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I. Form 5472 – here’s what you need to know
We’ve had several enquiries about Form 5472 by some of our Asian based investors into the US. Therefore it is natural that it be the subject of my next blog entry.
As of 2015, over 6.8 million United States (US) workers were employed by foreign-owned companies. To ensure that foreign investment and foreign business activity is reported and taxed, Internal Revenue Code (IRC) §§ 6038A and 6038C impose reporting and substantiation requirements on foreign-controlled businesses. IRS Form 5472, Information Return of a 25% Foreign-Owned U.S.
Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, is used to report the information required under IRC §§ 6038A and 6038C. The consequence for failing to file IRS Form 5472 includes the denial of deductions for payments to related parties, an initial $25,000 failure to file penalty, and continuation penalties of $25,000 per 30-day period until the taxpayer gets into compliance. Below, we review the reporting and record-keeping requirements of Foreign- Owned U.S. Corporations and Foreign Corporations doing business in the US.
That related-party transactions (as defined by I.R.C. § 6038A(b) which is discussed further in the following section) should be subject to extra scrutiny is not unique to foreign business activity. Transfer pricing examinations under IRC § 482 are routine. Historically, the IRS had trouble obtaining transfer pricing data from foreign companies.
The reporting and recordkeeping requirements of IRC §§ 6038A and 6038C were intended to reduce transfer pricing abuses and assist the IRS in examining related-party transactions involving foreign investors and corporations. A US business that is foreign-owned is subject to IRC §6038A. Foreign corporations with US operations are governed by IRC § 6038C.
IRC § 6038A “Information with respect to foreign-owned corporations” provides:
If, at any time during a taxable year, a corporation . . .
(1) is a domestic corporation (in accordance with I.R.C. § 7701(a)(3) & (a)(4)), and
(2) is 25-percent foreign-owned, such corporation shall furnish, at such time and in such manner as the Secretary shall by regulations prescribe, the information described in sub-section (b) and such corporation shall maintain . . . such records as may be appropriate to determine the correct treatment of transactions with related parties as the Secretary shall by regulations prescribe. . . .IRC § 6038C, “Information with respect to foreign corporations engaged in U.S. business,” provides: If a foreign corporation . . . is engaged in a trade or business within the United States at any time during a taxable year–
(1) such corporation shall furnish . . . the information described in subsection (b) and
(2) such corporation shall maintain . . . such records as may be appropriate to determine the liability of such corporation for tax under this title as the Secretary shall by regulations prescribe . . . .
Despite the statutory separation, the two tax provisions share the same regulations (i.e., those under IRC § 6038A), and corporations subject to either provision must supply the IRS with information each year on Form 5472. The regulations treat domestic disregarded entities, which are wholly owned by a foreign person, as US domestic corporations for Form 5472 filing purposes.
Disregarded entities must submit the Form 5472 with a pro forma Form 1120.
As foreign investment in the United States grows, an increasing number of international investors are establishing subsidiaries and affiliates in the country. Many of those U.S. subsidiaries and affiliates will find themselves subject to a multitude of information reporting requirements that exist under federal income tax law. Those requirements are complex, fraught with pitfalls, and carry severe consequences for errors. As a result, it is essential that foreign-owned U.S. affiliates — whether small or large — understand their reporting obligations and do their best to comply with them.
II. Form 5472: Introduction
A. History and Purpose
Congress initially promulgated section 6038A (the statute authorizing Form 5472 reporting requirements and corresponding penalties) as part of the Tax Equity and Fiscal Responsibility Act of 1982.
The original section 6038A imposed reporting obligations on U.S. corporations that were 50 percent or more owned by a foreign person, and it required disclosure of the filer’s transactions with corporations that were a part of the same controlled group as the filer.
The Joint Committee on Taxation noted:
Under prior law, a U.S. parent corporation was required to report transactions with its foreign affiliates and transactions between its foreign affiliates, but no such reporting was required of transactions between a U.S. subsidiary of a foreign corporation and its foreign affiliates . . . [so] the existence of such transactions did not necessarily come to the attention of the Internal Revenue Service.
The goal of the new reporting requirement was quite clear: to reduce transfer pricing and “similar abuses” and “place foreign controlled U.S. entities on an equal footing with U.S. corporations controlled by U.S. persons.”
Section 6038A underwent revisions throughout the years. The Tax Reform Act of 1986 required reporting of transactions with noncorporate related parties, such as individuals, trusts, or partnerships. The Omnibus Budget Reconciliation Act of 1989, among other measures, lowered the reporting threshold to 25 percent or greater foreign ownership.
B. What and How to Report
In its current form, section 6038A requires any 25 percent foreign-owned domestic corporation to “furnish, at such time and in such manner as the Secretary shall by regulations prescribe,” certain information concerning its related parties and related-party transactions. A corporation fulfills this obligation by filing a Form 5472 together with its federal income tax return.
Form 5472 consists of three pages. Page 1 includes the basic information about the filer (Part I), as well as (in Part II) the information about the filer’s direct and indirect 25 percent foreign shareholders. Parts III and IV on page 2 require the filer to list its domestic and foreign related parties and the dollar amounts of transactions between the taxpayer and each related party that is not a U.S. person. There are 13 categories of transactions for the seller-recipient and purchaser-payee sides, plus a catchall provision for “other amounts received/paid.” A taxpayer can use a reasonable estimate if actual amounts are not determinable. The regulations presume that an amount within 75 to 125 percent of the actual amount is a reasonable estimate.
Page 2 of Form 5472 also includes parts V and VI. The former is relevant only to “foreign-owned U.S. disregarded entities” and is discussed later in the report. The latter asks about nonmonetary or less-than-full-consideration transactions, if any, between the filer and a foreign related party.
Part VII on page 3 of the form lists extra questions that pinpoint common transfer pricing risk areas. For instance, questions 42a and 42b ask about any related-party loans or borrowings for which the regulatory safe harbor was available but not elected by the taxpayer. Part VIII requires the filer to describe each cost-sharing arrangement (CSA) in which it was a “controlled participant.” Lastly, Part IX requires reporting of certain amounts relevant to computation of the section 59A base erosion and antiabuse tax.
A taxpayer must file a separate Form 5472 for every related party with which it had transactions during the tax year. A taxpayer that had transactions with 10 related parties during the year will have to file 10 Forms 5472. Both Form 5472 (page 1) and Form 1120, “U.S. Corporation Income Tax Return,” require the filer to list the total number of Forms 5472 filed for a particular year.
C. Exceptions
The instructions list six exceptions to the Form 5472 filing requirements. First, a taxpayer does not need to file the form for a domestic or foreign related party with which it had no transactions at all during the year. The “transactions” here include those reportable in parts IV, V, or VI of the form. The second exception applies when the foreign related party is also a controlled foreign corporation, but only if the CFC’s U.S. shareholders report the related-party transactions on Schedule M of the CFC’s Form 5471.
The third exception relates to foreign sales corporations, while exceptions 4 through 6 appear mostly relevant to foreign corporations engaged in a U.S. trade or business that must file Form 5472 under another code section.
Conversely, no exception is available based on the taxpayer’s size or the volume or complexity of its related-party transactions. In other words, a small U.S. subsidiary of a foreign group has the same reporting obligations as a large foreign-invested U.S. enterprise.
III. Form 5472: Penalties and Abatements
A. Penalties
When TEFRA first enacted section 6038A, the basic penalty for violating the reporting obligations was $1,000, equivalent to $3,190 in March 2024 prices. Subsection (d)(2) imposed an enhanced penalty (at a rate of $1,000 for every 30 days) of up to $24,000 ($76,568) when the taxpayer did not report the information within 90 days after being notified by the IRS.
OBRA 1989 increased the penalties considerably. The basic penalty went up to $10,000, while the enhanced penalty was increased to $10,000 for every 30 days without a specified maximum. In 2013 the IRS began assessing section 6038A penalties systemically (that is, automatically) when receiving a late-filed Form 1120 that had Form 5472 attached to it. Lastly, the Tax Cuts and Jobs Act of 2017 increased both the basic and the enhanced penalty to $25,000.
The $25,000 penalty under section 6038A is a fixed amount. There is no correlation between the penalty amount and the understatement or underpayment of tax caused by the unreported transactions. The same $25,000 penalty would apply even if the taxpayer’s unreported dealings with its related parties were perfectly compliant with the arm’s-length principle and the taxpayer properly reported and paid the tax due in the United States. What may be even more shocking to a taxpayer is that the penalty applies on a per-form basis. For instance, a taxpayer that had dealings with 10 related parties and did not file Form 5472 at all faces a basic penalty of $250,000 (that is, $25,000 times 10 forms) and not just $25,000.
Throughout the years, the IRS has been assessing Form 5472 penalties using deficiency procedures. The Tax Court decision in Farhy suggested that a similar penalty under section 6038(b) is not an “assessable penalty” and that the IRS can collect that penalty only through a civil action. However, the D.C. Circuit recently reversed the Tax Court in a decision relying on a close examination of the statute and its legislative history. Although other circuits may or may not agree with the D.C. Circuit’s holding, and the taxpayer in Farhy still has the right to petition the Supreme Court for a writ of certiorari, the IRS’s current practice of Form 5472 penalties collection appears to be valid, at least for now.
Additional monetary penalties may arise on the state level because some states require the taxpayer to furnish a copy of Form 5472 and other federal information returns as an attachment to the state tax return. For instance, a $10,000 per-form penalty applies under section 19141.5 of the California Revenue and Taxation Code.
B. Statute of Limitations Extension
Section 6501(c)(8) outlines another less-known consequence of Form 5472 noncompliance. The general rule under section 6501(a) is a three-year statute of limitations that begins with the filing of the return, with the most well-known exceptions including substantial omissions (six years) or fraud (unlimited).
However, under subparagraph (c)(8), the statute of limitations does not begin to run for a taxpayer that did not provide the information required by section 6038A (Form 5472) and/or some other sections of the code. Effectively, a taxpayer’s otherwise valid return will be open for IRS audit indefinitely, until the taxpayer files the omitted Form 5472 and other forms with the IRS, and three years pass from that date.
The statute remains open for the entire return, unless the failure to comply was attributable to reasonable cause and not willful neglect, in which case the statute of limitations will be open only for the items related to that failure.
C. ‘Substantially Incomplete’ Filing Equals Not Filing
The regulations under section 6038A — specifically, reg. section 1.6038A-4(a)(1) — provide that “the filing of a substantially incomplete Form 5472 constitutes a failure to file Form 5472.” Under this provision, a taxpayer cannot meet its reporting obligations by filing a Form 5472 that is blank or has clearly inadequate information. However, the outcome is much less predictable when Form 5472 is complete to a certain extent but some information is incorrect or missing. For instance, would the IRS penalize a taxpayer that has filled all three pages of the form but forgot to disclose one or two transactions? What about dollar errors?
The regulations under section 6038A are silent on how big an error or omission will make the form “substantially” incomplete. The IRS has given limited nonprecedential guidance on the subject in a 2004 internal legal memorandum (ILM 200429007) and field service advice issued in 2000 (FSA 200026005) (collectively, chief counsel advice). Moreover, the IRS Large Business and International Division issued a practice unit on this subject in 2017. None of that informal guidance identifies a clear threshold that a taxpayer should meet for substantial completeness; however, it implies a standard higher than the “substantial compliance” in Beard and other decisions.
ILM 200429007 (cited in the practice unit) lists two approaches. One is strict compliance, which requires that all information be exact in every respect unless the law or regulations specifically allow the use of estimates. The other is a facts and circumstances approach, which considers seven factors to judge the magnitude of an error. The internal legal memorandum says that the strict compliance approach is “a rigorous interpretation of the regulations and, depending on the particular circumstances, may yield a harsh result.” However, it gives no opinion on which approach is better or which approach IRS examiners should use.
Unfortunately, the factual situations and examples provided in the chief counsel advice and the LB&I practice unit all include significant errors on the taxpayer’s part. Accordingly, it is not surprising that the IRS found the forms to be substantially incomplete in each of those situations. For instance, in the field service advice, the taxpayer omitted a transaction to the tune of millions of dollars and one-third of its gross receipts. The question that the IRS left unanswered is how big a mistake should be tolerable to the examiners under the substantially (in)complete standard. Taxpayers and their advisers should also note that the chief counsel advice is highly informal guidance that is not binding on the IRS. In theory, IRS examiners may adopt a different approach in a particular audit case.
D. Abatement Options
As of now, the statute (section 6038A(d)(3)) provides only for a general reasonable cause defense against the monetary penalties. The regulations go a bit further, saying that the reasonable cause exception shall apply “liberally” for a corporation that has no more than $20 million of gross receipts in the year, had no knowledge of the requirements imposed by section 6038A, has limited presence in and contact with the United States, and promptly and fully complies with the IRS information requests. However, this is in no way a waiver of the reasonable cause requirement. It is still up to the examination team to determine whether reasonable cause exists in any given case.
Internal Revenue Manual 20.1.1.3.3.2.1 excludes Form 5472 penalties from the scope of the first-time abatement (FTA) policy. As an exception, IRM 20.1.9.5.5 allows for a one-time waiver of the penalty when (1) Form 5472 was attached to a late-filed corporate tax return; (2) the taxpayer had no similar Form 5472 penalties in three prior years; and (3) the taxpayer’s Form 1120 was filed timely in three prior years.
Lastly, the IRS granted relief to taxpayers that did not timely file their income tax returns and international information returns (including Form 5472) for the 2019 and 2020 tax years. However, this relief expired September 30, 2022.
IV. Form 5472: Challenges for Taxpayers
A. Before Filing: Clarification Needed
As mentioned earlier, the IRS applies a higher standard regarding correctness and completeness for international information returns (including Form 5472) compared with regular income tax returns. That position has its justifications. The IRS needs Form 5472 to select higher-risk transfer pricing cases and plan its audits accordingly. An incorrect or missing piece of information, if significant enough, can lead to a wrong decision. This can be an audit opportunity not pursued, or valuable resources wasted on a wrong issue.
However, even the most recent revision of Form 5472 has persistent problems that may jeopardize the accuracy of information that taxpayers report. The lack of guidance creates risks for both the IRS and taxpayers. The IRS may be comparing apples with oranges when different taxpayers understand and respond to the same question differently. Meanwhile, taxpayers and their tax advisers may understand a certain question differently from the way the IRS expects them to, which creates a potential penalty exposure given the uncertainty with the term “substantially incomplete.”
Examples follow:
- Part IV of Form 5472 uses the terms “received” and “paid” for most transaction types (for example, “rents received,” “interest received,” or “commissions paid”). However, the language is often misleading. As clarified in the instructions, the terms “paid” and “received” include accrued payments and receipts. This not only confuses taxpayers but also makes it difficult for the IRS to compare Form 5472 information with taxpayers’ forms 1042 and 1042-S concerning nonresident withholding, or to identify the common section 267(a)(3) adjustments.
- Question 39 on page 3 (Part VII) asks: “During the tax year, was the foreign parent corporation a participant in any cost sharing arrangement (CSA)?” If the answer is yes, the taxpayer is directed to provide information regarding the CSA in Part VIII of the form. However, the instructions to Part VIII suggest that a taxpayer should complete it only for a CSA to which the taxpayer was a “controlled participant.” Therefore, it is unclear whether and how one should report a purely foreign-to-foreign CSA that is entered into by the foreign parent company but does not concern the taxpayer or any other U.S. entity. Should a taxpayer in this case just answer no? The instructions give no comments.
There are also important questions that section 6038A regulations can answer; however, the answers are not obvious from the form itself or the form’s instructions:
- Lines 17 and 31 require reporting of “amounts loaned” and “amounts borrowed.” A question may arise of whether this includes only loans and borrowing that generate (or should generate) interest, or whether non-interest-bearing accounts receivable or payable should count as well. The regulations suggest that taxpayers should exclude ordinary trade receivables and payables from the amount on those lines. However, the form and the instructions do not mention this at all. Another unanswered question is whether a taxpayer must report those receivables or payables as “other amounts received” or “other amounts paid” since they may still be relevant to the IRS.
- The form and instructions are also silent on whether a taxpayer that does not meet the BEAT gross receipts test should still complete Part IX and list the potential base erosion payments and base erosion tax benefits. The regulations suggest that nonapplicable taxpayers do not need to fill in this part; however, further clarification in the instructions would certainly help.
B. After Filing: How to Remedy Noncompliance?
The situation gets even more complicated when the problem — either a missed or incorrect Form 5472 — is discovered some time after the tax return was filed. Sometimes, it is the taxpayer or their tax adviser that discovers the error. Sometimes, it is a third party, such as a potential buyer conducting a due diligence exercise. This discussion assumes that the IRS has not yet discovered the missing or erroneous filing.
The potential exposure in that case is twofold. On the one hand, the taxpayer faces monetary penalties. The IRS can impose Form 5472 penalties on a per-form, per-year basis, so that the penalty amount may be in the range of tens or hundreds of thousands of U.S. dollars. On the other hand, the problematic returns remain open for an IRS audit indefinitely — and, given the general rule of section 6501(c)(8), the IRS may be able to audit any issues, even those not related to Form 5472 at all (for example, substantiation of deductions).
As a result, a taxpayer will face a dilemma. There is no way to “sit out” and let the statute of limitations expire. However, amending a return to attach the missing or corrected Forms 5472 has its risks as well. The IRS allows the taxpayer to correct noncompliance under the delinquent international information return submission procedures (DIIRSP), which include submitting an amended return with missing or corrected Form 5472 and other applicable forms attached before the agency discovers the issue. However, a taxpayer that follows these procedures must still prove a reasonable cause to secure penalty abatement.
The regulations and the IRM mention some situations in which a reasonable cause defense may be sustained, such as: the taxpayer reasonably not knowing about 25 percent foreign ownership; death; serious illness or unavoidable absence; fire, casualty, or natural disaster; reliance on (erroneous) professional advice; or inability to obtain records. However, the examiners will judge every case on its merits, and it may be difficult for a taxpayer or a tax professional to predict the outcome, especially when the circumstances are less compelling. As a result, a taxpayer that follows the DIIRSP may end up subject to the same per-form, per-year penalty if the IRS finds their conduct to lack reasonable cause.
C. A Special Challenge: Foreign-Owned U.S. Disregarded Entities
While foreign investors often form their U.S. entities as C corporations for tax purposes, there are those who use disregarded entities (that is, a limited liability company without a check-the-box election) for various tax or nontax purposes. As the word “disregarded” implies, a disregarded LLC is not a separate taxpayer for federal income tax purposes. It does not file its own federal income tax return or pay any federal income tax. In fact, this will often be a response given to the LLC or its owner by a tax adviser. However, a small provision hidden deep in the regulations may come as a surprise for an LLC with a foreign owner.
Reg. section 301.7701-2(c)(2)(vi) provides an exception from the general rule of “disregarding” the entity. It says that an entity that is disregarded as an entity separate from its owner “is treated as an entity separate from its owner and classified as a corporation for purposes of section 6038A if (1) the entity is a domestic entity; and (2) one foreign person has direct or indirect sole ownership of the entity.”
In other words, the regulations treat a disregarded LLC whose owner is a foreign individual or corporation as if it were a “reporting corporation” subject to all requirements of section 6038A. That LLC has no tax return filing or tax payment obligations but must file Form 5472 with the IRS. The form and its instructions call those LLCs “foreign-owned U.S. disregarded entities.”
An LLC that is unaware of these rules and does not file Form 5472 on time is subject to the same penalties as a regular C corporation. The same is true for an LLC that files a substantially incomplete Form 5472. The regulations and instructions render the second, third, and sixth filing exceptions (CFC, FSC, and foreign-to-foreign transactions without U.S. tax impact, respectively) inapplicable to foreign-owned U.S. disregarded entities. Meanwhile, the first exception (no transactions to report) may be more difficult to apply for a foreign-owned U.S. disregarded entity. The regulations require that entity to report transactions with its tax owner, including those related to “formation, dissolution, acquisition and disposition of the entity,” which includes “contributions to and distributions from the entity.” It would be rare for an LLC to have no such transactions at all — at a minimum, there should have been some capital contributed, or earnings distributed, by or to the LLC’s owner.
Given design limitations, an LLC must attach Form 5472 to a pro forma Form 1120. The same April 15 due date applies, although an LLC can request an extension to October 15 using Form 7004. Electronic filing is not available, and an LLC must use a specific mailing address or fax number in the Form 5472 instructions to file the forms. Filing the pro forma Form 1120 and Form 7004 to a wrong address — such as one in Form 1120 instructions — creates risk of it being not timely filed, thus subjecting the taxpayer to applicable penalties.
An LLC that discovers its failure to file a Form 5472 after the due date would face the same consequences and difficult choices as a foreign-owned U.S. subsidiary.
IRC § 6038A, Treas. Reg. § 1.6038A-1, and the Who, What, When, and Where of Filing Form 5472.
The Form 5472 requests information the IRS deems necessary to investigate whether foreigners are manipulating related-party transactions and consequently decreasing US tax revenues. To this end, Form 5472 requires identifying information from reporting corporations and 25% foreign shareholders. Regarding what information must be provided, IRC § 6038C(b)(1) adopts the requirements of IRC § 6038A(b), which include:
1. the name;
2. principal place of business;
3. nature of the business; and
4. the country or countries in which each related party—with any transaction with the reporting corporation—is organized or resides.
Once the related party is listed, information regarding how the reporting corporation is related to each related party must be provided. Then, any transactions between the reporting corporation and each foreign person which is a related party must be detailed.
IRC § 6038A and Treas. Reg. § 1.6038A-2 through 1.6038A-7 detail which foreign-owned US corporations and foreign corporations engaged in trade or business within the US must file Form 5472, what records must be maintained, and what information must be available for audit.
IRC § 6038A(c)(1) defines a reporting corporation required to file Form 5472 (sometimes the “Taxpayer”) as a domestic corporation that is 25-percent foreign-owned. Foreign-owned means ownership by one foreign person of either 25 percent of the voting stock or 25 percent of the value of all classes of the domestic corporation’s stock. A “foreign person” is any person who is not a “United States person” under IRC § 7701(a)(30). The attribution rules, under IRC § 318, apply when determining if a corporation is 25-percent foreign-owned and whether someone is a related party for IRC § 6038A purposes. Form 5472 is also required from each foreign or domestic related party with which the reporting corporation had a reportable transaction.
Under IRC § 6038A(b), the term related party means:
1. any 25-percent foreign shareholders of the reporting corporation;
2. any person related, as defined by § 267(b) and 707(b)(1), to the reporting corporation or to a 25-percent foreign shareholder of the reporting corporation; and,
3. any other person related to the reporting corporation, as defined under § 482.
Reportable transactions are defined in Treas. Reg. § 1.6038A-2(b)(3)&(4). Related-party transactions reported on Form 5472 include:
1. sales or stock or property;
2. commissions paid and received;
3. rents and royalties paid;
4. consideration for services; and
5. amounts loaned and borrowed.
- There is a Small Amounts Exception – Treas. Reg. § 1.6038A-2(b)(7) provides that, “[i]f any actual amount required under this section does not exceed $50,000, the amount may be reported as “$50,000 or less.”
- The Preparer May Use Reasonable Estimates – Treas. Reg. § 1.6038A-2(b)(6)(i) provides that “[a]ny amount reported under this section is considered to be a reasonable estimate if it is at least 75 percent and not more than 125 percent of the actual amount.”
- There is a Small Corporation Exception that Excuses Some Recordkeeping Requirements. Reporting corporations with less than $10,000,000.00 in gross receipts for a taxable year must file a Form 5472 but they are excused from the heightened record maintenance requirements in Treas. Reg. § 1.6038A-3 and the requirement to have an authorized agent, under Treas. Reg. § 1.6038A-5.
- The How, When, & Where of Filing Form 5472 – Form 5472 is due on the due date of the Taxpayer’s Form 1120, including extensions. Form 5472 should be attached to the corporation’s income tax return on the filing deadline, which also includes extensions. Disregarded entities cannot file their Form 5472 electronically. Form 5472 should be attached to the Form 1120 and filed either: electronically; via fax (300 DPI or higher) to (855) 887-7737; or mailed to Internal Revenue Service, 201 West Rivercenter Blvd., PIN Unit, Stop 97, Covington, KY 41011.
The Penalty for Failing to File Form 5472 Starts at $25,000
Failure to file Form 5472 can result in a penalty of $25,000.00 per year (was $10,000.00 prior to 2018). There is also a continuation penalty. This means that if the Taxpayer does not file a substantially complete Form 5472 within 90 days of being notified to do so by the IRS, the IRS can assess an additional $25,000.00 penalty for each 30-day period that the taxpayer fails to cure the failure to file. Unlike other continuation penalties, there is no limit to the continuation penalty for a failure to file Form 5472.
The Fifth Amendment implications of this penalty are beyond the scope of this overview. The $25,000 Penalty Applies to Forms 5472 that are Not Substantially Complete Treas. Reg. § 1.6038A-4(a)(1) memorializes the IRS’s position that filing a Form 5472 that is not “substantially complete” (i.e., a substantially incomplete filing) should be penalized as a failure to file.
By contrast, Treas. Reg. § 1.6038A-2(b) provides:
(6) Reasonable estimate –
(i) Estimate within 25 percent of actual amount. Any amount reported under this section is considered to be a reasonable estimate if it is at least 75 percent and not more than 125 percent of the actual amount.
(ii) Other estimates. If any amount reported under this paragraph (b) of this section fails to meet the reasonable estimate test of paragraph (b)(6)(i) of
this section, the reporting corporation nevertheless may show that such amount is a reasonable estimate by
making an affirmative showing of relevant facts and circumstances in a written statement containing a declaration that it is made under the penalties of perjury. The District Director shall determine whether the amount reported was a reasonable estimate.
(7) Small amounts. If any actual amount required under this section does not exceed $50,000, the amount may be
reported as “$50,000 or less.”
Against this background, whether an item “under or over-reported” on a Form 5472 renders the Form 5472 “substantially incomplete” is determined case by case considering the safe harbors provided by regulation.
The IRS guidance suggests that the tax professional contesting the penalty should perform a two-prong balancing test:
(1) what is the magnitude of the errors
and
(2) what is the effect of the noncompliance on the IRS ability to audit the information as required by statute and regulations.
Stated another way, tax professionals should argue that the regulations on whether a Form 5472 complies or substantially complies with the statute and regulations essentially incorporates the Beard test for whether a return is validly filed, as adopted by the Tax Court in Beard v. Commissioner, 82 T.C. 766 (1984).
The IRS rarely applies the First Time Abatement procedure to Form 5472 based penalties
Many have reported that the IRS has been automatically imposing Form 5472 penalties whenever a Forms 5472 is filed late. This automatic penalty is authorized by IRM 21.8.2.21.2 (4-28-2017). The automatic penalty assessment causes the IRS to issue a CP 215 notice to the taxpayer. The CP 215 notice starts the collection process. Tax professionals receiving CP 215 notices should file a request under the Freedom of Information Act (“FOIA”) requesting verification of the IRS’s compliance with IRC § 6751(b)’s managerial approval requirement.
The first-time abatement (FTA) penalty relief provisions rarely apply to event-based filing requirements, such as with Form 5472. However, the IRM authorizes abatement of the Form 5472 penalty if the related abatement on the Form 1120 was made using FTA. The Penalty Can Be Excused or Mitigated on a Showing of Reasonable Cause IRC § 6038A(d)(3) and Treas. Reg. § 1.6038A-4(b)(1) provide that “[c]ertain failures may be excused for reasonable cause, including not timely filing Form 5472, not maintaining or causing another to maintain records as required by § 1.6038A-3.” To show that reasonable cause exists, Treas. Reg. § 1.6038A-4(b)(2) requires that the Taxpayer make an affirmative showing of the facts in a written statement signed by the Taxpayer and submitted under penalties of perjury. Treas. Reg. § 1.6038A -4(b)(2)(iii) explains that the IRS determines whether a taxpayer acted with reasonable cause and in good faith on a case-by-case basis, considering all facts and circumstances. Under Treas. Reg. § 1.6038A-4(b)(2) reasonable cause includes but is not limited to:
1. Reliance on an information
return;
2. Professional advice;
3. A reasonable belief that the reporting corporation it is not owned by a 25-percent foreign share- holder; and
4. An honest misunderstanding of fact or law that is reasonable in light of the experience and knowledge of the taxpayer. Small taxpayers requesting penalty abatements should direct the examiner’s attention to Treas. Reg. §1.6038A-4(b)(2)(ii) which provides:
- The District Director shall apply the reasonable cause exception liberally in the case of a small corporation that had no knowledge of the requirements imposed by section 6038A;
- has limited presence in and contact with the United States; and promptly and fully complies with all requests by the District Director to file Form 5472, and to furnish books, records, or other materials relevant to the reportable transaction.
- A small corporation is a corporation whose gross receipts for a taxable year are $20,000,000 or less.
Tax professionals preparing reasonable cause statements should address the items referred to IRM Exhibit 21.8.2-2, Failure to File or Late-Filed Form 5472-Decision Tree.
The Statute of Limitation to Penalize a Taxpayer and/or Audit a Form 5472 does not begin until the
Form 5472 is filed. Besides the penalties resulting from not filing or late filing Forms 5472, failing to file Form 5472 extends the time that the IRS has to audit the taxpayer’s return.
Effective for tax years beginning after March 18, 2010, IRC § 6501(c)(8) states:
In the case of any information which is required to be reported to the Secretary pursuant to under. . . section[s] . . .
6038, 6038A, 6038B, 6038D, 6046, 6046A, or 6048, the time for assessment of any tax imposed by this title with respect to regarding any tax return, event, or period to which such information relates shall not expire before the date which is 3 years after the date on which the Secretary is furnished the information required to be reported under such section.
The statute of limitations for tax returns requiring a Form 5472 does not begin until the Form 5472 is filed. Failure to file Form 5472 thus risks giving the IRS an indefinite amount of time to assess penalties against the taxpayer.
The Recordkeeping Requirements of IRC § 6038A and IRC § 6038C have procedural and substantive due process consequences for the examination of Taxpayers Tax professionals accustomed to domestic substantiation cases will quickly observe that the first difference between the examination of a domestic and foreign corporation is that IRC § 6038A imposes a penalty for failure to maintain (or cause another to maintain) records as required.
Failure to maintain adequate records also comes with a $25,000.00 penalty per year. The IRC § 6038A penalty is also subject to a limitless continuation penalty. The penalties for failing to maintain records in IRC § 6038C which applies to foreign corporations engaged in US trade or business mirrors the language and requirements of IRC § 6038A. Penalties, including continuation penalties, for violations of both failure to file and failure to maintain adequate books and records can run concurrently; meaning that if a foreign-owned US corporation does not comply with both, it will be subject to two $25,000 penalties and to potentially double continuation penalties, which would amount to $50,000 per 30-day period.
Professionals representing small corporations should know that although small corporations must maintain records to substantiate deductions, they are exempt from penalties for failure to maintain these records. Likewise, reporting corporations making or receiving gross payments from foreign related parties regarding related party transactions will not be penalized for a failure to maintain records (or for a failure to authorize an agent under Treas. Reg. § 1.6038A-5) if the value of the transactions is not more than $5,000,000.00 or 10% of the company’s U.S. gross income.
The second difference between the examinations in domestic substantiation cases and cases involving foreign corporations is the IRS’s claim that the Cohan Rule (which allows the estimate of an expense where the taxpayer has established that the expense is a business expense but cannot prove the amount of the expense) does not apply. The IRS’s position results from the tension between Treas. Reg § 1.6038A-2’s authorization of “reasonable estimates” for
return preparation and the IRS discretion to reduce or deny the deduction for any amount paid or incurred by Taxpayer to a related party when the taxpayer has not kept “adequate records.”
As explained above, for purposes of determining whether a Form 5472 is filed, Treas. Reg. § 1.6038A-2(b) (6) authorizes a tax preparers use of reasonable estimates. In traditional audits, the tax professional argues that under the Cohan Rule taxpayers unable to produce records of actual expenditures may use indirect methods to substantiate their estimates and deductions.
By contrast, in the absence of books and records, IRC § 6038A(e)(3) allows the IRS to determine, in its sole discretion:
(A) the amount of the deduction allowed under subtitle A for any amount paid or incurred by the reporting corporation to the related party in connection with such transaction, and
(B) the cost to the reporting corporation of any property acquired in such transaction from the related party (or transferred by such corporation in such transaction to the related party).
IRS examiners contend that absent records, IRC § 6038A(e)(3) gives the IRS the discretion to reduce or deny the deduction for any amount paid or incurred by Taxpayer to a related party based on the failure to maintain adequate records. The IRS claims that the noncompliance penalty of IRC §6038A(e)(3) also applies in the case of a failure to substantially and timely comply with a summons to produce records or testimony during the examination. There are no reported cases on whether the Tax Court can review the reasonableness of the IRS’s exercise of discretion or on what the limits of that exercise of discretion might be.
Read together IRC § 6038A(e)(3) and IRC § 982 mean that failing to comply with the formal document requests issued by the IRS during an examination will preclude de novo review of an IRS determination. Another major difference in the Form 5472 examination is the document request process. Document requests in domestic examinations are not self-enforcing. If a taxpayer ignores or refuses to comply with an IDR or a summons, the IRS must bring a proceeding in US District Court to obtain the documents. The taxpayer’s failure to comply with an IRS document request had little consequence if the taxpayer petitioned the Tax Court. In Greenberg’s Express, the Tax Court held that the Tax Court trial is a de novo proceeding in which the administrative record is irrelevant.
In Form 5472 examinations the IRS is authorized by IRC § 982(c)(1) to issue a Formal Document Request (FDR) to any taxpayer to request foreign-based documentation. An FDR is “any request (made after the normal request = procedures have failed toproduce the requested documentation) for the productionof foreign-based documentation which is mailed by registered or certified mail to the taxpayer at his last known address and which sets forth” certain information. Documentation includes books and records; “foreign-based documentation” is defined as “any documentation which is outside the United States and which may be relevant or material to the tax treatment
of the examined item.” IRC § 982(d)(1), (2).
The FDR discourages taxpayers from delaying or refusing to disclose certain foreign-based information to the IRS. If the taxpayer fails to substantially comply with the FDR within 90 days of the mailing of the request and fails to bring a proceeding to have the FDR quashed, the statute imposes an exclusionary rule. In any subsequent civil proceeding concerning the tax treatment of an examined item, the court then having jurisdiction, on motion of the IRS, can prohibit the taxpayer from introducing any foreign-based documentation covered by the FDR.
An exception to this exclusionary rule will apply if the taxpayer establishes in that subsequent civil proceeding reasonable cause for non-compliance with the FDR. Any person mailed an FDR may begin a proceeding to quash the FDR if the proceeding is filed within 90 days after the FDR was mailed.
If the taxpayer files a proceeding, the Secretary may seek to compel compliance with the FDR in the same proceeding. If the taxpayer files a petition to quash the FDR but does not prevail, res judicata (which is a legal doctrine that prevents litigants from re-litigating a previously litigated matter or issue) applies so that the exclusionary rule will apply in any such subsequent civil proceeding if the taxpayer continues to fail to substantially comply with the FDR. Appeals Considers Challenges to Form 5472 Penalties Post Assessment IRC § 6038A(d) authorizes the IRS to assess applicable penalties without first sending a notice of deficiency. Existing procedures provide for the automatic assessment of the Form 5472 penalty. Appeal rights for Form 5472 are post-assessment pre-payment penalty rights.
IRC § 6751(b) provides: “No penalty under [the I.R.C.] shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” To comply with IRC § 6751(b), the initial penalty is asserted on a Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties. Once this Form 8278 is processed, the taxpayer will be sent a CP215, Notice of Penalty Charge. The collection process begins, regardless of whether the taxpayer includes with the late Forms 5472 a statement of reasonable cause or a Form 843 request for abatement.
If the taxpayer does not pay the penalty after the CP 215 notice, the IRS sends a CP 504B, Notice of intent to seize (levy) your property or rights to property, pursuant to IRC § 6330. This notice provides the taxpayer with the option of pursuing an Appeals conference, by filing a Form 9423, Collection Appeal Request. More importantly, a taxpayer can also file a Form 12153, Request for a Collection Due Process or Equivalent Hearing. To request Appeals Office consideration of the penalty and preserve the taxpayer’s rights for Tax Court prepayment review of the penalty, the taxpayer should request a de novo review of the penalty by requesting a Collection Due Process Hearing on Form 12153. The Form 12153 should also request that the Appeals Office verify compliance with IRC § 6751(b). Form 5472 based penalties must be approved, in writing, by the revenue agent’s manager, under IRC § 6751(b).
The manager must approve the case-control, sign the notice letters, and approve the penalty by signing the Form 8278 prior to closing the case. Tax professionals challenging the Form 5472 based penalty should request that the Appeals Office verify the IRS compliance with IRC § 6751(b). To obtain an expedited hearing, along with the Form 12153, the taxpayer should submit a Qualified Offer under IRC § 7430. IRM 8.7.15.1.4 (10-01-2012) provides that cases with qualified offers must be expedited and the Appeals Office will try to resolve the issues within 90 days of when the qualified offer is filed.
Substantive Tax relating to Form 5472 Tax Deficiency are Litigated In Deficiency Proceedings While Penalty Appeals are Litigated in Post-Collection Due Process Hearing Litigation Before the Tax Court If the IRS examination of Forms 5472 results in a deficiency determination, the taxpayer can file a petition for redetermination of the deficiency in the Tax Court. To date, the Tax Court has only issued one opinion: ASAT, Inc. v. Comm’r, 108 T.C. 147 (1997). ASAT reinforces the importance of recordkeeping and internal controls: Section 6038A was enacted to insure that the IRS would have either timely access to the information necessary to make a complete analysis of costs between related parties or the right to make an adjustment based solely on the information that it did have.
Whether the taxpayer can later justify a cost is irrelevant: Accordingly, the amounts established by the
Secretary cannot be overturned by a court on the basis that they diverge from actual costs or other amounts incurred, or on the basis that they do not clearly reflect income. The fact that amounts established by the Secretary can be proven to be clearly erroneous, by reference to information or materials that were not within the Secretary’s knowledge or possession, would not alone, in the conferees’ view, be sufficient cause for a court to redetermine allowable amounts of deductions and the costs of goods sold.
* * * [H. Conf. Rept. 101-386, at 594 (1989).]
By contrast, the Form 5472 compliance-related penalties are not subject to the notice of deficiency requirement in IRC § 6212 (i.e., the penalties are immediately assessable). If the taxpayer disagrees with the Appeals Office’s determination made at the Collection Due Process hearing, the taxpayer may appeal to the US Tax Court. The Tax Court is the only post-assessment pre-payment forum available outside of bankruptcy. Under IRC § 6330, a taxpayer has 30 days from the IRS’s determination (which must be left at taxpayer’s dwelling or sent by certified or registered mail to the taxpayer’s last known address) to petition for relief in Tax Court.
To initiate a Tax Court case, the taxpayer (now known as petitioner) will file a petition, designation for place of trial, and a statement with the taxpayer’s identification number, which will accompany a filing fee of $60 (made payable to Clerk, US Tax Court). Petitions must include, among other items, facts and legal theories on why the petitioner
should prevail. Any issue not contested in the petition is deemed conceded by petitioner (except for statutorily required issues, such as § 6751(b) compliance). Also, the notice being appealed must be attached and any taxpayer identification numbers (such as social security number) must be redacted. Form 5472 Litigation before the US Court of Federal Claims or the US District Court Except for litigation about FDRs, most tax litigation relating to Form 5472 is brought by taxpayers in the Tax Court because it is a pre-payment forum. However, some taxpayers may want to litigate in the US Court of Federal Claims or the US District Court. Before commencing suit in these courts, the taxpayer must first pay the tax and file a claim for refund from the IRS.
Claims for refund must include the grounds on which a refund is claimed and facts to support those grounds; all of which must be sworn to under penalties of perjury. There are no reported cases from US Court of Federal Claims or the US District Court that would allow us to opine on whether the refund litigation pertaining to Form 5472 is preferable to litigation before the Tax Court.
DIIRSP and Correcting the Failure to File a Form 5472
The Delinquent International Information Return Submission Procedure (“DIIRSP”) allows eligible taxpayers to correct their failure to file, as opposed to failure to comply with the record-keeping requirements, without penalty. DIIRSP allows taxpayers who are not compliant to file late returns if these criteria are met:
1. the taxpayer did not file one or more required international information returns;
2. the taxpayer has a reasonable cause for not timely filing the information return;
3. the taxpayer is not under a civil examinati on or criminal investigation by the IRS; and
4. the IRS has not already contacted the taxpayer regarding the delinquent return.
If a taxpayer has not filed a Form 5472, due to a reasonable cause, and the IRS is neither investigating him nor has contacted him, then he can file his delinquent returns without being penalized. The delinquent returns must be filed with a reasonable cause statement. This reasonable cause statement should include a certification that the foreign entity was not engaged in tax evasion. Reasonable cause statements should be attached to every delinquent return being filed. If the IRS does not accept the taxpayer’s reasonable cause then a penalty may apply. Anecdotal data suggests that the IRS is applying reasonable cause liberally when delinquent Forms 5472 are filed under the DIIRSP procedure.
Conclusion
One of the major trends in tax practice is the globalization of small business. To address the challenges of international tax administration, the IRS has increased its enforcement efforts on international information reporting and recordkeeping requirements and increased assessments of related penalties. Until recently, taxpayers, and many tax preparers, were unaware of the additional compliance obligations resulting from foreign investment in a domestic corporation or foreign business activity. The increased enforcement efforts together with the increased cost of non-compliance (i.e., penalties) now requires taxpayers to understand the reporting and recordkeeping requirements associated with IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business
