gains of another look-through subsidiary or of a tested foreign corporation.

      [1] IRC Sec. 1297(a)(1).

      [2] IRC Sec. 1297(b)(1), referencing IRC Sec. 954(c).

      [3] IRC Sec. 1297(b)(1). See IRC Sec. 954(c) for definition of “passive income.”

      [4] IRC Sec. 954(c)(3)(A)(i).

      [5] IRC Sec. 954(c)(3)(A)(ii).

      [6] Prop. Treas. Reg. §§1.954-2(b)(3), which cross-references IRC Sec. 103.

      [7] IRC Sec. 954(c).

      [8] IRC Sec. 954(c)(1)(B).

      [9] IRC Sec. 954(c)(1)(C).

      [10] IRC Sec. 954(c)(1)(D).

      [11] IRC Sec. 954(c)(1)(F).

      [12] Prop. Treas. Reg. § 1.1297-1(c)(1)(ii); IRC Sec. 954(c).

  • 979. What is the passive asset test that applies when determining PFIC status?

    • A foreign corporation is a PFIC if at least 50 percent of its assets produce passive income or are held for the production of passive income.[1]  The passive asset test is calculated by determining the value of the foreign corporation’s assets each tax year. Asset valuation is based on fair market value unless the corporation is also a controlled foreign corporation (CFC), in which case assets are valued based on their adjusted bases.[2]

      An asset will be treated as though it is held for the production of income if it is held to produce capital gains and/or foreign currency gains.[3]

      The asset test applies on a gross basis.  In other words, if the corporation’s liabilities are secured by particular assets, that fact does not reduce the value of those assets for purposes of the 50 percent test.

      The 50 percent test is based on the average of the fair market value of the foreign corporation’s assets determined at the end of each quarterly period.  Typically, foreign corporations will not be required to obtain an independent appraisal to apply the 50 percent test.[4]

      The average percentage of a foreign corporation’s assets is determined using the average of the gross values (or adjusted bases) at the end of each quarter of the foreign corporation’s tax year.[5] The foreign corporation can also measure asset value more frequently than quarterly. The quarter (or shorter period) used by a tested foreign corporation is referred to as its “measuring period.” Applying the asset test based on a period that is shorter than a quarter can provide a more accurate measurement of average asset value, but the more frequently recurring time period is not required because of the potential administrative burden that it could impose on shareholders.

      The same measuring period must generally be used for the tested foreign corporation for the initial tax year (including any short year in which the shareholder elects to use the alternative measuring period) and all subsequent years unless the election to use the more frequently recurring measuring period is revoked.[6] In the case of a short tax year, the quarterly measuring dates for purposes of the asset test are the same as for a full tax year, except that the final quarterly measuring date will be the last day of the short tax year.[7]

      A foreign corporation’s income and assets may also include assets and income of lower-tier corporations if the corporation owns at least 25 percent of the stock.[8] This look-through rule means that a foreign corporation cannot use subsidiaries to avoid PFIC status. Indirect stock ownership is determined under the general rules used in determining ownership by value.[9] These rules apply without regard to whether entities are domestic or foreign, meaning that indirect ownership includes corporate ownership through intermediate corporations, partnerships, trusts, and estates, regardless of where the entity is organized. Further, stock treated as owned by application of the indirect ownership rules is generally considered actually owned for purposes of reapplying the indirect ownership rules.[10]

      The foreign corporation is deemed to own its proportionate share of the lower-tier entity’s assets and income.[11] However, when lower-tier entities are operating subsidiaries, the foreign corporation may avoid PFIC treatment because dividends and interest derived from them are not considered passive income. Under the look-through rule, interest and dividends passed from lower-tier entities retain their character as operating income when passed to the parent corporation.[12]

      For purposes of the passive asset test, a foreign corporation that directly or indirectly owns an interest in a partnership is treated as if it held its proportionate share of the assets of a partnership, provided the tested foreign corporation owns, directly or indirectly, at least 25 percent, by value, of the interests in the partnership.[13] A corporation’s proportionate share of a partnership asset is treated as passive to the extent the asset produced, or was held to produce, passive income in the partnership’s hands, taking into account only the partnership’s activities. If a foreign corporation owns less than 25 percent of the value of the partnership, its interest in the partnership is treated as a passive asset.[14]

      The look-through rule does not always apply to a domestic corporation or any subsidiaries of the domestic corporation.  That’s true if the stock of the domestic corporation is treated as a non-passive asset that produces non-passive income.[15]

      A foreign corporation may attempt to avoid PFIC status regardless of direct and indirect ownership of passive assets by ensuring that a sufficient amount of the assets are held indirectly through two tiers of domestic subsidiaries.[16] For example, a foreign corporation might hold stock in another foreign corporation that is PFIC, but use a two-tiered domestic chain holding passive assets to avoid being treated as a PFIC.  In this case, a U.S. person holding stock of the foreign corporation would generally not be treated as a shareholder of the PFIC stock owned by the tested foreign corporation.[17]


      Planning Point: An anti-abuse rule provides that look-through exceptions regarding a foreign corporation subject to the accumulated earnings tax will not apply if the tested foreign corporation would be a PFIC if the qualified stock or any income received or accrued with respect to such stock were disregarded.[18] A second anti-abuse rule provides that the exception will not apply if a principal purpose for the foreign corporation’s formation or acquisition of the 25-percent-owned domestic corporation is to avoid PFIC status.  The law presumes such a principal purpose exists if the 25-percent-owned domestic corporation is not engaged in an active U.S. trade or business.[19]


      An asset is passive for purposes of the asset test if it produces passive income or is held for the production of passive income.  However, if the asset produces both passive income and non-passive income during the same tax year, it is treated as two separate assets (one passive and one non-passive).[20] The asset is treated as partly a passive asset and partly a non-passive asset in proportion to the proportionate amounts of income generated by the asset during the year.[21]  For purposes of the asset test, the fair market value (or adjusted basis) of the asset is allocated between the passive assets and non-passive assets based on the ratio of passive income produced by the asset during the tax year to non-passive income.

      [1] IRC Sec. 1297(a)(2).

      [2] IRC Sec. 1297(e).

      [3] IRC Sec. 954(c).

      [4] Notice 88-22, 1988-11 IRB 1.

      [5] Prop. Treas. Reg. §1.1297-1(d)(1)(i) and (d)(1)(ii)(A).

      [6] Prop. Treas. Reg. §1.1297-1(d)(1)(ii)(B).

      [7] Prop. Treas. Reg. §1.1297-1(d)(1)(ii)(C).

      [8] IRC Sec. 1297(c).

      [9] Prop. Treas. Reg. §1.1297-2(b)(1); IRC Secs. 1297(c) and 958(a).

      [10] Treas. Reg. §1.958-2(f)(1).

      [11] IRC Sec. 1297(c).

      [12] H. Rep. No. 841 at II-644.

      [13] Prop. Treas. Reg. §1.1297-1(d)(3)(i).

      [14] Prop. Treas. Reg. §1.1297-1(d)(3)(ii).

      [15] Prop. Treas. Reg. §1.1297-2(b)(2)(iii) referencing both IRC Secs. 1297(c) and 1298(b)(7).

      [16] Under IRC Sec. 1298(b)(7), qualified stock held by a domestic corporation is treated as an asset that does not produce passive income when the foreign corporation is subject to the IRC Section 531accumulated earnings tax.

      [17] See Prop. Treas. Reg. § 1.1298-4(e); IRC Sec. 1298(a)(2) and Treas. Reg. §1.1291-1(b)(8)(ii)

      [18] Prop. Treas. Reg. §1.1298-4(f)(1).  See also the exception in IRC Sec.1298(b)(7).

      [19] Prop. Treas. Reg. §1.1298-4(f)(2).

      [20] Prop. Treas. Reg.  §1.1297-1(d)(2).

      [21] Notice 88-22.

  • 980. Are there any situations where a foreign entity that would gain PFIC status can avoid this PFIC treatment based on its ownership of passive assets?

    • Corporations are most likely to hold passive assets (1) in a start-up year when investors may have recently invested significant amounts of cash or (2) in a year when the corporation sells an active trade or business and holds the proceeds while it looks for new business opportunities.

      Two safe harbor rules allow a corporation to escape PFIC status under these circumstances. In its first year of operation, a corporation is not treated as a PFIC it can demonstrate to the IRS that it will not be a PFIC in the two years following its initial year of operations.[1] Further, a corporation that ceases an active business and then resumes another active business will not be treated as a PFIC during the interim period, so long as it was not a PFIC in any prior year and it demonstrates that it will not be a PFIC in the following two years.  These safe harbors apply only if the corporation does not actually attain PFIC status in the relevant two-year period.

      An exception also exists if a foreign corporation is in transition from one active business to another active business.   This change-of-business exception applies for the foreign corporation’s tax year if:

      • neither the foreign corporation nor a predecessor of the foreign corporation was a PFIC in a prior tax year;
      • the foreign corporation can demonstrate that (A) substantially all of the passive income of the foreign corporation for the tax year is attributable to proceeds from the disposition of one or more active trades or businesses, and (B) the foreign corporation will not be a PFIC in either of the following two tax years following; and
      • the foreign corporation is not, in fact, a PFIC for either of the following two tax years.[2]

      In other words, a foreign corporation may qualify for the change-of-business exception even if it does not engage in an active business after a disposition.

      If, however, the activity attribution rules would cause the activities of another entity to be taken into account, those activities are considered for purposes of determining whether the change-of-business exception is available.[3] Also, income attributable to proceeds from the disposition of an active trade or business means income earned on investment of the proceeds, but excludes the actual proceeds themselves.[4] The change-of-business exception may apply in either a tax year when the active trade or business is disposed of, or the year that immediately follows, but can apply in only one year in the case of a disposition.[5] In other words, a foreign corporation that receives proceeds from a disposition in more than one year may only apply the change-of-business exception in a single year. If the exception could apply in multiple years, the foreign corporation can choose which year it applies.

      Post-2017 Insurance Exception

      For tax years beginning after December 31, 2017, the 2017 tax reform legislation created a new insurance exception.  Under the PFIC insurance exception, a foreign corporation’s income attributable to an insurance business will not be considered passive income unless the corporation’s insurance liabilities equal more than 25% of the corporation’s total assets.[6]  Asset value, for this purpose, means asset value as reported on an applicable financial statement ending with or within the taxable year.[7]

      [1] IRC Sec. 1298(b)(2).

      [2] IRC Sec. 1298(b)(3).

      [3] Prop. Treas. Reg. §1.1298-2(c)(3) referencing IRC Sec. 954(h)(3)(E).

      [4] Prop. Treas. Reg. §1.1298-2(c)(1).

      [5] Prop. Treas. Reg. §1.1298-2(e).

      [6] IRC Sec. 1297(f)(1).

      [7] IRC Sec. 1297(f)(1)(B).

  • 981. When is a U.S. taxpayer treated as a PFIC shareholder?

    • The PFIC rules apply if a U.S. person owns any number or value of shares in a PFIC. Under prior law, when an interest in a PFIC is owned by a domestic partnership, the partnership itself was treated as the U.S. shareholder for purposes of making certain PFIC elections.  A new rule proposed by the IRS on January 24, 2022 would treat the partners in the domestic partnership as the PFIC shareholders, rather than the partnership itself.  Any qualified electing fund (QEF) or mark to market elections for the PFIC will be made at the partner level if the proposed rule change becomes effective.  Similar rules will also apply to treat S corporation shareholders as the PFIC’s “U.S. shareholders” for various elections made with respect to the PFIC.

      The PFIC rules are much broader than those that apply in the controlled foreign corporation (CFC) context, where a U.S. shareholder is defined as a U.S. person that owns at least a 10 percent stake (measured by voting power or by value) in a foreign corporation.   A U.S. shareholder (by the CFC definition of a CFC) is governed exclusively under CFC reporting and is not subject to the PFIC regime.[1] A U.S. person who is a shareholder of a foreign corporation, but does not own sufficient stock for CFC purposes, may still be treated as a PFIC shareholder.  A CFC cannot be a PFIC with respect to U.S. shareholders who reach the 10 percent threshold, but a CFC can be characterized a PFIC with respect to U.S. persons owning shares beneath the 10 percent threshold.

      One exception regarding a U.S. shareholder of a CFC being treated as a PFIC shareholder exists.  If the U.S. shareholder formerly held a less-than-10-percent stake in the CFC that was also a PFIC, the U.S. shareholder will continue to be treated as a PFIC shareholder.  To escape the PFIC shareholder treatment, the U.S. shareholder must file a PFIC “purging” election and pay any tax liability due because of the PFIC stake.[2]  From that point forward, the U.S. shareholder will be treated as a CFC shareholder instead of in a PFIC.

      [1] IRC Sec. 1297(d).

      [2] IRC Sec. 1298(b).

  • 982. How is a U.S. PFIC shareholder taxed?

    • The PFIC rules tax gains and distributions at the highest applicable tax rate.  They also subject U.S. taxpayers to interest charges during the period where taxation would otherwise be deferred.  The basic premise is that the shareholder is treated as though they received gain on a PFIC investment over their entire ownership.  It’s also assumed that the taxpayer is in the highest tax bracket during all prior ownership years.  So, although the top rate is currently 37 percent in 2021, it’s possible that PFIC shareholders could be taxed at the higher 39.6 percent tax rate that applied in earlier years.[1]


      Planning Point: The taxation of PFICs is extremely complex and largely beyond the scope of this text.  It’s important to seek qualified tax advice in any situation where PFIC taxation is possible.


      In other words, a U.S. person as a shareholder is taxed on actual PFIC distributions.  However, certain distributions are also subject to an addition to tax (in the form of an interest charge).  The special Section 1291 tax regime applies to (1) any gain on the disposition of PFIC stock and (2) “excess distributions.”[2]

      Excess distributions occur to the extent that gains and distributions for the tax year exceed 125 percent of the average distributions during the three preceding tax years (or the period the taxpayer held the stock, if shorter).[3] No excess distributions are permitted in the first year the U.S. shareholder holds PFIC stock.[4]

      If the taxpayer does not hold the stock for an entire year, any distributions are annualized.[5] Additionally, the shareholder’s holding period will be deemed to end on the day of a distribution for purposes of testing whether it is an excess distribution.  Gain is tested in the same way to determine whether it is treated as an excess distribution.  The portion of the gain that is treated as an excess distribution is the excess over 125 percent of the average amount received during the three preceding tax years.[6]  IRC non-recognition rules generally do not apply to prevent recognition of gain on disposition of PFIC stock.[7]

      To determine excess distribution status under the 125 percent test, calculations are made using the foreign currency in which the distributions are made. The amount need not be translated into U.S. dollars until it is determined that there has been an excess distribution.[8]  Further, determinations under the PFIC rules are made on a share-by-share basis.  However, blocks of stock with the same holding period may be aggregated.[9] Adjustments must also be made to the number of shares to reflect stock splits and stock dividends.[10]

      If PFIC stock has a transferred basis (for example, if the stock was acquired by gift), or a stepped-up basis (if the stock was acquired from a decedent), distributions over the three-year (or shorter) period include distributions received by the person from whom the U.S. shareholder acquired the stock.[11] If multiple distributions are received in a single tax year, the excess for the year is prorated among the distributions.[12]

      The amount allocated to each distribution is treated as a separate excess distribution for purposes of calculating the special PFIC tax. The amount of an excess distribution is allocated ratably to each day in the U.S. shareholder’s holding period for the stock.[13]

      A U.S. person who owns a publicly traded PFIC (including foreign mutual funds) may elect to mark his shares to market at the end of the year.  The gain or loss that results from making the election is ordinary gain or loss.  The loss is allowed only to the extent that the shareholder recognized market-to-market gains on the stock in a prior year.  Once the election is made, it is binding for all future years until the PFIC stock is no longer marketable stock or a request is made and approved to revoke the election.[14]

      [1] PFICs are taxed under IRC Sec. 1291.

      [2] IRC Secs. 1291(a)(1) and (2); see also Prop. Treas. Reg. §1.1291-2(e)(2)(ii).

      [3] IRC Sec. 1291(b)(2)(A).

      [4] IRC Sec. 1291(b)(2)(B).

      [5] IRC Sec. 1291(b)(3).

      [6] IRC Sec. 1291(b)(2)(A)(ii).

      [7] IRC Sec. 1291(f).

      [8] IRC Sec. 1291(b)(3)(E).

      [9] IRC Sec. 1291(b)(3)(A).

      [10] IRC Sec. 1291(b)(3)(B).

      [11] IRC Sec. 1291(b)(3)(D).

      [12] IRC Sec. 1291(b)(1).

      [13] IRC Sec. 1291(a)(1)(A).

      [14] IRC Secs. (c)(1)(B)(ii); 1296(k). Treas. Reg. § 1.1296-1.

  • 983. Are there any tax credits available for PFIC shareholders?

    • There are separate foreign tax credit rules for PFICs. Generally, non-corporate PFIC shareholders may not take advantage of foreign tax credits.[1]

      However, a corporate shareholder that owns 10 percent of the PFIC’s voting stock is entitled to a “deemed paid” foreign tax credit. The shareholder must allocate the foreign taxes between excess distributions (which is treated as foreign sourced income) and non-excess distribution amounts, and between pre-PFIC and PFIC years. The credit must then be applied to those various amounts.[2]

      [1] IRC Sec. 902; see Prop. Treas. Reg. §1291-5.

      [2] Prop. Treas. Reg. §1.1291-5(b).

  • 984. What reporting requirements apply to U.S. investors in PFICs?

    • Both FATCA and FBAR reporting requirements may apply to U.S. investors in PFICs.

      Generally speaking, FATCA provides that U.S. taxpayers with certain financial assets[1] held outside the U.S. must report those assets to the IRS.  FATCA requires those U.S. taxpayers holding foreign financial assets with an aggregate value exceeding $50,000 to report certain information about those assets on Form 8938.  Form 8938 must be attached to the taxpayer’s annual tax return.[2]  Failure to report foreign financial assets will result in
      a penalty of $10,000 (and a penalty of up to $50,000 for continued failure after IRS notification).[3]

      Also, foreign financial institutions (“FFI”) must report to the IRS information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest.  FFIs include banks, brokerage firms, and investment managers.

      FATCA also requires PFIC shareholders to file an annual information return disclosing their PFIC ownership interest.[4] Under prior law, this disclosure was required only when taxpayers made a qualifying elective fund election (see Q[9]), received certain distributions from the PFIC, or disposed of their interest in the PFIC.

      The FATCA reporting requirements are in addition to FBAR reporting for foreign financial accounts exceeding $10,000 U.S. dollars under FinCEN regulations for a detailed discussion of FBAR reporting obligations).

       

      [1] Taxpayers must hold an interest in a “specified foreign financial asset,” which is: (1) any financial account maintained by a foreign financial institution and (2) any of the following assets which are not held in an account maintained by a financial institution: (A) any stock or security issued by a person other than a U.S. person, (B) any financial instrument or contract held for investment that has an issuer or counterparty which is other than a U.S. person, and (C) any interest in a foreign entity. (Under 26 U.S.C. § 6038D(b).)

      [2] 26 U.S.C. § 6038D.

      [3] Underpayment of taxes attributable to non-disclosed foreign financial assets may be subject to an additional 40 percent penalty. See https://www.irs.gov/businesses/corporations/summary-of-fatca-reporting-for-us-taxpayers.

      [4] IRC Sec. 1298(f). The PFIC disclosure was effective March 18, 2010.

  • 985. What is a Qualifying Election Fund (QEF) election and what are the tax consequences?

    • The special PFIC tax can be avoided if the PFIC elects to become a “qualified electing fund” (QEF). A U.S. shareholder in a QEF is taxed currently on his ratable share of the PFIC’s earnings for the year.[1] However, a disposition of PFIC stock is not subject to the special tax on excess distributions, as long as the PFIC is a QEF for all years (after 1986) that the U.S. shareholder holds the stock.[2]


      Planning Point: Because a shareholder in a PFIC may not be able to require distributions annually to generate funds necessary to pay taxes, a shareholder in a QEF may elect to defer taxation until actual distributions are received.[3]


      The PFIC shareholder makes the election to be treated as a QEF by filing Form 8621 with the shareholder’s annual tax return.[4] The Form 8621 must contain the information provided in the PFIC Annual Information Statement.[5] The election may only be revoked with the consent of the IRS.[6]

      However, the shareholder election does not have to contain the full information required in a PFIC election. To the extent the shareholder has the relevant information, the statement must include the PFIC’s name, address, taxpayer identification number (TIN), country and year of incorporation, and the tax year to which the election applies. The shareholder statement must also include information about the U.S. shareholder, including a representation that the individual was a shareholder of the PFIC for the year to which the election relates.[7]

      If a company elects QEF status and it is later determined not to be a PFIC, the election will have no effect for federal tax purposes.[8]

      The shareholder may make a Section 1295 election after the normal due date for the election if he or she (a) reasonably believed that the foreign corporation was not a PFIC during the year for which the retroactive election is to be filed; (b) files a Protective Statement; and (c) complies with various procedural requirements.[9]

       

      [1] IRC Sec. 1291(d)(1)(A).

      [2] IRC Sec. 1291(d)(1)(B).

      [3] IRC Sec. 1294.

      [4] IRC Sec. 1295(b). Treas. Reg. §§1.1295-1(d)(1), 1.1295-1(f). Only the PFIC shareholder may make the election, not the PFIC itself. Prop. Treas. Reg. § 1.1295-1(b)(2)(i).

      [5] Treas. Reg. § 1.1295-1(f)(iii).

      [6] IRC Sec. 1295(b).

      [7] Notice 88-31.

      [8] Notice 88-22, 1988-11 IRB 1.

      [9] Treas. Reg. § 1.1295-3(b).

  • 986. What is a controlled foreign corporation, or CFC?

    • A controlled foreign corporation (CFC) is a corporation that conducts business in a different jurisdiction than where its controlling owners are domiciled.  Typically, CFCs are used when the cost of doing business in a foreign jurisdiction is lower than conducting business in the U.S. (even considering CFC tax implications) or the business wishes to expand into global markets.  CFC rules were created to avoid tax evasion by corporations who set up business in low-tax jurisdictions to shelter income from U.S. taxation.

      Most countries have their own version of CFC laws.  For U.S. tax purposes, generally, a CFC is any foreign corporation in which (1) more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned (whether directly, indirectly, or constructively) by U.S. shareholders on any day during the taxable year of the foreign corporation or (2) more than 50 percent of the total value of the stock is owned (directly, indirectly or constructively) by U.S. shareholders on any day during the tax year of the corporation.[1]

      U.S. shareholders may be required to pay taxes on undistributed earnings of the CFC in order to prevent tax deferral (or evasion).  (Typically, shareholders in a U.S. corporation only pay taxes on corporate earnings when they receive dividends.)

      Note that there are special rules for determining whether a foreign corporation is a CFC for purposes of IRC Section 953(a) (which deals with insurance income).

      Also note that there are special rules for determining whether a foreign corporation is a specified foreign corporation (SFC) for purposes of IRC Section 965.  IRC Section 965 increases the Subpart F income of a deferred foreign income corporation (DFIC), a type of SFC, for its last tax year beginning before January 1, 2018 by the greater of certain of its post-1986 earnings and profits as of November 2, 2017 or December 31, 2017.  Under these rules, SFCs include all CFCs and certain other foreign corporations.

      [1] See https://www.irs.gov/pub/irs-utl/FEN9433_01_03R.pdf.

  • 987. Who is a U.S. Shareholder for purposes of the CFC rules?

    • For purposes of the CFC rules, a U.S. shareholder is a U.S. person (defined in IRC Section 957(c)) who owns (directly, indirectly, or constructively) (1) 10 percent or more of the total combined voting power of stock entitled to vote or (2) 10 percent or more of the total value of all classes of stock entitled to vote in a foreign corporation.

      IRC Section 958(a) provides rules for determining direct and indirect stock ownership of a corporation.   Under IRC Section 958(b), the constructive ownership rules of IRC Section 318(a) apply to the extent that the effect is to treat a U.S. person as a U.S. shareholder or a foreign corporation as a CFC.

      For tax years ending on or before December 31, 2017, IRC Section 958(b)(4) essentially turned off certain “downward attribution” rules that would have otherwise applied.  This prevented a U.S. person from being treated as owning stock that is owned by a non-U.S. person.

      The 2017 tax reform legislation repealed IRC Section 958(b)(4).  As a result, for tax years beginning on or after January 1, 2018, the “downward attribution” under IRC Section 318(a)(3) does apply to treat U.S. persons as owning the stock of non-U.S. persons.  This new provision will essentially create new U.S. shareholders and, in turn, create CFCs that were not treated as CFCs in prior years.

  • 988. How is voting power determined for purposes of determining whether an entity is a CFC when multiple classes of stock are outstanding?

    • Determining the allocation of the voting power of the stock of a corporation is fairly simple when the foreign corporation has only one outstanding class of stock.  However, the foreign corporation may have more than one class of stock outstanding. The process of defining whether U.S. shareholders own more than 50 percent of the combined voting power is more complicated under these circumstances.

      CFC status is determined under these circumstances by considering the combined voting power of all classes of stock entitled to vote, as well as all of the facts and circumstances of each particular case.[1]

      Example: Assume that a Swiss corporation has two classes of capital stock outstanding: 60 shares of class A stock, and 40 shares of class B stock. Each share of each class of stock has one vote for all purposes. A U.S. shareholder owns 51 shares of the class A stock. The Swiss corporation is a CFC because more than 50 percent of the combined voting power is owned by a U.S. shareholder (namely, the U.S. shareholder owning 51 percent of the total voting shares).[2]

      Under certain circumstances, U.S. shareholders will be deemed to own the requisite percentage CFC classification purposes even though the nominal ownership by U.S. shareholders is not more than 50 percent.[3]

      Example: Assume that the voting power of the foreign corporation is divided equally between two shareholders, a foreign shareholder and a U.S. shareholder.  The U.S. shareholder has the power to elect a majority of the board of directors.  In this case, the requisite majority voting power will reside with the U.S. shareholder and the foreign corporation will be classified as a CFC for U.S. tax purposes.

      [1] Treas. Reg. §1.957-1(b)(1).

      [2] See Treas. Reg. §1.957-1(c), Example (1).

      [3] See Treas. Reg. §1.957-1(b)(1).

  • 989. When is a U.S. Shareholder in a CFC subject to immediate taxation?

    • Under IRC Section 951(a), if a foreign corporation is a CFC for any day during a taxable year, every person who is a “United States shareholder” in that corporation on the last day of the year must include the following amounts in gross income for the taxable year in which, or with which, that taxable year of the corporation ends:[1]

      • His pro rata share of the corporation’s Subpart F income (see Q[5]) for such year; and,
      • The pro rata share of the corporation’s increase in earnings invested in U.S. property for the year.[2] (Note that, in this context, if the “investment in U.S. property” rule is applicable, the required U.S. income inclusion is not limited to tax haven or “tainted” (i.e., Subpart F) income.)

       


      Planning Point: These income inclusion rules are extremely complex.  Any U.S. shareholder in a CFC should consult competent tax counsel when determining U.S. income tax liability, as well as when determining U.S. reporting obligations.


      Further, two additional and more arcane income inclusion rules may apply, including: (i) income previously deferred and repatriated from less developed countries and (ii) previously deferred foreign base company shipping income.[3]

      Prior to 1996, inclusion was also required for a shareholder’s pro rata share of the corporation’s earnings invested in excess passive assets, but this inclusionary provision was repealed.[4]

      [1] IRC Sec. 951(a).

      [2] IRC Secs. 951(a)(1)(B), 956.

      [3] This would be the pro rata share of the corporation’s previously excluded Subpart F income withdrawn from foreign base company shipping operations for the year.

      [4] Small Business Job Protection Act of 1996, P.L. 104-188, 1501(a)(2), repealing IRC Sec. 956A, and P.L. 104-188, 1501(a)(1), eliminating IRC Sec. 951(a)(1)(C).

  • 990. How is a U.S. shareholder taxed on sale or liquidation of a CFC?

    • A U.S. shareholder’s gain on a sale of stock in a domestic corporation is ordinarily taxed as a capital gain (whether long-term or short-term). This same U.S. income tax characterization rule applies to gains realized when a U.S. shareholder receives proceeds upon the complete liquidation of a domestic corporation (essentially in a transaction where the shares are cancelled and the corporation is dissolved).

      Under IRC Section 1248, however, all or a portion of the gain derived from the sale or exchange of the stock in a CFC by a U.S. shareholder (including when proceeds are derived from a liquidation distribution) may be required to be treated as an ordinary dividend.  For a corporation receiving this deemed dividend treatment, the 100 percent dividends-received deduction (DRD) will apply for the earnings derived from a foreign source.[1]   For individuals, however, this rate could be the maximum 20 percent rate applicable to ordinary dividends in addition to the 3.8 percent net investment tax.[2]

      The dividend portion of the gain realized by the shareholder upon the share disposition will be the earnings and profits of the CFC accumulated (i) while the corporation was a CFC (after 1962) and (ii) proportionately allocable to that CFC stock which is sold.[3]

      This ordinary dividend treatment does not apply to all shareholders.  It applies only to a U.S. person who owned at least 10 percent of the stock of the CFC at any time during the five-year period ending on the date of the sale or other taxable disposition.[4]  10 percent ownership status will be measured, however, by considering shares that the shareholder owns indirectly and constructively.

      [1] IRC Sec. 245A(j).

      [2] See IRC Sec. 1(h)(11)(B)(i)(II) which specifies that qualified dividend income for this purpose includes dividends received from a “qualified foreign corporation.” IRC Sec. 1(h)(11)(C) provides that the term “qualified foreign corporation” means any foreign corporation if the corporation is eligible for the benefits of a comprehensive income tax treaty with the U.S. that IRS determines is satisfactory for purposes of this provision and which includes an exchange of information program. See also IRS 2006-2 C.B. 930, Notice 2006-101, and IRS 2004-2 C.B. 724, Notice 2004-70, which specifies that dividends as classified under IRC Sec. 1248 will qualify for the long-term capital gains tax rate.  The IRC Sec. 1411 3.8% net investment income tax may apply to the dividend income of certain high-earning taxpayers.

      [3] IRC Sec. 1248(c).

      [4] IRC Sec. 1248(a)(2).

  • 991. What is Subpart F? What types of income trigger the Subpart F tax in the CFC context?

    • Once an entity is classified as a CFC, it becomes necessary to determine whether the CFC income is currently taxable to U.S. shareholders.  Currently taxable income is generally defined in Subpart F.  Under the Subpart F rules, certain types of CFC income must be included in the U.S. shareholder’s gross income in the year the income is earned by the CFC even though it has not yet been distributed to the U.S. shareholder.

      The 2017 tax reform legislation (the TCJA) significantly changed the tax treatment of foreign income earned by CFCs.  Certain previously deferred earnings were made immediately taxable under the IRC Section 965 transition tax.  Further, the TCJA established a new Subpart F tax regime for global intangible low-taxed income (GILTI) and a dividends-received deduction for foreign source dividends.  The GILTI rules are extremely complex and are generally beyond the scope of this text.

      Under the Subpart F provisions, income realized by certain activities conducted by corporations controlled by U.S. shareholders is deemed to be currently received by certain of those U.S. shareholders.[1]  In other words, the income becomes taxable before the individual actually receives dividend distributions from the foreign corporation.[2]

      In summary, these rules provide that if more than 50 percent of (i) the voting power of the foreign corporation or (ii) the value of the stock of the foreign corporation is owned by U.S. persons who own 10 percent or more
      (whether owned directly, indirectly or constructively) of the total combined voting power of all classes of stock entitled to vote of such foreign corporation or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation, the “deemed income” rules apply to those 10 percent-or-greater owners.[3]

      This concept is known as “downward attribution” from a foreign person to a related U.S. person, where the stock of a foreign corporation owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a U.S. shareholder of the foreign corporation.[4]

      The pro rata share of a CFC’s Subpart F income that a U.S. shareholder is required to include in gross income, however, continues to be determined based on direct or indirect ownership of the CFC, without application of the downward attribution rule. Consequently, the Subpart F provisions are aimed at significant shareholders of foreign corporations which are closely held and controlled by U.S. taxpayers. Obviously, therefore, these rules would apply to the U.S. shareholder of a wholly owned foreign corporation, but also apply in situations of lesser ownership, assuming some degree of control.

      The specific categories of CFC income that may be classified as tax haven-type income and, therefore, deemed currently received by those U.S. shareholders include:

      1. foreign personal holding company income (i.e., passive investment-type income, such as dividends, rents, royalties, interest, etc.);
      2. foreign base company sales income, (i.e., sales income from property purchased from, or sold to, a related person, if the property is manufactured and sold for use, consumption, or disposition outside the country of incorporation of the base company); and
      3. foreign base company services income, (i.e., service income from services performed outside the country of incorporation of the base company, when those services are performed for or on behalf of related persons).

      The statute refers to these various types of income as “foreign base company income.”  In addition, income derived by a CFC from the insurance of risks outside the country of its organization will be subject to current income inclusion to the shareholders (i.e., it will be treated as Subpart F income).[5] The foreign base company income and this insurance income are collectively referred to as “Subpart F income.”

      The Subpart F rules also provide that earnings (whether or not the earnings are categorized as “Subpart F income”) of CFCs are currently taxable to U.S. shareholders if the earnings are invested in certain U.S. property (thereby treated as effectuating a deemed taxable repatriation of those foreign based profits). These provisions have been evolving over several decades. Some of the provisions which have been repealed can have continuing significance.

      For example, until the Tax Reduction Act of 1975,[6] various exceptions to this current taxation of undistributed tax haven-types of CFC income applied.  An exception was available if the foreign corporation properly elected and satisfied a “minimum distribution” requirement.[7]  A second exception was the “less developed country exception” that allowed U.S. income tax deferral if foreign-based profits were reinvested into qualified investments in “less developed countries.”[8]

      See Q[7] for a discussion of situations where U.S. taxpayers may be able to prevent current taxation of Subpart F income.

       

      [1] IRC Secs. 951–964.

      [2] This income tax is imposed on the U.S. shareholders, rather than on the foreign corporation, and, therefore, is not considered to constitute an infringement of another country’s national sovereignty. See, e.g., Dougherty, 60 TC 917 (1973), where the Subpart F provisions withstood a U.S. constitutional challenge, permitting U.S. income taxation of a U.S. taxpayer’s economically accrued, but unreceived, income. See also Garlock, Inc. v. Commissioner, 489 F.2d 197 (2d Cir. 1974); and Est. of Whitlock v. Commissioner, 494 F.2d 1297 (10th Cir. 1974).

      [3] IRC Sec. 951(b).

      [4] The TCJA (Pub. L. 115–97, title I, § 14213(a)) repealed IRC Sec. 958(b)(4) that previously prevented the downward attribution from applying.

      [5] See IRC Secs. 952(a), 953.

      [6] P.L. 94-12, 94th Cong., 1st Sess.

      [7] Former IRC Sec. 963.

      [8] Former IRC Sec. 955

  • 992. Are there any exceptions that can prevent Subpart F income from being currently taxable to U.S. shareholders in a CFC?

    • Various exceptions are included in the Subpart F provisions to provide relief for U.S. taxpayers. I n limited situations, the exceptions may be useful in the U.S. tax planning context.  These exceptions include a de minimis rule which prevents Subpart F income from being currently includable in gross income when that income is a very small component of the CFC’s income. Further, Subpart F income is not currently taxable if it has already been subjected to a high rate of foreign income tax.

      The 5-70 Rule

      None of a CFC’s gross income for a taxable year is treated as foreign base company income (or tax haven insurance income) if the sum of the corporation’s gross foreign base company income (and gross tax haven insurance income) for the year is less than the lesser of (i) five percent of its gross income or (ii) $1 million.[1]

      CFCs with a functional currency other than the U.S. dollar must translate income using the appropriate exchange rate.[2]  If, however, the foreign base company income of the CFC exceeds 70 percent of the CFC’s gross income, the CFC’s entire gross income for the year (not limited to its Subpart F income) is treated as foreign base company income (and, therefore, currently included in the income of the U.S. shareholders).[3]

      If the foreign base company income is between five percent and 70 percent of the CFC’s gross income, the actual portion of gross income which is foreign base company income is to be so treated for current income inclusion purposes.[4]

      An anti-abuse rule applies in this context.  The income of two or more CFCs must be aggregated and treated as the income of a single corporation if a principal purpose for separately organizing, acquiring, or maintaining the structure is to avoid the application of either (i) the de minimis rule or (ii) the full inclusion rule.[5]

      The “High Foreign Tax” Exception

      Under the “high foreign tax exception”, foreign base company income and insurance income does not include any item of income received by a CFC if the taxpayer has established that the specific income item was subject to an effective rate of foreign country income tax greater than 90 percent of the maximum corporate income tax rate specified in IRC Section 11.[6]

      The taxpayer may make an election to use this exception and exclude the specific income item from the computation of Subpart F income.[7]

      In other words, because the current U.S. corporate tax rate is 21%, the foreign effective tax rate with respect to the particular income item must exceed 18.9 percent to qualify under this exception.


      Planning Point: Note that what is required to qualify for this exception is an “effective rate” and not a nominal tax rate. The effective rate at which taxes are imposed on a net item of income is (i) the U.S. dollar amount of foreign income taxes paid or accrued (or deemed paid or accrued) with respect to the net item of income divided by (ii) the U.S. dollar amount of the net item of foreign base company income, as increased by the amount of attributable taxes.[8]


      For purposes of determining a CFC’s foreign base company income, the CFC may take into account deductions properly allocable to the income.[9]  These rules essentially incorporate the deduction rules that apply to domestic corporations.

      [1] RC Sec. 954(b)(3).

      [2] See Treas. Reg. §1.954-1(b)(1)(B), which provides that the appropriate exchange rate is the rate provided under IRC Sec. 989(b)(3) for amounts included in income under IRC Sec. 951(a).

      [3] IRC Sec. 954(b)(3)(B). The assumption in this context is that essentially all of its activities are conducted for a tax haven purposes, as defined under the Subpart F provisions.

      [4] IRC Sec. 951(a)(1)(A)(i) provides for the inclusion of the pro rata share of the corporation’s subpart F income for that year.

      [5] Treas. Reg. §1.954-1(b)(4).

      [6] IRC Sec. 954(b)(4). This provision does not apply to foreign base company oil-related income, as described in IRC Sec. 954(a)(5).

      [7] Treas. Reg. §1.954-1(d)(1). Rules are provided for determining the effective rate at which taxes are
      imposed. Certain consistency rules also apply and require that an election to exclude income from the computation of Subpart F income for a taxable year must be made consistently with respect to all items of passive foreign personal holding company income eligible to be excluded for the taxable year. Treas. Reg. §1.954-1(d)(4)(i).

      [8] Treas. Reg. §1.954-1(d)(2).

      [9] See IRC Sec. 954(b)(5) and Treas. Reg. § 1.954-1(a)(4) which specifies that adjusted gross foreign base company shall be reduced so as to take into account deductions (including taxes) properly allocable or apportionable to the income. Treas. Reg. §1.954-1(c) provides rules for allocating deductions against gross foreign base company income.

  • 993. Are there any techniques that can be used to avoid CFC status for U.S. tax purposes?

    • Various planning approaches may be considered when structuring ownership arrangements in a foreign corporation to avoid CFC status, assuming that this is the desired U.S. tax planning result.

      In a two-shareholder situation, the simplest way to avoid CFC status is for the U.S. shareholder to own only 49 percent, the non-U.S. shareholder to own the remaining 51 percent, assuming that the parties have no understanding about the minority owner having any superseding powers. In some developing countries this share ownership arrangement may actually be dictated by host country laws restricting permissible foreign investment in that country, but this is decreasingly the situation under most foreign country investment laws.

      Splitting U.S. Ownership

      Another alternative for avoiding CFC status is for the U.S. shareholder to own 49 percent, with the remaining 51 percent owned by U.S. (or other) investors who are not ten percent shareholders (and, therefore, are not “United States shareholders”).

      This assumes these “less than 10 percent” shareholders are (i) unrelated to the 49 percent shareholder and (ii) unrelated to each other to the extent a ten-percent-or-greater shareholder would be deemed to exist. Otherwise, the constructive ownership rules could inadvertently cause U.S. shareholder status to occur for one of these minority shareholders, triggering CFC status.

      Informal Stock Ownership

      The diversification of the U.S. ownership (as identified above) of a foreign corporation to avoid CFC status can be accomplished through a distribution of the shares of a foreign corporation to the U.S. shareholders. This technique might be particularly useful for a U.S. publicly held corporation that owns the majority of shares in a foreign subsidiary.  Assuming a reasonably diverse shareholder group, the foreign corporation will not be a CFC after that distribution of its shares.

  • 994. How is a CFC’s tax year determined? Why is this important?

    • A CFC may be required to adopt the tax year of its majority U.S. shareholders, rather than the period it uses for purposes of its financial and tax accounting in the foreign jurisdiction.[1]  This rule applies to CFCs if, on each testing day, more than 50 percent of the total voting power of all classes of stock (or the total value of all stock) is owned by a single U.S. shareholder (and certain related shareholders). The year that the corporation is required to adopt is the tax year of the majority U.S. shareholder.[2]


      Planning Point: If a foreign corporation is required to change its tax year under these rules (i) the change shall be treated as initiated by the taxpayer, (ii) the change will be treated as having been made with the consent of IRS, and (iii) if, by reason of the change, any U.S. person is required to include in gross income for one tax year amounts attributable to two tax years of that foreign corporation, the amount which would otherwise be required to be included in gross income for such one tax year by reason of the short tax year of the foreign corporation resulting from such change shall be included in the gross income ratably over the four-taxable year period beginning with the one taxable year.


      The objective of this provision is to prevent a majority U.S. shareholder of a CFC from deferring tax on its Subpart F income required inclusions by having the foreign corporation adopt a tax year that differs from the majority U.S. shareholder’s tax year.  If the foreign corporation has no Subpart F income, no income inclusion is required for the U.S. shareholder and, therefore, this tax year requirement becomes irrelevant.[3]

      The majority U.S. shareholder is identified on the testing day which is the first day of the corporation’s tax year (determined without regard to this rule) or a day prescribed by the IRS. A CFC may elect, in lieu of the majority
      shareholder’s tax year, a tax year that begins one month earlier than the majority U.S. shareholder year, thereby permitting a one-month deferral.[4]

      Note that certain foreign corporations that are required to change their taxable years for U.S. tax purposes may not be able to make a conforming change in their taxable years for purposes of reporting taxable income in foreign countries.  The foreign country may have its own rules about the establishment of a taxable year for reporting for its own tax and financial reporting requirements.  The regulations address how these issues are to be resolved.[5] Problems that may arise because of nonconforming tax years can include issues related to the determination of creditable foreign taxes for purposes of the deemed paid foreign tax credit, the foreign tax credit separate limitation rules, and the foreign tax redetermination rules.

      If the CFC has no majority U.S. shareholder or has no income includable because of the Subpart F rules, these mandatory taxable year rules are not applicable. Under these circumstances, no income is includable prior to receiving a dividend distribution and the foreign corporation’s tax year would not be impacted by U.S. income tax rules.

      [1] IRC Sec. 898. See P.L. 101–239, § 7401(d)(2); Prop. Treas. Reg. §1.898-4(b).

      [2] As a result of applicable stock ownership attribution rules, more than one majority U.S. shareholder can exist with respect to a specified foreign corporation. Under these circumstances, the required taxable year is the taxable year that results in the least aggregate deferral of income to the U.S. shareholders. See Prop. Treas. Reg. §1.898-3(a)(4)(i).

      [3] Prop. Treas. Reg. §1.898-1(c)(1).

      [4] IRC Sec. 898(c)(2); Prop. Treas. Reg. §1.898-3(a)(2).

      [5] Prop. Treas. Reg. §1.898-4(c).

  • 995. What reporting requirements apply to U.S. shareholders in CFCs?

    • U.S. shareholders with controlling interests in a CFC are subject to certain U.S. reporting requirements.  They must generally report their share of income from the CFC, as well as their share of CFC earnings and profits that are invested in U.S. property. For these purposes, U.S. property includes investments, tangible property and assets, and stock in the CFC itself.

      The CFC is required to file an annual report on IRS Form 5471,[1] Information Return of U.S. Persons With Respect to Certain Foreign Corporations. This form is completed and attached to the corporation’s income tax return. Form 5471 reports information such as:

      • S. citizens who are officers, shareholders, and directors
      • A list of all U.S. shareholders and their stock ownership
      • The corporation’s classes of stock and shares outstanding
      • The corporation’s balance sheet and income statement for the tax year

      In addition to the Form 5471, a separate report is required for each U.S. shareholder, officer, or director who meets the 50 percent criteria discussed in Q[1] above. This report provides information about the individual’s income from the CFC, including dividend income and income from other investments.

      Note that CFC shareholders may also be subject to FBAR filing requirements (see Q[]-Q[]).

      [1] Available at https://www.irs.gov/instructions/i5471.

  • 996. What U.S. tax issues may arise when U.S. citizens live and work in a foreign country?

    • An estimated nine million U.S. citizens are resident in a foreign country.[1]  In many cases, these individuals are employed by either a U.S. business or a foreign business while living in the foreign location.  However, many other types of situations be relevant for U.S. tax purposes in this context. Examples include situations where:

      • A U.S. citizen/individual may be engaged in a foreign country as either a sole proprietor or as a partner in a U.S. or foreign partnership located in the foreign jurisdiction;
      • A foreign individual may be engaged in any of these activities (i.e., as an employee, sole proprietor, or a partner in a partnership) and that foreign individual may be a resident alien in the United States for U.S. income tax purposes;[2] or
      • A U.S. citizen/individual or a resident alien may have retired from gainful employment, while continuing to live in a foreign jurisdiction and receiving some type of retirement income distribution (or investment income sourced from outside the U.S.).

      All of these individuals are subject to the global applicability of the U.S. income tax.

      It’s important for U.S. employers and individuals to consider the various issues that can arise in these situations.  Examples of the types of both foreign country and U.S. income tax planning issues which these various individuals must confront can include:

      • Potential exposure to income tax (and other important taxes) in their residence jurisdiction, considering how any potential individual income tax costs at that location be moderated
      • S. income tax exposure for these individuals and the U.S. tax obligations and tax planning opportunities for both the employer and the employee because of this foreign status
      • Exposure of foreign-based individuals to U.S. income tax upon the receipt of deferred compensation?
      • The obligations of these individuals to contribute both to the U.S. Social Security system and to any foreign country government-supported retirement/social welfare programs, and the U.S. and foreign country income taxation of any benefits received under these government pension/retirement income systems
      • S. financial account reporting obligations, distinct from income tax obligations, that may apply for these individuals

      Importantly, these various questions might be resolved under applicable statutory rules, but might also be impacted by the provisions of an applicable bilateral income tax treaty.[3]

      [1] See CA by the Numbers, U.S. Department of State’s Bureau of Consular Affairs (December 2018).

      [2] A foreign based individual can still be deemed a resident of the United States for U.S. income tax purposes (and subject to U.S. worldwide income taxation) while living outside the United States. This would occur, for example, where the individual has a “greencard,” that (for U.S. immigration law purposes) provides a right to live permanently in the United States. See IRC Sec. 7701(b)(1)(A).

      [3] In other cases, it’s possible that a “totalization” agreement may be relevant.  This type of agreement is a type of tax treaty concerning government Social Security plan contributions and benefits.

  • 997. How is the income of U.S. citizens or resident aliens working in a foreign country taxed?

    • As noted, the general rule is that U.S. citizens are usually subject to U.S. federal income taxation regardless of where they live and work.

      However, a U.S. citizen or a U.S. resident alien who is assigned to work in a foreign country may be subject to the foreign country income tax (and similar tax) rules applicable to earned income either (i) derived in that foreign country, or (ii) derived by an individual deemed to be a “resident” of that foreign country.

      This foreign country income tax exposure:

      • Is initially determined by the domestic income tax law of the foreign country of residence, including through that country’s determination that it has primary income tax jurisdiction over (a) the person, or (b) even if not the person, that person’s source of income; but,
      • This initial outcome may be modified by a bilateral income tax treaty to which that foreign country is a party with the United States (or some other third country) which is the home jurisdiction of the U.S. taxpayer individual realizing the income.

      Further, this foreign country income tax treatment of the U.S. employees may be modified under the terms of a specific contract which the employer has arranged for the benefit of its employees with the government of the country (or an agency of that country) where the services are being performed.

  • 998. Are U.S. workers abroad subject to double taxation? What is the foreign tax credit?

    • Assuming that a foreign country does assess its income taxes against compensation paid to a U.S. taxpayer located in that country and, recognizing that (except for the earned income exclusions discussed in Q[953]) the U.S. taxpayer must also pay U.S. federal income tax because of the global applicability of U.S. income taxation, the question becomes whether any relief exists to reduce the impact of this potential double taxation to the U.S. taxpayer earning income abroad.

      Under IRC Section 901 a foreign tax credit is available to the foreign-based U.S. individual taxpayer for foreign income taxes paid, subject to certain limitations.  Alternatively, a deduction for the foreign income tax paid is available.[1]  If the foreign tax credit is not fully used during the current year, a carryback or carryover of these unused credits might be available.[2]

      An individual claiming the foreign earned income exclusion is not allowed a foreign tax credit with respect to the foreign income taxes which are allocable to those amounts that are excluded from gross income under both the foreign earned income exclusion and the housing cost deduction (see Q[955]).[3]  Thus, foreign income taxes that are paid on the amounts excluded from gross income are not creditable against the tentative U.S. income tax liability.  These foreign taxes paid are also not deductible even if not creditable under this rule.  If a taxpayer claims a foreign tax credit for the foreign earned income which is eligible for the IRC Section 911 exclusion, the Section 911 election will be considered revoked. The IRS has indicated that the Section 911 do not provide an exclusive method for revoking the Section 911 elections. If good faith computational errors are made in determining the amount of foreign earned income that is excluded and those errors may affect the amount of the allowable foreign tax credit,
      the IRC Section 911 election will not be treated as revoked, however.[4]

      In some foreign high tax jurisdictions, the tax planning focus for U.S. individuals working outside the United States is often focused on reducing the foreign country income tax liability (rather than the U.S. income tax liability) on the income earned in that foreign jurisdiction. Under these circumstances, the U.S. taxpayer may decide to forgo the IRC Section 911 income exclusion. The taxpayer would instead be able to use the entire amount of the foreign tax credit (without allocating a portion of the foreign tax credit to a tax-exempt foreign earned income exclusion amount). Those U.S. taxpayers who anticipate moving from a high-tax to a low-tax foreign jurisdiction, or vice versa, need to carefully review their overall foreign and U.S. income tax situations before deciding whether to elect the foreign earned income exclusion or to revoke a prior election.


      Planning Point: After revocation, a subsequent IRC Section 911 exclusion election cannot be made for five years after the time of revocation, except with the consent of the Commissioner. The Service will often permit a new election, however, if the taxpayer can demonstrate that the taxpayer’s tax circumstances have changed significantly.


      [1] IRC Sec. 164(a). IRC Sec. 275(a)(4) provides that no deduction is allowed for these taxes if “the taxpayer chooses to take to any extent the benefits of the [foreign tax credit].”

      [2] IRC Sec. 904(c).

      [3] See IRC Sec. 911(d)(6) and Treas. Reg. §1.911-6(c).

      [4] See Rev. Rul. 90-77, 1990-2 C.B. 183.

  • 999. How does a U.S. worker who is employed abroad pay foreign income taxes?

    • Under many circumstances, the U.S. employee will receive his compensation in U.S. dollars (the amounts may even be deposited into a U.S. bank account) regardless of the fact that the worker both (1) performs services in a foreign country and (2) is a bona fide resident (or is “physically present”) in that foreign country.  See Q[954] for a discussion of the bona fide residence and physical presence tests.  If the amounts are paid in U.S. dollars, no translation into U.S. dollars is required.

      However, income reported on a U.S. federal income tax return must be reported in terms of U.S. dollars.  If all or any part of the individual’s compensation is received in the currency of the foreign country where he is employed and is rendering services (or in the currency of some other foreign country), those foreign currency payments must be translated into U.S. dollars.

      The value of the foreign currency received must be translated into U.S. dollars at the exchange rates prevailing at the time the income (measured in foreign currency) is actually or constructively received by the taxpayer.[1]

      [1] See IRC Sec. 988(c)(1)(C).

  • 1000. Can any state-level income tax benefits result if an individual is able to exclude foreign earned income for federal income tax purposes?

    • Certain foreign earned income can be excluded from gross income (see Q[953]) and will not be subject to federal income taxation if an individual establishes that he has been a “bona fide resident” of a foreign country or countries. This foreign country residency status must exist for an uninterrupted period which includes an entire taxable year (as defined for U.S. income tax purposes, see Q[954])).[1]

      As beneficial side-effect of establishing this foreign residency, the individual may be able to avoid continuing state income tax jurisdiction that the U.S. state might otherwise seek to exercise. An individual, although employed abroad, may be subject to state-level income tax where he is deemed to be resident or domiciled in the United States (for that state’s income tax purposes) unless he can demonstrate that his residency has been removed from that state.

      However, notwithstanding qualifying residency status in a foreign country for IRC Section 911 purposes, some state income tax authorities may continue to assert jurisdiction for their tax purposes, suggesting that a more rigorous standard exists (than exists for federal income tax purposes) to enable a shifting of residency from that state for that state’s income tax purposes. More liberal standards might be applied, however, for a change of residency to another state in the United States during the time that the employee is actually engaged in activities in a foreign country. Such a state income tax planning opportunity should be carefully examined.


      Planning Point: For example, the employee might be able to relocate residency to a state in the United States which does not have a state income tax.  Often the state of Texas is chosen in this context because the Constitution of the State of Texas prohibits the adoption of a state personal income tax.


      [1] IRC Sec. 911(d)(1)(A) and Treas. Reg. § 1.911-2(a)(2)(i).