The IRS issued a much-needed clarification on the meaning of “substantially complete” in the context of international taxes. The clarification was issued in a long-awaited International Practice Unit (IPU). This update provides much-needed guidance to help ensure that international informational returns are substantially complete to avoid significant penalties. Practice Units are not official pronouncements of law or directives and cannot be relied on as such.
The IPU discusses the meaning of the phrase “substantially complete” for the purpose of evaluating whether certain international information returns are sufficient enough to avoid penalties under Code Sec. 6038 and Code Sec. 6038A.
In the IPU, the IRS stated that the Substantial Compliance Doctrine may be used either to supplement the existing guidance or to suggest a “general approach” in the absence of other guidance, even though the phrase “substantially complete” is not defined in regulations or by statute.
The IPU also noted that two standards may apply – strict compliance and substantial compliance – when determining whether a tax return satisfies a reporting requirement, or whether a taxpayer has complied with a statute or regulatory requirement. Accordingly, courts can consider whether the particular information or requirement goes to the “substance or essence” of the statute or regulation to determine which standard applies. In this case, strict compliance is necessary. Conversely, if the requirement is “procedural or directory,” substantial compliance may apply.
In regard to a return, the IPU refers to the “Beard” test by which a tax return will generally be considered valid (in other words, will satisfy the substantial compliance doctrine) for purposes of beginning the statute of limitations on assessments if the following conditions are met:
- It provides sufficient data to calculate tax liability
- The document purports to be a return
- There has been an “honest and reasonable attempt” to satisfy tax law requirements
- It is signed under penalties of perjury
In regard to elections, the IPU observed that the doctrine of substantial compliance often applies in cases where taxpayers fail to strictly comply with certain requirements that do not go to the “substance” of the election itself but are intended instead to provide information that is helpful to the IRS.
Generally speaking, the IRS noted that strict compliance applies to statutory requirements, while substantial compliance applies to regulatory requirements.
Understanding Code Sec. 6038 and Code Sec. 6038A
Code Sec. 6038 specifies that certain U.S. persons who are officers, directors or shareholders in foreign corporations must file an information return with respect to each foreign corporation and foreign partnership “controlled” by them. With regard to foreign corporations, the U.S. person must file Form 5471 – “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.”
Code 6038A specifies that a U.S. corporation that is “25% foreign-owned” must furnish certain information to the 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 the form used for this requirement.
Penalties await taxpayers who don’t comply
It’s important to note that a taxpayer that is required to but does not file one of the above forms by the due date and in the manner prescribed may be subject to penalties under Code Sec. 6038(b) and Code Sec. 6038A(d). That said, exceptions do apply. Specifically, under Reg. §1.6038-2(k)(3)(ii), a taxpayer may be relieved from liability for the penalty if the IRS determines that said taxpayer “substantially complied” with Code Sec. 6038’s reporting requirements.
Likewise, Reg. §1.6038A-4(a)(1) provides that a taxpayer that files a “substantially incomplete” return is subject to penalty; yet said taxpayer could be relieved from liability if the IRS determines that such taxpayer “substantially complied” with code Sec. 6038A’s reporting requirements.
In addition to the information outlined above, the IPU also offers clarity on issues related to income tax returns vs. information returns, as well as “substantially complete” international information returns.
Do you have questions about this IPU, or other international tax issues? Please contact your MarksNelson professional at 816-743-7700.