4.1.8  Special Examination Features and Programs  (10-24-2006)

  1. This chapter provides guidance and instruction on the classification and assignment of returns with international issues.  (10-24-2006)
Standards for Classification

  1. In selecting returns for examination, consider the objectives of the International Enforcement Program. Select returns that contain significant international issues that are:

    1. Likely to result in tax changes

    2. Require examination to achieve voluntary compliance by an identifiable group

  2. General procedures in this IRM, and in the Law Enforcement Manual,are applicable to international classifiers.  (10-24-2006)
General Information

  1. Generally, returns received for classification for international potential will already have been classified for domestic issues. The international examiner, subject to Area instructions to the contrary, will not screen returns for domestic issues.

  2. Returns accepted as filed for international features during centralized classification that have not been previously classified for domestic issues will be routed through regular classification at the campus.

  3. Returns selected for international features will be routed to the PSP Territory Manager in the Area office. These returns will be filed in Central Files, Priority Suspense Files, or assigned to groups following Area procedures.

  4. Review the attached Form 5546, Examination Returns Charge-Out. This document contains information that may be beneficial when deciding whether to select or accept a return.

  5. AIMS—Use of Forms and Special Handling Notices Handbookhighlights areas of the Form 5546used for classification. It contains a detailed explanation of all items on the Form 5546.

  6. In classifying a return, if the classifier determines the taxpayer is part of an identified LMSB coordinated examination, transfer to the appropriate LMSB industry.

  7. International classifiers separate returns into six categories:

    1. Domestic issues not classified—selected for International

    2. Domestic issues not classified—accepted for International

    3. Accepted on classification for domestic issues—selected for International

    4. Accepted on classification for domestic issues—accepted for International

    5. Open in Area

    6. Transfers (show transferee Area)

  8. Classification stamps provided for selected and accepted international returns are:

    1. Returns not having international potential are stamped as follows:
      " International—Accepted as Filed Referral Not Mandatory "

    2. Returns having International potential, or meeting mandatory selection criteria, are stamped as follows:
      " International—Selected "  (10-24-2006)
Procedures for Processing International Returns During Classification

  1. With returns meeting mandatory selection criteria and/or selected for examination based on international features, international classifiers will:

    1. Affix AIMS status update labels to Form 5348(Examination Update).

      If a return has: Then
      Tax Haven issues Place a red "T" for Tax Haven in the lower left-hand corner of the AIMS status date label.
      A Form 5713 Place a red "B" for Boycott in the lower left-hand corner of the AIMS status update label.

    2. Stamp " International—Selected " on the face of return.

  2. For returns accepted as filed during international classification, classifiers will:

    1. Affix AIMS status update label to Form 5351Nonexamined Closing.

    2. Place a red "B" in the lower left-hand corner of labels if returns have a Form 5713 .

    3. Stamp returns:
      " International—Accepted as Filed Referral Not Mandatory "

  3. Chief, Classification Section will ensure that:

    1. Copies of Form 5348 and Form 5351 are forwarded to the Unit Manager of Central Files and Scheduling..

    2. Selected cases, except returns with tax havens, are updated to Project Code 090 before forwarding to Area PSP Territory Managers.  (10-24-2006)
Procedures for Processing Form 1120F Returns During Classification

  1. Form Form 1120F returns are filed at the Ogden Campus.

  2. All returns with assets < $ 10 million are the jurisdiction of SBSE and are classified by SBSE international examination personnel.

  3. All returns with assets > $10 million are the jurisdiction of LMSB and are to be classified by international examiners.

  4. The returns selected for examination will be updated to Project Code 0162.  (10-24-2006)
Procedures for Processing Form 1040 Returns with Form 2555 During Classification

  1. Returns claiming the foreign earned income exclusion on Form 2555 are filed at the Ogden Campus and are under the jurisdiction of SBSE International.

  2. The following factors must be considered when classifying these returns:

    1. Is the income from all foreign sources reported on the U.S. income tax return?

    2. Has the taxpayer used the proper exchange rate for converting the foreign income?

    3. Is the taxpayer an employee of the U.S. Government?

    4. Is there a Form 1116Computation of Foreign Tax Credit—Individua, Fiduciary, or Non-Resident Alien Individual) attached to the return?

    5. If Form 1116is attached to the return, determine if the credit claimed is at the treaty rate or at the foreign country’s statutory rate. A citizen or resident claiming the treaty benefit from a foreign country is limited to the treaty rate as a foreign tax credit or deduction on the tax return. Rev. Rul. 57–116, 1957–1, C.B. 245,, states in part the allowance of a credit for taxes paid to a foreign country is limited to the tax that is a legal and actual liability. Tax withheld at the source is merely an advance collection of what may or may not be an actual tax liability.  (10-24-2006)
Classifying or Screening Foreign Corporate Returns (Form 1120F)

  1. Every foreign corporation, whether a resident or nonresident, which is subject to tax under Subtitle A of the Internal Revenue Code must file a Form 1120F, regardless of whether it has taxable income or gross income. If it has no gross income for the taxable year, it is not required to complete the return schedules. However, it must attach a statement to the return showing the nature of any exclusions claimed and the amount of such exclusions to the extent they are readily determinable.

  2. A Form 1120F is similar to Form 1120 filed by a U.S. corporation. The major difference is an additional section on Form 1120F for U.S. source income not effectively connected with a U.S. trade or business. Unlike a U.S. corporation, which is required to include worldwide gross income on Form 1120, a foreign corporation includes on Form 1120F only:

    1. U.S. source income not effectively connected with a U.S. trade or business ( IRC §881)

    2. Gross income effectively connected with a U.S. trade or business, regardless of the source IRC §8812 )  (10-24-2006)
Identification of Issues on Form 1120F Returns

  1. Effectively connected income is income generated from the active conduct of a trade or business in the United States. During classification:

    1. Review questions "A" through "L" on page 1 and questions "M" through "P" on page 5. Pay particular attention to location of books and records, type of business, and foreign country.

    2. Foreign-sourced business profits are taxable in the United States, if they are attributed (effectively connected) to the U.S. business.

    3. Check to see if interest, dividend, or other passive type income is being reported as effectively connected income (Section II of Form 1120F) as opposed to not effectively connected income (Section I of Form 1120F) and, therefore, subject to tax at a flat rate with no deduction allowed, particularly if the return is showing a loss in Section II. Check the balance sheet to see if there are investments that should be paying interest or dividends.

    4. Check foreign-sourced income that is being excluded on Schedule M–1. Are deductions being allocated to U.S. sourced and foreign sourced income? Are the allocated deductions being excluded in Schedule M–1.

    5. Review IRC §864(c)(4) for the definition of other types of income from sources outside the United States

  2. Review the definition in Treasury Reg. 1.864–2. Note those activities that are not included in the general definition of a trade or business. Review questions "A" through "F" on page 1 of the tax return and "M" through "P" on page 5. Does the taxpayer meet the treaty definition of a trade or business? Indications of a U.S. place of business are:

    • The return address

    • Rents being paid and deducted on page 3

    • Property taxes paid and depreciation schedule deductions

    • Salaried employees

    • Location of books and records

  3. Treaty Benefits:

    1. Check tax rates on income reported on page 2, which is not effectively connected income.

    2. If a treaty country is involved, rates could be different.

  4. Schedule M–1 or M–2:

    1. If foreign sourced income or tax-exempt income is excluded for tax purposes, are there corresponding adjustments to deductions? Is income excluded reasonable in relation to the type of business?

    2. Are there any distributions that may be subject to IRC §1042withholding?

  5. IRC §1042 Liability:

    1. Check Schedule M–2 for any distributions that may be subject to withholding.

    2. Is the taxpayer paying interest, rent, royalties, or contract labor to foreign sources that could be subject to withholding? Besides Schedule II deductions, consider excluded deductions on Schedule M–1, or expenses used in the computation of a foreign tax credit.

  6. Home Office Expense or General and Administrative Expense:

    1. Review the method of allocating home office expense to the U.S. operation.

    2. Is the allocation made among U.S. source, foreign source, and tax exempt income?

  7. Banks must report U.S. and foreign sourced income if effectively connected with a U.S. business, unless the income is excluded by treaty.

    1. Check treaty provisions if income is excluded on the return.

    2. If income is excluded under the treaty, or is tax exempt, check for allocation of expenses to the excluded income.

    3. Check for computation of interest expense under Treas Reg. 1.882–5, Determination of interest deduction.

    4. Check allocation of home office expenses to U.S. trade or business including allocation to excluded income.

    5. Computation of Reserves for Bad Debts— If the percentage method is used, verify allowable percentage of eligible loans; eligible loans at year end [Treas.Reg. 1.585-1]; loans applicable to foreign sourced income for purposes of minimum tax preference items; and write-offs.

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