Tax Notes logo

When Is a Late Return Not Really “Late”?? – Part 1

Posted on Dec. 3, 2021

Today guest poster Bob Probasco walks us through the case law and recent IRS memo addressing a foreign corporation which files a return after a normal due date because it only later realizes it has a filing obligation. The issue is one I recently discussed but in today’s first of two parts Bob digs deeper. Les

The IRS released a legal memo recently on an issue I had never thought of before. Would a tax return by a foreign corporation claiming a refund, filed after the normal filing date, be considered “late,” when the corporation did not realize by the filing deadline that it had a filing obligation at all? That has implications for how much interest the IRS must pay on the refund. Les wrote a great post about it. As I reviewed the memo and related cases, though, I had some nagging questions that Les didn’t have time to address. (The memo was released on Friday and Les’s post was up early Monday, before I saw the memo itself on Tax Notes Today.) So, here I am.

Part 1 provides some additional background from the previous court cases and then the recent IRS legal memo. Part 2 then moves on to those questions – I always have questions – and some very tentative possible answers: this memo may not only be wrong but also apply more broadly than realized.

The legal memo follows two particularly relevant court cases, which provide a good background for the discussion.

MNOPF Trustees, Ltd.

MNOPF Trs. Ltd. v. United States, 123 F.3d 1460 (Fed. Cir. 1997) involved foreign entities that were trustees of pension funds of the British merchant marine. (There were two different entities involved, but from here on I will just refer to “MNOPF.”) It was a tax-exempt labor organization (Section 501(c)(5)), had no business income in the United States, and therefore was not required to file income tax returns. However, it invested in securities of U.S. corporations and received dividend payments. The custodian banks which received the payments withheld thirty percent and transmitted the withheld amount to the IRS, with an annual return on Form 1042. The banks improperly withheld the 30% from MNOPF’s dividends, since it was tax-exempt; MNOPF filed refund claims on Form 843 in December 1987 for amounts withheld on dividends paid in 1985 and 1986.

The IRS rejected the Forms 843, stating “A return must be filed to claim the refund, even if in past years you have received refunds by filing only Form 843 without a return.” The IRS also told MNOPF that it should file Form 1120-F. MNOPF refused to do so, because it wasn’t a corporation, and instead filed Form 990-T, “Exempt Organization Business Income Tax Return,” in December 1989, although it did not have business income. The IRS accepted that form and refunded the amounts withheld but paid overpayment interest only from the date it received the Form 990-T, because the return was filed late, relying on Section 6611(b)(3):

Notwithstanding paragraph (1) or (2) in the case of a return of tax which is filed after the last date prescribed for filing such return (determined with regard to extensions), no interest shall be allowed or paid for any day before the date on which the return is filed.

The Federal Circuit disagreed. Treas. Reg. § 301.6402-3(a)(1) says: “In general, in the case of an overpayment of income taxes, a claim for credit or refund of such overpayment shall be made on the appropriate income tax return.” The rest of the subsection encompasses both original income tax returns and amended tax returns as methods to make a refund claim. But there was no “appropriate income tax return” for MNOPF since the regulation did not apply to tax-exempt organizations and MNOPF had no taxable liability. The court concluded: “The Court of Federal Claims correctly held that a claim for refund is not a late-filed tax return when the organization is not required to and did not file a tax return.” Therefore, overpayment interest would start running with the date of the overpayments, rather than the date MNOPF filed Form 990-T. (Because MNOPF was tax-exempt, the date of the overpayment was the date that the custodian banks were required to file Form 1042. That was the primary distinction between MNOPF and the next case.)

Overseas Thread Industries, Ltd.

Overseas Thread Indus. v. United States, 48 Fed. Cl. 221 (2000) moved to the subject very similar to that addressed by the IRS legal memo. OTI was a foreign corporation with its principal office and headquarters in England and a United States subsidiary, TFI. TFI made distributions to OTI in 1987, 1988, and 1989; at the time both TFI and OTI thought the distributions were taxable dividends. TFI withheld five percent of the distributions, pursuant to the US-UK tax convention, and remitted the amount withheld to the IRS along with Form 1042. OTI did not file an income tax return for those three years, because it was not engaged in a U.S. trade or business.

Sometime in the last quarter of fiscal year 1990 – roughly October through January – OTI determined that a portion of the distributions were non-taxable returns of capital, on which tax should not have been withheld. TFI filed amended Forms 1042 at the end of January, and OTI filed Forms 1120-F in mid-February, reporting the amounts of the overpayments. The IRS issued refunds in early 1992, but later demanded that OTI repay a portion of the associated interest, concluding that overpayment interest would start running only when the Forms 1120-F were filed in 1991, thereby treated as “late returns.”

In its briefs for the cross motions for summary judgment, OTI argued that the returns were not “late.”. That applies when the returns are not “required,” according to MNOPF. OTI pointed to Treas. Reg. § 1.6012-2(g)(2)(i)(a), which creates an exception to the general rule that corporations must file income tax returns:

A foreign corporation which at no time during the taxable year is engaged in a trade or business in the United States is not required to make a return for the taxable year if its tax liability for the taxable year is fully satisfied by the withholding of tax at source under chapter 3 of the Code.

That makes sense. The corporation is taxable on income that is not effectively connected with a U.S. trade or business at 30% (or lower if specified in a treaty). The payor is required to withhold at that same amount. The net amount will be $0; why require an income tax return?? (At least, that’s my recollection from my law school class on International Tax. I haven’t really looked at that in the last 21 years.)

But the government, in its briefs, pointed to Treas. Reg. § 1.6012-2(g)(2)(i)(b)(2), which states that the preceding exception does not apply:

To a foreign corporation making a claim under § 301.6402-3 of this chapter (Procedure and Administration Regulations) for the refund of an overpayment of tax for the taxable year

The court concluded this was a “quandary” and stated its task as “to harmonize these provisions into a coherent whole that achieves the object of the regulation, yet does not yield preposterous or odd results.” The government’s interpretation, though, leads to an odd result. Foreign corporations that apparently qualify for the exception of Treas. Reg. § 1.6012-2(g)(2)(i)(a) would have to file a return at the filing due date anyway, simply because “an overpayment may be discovered in the future.” (emphasis added) Failing to do so would “forfeit its ability to maximize interest on any resulting overpayment.”

The court’s solution: if the corporation were making a claim for refund “during the requisite filing period” it was required to file an income tax return by the normal deadline. If the corporation “later discovers the existence of an overpayment after the close of the applicable income tax return filing period,” it would have to file a return to claim the refund but the return would not be considered a late-filed income tax return and Section 6611(b)(3) would not apply. Apparently, the parties did not dispute when OTI discovered the overpayment, so the court’s solution decided the case in OTI’s favor.

The New IRS Legal Memo

I don’t think the memo really decided much beyond Overseas Thread. It cited and quoted that case, along with MNOPF, and basically relied on those decisions. The one thing perhaps new in the memo was that it was more explicit than Overseas Thread, in recognizing that the application of that rule might require information that the IRS might not have. The field unit requesting advice did not specify that information, so the memo’s answer was not conclusive.

As Les pointed out in his post: “The knowledge standard raises significant challenges for tax administrators who may not be able to determine that knowledge on the face of a return.” I agree whole-heartedly. Particularly in cases like these, interest may be computed with minimal or no interaction with the taxpayer. The computer may (?) automatically apply Section 6611(b)(3) based on the information available without anyone intervening to ask when the taxpayer became aware that there was an overpayment. It would be up to the taxpayer to realize the IRS position was inconsistent with case law and claim additional interest. I also would very much prefer a bright line rule.

In Part 2, I’ll turn to how the Overseas Thread court might have reached it decision without having to apply a knowledge standard. I think that decision – or at least the rationale – arguably was wrong. If so, that also suggests a particular direction in which the bright line rule should run. Part 2 also addresses why this issue could affect many more taxpayers than foreign corporations without a U.S. trade or business.


Subject Areas / Tax Topics
Copy RID