International Reporting Penalties – The Doctrine of Substantial Compliance by Steven Toscher
Posted by Hochman Salkin Toscher Perez P.C. 
Posted on Tuesday, October 17, 2017
As part of the Internal Revenue Service’s (“IRS”) continuing international enforcement effort, it recently released training materials on what it means to be “substantially complete” for an international information return. The training is significant because the failure to file a “substantially complete” foreign information return can subject the filer to substantial penalties and the failure to file a “substantially complete” form could also leave open the statute of limitations on the assessment of additional taxes and penalties.
The training of IRS agents on the topic of “substantially compete” and substantial compliance reflects the evolution of the seriousness of the Service’s commitment to enforce international reporting obligations. Historically, the IRS was quite forgiving of a taxpayer’s failure to file required information reporting forms. The forgiving attitude has been evolving over the last ten (10) years and the IRS, absent the demonstration of “reasonable cause,” is not as forgiving. Moreover, historically most IRS agents were not familiar with the numerous international reporting forms which lent itself to a more accommodating position with taxpayers. If IRS agents do not know the requirements, how can a taxpayer be held to a higher standard?
The IRS is more closely focusing on the requirements for filing the international reporting forms. Not only must they be filed to avoid the potential penalties and statute of limitations issue, they must be “substantially complete.”
There are numerous international reporting forms (beyond the scope of this blog), but the more important ones are:
Form 5471 – relating to a controlled foreign corporation; Form 5472 – relating to foreign ownership of a U.S. corporation; Form 8865- return of U.S. persons with respect to certain foreign partnerships; Form 8858- information return of U.S. persons with respect to certain foreign disregarded entities; Form 926 – return for U.S. transfer of property to a foreign corporation; and Forms 3520 and 3520-A – the annual returns to report transactions with foreign trusts or the receipt of certain foreign gifts. Each of the forms carries with it substantial penalties for a failure to comply.
While the focus of the completeness of the information reporting forms is a new development of the IRS international enforcement effort, there is a long common law history of what is “substantial compliance.” The Court precedent relates primarily to non-foreign information reporting, but will provide guidance to the IRS, taxpayers and the Courts as to whether there has been “substantial compliance.”
The IRS’ position is that in determining whether a tax return satisfies a reporting requirement or whether a taxpayer has complied with a statutory or regulatory requirement, two different standards that may apply. The first requires “strict compliance” with the statute or regulatory requirement; the second requires “substantial compliance.” In analyzing the statue or regulatory requirement, the first step is to determine which standard applies – – and that may not be clear. The Service has indicated the Courts may consider the following:
– – if the particular information requirement be relates to the “substance or essence” of the statute or regulation, strict compliance is necessary. On the other hand, if the requirement is seen as “procedural or directory” then substantial compliance can apply.
If an IRS agent raises an error or an omission in a form, the taxpayer will want to try to fit the issue within the “substantial compliance” doctrine.
The leading case cited by the IRS is an old Board of Tax Appeals case (the predecessor to the Tax Court) by the name of Indiana Rolling Mills Co. v. Commissioner, 13 B.T.A. 1141 (1928) – – yes, in 2017 in connection with the international enforcement effort, we are looking back to guidance in the 1920’s.
The Indiana Rolling Mills Co. v. Commissioner case deals with the required signatures on a domestic corporate tax return. The statute required that the corporate tax return be sworn to by the President and the Treasurer of the company. In Indiana Rolling Mills, the corporate return was sworn to by the Vice-President and Secretary. The IRS argued that the return was not valid for purposes of the statute of limitations. A harsh position indeed.
The Court stated the general rule of statutory construction is that provisions that relate to the “essence of the thing to be done are mandatory,” those that do not relate to the essence of the thing to be done are “directory.” Here, the essence of the statute was making an honest return. If the return represented information fairly and honestly given and sworn to by officers of the corporation who are familiar with its affairs, the Court determined the taxpayer “substantially complied” with the statute. The fact that the Treasurer or Assistant Treasurer did not swear the return did not go the essence of the statute.
There are a number of cases in the area and it should be kept in mind that the “substantial compliance” doctrine is taxpayer favorable. Taxpayers do not need to be perfect, but they need to be in good faith and substantially comply with what the statute or regulations require.
The IRS has issued some internal guidance in connection with the application of the substantial compliance doctrine for international information reporting penalties. The leading internal guidance is Chief Counsel Advice (“CCA”) 20429007 entitled “Whether Form 5472 was Substantially Complete.” CCA 20429007 concerns the meaning of the term “substantially incomplete” in regard to a Form 5472, relating to an information return of a 25% foreign owned U.S. corporation as that term is used in Regulation Section 1.6038A-4(a)(i). The CCA considered whether a taxpayer’s return would be considered incomplete and therefore subject to penalty under a variety of factual scenarios. The CCA identifies two approaches that could be used to determine whether a return is substantially complete. The first is “strict compliance,” an interpretation of the rules under which virtually any substantive inaccuracy could render the return substantially incomplete. The second is the facts and circumstances approach. The CCA provides a list of seven (7) factors that should be considered in a facts and circumstances analysis. These factors deal with the proportionality and magnitude of the errors and its impact on the IRS to be able to efficiently examine the information required by the statute and regulations.
It is indeed a new world. Not many years ago, failures or inaccuracies in international reporting were often forgiven by the IRS; now, with the IRS’ new focus on international enforcement, not only must the information returns be filed, they will be scrutinized for completeness and at a minimum meet the substantial compliance standard.
This new IRS scrutiny has significant consequences. We are familiar with situations where the IRS solicits information reporting forms and not only are there initial penalties for failure to file the form, there are what is referred to as “continuation” penalties for the continued failure to file the form. These can become very significant. We have seen situations where the information forms have been filed, but the Service has taken the position that they were not “substantially complete” and sought to impose continuation penalties. It is dangerous out there. Get it right the first time but if the examining agent raises the issue, think “substantial compliance.”
