Tax information reporting and compliance in the cross-border context.

I. INTRODUCTION

As in the domestic context, tax information reporting in the cross-border context serves the four-fold purpose of providing a cross-check for the Internal Revenue Service (Service) on the reporting of transactions and income, aiding the Service in assessing whether to audit returns with certain kinds of transactions or activities, serving as a reminder to taxpayers of income and credits/deductions to report and, where tax is withheld, providing a means to identify the deposit of the withheld taxes with the taxpayer entitled to claim the benefit of that deposit. In addition, it provides a means for information exchange with tax authorities in other countries.

Information reporting has been receiving considerable attention in recent months in connection with discussions of the "tax gap." The most current Service estimate of the size of the "gross tax gap" is $345 billion per year, with the "net tax gap" being approximately $290 billion per year. (1) Of that amount, about seventy percent is estimated to be attributable to underreporting of income and self-employment taxes by individuals. (2) It has been suggested that cross-border transactions may account for as much as $100 billion of the total "tax gap" income estimate. (3)

The inherent nature of the subject and the fact that the Treasury Department figures are generated from various data sources, some rather dated, opens the accuracy of these estimates to question. Any figures for the cross-border element are even less certain, especially the portion resulting from the failure of individuals to report income from cross-border transactions. Nevertheless, even when allowing for some overstatement, the figures would be substantial (and, of course, would be even more attention-getting if the estimates are considered to be on the low side).

A number of studies and the Service have concluded that information reporting, particularly third-party reporting, significantly increases the extent to which taxpayers pay the tax due on the taxable income affected. (4)

This article focuses on tax information reporting in the cross-border context, primarily as it relates to third-party reporting of transactions and investments by individuals (and small businesses), with a view to highlighting some additional issues and problems that are presented in comparison to the purely domestic context. Part II presents some possible revisions as a basis for considering what the present information reporting system realistically can be made to do to help compliance and enforcement in the cross-border context. The discussion in that portion of the article is a selective, rather than a comprehensive, comment on the current reporting systems. (5) It has two principal focal points. One is how gaps in the current third-party reporting fabric reflect, in this writer's view, an overly restrictive adherence to traditional tax distinctions among corporations, partnerships, and trusts. The other is how much more the tax reporting system can realistically be used to reduce the current amounts of noncompliance. Part III then discusses other steps that may or may not help in that context. Part IV sets forth some broad summary conclusions.

II. SOME POSSIBLE CHANGES IN THE CURRENT

A. Information Reporting System in the Code

Current information reporting in the cross-border context is an amalgam of several regimes in the Internal Revenue Code (Code). It includes reporting provisions that also are applicable to purely domestic transactions in addition to regimes applicable only to cross-border transactions or ownership situations. The former typically have been developed primarily from the point of view of the domestic reasons for imposing the reporting obligation, with some modifications then added that reflect perceived limitations in U.S. taxing jurisdiction. They encompass the information reporting provisions in sections 6041 through 6050V (other than sections 6046, 6046A, and 6048), (6) the related "back-up" withholding provisions of section 3406, (7) and the "wage" withholding and reporting provisions in sections 3401 through 3405 (8). Reporting provisions dealing with just cross-border ownership and funds transfers include the "source" withholding provisions in sections 1441 through 1463, and a variety of information returns, including sections 6038 through 6038C, 6039C, 6039E through 6039G, 6046, 6046A, and 6048. (9)

Even a cursory review of the current information reporting fabric reflects how detailed and complex the system as a whole is for the cross-border arena. The detail exhibits an effort to make the reporting framework as thorough as feasible--within the limits of traditional concepts of the U.S. tax structure and taxing jurisdiction--while also seeking to provide a high degree of certainty, and thus "grass roots" administrability, through making the reporting provisions as specific and mechanical as possible in their application. (10)

The complexity is driven in part by the current complexity of the substantive statutory provisions. This is most dramatically illustrated by the information reporting requirements for foreign corporations and foreign partnerships that are controlled by "U.S. persons" and, more fundamentally, by the extent to which the provisions take into account basic income tax concepts, such as differences between the taxation of corporations and pass-through entities. It also is influenced, if more subtly, by exceptions to withholding such as those that exist for bank deposit interest and discount on short-term debt obligations.

Any simplification of the substantive provisions in the tax law has a life of its own and is beyond the scope of the discussion in this article. However, it is a fair question to consider whether there are steps that can be taken to improve the present reporting structure as applied to the cross-border arena. An appropriate place to begin that reconsideration is an assessment of the changing patterns of cross-border economic activity and where these patterns might be expected to lead in upcoming years.

B. Changes in Cross-Border Business and Investment Patterns

There is no question that the last several years have witnessed a rapid growth in the development of a global economy and global capital markets that is likely to continue at an accelerating rate for the foreseeable future. That growth, and the changing patterns it has brought, is creating a dichotomy in terms of measures that may be needed or useful in improving taxpayer compliance.

Twenty or thirty years ago, the great bulk of cross-border activity was done by large, publicly-traded industrial companies, based in the United States or another industrialized country, whose business was taken across national boundaries largely through wholly-owned (or sometimes majority-controlled), local subsidiaries. (11) Cross-border business operations continue to be dominated by large multinational corporations. But the pattern is changing. The number of wholly-owned affiliates of U.S.-based multinationals has increased significantly over roughly the last decade. (12) The number of less-than-wholly-owned affiliates indicates that multination corporations continue to join with one or more similar corporations to conduct activities in joint venture form in one of their countries or even in yet another one or more third countries. In the writer's experience, however, such joint ventures now are more likely to be organized in a tax flow-through form as to the tax laws of one or more of the countries where the venture is conducted or the principals are located. The joint venture also may be funded, at least in part, with debt or equity capital raised outside the "home" country of the issuer, whether that issuer is the joint venture itself or its equity owners.

International accounting practices and the discipline of the financial markets make it unlikely that cross-border activities by large, publicly-traded companies will include outright tax fraud or filing a knowingly false or incomplete tax return. As recent history teaches, such companies can engage in sophisticated and aggressive tax planning of varying degrees of questionability. It does not appear, however, that further reporting by third parties is needed here as a cross-check, but rather increased visibility from mandated self-reporting to allow the Service to deploy its auditing resources more effectively.

There already are a number of statutory provisions and current administrative practices that require or pressure a taxpayer to disclose potentially questionable positions taken by the taxpayer in order to avoid penalties if that position is determined to be incorrect. At least for larger corporations, disclosure on the tax return generally is necessary to avoid substantial understatement penalties where (1) there is no "substantial authority" for the position and (2) the taxpayer is not able to properly rely on an opinion of a tax advisor stating that the position will "more likely than not" be sustained (and cannot properly make that determination itself). (13) In addition, penalties for a substantial understatement by a corporation are increased with respect to tax liability from participating in either an undisclosed "reportable transaction" if a significant purpose of the transaction is the avoidance or evasion of federal income tax or an undisclosed "listed" transaction. (14)