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Treasury and Internal Revenue Service Publish Regulations on Failure to File Gain Recognition Agreements

Posted in Federal Tax Regulations

The Service and Treasury, in T.D. 9704, 2014-50 IRB 922 have published final regulations which clarify, as well as update, the rules on the consequences faced by U.S. and foreign persons for failing to file GRAs or other reporting obligations and resulting penalties under §6038B with respect to certain transfers of property made to foreign corporations in a non-recognition transaction. The Service had previously issued regulations in 2013 (proposed regulations) which required a U.S. person that transfers property to a foreign corporation to file a Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation,” regarding a transfer of stock or securities when a GRA is filed as well to avoid penalties under §6038B. The proposed regulations did not require the U.S. transferor to report any specific information regarding the transferred stock or securities. The final regulations modify Treas. Reg. §1.6038-1(b)(2)(iv) and require the U.S. transferor report the FMV, adjusted tax basis and gain recognized on the transferred stock or securities and other information.

The proposed regulations apply to requests for relief submitted on or after the date the final regulations become effective. The final regulations set forth a procedure whereby U.S. transferors can resubmit previously filed requests, including requests that were denied. Relief has been extended for non-willful failures with respect to other reporting obligations under §367(a) that were not covered in the proposed regulations. See Treas. Regs. §§1.367(a)-2 and 1.367(a)-7. The previously issued temporary regulations under Treas. Reg. § 1.367(a)-7T regarding reasonable cause relief has been removed.
The final regulations permit in certain instances, a U.S. transferor to attach a copy of a previously filed Form 8838, “Consent to Extend the Time to Assess Tax Under Section 367 — Gain Recognition Agreement,” to an amended return.

Preamble Summary to Final Regulations of Comments and Explanation of Revisions

A. Meeting the Requirements Under Section 6038B Where GRA is Filedatisfaction of Section .
The proposed regulations (issued in January, 2013) under §6038B require a U.S. person that transfers property to file a Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, with respect to a transfer of stock or securities in all cases in which a GRA is filed in order to avoid penalties under section 6038B. The proposed regulations do not require that the U.S. transferor report on Form 926 any specific information regarding the transferred stock or securities.
The final regulations require that similar information that must be provided for other types of transferred property, the U.S. transferor should report on the Form 926 the fair market value, adjusted tax basis, and gain recognized with respect to the transferred stock or securities, as well as any other information that Form 926, its accompanying instructions, or other applicable guidance require be submitted with respect to the transfer of the stock or securities. See Treas. Reg. §1.6038B-1(b)(2)(iv)(as modified by the final regulations).

B. Previously Filed Requests

The proposed regulations (2013) in Treas. Reg.§ 1.367(a)-8(p) only apply to requests for relief submitted on or after the date the proposed regulations are adopted as final regulations. The final regulations provide relief for certain failures to file or otherwise comply with the GRA rules where such GRA failures that were not willful and that were the subject of requests for relief submitted under Treas. Reg.§ 1.367(a)-8(p) of the existing final regulations (or submitted under Treas. Reg. § 1.367(a)-8T(e)(10) or predecessor provision. Treas. Reg. § 1.367(a)-8(r)(3) of the finalized regulations sets forth a procedure under which U.S. transferors may resubmit certain previously filed requests (including requests that were denied). By submitting a previously filed request under this procedure, a U.S. transferor agrees that the newly issued final regulations under Treas. Reg. § 1.6038B-1 will apply to any transfer that is the subject of the request. This change is intended to provide equal treatment between similarly situated U.S. transferors and promote the policies underlying the proposed regulations by ensuring that a U.S. transferor that establishes its failure was not willful under Treas. Regs.§ 1.367(a)-8(p) is still subject to penalties under §6038B if its failure was not due to reasonable cause.

C. Amended Return Filing as a Requirement to Seeking Relief

A comment had been noted in the Preamble pertaining to § 1.367(a)-8(p)(2) of the proposed regulations for establishing that failures to file GRA documents, or failures to comply, were not willful. The comment requested that final regulations excuse Coordinated Industry Case (CIC) taxpayers from the requirement under § 1.367(a)-8(p)(2) of filing an amended return promptly after discovering a failure to file or a failure to comply. Such commentator suggested that the final regulations could be adopted to allow CIC taxpayers to submit the materials required under § 1.367(a)-8(p)(2) when the taxpayers effect a “qualified amended return” under Rev. Proc. 94-69, 1994-2 CB 804 (generally providing special procedures for certain taxpayers to show additional tax due or make adequate disclosure with respect to an item or position on a tax return prior to an audit). This suggestion was not adopted by in the final regulations cited that the same concerns exist in other international contexts thereby making this request inappropriate to create different procedures and exceptions for required information. The Preamble noted, however, that the issue was still under study.

D. Modifying the Reported Fair Market Value of Transferred Stock

Another comment received requested the final regulations provide a procedure under which taxpayers may modify the fair market value of transferred stock or securities reported on a previously filed GRA. In support, the commentator alleged that taxpayers often determine the fair market value of stock or securities before the date that the stock or securities are transferred to a foreign corporation; these determinations are based on projected financial information that may, in some cases, deviate from the actual financial information on the date of the transfer.

This recommendation was also declined based on the view that the proposed regulations had adequately addressed this issue. First, because a GRA is filed when a taxpayer files its tax return (rather than at the time of an outbound transfer of stock or securities), a taxpayer has, not including extensions, at least two and a half months following a transfer to reconcile projected financial information with actual financial information. Furthermore, a taxpayer may file an extension if it needs additional time to comply with the requirements of § 1.367(a)-8. Finally, a taxpayer that fails to materially comply with the requirements of § 1.367(a)-8, including the requirement to include the fair market value of the transferred stock or securities in the GRA pursuant to Treas. Reg. § 1.367(a)-8(c)(3)(i)(B), may be eligible to correct the GRA by seeking relief based on a claim that the failure was not willful.
E.Extension of Relief for Failures that are Not Willful to Other Section 367(a) Reporting Obligations
Treas. Reg. §1.367(a)-2 has been revised to provide an exception to gain recognition under §367(a)(1) for assets transferred outbound for use in the active conduct of a trade or business outside of the United States) and Treas. Reg. § 1.367(a)-7 (application of §367(a) to an outbound transfer of assets by a domestic target corporation in an exchange described in § 361) so that a taxpayer may, solely for purposes of §367(a), be deemed not to have failed to comply with reporting obligations under Treas. Regs. §§ 1.367(a)-2 and 1.367(a)-7 by demonstrating that the failure was not willful. Temp. Reg. § 1.367(a)-7 regarding reasonable cause relief is removed. Because the cases in which relief is sought under § 1.367(a)-2 and many of the cases in which relief is sought under Treas. § 1.367(a)-7 are also subject to reporting under §6038B and the regulations thereunder, the penalty imposed under § 6038B for failure to satisfy a reporting obligation has been determined to be sufficient to encourage proper reporting and compliance.

F. Withdrawal of Prior GRA Directive

On July 26, 2010, the Deputy Commissioner International (LMSB) issued directive LMSB-4-0510-017 (Directive). The Directive permits taxpayers to remedy, without having to demonstrate reasonable cause, unfiled or deficient GRA documents associated with a timely filed initial GRA or a timely filed document purporting to be an initial GRA. The Directive explained that the means to best ensure compliance with the GRA provisions was under study and that, pending the study, the Directive would be effective “until further notice.” Because this Treasury decision provides comprehensive guidance that is designed to ensure compliance with the GRA provisions, the Deputy Commissioner (International), Large Business & International will revoke the Directive effective on November 19, 2014.

G. Including an Original Form 8838 with a Request for Relief

The proposed regulations § 1.367(a)-8(p)(2)(i) provided that a U.S. transferor who seeks relief for a failure to file or failure to comply with the GRA rules must, among other requirements, file an original Form 8838, Consent to Extend the Time to Assess Tax Under Section 367 — Gain Recognition Agreement, with an amended return. The Form 8838 must, with respect to the gain realized but not recognized on the initial transfer, extend the period of limitations on the assessment of tax to the period specified in § 1.367(a)-8(p)(2)(i) of the proposed regulations.

The government stated in the Preamble it recognized that in certain cases (for example, certain cases in which a U.S. transferor seeks relief for an unfiled annual certification), the U.S. transferor will already have filed an original Form 8838 that extends the period of limitations through the required time period. The final regulations provide that, in these cases, a U.S. transferor need not file another Form 8838 with the amended return; rather, the U.S. transferor must attach a copy of the previously filed Form 8838 to the amended return. A similar modification is made to these final regulations under Treas. Reg. § 1.367(e)-2 concerning outbound liquidations and certain foreign-to-foreign liquidations described in §332.

H. Failure to Comply and Extension of Period of Limitations

Treas. Reg. §1.367(a)-8(j)(8) of the existing regulations provides that a failure to comply with the GRA provisions extends the statute of limitations until the close of the third full taxable year ending after the date on which the Director of Field Operations or Area Director receives actual notice of the failure to comply from the U.S. transferor. The same provision was included in the proposed regulations. Prop. Reg. §1.367(e)-2(e)(4)(ii)(B) contains a similar rule with respect to a liquidation document.

The government has now concluded that the extension of the statute of limitations under this regulations should be based on when the taxpayer furnishes to the Director of Field Operations International, Large Business & International (or any successor to the roles and responsibilities of such person) the information that should have been provided under the §§ 1.367(a)-8 or 1.367(e)-2 regulations, as applicable. The final regulations, in Treas.Regs. §§ 1.367(a)-8(j)(8) and 1.367(e)-2(e)(4)(ii)(B), have been modified accordingly.

The regulations in pertinent part have also been revised to clarify that when a taxpayer files a GRA under Treas. Reg. § 1.367(a)-8 or a liquidation document under Treas. Reg. § 1.367(e)-2, the taxpayer agrees to extend the period of limitations on assessment of tax, in the circumstances provided in §§ 1.367(a)-8(j)(8) and 1.367(e)-2(e)(4)(ii)(B), as applicable. This agreement is deemed consented to and signed by the Secretary for purposes of § 6501(c)(4).

I. Reporting Requirement Contained in Treas. Reg. § 1.367(a)-3(c)(6)(i)(F)(3)

Treas. Reg. §1.367(a)-3(a) of the existing final regulations provides, in general, that a U.S. person must recognize gain on certain transfers of stock or securities to a foreign corporation. In relevant part, Treas. Reg. § 1.367(a)-3(c) of the existing final regulations provides an exception for certain transfers of stock or securities of a domestic corporation. In particular, Treas. Reg. § 1.367(a)-3(c)(1) provides that, except as provided in Treas.Reg. § 1.367(a)-3(e) (providing rules for transfers of stock or securities by a domestic corporation to a foreign corporation pursuant to an exchange described in section 361), a transfer of stock or securities of a domestic corporation by a U.S. person to a foreign corporation that would otherwise be subject to gain recognition under §367(a)(1) pursuant to Treas. Reg. § 1.367(a)-3(a) will not be subject to gain under § 367(a)(1) if certain requirements are satisfied.

In particular, the domestic corporation the stock or securities of which are transferred (referred to as the U.S. target company) must comply with each of the reporting requirements in Treas. Reg. § 1.367(a)-3(c)(6) and each of the four conditions set forth in § 1.367(a)-3(c)(1)(i) through (iv) must be satisfied. The condition set forth in Treas. Reg. § 1.367(a)-3(c)(1)(iv) requires that the active trade or business test (as defined in Treas. Reg. § 1.367(a)-3(c)(3)) must be satisfied. To satisfy the active trade or business test, the substantiality test (as defined in § 1.367(a)-3(c)(3)(iii)) must be satisfied (among other requirements). The substantiality test is satisfied if, at the time of the transfer, the fair market value of the transferee foreign corporation is at least equal to the fair market value of the U.S. target company.

Under Treas. Reg. § 1.367(a)-3(c)(6)(i)(F)(3), the U.S. target company must submit a statement which confirms that the value of the transferee foreign corporation exceeds the value of the U.S. target company on the acquisition date. The standard that applies for purposes of the reporting requirement of Treas. Reg. § 1.367(a)-3(c)(6)(i)(F)(3) is intended to be the same as the standard that applies for purposes of the substantiality test. The final regulations modify Treas. Reg. § 1.367(a)-3(c)(6)(i)(F)(3) so that the U.S. target company must submit a statement demonstrating that the value of the transferee foreign corporation equals or exceeds the value of the U.S. target company on the acquisition date.

Service Issues Notice 2014-44 on Foreign Tax Credits and Covered Asset Acquisitions

Posted in Federal Tax Rulings

In Notice 2014-44, 2014-32 IRB 270 (7/21/2014), the Service announced on July 21 of last Summer, that it will be issuing regulations under §901(m)(1) to dispositions of assets following a covered asset acquisition and to covered asset acquisitions described in §901(m)(2)(C) which also intersects with §754 elections. This will be accomplished by providing a new definition for dispositions of assets followed a covered asset acquisition. The tax planning community had waited patiently for guidance under §901(m). The Notice addresses transactions that have been seen as allowing avoidance of foreign tax credit disqualification with respect to assets for which the foreign tax basis differs from the U.S. income tax basis. According to the notice, the IRS and Treasury intend to issue new regulations consistent with the notice that will be effective from July 21.

The Notice targets transactions that apply the statutory disposition rule under §901(m)(3)(B)(ii) when a foreign corporation acquired by a foreign subsidiary in a §338(g) covered asset acquisition and later becomes a disregarded entity in a check-the-box election. For U.S. tax purposes, the disregarded entity election is treated as a distribution of the foreign corporation’s assets and liabilities to the foreign subsidiary in a deemed liquidation. The Notice, as discussed below, claims that the deemed liquidation should be treated as a disposition of the relevant foreign assets (RFAs) under §901(m)(3)(B)(ii). As a result, taxpayers claim that all of the basis difference with respect to the RFAs is allocated to the final taxable year of [the foreign corporation] that occurs by reason of the deemed liquidation, and that no basis difference with respect to the RFAs is allocated to any later taxable year,”

Background

New legislation (enacted in August 2010) contained various international revenue raisers that will impact the effective use of foreign tax credits: including; (i) the FTC “splitter transaction” rules under §909; (ii) the denial of FTCs for “covered asset acquisitions under §901(m); (iii) the limitation on foreign taxes paid under §956—the “hopscotch rule” (new §960(c)) and (iv) a new separate basked limitation under §904(d) for items “resourced” under tax treaties. This post pertains to the Notice issued with respect to the issuance of regulations under the covered asset acquisition rule in §901(m).
Section 901(m)(1) provides that with respect to a CAA (covered asset acquisition), the disqualified portion of any foreign income tax with respect to the income or gain derived from “relevant” foreign assets (RFAs) will not be taken into account in determining the allowable foreign tax credit (FTC) allowed under §901(a), and, in the case of a foreign income tax paid by a §902 corporation, will not be taken into account under §§902 or 960. In such case the disqualified portion of any foreign income tax is allowed as a deduction under §164.

Section 901(m)(2) provides that a CAA is: (i) a qualified stock purchase per §338(d)(3) to which §338 applies; (ii) any transaction treated as an asset acquisition for U.S. income tax purposes and as the acquisition of stock of a corporation (or is disregarded) for foreign income tax; (iii) an acquisition of an interest in a partnership which has an election in effect under §754; and (iv) to the extent provided by regulation, any other similar transaction.

Section 901(m)(4) provides that RFA means, with respect to any CCA, any asset, including goodwill, going concern value or other intangible, with respect to such acquisition if income, deduction, gain or loss attributable to such asset is taken into account in determining foreign income tax per §901(m)(1).
Section 901(m)(3)(A) provides that the term “ disqualified portion” means, with respect to any CAA, for any taxable year, the ratio (expressed as a percentage) of: (1) the aggregate basis differences (but not below zero) allocable to such taxable year with respect to all RFAs; divided by (2) the income on which the foreign income tax referenced in §901(m)(1) is determined. If the taxpayer fails to substantiate the income on which the foreign income tax is determined to the satisfaction of the Secretary, such income will be determined by dividing the amount of such foreign income tax by the highest marginal tax rate applicable to the taxpayer’s income in the relevant jurisdiction. Section 901(m)(3)(C)(i) provides that basis difference means, with respect to any RFA, the excess of (1) the adjusted basis of such asset immediately after the CAA, over (2) the adjusted basis of such asset immediately before the CAA. The basis difference can be either a positive or a negative number.

Section 901(m)(3)(B)(i) provides the general rule that the basis difference with respect to any RFA will be allocated to taxable years using the applicable cost recovery method for U.S. income tax purposes. Section 901(m)(3)(B)(ii) provides that, except as otherwise provided by the Secretary, if there is a disposition of any RFA, the basis difference allocated to the taxable year of the disposition will be the excess of the basis difference of such asset over the aggregate basis difference of such asset that has been allocated to all prior taxable years (Unallocated Basis Difference). No basis difference with respect to such asset will be allocated to any taxable year thereafter.

The Staff of the Joint Committee on Taxation’s explanation of §901(m) with respect to disposition of RFAs sets forth:
“If there is a disposition of any relevant foreign asset before its cost has been entirely recovered or of any relevant foreign asset that is not eligible for cost recovery (e.g., land), the basis difference allocated to the taxable year of the disposition is the excess of the basis difference with respect to such asset over the aggregate basis difference with respect to such asset that has been allocated under this provision to all prior taxable years. Thus, any remaining basis difference is captured in the year of the sale, and there is no remaining basis difference to be allocated to any subsequent tax years. However, it is intended that this provision generally apply in circumstances in which there is a disposition of a relevant foreign asset and the associated income or gain is taken into account for purposes of determining foreign income tax in the relevant jurisdiction.”
Staff of the Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to H.R. 1586, Scheduled for Consideration by the House of Representatives on August 10, 2010, at 15 (August 10, 2010) (emphasis added). Section 901(m)(7) authorizes the issuance of legislative regulations or other guidance to carry out the purposes of §901(m) including its application with respect to CAAs and RFAs to which the basis difference is ineglible.

Problems With Statutory Disposition Rule

The statutory disposition rule in § 901(m)(3)(B)(ii) applied to a RFA is, according to the Notice, appropriate where gain or loss from the disposition is fully recognized for purposes of both U.S. income tax and a foreign income tax. However, in certain cases, including cases in which the gain or loss from the disposition is recognized for purposes of U.S. income tax but not for purposes of a foreign income tax, or cases in which no gain or loss is recognized for purposes of U.S. income tax or the foreign income tax, it may not be the appropriate time for all, or any, of the Unallocated Basis Difference to be taken into account. Furthermore, §901(m) should continue to apply to the remaining Unallocated Basis Difference.

The Notice further announced that the IRS and the Treasury Department are aware that certain taxpayers are engaging in transactions shortly after a CAA occurs that are intended to invoke application of the statutory disposition rule under §901(m)(3)(B)(ii) to avoid the purpose of §901(m).
Example: USP, a domestic corporation, wholly owns FSub, a foreign corporation, and FSub acquires 100% of the stock of FT, a foreign corporation, in a qualified stock purchase (per § 338(d)(3)) for which an election under §338(g) is made. The acquisition of the stock of FT is a §338 CAA, and the assets of FT are RFAs with respect to that §338 CAA. Shortly after the acquisition of FT in the § 338 CAA, FT becomes disregarded as an entity separate from its owner pursuant to an entity classification election under Treas. Reg. § 301.7701-3. As a result of the entity classification election, FT is deemed, solely for U.S. tax purposes, to distribute all of its assets and liabilities to FSub in liquidation (deemed liquidation) immediately before the closing of the day before the election is effective. Consider Treas. Regs. § 1.338-3(c)(1) and § 301.7701-3(g)(1)(iii) and (g)(3)(ii). On these facts, no gain or loss is recognized on the deemed liquidation by either FT or FSub pursuant to §§332 and 337.
The Service, in the Notice, commented that taxpayers take the position that the deemed liquidation constitutes a disposition of the RFAs for purposes of § 901(m)(3)(B)(ii). As a result, taxpayers claim that all of the basis difference with respect to the RFAs is allocated to the final taxable year of FT that occurs by reason of the deemed liquidation, and that no basis difference with respect to the RFAs is allocated to any later taxable year.

This pro-taxpayer argument is made notwithstanding that (i) the disparity in the basis in the assets of FT for purposes of U.S. income tax and the foreign income tax that arose as a result of the §338 CAA continues to exist after the deemed liquidation, and (ii) because no gain is recognized for foreign income tax purposes as a result of the deemed liquidation, there is also no foreign income tax that is subject to disqualification under §901(m) as a result of the liquidation. Although the deemed liquidation of FT is also a CAA, the basis difference that arises with respect to this subsequent CAA generally would be minimal. Taxpayers have engaged in other variations of this transaction, each of which raises significant policy concerns.

Regulations to Be Issued

Application of Section 901(m) to a Disposition of an RFA
For purposes of §901(m), a disposition means an event (for example, a sale, abandonment, or mark-to-market event) that results in gain or loss being recognized with respect to an RFA for purposes of U.S. income tax or a foreign income tax, or both. For example, in transactions such as those described in section 3 of this Notice, the tax-free deemed liquidation arising upon FT’s entity classification election does not result in a disposition of an asset for purposes of §901(m).
The portion of a basis difference with respect to an RFA that is taken into account for a taxable year as a result of a disposition (Disposition Amount) will be determined pursuant to either of two rules.
First, if a disposition is fully taxable (that is, results in all gain or loss, if any, being recognized with respect to the RFA) for purposes of both U.S. income tax and a foreign income tax, the Disposition Amount is equal to the Unallocated Basis Difference. This is because generally no longer will there be a disparity in the basis of the RFA for purposes of U.S. income tax and the foreign income tax (U.S. Basis and Foreign Basis, respectively).

Second, if a disposition is not fully taxable for purposes of both U.S. income tax and a foreign income tax, generally a disparity will continue in the U.S. Basis and the Foreign Basis following the disposition, and it is appropriate for the RFA to continue to be subject to §901(m). To the extent that the disparity in the U.S. Basis and the Foreign Basis is reduced as a result of the disposition, however, a portion of the Unallocated Basis Difference (or in certain cases, all of the Unallocated Basis Difference) should be taken into account. Whether the disposition reduces the basis disparity will depend on whether the basis difference is positive or negative and the jurisdiction in which gain or loss is recognized.

In the case of a positive basis difference, a reduction in basis disparity generally will occur upon a disposition of an RFA if (i) gain is recognized for purposes of a foreign income tax (Foreign Disposition Gain), which generally results in an increase in the Foreign Basis of the RFA, or (ii) loss is recognized for U.S. income tax purposes (U.S. Disposition Loss), which generally results in a decrease in the U.S. Basis of the RFA. Accordingly, if the RFA has a positive basis difference, the Disposition Amount equals the lesser of: (i) any Foreign Disposition Gain plus any U.S. Disposition Loss (solely for this purpose, expressed as a positive amount), or (ii) the Unallocated Basis Difference.
In the case of a negative basis difference, a reduction in basis disparity generally will occur upon a disposition of an RFA if (i) loss is recognized for purposes of a foreign income tax (Foreign Disposition Loss), which generally results in a decrease in the Foreign Basis of the RFA, or (ii) gain is recognized for U.S. income tax purposes (U.S. Disposition Gain), which generally results in an increase in the U.S. Basis of the RFA. Accordingly, if the RFA has a negative basis difference, the Disposition Amount equals the greater of the following amounts: (i) any Foreign Disposition Loss plus any U.S. Disposition Gain (solely for this purpose, expressed as a negative amount), or (ii) the Unallocated Basis Difference. To the extent the entire Unallocated Basis Difference is not taken into account as a Disposition Amount, §901(m) continues to apply to the remaining Unallocated Basis Difference.

Special Rules for a Section 743(b) CAA

Where an RFA is subject to a §743(b) CAA, the basis difference generally is the resulting basis adjustment under §743(b) that is allocated to the RFA under the rules of §755. If an RFA was subject to a §743(b) CAA and subsequently there is a disposition of the RFA, consistent with the computation of basis difference in a §743(b) CAA, the computation of the Disposition Amount only takes into account the amount of gains and losses that are attributable to the partnership interest that was transferred in the §743(b) CAA.

Therefore, the Notice states that for determining the Disposition Amount, Foreign Disposition Gain or Foreign Disposition Loss means the amount of gain or loss recognized for purposes of a foreign income tax on the disposition of the RFA that is allocable to the partnership interest that was transferred in the §743(b) CAA. In addition, U.S. Disposition Gain or U.S. Disposition Loss means the amount of gain or loss recognized for U.S. income tax purposes on the disposition of the RFA that is allocable to the partnership interest that was transferred in the §743(b) CAA, taking into account the basis adjustment under §743(b) that was allocated to the RFA under §755.

Continuing Application of Section 901(m) to Remaining Basis Difference

The Notice further states that §901(m) continues to apply to an RFA until the entire basis difference in the RFA has been taken into account under § 901(m)(3)(B)(i) using the applicable cost recovery method for U.S. income tax purposes or as a Disposition Amount (or both). Thus, even if there is a change in the ownership of an RFA, for example, by reason of a transaction that is a disposition only for U.S. income tax purposes, §901(m) continues to apply to the RFA until any remaining Unallocated Basis Difference in the RFA has been taken into account. The IRS and the Treasury Department are continuing to consider whether and to what extent §901(m) should apply to an asset received in exchange for an RFA in a transaction in which the basis of the asset is determined by reference to the basis of the RFA transferred.

If an RFA is subject to multiple §§743(b) CAAs (Prior Section 743(b) CAA and Subsequent Section 743(b) CAA) and the same partnership interest is acquired in both the Prior §743(b) CAA and the §743(b) CAA, the RFA will be treated as having no Unallocated Basis Difference with respect to the Prior §743(b) CAA for purposes of applying § 901(m) to the Subsequent §743(b) CAA if the basis difference for the Subsequent §743(b) CAA is determined independently from the Prior §743(b) CAA. In this regard, see generally Treas. Reg. § 1.743-1(f) and proposed Treas. Reg. § 1.743-1(f)(2). If the Subsequent §743(b) CAA results from the acquisition of only a portion of the partnership interest acquired in the Prior §743(b) CAA, then the transferor will be required to equitably apportion the Unallocated Basis Difference attributable to the Prior §743(b) CAA with respect to the RFA between the portion retained by the transferor and the portion transferred. With respect to the portion transferred, the RFA will be treated as having no Unallocated Basis Difference with respect to the Prior §743(b) CAA for purposes of applying §901(m) to the Subsequent § 743(b) CAA if the basis difference for the Subsequent §743(b) CAA is determined independently from the Prior §743(b) CAA.

Example 1. (i) Facts. USP, a domestic corporation, wholly owns CFC, a foreign corporation organized under the laws of Country A. FT is an unrelated foreign corporation organized under the laws of Country A and subject to Country A income tax. FT owns one asset (Asset), a parcel of land. On January 1, Year 1, CFC acquires all the stock of FT in exchange for 300u (Acquisition) in a qualified stock purchase for which an election under section 338(g) is made. The Acquisition is treated as an asset acquisition for U.S. income tax purposes and as a stock acquisition for Country A income tax purposes. Immediately before the Acquisition, Asset had a U.S. Basis and Foreign Basis of 100u. Effective on February 1, Year 1, FT elects to be disregarded as an entity separate from its owner pursuant to Treas. Reg. § 301.7701-3. As a result of the election, FT is deemed, solely for U.S. tax purposes, to distribute Asset to CFC in liquidation (Deemed Liquidation) immediately before the closing of the day before the election is effective pursuant to Treas.Regs. §§ 301.7701-3(g)(1)(iii) and -3(g)(3)(ii). No gain or loss is recognized on the Deemed Liquidation for purposes of either U.S. income tax or Country A income tax. (ii) Analysis. The Acquisition is a § 338 CAA because § 338(a) applies to the qualified stock purchase of FT stock with respect to which the §338(g) election is made. Immediately after the Acquisition, Asset is an RFA owned by CFC with a basis difference of 200u (300u – 100u). Because the Deemed Liquidation does not result in gain or loss being recognized with respect to Asset for purposes of U.S. income tax or Country A income tax, there is no disposition of Asset for purposes of section 901(m). Accordingly no basis difference with respect to Asset is taken into account by FT as a result of the Deemed Liquidation. Furthermore, section 901(m) will continue to apply to the basis difference with respect to Asset, as held by CFC for U.S. income tax purposes, until the entire 200u basis difference has been taken into account under §901(m)(3)(B).

Example 2.(i) Facts. Same as in Example 1 except that FT does not elect to be disregarded as an entity separate from its owner. Instead, on March 1, Year 1, FT transfers Asset (worth 300u and U.S. Basis of 300u) to FC (Transfer), an unrelated controlled foreign corporation organized under the laws of Country A, in exchange for stock of FC worth 250u and 50u of cash. The Transfer results in gain of 50u recognized for Country A income tax purposes. Although the Transfer is a taxable transaction for U.S. income tax purposes, no gain or loss is recognized for U.S. income tax purposes because the amount realized and the U.S. Basis are the same amount. (ii) Analysis. Because the Transfer results in gain being recognized by FT with respect to Asset for Country A income tax purposes, there is a disposition of Asset for purposes of § 901(m). Accordingly, FT takes into account the portion of the basis difference with respect to Asset equal to the Disposition Amount of 50u (the lesser of the Foreign Disposition Gain of 50u or the Unallocated Basis Difference of 200u). Section 901(m) will continue to apply to Asset, as held by FC, until the remaining 150u basis difference (200u – 50u) has been taken into account under § 901(m)(3)(B).

Effective Date

Except as provided in §5 of the Notice, the regulations described in this notice will apply to dispositions occurring on or after July 21, 2014. The regulations described in the first paragraph of section 4.02 and second paragraph of section 4.03 of this notice will apply to §743(b) CAAs occurring on or after July 21, 2014, but taxpayers may consistently apply the guidance in those paragraphs to all §743(b) CAAs occurring on or after January 1, 2011. The regulations described in the first two sentences of the first paragraph of section 4.03 of this notice will apply to any Unallocated Basis Difference with respect to an RFA as of July 21, 2014 and any basis difference with respect to an RFA that arises in a CAA occurring on or after July 21, 2014. The Notice further states that no inference is intended as to the treatment of transactions such as those described in section 3 of this notice under current law, and the IRS may challenge such transactions under applicable Code provisions or judicial doctrines.

China Announces Retroactive Ten Percent Trading Profits Tax

Posted in Foreign Tax Law Developments

In a news release issued by Reuters on February 27, 2015, China’s tax authorities have warned foreign investors with a proposed capital-gains tax which would take 10% of trading profits or gains without reduction for trading losses. Chinese tax regulations finally revealed the details of how China plans to tax past profits of foreign institutional investors through cross-border investment programs. The plan would apply to investors who have traded stocks and other equity-based instruments through China’s two largest portfolio investment schemes for foreigners, and would be levied retrospectively on profits made over the past five years. So much for the non-discrimination provisions of any bilateral tax convention entered into by China and another country, including the United States. See Article 23, U.S.-China Income Tax Treaty.

The details of the tax plan were announced in Beijing by municipal representatives of China’s State Administration of Taxation. The Tax Authority stated that “Transactions of equity investments are taxed based on gains from each transaction, and the applicable tax rate is 10% without netting for losses. The tax applies to investors in the Qualified Foreign Institutional Investor (QFII) program and the renminbi-denominated version of the same program (RQFII) between Nov. 17, 2009 and Nov. 16, 2014. “ Investors in such transactions, representing a total $116 billion in investment, had been long expecting a retrospective tax to be imposed and had set aside some of their profits in anticipation. But many assumed it would be levied on net rather than gross gains, in keeping with international tax norms. Hundreds of millions of dollars have been withheld by QFII and RQFII asset managers waiting for the government’s position to be announced. That means the money they have set aside over the past few years is likely to fall short of their actual tax bill, possibly by as much as $4 billion, according to Shanghai-based investment analysts Z-Ben Advisors.

Chief Counsel Advisory 201501013 Warns Foreign Fund Manager Activity in the U.S. May Constitute Trading in Stock and Securities For the Fund and Its Foreign Investors

Posted in Federal Tax Rulings

In CCA 201501013 (1/2/2015) the Office of Chief Counsel of the IRS ruled that the lending and underwriting (stock distribution) activities of a foreign partnership (Fund) were considerable, continuous and regularly carried on, and therefore that such activities, conducted on its behalf through its U.S. agent (Fund Manager) under the particular facts before it, constituted the carrying on of a U.S. trade or business and the activities. The Fund did not, in its view, qualify under the “trading in stocks and securities” safe harbor exceptions under Section 864(b)(2)(A). This resulted in a foreign corporation that is a partner of the Foreign Feeder Fund as also being engaged in a U.S. trade or business.

Facts Involved

Fund was organized in a State within the U.S. and then in the subsequent year, converted from a State A limited partnership to a foreign jurisdiction exempted limited partnership. During year 1 and 2, the Fund constituted a partnership for U.S. income tax purposes. During the same two years, Foreign Feeder, a foreign entity treated as a corporation for U.S. income tax purposes, was a limited partner in the Fund. The foreign corporation (FC) was organized in a jurisdiction which does not have a bilateral income tax convention with the U.S.

The Fund had no employees during years 1 and 2. The management of Fund was vested exclusively in Fund Manager. Fund and Fund Manager entered into a management agreement pursuant to which Fund appointed Fund Manager as Fund’s agent and irrevocable attorney-in-fact with power to buy, sell, and deal in securities and related contracts for the Fund’s account. Fund further granted Fund Manager the power and authority to perform every act necessary and proper to be done. Pursuant to that grant of authority, Fund Manager conducted an extensive lending and stock distribution business on behalf of Fund. Fund Manager conducted these business activities and otherwise managed Fund primarily through an office in the United States. Fund Manager provided similar services for other investment entities, and no employees of Fund Manager worked exclusively for Fund.

Fund Manager held Fund out to the markets as a lender and underwriter, generating business for Fund in a variety of ways. Fund Manager had many investment professionals who used their extensive business and personal relationships to generate lending and stock distribution deals for Fund. As a result of the efforts of these investment professionals, accounting firms, securities attorneys, and third-party investment bankers referred potential borrowers and stock issuers to Fund. In marketing materials, Fund touted its Fund Manager also sponsored and attended industry conferences relating to deal origination to generate lending and stock distribution opportunities for Fund.

Fund Manager, acting on Fund’s behalf pursuant to the management agreement, committed extensive time and resources to Fund’s lending activities. During years 1 and 2, Fund held a redacted number of convertible debt instruments and redacted number of promissory notes. Fund made many of the loans associated with those convertible debt instruments and promissory notes during years 1 and 2. Presumably the scale of the economic activity involved was substantial.

Fund Manager negotiated directly the loan agreements with borrowers. Before agreeing to make a loan, Fund conducted extensive due diligence on each potential borrower. Often, Fund lent borrowers money in return for debt instruments that were convertible into the borrowers’ stock at a future date. Typically, the conversion prices were discounted from the trading prices of the borrowers’ stock, determined at the time of conversion. After converting a debt instrument into stock at a discount, Fund sought to earn a spread by quickly disposing of the stock. Fund often received other property in connection with its lending agreements, including warrants to purchase additional shares of borrowers’ stock. Borrowers also paid Fund various fees. Aside from Fund Manager, no other entity participated in Fund’s lending activities.

Fund Manager, acting on Fund’s behalf pursuant to the management agreement, also committed extensive time and resources to conducting Fund’s stock distribution, or underwriting, activities. It entered into Distribution Agreements with unrelated issuers and negotiated the terms of each Distribution Agreement directly with the issues. A typical Distribution Agreement entitled an issuer to periodically issue and sell to Fund shares of stock in an amount equal to a total specified purchase price (“Fund’s commitment amount”). However, an issuer could typically only request a portion of the commitment amount (referred to as an advance) at any given time. The issuer was prohibited from requesting an advance until the issuer had filed with the Securities and Exchange Commission a registration statement registering the issuer’s stock for resale by the Fund, and the registration statement had become effective. An issuer requested an advance by providing Fund with a written notice. After the issuer provided notice, Fund was irrevocably bound to purchase stock from the issuer after a specified number of business days (the “[Redacted Text] Period”). During the [Redacted Text] Period, Fund endeavored to pre-sell an amount of the issuer’s stock that would generate enough cash to fund the advance requested by the issuer. Typically, Fund succeeded. Fund’s sales of stock included sales to U.S. purchasers.

At the end of the [Redacted Text] Period, the issuer sold stock to Fund at a discounted price (generally [Redacted Text] percent below the stock’s lowest daily trading price during the [Redacted Text] Period). Because Fund sold the stock at the current market price, but received stock from the issuer at a discount, Fund earned a spread on each share sold. Usually, an issuer also paid fees to Fund, including commitment, structuring, and due diligence fees.

General Tax Background

Taxation of Foreign Corporations Engaged in a Trade or Business Within the United States
A foreign corporation which engages in a trade or business within the United States is taxable on a net basis on its taxable income which is effectively connected with the conduct of a trade or business within the United States. §882(a)(1). Important to recognize in this case is that a foreign corporation who is a member of a partnership that is engaged in a trade or business within the United States it deemed to also be engaged in a trade or business within the United States. §875(a)(1).

The term “trade or business within the United States” includes the performance of personal services at any time within the taxable year for example but does not include certain de minimis personal service activity and does not include, in certain instances, “trading in stock or securities” or trading in commodities. §864(b)(2)(A).

The determination of when a foreign person is engaged in a trade or business in the United States is a question of fact based on review of all relevant facts and circumstances concerning the foreign corporation’s profit activities. Such profit-oriented activities within the U.S. must be considerable, continuous and regular. De Amodio v. Comm’r, 34 T.C. 894 (1960), aff’d, 399 F.2d 623 (3rd Cir. 1962); Pinchot v. Comm’r, 113 F.2d 718 (2nd Cir. 1940). Mere managerial activities associated with investments is insufficient to cause a foreign person to be engaged in a trade or business within the U.S. This is based from the Supreme Court’s landmark decision in Higgins v. Comm’r 312 U.S. 212 (1941). Similarly ministerial activities or activities ancillary to a business conducted outside of the United States are also insufficient to result in a finding of the conduct of a trade or business within the U.S. Scottish American Investment Co. v. Comm’r, 12 T.C. 49 (1949).

In Pinchot, supra, the Second Circuit held that a nonresident alien’s management of real estate constituted a trade or business within the United States rather than “investment and re-investment of funds in real estate” based on the nature and degree of activity necessary to manage real estate. The level of management activity “required regular and continuous activity of the kind which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and many other things which come within the definition of business… and within the commonly accepted meaning of that word.” Isolated or occasional activities, on the other hand, generally do not give rise to a trade or business. Pasquel v. Comm’r, 12 T.C.M. 1431 (1953) (holding that a nonresident alien was not engaged in a trade or business within the United States on account of the nonresident alien’s limited involvement in a single, isolated loan transaction); See Linen Thread Co. v. Comm’r, 14 T.C. 725 (1950) (holding that two small, isolated transactions did not give rise to a trade or business within the United States).

The activities of agents on behalf of a foreign person must be carefully examined since the acts of the agent are imputed or deemed to be performed by the foreign person regardless of the degree of control the foreign person exercises over the agent. Adda v. Comm’r, 10 T.C. 273 (1948), aff’d, 171 F.2d 457 (1948)(nonresident alien engaged in U.S. trade or business when non-resident granted a U.S. resident agent authorization to engage in trading commodity futures for the non-resident alien’s account); Lewenhaupt v. Comm’r, 20 T.C. 151 (1953), aff’d, 221 F.2d 227 (9th Cir. 1955).

Safe Harbors Under Section 864(b)(2)(A) For Certain Trading Activities

There are two statutory safe harbors pursuant to which certain trading activities conducted by or for a foreign person are treated as not being a trade or business within the United States. One requires that the foreign person not conduct those activities through an agent who has been granted discretionary authority or through a U.S. office of the foreign person. The other permits trading through an agent with discretionary authority or through the foreign person’s U.S. office but requires that the foreign person not be a dealer.
1. The First Trading Safe Harbor.
The §864(b)(2)(A)(i) or first Safe Harbor provides that the term “trade or business within the United States” does not include “[t]rading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent.” § 864(b)(2)(A)(i). Any foreign person, including a foreign dealer in stocks or securities, may use the (A)(i) Safe Harbor. Treas. Reg. § 1.864-2(c)(1). The first Safe Harbor does not apply if the foreign person has an office or other fixed place of business in the United States at any time during the taxable year through which the transactions in stocks or securities are effected. § 864(b)(2)(C).
2. The Second Trading Safe Harbor
The §864(b)(2)(A)(ii) or second Safe Harbor provides that the term “trade or business within the United States” does not include “[t]rading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions.” § 864(b)(2)(A)(ii). A dealer in stocks or securities may not use the (A)(ii) Safe Harbor. However, the (A)(ii) Safe Harbor may apply to a foreign person who has an office or other fixed place of business in the United States.

B. The Meaning of “Trading in Stocks or Securities” for Purposes of the Trading Safe Harbors

Both Trading Safe Harbors broadly define, by regulation, what is meant by “trading in stocks or securities.” It includes “buying, selling (whether or not by entering into short sales), or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise[.]” Treas. Regs. §§ 1.864-2(c)(2)(i) and (ii). The volume of stock or security transactions effected during a taxable year is not taken into account in determining whether a taxpayer’s activities qualify for the Trading Safe Harbors. See Treas. Regs. §§ 1.864-2(c)(1) & (2). The term “securities” means any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing. Treas. Reg. § 1.864-2(c)(2).

C. The Meaning of “Dealer in Stocks or Securities” For Purposes of the (A)(ii) Safe Harbor

The §864 regulations define a “dealer in stocks or securities” as “a merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom.” Treas. Reg. § 1.864-2(c)(2)(iv)(a). A person that buys and sells, or holds, stocks or securities solely for investment or speculation is not a dealer. A person’s transactions in stocks or securities effected both in and outside the United States are taken into account to determine whether the person is a dealer in stocks or securities.
The regulations provide two exceptions to the definition of the term “dealer in stocks or securities.” A foreign person that otherwise may be considered a “dealer in stocks or securities” is not considered a dealer: (1) solely because he acts as an underwriter, or as a selling group member, for the purpose of making a distribution of stocks or securities of a domestic issuer to foreign purchasers of such stocks or securities, irrespective of whether other members of the selling group distribute the stocks or securities of the domestic issuer to domestic purchasers, or (2) solely because of transactions effected in the United States in stocks or securities pursuant to his grant of discretionary authority to make decisions in effecting those transactions, if he can demonstrate to the satisfaction of the Commissioner that the broker, commission agent, custodian, or other agent through whom the transactions were effected acted pursuant to his written representation that the funds in respect of which such discretion was granted were the funds of a customer who is neither a dealer in stocks or securities, a partnership described in subdivision (ii)(b) of this subparagraph, or a foreign corporation described in subdivision (iii)(b) of this subparagraph. Examples are contained in the regulations. See Treas. Reg. §1.864-2(c)(2)(iv)(b).

CCA’s Finding of Conduct of U.S. Trade or Business Under the Facts

Fund’s position before the Service is that the Fund’s lending and stock distribution activities in years 1 and 2 constituted mere investment activity, and did not constitute a trade or business within the United States. Alternatively, Fund argued that its lending and stock distribution activities constituted “trading in stocks or securities,” and that Fund qualifies for the Trading Safe Harbors.
The CCA concluded that during year 1 and 2: (1) the nature and extent of Fund’s lending and underwriting, which were conducted by Fund Manager acting as Fund’s agent, caused the Fund to be engaged in a trade or business within the United States and therefore under §875(1), FC was engaged in a trade or business within the U.S. as well; (2) Fund’s lending and underwriting did not constitute “trading in stocks or securities” for purposes of the Trading Safe Harbors; and (3) even if Fund’s lending and underwriting had constituted “trading in stocks or securities” for purposes of the Trading Safe Harbors, Fund would not have qualified for the Trading Safe Harbors.

The Fund would have failed the first Safe Harbor on the basis that the U.S. Fund Manager had discretionary authority to conduct the lending and stock underwriting activities for the Fund and was not an independent agent. The second Safe Harbor in the view of the Service was also left unsatisfied because its underwriting activities made it a “dealer in stocks or securities”.
The government concluded that the foreign corporation as a member of the Fund was subject to U.S. income tax on income effectively connected with its U.S. lending and underwriting business.

So, it looks like the Service has its sights on challenging foreign funds conducting investment and/or lending activities in the U.S. from successfully taking the position that its activities within the U.S. do not constitute the carrying on of a trade or business or otherwise qualify under one of the two safe harbors for securities trading under Section 864(b)(2)(A).

Determining Stock Ownership and Filing Requirements for PFIC Shareholders

Posted in Federal Tax Regulations

In an article I recently submitted to Business Entities (WG&L), Mar/Apr 2014, in which I serve as the (outside) Editor-in-Chief, I discussed the stock ownership and filing requirements for a passive foreign investment company or “PFIC” under recently issued regulations to §1298(f). These regulations provide guidance on reporting requirements for U.S. taxpayers owning interests in PFICs. The regulations were welcome but concerns were expressed that the Service left many or at least several important questions unanswered, including the treatment of tax-exempt organizations under the interest charge method.

Approximately three years following enactment of the filing requirement for shareholders in passive foreign investment companies (PFICs) in § 1298(f), the Service issued regulations in 1992 requiring direct and indirect U.S. holders of PFIC shares to annually file Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” However, this information return requirement was never finalized. In the interim period between 1992 and 2013, the Service issued final regulations on PFIC purging elections, deemed sale elections, mark-to-market (MTM) elections, and qualified electing fund (QEF) elections.

In TD 9650, the Service issued immediately effective in 2013, temporary (and final) regulations to be used as guidance in determining PFIC ownership and filing requirements. The regulations further clarify an exception to ]the requirement that some shareholders of certain foreign corporations (CFCs) file Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations.” Guidance is provided in proposed regulations on determining ownership of a PFIC, and annual filing responsibilities. The regulations to §1298(f) attempt to avoid duplicative information return filings for U.S. shareholders of PFICs and to provide better guidance on determining indirect ownership. Additional regulations were issued on PFICs (definitional rules) in December 2013.

Ok; What are PFICs?

The PFIC provisions were enacted into law as part of TRA ’86. Under §1297(a), a PFIC is a foreign corporation that, during any tax year, has either: (1) 75 % of its gross income as passive income (per §1297(b)(1)) or (2) 50% (by value) of its assets as passive assets. Obviously, there will be overlap between the PFIC rules and the controlled foreign corporation (CFC) provisions. This would occur with respect to any tax year where a 10% U.S. shareholder meets the control test for CFC status under § 957(a), and the foreign corporation meets either one of the PFIC requirements. TRA ’97 provided that the CFC rules would, subject to a special grandfather provision, control if there was overlap. The purpose of the PFIC legislation was to limit opportunities for U.S. taxpayers to avoid taxation by making investments in foreign corporations holding passive assets. Deferral of foreign-source passive income was not the sole target of the legislation. Also at issue was the ability of such U.S. taxpayers to convert ordinary income into capital gains, by not receiving distributions of foreign passive income and later selling their stock (to generate long-term capital gains). The main regime imposed was an interest charge on such tax deferrals until the earnings were distributed to U.S. taxpayers in the form of dividends (or there was an intervening sale of stock in the PFIC). While Congress was concerned that some U.S. investors may lack access to tax records with respect to PFICs, it allowed for current reporting of income from a PFIC by special election, i.e., qualified electing fund (QEF).

General PFIC Rules

Sections 1291 through 1298 provide three separate methods or regimes for computing taxable income for PFIC shareholders: (1) The excess distribution rules under §1291. (2) The QEF rules under Section 1293. (3) The marked-to-market (“MTM”) rules under §1296.

Special terms used in the PFIC tax provisions include the “pedigreed QEF” and the “unpedigreed QEF.” A pedigreed QEF is a PFIC that has been a QEF as to a U.S. shareholder for all years during the shareholder’s holding period in the PFIC. Under §1291(d)(2), a U.S. shareholder may make a QEF (deemed sale) election as to a prior unpedigreed QEF eliminating further application of § 1291. An unpedigreed QEF is a PFIC which is a QEF for the taxpayer year but the company has not been a QEF for the years required for pedigreed qualified electing fund status and with respect to which the U.S. shareholder has not made a purging election under §1291(d)(2). Section 1291, therefore, applies to a shareholder with respect to an unpedigreed QEF.

In general, §1291 imposes a special (income) tax and interest charge with respect to the deferred taxes on a U.S. person’s share of PFIC income, when such U.S. shareholder receives an excess distribution (within the meaning of § 1291(b)) from a PFIC or recognizes gain derived from a disposition of stock in a PFIC that is treated as an excess distribution (within the meaning of §1291(a)(2)). Section 1291 imposes the PFIC interest charge on all distributions, including dividends from current or accumulated earnings and profits. In this regard, §1291 can impose tax and interest on what would otherwise be a tax-free recovery of basis under §301(c)(2).

Under §1297(e), the CFC rules will override application of the PFIC provisions, including § 1291, without regard to whether a QEF election is made with respect to its U.S. shareholders (as per §951(b)).
Dispositions of stock subject to the “§ 1291 fund” rules are subject to the interest charge provision. Indirect dispositions falling within this provision include: (1) The disposition of §1291 fund stock by a PFIC through which the U.S. shareholder owns the §1291 fund; (2) A disposition of§ 1291 fund stock by a foreign corporation that is not a PFIC where the U.S. shareholder owns, directly or indirectly, 50% or more (by value) of the foreign corporation; (3) A disposition of stock by the U.S. shareholder (or any other person) in a person through whom stock in the §1291 fund is attributable to the U.S. shareholder; and (4) A transaction which reduces a U.S. shareholder’s indirect ownership in a §1291 fund.

The 1992 proposed regulations provided for the override of certain nonrecognition provisions. For example, the exchange of PFIC stock for equivalent PFIC stock would not trigger gain recognition; and in a carryover basis transaction involving PFIC stock, the PFIC gain and holding period would carry over and avoid gain recognition. A shareholder who is subject to the QEF rules includes amounts in gross income under §1293 on the undistributed earnings of the PFIC. The election, which again is made at the shareholder level, in accordance with §1295, is irrevocable. The shareholder can, however, defer payment of the tax on his or her share of undistributed income per §1293 by electing an extension of time to pay such tax under §1294.

In 1997, Congress added an elective MTM regime for shareholders of a publicly traded PFIC. If MTM is elected, year-end “marked” gains constitute ordinary losses, “marked” losses are losses (but only to the extent of previously included gains), basis is adjusted to reflect the “marked gains and losses,” and source of income is based on the residence of the seller (e.g., sale of personal property rules) and is irremovable once made.
Section 1298 sets forth special rules applicable to shareholders of PFICs, including attribution rules that treat a U.S. person as the owner of PFIC stock that is owned by another person (other than an individual).

Comments and Suggested Changes to Rules

Following publication of the 1992 proposed regulations under §§ 1291, 1293, 1295, and 1297, the Service received numerous comments for revisions to the PFIC rules. Nearly all comments submitted seek modifications that shrink the universe of entities qualifying as PFICs and that make it easier for U.S. shareholders to make QEF elections (e.g., by allowing some shareholders to use the foreign corporation’s financial statements to both determine whether the corporation qualifies as a PFIC and to compute the holder’s pro rata share of PFIC income). Two particularly good critiques of the PFIC rules were issued by the New York State Bar Association, Section of Taxation (NYSBA Section), in May 2001 and March 2010.The NYSBA Section’s 2001 Report felt that the PFIC rules as then in place would, in some instances, cause active businesses to be illogically classified as PFICs . More particularly, the NYSBA Section recommended: (1) Providing a QEF election for shareholders and option holders of PFICs that do not have net earnings. (2) Offering a modified QEF election to option holders. (3) Specifying that liquid assets held for the reasonable needs of an active business will not constitute “passive assets.” (4) Allowing for more retroactive QEF elections. The NYSBA Section subsequently issued a report in March 2010 on making improvements to the PFIC rules through the regulatory, rulemaking process. This second report addressed various parts of the PFIC rules including their application to banking and financial institutions. as to the non-banking reforms, the report made several recommendations including that the final regulations treat working capital, if held for use in an active trade or business, as a nonpassive asset so long as the amount is reasonable.

Taxpayer Relief Act of 1997

Congress changed certain PFIC rules in TRA ’97. Section 1122(a) of TRA ’97 added the MTM regime under §1296, and §1121 of the Taxpayer Relief Act added §1297(d). Section 1297(d) provides that, in certain situations, a PFIC that is also a CFC is not treated as a PFIC with respect to certain shareholders. However,§ 1298(a)(2)(B) provides that a foreign corporation that would, but for the rules of § 1297(d), be a PFIC is treated as a PFIC with respect to its shareholders for purposes of determining whether the shareholders own an interest in any PFIC held by the foreign corporation. Nonrecognition events can be overridden by regulations to the PFIC rules in accordance with § 1291(f). Under this grant of authority, regulations issued in proposed form in 1992 pertaining to an exchange of PFIC stock resemble examples of exchanges of FIRPTA property described in §§ 897(d) and 897(e). More particularly, under Prop. Reg.§ 1.1291-6(b)(1), subject to §1297(e) (CFC override), gain realized on the exchange of PFIC stock is taxable unless the transaction qualifies for an exemption contained in the proposed regulations.

Hiring Incentives to Restore Employment Act of 2010.

In the Hiring Incentives to Restore Employment Act of 2010 (HIRE), new paragraph (f) was added to §1298 effective as of the date of the act, 3/18/2010. Section 1298(f) requires a U.S. person who owns stock in a PFIC to file an annual report with respect to his stock ownership. HIRE also amended §6501(c)(8) to extend the statute of limitations for assessment of tax for shareholders that fail to comply with the reporting requirements of §1298(f).

In Notice 2010-34 the IRS announced that further guidance would be issued for the reporting obligations under §1298(f) and, adding a change in effective dates, eliminated the filing requirement for tax years beginning before 3/18/2010.

In Notice 2011-55 the government announced that regulations would be issued under §1298(f) including a revised Form 8621 modified to reflect the reporting requirements under Section 1298(f). Notice 2011-55 suspended the §1298(f) reporting requirements until the release of the revised Form 8621 for PFIC shareholders that were not otherwise required to file Form 8621 under the then-current Instructions to Form 8621. The notice stated that PFIC shareholders with Form 8621 reporting obligations as provided in the then-current Instructions to Form 8621 were required to continue filing Form 8621 with an income tax or information return filed prior to the release of the revised Form 8621.

Notice 2011-55 further provided that following the release of revised Form 8621, PFIC shareholders for which the filing of Form 8621 had been suspended under the notice would be required to attach the form for the suspended tax year to their next required income tax or information return. The Notice also provided that a failure to furnish Form 8621 for a suspended tax year could result in the extension of the statute of limitations for such year under §6501(c)(8), and penalties could apply.

However, subsequent to issuance of Notice 2011-55, the IRS determined that it is not necessary for taxpayers to file a Form 8621 under §1298(f) for suspended tax years. Accordingly, the recently issued temporary regulations provide that PFIC shareholders are not required to file Form 8621 under §1298(f) with respect to tax years ending before 12/31/2013.

The recently (2013) issued regulations also make corresponding changes to §§ 6038 and 6046 and take into account certain statutory changes made in TAMRA and § 1146 of TRA ’97. The first statutory change relates to the requirement for persons treated as U.S. shareholders under §953(c) to file an information return under § 6046. The specifics of these changes are set forth in the temporary regulations and still others remain in proposed form. The stock ownership percentage in a PFIC requiring the filing of an annual report under Section 6046 was 5%. The newly issued temporary regulations revise Treas. Reg. §1.6046-1 to a 10% ownership threshold made under TRA ’97. Finally, these regulations revise Treas. Reg.§ 1.6046-1 to reflect the current name and form number of the information return required to be filed pursuant to Section 6046.

Specific Provisions of the Temp. Treas Reg. §1.1291-9(j)(2)(ii) contains a definition of the term pedigreed QEF that is similar to what was included in the 1992 proposed regulations. Temp. Reg. §1.1291-1T(b)(2)(ii) adopts the 1992 proposed regulations’ definition of pedigreed QEF without substantive modification. The definition of pedigreed QEF in the 1992 proposed regulations is withdrawn.

Definition of Section 1291 Fund. The 1992 proposed regulations referred to § 1291 fund as an unpedigreed QEF or a nonqualified fund. The new temporary regulations adopt the 1992 proposed regulations’ definition of §1291 funds with some modifications to reflect the enactment of the MTM rules under §1296, which occurred after the 1992 proposed regulations were published.
Under Temp. Reg. 1.1291-1T(b)(2)(v), a PFIC is a §1291 fund with respect to a shareholder unless the PFIC is a pedigreed QEF as to such shareholder, or, alternatively, if the U.S. shareholder made a MTM election under §1296. The definition of §1291 funds in the 1992 proposed regulations was withdrawn.

“Shareholder” and “Indirect Shareholder” Defined. The 1992 proposed regulations defined the terms “shareholder” and “indirect shareholder” in §1291. These definitions are cross-referenced in the definition of shareholder provided in Treas. Reg. 1.1291-9(j)(3). However Treas, Reg. 1.1295-1(j) defines shareholder for QEF purposes, and §1296(g) and Treas.Reg. §1.1296-1(e) provide a separate set of attribution rules for purposes of applying the MTM rules to U.S. persons that own an interest in a PFIC.
The temporary regulations, in general, adopt the definition of shareholder set forth in the 1992 proposed regulations. Under Temp Reg. §1.1291-1T(b)(7), the term shareholder means any U.S. person that owns stock of a PFIC directly or indirectly. A domestic partnership or an S corporation is treated as a shareholder of a PFIC only for purposes of the information reporting requirements of §§1291 and 1298, including §1298(f). The 2013 regulations provide that a domestic grantor trust is treated as a shareholder of a PFIC only for purposes of the information reporting requirement set forth at Temp. Reg.§ 1.1298-1T(b)(3)(i), which applies to domestic liquidating trusts and fixed investment trusts.T he definition of “indirect shareholder” as set forth in the 1992 proposed regulations is revised in Temp. Reg. §1.1291-1T(b)(8) defines the term indirect shareholder as a U.S. person that indirectly owns stock in a PFIC and provides rules for attributing ownership of PFIC stock through corporations, partnerships, S corporations, estates, and trusts.

The rule in the 1992 proposed regulations concerning ownership through a PFIC has been revised in Temp. Reg. 1.1291-1T(b)(8)(ii)(B) to incorporate a subsequent statutory change to §1298(a)(2)(B) which provides that § 1297(d) does not apply for purposes of determining whether a U.S. person owns a PFIC indirectly through a foreign corporation. Therefore, where a U.S. person owns stock of a PFIC that is also a CFC, notwithstanding that under §1297(d) such corporation may not be treated as a PFIC with respect to certain shareholders, the foreign corporation is treated as a PFIC with respect to the shareholder for purposes of determining whether the shareholder owns an interest in any stock of a PFIC held by the foreign corporation.

The article in Business Entities also addresses other important aspects of the 2013 regulations which are recommended for your further review. The recently issued regulations are helpful, particularly with respect to the information return requirements and applying the stock ownership test to pass-through entities. However, the guidance fails to address much of what was sought in prior comments (and criticisms) of the PFIC rules in the form of modifications, changes, and clarifications. Readers should consult the NYSBA Section’s recommendations in order to identify the rulemaking that remains to be considered and issued in this area.

IRS Notice 2014-28, 2014 IRB 990 (4/14/2014)

Last Spring the government issued guidance on §1291, and in particular, concerning the interest on tax deferral rule on PFIC stock owned by a tax exempt organization, including a qualified retirement plan or IRA. As discussed, §1291 imposes a special tax and interest charge on a U.S. person that is a shareholder of a PFIC and receives an excess distribution (within the meaning of §1291(b)) from the PFIC or recognizes gain derived from a disposition of the PFIC that is treated as an excess distribution (within the meaning of §1291(a)(2)). Section 1298(a) contains attribution rules that treat a U.S. person as the owner of PFIC stock that is owned by another person. The §1298(a) attribution rules will not apply to treat stock owned (or treated as owned) by a U.S. person as owned by any other person, except to the extent provided in regulations. Section 1298(f) provides that a U.S. person that is a shareholder of a PFIC must file an annual report containing the information required by the Secretary. Section 1298(g) provides that the Secretary shall provide such regulations as may be necessary or appropriate to carry out the purposes of §§1291 through 1298.

In Notice 2014-28, the Treasury and IRS stated their view that the application of the PFIC rules to a U.S. person treated as owning stock of a PFIC through a tax exempt organization or account described in Treas. Reg. § 1.1298-1T(c)(1) would be inconsistent with the tax policies underlying the PFIC rules and the tax provisions applicable to tax exempt organizations and accounts. For example, applying the PFIC rules to a U.S. person that is treated as a shareholder of a PFIC through the U.S. person’s ownership of an individual retirement account (IRA) described in § 408(a) that owns stock of a PFIC would be inconsistent with the principle of deferred taxation provided by IRAs. Therefore, the Treasury and Service announced it would amend the definition of shareholder in the § 1291 regulations to provide that a U.S. person that owns stock of a PFIC through a tax exempt organization or account (as described in Treas. Reg. § 1.1298-1T(c)(1)) is not treated as a shareholder of the PFIC. The regulations incorporating the guidance described in this notice will be effective for taxable years of U.S. persons that own stock of a PFIC through a tax exempt organization or account ending on or after December 31, 2013.

New Value Added Tax Case Decided by European Court of Justice Against Skandia America Corp.(USA)

Posted in Foreign Tax Law Developments

Last Fall, the European Court of Justice (ECJ) held that Skandia America Corp. was liable for the VAT on supplies of services to its Swedish branch. Sverige v. Skatteverket, C-7/13, September 17, 2014. In 2007 and 2008, Skandia America Corp. (SAC), a corporation organized in the U.S., served as the world-wide purchasing company for IT services for the Skandia group and carried out its activities in Sweden through its branch, Skandia Sverige. SAC distributed purchased IT services to various companies in the Skandia group and to Skandia Sverige which, since July 11, 2007, has been registered as a member of a VAT group.

Skandia Sverige then processed the externally purchased IT services to produce a final product, “IT-production.” The “IT-production” was then supplied to various companies in the Skandia group, both within and outside the VAT group. A 5% markup was charged on each supply of services, both between SAC and Skandia Sverige and between the latter and other companies in the Skandia group. Costs were allocated between SAC and Skandia Sverige by the issuance of internal invoices.

The Swedish tax authority (Skatteverket) assessed VAT on the supplies of IT services from SAC to Skandia Sverige for 2007 and 2008 based on its determination that the supplies provided constituted taxable transactions and considered SAC to be liable for VAT. Consequently, Skandia Sverige was identified as also liable for VAT and it was charged the tax relating to those supplies on the ground that it was SAC’s branch in Sweden.

In challenging the imposing of the Swedish VAT, Skandia Sverige brought an action against those decisions before the referring court. The Stockholm Administrative Court stayed the proceedings and referred two questions to the ECJ for a preliminary ruling: (1) whether supplies of services from a main establishment in a third country to its branch in a member state constitute taxable transactions when that branch belongs to a VAT group in the member state in which the branch is established; and, if so (2) whether the person liable to pay the VAT is the supplier (the main establishment in the third country) or the recipient (the VAT group in the member state) of the services. Thus, the EU court’s reasoning was that only the branch of an overseas company forms part of the single taxable person constituted by the relevant VAT group and that the overseas establishment of the company and its branch take on separate identities so that the overseas company remains capable of making a taxable supply of services to the VAT group of which that company, through its branch, is a member.

The ECJ noted that under the grouping provisions in Sweden, the main establishment of Skandia American Corporation and the VAT group were separate taxable persons and found, therefore, that the supplies in question constituted taxable transactions. Under the “reverse charge procedures” (Article 196 of the PVD), as the recipient of such services, the VAT group is liable for the VAT.

U.S. corporations with branches in EU member states should take careful note of this decision and there may be the possibility that the recent decision may pose a VAT trap for the unwary.

Switzerland Proposes Major Corporate Tax Reforms For Consideration of the Swiss Parliament This Year

Posted in Foreign Tax Law Developments

As reported in a recent article by Marnin Michaels in Zurich, Switzerland, which article was recently published in the Journal of International Taxation, the Swiss government recently published a draft bill last Fall, as well as an explanatory report, concerning tax measures for strengthening the competitiveness of Switzerland as a business location. The reforms proposed to the corporate tax rules in Switzerland are broad and will have a profound inpact. It will abolish certain current preferential tax regimes which will be replaced with them new competitive measures which conform with international standards.

The draft of “Corporate Tax Reform III” comes as a result of long-standing criticism and pressure from various countries, including the countries comprising the EU, for Switzerland to modify if not repeal preferential tax regimes and practices currently applied in Switzerland (for example, the mixed company regime at the cantonal level, and the Swiss finance branch and principal company regime at the federal level). Michaels reports that “[t]he Swiss government aims to abolish those regimes and to introduce new measures that conform to international standards to secure and even enhance Switzerland’s attractiveness as a business location.

The new measures proposed by the Swiss government include: (i) a new patent box regime that would allow preferential treatment of income arising from patents. The Swiss patent box would permit privileged tax treatment of “embedded IP” income and provide for a maximum tax base reduction of 80%, resulting in an effective total tax rate of 9%-10% for qualifying IP income. So “earnings stripping” through using Switzerland as a base to warehouse intangibles is going to be part of the “reform”; (ii) a new notional interest deduction (NID) on equity to establish equal tax treatment of debt and equity. However, the NID would apply only to “excessive equity,” i.e., the part exceeding the equity required for carrying out the respective company’s business; (iii) a new tax-neutral step-up (including on self-generated goodwill) for companies transitioning from a former preferential tax regime to ordinary tax status, as well as for companies relocating to Switzerland. This measure would allow companies that currently benefit from a preferential tax regime that might be abolished under the tax reform to maintain their beneficial tax rate for a transitional period; (iv) the transition from an indirect to a direct participation exemption regime regarding dividends and capital gains, including abolition of the minimum participation threshold and minimum holding period requirement; (v) the extension of NOL term from 7 years under current law to unlimited period but the loss offsetting per year will be limited to 80% of taxable profit (before offsetting it with the loss); and (vi) Swiss parent companies will be allowed to assume final tax losses from their Swiss and foreign subsidiaries. Other changes are noted.

It is anticipated that the enactment of Corporate Tax Reform will reduce tax revenues sharply. In response the Swiss government suggests additional financing measures, which include introduction of a capital gains tax on shares and other securities held as private assets by individuals; 70% of the respective capital gains (as well as of dividend income) would be subject to income taxes. Currently, capital gains on movable private assets are generally tax free in Switzerland. Perhaps a more transparent Switzerland as well as a more neutral climate for conducting business within and outside of Switzerland will be favorably received by multi-national companies as well as the taxing agencies of the U.S., EU and G-20.

It is anticipated that the legislation will be passed by the Parliament in Switzerland sometime next year with applicable grandfather rules and transitional rules over a term certain.

Remember, Informal Voting Agreements or Nominee Ownership of Stock in A Foreign Corporation Is Attributed to the Beneficial Owner for Controlled Foreign Corporation Purposes

Posted in Federal Tax Rulings

Every now and then a client may visit a lawyer or tax advisor and describe the stock ownership (of record) in a foreign corporation. Based on the stock ledgers, the foreign corporation may not meet the definition of a controlled foreign corporation or “CFC”. However, in digging a little deeper, one of the shareholders is simply the “nominee” or “straw party” for the true owner or beneficial owner who just happens to be a U.S. shareholder. There could be a voting arrangement where the nominee shareholder will vote at the direction of the beneficial owner. This latter situation came to the attention of Chief Counsel’s office several years ago but since we are in tax return season, tax return preparers need to exercise due diligence in determining whether a client must file one or more CFC schedules on Form 5471.

CCA 201104034 (1/28/2011) is a reminder that the Service is “on guard” for finding “nominee” type shareholders in the CFC context. The facts in the CCA involved retained ownership through an “informal voting arrangement”. The question from the field was “whether a person that transfers nominal or mere title ownership of stock in a foreign corporation could nevertheless be considered under the provisions of subpart F to be a U.S. shareholder of that foreign corporation (which would then be a CFC), as well as …… the statute of limitations and penalties that would apply for failure to file a Form 5471 for such entity.

A CFC, as we all know, is any foreign corporation with more than 50% of either the total combined voting power of all classes of stock of the corporation entitled to vote or the total value of the stock of the corporation, is owned by United States shareholders on any day during the taxable year of such foreign corporation. § 957(a). Mere title ownership is not determinative of who holds the voting power of the stock; any arrangement to shift formal voting power away from U.S. shareholders will not be given effect if, in reality, voting power is retained. Treas. Reg. § 1.957-1(b)(2).

The regulations provide examples of when voting power will be considered to have been retained which in turn could result in CFC status. Indeed, CCA 201104034 directs the reader to consider Example 5 of Treas. Reg. § 1.957-1(c) to drive home the point that a foreign corporation may qualify as a CFC solely as a result of a U.S. shareholder actually owning more than 50% of the voting power of the corporation where nominal owner ship and voting power is vested in a non-resident alien.

In Example 5, N, a U.S. person owns 50% of the outstanding shares of foreign corporation R, foreign corporation S owns 48% of the outstanding shares, and the remaining 2% are nominally owned by a non-resident alien. However, because the non-resident alien regularly acts as an attorney for N, reduces fees in conjunction with dividends received on the shares, and permits N to borrow against the shares, the example finds an implied agreement for N to “hold dominion” over the stock and the corporation is determined to be a controlled foreign corporation because N “owns” a total of 52% of the stock. This is the case despite the fact that the non-resident alien actually votes his shares at shareholder meetings.

The regulations under § 957 have been applied by courts to find U.S. ownership in CFCs where only informal voting power was retained by a non-title owner. In Garlock v. Commissioner, 489 F.2d 197 (2nd Cir. 1973), a U.S. corporation reduced its title ownership in the voting stock of a Panamanian subsidiary from 100% to 50% in order to avoid tax under the CFC provisions in the Code. In the recapitalization, preferred shares were issued to foreign investors who nominally received 50% of the voting power. The Second Circuit held that the voting power of the stock was actually retained by the U.S. corporation, which was therefore required to include subpart F income from the subsidiary. In reaching its determination that the voting power of the preferred shareholders was illusory, the court considered that the stock had been deliberately placed with investors who would vote their stock as instructed, the transfer of shares was prohibited without prior written consent, and even though the investors could have technically voted independently, there was no evidence that they did, and the board in fact always consisted of the U.S. corporation’s officers. Another case cited in this area is Koehring Co. v. Commissioner, 583 F.2d 313 (7th Cir. 1978). In Koehring, a foreign corporation was determined to be a CFC based on an informal side agreement granting actual voting power.

Filing Requirements and Penalties The Form 5471 filing requirements apply to all U.S. shareholders of a CFC. There is no exception for a person who is a U.S. shareholder as a result of informal voting power arrangements. The statute of limitations and penalty provisions that apply when a U.S. shareholder of a CFC fails to file Form 5471 will apply to an individual who, though not the nominal title owner of shares, is a U.S. shareholder as a result of an informal voting power arrangement. When a person who is a U.S. shareholder as a result of informal voting power arrangements fails to file Form 5471, the statute of limitations for assessing tax imposed with respect to any tax return, event, or period to which the information required to be reported on the form relates will not begin to run under § 6501(c)(8) until the shareholder files the required Form 5471. Similarly, a person who is a U.S. shareholder as a result of informal voting power arrangements is subject to the penalties under § 6038 for failure to file Form 5471.

Senate Democrats Push For IRS to Expand Reach of the Anti-Inversion Rules

Posted in Federal Taxation Developments

Prior to the Christmas recess, five leading Democrat Senators, Reed (D-R.I.), Hirono (D-Hawaii), Baldwin (D-Wis.) Durbin (D-Ill.) and retiring Carl Levin (D-Mich) delivered a letter to the IRS asking the National Office to address several types of transactions that companies have used in connection with an inversion in. The Senators want the Treasury and IRS to issue new rules to further prevent or reduce earnings stripping, the use of so-called “hopscotch” loans and the avoidance of gain recognition through use of inverted corporations.

The Service had issued guidance to prevent further exploitation of the inversion rules last September, including use of spin-offs and “hopscotch” loans. Another strategy that is on the Treasury’s anti-inversion “hit list” is the so-called skinnying down” device in which companies pay special dividends prior to a merger to avoid or soften the application of the inversion provisions.

What is clear to members of Congress is that U.S. based companies have not reduced their desire to re-incorporate off-shore despite the inversion provisions. Indeed, there are new ways to exploit the policing rules. Thus, according to certain members of Congress and certainly the Obama Administration, Treasury and IRS, there must be new impediments to going off-shore. Well, that’s one way at looking at the continued migration to outside of the United States by our biggest U.S. multi-nationals. But it is not the only way. Indeed, a better, much better solution should be to enact into law new incentives to U.S. based corporations to remain in the U.S., most notably by lowering the corporate tax rate to 25% or even lower to more than offset the advantages of having engaged in a corporate expatriation. With the highest corporate tax rate in the world, Democrats and the President delude themselves that corporate inversions have no rationale other than tax avoidance on a massive scale. What they need to understand is a simple economic fact of life, the U.S. corporate tax rates must be reduced in order to keep capital and labor engaged in the United States and for corporations to be persuaded not to reinvent themselves elsewhere.

The Anti-Inversion Rule on the “Books”

An “inversion” is described in Section 7874 as a series of transactions whereby a U.S. corporation becomes a foreign corporation that is not subject to the general taxing jurisdiction of the United States, or similar transactions whereby the U.S. corporation’s shares or assets are placed under a new foreign holding company. The anti-inversion rules contained in Section 7874 are designed to restrict inversion transactions by treating inverted foreign corporations as domestic corporations. If three requirements are met under Section 7874, a foreign corporation will be treated as a “surrogate foreign corporation” that will be classified as a domestic corporation for all U.S. income tax purposes: (i) the foreign corporation acquires substantially all of the properties of a U.S. corporation after March 4, 2003; (ii) the former shareholders of the U.S. corporation hold 80% or more (by vote or value) of stock of the foreign corporation after the transaction by reason of having held equity interests in the U.S. corporation (disregarding stock owned by members of the expanded affiliated group and stock sold in a public offering related to the acquisition) (the “shareholder continuity” test); and (iii) the foreign corporation and its expanded affiliated group do not have substantial business activities in its country of incorporation (compared to the business activities of the expanded affiliated group outside such country).

An “expanded affiliated group” will meet the “substantial business activities” test if at least 25% of its employees, 25% of its assets, and 25% of its income are located in, or in the case of income, derived from, that foreign country. Treas. Reg. Section 1.7874-3T(b).

In addition, where the above three requirements would be satisfied if “60%” was substituted for “80%” in the shareholder continuity test, the foreign corporation will remain a “foreign” corporation for U.S. tax purposes, but special rules are triggered, including that the expatriating domestic corporation (or any U.S. person who is or was related within the meaning of Section 267(b) to such expatriating domestic corporation) will not be permitted to use its tax attributes (e.g., net operating losses or available foreign tax credits) to reduce its U.S. income tax liability attributable to certain “inversion gains” (essentially income and gains from shifting assets outside of the U.S. taxing jurisdiction to the foreign acquirer or to related persons).

Stay tuned for sure. Congress may end up doing the “right” thing and reduce the corporate income tax rate to 25% (or less).

Internal Revenue Service Getting Tough on Production of Evidence From Current and Former Microsoft Executives In Connection With Its Transfer Pricing Audit

Posted in Federal Taxation Developments

In recent court filings made in various federal district courts in Washington and California, the Internal Revenue Service is seeking to enforce testimonial summonses issued to current or former Microsoft employees, including former CEO Steven A. Ballmer. The summons had been issued earlier this fall. Microsoft’s outside tax counsel responded to the summonses by stating that the various witnesses would not be made available to the Service. The summonses were issued to obtain information relevant to Microsoft’s internal pricing of intangibles transferred under two separate cost-sharing arrangements for tax years 2004-2006.

An earlier summons further directed the company “to appear on November 20, 2014, and to produce for examination books, records, papers, and other data.” Court proceedings were initiated on December 11 to enforce the summons alleging that while Microsoft appeared on the designated date it failed to fully comply in “producing all the books, records, papers, and other data as demanded in the summons.”

Microsoft recently filed a motion to hold a status conference before the applicable court(s) would issue an order to show cause to “enable the Court to gain a clearer understanding of the factual and procedural background and Microsoft’s affirmative defenses, to clarify the potential scope of the enforcement proceeding, to establish a briefing schedule, and to discuss whether an evidentiary hearing would be helpful to the Court.”

The Department of Justice Attorneys, on behalf of the United States, objected to such requests and informed the Court that it had previously filed at least 11 related summons enforcement actions. In addition to the individual summonses mentioned above, two related summons enforcement actions had been filed against Microsoft directly and one against a consultant.

The IRS has to decide on which of two options it must take before the statute of limitations on assessment expires on December 31, 2014. The first option would be to issue a statutory notice of deficiency or, in order to stay the statute of limitations from expiring, to timely petition to enforce the outstanding summonses. Apparantly the government is pursuing the later strategy but it is still possible that the government will move ahead with issuing a stat notice.

Summons Enforcement Filing Against Former Microsoft CEO Steven Ballmer

The enforcement action against Ballmer was filed by the government in the U.S. District Court for the Western District of Washington under 26 U.S.C. Sections 7602, 7609. In its complaint the government stated that the IRS is conducting an examination of the federal income tax liabilities of Microsoft Corporation and includible subsidiaries (“Microsoft”) for the taxable periods ending June 30, 2004, June 30, 2005, and June 30, 2006. Understanding the role of sales and marketing in generating profits, the pleading asserted, is central to evaluating Microsoft’s transfer pricing valuations related to its cost sharing arrangements. This relationship was at the heart of the examination that the Service wanted to conduct from former CEO Ballmer who served in such capacity for 14 years, 2000-2014.

In interviews conducted by the IRS in September and October 2014, current Microsoft employees repeatedly identified Mr. Ballmer as a central decision maker with overall responsibility for sales and marketing priorities and strategies. Microsoft’s 2005 10-K also identifies Mr. Ballmer as the “chief operating decision maker” responsible for “deciding how to allocate resources and in assessing performance.” The testimony sought from Mr. Ballmer may be relevant to the IRS’s consideration of whether the transfer pricing Microsoft adopted for its Asia-Pacific and Americas (the United States, Canada, and Latin America) cost sharing arrangements satisfies the arm’s length pricing standard under 26 U.S.C. § 482 and the regulations thereunder. More specifically, Mr. Ballmer’s testimony may be relevant to evaluating the role of sales and marketing in Microsoft’s operations in the Asia-Pacific and Americas regions, and the relative value of non-technology intangibles in those operations.

Cost-Sharing Arrangements For The Years In Issue In Microsoft: 2004-2006

Congress, in enacting Section 482, wanted to provide the Internal Revenue Service with an appropriate policing statute to prevent affiliates or other related taxpayers from engaging in tax evasive transactions and ensure that taxpayers clearly reflect income relating to transactions between controlled entities. Section 482 therefore authorizes the Commissioner to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among controlled entities if he determines that such distribution, apportionment, or allocation is necessary to prevent evasion of taxes or to clearly reflect the income of such entities. In determining the true taxable income, “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” Treas.Reg. Section. 1.482-1(b)(1).

With respect to intangible property, Section 482 provides that in the case of any transfer of intangible property the income with respect to the transfer shall be commensurate with the income attributable to the intangible. In a qualified cost-sharing arrangement, controlled participants share the cost of developing one or more items of intangible property. Treas. Reg. Section 1.482-7(a)(1). When a controlled participant makes preexisting intangible property available to a qualified cost-sharing arrangement, that participant is deemed to have transferred interests in the property to the other participant and the other participant must make a buy-in payment as consideration for the transferred intangibles. Treas. Regs. Sections. 1.482-7(g)(1) and (2).

The buy-in payment, which can be made in the form of a lump-sum payment, installment payments, or royalties, is the arm’s-length charge for the use of the transferred intangibles. Treas. Regs. Sections 1.482-7(g)(2), (7).
Section 1.482-7(g)(2), requires buy-in payments to be determined in accordance with Treas. Regs. Sections 1.482-1 and 1.482-4 through 1.482-6.

Treas. Reg. Section 1.482-4(a) provides: (a) In general. The arm’s length amount charged in a controlled transfer of intangible property must be determined under one of the four methods listed in this paragraph (a). Each of the methods must be applied in accordance with all of the provisions of Treas. Reg. Section 1.482-1, including the best method rule of Treas. Reg. Section 1.482-1(c), the comparability analysis of Treas. Reg. Section 1.482-1(d), and the arm’s length range of § 1.482-1(e). The arm’s length consideration for the transfer of an intangible determined under this section must be commensurate with the income attributable to the intangible. See Treas. Reg. Section 1.482-4(f)(2) (Periodic adjustments). The available methods are — (1) The comparable uncontrolled transaction method, described in paragraph (c) of this section; (2) The comparable profits method, described in Treas. Reg. Section 1.482-5; (3) The profit split method, described in Treas. Reg. Section § 1.482-6; and (4) Unspecified methods otherwise described in the regulations.
Where the recipient of the intangibles fails to make an arm’s-length buy-in payment, the Commissioner is authorized to make appropriate allocations to reflect an arm’s-length payment for the transferred intangibles. Treas. Reg. Section 1.482-7(g)(1). The Commissioner’s authority to make Section 482 allocations is limited to situations where it is necessary to make each participant’s share of costs equal to its share of reasonably anticipated benefits or situations where it is necessary to ensure an arm’s-length buy-in payment for transferred preexisting intangibles. Treas. Reg. Section 1.482-7(a)(2). See Veritas v. Comm’r, 133 T.C. 297 (2009).

Subsequent Years’ Revised Regulations Under Cost-Sharing Arrangements

Although not in issue in the Microsoft audit, the IRS has published temporary regulations in 2009 (T.D. 9441) and then final regulations in 2011 (T.D. 9568) on determining taxable income from cost-sharing arrangements (CSAs) under section 482.

The final regulations provide guidance on the determination of and compensation for all economic contributions by all controlled participants of a CSA in accordance with the arm’s-length standard. For purposes of determining the best method of measuring the arm’s-length results of a CSA and any related controlled transactions, the final regulations employ the same standards used in the temporary regulations in 2009 on assessing the potential applicability of the comparable uncontrolled transaction method. The final regulations also adopt the specified income method, the specified residual profit-split method, the acquisition price method, and the market capitalization method. Additional changes were made in the 2011 regulations with respect to qualified CSAs.