By Anthony Diosdi
An exam of a multinational’s tax return(s) will begin much the same manner as any other audit in that the taxpayer will receive a letter from the Internal Revenue Service (“IRS”) notifying it of the audit. However, unlike a typical audit, the examiner will likely be specially trained to deal with issues involving controlled foreign corporations, cross-border transfers and reorganizations, transfer pricing, calculation of foreign tax credits, utilizing bilateral tax treaties, and the branch profits tax. Given the extraordinary complexity of these international provisions, special procedural issues may arise in multinational corporate audits that will not typically arise in an audit of an individual taxpayer or small business. This article explores the special procedural tools that are unique to an IRS examination of a multinational corporation and should be considered as early as possible during the audit process.
The Examination and the Information Document Request
Once the audit commences, as in any other audit, the international examiner will examine the multinational corporation’s tax returns, books, and records. The international examiner will often begin by issuing an Information Document Request (“IDR”) for information relevant to the scope of the audit. For example, if intercompany purchases or sales of inventory exist, a typical IDR would request a copy of any intercompany pricing agreements as well as any contemporaneous documentation of transfer pricing methodology. If an issue exists in the calculation of Foreign-Derived Intangible Income (“FDII”) and Global Intangible Low-Taxed Income (“GILTI”), a typical IDR would request supporting documentation determining how the Deduction Eligible Income (“DEI”) or Deemed Intangible Income (“DII”) was determined. If the international examiner is examining the deductibility of foreign taxes, the international examiner will generally request copies of appropriate foreign tax returns and proof of payment of foreign taxes to substantiate a foreign tax credit. After reviewing the information gathered from the initial IDRs, the international examiner will probably focus on the areas with the potential largest tax increase. At this point, the IDRs will generally become more narrow in scope.
IDR requests can sometimes become a problem for foreign owned U.S. entities that may not have records that are in a usable format. Records are often stated in foreign currency and prepared in foreign languages. This may result in the foreign taxpayer with a U.S. branch or wholly owned U.S. entity spending a large amount of time and money translating and explaining documents requested in an IDR. This problem was confronted in the case of Nissei Sangyo America, Ltd. v. U.S. 31 F.3d 435 (7th Cir. 1994) involved the audit of a U.S. subsidiary of a Japanese parent. In response to an IRS summons, the U.S. subsidiary had randomly selected documents relating to the issue under examination and provided full translations. The Japanese parent had also randomly selected and translated documents. In addition, it translated the subject matter headings or titles of 1,441 pages of Japanese correspondence and prepared English translation keys for the travel expense authorization forms. The IRS demanded that all documents described in the summonses be translated into English, which the company estimated would cost from $850,000 to $1.5 million. The court held that the IRS could not compel the translation of documents that were not relevant to the tax liability or that the IRS already had in its possession. Although this case involved a response to an IRS summons, the translation issue may arise in any type of response to an IRS procedural tool. Anytime the IRS demands that a foreign corporation translate foreign financial statements, Nissei should be considered to limit the scope of the IRS’s demand. This may not only limit the scope of the audit, but it may also save the foreign taxpayer a significant amount in translation costs.
Formal Document Requests
If the IRS is unable to gather through IDRs the foreign information it considers necessary to conduct its audit, the IRS may issue a formal document request (“FDR”). The FDR is not intended to be used as a routine tool at the beginning of an audit, but instead as a tool for securing information that could not be obtained through an IDR. When used by the examiner, the FDR must be sent by registered or certified mail and state the following:
1. The time and place for the production of the documentation;
2. A statement of the reason the documentation previously produced is not sufficient;
3. A description of the documentation being sought;
4. The consequence to the taxpayer of the failure to produce the requested documents.
If the information requested is not produced within 90 days of the mailing of the FDR, the documents requested cannot be later introduced in future proceedings. In cases of multinational corporate examinations, the IRS is often seeking foreign based documentation in an FDR demand. For this purpose, foreign based documentation is “any documentation which is located outside the U.S. and which may be relevant or material to the tax treatment of an examined item.” See IRC Section 982(d). The IRS has broad authority to request virtually any relevant information as long as the request is a legitimate purpose of the examination and the material sought is relevant to the audit. To avoid the application of the FDR rules, the corporate taxpayer must substantially comply with the FDR. Whether there has been substantial compliance will depend on all the facts and circumstances of the FDR and response.
Any taxpayer being audited that receives a FDR has the right to begin proceedings to quash the request within ninety days after the request was mailed. Through a proceeding to quash, the audited corporation may contend, for example, that the information requested is irrelevant, that the requested information is available to the IRS, or that reasonable cause exists for the failure to produce or delay the information demanded. Reasonable cause generally does not exist where a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer for disclosing the requested documentation. During the period that a proceeding to quash or any appeal from that proceeding is pending, the statute of limitations for assessments is suspended. See IRC 982(c).
There are three specific factors that should be considered in determining whether there is reasonable cause for failure to furnish requested documentation. These factors are: 1) whether the request is reasonable in scope; 2) whether the requested documents are available within the United States; and 3) the reasonableness of the place of production within the United States.
For the first factor, an example of an unreasonable scope may be a request “for all the books and records and all the supporting documents for all entries made in such books or records” for a particular foreign entity that is controlled by the multinational. However, a request for the general ledger, an analysis of an account, and supporting documents for a particular transaction of such a foreign entity may be reasonable. The second factor indicates that the IRS may not seek original documents if copies of such documents are available in the United States. Finally, the place of production of records is generally at the corporation’s place of business or the examiner’s office. Requesting the production of records in Miami, Florida by a corporation that engages in business in San Francisco, California may be considered unreasonable. For reasonableness, the place of production is a place mutually convenient to both parties.
If a corporation receives an FDR, the party that receives the FDR should consider carefully consider the following:
1. Was the FDR unreasonable in scope?
2. Was there a legitimate purpose for the requested documentation related to the audit in the FDR?
3. Does the IRS already have in its possession the material sought in the audit?
If it is determined that the IRS unreasonably issued an FDR, the party receiving the FDR may initiate a proceeding to quash the FDR in a United States district court. If a domestic taxpayer initiates quash proceedings, it must file suit in the district court where it resides. If the FDR is issued to a foreign party, it must file quash proceedings in the U.S. district court for the District of Columbia.
Sections 6038A and 6038
Any business involved in cross-border transactions must not only properly determine its global tax liability on the cross-border transactions, the business (whether domestic or foreign) must comply with a number of reporting burdens. Failure to comply with these reporting burdens can easily trigger an IRS international tax audit.
Internal Revenue Code Section 6038A places a reporting burden for intercompany transactions on the 25 percent or greater foreign-owned corporation with a U.S. subsidiary. These U.S. taxpayers, the “reporting corporations,” must furnish certain information annually and maintain records necessary to determine the correctness of the intercompany transactions. In addition, the reporting corporation must file a Form 5472 with the IRS on an annual basis.
Treasury Regulation Section 1.6038A-3(a)(1) provides that “[a] reporting corporation must keep the permanent books of account or records as required by Section 6001 that are sufficient to establish the correctness of the federal income tax return of the corporation, including information, documentation, or records to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with related parties.” Such records may include cost data, if appropriate, to determine the profit or loss on intercompany products and services.
Failure to maintain or timely furnish the required information may result in a penalty of $25,000 for each taxable year in which the failure occurs for each related party. If any failure continues for more than ninety days after notice of the failure to the reporting corporation, an additional penalty of $25,000 per thirty-day period is imposed while the failure continues. Additional penalties can be levied if it is determined the taxpayer failed to maintain records after the ninety-day notification. Within thirty days after a request by the IRS, a foreign-related party must appoint the reporting corporation as its limited agent. Section 6038A(e) allows the IRS to reduce the cost of goods sold when a taxpayer does not obtain its foreign parent’s permission to be an agent for the request of certain documents. Failure to appoint such an agent can result in penalties for noncompliance. In Asat, Inc. v. Commissioner, 108 TC 147 (1997), the Tax Court literally applied Section 6038A against a corporate taxpayer, upholding the IRS’s reduction to the cost of goods sold. The Tax Court’s decision in Asat is demonstrated in Illustration 1.
A distributor of power tools, Powerco is a subsidiary of Chinaco. Powerco buys power tools from Chinaco and resells them in the U.S. An IRS international examiner conducts a transfer pricing audit of Powerco. Pursuant to Internal Revenue Code Section 6038A, the international examiner requests that Chinaco appoint Powerco as its agent. If Powerco is not appointed as Chinaco’s agent and does not provide pricing data to the international examiner, the IRS can reduce Powerco’s cost of goods sold to $0.
Internal Revenue Code Section 6038 is another reporting provision of the Internal Revenue Code. Section 6038 places the reporting burden for intercompany transactions on a U.S. owner of a controlled foreign corporation. This information is reported by the U.S. owner on an IRS Form 5471. The failure to maintain or timely disclose intercompany transactions may result in a penalty of $10,000 for each tax year in which the failure occurs. See IRC Section 6038(b). If any failure continues for more than 90 days after notice of the failure, an additional penalty of $10,000 is assessed per 30-day period while the failure continues. Additional penalties can be levied if the U.S. owner of a CFC fails to maintain records after receiving notice from the IRS. Besides the $10,000 penalty discussed above, the IRS can further reduce any direct foreign tax credits taken by the U.S. owner by 10 percent.
The only way to avoid Section 6038A and Section 6038 penalties is to establish that there was substantial compliance with a specific reporting requirement or the failure to report the transactions on Form 5472 and/or Form 5471 was due to reasonable cause.
If during an audit the IRS is considering assessing Section 6038A and/or Section 6038 penalties, every effort should be made to negotiate a reduction or removal of these penalties at the audit level. Section 6038A and Section 6038 penalties are known as “assessable penalties,” meaning that they may typically be assessed and collected by the IRS without a taxpayer’s ability to contest them in court, unless the assessed penalties are paid in full. Since these penalties are assessed annually and pyramid quickly, many taxpayers (domestic or foreign) do not have the ability to satisfy the aforementioned penalties in full in order to contest them in court. If possible, any Section 6038A and Section 6038 penalties should be resolved either in the audit or through an audit administrative appeal which will be discussed below.
Exchanges of Information Under Treaties
Many international tax audits involve foreign corporations that do not have any U.S. shareholders. Because of cultural and translation issues, IRS demands for records may not be timely satisfied. Failure to provide the IRS with requested information may result in a treaty request for information. Under the exchange of information provision contained in most tax treaties, the IRS can generally request information from a foreign country that is either in the foreign country’s possession or available under the respective taxation laws of the foreign country. These provisions generally do not require the exchange of information that would disclose any trade or business secret.
In general, the IRS will not request information from another country unless: 1) there is a good reason to believe that the information is necessary to determine the tax liability of a specific taxpayer; 2) the information is not otherwise available to the IRS; and 3) the IRS is reasonably sure that requested information is in the possession of, or available to, the foreign government from whom the information is being requested. See Illustration 2 below for an example of a treaty request in an audit.
Sike is a distributor of “cool shoes” sports shoes. Sike is a subsidiary of Chinaco. Sike buys sports shoes from Chinaco and resells them in the U.S. An IRS international tax examiner conducts a transfer pricing audit of Sike. After Sike fails to respond to an IDR request of all agreements between Sike and Chinaco, the international examiner requests the information from the Chinese tax authorities, Chinaco’s home country taxing authority pursuant to the exchange of information provision in the U.S-China bilateral tax treaty.
Although a treaty request will not necessarily result in an additional U.S. income tax liability or U.S. penalty assessment, a treaty request can cause other immeasurable harm to the foreign taxpayer. A treaty request will typically result in a visit to the taxpayer’s place of business by foreign taxing authorities. Visits by local taxing authorities in countries such as China can have an extremely detrimental effect on the foreign taxpayer. It is best to work with the IRS as soon as possible to prevent an exchange of information in a treaty request.
Conclusion of an Examination
At the conclusion of the examination, the international examiner will prepare a report summarizing the findings. The report is then incorporated into the field agent’s report. Any disputed issues from the international auditor’s report may be pursued administratively through the IRS Appeals Division. Given the extraordinary complexity of the international provisions of the Internal Revenue Code, the IRS appeals process is significantly different than the appeals process for a domestic tax audit. This article will highlight the differences in the appeals process below and discuss the procedural opportunities available to taxpayers involved in international tax disputes with the IRS.
The Appeals Division of the IRS
Upon the completion of an international examination, the examining office may issue the taxpayer a thirty-day letter proposing a deficiency. The taxpayer may object to any proposed tax deficiency and request a conference with the Appeals Division by filing a protest with the Appeals Division. The taxpayer must formally request the conference by means of a document known as a protest. The protest must be in writing and must include certain elements to meet the requirements of the Appeals Division. Initially, at least procedurally, an international case brought before proceeds much the same as a domestic tax dispute.
Once the case is assigned to the Appeals Division and the case is scheduled for a hearing, proceedings before the Appeals Division are informal. Testimony is not taken under oath, although the Appeals Office may require matters alleged to be true to be submitted in the form of affidavits or declarations under the penalties of perjury. The taxpayer or the representative will meet with the Appeals Officer and informally discuss the pros and cons of the various positions taken by the taxpayer and the IRS. Under the regulations, Appeals will follow the law and the recognized stands of legal constructions in determining facts and applying the law. Appeals will determine the correct amount of the tax with strict impartiality as between the taxpayer and the IRS, and without favoritism or discrimination between the taxpayers.
Although an Appeals Officer is to maintain the standard of impartiality set forth by the Conference and Practice rules, he or she must, nevertheless, protect the rights of the IRS and act as an advocate on behalf of the IRS. Therefore, an Appeals Officer can raise a new issue or propose a new theory in support of the examining agent’s proposed adjustment. However, an Appeals Officer generally will not do so unless the grounds for raising such new issues are substantial and the effect on the tax liability is material.
Competent Authority Process
On many occasions, International tax disputes involve two taxing sovereigns. This is particularly the case involving tax treaties. These types of cases cannot always be resolved equitably before the IRS Appeals Division. If the multinational taxpayer has been unable to agree with Appeals on an adjustment that results in double taxation, the next course of action is to seek competent authority relief. An integral part of the U.S. Income Tax Treaties is a mutual agreement procedure which provides a mechanism for relief from double taxation. The Office of the Director International acts as the U.S. Competent Authority. The Competent Authority’s primary objective is to make a reasonable effort to resolve double taxation cases and situations in which U.S. taxpayers have been denied benefits provided for by a treaty. The taxpayer may request the competent authority process when the actions of the United States, the treaty country or both will result in taxation that is contrary to provisions of an applicable tax treaty.
When the IRS proposes adjustments that are inconsistent with a treaty provision or would result in double taxation, the taxpayer is encouraged to seek competent authority relief after the amount of the proposed adjustment is determined and communicated to the taxpayer in writing. Generally, taxpayers must use the Appeals process to try to resolve the adjustments before competent authority assistance is sought. Where it is in the best interest of both parties, competent authority assistance may begin prior consideration by the Appeals office. However, the U.S. competent Authority may require the taxpayer to waive the right to the appeals process at any time during the competent authority process.
Mutual Agreement Procedure
Another avenue a multinational taxpayer may consider to resolve an international tax dispute with the IRS is through the mutual agreement procedure (“MAP”). MAP could be used when there is a dispute involving tax treaties and transfer pricing. Below, see Illustration 3 how a taxpayer may be subject to double taxation of the same income and how MAP may assist this taxpayer.
Suma, a distributor of sports shoes is a subsidiary of Germanco. Suma buys sports shoes from Germanco for $100 and resells them in the United States $105. The IRS takes the position that the arm’s-length price from Germanco to Suma should be $90 and proposes a U.S. federal tax assessment. Because $10 of income (the difference between the $100 Germanco charged and the $90 the IRS believes is arm’s-length) is taxed by both the United States and Germany, the home country of Germanco, either Suma and Germanco can request relief from their respective competent authorities. The competent authorities will negotiate with each other to determine who will tax the $10.
Simultaneous Appeals Procedure
If the multinational taxpayer could be unfairly double taxed by the U.S. and another foreign country, the multinational taxpayer should consider utilizing the Simultaneous Appeals Procedure or (“SAP”). See Rev. Proc. 2006-54. SAP may allow a multinational taxpayer to seek simultaneous Appeals and Competent Authority consideration of an issue. This procedure allows taxpayers to obtain Appeals involvement in a manner consistent with the ensuing competent authority process and should reduce the time required to resolve disputes by allowing taxpayers more proactive involvement in the process. By informally approaching Competent Authority before submitting a formal request, the Competent Authority effectively becomes the taxpayer’s advocate. See Practical Guide to U.S. Taxation of International Transactions, Sixth Edition (2007) CCH. SAP further opens the possibility of developing strategies to explore the view likely to be taken by other countries.
Multinational taxpayers may request SAP with Competent Authority in three situations:
1. After examination has proposed an adjustment with respect to an issue that the taxpayer wishes to submit to Competent Authority;
2 After Examination has issued a 30-day letter. The taxpayer can file a protest, sever the issue, and seek Competent Authority assistance while other issue are referred to or remain in Appeals;
3. After the taxpayer is in Appeals and it is evident that the taxpayer will request Competent Authority assistance on an issue.
The multinational taxpayer also can request SAP with Appeals after a competent authority request is made. Generally, the request will be denied if the U.S. position paper has already been communicated to the foreign Competent Authority. The U.S. Competent authority also can request the procedure.
SAP is a two-part process. First, the Appeals representative will prepare an Appeals Case Memorandum (“ACM”) on the issue. The ACM is shared with the Competent Authority representative, but not with the taxpayer. The ACM is a tentative resolution that is considered by the U.S. Competent Authority in preparing the U.S. position paper for presentation to the foreign Competent Authority. Second, the U.S. Competent Authority prepares and presents the U.S. position paper to the foreign Competent Authority. The U.S. Competent Authority meets with the taxpayer to discuss the technical issue to be presented to the foreign Competent Authority and the Appeals representative may be asked to participate. If either the Competent Authority fails to agree or if the taxpayer does not accept the mutual agreement reached, the taxpayer is allowed to refer the issue to Appeals for further consideration.
In the event that an international tax matter cannot be resolved with the IRS or any of the other procedures discussed above, the multinational taxpayer can litigate the controversy before a federal court. A taxpayer may contest an adverse IRS determination in one of three tribunals. First, a multinational taxpayer may potentially challenge a liability before the United States Tax Court before it is satisfied. Challenging an assessment before the United States Tax Court involves the filing of a petition before the court. The deficiency will be stayed until the Court’s decision on the disputed liability becomes final. The Tax Court is a good forum to litigate international tax controversies. However, the Tax Court’s jurisdiction over so-called international penalties is extremely limited. A taxpayer may also contest a tax or international penalties before a United States district court or Federal Court of Claims. However, in most cases, the taxpayer must pay the entire tax and penalty deficiency, including interest before proceeding with a lawsuit before either of these courts.
Procedurally and substantively, tax audits involving multinational corporations tend to be far more complicated than domestic audits. If your corporation is subject to an international examination by the IRS, make sure that you retain the services of a qualified international tax attorney. Diosdi Ching & Liu, LLP focuses on international taxation, assisting clients ranging from small entrepreneurs to major multinational corporations.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: email@example.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.