IRS moves its systems ahead 60 years

This article was originally published on May 31 2019 by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.

The Internal Revenue Service (IRS) in the U.S. is bringing its IT systems into the 21st century, which is good news for American taxpayers and Canadians who must file U.S. returns. It is also good news for tax lawyers and tax accountants.

The IRS Integrated Modernization Business Plan is a 45-page, six-year plan laid out in detail with initiatives categorized under four pillars:

  • Taxpayer Experience
  • Core Taxpayer Services & Enforcement
  • Modernized IRS Operations
  • Cybersecurity & Data Protection

The first pillar focuses on modernizing the taxpayer experience. The goal is to make interacting with the IRS and with personal tax information as easy as online banking. Some of the perks highlighted in the report include simplified online interfaces, better access to information and self-service options, and improved customer service through callback technology, online notices and live online customer support, all while protecting taxpayer information and data.

The second pillar, Core Taxpayer Services & Enforcement, involves programs and initiatives that aim to retire outdated systems and consolidate  disparate  systems  and  data  into  updated solutions. For example, 60 different case management systems will be decommissioned and replaced with a single, consolidated, enterprise-wide platform. The IRS says the new system will  be an “end-to-end view of taxpayer cases and interactions.”

Phase two also introduces real-time tax processing, which is described as “near real-time data processing” that will allow taxpayers to easily adjust their return online after they file. As Canadian taxpayers, we are painfully aware that the CRA’s online system is currently not close to “near real-time” and plans to make improvements are high-level at this time.

The third pillar, Modernized IRS Operations, aims to simplify infrastructure and implement new technologies such as data analytics and automation in order to create efficiencies. The IRS modernization plan anticipates that the initial investment in emerging high-tech solutions  will result in significant long-term savings for the agency through improved processes and optimized systems.

The last pillar, Cybersecurity & Data Protection, has three main initiatives: 1) Identity & Access Management, 2) Security Operations & Management, and 3) Vulnerability & Threat Management. With this one the IRS will try to better protect taxpayer data from the persistent risk of cyber threats. Incredibly, the report says the agency faces 1.4 billion attacks every year.

Why did the IRS need this integrated modernization business plan? The agency recognized that it has been experiencing its own financial struggles for decades with trillions of dollars lost to tax evasion and a tax gap of over US$450 billion (which  represents  the  difference between  taxes owed and taxes paid on time). Intensifying these shortfalls is the fact that 45 per cent to 55 percent of the IRS workforce is on the verge of retiring.

On April 10, IRS commissioner Charles Rettig announced to the Senate Committee on Finance that the agency requires US$2.3 billion to US$2.7 billion over a six-year period to implement an IT modernization plan that would include revamping its IT systems. Why? U.S. Senate Finance Committee chair Charles Grassley called the agency’s IT systems and infrastructure “woefully outdated,” and expressed concern that past efforts and investments to update its technology may not have been money well spent.

In 2018, the IRS processed almost 141 million tax returns and any agency with a volume like that needs the latest IT technology. The IRS has already been under the strain of updating disparate systems for the 2017 Tax Reform Act, not to mention the five-week government shutdown earlier this year.

Modernization is key for several reasons: to 1) improve the agency’s ability to recoup monies owed; 2) prevent further losses due to tax evasion and fraud; 3) create much-needed efficiencies and 4) ensure ongoing compliance with tax laws for taxpayers.

Since almost 90 per cent of U.S. taxpayers file their returns online these days, nobody at the IRS wants more outages on deadline day, which they refer to as Tax Day.

On April 17, 2018, the IRS announced that its systems were experiencing technical difficulties   (i.e., they crashed) due to transmissions from software providers to the agency’s tax-processing systems. Those systems were more than 60 years old. And guess what? The IRS system crashed again this year on the last Tax Day. A similar outage occurred in March on the CRA website when online services were down for a day.

I wouldn’t say that exciting times are ahead for taxpayers and their representatives, but these real and sustainable improvements to services, operations and security for the IRS are most welcome. From the perspective of a tax practitioner, the planned consolidation of various data sources for greater risk management, tax compliance, tax enforcement and information sharing have me (almost) looking forward to next year’s tax season. Or maybe the tax season six years from now.

 

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Changes Made to the High Tax-Exception for Exclusion from Subpart F Income

What is Subpart F Income?

Generally, the taxation of earnings and profits in the U.S. of a controlled foreign corporation (“CFC”) are deferred until repatriation through the distribution of dividends. A CFC is a foreign corporation that is owned more than 50 per cent of vote or value by a U.S. person or persons (i.e. U.S. citizens, resident individuals, U.S. partnerships and corporations, non-foreign estates and U.S. trusts) who each own at least 10 per cent of vote or value. However, there are exceptions to the deferral with respect to passive and certain types of active business and personal services income. These types of income, under specific circumstances, are taxable in the hands of the U.S. person whether or not distributed to the shareholder. The deemed income inclusion is what is referred to as “Subpart F” income. The Subpart F rules are anti-deferral provisions to prevent U.S. persons from delaying the recognition of taxable income through the use of foreign entities.

What are the changes?

Beginning in 2018, a US citizen resident in Canada, who is required to accrue passive income (or other subpart F income) on his US personal tax return under the subpart F provisions of the CFC rules, will exclude the income from his US tax return if a Canadian corporate tax of over 18.9 per cent is paid on the income. This is what is commonly referred to as the “high-tax exception”. In Ontario, investment income is taxed at 50.17 per cent to the CFC (including capital gains taxed at 25.09 per cent), therefore, the high-tax exception would apply to exclude the investment income from being taxed currently as subpart F income. The current provisions ignore any subsequent reduction to the corporate tax as a refundable dividend tax on hand (“RDTOH”) once the income is distributed to the shareholder as a dividend for purposes of the high-tax exception.

Why were the changes enacted?

Treasury is aware that certain jurisdictions use a tax integration system where the corporate income tax paid by the CFC is refunded when the income is distributed, even if the shareholder is subject to little or no tax on receipt. This has raised concerns where CFCs are formed specifically to exempt passive income (or other subpart F income) from US taxation under the high-tax exception. To address this perceived abuse, proposed regulations were released on November 28, 2018 that modify the high-tax exception. Now, if foreign taxes paid or accrued are reasonably certain to be refunded to the shareholder on a subsequent distribution, such foreign taxes are not treated as paid or accrued for purposes of the high-tax exception.

What about capital gains?

As previously noted, Ontario’s tax rate on investment income is 50.17 per cent. After the RDTOH, the tax is reduced to 19.5 per cent on a subsequent distribution and the high-tax exception should apply. However, the high-tax exception with respect to capital gains will not be available due to a reduced tax rate of 9.75 per cent after the credit for the RDTOH. There may be situations where accumulated RDTOH can reduce the effective tax rate to below 18.9per cent. In this case, the high tax exception will not apply.

The regulations are still in proposed form and may change after the IRS receives comments from the public. If enacted in its original or revised form, it will be effective for tax years ending after December 4, 2018.

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TAXPAYERS BEWARE – GREATER COMPLEXITY IN OBTAINING EIN IS COMING YOUR WAY

Three things to know about updates to the EIN application form

In an effort to improve security and transparency around the Employer Identification Number (EIN) application process, the Internal Revenue Service has published updated instructions to Form SS-4, Application for Employer Identification Numbers.

An EIN is an identification number assigned to sole proprietors, corporations, partnerships, estates, trusts, employee retirement plans and other entities. It is the equivalent to a Canadian Business number and all businesses operating in the U.S. must have an EIN in order to file tax returns or entity classification elections with the IRS. In some cases, it is also required to open a U.S. bank account.

If you are a Canadian doing business in the U.S., there are three key takeaways from these updates:

1) Requirement for an SSN or ITIN. EFFECTIVE MAY 13, 2019, taxpayers cannot apply for an EIN unless the responsible party named on the application has either a social security number (SSN) or Individual Taxpayer Identification Number (ITIN). While it is not expressly described in the new instructions to the application, it is understood that an EIN can be assigned to an international applicant (i.e. an entity that has no legal residence, principal office, or agency in the United States or a U.S. possession) if an SSN, ITIN, or EIN for the responsible party is not available. In this case, the applicant can enter “foreign domicile” on line 7b of Form SS-4.

2) Change to the definition of “responsible party”. As of December 2017, the IRS requires that an EIN applicant’s “responsible party” must be an individual who owns or controls the entity or exercises ultimate effective control over the applicant. The responsible party can be a U.S. or non-U.S. person, but it can no longer be an entity. (Government entities and military are exempt.)

3) Elimination of the “check-the-box” exception. The “check-the-box” exception no longer applies. Prior to this change, a SSN or ITIN was not required to apply for an EIN if the reason for obtaining an EIN was to file IRS Form 8832, Entity Classification Election (i.e. a “check-the-box” election to change the entity’s classification for federal tax purposes). In the most recent version of the application, the IRS has eliminated this exception.

The check-the-box election as a planning tool

The “check-the-box” election has been a popular post-mortem planning tool used by Canadians to avoid the U.S. estate tax on U.S. situs assets held by a non-U.S. taxpayer at death. A Canadian partnership is initially created to own the U.S. situs assets and, following the death of the non-U.S. taxpayer, a check-the-box election is made to treat the Canadian partnership as a corporation for U.S. tax purposes. A non-U.S. decedent who, at death, holds shares of a foreign corporation (which serves as a “blocker”) that owns U.S. situs assets is not subject to the U.S. estate tax. The “check-the-box” election can be effective up to 75 days prior to the date the election is filed, which effectively permits the ownership by the non-U.S. decedent of the “foreign corporation” to occur prior to the date of death.

The U.S. estate tax is assessed at up to 40% of the fair market value (and not the gain) of the U.S. situs assets, however, the lifetime estate tax exclusions that are permitted under the Canada-U.S. Treaty may provide relief from the U.S. estate tax. Because the lifetime estate tax exclusions have doubled for 2018 through 2025 under the Trump Administration’s new tax Act, this planning tool may prove to be less effective until the end of 2025.

Advance Planning is Highly Recommended

Limited Liability Companies (“LLC”) that are wholly-owned by non-US persons must now comply with the reporting requirements of Form 5472, Information returns of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.  The Form must be attached to a proforma U.S. tax return (i.e. Form 1120, U.S. Corporation Income Tax Return) and is due by the 15th day of the fourth month following the end of the foreign owner’s tax year or calendar year. For a calendar year foreign owner, the tax return is due April 15.

Because the ITIN application process is quite onerous and may take months to complete, advance planning is critical to ensure that elections are made in a timely manner and the U.S. filing requirements are met by the due date.

There is no change to the application process for tax professionals who act as a designated third-party in completing the process for an entity.

 

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California Legislature Approves Marketplace Bill

Non proprietary. This article was originally published by Paul Jones on April 10 2019 on Taxnotes.com

The California State Legislature has passed a remote seller and marketplace facilitator bill with a $500,000 sales threshold.

The Senate passed A.B. 147 with amendments on a 36–0 voteApril 4, and the Assembly concurred with the Senate changes on a 67–0 vote April 8. The bill now goes to the desk of Gov. Gavin Newsom (D).

A.B. 147 would require remote retailers and marketplace facilitators to collect and remit state and local sales tax when the value of their annual sales into California exceeds $500,000. For marketplaces such as Amazon and eBay, the sales counting toward that threshold would include both their own sales and those they facilitate for their third-party sellers.

Following the Supreme Court’s decision in South Dakota v. Wayfair Inc., California implemented stopgap regulations that required remote retailers to collect and remit sales tax when their annual sales into the state meet $100,000 or 200 separate transactions, effective April 1. A.B. 147 would eliminate those thresholds in favor of the $500,000 limit. The bill’s remote seller provisions would also be effective back to April 1.

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US Persons with Foreign Interests may be overlooking important reporting requirements

IRS Form 5471 Penalty

U.S. citizens or residents who are officers or directors of a foreign corporation (e.g. a Canadian corporation) often overlook their U.S. filing obligations, and it is important to understand the stiff penalties for not properly disclosing foreign interests.

If a U.S. citizen or resident is an officer or a director of a foreign corporation in which a U.S. person has: 1) acquired 10% or more of votes or value of the corporation during the year or 2) acquired an additional 10% or more of votes or value of the corporation during the year, the officer/director is required to report as a Category 2 filer on Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations).  Reporting is required whether or not the officer/director owns shares in the foreign corporation and regardless of whether the foreign corporation is a controlled foreign corporation (“CFC”).

Failure to file, or filing an incomplete Form 5471, can result in penalties of $10,000 per foreign corporation, unless a reasonable cause defense exists. At any time, the IRS may issue a written request to file Form 5471 within 90 days. If not filed, the continuous penalty applies at $10,000 per month to a maximum of $50,000. The combined penalty is capped at $60,000.

Other information returns that are either filed late or incomplete may attract initial and similar continuous penalties and are summarized as follows:

 

Form Initial Penalty Continuous Penalty Maximum Penalty
Form 8938, Statement of Foreign Financial Assets $10,000 per return Additional $10,000 penalty per month that the failure continues, beginning 90 days after initial notice Maximum continuous penalty of $50,000 for a combined penalty of $60,000
Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts Greater of $10,000 or 35% of the gross reportable amount

 

In the case of greater than $100,000 of foreign gifts received, the penalty is 5% of the value of the gift per month.

 Additional $10,000 penalty per 30-day period, or a fraction thereof, that the failure continues beginning 90 days after initial notice Gross reportable amount plus initial penalty

 

 

 

 

Maximum penalty of 25% of the value of the gift
Form 3520-A, Information Return of a Foreign Trust with a U.S. Owner Greater of $10,000 OR 5% of the gross value of trust assets owned by the U.S. person Additional $10,000 penalty per 30-day period, or a fraction thereof, that the failure continues beginning 90 days after initial notice Gross reportable amount plus initial penalty

 
Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation 10% of the value of the property transferred Not applicable $100,000

 

No maximum if due to intentional disregard
Form 8865, Return of U.S. Persons with Respect to Foreign Partnerships $10,000 for failure to file

 

 

 

Plus, 10% of the value of any unreported transferred property

 Additional $10,000 penalty per month that the failure continues beginning 90 days after initial notice Maximum continuous penalty of $50,000 for a combined penalty of $60,000

 

 

$100,000
Form 5472, Information Return of a 25% Foreign Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business $25,000 per foreign corporation ($10,000 prior to 2018) Additional $25,000 penalty per month that the failure continues beginning 90 days after initial notice NO MAXIMUM PENALTY
Form 114, Foreign Bank Account Report Willful penalty of the higher of $100,000 or 50% of the total balance of the foreign financial account per violation

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-willful penalty of up to $10,000 per account per year

 

 

 

 

 Not applicable. Aggregate of all accounts that does not exceed $50,000, penalty is greater of $1,000 per violation on 5% of the maximum account balance in the calendar year

 

Aggregate balance of more than $50,000 but no more than $250,000, penalty is the greater of $5,000 per violation or 10% of the maximum account balance

 

Maximum aggregate balance is greater than $250,000 and less than $1,000,000, penalty is greater of 10% of the maximum account balance or 50% of the closing balance in the account on the last day for filing the FBAR

 

If the account exceeds $1,000,000, the penalty is the greater of $1,000,000 or 50% of the closing balance of the account

 

In most cases, the total penalty amount for all years under examination will be limited to 50% of the highest aggregate balance.  Although penalty may be higher or lower, the total penalty should not exceed 100% of the highest aggregate balance.

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Aggregate of all accounts that does not exceed $50,000, penalty is $500 per violation not to exceed $5,000

 

Aggregate of all accounts that exceed $50,000 but less than $250,000, penalty is lesser of $5,000 or 10% of the highest balance in the account during the year

 

For violations regarding an account exceeding $250,000, the maximum penalty is $10,000 per violation.

 

In no event will the penalties for non-willful violations exceed 50% of the account balances.

 

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GILTI Relief for US Individual Taxpayers

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The Anti-Abuse Rules under Transition Tax (Section 965) Final Regulations

Code Section 965 of the Tax Cuts and Jobs Act requires some US shareholders to pay a one-time transition tax on the untaxed foreign earnings of certain specified foreign corporation (“SFC”) as if those earnings had been repatriated to the US. Very generally, section 965 of the Code allows taxpayers to reduce the amount of such inclusion based on deficits in earnings and profits with respect to other SFCs.

On January 15, 2019, the final regulations of the transition tax under Section 965 were released. The final regulations are fundamentally the same as the proposed regulations (with some modifications) and apply to the last taxable year of a specified foreign corporation (“SFC”) beginning before January 1, 2018 with respect to a US shareholder.  For 2017 calendar year SFCs, the transition tax is calculated in 2017, and for fiscal year SFCs ending in 2018, the transition tax applies to the 2018 tax year.

It is important to note the anti-abuse provisions of the transition tax, which also remain similar to the proposed regulations, with some modifications.  Under the anti-abuse provisions, a transaction is disregarded when determining the “section 965 element” if each of the following conditions are met:

  1. Any part of the transaction occurs on or after November 2, 2017;
  2. The purpose of the transaction is to change the amount of a “section 965 element” of the US shareholder; and
  3. The transaction, in fact, changes the amount of the section “965 element” of the US shareholder.

The final regulations define “section 965 element” as any of the following amounts:

  1. The US shareholder’s section 965(a) inclusion (i.e. reduces earnings or increases a deficit) amount with respect to the SFC;
  2. The aggregate foreign cash position (i.e. reduction to cash position) of the US shareholder; or
  3. The amount of the foreign income taxes (i.e. increase in foreign taxes paid) of a SFC deemed paid by the US shareholder under the provisions of Sec. 960 as result of the section 965(a) inclusion. The deemed foreign tax credit is only available to US corporate shareholders that own at least 10% of a SFC and is not applicable to individual US shareholders.

According to the regulations, the transactions that may change the “section 965 element” include accounting methods, entity classification elections, specified payment and double counting rule, and certain cash reduction transactions.

Due to higher Canadian tax rates, one option is for individual US shareholders to create excess foreign tax credits in the year after the transition tax year that are sufficient enough to carryback to the previous year and offset the transition tax.  For US tax purposes, a foreign tax credit for Canadian taxes paid can be carried back one year.

For example, a significant bonus can be paid in 2018 for a 2017 transition tax year (or 2019 for a 2018 transition tax year for fiscal year SFCs), a dividend distribution can be taken, or some combination of both. However, any Canadian tax paid on a dividend distribution to reduce previously taxed income (i.e. income inclusion for transition tax purposes) is subject to a reduction in foreign tax credits that is equal to the ratio of the participation exemption deducted against total earnings and profits subject to transition tax. The participation exemption is the amount of exclusion that is applied against the earnings and profits.

It is not clear if the payment of a salary would also be subject to a reduction in foreign tax credits if it reduces pre-taxed cumulative earnings and profits.

In summary, we believe that increasing the foreign tax credit for carryback to recoup the transition tax is not within the scope of the anti-abuse provisions of the regulations.

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IRS shutdown may lead to complications for Canadians

IRS

With the United States government shutdown in its fifth week — the longest government shutdown in U.S. history — its effects are beginning to take a toll on those north of the border.

For Canadians with financial interests in the U.S., the shutdown of non-essential government agencies such as the Internal Revenue Service may prove to be more than just a minor inconvenience.

Azam Rajan, lawyer and director of U.S. tax law at Moodys Gartner Tax Law in Calgary, says the “procedural snafu” created by the shutdown of the IRS can mean higher than anticipated costs and complications during the upcoming tax season that may stifle cross-border investment.

Transactions involving Canadian sellers of U.S. real estate are being delayed as well, as non-residents are typically required to abide by the Foreign Investment in Real Property Tax Act. The law requires non-residents to withhold 15 per cent of the sale price as tax, Rajan says. However, sales resulting in a net profit loss are not subject to taxation and the seller is permitted to obtain that money back from escrow, but only through the submission of a withholding certificate from the IRS.

“Unfortunately, now that money is being held in the escrow agent’s office and they then are required to submit it to the IRS,” Rajan says. “You now have to file a tax return with the IRS to get the money back and this is the wrong way of doing it.”

Elena Hanson, founder and managing director of Hanson Crossborder Tax, says that since the shutdown of the IRS on Dec. 22, taxpayers and tax practitioners with past or future U.S. tax obligations have been unable to access services that may be required to comply with Canada Revenue Agency regulations such as notice of assessments for past foreign tax credits.

Given the duration of the shutdown, many of these concerns are expected to continue once the IRS commences operations for the upcoming tax season on Jan. 28. The IRS Lapsed Appropriations Contingency Plan stipulates that only 57.4 per cent of furloughed workers will be retained, leading to immense and inevitable backlog.

“During normal operations, there were a lot of inefficiencies. It typically takes somewhere from half an hour to two hours if you want to address an inquiry over the phone with an agent,” Hanson says. “We cannot even imagine how long it’s going to take to ask a question.”

The subsequent backlog may lead to a delay in returns that will extend far into 2019, Hanson says, and cause some Canadians to file late with the CRA if they choose to wait for the funds from U.S. returns to finance CRA tax payments.

As of this moment, Hanson says she is not aware of any accommodations the CRA plans to make for those filing abroad. However, she says, in the past, they have been quite lenient.

“This is a major hurdle for everyone affected and, unfortunately, we don’t have control or we don’t have any other options,” Hanson says. “We just have to wait and be organized once the revenue services are back to normal or semi-normal.”

Marsha Dungog, also a director of U.S. tax law at Moodys Gartner Tax Law, says the IRS shutdown can affect Canadians on a more personal level as well. A few years prior, the U.S. began a controversial passport revocation program in which individuals owing more than $50,000 in taxes would have their U.S. passports revoked by the Department of State when crossing the border and not returned until payment was made, Dungog says.

There is currently no staff available to either process payments owed or contact the State Department for re-certification of the passport, which severely hampers the ability of those individuals to travel for either business or personal reasons, Dungog says.

A lack of staff may also impact lawyers with clients involved in the tax appeal process.

“Lawyers dealing with the IRS already on what we call appeals or higher-level administrative review of the file for their clients, all the correspondences are going to get delayed because there are no actual IRS personnel there to answer,” Dungog says. “The IRS was supposed to be rescheduling, but they don’t know when they’re going to open.”

As those delays in appeals endure, not only do penalties and interest continue to accrue but individuals may be subject to tax liens imposed through the IRS’s functioning automated system, Dungog says. Although these are remediable conditions, Dungog anticipates they would require a “Herculean effort” to amend once the IRS is up and running.

“We’ll just have to learn how to deal with uncertainty for now on both sides of the border,” she says.

Written By Julia Nowicki
Source CanadianLawyer article published January 23,2019
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