Is a summons issued by the IRS to examine books, records or other data in the custody or control of a foreign related party enforceable? The Internal Revenue Code provides the IRS with a mechanism to summon such records in certain situations – or to effectively impose a penalty against the domestic reporting corporation (“DRC”) (defined below) for failing to comply. One particular route is available where the records at issue involve a transaction of a DRC that is 25-percent (or more) owned by a foreign related party. In that situation, the Service may have a formidable weapon: a section 6038A summons.
Generally, a foreign related party is required to designate the domestic corporation as its agent. When it fails to do so, a noncompliance rule applies. Under the noncompliance rule, the IRS has sole discretion to determine the DRC’s deductions related to, and the cost of property purchased from (or transferred to), that foreign related party.
For purposes of section 6038A, a DRC is either a domestic corporation that is 25-percent foreign-owned or a foreign corporation that is 25-percent foreign-owned and engaged in trade or business within the United States. A foreign related party is one of the following: a 25-percent foreign shareholder of the DRC, a person related to a 25-percent foreign shareholder, or a foreign person who is related to the DRC. A DRC is required to file a Form 5472, Information Return of a 25% Foreign-Owned US Corporation or a Foreign Corporation Engaged in a US Trade or Business, for every foreign related person that the DRC completes a transaction with during that tax year. See our prior posts on new 5472 rules: Foreign-owned domestic disregarded entities: The new reporting requirements; IRS Issues Final Regulations Governing Foreign-Owned Single Member LLCs; An Update on International Tax Enforcement.
The IRS may issue an IRC 6038A summons when:
- The taxpayer under exam is a domestic corporation with a 25-percent or more foreign shareholder,
- There was a transaction between the DRC and such 25-percent foreign shareholder or any foreign person related to the DRC or to such 25-percent foreign shareholder, and
- The DRC is appointed to act as a limited agent for purposes of IRC 7602, 7603, and 7604 with respect to any request by the IRS to examine records or produce testimony that may be relevant to the tax treatment of any transaction between DRC and a foreign related party.
When a DRC fails to comply with a section 6038A summons in a timely manner, the Service has the sole discretion to determine the DRC’s deductions related to transactions with the foreign related party. The only way for a DRC to successfully challenge the noncompliance penalty is to prove the IRS abused its discretion by clear and convincing evidence.
A section 6038A summons provides an avenue for the IRS to summon records related to a transaction between a DRC and a foreign related party. If the DRC does not comply with the 6038A summons, then the IRS has sole discretion to determine the tax deductions for the foreign related person and to make adjustments. For some, this will be a steep price to pay.