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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.

Kentucky Businessman Pleads Guilty To Tax Evasion, Fraud, Bribery and Related Crimes in Connection with $53 Million Tax Scheme and Fraud

Posted in Federal Taxation Developments

In a press release issued on December 23, 2014 by the Department of Justice, Tax Division, it was announced that Wilbur Anthony Huff, a Kentucky businessman, pleaded guilty in Manhattan federal court to various tax crimes that caused more than $50 million in losses to the Internal Revenue Service, and a massive fraud that involved the bribery of bank officials, the fraudulent purchase of an insurance company, and the defrauding of insurance regulators.

Huff, 53, of Caneyville and Louisville, Kentucky, pleaded guilty to one count of corruptly endeavoring to obstruct and impede the due administration of the internal revenue laws, which carries a maximum penalty of three years in prison, one count of aiding and assisting with the preparation and presentation of false and fraudulent tax returns, which subjects the offender to a maximum three years in prison, one count of failing and causing the failure to pay taxes to the IRS, which carries a maximum penalty of one year in prison, and one count of conspiracy to (a) commit bank bribery, (b) commit fraud on bank regulators and the board and shareholders of a publicly-traded company, and (c) fraudulently purchase an Oklahoma insurance company, which carries a maximum penalty of five years in prison. Sentencing is scheduled for April 8, 2015 before Federal District Court Judge Buchwald.

As part of his plea, Huff also agreed to forfeit $10.8 million to the United States and to provide restitution in the following amounts to victims of his crimes: $70,100,000 to the Receiver for Park Avenue Property and Casualty Insurance Company; $4,857,266.62 to the Federal Deposit Insurance Corporation (FDIC); $597,420.29 to Valley National Bank (the successor of Park Avenue Bank); and $53,094,219 to the IRS. That’s in excess of $125,000,000 in restitution.

Background

Huff was a businessman who controlled numerous entities located throughout the United States. Huff controlled the companies and their finances, using them to orchestrate a $53 million fraud on the IRS as well as other illegal schemes. However, rather than exercise control of these companies openly, Huff concealed his control by installing other individuals to oversee the companies’ day-to-day functions and to serve as the companies’ titular owners, directors or officers. Huff also maintained a corrupt relationship with Park Avenue Bank and its executives, Charles J. Antonucci Sr., the president and CEO, and Matthew L. Morris, the senior vice president.

Tax Crimes

From 2008 to 2010, Huff controlled O2HR, a professional employer organization (PEO) located in Tampa, Florida. Like other PEOs, O2HR was paid to manage the payroll, tax, and workers’ compensation insurance obligations of its client companies. However, instead of paying $53 million in taxes that O2HR’s clients owed the IRS, and instead of paying $5 million to Providence Property and Casualty Insurance Company (Providence P&C) – an Oklahoma-based insurance company – for workers’ compensation coverage expenses for O2HR clients, Huff stole the money and diverted millions of dollars from O2HR to fund his investments in unrelated business ventures, and to pay his family members’ personal expenses. The expenses included mortgages on Huff’s homes, rent payments for his children’s apartments, staff and equipment for Huff’s farm, designer clothing, jewelry, and luxury cars.

Conspiracy to Commit Bank Bribery, Defraud Bank Regulators, and Fraudulently Purchase an Oklahoma Insurance Company

From 2007 through 2010, Huff engaged in a massive multi-faceted conspiracy, in which he schemed to (i) bribe executives of Park Avenue Bank, (ii) defraud bank regulators and the board and shareholders of a publicly-traded company and (iii) fraudulently purchase an Oklahoma insurance company. As described in more detail below, Huff paid bribes totaling hundreds of thousands of dollars in cash and other items to Morris and Antonucci, in exchange for their favorable treatment at Park Avenue Bank.
As part of the corrupt relationship between Huff and the bank executives, Huff, Morris, Antonucci, and others conspired to defraud various entities and regulators during the relevant time period. Specifically, Huff conspired with Morris and Antonucci to falsely bolster Park Avenue Bank’s capital, by orchestrating a series of fraudulent transactions to make it appear that Park Avenue Bank had received an outside infusion of $6.5 million, and engaged in a series of further fraudulent actions to conceal from bank regulators the true source of the funds.

Huff further conspired with Morris, Antonucci, and others to defraud Oklahoma insurance regulators and others by making material misrepresentations and omissions regarding the source of $37.5 million used to purchase Providence Property and Casualty Insurance Company, an Oklahoma insurance company that provided workers’ compensation insurance for O2HR’s clients, and to whom O2HR owed a significant debt.

Bribery of Park Avenue Bank Executives

The DOJ press release further states that from 2007 to 2009, Huff paid Morris and Antonucci at least $400,000 in exchange for which they: (1) provided Huff with fraudulent letters of credit obligating Park Avenue Bank to pay an investor in one of Huff’s businesses $1.75 million if Huff failed to pay the investor back himself; (2) allowed the Huff-controlled entities to accrue $9 million in overdrafts; (3) facilitated intra-bank transfers in furtherance of Huff’s frauds; and (4) fraudulently caused Park Avenue Bank to issue at least $4.5 million in loans to the Huff-controlled entities.

Other charges were also filed and were part of the guilty plea entered by Huff, including fraud on bank and insurance regulators.

Cases are still pending against other defendants involved in the fraudulent schemes.

Why Has the IRS Outsourced Microsoft’s Transfer Pricing Audit to a Private Law Firm?

Posted in Federal Taxation Developments

Perhaps it was just a matter of time until the Internal Revenue Service decided to “outsource” its tax audit and litigation function to a private entity, i.e., a law firm. As reported in the December 8th issue of Tax Notes, the Service has hired the law firm of Quinn Emanuel Urquhart & Sullivan LLP, at a cost of more than $2 million, to assist in the transfer pricing audit of Microsoft Corp., signaling a resolve to aggressively litigate disputes over buy-in payments in cost-sharing agreements (CSAs), and raising the prospect of Quinn Emanuel lawyers participating in summons interviews of Microsoft executives. Does that work delegation to render legal advice to the Service sound appropriate, or even legal? For those of you who are not quite familiar with Quinn Emanuel the litigation-only global law firm is rumored to have the second highest profits per equity partner of any law firm in the world. The firm is headquartered in Los Angeles, California and currently employs 650 attorneys throughout eleven locations around the world, with its largest office located in New York City.

So What’s The Cost to the Taxpayer? Two Million One Hundred Eighty Five Thousand Dollars

Certainly Microsoft wanted to know. It filed a complaint on November 24 in the U.S. District Court for the District of Columbia under FOIA for the IRS to produce “all documents representing proposals” and “all documents representing agreements for the performance of services to be rendered by Quinn Emanuel.” Attached to the complaint as an exhibit is “what purports to be a copy of a[n] excised portion” of the IRS’s contract with Quinn Emanuel, which the Service gave to Microsoft on September 10 . Quinn Emanuel, such contract provides, will “assist with the evaluation, analysis, presentation and defense of claims or adjustments related to the issues under examination,” including “transfer pricing issues relating to the license of intangible property rights in association with a cost sharing arrangement and related transactions.”

According to a website maintained by the Office of Management and Budget, the contract was signed May 19, 2014, with a completion date of December 31, 2016, and a payment obligation of $2,185,500. The website categorizes the service to be supplied by Quinn Emanuel as “Support-Professional: Expert Witness,” suggesting that the law firm’s services may be limited to identifying and supporting expert witnesses. It is speculated that Quinn Emanuel’s involvement could also extend to be involved in the trial preparation phase. The contract further reveals, according to Tax Notes, that Quinn Emanuel will be closely associated with the IRS examination team during the audit phase, stating that the “Contractor will work collaboratively with the Service to support the examination.” Particularly, the law firm is tasked with reviewing all “the key documents (including reports, position papers, IDR responses, etc., prepared by or on behalf of the Taxpayer or the Service) and all relevant legal authorities to build a thorough understanding of the factual and legal issues and the record to date.” Among the various transfer pricing issues that the audit may involve includes a cost-sharing agreement with respect to the sufficiency of buy-in payments by an offshore affiliate of Microsoft’s in exchange for licensing intangibles.

According to the disclosed portions of the contract, Microsoft’s case spans two examination periods: tax years ended June 30, 2004, through June 30, 2006, and those ended June 30, 2007, through June 30, 2009. The Service alleges that in July, 2005 Microsoft licensed to its foreign affiliate rights to ‘technology intangibles’. in certain software products sold by Microsoft to third-parties in the Americas geographic region.” In exchange, the foreign affiliate made a buy-in payment to compensate Microsoft “for the value of the rights that it received and assumed responsibility for funding future research and development associated with the technology intangibles.” Finally, Microsoft and the affiliate established a transfer price “to determine how to share revenues that are collected, after licensing of the technology intangibles to the foreign affiliate, on future sales of the software products in question to third parties.”

Well, presumably the Service thinks the buy-in payment was far too low based on the standards contained in the regulations at that time. The new regulations apply to transactions entered into or after January 5, 2009. The current regulations value intangibles contributed to a CSA not just to “make or sell rights” for products incorporating the preexisting intangible, but also to a “platform” or foundation for developing new intangibles to be used in future products. That approach inserts an investor model for quantifying an arm’s-length buy-in payment under which an affiliate entity contributing only cash to a CSA is treated as making a low-risk investment and is therefore required to make a proportionately larger buy-in payment. The same additional platform argument was made in the Veritas case which the Tax Court flatly rejected. It criticized the IRS for making an argument as to “platform contribution intangibles,” a phrase that does “not appear in the regulations applicable to the CSA” but was introduced in the then-temporary regulations issued in 2009. The Tax Court opined that thus, the IRS’s “litigating position appears to mirror transfer pricing regulations promulgated 10 years after Veritas U.S. and Veritas Ireland signed their CSA.” Dismissing the notion that the contributed intangibles had ongoing value, the court limited itself to the intangibles’ make or sell rights, holding that a comparable uncontrolled transaction, and not a discounted cash flow, was the appropriate mode of analysis.

After its defeat in Veritas the Service reportedly re-examined its litigation position as to pre-2009 revised (final) regulations. But the Service would continue in proceeding against Amazon again over the buy-in payment notion. Now, in another pre-2009 case, the Service is willing to fork over $2 million for outside legal assistance in auditing Microsoft’s CSA and buy-in payments. Will Microsoft “flinch” into a more favorable settlement for the IRS just because Quinn Emanuel is on board?

The Quinn Emanuel contract and its price tag also suggest how high the stakes may be in the IRS’s dispute with Microsoft. Regardless of its outcome, the dispute, just like the Veritas and Amazon cases, will have limited precedential value on the jurisprudence of CSAs and buy-in payments, since they involve regulations that have been superceded. Still the potential deficiencies in tax are substantial. The determined deficiencies in Veritas and Amazon were $758 million and $234 million, respectively. No doubt the Microsoft case will be in the same range if not higher; why else go outside the government’s trial lawyers?

Cost Sharing Agreements Involving Intangibles In a Cross-Border Context

A typical CSA in the U.S. multinational context involves a sequence consisting of three parts: (i) a U.S. taxpayer licenses preexisting technology to a foreign affiliate; (ii) the foreign affiliate makes a buy-in payment and proceeds to further develop (or co-develop) the intangibles; and (iii) the U.S. taxpayer and foreign affiliate agree to share rights to, and revenue from, exploiting the developed intangibles. The U.S. taxpayer seeks to shift as much value and future profits over to the foreign affiliate(s) with a low buy-in payment. Obviously the Service will disagree where it believes a “stranger” would pay a much great value or make a much higher buy-in payment. Based again on the potential range of values that could be given to intangibles already in place, the stakes to the litigation that might ensue become quite high to both parties.

The arm’s length pricing analysis under section 482 begins with the factual and functional analysis of the actual transaction or transactions among the controlled taxpayers. In the context of a CSA, the controlled participants make economic contributions of two types, (i) mutual commitments to prospectively share intangible development costs in proportion to their reasonably anticipated benefits from exploitation of the cost shared intangibles (cost contributions) and (ii) provide any existing resources, capabilities, or rights that are reasonably anticipated to contribute to developing cost shared intangibles (platform contributions). CSAs may also involve economic contributions by the controlled participants of other existing resources, capabilities, or rights related to the exploitation of cost shared intangibles (operating contributions). The concepts of platform and operating contributions are intended to encompass any existing inputs that are reasonably anticipated to facilitate developing or exploiting cost shared intangibles at any time, including resources, capabilities, or rights, such as expertise in decision-making concerning research and product development, manufacturing or marketing intangibles or services, and management oversight and direction. The regulations provide guidance for determining the arm’s length charge for all such contributions to clearly reflect the incomes of the controlled participants.

Delegation of Power to Question A Taxpayer By Another Taxpayer Acting Under Authority of A Governmental Agency

The author of the Tax Notes report on the hiring of Quinn Emanuel, Ajay Gupta, comments that “[m]uch more significant than the money that will be paid under the contract to Quinn Emanuel, however, is the power that will be conferred on the law firm. The contract states that the contractor may “as necessary for the performance of his or her duties under this Contract, be given access to confidential tax returns and return information, as those terms are defined in section 6103(b)(I) and (2), respectively.” Quinn Emanuel is thus described in section 6103(n) and reg. section 301.6103(n)-1(a) as a person to which the IRS is authorized to disclose returns and return information “for purposes of tax administration . . . in connection with a written contract or agreement” for services.”
More particularly new temporary and proposed regulations issued in 2014 provides that “persons described in section 6103(n) and reg. section 301.6103(n)-1(a) with whom the IRS or Chief Counsel contracts for services may receive books, papers, records, or other data summoned by the IRS and take testimony of a person who the IRS has summoned as a witness to provide testimony under oath.” The temporary regulations were issued one month after the contract with Quinn Emanuel was inked. The temporary regulations apply to “to summons interviews conducted on or after June 18, 2014.” So, the regulations will permit Quinn Emanuel lawyers to participate in interviewing Microsoft employees and tax return preparers and others, and under statutory penalty of perjury. Can this be right? Can a private contractor be granted the legal authority to examine a witness for the IRS? Take a look at sections 7602, 7701(a)(11) and 7701(a)(12)(A) and after looking at the statutory language, you might think the answer is “no”! If the answer is yes, then the outsourced law firm effectively steps into the shoes an an “agency of the Treasury Department” under section 7602.

As Mr. Gupta points out, the Service’s calling a private law firm to help fight Microsoft may be admitting too much. While the idea of hiring an expert is not unusual or even suspect, the hiring of outside legal counsel to participate in an audit and perhaps more is close to if not a direct admission. Moreover, as mentioned it may be improper. Another noteworthy item is that Quinn Emanuel does not hold itself out as a specialist in transfer pricing or even tax controversy. The firm’s website doesn’t list those or any related fields among its more than two dozen categories of practice specialties. Its contract with the IRS describes the firm’s lawyers as “highly skilled commercial litigation attorneys with extensive complex litigation experience evaluating, preparing and presenting cases dealing with multifaceted facts, complex economics and multiple legal issues.”

So perhaps Microsoft’s CSA is not the only item of public interest….indeed using taxpayer money to have an outside law firm help in trying a tax case which firm is the second most profitable in the world is indeed going to attract attention. In other words, the IRS is contracting with Quinn Emanuel to obtain general commercial litigation expertise, which implies that that kind of expertise is unavailable among the tens of thousands of government attorneys who litigate civil, criminal, and administrative actions day in and day out at the dozens of federal agencies.
What’s Next?

So, let’s see if the Department of Justice and Chief Counsel can leverage its litigation position through the help of a multinational and prestigious litigation law firm. After the Service’s loss in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009) nonacq. AOD 2010-005 and its current case against Amazon, No. 31197-12 (T.C. 2014) perhaps the Service felt there’s nothing wrong with getting a little help from a “new” friend. Microsoft is not only seeking to understand Quinn Emanuel’s role in the case by having filed the motion referred to above, but predictably will want this or another federal court to rule that it may not participate as co-counsel on behalf of the Treasury of the United States or its delegate.

Second Circuit in Barnes Group, Inc. And Subsidiaries Sides With U.S. Tax Court and Government on Foreign Subsidiary to Parent Dividend

Posted in Federal Tax Case Law Decisions

In Barnes Group, Inc. and Subsidiaries, v. Commissioner, 114 AFTR 2d 2014-XXXX, (CA2), 11/05/2014, the taxpayer appealed an adverse decision from the United States Tax Court, 105 T.C. M. 1654 (2013) which sustained the adjustments made by the IRS to Barnes 2001 and 2000 federal income tax returns as well as the imposition of a 20% accurancy penalty for substantial understatement of tax. The penalty was held appropriate even though the taxpayer received a more likely than not opinion as well as a substantial authority position from its tax advisor

Factual Background

Barnes Group, Inc., manufactures and distributes specific metal parts and industrial supplies. By 1999, Barnes operated there separate businesses via domestic and foreign subsidiary corporations, i.e., Associated Spring, Barnes Aerospace, and Barnes Distribution. In 2001 a reinvestment plan was entered into by Barnes, as the parent corporation, and its subsidiaries. The reinvestment plan had as its objective the expansion of the company’s business through domestic and international acquisitions. Several acquisition, which in the aggregate cost approximately $200 million, were made in 1999 and 2000. Prior to the acquisitions, Barnes had $50 million of outstanding long-term debt and no outstanding balance on a revolving credit line. By the end of 2000, Barnes had approximately $230 million of outstanding debt and $50 million outstanding on its revolving credit line. This significantly lowered the overall capitalization of the companies which was, in comparison with its industry, more higly leveraged.

By June 1, 2000, Barnes and subsidiaries had $45.2 million in cash worldwide with the bulk or $43 million held by its foreign subsidiaries. Barnes wanted to use its Asian second tier subsidiary, ASA, excess cash position to help pay donw its acquisition indebtedness. Were Barnes to receive a dividend or a loan from ASA, Barnes US income tax liability would increase. In addition, Barnes had overall foreign losses at the time per section 904(f) and was not in a position to currently utilize indirect tax credits under section 902.

Barnes, through its vice president, tax, worked with three major accounting firms on how to avoid the adverse U.S. income tax consequences yet get the foreign cash earnings repatriated to the U.S. parent corporation. The solution arrived at, was a domestic and foreign finance structure. A blended fee based fee agreement was executed by Barnes and PWC. PwC issued a favorable opinion on its recommended strategy.

The basic outline of the plan to cause cash to come from ASA to the United States without a tax liability was as follows: (i) Barnes first creates a domestic financing entity; (ii) ASA creates a foreign financing entity; (iii) ASA exchanges its cash for the foreign financing entity’s stock; and (iv) the foreign financing entity transfers cash and its stock to the domestic financing entity in exchange for the domestic financing entity’s stock. Subsequently an exit strategy or unwind plan was added to the mix were Barnes to return the funds to ASA. A “draft” of a “business purpose” for the reinvestment plan was developed. The exit strategy involved the foreign financing entity’s purchse of the domestic financing entity’s stock from Barnes and then liquidating the domestic financing entity. The stated business purpose, international cash management. The plan was approved by Barnes’ board of directors on October 112, 2000.

Drilling down to the document facts, Barnes formed Bermudian and Delaware wholly onwed subsidiaries in late August and early September 2000. At such time ASA was still a second tier subsidiary of Barnes. Bermuda and ASA were CFCs of Barnes under section 957(a). The first part of the reinvestment plan was: (i) in a section 351 exchange, ASA and Barnes would trasfer foreign currency to Bermuda for Bermuda common stock; (ii) in a second section 351 transaction Bermuda and Barnes would transfer foreign currency and Bermuda common stock to Delaware for Delaware stock with Barnes receiving common stock and Bermuda preferred stock; and (iii) Delaware would convert the foreign currencies into U.S. dollars and lend the funds to Barnes. Under part II of the restructuring or reinvestment plan, ASA would borrow funds from a Singapore Bank before completing the two section 351 transactions. After completion of the plan, ASA and Delaware would own all of the common stock of Bermuda and Bermuda wouldl own all of the preferred stock of Delaware. The first part of the plan was effectuated in late 2000 and the send part effectuated in July 2001.

Prior to effectuation of the reinvestment plan in September 2000, the national acccounting firm which designed the plan issued a draft of an opinion letter. The opinon letter addressed whether the Bermuda and Delaware section 351 exchanges would result in income inclusion under sections 951 and 956. The opinion concluded that the preferred stock held by Bermuda in Delaware should consitute an investment in U.S. property under section 956(c)(1) but Bermuda should have a zero basis in the Delaware preferred stock. Since the income to be included under section 956 is limited to the adjusted basis that Bermuda has in the Delaware preferred stock, the opinion stated that no amount should be included in Barnes’ income as a result. The opinion also touched upon the step transaction doctrine, section 301 and section 269. The letter concluded that section 269 was inapplicable and the the transaction should not result in a repatriation of funds under section 301. It also commented that step transaction analysis should not apply since there “is no plan to alter the interests and relationships among the paries”. Citing Esmark Inc. v. Commissioner, 90 T.C. 171 (1988), aff’d w/o pub. Op., 886 F.2d 1318 (7th Cir. 1969). The national accounting firm involved, PwC, found “substantial authority” supported its conclusions within the meaning of section 6662 and Treas. Reg. §1.6662-4(d). It also reach a more likely than not opinion on the issues involved.

Barnes Tax Returns and IRS Notice of Deficiency.

For the years in issue, on Barnes consolidated icncome tax return it reported: (i) taxable income of $39.7M for 1998; (ii) a taxable loss of .503M for 2000; and (iii) a taxable loss of $10.7 million for 2001. The various section 351 transactions involving Barnes, Delaware, Bermuda and ASA werer fully reported.

In the notice of deficiency dated August 20, 2009, respondent IRS: (i) increased Barnes’ 2000 taxable income by $38,919,950, which represented ASA’s $39 million aggregate transfer (minus a minor conversion rate adjustment) that eventually was transferred to Barnes; and (ii) increased Barnes’ 2001 taxable income by $19,378,596, which represented ASA’s $23,311,897 transfer (minus a conversion rate adjustment and an earnings and profits adjustment) that eventually was also transferred to Barnes; (iii) determined that the value of the four 10,000 PPM clean rooms was $2,520,000 and that as a result Barnes should have recognized additional income of $820,000 for the 2001 tax year on an unrelated issue; and (iv) disallowed Barnes’ 1998 net operating loss carryback of $503,654 from its 2000 tax year.

After filing its petition with the U.S. Tax Court, the taxpayer argued that was entitled to rely on Rev. Rul. 74-503, 1974-2 C.B. 117 and Rev. Rul. 2006-2, 2006-1 C.B. 261, which stated that per section 7805(b) “the Service will not challenge a position taken prior to December 20, 2005 by a taxpayer that reasonably relied on Rev. Rul. 74-503, supra. Rev. Rul. 74-503 provides guidance where treasury stock is exchange for newly issued stock of another corporation. See also section 358(a), 362 and Treas. Reg. §1.1032-1(d). The Service argued the ruling inquestion does not apply to the facts at bar. The Tax Court agreed with the Service and found “vast factual disparities between the reinvestment plan and Rev. Rul. 74-503. Therefore the Service was not precluded from challenging the reinvestment plan.

Tax Court Proceeding

The Tax Court started its analysis with respect to the merits of the reinvestment plan having recognize that Barnes needed cash sourced from low-taxed profits of ASA to help amortize its large amounts of debt. In order to obtain ASA funds, Barnes had three basis options. First was a dividend from ASA that would be taxable as dividend income to Barnes. Second, a loan or equity investment by ASA to Barnes would trigger subjpart F income and also would be includible in gross income. Barnes is the U.S. shareholder of Bermuda and ASA, both CFCs. Barnes, therefore, would recognize a section 951 income inclusion to the extent of the adjusted basis of U.S. property held by Bermuda or ASA as a result of the reinvestment plan (to the extent that Bermuda or ASA had earnings and profits).
Here Barnes argued that Bermuda made investments in Delaware’s preferred stock in section 351 transactions. Under Rev. Rul. 74-503, Bermuda would obtain a zero basis in Delaware’s preferred stock. Therefore Barnes section 951 income inclusion is based on “adjusted basis” of property distributed and since basis was $0 there was no dividend income. The government argued that the substance of the transactions was not reflective by its form and that in such instance the substance controls. Commissioner v. Court Holding, 324 U.S. 331, 334 (1954); Gregory v. Helvering, 293 U.S. 495 (1935); Coltec Industries , Inc. v. United States, 454 F.3d 1340, 1354 (Fed. Cir. 2006). In short, Rev. Rul. 74-503, supra, may have been relied upon by Barnes but the substance of the transaction here, i.e., the reinvestment plan, fell well outside the parameters of the ruling.

Tax Court Holding: For Government; Where’s the Business Purpose?

As with tax litigation cases in general, petitioners bear the burden of proof and in this case such obligation requires Barnes prove the merits of the reinvestment plan for federal income tax purposes and that such stratgey was not to circumvent the current inclusion of income from the deemed distribution of a dividend(s) from ASA to Barnes. In addition, the Court noted that the reinvestment plan deserves extra scrutiny, petitioners’ vague assertions regarding Singapore law impediments, state tax benefits, and cash management are insufficient to support a finding that Bermuda and Delaware were created for legitimate nontax business purposes. Furthermore, petitioners have not shown that they respected the form of the reinvestment plan.

Based on the record, the taxpayer did not meet its burden of proof. The Tax Court concluded that Bermuda and Delaware did not have a valid business purpose and that the various intermediate steps of the reinvestment plan are properly collapsed into a single transaction under the interdependence test as part of the step-transaction doctrine. While petitioners assert that the reinvestment plan was always intended to be a temporary structure, the Court found that the objective facts suggested otherwise. ASA transferred a substantial amount of cash to Barnes (funneled through Bermuda and Delaware) which Barnes used to pay off its debt. Barnes has not shown that it returned any of ASA’s funds. After review of the record and the briefs filed by the parties, the Tax Court found that the reinvestment plan was in substance dividend payments from ASA to Barnes in 2000 and 2001, taxable under section 301.

Second Circuit Court of Appeals Finds for Commissioner

On appeal to the Second Circuit, the Tax Court’s decision was affirmed. The three judge panel agreed that Barnes position ignored not only the business purpose doctrine but proper application of the step transaction doctrine. Therefore, Barnes’ stated reliance on Rev. Rul. 74-503, supra, was misplaced as the ruling only applied to an isolated exchange of stock and “provided no guidance on when the individual steps in an integrated series of transactions will be disregarded under the step transaction. Reliance on Revenue Rulings can only be made where the facts and circumstances are substantially the same. 26 C.F.R. §601.601(d)(2)(v)(i).

On application of the step-transaction doctrine, the Tax Court properly collapsed the series of transactions through which Barnes obtained the funds of its Singaporean subsidiary, Associated Spring-Asia PTE Ltd. (“ASA”), by channeling the funds through a foreign financing subsidiary (“Bermuda Finance”) and a domestic financing subsidiary (“Delaware Finance”), both created solely to facilitate the transfer. Each transaction in this series but the last purported loan to Barnes from Delaware Finance was completed pursuant to an Agreement and Plan of Reinvestment that acknowledged these transactions comprised “a single integrated plan. Indeed, that transfer was the entire purpose of the series of transactions from the beginning. Thus, the steps by which ASA provided funds from its earnings to Barnes were correctly treated as a series of integrated steps included in one transaction.

The Second Circuit also agreed with the Tax Court that the channeling of ASA’s funds through Bermuda and Delaware rather directly to Barnes did not serve any business purpose other than to transfer ASA’s funds to Barnes in a manner that had the appearance of a non-taxable transaction. Accordingly the transactions werer in substance dividend payments from ASA to Barnes.

It also affirmed the Tax Court’s imposition of a substantial underpayment penalty finding that Rev. Rul. 74-503, supra, was not sustantial authority and that Barnes did not reasonably rely on it. The opinion issued by PwC suffered from the same defects as to its reliance on Rev. Rul. 74-503, supra and does not advise of the tax consequences of the entire series of transactions transferring funds from ASA to Barnes. Therefore, in effect, the opinion was of no value for penalty avoidance.