Passive Foreign Investment Companies and Tax Treatment – Understanding PFIC reportingArticle by Stephen M. Moskowitz, J.D., LL.M Senior Partner

Individual Highlights:

Passive Foreign Investment– 2 California Voluntary Disclosure– 5 Barry Bonds Prosecution – 8Offshore Compliance Initiative– 4 Government Enforcement – 7 Catch Steve on TV – 8

Special Interest Articles:

Offshore Compliance Amnesty– taxpayers have another chance

Government Enforcement – the end of foreign bank secrecy

Barry Bonds’ recent prosecution – what we can learn

SteveMoskowitz.com

Law Offices of Stephen Moskowitz, LLP 180 Montgomery St., Suite 1950, San Francisco, CA 94104 (415) 394-7200

Tax Times Today Special Issue: Foreign Bank Accounts

JUNE 2011

Beginning in 2009, taxing authorities in the United States gained the cooperation of foreign financial institutions and can now identify individuals and businesses that hold offshore accounts. The government’s access to this previously unknown information has created a heightened awareness of foreign income. All foreign bank accounts and income may be taxable or subject to specific reporting guidelines.

The Federal income tax rules regarding Passive Foreign Investment Companies (“PFIC”) are complicated.  It is important to have a basic understanding of PFIC treatment for income tax purposes, so that a holder will be able to have an adequate dialogue with his or her tax and legal professional.  Full detail of the treatment of PFICs can be found in the United States Tax Code §§1291-1298; general information regarding the PFCI provisions follows:

Foreign Bank Accounts?IRS Amnesty

Expires August 31, 2011Call for your Risk Benefit Analysis

(415)394-7200

“…Shareholders of a PFIC must file a form 8621 with the Internal Revenue Service every year….”

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located in the San Francisco Financial District

Passive Foreign Investmentcontinued

A foreign corporation is categorized as a Passive Foreign Investment Company when it passes either the “asset test” or the “income test.” Passive income is different from the standard income produced by the operation of a business and generally includes, but is not limited to, dividends, interest, royalties, rents, annuities, and certain gains from property transactions, commodities trading, and foreign currency, with exceptions. 

The asset test is passed when at least 50 percent of the assets produce or are intended to produce passive income.   The income test is passed when at least 75 percent of the gross income is passive income. 

Shareholders of a PFIC must file a form 8621 with the Internal Revenue Service every year during which the person recognizes certain gains or distributions, or makes a certain “election” (discussed below). 

Making a QEF Election

It is almost always advantageous for a U.S. taxpayer to elect to treat the PFIC as a Qualified Electing Fund (QEF), which can be done by the first U.S. person who is a direct or indirect shareholder of the PFIC.  The election should be made by the shareholder’s due date for filing taxes for the year

for which the election applies and it will remain active until revocation.    When a PFIC is treated as a QEF, the income or gains will be included in income and increase the PFIC stock basis, with the income treated as ordinary income and the capital gain treated as long-term capital gain.  Distribution of current or previously recognized income will be excluded from income but will reduce the PFIC stock basis; however, any excess distributions will be treated as a capital gain.

If a QEF is Not Elected

When a QEF is not elected, distributions are subject to taxation in the current year.  “Excess distributions,” which are those greater than 125 percent of the average annual distributions received in the preceding three years (or shorter time period if held for less than three years) are allocated pro rata to every day the taxpayer held the shares.  For those days in the current year, QEF is treated as ordinary gross income.   For the amount allocated to previous years the amount is subject to the highest rate of tax applicable for the taxpayer, plus interest.

“the shareholder can make the ‘market to

market’ election and may include in his or her

income the excess of the fair market value...”

Making the QEF Election in Later Years

While a taxpayer can make a QEF election in later years, there are complicated rules associated with not having the QEF in place from the first year, since the PFIC will be subject to both sets of rules.   Fortunately, taxpayers have some options to help with the situation.   One option is to treat PFIC shares as if they were sold at the beginning of the QEF election and pay any deferred tax.   Another option is to treat the PFIC shares as if they actually were part of a QEF from the beginning, either by taxing them appropriately or by filing a “protective statement.”   Certain requirements must be met to take advantage of any of these options.  

Making a Mark-to-Market Election

If the PFIC stock is “marketable,” a defined term that basically requires it to be traded on certain listed systems or marketable under other listed circumstances, the shareholder can make the “mark-to-market” election and may include in his or her income the excess of the fair market value of the stock over the adjusted basis. 

A Note on Controlled Foreign Corporations

Some PFICs are also Controlled Foreign Corporations (CFCs), which are defined as foreign corporations controlled more than 50 percent by U.S. shareholders who each own at least 10 percent of the foreign corporation.  The Taxpayers Relief Act of 1997 helped to simplify the rules associated with PFICs that are also CFCs by making the PFIC not subject to certain CFC pass-through rules for those U.S. shareholders that own at least 10 percent.

It is imperative to remember that this is an oversimplification of the rules relating to PFICs and there are many exceptions, qualifications and further requirements regarding most of the c i r c u m s t a n c e s d i s c u s s e d .  Additionally, these rules are based on the U.S. tax code and discussion of California tax treatment was beyond the scope of this article as it differs from the federal treatment.

Should you have any questions regarding your interest or potential interest in a PFIC, feel free to contact the professionals at our firm.

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Passive Foreign Investmentcontinued

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Individuals and companies in the United States are required to account for income and pay appropriate taxes on foreign investments. This is not a new tax requirement, just one that readily enforced by the Internal Revenue Service. The Department of Justice is seeking maximum enforcement.

The Commissioner of the IRS continues to reiterate that combating international tax evasion is of top importance and that pursuit of those who use international borders to cheat honest taxpayers will continue. The tax treaty between the U.S. and Swiss governments finalized in August 2009 disabled the secrecy of many foreign banks thus making account holder information readily available to the U.S. Treasury and IRS.

As a result, on February 8, 2011, the Internal Revenue Service (IRS) announced the 2011 Offshore Voluntary Disclosure Initiative (OVDI) for taxpayers with unreported foreign financial accounts, entities, or income. This initiative is the second compliance program administered by the IRS; the previous amnesty successfully brought in hundreds of millions of dollars and over 1500 particapants avoided criminal prosecution.

Taxpayers that wish to participate in the 2011 OVDI have only until August 31, 2011 to complete all requirements of the program. Participants in the OVDI will be required to disclose all foreign income, foreign bank accounts, and

ownership interests in foreign entities to the IRS for the 2003 through 2010 tax years. There is a formal disclosure process, including but not limited to, filing amending tax returns and filing all required information tax returns. The information returns must disclose all foreign bank accounts and interests in foreign entities such as corporations, partnerships, and trusts. The participant must also pay the tax, interest, and penalties by August 31, 2011. If an individual cannot pay all tax, interest, and penalties for the 2003 through 2010 tax years, in certain circumstances, the IRS may be willing accept monthly payment arrangements.

There are many requirements to qualify for this program, including but not limited to, a timely disclosure. This 2011 OVDI is not for all U.S. individuals with foreign bank accounts and asse ts . Upon consultation we can determine if participation would be beneficial and further advise you as to your situation. We have many years of substantial experience with the voluntary disclosure program, international tax issues, and related matters in advice, execution, and legal defense. If you have any questions or concerns regarding foreign business or investments, foreign bank accounts, report ing issues and amnesty programs please contact us.

Off Shore Compliance InitiativeArticle by Stephen M. Moskowitz, J.D., LL.MSenior Partner

“Seeking the protection of this voluntary disclosure program is a serious decision and should be done knowingly and properly.”

“Some of the year's business losses can be used to reduce taxable income in future years

and some losses can transfer to partners.”

California Offshore Voluntary Disclosure - New Voluntary Compliance Initiative for CaliforniaArticle byStephen M. Moskowitz, J.D., LL.MSenior Partner

In March, 2011, California passed legislation to allow a program similar to the federal 2011 Offshore Voluntary Disclosure Initiative (OVDI).    Senate Bill 86 was passed by the California legislature, signed by Governor Brown, and entered into California law.  While SB 86 amends several sections of the Revenue and Taxation Code, one important change is the authorization of a new voluntary compliance initiative.  The legislation authorizes the Franchise Tax Board to develop and administer a voluntary compliance initiative to be conducted between August 1, 2011 and October 31, 2011.   SB 86 represents the first voluntary disclosure program in California since the first quarter of 2004.

This initiative is similar to the 2011 Offshore Voluntary Disclosure Initiative from the federal government that encourages disclosure of offshore financial arrangements.  In addition to overseas money, California’s voluntary compliance initiative will include provisions for the disclosure of abusive tax shelters—an important distinction to the Federal OVDI.

Procedures for Compliance and Disclosure

Under the compliance initiative, a taxpayer will may be eligible to minimize penalties and avoid criminal prosecution for unreported or underreported income gained by abusive tax shelters or from foreign financial arrangements in previous tax years if he or she complies with the disclosure program.  Compliance with the program includes but is not limited to:

• filing an amended tax returns for each year that abusive tax shelter income or overseas money was not previously included; and

• payment in full all taxes and interest due according to the amended returns.

The amended returns must not contain deductions from any transaction costs associated with the previously-unreported income.   Also, the taxpayer will not be credited or refunded any money from any penalties the taxpayer paid in prior years.   Fortunately for many taxpayers, installment plans are authorized to be available so long as final payment is paid by June 15, 2012.

Please note, we strongly advise you to seek tax counsel from an attorney before proceeding in any tax matter as you could harm your case or miss valuable insights.

Certain taxpayers are not eligible for the voluntary compliance initiative, including those who, with regards to the abusive tax avoidance transaction or income from the offshore financial arrangement, are the subject of criminal investigation or have had a criminal complaint filed against them on or before July 31, 2011.

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California Offshore continued

Federal OVDI and CA program - An Important Difference

It is important to understand the difference between the federal disclosure initiative and California’s voluntary compliance initiative.  Taxpayers will be protected from criminal penalties associated with abusive tax schemes under California’s initiative, but abusive tax schemes are not protected under the federal program.  Should the Internal Revenue Service receive information disclosed to the Franchise Tax Board regarding a taxpayer’s participation in

an abusive tax scheme, he or she may not be provided the same protection from the federal government.   All circumstances should thus be examined carefully with a tax attorney before participating in any disclosure or compliance program to determine if it is right for you.

If you have any questions or concerns regarding foreign income, foreign bank accounts, reporting issues, the amnesty program, or any other legal issue, we would be happy to schedule a complimentary attorney-client privileged consultation.

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The U.S. Department of Justice has a mission statement: To enforce the law and defend the interests of the United States according to the law; to ensure public safety against threats foreign and domestic; to provide federal leadership in preventing and controlling crime; to seek just punishment for those guilty of unlawful behavior; and to ensure fair and impartial administration of justice for all Americans.

While the intention of the Department of Justice is to protect American citizens, many honest U.S. residents may be targeted for criminal tax fraud. The Tax Division of the Department of Justice is pursuing U.S. foreign account holders as criminal tax evaders, regardless of their intent to defraud the government of owed taxes. In 2008, a report from the Senate determined that these unreported accounts cost the U.S. Treasury in excess of $100 billion annually.

In August 2009, an agreement was negotiated between the Swiss government and the U.S. Tax Division that eliminated the secrecy of foreign accounts held by U.S. taxpayers in Swiss banks. Under the agreement, the IRS will receive information on accounts of various amounts and types, including bank-only accounts, custody accounts in which securities or other investment assets were held, and offshore company nominee accounts through which an individual indirectly holds beneficial ownership in the accounts. Continuing the crackdown on secret accounts, in April 2011 the U.S,

government received permission to authorize the IRS to request information from HSBC Bank USA, N.A. about U.S. residents who may be using accounts at The Hong Kong and Shanghai Banking Corporation in India (HSBC India) to evade federal income taxes. HSBC Bank will continue to be closely scrutinized, as account holders living in the U.S. have entered tax evasion guilty pleas in recent weeks.

Published statistics from the Justice Department show that approximately 150 grand jury investigations of offshore-banking clients have been initiated, of which 30 cases have been charged, with 24 guilty pleas having been entered, 2 convicted after trial, and 4 awaiting trial. Those who assisted clients with hiding assets are not immune to the law and many been indicted, charged, and await trial. Further, the governement is uncovering additional cases by investigating and prosecuting OVDI cases and hold outs.

All of the civil and criminal litigation publicity has not gone unnoticed by U.S. taxpayers with foreign bank accounts. With Swiss bank secrecy gone, a voluntary initiative to “come clean” brought in close to 18,000 taxpayers in 18 months and hundreds of millions of dollars to the U.S. Treasury. The success of that initiative ending in February 2011 prompted the IRS to announce a second voluntary disclosure program that will end on August 31, 2011.

The voluntary disclosure programs combined with the Tax Division’s civil and criminal litigation efforts have given the IRS the opportunity to procure significant additional information about tax fraud and those that promote it. The government is aggressive and will only be increasing efforts to find those who believe they are above the law in tax matters.

The GovernmentEnforcement of Foreign BankingArticle byStephen M. Moskowitz, J.D., LL.MSenior Partner

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We’re on the Web!Visit us at:

www.stevemoskowitz.com

Steve Moskowitz is the Sports Legal Analyst for Comcast SportsNet TV.You can catch Steve every Thursday evening on Chronicle Live.

Channel 40 also available in HD and Direct TV – channels 696, 696-1 & 697.For a full TV channel location listing visit

www.csnbayarea.com/pages/channels_bayarea

As the IRS amnesty deadline approaches, we urge you to discuss the options available to you so that you may take full advantage of the amnesty program. If you have a foreign account, please contact our law office to discuss your tax situation and what we can do for you.

Our practice covers the entire spectrum of the Tax Code in light of individual and business needs. Providing legal tax services for over three decades, we pride ourselves with our continual innovation and legal creativity when it comes to strategizing for, and defending, our clients.

My staff and I look forward to helping you. -- Steve

180 Montgomery St.Suite 1950San Francisco, Ca 94104

Phone:(415)394-7200

Fax:(415)398-6501

E-Mail: steve@stevemoskowitz.com

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Finding SolutionsThat Make a Difference

Note from Steve:

What the Barry Bondscase tells us aboutour government.

The case USA v. Barry Bondswhich ended in April 2011,demonstrated the magnitude thegovernment will pursue someonesimply on the grounds of lying.At the Law Offices of Stephen Moskowitz, LLP, we routinely handle clients who are presumed by the IRS to have lied about something on their tax return. Efforts to investigate by the IRS or State are unrelenting and intrusive. What we can learn from the Bonds case is that the government will use all of its resources and power to prosecute someone if they think they lied. If, for any reason, you are under investigation we recommend that you seek immediate representation.

Look for Steve on TV! He is featured on Sports and the Law every Thursday evening on the Chronicle Live TV Program providing the legal perspective on athletes that are accused of wrongdoing and other areas. The Sports and the Law segments cover the legal issues of the NFL, NBA and MLB, back room deals, athletes in trouble and more. Steve can also be seen in a special extended sports segment discussing controversial subjects such as “sports and sex.” Special segments will be promoted by Comcast news throughout the month.