The IRS has recently explained the Code Sec. 6679 penalty for certain U.S. persons that are required to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, but fail to file, fail to file on time, or file an incomplete form.
In a recently updated international practice unit (IPU), the IRS includes, amongh other things, insight a to what constitutes reasonable cause for failure to file.
What is an IPU?
IPUs are not official IRS pronouncements of law or directives and cannot be used, cited, or relied upon as such. Nonetheless, they identify strategic areas of importance to IRS and can provide valuable insight as to how IRS examiners may audit a particular issue or transaction.
Code Sec 6046
Under Code Sec. 6046, an information return on the acquisition of stock of a foreign corporation must be filed by:
A U.S. citizen or resident who is at any time an officer or director of a foreign corporation, more than 10% (by vote or value) of whose stock is owned by a U.S. person (USP; i.e., a U.S. citizen or resident, a domestic corporation or partnership, or certain estates or trusts);
A USP who acquires stock in a foreign corporation which, when added to his previous holdings, equals 10% or more (by vote or value) of the total stock of the corporation, or who acquires an additional 10% (by vote or value) of the stock;
A USP who is treated as a U.S. shareholder of a foreign corporation;
A person who becomes a USP while owning 10% or more (by vote or value) of a foreign corporation’s stock.
Form 5471 is used by certain U.S. citizens and residents who are officers, directors, or shareholders in certain foreign corporations to satisfy the reporting requirements of Code Sec. 6046. It is filed by attaching it to an individual income tax return, a partnership return, a corporation return, an estate return or a trust return, by the due date including extensions for that return.
Code Sec. 6679(a)
Under Code Sec. 6679(a), any person required to file an information return under Code Sec. 6046(a) who fails to file the return, fails to file the return by its due date, or files a return which does not show the required information, is subject to an initial penalty of $10,000 unless it is shown that the failure is due to reasonable cause. In addition, a continuation penalty of $10,000 per Form 5471 is imposed for every 30-day period (or fraction thereof) beginning 90 days after the USP was notified that a failure exists. The maximum continuation penalty per Form 5471 is $50,000 (for a total maximum penalty of $60,000). These penalties may apply to each required Form 5471.
Category 2 & Category 3 filers
The instructions for Form 5471 separate USPs into different filing categories based on their relationship to the foreign corporation. Which category the USP is in determines what information the USP is required to provide. The IPU concerns penalties on Category 2 filers and Category 3 filers, who are subject to the Code Sec. 6046 reporting requirements.
A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which a USP has acquired, in one or more transactions:
Stock which meets the 10% stock ownership requirement (described below) with respect to the foreign corporation, or
An additional 10% or more (in value or voting power) of the outstanding stock of the foreign corporation.
For purposes of both Categories 2 and 3, the stock ownership threshold is met if a USP owns 10% or more of the:
Total value of the foreign corporation’s stock, or
Total combined voting power of all classes of stock with voting rights. (Reg. § 1.6046-1(a), Reg. § 1.6046-1(c))
A USP is treated as having acquired stock in a foreign corporation when the person has an unqualified right to receive it. (Reg. § 1.6046-1(f)(1))
A Category 3 filer is:
A USP who acquires stock in a foreign corporation which, when added to any stock owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation,
A USP who acquires stock which, without regard to stock already owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation,
A person who is treated as a U.S. shareholder under Code Sec. 953(c) with respect to the foreign corporation,
A person who becomes a USP while meeting the 10% stock ownership requirement with respect to the foreign corporation,
A USP who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the 10% stock ownership requirement. (Code Sec. 6046, Reg. § 1.6046-1(c))
There are a number of exceptions to the filing requirement for Category 2 and 3 filers, including when multiple persons are required to file Form 5471 and applicable schedules with respect to the same foreign corporation for the same period (in which case the form may be jointly filed). In addition, Category 3 filers are not required to file in certain situations where the USP has no direct ownership in the foreign corporation (i.e., under the “constructive ownership” exception in Reg. § 1.6046-1(e)(4)(iii)), and Category 2 filers don’t have to file the form if, immediately after a reportable stock acquisition, three or fewer USPs own 95% or more in value of the outstanding stock of the foreign corporation and the USP making the acquisition files a return for the acquisition as a Category 3 filer. (Reg. § 1.6046-1(e)(4)(ii))
Guidance for examiners. IRS examiners are instructed to determine whether a taxpayer who is required to file Form 5471 in fact filed a timely and accurate form. As noted above, the Form 5471 is due when the USP’s income tax return is due, with extensions (and taking into account if the last day for filing was a weekend or legal holiday), and must be filed with that return. If one was not timely filed, or it wasn’t complete, then penalties may be asserted unless the failure was due to reasonable cause. While identifying Forms 5471 that were required, but not filed, for the exam year(s), examiners are instructed to consider reviewing whether similar failures occurred in earlier tax years.
The IPU notes that the related income tax returns for the prior years are not required to be under exam to assess penalties under Code Sec. 6679. In determining whether the Form 5471 was complete, examiners should make sure that the following aren’t omitted or incorrect: the category of the filer, the percentage of the foreign corporation voting stock owned, certain information regarding the foreign corporation (e.g., address, principal business activity), and the “reference identification number”. Common types of noncompliance include stating that required information will be furnished upon request or audit and providing consolidated financial statements of multiple foreign corporations.
The IPU notes that the doctrine of substantial compliance may apply in considering whether a Category 2 or 3 filer timely filed complete Form(s) 5471. Once the examiner determines that the taxpayer failed to file a timely and accurate information return, the examiner should establish a penalty case file and issue the notice letter. The notice letter should inform the USP of its failure to file Form 5471 (or failure to file a timely or complete form) and explain that the initial penalty will be imposed and that the continuation penalty (described above) will apply if a complete Form 5471 isn’t provided. The notice letter should be mailed as soon as possible, both to obtain information early to effectively conduct the exam, and to start the 90-day notice period under Code Sec. 6679. While there is no provision under Code Sec. 6679 to extend the 90-day period, such extensions can be allowed when reasonable, such as for extreme hardship or a natural disaster.
Examiners are cautioned not to discuss the notice letter, or penalty issues generally, with a representative who isn’t authorized for such discussions. A representative must be designated on a Form 2848, Power of Attorney and Declaration of Representative, and the entry describing the matter should include words similar to “Miscellaneous Penalty Under IRC 6679”. The IPU cautions that a power of attorney for the underlying income tax return does not cover the penalty issue. In determining penalties under Code Sec. 6679, the examiner must consider whether the taxpayer has shown that its failure was due to reasonable cause. Only the initial $10,000 penalty, and not the continuation penalty, can be considered for the reasonable cause exception.
The USP must provide a written statement that provides all of the facts alleged as reasonable cause, as well as a declaration that the statement was made under penalties of perjury, as required under Reg. § 301.6679-1(a)(3). Examiners should consider the USP’s compliance with Code Sec. 6046 reporting and recordkeeping requirements, and whether the USP exercised ordinary care and prudence but was nonetheless unable to provide any item of information required under Code Sec. 6046. Facts indicating reasonable cause include erroneous advice, an inability to obtain records, and death or serious illness. . The fact that a foreign jurisdiction would penalize the taxpayer for disclosing the information doesn’t generally constitute reasonable cause. Form 8278 is the assessment document for international penalties. If both a continuation penalty and initial penalty are proposed, a separate Form 8278 is required for each.