K-1 Aggregation and International Filing Requirements

The problem that investors face is that their foreign reporting obligations are based on all their proportionate shares of partnership investments computed on a cumulative basis. Thus, if an investor has an ownership interest in 500 domestic partnerships, and 10 of these partnerships have invested in the same foreign partnership or corporation, the tax-exempt investor’s combined investment may exceed $100,000 on a cumulative basis. However, to determine if the reporting threshold has been exceeded, every footnote reporting foreign corporate or partnership investments will have to be tabulated by the investor. This will require partners to identify and calculate the information they receive in the footnotes of their Schedules K-1 about the partnerships’ underlying investments in foreign corporations and foreign partnerships. An investor who has hundreds of footnotes to review and categorize may determine, at the end of this exercise, that there is no foreign filing obligation because the $100,000 reporting thresholds have not been reached.

As with so much of the Schedule K-1 information reporting, one or two or 10 Schedules K-1 are manageable, but hundreds put a real strain on the tax professionals conducting this information- gathering process. There is added complexity due to the rolling 12-month rule that requires this aggregation and analysis to be done not just by aggregating all K-1s in a single year but also reviewing all prior-year transfers to test for the rolling 12-month reporting requirement.  

TCJA increased international compliance burden

The Tax Cuts and Jobs Act of 2017 (TCJA) made significant changes to the international tax rules. As a result, investors with outbound investments now face increased compliance burdens. Most changes took effect January 1, 2018, while other changes were retroactive, taking effect as of the beginning of the 2017 tax year.

Foreign corporations, foreign disregarded entities, and foreign branches

1. Form 5471
   Generally, U.S. persons that own foreign corporation stock are required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, if they meet certain ownership thresholds. A U.S. person is defined as a citizen or resident of the United States, a domestic partnership, a domestic corporation, or an estate or trust that is not a foreign estate or trust. An annual Form 5471 must be filed as a Category 5 filer by a U.S. shareholder of a controlled foreign corporation (CFC) who owned stock in the CFC on the last day of the CFC’s tax year. A CFC is a foreign corporation that has U.S.  shareholders that own directly, indirectly, or constructively more than 50% of the total combined voting power of all classes of its voting stock, or the total value of the stock of the corporation. Prior to TCJA, the definition of a U.S. shareholder did not include the value component. Consequently, many investors structured their investments to hold only non-voting shares, which kept them from meeting the ownership requirement.
   
   With the addition of a value component to the definition of U.S. shareholder, investors may be required to file additional Forms 5471 going forward. A review of all foreign investments in which the organization holds non-voting shares should be performed to ensure that all filing requirements are met. It should also be noted that due to the extensive international tax changes as a result of TCJA, Form 5471 has been expanded greatly and additional time and effort will be required to prepare a complete and accurate return.
2. Form 8858 
   An additional change made by TCJA expanded the scope of Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities and Foreign Branches. Prior to the     Act, a Form 8858 was only required to be filed for each foreign disregarded entity (FDE). An FDE is a separate legal entity that is disregarded for U.S. tax purposes. Under the new rules, foreign branches, including qualified business units, must now also file a separate Form 8858 each year. This includes foreign branch activity of a U.S. person, a CFC, or a controlled foreign partnership (CFP). The term foreign branch means an integral business operation carried on outside of the U.S. Whether the activities performed outside the U.S. constitute a foreign branch must be determined under all facts and circumstances. Evidence of a foreign branch includes, but is not limited to, the existence of a separate set of books and records, and the existence of an office or other fixed place of business used by employees or officers of the U.S. person, CFC, or CFP in carrying out business activities outside the U.S. If the activities performed outside the U.S. constitute a permanent establishment under the terms of an income tax treaty between the U.S. and the country in which the activities are carried out, the activities will be deemed to constitute a foreign branch. Investors should review their offshore activities in light of these new requirements    to ensure proper compliance.
3. GILTI, Transition Tax, and BEAT
   TCJA enacted the new Global Intangible Low-Taxed Income (GILTI) regime, which requires a U.S. shareholder of a CFC to include its share of GILTI  income each taxable year in its gross income.    In general, GILTI is the amount of the aggregate of all of an organization’s CFCs’ earnings in  excess of a certain return on their fixed assets. GILTI is treated as a deemed dividend and, as   such, should generally be excluded  from  UBI. Although  the GILTI  inclusion may  not  be taxable, if the organization has a Form 5471 filing requirement as a U.S. shareholder of a CFC, the GILTI components will need to be computed to properly file Form 5471 and its related schedules.
   
   Finally, Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income, must  be filed by any U.S. shareholder of one or more CFCs that must take into account its pro rata share of the tested income or tested loss of the CFC in determining the U.S. shareholder’s GILTI inclusion. To the extent the GILTI inclusion is taxable to the organization, it may be allowed a 50% deduction against the GILTI inclusion. which would be calculated and reported on the new Form 8993, Section 250 Deduction for Foreign Derived Intangible Income and Global Intangible Low-Taxed Income. The final regulations made a change to the prior proposed GILTI regulations. This change requires an investor to include its pro rata share of GILTI income to the extent its direct or indirect investment in the foreign corporation exceeds 10%. This is an especially important change as it relates to partnerships since the ultimate investor looks through the partnership to determine its ownership in the foreign corporation. This adds complexity to the K-1 reporting since the partnership must provide enough information for each partner to determine its own impact of the GILTI income. This also means that each partner will have to do a detailed analysis of the information provided to determine if it has a taxable inclusion or if it needs to adjust information provided on the fact of the K-1 that is not taxable to the specific partner.    
   
   As many organizations learned in the prior year,  TJCA  also imposed a “transition tax,”  which was a one-time tax on the accumulated earnings and profits of certain foreign corporations. For those organizations that did have a taxable income inclusion related to the transition tax, Form 965, Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System, is required beginning in 2018 to report the calculation of the transition tax and to track any related installment payments. The amounts from all K-1s must be aggregated for this purpose as well. 
   
   Finally, organizations with average gross receipts of greater than $500 million in the three preceding tax years are subject to the new base erosion anti-avoidance provisions (BEAT). The $500 million includes gross receipts earned directly and an organization’s pro rata share of gross receipts of partnerships in which it holds an investment. In short, the BEAT  rules impose  a minimum tax with respect to certain base erosion payments made by corporations. The test    is done on an affiliated group level. Investors would be required to file Form 8991, Tax on Base Erosion Payments of Taxpayers With Substantial Gross Receipts. This is an area where the aggregation of K-1 information will be crucial in determining whether the thresholds for BEAT application are met.   
   
   Given the expanded scope and the increased complexity of foreign informational reporting requirements, investors will need to do a deeper dive into their international operations in   order to timely file the required forms and to minimize compliance risk. The penalties for   failure to file could be as much as $10,000 per form and could result in potential reduction in allowable foreign tax credits. Proper analysis of K-1 footnotes is necessary to mitigate risk to any organization with alternative investments.

Conclusion

Tax preparation related to alternative investments is difficult to manage. The diligence it takes to ensure you’re capturing all relevant data points for the current year, as well as throughout the life of the partnership, often takes more time than is available. But the risks of not capturing and tracking the information are too great to ignore. There are approaches to managing the issues involved, and while there appears to be an infinite number of ways to receive information from a K-1,  there is a    finite amount of information necessary to feel confident that you’re protected.