Tax Court strikes down timely filing requirement for foreign taxpayers.

• Author: Janiczek, Randall J.

In a January 2006 decision, the Tax Court ruled for the taxpayer in Swallows Holding Ltd., 126 TC No. 6, effectively striking down the Sec. 882 requirement that entitles a foreign corporation to take deduction against its gross income, but only if it timely files a U.S. income tax return. The decision will probably have a significant effect on whether foreign corporations decide to file U.S. tax returns, especially when they are uncertain about whether they are supposed to file and/or whether they have been reluctant to file late returns.

Background

In 1990, Treasury amended the regulations under Sec. 882 to include a provision allowing foreign corporations to deduct expenses against their effectively connected income, but only if they timely filed a U.S. tax return. Under these regulations, foreign corporations that failed to timely file could be subject to income tax on their entire U.S. gross income without the benefit of deducting expenses incurred to generate gross income. Under this regime, it was possible to have no actual net income, or even a net loss, yet still incur a significant tax liability. This harsh treatment was one of the most significant factors foreign corporations considered in deciding whether they had a U.S. filing requirement. Foreign corporations that may not have been required to file or that were uncertain about whether to file often decided to file a protective U.S. tax return to avoid the possibility of being disallowed deductions if later it was determined that they should have filed. Prior to the 1990 regulations, the requirement to timely file did not exist.

Taxpayer's Argument

In Swallows, the Tax Court ruled that Swallows could deduct expenses against its gross income in determining its U.S. tax liability, although the corporation did not timely file its return. Swallows is a Barbados corporation that was incorporated June 1, 1991. It received 160 acres of real estate in California as a capital contribution in November 1991. The corporation's sole activity was receiving rental and option income related to the real estate.

On Sept. 14, 1992, Swallows timely filed an initial U.S. tax return for its fiscal year ending May 31, 1992. On July 23, 1999, without being contacted by the IRS, Swallows filed U.S. tax returns reporting net losses in tax years 1993-1996. The IRS issued a deficiency notice disallowing all deductions reported on the untimely filed tax returns and assessing tax on Swallow's gross income...