Nonresident aliens and foreign corporations may be subject to full income taxes on their gross U.S. receipts. (International Taxation)by Tenenbaum, Stephen
The IRS has published final regulations, Secs. 1.874-1 and 1.882-4, which predicate the ability of non-resident aliens and foreign corporations to claim deductions and credits against their U.S. effectively connected income on filing a true and accurate return. While the statutes underlying these regulations have been in force for many years, the introduction of a timely filing requirement conflicts with a fairly well established line of judicial decisions that allowed deductions when a return was filed prior to assessment by the IRS. The final regulations, which are effective July 31, 1990, for taxable years ended after that date, will present significant issues to all nonresident alien and foreign corporate taxpayers, especially those for whom the determination of whether they are engaged in a U.S. trade or business is less than clear.
The law. Sec. 874(a) permits deductions and credits when a taxpayer files or causes to be filed a true and accurate return, in the manner prescribed in subtitle F, including therein all information the Secretary may deem necessary for calculation of such deductions and credits.
The Regulation. Reg. Sec. 1.874-1 reads in part that deductions and credits, except for those specifically exempted from Sec. 874 by their own terms (that is, Secs. 31, 33 and 34), as well as those added by the regulation (Secs. 32 and 852(b)(3)(D)(ii)) will be allowed ... "only if the nonresident alien individual 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 the income which is effectively connected... with the conduct of a trade or business within the United States by the nonresident alien individual." It should be noted that the timely filing requirement has been introduced and defined by the recently issued final regulations. Sec. 874 itself, which had its origins prior to the 1954 code, did not and does not have a timely condition. Congress, aware that there was no timeliness element in the statute, could have enacted such a requirement into Sec. 874. Despite at least six amendments, it failed to see a need to do so.
The final regulations proceed to define precisely what constitutes a timely filing. The date is dependent on whether a return was filed for the taxable year immediately preceding the current taxable year. If a return was either filed for the immediately preceding taxable year, or if IRS determines that the current year is the first taxable year in which a return is required, the current year's return must be filed within 16 months of the original due date. If the IRS determines that a return was due for the immediate prior year but was not filed, this 16- month period could be reduced merely by the IRS mailing a notice informing the nonresident alien individual that deductions and credits will not be allowed.
Waivers from the disallowance of deductions and credits are reserved for rare or unusual circumstances where the taxpayer establishes good cause. Income tax treaties will be ignored if a "timely" filing is not made.
Protective returns can be filed by nonresident alien individuals, if filed on a timely basis, when they cannot determine themselves that they will owe a return. This will reserve the right of such individuals to utilize deductions and credits if IRS later determines that a return was due.
Because similar treatment is not imposed on U.S. persons, it would seem to violate nondiscrimination clauses of U.S. income tax treaties and friendship, commerce and navigation treaties. A nonresident individual may have very subtle ties to the U.S., such as those resulting from different sourcing rules in the country of residence, the use of a different functional currency, or being swept into the U.S. tax regime by a conduit in a manner contrary to the rules of the individual's country of residence. Such individual may honestly not realize the need to file a return or have any income at all from the U.S. Before deductions are disallowed, such a nonresident may not have any U.S. taxes to pay because he or she experienced losses in the U.S. Other difficulties may arise. A nonresident alien spouse may have U.S. source income solely due to community property laws as translated by IRS on sources of income of which the spouse has no knowledge. A former nonresident alien spouse may have alimony income sufficient to require filing of a U.S. return, even though no U.S. return would otherwise have been due because, unknown to the former spouse, either the ex-mate became a U.S. resident, or a property settlement in their home country was treated as alimony by the IRS after the ex-mate became a U.S. resident.
The Law. Similar to the rules applicable to nonresident alien individuals, IRC Sec. 882(c)(2) permits deductions and credits when a foreign corporation files, or causes to be filed, a true and accurate return in the manner prescribed by subtitle F, which includes all the information the Secretary may deem necessary for the calculation of such deductions or credits.
The Regulation. Reg. Sec. 1.882-4(2) reads in part, "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." In the case of a corporation, deductions under Sec. 170 and credits allowed under Secs. 33, 34 and 852(b)(3)(D)(ii) are allowed without regard to the timely filing requirement. Tax conventions seem to have more weight for a corporation than for an individual. Of course, the regulations under Sec. 6114 on treaty based positions have to be weighed in this judgment.
For foreign corporations engaged in a U.S. trade or business, the deadline for filing income tax returns is 18 months after the original due date. This can be accelerated to the time of the mailing of a notice of failure to file by IRS if it determines that a return was due but not filed for the immediately preceding year. It is therefore possible that the opportunity to file for the second year can be cut off earlier in time than the date to file for the prior year. It is not clear what would happen to the validity of an IRS notice for year two if the return for year one was filed after the date of the notice but prior to the 18- month period of the original due date for the year one return. As with an individual, a protective return can be filed.
As is the case with Sec. 874, Sec. 882 has been amended at least eight times without enactment of a timely filing requirement by Congress.
Playing the Audit Lottery
Some IRS personnel have argued that foreign corporations and nonresident aliens have chosen to "play the audit lottery" by not filing and that the regulation is an attempt at preventing this. The authors are aware of the term "audit lottery" but have previously only heard it in reference to information shown on a filed return. Some IRS personnel have stated that the IRS needs this weapon because it is harder to obtain information about foreigners' returns. This argument becomes questionable in the case of foreign corporations in light of the enactment of new Sec. 6038C, which imposes onerous reporting obligations on all foreign corporations engaged in a U.S. trade or business. In a self-assessing system it becomes the responsibility of the taxpayer to substantiate deductions, whether resident or nonresident. The authors feel that these regulations reach beyond the statute and are not equitable when there is an honest disagreement on the factual situation or even where the foreign individual or corporation has made an honest attempt to comply but had a bona fide disagreement with the IRS on interpretation of the law. The regulation as currently drafted can result in tax penalties and interest of many thousands of times the net profit and cause a positive income tax on losses.
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