Over the next several weeks, the Internal Revenue Service (IRS) will be sending letters to foreign businesses active in the US to inquire about their compliance with US federal income tax laws. The initiative targets large multinationals importing goods into the US as well as middle-market global companies with US customers. This comes on the heels of tax authorities in Europe recently taking aggressive stances against foreign multinationals and electronic commerce giants. The US tax administration is signaling it is now its turn to act.
The effort is part of a new examination strategy announced earlier this year by the IRS Large Business and International (LB&I) Division. To make the best use of limited resources, the IRS has identified 13 specific areas at high risk of non-compliance that will drive the selection of returns and issues for examination over the next several months. One of the 13 “campaigns” — referred to as “Form 1120-F Non-Filer Campaign” — directly targets global companies that sell products or services in the US and do not currently file an income tax return with the IRS.
The tax administration stated that it has “data suggesting that many of these companies are not meeting their filing obligations.” Accordingly, such companies may be improperly avoiding a substantial amount of federal income taxes, which the IRS sees as low-hanging fruit driving the initiative.
Background: Tax Obligations of Companies Doing Business in the US
A foreign corporation is generally subject to US federal income tax on a net income basis if it engages in a US trade or business (USTB). While this concept does not have a comprehensive definition in the statute, case law provides that a company engages in a USTB when it carries on “considerable, continuous, and regular” activities in the US. Notably, this is not a hard test, but rather a fact-intensive and potentially subjective determination.
If the IRS can establish that a foreign company has a USTB, then the US can extend its taxing jurisdiction to the company’s net income that is attributable or otherwise considered “effectively connected” to such USTB (the so-called “effectively connected income,” or ECI). Further protection from US federal taxation may exist for businesses eligible to claim the benefits of a tax treaty between the US and their home country. Many treaties allow taxing jurisdiction only if the foreign corporation meets the “permanent establishment” standard, a stricter and better-defined test as compared to the concept of USTB.
US federal income statutes require any foreign company engaging in a USTB to file a US federal tax return, Form 1120-F, regardless of whether the company has any ECI resulting in US tax liability or it is eligible for treaty benefits.
If a return is not filed to start the statute of limitations, a taxpayer may be subject to examination by the authorities for an indefinite number of years. Furthermore, by not filing an income tax return, a foreign corporation may lose the right to deduct certain expenses, should the IRS subsequently find that taxable income existed and/or be subject to penalties for failing to disclose a tax treaty position. The filing of the Form 1120-F does not constitute an admission of a USTB.
Given the subjective nature of the USTB standard, foreign companies with somewhat limited activities in the US are faced with the dilemma of flying “under the radar” in reliance of their lack of a USTB or coming forward and disclosing their position.
Which companies are likely to be contacted and how?
The tax administration is signaling it is stepping up its detection capabilities. The LB&I announced it would “use various external data sources to identify these foreign companies and encourage them to file their required returns.” During a webcast 23 May 2017, IRS officials involved in the initiative suggested the data analysed will include trade and customs records as well as information obtained from state and local authorities, such as sales tax records or registrations with state departments. Businesses with material import records and companies that have registered with local jurisdictions to conduct business in a state or to collect sales taxes are likely to be within the scope of the letter outreach.
In addition, it has been suggested that the IRS will consider contacting foreign companies that have provided their US customers with a form W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States. The form is generally used by a foreign company to certify to its US clients that the company is engaged in a USTB and properly reports its US income. If there is no record of a tax return to back up such certification, the IRS may notify the foreign company and request to reconcile the discrepancy.
A first round of mailings was expected by the end of May. The IRS will use the first batches of letters and the replies it expects from the recipients to fine-tune the programme before extending the scope of the outreach as appropriate.
The “soft letters” being dispatched do not constitute audit notices nor assessments of tax. Rather, it is expected that the initial correspondence will notify the foreign company that the IRS has reviewed data suggesting a potential tax obligation. A response will be requested from the business to explain the potential discrepancy. The agents will evaluate the answers, or lack thereof, on a case-by-case basis before initiating further steps that might include examinations to determine the correct tax liability.
Global importers and service providers should re-evaluate their US tax exposure and analysis whether they have a permanent establishment, USTB and/or ECI. The recent IRS announcements suggest it will be more aggressive in this area, using available commercial data to identify non-US companies with substantial sales and activities in the US. The IRS may reach out to many of these companies with letters suggesting potential tax obligations. These letters and notices should not be ignored; rather, competent advice should be timely sought to minimise the risk of adverse outcomes.
Businesses that entertain regular development efforts in the market, either directly or indirectly through agents or local subsidiaries, are the most exposed to US federal income tax liabilities. Furthermore, US state and local tax jurisdictions are not bound by tax treaties and may assert taxing rights even in absence of a treaty-defined permanent establishment. Companies that identify significant exposure should consider adopting appropriate filing and disclosure positions, both at the federal and state level.
Further information about this news can be obtained by contacting Pietro Stuardi and Jim Alajbegu from Baker Tilly in the US.