IRS Delinquent 1120F Campaign – Are You Prepared?
BY: LOU CARLOW
The IRS has identified the failure to file Forms 1120-F as the most recent front for its enhanced campaign to enforce compliance. This campaign sends a clear message to foreign businesses with a U.S. business nexus – comply or beware:
Foreign companies doing business in the U.S. are often required to file Form 1120-F. LB&I has data suggesting that many of these companies are not meeting their filing obligations. In this campaign, LB&I will use various external data sources to identify these foreign companies and encourage them to file their required returns. The treatment stream for this campaign will involve soft letter outreach. If the companies do not take appropriate action, LB&I will conduct examinations to determine the correct tax liability. The goal is to increase voluntary compliance by foreign corporations with a U.S. business nexus.
This focus on delinquent Forms 1120F should be productive for the IRS since historically the agency has given a very low priority to the examination of Forms 1120F or the enforcement of the filing requirement. Lack of attention typically means lack of compliance, which, in turn, means loss of tax revenues. The Large Business and International (LB&I) Operating Division has collected data indicating that many foreign companies are not meeting their filing obligations. This is not a new problem, just one that has never been properly addressed by the IRS in many years. In the past, the IRS has shown very limited audit activity identifying non-filers of 1120F’s because they are very difficult to identify and even more difficult to audit. But that was then; this is now.
This change in the IRS’s enforcement approach to searching out and identifying delinquent Forms 1120F and Permanent Establishment (“PE”) issues was prompted by several developments, including: (1) companies around the world are expanding their businesses globally; (2) information about foreign companies is becoming much easier to access online; (3) many foreign governments are themselves raising PE issues in the context of their income tax examinations, and these issues are finding their way into the U.S. Competent Authority process; and (4) the IRS has designated technical specialists charged specifically with helping Revenue Agents in the field develop PE issues.
What is a Permanent Establishment?
The notion of a permanent establishment is created under Tax Convention (treaty). If there is no relevant Tax Convention, there can be no permanent establishment issue. A permanent establishment may be defined as a fixed place of business through which activities of an organization are wholly or partially carried on. The term is broad and includes, inter alia, a place of management, a branch, an office, a factory, or a workshop. If a non-U.S. enterprise maintains a fixed place of business within the U.S., it has a permanent establishment within the U.S. (and vice versa). As noted in the Conventions, the enterprise must carry on business in the Contracting state through a fixed place. The term “fixed place” implies a certain degree of permanence as opposed to a mere temporary accommodation.
The concept of a permanent establishment is not limited to a fixed place of business; it may extend to include an agent who is legally separate from an enterprise but sufficiently connected and dependent upon the enterprise so that a permanent establishment is implied to exist through the actions of that agent.
Why is a Permanent Establishment so Important?
The U.S. is able to tax foreign companies if they have income sourced in or effectively connected to the U.S. To determine whether the concept of PE is relevant, it must first be determined whether the foreign corporation is a resident of a treaty country and entitled to benefits under the treaty. Although the United States has treaties with many countries, not all corporations alleging benefits under a treaty are actually resident in a treaty country, nor are all corporations resident in a treaty country entitled to treaty benefits. If the taxpayer does not qualify for treaty benefits, the issue of whether it has a PE is irrelevant.
It is difficult to determine whether a foreign corporation is engaged in a trade or business and if the corporation conducts business through a permanent establishment. If the IRS determines that there is a permanent establishment, its next step would be to determine income effectively connected to the permanent establishment, thereby triggering the potential for a tax liability in the U.S. The U.S. tax liability would also be expanded with the IRS assessing interest, failure to file and pay penalties, and substantial understatement penalties. In such instances, the IRS would likely not allow deductions for ordinary and necessary business expenses or other credits, leaving it to the company to substantiate all that it believes it is entitled to.
If a taxpayer is unsure of its effectively connected income or income attributable to a permanent establishment, it may file a protective return pursuant to Treas. Reg. 1.882-4(a) (3)(iv) to avoid losing the right to deductions if it ultimately turns out that tax is due.
The importance of the protective return is found in Regs § 1.882-4(a) (2):
- Return necessary. –A foreign corporation shall receive the benefit of the deductions and credits otherwise allowed to it with respect to the income tax, only if it timely files or causes to be filed with the Philadelphia Service Center, in the manner prescribed in subtitle F, a true and accurate return of its taxable income which is effectively connected, or treated as effectively connected, for the taxable year with the conduct of a trade or business in the United States by that corporation. The deductions and credits allowed such a corporation electing under any other guidance issued by the Commissioner.
If there is no relevant treaty, thus eliminating a permanent establishment issue, Revenue Agents are instructed to return to Internal Revenue Code standards exclusively. They would then determine whether the foreign corporation is engaged in a trade or business in the U.S. and/or whether it had income subject to withholding.
Who is Vulnerable?
So, who may be vulnerable under this new IRS initiative? Potential targets include:
- Protective Filers of Forms 1120F
- Foreign companies with any presence in the U.S.
- Foreign companies with an unexpected change in business operations in the U.S.
- Inverted companies
Exposure- What is the IRS’ “Ideal” Permanent Establishment Case?
To the IRS international examiner, the “ideal” permanent establishment case arises when he or she can establish:
- A fixed place of business, or
- A dependent agent to give the foreign company a fixed place of business.
So, foreign companies particularly vulnerable to IRS scrutiny would include those with a distinctly identifiable U.S. place of business, such as a branch office or factory, with a degree of permanency rather than a temporary accommodation. The IRS will look for evidence of day-to-day management of the U.S. operations by an employee of the foreign company. Particularly vulnerable activities would, of course, include those generating substantial income. Examples of that type of significant activity are intense sales, service, or production activity within the United States; open negotiation and/or execution of contracts by employees of the foreign company in the United States; and active marketing and advertising within the U.S.
Interestingly, if the foreign company is performing market research and development, purchasing, and information-gathering activities in the U.S., the IRS may perceive this as evidence against a permanent establishment because it would indicate more exploratory, preparatory, or auxiliary activities rather than actual business activity. Likewise, a foreign company’s mere warehousing or storage of goods for display or delivery in the U.S. would generally not rise to the level of a permanent establishment.
How does the IRS perform a Permanent Establishment Audit?
The IRS uses a diverse array of procedures, including analysis of publicly available data, Information Document Requests (“IDRs”), interviews, a functional analysis, and perhaps even email traffic to determine if a foreign company has a permanent U.S. establishment and therefore a U.S. filing obligation.
Much of the information available to the IRS is public, so it is very likely that the IRS has developed its permanent establishment determination regarding a taxpayer even before it contacts the taxpayer for examination. The IRS often obtains “leads” on permanent establishments from a related examination or a protective 1120F filing. In this situation, the international examiner will do an elaborate pre-audit plan considering IRS internal data as well as publicly available information. Indeed, one of the most damaging IRS audit tools may be a taxpayer’s own website. For example, if a foreign company has a link for “contact us,” and the link then shows U.S. sites, this could be perceived as prima facia evidence of a U.S. operation. Likewise, if the website suggests that the foreign company performs services in the U.S., the taxpayer will have an uphill battle overcoming a permanent establishment argument. One strong permanent establishment case was established in a matter where no protective filing was made and the taxpayer’s website actually made the statement that “the U.S. headquarters is located in Miami, FL.” In this situation, the tax department had no idea the operations department had placed that verbiage on the foreign company’s website.
Once these and other possible clues suggest the existence of a PE, the service will commence an audit. A series of IDRs will be issued. Initial IDRs will request an organizational chart of the entire group so the Revenue Agent can determine the size and locations of all of the company’s worldwide operations. This request will ask for all related partnerships and joint ventures. The next series of IDRs may request much of the following:
- The nature of your worldwide business
- The names of your biggest customers situated in the US
- The names of any representatives in the United States.
From these IDR’s the IRS will most certainly ask for more documents as the audit progresses. Once the IRS agent has gotten this far, it may be difficult to persuade him/her that a U.S. permanent establishment does not exist because substantial time has now been invested. Revenue Agents will also determine what they believe to be the correct income to be reported and the taxpayer would then have to defend what the correct number is. The agent will review the parent’s financial statements and state with the gross income report as the starting point to identify US source income.
Foreign companies should be aware that they should not engage in certain U.S. based activities to assure themselves of the best chance of minimizing the risk that non-U.S. companies will become subject to U.S. taxation. Some general guidelines of activities to avoid are as follows:
- Board meetings should be held exclusively outside the U.S.
- Committees should meet outside the U.S. and minutes kept to reflect where those meetings are held.
- Using the same officers for a holding company and an operating company. The same holding company officers should not provide any non-stewardship services, including management or consultancy.
- Officers should not hold themselves out as a representative for any U.S. entity, nor make any substantive decisions.
- Contracts should be negotiated and executed outside the U.S.
- Officers/employees should avoid traveling to the U.S. to conduct business.
- The company should not have a U.S. postal address, including a PO Box.
- All corporate books and records should be maintained and stored outside the U.S. It is critical that all companies maintain detailed records such as employee logs, travel records and minutes of board and committee meetings to document that directors, officers and employees are operating appropriately.
Companies should develop, as part of their internal controls, more detailed and inclusive lists based on their unique facts and circumstances.
My years of experience have taught me that most tax directors fret over their company’s exposure to the permanent establishment issues due to the limited internal controls in place with respect to the issue. Business staff may pay lip service to any rules that are provided, but such false homage is insufficient, particularly in light of the new IRS initiative. Companies with any exposure to these issues should consult with professionals with both IRS and private experience to perform a review of their operations, a PE compliance audit to identify and correct any potential problems. It is crucial to understand one’s is exposure and to control processing and filing of delinquent returns without losing appropriate deductions or credits or incurring failure to file and pay penalties. The longer the issue festers, the more likely it will become noticed by the company’s auditors as well as the IRS. An IRS audit of a protective or delinquent Form 1120-F is very time consuming and intrusive consequence. Tax Directors should, therefore, be proactive and prepare for an IRS audit before it starts. An ounce of prevention is worth a pound of cure.
Any questions about this article please contact Lou Carlow, Director of International Compliance at the law firm of Andreozzi Bluestein, LLP.