Foreign reporting rules should encourage voluntary compliance.

Taxpayers currently face a confusing morass of foreign reporting requirements, with stiff penalties (e.g., $10,000) for each failure to comply. These penalties should be revised so that they will not apply if the taxpayer files the requisite form (e.g., Form 5471, Information Return of US. Persons With Respect To Certain Foreign Corporations, or Form 5472, Information Return of a 25% Foreign-Owned US. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code)) before first being contacted by the Service in connection with an examination of the return for the year to which the form relates. This type of "qualified amended return rule" is used in other areas (e.g., for purposes of the Sec. 6,662 taxpayer accuracy-related penalty). Penalty relief for returns filed before IRS contact encourages voluntary compliance with the tax laws, by providing an incentive for taxpayers to correct errors at the earliest possible date and by making the laws fairer.

Current Penalty Regime

Sec. 6679(a), as amended by the Taxpayer Relief Act of 1997 (TRA '97), generally imposes a $10,000 penalty for each failure to timely file a complete Form 5471 for information required by Secs. 6035 (returns of officers, directors and shareholders of foreign personal holding companies (FPHCs)) and 6046 (returns as to organization or reorganization of foreign corporations and as to acquisition of their stock). The penalty increases if the information is not provided within 90 days after notice from the Service (to a maximum of $50,000 per form). (A special rule in Sec. 6679(a)(3) limits the penalty to $1,000 for failing to file a return relating to an FPHC.) There is a reasonable cause exception to the penalty in Sec. 6679(a)(1).

Sec. 6038 (as amended by the TRA '97) also imposes information reporting requirements and penalties with respect to interests of U.S. persons in certain foreign business entities. The penalty for failure to timely file a complete Form 5471 is generally $10,000 for each annual accounting period with respect to which the failure occurs (increasing to $50,000 per failure if the information is not provided within 90 days after IRS notice), plus a 10% reduction in taxes that otherwise would be taken into account in computing a foreign tax credit (FTC) under Secs. 901, 902 and 960; see Sec. 6038(b) and (c). The reduction in taxes otherwise taken into account in computing a FTC also increases if the information is not provided within 90 days after notice from the Service. The amount of the reduction, however, cannot exceed the greater of $10,000 or the income of the foreign business entity for its annual accounting period with respect to which the failure occurs. There is a reasonable cause exception to the penalty in Sec. 6038(c)(4)(B).

Secs. 6038A and 6038C (which were not changed by the TRA '97) add further reporting obligations. Under these provisions, a 25% foreign-owned U.S. corporation (Sec. 6038A) and a foreign corporation engaged in a US. trade or business (Sec. 6038C) must report certain transactions with related parties on Form 5472. The penalty for each failure to timely file an accurate Form 5472 is $10,000. If the taxpayer does not provide the information within 90 days after IRS notice, the penalty increases by $10,000 for each 30-day period (or fraction thereof after the 90-day period (without any cap). There is a reasonable cause exception to the penalty; see Secs. 6038A(d)(3) and 6038C(c).

The Case for Reform

These penalties can be extremely harsh; even a single day's delay in filing a form triggers a $10,000 penalty (more if an FTC reduction is involved). The penalty amount can fairly easily exceed the taxpayer's aggregate tax liability for the year if multiple filings are required. Although there is a reasonable cause exception to each of these penalties, the exceptions are often ineffective; they are inherently subjective and it is unclear how the exceptions apply if the taxpayer (or practitioner) supply did not know that the form was required. Moreover, protesting the penalties consumes scarce time and resources of taxpayers (and practitioners). The potential magnitude of the penalties also may encourage agents to use the penalties as bargaining chips in negotiations.

These penalties are often unfair as well, given the inordinate complexity of the reporting rules and the compliance, burden. It may be difficult not only to determine whether and how the rules apply, but also to assemble and present the required information. For example, a U.S. person required to report information may have little leverage in getting the foreign entity to provide the information in a, timely manner, especially if the information may have no effect on the U.S. person's tax liability. Even if the information can be obtained on time, it is often not in a form compatible with U.S. income tax reporting requirements. Arranging for translations of foreign information into English can also take tune. These penalties are also traps for the unwary, because the forms are due by the extended due date of the underlying return, regardless of whether the taxpayer owes any tax for the year (e.g., there might be a large net operating loss for the year).

Conclusion

According to the Service's Penalty Policy Statement:

Penalties constitute one important tool of the Internal Revenue Service in pursuing its mission of collecting the proper amount of tax revenue at the least cost. Penalties support the Service's mission only if penalties enhance voluntary compliance.

The incentive to report information required by the current rules is too little, too late. The "carrot" is merely to avoid penalties in excess of $10,000 per failure (not to avoid the initial $10,000 penalty) and is offered only after the IRS notifies the taxpayer that a failure has occurred, which could be years after the form was required.

The penalty rules would better support the Service's mission if they encouraged voluntary compliance with the tax laws by offering an incentive to file the requisite forms promptly as soon as any error was discovered. This approach furthers voluntary compliance both by providing an incentive to correct mistakes at the earliest possible date (when information may be more readily available) and by making the laws more fair. There is precedent for this approach in other areas, such as the "qualified amended return rules" for the taxpayer accuracy-related penalty in Sec. 6662; see, e.g., Regs. Secs. 1.6662-3(c)(2) (disregard of rules or regulations penalty), 1.6662-4(f)(1) (substantial understatement penalty) and 1.6664-2(c)(3) (definition of qualified amended return).