The IRS refocused its efforts on international tax issues about ten years ago. This effort has yielded scores of transfer pricing, foreign tax credit, and similar tax disputes.
While not as prominent as transfer pricing and foreign tax credit disputes, the IRS has also focused on U.S.-sourced income that is not reported. The IRS has had several compliance initiatives that focus on finding this type of unreported income.
The recent Adams Challenge (UK) Ltd. v. Commissioner, 156 T.C. No. 2 (2021) provides an example of this. The case involves a foreign corporation that earned U.S. sourced income and failed to file tax returns to report the income. As the case shows, the consequences of not filing can be quite severe.
Facts & Procedural History
The taxpayer is a UK limited liability company. It is a subsidiary of a foreign entity that was formed to hold and charter a boat.
The taxpayer chartered the boat to a third party from 2009-2011. The third party operated the boat in the Gulf of Mexico during this time.
The IRS conducted a compliance program aimed at foreign boats operating in the U.S. outer continental shelf. It did so by using a third party satellite-enabled tracking service. This allowed the IRS to determine the number of days the boats operated on the outer continental shelf. The IRS then matched this information to the tax returns filed. Those who did not file tax returns were audited or sent adjustment notices.
In this case, the IRS made a jeopardy assessment for the 2009-2011 tax years. The assessment was for $23 million of tax. The taxpayer was successful in convincing the IRS Office of Appeals to abate the jeopardy assessment.
The taxpayer filed a Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, for 2011. This return was filed with the IRS’s office in Houston, Texas. The IRS then prepared substitute for returns (or SFRs) for the 2009 and 2010 tax years.
The IRS then issued a notice of deficiency for the 2009-2011 tax years. The notice computed the taxpayer’s income tax without including any tax deductions or credits. Tax litigation ensued.
The question for the court was whether the taxpayer, a foreign entity that failed to timely-file its tax returns, was entitled to any tax deductions or credits.
Tax Deductions for Foreign Corporations
Taxpayers are generally allowed to deduct their business expenses when computing their income tax liability.
There are limits on tax deductions by certain foreign corporations. These tax deductions are limited to those connected to income that is effectively connected to a U.S. trade or business. To secure these tax deductions, the foreign corporation generally has to file a tax return with the IRS.
The rules for filing returns to secure these deductions do not impose a time limit for the filing. This is the question the court had to answer. Is there a time limit for a foreign corporation to file a tax return to be able to take tax deductions for income effectively connected with a U.S. trade or business?
The Regulations for Foreign Corporations
The court reviewed its prior decisions in this area. One of the prior decisions held that there was no time limit for a foreign corporation to file a tax return with the IRS to avail itself of tax deductions. Another prior decision held that there was a time limit if the IRS prepares a SFR. The court said that:
a foreign corporation loses its right to deductions and credits if it does not file a return until after the IRS has prepared a return for it and notified the taxpayer of the deficiency determination.
The Treasury issued regulations that confirmed that the “terminal date” is the date the IRS prepares an SFR. After that, the foreign corporation cannot file a tax return to claim tax deductions that it would otherwise be entitled to.
Should a foreign corporation not believe that it has a U.S. filing requirement, the regulations allow the corporation to file tax returns reporting zero income and deductions. This preserves the right to take tax deductions later should the IRS determine that there was a U.S. tax return filing requirement.
The regulations also provide a good faith defense.
The court in the present case concluded that the taxpayer was not entitled to any tax deductions. While the taxpayer attempted to file returns, it only did so after the IRS had issued a SFR and after the IRS had issued a notice of deficiency.
The court did not even reach the taxpayers argument that the deadline in the regulations was invalid. The court concluded that existing case law was sufficient to deny the tax deductions.
This case serves as a reminder to foreign corporations that they should consider filing U.S. tax returns, even if they report no income or deductions, to preserve their rights. The failure to do so can result in the foreign corporation having U.S. income with no offsetting tax deductions, as in this case.