- 4.1.8 Special Examination Features and Programs
- 220.127.116.11 Overview
- 18.104.22.168 Standards for Classification
- 22.214.171.124.1 General Information
- 126.96.36.199.2 Procedures for Processing Form 1120-F Returns During Classification
- 188.8.131.52.3 Procedures for Processing Form 1040 Returns With Form 2555 During Classification
- 184.108.40.206.4 Classifying or Screening Foreign Corporate Returns (Form 1120-F)
- 220.127.116.11.5 Identification of Issues on Form 1120-F Returns
Part 4. Examining Process
Chapter 1. Planning and Special Programs
Section 8. Special Examination Features and Programs
June 18, 2014
(1) This transmits revised IRM 4.1.8, Planning and Special Programs, Special Examination Features and Programs.
(1) Minor editorial changes were made throughout this IRM. Form and IRM references were reviewed and updated as necessary.
(2) Throughout this IRM, Large and Mid-Size Business (LMSB) references was changed to Large Business and International (LB&I) to reflect the name change. Also the IRM was updated to reflect SB/SE International moving to LB&I International Individual Compliance (IIC).
(3) Deleted IRM 18.104.22.168.2, Procedures for Processing International Returns During Classification, as a separate section. Procedures for classification of international returns are throughout this IRM.
Acting Director, Examination Planning & Delivery
This chapter provides guidance and instruction on the classification and assignment of returns with international issues.
In selecting returns for examination, consider the objectives of the international enforcement program. Select returns that contain significant international issues that are as follow:
Likely to result in tax.
Require examination to achieve voluntary compliance by an identifiable group.
Generally, returns received for classification for international potential will have already been classified for domestic issues. The international examiner, generally will not screen returns for domestic issues.
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.
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.
Returns identified as part of a Large Business and International (LB&I) coordinated examination during classification are transferred by the classifier to the appropriate LB&I industry.
International classifiers separate returns into six categories:
Domestic issues not classified—selected for international
Domestic issues not classified—accepted for international
Accepted on classification for domestic issues—selected for international
Accepted on classification for domestic issues—accepted for international
Open in an area
Transfers (show transferee area)
Classification stamps provided for selected and accepted international returns are as follow:
Returns not having international potential are stamped
"International—Accepted as Filed; Referral Not Mandatory"
Returns having International potential, or meeting mandatory selection criteria, are stamped
IRM 4.4.1, AIMS Procedures and Processing Instructions, highlights areas of the Form 5546, Examination Returns Charge-Out, used for classification.
It contains a detailed explanation of all items on the Form 5546.
Form 5546 should be reviewed because it contains information that may be beneficial when deciding whether to select or accept a return.
Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, returns are filed at the Ogden Campus.
All returns with assets > $ 10 million are the jurisdiction of LB&I International Individual Compliance (IIC) and are classified by LB&I, IIC examination personnel.
All returns with assets < $10 million are the jurisdiction of LB&I International Business Compliance (IBC) and are to be classified by international examiners.
The returns selected for examination will be updated to Project Code 0162.
Returns claiming the foreign earned income exclusion on Form 2555, Foreign Earned Income, are filed at the Austin Campus and are under the jurisdiction of LB&I, (IIC). Refer to IRM 22.214.171.124.5, Classification of Returns, and IRM 126.96.36.199.17, Form 1040 Returns With Form 2555.
The following factors must be considered when classifying these returns:
Is the income from all foreign sources reported on the U.S. income tax return?
Has the taxpayer used the proper exchange rate for converting the foreign income?
Is the taxpayer an employee of the U.S. government?
Is there a Form 1116, Foreign Tax Credit, attached to the return?
If Form 1116 is 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.
Every foreign corporation, whether a resident or nonresident that is subject to tax under Subtitle A of the Internal Revenue Code must file a Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, regardless of whether it has taxable income or gross income. If a foreign corporation has no gross income for the taxable year, it is not required to complete the return schedules. However, the foreign corporation must attach a statement to the return showing the nature of any exclusion claimed and the amount of such exclusion to the extent it is readily determinable. A Form 1120-F is similar to a Form 1120, U.S. Corporation Income Tax Return, filed by a U.S. corporation. The major difference is an additional section on Form 1120-F 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 1120-F only the following:
U.S. source income not effectively connected with a U.S. trade or business. See IRC 881.
Gross income effectively connected with a U.S. trade or business, regardless of the source. See IRC 882.
Effectively connected income is income generated from the active conduct of a trade or business in the United States. During classification:
Review questions "A" through "M" on page 1 and questions "N" through "R" on page 2 of Form 1120-F. Pay particular attention to location of books and records, type of business, and foreign country.
Foreign-sourced business profits are taxable in the United States if they are attributed (effectively connected) to the U.S. business.
Check to see if interest, dividend, or other passive type income is being reported as effectively connected income (Section II of Form 1120-F) as opposed to not effectively connected income (Section I of Form 1120-F) 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.
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?
Review IRC 864(c)(4) for the definition of other types of income from sources outside the United States.
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 "N" through "R" on page 2. Does the taxpayer meet the treaty definition of a trade or business? Indications of a U.S. place of business are as follows:
The return address
Rents being paid and deducted on page 3
Property taxes paid and depreciation schedule deductions
Location of books and records
Consider if there are tax treaty benefits:
Check tax rates on income reported on page 2, which is not effectively connected income.
If a treaty country is involved, rates could be different.
Review Schedule M–1 or M–2:
If foreign sourced income or tax-exempt income is excluded for tax purposes, are there corresponding adjustments to deductions?
Is the income excluded reasonable in relation to the type of business?
Are there any distributions that may be subject to IRC 1042 withholding?
Determine if there is IRC 1042 liability:
Check Schedule M–2 for any distributions that may be subject to withholding.
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.
If there are home office expense or general and administrative expense deductions:
Review the method of allocating home office expense to the U.S. operation.
Is the allocation made among U.S. source, foreign source, and tax exempt income?
Banks must report U.S. and foreign sourced income if effectively connected with a U.S. business, unless the income is excluded by treaty.
Check treaty provisions if income is excluded on the return.
If income is excluded under the treaty, or is tax exempt, check for allocation of expenses to the excluded income.
Check for computation of interest expense under Treasury Reg. 1.882–5, Determination of Interest Deduction.
Check allocation of home office expenses to U.S. trade or business including allocation to excluded income.
Review the computation of reserves for bad debts—If the percentage method is used, verify allowable percentage of eligible loans; eligible loans at year end [Treasury Reg. 1.585-1]; loans applicable to foreign sourced income for purposes of minimum tax preference items; and write-offs.