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

Posted in Federal Taxation Developments

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

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

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

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

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

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

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

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

Cost Sharing Agreements Involving Intangibles In a Cross-Border Context

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

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

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

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

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

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

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

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

Posted in Federal Tax Case Law Decisions

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

Factual Background

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

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

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

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

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

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

Barnes Tax Returns and IRS Notice of Deficiency.

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

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

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

Tax Court Proceeding

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

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

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

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

Second Circuit Court of Appeals Finds for Commissioner

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

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

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

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

Service Legal Memorandum Issued on Foreign Tax Credits Paid By Foreign Subsidiary Are Ineligible For Crediting to U.S. Parent Corporation

Posted in Federal Tax Rulings

In a recently issued and published (FOIA) IRS Legal Memorandum, ILM 201441015, the IRS concluded that a domestic parent corporation will not be deemed to have paid foreign income taxes under sections 902 and 960, which taxes in fact were paid by its foreign subsidiary as a result of a foreign tax redetermination. The facts also involved a complex corporate restructuring of various foreign subsidiaries several of which converted into defective entities in accordance with the check-the-box regulations.

Sections 902, 960 and 78

Under section 902, a domestic corporation is treated as having paid foreign income taxes paid by a foreign corporation as it receives or is deemed to have received dividend income provided the domestic corporation owns at least 10% of the foreign corporation’s voting stock. The amount of the deemed foreign tax paid is determined by allocating the foreign corporation’s foreign income taxes among its earnings and profits and then charging such portion of the tax to the earnings and profits wrapped in the dividend. For example, if a foreign corporation distributes 40% of its earnings and profits in the form of a dividend to a domestic corporation owning 40% of its stock, the U.S. corporation receiving the dividend is treated as having paid 40% of the amount of the earnings and profits included in the dividend which represents the foreign corporation’s foreign income taxes with respect to such dividend. The deemed dividend under section 902 is creditable under section 901 subject to the overall foreign tax credit limitation in section 904(a) as well as other applicable FTC limitations. Section 78 also enters into the mix requiring the domestic corporation receiving the dividend from the foreign owned subsidiary to include the deemed taxes (foreign) paid in the amount of the dividend includible in gorss income. The indirect foreign taxes paid regime also applies to U.S. shareholders of controlled foreign corporations (CFCs) under the subpart F provisions. Section 960 requires that a subpart F inclusion is treated as a dividend for FTC purposes and implicates sections 902 and 78.

The indirect or deemed FTC under section 902 is sourced or connected with the foreign corporation’s post-1986 foreign income taxes which is the sum of foreign income taxes paid with respect to the tax year of the dividend plus all foreign taxes for prior years starting after 1986. The foreign corporation’s pool of post-1986 foreign income taxes is reduced when dividends are made to which foreign taxes are attributed. See sections 902(c)(2)(B), 960(a)(2). The earnings and profits pool is reduced when dividends are paid to a shareholder that does not qualify for or does not claim the indirect foreign tax credit. See Treas. Reg. §1.902-1(f). There may be some tax advisors who may take issue with this last sentence.

As to pre -1987 earnings and profits, such e&p is allocated to specific years and distributions sourced to such pre-1987 earnings and profits are “layed” to the proper tax year per section 902(c)(6). TRA 1986 changed this rule for post-1986 tax years, treating such earnings and profits as a single multi-year pool . As of August 5, 1997, the Taxpayer Relief Act of 1997 clarified that in determining the deemed paid credit for a tax year, a foreign corporation’s post-1986 foreign income taxes includes foreign income taxes with respect to prior post-1986 tax years to the extent those taxes are not attributable to (rather than deemed paid with respect to) dividends distributed by the foreign corporation in prior tax years. Pub. L. No. 105-34, § 1163. Once all post-1986 pools of earnings and profits are eliminated, dividends are considered paid out of pre -1987 earnings and profits. Section 902(d)(6). Such dividends reduce earnings and profits available to be distributed as a dividend, but do not reduce the components of the deemed-paid credit formula.

Now onto ILM 201441015.

ILM 201441015
The facts beging with a U.S. corporation (P) owning 100% of CFC1, which foreign corporation was incorporated in country X. P also owned 100% of CFC4 that owned 100% of CFC5. Both CFC4 and CFC5 were incorporated in country Y. Since 2002 the U.S. parent and CFC5, together, owned 100% of US Corp2 which was a member of P’s consolidated group.

In 2001, prior to being acquired by P, USCorp2 acquired more than 10% but less than 50% of the voting stock of CFC2, a country X corporation. Accordingly, CFC2 and its wholly-owned country X subsidiaries became noncontrolled section 902 corporations. See section 904(d)(2)(E) in 2001. CFC2 was renamed CFC3 and it became a member of a qualified group through a chain of ownership as defined in section 902(b)(2) because 100% of its voting stock was owned by CFC1 and CFC5.
Now let’s fast forward to 2010 in which a number of CFCs wholly owned by CFC (and incorporate in country X) became disregarded entities under Treas. Reg. §301.7701-3(c) and were deemed liquidated under section 332. Under section 381, and in accordance with Treas. Regs. §§ 1.367(b)-7(d) and -7(e), CFC3 succeeded to the post-1986 undistributed earnings and post-1986 foreign taxes paid by the wholly owned subsidiaries, now defective entities, as well as their pre-1987 accumulated profits and pre-1987 foreign income taxes paid.

Also in 2010, CFC1 elected deemed liquidation treatment in becoming a defective entity resulting in a deemed dividend to the U.S. parent to the extent of CFC1′s earnings and profits under Treas. Reg. §1.367(b)-3(b)(3)(i). CFC3 elected to be treated as a partnership in a deemed liquidation under section 331 and gain on the sale of CFC3 was recharacterized as a dividend under section 1248 to US Corp2, CFC1, and CFC5, a portion of which was attributable to post-2001 earnings and profits but not pre-1987 accumulated profits.

So, what is the issue(s)? The ILM was issued in response to whether P, in computing its 2010 deemed FTC under sections 902 and 960, properly included in its country X CFC’s post-1986 foreign income tax pools, amounts paid by CFC3 in 2007 as a result of a foreign tax redetermination regarding its pre-1987 accumulated profits for its 1994-1999 tax years.

The answer provided in ILM 201441015 was that P country X CFC pools of post-1986 undistributed earnings and post-1986 foreign income taxes include amounts from CFC3 for tax years after 2000, when US Corp2 first satisfied the minimum ownership requirements in section 902(c)(3)(B). Further, the foreign income taxes paid by CFC3 in 2007 related to pre-1987 accumulated profits and could be used to adjust the parent’s country X CFC pools of pre-1987 accumulated profits and pre-1987 foreign income taxes paid but are excluded from post-1986 foreign income taxes under Treas. Regs. §§1.902-1(a)(10), -1(a)(13), and Temp. Reg. § 1.905-5-5T.
However, because the CFCs’ pre-1987 accumulated profits were eliminated by the CFCs’ check-the box elections in 2010, no portion of the earnings had been or ever will be included in the taxable income of the parent’s consolidated group. As a result, P’s country X pools of pre-1987 foreign income taxes were found to be ineligible for a deemed FTC. Since the foreign taxes paid by CFC3 relate to tax years when it and its lower-tier entities were not CFCs, taxes paid below the third tier in the qualified group are nevertheless ineligible for a deemed FTC as provided in section 902(b)(2) for post-1997 tax years in which the corporation was a CFC.

Interaction of Section 338 Elections and Section 901(m) On Covered Acquisitions and Impact on Use of Foreign Tax Credits

Posted in Federal Taxation Developments

Section 901(m) reduces the foreign tax credits (FTCs) under Sections 901, 902 or 960 where a U.S. company acquires a target foreign subsidiary under a deemed asset sale approach by making a Section 338(g) election or similar election under Section 338(h)(10). Where the deemed purchase price exceeds the target’s basis in its assets, the excess amount will increase the asset basis in the target’s assets. Generally, the foreign target will not incur foreign income taxes as a result of the deemed asset sale nor will it incur U.S. income tax on the deemed asset sale provided it is not engaged in a U.S. trade or business although it presumably will retain its existing cost basis in its foreign based assets for foreign income tax purposes.

Where the target is a foreign (subsidiary) corporation, the U.S. corporation-acquisition company will consider several factors in whether to make a Section 338(g) or join in the making of a Section 338(h)(10) election with the seller U.S. parent corporation. Such factors include the tax basis of the stock or assets acquired; the retention or elimination of the target’s earnings and profits, particularly with respect to a target controlled foreign corporation; the potential impact of Section 1248 to the selling corporation, and the foreign tax credit position of the target. The basis in the target’s assets are stepped-up to fair market value based on the seven tier allocation approach under Section 1060 principles and in accordance with the regulations to Section 338.

Where the foreign target corporation has U.S. shareholders or if the corporation has assets which are effectively connected with the conduct of a U.S. trade or business, there may be U.S. income tax incurred as a result of the gain from the stock sale or deemed asset sale of the target’s assets under Section 338. If the foreign target corporation is controlled by U.S. shareholders thereby making it a controlled foreign corporation (“CFC”), Section 1248 may apply with respect to the stock sale and Subpart F income may also be of consequence to the U.S. parent corporation acquiring the target’s stock. See the limitation on importation of built-in losses under Section 362(e)(1). Where the target is a CFC and a Section 338 election is made, then under Treas. Reg. §1.338-9, the U.S. sellers of the CFC stock are treated as owners of the stock through the acquisition date, any Subpart F income or earnings and profits affected by the deemed asset sale generally impacts the seller. Where a Section 338 election is made for any foreign subsidiaries of the CFC target, the deemed sales for the foreign subsidiary stock are ignored, but the earnings and profits resulting from the subsidiaries deemed asset sales will result in additional dividend income under Section 1248 to the U.S. sellers of stock. Where a Section 338 election is not made for a foreign subsidiary of the foreign target but such an election is made for the target, the deemed sale of the subsidiary stock is recognized and will generate additional earnings and profits. See Treas. Regs. §§1.338-9(b)(3), 1.338-5(b)(3).

A purchasing corporation, U.S. or foreign, may make a Section 338(g) or Section 338(h)(10) election in purchasing the stock of a foreign corporation provided certain requirements are met. See also Section 336(e). On the foreign tax credit impacts, a Section 338 election eliminates the foreign target’s pre-acquisition pools of post-1986 earnings and profits and post-1986 foreign taxes, which are required to be maintained in computing the indirect foreign tax credit under Section 902. This removes having to compute the pre-acquisition amounts of FTCs of the foreign target. While the purchasing corporation gets a basis step up (where there is unrealized appreciation in the target’s assets), there will be no tax imposed on the deemed sale for foreign income tax purposes.
Several years ago, the Chief Counsel’s Office, in IRS Advice Memorandum 2007-006, in response to a request for advice under Section 338 with respect to the acquisition of a foreign subsidiary, opined that Section 338 does not require that a purchasing or target corporation must be a domestic corporation. See Treas. Regs. §§1.338-2(e)(foreign purchasers of foreign targets) and 1.338-9. This access to Section 338 is available even if the deemed asset sales does not implicate foreign taxes but still allows for a basis step-up in the foreign target’s assets. See also Treas. Reg. §1.338-2(c)(18).

Section 901(m), which was enacted into law in 2010, P.L. 111-226, §212, reducesthe FTCs of a U.S. acquisition corporation where it reduces its taxable income by amortizing the acquired intangibles on the purchase of a foreign subsidiary unless the seller incurs U.S. taxes on the sale. Under Section 901(m)(1), where a covered asset acquisition has occurred, the ‘disqualified portion‘ of any foreign income tax determined with respect to income or gain attributable to that acquisition is not creditable for FTC purposes under Sections 901, 902 or 960. The disqualified portion of the foreign income tax in any particular year is equal to the amount of the tax, multiplied by a fraction—the numerator is the ‘aggregate basis differences‘ allocable to that year, and the denominator is the income on which the foreign income tax is determined. Despite denying a FTC on the stepped-up asset base in the target’s foreign assets, Section 901(m) does allow the taxpayer to deduct foreign taxes subsequently incurred on the lower asset basis that is presumably still required to be used in the applicable foreign jurisdiction. Section 901(m) further does not prohibit the foreign corporation from reducing its earnings and profits by the foreign taxes incurred.

NOL Poison Pills Designed to Prevent an Ownership Change Under Section 382? Now That’s Something to Think About

Posted in Federal Taxation Developments

Section 382’s Limitation on Use of a Target’s Net Operating (and Built-in) Losses

Section 382 provides a limitation on change of control transactions involving loss corporations, i.e., target corporations with net operating loss carryovers or certain built-in losses. In general, a net operating loss may be carried back 2 years and forward 20. Section 172(b)(1)(A). Alternatively, an election may be made to carryforward the net operating loss for the 20 year period. States corporate income tax statutes also have their own NOL provisions.

Where there has been an “ownership change” as defined, Section 382 limits the amount of the post-acquisition use of the net operating losses on an annual basis by multiplying the loss corporation’s value at the time of the ownership change by the long term tax-exempt rate published by the Service. Using the vernacular of Section 382, Section 382(a) provides that a “new loss corporation” is not permitted to deduct “pre-change losses” in an amount greater than the “Section 382 limitation”. An ownership change occurs where the shareholders who own 5% or more of the loss corporation, as a result of the change in control event, tested over a statutory measuring or “testing” period of 3 years, increase their ownership in a loss corporation by more than 50 percentage points.
While the testing rules for ownership changes (as well as equity structure shifts where applicable under the facts such as in a recapitalization) are quite complex, many acquisitions of a target corporation will be easily identified as resulting in an ownership change and therefore trigger application of Section 382. Where a loss corporation has a substantial net operating loss, then the deferred tax asset associated with the timely utilization of such loss can have substantial value. See FASB ASC 740. However, where Section 382 applies, and the loss corporation’s value has declined, full absorption of the net operating losses (and built-in losses) after the acquisition is consummated may be in doubt. This results in a partial write down of the deferred tax asset.

Corporate Anti-Takeover Defense: The Poison Pill

A poison pill plan refers to a plan used by the board of directors of a corporation to make it more difficult or costly, and therefore less attractive, to acquire the target corporation. The poison pill plan is one strategy corporations, whose stock is publicly traded, employ to prevent hostile takeover attempts and invariably involves the adoption of shareholder rights agreements. The traditional poison pill plan’s goal was protection of the shareholder control premium. See Moran v. Household International, Inc., Del. Supr., 500 A.2d 1346 (1985); Revlon, Inc., et al, v. Forbes Holdings, Inc., 506 A.2d 173 (1986); Unocal Corporation v. Mesa Petroleum Co., 483 A.2d 946 (1985). Poison pill plans issue rights are in essence the issuance of options to purchase shares by the existing target shareholders, thereby diluting the purchased ownership of the hostile acquirer. The issuance of such rights generally does not require shareholder approval. See Air Products & Chemicals, Inc. v. Airgas, Inc., 16 A.3d 48 (Del. Ch., 2011).

There are two general forms of poison pill plans, the so-called “flip-in plan” and a “flip-over plan”. Their use is not mutually exclusive. The “flip-in plan” may be set up to be triggered where there is a purchase of 10% to 20% of the corporation’s stock by an outside party. For public company targets in particular, this percentage of newly acquired stock ownership raises the spectre of a takeover effort. The flip-in plan allows shareholders, excluding the potential suitor or buyer of the target, to buy additional shares of the target at a discount thereby diluting the buyer’s ownership percentage. In such instance the acquirer may sell its position in the target in the market or continue to suffer further loss by increasing levels of dilution of share ownership.

The “flip-over plan” is triggered only where the buyer successfully merges the target into itself or into an acquisition subsidiary or affiliate. The “flip-over” plan requires the buyer to offer the target shareholders the opportunity to purchase the acquiring corporation’s shares at a discounted price again causing dilution of the buyer’s existing shareholders. You can see from this brief description of the “flip-over plan” that it can be the second stage which is added to a pre-existing “flip-in plan”.

There are other methods use to deter acquisitions including golden parachute payment plans and payouts of deferred compensation, etc., See, e.g., Section 280G. While there are various species of anti-takeover measures, the idea is that of deterrence to make the acquisition unduly costly to a potential buyer. Thomas, ‘Judicial Review of Defensive Tactics in Proxy Contests: When Is Using a Rights Plan Right?,‘ 46 Vand. L. Rev. 503 (1993).

NOL Poison Pill Plans

An NOL poison pill plan is another defensive tactic to prevent a hostile takeover. The primary objective of the NOL poison pill plan focuses on the target’s continued (full) use of its net operating loss which, as mentioned, is a deferred tax asset for financial accounting purposes. In many cases the NOL poison pill plan sets a lower threshold of ownership change that ties into the Section 382 ownership change rules. It accomplishes that by setting the ownership threshold for triggering the NOL poison pill plan at slightly under 5% (ownership change testing threshold) to 4.9%.

The key structural difference between an NOL poison pill plan and a traditional poison pill plan is the ownership threshold trigger. In a traditional poison pill plan, the pill is triggered when 10%-20% ownership is reached. For an NOL poison pill that seeks to avoid Section 382 NOL limitations, the ownership threshold trigger is set below 5%, usually at 4.9%. A NOL plan may be waived by the board of directors if the buyer is otherwise attractive or the purchase price for the target’s stock continues to climb.

So How is the NOL Poison Pill Actually Employed And Will A Court In Review Uphold Its Enforceability.

In Versata Enterprises Inc. v. Selectica, Inc., No. 193, 2010 (Del. Oct. 4, 2010), the Delaware Supreme Court addressed the validity of a shareholder rights plan, or “poison pill”, for the first time in a number of years. The court upheld the adoption of a poison pill with a 4.99% trigger designed to protect a company’s NOLs and the subsequent adoption of a “reloaded” poison pill to protect against future threats to those net operating losses.

The Facts
Selectica, a micro-cap software company generated $160M in NOLs after its IPO. One of Selectica’s largest shareholders was Trilogy, Inc., which, together with its affiliate Versata, acquired 6.7% of Selectica’s shares. Trilogy was a competitor of Selectica which had entertained the notion of acquiring Selectica in 2005. It had already sued Selectica twice for patent infringement and Selectica owed Trilogy millions of dollars after an adverse court decision and subsequent settlement. Trilogy continued its decision to acquire Selectica at various times through 2008. While aware of Selectica’s large NOLs, Triology decided that the threatened impairment of Selectica’s NOLs might be a useful means of coercing the company into a transaction benefiting Trilogy. In other words, the Section 382 ownership change and its consequences to the absorption rate to the post-change in ownership, “new loss corporation”, was not that important to Trilogy.

Trilogy began buying Selectica stock in November 2008 and hit the 5% threshold under Section 382 by November 10 and filed a Schedule 13D on November 13, and acquired an additional 1% in the days thereafter. Selectica had already in place a traditional poison pill with a 15% trigger. The board decided to amend its rights plan to reduce the triggering threshold from 15% to 4.99% to prevent additional 5% owners from falling in the change of ownership testing test. The amended rights plan also allowed existing 5% shareholders, including Trilogy, to purchase an additional 0.5% without triggering the rights.

In response, Trilogy increased its ownership in Selectica and trigger the NOL poison pill plan. This in turn forced Selectica’s board to respond. Trilogy informed Selectica that it had bought additional shares and proposed that Selectica repurchase Trilogy’s shares at a premium, i.e., so-called “greenmail” type payments, accelerate the payment of debt, terminate its license with a client and make an additional $5 million payment to Trilogy to settle outstanding issues between the companies. Selectica’s board reacted by attempting to negotiate a standstill agreement with Trilogy to allow for further negotiations between the parties in exchange for the board declaring Trilogy an “exempt” person under the terms of the pill, which would have prevented the dilution of Trilogy.

After Trilogy rejected Selectica’s standstill proposals, the directors of Selectica concluded that the NOL poison pill plan should be applied to Trilogy to enhance shareholder value through full use of the NOLs. The poison pill’s exchange doubled the number of outstanding shares held by other Selectica shareholders and diluting Trilogy’s beneficial holdings from 6.7% to 3.3%. The special committee of the board of the target also adopted a “reloaded” NOL rights plan, which was a new poison pill plan with substantially the same terms. Selectica then sought a declaratory judgment in the Delaware Chancery Court that the actions of Selectica’s directors were valid and proper.

The Delaware Chancery Court

Applying the judicial test adopted by the Delaware Supreme Court in Unocal Corp. v. Mesa Petroleum Corp., 493 A.2d 946, 955 (Del. 1985): that the use of defensive measures are protected by the business judgment rule so long as: (i) the board had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and (ii) the defensive response was reasonable in relation to the threat posed. The Chancery Court found that the directors of Selectica met their burden of proof under each prong of this test, and upheld the directors’ action.

Delaware Supreme Court Opinion

The Supreme Court began its analysis by affirming the Chancery Court’s finding that “the protection of company NOLs may be an appropriate corporate policy that merits a defensive response” when threatened. The court noted that Delaware courts have approved the use of poison pills as an anti-takeover device and have applied the Unocal test to analyze a board’s response to an actual or potential hostile takeover threat. While the court noted that an NOL poison pill was not principally intended to prevent a hostile takeover, it held that “any Shareholder Rights Plan, by its nature, operates as an anti-takeover device,” and “notwithstanding its primary purpose, a NOL poison pill must also be analyzed under Unocal because of its effect and its direct implications for hostile takeovers.”

Turning to the first part of the Unocal test, the Delaware Supreme Court noted that the Selectica board had repeatedly analyzed its NOLs and received a variety of expert advice on their value. Given these facts, the Court found that the record supported the lower court’s finding that the board acted in good faith reliance on the advice of experts in concluding that the NOLs were an asset worth protecting and that their preservation was an important corporate objective.
The court also found that the record supported the reasonableness of the board’s decision to quickly reduce the trigger of Selectica’s existing poison pill from 15% to 4.99% because (i) the company’s accountant informed the board on November 16 that the change-of-ownership calculation under Section 382 already stood at 40%, (ii) the board reasonably believed Trilogy intended to continue buying more stock and (iii) nothing prevented others from acquiring stock in amounts up to the existing 15% trigger. Such additional acquisitions could push the 40% Section 382 calculation to above 50%, at which point the value of the NOLs would be permanently impaired.

On the second part of the Unocal test, the Court stated that Unocal standard requires an evaluation of whether a board’s defensive response to the threat was preclusive or coercive and, if neither, whether the response was reasonable in relation to the threat identified. Taking the opportunity to clarify the test for preclusivity under Delaware law, the Court held that a defensive measure is preclusive where it makes a bidder’s ability to wage a successful proxy contest and gain control “realistically unattainable.”

Trilogy claimed that Selectica’s NOL poison pill, with a 4.99% trigger, prevented a shareholder from signaling its financial commitment so as to establish sufficient credibility to win the necessary supporters in a proxy fight. While this 5% trigger is lower than the normal poison pill thresholds, the Court concluded that the NOL pill and the reloaded NOL pill would not render a successful proxy contest realistically unattainable given the specific factual context.
The Court further rejected Trilogy’s claim that the response of Selectica’s board was not reasonable in that both the original and the reloaded pill were necessary to overcome the threat that Trilogy’s purchases would prevent Selectica from using its NOLs. In finding for Selectica, the Delaware Supreme Court stated that its holding should be narrowly construed. In other words, “the fact that the NOL Poison Pill was reasonable under the specific facts and circumstances of this case, should not be construed as generally approving the reasonableness of a 4.99% trigger in the Rights Plan of a corporation with or without NOLs.” The Court noted that although the Selectica board carried its burden of proof under the two part test under its prior precedent setting decision in Unocal, the adoption of a poison pill is not absolute, and under Delaware law, “the ultimate response to an actual takeover bid must be judged by the Directors at that time.”


The use of NOL poison pills is becoming more fashionable and has reportedly been used by Ford Motor Co., Mirant Corp., Citigroup, and many other corporations. The legal considerations involved, including the fiduciary duties of the target’s boards, the terms of the NOL poison pill, its potential integration with other anti-takeover measures, must be carefully evaluated by legal counsel for the corporation. While the low threshold for invoking a NOL poison pill might look formidable, many corporations and others intending to acquire control or majority ownership of a target may not be persuaded by that maneuver alone will drive the projected cost of the acquisition to an unmanageable level. Given the prices paid for control premiums in the market place for acquisitions of public companies, the capitalized earnings value of a target that has a significant or substantial amount of NOLs may not dissuade the acquiring corporation to back off and seek a “greenmail” buy back. Moreover, the shareholders of the target may be adverse to the NOL poison pill in general or in a particular instance and may approach its board demand a waiver if the purchase price being offered will maximize shareholder value

New Streamlined Domestic Offshore Procedures Announced by Internal Revenue Service For Taxpayers Residing in the United States

Posted in Federal Taxation Developments

On October 10, 2014, the Service released “streamlined” domestic offshore procedures for U.S. taxpayers residing in the United States.The guidance is posted on the IRS website and includes a description of the steamlined filing compliance procedures, frequently asked questions, a description of the streamlined filing compliance procedures for U.S. taxpayers living overseas and a related FAQ; and a descrption of the procedures for filing a delinquent information related and related FAQ.

Among the changes made to the OVDP is an increase in the miscellaneous offshore penalty from 27.5% to 50% where the individual had an account at or was a client of a bank or facilitator publicly identified by the Justice Department on or after August 4, 2014. Participating taxpayers must now provide more detailed information earlier in the process, and payment of the offshore penalty is due at the time of the OVDP submission .

The IRS expanded the streamlined filing compliance program to cover all U.S. taxpayers who are not currently under audit or criminal investigation by the Internal Revenue Service. Previously, eligibility for streamlined filing was limited to nonresident taxpayers who could demonstrate a low level of compliance risk and did not owe more than $1,500 of tax for each of the three years covered by the program. In addition to permitting resident U.S. taxpayers to use the streamlined program, the IRS has eliminated the $1,500 tax threshold and the risk questionnaire. Taxpayers must certify under penalty of perjury that previous compliance failures were not willful. This may be easier to say it the failures were “not willful” and to do so under penalty of perjury.

The IRS announced in the release that all penalties will be waived for nonresident U.S. taxpayers, and resident taxpayers will be subject only to a miscellaneous offshore penalty equal to 5% of the foreign financial assets that gave rise to the tax compliance issue.

As to the U.S. resident streamlined procedure for offshore accounts the taxpayer must also: (i) fail to meet the applicable non-residency requirement (for joint return filers, one or both of the spouses must fail to meet the applicable non-residency requirement described in 2.A. above); (2) previously filed a U.S. tax return (if required) for each of the most recent 3 years for which the U.S. tax return due date (or properly applied for extended due date); (3) failed to report gross income from a foreign financial asset and pay tax as required by U.S. law, and may have failed to file an FBAR (FinCEN Form 114), and/or one or more international information returns (e.g., Forms 3520, 3520-A, 5471, 5472, 8938, 926, and 8621) with respect to the foreign financial asset, and (4) such failures resulted from non-willful conduct. Non-willful conduct is conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.

Description of Scope and Effect of Procedures
U.S. taxpayers (U.S. citizens, lawful permanent residents, and those meeting the substantial presence test of section 7701(b)(3) eligible to use the Streamlined Domestic Offshore Procedures must (1) for each of the most recent 3 years for which the U.S. tax return due date (or properly applied for extended due date) has passed (the “covered tax return period”), file amended tax returns, together with all required information returns (e.g., Forms 3520, 3520-A, 5471, 5472, 8938, 926, and 8621), (2) for each of the most recent 6 years for which the FBAR due date has passed (the “covered FBAR period”), file any delinquent FBARs (FinCEN Form 114, previously Form TD F 90-22.1), and (3) pay a Title 26 miscellaneous offshore penalty. The full amount of the tax, interest, and miscellaneous offshore penalty due in connection with these filings should be remitted with the amended tax returns.

The Title 26 miscellaneous offshore penalty is equal to 5% of the highest aggregate balance/value of the taxpayer’s foreign financial assets that are subject to the miscellaneous offshore penalty during the years in the covered tax return period and the covered FBAR period. The highest aggregate balance/value is determined by aggregating the year-end account balances and year-end asset values of all the foreign financial assets subject to the miscellaneous offshore penalty for each of the years in the covered tax return period and the covered FBAR period and selecting the highest aggregate balance/value from among those years.

A foreign financial asset is subject to the 5% miscellaneous offshore penalty in a given year in the covered FBAR period if the asset should have been, but was not, reported on an FBAR (FinCEN Form 114) for that year. A foreign financial asset is subject to the 5% miscellaneous offshore penalty in a given year in the covered tax return period if the asset should have been, but was not, reported on a Form 8938 for that year. A foreign financial asset is also subject to the 5% miscellaneous offshore penalty in a given year in the covered tax return period if the asset was properly reported for that year, but gross income in respect of the asset was not reported in that year.

Foreign financial assets may include: (i) financial accounts held at foreign financial institutions; (ii) financial accounts held at a foreign branch of a U.S. financial institution; (iii) foreign stock or securities not held in a financial account; (iv) foreign mutual funds; and (v) foreign hedge funds and foreign private equity funds.

The Procedure states that a taxpayer eligible to use the Streamlined Domestic Offshore Procedures and who complies with all of the instructions set forth on the IRS website will be subject only to the Title 26 miscellaneous offshore penalty and will not be subject to accuracy-related penalties, information return penalties, or FBAR penalties. Even if returns properly filed under these procedures are subsequently selected for audit under existing audit selection processes, the taxpayer will not be subject to accuracy-related penalties with respect to amounts reported on those returns, or to information return penalties or FBAR penalties, unless the examination results in a determination that the original return was fraudulent and/or that the FBAR violation was willful. Any previously assessed penalties with respect to those years, however, will not be abated. Further, as with any U.S. tax return filed in the normal course, if the IRS determines an additional tax deficiency for a return submitted under these procedures, the IRS may assert applicable additions to tax and penalties relating to that additional deficiency.

For returns filed under the streamlined procedures, retroactive relief will be provided for failure to timely elect income deferral on certain retirement and savings plans where deferral is permitted by the applicable treaty. The proper deferral elections with respect to such plans must be made with the submission. See the instructions below for the information required to be submitted with such requests.

Taxpayer Prevails With Respect to Claimed Research And Development Tax Credits in Eric G. Suder, et al. v. Commissioner, TC Memo 2014-201

Posted in Federal Tax Case Law Decisions

The decision in this case, issued as a Memorandum decision by the Court, J. Vasquez, reflects the analytical complexity of the Section 41 tax credit rules for qualified research and development costs and further highlights the taxpayer’s burden to prove that it properly claimed the tax credits based on the evidence presented on the record at trial or by stipulation prior to trial, and including the submission of expert reports. The research tax credit is one of the most complicated provisions in the Code. Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.

General Rules Under Section 41

Section 41(a)(1) allows a taxpayer a tax credit up to an amount equal to 20% of the excess, if any, of the taxpayer’s qualified research expenses (QREs) for the taxable year (credit year) over the base amount. QREs are defined as the sum of a taxpayer’s in-house research expenses and contract research expenses paid or incurred by the taxpayer during the credit year in carrying on a trade or business. §41(b)(1). The base amount is the product of the fixed-base percentage and the ave. annual gross receipts of the taxpayer for the four years preceding the credit year. §41(c)(1). The base amount still may not be less than 50% of the QREs for the credit year. §41(c)(2). The fixed-base percentage is generally the lesser of 16% or the percentage that the aggregate QREs of the taxpayer for certain years (base period) is of the aggregate gross receipts of the taxpayer for those years. §§41(c)(3)(A) and (C).

The Taxpayer In Suder v. Commissioner

The taxpayer company, ESI, computed its research tax credit using a fixed-base percentage of 16%, the maximum allowable under the statute, for each of the years at issue. A taxpayer must determine its QREs in computing its fixed-base percentage “on a basis consistent with” its determination of QREs for the credit year (the consistency requirement). § 41(c)(6). Chief Counsel, in its pretrial memorandum, raised the consistency requirement, contending that petitioners must provide evidence as to the correct amount of ESI’s base period QREs to substantiate the research tax credits claimed. Neither petitioners nor respondent addressed the consistency requirement or ESI’s base period QREs in the opening or reply briefs. The court found that both parties conceded any arguments they might have otherwise had on the consistency requirement. See Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989); Money v. Commissioner, 89 T.C. 46, 48 (1987).
Accordingly, the taxpayer’s entitlement to the research tax credits turns on whether ESI incurred QREs during the years at issue. As previously stated, QREs are defined as the sum of a taxpayer’s in-house research expenses and contract research expenses. This consists of in-house expenses for wages paid to employees for “qualified services” and amounts paid or incurred for supplies used for qualified research. §§ 41(b)(2)(A)(i) and (ii). Qualified services consist of engaging in qualified research or engaging in the direct supervision or direct support of research activities which constitute qualified research. §41(b)(2)(B). Contract research expenses are equal to 65% of the amounts paid or incurred by the taxpayer in relation to a person other than an employee of the taxpayer for qualified research. §41(b)(3).
Therefore, to be eligible for a credit under section 41(a)(1), petitioners had to prove that ESI performed qualified research, or paid someone else to perform qualified research, during the years at issue.

The Four Tests for Qualified Research.

Qualified research is research that satisfies four tests. First, expenditures connected with the research must be eligible for treatment as expenses under section 174 (the section 174 test). Second, the research must be undertaken for the purpose of discovering technological information (the technological information test). Third, the taxpayer must intend that the information to be discovered be useful in the development of a new or improved business component of the taxpayer (the business component test). Fourth, substantially all of the research activities must constitute elements of a process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality (the process of experimentation test). A fifth test, in effect, is the limitation under section 174(e).
The tests are applied separately with respect to each business component. A “business component” is defined as a product, process, computer software, technique, formula, or invention that the taxpayer holds for sale, lease, or license or uses in its trade or business. If a business component as a whole fails the qualified research tests, the “shrinking-back rule” applies, which allows the court to apply the qualified research tests to a subset of the business component if doing so will allow the subset to satisfy those tests. See Treas. Reg. §1.41-4(b)(2). The shrinking-back rule provides that if the qualified research tests are not satisfied at the level of the discrete business component, they are then applied to the most significant subset of elements of the business component. The shrinking-back continues until either a subset of the business component satisfies the tests or the most basic element of the business component is reached and fails to satisfy the tests.
Certain types of research are specifically excluded from the definition of qualified research. They include research conducted after the beginning of the commercial production of a business component, research related to the adaption of an existing business component to a particular customer’s requirement or need, foreign research, research in the social sciences, arts, or humanities, and funded research. §41(d)(4). Furthermore, research relating to style, taste, cosmetic, or seasonal design factors is not a qualified purpose under the process of experimentation test and is thus not qualified research. §41(d)(3)(B).

A. The Section 174 Test.

The section 174 test requires that expenditures connected with the research activities be eligible for treatment as expenses under section 174. Section 174 provides alternative methods of accounting for “research or experimental expenditures” that taxpayers would otherwise capitalize. Sec. Treas. Reg. §1.174-1. The regulations define “research or experimental expenditures” as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” Treas. Reg. §1.174-2(a)(1).
At issue in the case were 12 projects undertaken incurred in connection with ESI’s trade or business. The Service contended, in challenging the claimed tax credits, that the petitioners introduced “very little evidence that showed uncertainty regarding the capability, method, or appropriate design of the 12 projects as of the beginning of ESI’s product-development activities.” The government’s expert report set forth that “[h]alf of the projects created products that merely matched products already available from other vendors. The expert opined that there was no technical challenge in those projects that would require resolving uncertainty through experimentation.” He further states that “ESI’s strength is building low-cost, easy-to-use telephone systems that match products introduced earlier by industry leaders such as Avaya and Cisco.”
The Court was not persuaded by the government’s expert and found that many statements in his report are contradicted by credible evidence in the record. Accordingly, the Court found that government’s expert’s testimony “unreliable”. That essentially left the record open for the taxpayer to prevail based on its expert testimony provided it was credible.
The taxpayers argued that “ESI provided the Court testimonial and documentary evidence of the numerous technical uncertainties it faced in building exponentially larger phone systems than it had ever attempted, adding innovative and improved software features, and incorporating the new and different technological hardware components needed to stay competitive.” Petitioners further argued that “[e]very single one of these identified uncertainties was of a type specifically contemplated by Section 41 of the Internal Revenue Code and thus eligible for consideration in ESI’s credit calculation.”
The Court agreed with the taxpayers that uncertainties as to capability, method, or appropriate design were present in all 12 projects. Each of the 12 projects began as an idea to develop a new hardware product, software product, or both. Senior management vetted the ideas in the senior product strategy meetings and followup meetings. ESI’s product managers, engineers, technicians, and other employees then transformed the ideas into commercially ready products. On the basis of the foregoing, Judge Vasquez concluded that all 12 projects satisfy the section 174 test.

B. The Technological Information Test.

The technological information test requires that the research be undertaken for the purpose of discovering information that is “technological in nature”. §41(d)(1)(B)(i). Information is “technological in nature” if it “fundamentally relies on principles of the physical or biological sciences, engineering, or computer science”. H.R. Conf. Rept. No. 99-841 (Vol. II), at II-71 through II-72 (1986), 1986-3 C.B. (Vol. 4) 1, 71-72. The government conceded that this test was met by the taxpayer.

C. The Business Component Test.

The business component test requires the taxpayer intend the information to be discovered will be useful in the development of a new or improved business component of the taxpayer. § 41(d)(1)(B)(ii). To be useful for this purpose, the research need only provide some level of functional improvement to the taxpayer. Norwest Corp. & Subs. v. Commissioner, 110 T.C. 454, 495 (1998). Again, the IRS conceded the taxpayer’s meeting this test at trial.

D. The Process of Experimentation Test.

The process of experimentation test has three elements: (1) substantially all of the research activities must constitute (2) elements of a process of experimentation (3) for a qualified purpose. §41(d)(1)(C). The “substantially all” element means that 80% or more of the taxpayer’s research activities for each business component, measured on a cost or other consistently applied reasonable basis, must constitute a process of experimentation for a qualified purpose. Norwest Corp. & Subs. v. Commissioner, 110 T.C. at 497; Treas. Reg. §1.41-4(a)(6).A taxpayer does not fail this requirement even if the remaining 20% (or less) of its research activities with respect to the business component do not constitute elements of a process of experimentation for a purpose described in section 41(d)(3) as long as the remaining research activities satisfy the requirements of section 41(d)(1)(A) (the section 174 test) and are not otherwise excluded under section 41(d)(4). Treas. Reg. §1.41-4(a)(6).
Where a business component fails the process of experimentation test because of the “substantially all “requirement, again, as mentioned above, the Court may apply the shrinking-back rule, until an element that satisfies the test is reached. Norwest Corp. & Subs. v. Commissioner, 110 T.C. at 497. A process of experimentation is “a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.” A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).
On this test the government argued that “design alternatives” of information already of public knowledge is not a process of experimentation as required. The taxpayers argued, to the contrary. Their argument was that ESI clearly had in place a very detailed, multi-level, systematic process for development of all facets of its phone systems which involved 1) conceptually hypothesizing how numerous technical alternatives might be used to develop new and improved phone systems, 2) testing these alternative in a scientific manner, 3) analyzing the results, 4) refining the initial hypothesis or discarding it for another if necessary, and 5) repeating the same, if necessary.
The Court, as per Judge Vasquez’s opinion, agreed that ESI used a process of experimentation to resolve uncertainties in all 12 projects. Contrary to respondent’s argument, publicly available knowledge describing the appropriate design of the products being designed in the 12 projects did not exist. ESI’s hardware engineers consulted data sheets, design manuals, application notes, field service engineers, and online materials for general information on components. ESI’s software engineers, researched general code design. The hardware and software engineers then applied their knowledge of engineering and computer science, respectively, to create an appropriate design for the products. On the basis of the record, the Court found that of the 12 projects 80% or more of the activities with respect to each constituted elements of a process of experimentation and found that the experimentation undertaken with respect to 11 of the 12 projects was for a qualified purpose. The Court held, therefore, that 11 of the 12 projects satisfy the four-part test for qualified research and that 91.67% (eleven-twelfths) of the 76 projects constitute qualified research.
The next issue was that of substantiation of ESI’s QREs.

IV. Substantiation of ESI’s QREs.

Where an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expense. Treas. Reg.§1.41-2(d)(1). If substantially all of the services performed by an employee during the taxable year consist of engaging in qualified research or engaging in the direct supervision or direct support of research activities which constitute qualified research, the term “qualified services” means all of the services performed by the employee during the taxable year. §41(b)(2)(B)(flush language). The “substantially all” threshold is satisfied with respect to an employee if the wages appropriately apportioned to qualified research services constitute at least 80% of the wages paid to or incurred by the taxpayer for the employee during the taxable year. Treas. Reg. §1.41-2(d)(2).
The amount of wages properly allocable to qualified services is determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time actually spent by the employee in the performance of qualified services for the employer to the total time spent by the employee in the performance of all services for the employer during the taxable year. Another allocation method may be used if the taxpayer demonstrates the alternative method is more appropriate.
A taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.. A taxpayer is not required to keep records in a particular manner so long as the records maintained substantiate his or her entitlement to the credit. Shami v. Commissioner, 741 F.3d 560, 567 (5th Cir. 2014), aff’g in part, vacating in part, and remanding T.C. Memo. 2012-78; see also T.D. 9104, 2004-1 C.B. 406, 408 (“[T]he 2001 proposed regulations do not contain a specific recordkeeping requirement beyond the requirements set out in section 6001 and the regulations thereunder.”).
Under the often-called “Cohan Rule”, where a taxpayer can prove that its employees engaged in qualified services, the Court may estimate the expenses associated with those activities. See United States v. McFerrin, 570 F.3d 672, 679 (5th Cir. 2009); see also Shami v. Commissioner, 741 F.3d at 568 (stating that the rule of Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), applies in the context of the section 41 research tax credit). The Court “should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate.” McFerrin, 570 F.3d at 679 (citing Fudim v. Commissioner, T.C. Memo. 1994-235). For the Cohan rule to apply, however, a reasonable basis must exist on which the Court can make an estimate. Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); see also Shami v. Commissioner, 741 F.3d at 568-569.
The government argued that “petitioners neither substantiated the QREs claimed nor produced sufficient evidence for this Court to make reasonable estimates for QREs.” Respondent contends, specifically, that “[p]etitioners failed to provide any nexus between the expenses claimed and qualified research activities, if any, performed.”
The taxpayers argued that they did in fact introduce “sufficient and credible documentary and testimonial evidence to support the estimated percentages of time ESI’s employees spent performing qualified services during the tax years at issue.” The Court agreed.

V. A Reasonableness Test for Qualified Research Credits? Yes, in Section 174(e).

In Driggs v. United States, 706 F. Supp. 20 [63 AFTR 2d 89-804] (N.D. Tex. 1989), the District Court held that section 174 did not impose a reasonableness requirement as to the deductibility of research and development expenditures. Less than a year later, Congress added section 174(e) to the Code in the Omnibus Budget Reconciliation Act of 1989 (OBRA), Pub. L. No. 101-239, sec. 7110(d), 103 Stat. at 2325. The House report accompanying OBRA, H.R. Rept. No. 101-247, at 1203 n.12 (1989), explains that the bill provides for a rule contrary to the holding in Driggs v. United States, 706 F. Supp. 20 (N.D. Tex. 1989).
Under section 174(e) a taxpayer may deduct a research and development expenditure only to the extent that “the amount thereof is reasonable under the circumstances.” The amount of an expenditure is reasonable if the amount would ordinarily be paid for like activities by like enterprises under like circumstances. Treas. Reg. §1.174-2(a)(6). So the government challenged the reasonableness of Mr. Suder’s wages as QREs under section 174(e).
The question of reasonableness is one of fact that must be resolved on the basis of all of the facts and circumstances. Citing the multi-factor test in Mayson Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir. 1949), for determining the reasonableness of compensation the opinion listed the factors to be applied: (1) the employee’s qualifications; (2) the nature, extent and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with gross income and net income; (5) the prevailing general economic conditions; (6) comparison of salaries with distributions to stockholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; and (8) the salary policy of the taxpayer as to all employees. The Court found that a portion of Mr. Suder’s wages was in fact unreasonable and excessive.

VI. Accuracy-Related Penalties. When the Taxpayer Carries 11/12ths of the Case?

Pursuant to section 6662(a) and (b)(1) and (2), a taxpayer may be liable for a penalty of 20% on the portion of an underpayment of tax due to: (1) negligence or disregard of rules or regulations or (2) a substantial understatement of income tax. “Negligence” is defined as any failure to make a reasonable attempt to comply with the provisions of the Code; this includes a failure to keep adequate books and records or to substantiate items properly. Negligence has also been defined as the failure to exercise due care or the failure to do what a reasonable person would do under the circumstances. “Disregard” means any careless, reckless, or intentional disregard. §6662(c). “Understatement” means the excess of the amount of the tax required to be shown on the return over the amount of the tax imposed which is shown on the return, reduced by any rebate. §6662(d)(2)(A). A “substantial understatement” of income tax is defined as an understatement of tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. §6662(d)(1)(A).
The Commissioner bears the initial burden of production. Where the Commissioner satisfies his burden, the taxpayer then bears the ultimate burden of persuasion. The accuracy-related penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer shows that he or she acted with reasonable cause and in good faith. § 6664(c)(1).
The Court would find for the Petitioners here. It opined that regardless of whether respondent has met his burden of production, petitioners are not liable for accuracy-related penalties for 2004-07 because they meet the reasonable cause and good faith exception. While a portion of the wages were excessive the taxpayers made a honest understanding of the tax law that was reasonable in the light of all the facts and circumstances. See Treas. Reg. §1.6664-4(b). Accordingly, we find that petitioners acted with reasonable cause and good faith in claiming excessive research tax credits for 2004-07. Therefore, the Tax Court held that the petitioners are not liable for accuracy-related penalties for 2004-07.

Senators Schumer and Durbin Introduce Legislation to Curb Corporation Inversion Transactions by Focusing on Earnings Stripping Rules: Treasury Also Will Enter Into the Fray In Issuing Anti-Inversion Regulations Under Section 385

Posted in Federal Tax Legislation

There have reported to have been approximately 15 major inversion transactions engaged in by U.S. multinationals this year, including most recently Burger King’s foray into foreign “statehood”. This adds to the exodus of U.S. based companies which have previously engaged in an inversion transaction and already have a new foreign parent corporation while retaining 60% or more of its shareholder base intact. This effectively limits post-inversion U.S. taxation to U.S. source income and eliminates application of the CFC rules.
Where the foreign corporation does not have substantial business activities in its jurisdiction of formation and the retained ownership percentage is 80% or more, then the foreign corporation is required to be disregarded under Section 7874(b). Where a U.S. corporation inverts at the 60% or more but less than 80% standard or test, then such arrangement may yield further tax benefits than simply limiting U.S. taxes on income to only U.S. source income, through having the foreign parent corporation loan funds back to the U.S. based subsidiary with interest payments being deductible in computing the U.S. tax. In contrast, where a U.S. parent corporation borrows funds from a foreign based controlled foreign corporation, the transaction can be treated as a distribution of a dividend from the CFC’s earnings and profits under Section 956.

Schumer-Durbin Legislation
In a press release issued on September 10, Senators Charles E. Schumer (D-NY) and Richard Durbin (D-IL) published their proposed bill specifically targeting the practice of earnings stripping which is frequently a sport engaged in after the inversion transaction is closed. According to Senator Schumer’s press release: “In earnings stripping, one of the most egregious practices of corporate inversions, inverted companies load their U.S. subsidiary up with excessive debt that is “owed” to the foreign headquarters so they can deduct interest payments on this debt, further allowing the company to avoid paying U.S. taxes.” The Schumer-Durbin legislation is the first Senate Democratic proposal to address the practice of earnings stripping by companies that move their domicile overseas and will work with Senate Finance Chairman Wyden and Senator Levin’s efforts to put together a comprehensive package of legislative proposals to address corporate inversions. The Senators also noted that proposals to address the recent wave of corporate inversions must also be used as a bridge to comprehensive corporate tax reform.
“Earnings stripping is the number one incentive driving the wave of inversions we’ve seen in recent months and we need to shut it down,” said Schumer. “This bill curtails the incentive for companies to use shady accounting gimmicks to avoid paying their U.S. tax obligations. The only way to solve this problem for good is passing legislation, and our preference is to work with our Republican colleagues to pass a strong bill.”
“Earnings stripping is a particularly shady maneuver used in the growing trend of corporate tax dodging,” said Durbin. “Families and small businesses in Illinois and across the country don’t have teams of tax lawyers to shift their tax domiciles overseas, or shift their profits and debts on or off their books, or any other shifty schemes that increase the tax burden on the rest of us. That’s wrong, and this bill will help begin to right it.”

Specifically, the legislation will:

• Repeal the debt-to-equity safe harbor so that limitations on the interest expense deduction will apply to all inverters, regardless of their financial leverage;
• Reduce the permitted net interest expense to no more than 25 percent (down from 50 percent) of the subsidiary’s adjusted taxable income;
• Repeal the interest expense deduction carryforward and excess limitation carryforward so that inverters cannot take advantage of the deduction in future years; and
• Require the U.S. subsidiary to obtain IRS preapproval annually on the terms of their related-party transactions for 10 years immediately following an inversion.
The legislation is co-sponsored by Senators Sherrod Brown (D-OH), Chris Coons (D-DE), Jay Rockefeller (D-WV), Debbie Stabenow (D-MI), Ben Cardin (D-MD), Jack Reed (D-RI), Bob Menendez (D-NJ) and Edward Markey (D-MA).

Treasury Expected to Issue Anti-Inversion Regulations Under Section 385
The earnings stripping impacts of a post-corporate inversion transaction has been viewed by the Treasury as an area for tougher regulations. Perhaps this could come in the form of regulations under Section 163(j) or perhaps, more expansively, under its authority to issue regulations defining equity (and non-equity) under Section 385. See Treasury, “Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties,” (Nov. 2007). So the question becomes can the Treasury issue far-reaching regulations to combat corporate expatrations and inversions?

The beginning point of course is Section 7805. Section 7805(a) provides that the Secretary of the Treasury “shall prescribe all needful rules and regulations for the enforcement of [the Code], including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.” Section 7805(b) provides that the Secretary may prescribe “the extent, if any, to which any ruling or regulation…shall be applied without retroactive effect.” These powers have been delegated by the Secretary to “the Commissioner [of Internal Revenue], with the approval of the Secretary,” so that formal authority in this area is divided between the IRS and the Secretary. Similarly, the authority to prepare and distribute instructions, directions, forms, and similar items, granted by § 7805(c) to the Secretary, has been delegated to the IRS, under the direction of the Secretary. In addition, provisions contained throughout the Internal Revenue Code authorizes the issuance of regulations covering many specialized subjects.

In 1984, in Chevron U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), the Supreme Court established the framework to evaluate the exercise of delegated authority from Congress to the Treasury in issuing regulations: “If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute.” For the treatment of an interest in a corporation as stock or debt, Congress looks like it explicitly gave Treasury specific authority to fill the gap so to speak.

Ҥ 385 Treatment of certain interests in corporations as stock or indebtedness.
(a) Authority to prescribe regulations. The Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness).”
The Chevron Court further stated: “When a challenge to an agency construction of a statutory provision . . . really centers on the wisdom of the agency’s policy, rather than whether it is a reasonable choice within a gap left open by Congress, the challenge must fail.” Thus, the Court affirmed that disagreeing with the agency’s policy decision is not grounds for objecting to its action.

The Supreme Court had another look at “deference” to the Treasury in issuing regulations under the Internal Revenue Code in Mayo Foundation. 107 AFTR 2d 2011-341, 178 L Ed 2d 588 (2011). This regulations in issue here defined medical education and research. In Mayo Foundation, the Supreme Court unanimously concluded that the validity of all regulations—whether interpretive or expressly authorized by Congress—should be determined using the two-part analysis set forth in its decision in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 US 837, 81 L Ed 2d 694 (1984), and not the multi factor-based test previously announced in National Muffler Dealers Ass’n, Inc., 43 AFTR 2d 79-828, 440 US 472, 59 L Ed 2d 519, 79-1 USTC ¶9264, 1979-1 CB 198 (1979). As mentioned, Chevron approved “gap filler” type regulations based on a proper delegation by the Congress.

In Mayo, the Supreme Court also held that “the principles underlying our decision in Chevron apply with full force in the tax context.” Under those principles, Treasury may change its regulatory approach and the new approach will still benefit from Chevron deference. The Court also noted that “neither antiquity nor contemporaneity with a statute is a condition of a regulation’s validity.”

Now, what about Section 385 regulations designed to curtail inversions through debt-equity rules and anti-earnings stripping provisions? As it announced in Chevron, supra, the Supreme Court has held that Congress is expressly authorized Treasury to write “appropriate” regulations to treat an interest in a corporation as stock or debt in particular factual situations. The courts will uphold Treasury’s regulations unless they are (1) procedurally defective, (2) arbitrary or capricious, or (3) manifestly contrary to the statute (or perhaps another statute contained in the Code).

Treasury’s Attacking Inversions Using Section 385 Regulations: A Good Idea?
Treasury Secretary Lew has recently announced that anti-stripping regulations under Section 385 will be issued in the near future. The primary focus will no doubt be on treating corporate obligations as stock and not debt under Section 385. Perhaps this can be done, as has been suggested by a well-known authority on international taxation, Harvard Professor Stephen E. Shay, that the Treasury may write a regulation to classify as equity any debt issued by an expatriated entity to a foreign affiliate to the extent that the debt was excessive based on a test of the expatriated entity’s debt-equity ratio and the size of its interest deductions. Perhaps a non-quantitative approach, based on factors and not simply financial ratios could also be set forth. Another commentator, Steven M. Rosenthal, in his recent article in Tax Notes, comments “I believe Shay’s approach would work, but I suggest Treasury instead simply identify particular factors that, if satisfied, would automatically treat a corporate interest as stock. I think this factor approach aligns better with the delegation in section 385….For example, Treasury could treat obligations of a corporation as equity if (1) the obligations were issued in connection with an inversion in which its former shareholders retain a majority ownership of the corporation (or, if Treasury desired a broader factor, in connection with any specified corporate merger and acquisition transaction involving its shares); (2) the obligations were held by a related person (including a corporation) that is not subject to U.S. tax; (3) the corporation’s debt-equity ratio substantially exceeds the average debt-equity ratio of its affiliated group; and (4) the corporation’s interest deductions exceed 25 percent of its earnings before interest, taxes, depreciation, and amortization.

Congress should tackle the anti-inversion trend before it’s too late. The barn door has already been open for a long time. In closing the door on abusive inversions, Congress at the same time, should create incentives to allow U.S. based multi-national corporations to allow a lower tax rate on worldwide income. The current 35 per cent federal rate is much too high although it is recognized that many public corporations do not have an effective rate of tax anywhere near 35 per cent. The competition from foreign countries for the migration of U.S. capital and labor continues, and where is Congress? Stuck in partisan bickering. Perhaps Congress will do something that addresses these issues before we really have a corporate tax system that is territorial based, by election.

Supreme Court in U.S. v. Woods, 134 S.Ct. 557 (2013) Determines that Partnership Level TEFRA Judicial Proceedings Can Include the Imposition of A Gross Valuation Understatement Penalty

Posted in Federal Tax Case Law Decisions

The case involved an abusive tax shelter which resulting in the purchase offsetting options by the taxpayer, Gary Woods, and his employer, Mc Combs. The tax shelter transaction was promoted to the taxpayer as one which would generate substantial tax losses to reduce anticipated taxable income. The taxpayers, pursuant to the tax strategy, purchased from Deutsche Bank a series of currency-option spreads. Each spread had a long-leg, for which the parties paid a premium, and a short option, which Woods and McCombs sold to the Bank and for which they received a premium. The tax shelter program was promoted by members of the firm of Jenkins&Gilchrist under the name “Current Options Bring Reward Alternatives,” or COBRA. Since the premium paid for the long option was largely offset by the premium received for the short option, the net cost to Woods and McCombs was substantially less than the cost of the long option alone. Woods and McCombs contributed the options, along with cash, to two partnerships, which used the cash to purchase stock and currency.
In calculating basis under Section 752, Woods and McCombs considered only the long component of the spreads and disregarded the nearly offsetting short component. As a result, when the partnerships’ assets were disposed of for modest gains, Woods and McCombs claimed huge losses. Although they had contributed roughly $3.2 million in cash and spreads to the partnerships, they claimed losses of more than $45 million.
The tax shelter, like other variants of son-of-boss basis strategies, drew the attention of the Internal Revenue Service. After auditing the partnerships that were created under the transaction, the Internal Revenue Service sent a Notice of Final Partnership Administrative Adjustment (FPAA) to each partnership contending that the partnership level losses should be disallowed and that the partnerships were to be ignored. As to this latter point, the Service argued that the partnerships lacked “economic substance,” i.e., they were shams. As there were no valid partnerships for tax purposes, the Service determined that the partners could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments would be subject to a 40% penalty for gross valuation misstatements.
After filing suit in the federal district court, the trial court held that the partnerships were properly disregarded as shams but that the valuation-misstatement penalty did not apply. The Fifth Circuit Court of Appeals affirmed the lower court’s decision. It held that the District Court had jurisdiction to determine whether the partnerships’ lack of economic substance could justify imposing a 40% gross valuation misstatement penalty on the partners.
Under the TEFRA (1982) entity level audit rules, “partnership items” are adjusted at the entity level. §§6221, 6231(a)(3). Once the adjustments are finalized, the Service may engage in further proceedings at the partner level in making any resulting “computational adjustments” in the tax liability of the individual partners. §§6230(a)(1)–(2), (c), 6231(a)(6). In a TEFRA level judicial proceeding, the court has jurisdiction to determine “the applicability of any penalty … which relates to an adjustment to a partnership item.” §6226(f). A determination that a partnership lacks economic substance is such an adjustment.
Therefore, TEFRA granted the courts in partnership-level proceedings authority to provisionally determine the applicability of any penalty that could result from an adjustment to a partnership item, even though imposing the penalty requires a subsequent, partner-level proceeding. In that later proceeding, each partner may raise any reasons why the penalty may not be imposed on him specifically. As to the case at bar, the District Court had jurisdiction to determine the applicability of the valuation-misstatement penalty. §§6662(a), (b)(3), (e)(1)(A), (h). Once the partnerships were found by the trial court to be shams and therefore were deemed not to exist for tax purposes, no partner could legitimately claim a basis in his partnership interest greater than zero. Any underpayment resulting from use of a non-zero basis would therefore be “attributable to” the partner’s having claimed an “adjusted basis” in the partnerships that exceeded “the correct amount of such … adjusted basis.” §6662(e)(1)(A). It is not difficult, therefore, to conclude that when an asset’s adjusted basis is zero, a valuation misstatement is automatically deemed gross. The gross valuation understatement applies to both factual errors as well as errors of law.
The Supreme Court granted the taxpayer’s writ of certiorari from the Fifth Circuit. While the Woods case was on appeal to the Fifth Circuit by the government, i.e., the trial court ruled that the valuation-misstatement penalty does not apply when the relevant transaction is disregarded for lacking economic substance, the Fifth Circuit held in a similar case that the valuation-misstatement penalty does not apply when the relevant transaction is disregarded for lacking economic substance. Bemont Invs., LLC v. United States, 679 F. 3d 339, 347–348 (2012). In a concurrence joined by the other members of the panel, Judge Prado acknowledged that this rule was binding Circuit law but suggested that it was mistaken. Two Circuit Courts of Appeals had held that District Courts lacked jurisdiction to consider the valuation-misstatement penalty in similar circumstances, see Jade Trading, LLC v. United States, 598 F. 3d 1372, 1380 (Fed. Cir. 2010); Petaluma FX Partners, LLC v. Commissioner, 591 F. 3d 649, 655–656 (D.C. Cir. 2010).

Under TEFRA, partnership-related tax matters are addressed in two stages. First, the Service is required to initiate proceedings at the partnership level to adjust “partnership items”. §§6221, 6231(a)(3). It does so by issuing an FPAA notifying the partners of any adjustments to partnership items, §6223(a)(2), and the partners may seek judicial review of those adjustments, §6226(a)–(b). Once the adjustments to partnership items have become final, the Service may undertake further proceedings at the partner level to make any resulting “computational adjustments” in the tax liability of the individual partners. §6231(a)(6). Most computational adjustments may be directly assessed against the partners, bypassing deficiency proceedings and permitting the partners to challenge the assessments only in post-payment refund actions.§§6230(a)(1), (c). Deficiency proceedings are still required, however, for certain computational adjustments that are attributable to “affected items,” that is, items that are affected by (but are not themselves) partnership items. §§6230(a)(2)(A)(i), 6231(a)(5). Under the entity level audit rules, the court in a TEFRA partnership level proceeding has jurisdiction to determine not just partnership items but also “the applicability of any penalty … which relates to an adjustment to a partnership item.” §6226(f). The determination whether a partnership lacks economic substance is an adjustment to a partnership item.

The issue before the Supreme Court therefore was whether the valuation-misstatement penalty “relates to” the determination that the partnerships Woods and McCombs created were shams. The Service’s view was there can be no outside basis in a sham partnership (which, for tax purposes, does not exist), so any partner who underpaid his individual taxes by declaring an outside basis greater than zero committed a valuation misstatement. The taxpayer argued that because outside basis is not a partnership item, but an “affected item”, a penalty that would rest on a misstatement of outside basis cannot be considered at the partnership level. In other words, the taxpayer asserts that a penalty does not relate to a partnership-item adjustment if it “requires a partner-level determination,” regardless of “whether or not the penalty has a connection to a partnership item.” See §6226(f). Maracich v. Spears, 570 U. S. ___, ___ (2013) . Perhaps the taxpayer’s argument was a bit too narrow.

The majority of the Supreme Court was of the view that prohibiting courts in partnership-level proceedings from considering the applicability of penalties that require partner-level inquiries would be inconsistent with the nature of the “applicability” determination that TEFRA requires. Under TEFRA’s two-stage structure, penalties for tax underpayments must be imposed at the partner level, because partnerships pay no taxes. And imposing a penalty always requires some determinations that can be made only at the partner level. Even where a partnership’s return contains significant errors, a partner may not have carried over those errors to his own return; or if he did, the errors may not have caused him to underpay his taxes by a large enough amount to trigger the penalty; or if they did, the partner may nonetheless have acted in good faith with reasonable cause, which is a bar to the imposition of many penalties, see §6664(c)(1). None of those issues can be conclusively determined at the partnership level.
Notwithstanding that every penalty must be imposed in partner-level proceedings after partner-level determinations, TEFRA provides that the applicability of some penalties must be determined at the partnership level. The applicability determination is therefore inherently provisional; it is always contingent upon determinations that the court in a partnership-level proceeding does not have jurisdiction to make. Barring partnership-level courts from considering the applicability of penalties that cannot be imposed without partner-level inquiries would render TEFRA’s authorization to consider some penalties at the partnership level meaningless. SEE §§6230(a)(2)(A)(i), 6230(c)(4)(partner level defenses). Both these provisions assume that a penalty can relate to a partnership-item adjustment even if the penalty cannot be imposed without additional, partner-level determinations.
The Supreme Court, per Justice Scalia, concluded that the legislative intent behind the enactment of TEFRA, as reflected in the statutory language on the jurisdiction of trial courts to determine “partnership items” in a partnership-level proceeding, also grant to such trial courts jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or non-partnership items such as outside basis. At the same time, TEFRA allows each partner the ability to raise, in subsequent, partner-level proceedings, any reasons why the penalty may not be imposed on him specifically.
Therefore, the District Court had jurisdiction to determine the applicability of the valuation-misstatement penalty—to determine, that is, whether the partnerships’ lack of economic substance (which all agree was properly decided at the partnership level) could justify imposing a valuation-misstatement penalty on the partners. When making that determination, the District Court was obliged to consider Woods’ arguments that the economic-substance determination was categorically incapable of triggering the penalty. Deferring consideration of those arguments until partner-level proceedings would replicate the precise evil that TEFRA sets out to remedy: duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners. To be sure, the District Court could not make a formal adjustment of any partner’s outside basis in this partnership-level proceeding. But it nonetheless could determine whether the adjustments it did make, including the economic-substance determination, had the potential to trigger a penalty; and in doing so, it was not required to shut its eyes to the legal impossibility of any partner’s possessing an outside basis greater than zero in a partnership that, for tax purposes, did not exist. Each partner’s outside basis still must be adjusted at the partner level before the penalty can be imposed, but that poses no obstacle to a partnership-level court’s provisional consideration of whether the economic-substance determination is legally capable of triggering the penalty.

Fifth Circuit Cites United States v. Woods in Recent Decision. This blog will discuss in the near future the recent decision of the Fifth Circuit in Chemtech Royalty Associates, L.P. which ruled in evaluating the tax consequences involving Dow Chemcial Company and a number of foreign banks which generated over one billion dollars in tax deductions for Dow, that the partnerships were shams and remanded he case back to the trial court per United States v. Woods, 134 S. Ct. 557 [112 AFTR 2d 2013-6974] (2013), as to the penalty award.

Treasury States It Will Issue Regulations To Stop Abusive Corporate Tax Inversions

Posted in Federal Taxation Developments

Corporate tax inversions have emerged as one of the hottest topics in Washington, with President Obama and other Democrats threatening action to stem the use of cross-border mergers to escape U.S. taxes. Bills have been introduced in the Senate and House which would cut-back the 80% shareholder test to treat a foreign parent corporation as a domestic corporation to simply a 50% requirement. The business press has been actively reporting both the increasing number of corporations that have expatriated through an inversion or similar transaction. Economist Paul Krugman recently referred to inversions as the “tax avoidance du jour” in an op-ed piece published by the New York Times.
The rules under Section 7874 attempt to prevent U.S. companies from moving their tax residence overseas. Their application varies depending on certain ownership thresholds, and they will not apply to a merger scenario where the combined companies have substantial business activities in the country of organization of the new foreign parent.
Corporate inversions involve readjustment or reorganizations of the corporate structure of a U.S. based multinational corporation (i.e., a U.S. parent corporation with domestic and foreign subsidiaries). The U.S. parent may re-arrange its stock so that a new foreign corporation, conveniently located in a tax haven or jurisdiction with a low corporate tax rate, essentially steps in the shoes of the U.S.-based holding company, relegating the U.S. holding company to a first-tier subsidiary. Inversions can be effectuated by either stock or asset transfers although most reported corporate inversions are in the form of stock transfers. In stock inversions, the U.S. corporation’s shareholders exchange their shares of U.S. parent (pre-inversion) stock (and/or securities) for shares of the new parent, foreign corporation. An asset inversion is effectuated by merger of the U.S. holding company with a new foreign corporation organized and managed outside of the U.S. Other asset or stock transfers moving down the corporate chain of subsidiaries may also be part of the prearranged plan.
Inversion transactions may give rise to immediate U.S. tax consequences at the shareholder or the corporate level, depending on the type of inversion. In stock inversions, the U.S. shareholders generally recognize gain (but not loss) under Section 367(a), based on the difference between the fair market value of the foreign corporation shares received and the adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation’s share value has declined, or it has many foreign or tax-exempt shareholders, the effect of this Section 367(a) “toll charge” is reduced. The transfer of foreign subsidiaries or other assets to the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level (e.g., gain recognition and earnings and profits inclusions under Sections 1001, 311(b), 304, 367, 1248, or other provisions). The tax on any income recognized as a result of these restructurings may be reduced or eliminated through the use of net operating losses, foreign tax credits, and other tax attributes.
While the Senate and House Democratic side of Congress wants to enact impediments to the continuing exodus of U.S. based multinationals, the Republican side has taken another approach. It wants a reduction in the corporate tax rate to 25% or lower to match the competition that foreign jurisdictions have used to extract capital and labor from the U.S. to their countries. So, Congress may be deadlocked on what to do on inversions absent compromise legislation. Is that likely to occur? Perhaps note. As reported in the September 15th issue of Tax Notes, Treasury will make a decision “in the very near future” on what actions it can take regarding corporate inversions under its regulatory authority. That would of course please the President and would end run the Congressional deadlock.

Treasury Secretary Jacob Lew said September 8 that the Treasury would pick up the baton and issue additional regulations designed to restict the benefits of inversion as well as widen the scope of Section 7874(b), although he did not provide more details on a timeline for guidance. Speaking at an event in Washington sponsored by the Urban-Brookings Tax Policy Center, Lew cautioned that any Treasury action designed to make inversions less economically attractive would not be a substitute for legislation, which he said would still be needed but may not move fast enough to address the growing number of transactions. Any action Treasury takes will have a strong legal and policy argument, Lew said. However, he added that any Treasury response would deal with only part of the economics behind inversions.
There was comment made on effective date. Some in the Congress, such as Senator Schumer, have remarked that statutory and/or regulatory reforms to Section 7874 should be retroactive the the 2003 effective date of Section 7874. The regulations may broaden the types of transactions that are within Section 7874 and would further be subject to penalty. A second level of sanctions would impose additional loss of tax benefits or attributes available to corporations after the inversion transaction has occurred. Perhaps this authority to issue regulations will be under Section 385, which gives the Treasury the authority to reclassify debt as equity. Another potential source for reg writing might be under Section 956 pertaining to untaxed (deferred) earnings of a controlled foreign corporation. Also in the mix for regulatory reform might be the anti-interest stripping rules under Section 163(j). Some commentators have questioned that the Treasury does not have the authority to target specific types of transactions as running afoul of Congress’ intent under Section 7874. Instead, these critics assert that only legislation can effectively put additional clamps and limitations on inversions and the resulting tax effects of a corporate expatriation event.

There’s alot more to discuss about inversions.