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to furnish those records or produce statements to the IRS (sec. 6001). Initial requests for information necessary to an audit are generally submitted to the taxpayer under audit by the IRS in the form of Information Document Requests (IDRs). The IRS is empowered, for the purpose of ascertaining the correctness of any return, making a return where none has been made, determining the tax liability of any person, or collecting any such liability, to (1) examine any books, papers, records, and other data that may be relevant or material to such inquiry, (2) to summon the person liable for tax or required to perform the act, or any officer or employee of such person, or any person having possession, custody, or care of books of account containing entries related to the business of the person liable for tax or required to perform the act, or any other person the IRS may deem proper, to appear before the IRS at a time and place named in the summons and to produce such books, papers, records, or other data and to give such testimony, under oath, as may be relevant or material to such inquiry, and (3) to take such testimony of the person concerned, under oath, as may be relevant or material to such inquiry (sec. 7602(a)). The United States district court for the district in which the summoned person is found has jurisdiction by appropriate process to compel such person to comply with the summons (sec. 7604(a)).

In cases involving intercompany pricing of goods manufactured by a foreign parent company and sold to a U.S. subsidiary, for example, it is often necessary to obtain relevant cost and pricing information from the foreign parent in order to ascertain the arm's length price of the goods in question. The scope of the IRS' summons authority in such cases has been the subject of litigation. IRS summonses have been ordered to be enforced against a foreign parent that sells goods in the U.S. through a U.S. subsidiary. See, e.g., United States v. Toyota Motor Corp. 33 However, as a practical matter it may be difficult for the IRS to enforce a summons and obtain information from parties in foreign jurisdictions for various reasons, including the possibility that the required information is not in existence at the time the summons is issued. Furthermore, enforcement of the summonses in Toyota was based on several factors including the fact that the boards of directors of the foreign parent and the U.S. subsidiary had interlocking membership, and the fact that the foreign parent itself had significant business activities in the United States. In the absence of such factors, the courts have not clearly determined the standards for enforcement of summonses against foreign parents of U.S. subsidiaries.

Through the use of whatever information the IRS is able to obtain, it will generally attempt to construct, through economic analysis and other means, what it believes to be an appropriate arm's length price, and to the extent that this price differs from the price actually charged in the transaction under review, make appropriate adjustments to the tax liability of the taxpayer. In situations where the taxpayer believes that the arm's length price constructed by the IRS is erroneous, and is unable to reach a settlement of the issue with the examining agent or through the IRS Ap

33 United States v. Toyota Motor Corp., 561 F.Supp. 354 (C.D. Cal. 1983); 569 F.Supp. 1158 (C.D. Cal. 1983).

peals Office, it may choose to litigate the matter or go to competent authority when a treaty applies.

Reporting, recordkeeping and related requirements (sec. 6038A)

In general

The rules detailed below generally apply in the case of U.S. entities that have significant foreign ownership (as defined) for taxable years beginning after July 10, 1989, and reflect amendments made by the Omnibus Budget Reconciliation Act of 1989 (the "1989 Act").34 For audits of tax years beginning prior to or on July 10, 1989, less stringent rules currently apply. However, as noted below, legislation has been proposed that would make the 1989 Act amendments applicable to all taxable years for which the statute of limitations has not closed.

Information reporting and maintenance

Any corporation (U.S. or foreign) that conducts a trade or business in the United States and that is 25-percent owned by a foreign person ("reporting corporation") must furnish the IRS with such information as the Secretary may prescribe regarding transactions with certain foreign persons treated as related to the reporting corporation ("reportable transactions") (sec. 6038A).35 Under current regulations, the IRS requires the annual filing of an information return reporting all related-party transactions (Treas. Reg. sec. 1.6038A-1).36 In addition, a reporting corporation is required to maintain (or cause another person to maintain), in the location, in the manner, and to the extent prescribed by regulations, any records deemed appropriate to determine the correct tax treatment of reportable transactions (sec. 6038A(a)).

Application of U.S. legal process to foreign persons

As previously mentioned, the statutory scope of general IRS summons authority extends to certain persons that are not themselves subject to tax in the United States. However, such summonses may not be practically or legally enforceable in all appropriate cases, especially where summoned materials are in the possession of a foreign person. The Code provides that in order to avoid the consequences of the noncompliance rules (discussed below) with respect to certain reportable transactions, each foreign person that is a related party of a reporting corporation must agree to authorize the latter to accept service of process as its agent in connection with any request or summons by the IRS to examine books, records, or other materials, to produce such materials, or to take testimony related to any reportable transaction, solely for the purpose of determining the tax liability of the reporting corporation (sec.

34 Code section 6038 contains rules relating to information that must be provided by U.S. persons who control a foreign corporation.

35 Similarly, U.S. shareholders that control foreign corporations are required to report certain information with respect to such foreign corporations and all transactions with such foreign corporations (sec. 6038). Noncompliance with the requirements of section 6038 can be sanctioned by monetary penalties, as well as by the reduction or elimination of foreign tax credits allowed to U.S. shareholders that fail to report the required information (sec. 6038(c)).

36 However, the regulation has yet to be amended to reflect the broadening in the 1989 Act (sec. 7403(a)) of the definition of a related party.

6038A(e)(1)). Thus, assuming such authorization is given, IRS examination requests and summonses with respect to related-party transactions involving U.S. taxpayers can be served on related foreign persons that do not directly engage in trades or businesses in the United States.

Sanctions for noncompliance

Monetary penalty.-Failure to furnish the IRS with information or to maintain records as required under section 6038A(a) and (b) is sanctioned by a monetary penalty of $10,000, and additional penalties are imposed if the failure continues more than 90 days after the IRS notifies the taxpayer of the failure (sec. 6038A(d)). The additional penalties are $10,000 for each 30-day period (or fraction thereof) during which the failure continues after the 90th day after IRS notification.

Noncompliance rule.-Failure of a related party to designate a reporting corporation as its agent for accepting service of process in connection with reportable transactions (as discussed above), or, under certain circumstances, noncompliance with IRS summonses in connection with reportable transactions, can result in the application of noncompliance rules in computing tax liability. For certain payments to related parties in connection with reportable transactions, this rule permits the IRS to allow the reporting corporation only those deductions and amounts of cost of goods sold as shall be determined by the Secretary in the Secretary's sole discretion, based on any information in the knowledge or possession of the Secretary or on any information that the Secretary may obtain through testimony or otherwise (sec. 6038A(e)).

Proposed amendments to statutory information provisions Earlier this year, the Foreign Tax Equity Act of 1990 was introduced in both Houses of Congress. 37 Included in this proposed legislation are three provisions affecting transactions undertaken between U.S. taxpayers and foreign related persons. First, the proposed legislation would make the amendments to section 6038A enacted in 1989 (i.e., reduced ownership threshold, increased monetary penalty, noncompliance rule, and requirement that related foreign persons designate U.S. agents for service of process purposes) applicable to any taxable year for which the limitations period had not expired as of March 20, 1990. Second, the bill would create a new section 6038C, with substantive rules similar to those found in section 6038A (as it would be amended by the bill) which would apply to foreign corporations engaged in business in the United States through a branch. This provision would apply not only to related party transactions, but, as specified by the Secretary, to other items related to the determination of the foreign corporation's U.S. tax liability. Third, the legislation, if enacted, would authorize the Secretary to extend the period for assessment for up to three additional years in certain cases involving deficiencies of either a foreign-owned domestic corporation (as defined in section 6038A) or a foreign corporation, without the consent of the taxpay

37 H.R. 4308 (introduced March 20, 1990), and S. 2410 (introduced April 3, 1990) (101st Cong., 2nd Sess.).

er. The authority to extend the assessment period would apply to any case where the Secretary is unable to accurately assess a deficiency prior to the expiration of the regular assessment period (including extensions thereof) by reason of delay or other actions of the taxpayer, and where the deficiency is related to a transaction (or other item) reporting for which would be required under section 6038A or 6038C.

Section 982

The Code also provides a specific sanction for the failure to comply with certain IRS requests to produce foreign-based documentation. If, in connection with the examination of any item, a taxpayer fails to timely and substantially comply with a request issued by the IRS for any relevant or material documentation which is located outside the United States, the requested documentation becomes inadmissible as evidence in any subsequent civil proceeding in which the examined item is an issue. However, this sanction does not apply if the taxpayer establishes that the failure to provide the documentation was due to reasonable cause (Code sec. 982).

IRS consideration of advance determination process

It has been reported that the IRS is considering and probably will propose a method for granting advance determination rulings on international transfer pricing. According to these reports, one approach under consideration would permit the taxpayer to provide the IRS in advance with a full explanation of its pricing method and to seek an advance determination letter. Such an advance determination letter would typically be effective for three years with the possibility of unlimited three year extensions. However, an agreed method would not bind the IRS if the taxpayer provided inaccurate information or failed to comply with the conditions of the letter, or if critical assumptions on which the letter was based proved to be substantially invalid. 38

E. Tax Treaties

"Associated enterprises" provisions of treaties generally

As a general rule, tax treaties are entered into for two purposes. One purpose is to avoid double taxation by the two treaty countries of the income of a resident of either country. The other is for the prevention of fiscal evasion with respect to the income taxes of the two countries.

Most treaties include an article dealing with "associated enterprises." As an example of such an article, Article 9 of the 1981 proposed model income tax treaty (the "U.S. model") provides a special rule applicable to cases where either an enterprise of a treaty country participates directly or indirectly in the management, control, or capital of an enterprise of the other treaty country, or the same persons participate, directly or indirectly in the management, control or capital enterprises of both treaty countries. In either of

38 See, eg., Bureau of National Affairs Daily Report for Executives No. 113, G-5 (June 12, 1990); see also Tax Notes International, 565 (June 1990) 47 Tax Notes No. 10, 1151 (June 4, 1990).

these cases, if conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between two independent enterprises, then any profits which, but for those conditions would have accrued to one of the enterprises, but by reason of those conditions have not so accrued, may be included in the profits of that enterprise and taxed accordingly.39 In addition, the U.S. model expressly permits application of internal law provisions which permit the distribution, apportionment, or allocation by the government of a treaty country of income, deductions, credits, or allowances between persons, whether or not residents of a treaty country, owned or controlled directly or indirectly by the same interests, when necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such persons.

The distribution, apportionment, or allocation by the government of a treaty country of tax items between related enterprises could, in some cases, give rise to actual or economic double taxation. For example, if an amount is originally included in the income of a treaty country enterprise, thereby becoming taxable in that country, and is subsequently included in the income of a related enterprise located in the other treaty country (by way of the associated enterprises article of the relevant treaty), and thus is also taxed in that other country, double taxation of the same item of income would occur. In an attempt to avoid this result, treaties often provide that if the first country agrees that the allocation by the other country was correct then it shall make an appropriate adjustment (often referred to as a correlative adjustment) to the amount of the tax paid by the first enterprise which was attributable to the amount that was so allocated. It should be noted that under the OECD model treaty, a correlative adjustment is not automatically required to be made by the first country. Rather, it is generally required only if the first country considers that the amount of adjusted profits correctly reflects what the profits would have been if the transaction had been conducted at arm's length.40 The method by which such an adjustment is to be carried out is generally not specified.41

Competent authority

In general

Administration of the associated enterprises provision discussed above is generally handled by the "competent authorities" of the two treaty countries. In the case of the United States, the competent authority is the Secretary of the Treasury or his delegate. 42 In 1973, responsibility for administration and implementation of tax treaties was delegated to the Commissioner of the Internal Revenue Service, and since 1986 has been the responsibility of the Office of the Assistant Commissioner (International) of the Internal

39 A similar provision is included in Article 9 of the Organization for Economic Cooperation and Development (OECD) Model Double Taxation Convention on Income and on Capital. 40 See, eg, The Model Double Taxation Convention on Income and on Capital of the OECD: Report of the OECD Committee on Fiscal Affairs (1977), Commentary on Article 9, p. 88, paragraph 3.

41 Id. at 88-89, paragraph 4.

42 Paragraph 1(e)(i) of Article 3 of the U.S. model.

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