By Anthony Diosdi
An exam of a multinational corporation 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 or “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.
Production of Information Located Outside the United States
Probably the most common area audited in the international context is transfer pricing. During a transfer pricing audit, the IRS examines whether taxpayers are operating in accordance with arm’s-length or market rate principles. Internal Revenue Code Section 482 authorizes the IRS to make adjustments to income and deductions allocations among related parties. In order to effectively audit the transfer prices used by U.S. subsidiaries of a foreign corporation, the IRS often must examine the books and records of the foreign parent corporation. Historically, foreign parties have resisted making their records available to the IRS, or have not maintained sufficient records sufficient to determine arm’s-length transfer prices. In response, Congress provided the IRS with a number of procedural tools to obtain records located offshore needed in a transfer pricing audit.
The IRS Summons Power
If the IRS cannot obtain records it needs to determine whether or not taxpayers are operating in accordance with arm’s-length or market rate principles, it may use its summons power. The IRS has been granted the power to compel parties to produce records and to testify under oath. However, the IRS’s use of summonses to obtain information located outside the United States is limited to instances in which a district court has personal jurisdiction over the summoned person. For this purpose, United States citizens and residents not currently residing in the United States are treated as residing in the District of Columbia for purposes of enforcing summonses. See IRC Section 7701(a)(39)(B). Under these rules, the IRS can compel a U.S. person involved in an audit to testify. When a corporation is under examination, the summons may be directed to either a specific corporate officer or the corporation itself. If an individual or entity refuses to testify, the IRS may utilize a district court with proper venue to enforce the summons. Although the IRS can compel the testimony of an individual or corporate officer, the IRS cannot compel the production of books and records located outside the United States. The IRS is generally limited to making a document request without having any authority, in the absence of a special treaty provisions, to compel the production of such records. Under the exchange of information provisions of most bilateral income tax treaties, the IRS can generally request information from a foreign country that is either in its possession or can be obtained under that foreign country’s laws.
Formal Document Requests and Section 982
Section 982 provides the IRS with a procedure by which evidentiary sanctions can be imposed on a domestic taxpayer who does not produce foreign-based documentation in response to a “formal” document request” by the IRS. A formal document request is made on IRS Form 4564 entitled “Information Document Request.” A formal document request is defined for this purpose as any request that is made after the normal request procedures have failed and that is sent to the taxpayer at the last known address by registered or certified mail. The request must state the following: 1) the time and place for production; 2) a statement of the reason any previously produced documents are considered insufficient; 3) a description of the documents sought; and 4) the consequences to the taxpayer of a failure to produce the records requested. Under this provision, if a taxpayer does not “substantially comply” with a formal document request within 90 days after the date of mailing of the formal request, on motion by the government in any subsequent civil proceeding in which the tax treatment of the examined item is an issue, the court may prohibit the introduction by the taxpayer of any foreign-based documentation covered by the IRS’s request in a proceeding contesting the related substantive issues. Whether there has been substantial compliance will depend on all the facts and circumstances of the case.
The sole statutory exception is where the taxpayer can establish that the failure to provide the documentation was due to reasonable cause. Reasonable cause does not exist where a foreign jurisdiction would impose a civil or criminal penalty on the entity being audited for disclosing the requested documentation. Three factors should be considered in determining whether there is a reasonable cause defense. These factors are: 1) whether the request is reasonable in scope; 2) whether the requested documentation is available within the United States; and 3) the reasonableness of the requested place of production within the United States.
A party to whom a formal document request has been made under Section 982 can bring an action to quash the request. Such an action must be brought within 90 days after the request was mailed. Proper venue for the action is the United States district court for the district in which the person to whom the request was made either resides or is found. The United States may counterclaim to compel production in such a proceeding, and any order denying the taxpayer’s complaint is a final order that can be appealed.
Sections 6038A and 6038
Internal Revenue Code Sections 6038A and 6038 require certain foreign-owned corporations and foreign corporations engaged in United States business, respectively , to maintain and furnish to the IRS specified information and documents. Section 6038A imposes reporting burdens on 25 percent or greater foreign-owned corporations with a U.S. subsidiary. These so-called “reporting corporations” must furnish certain information to the IRS and maintain records necessary to determine the accuracy of intercompany transactions.
The regulations under Section 6038A provides as follows: [that] reporting corporation[s] must keep 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, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with related parties.” See Treas. Reg. Section 1.6038A-3(a)(1).
Noncompliance with Section 6038A subjects the affected corporate taxpayer to financial penalties and to determinations as to allowed deductions or tax treatment in the “sole discretion” of the IRS based on its “own knowledge” or such information as it may otherwise obtain. The penalties for noncompliance are stiff. Failure to maintain or timely furnish required information may result in a penalty of $25,000 for each tax year in which the failure occurs for each so-called related party. If the failure to provide records continues for more than ninety days after a written notice, an additional penalty of $25,000 per-thirty-day period is imposed while the failure continues. There is no maximum limitation on this penalty.
United States corporate entities that own foreign subsidiaries have similar recording keeping requirements as “reporting corporations” under Section 6038. Penalties may also be issued by the IRS for failure to comply with Section 6038.
The IRS may issue summons to produce testimony or any records required to be maintained to determine the correctness of the tax consequences of intercompany transactions. If the IRS issues a summons to produce testimony or any records required to be maintained, the reporting corporation has a statutory right to commence a proceeding to quash such a summons. Such a proceeding must be brought no later than 90 days after the issuance date of the summons. Alternatively, if the entity complies, but the IRS notifies the entity that it considers such compliance inadequate, the entity can bring an action within 90 days after the date of such notice in the federal district court where the entity resides or is found to review the IRS’s determination.
Procedurally and substantively, tax audits involving multinational corporations tend to be far more complicated than domestic audits. If you are a “reporting corporation” or a U.S. -owner of foreign subsidiaries that are subject to an international examination by the IRS, make sure that you retain the services of a qualified international tax attorney.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
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.