Philip Bekmessian and Matthew Talia
This is one of the most significant changes to international reporting in recent memory, and the tax industry is concerned about the impact on administrative, financial, and tax risk repercussions of adopting this new reporting structure. The tension reached a peak as more guidelines and instructions were made available. Many were encouraged by the effort to standardise the reporting of items of international significance; however, the implementation of these forms during a condensed tax season and the accompanying voluminous instructions left many wondering whether this could be implemented accurately, fairly, and efficiently for tax year 2021.
For the benefit of partners, stockholders, and the Internal Revenue Service, the new Schedules K-2 and K-3 were developed. Schedule K, Line 16 (Line 14 for S companies) and footnote attachments were the only places where items of foreign tax importance were previously pooled and disclosed. Previously, pass-through businesses were not required to report this information in a defined manner on Schedules K and K-1. It is hoped that the introduction of Schedules K-2 and K-3 would help taxpayers better meet their own filing and reporting requirements, particularly when it comes to claiming the Foreign Tax Credit on Form 1116.
While spot rates on the day foreign taxes were deducted and translated to USD were previously optional, now they must be provided. An company that has a large international dividend-paying portfolio may confront a difficult administrative burden with little advance notice. Schedules K-2 and K-3 came with a slew of complicated instructions, leading many sane people to disagree on how they should be filled out. For companies with different tax profiles, it’s not apparent how to identify and source revenue and costs.
According to a report in The New York Times, tax experts have blasted the IRS for its handling of the new form submission and processing. For the 2022 filing season, MeF/XML e-filing for the schedules will not be accessible, according to the FAQ. The IRS has stated that PDF attachments of schedules may be filed electronically with forms for those who are unwilling to prolong their returns. Anyone who want to file their schedules in XML will have to do so in 2021. If tax preparers don’t wait for further guidelines and industry standard practises to evolve, they face the danger of submitting the forms erroneously. It’s possible that returns that were previously filed early in the tax season would now be delayed. During a recent meeting of the United States Senate Committee on Finance on February 17, 2022, the IRS’ processing problems were brought to light. According to Jan Lewis, AICPA Tax Executive Committee chair, the IRS has a backlog of notifications, returns, and other submissions that need to be processed. According to AICPA, the forms will be delayed for at least one year.
In June 2021, the IRS offered transition penalty reduction via Notice 2021-39 in response to the increased financial and administrative costs posed by the new forms for both tax professionals and individual taxpayers. As stated in Notice 2021-39, penalties would be waived if the taxpayer exhibited a good faith attempt to comply with the new regulations. It is also required that taxpayers show modifications in processes, methods, and systems that are necessary for the filing of Schedules K-2 and K-3, among other prerequisites. There was a general consensus that although penalty reduction was welcomed, the tax community felt that it did not replace clear instructions on who should submit the forms and how.
On February 16, 2022, the IRS revised the filing requirements and issued new advice for these schedules as a result of widespread public comment. The IRS has issued a list of exceptions to the need to submit forms K-2 and K-3 for organisations that fulfil the requirements. These are some of the exclusions, as listed in the FAQ:
- In 2021, domestic partnerships will no longer include foreign partnerships, companies, people, estates, or trusts as direct partners.
- There will be no international activity in the domestic partnership or S corporation in 2021, including foreign taxes paid or accrued, or ownership of assets that produce, have produced, or may reasonably be anticipated to generate revenue from foreign sources.
- Line 16 of Form 1065 and Line 14 of Form 1120-S were not provided or requested by the domestic partnership or S corporation in 2020.
For tax year 2021, the partners or shareholders of a domestic partnership or S company have no idea that they are asking this information.
US-based companies with US-based partners and activities will be relieved by this. For the most part, it will enable them to finish their returns at a more convenient time and with less hassle. Due to a lack of clarity from both an entity and tax preparer standpoint, the last bullet point is critical. If a shareholder or partner informs the company that it requires information from Schedules K-2 and K-3, the company is required to comply. Schedules K-2 and K-3 must be completed if a partner or shareholder tells the company that they require the information before the return is submitted. In order to avoid having to complete and give this information at a later date, it is recommended that an organisation that qualifies for these exceptions contact its partners in advance to confirm their need for this information.
This year’s tax return will include data from 2020, which is something to keep an eye on. The revised forms must still be filed by entities that reported foreign items of importance in 2020, even if they have no overseas activity in 2021. Line 16 of Form 1065 and Line 14 of Form 1120-S were often used by companies with exclusively US operations to submit information. If this is the case, many organisations will be unable to take use of this exemption.
Those who would have had the simplest K-2 and K-3 forms have received some respite, but the forms are still burdensome for those who have international business operations. Although there are a lot of rules and procedures to follow, they’re still up to interpretation. An S corporation or partnership shareholder may get paperwork filled out in an inconsistent way in the first year of ownership. The IRS’s stated purpose of standardising the reporting of foreign taxes would be at odds with this move. Once the paperwork reach the individual taxpayer, claiming the Foreign Tax Credit will be substantially more difficult. However, the IRS’s recent guidelines demonstrates that tax practitioners’ input has been heard loud and clear.