A recent tax court case highlights the nearly unbelievable risks for foreign corporations that fail to report their United States based income. In Adams Challenge Limited v. Commissioner of the Internal Revenue Service a UK company chartered a large vessel to a U.S. company. That vessel assisted in the removal of debris and the decommissioning of oil and gas wells in the U.S. Continental Shelf in the Gulf of Mexico. The gross income (the total amount paid to the company, not considering any expenses) was around $32,000,000. This UK company did not file any returns with the U.S. and maintains that they were unaware of any obligation to file returns in the U.S. They must have been shocked when two years after the tax period in question, they received a bill from the IRS for over $23,000,000.
There are two interesting components to this particular assessment, and you can be the judge of which is more outrageous. The first component is the factual circumstances that led to this assessment, and the second is the law that has been applied to dramatically increase the assessment.
Let’s start with the factual circumstances. This company, which we will call ‘Taxpayer’, was a UK company that chartered out a vessel to a U.S. company. Taxpayer didn’t provide any information to the IRS, and maintains that they had no idea that they had an obligation to file in the U.S. The question then becomes, how did the IRS become aware of Taxpayer’s activity to make the determination that this was income effectively connected to a U.S. trade or business? They must have gotten the information from the U.S. company that chartered the vessel, right? Wrong. The IRS started a compliance initiative specifically targeting foreign vessels operating on the Outer Continental Shelf.
Let’s take a step back and speculate as to how this initiative developed. Someone at the IRS thought - ‘hmmm, boats are really expensive, and there are foreign boats cruising around the U.S. all the time, there has to be some money that we can find there’ - That line of inquiry develops into - ‘well, there are a lot of really expensive boats working on oil and gas related things, a valuable industry’ - Next thing you know the IRS is looking for foreign boats near the Outer Continental Shelf that they can use to generate gigantic tax assessments.
Now let’s stop speculating and discuss how the IRS actually found these ships and made these assessments. Would you believe they identified these ships using satellite tracking tools? That is exactly how they identified them. Using satellite tracking tools, they determined the number of days that the vessels were working on the Outer Continental Shelf. The IRS then used a private company that provided the average day rate for different types of vessels, multiplied that rate by the number of days and decided that this was the amount of unreported U.S. income for the foreign vessels.
I hate to take another step back, but is the day rate for renting something really equivalent to the longer term rate you would pay to rent it for a year or even a month? How does your one night in a hotel room stack up to 1/30th of your rent or your mortgage?
Now that we’ve covered the factual component, let’s turn to the legal component that highlights the unbelievable nature of this assessment. After the IRS made this assessment against Taxpayer, Taxpayer prepared and submitted tax returns, 1120-Fs, for the years in question. The IRS took those returns, hopped over to the list of expenses associated with the income, and DELETED ALL OF THEM. Taxpayer was unable to deduct any of the associated expenses against the income that they earned. Even more surprising, based on the law, the IRS had the right to disregard these expenses.
Internal Revenue Code section 882(c)(2) states(in relevant part): A foreign corporation shall receive the benefit of the deductions and credits allowed to it in this subtitle only by filing or causing to be filed with the Secretary a true and accurate return, in the manner prescribed in subtitle F, including therein all the information which the Secretary may deem necessary for the calculation of such deductions and credits. …
The natural counter argument, that they did file a return after the IRS put them on notice of their obligation, was not accepted by the court: “‘the Commissioner's preparation of a substitute return for the corporation is generally considered to be the corporation's return for Federal income tax purposes and divests the taxpayer of its entitlement to file a return for itself.’ … noting that this Court had previously “reject[ed] any argument that the taxpayer's returns [submitted after the IRS had prepared returns for it] were 'returns' for this purpose.).”
Taxpayer next argued that he was entitled to deductions under the income tax treaty, but the court disagreed with this argument as well.
This leaves Taxpayer staring down the barrel of an enormous assessment, an assessment that includes interest and penalties.
Where does it leave every other foreign company that could potentially have U.S. source income? Probably awfully motivated to file returns to disclose their U.S. income, an effect that was certainly one of the primary objectives of the IRS in creating this initiative.
Even more frightening than the outcome in this case, is the possibility that this code section that disallowed Taxpayer’s expenses could also be used to disallow the expenses of companies that file returns that have mistakes, because under this statute, a company can lose the right to claim deductions if the return they file isn’t ‘true and accurate.’