Tax Treaty Savings Clause Question

Facts: A U.S. citizen and permanent resident of Israel incurs capital gains from the sale of stock of a U.S. corporation.

U.S. - Israel Income Tax Treaty Provisions:

Article 15, Paragraph 1: “[a] resident of one of the Contracting States shall be exempt from tax by the other Contracting State on gains from the sale, exchange, or other disposition of capital assets.”

Article 6, Paragraph 3: ““[n]otwithstanding any provisions of this Convention except paragraph (4), a Contracting State may tax its residents and its citizens as if this Convention had not come into effect.”

Question: Can the U.S. subject the taxpayer’s gain to U.S. income tax?

Answer: Yes. The Article 6 savings clause overrides the exclusion from tax in Article 15.

One has to wonder why the taxpayer took this all the way to the Tax Court. Nonetheless, the case is illustrative of a basic principle for U.S. citizens and residents - treaty provisions will often provide benefits for them vis-a-vis the taxes of the OTHER country, but not as to their U.S. taxes. Still, each treaty and fact pattern must be looked at, since sometimes the applicable savings clause that allows the U.S. to tax its citizens and residents without regard to the treaty will not always apply to all provisions of the treaty.

Cole, TC Summary Opinion 2016-22

Applicable Federal Rates - June 2016

Form 5472 Reporting by Foreign Owned Disregarded Entities Established in the U.S. - Coming Soon!

Presently, a domestic single member LLC, and other similar single owner entities, absent a check-the-box election to the contrary, are disregarded for almost all U.S. tax purposes.

Presently, a foreign owner of such disregarded entity need not file a Form 5472 regarding that entity, since it is a non-entity for tax purposes. The Form 5472 form (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business) is authorized under Code Sections 6038A and 6038C, with respect to each related party with which the reporting corporation has had any “reportable transactions.” These corporations must also keep permanent books of account or records as required by section 6001 that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with related parties. Failure to report can result in significant penalties.

New proposed regulations will treat such entities as a corporation for purposes of Section 6038A, thus giving rise to the above reporting requirement. Transactions between the disregarded entity and its owner will now be reportable transactions. Interestingly, safe harbors from reporting for entities of less than $10M in U.S. gross receipts or whose related party transactions do not exceed certain thresholds will NOT apply.

Let’s be clear - this reporting has NOTHING to do with enforcing the collection of taxes due the U.S. Transactions between such a disregarded entity and its owner are disregarded for U.S. tax purposes - that is why the IRS does not presently require information about them.

This reporting has EVERYTHING to do with the political judgment by some in the U.S. that the U.S. is not adequately disclosing the ultimate beneficial ownership of U.S. entities, and that is impeding the tax collection of other countries.

The costs and burdens of information reporting have increased exponentially in recent years. Here is a new filing, with new costs and burdens, that won’t raise a penny of U.S. tax collection, to add to the burden.

Perhaps a reasonable middle ground would be a requirement for filing a short form report by these entities reporting their beneficial ownership, and leave it at that. Alternatively, the $10M U.S. gross receipts and small related party receipts exceptions should be made applicable, so at least smaller entities will not be subject to these expanded rules. Requiring reporting of transactions that are utterly disregarded for U.S. tax purposes, for the sake of non-U.S. government interests, is not surprising in today’s day and age, but is it appropriate?

The new regulations are only proposed, and will not go into effect until 12 months after they are adopted as temporary or final regulations.

REG-127199-15. Treatment of Certain Domestic Entities Disregarded as Separate From Their Owners as Corporations for Purposes of Section 6038A (5/10/2016), amending regulations Sections 1.6038A-1, 1.6038A-2, and 301.7701-2.