Disclosure of treaty-based return positions.

DISCLOSURE OF TREATY-BASED RETURN POSITIONS

The IRS recently released final regulations on mandatory disclosure of treaty-based return positions under tax code section 6114. Generally, if a taxpayer relies on a U.S. treaty to reduce the tax otherwise imposed by the tax code, it must disclose that position in its U.S. income tax return. If no tax return need otherwise be filed, the regulations still require filing an information return that discloses the use of a treaty.

The regulations set forth a non-exclusive list of positions that require disclosure. Among these are the following:

* Where an exemption from or reduction in the U.S. branch tax is claimed.

* Where an exemption from tax on U.S. business income is claimed on the basis that such income is not attributable to a permanent establishment.

* Where a treaty alters the source of income or deductions.

* Where an exemption from or reduction of tax on gain or loss on disposition of a U.S. real property interest is claimed.

* Where a treaty grants a credit for a foreign tax that is not creditable under the tax code.

These requirements are waived, however, for certain return positions, including

* A claim that income such as dividends, interest, rents and royalties is subject to a reduced rate of withholding. In the case of certain related or controlled corporate payers, however, the waiver applies only if the income is properly reported on form 1042S.

* A claim that a nondiscrimination provision allows a foreign corporation to elect treatment as a domestic corporation for purposes of the Foreign Investment in Real Property Tax Act.

* A claim that a treaty either reduces or modifies the tax levied on certain types of personal income, such as personal services or pensions.

When disclosure is required, the tax return should include the taxpayer's name, address, identification number and a separate statement of facts to support each position taken.

The information required in the statement of facts includes information on the nature and amount of each gross payment or income item for which a treaty benefit is claimed, the treaty provisions relied on and the tax code provisions overruled or modified. Consequently, a separate disclosure will be required for each class of income (for example, rent, interest and business income) reported separately by the payer. It also should be indicated that each payment in that class is covered.

A penalty of $10,000 for corporations and $1,000 for other taxpayers will be charged for each failure to disclose a treaty-based position.

Observation: Taxpayers that have never had to file returns before now may be required to file and disclose the nature of their claim for tax exemption.

The penalties may be severe, since multiple penalties can be imposed each year. This is because a separate penalty may be imposed for each payer, even if the class of income is the same, to the extent the taxpayer failed to disclose the treaty-based position.

Indeed, each payment from the same payer also could be subject to a separate penalty, unless the IRS exercises its discretion to aggregate those payments for penalty purposes.

Robert Willens, CPA, senior vice-president-corporate finance at Shearson Lehman Hutton, New York City; Andrew R. Biebl, CPA, partner at Biebl, Ranweiler & Company, New Ulm, Minnesota; and Marianne Burge, CPA, partner, international tax services, at Price Waterhouse, New York City.