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Just as US corporations must file a US corporate tax return, so must a foreign corporation file a US corporate tax return (Form 1120-F, U.S. Income Tax Return of a Foreign Corporation) if it is considered to be doing business in the US.

The challenge that foreign corporations frequently face is determining if the level of business that they perform in the US gives rise to a US corporate tax filing requirement. Specifically, a foreign corporation must file Form 1120-F if, during the tax year, it

(a) is engaged in a US trade or business, regardless of whether it has any income that was effectively connected with such trade or business (ECI),
(b) has income, gains, or losses that are treated as if they are ECI,
(c) is not engaged in a US trade or business, but its tax liability on other US source income has not been fully paid by tax withholding,
(d) claims a refund of taxes paid or withheld,
(e) claims the benefit of any deductions or credits,
(f) is required to disclose the position that an income treaty overrules or modifies any provision of the Internal Revenue Code.

The above situations are complex and reviewing each one is beyond the scope of this article. However, needless to say, there can be situations where the US filing requirement of a foreign corporation is unclear.

The Penalty

If the IRS determines that a foreign corporation is required to file a US tax return and the corporation does not file one, the penalty is severe – the IRS can disallow the business-related deductions and credits to which the foreign corporation is normally entitled. Therefore, the foreign corporation would be taxed on gross income, instead of net income. For example, a foreign corporation (“FC”) became a 10% passive investor in a U.S. limited partnership that was engaged in a U.S. trade or business. The U.S. partnership had $100,000 of gross income which was offset by $120,000 in related deductions. FC incorrectly concluded that FC was not required to file a Form 1120-F due to its passive participation and the expectation of a net US sourced loss. Upon audit, the IRS determined that FC was required to file a US corporate income tax return due to the fact that it received Effectively Connected Income from a US partnership. Since FC didn’t file a US corporate tax return, FC lost the benefit of claiming its share of the $120,000 in deductions, and, therefore, was subject to tax on its share of the $100,000 gross income or $10,000 (due to the 10% ownership in the partnership) even though there was an overall economic loss.

The Solution – Protective Claim Return

Due to the severe consequences for not filing Form 1120-F timely, foreign corporations who are uncertain whether they are required to file a U.S. tax return, or uncertain whether their income is ECI, can file a protective Form 1120-F to preserve the right to claim allowable deductions and credits. A protective Form 1120-F is filed by checking the “protective return” box on the upper right-hand corner of page 1 and completing limited questions on the form as specified in the instructions. Generally, no income information is required to be disclosed on a protective return. Also, if the protective return is being filed to invoke the benefits of a particular tax treaty, usually Form 8833, Treaty Based Return Position Disclosure under Section 6114 or 7701(b), is attached to the protective return.

Foreign corporations generally have 18 months from the due date of the return to file a protective return in order to preserve the benefits to claim deductions related to the US income.

WG Comment

Many foreign corporations are reluctant to file a protective return for fear that it will lead to an income tax audit. While this reluctance is understandable, the potential liability arising from being taxed on gross income (before expenses) rather than net income (after expenses) in most cases makes the decision to file a protective return much easier.

If you have questions regarding this or any other international tax topic, please contact your WilkinGuttenplan advisor.