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IRS seeks FC and NRA nonfilers.

As part of its initiative to seek out nonfilers and underreporters of income, the IRS issued Notice 2003-38, under which it waived certain penalties for nonresident aliens (NRAs) and foreign corporations (FCs) that failed to file income tax returns. The waivable penalties included the denial of benefits for deductions and credits (under Sec. 874(a) or 882(c)(2)) and the Sec. 6651 (f) 75% fraudulent-failure-to-file penalties. To qualify, a taxpayer had to pay its tax liability for each outstanding return year (plus interest and other penalties, as determined by the IRS) and agree to cooperate with any IRS requests to calculate and pay the liability. This limited amnesty extended only to Sept. 15, 2003, an extremely short period given the issues involved and the difficulty in obtaining the appropriate information.

However, because the IRS is focused on this issue, the discussion below highlights the "penalties" that the Service can impose on "nonfiling" FCs and NRAs, offers commentary and provides some planning ideas. Also discussed are the notice's restrictions on relief eligibility and the unlikelihood that more than a handful of NRAs and FCs could have benefited. (The statutory rules on NRAs are not discussed, but are very similar to those on FCs.)


Sec. 882 states that an FC engaged in a trade or business within the U.S. is subject to tax on its taxable income effectively connected (EC) with its U.S. trade or business. "Taxable income" includes EC gross income, reduced by deductions connected with EC gross income.

Under Sec. 882(c)(2), an FC may receive the benefit of the deductions (and credits) only if it files a true and accurate return in the manner prescribed. Regs. Sec. 1.882-4(a)(2) interprets this to require a timely filed return. The "timely" filing deadline for receiving the benefits of deduction is generally 18 months from the return's due date, according to Regs. Sec. 1.882-4(a)(3). If a return is not filed by such date, the FC must pay tax on its gross income, even if a significant loss was generated in such year. Under Regs. Sec. 1.882-4(a)(3)(ii), the IRS may waive the filing deadline if the FC establishes to its satisfaction that, based on the facts and circumstances, the FC acted reasonably and in good faith in failing to file a U.S. tax return.

An FC has not acted reasonably if it "knew" that it was required to file and chose not to do so. Under Regs. Sec. 1.882-4(a)(3)(ii)(A)-(F), the Service considers the following factors in determining reasonable basis: 1. Whether the FC voluntarily identifies itself to the IRS as hiving not filed a U.S. tax return; 2. Whether the FC did not become aware of its ability to file a protective return by the 18-month deadline; 3. Whether the FC had not previously filed a U.S. tax return; 4. Whether the FC failed to file because, after exercising reasonable diligence (considering its relevant experience and sophistication), it was unaware of its filing requirement; 5. Whether there were events beyond the FC's control or other mitigating or exacerbating factors.

Regs. Sec. 1.882-4(a)(3)(iii) offers six examples of the IRS'S perception of good faith. The examples focus on the taxpayer's sophistication, its willingness to seek professional tax advice, whether it cooperates with IRS examiners and any actions it takes once a return requirement is discovered. In the examples provided, the good-faith and reasonable-basis standards are met when the taxpayer or its adviser promptly contacted the appropriate examining personnel and cooperated with the IRS on discovering its failure. No procedure is identified for notifying the IRS.

Protective Returns

If an FC conducts limited activity in the U.S. (such as conducting market research with occasional sales) and determines that its activity does not give rise to a U.S. trade or business, it may nonetheless file a return for such year on a timely basis. This "protective" return would preserve the FC's right to receive the benefit of deductions and credits, if the original determination was incorrect. The FC need not report any gross income on the protective return, but should attach a statement that indicates the return is being filed to meet the timely filed standard of Regs. Sec. 1.882-4(a)(3).

The same procedure should be followed if an FC's U.S. trade or business does not rise to the level of a permanent establishment (PE) under a U.S. income tax treaty with a country in which the FC is a resident. An FC availing itself of a PE treaty exemption may also use a protective return to satisfy its obligation to disclose its treaty-based return position under Sec. 6114.

Example: FC is a producer of a well-known product that has been sold in the U.S. for decades, but has never reached full market penetration. In year 1, FC decides to engage an independent U.S. agent to market and sell its product in the U.S. An arm's-length agreement is drafted, under which the agent is to seek potential purchasers of FC's product. The agent has no authority and does not exercise any in concluding contracts in FC's name; title to the product passes outside the U.S. The agent is paid a commission for a successfully completed sale. As time goes by (sometime in year 3), the agent becomes very successful with FC's products, decides to market and sell only those products and obtains an exclusive agreement with FC. Although the agent remains legally independent from FC, it becomes financially dependent on FC's products being successfully sold in the U.S. The agent still has no authority to conclude contracts, but has in fact authorized certain repeat sales on occasion. FC is a resident of a country that has a tax treaty with the U.S. containing a PE article. FC has never fried a U.S. tax return nor disclosed a treaty-based position.

Under these facts, at some point, FC must decide whether it is engaged in a U.S. trade or business. FC's tax adviser, who is not aware of the protective-return possibility, does not recommend a U.S. tax return be filed. FC believes it has acted reasonably in not having filed a U.S. return.

Based on the above, FC will lose its ability to claim deductions and credits 18 months after the due date of the nonfiled returns. A more prudent course would have been to timely file a protective return (and possibly, a treaty-based position disclosure) for tax years. However, FC now must make a decision as to the years for which the 18-month deadline has already passed.

Unfortunately, Notice 2003-38 does not provide FC an opportunity to protect its right to take deductions while maintaining its position that no U.S. trade or business exists (i.e., allow for late-filed protective returns). In Notice 2003-38, the IRS missed the opportunity to bring many FCs (and NRAs) forward that would not otherwise be visible.


Notice 2003-38 has apparently missed the mark in its attempt to encourage those FCs that have not met the 18-month filing deadline to file tax returns, because the program was not available for any year in which an FC had previously filed a return (including a protective return). In addition, an FC was required to file all returns for 1996 forward, or the IRS reserved the right to examine all potential filing years before 1996. Apparently, if a FC filed for amnesty for 1997-2000, and a 1996 return is required, the IRS would then examine all open years prior to 1997. If a return had never been fried, all years since the inception of the FC's U.S. activity could he audited, and no amnesty provided.

For the reasons stated and shown in the above example, the compliance initiative announced in the notice, in all likelihood, did not result in many FCs coming forward to file returns. The most restrictive requirement is that no previous tax return (either actual or protective) could have been filed. In addition, the notice draws no correlation between the reasonable-basis waiver in the regulations and the waiver granted by the notice.

FCs that have conducted reasonable diligence should be protected by the good faith exception under Regs. Sec. 1.882-4(a)(3)(ii), but filing a return under Notice 2003-38 seems to preclude this argument (in effect, stating that a return should have been filed all along).


Time will tell whether Notice 2003-38 has succeeded in getting FCs to file tax returns not previously filed. However, to deal effectively with this issue (which can be extremely complex and subjective), future initiatives should allow for protective returns. FCs that could potentially be deemed engaged in a U.S. business would then have a method to protect their ability to take deductions, use credits, etc., without relinquishing the position that no trade or business exists, in addition, future initiatives should allow for treaty-protected FCs to disclose a non-PE position. Short of these proposals, many FCs will stand on the sidelines instead of paying U.S. tax on gross income.

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Title Annotation:foreign corporations, nonresident aliens
Publication:The Tax Adviser
Date:Nov 1, 2003
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