Temp. regs. expand relief for foreign persons failing to file U.S. returns.
Obligation to File a Return
In general, a foreign person engaged in trade or business in the U.S. at any time during the tax year or subjected to U.S. income tax must file a U.S. income tax return; see Regs. Secs. 1.6012-1(b)(1)(i) (NRAs) and-2(g)(1)(i) (foreign corporations). A foreign person is exempt from this requirement if it (1) was not engaged in a trade or business in the U.S. during the tax year, (2) fully satisfied its tax liability by withholding tax at source (under chapter 3 of the Code) and (3) is not required to report a treaty-based return position; see Regs. Sec. 1.6012-1(b)(2)(i) (NRAs) and -2(g)(2)(i) (foreign corporations), and Regs. Sec. 301.6114-1 (treaty-based reporting requirements). Basically, the exemption pertains to income subject to U.S. taxation on a gross basis, under Secs. 871(a) and 881(a), for which the taxpayer withholds the proper U.S. tax amount.
For income subject to tax on a net basis, a foreign person will receive the benefit of deductions and credits only by filing a true and accurate U.S. return; see Secs. 874(a) (NRAs) and 882(c)(2) (foreign corporations). Under Sec. 874(a), if an NRA files a return for the immediately preceding tax year (or for the current tax year, if it is the first tax year that he has to file), he would have to file the return within 16 months of the due date set forth in Sec. 6072. If he has not filed a return for the tax year immediately preceding the current tax year (other than the one that he had to file for the first tax year), he must file the return no later than the earlier of (1) 16 months after the due date set forth in Sec. 6072 or (2) the date the IRS mails a notice advising him that he has not filed a current-year return and therefore is not entitled to any deductions or credits (other than those allowed under Secs. 31, 32, 33, 34 and 852(b)(3)(D)(ii)); see Regs. Sec. 1.874-1(b). For foreign corporations, the regulations under Sec. 882 generally contain a similar role, substituting 18 months for 16 months, while also allowing a deduction for charitable contributions under Sec. 170; see Regs. Sec. 1.882-4(a)(3).
Consequences of Not Filing
If a foreign person does not file a return in accordance with these regulatory guidelines, it will be subject to tax on a gross basis, without the benefit of most deductions and credits. This can result in particularly surprising (not to mention costly) tax consequences for a foreign person that does not believe it is subject to U.S. tax on a net basis under Sec. 871(b) or 882 and fails to file a "protective return" under Regs. Secs. 1.874-1(b)(4) and 1.882-4(a)(3)(iv), respectively. Further, given that delinquent U.S. taxpayers are generally not denied deductions and credits for failing to file returns, the treatment of foreign persons under these rules is severe. In a series of rulings issued in 1999, the IRS explained that the additional requirements imposed on foreign persons are a valid exercise of administrative authority and do not conflict with underlying treaty obligations, specifically the business-profits article (i.e., allowance of attributable deductions), and the nondiscrimination article; see FSAs 9944026 (U.K.-U.S. income tax treaty) and 9940012 (Germany-U.S. income tax treaty), and TAM 9941007 (Canada-U.S. income tax treaty). Moreover, in addition to the punitive-like consequences that result from a denial of deductions under Secs. 874(a) and 882(c)(2), foreign persons may also be subject to failure-to-file and accuracy-related penalties under Secs. 6651 and 6662, respectively.
Under the prior regulations, Congress gave the District Director or Assistant Commissioner (International) the authority to waive the filing deadline in "rare and unusual circumstances," but only if the foreign person established "good cause"; see former Regs. Secs. 1.874-1(b)(2) (NRAs) and 1.882-4(a)(3)(ii) (foreign corporations). The absence of taxpayer-favorable rulings emphasized that taxpayers rarely satisfied this standard since it was promulgated in 1990. Even though the IRS issued a few letter rulings and FSAs, it was not required to explore the meaning of "good cause" or "rare and unusual circumstances" because the foreign persons failed to present evidence that they acted reasonably and in good faith, a lower standard than "good cause." In fact, it was only in 2000 that the IRS offered an example indicating how a foreign corporation could satisfy the "good cause" standard. The example (found in a pair of IRS chief counsel advice (CCA) memoranda) demonstrated that if a foreign corporation established that it supplied complete and accurate information to competent tax counsel (as well as affidavits proving that counsel provided such advice and the corporation heeded it), the District Director or Assistant Commissioner (International) should find that the circumstances were rare and unusual and the foreign corporation established good cause; see 2000 IRS CCA 54 and 2000 IRS CCA 65.
New Temporary Regulations
In the preamble to the temporary regulations, the IRS explained that the prior standard was too restrictive and did not properly balance Congress' intent that strong compliance measures be established by the government, against the need to provide the IRS with a means to grant relief in appropriate Cases. Consistent with this reasoning, the temporary regulations replace the prior standard for relief with a more precise standard that should expand the number of instances in which the IRS will grant relief. The temporary regulations provide that the filing deadlines "may be waived if the [foreign person] establishes to the satisfaction of the Commissioner or his or her delegate that [such foreign person], based on the facts and circumstances, acted reasonably and in good faith in failing to file a U.S. income tax return (including a protective return)"; see Temp. Regs. Secs. 1.874-1T(b)(2) (NRAs) and 1.882-4T(a)(3)(ii) (foreign corporations).
The temporary regulations essentially establish a two-step process for determining whether relief is appropriate. In the first step, the foreign person will not be granted relief if it either: (1) knew it had to file a return and chose not to file such return or (2) does not cooperate in the process of determining its income tax liability for the tax year for which it did not file a return. Provided that neither disqualifier is found, the IRS then uses six conditions to determine whether relief is appropriate; see Temp. Regs. Secs. 1.874-1T(b)(2) and 1.882-4T(a)(3)(ii):
1. Whether the foreign person voluntarily identifies itself to the IRS as having failed to file a U.S. return before the IRS discovers the failure to file;
2. Whether the foreign person did not become aware of its ability to file a protective return by the deadline for filing that return;
3. Whether the foreign person had not previously filed a U.S. return;
4. Whether the foreign person failed to file a U.S. return because, after exercising reasonable diligence (taking into account relevant experience and level of sophistication), it was unaware of the necessity for filing the return;
5. Whether the foreign person failed to file a U.S. return because of intervening events beyond its control; and
6. Whether other mitigating or exacerbating factors existed.
The temporary regulations do not explain the relative weight the IRS gives to each condition or whether the existence (or nonexistence) of one or more of the conditions precludes or requires relief. However, the regulations for NRAs and foreign corporations each contain the same six basic examples that indicate how the IRS will apply the factors. In the first three examples, a passive foreign investor owned a limited partnership interest in a U.S. partnership. The limited partnership was engaged in a U.S. trade or business but incurred losses in the first four years. In the first example, the foreign person was incorrectly advised by its non-U.S. tax adviser that, because it was a limited partner and only derived losses from its investment, it did not have to file a U.S. income tax return. In the fifth year, the partnership was profitable and the foreign person engaged a U.S. tax adviser to handle its U.S. filing obligation. The adviser discovered that the foreign person had not filed returns for the first four years and that the filing deadlines had passed. At the foreign person's direction, the U.S. tax adviser contacted the appropriate IRS examining personnel and cooperated in determining the foreign person's income tax liability. The example concluded with the foreign person meeting the standard for a waiver; see Temp. Regs. Secs. 1.874-1T(b)(3) (Example 1) and 1.882-4T(a)(3)(iii) (Example 1).
In the third example, the facts are the same as in Example 1, except the foreign person was initially advised by its U.S. tax adviser that it was uncertain about whether the foreign person had to file U.S. returns for the first four years. However, the adviser suggested that the foreign person can protect its right to claim loss carryforwards by filing protective returns. The foreign person did not file returns for these years and no intervening events beyond its control or other mitigating factors existed. The example concluded that the foreign person did not meet the standard for a waiver; see Temp. Regs. Secs. 1.874-1T(b)(3) (Example 3) and 1.882-4T(a)(3)(iii) (Example 3).
Three other examples involve foreign persons directly engaged in U.S. business activities. In the first of the three examples, a foreign person sold software in the U.S., which it produced outside the U.S. It had minimal international and U.S. business or tax experience, and was not aware of its U.S. filing obligation or of its ability to file protective returns. Soon after the filing deadline on the foreign person's first two years of U.S. activities, it hired U.S. counsel in connection with an unrelated legal matter and was advised that it should have been filing U.S. returns for the previous years. The foreign person immediately engaged a U.S. tax adviser that, at the foreign person's direction, promptly contacted the appropriate IRS personnel and cooperated in determining its income tax liability. The example concluded that the foreign person met the standard for waiving applicable filing deadlines; see Temp. Regs. Secs. 1.874-1T(b)(3) (Example 4) and 1.882-4T(a)(3)(iii) (Example 4).
In the next example, the facts are the same as in the previous example, except that despite the foreign person's extensive experience conducting similar business activities in other countries, it failed to seek U.S. tax advice and did not file U.S. tax returns. The foreign person was contacted by an IRS examiner and cooperated in determining its income tax liability. There were no intervening events beyond the foreign person's control or other mitigating factors. The example concluded that the foreign person did not meet the standard for a waiver of the filing deadlines; see Temp. Regs. Secs. 1.874-1T(b)(3) (Example 5) and 1.882-4T(a)(3)(iii) (Example 5).
As these examples illustrate, the IRS is less inclined to grant relief when a foreign person is aware (or should have been aware) of its filing obligations, absent specific intervening or mitigating events. Consequently, a business-savvy individual or foreign corporation will have a more difficult time establishing a case for relief than a less sophisticated one. The examples do not address all of the possible scenarios or how the circumstances weigh against each other. For instance, the examples do not indicate whether a less sophisticated foreign person would be eligible for relief if the IRS (rather than the foreign person) discovers the non-filing error (presumably a common situation). Of course, it remains to be seen how the IRS will apply the new relief provision to this situation and others.
The temporary regulations are applicable to open years for which a foreign person files a request for a waiver on or after Jan. 29, 2002. The IRS has scheduled a hearing on June 3, 2002 for comments on these regulations.
FROM CLEVE LISECKI, J.D., CPA, WASHINGTON, DC
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|Title Annotation:||IRS temporary regulations|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2002|
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