International Tax Monthly December 2017 Issue

IRS Continues Its Fusillade of Audit Campaigns

The Large Business and International (LB&I) division of the IRS recently announced 11 additional issues that it will be targeting as part of its “compliance campaign” audit strategy.

The IRS had previously announced 13 compliance campaigns in January of 2017. The issue-based strategy is aimed at identifying areas that represent a risk of noncompliance.

New Campaigns

The IRS identified the additional campaigns following LB&I data analysis and suggestions from IRS compliance employees. Seven of the additional campaigns involve the following international compliance issues:

1. Form 1120-F refunds. This campaign is designed to verify withholding at source for Forms 1120-F (“U.S. Income Tax Return of a Foreign Corporation”) claiming refunds. To make a claim for a refund or credit to estimated tax with respect to any U.S. source income withheld under Chapters 3 or 4 of the Internal Revenue Code, a foreign entity must file a Form 1120-F. Before a refund is paid or a credit allowed, the IRS must verify that withholding agents have filed the required returns (Forms 1042, 1042-S, 8804, 8805, 8288 and 8288-A).

2. Swiss Bank Program. In 2013, the U.S. Department of Justice announced the Swiss Bank Program as a path for Swiss financial institutions to resolve potential criminal liabilities. Banks that are participating in this program provide information on the U.S. persons with beneficial ownership of foreign financial accounts. This campaign will address noncompliance involving taxpayers who are or may be beneficial owners of these accounts.

3. Foreign earned income exclusion. Individuals who meet certain requirements may qualify for the foreign earned income exclusion and/or the foreign housing exclusion or deduction. This campaign addresses taxpayers who have claimed these benefits but don’t meet the requirements.

4. Form 1042-S credit. This audit campaign is intended to ensure that:

  • The amount of withholding credits or refund/credit elect claimed on Forms 1040NR (“U.S. Nonresident Alien Income Tax Return”) is verified, and
  • The taxpayer has properly reported the income reflected on Form 1042-S (“Foreign Person’s U.S. Source Income Subject to Withholding”). The IRS verifies the withholding credits reported on the Form 1042-S before issuing a refund.

5. Corporate direct foreign tax credit (FTC). Domestic corporate taxpayers may elect to take a credit for foreign taxes paid or accrued, rather than a deduction. The goal of this campaign is to improve return/issue selection and resource utilization for returns that claim a direct FTC for taxes paid to a foreign country based on realized net income. This campaign will focus on taxpayers who are in an excess limitation position.

6. Section 956 avoidance. This campaign focuses on situations where a controlled foreign corporation (CFC) doesn’t include in income money it lent to a U.S. parent. The goal is to determine to what extent taxpayers are using cash pooling arrangements and other strategies to improperly avoid taxes.

7. Individual foreign tax credit (FTC). Individuals file Form 1116, “Foreign Tax Credit,” to reduce their U.S. income tax liability for the amount of foreign taxes paid on foreign source income. Due to the complexity of computing the FTC and challenges associated with third-party reporting information, some taxpayers face the risk of claiming an incorrect FTC amount.

In addition, the IRS recently launched four other campaigns involving:

  • Economic development incentives,
  • The agricultural chemicals security credit,
  • The deferral of cancellation of indebtedness income, and
  • The energy efficient commercial building deduction.

More to Come

These campaigns are the second wave of LB&I’s issue-based compliance work. The IRS says “more campaigns will continue to be identified, approved and launched in the coming months.” If you have one of the identified issues, consult with your tax advisor to help you prepare for the possibility of an audit.

IRS Guides Auditors on Foreign and Domestic Check-the-Box Rules

In an international practice unit (IPU), the IRS has provided its auditors with guidance about various aspects of the “check-the box” rules, including rules that differ for foreign and domestic entities.

Note: IPUs aren’t official IRS pronouncements of law or directives and can’t be used, cited, or relied upon as such. Nonetheless, they identify strategic areas of importance to the IRS and can provide valuable insight as to how IRS examiners may audit a particular issue or transaction.

When a business entity is created, its tax classification must be made. This indicates how it would be treated for U.S. income tax purposes.

Final classification regs, also known as check-the-box or CTB regs, are generally effective January 1, 1997, for all domestic and foreign eligible entities. For U.S. income tax purposes, the regs allow an eligible entity to elect to be classified as a corporation (also known as an association) or a flow-through (partnership or an entity disregarded from its owner). If no election is made, a default classification applies, depending on the number of owners and, for a foreign entity, whether the owners have limited or unlimited liability.

In the recent IPU, the IRS sets out instructions for its auditors when they audit taxpayers’ application of the CTB rules.

Domestic vs. Foreign Entity

Auditors must first determine whether an entity is a domestic or a foreiEn business entity. A business entity is domestic if it is created or organized as any type of entity:

  • In the U.S.,
  • Under the laws of the U.S. or of any state, or
  • In both the U.S. and in a foreign jurisdiction.

A business entity is foreign if it isn’t domestic. The determination of whether an entity is domestic or foreign is made independently from the proper classification of the entity.

One of the results of the elective nature of the CTB regs is that a foreign entity may be treated differently for U.S. tax purposes than it is treated under foreign law. An entity may be classified as a flow-through for U.S. tax purposes but as a corporation for foreign tax purposes (commonly referred to as a “hybrid entity”) or as a corporation for U.S. taxes and a flow-through for foreign taxes (a “reverse hybrid entity”).

To be eligible to make the election, the entity must be a separate entity. Whether an entity is separate from its owner is a matter of federal, not local, law. Joint undertakings or contractual arrangements may be separate if used to carry on a trade, business, venture or the like where participants divide the profits. However, mere expense sharing or passive co-ownership won’t create a separate entity. Cost sharing arrangements are specified as not being separate.

“Per Se” Corporations

For both foreign and domestic entities, “per se” corporations can’t make a CTB election; they must be treated as corporations for tax purposes.

A domestic entity is a “per se” corporation, and not eligible to elect, if it’s:

  • Organized under a federal or state statute (or a statute of a federally recognized Indian tribe) if the statute describes or refers to the entity as incorporated, or as a corporation, body corporate, or body politic,
  • A joint-stock company or association,
  • An insurance company,
  • A state-chartered bank,
  • An entity owned by a state, political subdivision, or foreign government, and
  • A business entity that’s generally, but not always, taxable as a corporation under a provision of the Internal Revenue Code.

For foreign entities, federal regulations list, on a country-by-country basis, which entities in those countries are per se corporations. There are limited exceptions to the list.

Failing to Elect

Failure to timely make a CTB election on Form 8832 (“Entity Classification Election”) may be corrected under the following circumstances:

  • Automatically under certain circumstances within three years and 75 days of the requested effective date of the eligible entity’s classification election,
  • Automatically for certain foreign entities where a mistake in the number of owners exists, or
  • When “9100 relief” is available to extend the time to make elections.

IRS auditors lack the authority to cure a late filed Form 8832.

Taxpayer Found Liable for Million Dollar FBAR Penalty

The U.S. Court of Appeals for the Ninth Circuit upheld a district court ruling, finding that a taxpayer had willfully failed to file a Report of Foreign Bank and Financial Accounts (FBAR).

The court rejected a variety of the taxpayer’s arguments, ranging from the contention that the imposition of the penalty violated the U.S. Constitution’s ban against excessive fines, due process, and ex post facto clauses, to assertions that the court was barred by statute of limitations or treaty provisions.

Basics of FBAR Filing

Each U.S. person who has a financial interest in or signature or other authority over foreign financial accounts, including bank, securities, or other types of financial accounts in a foreign country, must file an FBAR each calendar year if the aggregate value of the accounts exceeds $10,000 at any time during the year. The civil and criminal penalties for noncompliance are significant. Civil penalties can range up to $10,000 for each violation.

If the violations are found to be willful, the penalties can range up to the greater of $100,000 or 50% of the amount in the account at the time of the violation. (These amounts are adjusted for inflation — for penalties assessed after January 15, 2017, the amounts are $12,663 for nonwillful violations and $126,626 for willful violations.) A “reasonable cause” exception exists for nonwillful violations, but not for willful ones.

Facts of the Recent Case

In June 2013, the IRS assessed a penalty of approximately $1.2 million against a woman for failing to disclose her financial interests in an overseas account on her 2006 tax return, which she was required to report in 2007. She didn’t pay the penalty and the IRS filed suit.

In that suit, the district court found that she had willfully failed to file an FBAR; the court granted partial summary judgment to the IRS but reduced the fine. The woman appealed.

While the taxpayer admitted that she’d willfully failed to disclose her financial interests in her overseas account on her 2006 tax return, she raised the following eight arguments, which the appeals court rejected:

1. The IRS penalty violated the Excessive Fines Clause of the Constitution.

Generally, “a punitive forfeiture violates the Excessive Fines Clause if it is grossly disproportional to the gravity of a defendant’s offense,” according to a 1998 U.S. Supreme Court case (U.S. v. Bajakajian). The Ninth Circuit found that the penalty wasn’t grossly disproportionate to the harm the taxpayer caused because she’d defrauded the government and reduced public revenues.

2. The IRS violated the statute of limitations.

The appeals court determined that there were no violations of the applicable statute of limitations, which was six years. The taxpayer failed to disclose her financial interests in 2007, so the statute of limitations began to run at that time. The IRS assessed a penalty against her in June 2013 — within the statutory period — and the claim against the taxpayer was connected to that assessment, the appeals court said.

3. The assessment violated the taxpayer’s due process rights.

The court stated the penalty didn’t violate the taxpayer’s due process rights because the IRS could have brought the claim against her earlier. The IRS claim was connected to the taxpayer’s failure to report assets in 2007, so the court found that the tax agency couldn’t have brought its claim before 2007. In any event, the court said, the IRS brought its claim within the statute of limitations.

4. The penalty violated the Ex Post Facto Clause of the Constitution.

Not so, said the appeals court. That clause prohibits the imposition of a new criminal punishment for conduct that has already taken place. Because the Ex Post Facto clause doesn’t apply to civil statutes unless they have a punitive purpose or effect, the court determined that it wasn’t applicable here.

5. The taxpayer received “multiple punishments” for the same underlying offense.

Again, the court rejected the claim. It said that, even if the funds at issue here were traceable to the funds at issue in the taxpayer’s criminal prosecution, the offense in this case — failing to report her foreign bank account on her 2006 tax return — was unrelated to her criminal conviction.

6. The IRS abused its discretion in calculating the penalty and the district court erred by not analyzing the reasonableness of the penalty.

The Ninth Circuit stated that the district court reviewed the taxpayer’s penalty when it reduced it, and the assessment was consistent with the limits set by Congress.

7. The government’s claim is barred by laches (an equity defense based on an unreasonable delay in asserting a claim).

Noting that the United States isn’t generally “bound by laches in enforcing its rights” and that the courts have consistently adhered to the principle that “laches is not a defense against the sovereign,” the Ninth Circuit found that the laches defense was inapplicable here.

8. Introducing banking evidence at the district court violated an international treaty between the U.S. and Switzerland.

The Ninth Circuit concluded that the taxpayer wasn’t entitled to relief under this theory because she hadn’t shown that the treaty she relied on creates an enforceable right.

If you have questions about filing an FBAR, consult with your Sol Schwartz & Associates tax advisor.