A foreign person (including a corporation) that is engaged in a U.S. trade or business generally is subject to tax on a net basis on its effectively connected income at a rate of 35%.
U.S. federal income tax law provides a safe harbor by exempting from U.S. trade or business status trading for one’s own account in stocks, securities (including debt instruments), commodities, and derivatives thereof. Most offshore funds rely on this exemption. The safe harbor does not apply to persons that are characterized as dealers for U.S. federal income tax purposes or for activities outside the scope of the exemption.
Many offshore corporations file a protective tax return to ensure both the ability to claim deductions as well as the running of a statute of limitations even though the safe harbor exemption should be available.
In general, the Internal Revenue Code provides that a foreign corporation will receive the benefit of deductions and credits only by “filing or causing to be filed with the Secretary a true and accurate return.” Treasury regulations generally provide that such a return is timely only if it is filed within 18 months of the ordinary due date for the return.
In Swallows Holding, Ltd. v. Commissioner, 126 T.C. No. 6 (Jan. 26, 2006), the Tax Court has ruled that the timely filing requirement in the regulations is invalid.
The decision will be welcomed by foreign corporations that did not file protective returns within the time frame required by the regulations but would now like to do so. Under this decision, a foreign corporation that files a delinquent U.S. income tax return would still receive the benefits of the deductions and credits allowed to it under the Code if the return is filed before the IRS files a substitute return in the taxpayer’s name.
The Tax Court held that the taxpayer would be allowed the benefit of its deductions, notwithstanding that the return was filed after the expiration of the regulatory due date and the taxpayer did not qualify for any other relief. The court made clear that the taxpayer’s ability to file late returns was not without limit–if the IRS files a substitute return on behalf of the taxpayer, the ability to benefit from deductions and credits is generally lost. Accordingly, taxpayers that want to take advantage of this opinion, assuming that it is not overturned on appeal, should file protective returns to preserve the benefit of deductions and credits.
Howard Leventhal, (212) 773-0574, email@example.com, co-national director of Ernst & Young’s Asset Management Tax Practice, is a partner in Ernst & Young’s Global Hedge Fund Practice and is based in the firm’s Financial Services Office. Debra F. Taylor, (212) 773-2978, firstname.lastname@example.org International Tax principal, is also based in Ernst & Young’s Financial Services Office.
Contact Bob Keane with questions or comments at email@example.com.