In early 2007, the IRS published a substantially revised Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, to be used for tax years beginning in 2007. The revisions were intended to provide for increased disclosure of information regarding items such as allocable interest expense and home office expense allocations, as well as effectively and noneffectively connected income reported on Form 1120-F.
At that time, the IRS indicated that these changes—along with the new Schedule M-3, Net Income (Loss) Reconciliation for Foreign Corporations with Reportable Assets of $10 Million or More—would enable the IRS to identify high-risk returns requiring compliance action. To this end, the IRS issued the following new Form 1120-F schedules:
- Schedule H, Deductions Allocated to Effectively Connected Income Under Regulations Section 1.861-8;
- Schedule I, Interest Expense Allocation Under Regulations Section 1.882-5; and
- Schedule P, List of Foreign Partner Interests in Partnerships.
Based on taxpayer queries during the 2008 compliance season, significant confusion in completing the new form and schedules ironically arose among taxpayers with the least complex U.S. tax situations. Some of the issues and concerns expressed by those taxpayers about the revised form and schedules are briefly discussed below.
Foreign Corporations Filing Certain Protective Returns
Prior to the revision of Form 1120-F, some foreign corporations filing protective returns under the procedures prescribed by Regs. Sec. 1.882-4(a)(3)(vi) did not answer the questions on page 1 of the form because they typically did not view these questions as relevant to a protective return. The instructions for the 2007 Form 1120-F now require taxpayers to answer page 1 questions, such as whether they had a U.S. agent or whether they were engaged in the conduct of a U.S. trade or business. In some cases the requirement has resulted in a fairly significant additional compliance burden, particularly when the questions did not seem relevant to many protective return filers.
A frequent complaint came from foreign corporations that felt strongly they had no permanent establishment (PE) in the United States under the provisions of a relevant income tax treaty and that properly disclosed that position on an attached Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b). Eligibility for an exemption under treaty permanent establishment provisions generally precludes the need to determine whether a foreign corporation is engaged in a U.S. trade or business under the rules of Sec. 864(b). Similar confusion arose about other page 1 questions, causing some foreign corporations to ask whether the requirement to answer these questions could cause them to undertake otherwise unnecessary research.
Complexity of Schedules H, I, and P
Many foreign corporations questioned the complexities associated with completing Schedules H, I, and P, especially if all the corporation’s income and assets were effectively connected with a U.S. trade or business, either as a result of the direct conduct of a U.S. trade or business or the indirect conduct, through an investment in a partnership, of a U.S. trade or business. Although these schedules accurately reflect the rules in Regs. Secs. 1.861-8 and 1.882-5, the full complexities of those rules apparently had not been fully appreciated by many foreign corporations, especially those with seemingly simple tax situations. Even the use of phrases such as “home office” on those forms was confusing for some of these taxpayers, which did not recognize the general application of language normally applicable primarily to the banking industry. This confusion may be more indicative of the complexity of these regulations, which generally do not permit the use of simplified methodologies.
With respect to Schedule P, many foreign investors found themselves unable to complete much of the required information because partnerships do not normally provide the information on or attached to a Schedule K-1. Where foreign investors hold noncontrolling interests in partnerships, from a practical perspective it is often difficult to obtain the information requested by Schedule P. Even in those cases in which a U.S. partnership may wish to provide information to foreign investors, the partnership’s computer systems and tax expertise may be inadequate for the task.
Although the IRS expended significant efforts in revising the Form 1120-F, it did not clarify some items that many foreign taxpayers have found unclear or confusing. For example, beginning with reporting for 2007, the instructions to Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, were modified to indicate that a Form 1042-S is issued in the name and under the employer identification number (EIN) of a foreign disregarded entity (FDE) eligible to claim treaty benefits when the FDE is the beneficial owner of payments subject to reporting on Form 1042-S. However, so far there has been no coordination of 1042-S reporting for these FDEs with reporting on Form 1120-F where such reporting may be required.
In other words, is such an FDE eligible to file its own Form 1120-F even though it is not a corporation or a taxpayer for U.S. federal income tax purposes, or is the sole corporate owner of the FDE required to file the Form 1120-F when filing is required for overwithholding or underwithholding of tax on Forms 1042-S? If the latter, how does the IRS intend to match or reconcile the payments reported by a withholding agent under the FDE’s EIN when there is as yet no place on the 1120-F to reflect an FDE’s EIN?
Another area of confusion for many taxpayers has been the definition of U.S. net equity for branch profits tax purposes. Although this definition has been unchanged since it was introduced by the Tax Reform Act of 1986 and is described in the instructions to Form 1120-F, many foreign taxpayers continue to believe that U.S. net equity is based on book or financial statement equity rather than on a computed tax-based amount. This belief may be a function of the higher importance accorded to financial statement figures under the tax laws of many foreign countries. The expansion of the branch profits tax section of the Form 1120-F to clarify the required method of computing U.S. net equity would do much to dispel this incorrect belief.
Annette Smith is with Price-waterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Pricewater-houseCoopers LLP.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.