Planning to file a Delinquent 1120F Return? Make sure you know the Risks.
By: Lou Carlow
On February 1, 2018 the Commissioner of Internal Revenue, Large Business and International Division (LB&I) issued a memorandum providing guidelines for handling delinquent Forms 1120-F and requests for waivers pursuant to Treas. Reg 1.882-4(a)(3)(ii), that states “No one involved in a compliance function should accept as filed a delinquent Form 1120-F from a taxpayer or discuss in advance of filing a return whether a waiver will be granted. Once a return is filed, and LB&I has selected the return for examination, these guidelines for handling waivers will apply.”
Under Internal Revenue Code Section 882(c)(2), a foreign corporation that is engaged in a trade or business within the United States is allowed deductions and credits only for expenses relating to income that is effectively connected with the conduct of a trade or business (“ECI”). Those deductions and credits are further conditioned on the foreign corporation filing a true and accurate return in the manner required by the Code’s subtitle F, including all the information necessary for the calculation of such deductions and credits.
Section 6072 provides the due dates for foreign corporations required to file an income tax return (Form 1120-F). The due date depends on whether the foreign corporation has an office or place of business in the United States. If it does have such an office or place of business, the return is due at the same time as a return of a domestic corporation
Under Treas. Reg.§ 1.6012-2(g) (1), a foreign corporation is required to file a tax return if it is engaged in a U.S. trade or business, even if it has no ECI or its income is exempt from tax under a tax treaty. However, if the foreign corporation has no gross income for the taxable year, it is not required to complete the return schedules, but must attach a statement indicating the nature of any exclusions claimed and the amount of the exclusions, to the extent such amounts are readily determinable.
Treas. Reg.§ 1.882-4(a)(3)(i) prevents a foreign corporation from receiving the benefit of deductions and credits otherwise allowable (with the exceptions for deductions and credits noted in the statute) if it fails to meet the following special filing dates, as applicable, set forth in the regulations:
- If a return was filed for the immediately preceding taxable year, or if the current taxable year is the first taxable year of the foreign corporation for which a return is required to be filed, the required return for the current taxable year must be filed within 18 months of the due date as set forth in section 6072 and the regulations under that section.
- If no return for the taxable year immediately preceding the current taxable year has been filed, the required return for the current taxable year (other than the first taxable year of the foreign corporation for which a return is required to be filed) must have been filed no later than the earlier of the date which is 18 months after the due date, as per Section 6072, for filing the return for the current taxable year or the date the IRS mails a notice to the foreign corporation advising the corporation that the current year tax return has not been filed and that no deductions or credits (other than those excepted by statute) may be claimed by the taxpayer.
Under Treas. Reg.§ 1.882-4(a)(3)(vi),a foreign corporation that conducts limited activities in the United States that it determines do not give rise to ECI may nonetheless file a return for the taxable year on a timely basis under Treas. Reg.§ 1.882-4(a)(3)(i) to protect its right to receive the benefit of deductions and credits if it is later determined, after the return is filed, that the determination is incorrect. The return does not need to report any gross income as ECI or any deductions or credits but should include a statement that the return is being filed to protect the foreign corporation’s right to deductions and credits. A foreign corporation may follow the same procedure if it determines initially that it has no U.S. tax liability under the provisions of an applicable income tax treaty. If it is claiming it does not have a permanent establishment in the United States, it must also generally disclose that position on Form 8833. Failure to attach a Form 8833 to a Form 1120-F results in penalty annually of $10,000. See section 6712.
Under Treas. Reg.§ 1.882-4(a)(3)(ii), the filing deadlines set forth in Treas. Reg. § 1.882-4(a)(3)(i) may be waived if the foreign corporation establishes to the satisfaction of the Commissioner or his or her delegate that the corporation, 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 (as described in Treas. Reg.§ 1.882-4(a)(3)(vi)). For this purpose, a foreign corporation shall not be considered to have acted reasonably and in good faith if it knew that it was required to file the return and chose not to do so.
Before this guidance was issued the IRS did not have a standard procedure to process these requests for waiver relief. Often taxpayers would approach an International Manager and lay out the facts on a no-name basis. If the manager was satisfied with the explanation the IRS would solicit the delinquent returns and process them allowing the SG&A expenses. Often the issue of “reasonable cause” for waiver of failure to file and failure to pay penalties was also considered in the reasonable cause letter presented to the manager and if reasonable cause was approved by the manager then those penalties were also waived.
Penalties are a very real and immediate concern. The failure to file Penalty Under IRC § 6651(a)(1), the failure to pay penalty under IRC § 6651(a)(2), and failure to pay estimated tax penalty under IRC § 6654 will automatically be assessed if they are not addressed and waived in the Section 882 request or during the examination. The penalty for failure to file is 5 percent of the unpaid taxes for each month or part of a month that a return is late. This penalty will not exceed 25 percent of the unpaid taxes. Failure to pay the penalty is ½ of 1 percent of your unpaid taxes for each month or part of a month after the due date that the taxes are not paid.
While these procedures give taxpayers a road map to follow if they want to file delinquent returns they also raise many risks. A mistake in moving forward under these procedures could result in the taxpayer being subject to an extensive, expensive and time-consuming audit, as well as being taxed at the gross income level with the addition of failure to file and pay penalties. Also, if the revenue agent felt the reasonable cause was not accurate or complete then they could also add on Section 6662 substantial understatement penalties as well.
The taxpayer would be subject to an examination that would surely include requests by the agent for emails for foreign and domestic key employees, travel logs of key employees, board of director meeting minutes, transfer pricing documentation, world wide organizational charts, lists of key employees and the duties they perform, management agreements between related parties, and discussions with foreign company’s US customers. Failure to produce such records may result in the issuance of a summons for the information. Likewise, third-party sources are not off-limits. The IRS would do a complete internet search of the world-wide operation of the parent foreign company. Also, there is nothing to keep the IRS from going back to years prior to 2014 and request records for those potential returns since there would be no statute of limitations to consider. The agent would also review the calculations that were used to allocate income and expenses between the 1120-F and the foreign parent and decide if there was a reasonable approach used. The starting point would be the financial statements of the parent company.
Imagine a tax director explaining to his CFO that because he/she made a voluntary disclosure to the IRS, the company is now being assessed income tax on the gross income as well as failure to pay and file penalties, plus interest.
The take-away from this new procedure is that tax directors need to do their homework before they file delinquent 1120F’s under these new guidelines.
Items a tax director should consider include:
- Should we file a protective return?
- Should we file delinquent protective returns?
- Should we submit a voluntary disclosure according to the Memo instructions?
- What are the reasons for the delinquent filings and how was the issue identified?
- How long have we known that we should have filed delinquent returns and didn’t take any action?
- How far back does the failure to file go back? Three, six years, more years? Do we need to file all the years or can we negotiate this with the IRS?
- Did we have procedures in place to guard against having “effectively connected income” or a permanent establishment? Were these procedures followed? What type of tests were performed to confirm no foreign employee negotiated or executed contracts while they were in the US?
- Did we conduct a “mock audit” to make sure we have no issues that would come up on an IRS examination?
- If delinquent returns are filed what method was used to allocate income and expenses from the home country?
- Are there competent authority considerations that need to address and could the parent company obtain correlative relief if they allocate income to the US firm?
There are many considerations a tax director must consider before they make a submission in accordance with this memorandum. The cost of not properly planning or thinking through this decision could be a job ending event.
The professionals at Andreozzi Bluestein are well versed in the nuance of LB&I guidelines relating to 1120F returns and have extensive experience guiding clients through their difficult filing requirements. We’ve worked extensively with companies to answer the questions highlighted above that all Tax Directors should be asking themselves. Our early involvement in the process can help to mitigate significant costs and headaches associated with improper delinquent 1120F filings.
If you think you may have an issue related to a delinquent 1120F filing please contact the professionals at Andreozzi Bluestein today with no obligation.
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