The Internal Revenue Service’s (IRS) Large and Mid-Size Business (LMSB) Division serves approximately 224,000 business taxpayers with assets of more than $5 million. These taxpayers make annual cash payments of $712 billion. The LMSB Division annually examines 20,000 returns, including 450 to 575 of the nation’s largest corporations. Part of the Division’s mission is to be a world class organization, responsive to the needs of business taxpayers in a global environment, while applying innovative approaches to customer service and compliance.

One of the LMSB Division’s four strategic initiatives to meet its mission is to build a tax administration to effectively deal with globalization. The LMSB Division is responsible for identifying, screening, and determining whether returns with international features require examination, for both the LMSB and the Small Business/Self-Employed (SB/SE) Divisions.

The Foreign Controlled Corporation (FCC), also referred to as a foreign controlled domestic corporation, is part of the globalization that the LMSB Division must address. Potential FCCs comprised 65,726 returns (3 percent) of the approximately 2.2 million corporation returns filed in the United States (U.S.) for Tax Year (TY) 1997. An FCC is a corporation incorporated in the U.S. that is controlled by a foreign entity or entities, directly or indirectly. Control is defined as the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock. The IRS identifies corporations with 25 percent or greater foreign ownership as potential FCCs for internal processing.

Our objective was to determine whether the LMSB Division’s processes effectively address the compliance of FCCs.

The LMSB Division’s processes for research and planning, as well as controls over FCC returns selected for examination by International Examiner revenue agents, need improvement. Effective research and planning necessitates access to accurate and timely information from the Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Form 5472). These returns have not been timely processed for use. In addition, referral controls need to be improved to ensure that all FCC returns selected for examination by international classifiers are timely referred to the International Examination groups by the Domestic revenue agents. Overall, we were not able to determine whether the IRS has an effective process to ensure the compliance of FCCs.

Form 5472 is required to be filed in duplicate by the reporting corporation. The reporting corporation files one or more copies of the Form 5472 separately with the Philadelphia Submission Processing Center (PSPC). The reporting corporation is also required to attach one or more copies of Form 5472 to the corporate income tax return that it files. The PSPC annually received approximately 95,000 Form 5472 returns for TYs 1996 to 1999. However, due to insufficient resources, the PSPC processed none of the TY 1996 and 1997 returns, while timely processing 100 percent of the TY 1998 returns and 65 percent of the TY 1999 returns into the Foreign Information System (FIS). The IRS’ ability to perform research, identify trends, and estimate the effect of transfer pricing issues related to foreign-owned U.S. corporations and foreign corporations engaged in a U.S. trade or business depends on the availability of timely and complete FIS data. In December 2000, the LMSB Division provided additional resources to process the Forms 5472.

All corporate returns with 25 percent or more foreign ownership are identified during returns processing in each of the IRS’ submission processing centers. These returns are forwarded to a unit to await screening for examination potential. Periodically, the LMSB Division sends a team of International Examiners to each of the submission processing centers to screen these returns. The returns selected are marked for referral to an International Examination group. The selected returns are then forwarded to Domestic Examination groups in the LMSB and the SB/SE Divisions for further evaluation.

Controls to ensure these selected returns are actually referred by Domestic Examination groups to International Examination groups are currently not required. Our survey of four submission processing centers showed only one had established a computer code to prevent returns from being closed without a referral to an International Examination group.

The Commissioner, LMSB Division, in consultation with the Commissioner, SB/SE Division, should establish a uniform control to prevent local Domestic Examination groups from making a decision not to examine a selected return with international features without the concurrence an International Examination group. This can be done by establishing a computer freeze code at the submission processing centers on the selected returns that can be released only by the International Examination groups once the return has been referred.

Management’s Response: The LMSB Division formed an International Classification Task Force that has been looking at the non-referral problem and is considering various options to ensure timely referrals by domestic examiners to international groups. Until the task force completes its work, the LMSB Division will emphasize using the freeze code to prevent domestic examiners from prematurely closing cases they should refer to the International Examination groups. In addition, managers in the LMSB and SB/SE Divisions will coordinate closer to ensure timely referrals of international cases and the use of an interim freeze code. Management’s complete response to the draft report is included as Appendix IV.