As I described in a previous post on Deducting S Corporation Losses in Excess of Basis, the IRS announced a shift in 2017 toward issue-specific enforcement practices for its Large Business and International (LB&I) division, built around 13 initial “compliance campaigns.”
One of those campaigns centers on Form 1120-F, which many foreign business entities conducting operations in the U.S. are required to file. The IRS has stated in its own announcement of the campaigns that the LB&I has good reason to believe that many foreign corporations are failing to meet their 1120-F filing obligations. An IRS judgment of failure to file can result in the assessment of tax on gross income, with no allowed deductions—an extremely harsh financial penalty in most cases.
Does My Company Have to File Form 1120-F?
In broad terms, any foreign business entity meeting any of the following criteria must file Form 1120-F:
- The company conducts a business or trade within the United States. Note that the form must be filed even if the company derived no income from U.S. sources related to the business or trade, and/or any such income is exempt from U.S. tax liability under a tax treaty.
- The company had any income or losses that are either legally defined or treated by the company for tax calculation purposes as “effectively connected” to business activity in the U.S.
- The company derived income from any U.S. source, if the resulting tax obligations have not been fully met by withholding at source, regardless of whether the company was engaged in business activities within the U.S.
As detailed in the IRS instructions for Form 1120-F, there are a few exceptions to these rules, along with many additional scenarios under which filing of the form is necessary. If you have any doubt about whether your company is required to file, research the requirements thoroughly and seek guidance from a qualified tax professional.
How Is the IRS Monitoring Compliance With Filing Requirements?
The short answer is, quite easily for the most part. The Internet has opened the door for many companies to attract customers from all over the world, but it has also greatly increased the amount of information about each company’s activities that is readily available to anyone. Often, IRS enforcement officers can determine whether a foreign company has established itself within U.S. borders for the purpose of conducting business simply by clicking on the “Contact Us” tab on the company’s website. There are also more sophisticated ways to glean information from a company’s Internet presence, such as accessing public records on web domain ownership.
In fact, the far greater ease with which the IRS can track the business activities of foreign corporations today compared with 25 years ago seems to have been a major factor in the LB&I’s selection of this issue for a compliance campaign. In the present era, it is naïve for any company to believe it can fly under the LB&I’s radar.
What Is a “Protective Return” and Why Should a Company File One?
As noted above, if the LB&I determines that a company has failed to file a required Form 1120-F, especially after the LB&I has sent the company a “soft letter” (read: warning shot across the bow), the company’s entire gross income may be subject to tax liability, with no allowed deductions or credits. Such an assessment could be a financial death penalty.
So what should a foreign corporation do if its own internal auditing indicates that the company has no income from U.S. sources that would be subject to U.S. tax? The best option to comply with IRS rules may be to file a protective return. Filing a protective return involves checking a designated box on Form 1120-F and simply providing basic information on the nature, location, and activities of the company.
A protective return does not exempt the corporation from paying U.S. tax. It does protect the corporation’s right to claim deductions and credits if the IRS later determines that the company actually has U.S. tax liability and is required to file a complete Form 1120-F. Note that in such cases, IRS penalties for late payment and/or inaccurate reporting may still be assessed.
Conclusion: Be a Known Unknown
Filing a protective return for Form 1120-F does not reduce the likelihood that the LB&I will examine a company. In fact, it makes such scrutiny more likely, since the company has effectively announced its U.S. presence. Yet as Secretary of Defense Donald Rumsfeld famously pointed out, “unknown unknowns” are more dangerous than “known unknowns.” The LB&I’s enforcement campaign reserves the most devastating penalties for companies that attempt to completely escape detection of their U.S. business activities. Be proactive and file the required returns. Meet the IRS out in the open.
