The IRS has published final regulations, Secs. 1.874-1 and 1.882-4, which predicate the ability of nonresident aliens and foreign corporations to claim deductions and credits against their U.S. effectively connected income on filing a true and accurate return. While the statutes underlying these regulations have been in force for many years, the introduction of a timely filing requirement conflicts with a fairly well established line of judicial decisions that allowed deductions when a return was filed prior to assessment by the IRS. The final regulations, which are effective July 31, 1990, for taxable years ended after that date, will present significant issues to all nonresident alien and foreign corporate taxpayers, especially those for whom the determination of whether they are engaged in a U.S. trade or business is less than clear.
The law. Sec. 874(a) permits deductions and credits when a taxpayer files or causes to be filed a true and accurate return, in the manner prescribed in subtitle F, including therein all information the Secretary may deem necessary for calculation of such deductions and credits.
The Regulation. Reg. Sec. 1.874-1 reads in part that deductions and credits, except for those specifically exempted from Sec. 874 by their own terms (that is, Secs. 31, 33 and 34), as well as those added by the regulation (Secs. 32 and 852(b)(3)(D)(ii)) will be allowed..."only if the nonresident alien individual timely files or causes to be filed with the Philadelphia Service Center, in the manner prescribed in subtitle F, a true and accurate return of the income which is effectively connected...with the conduct of a trade or business within the United States by the nonresident alien individual." It should be noted that the timely filing requirement has been introduced and defined by the recently issued final regulations. Sec. 874 itself, which had its origins prior to the 1954 code, did not and does not have a timely condition. Congress, aware that there was no timeliness element in the statute, could have enacted such a requirement into Sec. 874. Despite at least six amendments, it failed to see a need to do so.
The final regulations proceed to define precisely what constitutes a timely filing. The date is dependent on whether a return was filed for the taxable year immediately preceding the current taxable year. If a return was either filed for the immediately preceding taxable year, or if IRS determines that the current year is the first taxable year in which a return is required, the current year's return must be filed within 16 months of the original due date. If the IRS determines that a return was due for the immediate prior year but was not filed, this 16-month period could be reduced merely by the IRS mailing a notice informing the nonresident alien individual that deductions and credits will not be allowed.
Waivers from the disallowance of deductions and credits are reserved for rare or unusual circumstances where the taxpayer establishes good cause. Income tax treaties will be ignored if a "timely" filing is not made.
Protective returns can be filed by nonresident alien individuals, if filed on a timely basis, when they cannot determine themselves that they will owe a return. This will reserve the right of such individuals to utilize deductions and credits if IRS later determines that a return was due.
Because similar treatment is not imposed on U.S. persons, it would seem to violate nondiscrimination clauses of U.S. income tax treaties and friendship, commerce and navigation treaties. A nonresident individual may have very subtle ties to the U.S., such as those resulting from different sourcing rules in the country of residence, the use of a different functional currency, or being swept into the U.S. tax regime by a conduit in a manner contrary to the rules of the individual's country of residence. Such individual may honestly not realize the need to file a return or have any income at all from the U. …