Under IRS regulations, foreign corporations and nonresident aliens who do not file a U.S. income tax return within certain time limits forfeit the ability to take otherwise available deductions against their income that is taxable in the U.S. While the regulations do not require that the return be filed on time, generally if the return is not filed within 18 months of the due date the deductions are lost.
This rule can be harsh for taxpayers that mistakingly conclude that they did not need to file a return based on a lack of income that is taxed in the U.S., that thought that having no net income after deductions meant they did not need to file a return, or that just did not realize that they needed to file a U.S. return. Such taxpayers will end up owing more tax than would have been the case if they had filed within the time limits. Indeed, taxpayers who might otherwise have been in a net loss position after deductions will now owe income tax regardless of their losses.
In 2006, the Tax Court found no statutory authority for the corporate version of the regulations, and declared them invalid. Now, the Third Circuit Court of Appeals has reversed the Tax Court and found the regulations are valid interpretative regulations. This occurred notwithstanding other long-standing precedent (that preceded the regulations) that a timely filing is not a prerequisite for being able to take deductions.
If and until the issue is addressed in a different manner by a different Court of Appeals, delinquent taxpayers are at substantial risk now for loss of deductions, and need to consider whether to file protective returns if they are uncertain as to whether they need to file a U.S. return.
The regulations will also have the unfortunate effect of discouraging innocent foreign nonfilers, who learn of U.S. tax and filing requirements after the time limits of the regulations, from coming clean and filing returns for prior missed years. There are lots of those nonfilers out there - while the regulation writers assume that all foreign persons will or should know and keep up with U.S. requirements, there truly are many who do not pick up on the requirements until after the deadlines have passed.
By allowing the regulations to stand, the appeals court essentially has authorized the Treasury Department to add late filing penalties that are not otherwise provided for in the Internal Revenue Code, and allows the conversion of a tax on "income" to a tax on gross receipts.