An Inquiry Into the Factors Aiding Clemency for Foreign Corporations Requesting Protective Tax Return Filing Deadline Waivers

• Publication year: 2019
• Author: By Anthony Malik

An Inquiry into the Factors Aiding Clemency for Foreign Corporations Requesting Protective Tax Return Filing Deadline Waivers

By Anthony Malik¹

I. INTRODUCTION

Foreign corporations ("FCs") often have varying degrees of U.S. business activities which in turn subject them to varying degrees of U.S. tax exposure. Depending on a given FC's country of incorporation, size, business model, and activities it can be difficult—even for seasoned international tax specialists—to accurately assess the FC's U.S. tax position without diligently analyzing the facts and circumstances. Despite said difficulty, it is not uncommon for such FCs to receive advice regarding their U.S. tax positions from their foreign or U.S. generalist tax advisors. Unfortunately this often leads such FCs to have a false sense of their U.S. tax exposure thereby potentially putting them at severe risk of adverse action by the various U.S. tax authorities.

Given the fact-intensive nature of U.S. taxability determination, it is often in a FC's best interest to consider the advantages of filing protective tax returns.² In practice, however, many FCs are either unaware of the option, or are specifically advised not to, file protective tax returns. This may be, depending on the factual situations, perfectly harmless, less so, or flat-out unwise. The reason being that protective tax returns, as do virtually all (if not all) U.S. tax returns, have legally prescribed due dates³ by which they must be filed with the Internal Revenue Service ("IRS" or "Service"). Much more importantly, apart from the open-ended statute of limitations under Internal Revenue Code ("IRC" or "Code") Section 6501 and the potentially applicable penalties under IRC Section 6651, that most U.S. tax practitioners are familiar with, the real peril for non-filing FCs is the potential disallowance of otherwise allowable deductions and credits⁴ for purposes of computing their U.S. taxable incomes⁵ if it is later determined that such FCs derived income that was effectively connected ("ECI")⁶ with the conduct of a U.S. trade or business ("USTB").⁷ Consequently FCs that do not file, when the prevailing facts and circumstances warrant the filing of, protective tax returns are at undue risk of being taxed on their gross incomes from U.S. sources.⁸

Fortunately for FCs in such predicaments, the IRS has established procedures⁹ whereby they can request filing-deadline waivers for their prior years' unfiled protective tax returns pursuant to Treasury Regulation Section 1.882-4(a) (3)(ii).¹⁰ A waiver then enables such FCs to file their prior years' protective tax returns and reclaim the ability to preserve all allowable deductions and credits. For this purpose, a given FC seeking a waiver must establish to the satisfaction of the Commissioner (and his or her delegates) that the FC, based on the facts and circumstances, acted reasonably and in good faith in not filing a prior year's protective tax return. The Commissioner will in turn consider the following factors to determine whether the FC acted reasonably and in good faith:

• Whether the FC did not become aware of its ability to file a protective tax return by the deadline for doing so;¹¹
• Whether the FC had not previously filed a protective tax return;¹²
• Whether the FC voluntarily identifies itself to the IRS as having failed to file a protective tax return;¹³
• Whether there are other mitigating or exacerbating factors; and¹⁴
• Whether the FC failed to file a protective tax return due to intervening events beyond its control.¹⁵

In addition to these factors, the waiver is also preconditioned on the stipulation that:

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• The FC cooperate in the process of determining its income tax liability for the taxable year for which the protective tax return was not filed.¹⁶

Despite the regulatory text's listing of the above factors, it should be noted that the requirement is not that one must satisfy each factor. Rather, the Commissioner's determination of a given FC's reasonable behavior and good faith is primarily based on the preponderant merit of its cumulative facts and circumstances. There is a conspicuous degree of overlap between some of the factors and different combinations of these factors will be more relevant in developing strong claims in different situations.¹⁷

In the ensuing sections, we will inquire into the aforementioned factors designed to aid clemency for FCs requesting protective tax return filing deadline waivers. Obviously, this paper cannot examine each factor by holding it up to the lens of every reasonably possible eventuality an international tax practitioner may encounter. Rather, what follows is a general discussion meant to help readers construe the factors more productively in developing compelling claims.

II. UNAWARE OF ABILITY TO FILE A PROTECTIVE TAX RETURN BY THE DEADLINE

Before moving forward, it should be briefly mentioned that an understanding of the longstanding authorities regarding what constitutes "reasonable cause," would be highly useful in construing these factors.¹⁸ That said a FC's previous non-filing due to ignorance of the U.S. law is normally acceptable as an indicator of reasonable behavior and good faith. This is because unlike U.S. taxpayers, foreign taxpayers, let alone awareness with respect to technical U.S. tax return filing options, are not at all oriented to the U.S. tax system. As foreign taxpayers with limited U.S. business activities (and thus prospective protective tax return filers), it is understandable that FCs are often not—and cannot reasonably be expected to be—aware of the option to timely file protective tax returns.¹⁹

Some readers may no doubt ponder this seeming deviation from the general principle of Boyle²⁰ (i.e., ignorance of filing dates is not acceptable). However, apart from the fundamentally different fact patterns in cases involving foreign protective tax return filers, the touchstone of this factor is not unawareness of the filing due date but rather the abject unawareness of the option to file a protective tax return in the first instance. Perhaps the potency of such base-level unawareness lays in the fact that it would summarily withdraw, from even the most prudent taxpayer, all reason to explore filing deadlines or for that matter any other tax obligations related to, or springing from, the filing requirement itself.²¹

In practice, a situation that often occurs which allows making a strong claim with respect to this factor is when such a FC's foreign tax advisor, without any input from a U.S. international tax specialist, begins rendering U.S. tax advice. To such foreign tax advisors' credit, they are usually familiar with the international tax treaty concept of permanent establishment ("PE").²² They consider a given FC's facts and circumstances, correctly determine that the FC does not have a U.S. PE,²³ and then incorrectly advise the FC that it need not concern itself with U.S. tax matters. Consequently, such a FC is led to an incorrect understanding of its U.S. tax exposure because PE is not the correct standard for initially determining U.S. taxability (and thus not the correct standard for determining U.S. tax compliance obligations). Rather, the correct standard to initially determine U.S. taxability is the lower USTB threshold. Generally foreign tax advisors are unfamiliar with this U.S. law concept unless they regularly collaborate with U.S. international tax advisors to serve international businesses with U.S. activities.

Another common scenario is when such FCs engage general U.S. tax practitioners (i.e., not U.S. international tax practitioners) to advise them regarding their U.S. tax positions. These generalists, unfamiliar with the finer points of U.S. international taxation, then hurriedly skim the international provisions of the Code. These generalists may succeed in learning about the option of filing protective tax returns to the point where they can excursively discuss them with the FCs. However, it is quite rare for these generalists to, in such a short amount of time, gain enough competence in this specialized area of practice to coherently advise the FCs regarding the benefits of filing, the possible consequences of non-filing, and even the deadlines of filing such forms. Moreover, such generalists, due to their inexperience in this area, are usually squeamish about the prospect of preparing tax forms for international businesses and thus have a tendency to implicitly advise non-filing. Consequently, many FCs walk away mistakenly feeling that exploring protective tax returns is not a useful or necessary endeavor.

The challenge of such a scenario is that it provides for attenuated (though not ineffectual) claims with respect to this factor. While the generalist may have made the FC aware of its ability to file a protective tax return, the generalist may not necessarily have made the FC "aware of its ability to file a protective return . . . by the deadline for filing a protective return."²⁴ Given the optional nature of protective tax returns and the framing of the advice, it is not inconceivable for a FC to think that such returns are not subject to filing deadlines. In fact, protective tax returns were previously not subject to filing deadlines under prior law.²⁵ The point being that FCs

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do not necessarily forego learning about the relevant due dates willfully or negligently.

Nonetheless, given its weaker position, it is important to bolster such a claim with additional support. As an example, one could point towards the generalist's infractions of various provisions of Treasury Department Circular No. 230 ("Circ. 230")²⁶ and invoke reasonable cause due to reliance on a tax advisor.²⁷ As another example, one could point towards the lack of a meaningful incentive to not file to support their claim of unawareness of the necessity of filing by a deadline. Protective tax returns are tax-inconsequential, i.e., they essentially serve information reporting rather than...