Thanks to Steve Suarez and Stephanie Wong with Borden Ladner Gervais LLP in Toronto who assembled the commentary which was published in Tax Notes International. I will only list in bullet form those developments in Canada that they highlighted. This Blog has previously featured tax developments in Canada from time to time.

Legislative Developments

l Effective January 1, 2011,  proposed amendments were made to the REIT rules to permit exemption from corporate income tax for qualifying flow through entities.

l Prposed amendments to eliminate the tax advantages of stapled securities (debt and equity securities "stapled" together), which will affect arrangements previously implemented by some corporations and REITs to avoid the specified investment flow-through tax.

l On March 16 the government announced draft legislative proposals in response to three Federal Court of Appeal decisions, including Collins v. The Queen (regarding reducible expenses) and Lehigh Cement Limited v. The Queen (regarding nonresident interest withholding tax).

l Proposed new business tax provisions as part of 2011 federal budget; including elimination of a corporation’s ability to defer taxation through a partnership with different fiscal year ends from that of the corporation (See IRC §§444 and 7519); reduction in tax incentives for Canadian oil shale expenditures; and the amendment or extension of various rules regarding flow-through shares.

l Outbound proposals for foreign affiliates of Canadian taxpayers. Includes provision for new upstream loan rules and “hybrid surplus” regime.

l Technical corrections provisions released, including proposals to expand the application of the shareholder benefit and debt rules to address partnerships and issues arising from foreign spinoffs, and to amend rules regarding the recognition of capital losses by Canadian beneficiaries of nonresident trusts and the treatment of nonresidents with Canadian service providers.

l Reportable transactions. Under the mandatory reporting regime for aggressive tax avoidance transactions, which was proposed in August 27, 2010, draft legislation, a reportable transaction entered into after 2010 (or that is part of a series of transactions that began before 2011 but is completed after 2010) must be reported by June 30 of the year after it first became a reportable transaction.

l Nine TIEA Agreements Executed. Canada's first nine tax information exchange agreements were entered into force (with the Netherlands Antilles, the Cayman Islands, Bahamas, Bermuda, St. Kitts and Nevis, St. Vincent and the Grenadines, Anguilla, San Marino, and the Turks and Caicos Islands). Canada also signed a protocol updating its 1980 income tax convention with Barbados to make it more consistent with current Canadian and international tax treaty policies.

Court Decisions

lTransfer Pricing. The Federal Court of Appeal upheld the Tax Court of Canada's decision in The Queen v. General Electric Capital Canada Inc. Guarantee fees the taxpayer paid to its indirect U.S. parent satisfied the arm's-length standard in Canada's transfer pricing rules. The Crown did not appeal.

In Alberta Printed Circuits Ltd. v. The Queen, the Tax Court substantially upheld the fees paid by the taxpayer to a non-arm's-length Barbadian corporation as representing arm's-length prices

lGeneral Antiavoidance Rule or “GAAR”.

The SCC heard the appeal of Copthorne Holdings Ltd. v. The Queen in January 2011 pertaiing to the proper computation of a corporation's paid-up capital following a horizontal reorganization. The SCC's decision remains pending.

The SCC granted the taxpayer in Garron Family Trust (Trustee of) v. The Queen leave to appeal the lower courts' decision, which applied a central management and control test to determine that a Barbadian trust was resident in Canada for tax purposes.

The Tax Court considered three artificial loss cases in which a series of transactions were implemented to generate a capital loss to offset a previously realized capital gain.

The general antiavoidance rule was applied in Triad Gestco Ltd. v. The Queen and 1207192 Ontario Limited v. The Queen for different reasons, while the GAAR was not applied in Global Equity Fund Ltd. v. The Queen. All three cases are being appealed.

Other Court Decisions

In Imperial Tobacco Canada Ltd. v. The Queen, the Federal Court of Appeal upheld the Tax Court's decision denying the taxpayer a deduction for employee stock option surrender payments made during its takeover, as the payments were capital outlays.

The Tax Court rejected the government's first challenge of so-called foreign tax credit generator arrangements in 4145356 Canada Limited v. The Queen.

In Sommerer v. The Queen (under appeal), the Tax Court found that a trust relationship existed and held that gains realized by a nonresident trust were exempt from Canadian taxation under the treaty and could not be attributed to the person who sold the property to the trust.

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On December 19, 2011, the Service issued final regulations (T.D. 9563) with respect to foreign base company sales income under §954(d) for situations involving the sale of personal property by a corporation foreign corporation (CFC) which is purchased, sold, manufactured, produced, grown, extracted, or constructed by one or more branches of the CFC. The final regulations adopt, for the most part, the set of proposed regulations that were issued on the same subject in 2008 and that were followed up with temporary regulations which were to expire on December 23.  The final regulations apply to tax years of CFCs commencing after June 30, 2009 and for tax years of U.S. shareholders in which the tax years of the CFCs end. The good news is that the final regulations only make minor modifications to the expiring temporary regulations in this area.

Under §954(d)(1), foreign based company sales income (FBCSI), which goes into the calculation of Subpart F income, means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where— (A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and (B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country. For purposes of this subsection, personal property does not include agricultural commodities which are not grown in the United States in commercially marketable quantities.

A special branch rule is contained in §954(d)(2) for CFCs which have a branch located outside of their country of incorporation. It applies where the CFC is engaged in purchasing, selling, manufacturing, producing, constructing, growing or extracting activities by or through the branch, and the carrying on of such activities has substantially the same effect were the branch a wholly subsidiary of the CFC. As a result, the branch and the CFC will be treated as separate corporations for purposes of determining the FBCSI of the CFC.

The "substantially same tax effect" determination is made pursuant to a tax rate disparity test set forth in Treas. Reg. § 1.954-3(b)(1)(i)(b) and  Treas. Reg. § 1.954-3(b)(1)(ii)(b). With respect to a sales or purchase branch, the tax rate disparity test requires comparing the rate of tax imposed on the income derived from the purchasing or selling activities of the branch with the rate of tax that would apply if the income were earned by the remainder of the CFC. With respect to a manufacturing branch, the tax rate disparity test is applied by comparing the rate of tax imposed on the income derived from the purchasing and selling activities of the CFC with the rate of tax that would apply to such income under the laws of the country in which the manufacturing branch is located.

These final regulations provide guidance on the application of the branch rule, in particular with respect to a CFC that has multiple branches. For example, the regulations set forth rules on how to determine whether a CFC earns FBCSI if purchase and sales activities are conducted by multiple branches and if multiple branches are involved in the manufacture of either a single or multiple items of personal property that is sold by the CFC. The final regulations, in changing the temporary regulations, omit the word “demonstrably” in determining whether the tested manufacturing location or tested sales located provided a greater contribution instead of a “demonstrably greater contribution”.

1. Demonstrably greater contribution . Treas. Reg. § .954-3T(b)(1)(ii)(c)(3)(iii) provides that if none of the branches or the remainder of a CFC independently satisfies the substantial contribution test, but the CFC as a whole made a substantial contribution, then for purposes of applying the tax rate disparity test, the location of manufacture, production or construction is the "tested manufacturing location" unless the "tested sales location" provided a "demonstrably greater" contribution. uncertainty, the word "demonstrably" has been deleted from § 1.954-3(b)(1)(ii)(c)(3)(iii).

2. Grouping of branches . Treas. Reg. § 1.954-3T(b)(2)(ii)(a) provides, in general, that for the grouping of branches which do not have tax rate disparity with a purchasing or selling branch, or with the remainder of the CFC treated as purchasing or selling on behalf of a manufacturing branch. This grouping rule applies for purposes of  Treas. Reg. § 1.954-3T(b)(2)(ii), which sets forth the rules that apply after it has been determined that a branch and the remainder of a CFC will be treated as separate corporations. The rules in Treas. Reg. § 1.954-3T(b)(2)(ii) allow a CFC to aggregate the activities of branches that do not have tax rate disparity with a sales or purchasing branch (or remainder) when applying the separate corporation analysis to determine whether the sales income of the sales or purchase branch (or remainder) is FBCSI. § 1.954-3(b)(1)(ii)(c)(3)(v), Example 1.  This change to add the phrase “the activities of” to Treas. Reg. §1.954-3(b)(2)(ii)(a) was made to clarify that the grouping rule for branches that don’t have tax rate disparities between manufacturing and sales locations applies only to the activities and not the income of the branches.

C. Deletion of  Treas. Reg. § 1.954-3(b)(2)(ii)(d)  The final regulations delete paragraph (d) of Treas. Reg. § 1.954-3(b)(2)(ii), which provided that income that is FBCSI as a result of the application of Treas. Reg. § 1.954-3(b)(1)(i) (purchasing or selling branch rules) is not again classified as FBCSI as a result of the application of Treas. Reg. § 1.954-3(b)(1)(ii) (manufacturing branch rules). This change was made because it was redundant.

D. Future Guidance .The IRS and the Treasury Department announced it would continue to study additional FBCSI issues, and are considering whether to issue additional guidance, including guidance regarding when a branch should be treated as a separate corporation under  §954(d)(2), and the scope of, and relationship between, FBCSI and foreign base company services income. Perhaps some may think that the guidance would extend to Treasury’s adding a definition of a “branch” for this purpose.

The final regulations for §954(d), contract manufacturing, for controlled foreign base company sales income included in Subpart F under the so-called branch rules, made relatively minor changes to previously issued temporary regulations that were to expire on December 23. Thus, some relief is in order that the final regulations did not take on new broad paths. Commentary on the final regulations welcomed however the change of the phrase “demonstrably greater” with using simply “greater” for purposes of Treas. Reg. §1.954-3(b)(1)(ii)(c)(3)(iii). There was concern that the additional word could be viewed by the courts as increasing the taxpayer’s burden of proof.

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Potential Penalties Applicable to Dual U.S. Citizens and Residents

The federal government has known for some time that taxpayers who are dual citizens or dual residents of the United States and another country may have knowingly or innocently failed to timely file U.S. federal income tax returns. This would occur, for example, where a U.S. citizen lived outside of the United States for an extended period of time without having formally expatriated both for U.S. immigration and tax law purposes. Such individuals may therefore have failed to file annual U.S. income tax returns, including quarterly estimated tax returns (and payments), and timely paid U.S. income taxes due, net after application of the foreign tax credit rules, other provisions in the Internal Revenue Code resulting in a reduction of U.S. income tax or by application of a pertinent income tax treaty or convention. The same problems could also arise with dual residents who, despite thinking they could be advantaged by a favorable tie-breaker provision in an applicable treaty, would still be accountable to file FBAR and other ownership disclosure forms despite holding a belief, in good faith, that they were “non-resident” for all purposes.

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U.S. Income Tax Treatment of Personal Service Income or Royalty Income of a Non-resident

Non-residents of the U.S. are subject to U.S. income tax on U.S. source fixed and determinable annual or periodic income, as described in Section 871(a), which income, subject to treaty override, is subject to a flat 30% tax rate without deductions. Such persons are further subject to U.S. income taxation on a “net” basis and at graduated rates with respect to income derived from the carrying on of a U.S. trade or business under Section 864(b).  As applied to a non-resident, professional athlete, engaging in a U.S. trade or business includes any  business activity in the United States that involves one's own physical presence. Treas. Reg. §1.864-2.  It is clear that earnings derived from Goosen’s playing in golf tournaments in the U.S. is income from carrying on a U.S. trade or business. On the other hand, U.S. source income from royalties is generally treated as fixed and determinable annual or period income (“FDAP”). Royalty income paid for the right to use intangible property generally is sourced where the property is used or is granted the privilege of being used. § 861(a)(4). Neither foreign source royalty income nor foreign source personal services income is subject to U.S. tax unless it is related to the conduct of a U.S. trade or business.

Petitioner Retief Goosen

This case involved Retief Goosen, the 2001 & 2004 U.S. Open Champion and considered by many to be one of the leading golfers in the world. His official website, www.retiefgoosen.com, highlights his many achievements in professional and amateur golf. 

IRS Issues Notice of Deficiency Issued Against Mr. Goosen for 2002 and 2003

Goosen’s U.S. income tax liability with respect to his U.S. source income for 2002 and 2003 was the subject of a challenge by the IRS and led to a decision by the Tax Court, J. Kroupa, finding for the Petitioner in part and for the Commissioner in part.  At the time the Tax Court Petition was filed, Goosen was a citizen of South Africa but a tax resident of the United Kingdom. His wife is a U.K. citizen and resident.

In a summary of the facts set forth in the Official Tax Court Syllabus, Goosen had entered into endorsement agreements with sponsors Acushnet, TaylorMade, Izod, Upper Deck, Electronic Arts and Rolex. He agreed to allow all sponsors to use his name, face, image and likeness in advertising and marketing campaigns worldwide. Goosen also agreed to perform some services for the sponsors. All endorsement agreements paid Mr. Goosen a base endorsement fee. Acushnet, TaylorMade and Izod prorated the base endorsement fee if he did not annually play in a specified number of golf tournaments, i.e., on-course endorsement fees. Moreover, Acushnet, TaylorMade and Izod provided bonuses to Goosen for achieving a specific finish in a PGA or European Tour tournament or a specified ranking on the World Golf Rankings.

Goosen characterized the endorsement fees and bonuses from Acushnet, TaylorMade and Izod as 50% personal services income and 50% royalty income on his nonresident Federal income tax returns (Forms 1040NR) for 2002 and 2003. He treated or characterized the endorsement fees from Upper Deck, Electronic Arts and Rolex as 100% royalty income. He reported approximately 7% of the total endorsement income as U.S.-source income. The Service asserted that Goosen should have characterized the endorsement fees and bonuses from Acushnet, TaylorMade and Izod as 100% from personal services income. It also reallocated a larger percentage of Goosen’s endorsement fees as U.S.-source income. The deficiency proposed by the Service was $20,224 for 2002 and $144, 474 for 2003.  Accuracy related penalties were set forth in the deficiency notice but were later conceded prior to trial by the Service.

Tax Court’s Analysis and Decision

First, the Court considered whether the endorsement income was, in whole or in part,  personal services income or royalty income. Both parties agreed that endorsement fees under the off-course endorsement agreements that Goosen had received were royalty income.  The issue then was whether endorsement income derived solely from  the on-course endorsement agreements,  which includes the TaylorMade, Izod and Acushnet agreements, was royalty income  (or personal service income) as well.  

The taxpayer’s argument for treating on-course endorsement payments as royalty income was that under such agreements he was paid for the right to co-market and co-brand the sponsors' products with petitioner's name and likeness. His counsel relied upon case law that supported the notion that such  payments are royalties because the person has an ownership interest in the rights granted. See Cepeda v. Swift & Co., 415 F.2d 1205 (8th Cir. 1969); Haelan Lab., Inc. v. Topps Chewing Gum, Inc., 202 F.2d 866 (2d Cir. 1953). Cf.  Boulez v. Commissioner, 83 T.C. 584 (1984) (intellectual property creator receives only personal services income if the creator lacks an ownership interest in the underlying property); Kramer v. Commissioner, 80 T.C. 768 (1983); Uhlaender v. Hendricksen, 316 F. Supp. 1277 (D. Minn. 1970).  The taxpayer adduced expert testimony to support the argument that the three companies primarily paid for his name and likeness rather than for the performance of services.

The IRS position as to the on-course endorsement income was that Goosen was primarily paid to perform personal services including playing golf and carrying or wearing the sponsors’ products and logos. The IRS relied upon the fact that the endorsement agreements provided for a proration (partial reduction) of the endorsement fees if Goosen did not play in a minimum number of golf tournaments. Therefore, any income received by Goosen from such on-course endorsements was only marginally for use of his name and likeness (royalty income). After review of the record, the Court  found that the income received from the on-course endorsement agreements was part royalty income and part personal services income citing  Kramer v. Commissioner,  80 T.C. 584 (1983). The Court allocated 50% of the on-course endorsement income as personal services income and 50% as royalty income.

The next issue was what portion of the on course endorsement income is sourced to the United States and whether any U.S. source royalty income was effectively connected to a U.S. trade or business.  §861(a)(4), §862(a)(4). The burden is on the taxpayer to demonstrate that he made a reasonable allocation of the royalty income between U.S. and foreign sources. The sponsors had the right to use Goosen’s name and likeness worldwide and the contracts allocated 25% of the royalty income as sourced to the United Kingdom and 75% to the rest of the world. No provision was contained in the agreement on how to source the royalty to the United States. The Tax Court rejected the contractual sourcing provision for determining U.S. source royalty income.  Where the contracting parties fail to make a reasonable allocation, the courts have generally allocated all of the royalty income to the U.S. unless the taxpayer can demonstrate a sufficient basis for making a proper allocation. A sufficient basis is present when a taxpayer establishes that he has property rights outside of the U.S. and furnishes evidence on the value of such rights. The Tax Court made fact findings on each endorsement agreement and the proper allocation of U.S. source royalty income from non-U.S. source royalty income. The allocations determined to be proper by the Court varied with each contract. For example, the Upper Deck endorsement agreement royalty payments were found to be 92% U.S. source income and the Electronic Arts royalty to be 70% U.S. source income.

The next issue was whether the non-U.S. source royalty income is effectively connected to a U.S. trade or business. It was undisputed that  Goosen was engaged in the U.S. trade or business of playing golf (“ECI”)  when playing in the U.S. and that his tournament earnings were to be taxed at regular graduated rates.   The IRS did not assert however, and the Court agreed, that  since Goosen did not maintain an office or fixed place of business in the U.S. his non-U.S. source royalty income is not part of his trade or business of playing golf.  The succeeding issue was to what extent the U.S. source royalty income should be treated as royalty income or personal services income.  Under Treas. Reg. §1.864-4(c)(3)(i), U.S. source royalty income is ECI where the activities of the trade or business are a material factor in realizing the royalty income.  

The Court ruled that Goosen’s U.S. source royalty income from on-course endorsement agreements was ECI but that that his U.S. source royalty income from off-course endorsement agreements was not ECI since the payments did not depend on whether he played in any golf tournaments in the U.S. Treas. Reg. §1.864-4(c)(3)(ii), Ex. (2). Thus, such U.S. source royalty income was FDAP and subject to a 30% flat rate.

The final issue was whether, as Goosen had argued, he was entitled to treaty protection in reducing the rate or avoiding the imposition of tax on his U.S. source royalty income by application of the U.S.-U.K. tax conventions. See §894(a)(1). Under the tax conventions, the U.K. will tax a U.K. resident, non-domiciliary on non-U.K. source income only to the extent the income is remitted to or received in the United Kingdom. See U.S.-U.K. tax treaty art. 1(7). The U.S. can not subject the same taxpayer to double taxation. Goosen failed to meet his burden of proof that his non-U.K. endorsement income was remitted to or received in the U.K. Therefore, the Tax Court held  that Goosen was not eligible for any treaty benefits.

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In 2010, the Service issued Announcments 2010-9, 2010-7 I.R.B. 408, 2010-17, 2010-13 I.R.B. 515 and 2010-30, I.R.B. 2010-19 stating that it was in the process of developing a schedule requiring certain business taxpayers to report uncertain tax positions in a separate schedule with their tax returns and requested comments both on the proposal and on a draft schedule and instructions. 

After the April 19, 2010 release of the first announcement and request for comments. The Service received a large number of comments on the overall proposal, including whether and how the Service should implement the requirement to file a schedule reporting uncertain tax positions, as well as the draft schedule and instructions.Many of the comments expressed concerns regarding how the Service would use the reported information, the interaction of the new reporting requirement with the existing policy of restraint, the additional burden the reporting requirement would place on affected corporations, and the impact the reporting requirement would have on the relationship between the corporation and the Service or the corporation and its advisors or independent auditors. Some commentators questioned the Service's authority to require reporting of uncertain tax positions with the corporation's tax return

The final schedule and instructions issued in Announcement 2010-75, issued on Septerm 24, 2010, removed several controversial proposals contained in the initially drawn UTP Schedule such as the elimination of the proposed maximum tax adjustment computation (which in many cases could exceed the taxpayer's financial statement reserves for uncertain taxes), elimination of requiring the reason and nature of the uncertainty to be set forth in a concise description of each uncertain position, the removal of reporting in reliance upon  administrative tax positions, and a five-year phase-in of the reporting requirement based on a corporation's asset size with the initial filings to be made for companies with over $100 million in assets starting with 2010 tax years. The requirement for filing applies to public or privately held corporation which issued audited financial statements and file Form 1120, 1120-F, 1120-L or 1120-PC. The total asset threshold is reduced to $50 million commencing in 2012 tax years and then to $10 million in asset value starting with 2014 tax years. The Service is considering extending the Schedule UTP reporting to other taxpayers including pass-through entities and tax exempt entities.

As reported in the December 6, 2011 issue of Tax Notes Today, the Associate Chief Counsel (Procedure and Administration) issued a somewhat surprising comment that only $1,500 corporate returns had an attached Schedule UTP with their return. The average number or items listed by the coordinated industry case (CIC) taxpayers was only 3.2 positions. Non CIC companies filing the Schedule UTP average only 1.8 items on the schedule. A representative of the Chief Counsel’s Office may have felt a sense of both frustration and skepticism when quoted with saying “People have very few uncertain tax positions these days”. The areas most frequently noted on the UTP schedules filed involved research tax credits, ordinary and necessary business deductions and quite expectedly, transfer pricing issues under Section 482.

The Chief Counsel and Commissioner can’t be pleased with this limited and unexpected luke-warm response. Perhaps the Service will be less willing to back off proposed accuracy related penalties in issuing notices of deficiency or conceding such issues prior to trial when the item(s) being challenged by the Service were not reflected on the Schedule UTP. From another perspective, perhaps the taxpayers first subject to filing the schedule did not want to provide the Service with a detailed set of road maps as to every potential issue that could be challenged by the Service upon audit. This will make for some interesting Q&As at audit as to why items were left off the UTP Schedule.

It is certain (not “uncertain”) that the 2010 filing results and those received by the Service for 2011 returns will result in the Commissioner’s possible reassessment of the Schedule UTP itself or whether further reforms are needed.

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Background

Taxpayers using the accrual method of income are required to recognize gross income in the taxable year in which “all the events which have occurred which fix the right to receive such income and the amount….can be determined with reasonable accuracy”. Treas.Reg. § 1.451-1(a).  Deductions are allowed to the accrual method taxpayer when “all the events have occurred which determine the fact of the liability,” the amount of the deductible item “can be determined with reasonable accuracy,” and economic performance has occurred with respect to the item. § 461(h); Treas. Reg. § 1.461-1(a)(2); Prop. Reg. § 1.461-1(a)(2). See U.S. v. Anderson, 269 US 422, 440–41 (1926)(adopted the “all events test” for accruing expenditures); Spring City Foundry Co. v. Comm’r, 292 U.S. 182, 184-185 (1934). Where an expenditure results in the creation of an asset whose tax life extends substantially beyond the close of the taxpayer year must be capitalized. Treas. Reg. § 1.461-1(a)(2).

Treas. Reg. §1.461-1(a)(2)(i) provides that, under an accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, in the taxable year in which: (i) all the events have occurred that establish the fact of the liability; (ii) the amount of the liability can be determined with reasonable accuracy, and (iii) economic performance has occurred for the liability (collectively, the “ all events test”). See also Treas. Reg. § 1.446-1(c)(1)(ii)(A).

Exceptions to strict application of the “all events test” have been carved into various portions of the Internal Revenue Code and set by case law.  For example, payments for goods and services to be supplied in future years are generally included in gross income under the accrual method when received and not when earned. Deductions are generally not allowed for estimates of costs of meeting contractual obligations under current sales or repair contracts. Special statutory rules injecting cash basis principles onto accrual method accounting taxpayers are applicable for charitable donations, medical expenses, contributions to qualified pension and profit sharing plans. In such instances the deduction is granted when paid and not when the liability to pay arises. See §§ 170(a)(1) (charitable contribution deduction); 213(a)(medical expenses “paid”), 404(a)(profit sharing and pension plans).

Application to Year End Bonuses

Where an accrual method taxpayer is obligated to pay a fixed amount of bonuses to a group of employees at the end of tax year in when the services were rendered but does not know either the particular recipients who will receive the bonuses or the amount each such service provider will receive until after the end of the tax year, the question arises as to whether such uncertainties prevent the accrual of such bonuses at the end of the current year.

In Rev. Rul. 76-345, 1976-2 C.B. 134, the Service announced that it would not follow the decision reached by the United States Court of Claims in Washington Post Company v. U.S., 405 F.2d 1279 (1969) that an accrual method taxpayer may deduct the full amount under a profit sharing plan established for its independent circulation dealers, for which its liability is fixed and certain with respect to the group as a whole, but for which the ultimate recipients, the time of actual payout, and the amount payable to each recipient cannot be ascertained in the year of accrual. In the Service’s view the “fact of the liability” under the first prong of the “all events test” is left unsatisfied where the identity of the recipient or the amount of the bonus payable to each is not determinable until after the end of the tax year.

In Rev. Rul. 2011-29, 2011-49 IRB (11/9/2011) the Service reached the opposite conclusion and announced it was revoking Rev. Rul. 76-345, supra. This should help facilitate the expensing of year end incentive bonuses without having to finalize the service providers entitled to receive bonuses or the amounts of the bonuses before year end.

Ruling Facts

As set forth in the Ruling, the taxpayer used the accrual method and pays bonuses to a group of employees under a bonus plan for services rendered during the current tax year. The minimum total amount of the bonuses under the program is determined: (i) by formula that is fixed prior to the end of the taxpayer year taking into account financial information of the company’s operations as of the end of the year; or (ii) by corporate action, such as a resolution of the board of directors or compensation committee made prior to the end of the year. Such action fixes the bonuses payable to the entire group. Bonuses are paid after the end of the taxable year but within 75 days of the succeeding year. If the employee entitled to the bonus is not working with the company at the time paid, the bonus is forfeited. Therefore, any forfeiture of the minimum total amount of the bonus is reallocated.

Under the first prong of the all events test an accrual method taxpayer must establish that “all events” have occurred which establish the fact of the liability. See Rev. Ruls. 2007-3, 2007-1 C.B. 350; 80-230, 1980-2 C.B. 169; Rev. Rul. 79-41-, 1979-2 C.B. 213, amplified by Rev. Rul. 2003-90, 2003-2 C.B 353. While an expense may be deductible before it is due and payable it is required that liability for the expense must first be firmly established. See, e.g., U.S. v. General Dynamics Corp., 481 U.S. 239, 243 (1987).

As mentioned, Rev. Rul. 76-345, supra, expressed disagreement with the holding in the Washington Post case issued by the U.S. Court of Claims that the first prong of the all events test may be met where the total amount of the liability was fixed at the end of the taxable year.

Holding By Service

Similar to the holding in Washington Post was the Supreme Court’s decision in U.S. v. Hughes Properties, Inc., 476 U.S. 593 (1986) that permitted a casino operator to deduct amounts guaranteed for payments to be made on slot machine jackpots that were not yet won by patrons by the end of the tax year. Critical to the Court was the that that a fixed obligation to pay was present regardless of which particular patron won. 476 U.S. @602. Therefore, in Rev. Rul. 2011-29, supra, the Service agreed that the liability for the taxpayer’s minimum amount of bonuses was established by the end of the year in which the services were rendered. This fact of liability satisfied the first prong of the all events test under Treas. Reg. 1.461-1(a)(2)(i).

The Ruling ends by declaring that accrual method taxpayers changing their prior practice on the treatment of bonuses to obtain the benefits of Rev. Rul. 2011-29 are instituting a change of accounting method that must meet the requirements of §§446 and 481 and applicable administrative procedures. See Rev. Proc. 2011-14, 2011-4 I.R.B. 330, §19.01(2).

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In AM-2011-002, the IRS evaluated the separate return limitation on loss provision or “SRLY” with respect to the dual consolidated loss of a foreign disregarded entity under the check the box regulations.  As discussed below, the dual consolidated loss rule contained in §1503(d) and corresponding regulations, is designed to prevent a single economic loss from reducing the taxable income base of more than one taxing system, which frequently arises in instances in which one base is used in computing taxable income for U.S. income tax purposes and the other base is used in computing taxable income on a foreign tax return not subject to tax in the United States. The comments set forth herein are limited in scope and analysis and do not cover all of the material rules and issues in this area.

The facts involved in AM-2011-022 involve a common domestic parent, A, of a consolidated group of corporations. A owns 100% of B, a corporate domestic subsidiary included in the AB consolidated group. B owns 100% of C,  an entity organized under the laws of a foreign jurisdiction, Country X . C is subject to Country X’s income tax on its worldwide income but is disregarded as an entity separate from B for U.S. federal income tax purposes, i.e., a hybrid entity. C carries on a business in Country X that, if carried on by a U.S. person would be a foreign branch within the meaning of Treas. Reg. §1.367(a)-6T(g)(1) . B’s interest in C consists of a hybrid entity separate unit, and B’s indirect interest in the business operations of C is a foreign branch separate unit.  These two individual separate units are combined and treated as a single separate unit.

In Year 1, B generates $120x of net income that is attributable to the C Separate Unit; in Year 2, B incurs a net loss of $100x that is attributable to the C Separate Unit. B has no other items of income or loss for Years 1 and 2. The taxable income attributable to the AB group (without taking into account the C Separate Unit) is $300x and $150x respectively. The $100x net loss attributable to the C Separate Unit is a dual consolidated loss. As an alternative, the administrative guidance release analyzes the results if in Year 1 C generates only $60x of net income that is attributable to the C Separate Unit.

In general, the regulations prohibit the domestic use of a dual consolidated loss, with certain exceptions (including a domestic use election). The domestic use of a dual consolidated loss is deemed to occur when the dual consolidated loss is made available to offset, directly or indirectly, the income of a domestic affiliate in the year in which the dual consolidated loss is recognized or in any other tax year. In addition, a domestic use occurs when the dual consolidated loss  is included in the computation of the taxable income of a consolidated group.

When a domestic use limitation applies, the dual consolidated loss is treated as subject to the SRLY limitation set forth in Treas. Reg. §1.1502-21(c), and as modified by Treas. Reg. §1.1503-4. In the event the consolidated group makes a domestic use election under Treas Reg. §1.1503(d)-6(d), the domestic use limitation rules are inapplicable or yield to the rules under the special election procedure.  

In general, a corporation’s net operating loss that is subject to the SRLY limitation cannot use such loss to reduce consolidated taxable income, i.e., the loss arises in a separate return limitation year. Accordingly, a net operating loss subject to SRLY can only be used as a carryback or carryforward to the corporation which generated the loss. Unlike the general SRLY limitation, a dual consolidated loss may occur or arise in any taxable year, including a year in which the member is included in a consolidated group are recited in the administrative memorandum. The memorandum issued by the Service addresses when a dual consolidated loss (subject to SRLY),  may be used to offset consolidated taxable income in the year the dual consolidated loss is realized despite the fact that under SRLY principles such loss could not be utilized.

The administrative memorandum looks to the current SRLY regulations and the concept known as the “cumulative register.” Under this rule, the consolidated group may use a separate return limitation year net operating loss to reduce consolidated taxable income to the extent the SRLY member has contributed to the cumulative consolidated taxable income during the consolidated return years, as computed under the cumulative register. Because the dual consolidated return regulations fully incorporate the SRLY limitation, the memorandum concludes that the cumulative register concept applies to a dual consolidated loss that is subject to the domestic use limitation. Thus, under the facts of the memorandum, because the C  Separate Unit has a positive cumulative register of $120x, the AB group can use the C Separate Unit loss  of $100 in determining the group's consolidated taxable income in Year 2. The administrative memorandum further provides it is not necessary for the AB group to make a domestic use election to use the C dual consolidated loss.

Under the alternative facts, the AB group may use the C dual consolidated loss in Year 2 only to the extent of C Separate Unit’s cumulative register amount of $60x. Where the dual consolidated loss is greater than C Separate Unit's cumulative register, the excess remains subject to the domestic use (SRLY) limitation rule. The memorandum notes that the AB group may not file a domestic use election for a portion of a dual consolidated loss; rather, a domestic use election may be filed for only the entire C Separate Unit dual consolidated loss. The AB group may use the C Separate Unit's cumulative register or file a domestic use election for the entire C dual consolidated loss amount but not both.

Limitation on Use of Dual Consolidated Loss

The United States generally allows a domestic corporation, which is taxable on gross income from sources both within and without the United States, is similarly allowed, in computing taxable income,  to deduct items, including losses,  regardless of where the corporation incurs those losses. Thus, subject to applicable limitations, a domestic corporation may offset its domestic source income by foreign-source losses. Under the consolidated return regulations, a domestic (eligible) corporation is permitted to file a consolidated tax return with other “affiliated domestic corporations”. §1504. Again, subject to certain limitations, the losses of one member(s) of a consolidated group may be used to offset the gross income of another member(s) in determining consolidated taxable income.

It is also possible for a corporation to be treated as a “domestic” corporation for U.S. income tax purposes while it is also treated as a “resident” of a foreign country for purposes of applying the domestic tax laws of such foreign jurisdiction. For example, the United States views as “domestic” any corporation which is formed or organized by a state situated in the U.S. On the other hand, some foreign countries also regard as “resident” a the place where management and control over the corporation is exercised. See Temp. Reg. § 1.1503-2T(b)(3)(“dual resident corporation”). Thus it is possible for a domestic corporation for U.S. federal income tax purposes to also be a resident of another country based on a differing definition of “resident”, such as in the United Kingdom or Australia. This is known as the concept of a “dual resident corporation”.  The application of a relevant tax treaty may avoid the issue or problem of double taxation by resolving a dual residency conflict.  

Where a dual consolidated corporation is operating on a deficit basis, it is possible that the same economic losses could be duplicated by being claimed in each jurisdiction of residence and despite the fact that double taxation of income may be avoided. Congress was concerned with the dual resident corporation phenomena and, as part of the Tax Reform Act of 1986, enacted §1503(d). A dual consolidated loss, which includes the net operating loss of a dual resident corporation or the net loss attributable to a separate unit, may not be used to reduce the taxable income of a domestic corporation, including the affiliated member of a consolidated group,  unless the loss does not reduce or offset the income of a foreign corporation. See Treas. Reg. §1.1503(d)-1 through Treas. Reg. § 1.1503(d)-7.  Final regulations under §1503(d) were promulgated in 1992 and again revised and issued in final form in 2007. What is important to recognize is that boundary of the dual consolidated loss regulations goes well beyond the consolidated return regulations. Indeed, the dual consolidated loss rules may apply to a U.S. corporation that simply owns an interest in a foreign partnership that incurs losses. The regulations also provide for an election to allow the current deduction of losses subject to certain limitations and a recapture provision. The revised regulations address the application of the dual consolidated loss regime with respect to the check-the-box entity classification regulations. The Service has a “no-ruling” position on §1503(d). See Rev. Proc. 2009-7, § 4.01(26), 2009-1 CB 226, 228; Rev. Proc. 2010-7, § 4.01(26), 2010-1 CB 231, 233; Rev. Proc. 2011-7, § 4.01(26), 2011-1 IRB 233, 235.

Illustration. X is a corporation formed in Pennsylvania and owns all of the stock of Y, a foreign corporation organized under the laws of Country A. X also has a wholly owned US subsidiary, Z. Y and Z are engaged in business operations in Country A and A is also the jurisdiction where management is sitused for both Y (foreign sub) and Z (domestic organized sub). Under the laws of Country A, Z is a dual resident corporation and its worldwide income is subject to tax in the U.S. and Country A. Both FS and DS conduct most of their business in Country X. Country X is also the place of effective management for both FS and DS. Under the laws of Country X, DS is a domestic resident and is taxable by Country X on its worldwide income. Thus, DS is a dual resident corporation, whose worldwide income is subject to tax in both the United States and Country X. In 2011, X has taxable income of $100M, Y has taxable income of $100M and Z has losses from operations of $100M. Country A’s tax law permits Z (domestic sub) loss of $100M to reduce Y (foreign sub) income of $100M to eliminate any tax owed to Country A. Under §§1503(d) and 1503(d)(2), domestic sub Z’s $100M net operating loss constitutes a “dual consolidated loss” and therefore such loss can not be used to reduce X’s income of $100M for U.S. income tax purposes. Y(foreign sub) can not join in the filing of a consolidated return with X since it is a foreign corporation. The consolidated taxable income of X and Y for the taxable year is $100.

For U.S. income tax purposes, Z (domestic sub)  has a $100M dual consolidated loss carryover which loss may be used to offset DS's future income which it realizes. This loss may not, however, offset the income of X or any other member of the affiliated group (except Z) in any future year. future year.

The disallowance rule  contained in §1503(d) applies only to a dual consolidated loss incurred by a “domestic corporation”. See §§7701(a)(3), 7701(a)(4). The term also includes “any corporation treated as a domestic corporation by the Internal Revenue Code.” See, e.g., §269B which may result in treating a foreign corporation as a domestic corporation if the foreign corporation and any domestic corporation are “stapled entities.”    It may also include a Canadian or Mexican corporation treated as domestic per §1504(d).  It is further important to recognize that under the regulations, a  “separate unit” or “branch” of a domestic corporation may be treated as a separate domestic corporation (and as a dual resident corporation) for purposes of §1503(d). See Treas. Reg. §1.367(a)-6T(g)(1). The regulations define “separate unit” as including an interest in a partnership, a trust, a foreign branch or an interest in an entity that is not taxable for U.S. corporation for U.S. purposes, but is subject to tax in a foreign country as a corporation either on its worldwide income or on a residence basis. This last category of a “separate unit” applies to a “hybrid entity separate unit” owned directly or indirectly by a domestic corporation.  A domestic reverse hybrid is not treated as a dual resident corporation.

Exceptions to Dual Consolidated Loss Rule.

If a foreign business operation is not a “permanent establishment” for treaty purposes or is not taxed on a net basis, it is not a separate unit provided the business is not carried on directly or indirectly by a hybrid or transparent entity. Treas. Regs. §§ 1.1503(d)-1(b)(4)(iii), 1.1503(d)-7(c). Other special rules are provided in the regulations.

Under section 1503(d)(2) and accompanying reulgations, section 1503(d) will not apply to a net operating loss, which, under the foreign income tax law, does not offset the income of any foreign corporation. In other words a “dual consolidated loss” does not include a net operating loss realized in a foreign country where such country’s income tax laws: (i) do not permit the dual resident corporation to use its losses to offset any other person's income that is recognized in the same taxable year; and (ii) do not permit the losses of the dual resident corporation to be carried over or back to offset the income of any other person in any other taxable years.

SRLY Treatment.  Generally, i.e., except as provided in Treas. Reg. §1.1503(d)-6, the domestic use of dual consolidated loss is not allowed except to offset, directly or indirectly, the income of a domestic affiliate (other than the dual resident corporation or separate unit which realized the loss) in the taxable year of the dual consolidated loss or any other year or when the dual consolidate loss is included in the computation of consolidated taxable income or the income of an unaffiliated owner. Where in a particular year in which a separate unit or dual resident corporation realizes a dual consolidated loss, such loss consists of a pro rata portion of each item of deduction and loss which is taken into account in computing the dual consolidated loss.

The dual consolidated loss is treated as incurred in a separate return limitation year (“SRLY”) by the dual resident corporation or separate unit. See Treas. Reg. §1.1502-21(c). It generally is eliminated in a §381 transaction except for Type F reorganizations involving a domestic corporation as the surviving entity. The SRLY limitation on remains in effect even after the loss corporation ceases to be a DRC. Other special rules apply.

Overall, this is a complex provision and requires much thought and evaluation in advising corporate clients engaged in domestic and international business operations.

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In Russian Recovery Fund, Ltd., 108 AFTR2d ¶2011-5494, the  Court of Federal Claims ruled that the Internal Revenue Service may proceed with a collection action against a partner in a lower-tier partnership or “indirect partner” provided such partner’s return was filed within three years of the issuance of a final partnership administrative adjustment (FPAA) to the upper-tier partnership with respect to partnership level items that were adjusted. The tax items finally resolved in the FPAA to the upper-tier partnership directly impacted on the tax liability of the lower-tier partner. The Court further held that the Internal Revenue Service was not allowed to proceed with collection action against an “indirect partner” who filed his individual return more than three years before the issuance of the final partnership administrative adjustment. 

In accordance with the entity level audit rules enacted into law as part of the Tax Equity and Fiscal Responsibility Act (“TEFRA”), 26 U.S.C. §§ 6221–6233 (2006), the case filed in this action is a petition for readjustment of partnership items brought under 26 U.S.C. § 6226(a) by Russian Recovery Advisors, LLC (“RRA”) as the tax matters partner for Russian Recovery Fund, LTD (“RRF”). Plaintiffs allege, inter alia, that the Internal Revenue Service's (“IRS”) issuance of a FPAA for the tax year ending December 31, 2000, was untimely and therefore invalid, and that the representative partners' 2000 and 2001 tax years are closed for adjustment and assessment. The Court of Federal Claims had previously held in this case it was improper for an FPAA to adjust an individual partner’s amount at-risk based on its distributive share of non-recourse partnership liabilities and that the remedy for improper adjustment of a non-partnership item set forth in an FPAA does not invalidate the FPAA. See Russian Recovery Fund Ltd. v. United States, 81 Fed. Cl. 793 (2008).

Entity Audit Rules under TEFRA

As announced by TEFRA, under the partnership audit rules, the tax treatment of any partnership item, including the applicability of any penalty, addition to tax or additional amount which relates to an adjustment to a partnership item, is generally determined at the partnership level. §6221. Where the Internal Revenue Services wants to adjust any  “partnership items,” it must notify the individual partners through issuing an FPAA. §6226. See also §§6229, 6501. For period of 90 days after the FPAA is issued, the tax matters partner of the entity level partnership (or LLC) has the exclusive right to  file a petition for readjustment of the partnership items in the Tax Court, the Court of Federal Claims, or a U.S. District Court. §6226(a). After this 90 exclusivity period expires, the other partners (members) are granted an additional period of 60 days to file a petition for readjustment. §6226(b)(1).  Any partner (member) whose individual tax liability might be affected by the outcome of the litigation of partnership items may participate in the proceeding. §6224. The Internal Revenue Service may assess additional tax liability against individual partners within one year of the final conclusion of the partnership's tax determination. §6229(d). A partner may challenge the tax liability so determined by paying the assessment and filing a refund suit in the Court of Federal Claims for example. The partner is prohibited from brining an action for a refund attributable to partnership items. See §7422(h).

Statutes of Limitation: Assessment of Income Tax

It is universally acknowledged that the general statutory period of limitations for the assessment of income tax may not be made more than three years after the later of the date the tax return was filed or the due date of the tax return. §6501(a). Subject to exceptions and special rules, similarly the period for assessing tax attributable to a partnership item (or affected item), for a partnership tax year won't expire before the date that is three years after the later of: (1) the date the partnership return was filed, or (2) the last day for filing the return for that year (without regard to extensions). §6229(a).

As the tax matters partner for the Russian Recovery Fund, LTD (“RRF”), Russian Recovery Advisors, LLC. (“RRA”), filed a petition with the U.S. Court of Federal Claims for readjustment of partnership items per §6226(a). It challenged the IRS on the basis that the FPAA that the Service issued on 10/15/2005 for the tax year ending 12/31/2000 was issued beyond the permitted statute of limitations and was invalid as it affected an indirect partner who had filed a return more than three years before the FPAA.  Accordingly, the Court of Federal Claims previously held it improper for an FPAA to adjust an individual partner's amount at-risk in its distributive share of nonrecourse partnership liabilities as part of such FPAA. A deposit issue was also involved. See §6226(e). RRF was a limited partnership of ten partners that specialized in distressed asset transactions. Two of its partners were RRA and FFIP, LP (FFIP).

RRF filed its 2000 income tax return on Aug. 14, 2001. In the 2000 tax year, RRF allocated $46,424,782 of net section 988 (foreign currency)  losses to FFIP. On Oct. 14, 2005, the Service  issued an FPAA to RRF for the 2000 tax year, proposing adjustments to RRF partnership items. In the 2000 FPAA, IRS proposed to characterize this $46,424,782 disallowed the entire claimed losses which were allocated to FFIP.

FFIP, a partner of RRF, and also a pass thru entity, filed its own 2000 partnership tax return on or before August 16, 2001. After netting the losses it received from RRF with its own losses, FFIP reported $4,205,838 in losses for the 2000 tax year and $25,272,185 in losses for the 2001 tax year. The original $46.4 million in foreign currency section 988 losses that were allocated from RRF make up a large portion of both of these loss figures.

Nancy Zimmerman was an indirect partner of RRF through FFIP. She filed her 2001 return on Oct. 15, 2002, which was less than three years before the FPAA was issued. She filed her 200 income tax return more than 3 years before the issuance of the 2000 FPAA to RRF.  James DiBiase was an indirect partner of RRF through FFIP. He filed his 2001 and 2000 returns more than three years before the FPAA.

On May 10, 2005, FFIP, through its TMP, entered into an extension agreement with the IRS on Form 872-P, Consent to Extend the Time to Assess Tax Attributable to Partnership. The extension effectively allowed the Service to assess additional federal income tax attributable to the partnership items of FFIP against any partner for the period ending December 31, 2001 through August 31, 2006. Beginning in 2005, the Service audited  FFIP's 2001 partnership return including a detailed review of RRF's net section 988 losses reported on FFIP's 2001 tax return. The IRS completed the review of FFIP's 2001 partnership return and issued a “no adjustments” letter to FFIP. This extension allowed IRS to assess any federal income tax attributable to the partnership items of FFIP against any partner for the period(s) ended Dec. 31, 2001 at any time on or before Aug. 31, 2006.

Conclusions of the Court

After setting forth a detailed analysis of the facts and the law on each issue that was the subject of cross motions for summary judgment, the Court of Federal Claims reached several conclusions.  

1. Statute of Limitations Affirmative Defense Raised by Indirect Partners. The IRS asserted that RRA, as TMP to RRF, lacked standing to assert the statute of limitations defense on behalf of indirect partners. The Court of Federal Claims held that §6226 permits partners other than the tax matters partner to raise the statute of limitation defense and yet such  in no way prevents the TMP from raising the defense of their behalf.  See, e.g., AD Global Fund, LLC. v. United States, 481 F.3d 1351 (Fed. Cir 2007); Blak Invs. v. Comm'r, 133 T.C. 431 (2009). It is noted in the Court’s analysis that when a partner attempts to raise the statute of limitations defense at a partner level proceeding, it is foreclosed because the defense must be raised in the partnership level proceeding. Prati v. United States, 603 F.3d 1301, 1307 (Fed. Cir. 2010);Chimblo v. Comm'r , 177 F.3d 119, 125 [83 AFTR 2d 99-2610] (2nd Cir. 1998).

In Keener v. United States, 551 F.3d 1358 (Fed. Cir. 2009), the Federal Circuit held that the subject of a statute of limitations defense is appropriately viewed as a partnership item and handled in a partnership proceeding as opposed to a partner-level proceeding. Section 6221 provides that “[e]xcept as otherwise provided in this subchapter, the tax treatment of any partnership item ... shall be determined at the partnership level.” 26 U.S.C. § 6221 (2006). The Court of Federal Claims read  Keener and section 6221 together to mean that it is necessary for a statute of limitations defense, as a partnership item, to be raised in the partnership-level proceeding. See §6226(d)(1)(B).  Thus, while the statute allows partners other than the tax matters partner to raise a statute of limitations defense, it does not prevent the tax matters partner from raising the defense on their behalf.

2. One Year Rule Under Section 6229(d). RRA contended that due to the running of the statutes of limitation under §§6229 and 6501, summary judgment should be granted to the petitioners since the FPAA in this case was issued more than 3 years after RRF filed its 2000 return FPAA. In accordance with §6229(d) the statute of limitation for assessing RRF’s (indirect partner) 2001 return for “any tax imposed . . . which is attributable to any partnership item (or affected item) for a partnership taxable year,” was suspended until one year after the Court's final decision. The  RRA argued that the Service could only have assessed the losses on RRA’s 2001 return by issuing an FPAA to FFIP for the 2001 tax year. The Service argued that such losses must be adjusted at their source, RRF, not at FFIP, a second-tier partnership. The Court said that IRS could have issued an FPAA to FFIP, but to adjust the losses, an FPAA had to be issued at their source (RRF). The issuance of the FPAA to RRF had the effect of disallowing the foreign currency section 988 losses in 2000. The Court then held that the losses reflected on Nancy Zimmerman’s  2001 individual return were “attributable to” the disallowed RRF 2000 losses.

3. Assessment Against Lower Tier Partner  Permitted.

The Court therefore concluded that RRF loss adjustments arising from the 2005 FPAA could result in the assessment of income taxes as to Zimmerman’s tax liability for 2001. Under §6229(d), the issuance of the FPAA to RRF on October 14, 2005 suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. Simply put, this means that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was  still open for assessment. Plaintiffs argue that the IRS could only have assessed the losses on Ms. Zimmerman's 2001 return by issuing an FPAA to FFIP for the 2001 tax year. Defendant responds that the losses must be adjusted at their source, RRF, not at FFIP, a second tier partnership. The question, therefore, is whether after FFIP carried the losses forward into 2001, they ceased to be RRF partnership items and moved beyond the reach of an RRF partnership proceeding.

The Service is permitted to issued multiple FPAAs in tiered partnerships. Since RRF was the source of the losses reported and allocated to FFIP, also a pass through entity, the issuance of an FPAA to the lower tier partnership, i.e., FFIP, would be inappropriate for disallowing the RRF losses. See Sente Investment Club Partnership v. Commissioner, 95 T.C. 243 (1990); Kligfield Holdings v. Commissioner, 128 T.C. 192, 202 (2007)(FPAA issued to adjust partnership items in a closed year in order to assess a deficiency in a partner's later year return). See also §6231(a)(6). from the source down to the indirect partners in order to consider whether individual partners owe any tax. Under TEFRA, losses must be disallowed at their point of origin.

The Court found the Plaintiffs' argument for the issuance of multiple FPAAs unconvincing. The IRS could have issued an FPAA to FFIP, but to adjust the §988 losses, an FPAA had to be issued at their source, which was RRF.   The issuance of the FPAA to RRF had the effect of disallowing the section 988 losses in 2000. The issuance of the FPAA to RRF on October 14, 2005, suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. This meant that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was, in the view of the Court, still open for assessment (but under the facts of the case, not for Ms. Zimmerman’s 2000 tax return). It does not matter if the disallowed losses are also FFIP partnership items in 2001 because that fact does not prevent the FPAA from disallowing the losses at the RRF origination point and then assessing Ms. Zimmerman's 2001 tax return through a computational adjustment. The Court held that the FPAA issued to RRF in 2000 validly suspended the limitation period for assessing Ms. Zimmerman's 2001 individual tax return relating to partnership tax items involving the upper-tiered partnership.

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Under 26 USC §897, which was adopted into law as part of the Foreign Investment in Real Property Tax Act (“FIRPTA”) in 1980, gain realized by a foreign person with respect to the disposition of  an interest in US real property (“USRPI”) is characterized as income effectively connected with the conduct of a U.S. trade or business and subjects the foreign person to U.S. income tax on the net income derived from such gain at normal U.S. income tax rates. In general, under §1445 a purchaser of a USRPI from a foreign person is required to withhold a tax equal to 10% of the amount realized (generally gross purchase price). §1445(c); Treas. Reg. §1.1445-1(a). See also §6039C.     

The person in control of the payment, usually the buyer, or the closing agent, is required to deduct and withhold such portion of the payment and pay it over to the IRS. The required withholding must be remitted to the IRS within 20 days. The foreign transferor must report the gain, e.g., for a non-resident by filing a U.S. income tax return on Form 1040NR, on which withheld amounts are credited against the liability. The law also permits individuals to reduce or eliminate the required withholding by obtaining prior to closing an exemption certificate from the IRS or submit a U.S. resident certificate (under penalty of perjury) containing the seller’s identification number and that the transferor is not a foreign person to the buyer or closing agent. If the transferee or other person required to withhold the §1445 tax fails to withhold or pay over the amount withheld, that person is liable for the tax required to be withheld, plus interest and potential penalties (to the extent that the transferor's tax liability on the transfer is not otherwise paid). §1461; Treas. Reg. §1.1445-1(e)(1).

A USRPI is an interest in real property located in the U.S. or the U.S. Virgin Islands and any interest (other than solely as a creditor) in a domestic corporation that is a U.S. real property holding corporation (USRPHC). §897(c)(1)(A). For this purpose “real property” includes land and unservered natural products of land such as minerals, oil and gas deposits, unharvested crops and uncut timber, buildings and permanent structures. Also included within the term “real property” is personal property associated with the use of such real property such as equipment used in farming, construction, forestry or mining, property used in lodging places or rented office space.

Under §897(c)(2), a USRPI also includes any  the stock of any corporation if the FMV of its USRPIs equals or is greater than 50% of the FMV of its USRPIs, its interests in real property situated outside of the US and including any other of its assets used in a trade or business. 

A USRPHC, i.e., US real property holding corporation, does not include any class of stock of a corporation which is regularly traded on an established securities market unless a foreign person who during the preceding 5 year period held more than 5% of such class of stock. Stocks in U.S. corporation are presumed to be USRPI unless it can be established otherwise. Taxpayers seeking to rebut this presumption must affirmatively certify that the stock is not USRPI no later than the date of the disposition.

Under §897(c)(4) in determining whether a USRPHC exists, a foreign corporation holding USRPIs is treated as a a domestic corporation (§897(c)(4)(A)) and under regulations assets held by a partnership, trust or estate are treated as held proportionately by its partners or beneficiaries. See §897(c)(4)(B). Under §897(c)(5)(A), under regulations, if any corporation holds 50% or more of the FMV of all classes of stock of a second corporation, then for purposes of determining whether the corporation is a USRPHC, the first corporation is treated as owning a portion of each asset of the controlled corporation equal to the percentage of the second corporation represented by the stock held by the first corporation.

Under §897(d)(1) a foreign corporation may be required to recognize gain on the distribution of a USRPI subject to an exception provided under §897(d)(2). Furthermore, §897(j) requires that a nonresident alien individual or a foreign corporation recognize gain on the contribution of a USRPI to a foreign corporation. The treatment of transfers of USRPIs and stock of a USRPHC in what otherwise would be treated as a nonrecognition transaction is set forth in §897(e). Section 897(e)(1) for starters explains that it overrides all the nonrecognition provisions set forth in the Code, at least in the absence of a specific exception. Therefore §897(e)(1) applies to an exchange of a USRPI for an interest the sale of which would be subject to tax. Under §897(d)(2) a foreign corporation may avoid gain recognition with respect to the distribution of a USRPI in certain instances such as under §337. Where §§897(e) and 897(d) are in conflict or overlap, §897(e)(1) requires that §897(d) control. In general, §897 will override any contrary treaty provision. But see Temp. Regs. §§1.897-5T(d)(2), 1.897-6T(a)(9).

As an illustration of the potential reach of §897 is with respect to transactions that would otherwise be entitled to nonrecognition treatment. See §§897(d), 897(e). Suppose FC, a foreign corporation sells shares of stock in a U.S. corporation which is not a USRPC. Nevertheless, the purchaser of the share would be required to withhold and remit to the IRS 10% of the gross sales price within 20 day of the closing. Then FC would be required to file a U.S. income tax return for the year of sale, report the gain, and pay the tax due, if any, with a credit for the amount withheld or apply for a refund. See §881(a). Alternatively, withholding could be avoided if prior to the date of sale the US corporation provided a certificate of non-USRPHC (based on the lack of USRPIs) to the seller and a copy is provided to the purchaser. Then after the closing, the U.S. corporation is required to provide the IRS with a notice of non-USRPI status and a copy of the statement of non-USRPI status within 30 days of providing the statement of non-USRPI status to the seller. 

To avoid the withholding, the seller could request a statement of non-USRPI status from U.S. Corp. no later than the date of the sale. Before that date, U.S. Corp. must provide the statement of non-U.S.RPI status to the seller and a copy must be provided to the buyer. Subsequently, U.S. Corp. must provide the IRS with a notice of non-USRPI status (i.e. a cover letter explaining non-USRPI status) and a copy of the statement of non-USRPI status within 30 days of providing the statement of non-USRPI to the seller.

Another illustration is also involves a U.S. corporation (USCorp1) which has no USRPIs. USCorp1 is owned 100% by FC which transfers its stock in USCorp1 to another wholly owned U.S. subsidiary USCorp2 as part of a non-taxable §351 transaction. In this case §351 will be overridden by the FIRPTA and USCorp2 would be required to withhold and remit to the IRS 10% of the FMV of USCorp1 on a timely basis unless the necessary exemption certificates were obtained and provided to USCorp2 prior to the transfer. See Treas. Reg. §1.897-6T(a)(3).

The regulations provide for an exception. In this regard, Treas. Reg. §1.897-6T(a)(1) provides that any nonrecognition provision , i.e., §351, shall apply to a transfer by a foreign person of a USRPI on which gain is realized only to the extent that the transferred property would be subject to U.S. taxation upon its disposition and the transferor complies with certain filing requirements. Treas. Reg. §1.897-5T. This exception is referred to as the “USRPI for USRPI” rule. The rationale for the exception is that the transferor would be subject to US income tax on the interest it receives back in the exchange, i.e., the US corporation is a USRPHC. See Treas. Regs. §§1.1445-2(d)(2)(iii); Temp. Reg. §1.897-5T(d)(1)(iii).

This is a short summary of the FIRPTA provisions which are quite detailed and complex. In certain instances, transactions which may look as falling outside of FIRPTA are clearly subject to its application. The up-swing in foreign investment in USRPI should spark renewed interest by the IRS in auditing taxpayers subject to these rules.

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A recent technical interpretation issued by the Canada Revenue Agency, Technical Interpretation 2011-0393411E5, provides that under Article XV of the Canada-U.S. Income Tax Convention, that after 2008, when a U.S. resident employee of a Canadian resident corporation acquires shares of the corporation on the exercise of employee stock options, the Canada Revenue Agency (CRA) would disallow that the income from the taxable amount would qualify for exemption from Canadian income tax under the Canada-U.S. Tax Treaty, even if the employer was not present in Canada for more than 183 days. The rationale of the CRA is that the income realized from the exercise of the Canadian stock option was "paid" to the employee by the Canadian resident corporation in applying Article XV(2)(b) of the Treaty.

Under the Canadian tax law, in general, the fair market value of the share of stock acquired by exercise of a compensatory stock option in excess of the amount paid to acquire the option is treated as income from employment. This is essentially the same result that is produced under Section 83 of the Internal Revenue Code and in particular, in accordance with Treas. Reg. §1.83-7 (non-qualified stock options not having a readily ascertainable fair market value on grant). ITA, ¶7(1). The basis of the acquired shares, referred to as the "adjusted cost base", is equal to the amount paid for the option, plus the strike price and the excess of the value of the shares acquired over the employees’s cost basis to acquire the stock. ITA, ¶53(1)(j). With respect to a nonresident employee, the spread between the value of the stock acquired by exercise of a compensatory option must be related to services rendered or performed of an employment in Canada. ITA ¶¶115, 2(3)(a). Unlike the deduction reported by the employer-issuer under IRC §83(h), in Canada the issuing corporation is not permitted to deduction the amount of the compensatory element of the exercised employment option. ITA, ¶7(3)(b).

Article XVof the Treaty provides:

The language under Article XV is fairly clear and unambiguous. Generally, income from services received by a resident of the U.S., for example, is not taxable in Canada unless the employment is exercised in Canada and then is taxable in Canada to the extent so derived. So much for XV(1). Then in XV(2) , and in particular, XV(2)(b), income for services rendered by a U.S. resident for employment exercised in Canada is only taxable in the U.S. where the service provider is present in Canada for a period(s) of time not exceeding 183 days for a 12 month period commencing or ending in the relevant fiscal year and the compensation is not paid by, or on behalf of a person who is a resident of Canada and is not economically borne by a permanent establishment of a nonresident employer situated in Canada.

The question present in the newly issued TI was whether the position the CRA previously took in TI 2002-0126537, was still the position of the CRA in light of the fifth protocol to the Treaty that was signed and entered into force in 2008 with respect to Article XV(2)(b). In Technical Interpretation 2002-0126537 the CRA opined that a resident U.S. for the purposes of the treaty who was employed in Canada for the purposes of the ITA and earned income from that employment under section 7 of the ITA would not be subject to Canadian tax on that income by virtue of Article XV(2)(b) of the treaty if: (1) the resident was not present in Canada for more than 183 days in the tax year; and (2) the stock option benefit was not available to the employer as a deduction in computing taxable income of either a Canadian resident employer or the permanent establishment of a nonresident employer.

In Technical Interpretation 2011-0393411E5, the CRA revised its position from the position taken in 2002. In particular, the CRA opined that under the new provision, the compensatory element of the exercise of a stock option realized by a U.S. resident that is included in the employee’s income under the Canadian ITA for a tax year beginning on or after January 1, 2009, as income from an office or employment will be exempt from tax in Canada per Article XV(2)(b) provided: (i) the U.S. resident is not present in Canada for more than 183 days in any 12-month period commencing or ending in the particular tax year; (ii) the stock option remuneration is not paid by, or on behalf of, a person who is a resident of Canada under the treaty; and (iii) the stock option remuneration is not borne by a permanent establishment in Canada. Remuneration is borne by a permanent establishment in Canada if the compensatory element is deductible in the computation of income attributable to the permanent establishment under Canadian ITA. Stock option compensation derived by a U.s. resident is not exempt under the Treaty where it is paid by, or on behalf of, a resident of Canada even where the compensatory element is not deducting in computing the income of the Canadian resident employer.

What seems to be controversial about the CRA’s position is that in light of the Fifth Protocol to the Treaty (2008), when a U.S. resident employee of a Canadian resident corporation acquires shares of the corporation on the exercise of employee stock options, the CRA would deny an exemption from Canadian tax under the treaty, even if the employer was not present in Canada for more than 183 days, since the amount of any resulting stock option remuneration will be paid to the United States-resident employee by the Canadian-resident corporation for the purposes of Article XV(2)(b). This result may produce discontinuities in the cross-border treatment of non-qualified stock options (NQSOs) and incentive stock options (ISOs). This is due to the fact that as to incentive stock options, the bargain element on exercise is not included in taxable income for regular tax purposes only for alternative minimum tax purposes. Instead, capital gain is realized when the stock is sold provided the sale occurs more than 2 years after the date of grant or 1 year after exercise. IRC §421(a)(1).

It is certain that this new TI issued by the CRA will generate some controversy and that the issue will ultimately by posited with the Canadian tax courts for review and interpretation.

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In Boltar LLC et al v. Commissioner, 136 T.C. No. 14 (4/15/2011) the Tax Court granted the government’s motion in limine, which motion was timely submitted pre-trial, to strike the admission of the taxpayer’s experts’ report into evidence at trial based on its argument that the report was  “unrealiable and irrelevant” under FREV 702 and the Supreme Court’s landmark decision in Daubert v. Merrell Dow Pharmaceutical, Inc., 509 U.S. 579 (1993). The Court , in a fully reviewed  decision, sustained the government’s motion in limine and excluded the taxpayer’s expert report from evidence and then agreed with the IRS’s expert’s determination of the value of the conservation easement . The government’s  notice of deficiency (Final Partnership Administrative Adjustment (“FPAA”)) was upheld for the amount stated.  The FPPA allowed only $42,400 out of a total $3,245,000 claimed as a charitable deduction on the partnership return of Boltar as the value of a conservation easement with respect to real property located in Indiana. The deficiency in the partners’ federal income tax resulting from the decision would approximate $1.12M (based on an assumed marginal income tax rate of 35% with respect to the disallowance of the excess deduction amount).

The Tax Court announced in Boltar, LLC, supra, that the standards of reliability and relevance  (for admitting expert testimony) apply in trials without a jury, such as in the United States Tax Court, subject to the discretion of the trial judge to receive such evidence. In this case the Court ruled that the taxpayer’s experts failed to apply the correct legal standard in that there was no determination made of the value of the donated conservation easement before and after the valuation, the valuation failed to value contiguous parcels owned by the partnership and assumed development which was not feasible on the subject property.

It is noteworthy that  there was no gross valuation misstatement or, alternatively, substantial valuation misstatement penalty, involved in this case. The penalty could have been 40% of the underlying deficiency based on the government's position on value.  Indeed, no penalty was proposed in the FPAA. Fifteen months after the government’s answer to the petition  was filed, 6 months after one continuance on respondent's motion, and 2-1/2 months before the next scheduled trial date, the  respondent-IRS moved to amend the answer to assert a "pass-through penalty adjustment of $1,281,040". The Court granted the taxpayer’s move to strike the penalty on the basis that the motion was untimely and prejudicial. Thus, further cost and damage to the taxpayer’s filing position and failed expert testimony was avoided.

Background: Deduction for Value of Donation of a Conservation Easement

Section 170(a)(1) allows a taxpayer to deduct, in computing taxable income, and as subject to further limitations, the amount or value of a qualifying charitable contribution. Under Treas. Reg. Section 1.170A-1(c)(1), where a contribution is made is property other than money, the amount of the charitable deduction “is the fair market value of the property at the time of the contribution". Fair market value, as defined by the regulations, "is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts." Treas. Reg. Section 1.170A-1(c)(2). For partial interests in property, the deduction is the fair market value of such partial interest at the time of the contribution.  

As is relevant to contributions of a perpetual conservation easement, Treas. Reg. Section 1.170A-14(h)(3)(i) provides that the value of the easement its is fair market value at the time of the contribution. Where a substantial record of sales of easements comparable to the donated easement (such as purchases pursuant to a governmental program) is present, the fair market value of the donated easement is based on the sales prices of such comparable easements. The regulations further explain that where no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule,  the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction. See Hilborn v. Commissioner, 85 T.C. 677, 688-689 (1985). The “before and after” approach is used in various contexts in resolving certain types of tax disputes. See, e.g., Browning v. Commissioner, 109 T.C. 303, 311-316 (1997); Symington v. Commissioner, 87 T.C. 892, 894-895 (1986); Thayer v. Commissioner, T.C. Memo. 1977-370; S. Rept. 96-1007, at 14-15 (1980), 1980-2 C.B. 599, 606; Rev. Rul. 76-376, 1976-2 C.B. 53; Rev. Rul. 73-339, 1973-2 C.B. 68.

Expert Reports Filed By the Parties

As required in accordance with TC Rule 143(g), the parties exchanged their expert reports at pre-trial conference and were submitted to the Court. Rebuttal reports would soon be filed before trial again in accordance with Tax Court rules. The tax return (partnership informational return) for the year of the charitable donation claimed by Boltar, 2003 attached the appraisal report filed by its experts, who reviewed only a draft of the easement prior to issuing their appraisal on March 7, 2004 and did not rely on the final version of the recorded easement.  The easement granted a Land Trust, Co., on December 29, 2003, to perpetually restrict the use of the subject  8 acres on the eastern side of a parcel (one of two) held by the partnership. The easement prevented any use of the property that would impair the conservation values of the property. Some of the factual nuances and details are set forth in the findings of fact made by the Court or as stipulated by the parties and are too lengthy to summarize in this post.

The taxpayer’s experts valued the subject property’s “highest and best use”,  as either raw land or multi-family development, and arrived at the foregone use value by virtue of the easement at $3,245,000 leaving a residual value to the subject property of only $68,000. The deduction claimed by Boltar LLC for 2003 was based then on the multi-family development scenario.  On the other hand, the government’s valuation expert stated that the value transferred (deductible) was only $42,400, and criticized the taxpayer’s expert report since it failed to determine the value of the restricted area both  before and after the grant of the easement as required in the regulations to Section 170. The government’s expert valued the eased property strictly on permitted land use restrictions, i.e., single family residences.

In accordance with the Court's standing pretrial order and Rule 143(g), the parties exchanged and submitted expert reports. Petitioner's expert report consisted of the Integra appraisal and a transmittal letter to petitioner dated March 7, 2004, and a letter to petitioner's counsel dated April 15, 2010. In the letter dated April 15, 2010, the taxpayer’s experts addressed the views of the Internal Revenue Service valuation engineer (rebuttal report) but did not make any adjustments in their value opinion, maintaining that the amount determined in their 2004 appraisal was "supportable and appropriate.

Government’s Criticism of Taxpayer’s Expert Report

Prior to trial, the government filed a motion in limine arguing that the taxpayers’ appraisal was not reliable and was also irrelevant for several reasons: (i) the report did not include both a before and after value of the subject eased property as required in the regulations although the petitioner argued that such comparision had been done; (ii) the taxpayer’s report did not value all contiguous parcels it owned and encumbered by the conservation easement at issue in this case as required by regulation; and (iii)  the 174 condominium unit development  analysis used by the taxpayer’s expert included as part of an alternative scenario in the taxpayer’s experts’ report was not a permitted  use on the eight acre subject property. The government contended that this hypothetical value on property that could not from a land use standpoint be converted into a 174 condominium unit project required that the taxpayer’s expert report be stricken. Indeed, this high-density potential (hypothetical) use caused the value “before” on the eased property to be substantially greater than the single family residential “highest and best” use scenario. The Court noted it would defer ruling on the motion in limine until all evidence was presented at trial. The Court deferred ruling on respondent's motion in limine because of the importance of the issues raised and the substantial effect on the case of eliminating petitioner's primary evidence. The taxpayer’s expert report was marked and the related testimony of petitioner's experts was heard solely as an offer of proof. Whether the report and testimony would ultimately  be received into evidence and considered in determining fair market value of the easement depended, in the Court’s view, on application of principles expressed in Daubert v. Merrell Dow Pharm., Inc., supra, 509 U.S. at 591, as related to rules 702 and 703 of the Federal Rules of Evidence. The Tax Court ruled, as discussed herein, it was inadmissible.

Taxpayer’s Arguments for Admissibility of Its Expert’s Report

The valuation experts claimed that there was nothing wrong with including in the appraisal a  hypothetical development project that could not fit on the land they purportedly valued, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future. As to the government’s invoking the Daubert rule, the taxpayer argued it is inapplicable in this instance since there is no jury in a Tax Court proceeding, and therefore TC Rule 143(g) requires that the report be received into evidence.

Federal Rule of Evidence 702  

FREV 702 provides that where scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if: (i) the testimony is based upon sufficient facts or data, (ii) the testimony is the product of reliable principles and methods, and (iii) the witness has applied the principles and methods reliably to the facts of the case.

The Supreme Court in Daubert, supra, acknowledged that it is the trial court that serves as the “gatekeeper” as to what evidence is excluded as unreliable. See Kumho Tire Co. v. Carmichael, 526 U.S. 137, 148 (1999), the Supreme Court applied the same standard to expert testimony that was not "scientific". More importantly, the application of the Daubert rule is not limited only to jury trials.. See Atty. Gen. of Okla. v. Tyson Foods, Inc., 565 F.3d 769, 779 (10th Cir. 2009); Seaboard Lumber Co. v. United States, 308 F.3d 1283, 1302 (Fed. Cir. 2002) (standards of relevance and reliability must be met in bench trials). In any event, rule 702 of the Federal Rules of Evidence applies to bench trials as well as to jury trials and specifically sets forth applicable standards of reliability.

The Tax Court then stated that like other federal courts it too would strike the admission of unreliable evidence as a gatekeeper of the admissibility of expert reports as well. Laureys v. Commissioner, 92 T.C. 101, 127 (1989).  The Tax Court further stated  that an expert loses usefulness as well as credibility when giving testimony tainted by overzealous advocacy. Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980)(other citations omitted). Expert opinions that disregard relevant facts affecting valuation or exaggerate value to incredible levels are rejected. See Estate of Newhouse v. Commissioner, 94 T.C. 193, 244 (1990)(other citations omitted).

The Tax Court, in an opinion written by Judge Cohen, stressed that the Court’s gatekeeper role in a non-jury trial enhances trial efficiency while at the same time making the fact finder more objective in reaching its final determination. It rejected being burdened by “  unreasonable, unreliable, and irrelevant expert testimony”.

At this point the opinion puts many tax professionals and valuation experts on notice. “ In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial Judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes.” (emphasis added). This case therefore has wide-sweeping implications since valuation issues arise in many contexts in the Code, including federal estate and gift tax valuation disputes.

Here, the taxpayer’s experts failed to apply realistic or objective assumptions. One alternative determination of value reached by the taxpayer’s experts was based on raw land which supported only a modest or small deduction.  Its alternative and yet unfeasible condominium use value supported the claimed deduction of $3,270,000 generating potential federal income tax savings in excess of $1.1 M.  While making these alternative assumptions, the report fails to determine the highest and best use of the property after the easement is granted, it did not consider potential residential use of the property and thus did not value the property at its highest and best use after the easement was granted. From other evidence presented at trial, including the existing zoning ordinances and restrictions, the Tax Court noted that only single-family residential use was feasible (as an alternative to valuation as raw land) after the easement was granted and could have been developed within  the conservation easement restrictions. Since the taxpayer’s experts made no attempt to determine the highest and best use of the property after the easement was granted by considering the potential for single-family residential development the report was stricken based on Daubert considerations and the deficiency om tax for the amount claimed by the Service upheld based on the value opined by the government’s experts.

The taxpayer also argued that the Service accepted the appraisal it filed as “qualified” under pertinent portions of the regulations and therefore the government should be estopped from denying such report's admissibility. The Tax Court quickly disposed of this argument by stating that an  appraisal may be "qualified", i.e., sufficiently independent,  for one purpose but lacking in evidentiary weight for another. See Section 170(f)(11)(E) (“qualified appraiser” requirement for substantiation of charitable contributions of property in excess of $500,000). See Evans v. Commissioner, T.C. Memo. 2010-207. TC Rule 143(a).

Therefore, the Court ruled that the taxpayer’s expert report was not the product of reliable methods and the appraisers did not apply reliable principles and methods reliably to the facts in the case. This is based on the finding that the report assumes scenarios that are unrealistic in view of the facts of the case and therefore are not relevant. It  granted the government’s motion in limine and found the record in the case fully supported the government’s experts of the valuation (deduction amount) for the conservation easements. Indeed it had no other conclusion to reach on the record assuming that the government's expert report was admissible which it was.

Implications of The  Tax Court's Boltar Decision 

The Boltar case should be viewed as a “wake up” call to tax practitioners and estate planners that the Tax Court will throw out biased or improperly based expert reports when, as to the latter situation, it finds that the reports themselves lack foundation based on methodology or ignore the essential facts concerning the nature of the property that is the subject of the valuation dispute. Note again that the government was very late in asserting penalties be imposed in this case and therefore the taxpayer lost the case but was not penalized . Had such penalties been timely raised by the government the taxpayer may have had a most difficult time to overcome its burden of persuasion  against an enhanced accuracy related penalty given the application of the Daubert principle by the Tax Court in this case. The penalty in this case could have been imposed for up to 40% of the underlying deficiency in tax. See Sections 6662(b)(3), 6662(b)(5), 6662(e), 6662(g) and 6662(h).

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On September 19, 2011 the President submitted to the Joint Select Committee on Deficit Reduction a limited number of international tax reform proposals which the Administration “scored” for budgetary purposes as reducing the deficit by approximately $112 billion over a 10 year period. The changes proposed were essentially the same ones that were part of the President’s 2012 budget proposal announced last February. Some tax commentators were disappointed that there is no real comprehensive reform, such as shifting from a worldwide system of taxation to a territorial or sourcing based system as some had advocated.

The idea of enacting wide ranging reforms in this area would first require a consensus of what such new or revised system would look like, perhaps with or without a value added tax being part of the mix as many treaty partners have added. Then, the conceptual reforms or policy reforms reflected in such new or revised system would undoubtedly  require a rethinking of many rules contained in or otherwise directly linked with the foreign tax provisions in the Code, including the subpart F rules for current inclusion of such income to U.S. shareholders of controlled foreign corporations, the passive foreign investment company or PFIC provisions,  reorganization provisions, dividend treatment from foreign based subsidiaries would be just several of a host of provisions that would have to be addressed. Such reforms would undoubtedly have treaty impacts which treaties might require revision or at least negotiations as to whether revisions were necessary.

So perhaps massive reforms in this area are not appropriate at this time given the uncertain economic times we are living through. Reshuffling the deck chairs of the "ship" of our international tax system might add to the uncertainties we currently face. Still, a simple reduction in the corporate tax rate to a rate competitive in the worldwide market might be quite attractive to inspire increased investment  and employment in the U.S. by both multinationals and U.S. based companies. For the “reformers” the President’s proposals have been criticized as unattractive and simply broadening the base of (foreign source) income that is subject to current taxation.

The International Tax Reforms Being Proposed by the Obama Administration At This Time

Defer deduction of interest expense related to deferred income. Under current law, a taxpayer that incurs interest expense properly allocable and apportioned to foreign-source income may be able to deduct that expense even if some or all of the foreign source income is not subject to current U.S. taxation. To provide greater matching of the timing of interest expense deductions and recognition of associated income,the proposal would defer the deduction of interest expense properly allocable and apportioned to foreign-source income to the extent the U.S. taxation of such income is deferred. This would reduce the deficit by $36 billion over 10 years.

Determine the foreign tax credit on a pooling basis. Under the proposal, a taxpayer would be required to determine foreign tax credits from the receipt of a dividend from a foreign subsidiary on a consolidated basis for all its foreign subsidiaries. Foreign tax credits from the receipt of a dividend from a foreign subsidiary would be based on the consolidated earnings and profits and foreign taxes of all the taxpayer's foreign subsidiaries. This would reduce the deficit by $53 billion over 10 years.

Tax excess returns associated with transfers of intangibles offshore currently. The IRS has broad authority to allocate income among commonly controlled businesses under section 482 of the Internal Revenue Code. Notwithstanding the transfer pricing rules, there is evidence of income shifting offshore,including through transfers of intangible rights to subsidiaries that bear little or no foreign income tax. Under the proposal, if a U.S parent transfers an intangible to a controlled foreign corporation (CFC) in circumstances that demonstrate excessive income shifting from the United States, then an amount equal to the excessive return would be treated as subpart F income. This would reduce the deficit by $19 billion over 10 years.

Limit shifting of income through intangible property transfers. The definition of intangible property for purposes of the special rules relating to transfers of intangibles by a U.S. person to a foreign corporation (section 367(d) of the Internal Revenue Code) and the allocation of income and deductions among taxpayers (section 482) would be clarified to prevent inappropriate shifting of income outside the United States. This would reduce the deficit by $1 billion over 10 years.

Limit earnings stripping by expatriated entities. Under the proposal, the rules that limit the deductibility of interest paid to related persons subject to low or no U.S. tax on that interest would be amended to prevent inverted companies from using foreign-related party and certain guaranteed debt to reduce inappropriately the U.S. tax on income earned from their U.S. operations. This would reduce the deficit by $4 billion over 10 years.

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Section 6662 imposes an accuracy-related penalty for various types of infractions in tax, including underpayments attributable to negligence or disregard of rules or regulations (§6662(b)(1)) or a “substantial understatement of income tax” (§6662(b)(2)). A substantial understatement of income tax exists where the amount of the understatement for a taxable year exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. For a regular or C corporation a substantial understatement of income tax is present where the amount of the understatement for the tax year exceeds the lesser of $10,000 or $10,000,000. The substantial understatement penalty is reduced by the portion of the understatement attributable to the tax treatment of any item contributing to the understatement for which there is or was “substantial authority”, or, alternatively where the questionable item was adequately disclosed on the tax return. This relief rule does not apply to “tax shelters” which term is broadly defined for purposes of this provision. Other accuracy-related penalties are imposed on valuation misstatements, substantial estate or gift tax valuation understatements or substantial overstatement of pension liabilities. More recently, Section 6662(b)(6) imposes a special accuracy related penalty of up to 40%, generally accuracy-related penalties are limited to 20% of the resulting tax caused by the violation, for claimed tax benefits that are undisclosed on the return which are disallowed by application of the economic substance doctrine under Section 7701(o). Penalties for the failure to comply with the reportable transaction rules also subjects a taxpayer to a separate penalty under Section 6662A.

Under Section 7491(c), the Commissioner bears the burden of production and must produce sufficient evidence that the imposition of the penalty is appropriate in a given case. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets this burden, the taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect. Tax Court Rule 142(a).

Mitigation of the Accuracy-Related Penalty

It is only natural that when the particular treatment of an item on a tax return runs the risk of being challenged by the Service, including the assertion of an accuracy-related penalty, the tax advisor will consult with its client and discuss the risks involved in taking what might be labeled as “aggressive” position and whether a penalty can be avoided if the item in question generates a deficiency in tax. As mentioned, in some cases the presence of “substantial authority” for the treatment of a particular item on the return (which treatment is ultimately determined to be incorrect) or the filing of an adequate disclosure statement giving the Service notice of the particular item in question and its treatment on the return, will, in many instances, avoid the imposition of the penalty.  In addition, there is always the idea that the taxpayer’s reliance on its tax advisor(s) in taking the questionable position on the return provides a sufficient basis to avoid the penalty. More specifically, Section 6664(c)(1) provides that "[n]o penalty shall be imposed under section 6662 ... with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion." Under Treas. Reg. §1.6664-4(b)(1), reliance on professional advice can meet the requirements of “reasonable cause” and “good faith” provided, under all circumstances, such reliance was reasonable and the taxpayer in fact acted with good faith. Treas. Reg. §1.6664-4(c)(1) states that "[a]ll facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer ... under Federal tax law.” The presence of actual reliance on a qualified professional tax advisor may not assure a successful defense to an accuracy-related penalty will be the outcome although dictum from the Supreme Court’s decision in Boyle might be persuasive that a “per se” rule is proper. In United States v. Boyle, 469 U.S. 241, the Supreme Court stated: "When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.... ‘Ordinary business care and prudence’ does not demand such actions." 

Under Treas. Reg. §1.6664-4(c)(2), “advice” is “any communication *** setting forth the analysis or conclusion of a person, other than the taxpayer”. (emphasis added). See §7701(a)(14). The determination of whether a taxpayer acted with reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer's efforts to assess its proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor.   The Tax Court recently addressed the reasonable cause defense in Seven W. Enterprises, Inc. v. Commissioner, 136 T.C. No. 26 (2011) and in Woodsum v. Commissioner, 136 T.C. No. 29 (2011). 

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Under §116 of The Canadian Income Tax Act (“CITA”), non-residents who dispose of certain taxable Canadian property, a/k/a “Canadian Taxable Property”, must notify the Canada Revenue Agency (“CRA”) of the pending sale either prior to the disposition or within 10 days after the closing. In addition, where the CRA has received either an amount to cover the tax on any gain the non-resident seller  may realize upon the disposition of property, or appropriate security is provided for the tax, the CRA will issue a certificate of compliance to the seller-non-resident and a copy of the certificate is also delivered to the purchaser.

Where the purchaser does not receive such certificate, the purchaser is required to remit a specified amount, i.e., 25% of the gross sales price,  to the Receiver General for Canada and is entitled to deduct the amount from the purchase price. Any payments or security provided by the non-resident seller and/or purchaser will be credited to the seller's account. A final settlement of tax will be made when the non-resident's income tax return for the year is assessed.

Canadian Taxable Property (“CTP”)

Canadian Taxable Property includes: (1) real property situated in Canada; (2) property used or held in, or eligible capital property in respect of, a business carried on in Canada;(3) designated insurance property of an insurer; (4) privately issued stock of a corporation resident in Canada; (5) shares of a non-resident, privately owned corporation that are not listed on a prescribed stock exchange if, at any time during the last sixty months(i) more than 50% of the fair market value of all the property of the non-resident corporation was made up of CTP, Canadian resource property, a timber resource property, an income interest in a trust resident in Canada, or an interest or option in such properties; and (ii) more than 50% of the fair market value of the shares was derived directly or indirectly from real property situated in Canada, Canadian resource properties or timber resource properties, or any combination of such properties; (6) publicly traded shares in a Canadian company if at any time during the last sixty months, 25% or more of the shares of the corporation belonged to the taxpayer and/or persons with whom the taxpayer did not deal at arm's length;(7) an interest in a partnership if, at any time during the last sixty months (i) more than 50% of the FMV of all property was of CTP, etc., and (ii) more than 50% of the FMV of the partnership interest was derived directly or indirectly from real property in Canada; (8) a capital interest in a Canadian resident trust (other than a unit trust; (9) a unit of a Canadian resident unit trust (other than a mutual fund trust); (10) a unit of a mutual fund trust if, at any time during the last sixty months, 25% or more of the units of the trust belonged to the taxpayer and/or persons with whom the taxpayer did not deal at arm's length; and (11) an interest in a non-resident trust if, at any time during the last sixty months, the trust  was essentially comprised by CTP. Certain types of Canadian property are excluded from the definition of CTP.

Section 116 does not provide for treaty exempt status. However, the CRA permits a non-resident taxpayer  to claim an exemption under a specific tax treaty at the time they file the notification of disposition. Non-resident sellers must state the applicable article and paragraph of the particular treaty that Canada has with their country of residence. To expedite the processing of the exemption, the necessary documentation to support the claim should be submitted along with the request. The documentation must be based on the particular tax treaty under which the exemption is claimed, and would include items such as proof of residency, or proof that the gain has been or will be reported in the vendor's country of residence.

Section 16 is a controversial part of the Canadian tax law since it is somewhat broad-sweeping in its application and imposes a substantial degree of notification, certification and advance tax requirements.

As recently reported in a just published Tax Notes article authored by Michael N. Kandev and Fred Purkey of Davies Ward Phillips & Vineberg LLP in Montreal, last year, the CRA attempted to limit the scope of §116, both on substantive and procedural rules. One new limitation is that “treaty exempt” property is no longer CTP.  See U.S.-Canadian Income Tax Treaty, Article XIII(3). Another new provision, this one effective March 4, 2010, narrowed the definition of CTP to certain Canadian real or business property and interests in entities that have substantial investments, based on value, in Canadian real property or mineral properties.  Under this narrowed framework, shares in a private Canadian corporation are CTP only to the extent that at any time during the five-year period preceding the disposition, they derived, directly or indirectly, more than 50% of their value from Canadian real property or Canadian resource properties.

Well-received by taxpayers and their advisers, the above changes were a significant change in the law in Canada. While the §116 reforms represented a favorable development for foreign investment in Canada, there are still certain rules that will continue to cause complexity and uncertainty. Among such problems noted by Messrs. Kandey and Purkey are the 5 year valuation lookback rule for shares and interests in partnerships and trusts

By far the main impediment to the intended results of the March 4, 2010, amendments has been the five-year valuation lookback for shares and interests in partnerships and trusts that is now the cornerstone of the amended definition of TCP.See Canadian Income Tax Act §248, ¶¶(d), (e). This 5 year lookback rule poses substantial uncertainty as to whether interests in private Canadian corporations holding ownership interests in real property are CTP or not period the business has not derived more than 50 percent of its value from Canadian real estate.

It is important to understand that a buyer of CTP from a non-resident, where the property is not “treaty exempt property”, still has potential liability in the transaction. As mentioned, the CRA must be notified of the sale, a tax clearance certificate must be obtained, and, in certain instances, the buyer must withhold and pay over within 30 days of the closing generally, 25%f the gross purchase price of the property.  Messrs. Kandey and Purkey warn that if the purchaser assumes incorrectly that the sale was exempt from tax on the erroneous belief that the subject property is not CTP, the CRA, in its view, is likely to turn first against the purchaser.  So, its “caveat emptor” to the purchaser of Canadian situs property from a non-resident. Reasonable cause does not appear to be a defense to the purchaser. Compounding this problem is that the purchaser’s liability, under CITA § 116(5), does not appear to be subject to a particular statute of limitations.  This can have major impacts on successor or transferee liability let alone buyers of companies which have purchased assets from Canadian non-residents.

Obviously, it is important to seek the advises of a Canadian tax advisor when this issue arises. There are also potential treaty issues involved, for example, if a U.S. owner of tax exempt property is trying to sell Canadian property and the buyer is resistant to accept such status for whatever reason. Witholding 25% of the gross sales price on an exempt sale (by treaty) where the buyer stubbornly refuses to accept a treaty exemption certificate statement will drive up the non-resident seller’s compliance costs. A U.S. tax adviser can advise U.S. persons on treaty issues that impact on the presence of tax exempt treaty property. Lurking  in the background for the U.S. seller of CTP are foreign tax credit issues.

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