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Losing Tax Deductions – Perils for Forei

September 4, 2013

Losing Tax Deductions – Perils for Foreign Corporations Doing Business in the U.S.

A foreign corporation may be eligible for a waiver of the deadline to file a U.S. tax return and thereby avoid losing deductions and credits against U.S. income if the foreign corporation can demonstrate it acted reasonably and in good faith.

Background and Overview

If a foreign corporation conducts a trade or business in the U.S., such foreign corporation is subject to U.S. taxation on any income that is effectively connected with such trade or business. A foreign corporation with a trade or business in the U.S. may avoid being taxed in the U.S. altogether if: 1) it is eligible for benefits of a tax treaty with the United States; and 2) the trade or business conducted by the foreign corporation in the U.S. does not rise to the level of a permanent establishment in the U.S., as defined under the applicable tax treaty. The risk of foreign corporations losing deductions and credits applies whether or not treaty benefits are available.

The Internal Revenue Code and corresponding treasury regulations offer little guidance regarding what constitutes a U.S. trade or business. Foreign corporations should tread delicately when asserting that their activities in the U.S. due not constitute a trade or business. The determination of whether or not a foreign corporation is engaged in a U.S. trade or business generally is a factual question that the IRS will not rule on in a private letter ruling.

Even if a foreign corporation determines it has no U.S. trade or business, it may still wish to consider filing a protective return to protect its right to deductions and credits in case it is audited and the IRS asserts it does have income effectively connected to a U.S. trade or business.

The “acting reasonably and in good faith” standard for waiver in the 2002 regulations appears to be more lenient than the 1990 regulations, which required an affirmative showing of “good cause” to be eligible for waiver. The IRS will analyze the following factors presented in the 2002 regulations to determine if a foreign corporation acted reasonably and in good faith:
1) Whether the corporation voluntarily identified itself to the IRS as having failed to file a U.S. income tax return before the IRS discovered the failure to file;
2) Whether the corporation did not become aware of its ability to file a protective return (as defined in the 2002 regulations) by the deadline for filing a protective return;
3) Whether the corporation had not previously filed a U.S. income tax return;
4) Whether the corporation failed to file a U.S. income tax return because, after exercising reasonable diligence (taking into account its relevant experience and level of sophistication), the corporation was unaware of the necessity for filing the return;
5) Whether the corporation failed to file a U.S. income tax return because of intervening events beyond its control; and
6) Whether other mitigating or exacerbating factors existed.

The 2002 regulations also present six helpful examples that conclude whether or not the foreign corporation will be granted waiver in different factual scenarios. We’ll examine these examples separately in future blog posts.

Practical Takeaway

When advising foreign corporations, it is critical to develop the facts, circumstances and actions taken by the foreign corporation prior to and after becoming aware of their U.S. tax return filing obligation. Filing a protective return when there is doubt whether the foreign corporation had income effectively connected to a U.S. trade or business could result in major tax savings, especially where the foreign corporation’s U.S. activities were profitable and expenses can be attributed to such profit generating activities.

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