US penalty imposition on international tax compliance
Bleak outlook for sympathy and forgiveness
TAX ALERT |
As many are aware, the IRS has devoted more attention and resources to international-related tax compliance. There are well-documented reasons for this significant attention. The illicit evasion of those with unreported income and hidden foreign bank accounts, the government's significant revenue gap and the need to gain valuable information about some of the sophisticated techniques used by corporate America to reduce its U.S. tax burden are some of the more noteworthy reasons. These factors, combined with the overall growth in the middle market's international activities, have increased IRS focus in this area.
The compliance burden arising from international activities is significant for middle-market companies. Financial and tax professionals need to ensure that they are aware of the company’s international activities and can obtain the data necessary to comply with complex tax reporting requirements. This is no easy task for a complex business operating across multiple divisions and functions.
There are many situations that may trigger international tax compliance obligations, but here are a few questions to consider:
- Do you have the proper documentation to support payments made to foreign parties without required withholding taxes
- Are you conducting business in a country that participates in a boycott of Israel?
- Do U.S. employees have signatory authority over foreign bank accounts used in the business?
- Have you made investments into foreign funds that have entered into transactions that require U.S. reporting?
Penalties associated with international tax compliance areas are typically more severe than many other noninternational portions of U.S. tax compliance. The penalty for failing to file Form 5471, Information Return by U.S. Persons With Respect to Certain Foreign Corporations, by the due date of the associated return, including extensions, is $10,000 per failure (i.e., if a taxpayer misses two Forms 5471, the penalty is $20,000). Historically, the IRS had been reasonable, if not complacent, in the assessment of tax penalties in this area of compliance. However, beginning with the 2008 processing season, the IRS instituted an important and critical shift in policy. The policy adjustment led to the initiation of computer-generated penalty notices to corporations that failed to file Form 5471.
In December 2013, a Treasury Inspector General for Tax Administration (TIGTA) report (the Report) was issued regarding the automatic penalties on late-filed Forms 5471 and the abatement of these penalties. The government conducted the analysis underlying the Report primarily to determine the effectiveness of the assessment and abatement of the penalties from both a revenue and IRS policy perspective. The Report concluded that the penalties for these late-filed forms were properly being assessed, but the controls over the abatement of penalties were insufficient, leading to incorrect abatement in a significant number of the tested cases. We have seen an increased level of scrutiny and even denials of abatement in many recent cases resulting in additional administrative costs from pursuing appeals and additional penalty costs.
The Report provides comments and suggestions with respect to IRS policy and, more importantly, suggests that the prospect of negotiating penalty abatements in future cases is quite bleak. Although the Report relates only to one specific form, it likely sheds light on how the IRS will handle penalties arising from failure to comply with other international tax filing obligations.
Some key points and takeaways from the Report include:
Abatement rates declining
- According to the Report, the rate of penalty abatement for the years preceding 2012 ranged from 76 to 78 percent.
- For the 2012 year, the penalty abatement percentage shrank to 39 percent.
Scrutiny of IRS abatement procedures
- Penalties were considered incorrectly abated in 40 out of 93 cases. This will clearly put pressure on penalty reviewers to follow abatement procedures.
- The IRS has a formal penalty abatement decision tree model that its personnel must follow (Internal Revenue Manual section 126.96.36.199.2) to determine whether a reasonable cause exists to abate the penalties. The reasonable cause standard evaluates whether the taxpayer has "exercised ordinary business care and prudence in determining their tax obligations." Some previously acceptable justifications for abatement are not supported when the decision tree is utilized (e.g., reliance upon a professional, first-time filing, taxpayer ignorance of the law, unobtainable records and unintentional failure to file an extension).
- A June 26, 2013, procedural update to the Internal Revenue Manual requires managers to review and approve all late-filed Form 5471 penalty abatements.
Future penalty assessment for other international tax compliance
- In 2013, the IRS also implemented systematic penalty assessments for late filings of Forms 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, for certain forms in the 1120 series.
- With respect to Form 1065, U.S. Partnership Tax Return, the IRS has added a question within the return identifying the number of Forms 5471 attached to the return and will begin the systematic assessment of penalties for late filing of Forms 5471 in 2014.
- With respect to Form 1040, the IRS is pursuing changes to Form 1040, Schedule B that would require identification of the number of Forms 5471 attached to the return.
The IRS is continuing to make the U.S. tax aspects of international compliance a key focus, with the imposition of penalties being a significant "stick" in their arsenal to increase overall taxpayer compliance with these reporting obligations. With the increased penalty assessments and the percentage of taxpayers granted abatements trending downward, taxpayers and their tax advisors will need to increase their awareness of the potential for international tax penalties and exercise more vigilance in this important reporting area.