Volume No. US-21-03
Form 8858, “Information Return for U.S. Persons With Respect to
Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs)”
In this U.S. Tax Tip we are going to look at expanded Form 8858. Form 8858 has grown, over the years, into a comprehensive and complex filing. This U.S. Tax Tip is not meant to be a comprehensive review of Form 8858 nor an in-depth analysis of relevant U.S tax law. A treatise could be written with respect to each. Rather, in light of the expanded January 1, 2018 filing requirement and the lack of specific IRS guidance we wish to highlight some issues that our readers may not be aware of. Unfortunately, as is typical, neither Congress, the United States Treasury nor the Internal Revenue Service consider the impact of these rules (and the associated compliance costs) on U.S. persons who live abroad. A lot of information is required to accurately complete the form and significant penalties may apply for non-compliance.
Form 8858 was originally introduced for tax years beginning after December 31st, 2003. The form was developed to enable the Service to more efficiently administer tax law with respect to U.S. persons that owned foreign disregarded entities (FDEs). The “check-the-box” classification regulations, effective as of January 1, 1997, facilitated the use of FDEs by U.S. persons with cross-border investments or operations.
The IRS stated that they had significant difficulties administering the relevant provisions of the tax law because the information reporting requirements, at that time, still dated from a time when the entity classification rules did not contemplate disregarded entities. As such, the lack of relevant information reporting had hindered the IRS’ ability to enforce relevant tax law.
The 2017 changes
The 2017 Tax Cuts and Jobs Act (P.L. 115-97) expanded the filing requirements to include foreign branch income. The TCJA introduced a new foreign income category entitled Foreign Branch Income.
Foreign business entity
For purposes of Form 8858, a foreign business entity means, in general, either a foreign corporation or foreign partnership. However, under various IRS guidance (statutory and regulatory) a foreign business entity also includes a foreign branch. A foreign branch includes a foreign “qualified business unit” (QBU). This is the issue that is now causing the (potential) additional filing requirements (since January 1, 2018).
What is a “qualified business unit” (QBU)?
In general, a QBU is any separate and clearly identified unit of a trade or business of a taxpayer AND for which separate books and records are maintained. Both tests must be met. Certain entities can constitute QBUs. For instance, a corporation is a QBU. Further, a partnership, trust, or estate is a QBU of a partner or beneficiary. Certain activities of the taxpayer, however, can also qualify as a QBU. In order for activities to create a QBU:
- The activities must constitute a trade or business, and
- A separate set of books and records must be maintained with respect to those activities.
In general, a trade or business for purposes of defining a QBU is: unified group of activities that constitutes (or could constitute) an independent economic enterprise carried on for profit, the expenses related to which are deductible…
It is a question of fact as to whether a separate set of books and records are being maintained. If the issue is foreign rental property does the taxpayer maintain a separate bank account just for the rental income and expenses? If not, do we have a QBU?
What’s the issue with respect to U.S. individuals living abroad?
Two possible client situations come to mind: (i) individuals who carry on a foreign sole proprietorship (reported on US Form 1040 Schedule C) and (ii) individuals who own foreign rental property that is NOT considered to be a passive activity (reported on US Form 1040 Schedule E). If these activities are considered to be QBUs not only does the information have to be reported on Form 1040 but Form 8858 must also be filed.
What’s the tax issue?
The issue has to do with how foreign source income is reported on the taxpayer’s U.S. tax return. In general, income from a QBU is computed in the foreign currency, though under U.S. tax principles. It is then converted into United States dollars at the “applicable exchange rate”. The applicable exchange rate, being in general, the average exchange rate for the taxable year of such qualified business unit.
So far so good, nothing earth shattering here! Now what happens, however, when funds are repatriated back to the United States (this is where these rules make little sense for U.S. citizens living abroad)? Such “repatriations” are converted into U.S. dollars at the spot rate. In all likelihood the exchange rate between when the income is reported on the U.S. return (at the average rate) is different from when it is repatriated to the U.S. (at the spot rate). This foreign exchange gain or loss is reported on the taxpayer’s U.S. return.
For example, assume the taxpayer is self-employed (has a QBU) and that net income (computed under U.S. tax principles) was Cdn $1,000. At the 2020 published IRS rate (1.341) that works out to US $746 which is then duly reported on Schedule C as foreign source self-employed income.
The taxpayer then takes out C$1,000 (from the business bank account) when the exchange rate is 1.2480. That works out to US $801. As such, the taxpayer has recognized a foreign exchange gain of US $55 by “deferring” the repatriation. This gain is required to be reported, as additional income, on his U.S. personal tax return.
What’s the problem?
If the U.S. citizen is resident in Canada at what point has there been an actual repatriation of funds back to the U.S. such that a US dollar foreign exchange gain or loss has truly been recognized? In many instances, there may not even be a dedicated Canadian bank account for the business.
There is a significant difference between a U.S. domiciled taxpayer (say a U.S. corporation) which operates an actual branch in a foreign country as opposed to a U.S. citizen living in that same foreign country and carrying on a self-employed business. Will the filing of Form 8858, for foreign domiciled U.S. persons, lead to better tax enforcement and an increase in U.S. tax revenues? Doubtful but that does not seem to matter to the IRS.
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The material provided in this U.S. Tax Tip is believed to be accurate and reliable as of the date of posting. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither Cadesky Tax nor Cadesky U.S. Tax can accept any liability for the tax consequences that may result from acting based on the contents hereof.