In CCA 2019060408545121, the IRS asked its tax attorneys whether a foreign corporation that conducts business with a limited partner in the U.S. had to produce records. Our tax laws provide address this very topic, as noted in the CCA. The CCA serves as a reminder that failing to provide records for transactions with foreign corporations can result in extraordinarily high taxes being assessed and then significant penalties assessed based on this high tax.
Reporting for those Engaged in U.S. Trade or Business
Our tax laws require foreign businesses that transact business in the U.S. to file certain tax forms. This includes a Form 1120F, U.S. Income Tax Return of a Foreign Corporation, or a Form 1040NR, U.S. Nonresident Alien Income Tax Return. These forms compute the foreign corporation’s or business owner’s U.S. income tax.
These returns are required if the foreign corporation or individual engages in business in the U.S. or has effectively connected income (“ECI”) and the income tax liability is not satisfied by withholding. The opposite is also true. The forms are not required to be filed if the taxpayer was not engaged in a trade or business in the U.S. and the tax liability was satisfied by withholding.
Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, may also have to be filed. This form reports certain transactions with 25 percent foreign-owned U.S. corporations. The transactions that have to be reported include just about any transaction, such as sales or purchases of inventory, interest paid or received, and consideration for services or transfer of properties.
Form 1120F, 1040NR, and 5472 may have to be filed in the U.S. even though the foreign corporation or non-resident had little to no presence in the U.S.
IRS’s Ability to Obtain Foreign Records
But what happens if the foreign or U.S. corporation or non-resident individual fails to file these tax returns? Can the IRS force the foreign or U.S. corporation or non-resident individual to produce records so the IRS can compute any tax due? What if the records are located overseas?
As a general matter, the IRS has broad administrative powers to require taxpayers and others to produce records. This includes the ability to issue an administrative summons. A valid summons can result in a court order authorizing the government to take possession of records or to hold the recordkeeper in contempt of court.
Section 6038C adds additional rules for foreign corporations and their U.S. counterparts. This law obligates foreign corporations and their U.S. counterparts to maintain records in the U.S. (absent an annual election to the contrary) and produce the records upon request. It also adds a tax penalty if the records are not produced upon request.
The penalty is $10,000 for each year the corporation or non-resident fails to meet the recordkeeping requirements. Once the IRS notifies the taxpayer of the non-compliance, there is another $10,000 penalty for each 30-day period for which records are not produced which starts 90 days after notice.
If the records are not produced, there can be other problems. One such problem is that the implementing regulations prevent taxpayers from taking deductions and credits if these forms are timely filed and the tax returns are accurate. Absent records, the IRS may assess tax based on information it has. This typically means that the tax will be assessed without any deductions or credits or other tax attributes, such as tax basis, loss carryforwards, etc. Thus, this can result in significant penalties being computed based on exorbitantly high tax liability.
These draconian rules can be avoided if the foreign corporation appoints a domestic counterpart to be its agent for providing records. This is the subject of the CCA that is noted above. In the CCA, the IRS’s tax attorneys conclude that absent the appointment of an agent by the foreign corporation, the IRS is authorized to estimate the tax due based on the information it has.
Advance Pricing Agreements
It was thought that advance pricing agreements (“APAs”) were the solution to these penalties. APAs typically spell out what records must be kept and produced in these situations. The use of APAs has varied over time based on the IRS’s budget (which has been severely constrained), manpower (which has been limited due to attrition in its workforce), and focus from the IRS (which has been diverted to other issues like tax reform).
The idea behind the APA makes sense. Taxpayers and the IRS are often better off agreeing to how foreign transactions are taxed. This allows the taxpayer to avoid double tax (i.e., tax in the U.S. and tax abroad) and, for the IRS, income shifting or tax avoidance resulting in no tax due in the U.S.
The IRS has focused on APAs for several decades now. But this has waned as of late given the circumstances noted above. Taxpayers have also started to question the usefulness of APAs in light of the Eaton v. Commissioner, T.C. Memo 2017-147 court case.
In Eaton, the taxpayer had entered into an APA that specified that compliance with the terms of the APA would satisfy the Sec. 6038C recordkeeping requirements. The IRS sought to unilaterally revoke its APA, which came as a surprise to many tax attorneys, causing the taxpayer to be in violation of Sec. 6038C. The consequence was that the IRS could force the taxpayer to produce foreign records and subject the taxpayer to significant taxes and penalties. Worse yet, the APA itself provided a roadmap to the IRS for how to most effectively assess and impose taxes and penalties.
We all stop to listen when the IRS IRS talks about foreign reporting and records, as the tax and penalties can be significant. This CCA is an example of that. Foreign corporations and those who assist foreign corporations in carrying out businesses in the U.S. should review their filings and processes to ensure that all required filings are made and made timely.