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Court of Federal Claims Allows Non-Resident to File Amended Returns Where Originally Filed Returns Erroneously Claimed “Resident” in United States Status

Posted in Federal Tax Case Law Decisions

In Montiel v. United States, 114 AFTR 2d 2014 (Ct. Fed. Cl. 8/7/2014), the Court of Federal Claims ordered a claim for refund for an overpayment of income taxes by a person alleged to be a non-resident, for 2007 and 2008, based on the fact that the original returns erroneously declared her to be a resident.

Facts of the Case
In March, 2008, the taxpayer filed a Form 1040 for 2007 as a resident alien listed a California residence. She paid tax and estimated income tax penalty. Subsequently, the taxpayer determined she was a “nonresident alien” under §7701(b)(1)(B) and should have filed a “nonresident” return for 2007, i.e., Form 1040 NR. In June, 2011, she filed an amended 1040X for 2007 requesting a refund for an overpayment of tax of approximately $9,000. The IRS denied the request as “untimely” since the taxpayer had to have filed her amended return form by April 15, 2011, i.e., 3 years from filing her income tax return for 2008 (due date) which was April 15, 2008, or more than 2 years after having paid the tax. See §6513(a). Essentially the same erroneous “resident” status was set forth on her return filed for 2008 and was later amended through a Form 1040X, again based on the correction in the taxpayer’s view of her “nonresident” status for 2008. The refund claim for 2008 was filed more than three years after the due date for the 2008 return on April 15, 2009 but within the applicable period for non-residents.

The taxpayer contended that as a non-resident, §6072(c) requires that the deadline for filing is June 15 of the succeeding taxable year and not April 15 which is applied to U.S. citizens and residents. The Service disagreed arguing that because the taxpayer originally filed as a resident alien, the government was entitled to and in fact justifiably relied on such representation and therefore the 3 year statute of limitations period for refunds should have commenced on April 15 of 2008 and 2009 respectively.
Application of the Tucker Act (and Not the Internal Revenue Code)

Under 28 U.S.C. §1491(a)(1), known as the “Tucker Act”, the Court of Federal Claims has jurisdiction to hear certain monetary claims against the United States. See U.S. v. Testan, 424 U.S. 392, 398 (1976). But the Tucker Act does not, in the view of the Court of Federal Claims, create a substantive right to monetary relief. Instead, a plaintiff must identify an additional money mandating statute in order to recover damages from the government. The Court noted, however, that §7422(a) of the Code provides the required statutory basis for tax refund suits provided there is satisfaction of the “duly filed” refund claim rules under §6511. As a result, the Court opined, §6511 and §7422 bar refunds suits when the underlying refund claims are filed out of time. See U.S. v. Brockamp, 519 U.S. 347 (1997), superseded in part by statute, the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, § 3302(a), 112 Stat. 685, 740–41, as recognized in Brosi v. Commissioner, 120 T.C. 5, 12 n.6 (2003). See also U.S. v. Clintwood Elkhorn Mining Co., 553 U.S. 1, 5 (2008).

The technical procedural rule invoked by the Service was that the court did not have jurisdiction of the case since the statute of limitations for refund had run. See Fed. R. Civ. Proc. 12(b)(1). In such instance, the court is required to construe all unchallenged factual allegations in the pleader’s favor. Still, the plaintiff, however, must prove any disputed jurisdictional facts by a preponderance of the evidence. (citations omitted).

Court’s Decision in Favor of the Plaintiff Moving the Case Forward
So, should the plaintiff-Ms. Montiel, be treated as a non-resident or resident for purposes of the jurisdictional rules on whether the claims for refund were timely filed? She was never a U.S. citizen. Therefore consideration of §7701(b)(1)(B) is required. Further required would be application of the residence tie-breaker provision in the tax treaty with Mexico, her jurisdiction of nationality and claimed residence.
An alien is deemed a resident for tax purposes if she has been lawfully admitted for permanent residence or has been substantially present in the United States. § 7701(b)(1)(A)(i), (ii). Section 7701(b)(3) provides that an individual is substantially present in the United States for tax purposes if she (i) was present in the United States on at least 31 days during the calendar year, and (ii) the sum of the number of days on which she was present in the United States during the current year and the two preceding calendar years (when multiplied by an applicable multiplier) exceeded 183 days. § 7701(b)(3)(A). The taxpayer argued she never qualified as a resident for 2007 or 2008 and was a citizen and resident of Mexico who was traveling in the U.S. for less than 60 days per year on a B1/B2 visa. Ergo, she should have never filed a “U.S. resident” return. See Treas. Reg. §1.6012-1(b)(1)(2012).
Here, the taxpayer was alleged to have filed claims for refund “untimely” based on a “U.S. resident” status as per her original reporting status. As a “non-resident” however, the refund claims were filed timely. See §6072(c). The defendant-U.S. did not argue that Ms. Montiel was a non-resident. Instead, it contended that by originally filing as a resident her status for refund claim procedural rules must also be determined by her representation. The Court noted that had Ms. Montiel filed her amended returns two months earlier, the case before it would not have been required.
Taking such arguments and facts into account, the Court of Federal Claims ruled that the government has not shown that Ms. Montiel’s filing of returns on Form 1040 precludes her as a matter of law from submitting her requests for refund based on Form 1040NR within the time allowed for nonresident aliens. Since the plaintiff has laid the proper foundation for her alleged status or qualification as a “nonresident alien” and has complied with the time limit for filing a claim for refund as a “non-resident” the case presents a justiciable issue for which the government’s summary judgment for lack of jurisdiction can only be denied. See Banks v. United States, 741 F.3d 1268, 1277 (Fed. Cir. 2014).

The Court ruled that the case will move forward and denied the respondent-United State’s motion to dismiss for lack of jurisdiction. The government’s answer is required to Ms. Montiel’s claim for refund in her complaint is required on or before September 5, 2014

FATCA’s Impact On Preparing Trusts With Offshore Business or Investment Activities

Posted in Federal Tax Legislation, Federal Tax Regulations

The Foreign Account Tax Compliance Act (FATCA) was enacted into law as part of the Hiring Incentives to Restore Employment (HIRE) Act of 2010. Its purpose was designed to prevent U.S. taxpayers from “hiding” under the cover of a foreign based entity or trust in evading U.S. income tax and possiblly evading U.S. transfer tax. For U.S. expatriates forming foreign trusts, consideration of the impact of Section 2801 must also be taken into account. FATCA is set forth in Chapter 4 of the Code and is more particularly set out in Sections 1471 to 1474. The FATCA withholding and disclosure rules are an “add-on” to the U.S. withholding and infromation reporting rules under Sections 1441 to 1446. In general, FATCA requires ‘foreign financial institutions‘ (FFIs) and ‘non-financial foreign entities‘ (NFFEs) to identify and disclose their U.S. accounts and substantial U.S. owners. Where the applicable disclosure and identification rules are not followed, a U.S. withholding agent will be required to withold 30% on all payments to be made to the FFI or NFFE as the case may be.

FACTA added Section 6038D which requires any individual who, during the taxable year, holds any interest in a “specified foreign financial asset” to attach a report (Form 8938) to his or her income tax return providing certain information regarding such financial assets when the aggregate value of all such assets exceeds $50,000 on the last day of the taxable year or $75,000 at any time during the taxable year. The dollar thresholds are doubled for married individuals filing a joint return.

A specified foreign financial asset is any financial account maintained at a foreign financial institution and also includes “any stock or security issued by any person other than a U.S. person,” “any financial istrument or contract held for investment that has an issuer or counterparty that is not a U.S. person”, and “any interest in a foreign entity”(per Section 1473). See Section 6038D(b). FATCA is viewed by some commentators and foreign tax authorities and financial institutions as imposing severe due diligence and disclosure requirements on foreign entities over which the U.S. would, in general, not have jurisdiction over, including foreign trusts and estates. In negotiations that were undertaken by the Treasury and IRS with many foreign governments, a set of intergovermental agreements were entered into with foreign governments which would require FFIs and NFFEs to report their disclosure information directly to the taxing authority of their home country instead of directly to the IRS as FATCA would otherwise require. All intergovernmental agreements (IGAs) contempate that a partner government will require all FFIs located in its jurisdiction that are not otherwise exempt will identify U.S. accounts and report information about U.S. accounts. In Announce. 2014-17, the Service posted on its website that the United States has signed IGAs with 26 jurisdictions and has reached agreements with many others. The final regulations provide that the IRS will publish a list identifying all countries that are treated as having a Model 1 or Model 2 IGA in effect. See Treas. Regs. Sections 1.1471-1(b)(78) and (79). Notice 2013-4, 2013-31 I.R.B.

The final regulations generally provide that, in order for the 30% FATCA withholding not to apply, a withholding agent must obtain an FFI’s GIIN (number) for payments made after June 30, 2014, and must confirm that the GIIN appears on the IRS FFI List. A special rule, however, provides that a withholding agent does not need to obtain a reporting Model 1 FFI’s GIIN for payments made before January 1, 2015. See Treas. Reg. Section 1.1471–3(d)(4)(iv)(A). Notice 2013–43 and Announcement 2014–1, 2014–2 I.R.B. 393, indicate that FFIs must register on the FATCA registration website by April 25, 2014 (GMT -5), to ensure they are included on the first IRS FFI List, which is expected to be electronically available on June 2, 2014 .

Last year the Service issued a set of final regulations under FATCA. TD 9610, 1/17/2013. The Final Regulations impose significant information-gathering and reporting requirements on fiduciaries of trusts and estates. As to trusts, FATCA is implicated where U.S. tax residents and citizens hold assets ouside of the United States and non-residents holding assets inside of the United States provided that they are tax residents of a country subject to a Model Intergovernmental Agreement to Improve Tax Compliance and Implement FATCA (a ‘Model IGA‘).

Individuals who are beneficiaries of trusts, U.S. and non-U.S. banks and individuals who are trustees of trusts, banks that custody trust assets, executors and beneficiaries of estates, and single- or multiple-family investment offices are all potentially affected by FATCA. For the most part a foreign trust will, by definition, be considered to be an FFI under FATCA unless a specific applicable IGA states otherwise.

The CTB regulations under Section 7701 provide a definition of a trust, both domestic and foreign. Under Treas. Reg. Section 301.7701-7, a trust is a U.S. person provided: (i) a court within the United States is able to exercise primary supervision over the administration of the trust (court test); and (ii) one or more United States persons have the authority to control all substantial decisions of the trust (control test). A trust is a United States person for purposes of the Internal Revenue Code on any day that the trust meets both the court test and the control test. For purposes of the regulations in this chapter, the term domestic trust means a trust that is a United States person. The term foreign trust means any trust other than a domestic trust. Therefore, a foreign trust is a trust that is: (i) not subject to the primary jurisdiction of the U.S. courts; or (ii) is subject to the authority of a non-U.S. person who can control substantial decisions of the trust.

Now to the FATCA part. A foreign trust will be treated as an FFI where the trust’s income is primarily derived from investments and the trust is professionally managed. See Treas. Reg. Section 1.1471-5(e)(4)(i). This will be the case of course if the trustee of a foreign trust is a trust company. The same standard will presumably be met where a non-trust company trustee hires a professional investment manager. See Treas. Reg. Section 1.1471-5(e)(4)(i)(A). The FFI outcome may still apply where a professional advisor or other person serving as “trustee” is a professional with respect to investments and management of a trust. If a foreign trust does not fall within the definition of an FFI, it is to be treated as a NFFE. An an NFFE, the foreign trust may be able to side-step withholding and disclosure in non-Model 1 IGA jurisidictions.

For FATCA to apply, an FFI must have one or more substantial U.S. owners. See Treas. Reg. Section 1.1471-5(a)(2). Ownership tests are set forth under the regulations which may seem awkward in applying such tests to trusts, particularly with respect to discretionary or accumulation trusts. For a foreign trust that is not an FFI but an NFFE, the application of the ownership tests may also be difficult and are different than the ownership tests used for the FFI. In addition, the provisions of an applicable IGA may preempt the ownership tests set forth in the regulations.

As to the FFI ownership rules, a foreign trust is treated as an FFI trust (and has a substantial U.S. owner) where: (i) a U.S. person is treated as the owner of a portion of the trust for federal income tax purposes under the grantor trust rules; (ii) a U.S. person is entitled to receive a mandatory distribution from the trust; or (iii) a U.S. person may receive a discretionary distribution from the foreign trust and does receive such a distribution in the applicable calendar year. Treas. Reg. Section 1.1471-5(b)(3)(iii)(B) .

As concerns the NFFE rules, a U.S. owner is present where: (i) a U.S grantor is treated as the owner of the property under the grantor trust rules; or (ii) a U.S. owner owns more than 10% of the trust. A U.S. owner is treated as owning 10% or more of the trust where such U.S. person: (i) received distributions of more than 10% of either all distributions made during the year or the total value of the trust; or (ii) has a mandatory distribution right that exceeds 10% of the trust value; or (iii) the sum of (i) and (ii) exceeds either 10% of all distributions made during the year or the total value of the trust. Treas. Reg. Section 1.1473-1(b)(3)(ii).

The FACTA rules if applicable to foreign trusts do impose some burdens and potentially few benefits. Unless an IGA applies to the contrary, an FFI that is deemed to have a substantial U.S. owner under FATCA must comply with the relevant registration and disclosure information. There also is Chapter 3 withholding rules on FDAP income that continue to apply. FFIs that have not registered with the IRS, so-called “non-participating FFIs” may not obtain refunds of overwitheld tax unless required by a treaty or the trust is not the beneficial owner of the income. Where the income is distributed by the FFI to a beneficiary, the beneficiary may be able to apply for the refund. The same holds true with respect to the grantor of a FFI trust. See Treas. Regs. Sections 1.1474-5(a)(1) and 1.1471-1(b)(7) .

Mitigating the Impact of FATCA on Foreign Trusts

There may be methods for a FFI Trust to avoid withholding under FATCA. One method is for the FFI Trust to enter into an agreement with the IRS and become a “participating FFI”. This would require any “affiliate” of the FFI Trust to enter into the agreement as well. See Reg. 1.1471-4 . Ownership is not based on the trustee but on the beneficiaries or grantor of a grantor trust. The “affiliate” test is based on 50% or more of the same owners. A FFI Trust having a grantor who created other foreign trusts may have problems with the affilite requirement. See Treas. Reg. Section 1.1471-5(f)(3) . A Participating FFI must register with the IRS; identify U.S. person beneficiaries and owners, and their interests, to the IRS; adopt verification procedures; complete various other requirements; and file Form 8966 annually.

Another potential way to mitigate FATCA problems for a FFI Trust is where the trust is situated in a Model 1 IGA jurisdiction. An FFI or NFFE situated in a country that entered into a Model 1 IGA with the United States may be exempt from FATCA withholding. For such entities there are no withholding requirements even with respect to payments to nonparticipating FFIs or account holders who have not made disclosures to the IRS. See Model 1 IGA Article 4 paragraphs 1 and 2.

Intergovernmental Model Agreements

There are essentially two types or formats used in the IGA area; Model 1 and Model 2. Under a Model 1 IGA, FFIs are required to report to their home country tax authority which in turn will share such information with the Internal Revenue Service. The benefit under a Model 1 IGA is that the FFI Trust does not provide information directly to the IRS and can avoid the 30% withholding by continually meeting the disclosure requirements. Under a Model 2 IGA, an FFI must still directly report to the IRS unless the IGA provides to the contrary. If an FFI Trust, for example, does not become a “participating FFI” or is otherwise exempt, it will not avoid withholding. See, however, Model 2 IGA Article 3 paragraphs 2 and 5.

Under a Model 1 IGA, a foreign trust, including a foreign trust which is an FFI or NFFE, must identify all controlling persons, including the settlor or grantor, trustees, beneficiaries, protectors, holders or a power of appointment and any other person having control of the trust under the country have jurisdiction over the trust. The applicable revenue agency of such jurisdiction of trust management must report such information to the IRS on behalf of the trust. Where the trust has one or more “controlling” U.S., regardless of ownership or beneficial interests, the ownership test is not applied and all NFFEs and FFIs must report this information. The trust is considered a U.S. account subject to FATCA.

Another situation is a U.S. trust with foreign beneficiaries. Assume, for example that the foreign beneficiaries reside in a Model 1 IGA jurisdiction. In this case the trustee will be required to report all information regarding controlling foreign persons to the IRS which in turn will report it to the country’s revenue agency. With “reciprocal” Model 1 IGAs, U.S. trust companies and banks serving as trustees must obtain detailed lists of all potential beneficiaries, including future, or contingent beneficiaries, as well as minor beneficiaries, to comply with FATCA and the IGAs. It is still uncertain whether individual professional trustees will have the same reporting obligations.

Drafting Foreign and Domestic Trusts In Light of FATCA

There are important issues that must be considered in drafting the terms of a trust that will be subject to the FATCA reporting rules taking into account whether the trust is “foreign” or “domestic”, the important persons involved and their country of residence, the residence of the trust and whether the jurisdiction in issue has an IGA with the United States.

Resolution of these important issues must be done with U.S. tax or estate counsel.

This blog post is intended for informational purposes only and is not legal advice and not may not be relied upon as legal advice rendered to any reader of this posting.

Recent Tax Court Decision Reflects Court’s Disallowance of Duplicated Deductions in Duquense Light Holdings, Inc.

Posted in Federal Tax Case Law Decisions

In last year’s Tax Court decision in Duquesne Light Holdings, Inc.,TCM 2013-216, the Tax Court held, citing the Supreme Court’s decision in Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934), that a subsisidiary was not permitted to report loss on the sale of its assets where such loss represented the same economic loss recognized in a prior sale of the subsidiary’s stock.

The Facts, In General
Duquesne Light was the common parent of a consolidated group of corporations. Its business was to distribute electricity throughout Pennsylvania through wholly owned subsidiaries. In the 1990s, Aqua Source, Inc. was organized as an indirect wholly owned subsidiary of Duquesne for acquiring water, wastewater and water services companies. The parent corporation funded Aqua Source by contributing funds and its preferred stock. In 2001, Duquesne transferred 4% of its stock in Aqua Source to its investment banker, Lehman Brothers, in exchange for services to be rendered that had been valued at $4 million. Duquesne reported a $200 million capital loss on its 2001 consolidated group return for the Davis-Keenan loss on the taxable disposition of its subsidiary stock and shortly thereafter filed a quickie refund request on Form 1139 in which it carried back to 2000 approximately $135 million of the 2011 stock loss which yielded a tentative refund of close to $135 million.

In 2002, Aqua Source sold several of its water subsidiaries claiming capital losses of $59.5 million (2002 asset losses) which were deducted on the 2002 consolidated return filed by the Duquesne group. Again, a tentative refund carryback was filed for 2002 back to 2000 yielding another tentative refund of $12.67 million.
In 2003, Aqua Source sold its remaining assets and Duquesne claimed a capital loss of $192.8 million (2003 asset losses). During 2004, Duquesne filed two additional tentative claims for refund which included the 2003 asset sale loss of $201.4 million back to the 2000 tax year. Again in 2004, Duquesne filed a second Form 1139, which it carried back from 2003, $16.5 million of long term capital losses back to 2000. A total of $201.4 million of long term capital losses were carried back from 2003 to 2000, of which $192.8 million was attributable to the 2003 asset sales. The service paid Duquesne tentative refunds of $40.3 million.

Overall, between 1997 and 2003, Duquesne contributed capital of $471,200,414 to AquaSource. There were operating profits in four years: $1,985,576 in 1999; $3,003,334 in 2002; $1,752,752 in 2004; and $1,509,861 in 2005, or total operating profits of $8,251,523. There were operating losses in five years: ($641,240) in 1997; ($140,354) in 1998; ($35,572,514) in 2000; ($4,089,268) in 2001; and ($14,409,389) in 2003, or total operating losses of ($55,032,765).

The refund statute of limitations under §6501(a), as extended in writing per §6501(c)(4)(A), the year 2000 expired on 12/31/2006. The period of limitations for refunds, again as extended by agreement, also expired on 12/31/2006. The period of limitations for refund for 2003 extended in the same manner would have expired on June 30, 2010 but the Court acknowledged was suspended under §6303(a) until the decision of the Tax Court becomes final.

Notice of Deficiency Issued by Service
In 2010, the Service issued a 90 day later which contained several alternative arguments as to the 2001 stock loss, the 2002 asset loss and the 2003 asset loss.
The parties then filed cross motions for partial summary judgment. The Court granted the Service’s motion.

Tax Court’s Decision
The government objected to the reporting of a duplicated loss by Duquesne Light. The first loss reporting event was the first stock loss transaction with Lehman Brothers on its 2001 disposition of 4% of AquaSource stock. The stock loss was attributable to a built-in loss in the assets of the subsidiary. When the subsidiary sold off assets that reflected the prior year’s loss realized on the stock transfer, the Service argued that the subsidiary loss on the asset sales in 2002 and 2003 could not be duplicated. The Court agreed with the Service citing Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934) and Thrifty Oil v. Commissioner, 139 T.C 198 (2012).

The Tax Court looked at the Third Circuit’s precedent in this area under its administrative Golsen Rule. See National Casket Co., 78 F.2d 940 (3rd Cir. 1935); Grief Cooperage Corp., 85 F.2d 365 (3rd Cir. 1936). It concluded that the Third Circuit would apply Ilfeld in any federal income tax case involving consolidated return where the groups claims a deduction for a tax year that duplicates another deduction already taken by the group for the same economic loss. Here, there was no factual issue as to whether a duplicated loss was in fact reported comparing the 2001 stock loss with the 2002 and 2003 asset losses. The Court distinguished the Federal Circuit Court of Appeals decision in Rite Aid Corp., 255 F.3d 1357 (Fed. Cir. 2001) which held a portion of the consolidated return regulations invalid where the effect of such regulation would be to effectively repeal another section of the Code, i.e., Section 165(g). See also Section 382. Notice 2002-11, 2002-1 CB 526. The Tax Court Memorandum decision noted that Rite Aid Corp., supra, was not applicable to the case before it. It still allowed the Service to prevent the duplication of deductions under Ilfeld, supra, to be applied.

On the statute of limitations issue, the Court noted that under §6501(k), where an amount has been refunded under §6411 by application of a loss carryback, the period for assessing a deficiency in tax for the prior tax year is extended to include that period of time set out in §6501(h), reduced by any amount that may be assessed solely by §6501(h). Section 6501(h) provides that the Service may assess a deficiency for a year to which a loss is carried back, at any time before the expiration of the period where a deficiency can be assessed for the tax year of the net operating loss or net capital loss.
Accordingly, the Court held that per §6501(k), the Service may assess a deficiency in tax for the year 2000 attributable to the duplicated losses from the 2002 asset sales provided that such deficiency does not exceed any tentative refund paid to Duquesne for 2000, reduced by any amount assessed for 2000 solely by application of §6501(h)(2003 asset sale loss duplication carryback).

The Duquesne Light Holdings case adds another court decision to the line of cases involving double deductions for stock and asset loss recognition events by members of a consolidated group. While the Service continues to revise its regulations to effectively reverse or at least take out the substantive point of law announced in the Federal Circuit Court’s decision in Rite Aid Corp., its efforts have not been rewarded by the courts. Here the Tax Court views Rite Aid as not applicable to the facts here, which clearly show a double deduction (for the same economic loss) to the group, but do not reorder or prioritize the reporting of an asset sale loss over a stock sale loss.

Internal Revenue Service Agrees to Settle Transfer Pricing Case Filed in the United States Tax Court Against Caterpillar Inc.

Posted in Federal Tax Case Law Decisions

In a case that had been docketed in the United States Tax Court, Caterpillar Inc. v. Commissioner, Docket No. 10790-13 (2013), the petitioner-corporation and respondent, Internal Revenue Service, entered into and filed a stipulated settlement on July 31, 2014 with the Court. In many instances a stipulated settlement will be reached by the parties prior to trial, which would further mean that no evidenced was adduced and possibly occured prior to the submission of stipulations of fact being filed with the court.

The compromise and settlement of tax cases is government by principles of contract law. Robbins Tire & Rubber Co., v. Commissioner, 52 T.C. 420, 435-436, supplemented by 53 T.C. 274 (1969); Brink v. Commissioner, 39 T.C. 602, 606 (1962), aff’d 328 F.2d 622 (6th Cir. 1964). Where a decision is entered under a stipulated settlement, the parties are generally held to their agreement without regard to whether the decision is correct on the merits. See Stamm International Corp. v. Commissioner, 90 T.C. 315, 321-322 (1988); Spencer M. Stillman, et ux., TC Memo 1995-591.

This case involved a Section 482 transfer pricing matter concerning the deductiblity (or non-inclusion of imputed income) with respect to royalty paments owed to the petitioner from its European subsidiaries in Belgium and France. The stipulated settlement requires that Caterpillar pay additional taxes totaling approximately $1.9 million for the tax years 1990 and 1992 to 1994. The amount includes a $3.3 million deficiency in tax for 1990 which is partialliy offset by a residual FTC balance of $1.475 million for the same year. The deficiency in income tax sought by the Service in its notice of deficiency was approximately $7.2 million.

The center of the controversy was the effect to be given to Caterpillar’s amendment of a long-standing licencing agreement(s) that had been in place for close to 30 years with its manufacturing subsidiaries in Belgium and France. Amendments agreed to in 1990 suspended the subsidiaries’ obligations to remit the required 5% of revenues ( net sales less direct costs) under the licensing contracts until the subsidiaries were once again profitable.

The licensing agreements covered the use by the foreign subsidiaries of groups of intangibles including Caterpillar patents, manufacturing methods, trademarks and copyrighted materials.
The amended licensing agreements suspended the royalty payments during year in which the subsidiaries incurrred net operating losses and further allowed the carryover of NOLs to reduce required payments in subsequent years. During the years in issue, the subsidiaries incurred losses, and therefore, under the 1990 amendments, made no royalty payments which in turn would result in Caterpillar’s not reporting any licensing income in such year.

The Internal Revenue Service regarded the amendments and therefore the suspension of royalty payments , as not reflectived of the arms’ length standard that is the central feature of Section 482 and the underlying regulations. It therefore wanted Catperillar to be treated as having received the required royalties under the orginial royalty agreements. The petitioner-corporation countered by claiming that suspending the royalties for loss years was still reflective of arms’ length pricing since the business purpose was to help restore the profitability of Caterpillar’s foreign manufacturing operations.

Prior to the Tax Court litigation, in 2000 Caterpillar Inc. filed for relief under the competent authority provisions of the U.S. income tax conventions with France and Germany. No agreement was reached. In 2005 Caterpillar challenged the assessment (proposed) with IRS Appeals but its efforts were similarly rejected.

In an earlier stipulation filed with the Tax Court in February, 2014, Caterpillar and the Internal Revenue Service agreed to increase Caterpillar’s income by $22 million with respect to the operations of the Belgian subsidiary and by $11 million for income as to its French subsidiary.

Senator Chuck Levun (D-Mich) Renews His Efforts to Attack “Basket Options” Used by Hedge Funds: “Hiding Behind the Large Partnership Audit Rules”

Posted in Federal Taxation Developments

As recently reported by the tax press, a Senate panel recommended on July 21 that the IRS step up its enforcement of the structured financial product referred to as “basket options” and related strategies, penalize banks that facilitate such tax avoidance, and revamp the rules governing large partnership audits.

A primary target of the investigation by the Senate was the use of so-called “basket options” by hedge funds which have the desired consequence of converting short-term capital gains into long term capital gains. It was recommended by government officials from the Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations appearing before the Senate panel that the IRS increase its enforcement efforts in this area and penalize banks for facilitating the basket option transaction. There was also a call to revamp the audit rules pertaining to large partnership options. Some have suggested that under current law large partnerships may be audit proof.

In its report the subcommittee concluded that at least two banks and more than a dozen hedge funds misused the basket option structure to claim “unjustified tax savings.” In the case of hedge fund Renaissance Technologies LLC, those savings amounted to an estimated $6.8 billion over more than a decade, according to the report. Subcommittee Chair Carl Levin, D-Mich., has expressed his concern that because the IRS has troubling auditing large partnerships, the full extent of the basket-option abuse is not known. Mr. Levun was quoted at a press conference as follows:

“This is very dramatic evidence of why there needs to be effective auditing. Too many partnerships — 99 percent of partnerships — go unaudited,” Levin said. While the low audit rate is due partly to a lack of IRS resources, it’s also a product of the partner notification requirements in the statute and regulations that have proved burdensome when thousands of partners are involved, he said, adding, “So you’ve got to perhaps change the law.”

On April 17 the Government Accountability Office released a preliminary report (GAO-14-379R ) showing that in fiscal 2012, the IRS closed field audits on only 0.8 percent of the more than 2,200 large partnerships (defined as having 100 or more direct partners and $100 million or more in assets). The GAO is still studying the issue and plans to release a full report this fall.

Proposals Waiting in the Wings to Fix the Large Partnership Audit Rules.

The Obama Adminstration’s proposal would essentially preserve the current set of rules but mandate an underused and currently voluntary streamlined audit regime for a much larger population of partnerships. (Treasury fiscal 2015 green book .)

Congressman Dave Camp, House Ways and Means Committee Chair
Camp’s plan, as laid out in his comprehensive tax reform draft released February 26, calls for a full repeal of the audit rules that apply to partnerships with more than 10 partners, which came about as part of the 1982 Tax Equity and Fiscal Responsibility Act. Camp would replace TEFRA with a brand-new regime that would effectively force partnerships (not their partners) to pay any tax due. While Camp’s position on this reform is somewhat radical, Senator Levun has been quoted as saying that Camp’s proposed solution is a viable option and that the issues of partnership audits and inversions are too pressing to wait for comprehensive, slow-moving tax reform.

A subcommittee staff member said the level of IRS audit activity of large hedge funds, private equity funds, and publicly traded partnerships is so small, it’s “scary.” The staff member added, “Some of the richest people in the country are investing in these entities. If the entity is not being looked at at the partnership level . . . the rich person then will not be audited on that activity, so it’s completely missed.”

Stay tuned as the Senate presumably will continue to push for greater enforcement in this area.

Will FATCA Increase The Number of U.S. Expats ?

Posted in Federal Taxation Developments

Under Section 877A(a)(1) a “covered expatriate”, i.e. a U.S. citizen renouncing his or her citizenship, or a long term resident renouncing his permanent visa or greencard, or otherwise moving out of the United States, is treated as having sold all of his assets (with some exceptions) on the day prior to the date of expatriation. The “mark-to-market” hypothetical sale is based on the deemed sale of the expat’s worldwide assets, including interests in privately held business entities. Under Section 2801, a U.S. distributee of a transfer or bequest from a US expat is subject to an “inheritance” tax on the value of the property received. A number of additional applicable rules are provided both for purposes of Sections 877A and 2801.

Many American expats and green card holders who have invested in an overseas pension contract are seemingly happy that they will not have to relinquish their US citizenship to mitigate the adverse effects of the withholdable payment rules under FATCA. A large percentage of overseas clients of the deVere Group were recently polled that they would no longer consider giving up U.S. citizenship to reduce the burden of the new law.

Still, according to Treasury Department statistics, 1001 Americans renounced their greencards or passports in the first quarter of 2014, which reflects a 47% increase from the prior year. Thus, it is expected that more than 3,000 Americans are expected to exit the U.S. before the end of 2014. A major factor in this migration out, is the FATCA provisions, contained in Section 1471-1474, which spreads the sovereignty of the U.S. on the receipt for tax information overseas and imposes sharp withholding requirements for non-compliance. Furthermore, banks in certain countries are rejecting the FATCA calculus, including entering into FFI agreements or having their country enter into a Model 1 or Model 2 intergovernmental agreements or IGA. The withholdable payment rules application to NFFEs may also be a factor in whether a U.S. citizen living abroad or otherwise may wish to renounce citizen then to comply with the reporting and disclosure requirements for being a “substantial U.S. owner” in an NFFE (that is not subject to an exception, such as the active business NFFE).

So there seems to be a direct relationship between the anticipated starting dates of the FACTA, which kicks off in real time on July 1, 2014, with its somewhat harsh rules and reporting requirements, and U.S. individuals deciding to establish their permanent residency elsewhere despite the cost of complying with Section 877A (and also Section 2801).

Internal Revenue Service Allows U.S. Residents to Proceed to Make Offshore Disclosure Under Streamlined OVDP Program Provided They Can Meet the Profile of a “Non-Willful Evader”

Posted in Federal Tax Rulings

In recent remarks made by IRS Commissioner John Koskinen on June 3 at the 2014 OECD International Tax Conference in Washington, D.C., Koskinen indicated that the Service will most likely modify in the “very near future” its offshore voluntary disclosure program to better account for the “law-abiding instincts of most U.S. citizens” who want to comply with their tax obligations and remedy past mistakes. This is particularly evident with respect to the “many U.S. citizens who have resided abroad for many years, perhaps even the vast majority of their lives,” Koskinen stated. The Commissioner added that “[W]e have been considering whether these individuals should have an opportunity to come into compliance that doesn’t involve the type of penalties that are appropriate for U.S.-resident taxpayers who were willfully hiding their investments overseas.”

What about U.S. residents or citizens residing in the United States with offshore accounts? Koskinen also gave hope to those taxpayers as well where their acts of noncompliance “clearly did not constitute willful tax evasion but who, to date, have not had a clear way of coming into compliance that doesn’t involve the threat of substantial penalties.”

The Commissioner wanted to “re-strike” the balance between enforcement and voluntary compliance now, given that FACTA’s operative date of July 1 approaches. That is true but the discretion to be exercised on when a particular taxpayer will be entitled to more favorable treatment on penalties and avoiding prosecution or at least the threat of prosecution is solely held by the Internal Revenue Service and also, particularly with FBAR litigation, with the Department of Justice.

Commissioner Koskinen delivered on his “promise”. On June 18, 2014, in FS-2014-6, the Service released a fact sheet highlighting three of if its offshore voluntary disclosure programs which have resulted in over 45,000 voluntary disclosures from individuals who have paid in approximately $6.5 billion in taxes, interest and penalties that had accrued from prior years’ violations. It also republished, as modified, its FAQs on the OVDI programs.

On June 18, 2014 the Service released to the press that it will allow certain eligible (“non-willful”) U.S. taxpayers to participate in its streamlined filing compliance program. The change was one of several made to the OVDI, including, unfortunately, increasing the miscellaneous offshore penalty from 27.5% to 50%. The IRS revised its “frequently asked questions” and “transition rules” as to the streamlined program. Commissioner Koskinen stated that the modifications are designed to increase taxpayer eligibility for the compliance program.

2009 Offshore Voluntary Disclosure Program (OVDP)

The IRS announced the 2009 Offshore Voluntary Disclosure Program (OVDP/OVDI) in March 2009. It offered taxpayers an opportunity to avoid criminal prosecution and a settlement of a variety of civil and criminal penalties in the form of single miscellaneous offshore penalty. It was based on existing voluntary disclosure practices used by IRS Criminal Investigation. Generally, the miscellaneous offshore penalty for the 2009 program was 20% of the highest aggregate value of the unreported offshore accounts from 2003 to 2008. Participants were also required to file amended or late returns and FBARs for those years. In the 2009 OVDP the IRS received 15,000 disclosures prior to the Oct. 15 closing date that year. It resulted in the collection of $3.4 billion in back taxes, interest and penalties. It also led to another 3,000 disclosures after the closing date.

2011 Offshore Voluntary Disclosure Initiative (OVDI)

While the 2009 program resulted in many disclosures and furthered the investigation of many individuals and financial institutions that facilitated non-compliance with U.S. tax law, the rules were modified somewhat in 2011. Of course the Department of Justice’s pursuit of U.S. taxpayers holding accounts with Swiss banks by forcing the banks to disclose the names and bank information of its U.S. clients did result in the delivery of many U.S. taxpayer identities. Those individuals are generally not eligible for OVDI relief unless they approached the Service prior to the DOJ’s receipt of their names and accounts.

The 2011 OVDI was announced in February, 2011 and continued until September 9, 2011. One change was to increase the penalty amount to 25% pf the miscellaneous offshore penalty on the highest aggregate value of unreported offshore accounts from 2003 to 2010. In addition, some participants were eligible for special 5% or 12.5-% penalties, depending on the severity of their noncompliance. The Service announced that the 2011 OVDI drew 15,000 disclosures and resulted in the collection of $1.6 billion in back taxes, interest and penalties for the 70% of cases that were closed that year.

2012 OVDP

In January 2012, the IRS revised the terms of the 2011 OVDI program and made it permanent until further notice. Under the 2012 Offshore Voluntary Disclosure Program, participants pay a penalty of 27.5% of the highest aggregate balance or value of offshore assets during the prior eight years. The 5% or 12.5 % penalties remained in effect for certain taxpayers. In June 2012, the IRS added an option to the existing disclosure program that enabled some U.S. citizens and others residing abroad to catch up on their filing requirements and avoid large penalties if they owed little or no back taxes. This option took effect in September of that year. According to government statistics, this 2012 program has drawn 12,000 disclosures since its inception.

2014 Changes to Offshore Programs

In June 2014, the IRS announced major changes in the 2012 offshore account compliance programs, providing new options to help taxpayers residing in the United States and overseas. The changes are anticipated to provide thousands of people a new avenue to come back into compliance with their tax obligations. The new guidance expanded the streamlined procedures for non-willful taxpayers and changed the OVDP program for taxpayers who may have engaged in willful non-compliance.
The government announced that all three voluntary programs have resulted in more than 45,000 voluntary disclosures from individuals who have paid about $6.5 billion in back taxes, interest and penalties.

Frequently Asked Questions and Answers; as Effective For OVDP Submissions Made on or After July 1, 2014.
To provide background into the OVDP program in general and incorporating some of the recent changes, the first 6 FAQs, as modified, are summarized below.

Q1. Is the new announcement introducing a new offshore voluntary disclosure program?
IRS Answer. No, it’s a continuation of the 2012 OVDP with modifications. Unlike the 2009 OVDP and the 2011 OVDI, the 2014 OVDP has no set deadline for taxpayers to apply. However, the terms of this program are subject to change at any time. For example, the IRS may increase penalties or limit eligibility in the program for all or some taxpayers or defined classes of taxpayers — or decide to end the program entirely at any time.

Q1.1 Were any significant changes made to the 2012 OVDP? If so, what are they?
IRS Answer. Among the changes made to the 2012 OVDP are:
• A 50% offshore penalty applies if either a foreign financial institution (FFI) at which the taxpayer has or had an account or a facilitator who helped the taxpayer establish or maintain an offshore arrangement has been publicly identified as being under investigation or as cooperating with a government investigation. See FAQ 7.2.

• As described below, FAQ 17 filing of delinquent FBAR reports, has been replaced and superseded. See “Options Available For U.S. Taxpayers with Undisclosed Foreign Financial Assets”.

• FAQ 18 concerning filing certain delinquent international information returns has been replaced and superseded. See “Options Available For U.S. Taxpayers with Undisclosed Foreign Financial Assets”.

• The reduced penalty structure under former FAQs 52 and 53 has been eliminated due to the expansion of the Streamlined Filing Compliance Procedures. See “Options Available For U.S. Taxpayers with Undisclosed Foreign Financial Assets”.

• FAQs 31 through 41 pertaining to the asset base to which the offshore penalty applies have been modified to promote clarity and consistency of application.

• FAQ 23 has been modified to require additional information for preclearance by Criminal Investigation.

• The Offshore Voluntary Disclosures Letter and attachment have been modified.

• FAQ 7 has been modified to require that the offshore penalty be paid at the time of the OVDP submission.

• FAQ 25, as modified, requires account statements be provided for all FFI accounts regardless of account balance and to provide that voluminous documents not requiring original signatures may be submitted on CD or DVD.

• Certain FAQs have been deleted as moot: 16, 17, 18, 19, 51.1, 51.2, 52, and 53.

Q1.2 What is the effective date of the modified FAQs (on the Service’s website)?
IRS Answer. For all new submissions made on or after July 1, 2014.

Q1.3 What if an individual applied for OVDP relief (mitigation) prior to the effective date of the modified FAQs and the case is still “open”, i.e., it has not be resolved via a closing agreement (Form 906). Can the individual request consideration under the modified program?
IRS Answer. Yes. An individual who has previously made an OVDP submission prior to July 14, 2014 may elect to have his case considered under the modified FAQs as part of the 2014 OVDP. This is accomplished by formal written request by the taxpayer or his representative and filed with the IRS examiner assigned to the case and further provided that all documents and information required by the modified FAQs is submitted. See, e.g., FAQ 25. If no examiner has been assigned to the case, the election needs to be filed along with any supporting or required documents with the IRS, Austin, TX.

Q1.4. What if the taxpayer applied under the OVDP prior to the effective date of the expanded Streamlined Filing Compliance Procedures. Can the individual request consideration under the modified rules which expand the Streamlined Filing Compliance program?

IRS Answer. Yes provided the taxpayer qualifies for “transitional treatment”under the terms of the Streamlined Filing Compliance Procedures applicable to the taxpayer’s situation.

Q2. What is the objective of the OVDP program in light of the modifications made in the notice and the expansion of the Streamlined Filing Compliance Procedures?
IRS Answer. The programs have the same objectives as the prior programs to bring in taxpayers with undisclosed foreign accounts and assets, including those held through undisclosed foreign entities to avoid or evade tax into compliance with the tax law of the U.S. and related laws.

Q3 What is different about the modified procedures, i.e., how do they differ from the IRS’s longstanding voluntary disclosure practice or the 2009 OVDP and 2011 OVDI?
IRS Answer. Voluntary Disclosure is a longstanding practice of the Criminal Investigative Division of the IRS. It processes and reviews “completed” voluntary disclosures in deciding whether to recommend to the Department of Justice (DOJ) that a taxpayer be criminally prosecuted. When a taxpayer truthfully, timely, and completely complies with all provisions of the voluntary disclosure practice, the IRS will not recommend criminal prosecution to the Department of Justice for any issue relating to tax noncompliance or failure to file a Report of Foreign Bank and Financial Accounts (FBAR report, Form TD F 90-22.1). The Department of Justice will exercise final authority with respect to the recommendation. It is also possible that an AUSA may wish to proceed with a criminal case or grand jury investigation in certain instances.

The current OVDP is a “counterpart” to the CID’s general Voluntary Disclosure Practice. Like its predecessors, the 2009 OVDP, which ran from March 23, 2009 through October 15, 2009, and the 2011 OVDI, which ran from February 8, 2011 through September 9, 2011, the current OVDP addresses the civil impacts of a taxpayer’s voluntary disclosure of foreign accounts and assets by defining the number of tax years covered and setting the civil penalties that will apply. Unlike the 2009 OVDP and the 2011 OVDI, there is no set deadline for taxpayers to apply. However, the terms of this program may change at any time, e.g., changing the amount of penalties to be impose or eligibility to be included in the program, or terminating the program entirely.

Q4. When should a taxpayer make a voluntary disclosure (under the OVDP)?
IRS Answer. U.S. taxpayers owning undisclosed FFIs and assets, including through undisclosed foreign entities, make a voluntary disclosure with the express purpose of becoming compliant, avoid substantial civil penalties, and generally to hope to eliminate the risk of criminal prosecution for all issues relating to tax noncompliance and failing to file FBARs. See FATCA, FFI reporting under §6038D, exchange of information under tax treaty or TIEAs.
Were a taxpayer to bypass the OVDP filings and simply file amended returns or file through the Streamlined Filing Compliance Procedure in a “quiet disclosure”, the Service cautions in the notice that such actions do not do not eliminate the risk of criminal prosecution. Making a voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving all offshore tax issues.

Taxpayers who do not submit a (formal) voluntary disclosure run the risk of detection by the IRS and the imposition of substantial penalties, including the fraud penalty and foreign information return penalties, and an increased risk of criminal prosecution.

Q5. Where a taxpayer doesn’t file under the OVDP what civil penalties is the taxpayer subject to?
• FBAR Failure to File Penalty. United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully (knowingly or perhaps even recklessly) failing to file an FBAR can be as high as the greater of $100,000 or 50% of the total balance of the FFI per violation. 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.

• Violation of Section 6038D. Starting with respect to 2011 income tax returns, Form 8938 requires a taxpayer to report his interest in cerain FFIs, certain foreign securities, and interests in foreign entities. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.

• Violation of Sections 6048 or 6039F.

o U.S. transferors of funds and other property to and owners of foreign trusts and certain other persons must file information returns under §6048. See also §§6048(d)(2), 6048(d)(4). A trust is a “foreign trust” unless a U.S. court is able “to exercise primary supervision of the trust’s administration” and a U.S. trustee has “authority to control all substantial decisions of the trust.” See §§7701(a)(30)(E), 7701(a)(31)(B). The reporting concerns three types of taxpayers: (i) U.S. persons who create or transfer property to a foreign trust; (ii) U.S. persons who are “grantors” of a foreign trust under the grantor trust provisions; and (iii) U.S. beneficiaries in receipt of distributions from foreign trusts. See §6048(c). The information required to be reported must be on Form 3520 (Annual Report to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) that is filed with the individual taxpayer’s U.S. income tax return. Separate filings are made with respect to each foreign trust. See also Form 3520-A (annual return by grantor of foreign trust). A “responsible person” must file a notice of a “reportable event” on Form 3520, such as the “creation of” a foreign trust, a U.S. person’s transfer of “money or property (directly or indirectly) to a foreign trust” whether this transfer occurs during the transferor’s lifetime or at death; or the death of a U.S. citizen or resident if the decedent was the owner of any portion of a foreign trust under the grantor trust rules or the decedent’s gross estate includes any portion of a foreign trust. See §679.

o A U.S. person (other than certain §501(c)(3) organizations) who receives purported gifts or bequests from foreign sources in excess of $10,000 per year (as indexed for inflation) is required to file a report of having received the gift in accordance with §6039F. See Rev. Proc. 2011-52, 2011-45 I.R.B. 701, §3.35 ($14,723 threshold for reporting (aggregate) foreign gifts/indexed for inflation)).

The penalty for the failure to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35% of the gross reportable amount, except for returns reporting gifts, in which case the penalty is 5% of the value of the gifts per month, up to a maximum penalty of 25% of the gifted amounts.

A penalty for failing to file Form 3520-A, Information Return of Foreign Trust With a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under § 6048(b). The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5% of the gross value of trust assets determined to be owned by the United States person.

• Violations of Section 6038 and 6046. A penalty for failing to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under §§ 6038 and 6046. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.

• Violations of Sections 6038A and 6038C. A penalty for failing to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Taxpayers may be required to report transactions between a 25 percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by IRC §§ 6038A and 6038C. The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.

• Violation of Section 6038B. A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under § 6038B. The penalty for failing to file each one of these information returns is 10% of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.

• Violation of Section 6046A. A penalty for failing to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. United States persons with certain interests in foreign partnerships use this form to report interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests under §6046A. Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.

• Civil Fraud. Fraud penalties may be imposed under §§ 6651(f) or 6663. Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75% of the unpaid tax.

• Failure to File Penalty. A penalty for failing to file a tax return imposed under § 6651(a)(1). Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5% of the balance due, plus an additional 5% for each month or fraction thereof during which the failure continues may be imposed. The penalty does not exceed 25% of the balance of tax due.

• Failure to Pay Amount of Tax Shown on Return. A penalty for failing to pay the amount of tax shown on the return under § 6651(a)(2). If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5% of the amount of tax shown on the return, plus an additional .5% for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25% of the unpaid balance.

• Accuracy Related Penalty. The Service may also impose in certain instances an accuracy-related penalty on underpayments imposed under § 6662. Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20% or 40% penalty.

Q6. What are the potential criminal charges that a taxpayer may be subject to for concealing foreign assets and/or income, etc. if not accepted in the OVDP and subsequently is subject to IRS examination.
IRS Answer. Possible criminal charges related to tax matters including tax evasion or concealment of the payment of tax (26 USC § 7201), filing a false return (26 USC § 7206(1)) and failure to file an income tax return (26 § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322. Additional possible criminal charges include conspiracy to defraud the government with respect to claims (18 U.S.C. § 286) and conspiracy to commit offense or to defraud the United States (18 U.S.C. § 371). There are also mail and wire fraud provisions that could be invoked. (18 U.S.C. §2).

A person convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000. A person convicted of conspiracy to defraud the government with respect to claims is subject to a prison term of up to not more than 10 years or a fine of up to $250,000. A person convicted of conspiracy to commit offense or to defraud the United States is subject to a prison term of not more than five years and a fine of up to $250,000.

Transitional Relief Under the Streamlined Filing Compliance Procedures. The announcement made by the Service as to “transitional relief” under the Streamlined Program was also published in Q&A format.

Q1. What is the purpose of transitional treatment under the OVDP?
IRS Answer. Transitional treatment under the OVDP may allow taxpayers currently participating in the OVDP who meet the eligibility requirements for the expanded Streamlined Filing published on June 18, 2014, with the opportunity to remain in the OVDP while taking advantage of the favorable penalty structure of the expanded streamlined procedures.

Q2. When is a taxpayer considered by the IRS as currently participating in an OVDP for purposes of qualifying and receiving transitional relief?
IRS Answer. A taxpayer will be considered to be currently participating in an OVDP for purposes of receiving transitional treatment if: (i) before July 1, 2014, the taxpayer has mailed to IRS CID his OVDP voluntary disclosure letter and attachments (OVDP FAQ 24) and (ii) as of July 1, 2014, the taxpayer has (a) remained in OVDP but not yet completed the OVDP certification process where a Form 906 Closing Agreement has been fully executed by the IRS; or (b) the taxpayer opted out of OVDP but had not received a letter initiating an IRS examination and enclosing a Notice 609; and (c) a taxpayer who, as of July 1, 2014, has completed the OVDP certification process where a Form 906 Closing Agreement has been fully executed by the Service will not be considered as currently participating in an OVDP and is ineligible for transitional relief treatment.

Q3. What is the outcome under transitional relief where a taxpayer made a request for OVDP pre-clearance before July 1, 2014 but has not yet made a full voluntary disclosure.
IRS Answer. In such instance, a taxpayer will not be considered as currently participating in OVDP for purposes of qualifying for transitional treatment unless, as of July 1, 2014, the taxpayer has mailed to IRS CID his voluntary disclosure letter and attachments as described in OVDP FAQ 24. Therefore a taxpayer who makes an offshore voluntary disclosure per FAQ 24 on or after July 1, 2014 will not be eligible for transitional treatment under OVDP despite the fact that he may have made a request for OVDP pre-clearance prior to July 1, 2014.

Q4. Can a taxpayer qualify for transitional relief where he submitted an OVDP disclosure prior to July 1, 2014 but the case was removed from OVDP by the IRS?
IRS Answer. In such instance, i.e., where a taxpayer’s case has been removed from the OVDP by the IRS, the taxpayer will no longer be eligible for transitional relief.

Q5. What is the effect if the taxpayer files and receives transitional relief treatment?
IRS Answer. Where approved by the IRS, taxpayers currently participating in the OVDP who meet the eligibility requirements under the Streamlined Foreign Offshore Procedures will not be required to pay the Title 26 miscellaneous penalty prescribed under the OVDP to continue participation in the OVDP but instead will be subject to the miscellaneous offshore penalty terms of the Streamlined Domestic Offshore Procedures.

Q6. How does a taxpayer obtain transitional (relief) treatment?
IRS Answer. The response is that the taxpayer is not required to opt out of the OVDP to receive transitional relief treatment but must provide to the IRS: (i) if not already submitted, all submission documents required under the voluntary disclosure program in which the taxpayer is currently participating, e.g., 2009 OVDP, 2011 OVDI, and 2012 OVDP; (ii) a written statement in proper certification form required under the Streamlined Filing Compliance Procedures signed under penalty of perjury certifying his non-willfullness with respect to all foreign activities/assets, specifically describing the reasons for the failure to report all income, pay all tax, and submit all required information returns, including FBARs, and if the taxpayer relied on a professional advisor, the name, address and phone number of the advisor and a summary of the advice, and (iii) full payment of tax, interest, and any accuracy-related, failure to file and/or failure to pay penalties that would be due under the OVDP, if not already made.

The required information must be provided to: (i) the IRS examiner currently working on the taxpayer’s OVDP; (ii) or if there is no current examiner working on the taxpayer’s OVDP, send the information to the Austin OVDP Unit at: Internal Revenue Service Offshore Voluntary Disclosure Unit– Streamlined Waiver Request, 3651 South IH-35, Mail Stop 4301 AUSC, Austin, TX 78741.

Q7. Is transitional relief treatment automatic?
IRS Answer. As you may have expected, the IRS response is “No”. The IRS must agree that the taxpayer is eligible for transitional treatment and must agree that the available information is consistent with the taxpayer’s certification of non-willful conduct.
Q8. How will the IRS process the request by the taxpayer for transitional treatment.

IRS Answer. Each request for transitional treatment will be reviewed to determine whether the taxpayer is eligible, the taxpayer’s certification of non-willfullness is complete, and the information available is consistent with the certification. The examiner assigned to the case will make an initial determination and the manager of the examiner must agree. A central review committee may also review the determination. In central review committee situations, the examiner is required to document the facts and rationale for the determination, document the taxpayer statement of facts, and prepare a summary of the case. The central review committee will review the file, etc., and the examiners determination and rationale to determine if it is consistent with other determinations made across the IRS.

The central review committee, upon completing its review, will advise the examiner of its concurrence, non-concurrence or additional actions required to process the request. The decision of the central review committee is final and may not be appealed. There are no appeal rights within the OVDP in general, including transitional treatment. Where the IRS does not agree that the taxpayer is entitled to transitional treatment, the case remains governed with the OVDP. Where the OVDP miscellaneous offshore penalty is unacceptable to the taxpayer, the taxpayer may opt out of the OVDP and choose to have the case resolved in an examination process.

Q9. Where a taxpayer files for and receives transitional treatment, how will the rest of the OVDP case be handled or affected?
IRS Answer. All other terms of the OVDP in which the taxpayer is participating in will continue, including, but not limited to: (i) the OVDP disclosure period, which remains the same; (ii) an executed Form 906 Closing Agreement is still required; (iii) payment of accuracy-related, failure to file and/or failure to pay penalties, if applicable, are required; and the (iv) the alternative mark-to-market PFIC computation will continue to be made available.

A Few Comments
The real question with all this transition treatment “stuff” is whether the Service will be able to thoughtfully and correctly determine in each instance, and from a policy standpoint, on a consistent basis as well, what is “willful” evasion and what is only “non-willful” evasion. Does motive and “evil intent”, otherwise not necessary to obtain a felony conviction for tax evasion or false return, or a civil fraud penalty, enter into the picture? What about “willful blindness” or “recklesslessness”?

It seems that under this program, it is the taxpayer and the party submitting the affidavit (instead of the government in a civil fraud case (“clear and convincing evidence”) or criminal case (“beyond any reasonable doubt”) that will have the burden of proving and persuading the Service’s examiner or CRC review, that he was “nonwillful” in his noncompliance (evasion).

Given this burden of proving “non-willful”, does the taxpayer take any risks by trying to file for non-willful status? The answer presumably is “yes”. In many instances, willful blindness or even reckless disregard for rules and regulations may be sufficient for penalizing a taxpayer, perhaps, in some instances it may be sufficient for an adjudication of guilty in a criminal tax case. Consider whether a taxpayer who checks the box “no” as to not having foreign bank accounts on his income tax return(s) can be considered as acting “non-willful” under the transitional relief or under the Streamlined Filing procedure. But it would seem that in many if not most instances, non-compliance in the offshore bank account situation will include an erroneous check of “no” on the foreign bank account question. Perhaps its only the uninformed heir of a foreign bank account held by a grandparent or a foreign trust for many years and then is distributed to such U.S. individual will satisfy the “non-willful” standard. Another illustration of the type of “non-willful evasion” that would qualify for transitional treatment could be a dual citizen who never lived in the U.S. and was completely unaware of the FBAR and other filing requirements and reported his offshore bank account interest income to his home country. But what if such person paid no tax at all on the account? Does that make such person’s failure to comply with his home state’s tax law evidence of “willfulness” for transitional relief.

Another question is undoubtedly going to surface and that is “what is the harm in applying if I am rejected for transitional relief”? Well, for starters, what about the “false statements” provision in the Code, §7206?. If a false affidavit is submitted, at least in the eyes of the Service, does this increase the likelihood of a criminal investigation and recommendation for prosecution? What if there is other evidence from bank personnel and accountants, lawyers, etc. over there in Europe who heard incriminating statements made by the taxpayer. Bringing those parties forward to rebut the statement of “non-willfullness” may have an adverse consequence to the taxpayer. It should….in other words, the non-willful statement should not be construed to invite self-serving statements of contrition when the Service wants to know if the taxpayer was innocent or unknowing of his responsibilities. Just hearing the sales pitch from foreign bankers and investment advisors on avoiding (evading) US tax should be enough to dissuade someone from seeking “non-willful” status. Shouldn’t it? Oh, before we end, what if the lawyer advising the client has reason to belief the client knew he was violating the law but has him sign the affidavit hoping the qualify for leniency? Well, the prudent advisor would never do that would he? Consider, nevertheless, §7207 (submission of false document).

This posting is solely made for informational purposes only and is not intended in any way to constitute the rendering of legal advice to the reader. Please consult with your tax counsel if you have any questions as to the government’s new notices.

Treasury and Internal Revenue Service Issue New Final Regulations on the Rendering of Written Tax Advice: The “Banners” on E-Mail Disclaiming Reliance on Tax Advice May Soon Disappear

Posted in Federal Tax Regulations

On June 9, 2014, the Service and the Treasury, under Section 330 of title 31 of the United States Code, authorizes the Secretary of the Treasury to regulate the practice of representatives of persons before the Treasury Department (Treasury). The Secretary has published regulations governing practice before the Internal Revenue Service in 31 CFR part 10 which regulations are reprinted as Treasury Department Circular No. 230 (Circular 230).

The policy goal of the Treasury and Internal Revenue Service in regulating the tax profession is that individuals, such as lawyers, accountants, tax return preparers and appaisers, and in some instances their firms, i.e., subject to Circular 230 must meet minimum standards of professional conduct in their representation of clients before the Internal Revenue Service including the issuance of written tax advice. Those found to be in violation of such standards are subject to disciplinary action, including suspension or disbarment. This frequently can result in fines or penalties as well as referrals to state licensing agencies or bar associations for appropriate review.

The regulations (Circular 230) were amended on December 20, 2004 (effective for written advice issued after June 6, 2005), and further amended in proposed reglations issued in September, 2012. This week’s issuance of final regulations pertains in substantial part to revision of the rules pertaining to the issuance of written tax advice. The 2004 revisions, which ushered in the “covered” opinion rules, set forth a set of detailed regulations in issuing written opinions. The 2004 regulations were made in response to various tax shelters and tax products that were marketed in the late 1990s and early 2000s which the Service and Treasury regarded as “abusive”. Many of these strategies were accompanied by a written tax opinion obtained from an individual employed or a partner in a professional service organization which opinion had the intended purpose of protecting the client from penalties in the event of a successul challenge by the Service against the transaction in issue.

The arcane and involved set of rules under §10.35 on covered opinions were met with a fair degree of skepticism as well as confusion. Many firms and practitioners placed carefully worded banners on their e-mail to disclaim reliance for penalty protection purposes in opting out of the detailed factual and document requirements for covered opinions provided tye “opt out” strategy was otherwise available.

On September 17, 2012, Treasury and the IRS published in the Federal Register (77 FR 57055) a notice of proposed rulemaking (REG-138367-06) proposing to amend Circular 230 by revising the rules governing written tax advice and other related provisions of Circular 230. Previously proposed amendments to the regulations regarding state or local bond opinions also were withdrawn.

The 2012 proposed regulations sought to eliminate the complex rules applicable to covered opinions in § 10.35 and to expand the requirements for written advice under § 10.37. The proposed regulations also recommended expansion of the procedures to ensure compliance under § 10.36 beyond the opinion writing and tax return preparation context to all matters within the scope of Circular 230. The proposed regulations further sought to clarify that practitioners must possess the adequate degree of knowlege and competence when engaged in the practice of representing persons before the IRS. Additionally, the proposed regulations expanded the categories of violations subject to the expedited proceedings in § 10.82 to include failures to comply with a practitioner’s personal tax filing obligations that demonstrate a pattern of willful disreputable conduct and clarified the Office of Professional Responsibility’s scope of responsibility.

Final Regulations, Treasury Decision 9668

Consistent with the recommendations set forth in the 2012 proposed regulations, the final regulations replace the “covered opinion” rules for written tax advice with a more flexible approach which dispenses with the widespread use of banners warning that the recipient of the communication containing tax advice may not rely upon the written communication to avoid the imposition of penalties. With the final regulations, there is one provision or standard in place for all written tax advice. Under §10.37 (of Circular 230), a practitioner must base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts the practitioner knows or should know. Accordingly, an individual rendering written tax advise must use reasonable efforts to identify and ascertain the facts relevant to written advice on a federal tax matter.

Another change made under the final regulations is the removal of the prior requirement that practitioners fully describe the relevant facts and the application of the law to the facts in the written advice itself. The final regulations further eliminate the use of Circular 230 disclaimers in documents and transmissions, including e-mail. Further, the final regulations, under §10.37(d), define a “federal tax matter” as any matter concerning the application or interpretation of (1) a revenue provision as defined in § 6110(i)(1)(B) of the tax code; (2) any provision of law affecting a person’s obligations under the internal revenue laws and regulations, including but not limited to the person’s liability to pay tax or obligation to file returns; or (3) any other law or regulation administered by the Internal Revenue Service.

The prior rule mandating that a practitioner not advise a client based on the likelihood of an audit or that in the event of an audit whether a particular tax issue(s) will be identified by the Service has been retained. The final regulations, however, eliminate the rule which prohibited a practitioner from taking into account the possibility that an issue will be resolved through settlement if raised by the Service when giving written advice evaluating a federal tax matter.

Section 10.36 Reforms on Firm Managers Overseeing Circular 230 Compliance

The final regulations create new responsibilities for firm managers overseeing Circular 230 compliance. Accordingly, firm management with principal authority and responsibility for overseeing a firm’s practice governed by Circular 230 are held to be responsible for establishing procedures to ensure compliance with all provisions of Circular 230 and not just the provisions on tax advice and tax return preparation. The final regulations clarify that firm managers not only must ensure that the firm has adequate procedures in place but also must ensure that those procedures are properly followed.

The final regulations extend the expedited disciplinary procedures to disciplinary proceedings against practitioners who have willfully failed to comply with their federal tax return filing obligations but prescribe limited circumstances in which the expedited procedures may be permitted. Lastly, the final regulations acknowledge that the Office of Professional Responsibility has exclusive responsibility for matters related to practitioner discipline, including disciplinary proceedings and sanctions.

I. Amendments To Rules Governing Written Advice in the Final Regulations

A. Elimination of Covered Opinion Rules in § 10.35.

As mentioned, former §10.35 provided a detailed set of rules pertaining to covered opinions. These provisions were higly criticized by tax professionals and clients. Many professional service organizations required all e-mail to be “bannered” with a disclaimer of reliance on the advises contained in the e-mail for penalty protection purposes. In many instances, the e-mails would not even contain tax advice. Thus, a consensus was reach several years ago which was reflected in the 2012 proposed regulations that the detailed covered opinion rules be deleted and replaced with a broader facts and circumstances standard and place greater specific emphasis on practitioner competence. was that former §10.35 should be eliminated Former § 10.35 provided detailed rules for tax opinions that were “covered opinions” under Circular 230. As discussed in the notice of proposed rulemaking, Treasury and the IRS revisited the covered opinion rules because their application increased the burden on practitioners and clients, without necessarily increasing the quality of the tax advice that the client received. Commenters on the proposed regulations overwhelmingly supported the elimination of former § 10.35 because the former rules were burdensome and provided minimal benefit to taxpayers. Commenters agreed that the rules in former § 10.35 contributed to overuse, as well as misleading use, of disclaimers on most practitioner communications even when those communications did not constitute tax advice.

The final regulations adopt the 2012 proposed regulation’s elimination of the covered opinion rules under §10.35 and subject all written tax advice to one standard under final § 10.37. The regulations note that the elimination of the collection of information required to issue a covered opinion “should save practitioners a minimum of $5,333,200”. Where did that number come from? The answer contained in the Preamble to the rule-making states: “(T)hese savings come from the elimination of the provisions in the former regulations requiring practitioners to make certain disclosures in a covered opinion. The 2004 estimated cost of complying with former §10.35 was based on an estimation that each practitioner would spend 5 to 10 minutes complying with the provision at an average of 8 minutes for a total burden of 13,333 hours. This burden is no longer imposed on practitioners. This commentator takes issue with these figures as not having any foundation in fact. Regardless of the rationale for removing §10.35’s set of arcane rules on covered opinions, including the bannering provisions, the elimination of the covered opinion rules is welcome.

Under former §10.35 a tax advisor issuing a covered opinion had to make certain disclosures in marketed opinions, limited scope opinions, and opinions that fail to conclude at a confidence level of at least more likely than not that the issue will be resolved in favor of the taxpayer. For example, a marketed opinion had to specifically contain a statement that the opinion was written to support the marketing of the transaction addressed in the opinion and that the taxpayer should seek advice from an independent tax advisor based on the taxpayer’s particular circumstances. The presence of certain relationships between the tax adviser and a person promoting or marketing a tax shelter were required to be disclosed. The final regulations do not include the above-referenced collection of information/disclosure requirements, and practitioners and taxpayers are relieved of the entire cost associated with those collection of information/disclosure requirements.

B. Revision of Requirements for Written Advice

1. General Requirements for Written Advice. In locating the written tax advice rules primarily in revised §10.37 of the final regulations, the Treasury and the IRS have determined that these written advice rules strike an appropriate balance between allowing flexibility in providing written advice, while at the same time maintaining standards that require individuals to act ethically and competently. Specifically, § 10.37 requires, inter alia, that the tax practitioner base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts that the tax advisor knows or reasonably should know. A practitioner must also use reasonable efforts to identify and ascertain the facts relevant to written advice on a Federal tax matter.

Unlike former §10.35, revised §10.37 does not require that the tax practitioner describe in the written advice the relevant facts (including assumptions and representations), the application of the law to those facts, and the practitioner’s conclusion with respect to the law and the facts. So, the revised regulations embrace “short form” opinions if such is otherwise reasonable and does not violate the standard of knowledge and competency.

Therefore, under revised §10.37, it is important to consider the scope of the engagement and the type and specificity of the advice sought by the client, in addition to all other appropriate facts and circumstances, in determining the extent to which the relevant facts, application of the law to those facts, and the practitioner’s conclusion with respect to the law and the facts must be set forth in the written advice. Also, under § 10.37, unlike former § 10.35, the practitioner may consider these factors in determining the scope of the written advice. Further, the determination of whether a practitioner has failed to comply with the requirements of § 10.37 will be based on all facts and circumstances, not on whether each requirement is addressed in the written advice.

Query, will this make it easier for the OPR to find a violation based on this rather broad and ambiguous standard of “all facts and circumstances”? Or, alternatively, will it be easier for the tax practitioner defending her written tax advice from falling short of the required standards to show conformity in fact? Consider, for example, if the analysis and conclusion reached is just wrong even though the factual assumptions and due diligence factors are satisfied.
Does issuing an “incorrect opinion” under this broader standard give the OPR a greater chance to impose a sanction or fine?

Under revised §10.37 practitioners must base the written advice on reasonable legal and factual assumptions whether or not such legal and factual assumptions are set forth in the writing. Still, it may be more desirable for the practitioner to describe all relevant facts, law, analysis, and assumptions as part of the written opinion. One should also not lose sight of the best practices provision in §10.33. Perhaps best practices requires such legal and factual assumptions to be set out in the applicable opinion. Note further the language change in §10.37 requiring the factual and legal assumptions made by the tax practitioner in issuing the written tax advice be “reasonable”. Stated differently, advice based on invalid representations, incorrect facts, or unreasonable assumptions has little value and therefore could run afoul of Circular 230′s written advice rules. Again, the final § 10.37 adopts the requirement of the 2012 proposed regulations to § 10.37 that practitioners rely on reasonable factual and legal assumptions.

2. Use of Banners Disclaiming For Penalty Protection.

Many practitioners (and firms) have, since mid-2005 when the covered opinion rules set forth in the 2004 final regulations became effective, been using a Circular 230 disclaimer at the conclusion of every e-mail or other writing to remove the communication from the covered opinion rules in former § 10.35. These types of disclaimers are routinely inserted in any written transmission, including writings that do not contain any tax advice. The removal of former § 10.35 eliminates the detailed provisions concerning covered opinions and disclosures in written opinions. (emphasis added). Since revised §10.37 does not contain any disclosure provisions as were contained in the covered opinion rules, the Treasury and the IRS expect that these amendments will eliminate the use of a Circular 230 disclaimer in e-mail and other writings. (emphasis added) . The Preamble to the final regulations specifically states that the rules in the final regulations are intended to eliminate the need for unnecessary disclaimers. The Preamble hedges on this issue by stating: “These rules do not, however, prohibit the use of an appropriate statement describing any reasonable and accurate limitations of the advice rendered to the client.”

3. Definition of Written Advice Addressing Federal Tax Matters.

The final regulations clarify that government submissions on matters of general policy are not considered written tax advice on a Federal tax matter for purposes of § 10.37. For example, if a law firm submitted comments on proposed regulations to Treasury and the Service on a client’s behalf, that submission does not constitute written advice on a Federal tax matter because comments on proposed regulations are government submissions on matters of general policy.

More importantly perhaps, the final regulations also clarify that continuing education presentations provided to an audience solely for the purpose of enhancing practitioners’ professional knowledge on Federal tax matters, such as presentations at tax professional organization meetings, are not considered written advice for purposes of § 10.37. Caution is required to be exercised by practitioners with respect to presentations marketing or promoting transactions. Such presentations will not be considered to be provided solely for the purpose of enhancing practitioners’ professional knowledge on Federal tax matters. Including contact information on a continuing education presentation provided solely for the purpose of enhancing professional knowledge, without more, does not convert an educational presentation into an item of written tax advice governed by the final regulations. Even though continuing education presentations provided to an audience solely for the purpose of enhancing practitioners’ professional knowledge on Federal tax matters are not considered written advice, Treasury and the Service nonetheless expect that practitioners will follow the generally applicable diligence and competence standards under §§ 10.22 and 10.35 when engaged in those activities.

Former § 10.35 governed written tax advice addressing Federal tax issues. Under the prior regulations, a Federal tax issue was defined as a question concerning the Federal tax treatment of an item of income, gain, loss, deduction, or credit, the existence or absence of a taxable transfer of property, or the value of property for Federal tax purposes. Because the final regulations eliminate former § 10.35, this definition is no longer applicable. Under final § 10.37(d), a Federal tax matter is any matter concerning the application or interpretation of (1) a revenue provision as defined in section 6110(i)(1)(B) of the Internal Revenue Code (Code), (2) any provision of law impacting a person’s obligations under the internal revenue laws and regulations, including but not limited to the person’s liability to pay tax or obligation to file returns, or (3) any other law or regulation administered by the Service.

4. Consideration of Audit Risk and Likelihood of Settlement.

Consistent with former § 10.37, the final regulations provide that a practitioner must not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that an issue will not be raised on audit. This limitation extends to the rendering of oral advice, i.e., the Treasury and the Service agree that audit risk should not be considered by practitioners in the course of advising a client on a Federal tax matter, regardless of the form in which the advice is given.

Settlement possibilities with respect to an issue can now be taken into account by tax practitioners. Indeed, the 2012 proposed regulation to § 10.37 attempted to eliminate the provision in the former regulations that prohibits a practitioner from taking into account the possibility that an issue will be resolved through settlement if raised when giving written advice evaluating a Federal tax matter. The Treasury and Service now view that the former rule may have unduly restricted the ability of a practitioner to provide comprehensive written advice because the existence or nonexistence of legitimate hazards that may make settlement more or less likely may be a material issue for which the practitioner has an obligation to inform the client. Now, it is permitted. That makes sense considering the UTP filing requirements for certain taxpayers and the ASC 740-10 rules on “recognition” and “measuring” of deferred tax liabilities for financial accounting purposes.

5. Standard for Significant Purpose Transactions

The 2012 proposed regulations provided that the Service will apply a heightened standard of review to determine whether a practitioner has satisfied the written advice standards when the practitioner knows or has reason to know that the written advice will be used as part of a “marketed opinion”, e.g., a transaction that involves promoting, marketing, or recommending an investment plan or arrangement a significant purpose of which is the avoidance or evasion of any tax imposed by the Code. Some commenters expressed concern that the term “heightened standard of review” was too vague and requested that Treasury and the IRS provide detailed rules and examples with respect to application of a heightened standard of review in these cases. The final regulations clarify in § 10.37(c)(2) that the Commissioner, or delegate, will apply a reasonable practitioner standard that considers all facts and circumstances with an emphasis given to the additional risk associated with the practitioner’s lack of knowledge of the taxpayer’s particular circumstances.

6. Reliance on Professionals

Under 2012 proposed regulations to § 10.37(b), i.e., reliance on the advice of another practitioner, it was uncertain whether such reliance could apply to advice from an appraiser or other individual not described as a practitioner in §§ 10.2 and 10.3 of Circular 230. Treasury and the Service have determined that the provisions of § 10.37(b) should apply to a practitioner who relies on advice from any other person, including appraisers and other individuals not defined as practitioners under Circular 230. Final § 10.37(b), therefore, reflects that the standards apply to a practitioner relying on advice from another person. This reliance provision in the final regulations is consistent with reliance standards in current §§ 10.22 and 10.34(d), and former § 10.35(d) Still the reasonable practitioner standard in §10.37(c) must be satisfied.

Proposed § 10.37(b)(1)-(3) provided that reliance is not reasonable when the practitioner “knows or should know” that the opinion of the other person should not be relied on, the other person is not competent to provide the advice, or the other person has a conflict of interest. The final regulations adopt this proposal and revise § 10.37(b)(1)-(3) to prohibit reliance when the practitioner “knows or reasonably should know” that the advice is disqualified as specified in each provision. See also final § 10.37(a) for reliance on representations also has been amended in a consistent manner.

So, where a tax practitioner in issuing written advise relies upon another person’s comments or analysis, it may impose a a duty on the practitioner to inquire into the skills and experience of the person whose advice is being relied upon. While Treasury and the Service do not believe this standard imposes an affirmative duty on a practitioner to inquire into the skills and experience of the other person when the practitioner is already aware of the other person’s background, Treasury and the Service believe practitioners should consider the skills and experience of a person when they are relying on the advice of that person. Relying on advice of another person without considering that person’s expertise and qualifications to provide that advice is inconsistent with the obligation of diligence required in § 10.22. Thus, a practitioner intending to rely on the advice of another person may have an obligation to inquire about that person’s background if the practitioner is not familiar with the person’s qualifications to render the advice on which the practitioner will be relying. Accordingly, the final regulations retain § 10.37(b)(2), which provides that a practitioner cannot rely on the advice of another when the practitioner knows or reasonably should know that the other person is not competent or lacks necessary qualifications to provide the advice.

Some commenters were concerned with 2012 proposed regulation § 10.37(b)(3), which provided that a practitioner could not rely on the advice of another when the practitioner knows or should know that the other practitioner has a conflict of interest as described in Circular 230. These commentators stated that this rule may prevent reliance when the other practitioner has a conflict of interest that has been properly waived by all affected clients, as permitted by § 10.29 of Circular 230. The Preamble to the final regulations notes that a practitioner should be able to rely on the advice of another person who has a conflict of interest when the practitioner knows that the other person’s conflict has been waived by all affected clients through informed consent and the representation is not prohibited by law.

II. Procedures to Ensure Compliance

Former § 10.36(a) set forth requirements for practitioners in charge of a firm’s tax practice to establish procedures to ensure compliance with the covered opinion rules in § 10.35. With the repeal of §10.35, also repealed was former §10.36(a). Section 10.36 has been amended and remains in place for practitioners in charge.

The idea in §10.36 is that firms, through their practice leaders or persons in charge, have procedures in place to ensure compliance with written advice, tax return preparation and Circular 230 in general. Under 2012 proposed regulation § 10.36, the requirement for procedures to ensure compliance were expanded to include all provisions in Subparts A (Rules Governing Authority to Practice), B (Duties and Restrictions Relating to Practice Before the Internal Revenue Service), and C (Sanctions for Violation of the Regulations) of Circular 230. The Treasury and the Service have clarified § 10.36 to require both the existence and implementation of adequate procedures. See §10.36(b)(2).

A further revision to § 10.36 is that it can apply to any member of a firm’s management which is subject to Circular 230. Although Treasury and the Service understand that in some instances no member of a firm’s management is subject to Circular 230. However, the Preamble to the final regulations observed that an overwhelming majority of firms will have one or more members of firm management who are subject to Circular 230. Treasury and the IRS believe it is reasonable to expect those members of firm management who are subject to Circular 230 to ensure that the firm will have in place and implement adequate procedures to ensure compliance with Circular 230. The final regulations make clear that in the absence of a person or persons identified by the firm as having principal authority and responsibility, the IRS may identify one or more individuals subject to Circular 230 who will be held responsible for taking reasonable steps to ensure that the firm has adequate procedures in effect for all members for purposes of complying with Circular 230.

One commentator stated that the expansion of § 10.36 should be limited to the practice standards prescribed in Subpart B of Circular 230, which pertains to Duties and Restrictions Relating to Practice Before the Internal Revenue Service. The Treasury and the Service disagree that final § 10.36 is limited to Subpart B because Subparts A (Rules Governing Authority to Practice) and C (Sanctions for Violation of the Regulations) also impose substantive standards with which firm members must comply. Treasury and the Service, however, do agree that it is not necessary for a firm’s procedures to ensure compliance with Subparts D (Rules Applicable to Disciplinary Proceedings) or E (General Provisions) of Circular 230, and have revised § 10.36 accordingly.

III. General Standard of Competence

In comments made by the Service and OPR over the past few years that emphasize the need for individuals be competent in rendering tax advice with due regard to conforming their rendering legal advice on tax matters as much as possible to best practices, etc., the final regulations provide that in representing clients in tax matters covered under Circular 230 an individual must possess the necessary competence to engage in practice before the Service and that competent practice requires the appropriate level of knowledge, skill, thoroughness, and preparation necessary for the matter for which the practitioner is engaged.

After reviewing comments to the proposed regulations on this issue, the competence standard in final regulation § 10.35 accepts that a tax advisor may become competent in a variety of ways, including, inter alia, consulting with experts in the relevant area and studying the relevant law. Whether consultation and/or research are adequate to make a practitioner competent in a particular situation depends on the facts and circumstances of the particular situation. In general, the final regulations provide that competence requires the “appropriate level of” knowledge, skill, thoroughness, and preparation necessary for the matter for which the practitioner is engaged. This standard is similar to the American Bar Association’s Model Rules of Professional Conduct. Although not binding on the IRS, Treasury and the IRS believe that the comments to Rule 1.1 of the Model Rules of Professional Conduct, State Bar opinions addressing the competence standard, and the American Institute of Certified Public Accountant’s competency standard are generally informative on the standard of competency expected of practitioners under Circular 230.

IV. Electronic Negotiation of Taxpayer Refunds

Proposed and final regulation § 10.31 provide that a practitioner may not endorse or otherwise negotiate any check issued to a client by the government in respect of a Federal tax liability, including directing or accepting payment by any means, electronic or otherwise, into an account owned or controlled by the practitioner or any firm or other entity with whom the practitioner is associated. This prohibition on practitioner negotiation of taxpayer refunds is intended to provide guidance in the modern-day electronic environment in which practitioners, taxpayers, and the IRS operate. Proposed and final § 10.31 also amend former § 10.31 to apply to all individuals who practice as representatives of persons before the IRS, not just those practitioners who are tax return preparers. Section 10.31, however, does not apply to an individual acting solely in the capacity of a trustee of a trust, or administrator/executor of an estate because that person is acting as the taxpayer, not as the taxpayer’s representative. See § 10.7(e) of Circular 230.

V. Expedited Suspension Procedures

Section 10.82 authorizes the immediate suspension of a practitioner who has engaged in certain conduct. The proposed and final regulations extend the expedited disciplinary procedures to disciplinary proceedings against practitioners who have willfully failed to comply with their Federal tax filing obligations. Amended § 10.82 only permits the use of expedited procedures in the limited circumstances when a tax noncompliant practitioner demonstrates a pattern of willful disreputable conduct by (1) failing to make an annual Federal tax return during four of five tax years immediately before the institution of an expedited suspension proceeding, or (2) failing to make a return required more frequently than annually during five of seven tax periods immediately before the institution of an expedited suspension proceeding. For purposes of § 10.82, the phrase “make a return” has the same meaning as used in sections 6011 and 6012 of the Code and § 10.51(a)(6) of Circular 230. Additionally, the practitioner must be noncompliant with a tax filing obligation at the time the notice of suspension is served on the practitioner for the expedited procedures to apply.

Acquisitions Involving Bonus Payments and Accelerated Vesting of Options or Option-Like Rights to Key Management of the Target Company: Beware of Section 280G and Section 4999

Posted in Federal Taxation Developments

Congress enacted Section 280G in 1984. This provision addresses the income tax treatment of certain excess parachute payments incident to a change of control or takeover of a corporation. In enacting this provision, Congress was concerned that “golden parachutes” schemes, which were specifically adopted to detract or prevent a potential acquirer from engaging in a “friendly” or “hostile” takeover by imposing a high surcharge to target management in the event of a change of control or takeover, should be discouraged.

Section 280G therefore disallows a corporation a deduction for certain compensatory type payments made to a “disqualified individual” (whether or not incident to termination of the individual’s employment) where the payment (1) is contingent on a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of a corporation’s assets, provided the present value of the payments exceeds three times a defined base amount, or (2) is paid pursuant to an agreement violating any generally enforced securities laws or regulations. Any payment made pursuant to an agreement or amendment entered into within one year before a change of ownership or control is presumed to be contingent on the change unless the contrary is established by clear and convincing evidence.

The term “disqualified individual” includes an officer, shareholder, or highly compensated individual (including a personal service corporation or similar entity), as well as any employee, independent contractor, or other person who performs personal services for the corporation and is specified in regulations. §280G(c). See Treas. Reg. §1.280G-1 (definitions of “highly-compensated individual” and “officer group”). A disqualified individual’s “base amount” is defined by reference to the individual’s average annual taxable compensation for a five-year base period preceding the change of control or ownership. The parachute payments that are compared with three times the base amount to determine the excess parachute payments are net of an allowance for amounts established as reasonable compensation for personal services that were rendered before the change (if not already compensated for) or that are to be rendered after the change as is pointed out again below. See §§280G(b)(3), 280G(b)(4). See Square D Co. v. Comm’r, 121 T.C. 168 (2003). The definition of “base amount” not only determines whether Section 280G will apply but also determines the amount of the deduction limitation, since only payments in excess of the portion of the base amount allocable to the payment are nondeductible.

Compensation payments, in addition to those made or modified within one year before the change in ownership, may also be subject to Section 280G under a “but-for” test set forth in the regulations, in other words, payments that were in fact contingent upon the change in ownership. The regulations, in general, define a “change of ownership” as the acquisition of more than 50% of the corporate stock (vote and value) by one person or a group of persons. A change in effective control is presumed to take place where one person or a group acting in concert acquires 20 percent or more of the total voting power or when a majority of the board is replaced during a twelve-month period against the wishes of a majority of the old board. A parachute payments does not include any payment to or from a qualified retirement plan.

There are several important exceptions to the applicability of Section 280G. First, is the exception provided for a “small business corporation, defined by Section 1361(b) as a corporation that is eligible to elect S corporation status (even where no S election is made) or, under another exception, a corporation whose stock is not publicly traded and further provided that the proposed parachute payments to disqualified individuals are consented to by owners of more than seventy-five percent of the corporation’s voting stock (not taking shareholders who are also disqualified individuals) after full disclosure has been made. See §280G(b)(5)(A)(ii). See also Treas. Reg. §1.280G-1, Q&A 23. See also §280G(b)(2)(A)(ii).

Under Section 280G(b)(4), the amount treated as a parachute payment does not include the portion of such payment which the taxpayer can establish, by clear and convincing evidence, is reasonable compensation for services to be rendered on or after the date of ownership change, and, similarly, the amount treated as an excess parachute payment is reduced by the portion of such payment which, under the same clear and convincing evidence standard, constitutes reasonable compensation for personal services actually rendered before the date of the change. It is important that thorough studies be made of the reasonable of the compensation to be paid (in its totalility) and that such studies will hold up to a Daubert challenge and ultimately will be persuasive under the “clear and convincing” standard that is the taxpayer’s burden of proof.

Where the target will be subject to Section 280G, the purchasing corporation will presumably reduce the amount or value of consideration to be paid for the additional tax liability generated by the non-deductibility of the excess parachute payments. Disallowance of the corporation’s deductions under Section 280G therefore represents an economic loss accrued (and later realized) by the preexisting shareholder group. That group bears the ultimate burden of both the golden parachute payments and the additional corporate tax attributable to Section 280G, because the prudent purchaser of target stock will reduce the purchase price by the obligation to make the parachute payments, assuming the buyer is the funding source for the payments, and any increase in the target’s federal (and state) income tax liability that it would effectively inherent.

Section 4999 imposes a 20 percent excise tax on the recipient of a golden parachute payment. While many golden parachute recipients will attempt to negotiate a “gross-up” for the excise tax (if applicable) and the “tax-on-tax”effect, generally a buyer will refrain from agreeing to such gross up payment. Withholding is required on any excess parachute payment (as wages under §3401 and §3402) and the amount to be withheld is to be increased by the Section 4999(a) tax.

Section 280G only applies to C corporations and not to amounts paid by partnerships or sole proprietors.

Federal Jury Finds for Department of Justice in Upholding FBAR Penalties of 145% of Peak Account Balance Against Defendant For Unfiled FBARs With Respect to Concealed Swiss Bank Account

Posted in Federal Taxation Developments

From a press release issued by the U.S. Department of Justice on May 28, 2014, a jury in Miami found Carl R. Zwerner responsible for civil penalties for willfully failing to file required Reports of Foreign Bank and Financial Accounts (FBARs) for the tax years 2004 through 2006 with respect to a secret Swiss bank account he controlled. As reflected in the evidence produced at trial, the balance of the bank account during each of the years at issue exceeded $1.4 million, and the jury found Zwerner should be liable for penalties for 2004 through 2006. Zwerner faced a maximum 50% penalty of the balance in his unreported Swiss bank account for each of the three years. The jury found that Zwerner’s failure to report the account was not willful for 2007, and the court will determine the final amount of the judgment after further proceedings in June 2014. It should be noted that no criminal charges were filed in this case. (See prior posting on the Zwerner case in this Blog).

Under part of the Bank Secrecy Act, each U.S. citizen who has an interest in, or signature authority over, a financial account is required to disclose the existence of such account on Schedule B, Part III of his individual income tax return. Additionally, a U.S. citizen must file an FBAR with the U.S. Treasury disclosing any financial account in a foreign country with assets in excess of $10,000 in which they have a financial interest, or over which they have signatory or other authority. A U.S. citizen who willfully fails to file his FBARs on a timely basis, due on or before June 30 of the following year, can be assessed a penalty of up to 50% of the balance in the unreported bank account for each year they fail to file a required FBAR.

The defendant in this case opened an account in Switzerland in the 1960s, which he maintained in the name of two different foundations he created. Zwerner used the proceeds of the account for personal expenses, including European vacations. Even though he filled out a tax organizer provided by his accountant, every year, Zwerner answered “no” to questions asking whether “you have an interest in or signature authority over a financial account in a foreign country, such as a bank account, securities account or other financial account” and whether “you have any foreign income or pay any foreign taxes.”

In court filings, Zwerner stated that he had paid all the back taxes due from the income earned in the account, that he instructed his attorneys to make a voluntary disclosure to the IRS, that FBAR penalties are discretionary, and that the damages suffered by the government should be taken into account. He even quoted a statement made by an IRS attorney at an American Bar Association Section of Taxation meeting in December 2013 that the “high-water mark” for such a penalty should be 50% of the account balance during the relevant period, not in each consecutive year.

The Department of Justice felt that Zwerner “deliberately engaged in ‘conduct meant to conceal or mislead sources of income,’” adding that “even if Zwerner was unaware of his FBAR reporting requirements, his failure to report his Swiss bank account was willful in that it was reckless or willfully blind.” The DOJ’s representatives stated that the penalties in this case did not violate the Eighth Amendment prohibition on excessive fines or penalties because they are “within the range” of penalties prescribed by Congress and because “Zwerner’s offense was not a mere reporting offense, but was committed in conjunction with tax evasion.”

The jury for the U.S. District Court for the Southern District of Florida found for the government, finding that Zwerner’s failure to timely file foreign bank account reports for three consecutive years was willful and not due to reasonable cause. The jury agreed to the assessed penalties for the three years, which amount to 50% of the balance in the account at the time of each violation. Based on the FBAR penalty assessed in 2006, the balance of the account was at one time about $1.5 million (United States v. Zwerner, No. 1:13-cv-22082-CMA (S.D. Fla. 2013)).