Limitations on the Use of Foreign-Based Documentation in Tax Litigation

The Internal Revenue Code places certain limitations on the taxpayer’s ability to present foreign-based documentation during tax litigation. These rules exists so that taxpayers who fail to produce certain items during audit procedures cannot rely upon those unproduced documents at a later date. While undergoing an audit, it is important to gain awareness of these rules and how they can impact a future tax litigation strategy.

What Limitations Exist with respect to Foreign Based Documentation?

Under Internal Revenue Code section 982, documents that are located outside of the United States cannot be admitted in court by the taxpayer during tax litigation if the taxpayer failed to produce those same documents during a formal document request in the course of an audit. The “foreign based documentation” encompassed by the rule includes books, records, and any other documents which are located outside of the U.S. and may be relevant to the tax treatment of the examined item.

What is a Formal Document Request for the Purposes of this Rule?

For the documentation to be excluded in court, the taxpayer must be found to have failed to “substantially comply” with a formal document request within 90 days after the request was mailed. On occasion, this 90-day period may be extended if the IRS allows. Under this particular code section, “formal document request” has a specific definition, meaning a request made after an “information document request” has failed to produce the necessary results.

An “information document request” is defined as “the standard [IRS] request for information that occurs during a routine audit.” For a document request to meet the threshold of being classified as a “formal document request,” it must be sent by registered or certified mail to the taxpayer’s last-known address of record. It must also describe the documents sought, state a date and time at which the taxpayer must produce the documents, and specify the penalties facing the taxpayer for failure to comply with the request. Finally, the formal document request must inform the taxpayer of any previous steps taken to obtain the documents and why they were unsuccessful.

What Constitutes Substantial Compliance of a Formal Document Request?

If a taxpayer “substantially complies” with a formal document request, then the foreign tax documentation will not fall within the scope of IRC § 982, and the documents can be admissible in court at a future date. Determining whether substantial compliance has occurred may depend on the facts and circumstances of each individual situation, including the taxpayer’s response time, the number of document requests sent by the IRS, and the relative importance of documents produced compared with documents withheld.

For example, even if a response is timely, it will not be considered substantially complied with if the most significant document was omitted. Similarly, a request is not substantially complied with for these purposes if the most significant document is not produced, even if it is a small majority of the total number of documents requested and produced. In such cases, IRC section 982(a) acts to bar admission of all the documents, even the ones supplied by the document request. Thus, the quality and importance of the documents produced is a more determinative factor than the sheer number of documents produced.

Exception Allowing the Taxpayer to Use Foreign Based Documentation in Court

While it is true that under IRC section 982, a taxpayer is prevented from admitting certain foreign-based documents in tax litigation if the taxpayer failed to produce those same documents during a formal document request in the course of an audit. This bar on foreign-based documentation can be lifted if the taxpayer is able to establish a reasonable cause for failing to produce the tax documents pursuant to a formal document request.

How Does a Taxpayer Establish Reasonable Cause Under IRC Section 982?

In assessing whether the taxpayer’s failure to provide documents during a formal document request was reasonable, the code instructs that the reasonableness will depend on “whether the request was reasonable in scope, whether the requested documents or copies thereof were available within the United States, and the reasonableness of the requested place of production within the United States.”

The IRS has indicated that one example of reasonableness for these purposes is the difficulty of translating voluminous documents into English in a short span of time. In this case, the difficulty of translating voluminous documents into English would serve as a reasonable cause for delay in producing the documents, but it would not excuse non-production altogether.

At the same time, the IRS has also clarified certain circumstances will not satisfy reasonable cause for failure to produce documents. For example, the IRS will not allow a taxpayer to rely on foreign secrecy laws as justification for failing to respond to audit requests for documentation.

Under this logic, a taxpayer who fails to produce certain documents on the grounds that doing so would expose the taxpayer to various civil or criminal penalties under some foreign law will not be able to meet the reasonable cause threshold under section 982. This essentially means that reliance on foreign secrecy laws will not later allow the taxpayer to admit foreign-based documents in tax litigation if those documents should have been produced by the taxpayer pursuant to a formal document request.

How a Tax Attorney Can Help

Responding to document requests in any audit situation can be confusing and complicated for a taxpayer. When these document requests pertain to documents located outside the U.S., the situation can be even more complex. The actions taken by a taxpayer at the audit phase can have implications down the road during a tax litigation case. To help you choose the best strategy for dealing with IRS document requests, you should consider consulting an experienced international tax attorney.

The The Tax Lawyer - William D. Hartsock has been successfully helping clients with tax issues related to their foreign assets since the early 1980s. Mr. Hartsock offers free consultations with the full benefit and protections of attorney client privilege to help people clearly understand their situation and options based on the circumstances of their case. To schedule your free consultation simply fill out the contact form found on this page, or call (858) 481-4844.