I.R.S. Explains 'Substantially Complete' In Relation To International Information Return

BACKGROUND

While determining whether a taxpayer has complied with its obligation to provide the I.R.S. with information on its international operations as required by Code §6038 for outbound transactions and by Code §6038A for inbound transactions, it is important that the taxpayer's information return is substantially complete. If it is not, penalties may be imposed for failure to comply with the taxpayer's information reporting obligation. Code §6038 requires certain U.S. persons who are officers, directors, or shareholders of foreign corporations to file Form 54711 with respect to each foreign corporation and foreign partnership that they control. Similarly, Code §6038A requires a U.S. corporation that is 25% foreign owned to furnish Form 54722 to the I.R.S.

Where a Form 5471 submitted by a filer omits certain required information or contains erroneous information, the filer may be relieved from penalty if, notwithstanding these shortfalls, the information in the return is substantially complete so that the I.R.S. may conclude that substantial compliance exists.3 The same holds true for an incomplete Form 5472.4 Thus, a taxpayer must substantially comply with the reporting obligations by providing substantially complete information returns in order to avoid penalties. However, the terms "substantially complete" and "substantially incomplete" are not defined in the Code or its regulations.

This article will discuss an I.R.S. Practice Unit published recently that addresses the I.R.S.'s view of substantial compliance in the context of existing U.S. case law.

" SUBSTANTIALLY COMPLETE" / " SUBSTANTIAL COMPLIANCE" - I . R. S. EXPLANATION

On June 19, 2017, the Large Business & International Division ("L.B.&I.") of the I.R.S. issued a Practice Unit5 providing guidance as to the meaning of the term "substantially complete" with respect to international information return penalties. It provides informal guidance to I.R.S. agents examining (i) a U.S. entity with foreign ownership, or (ii) a U.S. branch or subsidiary of a foreign corporation, for purposes of determining whether the required international information return is substantially complete, so that the filing requirement is met.

The Practice Unit begins by explaining the substantial compliance doctrine, which is a judicial concept that applies to certain tax returns, elections, and substantiation of deductions. While the concept of substantially complete has not been the subject of judicial review, the body of case law concerning the substantial compliance doctrine provides guide posts for how a court may interpret whether an international information return is substantially complete. This background can be applied to supplement existing informal guidance on substantial completion or, where the I.R.S. has not provided specific informal guidance, this background can suggest a general approach for an I.R.S. examiner to follow.

The Practice Unit discusses the difference between the strict compliance and substantial compliance doctrines. If a particular item of information or requirement at issue is determined to be related to the "substance or essence" of the statute or regulation, strict compliance is necessary. However, if the requirement is seen as "procedural or directory," then substantial compliance will suffice.

In the context of a full income tax return, the Practice Unit looked to Beard v. Commr.6 for guidance. There, the Tax Court summarized the requirements for a tax return to be considered valid for triggering the start of the period of limitations on assessment:

It must provide sufficient data to calculate tax liability. It must purport to be a return. It must reflect an honest and reasonable attempt to satisfy the requirements of the tax law. It must be signed under penalties of perjury. If a return fails to meet these requirements, it will not be considered valid and will not trigger the running of the statute of limitations. The Practice Unit then proceeded to address whether an election authorized by law is substantially complete. Taylor v. Commr.7 involved an election under prior law that allowed a farmer to obtain a certain tax benefit in connection with the sale of livestock. When made, the election prevented the application of a recapture rule that would convert some or all of the gain into ordinary income. The taxpayers followed the basic requirements for favorable treatment - including reporting the gain on a tax return - but failed to file a formal election to report the gain as capital gain. The statute required a taxpayer to file an election for the favorable treatment with the following language:

(B) Time, manner, and effect of election. — An election * * * for any e filed within the time prescribed by law (including extensions thereof) for filing the return for such taxable year, and shall be made and filed in such manner as the * * * [I.R.S.] shall prescribe by regulations. Such election shall be binding on the taxpayer for such taxable year and for all subsequent taxable years and may not be revoked except with the consent of the * * * [I.R.S.].8

In the case, the I.R.S. argued that the election was necessary for it to identify those taxpayers that claimed the benefit of the provision so that the validity of elections could be reviewed easily. To that end, the I.R.S. characterized the election as "indispensable to the smooth administration of the revenue laws." Nonetheless, the court determined that the I.R.S. had all information within the return to determine that an election was made. The taxpayer was in substantial compliance with Code §1251(b)(4)(B).

The test for determining the applicability of the substantial compliance doctrine has been the subject of a myriad of cases. The critical question to be answered is whether the requirements relate "to...