Foreign Income & Taxpayers
The IRS recently published new Internal Revenue Manual (IRM) Section 8.11.5, which permits taxpayers that have been assessed certain international information reporting penalties to elect prepayment review of those penalties by IRS Appeals. Section 8.11.5 provides for accelerated prepayment Appeals review in the case of Category 1 taxpayers and nonaccelerated prepayment Appeals review in the case of Category 2 taxpayers. The distinction between the two categories generally depends on the total value of a taxpayer’s assets and whether the penalties are assessed during an examination.
The new IRM procedure resolves prior uncertainty as to whether Appeals had jurisdiction to review assessed international penalties before payment. Specifically, the IRM procedures expand taxpayers’ appeals rights for penalties assessed under specific international reporting and recordkeeping penalty provisions contained in chapter 61 of the Internal Revenue Code and clarify that taxpayers may now seek prepayment Appeals review for such penalties. Prior to new IRM Section 8.11.5, taxpayers were arguably required to pay these penalties as a prerequisite to Appeals review. The IRM procedure is effective as of August 27, 2010.
U.S. persons are subject to myriad international reporting rules imposed under specific provisions in chapter 61. Each provision typically has its own complex requirements and attendant penalties for failure to comply. For instance, Sec. 6038(a)(1) generally requires a U.S. person (including, generally, a U.S. citizen, resident alien, U.S. corporation, and partnership) to furnish certain information related to any foreign corporation that such person controls for an uninterrupted period of 30 days or more during the corporation’s annual accounting period. For this purpose, “control” generally means ownership of more than 50% of the total voting power or stock value of the corporation. The U.S. person is required to file specified information on Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, which is filed with the person’s U.S. federal income tax return.
Sec. 6038(a)(4) requires certain information reporting by a U.S. person that is a U.S. shareholder (generally, a U.S. shareholder owning 10% or more of the total voting power) of a foreign corporation that is a controlled foreign corporation (CFC) for an uninterrupted period of 30 days or more during the tax year of the foreign corporation and that owned that stock on the last day of the tax year. That U.S. person is also required to file specified information on Form 5471, which is filed with the person’s U.S. federal income tax return.
Sec. 6038(a)(1) also requires a U.S. person to furnish certain information related to a foreign partnership that such person controls at any time during the partnership’s tax year. Control for this purpose means ownership of more than a 50% interest in such partnership. Such U.S. person is required to file specified information on Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships.
Sec. 6038(a)(5) requires certain information reporting by a U.S. person that owned, at anytime during the tax year, a 10% or greater interest in a foreign partnership controlled by U.S. persons that own 10% or greater interest in that partnership. The U.S. person is required to file specified information on Form 8865.
Monetary penalties and penalties of reduced foreign tax credits may be imposed under Secs. 6038(b) and (c), respectively, for failure to file the information required by Sec. 6038(a)(1) within the time prescribed. Regarding the monetary penalty, the regulations provide that a U.S. person that fails to timely and accurately comply with the reporting requirements of Sec. 6038(a) must pay a penalty of $10,000 for each annual accounting period or tax year of each foreign corporation or foreign partnership for which a failure to comply occurs. This penalty is increased if a failure to comply continues for more than 90 days after the date on which the IRS mails notice of the failure to the U.S. person required to file Form 5471 or Form 8865. Sec. 6038(c) provides that a failure to comply with the Sec. 6038 reporting requirements may also result in a reduction of foreign tax credits under Secs. 901, 902, and 960.
In another situation, Sec. 6038A requires a domestic reporting corporation that is 25% foreign owned to furnish information and maintain records regarding certain reportable transactions with related parties. Similarly, Sec. 6038C requires a foreign reporting corporation engaged in a trade or business within the United States at any time during the tax year to furnish information and maintain records regarding certain reportable transactions with related parties. Such foreign-owned U.S. corporations and foreign corporations engaged in trade or business within the United States must report the required information on Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Secs. 6038A(d) and 6038C(c) impose a monetary penalty of $10,000 for each tax year for which a failure to timely or accurately furnish or maintain the required information occurs. This penalty is increased if a failure to comply continues for more than 90 days after the date on which the IRS mails notice of the failure to the reporting corporation.
Sec. 6038B(a)(1) generally requires that certain information be furnished by a U.S. person that:
- Transfers property to a foreign corporation in an exchange described in Secs. 332, 351, 354, 355, 356, or 361; or
- Transfers property to a foreign partnership in a contribution described in Sec. 721.
With certain exceptions, a U.S. person that makes a transfer to a foreign corporation described in Sec. 6038B and the regulations thereunder must report the required information on Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, and file the form with its U.S. federal income tax for the year of the transfer. Similarly, a U.S. person that transfers property to a foreign partnership in a contribution described in Sec. 721 must report that transfer on Form 8865 if, immediately after the transfer, the U.S. person owns at least a 10% interest in the partnership, or the value of the property transferred, when added to the value of any other property transferred in a Sec. 721 contribution by the person (or any related person) to the partnership during the 12-month period ending on the date of the transfer, exceeds $100,000. Monetary penalties for failing to timely and accurately report such transfers are imposed under Sec. 6038B(c).
Finally, under Sec. 6038D, any individual who, during any tax year, holds any interest in a specified foreign financial asset is required to file an annual information return with his or her Form 1040, U.S. Individual Income Tax Return, for such assets if the aggregate value of such assets exceeds $50,000. Sec. 6038D(d) imposes a $10,000 penalty for a failure to timely and accurately furnish the required information. This penalty is increased if a failure to comply continues for more than 90 days after the date on which the IRS mails notice of the failure to the individual required to file.
Recent Changes in IRS Penalty Enforcement
In January 2009, the IRS began to automatically assess Sec. 6038 penalties on Forms 5471 attached to late-filed Forms 1120, U.S. Corporation Income Tax Return. The automatic assertion of these penalties was a departure from a long-standing IRS policy under which penalties for late-filed Forms 5471 were assessed at the discretion of the examiner after the return was selected for examination. One question raised by this new policy was whether taxpayers would have an opportunity to contest the automatic assertion of these penalties in Appeals prior to payment or whether they would be required to pay the penalties as a prerequisite to contesting them. For certain taxpayers and specified international information reporting penalties, new IRM Section 8.11.5 provides an answer to this question.
International Penalties Eligible for the New Appeals Procedures
IRM Section 8.11.5 provides prepayment Appeals rights for international information reporting penalties assessed under specific return and recordkeeping provisions of chapter 61. Penalties eligible for Appeals consideration include Sec. 6038 series penalties and additionally, in the case of Category 2 taxpayers, other specified penalties. According to IRM Section 18.104.22.168.2, Sec. 6038 series penalties include:
- Sec. 6038(b), which imposes monetary penalties on U.S. persons that fail to timely and accurately provide information on Forms 5471 and 8865 for foreign corporations and foreign partnerships in which they meet certain ownership thresholds as discussed above;
- Sec. 6038A(d), which imposes monetary penalties on 25% foreign-owned domestic corporations for failing to timely and accurately report on Form 5472 (or maintain records regarding) reportable transactions with related parties;
- Sec. 6038B(c), which imposes a monetary penalty on U.S. persons that fail to timely and accurately report on Forms 926 and 8865 information related to certain transfers or contributions to foreign corporations and foreign partnerships;
- Sec. 6038C(c), which imposes monetary penalties for the failure to timely and accurately provide information on Form 5472 (or maintain records) regarding foreign corporations engaged in a U.S. trade or business; and
- Sec. 6038D, which imposes monetary penalties on individuals that fail to timely and accurately provide required information for specified foreign financial assets in excess of $50,000.
According to IRM Section 22.214.171.124.1, other specified international reporting penalties eligible, in the case of Category 2 taxpayers, for the new IRM procedure include:
- Sec. 6039E(c), which imposes a monetary penalty on any individual that fails to provide specified information concerning resident status;
- Sec. 6039F(c)(1)(B), which imposes monetary penalties on a U.S. person that fails to timely and accurately provide information regarding large foreign gifts on Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts; and
- Sec. 6039G(c), which imposes a $10,000 penalty on the failure of any individual to timely and accurately file a tax return statement for the year of termination by an individual losing U.S. citizenship under Secs. 877(b) or 877A on Form 8854, Expatriation Information Statement.
Accelerated Appeals Consideration for Category 1 Taxpayers
IRM Section 126.96.36.199.1 provides an elective accelerated prepayment review procedure for Category 1 taxpayers meeting certain requirements. Category 1 taxpayers are taxpayers that have been assessed one or more Sec. 6038 series penalties during an examination and are either (1) taxpayers with assets totaling $100 million or more or (2) any other taxpayer that has been specifically designated as a Category 1 taxpayer by mutual agreement between Compliance and Appeals. Designation of a taxpayer as a Category 1 taxpayer by mutual agreement is intended to be made in cases where it is determined by Compliance and Appeals that such designation is in the best interest of tax administration.
For purposes of the IRM, a penalty is considered assessed during an examination if it is assessed for the purpose of obtaining information necessary to complete the related income tax examination. This might include, for example, penalties assessed upon discovery, during exam, of a taxpayer’s failure to adequately or correctly provide information on Form 5471 as required by Sec. 6038(b) and where the taxpayer is not forthcoming with that information during audit. A penalty is not considered assessed during an examination if it is assessed against a Category 1 taxpayer at the conclusion of the examination. A penalty is not assessed during exam if it is automatically assessed by the IRS Service Center upon receipt of a late original return with international reporting forms attached thereto.
If the Category 1 taxpayer elects accelerated prepayment consideration of its Sec. 6038 series penalty, that review will be its only opportunity to contest those penalties before Appeals. If the taxpayer disagrees with Appeals’ determination, it will need to pay the assessed penalties and sue for a refund. However, a Category 1 taxpayer that is eligible for accelerated consideration but is otherwise not provided an opportunity to elect accelerated Appeals consideration may dispute the penalty before Appeals on a nonaccelerated prepayment basis as a Category 2 taxpayer. A Category 1 taxpayer may also always dispute the penalty in Appeals under standard claim procedures following payment.
Under IRM Section 188.8.131.52, a Category 1 taxpayer elects accelerated consideration of Sec. 6038 series penalties assessed during examination by filing a protest with Compliance requesting accelerated Appeals consideration of the penalties and providing supporting documents and arguments. Upon receipt of the Category 1 taxpayer’s protest, Compliance will prepare a rebuttal to the protest and forward the case to Appeals under specified expedited handling and coordination procedures set forth in IRM Sections 184.108.40.206–220.127.116.11.2. The IRS will suspend collection activity while the case is before Appeals. Appeals will recommend an appropriate resolution of the penalties based on the hazards of litigation and merits of the issue within 120 days of receipt of the case by Appeals.
Nonaccelerated Prepayment Appeals Consideration for Category 2 Taxpayers
IRM Section 18.104.22.168.1 provides for an elective prepayment Appeals review of certain international information reporting penalties assessed against Category 2 taxpayers. Category 2 taxpayers are taxpayers that do not qualify as Category 1 taxpayers and have been assessed (1) one or more Sec. 6038 series penalties at any time except during examination or (2) any of the other specified international penalties (i.e., under Secs. 6039E, 6039F, or 6038G) at any time. Category 2 taxpayers include taxpayers liable for Sec. 6038 series penalties that were not assessed during examination (for example, Sec. 6038 series penalties are assessed against a Category 1 taxpayer at the conclusion of the examination). Category 2 taxpayers also include Category 1 taxpayers assessed Sec. 6038 series penalties during exam that were eligible for expedited Appeals consideration but were not offered an opportunity to elect that consideration. Category 2 taxpayers also include taxpayers liable for any Sec. 6038 series penalties or other specified international penalties automatically imposed by an IRS Service Center (for example, when the Service Center receives a late-filed Form 1120 with Forms 5471 attached).
If a Category 2 taxpayer elects nonaccelerated prepayment consideration of its eligible international penalties, that review will be its only opportunity to contest those penalties before Appeals. If the taxpayer disagrees with Appeals’ determination, it will need to pay the assessed penalties and sue for a refund. However, a Category 2 taxpayer that does not appeal its international penalties before payment may always dispute the penalty in Appeals under the standard claim procedures following payment.
According to Sections 22.214.171.124 and 126.96.36.199.1, a Category 2 taxpayer elects prepayment review of its eligible international penalties under standard Appeals procedures. If a Category 2 taxpayer appeals its penalties on a prepayment basis, the case will be forwarded to Appeals under the normal case-closing procedures once assessments have been completed and prior to payment. In the case of Category 2 taxpayers under examination, such taxpayers must make an affirmative request for Appeals consideration to Exam in accordance with the rules of Regs. Sec. 601.106. Under these rules, the nature of the request and the type of formal protest required vary depending on the type of examination and the amount of the proposed adjustment.
In the case of penalties automatically assessed by an IRS Service Center when it receives international reporting forms with a late-filed original return, typically the Service Center will send a notice to the taxpayer advising it of the penalty assessment and permitting the taxpayer to request an abatement of the penalty by providing a reasonable cause statement to the Service Center within a short period of time.
If, after the statement is timely submitted, the Service Center determines that the taxpayer does not have reasonable cause for the failure to timely file the international information returns and will not grant relief, then presumably the Category 2 taxpayer may elect nonaccelerated prepayment review of its eligible international penalties by making an affirmative request for Appeals consideration under the IRM and preparing any necessary formal protests in accordance with the requirements of Regs. Sec. 601.106. Upon receipt of the request, the Service Center will forward the case to Appeals for prepayment consideration.
The procedures in new IRM Section 8.11.5 expand and clarify taxpayers’ Appeals rights for certain assessed international information reporting penalties, as specified in the IRM. Most significantly, the new procedures clarify that taxpayers may now seek Appeals review of such assessed penalties in advance of payment. In the case of Category 1 taxpayers, the new procedures permit such taxpayers that desire to contest Sec. 6038 series penalties assessed during examination to immediately exercise their appeal right and have the dispute resolved in Appeals during exam under an expedited procedure. In the case of Category 2 taxpayers, the IRM clarifies that taxpayers may seek prepayment review of assessed Sec. 6038 series and other specified international penalties in Appeals on a nonaccelerated basis under current standard Appeals procedures. With respect to these categories of taxpayers and the penalties specified in Section 8.11.5, the new procedures resolve some of the historic uncertainty as to Appeals’ jurisdiction to consider international information reporting penalties on a post-assessment, prepayment basis, which is a welcome development.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.