Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

In press releases issued last week from the HM Revenue & Customs (HMRC) as well as the U.S. Internal Revenue Service (IRS) and Australian Tax Office (ATO), the tax administrators announced that have been and will continue to share over 400 gigabytes of data on the use of companies, foundations and trusts in a number of territories around the world, including the British Virgin Islands, the Cayman Islands, the Cook Islands and Singapore.  It was not revealed how the information was compiled although the size of the data  is enormous. The collected data includes the identities of owners of such entities and the advisers who helped establish such trusts, foundations and companies. The data may also be shared with other tax administrations, particularly among the G-20 counties, as part of a worldwide effort to fight against tax evasion.

Under the HMRC press release, it announced that it has identified over 100 individuals who benefited, presumably in an improper manner, from the use of such structures and a number of those individuals who had already been identified and are under criminal investigation for offshore tax evasion. The HMRC has identified more than 200 UK accountants, lawyers and other professional advisors who advise on setting up such structures, including foundations, trusts and companies and announced such professionals will be scrutinized and investigated.  The HMRC has announced a voluntary compliance initiative and encourages early disclosure of potential acts of tax evasion or other tax compliance failures. Failure to come forward may result in criminal prosecution or significant fines and penalties.  While both the Chancellor of the Exchequer and the HMRC Commissioner and Director General for Enforcement and Compliance acknowledged that there is nothing inherently illegal about adopting an international structure, especially in light of the global economy, when they involve tax evasion or other serious offenses, including money laundering, then such structures will lead to prosecution of the individuals involved, including the professional lawyers and accountants.

Similarly, the Internal Revenue Service announced in IR-2013-48 issued on May 9, 2013,  that the three counties have been working together already on the gathered data. Again, the Service warned that taxpayers who are non-compliant should participate in the IRS Offshore Voluntary Disclosure Program if and when appropriate or risk possible criminal prosecution. Ultimate authority whether to prosecute for tax evasion and FBAR failures as well as other U.S. Title 18 offenses, will lie with the Department of Justice.

On May 10, 2013, the Australian Tax Office (ATO) also announced the agreement among the three countries and acknowledged that more than 100 Australian taxpayers have been identified as being involved in suspicious offshore arrangements. The ATO is looking at cases involving “tens of millions of dollars” in suspected tax avoidance through the use of “shell companies” and “trusts” around the world including Singapore, the BVI, the Cayman Islands and the Cook Islands.  The ATO acknowledged that two cases have been referred for criminal investigation and 30 more cases are underway. 

In one case currently under investigation, the ATO described the conduct as involving a company based in Sydney which has extensive offshore loans (exceeding $20 million) which has alleged claimed millions of dollars in false interest expense. The loans appear to be shams since the offshore lender is controlled by the Australian taxpayers.

In another case under investigation, a Melbourne based individual has been involved in dealing extensively in Australian schemes. The taxpayer stated that he has transacted in securities on behalf of offshore entities or clients. But, the information mined under the data indicates that he is the real owner of such shares, which have a value in excess of $25,000,000. 

As with the U.K. and the U.S., Australia has also entered into numerous tax information exchange agreements with foreign countries, including non-treaty countries.

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In PPL Corporation & Subsidiaries, 111 AFTR 2d ¶2013-723 (5/20/2013), the Supreme Court, in an unanimous decision,  per Justice Thomas, resolved a split of authority between the Fifth and Third Circuits, and held that the United Kingdom’s one-time “windfall tax” paid by the taxpayer through a U.K. based partnership, were creditable foreign taxes  under §901(a). The Supreme Court agreed with the Tax Court below and the taxpayer that the windfall tax in issue  had the predominant characteristic of an “excess profits tax” within the meaning of Treas. Reg. §1.901-2(a) and therefore was creditable under §901.  Thus, the Court reversed the decision of the Third Circuit Court of Appeals holding to the contrary.

The “windfall tax” in issue was imposed under a new Labour Party adopted rule when it took over control of the Parliament in 1997.  Previously, the Labour Party objected to the concept of privatization embraced by the Conservative wing. The new tax was imposed on 32 U.K. companies that were authorized to privatize between 1984 and 1996 by the Conservative government. PP&L Resources, Inc. (PP&L) was a global energy company. Through various subsidiary corporations, it produced electricity, sold wholesale and retail electricity, and delivered electricity to customers. It provided such services in the United States in the Mid-Atlantic and Northeast regions and also in the United Kingdom. During 1997, South Western Electricity plc (SWEB) a U.K. private limited liability company, was PP&L’s indirect subsidiary. Its principle activities at the time included distribution of electricity to 1.5 million customers in England.

In 1990, the U.K. privatized 12 regional electric companies including SWEB. The ordinary shares or common stock of these companies were sold to the public as part of a “flotation”. Some of the companies were required to continue providing services for a fixed period at the same rates offered under government (pre-privatized) control. Many of these companies became far more efficient and earned substantial profits in the process of the privatization.  The one-time windfall profits tax was 23% of the difference between each company’s “profit-making value” and its “flotation value,” the price for which the U.K. government sold the stock which many British subjects felt was priced below value.

The relevant statute defined each company’s “profit-making value” as its average annual profit times its price-to-earnings ratio. Average annual profit was defined as the average daily profit over a stated “initial period” which for SWEB was the first four years after privatization times 364. Instead of using the companies’ actual price-to-earnings ratios, the statute imputed a ratio of 9 for all companies, as the government thought that such ration “approximates to the lowest average sector price-to-earnings ratio of the companies liable to the tax”. SWEB filed the windfall tax return with the Department of Inland Revenue in November 1997 and paid its windfall tax obligation.

Under §901(b), a credit for foreign taxes accrued or paid by a taxpayer is allowed only for those taxes imposed by a foreign country or U.S. possession which are income, war-profits, or excess profits taxes; or taxes imposed in lieu of income taxes upon gross income, gross sales, or units of production. For a foreign tax to be creditable, its predominant character must be that of an income tax in the U.S. sense. The predominant character of a foreign tax is that of an income tax in the U.S. sense if the foreign tax is likely to reach net gain in the normal circumstances in which it applies and isn't a soak-up tax (i.e., a tax liability which depends on the availability of a credit for the tax against an income tax liability to another country).  Treas. Regs. §§ 1.901-2(a)(1)(ii), Reg. § 1.901-2(a)(3).

The petitioner in the tax case, PPL Corporation, was a part owner of the privatized SWEB, and claimed, against its U.S. income tax liability, its pro rata share of the credit for the windfall tax the plc paid in 1997.  In doing so it relied upon §901(b)(1) which provides that any “income, war profits and excess profits taxes” paid overseas are creditable against U.S. income taxes. Treas. Reg. §1.901-2(a)(1)  provides that a foreign tax is creditable if its “predominant character” is that of an income tax in the U.S. sense. This regulation codified a longstanding principle that can be sourced to Biddle v. Commissioner, 302 U.S. 573, 578-579 (1938). See also United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 145 (1989(application to §902)).  

The Internal Revenue Service, in auditing PPL’s 1997 corporate income tax return, denied the foreign tax credits for the “windfall tax” paid by the U.K. plc for 1997.   SWEB’s windfall tax was approximately 90.5 million pounds. In response to proposing a deficiency in federal income tax for the believed to be “non-creditable” foreign tax, the taxpayer filed a petition with the Tax Court. The Tax Court found for PPL since the windfall tax was an amount, under U.S. tax principles, which could be viewed as a tax on excess profits in accordance with the regulations, i.e., its “predominant character” is that of an income tax in the U.S. sense. The tax was on the “net gain” derived by the U.K. plc of which a pro rata portion directly passed through to its U.S. partner. See 135 T.C. 304 (2010).

The government appealed the Tax Court’s decision before the Third Circuit Court of Appeals. The Tax Court’s decision was reversed. 665 F.2d 60, 68 (2011).  The appellate court opined that the terms “income, war profits, and excess profits” referred to in Treas. Reg. §1.901-2 should be thought of in the singular sense of whether it is an “income tax”. Accordingly, the Third Circuit stated that a foreign assessment is an “income tax” if it has the predominant character of an income tax in the U.S. tax sense. It therefore must satisfy the U.S. income tax concepts of: (i) a realization event requirement; (ii) the gross receipts requirement; and (iii) the net income requirement. See Treas. Reg. §1.901-2(b). The Service argued that the windfall tax did not meet either the gross receipts or net income requirement. The Third Circuit felt that that the tax base used in the windfall tax could not be the initial period profit alone unless the Court rewrote the tax rate.  In its view, the windfall tax is in substance a tax on the difference between the company’s “flotation value” and its imputed “profit-making value” the later term being based on a formula.  It is the price that the Labour government believed that each company should have been sold for given the actual profits earning during the initial period. The Third Circuit’s decision was in conflict with the Fifth Circuit Court of Appeals taxpayer-favorable decision in Entergy Corporation & Affiliated Subsidiaries v. Commissioner, 683 F.3d 233, 239 (5^th Cir. 2012).

The Supreme Court held that the “predominant character” of the windfall tax is that of an excess profits tax and is creditable under §901.  In reviewing the subject regulation, Treas.Reg. §1.901-2(a)(1), there are several principles that must be addressed. First, the “predominant character” of a tax or the normal manner in which a tax applies is controlling. A foreign tax on income, war profits, or excess profits, in most instances will be creditable even where it affects a handful of taxpayers differently.  Second, a foreign government’s characterization of the tax is not determinative for purposes of Treas. Reg. §1.901-2(a), instead it is its economic effect. Stated more directly, “foreign tax creditability depends on whether the tax, if enacted in the United States, would be an income, war profits, or excess profits tax”.  Third, the regulation provides that the predominant character of the tax is like a U.S. income tax “[i]f …the foreign tax is likely to reach net gain in the normal circumstances in which it applies”. There are three tests under the regulations for determining whether a foreign tax is imposed on net gain.  Again, as mentioned, those three parts are realization, gross receipts and net income . See Treas. Regs. §§1.901-2(b)(2), 2(b)(3) and 2(b)(4).  The Supreme Court viewed the windfall tax as imposed on realized net income which was disguised as a tax on the difference between flotation value and initial period value. In analyzing the algebraic formulation of the tax, the Court noted that the economic effect of the formula was to convert floatation value into the profits a company should have earned given the assumed price-earnings ratio.

The Supreme Court stated that the rearranged tax formula demonstrates that the windfall tax is economically equivalent to the difference between the profits each company actually earned and the amount the Labour government believed it  should have earned given its floatation value. For the 27 companies that had 1,461-day initial periods, the U.K. tax formula effectively imposed a 51.71% tax on all profits earned above a threshold; “a classic excess profits tax”.  It is not, as argued, an imputed gross receipts tax and not creditable.

Based on the logic set forth in the Tax Court’s opinion below and as further magnified in the opinion of Justice Thomas, it may be contended that reason and logic prevailed. It did.  Clearly the regulation in issue should not have been “compressed” into solely a tax on income as the Third Circuit felt. The fact the Court was unanimous in its view, although Justice Sotomayer, in her concurring opinion, wanted to note that if the record were different the tax may not have been analogous to an excess profits tax, is indeed important and may even be surprising to some. For PPL as well as many tax practitioners, the result made perfect sense.

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On May 15, 2013 the Service and the Treasury issued final regulations with respect to the election available under Section 336(e)  which allows certain sales, exchanges, and distributions by a domestic corporation of another corporation's stock as taxable sales of that corporation's assets. (emphasis added). The final regulations, effective on May 15, 2013, adopt, with some alterations, the proposed regulations issued on the subject in 2008. See REG-143544-44.

A major feature of section 336(e) is the disallowed loss rule. The final regulations narrow the scope of the rule as previously set forth in the proposed regulations. As revised, the final regulations, in general, allow the distribution of a controlled subsidiary’s stock or “deemed target” to realize losses in deemed asset disposition made pursuant to a Section 336(e) election to offset the amount of the target's realized gains. The final regulations do however continue the application of the disallowed loss rule where a Section 336(e) election is made and any stock of the target is distributed during a twelve month disposition period, whether or not as part of the qualified stock disposition, any net loss attributable to the stock distribution is disallowed. Any excess losses are permanently disallowed under the final regulations.

Background

Enacted in the Tax Reform Act as part of the repeal of the General Utilities doctrine, Section 336(e) authorizes the issuance of legislative regulations whereby a domestic corporation may elect to treat the distribution of certain stock of a controlled subsidiary to be treated as a sale, exchange or distribution of all of the controlled subsidiary’s (target corporation’s) assets. In order to qualify for the election, the distributing corporation must be in control of the target corporation under Section 1504(a)(2), i.e., owns at least 80% of both the combined voting power and value of the target corporation. Similar to an election under Section 338(h)(10) with respect to certain sales of stock of a controlled subsidiary, Section 336(e) was intended, once regulations were issued, to allow taxpayers to avoid incurring multiple levels of taxation of the same economic gain in instances where a transfer of appreciated stock in a controlled subsidiary is taxed and such gain realization does not provide for a corresponding step-up in basis of the assets of the corporation. See H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess., Vol. II, 198, 204 (1986), 1986-3 CB, Vol. 4, 198-207. 

Proposed Regulations Issued in 2008

On August 25, 2008, the IRS and Treasury issued a notice of proposed rulemaking in the Federal Register (REG-143544-04, 2008-42 IRB 947 [73 FR 49965-02]) (the proposed regulations) that, when finalized, would permit certain taxpayers to make an election to treat certain sales, exchanges, and distributions of another corporation's stock as taxable sales of that corporation's assets.

Summary of Proposed Regulations

Under the proposed regulations, an election under Section 336(e) is available for "qualified stock dispositions" of domestic target stock by domestic corporate sellers (seller). The proposed regulations generally adopt the structure and principles established under Section 338(h)(10) and the underlying regulations. For example, the proposed regulations generally incorporate the rules of Section 338 governing the allocation of consideration in the resulting deemed sale of the target's assets and the determination of target's basis in its underlying assets resulting from such deemed sale. The proposed regulations alter terms or concepts to reflect principles and factual circumstances relevant to Section 336(e).

Unlike an election under Section 338(h)(10), which is available only if target stock is acquired by a corporate purchaser, the proposed regulations do not require an acquirer of target stock to be a corporation, or even necessarily a purchaser. See Section 338(d)(1). Also unlike Section 338(h)(10), which generally requires that a single purchasing corporation acquire the stock of a target, the proposed regulations permit the aggregation of all stock of a target that is sold, exchanged, and distributed by a seller to different acquirers for purposes of determining whether there has been a qualified stock disposition of a target.

The proposed regulations provide two different models for the deemed transactions treated as occurring if a section 336(e) election is made. The first model generally follows the same structure used for the deemed transactions resulting from the making of a Section 338(h)(10) election (basic model) and is applicable to all qualified stock dispositions (including those consisting of taxable distributions of target stock) other than distributions described in Sections 355(d)(2) or 355(e)(2) (Sections355(d)(2) and (e)(2) transactions). Under the basic model, target, while owned by the seller (old target), is treated as selling all of its assets to an unrelated person and new target is treated as acquiring all of its assets from an unrelated person at the close of the date on which the threshold amount of target stock is disposed (deemed asset disposition).

Old target recognizes the Federal income tax consequences from the deemed asset disposition before the close of the date on which its stock was disposed. After recognizing the tax consequences of the deemed asset disposition, old target is generally treated as liquidating into the seller. In addition, to the extent that the qualified stock disposition consisted of one or more distributions (rather than sales or exchanges) of the stock of a target (other than in Section 355(d)(2) and (e)(2) transactions), the seller is treated as acquiring directly from new target an amount of new target stock equal to the amount of target stock distributed. The tax consequences of the purchaser(s) generally are unaffected by the Section 336(e) election.

The second model adopted by the proposed regulations for the deemed transactions resulting from a  Section 336(e) election applies to Sections 355(d)(2) and (e)(2) transactions (sale-to-self model). Under the sale-to-self model, old target (the controlled corporation) is deemed to remain in existence; old target is treated as if it sold its assets to an unrelated person and then repurchased those assets. Following the deemed asset disposition, old target (the controlled corporation) is not deemed to liquidate into seller (the distributing corporation). Instead, after old target's deemed repurchase of its own assets, seller is treated as distributing the stock of old target to its shareholders, with seller recognizing no gain or loss. Because no liquidation of old target into seller is deemed to occur, old target will generally retain the tax attributes it would have had if the Section 336(e) election had not been made, adjusted for the creation or absorption of attributes resulting from the election.

The Disallowed Loss Rule

The proposed regulations contain a rule that disallows the recognition of losses resulting from the deemed asset disposition to the extent the qualified stock disposition consisted of one or more distributions of target stock (disallowed loss rule). The preamble to the proposed regulations explains that the allowance of losses pursuant to a deemed asset disposition may be inconsistent with Sections 311(a) and 355(c) because had the target stock been distributed, any loss in the target stock would not have been recognized pursuant to these provisions.

Time and Manner of Making a Section 336(e) Election

The time and manner of making a section 336(e) election provided in the proposed regulations also differed from those for making an election under section 338(h)(10). Noting that a joint election may be burdensome in cases with multiple purchasers, the proposed regulations provide that a section 336(e) election is unilaterally made by a seller attaching a statement to its timely filed Federal income tax return for the taxable year that includes the disposition date.

The Disallowed Loss Rule

The IRS and Treasury Department received  comments that the disallowed loss rule of the proposed regulations was overbroad and might frustrate the intent of mitigating multiple levels of tax  that Section 336(e) was to mitigate.  In this regard it was noted by one commentator that the rationale for the disallowed loss rule, i.e., that asset losses should not be allowed because a loss in target stock would not be recognized under Sections 311(a) or 355(c), did not extend to a seller's distribution of target stock under Section 336(a). This is because the seller generally would recognize the loss with respect to the target stock in such a case.  It was suggested, for example, that realized losses in the deemed asset disposition should be netted against the amount of realized gains and that to the extent realized losses exceed realized gains, the net loss should be deferred by attaching the net loss to the basis of the assets in target's hands after the deemed asset disposition.

In response, the Service and Treasury share the view that  the disallowed loss rule as set forth in the proposed regulations is broader in scope than necessary to serve the purposes of Section 336(e). Accordingly, the final regulations modify the rule of the proposed regulations to generally permit target's realized losses in the deemed asset disposition to offset the amount of target's realized gains. Thus, the proposed regulations disallow a net loss of target (that is, losses realized in excess of target's realized gains) recognized on a deemed asset disposition, but only in proportion to the portion of target stock that was disposed of by seller in one or more distributions.

The loss disallowance rule in the proposed regulations only applied to distributions that were taken into account as part of the qualified stock disposition on or before the disposition date. Thus, stock distributions that occurred after 80% of target was disposed of were not subject to the loss disallowance rule. The final regulations modify the disallowed loss rule of the proposed regulations to take into account: (i) target stock distributed at any time within the 12-month disposition period, not just on or before the disposition date; and (ii)  target stock distributed within the 12-month disposition period that is not part of the qualified stock disposition, such as stock distributed to a related person.

The Preamble to the final regulations states that limiting disallowed losses to stock distributed on or before the disposition date could lead to manipulation because sellers who would otherwise distribute target stock on the disposition date may delay the distribution for the sole purpose of decreasing the disallowed net loss recognized by target. Further, if stock distributions that are not part of the qualified stock disposition, such as distributions to a related person, were not taken into account by the disallowed loss rule, target would be able to recognize a greater portion of its net loss by distributing stock to a related person than it would recognize if it distributed the stock to an unrelated person, a result that the IRS and Treasury Department believe would be improper. Accordingly, under the disallowed loss rule of the final regulations, if a Section 336(e) election is made and any stock of target is distributed during the 12-month disposition period, whether or not as part of the qualified stock disposition, any net loss attributable to such stock distribution is disallowed.

The government's recognition of what was the Congressional intent in providing for a Section 336(e) election is the prevention of multiple levels of gain covering the same economic transaction. It was not concerned with the preservation of loss. The suggestion that Section 336(e) should allow loss deferring by  adding the basis to target's assets would create administrative difficulties far outweighing the benefits, and disallowing losses rather than deferring losses is consistent with many other provisions within subchapter C. Accordingly, to the extent the disallowed loss rule of the final regulations applies, losses are allowed up to the amount of gains and any excess losses are permanently disallowed.

 Issues Relating to the Two Adopted Models

 In general, the final regulations retain the rules of the proposed regulations for deemed transactions under the basic model. In response to a critical comment received with respect to the proposed regulations,  the final regulations modify the proposed regulations by providing that in a distribution of target stock (and also with respect to stock in target that seller retains after the distribution date) seller is deemed to purchase the new target stock that is distributed or retained not from new target but from an unrelated person in a taxable transaction. Seller will not recognize any gain or loss on the deemed distribution of new target stock and purchaser will have a fair market value basis in new target stock received without any possible application of Section 351.

Some suggested that the second model, the "sale-to-self" model, be removed as well as the extension of the provisions of Treas. Reg. § 1.336-2(b)(1), with any necessary adjustments, to Section 355(d)(2) or (e)(2) transactions. It was felt that the sale-to-self model added unnecessary complexity and that existing law under Section 312(h) and that Treas. Reg. § 1.312-10 adequately addressed the concern of having sufficient earnings and profits to allocate to the controlled corporation. Although the IRS and Treasury Department agree with the commenters who pointed out that even if target was treated as a new corporation after the deemed sale of its assets, the rules of Section 312(h) and  Treas. Reg. § 1.312-10 would typically result in target having some level of earnings and profits after the distribution of its stock, the IRS and Treasury Department still believe that the sale-to-self model should be retained. While the deemed transactions resulting from the making of Section 336(e) elections with respect to taxable sales, exchanges, or distributions of target stock could actually be undertaken in a transaction involving the sale, exchange, or distribution of the assets of target, a transaction that included an actual sale or distribution of all the assets of target could not qualify under Section 355. Since a deemed sale of assets to a new target is not part of Section 355(d)(2) or (e)(2) transactions, the government takes the view  that the predominant feature of the Section 336(e) election with respect to a Section 355(d)(2) or (e)(2) transaction is the Section 355 transaction, the regulations adopt the sale-to-self model and treat the transaction as the distribution of old target stock. Additionally, the IRS and Treasury Department do not believe that the sale-to-self model adds significant complexity to the regulation; in fact, it may reduce complexity. 

On the other hand, some comments were to the effect that if the regulations retain the sale-to-self model, the regulations should address the wash sale rules of Section 1091 and the anti-churning rules of Section 197(f)(9). For example, old target's deemed disposition of stock or securities and subsequent repurchase of the same stock or securities could be treated as a wash sale, which could then be subject to loss disallowance under Section 1091(a) as well as the disallowed loss rule of these regulations. Under the Section 336(e) regulations, the basis of the stock or security deemed purchased by target should be its fair market value, while under Section 1091(d), the basis would be the basis of the stock or security deemed transferred plus or minus any difference in the sale and acquisition price of the stock or security.

The Preamble rejects this position and the final regulations did not adopt a rule whereby the sale-to-self model should cause Sections 197(f)(9) or 1091 to apply to a Section 336(e) election with respect to a Section 355(d)(2) or (e)(2) transaction.

Time and Manner for Making the Election

In modifying the proposed regulations, under the final regulations, in order to make a Section 336(e) election, seller(s), or in the case of an S corporation target, all of the S corporation shareholders for an S corporation target), and target must enter into a written, binding agreement to make a Section 336(e) election and a Section 336(e) election statement must be attached to the relevant return. Where the seller(s) and target are members of a consolidated group, the election statement is filed on a timely filed consolidated return and the common parent of the consolidated group must provide a copy of the Section 336(e) election statement to target on or before the due date (including extensions) of the consolidated group's consolidated Federal income tax return. If target is an S corporation, the election statement is filed on the S corporation's timely filed return. If seller and target are members of an affiliated group but do not join in the filing of a consolidated return, the election statement is filed with both seller's and target's timely filed returns.

Several commenters also requested changing the due date of the election from the due date of the seller's return to the 15th day of the ninth month after the disposition date, the same time for making a section 338 election. The commenters were concerned that the due date in the proposed regulations could result in many instances in which target's tax return would be due before the due date for the election (because target's taxable year will close upon its deemed dissolution), and therefore target would be required to file its return without knowing whether a Section 336(e) election was made. The final regulations retain the rule that the election must be made by the due date of the relevant tax return.  Reasons for taking this position were discussed in the Preamble.

Because the general requirements for who must file a section 336(e) election statement have been modified from the proposed regulations, these final regulations provide detailed requirements to assist taxpayers in making a section 336(e) election for an eligible subsidiary of target (target subsidiary). See Treas. Reg.  Sec.  1.336-2(h)(4) and (5). Some of these requirements are different than those for making a Section 336(e) election for target subsidiaries under the proposed regulations, which treated the seller of the directly disposed of target (ultimate seller) as the seller of the target subsidiary for purposes of the additional election statement to be attached to the ultimate seller's return. Some of these requirements also differ from those for making a Section 338 election for target subsidiaries on Form 8023, which treats the purchasing corporation(s) of the directly purchased target as the purchasing corporation(s) of any target subsidiary for purposes of completing and signing a Form 8023 for a target subsidiary that is filed outside of any return. For example, if seller and target are members of the seller consolidated group but target subsidiary is not, a Section 336(e) election for target subsidiary now requires that target subsidiary be a party to either the agreement entered into by seller and target, or that target and target subsidiary enter into a separate agreement to make such election. Because target subsidiary is not a member of the same consolidated group as target, the Section 336(e) election for target subsidiary requires that a Section 336(e) election statement must be attached to both seller's timely filed consolidated Federal income tax return and the timely filed Federal income tax return of the target subsidiary.

The Service announced its intent to modify Form 8883,  "Asset Allocation Statement Under Section 338," or create a new form, to include an election under Section 336(e). Until Form 8883 is modified or a new form is created, old target and new target should file Form 8883 to report the results of the deemed asset disposition, making appropriate adjustments as necessary to account for a Section 336(e) election. Examples of appropriate adjustments include treating a reference to Form 8023, a qualified stock purchase, the acquisition date, the 12-month acquisition period, or the aggregate deemed sales price on Form 8883 or the instructions thereto as a reference to the Section 336(e) election statement, a qualified stock disposition, the disposition date, the 12-month disposition period, or the aggregate deemed asset disposition price, respectively. In the case of a Section 336(e) election as the result of a transaction under Section 355(d)(2) or (e)(2), old target should file two Forms 8883 (or successor forms), one in its capacity as the seller of assets in the deemed asset disposition and one in its capacity as the purchaser of assets in the deemed purchase of assets under the sale-to-self model.

Intragroup Sales, Exchanges, or Distributions Prior to External Sales, Exchanges, or Distributions and Section 355(f)

Where stock of a corporation is sold or distributed within an affiliated group and then is transferred outside the affiliated group, a Section 336(e) election is not available for the intragroup transaction because the buyer and seller in the intragroup transaction are related persons after the disposition of target outside the affiliated group. While a Section 336(e) election may be available for the external transfer, the election could result in the affiliated group immediately recognizing multiple levels of gain, both on target's stock from the intragroup transaction and on target's assets from the deemed asset disposition.

Treas. Reg. Sec. 1.1502-13(f)(5)(ii)(C) provides an election a "§ 1.1502-13(f)(5) election") in the case of Section 338(h)(10) and comparable transactions. A Treas. Reg. § 1.1502-13(f)(5) election allows taxpayers to treat the deemed liquidation as the result of a Section 338(h)(10) election or an actual liquidation as a taxable liquidation in order to provide the consolidated group with a stock loss to offset some, if not all, of the intragroup seller's stock gain from the intragroup transaction.  The final regulations the position although the Treasury and Service commented that the general rule of  Treas. Reg. § 1.336-1(a) of the proposed regulations, a Treas. Reg.  § 1.1502-13(f)(5) election would be available for a Section 336(e) transaction without any express confirmation in the final regulations.

A non-group or "external" distribution under Section 355(d)(2) or (e)(2) that is preceded by an intragroup transaction raises the same concerns as those described in the preceding paragraph, but a  Treas. Reg. § 1.1502-13(f)(5) election would not provide relief because in a Section 355(d)(2) or (e)(2) transaction there is no deemed liquidation of target. The IRS and Treasury Department believe that the rationale behind Treas. Reg. § 1.1502-13(f)(5) to prevent multiple levels of taxation exists just as much with a Section 336(e) election as a result of a Section 355(d)(2) or (e)(2) transaction as with a non-section 355(d)(2) or (e)(2) transaction. Therefore, the final regulations provide that in the case of a Section 355(d)(2) or (e)(2) transaction that is preceded by an intragroup transaction, for the limited purpose of a  Treas. Reg. § 1.1502-13(f)(5) election, immediately after the deemed asset disposition of target's assets, target is deemed to liquidate into seller, thus providing seller with a stock loss that can offset some or all of the group's intercompany gain with respect to the intragroup transfer of target stock.

 Elections for S Corporations

The proposed regulations do not provide for a Section 336(e) election with respect to the sale of stock of an S corporation even though a corporation that acquires the stock of an S corporation in a qualified stock purchase may make a Section 338(h)(10) election. It is arguable that access to Section 336(e) should be provided to an S corporation and its shareholders. SeeH.R. Conf. Rep. No. 841, 99th Cong., 2d Sess., Vol. II, 198, 204 (1986) [1986-3 CB, Vol. 4, 198, 204]. After studying the issue, the final regulations permit a section 336(e) election to be made for S corporation targets and provide additional and special rules to allow section 336(e) elections to be made with respect to S corporation targets.

Where a Section 338(h)(10) election is made with respect to an S corporation target, all of the S corporation shareholders, including those who do not sell their S corporation target stock, must consent to the election. With respect to a Section 336(e) election, the final regulations provide the same requirement for purposes of making a Section 336(e) election. While S corporation shareholders consent to a Section 338(h)(10) election by signing Form 8023, to make a Section 336(e) election, the S corporation shareholders do not file a section 336(e) election statement. Instead, consent to make a Section 336(e) election is established by all the S corporation shareholders, including those who do not dispose of their stock in the transaction, and target entering into a written, binding agreement to make the election, on or before the due date (including extensions) of the S corporation target's income tax return. The section 336(e) election statement for an S corporation target is filed with the income tax return of the S corporation target.

Where a Section 336(e) election is made for an S corporation target, old target's S election continuesthrough the close of the disposition date (including the time of the deemed asset disposition and the deemed liquidation) at which time old target's S election terminates, and old target ceases to exist. If new target qualifies as a small business corporation within the meaning of Section 1361(b) and wants to be an S corporation, a new election for new target under Section 1362(a) must be made.

Determination of AGUB and ADADP

It was suggested by commentators that the Aggregate Deemed Asset Disposition Price (ADADP) and Adjusted Grossed-Up Basis (AGUB) be modified by grossing up the selling costs among all stock of target in order to determine ADADP and by grossing up the acquisition costs among all stock of target in order to determine AGUB. It was further requested that rules The disregard preferred stock in determining the percentage of stock disposed of in the qualified stock disposition, and then add back the value of the preferred stock in determining the grossed-up amount realized.

The gross up of selling costs to sellers and acquisition costs to buyers of target stock was address in the Preamble to the Proposed Section 338 regulations in 1999. The Service rejected this argument for costs not actually incurred. See REG-107069-97, 1999-2 CB 346, 353. Accordingly, the final regulations retain the rule of the proposed regulations.

With regard to the preferred stock issue, the determination of grossed-up basis in Section 338 is specifically provided for in the Code, and Congress included preferred stock in determining the percentage of stock attributable to recently purchased stock. The regulations under Section 338 apply the same rule in determining grossed-up amount realized.Accordingly, the final regulations to Section 336(e)  retain the rule of the proposed regulations.

Gain Recognition Elections

Under the proposed regulations, a holder of nonrecently disposed stock may make a gain recognition election, similar to the gain recognition election under Section 338, which treats nonrecently disposed stock as being sold as of the disposition date. The gain recognition election is mandatory if a purchaser owns (after the application of the rules of Section 318(a), other than Section 318(a)(4)), 80% or more of the voting power or value of target stock. Once made, a gain recognition election is irrevocable. The proposed regulations requested comments on whether the rules regarding gain recognition elections in the section 336(e) regulations are appropriate and whether the gain recognition election rules in regulations promulgated under section 338 should continue to apply. The final regulations retain this rule.

Related Party Rules

The proposed regulations provide that a transaction is not a  qualified stock disposition for purposes of Section 336(e) where target stock is sold, exchanged, or distributed to a related person. The proposed regulations, as applicable to the Section 338 regulations, treat persons as related if stock in a corporation owned by one of the persons would be attributed to the other person under Section 318(a), other than Section 318(a)(4).

In response to many comments on the application of the Section 318 attribution rules, the Service and Treasury have recognized that the attribution rules with respect to partnerships are more inclusive than is necessary for Section 336(e) purposes.  Because the attribution rules in Section 318(a) with respect to partnerships do not have a minimum ownership percentage, one partner holds a very small ownership in two different partnerships that own purchaser and seller, respectively, could, under the proposed regulations, prevent the making of a section 336(e) election.  Although some of the same concerns exist with respect to a Section 338(h)(10) election, in such case, the statute clearly prohibits a Section 338(h)(10) election.

With respect to a Section 336(e) election, there is no statutory prohibition against a partnership making the election. The final regulations in addressing this concern, modify the definition of related persons as pertaining to partnerships by providing that, solely for purposes of determining whether purchaser and seller are related for purposes of Section 336(e), the attribution rules of Sections 318(a)(2)(A) and 318(a)(3)(A) will not apply to attribute stock ownership from a partnership to a partner, or from a partner to a partnership if such partner owns, directly or indirectly, less than five percent of the value of the partnership. A 5% threshold is within the range suggested by comments for limiting upstream and downstream attribution under Section 318(a) between partners and partnerships, and is consistent with the 5% threshold of constructive ownership rules under Sections 267(e)(3) and 1562(e)(2) relevant to partners and partnerships.

The proposed regulations look to and build upon Section 338(h)(10) principles and guidelines that address taxable sales and exchanges of target stock. The proposed regulations expanded the Section 338(h)(10) model to include fully taxable distributions and Section 355(d)(2) and (e)(2) distributions. All of these transactions involve a basic taxable event relating to target's stock that is disregarded and in its place a sale of target's assets takes place.

Comments were received suggesting the extension of a Section 336(e) election to transactions in which the corporate level of tax is duplicated by other transactions such as Section 351 or Section 368.  The idea is to provide taxpayers relief from a potential multiple taxation at the corporate level of the same economic gain, which may result when a transfer of appreciated corporate stock is taxed without providing a corresponding step-up in basis of the assets of the corporation.H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess., Vol. II, 198, 204 (1986) [1986-3 CB, Vol. 4, 198, 204]. The final regulations do not address this suggestion and the Preamble notes that to consider the application of Section 336(e) within the context of these other provisions would significantly delay the finalization of the  regulations. In general, the final regulations do not permit an election to be made in non-taxable transfers of target stock. The issue will continue to be studied by the Treasury and the Service.  

International Provisions

The proposed regulations do not apply to transactions in which either seller or target is a foreign corporation. The final regulations contain the same restrictions although the issue will continue to be studied.  

With respect to foreign tax credits, the proposed regulations provide that if a Section 336(e) election is made and the target's taxable year under foreign law  does not close at the end of the disposition date, foreign income taxes paid by new target attributable to the foreign taxable income earned by target during such foreign taxable year are allocated to old target and new target under the principles of Treas. Reg. § 1.1502-76(b).  This would be consistent with a similar rule in Treas. Reg. § 1.338-9(d) for allocating foreign taxes paid by a target that is acquired in a transaction that is treated as an asset acquisition pursuant to an election under Section 338 if the foreign taxable year of target does not close at the end of the acquisition date. In addition, regulations under section 901, which were published on February 14, 2012, provide foreign tax allocation rules, consistent with Treas. Reg. § 1.338-9(d), for certain changes in ownership of a partnership or disregarded entity during the entity's foreign taxable year. See  Treas. Reg. § 1.901-2(f)(4). The final regulations at  Treas. Reg. § 1.336-2(g)(3)(ii) reflect modifications made to achieve consistency with Treas. Reg. § 1.901-2(f)(4). The regulations also provide that if target holds an interest in a disregarded entity or partnership, the rules of  Treas. Reg. § 1.901-2(f)(4) apply with respect to foreign taxes imposed at the entity level on the income of such entities.

Impact on Application of Section 901(m)

 Section 901(m)(1), which was enacted into law in 2010, P.L. 111-226,  provides, in part, that in the case of a covered asset acquisition, the disqualified portion of any foreign income taxes determined with respect to the income or gain attributable to a relevant foreign asset  is not to be taken into account in determining the foreign tax credit allowed under Section 901(a). Section 901(m)(2)(B) defines a covered asset acquisition to include any transaction that is treated as an acquisition of assets for U.S. income tax purposes and as the acquisition of stock of a corporation (or is disregarded) for purposes of a foreign income tax. Because a Section 336(e) election for target is treated as an acquisition of assets for U.S. income tax purposes, and is treated as the acquisition of stock of a corporation (or is disregarded in the case of tiered Section 336(e) elections) for foreign tax purposes, a Section 336(e) election for a target corporation is a covered asset acquisition. See Staff of the Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to H.R. 1586, Scheduled for Consideration by the House of Representatives on August 10, 2010, at 13, footnote 55 (August 10, 2010). Accordingly, the final regulations contain a cross-reference to the rules under Section 901(m), which, for example, could apply if target has foreign branch operations.

Retained Stock

Under the proposed regulations where a  seller retains any stock in target after the 12-month disposition period, seller is treated as purchasing the stock so retained on the day after the disposition date. The proposed regulations provide the holding period and purchase price (and thus the basis) of the retained stock. The regulations under Treas. Reg. § 1.338(h)(10)-1 provide a similar rule concerning retained stock, with the exception that the  Treas. Reg. § 1.338(h)(10)-1 rule only requires that the stock be retained after the acquisition date.

Where the seller of target stock  sells, exchanges, or distributes less than all of its stock prior to the disposition date, but sells, exchanges, or distributes additional stock after the disposition date but before the end of the 12-month disposition period, the proposed regulations do not address the  holding period and purchase price (and thus the basis) of such stock. If the later transaction is part of the qualified stock disposition, the basis and holding period may not be relevant, because no gain or loss is recognized on that transaction. However, if the stock is transferred in a transaction not part of the qualified stock disposition, such as a sale to a related person, the basis and holding period will be relevant. The final regulations adopt the rule contained in Treas. Reg.  § 1.338(h)(10)-1  providing that stock is retained if seller owns the stock after the acquisition date, should be adopted by the regulations under Section 336(e). Accordingly, the final regulations modify the rule of the proposed regulations, so that stock is retained if owned by seller after the disposition date.

Consistency Rules

The proposed regulations generally follow the principles contained in Section 338(h)(10), including the application of the consistency rules of Treas. Reg. § 1.338-8 which provides that if (1) a purchasing corporation (or an affiliate) acquires an asset meeting certain requirements from target (or a subsidiary of target) in a sale during the target consistency period, (2) gain from the sale is reflected in the basis of target stock as of the target acquisition date, and (3) the purchasing corporation acquires stock of target in a qualified stock purchase (but does not make a Section 338 election), then the purchasing corporation is required to take a carryover basis in the acquired asset.

Treas. Reg. § 1.338-8(b)(1)(iii) requires that the same corporate purchaser (or an affiliate) acquire both stock of target and an asset of target (or a subsidiary of target), because, unlike Section 338. In contrast, Section 336(e) does not require a single corporate purchaser of 80% of the stock of target. This means that the consistency rules could apply to any purchase of an asset of target (or a subsidiary of target) if there was also a qualified stock disposition of target, regardless of whether the purchaser of the asset was also the purchaser of target stock.  The Service and the Treasury agree with concerns expressed in comments about the potential breadth of the consistency rules as applied to Section 336(e).  The Preamble states that  the purposes of the consistency rules should not require a carryover basis for an asset unless the same person (or a related person) acquires both the asset of the target (or subsidiary of target) and more than a minimal amount of the stock of target. In addition, it would be inappropriate to limit the consistency rules for purposes of Section 336(e) to corporate purchasers. The final regulations provide that the consistency rules apply to an asset only if the asset is owned, immediately after its acquisition and on the disposition date, by a person (or by a related person to such a person) that acquires five percent or more, by value, of the stock of target in a qualified stock disposition.

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In the April 22^nd edition of Tax Notes, it was reported that the number of taxpayers who were previously accepted in the IRS’ 2012 Offshore Voluntary Disclosure Program and now were notified that they were ineligible was relatively small and that taxpayers “should not be afraid to enter the program”. A recent posting on this blog announced  the Service's initial notice that individuals and persons who were notified by disclosures made by certain banks to IRS demands for lists of account holders and depositors would not be eligible even if previously accepted into the program.

John Mc Dougal, special trial counsel and division counsel, IRS Small Business/Self-Employed Division stated during an ABA Tax Section webcast that media coverage of the policy position on disqualification was overblown and only “dozens” but not “hundreds” were affected. Although some U.S. taxpayers who had previously been accepted into the IRS's offshore voluntary disclosure program (OVDP) have since been deemed ineligible, the numbers are small, and taxpayers should not be afraid to enter the program, government officials said April 10. Individuals who attempt to block disclosure under bank secrecy laws of the jurisdiction in which the account is located or were previously identified on disclosures made to the IRS from the foreign financial institutions are stated to be ineligible.

The Service and apparently the Department of Justice Tax Division, who also had a senior litigation counsel on the program, felt that it had to continue to endorse the merits of the program. It will be interesting to see if individuals who were “accepted” and subsequently “disqualified” and subject to prosecution will be able to quash a resulting information or indictment on notions of due process or agency estoppel. In such case the government would be expected to vigorously challenge such efforts.

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The G-20 on April 19 called on all countries to adopt measures to facilitate the automatic exchange of information in tax matters and looked to the OECD to lead the way by developing a new multilateral standard. Shortly after the conclusion of the G-20 finance ministers' April 18-19 meeting in Washington, the group issued a communiqué  praising the progress made so far in the international movement toward automatic information exchange -- a topic that has in recent weeks dominated news headlines, especially in the EU. The portions of the Communique’ related to exchange of information and transparency of investors are set forth below; other provisions are deleted.

“Communiqué Meeting of Finance Ministers and Central Bank Governors

Washington, 18-19 April 2013

1. We, the G20 Finance Ministers and Central Bank Governors, met to discuss the current situation in the global economy and to bring forward the policy agenda for our Leaders’ summit in September.

14. More needs to be done to address the issues of international tax avoidance and evasion, in particular through tax havens, as well as non-cooperative jurisdictions. We welcome the Global Forum's report on the effectiveness of information exchange. We commend the progress made by many jurisdictions, but urge all jurisdictions to quickly implement the recommendations made, in particular the 14 jurisdictions, where the legal framework fails to comply with the standard. Moreover, we are looking forward to overall ratings to be allocated by year end to jurisdictions reviewed on their effective practice of information exchange and monitoring to be made on a continuous basis.  In view of the next G20 Summit, we also strongly encourage all jurisdictions to sign or express interest in signing the Multilateral Convention on Mutual Administrative Assistance in Tax Matters and call on the OECD to report on progress. We welcome progress made towards automatic exchange of information which is expected to be the standard and urge all jurisdictions to move towards exchanging information automatically with their treaty partners, as appropriate. We look forward to the OECD working with G20 countries to report back on the progress in developing of a new multilateral standard on automatic exchange of information, taking into account country-specific characteristics. The Global Forum will be in charge of monitoring. We welcome the progress made in the development of an action plan on tax base erosion and profit shifting by the OECD and look forward to a comprehensive proposal and a substantial discussion at our next meeting in July.

15. We reiterate our support for FATF work, notably the identification and monitoring of high-risk jurisdictions with strategic AML/CFT deficiencies. We must tackle the risks raised by opacity of legal persons and legal arrangements, and encourage all countries to take measures to ensure they meet the FATF standards regarding the identification of the beneficial owners of legal persons, other corporate vehicles and trusts, that is also relevant for tax purposes.

Financial Inclusion

16. We welcome the launch of the Financial Inclusion Support Framework. We welcome the upcoming Seminar on “Women and Finance” and the launch of the Women’s Finance Hub hosted by the SME Finance Forum, which will provide best practices and knowledge sharing.  We call on the Global Partnership for Financial Inclusion to report on the gaps and challenges in the global environment for SME finance, as well as potential policy responses, by our July meeting. We welcome the Financial Action Task Force’s revised Guidance on Financial Inclusion as an important step in helping to create an enabling regulatory environment for innovative financial inclusion.”

The Communique also stated: "We welcome progress made towards automatic exchange of information which is expected to be the standard and urge all jurisdictions to move towards exchanging information automatically with their treaty partners, as appropriate," the group said.

The G-20 comments came shortly after the OECD on April 19 released a report  prepared for the finance ministers' meeting to update them on the work the organization has been doing to tackle tax evasion and improve information exchange.

In particular, the report highlights the OECD's efforts to achieve a global standard on automatic information exchange and identifies the Multilateral Convention on Mutual Administrative Assistance in Tax Matters (the convention) as the quintessential tool to allow all nations to participate in that activity. The convention was developed by the OECD and the Council of Europe and has been open to all countries since June 2011.

As part of its efforts to improve tax transparency, the OECD has been working with member and nonmember countries (including Brazil, Russia, India, China, and South Africa) to develop a technical platform to implement automatic exchange of bank information. That work entails defining what information should be exchanged and deciding which legal instruments can be used to authorize the exchange, such as through bilateral tax treaties or the convention.

"The political support for automatic exchange of information on investment income has never been greater," OECD Secretary-General Angel Gurría said in a statement . This is proven by the FACTA legislation in the U.S. and the move towards Model IGA agreements for foreign governments to sign off on and still honor domestic law limitations.

Recently finance ministers from five EU countries -- France, Germany, Italy, Spain, and the United Kingdom -- announced on April 9 that they will begin a pilot multilateral automatic information facility based on the FATCA intergovernmental framework. Belgium, the Czech Republic, the Netherlands, Poland, and Romania announced on April 13 that they will take part in the pilot program if it is implemented.

Luxembourg, which prides itself on its long tradition of bank secrecy, announced on April 10 that as of January 2015, it will begin to automatically exchange information with its EU partners on interest payments made to EU residents holding bank accounts in Luxembourg. The G-20 is also pushing all jurisdictions to either sign or at least express an interest in signing the convention and tasked the OECD's Global Forum on Transparency and Exchange of Information for Tax Purposes with tracking and reporting on the countries' progress.

The G-20 countries will continue a peer review and update progress on the automatic exchange of information. Stay tuned for further development.

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The plaintiffs challenged a set of tax adjustments and related penalty determinations made by the Internal Revenue Service to nine partnership returns subject to the TEFRA entity audit rules that were introduced under the Tax Equity and Fiscal Responsibility Act of 1982 . Kearney Partners Fund, LLC (“Kearney Partners”), Nebraska Partners, and Lincoln Partners were formed as limited liability companies that were taxable as partnerships. On December 4, 2001, a Mr. Sarma acquired a direct partnership interest in Nebraska Partners and indirect partnership interests in Lincoln Partners and Kearney Partners based on Nebraska Partners' 99% ownership interest in Lincoln Partners and Lincoln Partners' 99% ownership interest in Kearney Partners. This three-tiered partnership structure is referred to by the acronym “FOCus”.

During 2002, the IRS started an investigation of FOCus and its use of a multi-tiered partnership structure, which it claimed was a “tax shelter” through which Sarma derived substantial tax benefits.

Under TEFRA rules, when the IRS initiates an audit of a partnership return, and believes that the positions taken on the return are not all correct, it is required to mail each partner a Notice of Beginning of Administrative Proceeding (“NBAP”) “no later than 120 days before” the issuance of the Final Partnership Administrative Adjustment (“FPAA”). 26 U.S.C. §§ 6223(a) & (d). The IRS' failure to do so entitles the partner the option to opt-out of the partnership examination or judicial proceedings. § 6226(e).

On June 6, 2003, the IRS issued Plaintiffs, but not Sarma, the NBAP. On December 9, 10, and 11 2009, the IRS sent Plaintiffs and Sarma the FPAAs with a cover letter advising Sarma that the IRS had failed to mail him the NBAPs within the required time and informing him of his right to opt-out of the partnership examination. On January 23, 2010, Sarma elected to opt out. However, on February 25, 2010, the IRS sent a letter to Sarma's counsel acknowledging that it had erred in informing Sarma of his right to opt-out because he was not entitled to directly receive the NBAPs and thus could not elect to not be bound by the partnership examination. The plaintiffs filed a motion for summary judgment arguing that Sarma properly opted out of this proceeding which divests this Court of subject matter and personal jurisdiction.

A motion to dismiss for want of subject matter jurisdiction as to one member, Sarma, was made.  The Federal District Court for the Middle District of Florida noted that, at its discretion, it may rule on a motion to dismiss on the basis of affidavits alone, may choose to permit discovery in aid of the motion, or may conduct an evidentiary hearing on the merits of the motion. See, e.g., Internet Solutions Corp. v. Marshall, 557 F.3d 1293, 1295 (11th Cir. 2009); Eaton v. Dorchester Dev., Inc., 692 F.2d 727, 730–31 (11th Cir. 1982) (recognizing a qualified right to jurisdictional discovery in the Eleventh Circuit).

TEFRA Entity Level Audit Rules

TEFRA, under Section 6223, sets forth  procedures designed to notify certain partners of the beginning and end of an administrative proceeding or audit. When the IRS audits a partnership with fewer than 100 partners, such as FOCus, TEFRA requires the Service to issue a notice of an administration proceeding at the partnership level, or NBAP, to the tax matters partner and to each notice partner who, because of the magnitude of their interests in the partnership are entitled to direct notice. §6223(a)(1).

Where the audit results in tax adjustments on partnership items, the IRS must send a notice of the final partnership administrative adjustment from such proceeding – an FPAA.   § 6223(a)(2). Section 6223 requires the Secretary to mail the NBAP no sooner than 120 days before the issuance of the FPAA. § 6223(d).  Therefore,  at least 120 days must separate the first (NBAP) and last (FPAA) notices to the partners. Where the IRS  fails to comply with this timeline, TEFRA, in Section 6223(e) allows each of the notice partners to whom a timely notice was not mailed to decide whether to opt-out of the partnership examination or judicial proceeding and to have his or her partnership items treated as non-partnership items.  

Jurisdiction of the Court Based on TEFRA Notice Provisions

The issue here was whether Sarma appropriately “opted out” of the partnership proceedings following Defendant's failure to send “the NBAPs less than 120 days before the FPAAs were mailed.” The parties agree that because this case is a federal income tax partnership proceeding brought under 26 U.S.C. § 6226(a) to contest the findings of the IRS with respect to Plaintiffs' partnership items, a partner's valid decision to opt-out of the partnership proceedings warrants dismissal of the partner from this action. Plaintiffs therefore argue that this Court has no subject matter or personal jurisdiction. Defendant responds that because the IRS was under no obligation to send the initial NBAP, Sarma had no right to opt-out.

Collateral Estoppel and Sarma's Right to Opt-Out of These Proceedings

The United States’ argued that Sarma was collaterally estopped from asserting his right to opt out of this TERFA action because the Tax Court rejected the same argument in a prior proceeding.  The U.S. further argued that the Tax Court  had previously dismissed Sarma's petition for a redetermination of his tax obligations due to a lack of subject matter jurisdiction. Under the IRS Code, once a partner decides to “opt out” by electing to convert partnership items into non-partnership items, the IRS must issue the partner a timely notice of deficiency. 26 U.S.C. § 6230(a)(2)(ii). The taxpayer may then challenge the deficiency in Tax Court.

On December 3, 2011, the IRS sent Sarma a notice of deficiency even though it had previously informed him that he had no right to opt-out of the partnership proceedings. The IRS sent the notice of deficiency  to protect its ability to assess and collect additional taxes if it were later determined that Sarma had validly opted out of the TERFA proceedings. The government further argued that had it until this question was submitted to this Court, the IRS would have been time-barred from assessing and collecting any additional taxes owed as a result of the FOC-us generated loss claimed on Sarma's tax return.  Once Defendant concluded that Sarma had no right to opt-out, it moved the Tax Court to dismiss Sarma's petition.

The government’s motion to dismiss before the Tax Court asserted nearly identical grounds of dismissal in the case at bar. Again, Sarma’s  petition to the Tax Court was invalid because he was not entitled to an NBAP and thus had no right to elect out of the partnership proceedings.

On June 30, 2011, Sarma filed his opposition to the motion, concurring that his petition before the Tax Court should be dismissed for lack of jurisdiction, but offering different bases for dismissal on jurisdiction grounds. Sarma averred that the IRS' notice of deficiency was invalid because the Agency was equitably estopped from issuing the notice due to its February 25, 2011 letter informing Sarma of his right to opt-out of the partnership proceedings. According to Sarma, the IRS' error in submitting the letter estopped it from issuing a notice and the tax court from exercising jurisdiction over the petition.

On March 16, 2012, the Tax Court entered an Order of Dismissal. The Order notes that both parties agree that the notice of deficiency was invalid and therefore that the court lacks jurisdiction over the case. And even though the court “granted [Defendant's] Motion to Dismiss for Lack of Jurisdiction,” the Order fails to explain the basis of dismissal and whether it adopted Defendant's argument that Sarma's petition was invalid because he had no right to opt out of the partnership proceedings. The Court concluded that it was unable to determine whether the issues material to the instant Motion to Dismiss were actually litigated before the Tax Court and whether the determination of these issues were critical and necessary to the Tax Court's decision to dismiss. Accordingly, the Court declined to decide Sarma's Motion to Dismiss on collateral estoppel grounds.

Sarma Was Not Entitled to Notice and Is Precluded From Electing Out of These Proceedings

The Federal District Court’s jurisdiction over Sarma is based on whether he was entitled to and received timely notice of the partnership audit. Plaintiffs argue that this Court has no subject matter or personal jurisdiction because Sarma elected to opt-out of these proceedings following the IRS' failure to issue an NBAP at least 120 days before the FPAAs were mailed.

The United States again stated that  Sarma was not entitled to an NBAP, that the IRS was under no obligation to send the notice, and that therefore Sarma had no right to opt-out of these proceedings.

The Service's duty to notify under Section 6223(a) arises only if the names, addresses, and profit interests of partners and indirect partners are furnished in one of two forms described in section 6223(c). Jaffe v. C.I.R., T.C.M. 2004-122, aff'd. 175 F. App'x 853 (9th Cir. 2006). First, the Service  may be provided the referenced information through the tax return of the partnership under audit. See 26 U.S.C. § 6223(c)(1). Second, the information can be provided in a statement to the IRS that fulfills the “regulations prescribed by the Secretary,” under 26 C.F.R. § 301.6223(c)-1(b). 4 26 U.S.C. § 6223(c)(2). Neither party argues that Plaintiffs provided the necessary information through either of these two means. Plaintiffs cite Section 6223(a) and Treas. Reg. §301.6223(c)-1(f) that the IRS should have relied on any other information available to it to mail an NBAP.

However, Treas. Reg. §301.6223(c)-1(f) indicates that even though the Secretary “may use other information in its possession (for example, a change in address reflected on a partner's return) ... the [Secretary] is not obligated to search its records for information not expressly furnished under this section” (emphasis added). 26 C.F.R. § 301.6223(c)-1(f).

The Federal District Court held that the permissive language of the regulation does not impose a duty on the IRS to rely on any other available information to issue a notice of an audit. The IRS may use other information that is available to it; however, it is not required to “search its records” to obtain information not provided in the forms required by Section 6223(c)”); Walthall v. United States, 131 F.3d 1289, 1296 (9th Cir. 1987) (“the mere fact that the IRS possesses in its database the name and address of indirect partners does not mean that it has been “furnished with” this information . Therefore, “[W]e thus hold that the Walthalls failed to trigger the notice requirement of Section 6223(a), and therefore were not entitled to direct notice pursuant to the Act”).

Plaintiffs’ reliance on  Murphy v. C.I.R., 129 T.C. 82 (2007) to suggest otherwise was incorrect.  The Murphy case  addressed whether the IRS appropriately elected to send an FPAA to the indirect partner as opposed to a direct partner of a partnership. The court held that the notice to an indirect partner was valid because TERFA and the applicable regulations permit, but do not require, the Secretary to rely on other readily available information to send an FPAA. As the court made clear, the Secretary's “duty to give notice under Section 6223(a) arises to the extent [it] is furnished with readily available information ... through the tax return of the partnership [or] ... a statement that meets the requirements of Treas. Reg. § 301.6223(c)-1T,”  whereas it has “no obligation to search his record to obtain information not provided to him under either of the ways set forth in section 6223(c)(1) and (2).”

Therefore, the Federal District Court found that  Murphy, supra contradicts Plaintiffs' assertion that Defendant was required to send notice of the partnership audit to Sarma. While the facts in the case might be unique, the court conceded, the IRS mistakenly sent a form letter to Sarma acknowledging that it had failed to send the notices within the time required under Section 6223(d) and informing him of his right to opt-out of the partnership proceedings. After Sarma elected to do so, the IRS reversed course by a letter that directed Sarma to “disregard” the February 8, 2010 letter, explaining that because the IRS was not required to provide the NBAP, Sarma did not have the right to elect out of the partnership proceedings.

Despite the Agency's mistake, the Court held that Sarma may not opt-out of this case. While the Agency's error (subsequently rescinded) is regrettable to the extent it muddied the waters, it does not alter the fact that there was no legal obligation to provide the NBAP to Sarma in the first place and the letter to the contrary does not change that circumstance.

Section 6223(e) of TERFA sets forth the circumstances under which a partner may opt-out of a partnership audit. The provision provides that “[t]his subsection applies where the Secretary has failed to mail any notice specified in subsection (a) to the partner entitled to such notice within the period specified ....” 26 U.S.C. § 6223(e)(1)(A). In other words, Section 6223(e)'s remedy provision, which includes the right to opt-out, applies only when a partner is entitled to but does not receive timely notices of the audit. Here, Sarma was not entitled to any notice because it failed to provide the requisite information to the IRS. Sarma may not capitalize on the IRS' mistake to invoke the right to a remedy that was not provided by the statute.

The Court therefore denied  Plaintiffs' Motion to Dismiss on jurisdictional grounds.

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While Christmas and the holiday gift giving may have passed, the Treasury and the Internal Revenue Service bundled up several “gifts” in the form of regulations under Section 367 that were issued on March 18, 2013 that have been long-awaited since proposed regulations were issued in this area in August 2008. The government generally maintained the framework set out in the August 2008 proposed regulations, though it did make some targeted changes to the proposed regulations' new elective exception under Section 367(a)(5), which allows a U.S. transferor to not recognize gain on a transfer of appreciated property in a Section 361 exchange if some conditions are met. Qualifying conditions include: (i) the requirement that the U.S. transferor be controlled per Section 368(c) by at least one but by no more than five domestic corporations (control group); (ii) gain recognition by the U.S. transferor; (iii) adjustments to basis of stock received by control group members are made; (iv) an agreement is made to amend or file a U.S. tax return to recognize gain; and (v) compliance with certain election and reporting requirements. Initial responses from members of the professional community overhaul have been favorable with the various rule-makings issued.

In T.D. 9614, the Treasury and the Internal Revenue Service finalized portions of the proposed regulations under Sections 367, 1248 and 6038B pertaining to the transfer of assets from domestic corporations to foreign corporations.

In T.D. 9615, the Treasury and the Internal Revenue Service issued guidance in the form of temporary regulations part of the 2008 proposed regulations pertaining to the Section 367(a) coordination rule exceptions and makes further revisions in temporary regulations of the February 2009 final gain recognition agreement regulations (see T.D. 9446) pertaining to outbound transfers of stock or securities.

The third “gift” delivered was REG-132702-10, which contains the text of the temporary regulations issued under T.D. 9615.  

This post will cover the first of the three releases, T.D. 9614, 78 F.R. 17024-17052. The content summarizes the explanation provided in the Preamble to the rule-making.

Final Section 367(a)(5) Regulations: T.D. 9614

The 2008 proposed regulations (REG-209006-89; 73 FR 49278, 2008-41 IRB 867) issued on August 20, 2008, addressed Sections 367 and 1248 as well as the related reporting requirement rule in Section 6038B pertinent transfers of property by a domestic corporation to a foreign corporation in an exchange described in either Section 361(a) or (b), and certain nonrecognition distributions of stock of a foreign corporation by a domestic. See also 73 FR 56535; 2008-41 IRB 867). While no public hearing was held on the 2008 proposed regulations, the government did receive comments. Much of the 2008 proposed regulations, with certain modifications, are retained in the final regulations just issued. A portion of the same 2008 proposed regulations is also adopted, as modified, as temporary regulations in a second rule-making also issued on March 18, 2013. The temporary regulations also modify final regulations under Section 367(a) concerning transfers of stock or securities by a domestic corporation to a foreign corporation in a Section 361 exchange.

General Framework of Section 367(a)

Section 367(a)(1) provides, in general, that a taxable realization event occurs with respect to  transfers of appreciated property by a U.S. person to a foreign corporation in connection with any exchange described in Sections 332, 351, 354, 355, or 361.  Moreover, Section 367(e) applies similar principles to outbound liquidation distributions under Section 337 and distributions under Section 355(c). There are certain exceptions from this rule of broad application. Section 367(a)(3)(A) allows  nonrecognition treatment for assets used in the active conduct of a trade or business transferred outside of the United States (subject to expansion or contraction by regulations). See Treas. Regs. § 1.367(a)-2T (1986). Med Chem (P.R.) v. Comm’r, 116 TC 308 (2001), aff'd 295 F.3d 118 (1st Cir. 2002) . Assets that are ineligible for the active foreign business exception (i.e., tainted assets) are listed in Section 367(a)(3)(B) and include: (i) inventory and copyrights not otherwise taxed under Section 367(d); (ii) installment obligations and receivables; (iii) foreign currency or property denominated in foreign currency; (iv) other intangibles not subject to Section 367(d); and (v)  property that is presently leased (other than to the transferee).

Section 367(a)(2) sets forth a second exception to the general realization of income rule providing non-recognition treatment with respect to a transfer of stock and securities of a foreign corporation, which is a party to a reorganization, to a foreign corporation. Under the regulations where a U.S. transferor transfers foreign stock or securities to a foreign corporation as part of a tax-free reorganization, gain is not required to be recognized under the general rule of Section 367(a)(1) where the transferor either owns (or is treated as owning) less than 5% of both the voting power and total value of the transferee's stock or (where the 5% test is not satisfied) enters into a five-year gain recognition agreement. Where the domestic corporation’s stock or securities are transferred to a foreign corporation, the regulations require that four conditions must be satisfied to avoid gain recognition: (i) the domestic transferors must not receive more than 50% of the transferee's stock (by vote or value) in the transaction; (ii) there must not be a “control group;” (iii) a U.S. person who is a 5% shareholder of the transferee must enter into a five-year gain recognition agreement (“GRA”); and (iv)  an active business test must be met. 

Certain transactions are treated as indirect stock transfers. For instance, where a triangular reorganization or asset merger is followed by a transfer of part or all of the transferred assets to a corporation controlled by the transferee corporation, the acquiring corporation (or the corporation to which the assets are transferred) is treated as the transferred corporation. In instances where assets are transferred, e.g., a triangular Type C reorganization, Section 367(a) is implicated with respect to the asset transfer while both Sections 367(a) and 367(b) can apply to the indirect stock transfer at the shareholder level. If the drop-down of assets is made by the foreign acquiring corporation back to a controlled domestic corporation, the regulations provide that in certain instances gain will not be recognized. See Treas. Reg § 1.367(a)-3(d)(2)(vi)(B)(1).

There will be instances in which Sections 367(a) and 367(b) overlap.  Section 367(a) rules generally apply before the Section 367(b) rules, because a transfer is generally fully taxable or not under the Section 367(a) rules. If the transfer is fully taxable under the Section 367(a) provisions, then the Section 367(b) provisions generally remain dormant. The 2008 proposed regulations under Section 367(a) reverse the priority rule to provide that where a transaction that is concurrently subject to both Sections 367(a) and 367(b), Section 367(b) would take precedence if the all earnings and profits amount is greater than the Section 367(a) gain.

Section 367(a)(5) and Coverage Under the 2008 Proposed Regulations and Recently Issued Final Regulations

Section 367(a)(5) provides that the exceptions to Section 367(a)(1) in Section 367(a)(2)(foreign stocks and securities) and (a)(3)(transfer of all assets of a trade or business outside of the United States) will not be applicable in the case of a Section 361 exchange in which a domestic corporation transfers assets to a foreign corporation, unless the U.S. transferor is controlled (within the meaning of Section 368(c)) by five or fewer (but at least one) domestic corporations (each a control group member, and together the control group) and basis adjustments and other conditions as provided in regulations are satisfied. See H.R. Rep. No 795, 100th Cong., 2d Sess. 60 (1988). See also Section 337(d)(regulations to protect the integrity of the repeal of the General Utilities doctrine as part of the Tax Reform Act of 1986).

The 2008 proposed regulations set forth rules and conditions for implementing Section 367(a)(5).  The 2008 proposed regulations provided an exception that at the election of the U.S. transferor and members of the control group (elective exception), subject to conditions intended, in part, to ensure that the net gain (if any) realized by the U.S. transferor in connection with the transfer of property subject to Section 367(a) (defined as “inside gain”) is, in the aggregate, recognized currently by the U.S. transferor or, to the extent permitted, preserved in the basis of the stock received in the reorganization by certain domestic corporate shareholders of the U.S. transferor.

Calculation of Inside Basis

In addition to the adjusted basis of certain transferred property,  in computing “inside gain”, the 2008 proposed regulations account for certain liabilities of the U.S. transferor that would give rise to a deduction when paid. See §361(c)(3). Section 361(c)(3) provides that the U.S. transferor recognizes no gain or loss on the satisfaction of a liability with stock received in connection with the reorganization, but does not prevent the U.S. transferor from obtaining a deduction on payment of the liability with the stock received. The policy rationale for allowing a deductible liability to reduce “inside gain” is that the U.S. transferor has not received a tax benefit for such liability but the liability reduces the value of the stock received. This concept is retained in the final regulations which provide that a so-called “deductible liability” is limited to a  liability that is assumed in the Section 361 exchange if payment of the liability would give rise to a deduction.

While several comments had suggested that besides “built-in deductions” other tax attributes be taken into account in computing inside gain, e.g., net operating losses and foreign tax credits, because those other tax attributes are similar to the adjusted basis of the transferred property and deductible liabilities or, alternatively permit the U.S. transferor to elect to recognize an amount of gain sufficient to utilize all or a portion of any additional tax attributes. The final regulations did not adopt either suggestion on the basis of undue complexity as well as recognizing that a a U.S. transferor can utilize any other available tax attributes by not electing to apply the elective exception.

Built-in Loss in Stock of the U.S. Transferor Corporation

Under the 2008 proposed regulations, to qualify for the Section 367(a)(5) exception, each control group member must make a downward adjustment in the basis of the stock received in the foreign corporation as part of the reorganization by the amount that its portion of the “inside gain” in the transferred assets exceeds the gain (or loss) unrealized in such  stock or “outside gain” but for the application of Section 367(a)(5). The Preamble notes that in some cases the required basis adjustment will actually convert built-in loss stock into built-in gain stock. As an illustration of the elective exception under Section 367(a)(5), a control group member has a $500x adjusted basis, per Section 358, in stock received that has a fair market value of only $300x. This yields a $200x built-in loss in the stock. If the control group member's share of transferred assets inside gain is $350x, its adjusted basis in the stock received must be reduced to $150x, resulting in $150x of built-in gain in the stock and eliminating the $200x pre-existing stock basis “outside” built-in loss.

While comments were received by the Treasury to take a different approach, the Preamble states that “the Treasury Department and the IRS believe that the amount of outside built-in gain or loss should not affect the required reduction to the adjusted basis of the stock received in the transaction. That is, the basis must be reduced to an amount such that the gain in the stock corresponds to the proportionate amount of inside gain.” See S. Rep. No. 445, 100th Cong., 2d Sess. 62-3 (1988).

The final regulations clarify that if a U.S. transferor does not have inside gain, i.e., there is no net built-in gain in the U.S. transferor's assets, stock basis adjustments are not required to be made by control group members, even if the outside stock loss of a control group member is greater than the net built-in loss attributable to the control group member.

Taxable Disposition of Section 367(a) Assets

The 2008 proposed regulations deny application of the elective exception under Section 367(a)(5) where, and provided the taxpayer has a principal purpose of avoiding U.S. tax, the foreign acquiring corporation disposes of a significant amount of the property received from the U.S. transferor. The regulations referred to this problem as the “disposition rule”.  The comments received by the Treasury and IRS recommended that the disposition rule be modeled after Treas. Reg. §1.367(a)-8 on GRAs. In general, GRAs generally require gain recognition only where a triggering event takes place during the GRA term,  which is the period ending with the close of the fifth full taxable year (not less than 60 months) following the year in which the transfer requiring the gain recognition agreement occurred.

Another comment asked that the final regulations include rules under the GRA provisions in Treas. Reg. §1.367(a)-8(k)(14) for certain non-recognition transfers. Such rules generally provide that a transfer of assets subject to a GRA that are disposed of in a non-recognition transfer will not be a GRA triggering event provide certain conditions are met. But see Treas. Reg. § 1.367(a)-2T(c)(1) which denies the exception under Section 367(a)(3) in certain cases when the transferred property is retransferred to another person as part of the same transaction.

The Treasury Department and the IRS stated in the Preamble that safeguards, in addition to the rule set forth in Treas. Reg. § 1.367(a)-2T(c)(1), are needed in the case of outbound reorganizations that qualify for the elective exception, but agree that adopting certain aspects of the GRAs rules are worthwhile. The final regulations deny the elective exception only if, with a principal purpose of avoiding U.S. tax, the foreign acquiring corporation disposes of a significant amount of the property received from the U.S. transferor during the 60-month period that begins on the date of distribution or transfer (per Treas. Reg. § 1.381(b)-1(b)), which generally is the date on which the transfer of property by the U.S. transferor to the foreign acquiring corporation is completed.

The final regulations also provide that property that is subsequently transferred pursuant to a non-recognition provision will not be treated as “disposed of” under the disposition rule under principles set forth under Treas. Reg. § 1.367(a)-8(k) as well as the broader rules under Treas. Reg. § 1.367(a)-8 as to GRAs.  

Another comment, also adopted in the final regulations, allows dispositions of property in the ordinary course of business will not result in denial of the elective exception even in instances where the disposition occurs within the two-year "presumption of tax avoidance" period following the reorganization.

Definitions of Section 367(a) Property and Section 367(d) Property

The 2008 proposed regulations, in general, define Section 367(a) property as any property other than Section 367(d) property. The final regulations clarify that Section 367(d) property is property described in Section 936(h)(3)(B).  In accordance with Section 936’s definition, “intangible property” means a: (i) patent, invention, formula, process, design, pattern, or know-how; (ii) copyright, literary, musical, or artistic composition; (iii) trademark, trade name, or brand name; (iv) franchise, license, or contract; (v) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or (vi) any similar item, which has substantial value independent of the services of any individual.

Section 367(d)(1) provides that, except as provided in regulations, if a United States person transfers any intangible property, per Section 936(h)(3)(B), to a foreign corporation in an exchange described in Section 351 or 361, Section 367(d) (and not section 367(a)) applies to such transfer. Therefore, income or gain attributable to the transfer of property by a U.S. person to a foreign corporation in a Section 351 exchange or Section 361 exchange is taken into account either in accordance with Sections 367(d)(2)(A)(ii)(I) or (d)(2)(A)(ii)(II), or in accordance with Section 367(a) and the regulations thereunder in the case of a Section 361 exchange subject to Section 367(a)(5). See Notice 2012-39, IRB 2012-31 (application of Section 367(d) in outbound asset reorganizations).

Section 367(a)(5)’s Application to a RIC, REIT, or S Corporation

Comments were received to the 2008 proposed regulations  that based on the policy rationale inherent in Section 367(a)(5) of preserving U.S. taxation of corporate level gain. Section 367(a)(5) should not apply to a real estate investment trust (REIT), regulated investment company (RIC) or S corporation since such entities are generally not subject to corporate income tax. Perhaps this relief would take into account such instances where such entities are subject to corporate income tax. This led to a suggestion that the final regulations should incorporate a targeted gain recognition rule in such instances. On the other hand, another comment  noted that exempting special corporate entities from the application of Section 367(a)(5) may circumvent the imposition of U.S. tax through the use or insertion of special corporate entities. It was also suggested that such special corporate entities should still be permitted to be members of the control group since the amount of inside gain preserved in stock received by special corporate entities could, when recognized, be wholly or partly subject to U.S. tax and includible in the shareholders’ taxable income.

Section 367(a)(1) contains rules for transfers of certain appreciated property by a U.S. person to a foreign corporation in certain non-recognition exchanges under the corporate tax provisions. These rules apply to regular corporations as well as the special corporate entities. The owners of special corporate entities participating in such exchanges generally receive a basis determined under Section 358 in the shares of the foreign acquiring corporation. This means that  preservation of corporate-level tax on the “inside gain” is not assured.  In addition, the Treasury and IRS was concerned that if a special corporate entity was treated as a member of a control group under Section 367(a)(5), whether the inside gain is ever subject to U.S. corporate tax depends on the extent of the domestic corporate ownership of the special corporate entity at the time the gain is recognized. Based on these concerns the final regulations did not adopt the position asserted in the comments relief be provided from the application of Section 367(a)(5) to special corporate entities, or allow special corporate entities to be control group members.

Indirect Stock Ownership

There are no attribution or constructive stock ownership rules under Section 368(c). Still, comments were received that the final regulations permit indirect ownership of the U.S. transferor through partnerships or foreign corporations to be taken into account for purposes of satisfying the control requirement of Section 367(a)(5). Section 367(a)(5) uses the direct ownership rule under Section 368(c) in testing for control. The final regulations do not contain a stock attribution rule.

            Treatment of Affiliated Group Members as a Single Corporation

The 2008 proposed regulations provided that members of an affiliated group of corporations for purposes of Section 1504 are treated as a single corporation under the control requirement of Section 367(a)(5). The question surfaced as to whether affiliated group members should also be treated as one corporation for other purposes such as to determine the amount of any required stock basis adjustments. The final regulations clarify the proposed regulation’s aggregation rule that members of an affiliated group are treated as a single corporation only for applying the control requirement.  

 Transfers Described in Other Nonrecognition Provisions

The 2008 proposed regulations attempted to clarify that Section 367(a)(5) applies to a transfer of property described in Section 351 if the transfer is also described in Section 361(a) or Section 361 (b). This clarification ensures that the policies underlying Section 367(a)(5) are not undermined by transfers described in Section 361(a) or  Section 361 (b) that also qualify for nonrecognition under Section 351. A comment was received that transfers falling with Sections 361(a) or 361(b) could also be described in non-recognition provisions other than Section 351, including Section 354. The final regulations modify the 2008 proposed regulations to provide that, unless a specific exception applies, the U.S. transferor recognizes any gain realized with respect to Section 367(a) property. Where a transfer of items of property that is described in Section 361(a) or (b) is also described in a non-recognition provision that is not excepted from Section 367(a)(1), e.g., Section 1036 exchanges, the U.S. transferor is required to recognize gain or loss realized on the transfer of such items of property, but the amount of loss recognized on the property may not exceed the amount of gain recognized on the property. But see for example, Section 267(f).

Other Clarifications and Modifications to the 2008 Proposed Regulations

The 2008 proposed regulations provide for that for purposes of the control group membership test, that such determination be made "at the time of the Section 361 exchange.” Interpreted literally this rule would not take into account the possibility that the property of the U.S. transferor may be transferred on more than one day to the foreign acquiring corporation. The final regulations revise the 2008 proposed regulations by striking the phrase "at the time of the Section 361 exchange" as the time for making certain determinations required under the regulations.  Thus, for example, the final regulations provide that determinations on whether the control requirement is met for Section 367(a)(5) purposes is made immediately before the reorganization. The final regulations further revise the computation of the ownership interest percentage to take into account certain distributions by the U.S. transferor of a portion of its property.  More particularly, the final regulations require the ownership interest percentage be determined after taking into account any distribution by the U.S. transferor of money or other property not received from the foreign acquiring corporation in exchange for property of the U.S. transferor acquired in the Section 361 exchange. Other semantic changes were made in the final regulations that were not considered by the Treasury or IRS to be substantive changes. There were also further coordinating modifications made to Treas. Reg. §1.367(a)-7 when the property transferred in the Section 361 exchange is stock or securities. See Treas. Regs. §§1.367(a)-3T(e), 1.367(b)-4, 1.1248(f)-1, and 1.1248(f)-2.

The 2008 proposed regulations set forth a “reasonable cause” relief rule in Treas. Reg. § 1.367(a)-7(e)(2), whereby a control group member's failure to timely comply with any requirement of Treas. Reg. § 1.367(a)-7 will be deemed not to have occurred if the failure was due to reasonable cause and not willful neglect. Included in the reasonable cause relief rule is a “deemed” cure provision whereby the control group member will be deemed to have established that the failure to comply was due to reasonable cause and not willful neglect where the control group member requesting relief is not notified by the IRS within 120 days of IRS acknowledgement of receipt of the request.  The final regulations eliminated the 120 day deemed cure provision. The rest of the reasonable cause relief provision is retained in the temporary regulations.

Other Regulations Issued under Section 367(a)

The 2008 proposed regulations would have modified Treas. Reg. § 1.367(a)-1T(b)(4)(i)(B) to provide that an increase in basis under Section 362 for gain recognized by the U.S. transferor under Section 367(a) is allocated among the transferred property with respect to which gain is recognized in proportion to the gain realized by the U.S. transferor. The final regulations clarify that where gain is recognized under Section 367 with respect to a particular item of property, the foreign transferee corporation increases its basis in that item of property for such gain. The final regulations also clarify gain recognized that is not with respect to a particular item of property (for example, gain recognized under the branch loss recapture rules) is to be allocated in proportion to the gain realized by the U.S. transferor with respect to all items of property transferred, but for this purpose the gain realized is determined after taking into account gain recognized under other provisions of Section 367 that apply with respect to particular items of property.

Regulations Issued under Section 367(b)

Modified Example 4 of Treas. Reg. § 1.367(b)-4(b)(1)

Final regulations issued under Section 367(b) on January 24, 2000, provide where a U.S. transferor who is a Section 1248 shareholder of a foreign acquired corporation transfers the stock of such corporation to a foreign acquiring corporation in a Section 361 exchange, the U.S. transferor must include in income the Section 1248 amount attributable to the stock of the foreign acquired corporation. Immediately after the exchange, 2000 final regulations provide that the U.S. transferor is no longer a Section 1248 shareholder because the stock of the U.S. transferor is cancelled even if the foreign acquiring corporation and the foreign acquired corporation are controlled foreign corporations per Treas. Reg. § 1.367(b)-2(a). See  Treas. Reg. § 1.367(b)-4(b)(1)(iii), Example 4.

The 2008 proposed regulations attempted to modify Treas. Reg. § 1.367(b)-4(b)(1)(iii), Example 4, to provide that the requirements in Treas. Reg. § 1.367(b)-4(b)(1)(i)(B) are applied immediately after the Section 361 exchange and prior to the distribution of the foreign stock under Section 361(c)(1).

In responding to comments concerning application of step-transaction analysis and disregarding transitory stock ownership for purposes of apply Section 367(b) regulations, see Rev. Rul. 83-23, 1983-1 C.B. 82, the Preamble to the final regulations provides that subject to a specific exception, the judicial doctrines and fundamental tax law principles, such as substance-over-form and the step-transaction doctrine, are to be applied in determining whether the conditions for an income inclusion under Treas. Reg. § 1.367(b)-4(b)(1) are satisfied. As an illustration, the issuance of stock by the foreign acquiring corporation in connection with the exchange being tested under Treas. Reg. § 1.367(b)-4 would be taken into account in determining whether an income inclusion under Treas. Reg. § 1.367(b)-4(b)(1) is required.

Still, the Treasury and IRS consider it necessary to respect the ownership of stock by the U.S. transferor in examining an outbound Section 361 exchange such as that described in Example 4. This is because the Section 1248 amount in the stock of the foreign acquired corporation will, in the aggregate, either be preserved in the hands of certain domestic corporate shareholders of the U.S. transferor pursuant to Treas. Reg. § 1.1248(f)-2(c), or be included in the gross income of the U.S. transferor as a result of the distribution of such stock under Section 361(c) and in accordance with Treas. Reg. § 1.1248(f)-1(b)(3).

The final regulations require that in an outbound transfer of stock of a foreign corporation in a Section 361 exchange, the requirements of Treas. Reg. § 1.367(b)-4(b)(1)(ii)(B) apply after the Section 361 exchange, but prior to and without taking into account the U.S. transferor's distribution under Section 361(c)(1).

The final regul

ations further modify Treas. Reg. § 1.367(b)-4(b)(1) by expanding the type of exchanges for which an income inclusion is not required to include a Section 361 exchange of foreign stock by a foreign target that is itself acquired in a triangular asset reorganization involving stock of a domestic controlling (parent) corporation.

Revisions to Section 1248(f) Regulations and Treas. Reg. §1.1248-8

Section 1248(a) provides that gain from  a U.S. person's disposition of controlled foreign corporation’s stock is treated as dividend income to the extent of the earnings and profits attributable to the stock that were accumulated during the term of the U.S. person’s stock ownership. A U.S. person is a person who owns, as provided in Section 958(a), or is considered as owning by applying the constructive ownership rules of Section 958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation at any time during the 5 year period ending on the date of the sale or exchange when such foreign corporation was a controlled foreign corporation defined under Section 957.  

As a protective rule to avoid the circumvention of Section 1248(a), Section 1248(f) provides that even though a U.S. person exchanges stock in a CFC in an otherwise non-recognition transaction, gain is recognized and characterized as dividend income in an amount that is equal to the Section 1248(a) dividend that the distributing corporation would have recognized if it sold the CFC stock for its full fair market value. For example, despite the fact that Section 337 generally allows for a tax-free liquidation of a controlled subsidiary into its parent corporation, where the subsidiary is a CFC and the parent is a domestic corporation, gain is required to be recognized. Section 1248(f) also requires a domestic corporation to recognize gain on distributing CFC stock to its shareholders pursuant to a plan of reorganization which would normally be non-taxable to the shareholders under Section 354. Exceptions from the gain recognition rule are also contained in Section 1248(f)(2) where the distributee of the CFC stock: (i) is also a domestic corporation; (ii) the transaction is an exchanged basis transaction allowing for tacking of holding period with respect to the transferred CFC stock; and (iii) the distribute would be subject to Section 1248(a) on a sale of the stock immediately after the distribution.

On August 20, 2008,  some thirty-two years after the enactment of Section 1248(f), which provided that certain otherwise non-taxable exchanges of stock involving a U.S. person’s disposition of CFC stock would still result in ordinary income treatment to the extent that the gain realized could be absorbed by the accumulated earnings and profits of the CFC, proposed regulations were issued under Section 1248(f). See Notice 1987-67.

The principal for preserving Section 1248 taint is contained in Treas. Reg. § 1.1248(f)-2. It provides that Section 1248 gain will not be implicated triggered by the distribution of stock by a Section 1248 stockholder so long as the Section 1248 taint on the distributed stock can be preserved through basis and holding period adjustments. Thus, Treas. Reg. § 1.1248(f)-2(a) deals with “§ 337 distributions” (in a Section 332 liquidation) of Section 1248 tainted stock and gain will not be triggered provided that the the distributee is an 80-percent parent and continues to be a Section 1248 shareholder, holding period for the stock carries over, and basis in the distributed stock is not stepped up.

Treas. Reg. § 1.1248-2(b), which pertains to “§ 355 distributions” of Section 1248 tainted stock, similarly provides that Section 1248 gain will not be recognized on the distribution of Section  1248 tainted stock by a domestic corporation if all the parties to the distribution so elect, and also agree to make appropriate adjustments to their basis and holding period for that stock so as to preserve the Section 1248 taint in the hands of the distribution of stock. In like fashion, Treas. Reg. §1.1248-2(c) deals with distributions pursuant to a plan of reorganization, and provides an election not to trigger Section 1248 taint on the distributed stock by agreeing to make appropriate bases and holding period adjustments so as to preserve the Section 1248 taint on the stock in the hands of the distributees. Examples are provided in the final regulations in Treas. Reg. §1.1248-2(d).

Section 337 Distributions

The 2008 proposed regulations under Section 1248(f) provided exceptions to the operative rule of section 1248(f)(1) that requires a domestic corporation (distributing corporation) that distributes stock of certain foreign corporations under Sections 337, 355(c)(1), or 361(c)(1) to include in income the Section 1248 amount (if any) in the foreign stock distributed. Except in the case of a Section 337 distribution, the exceptions apply only if an affirmative election is made (assuming the requirements for making the election are satisfied). The requirements for the election include making adjustments to the basis and holding period of the stock in the hands of the distributee to the extent necessary to preserve the Section 1248 amount in the foreign stock in the hands of the distributee. In the case of a Section 337 distribution, the exception applies if certain conditions are satisfied without the need to make adjustments to the basis or holding period of the distributed stock, which should generally be the case.  The final regulations allow taxpayers to elect to make necessary basis adjustments and holding period adjustments in an effort to avoid a Section 1248 realization even for Section 337 distributions.

Section 361(c)(1) Distributions of Stock With Respect to Section 361 Exchanges

The Preamble states in this area that the application of the 2008 proposed regulations under Section 1248(f), in combination with the 2008 proposed regulations under Treas. Reg. § 1.367(a)-7, could in certain cases result in aggregate basis adjustments and gain recognition (or deemed dividend inclusions) that exceed the built-in gain in the property transferred by the U.S. transferor in the section 361 exchange. The final regulations are modified to address this result.

As to allocations of stock basis, where in a Section 361 exchange the U.S. transferor transfers property, other than a single block of stock of a foreign corporation with respect to which the U.S. transferor is a Section 1248 shareholder, each share of stock of the foreign distributed corporation is required to be divided into portions. The 2008 proposed regulations provided that for purposes of computing basis in a portion of a share of stock of the foreign distributed corporation, the distributee Section 1248 shareholder's Section 358 basis in that share is allocated to a portion of a share pro rata based on the fair market value of the property to which the portion relates relative to the aggregate fair market value of all property received by the foreign distributed corporation.

The final regulations provide that the distributee's Section 358 basis in a share of the distributed foreign corporation is allocated to a portion of a share pro rata based on the basis of the property to which the portion relates relative to the aggregate basis of all property received by the foreign distributed corporation. As a result of this modification, the aggregate built-in gain in the respective portion of all shares to which a block of foreign stock transferred with a Section 1248 amount relates will more closely match the built-in gain in such foreign stock transferred. Since Section 1248 gain is limited to the built-in gain in the stock, the modification will minimize basis reductions to portions of shares that may otherwise be required to preserve the Section 1248 amount in foreign stock transferred.

The 2008 proposed regulations also provided that where the Section 1248(f) amount attributable to a portion of a share of stock (including a whole share, if appropriate) of the foreign distributed corporation received by a distributee Section 1248 shareholder in the distribution exceeds the distributee Section 1248 shareholder's postdistribution amount in the portion (excess amount), then the distributee Section 1248 shareholder's Section 358 basis in the portion is reduced by the excess amount. The final regulations modify this approach and provide that the Section 358 basis in the portion is not reduced below zero, and therefore to the extent the excess amount exceeds the Section 358 basis in the portion, the domestic distributing corporation must include that portion of the Section 1248(f) amount attributable to the portion of the share in gross income as a dividend. The excess amount may be greater than the Section 358 basis in the portion, for example, where the Section 1248(f) amount attributable to the control group member exceeds the inside gain attributable to the control group member. The final regulations also provide that the  Section 358 basis in a share of stock is allocated among portions of such share of stock based on the basis (rather than the fair market value) of the property transferred to the foreign distributed corporation in the Section 361 exchange will, in many cases, minimize the amount of basis decreases.

Multiple Classes Of Stock For Section 1248 Purposes

The 2008 proposed regulations did not contain rules for addressing the distribution of multiple classes of stock of the foreign corporation. This issue was covered in the final regulations.  The final regulations provide that if multiple classes of stock are received by a control group member, the Section 1248(f) amount "traced" to such control group member is attributed to a share (or portion of a share) of stock received by the control group member based on the ratio of the fair market value of such share to the fair market value of all shares received by the control group member. The final regulations also make consistent modifications to the regulations under Treas. Reg.  § 1.1248-8 (attribution of Section 1248 earnings and profits of stock of a foreign corporation transferred in a Section 361 exchange to a share or portion of a share of stock of the foreign distributed corporation received by a Section 1248 shareholder).

Other Modifications to the Regulations Under Section 1248(f)

The final regulations provide that where the domestic distributing corporation distributes stock of the foreign distributed corporation that it did not receive in a Section 361 exchange (existing stock) in addition to stock of the foreign distributed corporation that it did receive in the Section 361 exchange (new stock), then certain rules apply to the existing stock and another set of rules apply to the new stock. For example, this situation could arise where a domestic distributing corporation owns an existing foreign subsidiary and as part of the plan that includes a distribution of that stock that qualifies under Section 355, the domestic distributing corporation contributes additional property to the foreign subsidiary in exchange for additional stock of the foreign subsidiary. The final regulations refer to a distribution of stock that is not received in a section 361 exchange as an "existing stock distribution," and a distribution of stock received in a section 361 exchange as a "new stock distribution."

The 2008 proposed regulations, set forth a reasonable cause relief provision in  Prop. Reg. § 1.1248(f)-3, pursuant to which a reporting person's failure to timely comply with any requirement of Prop. Reg.  § 1.1248(f)-2 will be deemed not to have occurred if the failure was due to reasonable cause and not willful neglect. The reasonable cause relief provision includes a provision that the reporting person will be deemed to have established that the failure to comply was due to reasonable cause and not willful neglect if the control group member requesting relief is not notified by the IRS within 120 days of IRS acknowledgement of receipt of the request. The Treasury Department and the IRS believe it is appropriate to eliminate the 120-day provision from the reasonable cause relief provision of Prop. Reg.  § 1.1248(f)-3. Other than the elimination of the 120-day provision, the reasonable cause relief provision is retained in the temporary regulations.

Definition of "Sale or Exchange" for Purposes of Section 1248

The 2008 proposed regulations amended § 1.1248-1(b) to clarify the definition of the term "sale or exchange" to include gain recognized under section 301(c)(3). No changes to § 1.1248-1(b) are included as part of these final regulations because after issuance of the 2008 proposed regulations a temporary regulation was issued that included this amendment. See Treas. Reg. § 1.1248-1T(b), issued in TD 9444 (February 10, 2009), and changes finalized by TD 9585 (April 24, 2012).

Regulations under Section 6038B

The 2008 proposed regulations contain various reporting requirements. The 2008 regulations to Section 6038B explain the manner in which a U.S. transferor makes the election under Treas. Reg. § 1.367(a)-7(c), including requiring the U.S. transferor to file a statement containing specified information. The final regulations identify certain additional items of information that must be included with the statement making the election. The 2008 regulations also require the U.S. transferor to file a statement agreeing to file an amended return in certain cases if the foreign acquiring corporation subsequently disposes of a significant amount of Section 367(a) property acquired in the Section 361 exchange. The final regulations modify the disposition rules to provide that certain dispositions of Section 367(a) property are not dispositions for this purpose.

Elimination of Coordination Rule Exception in Treas. Reg. § 1.367(a)-3(d)(2)(vi)(B)(1)(i)

Treas. Reg. §1.367(a)-3(d)(2)(vi)(A) (coordination rule) provides that if in connection with an indirect stock transfer, i.e., Treas. Reg. § 1.367(a)-3(d)(1), a U.S. person transfers assets to a foreign corporation (direct asset transfer) in an exchange described in Sections 351 or 361, the rules of Section 367 and regulations apply first to the direct asset transfer and then to the indirect stock transfer.  There are two exceptions to this priority rule provision. The exceptions apply to  asset reorganizations to the extent the foreign acquiring corporation re-transfers the transferred assets to a controlled domestic corporation, but only if such domestic corporation's basis in the re-transferred assets is not greater than the U.S. transferor corporation's basis in the assets and the conditions in either paragraph Treas. Regs. §§ 1.367(a)-3(d)(2)(vi)(B)(1)(i) or (d)(2)(vi)(b)(1)(ii) are satisfied. The 2008 proposed regulations would modify the exceptions to the coordination rule exceptions, including clarifications described in Notice 2008-10 (2008-1 CB 277).  Under the temporary regulations just issued, the coordination rule contained in Treas. Reg. §1.367(a)-3(d)(2)(vi)(B)(1)(i) has been eliminated but the coordination rule exception in § Treas.Reg. §1.367(a)-3(d)(2)(vi)(B)(1)(ii) has been retained in the temporary regulations.

Effective Dates

The Preamble states that the final regulations under Sections 367(a) and 6038B, per Treas. Reg. § 1.367(a)-7 and the revisions to §§ 1.367(a)-1 and 1.6038B-1 apply to transfers occurring on or after April 17, 2013. The 2008 proposed regulations provide that the rules under Sections 367(b) and 1248(f), including the modification to Example 4 of § 1.367(b)-4(b)(1)(iii), apply to distributions or exchanges, respectively, occurring on or after the date that is 30 days after the date the regulations are published as final regulations in the Federal Register.

The Treasury Department and the IRS announced in the Preamble that taxpayers may not  rely on the modifications to Example 4 of  Treas. Regs. § 1.367(b)-4(b)(1)(iii) and § 1.1248-8, and the regulations under Section 1248(f) prior to the effective date. Taxpayers must apply section 1248(f), which does not include the exceptions provided in Treas. Reg. § 1.1248(f)-2 for such prior periods. Accordingly, distributions described in section 1248(f)(1) during such period result in an inclusion unless the exception described in Section 1248(f)(2) applies. Similarly, taxpayers must take into account Example 4 of Treas. Reg. § 1.367(b)-4(b)(1)(iii) (before amendment by these final regulations) for such prior periods. Since the regulations under Sections 367(b) and 1248(f) operate together with the rules of Treas. Reg. § 1.367(a)-7, the provisions should be subject to consistent effective dates. Therefore, the final regulations retain the 30-day delay in the effective date for these rules. Modifications to § 1.1248-6 apply to a sale, exchange, or other disposition of the stock of a domestic corporation on or after September 21, 1987.

Subject to rules implementing the effective dates announced in Notice 87-64 (1987-2 CB 375), the final regulations under Section 1248(f) are applicable as of the date that is 30 days following the issuance of the final regulations.

As mentioned, more commentary on the regulations package to follow. This posting is a start...perphaps a substantial one, but a start.

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[Editor's Note: While I try to post  exclusively on Federal Income Taxation matters, the New York Court of Appeal's Decision on the facial validity of the New York Internet Sales Tax is most noteworthy. The Commerce Clause and Due Process Clause challenges ultimately will have to be resolved by the U.S. Supreme Court.]

On March 28, 2013, the Court of Appeals for New York rejected the arguments made by Amazon.com. and Overstock.com. that New York’s sales tax on certain internet transactions, N.Y. Tax Law §1101(b)(8)(vi) was unconstitutional. The argument supporting that the Internet Tax should be struck down was that it violated the Commerce Clause or the Due Process Clause of the U.S. Constitution. Overstock com. v. New York State Department of Taxation and Finance, N.Y. Ct. App. Dkt. No. 33 (3/28/13) and Amazon. Com. V. New York State Department and Finance, N.Y. Ct. App. Dkt. No. 34 (3/28/13).

In a 4-1 decision, the Court of Appeals, in a majority opinion written by Chief Judge Jonathan Lippman, held that the Internet Tax does not violate the Commerce Clause or the Due Process Clause of the U.S. Constitution. The Court accordingly rejected the arguments advanced by the plaintiffs that the Internet Sales (and Use) Taxes imposed a tax on online retailers which did not have a physical presence in New York thereby violating the Commerce Clause or did not violate the Due Process clause by creating an irrational, irrebuttable presumption of solicitation of business within the State.

Background Facts

Amazon.com. is organized as a Delaware limited liability company or LLC. Amazon Services LLC is also an LLC formed in Nevada, which the Court collectively referred to as “Amazon”.

Its principal corporate offices are located in the State of Washington. Amazon is strictly an online retailer and sells merchandise solely through the Internet and represents that it does not maintain any offices or property in New York.

Amazon offers an "Associates Program". This program allows third parties to place links on their own websites that, when clicked, become direct users to Amazon's website. The Associates are compensated on a commission basis based on a percentage of revenue when a customer clicks on the Associate's link and completes a purchase from the Amazon site. The operating agreement governing the Associates Program recites that the Associates are independent contractors and that there is no employment relationship between the parties. Thousands of entities that enrolled in the Associates Program provided a New York address in connection with their applications.

The other plaintiff in the proceeding, Overstock.com is a Delaware corporation with its principal place of business in Utah. Overstock likewise sells its merchandise solely through the Internet and does not maintain any office, employees or property in New York. Similar to Amazon, Overstock had an "Affiliates" program through which third parties would place links for Overstock.com on their own websites. When a customer clicked on the link, he was immediately directed to Overstock.com, and if the customer completed a purchase, the Affiliate received a commission. As with the Associates Program conducted by Amazon, the Court also noted that the Affliates were independent contractors without the authority to obligate or bind Overstock.

In April 2008, the New York legislature amended the Tax Law to include the subdivision at issue here. In connection with the statutory definition of "vendor," the Internet tax provides that:

"a person making sales of tangible personal property or services taxable under this article ('seller') shall be presumed to be soliciting business through an independent contractor or other representative if the seller enters into an agreement with a resident of this state under which the resident, for a commission or other consideration, directly or indirectly refers potential customers, whether by a link on an internet website or otherwise, to the seller, if the cumulative gross receipts from sales by the seller to customers in the state who are referred to the seller by all residents with this type of an agreement with the seller is in excess of ten thousand dollars during the preceding four quarterly periods". NYS Tax Law §1101[b][8][vi].

 The statutory presumption of soliciting business through an independent contractor or other representative in New York may be rebutted by proof that the resident with whom the seller has an agreement did not engage in any solicitation in the state on behalf of the seller that would satisfy the nexus requirement of the United States constitution during the four quarterly periods in question.

Guidance on the Internet Tax was issued shortly after its adoption by the Department of Taxation and Finance. Its memorandum clarified that advertising alone would not invoke the statutory presumption, but further observed that, for purposes of this statute, the placement of a link to the seller's website where the resident was compensated on the basis of completed sales deriving from that link would not be considered mere advertising (see NY St Dept of Taxation & Fin Memorandum No. TSB-M-08[3]S). The memorandum also explained that the statutory presumption could be rebutted through proof that the residents' only activity in New York on behalf of the seller was to provide a link to the seller's website and that the residents did not engage in any in-state solicitation directed toward potential. New York customers (see NY St Dept of Taxation & Fin Memorandum No. TSB-M-08[3]S).

A second memorandum was issued by the Department of Taxation and Finance providing further details on how sellers could rebut the statutory presumption. The presumption would be deemed successfully rebutted if the seller satisfied two conditions: (i) where the parties' contract prohibited the resident representative from engaging in any solicitation activities in New York State on behalf of the seller, and (ii) where each resident representative submitted an annual, signed certification stating that the resident had not engaged in any of the proscribed solicitation (see NY St Dept of Taxation & Fin Memorandum No. TSB-M-08[3.1]S).

Amazon filed an action against the DTF on April 25, 2008 and Overstock commenced its action on May 30, 2008, and further sought injunctive relief. The New York Supreme Court, in separate decisions, granted DTF's motions to dismiss the complaints for failure to state a cause of action and denied plaintiffs' cross motions for summary judgment as moot, rejecting all of plaintiffs' challenges to the constitutionality of the statute (Amazon.com LLC v. New York State Dept.of Taxation & Fin., 23 Misc 3d 418 [Sup Ct, NY County 2009]).

The Appellate Division affirmed the portions of the orders that dismissed challenges to the Commerce and Due Process Clauses and declared the Internet Tax constitutional on its face (81 AD3d 183 [1st Dept 2010]). However, the Court modified by reinstating the as-applied challenges, finding that further discovery was required before those claims could be determined. Plaintiffs then entered into stipulations of discontinuance withdrawing their as-applied constitutional challenges with prejudice, which were deemed the final judgments. Then they filed appeals pursuant to CPLR 5601 (b)(1) and CPLR 5601 (d), bringing up for review the prior nonfinal Appellate Division order.

Court of Appeals Decides in Favor of the NY Department of Taxation and Finance

The plaintiffs then decided to bypass their as-applied challenges and sought a reversal from the Court of Appeals by meeting its burden to prove that the Internet Tax is unconstitutional on its face. Chief Judge Lippman noted that “It is well settled that facial constitutional challenges are disfavored”.  

"Legislative enactments enjoy a strong presumption of constitutionality… [and] parties challenging a duly enacted statute face the initial burden of demonstrating the statute's invalidity 'beyond a reasonable doubt.' Moreover, courts must avoid, if possible, interpreting a presumptively valid statute in a way that will needlessly render it unconstitutional" (LaValle v. Hayden, 98 NY2d 155, 161 [2002] [citations omitted]).

While the Court of Appeals noted that there is a dispute as to the proper standard for evaluating a facial (invalidity) challenge under the Commerce Clause, the Court stated that under either standard, i.e., the “no set of circumstances” under which the tax would be valid or the stricter test of “whether the statute has a plainly legitimate sweep”, the Internet Tax is constitutional on its face.

The Commerce Clause has been interpreted by certain courts to prohibit states from imposing an undue tax burden on interstate commerce. Matter of Orvis Co. v. Tax Appeals Trib. of State of N.Y., 86 NY2d 165, 170-171 [1995]). However, in the absence of an improper burden, entities participating in interstate commerce will not be excused from the obligation to pay their fair share of state taxes. More specifically, a state tax impacting the Commerce Clause will be upheld

"'[1] when the tax is applied to an activity with a substantial nexus with the taxing State, [2] is fairly apportioned, [3] does not discriminate against interstate commerce, and [4] is fairly related to the services provided by the State'" Moran Towing, 99 NY2d at 449; Complete Auto Transit, Inc. v. Brady, 430 US 274, 279 [1977]). The parties agree that the only prong at issue here is whether the statute satisfies the "substantial nexus" test.

In National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 US 753 1967, the United States Supreme Court held that a use tax could not be imposed on an out-of-state mail-order business that did not have offices, property or sales representatives in Illinois. The Supreme Court observed that, if Illinois were permitted to impose that type of tax burden, every other taxing jurisdiction in the country could do the same, which would result in a morass of obligations to local governments.

The Supreme Court confronted a similar issue involving a mail-order business in Quill Corp. v. North Dakota , 504 US 298, 314, 1992 and considered whether the emphasis in Bellas Hess on physical presence within the state had been rendered obsolete by the Court's shift toward "more flexible balancing analysis" under the Commerce Clause. While allowing that the result might have been different if the issue was being considered for the first time, the Court retained the bright line presence requirement articulated in Bellas Hess, recognizing the benefits provided by a clear rule that established the limits of State taxing authority.  

Questioning the Physical Presence Test as Outdated: Defer to U.S. Supreme Court

The Court of Appeals then observed that the “world has changed dramatically in the last two decades, and it may be that the physical presence test is outdated.” An entity may now have a profound impact upon a foreign jurisdiction solely through its virtual projection via the Internet. But Chief Judge Lippman noted that “That question, however, would be for the United States Supreme Court to consider. We are bound, and adjudicate this controversy, under the binding precedents of that Court, the ultimate arbiter of the meaning of the Commerce Clause.”

Subsequent to Quill, supra, the Court of Appeals for New York required that an in-state physical presence is necessary, it need not be substantial. Rather, it must be demonstrably more than a slightest presence. The presence requirement will be satisfied if economic activities are performed in New York by the seller's employees or on its behalf .

The Court acknowledged that there are clearly parallels between a mail-order business and an online retailer –- both are able to conduct their operations without maintaining a physical presence in a particular state. Indeed, physical presence is not typically associated with the Internet in that many websites are designed to reach a national or even a global audience from a single server whose location is of minimal import. However, through this statute, the legislature has attached significance to the physical presence of a resident website owner. The decision to do so recognizes that, even in the Internet world, many websites are geared toward predominantly local audiences — including, for instance, radio stations, religious institutions and schools -– such that the physical presence of the website owner becomes relevant to Commerce Clause analysis. Indeed, the Appellate Division record in this case contains examples of such websites urging their local constituents to support them by making purchases through their Amazon links. Essentially, through these types of affiliation agreements, a vendor is deemed to have established an in-state sales force.

Viewed in this manner the Court of Appeals held that New York's Internet Tax sales tax statute plainly satisfies the substantial nexus requirement. Active, in-state solicitation that produces a significant amount of revenue qualifies as "demonstrably more than a 'slightest presence'" under the Orvis standard. While not controlling per se, it also merits notice that vendors are not required to pay these taxes out-of-pocket. Rather, they are collecting taxes that are unquestionably due, which are exceedingly difficult to collect from the individual purchasers themselves, and as to which there is no risk of multiple taxation. The majority decision based its conclusion that “if a vendor is paying New York residents to actively solicit business in this State, there is no reason why that vendor should not shoulder the appropriate tax burden. We will not strain to invalidate this statute where plaintiffs have not met their burden of establishing that it is facially invalid.”

The Court next addressed the admittedly closely related challenge based on the Due Process Clause, which, as with the dormant Commerce Clause, limits the taxing powers of the states. Unlike the bright line presented by the Commerce Clause, physical presence is not required in order to satisfy due process test.Instead, the focus is on whether a party has purposefully directed its activities toward the forum state and whether it is reasonable, based on the extent of a party's contacts with that state and the benefits derived from such access, to require it to collect taxes for that state. Citing Quill, supra. Indeed, an entity "that is engaged in continuous and widespread solicitation of business within a State… clearly has fair warning that [its] activity may subject [it] to the jurisdiction of a foreign sovereign," even in the absence of physical presence (Quill, 504 US at 308 [internal quotation marks and citation omitted]). In this respect, the Court of Appeals opined that "a brigade of affiliated websites compensated by commission" are the equivalent of "a deluge of catalogs" and "a phalanx of drummers" .

Plaintiffs argued that the Internet tax violates due process because the statutory presumption is irrational and essentially irrebuttable. In order for the presumption to be constitutionally valid, there must be "a rational connection between the Facts proven and the fact presumed, and… a fair opportunity for the opposing party to make [a] defense" . Matter of Casse v. New York State Racing & Wagering Bd., 70 NY2d 589, 595 (1987).

Under the facts of both Associates Programs involved, residents of New York are compensated for referrals that result in purchases. The fact presumed is that at least some of those residents will actively solicit other New Yorkers in order to increase their referrals and, consequently, their compensation. The Court held that it is “plainly rational to presume that, given the direct correlation between referrals and compensation, it is likely that residents will seek to increase their referrals by soliciting customers. More specifically, it is not unreasonable to presume that affiliated website owners residing in New York State will reach out to their New York friends, relatives and other local individuals in order to accomplish this purpose.” The presumption would be less rational if it were applied to those who receive some types of "other consideration" i.e., those whose compensation is unrelated to actual sales.

Plaintiffs also claim that the presumption is irrebuttable because it will be extremely difficult, if not impossible, to prove that none of their New York affiliates is soliciting customers on the retailers' behalf. However, as noted above, DTF has set forth a method (contractual prohibition and annual certification) through which the retailers will be deemed to have rebutted the presumption. Obtaining the necessary information may impose a burden on the retailers, but inconvenience does not render the presumption irrebuttable. In addition, while not determinative, it is notable that the presumption sensibly places the burden on the retailers to provide information about the activities of their own affiliates –- information that DTF would have significant difficulty uncovering on its own . Lavine v. Milne, 424 US 577, 585 (1976).

The Court of Appeals therefore found that the New York Internet Tax is facially unconstitutional under either the Commerce or the Due Process Clause and affirmed the orders of the Appellate Division below.

Dissenting Opinion by Justice Robert S. Smith

In registering the lone dissent, Justice Smith starts off his analysis by noting that the majority opinion correctly summarizes the law by saying that "if New York residents were merely engaged to post passive advertisements on their websites" no tax could be collected, but that a vendor who "is paying New York residents to actively solicit business in this State" may be required to remit tax. In his view, the issue for the court was whether certain New York-based websites — Overstock's "Affiliates" and Amazon's "Associates" — are the equivalent of sales agents, soliciting business for Overstock and Amazon, or are only media in which Overstock and Amazon advertise their products. Justice Smith thought there was insufficient nexus based on the facts and that the tax was applied in an unconstitutional manner.

The Overstock and Amazon links that appear on websites owned by New York proprietors serve essentially the same function as advertising that a more traditional out-of-state retailer might place in local newspapers. The websites are not soliciting customers for Overstock and Amazon in the fashion of a local sales agent. Of course the website owners solicit business for themselves; they encourage people to visit their websites, just as a newspaper owner would seek to boost circulation. But there is no basis for inferring that they are actively soliciting for the out-of-state retailers. Justice Smith made further comment distinguishing the in-state website owners as not being the same as a direct commission agent.

The statute at issue here tries to turn advertising media into an in-state sales force through a presumption. The statute says that a seller "shall be presumed to be soliciting business through an independent contractor or other representative" if it enters an agreement under which a New York resident "for a commission or other consideration, directly or indirectly refers potential customers, whether by a link on an internet website or otherwise". But of course a statutory presumption cannot by itself permit a state to do what the United States Constitution forbids. To presume that every website that has an agreement under which it carries an Overstock or Amazon link is a sales agent for Overstock or Amazon would be to nullify the rule that advertising in in-state media is not the equivalent of physical presence.

According to Justice Smith, the scope of the Internet Tax suffers from overbreadth, i.e., the statute would reach essentially all internet advertising that links to a seller's website: it includes any agreement for referral of customers, by a link or otherwise, "for a commission or other consideration." Since this literal reading would unquestionably render the statute unconstitutional, the Department of Taxation and Finance has adopted a narrowing construction, largely ignoring the words "or other consideration," and applying the presumption only where the website receives a commission or similar compensation — i.e., where "the consideration for placing the link on the Web site is based on the volume of completed sales generated by the link" (NY St Dept of Taxation and Fin Memorandum No. TSB-M-08[3]S at 2). The narrowing construction, in Judge Smith’s view, does not save the statute. The Internet Tax is invalid under the Commerce Clause.

It has been mentioned that the case will be appealed to the United States Supreme Court. It would be hoped that the Supreme Court will grant certioari and hear the dispute and determine if the New York Internet Tax will require companies like Amazon.com and Overstock.com to collect and remit New York sales tax on internet sales sourced from websites having a New York address, etc.

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In a recent report (to be) published in Tax Notes Today, March 11, 2013, the Criminal Investigation Division of the Internal Revenue Service has been issuing letters to certain taxpayers who had previously been accepted into, and accordingly had made disclosures of financial and tax return information that would in many instances be of an incriminating nature, that they are no longer eligible for relief under the OVDP. 

As a quick summary of the background of the OVDP, in August 2009, the IRS announced that it had completed successful negotiation with the Swiss government that would allow it to receive requested information on U.S. account holders at Swiss bank UBS. Such requests would be made to the Swiss government under the treaty with the U.S. As a result, many taxpayers that had kept unreported income in unreported offshore accounts were no longer going to hold secure the belief that their identity and information would be protected by the Swiss bank secrecy rules.

It was at that time that the IRS announced the 2009 Offshore Voluntary Disclosure Program (“2009 OVDP”), under which taxpayers that voluntarily and timely disclosed unreported offshore income for 2003-2008 could qualify for reduced penalties and escape criminal prosecution. In February 2011, a second Offshore Voluntary Disclosure Initiative (“2011 OVDI”) allowed taxpayers with undisclosed income from undisclosed offshore financial and bank accounts for the 2003-2010 period the opportunity to restore their tax compliance profile. The initial deadline for the 2011 OVDI was August 31, 2011 and was extended until September 9 due to Hurricane Irene. The 2011 OVDI carries higher penalties than the original disclosure initiative, but also offered the promise of non-prosecution and reduced penalties. The 2011 OVDI allows a taxpayer to disclose his or her unreported offshore financial and bank accounts omitted from required F-BAR and other filings, including disclosure and reporting of income on federal income tax returns in exchange for a reduced 25% penalty (or in some cases, a 5% or 12.5% penalty) on the highest aggregate value of the accounts and any related assets for a particular tax year between 2003 and 2010, and payment of up to eight years of taxes and interest.

The IRS began an open-ended offshore voluntary disclosure program (OVDP) in January 2012 on the heels of strong interest in the 2011 and 2009 programs. The IRS has announced that it may end the 2012 program at any time in the future. The IRS is  currently offering people with undisclosed income from offshore accounts another opportunity to get current with their tax returns. The 2012 OVDP has a higher penalty rate than the previous program but offers clear benefits to encourage taxpayers to disclose foreign accounts now rather than risk detection by the IRS and possible criminal prosecution. That is what the relevant IRS website states. See http://www.irs.gov/uac/2012-Offshore-Voluntary-Disclosure-Program

Now, we fast forward to the Tax Notes Today news item that reported that disqualification (of OVDI/P) letters were sent to certain account holders of an Israeli bank, Bank Leumi le-Israel, Bm. The Department of Justice Criminal Tax Division had previusly opened an investigation alleging that Swiss branches of three of Israel’s largest banks, Bank Leumi le Israel BM, Bank Hapoalim and Mizrahi-Tefahot, were assisting their U.S. clients to evade taxes. In an August 31, 2012 letter sent by U.S. Deputy Attorney General James Cole to Michael Ambuehl, Swiss state secretary for international financial and tax matters, a demand was made for the immediate production of information related to private U.S. taxpayers who deposited at least $50,000 in Swiss accounts between January 1, 2002, and July 31, 2010. A similar demand for information and the identity of U.S. account holders was made to several Swiss banks, including Credit Suisse, which banks were also alleged to have conspired to help U.S. account holders evade U.S. taxes and associated filing obligations. The named banks would shortly issue statements acknowledging their cooperation with the U.S. Department of Justice and that the information demanded would be delivered. Some banks were then notifying their U.S. bank customers that they received such notices which in turn prompted many to race to file requests for eligibility under the OVDI with the IRS.  

Under the “Frequently Asked Questions” and responses notice on the OVDI issued by the Internal Revenue Service, FAQ #21 takes on heightened relevance in the context of the recent report in Tax Notes Today.

“21. If the IRS has served a John Doe summons, made a treaty request, or taken similar action seeking information that may identify a taxpayer as holding an undisclosed foreign account or undisclosed foreign entity, does that make the taxpayer ineligible to make a voluntary disclosure under this program?

No. The mere fact that the Service served a John Doe summons, made a treaty request or took similar action does not make every member of the John Doe class, or group identified in the treaty request or other action ineligible to participate. However, once the Service or the Department of Justice obtains information under a John Doe summons, treaty request or similar action that provides evidence of a specific taxpayer's noncompliance with the tax laws or Title 31 reporting requirements, that particular taxpayer will become ineligible for OVDP and Criminal Investigation's Voluntary Disclosure Practice. For this reason, a taxpayer concerned that a party subject to a John Doe summons, treaty request or similar action will provide information about him to the Service should apply to make a voluntary disclosure as soon as possible.

Furthermore, there are two other ways in which a taxpayer will become ineligible. First, if a taxpayer appeals a foreign tax administrator's decision authorizing the providing of account information to the IRS and fails to serve the notice as required under existing law, see 18 U.S.C. § 3506, of any such appeal and/or other documents relating to the appeal on the Attorney General of the United States at the time such notice of appeal or other document is submitted, the taxpayer will be ineligible to participate. Second, the IRS may announce that certain taxpayer groups that have or had accounts at specific financial institutions will be ineligible due to U.S. government actions in connection with the specific financial institution. Such announcements will provide notice of the prospective date upon which eligibility for the specific taxpayer group ends and will be posted to the web . . .” (emphasis added).

The anxiety and concern generated by the retraction notices from eligibility under the OVDP is quite logical. It is a cause for much if not great concern for those affected. Upon filing for the OVDP, which may have, in many instances, included a pre-clearance inquiry for eligibility under the program from CID, taxpayers, including those having previously undisclosed accounts with the Bank of Leumi,  were deemed eligible to participate in the program. They may have felt, therefore, that if they were forthcoming and paid all taxes, penalties and interest, that they would not be prosecuted for tax evasion or related criminal offenses. But that impression may have suffered from being overly optimistic where the Department of Justice may have already received information from cooperating foreign banks identifying such U.S. persons.

Under FAQ #21, such individuals were therefore ineligible to participate. This presumably is what happened to certain U.S. persons who filed for OVDP relief with respect to their Swiss accounts with Bank of Leumi and other banks where the Department of Justice already has mined the incriminating data by agreed production from the banks where CID does not know of such prior disclosures as to individuals it has given clearance to participate. 

Perhaps the take-away from this is that “post-clearance disqualification letters” are not new or unforeseeable under the OVDP/I. That is exactly what FAQ #21 explains. But the idea that CID would “accept” for participation a taxpayer who then volunteers incriminating information in the expectation of non-prosecution (and reduced penalties) only to later disqualify such individual based on information DOJ may already have on such individual should be expected to produce a judicial challenge. See Kastigar v. United States, 406 U.S. 441 (1972). It clearly reveals there’s a “catch-22” in a taxpayer’s seeking to expunge prior sins and obtain a clean bill of tax compliance and F-BAR reporting good health despite being told he or she has been declared “eligible” by the Criminal Investigative Division of the Internal Revenue Service for the OVDI.

So, disqualification by notice is not new but what if a taxpayer who filed under the OVDI program had made requests for information from the bank involved and the bank had previously submitted the offending information to the DOJ? The taxpayer receives the information from the bank but may not have been told that it had already delivered such information to the Department of Justice. Such individual is not to be envied since he may have  produced incriminating information in waiver of his rights under the Fifth Amendment, made incriminating statements and affidavits with CID, and in hindsight, through the acts of the bank that once shielded him under bank secrecy laws, has done so without any promise of immunity from prosecution being received from the government. The taxpayer considering the filing of an OVDP or has already been accepted under the program, is under much pressure to make sure his or her filings are made prior to the DOJ’s obtaining their names and account information directly from the foreign banks.

Consider the potential misfortune that a participating taxpayer may suffer as a result of the terms set forth FAQ #21 combined with the failure of the DOJ to notify CID that it has information that makes the taxpayer ineligible for the OVDI. It such taxpayer was declared "eligible" by CID under the OVDI program, he later receives a letter that he is disqualified. In the interim, the taxpayer has submitted amended tax returns, paid the outstanding taxes, interest and penalties due and filed F-BARs or supplemental F-BAR information with CID. Is the taxpayer still going to be prosecuted or has the case perhaps lost its jury appeal to the prosecution deciding what to do. Perhaps the prosecutor will move forward on the bank information and agree the taxpayer produced information is tainted. Are the amounts involved then determinative? Of course, the facts and various instances of acts of concealment and badges of fraud will be taken into account.  Also relevant would be whether other violations of law the Title 18 (U.S.C.), e.g., money laundering, would be in issue. So, whether the government will indict an “accepted” and later “disqualified” OVDI taxpayer for tax evasion and/or F-BAR criminal violations (as well as other related offenses) is a matter that is left for the Criminal Division of the Department of Justice to decide. See, e.g., United States v. Simon, 106 AFTR 2d 2010-6739 (D.C. Ind. 2010).

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In his State of the Union speech before Congress on February 12, President Obama again called upon members of Congress to reform the tax code, increase jobs and continue to grow our economy. He continued to endorse his set of corporate tax proposals, including international tax revisions, that he had announced last February in a Joint Report with the Treasury Department.

On February 22, 2012, President Obama released a Joint Report by The White House and the Department of the Secretary of the Treasury labeled “The President’s Framework for Business Tax Reform”. Among the key elements would be the reduction in the maximum marginal corporate income tax rate from 35% to 28% and eliminate approximately $250 billion in business tax expenditures. The Framework would also impose a minimum tax on foreign earnings, such as the earnings of a foreign subsidiary of a U.S. parent corporation, and reduces the top effective rate on manufacturers to 25% through a manufacturing deduction designed to encourage “greater research and development” as well as the production of clean energy.

Among the casualties of the Framework would be the oil and gas industry’s sacred cowl, the depletion allowance rules and write off of intangible drilling costs. The carried interest rule would be eliminated and taxed at ordinary income rates. The LIFO accounting method would also be eliminated. The overhaul would be fully paid for, according to the framework.

This post sets forth some of the more notable features and aspects of the Joint Report.

“PRESIDENT OBAMA'S FIVE ELEMENTS OF BUSINESS TAX REFORM

I. Eliminate dozens of tax loopholes and subsidies, broaden the base and cut the corporate tax rate to spur growth in America: The Framework would eliminate dozens of different tax expenditures and fundamentally reform the business tax base to reduce distortions that hurt productivity and growth. It would reinvest these savings to lower the corporate tax rate to 28 percent, putting the United States in line with major competitor countries and encouraging greater investment in America.

II. Strengthen American manufacturing and innovation: The Framework would refocus the manufacturing deduction and use the savings to reduce the effective rate on manufacturing to no more than 25 percent, while encouraging greater research and development and the production of clean energy.

III. Strengthen the international tax system, including establishing a new minimum tax on foreign earnings, to encourage domestic investment: Our tax system should not give companies an incentive to locate production overseas or engage in accounting games to shift profits abroad, eroding the U.S. tax base. Introducing a minimum tax on foreign earnings would help address these problems and discourage a global race to the bottom in tax rates.

IV. Simplify and cut taxes for America's small businesses: Tax reform should make tax filing simpler for small businesses and entrepreneurs so that they can focus on growing their businesses rather than filling out tax returns.

V. Restore fiscal responsibility and not add a dime to the deficit: Business tax reform should be fully paid for and lead to greater fiscal responsibility than our current business tax system by either eliminating or making permanent and fully paying for temporary tax provisions now in the tax code.”

I. Cut Loopholes and Subsidies, Broaden the Base, and Cut the Corporate Tax Rate

The United States has the second highest statutory tax rate among advanced countries. In April 2012, after the scheduled reductions in Japanese tax rates go into effect, the United States will have the highest statutory corporate income tax rate in the Organization for Economic Cooperation and Development (OECD).

COMPARISON OF STATUTORY CORPORATE TAX RATES

IN THE UNITED STATES AND OECD COUNTRIES

          TABLE 1: 2011 G-7 STATUTORY CORPORATE TAX RATES (IN PERCENT)

 ______________________________________________________________________________

                                     Statutory Corporate    Effective Marginal

                                     Tax Rate (including    Tax Rate (including

 Country                             subnational taxes)     subnational taxes)

 ______________________________________________________________________________

 Canada                                       27.6                    33.0

 France                                         34.4                    28.3

 Germany                                     30.2                     23.3

 Italy                                               31.3                    24.0

 Japan                                          39.5                    42.9

 United Kingdom                         26.0                     32.3

 United States                              39.2                     29.2

 G-7 average excl.U.S.                32.3                    31.9

 Distorting The Form of Investment by Industry and Asset Type

The Joint Report recognizes that our federal tax system is replete with industry type tax preferences which have the effect of favoring certain industry sectors over others and at wide margins. Take one comment made for example, “because of accelerated depreciation and other features of the tax code, in 2005 income from a typical investment in structures for oil and gas faced an effective total marginal tax rate (including corporate and investor level taxes) of about 9 percent as compared to a 32 percent rate for manufacturing buildings.”

This hodge-podge system of preferences produces an unlevel planning field that distorts investment decisions. This lack of horizontal equity based on industry tax incentives (or the lack of such incentives) is reflected in another table contained in the Joint Report.

             TABLE 2: EFFECTIVE ACTUAL FEDERAL CORPORATE TAX RATES

                          BY INDUSTRY FOR 2007 - 2008

 ______________________________________________________________________________

 Industry                                   Effective Actual Corporate Tax Rate

 ______________________________________________________________________________

 Agriculture, Forestry, Fishing and Hunting                   22%

 Mining                                                                              18%

 Utilities                                                                             14%

 Construction                                                                    31%

 Manufacturing                                                                  26%

 Wholesale and Retail Trade                                           31%

 Transportation and Warehousing                                  19%

 Information                                                                        25%

 Insurance                                                                           25%

 Finance and Holding Companies                                  28%

 Real Estate                                                                       23%

 Leasing                                                                             18%

 All Services                                                                       29%

 Average Effective Actual Tax Rate                                 26%

 ______________________________________________________________________________

 Source: U.S. Department of the Treasury, Office of Tax Analysis

Distortion in Financing Investment: Overuse of Debt

As we know, the corporate tax provisions, as with Chapter 1 of the Code in general, favors financing capital by the use of debt over equity. This is because interest is generally deductible in computing taxable income while dividends are not.  Adding to the advantage of debt is that depreciation allowances, including accelerated depreciation, yields even lower costs associated with debt capital. In many instances the advantages of debt-financed capital investment can yield an effective marginal tax rate that is negative. But added debt brings on added risk which is can ultimately result in bankruptcy or perhaps “quick” or “fire” sales of assets to avoid bankruptcy.

                 EFFECTIVE MARGINAL TAX RATES FOR DEBT AND EQUITY

            FINANCED CORPORATE INVESTMENTS: SELECTED OECD COUNTRIES

 ______________________________________________________________________________

                           Effective Marginal           Effective Marginal

                           Tax Rate                           Tax Rate

 Country             Equipment (Equity)          Equipment (Debt)     Difference

 ______________________________________________________________________________

 Australia                         31                                    -23                -54

 Austria                            27                                    -14                -41

 Belgium                            5                                     -50                -55

 Canada                           28                                    -21                -49

 Finland                            27                                    -18                -45

 France                            29                                     -59                -88

 Germany                         32                                     -10                -42

 Greece                            14                                     -26                -40

 Ireland                              15                                      -4                -19

 Italy                                   38                                       1                -37

 Japan                               49                                       -4                -53

 Netherlands                     27                                     -14                -41

 Norway                             33                                     -11                -43

 Portugal                           22                                     -34                -56

 Spain                               36                                     -22                -58

 Sweden                           24                                     -24                -48

 Switzerland                     22                                     -18                -40

 UK                                    30                                      -9                 -40

 United States                 37                                    -60                -97

 Average, Excl. US           34                                    -17                -51

 (unweighted)

 G-7 Average, Excluding U.S.       37                      -15                -51

 (unweighted)

 ______________________________________________________________________________

 Source: U.S. Department of Treasury, Office of Tax Analysis.

Distortion of Form of Business Organizations

The Joint Report then compared our tax entity friends, Subchapter S, Subchapter K  and noted the double tax, non-integrated tax system under Subchapter C. Subchapter S is partially integrated with the built-in gains tax under Section 1374 being the main corporate tax vestige. Subchapter K offers a fully integrated tax regime with taxes imposed at the owner level. The combined effect of this varying tax treatment has contributed to a lower effective tax rate for pass-through entities relative to C-corporations. The effective marginal tax rate on new investment by C-corporations is now 32.3 percent, while the effective marginal tax rate on new investment by pass-through businesses 26.4 percent. As a result, large companies are increasingly avoiding corporate tax liability by organizing themselves as pass-through businesses. Pass-through businesses represented less than one quarter of net business income in 1980, but more than 70 percent of net business income in 2008.

Distortions in Favor of Shifting Production and Profits Overseas

The higher corporate income tax rate in the U.S. is a major factor in outsourcing capital and labor from the United States to lower tax jurisdictions. In fact, there is no offsetting benefit in many instances by doing business overseas realized by the U.S. companies through foreign tax credits when the jurisdictions in which they are doing business have no or little tax.

The Joint Report notes that income-shifting behavior by multinational corporations is a significant concern. Note the controlled foreign corporation provisions which can be used to block or defer income in which case only the local country tax is paid which in many cases is lower than the United States.

Subject to the rigors of transfer pricing rules, there is more than anecdotal evidence to confirm that  companies generally purposely engage in efforts to shift income from high-tax foreign countries to low-tax foreign countries, and that this phenomenon is particular hard-felt in the United States. There are also "intangibles" relocations of brandnames, trademarks, and similar valuable intangibles to low tax jurisdictions. High U.S. corporate income tax rates also discourage foreign investment in the U.S. and many merger activity results in a non-U.S. situs for the pooled entities. These somewhat long-standing trends are viewed by the current Administration as matters which need to be corrected, corrected quickly and in a manner which attracts capital and labor to the U.S.

President's Framework for Reform

Well, many of us who have worked with our domestic and international tax laws have known the bias in favor of moving business operations overseas for many, many years. It was somewhat shocking to see the delay in not responding to this capital and labor drain from our economy. Perhaps some influential lobbyists kept the Congress asleep long enough to move business operations overseas. Indeed Congress did not wise up until perhaps the inversion provision was enacted which is contained in Section 7874.

Now, The President's Framework would eliminate dozens of different tax expenditures and fundamentally reform the business tax base to reduce distortions that hurt productivity and growth. The Reforms proposed by the President are designed to remove the distortions and bias under current law, and restore the United States to a more competitive environment for promoting growth in the United States for U.S. based companies and attract far more foreign investment.

The Specifics of the President’s Framework.

•           Reduce the corporate tax rate from 35 percent to 28 percent.

•           Eliminate dozens of business tax loopholes and tax expenditures. This would include. reductions in tax expenditures and loophole closers that should be part of any reform:

1. Eliminate "last in first out" accounting. Under the "last-in, first-out" (LIFO) method of accounting for inventories, it is assumed that the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. This allows some businesses to artificially lower their tax liability. The Framework would end LIFO, bringing us in line with international standards and simplifying the tax system.

2. Eliminate oil and gas tax preferences. This includes repeal of  the expensing of intangible drilling costs, a provision that allows oil companies to immediately write-off these costs rather than recovering the cost over time as for most capital investments in other industries. This includes repeal of  percentage depletion for oil and natural gas wells, which allows certain oil producers and royalty owners to recover the cost of oil and gas wells based on a percentage of the income they earn from selling oil and gas from the property rather than on the exhaustion of the property..

3. Reform taxation of insurance products and the insurance industry. Under current law, companies can invest in life insurance for their officers, directors, or employees, benefit from "inside build up" (gains on that investment) that are tax-deferred or never taxed, and finance that investment through debt that allows the corporation to take interest deductions earlier than any gain realized on the life insurance. The Framework would close this loophole and not allow interest deductions allocable to life insurance policies unless the contract is on an officer, director, or employee who is at least a 20 percent owner of the business. The Framework would also make a number of other reforms to the treatment of insurance companies and products to improve information reporting, simplify tax treatment, and close loopholes.

4. Taxing carried (profits) interests as ordinary income. Currently, many hedge fund managers, private equity partners, and other managers in partnerships are able to pay a 15 percent capital gains rate on their labor income (on income that is known as "carried interest"). The President proposes to tax carried interests in investment services partnerships (by its managers) at ordinary income tax rates.  

5. Eliminate special depreciation rules for corporate purchases of aircraft. Extend the useful life of aircraft (non-commercial) from 5 to 7 years.  

6.  Reform the corporate tax base to invest savings in cutting the tax rate and reducing harmful distortions. This Framework lays out a menu of options that should be under consideration in reform. At least several of these would be necessary to get the rate down to 28 percent:

7. Lighten up on accelerated depreciation. Lower corporate tax rates and a base broadening would end up with lower or slower rates of deprecation.

8. Reducing the bias toward debt financing. This is accomplished by lowering the corporate tax rate and perhaps reducing the overall deductibility of interest.

9. Establishing greater parity between large corporations and large non-corporate counterparts.

10. Improve transparency and reduce accounting gimmicks. Corporate tax reform should increase transparency and reduce the gap between book income, reported to shareholders, and taxable income, reported to the IRS. These reforms could include greater disclosure of annual corporate income tax payments.

Strengthen American Manufacturing and Innovation

The President wants to increase U.S. based manufacturing. He wants to enhance the continuation of R&D activities in the United States with building bridges for producing U.S. manufacturing and IT jobs that are produced from such new processes and inventions. The Framwork notes that R&D is especially important for manufacturing, which is a technology-intensive sector. In the 1980s, the United States was the leader in providing tax incentives for R&D through the Research and Experimentation Tax Credit (R&E Tax Credit). Today, however, many nations provide far more generous tax incentives for research than does the United States.

The President also wants to move to a  clean energy economy will reduce air and water pollution and enhance our national security by reducing dependence on oil. Cleaner energy will play a crucial role in slowing global climate change, meeting the President's goal of producing 80 percent of our nation's electricity from clean sources by 2035.

President's Framework for Reform To Strength American Manufacturing and Innovation

•           Effectively cut the top corporate tax rate on manufacturing income to 25 percent and to an even lower rate for income from advanced manufacturing activities by reforming the domestic production activities deduction. See Section 199. It would focus the Section 199 deduction more on manufacturing activity, expand the deduction to 10.7 percent, and increase it even more for advanced manufacturing. This would effectively cut the top corporate tax rate for manufacturing income to 25 percent and even lower for advanced manufacturing.

•           Expand, simplify and make permanent the R&E Tax Credit. Currently, businesses must choose between using a complex formula for calculating their R&E Tax Credit that provides a 20 percent credit rate for investments over a certain base and a much simpler one that provides a 14 percent credit in excess of a base amount. The complex formula is outdated that it takes into account the amount of a business's R&D expenses from 1984 to 1988. The President's Framework would increase the rate of the simpler credit to 17 percent and make it permanent.  

•           Extend, consolidate, and enhance key tax incentives to encourage investment in clean energy. The President's Framework would make permanent the tax credit for the production of renewable electricity, like wind and solar. In addition, the structure of renewable production and investment tax credits has required many firms to invest in inefficient tax planning through tax equity structures so that they can benefit even when they do not have tax liability in a given year because of a lack of taxable income. The President's Framework would address this issue by making the permanent production tax credit refundable.

Strengthen the International Tax System to Encourage Domestic Investment

The Framework reiterates that the current U.S. tax system subjects foreign subsidiaries of U.S.-based multinationals to taxes on their overseas income (while allowing a tax credit for foreign taxes paid). However, often corporations do not need to pay taxes in the United States on such income until repatriated. Many companies never repatriate foreign earnings which results in economic loss and reduced tax revenues. The use of the CFC rules and other planning schemes has made the payment of U.S. tax by U.S. multinationals somewhat elective. Indeed, the Administration knows that many companies are sensitive to higher rates of tax, and why not? So the country needs to be more competitive by lowering tax rates here while at the same time changing some of the tax incentives to moving business operations overseas. A table set forth in the report demonstrates that profits of some U.S. corporations reported in select, small countries with very low tax rates far exceeds the country's actual output,  which indicates that the earnings were generated outside of the tax havens.

The Framework notes that there are different proposals to reform the international tax rules. One proposal, previously finding support from the Bush 43 Administration is to switch to a pure territorial system under which all active foreign income would either be taxed little or not at all in the United States. However, President Obama believes that a pure territorial system could aggravate, rather than ameliorate, many of the problems in the current tax code.

Under a territorial system,  foreign earnings of U.S. multinational corporations would not be taxed at all creating even greater incentives to locate operations abroad or use accounting mechanisms to shift profits out of the United States. This could also foster a “race to the bottom” on international tax rates.

Instead, the Joint Report states that tax reform should be a foundation to maximize investment, growth and jobs in the United States. It should reduce tax incentives to locate overseas with the need for U.S. companies to be able to compete overseas; some overseas investments and operations are necessary to serve and expand into foreign markets in ways that benefit U.S. jobs and economic growth.

President's Framework for Reform In the Area of International Taxation

•           Require companies to pay a minimum tax on overseas profits. The President believes we must prevent companies from reaping the benefits of locating profits in low-tax countries, put the United States on a more level playing field with our international competitors, and help end the race to the bottom in corporate tax rates. Specifically, under the President's proposal, income earned by subsidiaries of U.S. corporations operating abroad must be subject to a minimum rate of tax. Foreign income deferred in a low-tax jurisdiction would now become subject to immediate U.S. taxation up to the minimum tax rate with a foreign tax credit allowed for income taxes on that income paid to the host country.

•           Remove tax deductions for moving productions overseas and provide new incentives for bringing production back to the United States. The tax code currently allows companies moving operations overseas to deduct their moving expenses -- and reduce their taxes in the United States as a result. The President is proposing that companies will no longer be allowed to claim tax deductions for moving their operations abroad. At the same time, to help bring jobs home, the President is proposing to give a 20 percent income tax credit for the expenses of moving operations back into the United States.

•           Other reforms to reduce incentives to shift income and assets overseas. The Framework would also clean up the international tax code and reduce incentives and opportunities to shift income and assets overseas. For example, as noted above, U.S. companies may use accounting rules or aggressive transfer pricing to shift profit offshore. This is particularly true in the case of profits associated with intangible assets (assets like intellectual property). The Framework would strengthen the international tax rules by taxing currently the excess profits associated with shifting intangibles to low tax jurisdictions. In addition, under current law, U.S. businesses that borrow money and invest overseas can claim the interest they pay as a business expense and take an immediate deduction to reduce their U.S. taxes, even if they pay little or no U.S. taxes on their overseas investment. The Framework would eliminate this tax advantage by requiring that the deduction for the interest expense attributable to overseas investment be delayed until the related income is taxed in the United States.

Simplify the Internal Revenue Code  and Cut Taxes for America's Small Businesses

President's Framework for Reform

•           Allow small businesses to expense up to $1 million in certain qualified investments.

•           Allow cash method of accounting on businesses with up to $10 million in gross receipts. Small businesses with up to $5 million in gross receipts are currently allowed to use this simplified form of accounting. Under the President's Framework, this threshold would increase to $10 million.

In the Budget, the President has also proposed a number of discrete reforms that simplify the tax code for small businesses and provide them with tax relief -- and that Congress could act on immediately and should also be included in any fundamental reform.

•           Double the deduction for start-up costs. This would double the amount of start-up expenses entrepreneurs can immediately deduct from their taxes from $5,000 to $10,000. This offers an immediate incentive for investing in starting up new small businesses, and it also simplifies accounting for small businesses, which must otherwise write off start-up expenses over a period of 15 years.

•           Reform and expand the health insurance tax credit for small businesses. This credit, created in the Affordable Care Act, helps small businesses afford the cost of health insurance. This reform would allow small businesses with up to 50 workers to qualify for the credit (up from 25), provide a more generous phase-out schedule, and substantially simplify and streamline the tax credit's rules.

Back to where we are now with the sequestration already upon us. Congress continues to engage in a partisan bickering that never seems to end. Still there may be hope that a compromise will be reached. The President has his own set of tax reforms on the table from the Joint Report as well as perhaps some new ones to be unveiled. There are other tax proposals, including on the international side, that are being made by members of Congress. It may be that this year both sides of the political fence will agree to rate reduction in exchange for base broadening. But then, maybe not. We shouldn't be surprised though if one Spring or Fall day in 2013, we learn that Congress has agreed on a comprehensive tax reform measure one that will hopefully lower the rate of tax on C corporations and create incentives to provide greater economic growth in the manufacturing, energy and other business sectors operating in the United States or looking to bring new capital and add jobs to our country.

Its about time!

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Chalk up another economic substance doctrine win for the Service. This one from a three judge panel of the Third Circuit Court of Appeals, in affirming the Tax Court below, in Crispin v. Commissioner, 111 AFTR2d 2013-XXXX (2/25/2013).  

The  taxpayer in this case , Neal D. Crispin, a businessman-entrepreneur  was involved in leasing, structured finance, aircraft acquisition and mortgaged back securities lending. He was a practicing CPA and  experienced in tax matters, including tax shelters. He had invested in a “custom adjustable rate debt structure” or CARDS transaction which was designed to generate a substantial artificial ordinary loss deduction.  The Service disagreed with the loss claimed an imposed an accuracy-related penalty under Section 6662. The Tax Court disallowed the claimed loss on the grounds that Crispin's CARDS transaction lacked economic substance and held that he could not avoid the penalty based on reasonable cause because he had not relied reasonably or in good faith on the advice of an independent and qualified tax professional. He was therefore saddled with a 40% gross valuation misstatement penalty. The Third Circuit affirmed.

Factual Background

For over 24 years, Crispin purchased and leased commercial aircraft through investment syndicates. The typical deal would involve his company’s (S corporation)  purchase of used aircraft with a cost between $1M and $10M and then leases the planes for 10 years before reselling them. In 2001, the year in issue, he planned on purchasing 3 aircraft through his S corporation which he owned 50-50 with another investor. Enter the CARDS transaction.

The Third Circuit referred to a CARDS transaction in less than glowing terms, i.e., a tax-avoidance scheme that was widely marketed to wealthy individuals during the 1990's and early 2000's. It purports to generate, through a series of pre-arranged steps, large “paper” losses deductible from ordinary income.

The general structure of a CARDS transaction is thoroughly explained  in Gustashaw v. Commissioner, 696 F.3d 1124, 1127 [110 AFTR 2d 2012-6169]–28, 1130–31 (11th Cir. 2012). As a quick summary, first, a tax-indifferent party, such as a foreign entity not subject to United States taxation, borrows foreign currency from a foreign bank (a “CARDS Loan”). Then, a United States taxpayer purchases a small amount, such as 15%, of the borrowed foreign currency by assuming liability for a an equal amount of the CARDS Loan. The taxpayer also agrees to be jointly liable with the foreign borrower for the remainder of the CARDS Loan and so the taxpayer purports to establish a basis equal to the entire borrowed amount. Then,  the taxpayer exchanges the foreign currency he purchased for U.S.dollars. That exchange is a taxable event, and the taxpayer claims a loss equal to the full amount of his supposed basis in the CARDS Loan, less the proceeds of the relatively small amount of currency actually exchanged. The taxpayer uses that loss to shelter unrelated income. CARDS marketing materials describe the transaction as providing “financing” to the taxpayer. However, there is no net cash available to the taxpayer, because the foreign bank requires that all of the currency purchased with the proceeds of the CARDS Loan (including the portion purchased by the taxpayer) remain at the bank as collateral for the CARDS Loan. The taxpayer only has access to the proceeds of the CARDS Loan if he delivers to the bank an equal amount of cash, cash equivalents, or other collateral acceptable to the bank.

The IRS, in Notice 2000-44, 2000-2 C.B. 255 (8/13/2000), placed the tax community on notice in 2000, prior to the events occurring in Crispin, supra, about claiming tax deductions sourced from artificial losses generated by inflated bases in certain assets. The Notice containing that warning said that the IRS would not recognize transactions that created an artificially high basis if they lacked economic substance or a valid business purpose.  Recognizing that the CARDS transaction was being used, it issued a second notice, Notice 2002-21, 2002-1 C.B. 730 (3/18/2002) again attacking CARDS transactions. It imposed disclosure obligations on CARDS promoters and users. Eventually, the IRS announced a settlement initiative that allowed CARDS users to avoid penalties for gross valuation misstatements applicable under Section provided that they conceded their CARDS-related tax benefits and agreed to pay a reduced penalty. See Announc. 2005-80, 2005-2 C.B. 967 (Oct. 28, 2005). Some 2,000 taxpayers elected to settle, paying roughly $2 billion in back taxes.

Crispin wanted to shelter more than $7M in corporate level income for 2001. He learned of the CARDS program and proceeded to wrap his intended aircraft purchase to be consummated by his S corporation as part of a CARDS transaction. The specific transaction involved a foreign entity  that would enter into a 30-year CARDS Loan denominated in a Swiss francs; the loan proceeds would be retained by the lender; Crispin would purchase 15% of the foreign currency obtained through the CARDS Loan, and he would agree to be jointly and severally liable for the entire CARDS Loan; he would agree to repay the principal at the maturity date; and he would exchange the foreign currency he purchased for United States dollars, claiming as his basis the full amount of the CARDS Loan and garnering a tax loss equal to 85% of the total loan value. Hahn also provided Crispin with a sample tax opinion blessing the transaction. The taxpayer thought he and his partner would offset his 2001 income of $7.6 million from the mortgage securities business from losses of an offsetting amount.

Crispin’s CARDS transaction was placed with Croxley Financial Trading LLC acting as the foreign borrower and  Zurick bank as the lender. In December ,2001, Zurich loaned $74 million Swiss francs to Croxley for a stated 30-year term but callable and repayable at any time after the first year. The proceeds of the CARDS Loan were transferred to Croxley's account at Zurich and pledged to Zurich as collateral for the loan. Later during the same month, Crispin purchased  4.8 million Swiss francs (the “loan assumption proceeds”) in exchange for Crispin's agreement to be jointly and severally liable for a share of the loan obligations to Zurich with a value of $9.4 million. Crispin immediately transferred the loan assumption proceeds to the Zurich account of the S corporation, which in turn guaranteed Crispin's loan obligations, and which pledged the Swiss francs to Zurich as collateral for the loan. On the same day, the S corporation exchanged 3.1 million Swiss francs for United States dollars. Crispin's S corporation received $1.8 million, which it used to purchase a Zurich promissory note that matured at the end of one year and that was held by Zurich as collateral for the corporation's guaranty of Crispin's obligations on the CARDS Loan.

In August 2002, Zurich notified Crispin that it was exercising its right to terminate the CARDS Loan. The collateral securing the S corporation’s  guarantee was transferred to Croxley, which used it, together with the remainder of the loan proceeds held by Zurich, to repay the loan. The Croxley loan ended up lasting approximately one year, typical of the CARDS Loans that Zurich provided to the financial advisor’s clients.

Prior to filing his 2001 return, Crispin hired a law firm, which had provided tax opinions to the financial advisor to other clients entering into CARDS transactions. While the law firm’s opinion noted the IRS’ opposition, as reflected in its notices, the law firm opined that Crispin's transaction “should have sufficient business purpose to be respected” by the IRS because “[t]he business purpose for [his] entering into the [t]ransactions is clear” and “[t]he financing available to [him] through the [t]ransactions has reduced [his] costs and has afforded [him] the ability to have access to large amounts of capital on a long-term basis to operate the  aircraft.

The aircraft business posted a loss of $7.6 million on its 2001 tax return, the difference between its claimed basis (equal to Crispin's $9.4 million assumed share of the CARDS Loan, guaranteed by the partnership) and the $1.8 million of proceeds it received from the currency exchange. That loss offset virtually all of operating entity’s income for 2001. As a result, Crispin reported only $3,244 of flow-through income from his allocable share of the net income of the S corporation.

IRS Audit

Upon audit, the IRS disallowed the venture’s $7.6 million ordinary loss. A notice of deficiency was eventually issued in July, 2007 by the Commissioner to Crispin seeking not only the tax, but imposing a $1.2 million penalty plus interest for 2001.

Tax Court Memorandum Decision, Judge Diane L. Kroupa

In March 2012, the Tax Court issued a memorandum opinion affirming the Commissioner's determination that Crispin was not entitled to an ordinary loss deduction from his allocable share of loss from his S corporation which directly participated in the CARDS transaction. The Service proposed to assess an accuracy-related penalty under Section 6662. The basis for its holding was that the CARDS transaction lacked economic substance because Crispin had no valid business purpose and had tax-avoidance as his primary motivation.  It further held that Crispin was liable for a 40% penalty for underpayment that results from a gross valuation misstatement, per Section 6662(h)(1), and that Crispin was not entitled to relief from the penalty under the exception applicable to taxpayers who rely on expert tax advice reasonably and in good faith, pursuant to Section 6664(c)(1).

Crispin appealed to the Third Circuit court of appeals. This timely appeal followed.

Third Circuit Affirm’s Tax Court’s Decision Below

Crispin’s loss needed to meet the requirements under Section 165(a) as a “bona fide loss”. For a loss to be bona fide, it must therefore satisfy the economic substance doctrine, among other requirements.  “The economic substance doctrine ... applies where the economic or business purpose of a transaction is relatively insignificant in relation to the comparatively large tax benefits that accrue (that is, a transaction ... which exploit[s] a feature of the tax code without any attendant economic risk) ....”Neonatology Assocs., P.A. v. Comm'r , 299 F.3d 221, 231 [90 AFTR 2d 2002-5442] n.12 (3d Cir. 2002) (citation and internal quotation marks omitted). “[I]n that situation, where the transaction was an attempted tax shelter devoid of legitimate economic substance, the doctrine governs to deny those benefits.” Id.

“The inquiry into whether the taxpayer's transactions had sufficient economic substance to be respected for tax purposes turns on both the objective economic substance of the transactions and the subjective business motivation behind them.”  (citations omitted). The subjective intent inquiry focuses on whether the taxpayer entered into the transaction intended to serve a useful business purpose (citations omitted).  The Tax Court found that Crispin's CARDS transaction failed both the objective and subjective tests for economic substance. The Court noted that Crispin experienced only a paper loss of $7.6 million,  and that, after the CARDS Loan was repaid, Crispin experienced no consequences other than receiving the tax deduction. As a result, the Court concluded that “[t]he ordinary loss claimed from the CARDS transaction was fictional” , which it noted was “the hallmark of a transaction lacking economic substance.”

As to Crispin's stated business purpose, the Tax Court determined that both the structure of the CARDS transaction and the record belie Crispin's contention that he engaged in the transaction to obtain long-term financing for use in his aircraft leasing business. Although the Zurich loan had a stated 30-year maturity, the proceeds remained in Zurich's complete possession and control as collateral for the loan, and Zurich had the ability to call the loan at any time after the first year, which it in fact did. Also, Crispin never took any action to obtain and use the proceeds of the loan, knowing that he would have to post an offsetting amount of cash collateral. Nor did he ever take any steps to secure Zurich's approval to substitute aircraft for cash as collateral for the loan. Finally, there was no potential for profit, because the interest rate charged on the CARDS Loan was greater than the interest paid on the proceeds deposited as collateral at Zurich. Based on the foregoing, all of which is well-supported by the record, the Third Circuit found no error, let alone clear error, in the Tax Court's ultimate finding that Crispin's CARDS transaction lacked economic substance.

The Penalty Phase

The taxpayer argued that even if he lost the case the gross valuation misstatement penalty should not apply.

1. Applicability of the Valuation Misstatement Penalty

Section 6662 of the Internal Revenue Code imposes a 20%  penalty on an underpayment that results from a “substantial valuation misstatement,” which includes a misstatement of “basis” if “the adjusted basis of any property[] claimed on any return of tax imposed by chapter 1 is 200% percent or more of the amount determined to be the correct amount of such ... adjusted basis.” See Sections 6662(b)(1)–(3), (e)(1)(A). Such penalty may be increased to 40% if the taxpayer claims an adjusted basis in the property that is 400 percent or more of the correct amount; this is known as a “gross valuation misstatement.” See 6662(h). The Third Circuit has held that “where a claimed tax benefit is disallowed because it is an integral part of a transaction lacking economic substance, the imposition of the valuation overstatement penalty is properly imposed ....”Merino v. Comm'r , 196 F.3d 147, 159 [84 AFTR 2d 99-6790] (3d Cir. 1999).

Here, the Third Circuit was concerned that the Tax Court may not have determined the correct basis of the particular “asset” in issue, which was the “loan assumption proceeds” even though it did conclude that Crispin made a gross valuation misstatement when he claimed $9.4 million in adjusted basis for that asset on his 2001 tax return.

There were two ways to analyze the penalty under a gross valuation misstatement lens. First, treat the entire CARDS Loan for which the taxpayer agreed to be jointly and severally liable ($9.4 million in Crispin's case). What was in fact the taxpayer’s cost to enter into that loan. That cost, which may be viewed as representing the taxpayer's basis, is limited to the value of th foreign actually purchased by the taxpayer and exchanged for U.S. dollars ($1.8 million). The amount of the valuation misstatement is thus the difference between the basis that the S corporation  claimed on its 2001 tax return and that cost. (The difference is the $7.6 million deduction claimed and disallowed by the S corporation causing an increase in Crispin’s taxable income).  

The second way of evaluating a gross valuation misstatement is to consider a CARDS loan is not as one transaction but as two closely related transactions: first, the purchase and exchange of the foreign currency (for which the taxpayer actually assumed liability) and second, the agreement to be jointly and severally liable for the amount of the CARDS Loan in excess of that purchase. So, by focusing only on the second CARDS-related transaction, the basis is zero because that part of the transaction plainly lacks economic substance. Therefore, the overstatement is the full amount of the basis attributable to that second transaction (the $7.6 million deduction disallowed by the Commissioner.) See Gustashaw, supra, 696 F.3d at 1133 (noting that “a basis of zero ... is the correct amount when a transaction lacks economic substance”).

While the Court noted the vagaries of the calculation of the penalty amounts, which it urged the Service to clarify, it ruled that because the underpayment in Crispin's taxes is directly traceable to the inflated basis in the loan assumption proceeds, that underpayment is “attributable to” a valuation misstatement of over 400%, then the 40% penalty is applicable.

2. Reasonable Reliance on the Pullman Opinion

Section 6664(c) provides a “reasonable cause” exception for avoiding a penalty under Section 6662 for any portion of an underpayment where the taxpayer can demonstrate reasonable cause and having acted in good faith. This is a factual test. See Treas. Reg. §1.6664-4(b)(1).

In analyzing the record, the facts did not support a reasonable cause defense for Crispin based on the law firm’s opinion. In fact the opinion referred to the outstanding guidance issued from the service that no loss would be allowed and that CARDS was a “listed transaction” on which penalties may be imposed. Crispin's “experience, knowledge, and education,” as a former CPA and chief financial officer also strongly suggest enough familiarity with tax matters that he should be expected to have understood the warnings that Pullman included in the opinion.

The Third Circuit noted that the taxpayer made a series of misrepresentations on why he entered into the transaction and its business purpose. He knew or should have know such representations were false.  It noted the Tax Court’s finding that “the record does not reflect that petitioner actually relied on the tax opinion” because “[Crispin] received the finalized opinion after the 2001 tax returns for [Crispin] and [the S corporation] were filed.”

Using a metaphor it couldn’t refrain from not using to drive home the point, the Third Court stated:

“When, as here, a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril.” (citation omitted). Crispin gambled at CARDS and lost, and he is liable for both the underpayment of his taxes and the accuracy-related penalty as determined by the Commissioner.

The Third Circuit affirmed the Tax Court on all grounds.

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In Bank of New York Mellon Corporation, Successor in Interest to the Bank of New York, Company, Inc. (“BNY”) v. Commissioner, 140 T.C. No. 2; No. 26683-09 (filed 2/11/2013), the Tax Court, in a fully reviewed decision with Judge Diane L. Kroupa writing for the majority, upheld a proposed deficiency in federal income tax against the BNY consolidated group for 2001 and 2002 in the amount of $100 million (2001) and $115 million (2002). It should be expected that BNY will appeal to the Second Circuit Court of Appeals.

The case involved BNY’s entering into a Structured Trust Advantaged Repackaged Securities transaction (STARS transaction). The STARS transaction provided BNY with allegedly below market cost financing from a U.K. bank, Barclays. It was part of a set of steps to generated foreign source income and foreign tax credits and expenses to BNY in a tax-arbitrage type play that the government would attack as lacking any economic substance other than to generate tax savings.

As part of the STARS transaction, BNY  transferred income-producing assets to a trust with a U.K. trustee and subject the trust asstes to U.K. tax on its income. As a result, BNY claimed foreign tax credits and deductible expenses on its 2001 and 2002 consolidated income tax returns as a result of the STARS transaction. It further reported income from the assets transferred to the trust as foreign source income on the returns.

Upon audit, the government alleged that the STARS transaction was a sham and lacked economic substance. It therefore disallowed the claimed foreign tax credits, the expense deductions and the reporting of the asset income as foreign source. The Court ruled that since the STARS transaction, based on the record before it, lacked economic substance and could not be respected for federal tax purposes, including treaty purposes. Accordingly, BNY could not claim foreign tax credits, the claimed deductible expenses or the foreign source income treatment.

The affiliated group through BNY entered into the STARS transaction in 2001 with Barclays Bank, PLC (Barclays), a global financial services company headquartered in London, United Kingdom. The STARS transaction generated approximately $199 million in foreign tax credits for the combined years at issue. The opinion sets forth the background leading up to the structuring and implementation of the STARS transaction. The key players were of course BNY, Barclays and KPMG, STARS was represented as a "below market loan" in KPMG's initial presentation. KPMG indicated that STARS required a U.K. counterparty and a certain trust structure holding income-producing assets. KPMG explained that the below-market cost would be achieved by the U.K. counter party "sharing" U.K. tax benefits from STARS through an offset to the cost of the loan. Finally, KPMG indicated that the U.K. tax benefits would be generated by subjecting income-producing assets held by a trust to U.K. tax and thus generating foreign tax credits that BNY could use to offset its U.S. tax liability.

BNY notified KPMG in August 2001 that it was prepared to move forward with a STARS transaction with Barclays as the U.K. counterparty. BNY proposed that it would contribute assets that would generate $93 million of annual U.K. tax costs and expected Barclays to reduce the loan's annual cost by half that amount. Shortly thereafter, BNY agreed to supplement STARS by engaging in a "stripping transaction." The effect would be to accelerate and increase the tax benefits STARS produced (i.e., foreign tax credits). And just before STARS closed, BNY indicated to Barclays that it had decided to increase the targeted benefit.

The specific components of the STARS transaction are chronicled in the factual background provided by the Court in rendering its decision. The interested reader should review carefully the Courts description of the transaction, including transaction models. The Tax Court noted that the STARS transaction represented a case of first impression for it to decide. 

Tax Court’s Analysis

I. Merits of the STARS Transaction Under the Economic Substance Doctrine

The Tax Court began by acknowledging the age-old axiom that taxpayers may structure business transactions that result in the lease amount of tax. The idea that there is no patriotic duty to pay more than what a taxpayer is required to pay. See Boulware v. United States, 552 U.S. 421, 430 n.7 (2008) (citing Gregory v. Helvering, 293 U.S. 465, 469 (1935)); Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. ___, ___ (slip op. at 163-164) (Aug. 30, 2012).

But formalistic adherence to the Code does not necessarily follow that Congress intended to cover the transaction and allow a tax benefit. Knetsch v. United States, 364 U.S. 361, 365 (1960); Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935).

In situations where complex, multi-party transactions are seeking validation for federal income tax purposes, the Supreme Court’s comments in  Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978),  are frequently invoked as a marker or guide, as was the case in BNY.

“[W]here, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties. * * *"

This leads to the application of the economic substance doctrine which has two prongs or consists of a two-factor test: (1) whether the transaction had economic substance beyond tax benefits (objective prong), and (2) whether the taxpayer had shown a non-tax business purpose for entering into the disputed transaction (subjective prong). (citations omitted). (Note that the years in issue here were prior to the codification of the economic substance test in Section 7701(o)).

As noted by the Tax Court, there has been a difference in judicial opinion as to the proper application of the economic substance doctrine. Some courts have required that only one of the two prongs be satisfied for the transaction under review to be respected. See, e.g., Horn v. Commissioner, 968 F.2d 1229, 1236-1238 (D.C. Cir. 1992), rev'g Fox v. Commissioner, T.C. Memo. 1988-570; Rice's Toyota World, Inc v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985), aff'g in part, rev'g in part 81 T.C. 184 (1983). Other appellate courts require that the two prong test of objective profit motive and subjective business purpose  be met. See Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006); Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313, 1316 (11th Cir. 2001), aff'g 113 T.C. 254 (1999); United Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014, 1018 (11th Cir. 2001), rev'g T.C. Memo. 1999-268; Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006).  A third view was to consider both as only factors in determining whether the transaction has economic substance beyond the intended tax benefits. See, e.g., ACM P'ship v. Commissioner, 157 F.3d 231, 248 (3d Cir. 1998), aff'g in part, rev'g in part T.C Memo. 1997-115.

Under the Tax Court’s administrative rule of convenience announced in Golsen v. Commissioner, 54 T.C. 742 (1970), aff'd, F.2d 985 (10th Cir. 1971), the appeal from the BNY case would rest with the Second Circuit absent a stipulation to the contrary. The Second Circuit was noted as approving of the flexible analysis test in determining economic substance and will evaluate both the subjective business purpose of the taxpayer in engaging in the transaction  and the objective potential for economic profit aside from tax benefits. Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991), aff'g T.C. Memo. 1989-684; Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), aff'd, 150 Fed. Appx. 40 (2d Cir. 2005).  The ultimate determination of whether a transaction lacks economic substance is a question of fact. See Nicole Rose Corp. v. Commissioner, 320 F.3d 282, 284 (2d Cir. 2003), aff'g 117 T.C. 328 (2001).

B. Scope of the Economic Substance Inquiry

After identify the applicable standard, the Court noted that the government argued that the components of the STARS transaction should be bifurcated into its two main.  The Court agreed. It stated that for applying the economic substance test it had to focus on the transaction that yielded the disputed foreign tax credits (FTCs). The FTCs were generated by circulating income through the STARS structure. Indeed the below-market loan was not needed for the STARS structure to yield the disputed FTCs. So the use of the STARS structure is the key factor in testing for economic substance.

C. Economic Substance of the STARS Structure

1. Objective Economic Substance of the STARS Structure

The objective economic substance test requires whether the transaction created a reasonable opportunity for economic profit; i.e., a profit exclusive of tax benefits. The Court, as had been argued by the Service, viewed that there was no reasonable opportunity for an economic profit aside from the tax benefits and therefore the STARS structured lacked objective economic substance. Corroborative of its holding was its finding that : (i) the STARS structure did not increase the profitability of the STARS assets in anyway. To the contrary, it reduced their profitability by adding substantial transaction costs, e.g., professional service fees and foreign taxes incurred as result of using the STARS structure; (ii) the activities or transactions that the STARS structure was used to engage in did not provide a reasonable opportunity for economic profit; and (iii) the STARS structure's main activity was to circulate income between itself and Barclays. More specifically, each month, as pre-arranged, the subisidiary of BNY involved in the transaction would transfer pre-determined amounts of income to the U.K. managed trust. Substantially all of the trust income was distributed to the Barclays blocked account, which in turn was immediately recontributed such funds to the trust and then passed the same funds back to the BNY subsidiary where it was available for BNY's use. These circular cashflows or offsetting payments had no non-tax economic effect. Circular cashflows strongly indicate a transaction lacks economic substance. See Altria Group, Inc., 658 F.3d at 289 (citing AWG Leasing Trust v. United States, 592 F. Supp. 2d 953, 983 (N.D. Ohio 2008)) (circular payments from and back to foreign bank "strongly indicate" that SILO transaction "has little substantive business purpose other than generating tax benefits"); Merryman v. Commissioner, 873 F.2d 879, 882 (5th Cir. 1989) (tax structuring disregarded where "money flowed back and forth but the economic positions of the parties were not altered"), aff'g T.C. Memo. 1988-72.  

The STARS structure was also used in connection with the interest stripping transaction that was part of the overall plan. The interest stripping transaction also resulted in a circular cashflow and did not provide a reasonable opportunity for economic profit. Here the trust sold its right to receive interest income from the trust collateral securities to the BNY subsidiary for a lump-sum payment taxable in the United Kingdom, which the BNY subsidiary made with funds provided by  BNY. This reallocated the income and principal payments associated with the trust collateral securities within the STARS structure. It did not alter the amount and timing of the cashflows generated by the underlying assets. And because the sale of the interest rights was funded by BNY and between entities within the STARS structure, the interest stripping transaction had no potential to generate a non-tax economic profit on the aggregate.

Furthermore, the Tax Court found that  BNY's control and management over the STARS assets did not materially change as a result of their transfer to the STARS structure.Additionally, the STARS structure had no effect on the income stream generated by the STARS assets. Accordingly, the STARS assets would have generated the same income regardless of being transferred to the trust. Thus, income from the STARS assets was not an incremental benefit of STARS, i.e., it had no objective economic substance.

2. Subjective Economic Substance

Did BNY have a legitimate non-tax business purpose for the use of the STARS structure? The taxpayer argued it used the STARS structure to obtain "low cost financing" from Barclays.The Court felt that the record does not support petitioner's claimed business purpose. The STARS structure lacked any reasonable relationship to the loan. And the loan was not "low cost." To the contrary, the Tax Court viewed the loan cost was overpriced and not by just a little an further required BNY to incur substantially more transaction costs than a similar financing available in the marketplace. The Tax Court found that BNY’s motivation for entering into the STARS transaction was tax avoidance and not a valid business purpose. It cited several factors in support which are set forth in some detail in the Court’s opinion.

3. BNY’s Argument That the STARS Transaction’s Generation of FTCs Was Authorized by Congress

With economic substance in doubt, the taxpayer argued Congressional intent. Thus, the taxpayer claimed that the disputed tax benefits, the FTCs, were intended to be allowed by Congress and that the economic substance doctrine does not warrant disallowing the disputed tax benefits because Congress intended the foreign tax credit for transactions like STARS. The Court took a jaundiced view of this “policy” argument. In responding, it indeed noted the tax policy of the foreign tax credit rules and that was to alleviate  double taxation arising from foreign business operations. See United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 139 (1989); Am. Chicle Co. v. United States, 316 U.S. 450, 451 (1942); Burnet v. Chicago Portrait Co., 285 U.S. 1, 7 (1932). Congress intended the foreign tax credit to neutralize the effect of U.S. tax on the business decision of where to conduct business activities most productively. 56 Cong. Rec. App. 677-678 (1918) (statement of Rep. Kitchin). The enactment of the foreign tax credit was also informed by fairness. See National Foreign Trade Council, Inc., International Tax Policy for the 21st Century, (Dec. 15, 2001).

The Tax Court viewed that the STARS transaction was outside of the circle of taxpayers that Congress wanted to benefit from paying foreign taxes on foreign source income. The STARS transaction was a complicated scheme centered around arbitraging domestic and foreign tax law inconsistencies. The U.K. taxes at issue did not arise from any substantive foreign activity. Indeed, they were produced through pre-arranged circular flows from assets held, controlled and managed within the United States. Based on the circular flow of funds involved herein, the Tax Court disagreed with BNY on its policy argument and concluded that  Congress did not intend to provide foreign tax credits for transactions such as STARS.

II. Deductibility of STARS-Related Expenses

Aside from the FTCs, which the Court denied, BNY claimed it was proper to deduct transactional expenses, including the zero coupon swap interest, associated with the STARS transaction for 2001 and 2002. It argued that the U.K. taxes paid on trust income are deductible where the FTCs are denied. Again, the Service argued that the transations lacked economic substance and therefore the claimed deductions, including for foreign taxes, should be disallowed.

The Tax Court made it clear as it did with the FTC issue that expenses incurred in furtherance of a transaction that is disregarded for a lack of economic substance are not deductible. See Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. at 294 (observing that "a transaction that lacks economic substance is not recognized for Federal tax purposes" and that "denial of recognition means that such a transaction cannot be the basis for a deductible expense"); see also Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. ___ (slip op. at 188). The claimed transactional expenses, the zero coupon swap interest expense and the U.K. taxes were all incurred in furtherance of the STARS transaction, are non-deductible for lack of economic substance.  

III. Foreign Source Income Adjustment

Another argument or position taken by BNY had to do with the IRS adjustment to BNY’s foreign source income. The taxpayer reported the income from the trust assets as foreign source income based on a "resourcing" provision in paragraph 3 of Article 23 of the U.S.-U.K. Income Tax Treaty. Again the government’s viewed was upheld by the Tax Court. The readjustment of the income as domestic source income was upheld on the basis that the STARS transaction, since it lacked economic substance, is disregarded for U.S. tax purposes. Therefore, the income generated from the trust was U.S. property and therefore U.S. source income. The Court, in its opinion, noted that the economic substance doctrine extends to tax treaties. Del Commercial Props., Inc. v. Commissioner, T.C. Memo. 1999-411 (citing Gregory v. Helvering, 293 U.S. 465, 470 (1935), and Johansson v. United States, 336 F.2d 809, 813 (5th Cir. 1964)), aff'd, 251 F.3d 210 (D.C. Cir. 2001).

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In T.D. 9600,  which was issued last Fall, the Service issued final regulations modifying the new markets tax credit (“NMTC”) program to promote investments in non-real-estate businesses in low-income communities. The final regulations became effective on September 28, 2012 and adopt, with two modifications, the proposed regulations (REG 101826-11) which were published in June, 2011.

Over the past few months the Service viewed that the current rules under Section 45D pertaining to the NMTCs made it difficult for community development entities (“CDE”s) to provide working capital and equipment loans to non-real-estate businesses. Such loans have shorter terms geared to the economic lives of the equipment, i.e., generally 5 years or less. The proposed regulations would modify the the reinvestment requirements under Treas. Reg. §1.45D-1(d)(2)(i) and allow a CDE which makes a qualified low-income community investment in a non-real-estate business to invest, during various times over a seven-year credit period,  certain returns of capital from those investments in unrelated certified community development financial institutions (“CDFI”s) that are CDEs under Section 45D(c)(2)(B).

CDFIs are financial institutions which provide financial services and make credit available to underserved markets and communities. The proposed regulations would allow an increase in the total amount to be invested in certified  that provide credit and financial services to underserved markets and populations. The proposed regulations  also allow an increasing aggregate amount to be invested in certified CDFIs and treated as continuously invested in a qualified low-income community investment late in the seven-year credit period.

New Market Tax Credits

Under Section 45D(a)(1), a taxpayer may claim a NMTC on certain credit allowance dates per Section 45D(a)(3) over a 7-year credit period with respect to a qualified equity investment in a qualified community development entity CDE.  Per Section 45D(b)(1), an equity investment in a CDE is a qualified equity investment if, among other requirements: (i) the investment is acquired by the taxpayer at its original issue (directly or through an underwriter) solely in exchange for cash, (ii) substantially all of the cash is used by the CDE to make qualified low-income community investments, and (iii) the investment is designated for purposes of Section 45D by the CDE.

Section 45D(b)(2) provides that  the maximum amount of equity investments issued by a CDE that may be designated by the CDE as qualified equity investments may not exceed the portion of the NMTC limitation in Section 45D(f)(1) that is allocated to the CDE by the Secretary of the Treasury per Section 45D(f)(2).

Section 45D(c)(1) provides that a domestic corporation or partnership is a CDE if: (i) the primary mission of the entity is serving, or providing investment capital for, low-income communities or low-income persons, (ii) the entity maintains accountability to residents of low-income communities through their representation on any governing board of the entity or on any advisory board to the entity, and (iii) the entity is certified by the Treasury as a CDE.

Section 45D(d)(1) defines qualified low-income community investment as: (i) any capital or equity investment in, or loan to, any qualified active low-income community business (as defined in Section 45D(d)(2)); (ii) the purchase from another CDE of any loan made by such entity that is a qualified low-income community investment; (iii) financial counseling and other services specified in regulations prescribed by the Secretary to businesses located in, and residents of, low-income communities; and (iv) any equity investment in, or loan to, any CDE.

Under Section 45D(d)(2)(A), a qualified active low-income community business is any corporation (including a nonprofit corporation) or partnership if for such year, among other requirements: (i) 50% or more of the total gross income of the entity is derived from the active conduct of a qualified business within any low-income community; (ii) a substantial portion of the use of the tangible property of the entity (whether owned or leased) is within any low-income community; and (iii) a substantial portion of the services performed for the entity by its employees are performed in any low-income community.

A qualified business is any trade or business. See §45D(d)(3). The rental of real property located in any low-income community is a qualified business only if the property is not residential rental property as defined in Section 168(e)(2)(A) and there are substantial improvements located on the real property.

Treas. Reg. §1.45D-1(d)(2)(i) requires that a CDE receiving returns on investments (including principal repayments from amortizing loans) must reinvest those proceeds into other qualified low-income community investments during the 7-year credit period. If the proceeds are not reinvested, then the credit may be subject to recapture under section 45D(g)(3)(B).

Generally, the NMTC investments concern real estate projects. Given the legislative history and purpose of the NMTC, this makes sense. This is because that improved real estate remains in the low-income community and loans for real estate can extend through the end of the 7-year period in which investors may take the credit on their investment. '

Still,  the 7-year credit period and the reinvestment requirements make it difficult for CDEs to provide working capital and equipment loans to non-real estate businesses because these loans are ordinarily amortizing loans with a term of five years or less. To facilitate investment in non-real estate businesses, the proposed regulations issued in 2011 reflected an effort to modify the reinvestment requirements for non-real estate projects.

Proposed Regulations Issued in 2011 to Inspire NMTCs for Non-real Estate Businesses

To encourage investments in non-real estate businesses for working capital and equipment, the proposed regulations modified the reinvestment requirement rules .The proposed regulations, issued in 2011, permit a CDE that makes a qualified low-income community investment in a non-real estate business to invest certain returns of capital from those investments in unrelated certified community development financial institutions that are CDEs under Section 45D(c)(2)(B) (certified CDFIs) at various points during the 7-year credit period. The proposed regulations also allow an increasing aggregate amount to be invested in certified CDFIs and treated as continuously invested in a qualified low-income community investment in the later years of the 7-year credit period.

Definition of Non-Real Estate Qualified Active Low-Income Community Business

The proposed regulations define a non-real estate qualified active low-income community business as any business whose predominant business activity, i.e., more than 50% of the gross income from such business, does not include the development (including construction of new facilities and rehabilitation/enhancement of existing facilities), management, or leasing of real estate. The purpose of the investment or loan must not be connected to the development (including construction of new facilities and rehabilitation/enhancement of existing facilities), management, or leasing of real estate. Comments asking the final regulations to extend the rule to include the development of owner occupied facilities as long as the facility is used in operating a business was rejected in light of the fact that many NMTC investments have already been for owner-occupied facilities. The final regulations want to encourage NMTC investments unrelated to real estate as well.

Commentators asked that if a non-real estate qualified active low-income community business is allowed to use investments for construction or improvements to real estate facilities primarily used in its business, then the definition of working capital under Treas. Reg. § 1.45D-1(d)(4)(i)(E)(2) should include the proceeds of an equity investment or a loan that the non-real estate qualified active low-income community business will expend for the construction of real property within 18 months (as opposed to 12 months) after the date of the investment or loan. The final regulations also reject this suggestion because the final rules for non-real estate qualified active low-income community businesses do not pertain to investments for construction or improvements to real estate facilities.

The final regulations clarify that an investment in a non-real estate qualified active low-income community business may be made through one or more CDEs. Thus, for example, a CDE that designates an equity investment as a non-real estate qualified equity investment may invest the proceeds in another CDE if that investment is directly traceable to a non-real estate qualified active low-income community business.

Payments of Capital, Equity, or Principal with Respect to a Non-Real Estate Qualified Active Low-Income Community Business

The proposed regulations provide that any portion that the CDE chooses to reinvest in a certified CDFI must be reinvested by the CDE no later than 30 days from the date of receipt to be treated as continuously invested in a qualified low-income community investment. Suggestions were made that in lieu of the narrow 30 day period, CDEs invested in a non-real estate qualified active low-income community business should have 12 months to decide whether to reinvest capital, equity, or principal in another non-real estate qualified active low-income community business or a certified CDFI under Treas. Reg. § 1.45D-1(d)(9)(ii) (similar to the 12-month reinvestment requirement in § 1.45D-1(d)(2)(i)). The final regulations did not adopt this suggestion  because a CDE that has not found a new non-real estate qualified active low-income community business to invest in at the expiration of the 30 day period can invest the capital, equity, or principal in a certified CDFI until it finds a suitable non-real estate qualified active low-income community business. It can then withdraw its investment in the certified CDFI and invest that capital, equity, or principal in the suitable non-real estate qualified active low-income community business.

Commentators wanted the final regulations to allow a CDE that makes an equity investment in a non-real estate qualified active low-income community business to reinvest up to 100% of its equity investment in a certified CDFI under Treas. Reg. § 1.45D-1(d)(9)(ii) after the first year of the 7-year credit period. The thought was the adoption of a rule permitting this would encourage venture capital investments in a non-real estate qualified active low-income community business because liquidity events (cashing out some or all of an investment) occurring early in the 7-year credit period, which often happen with venture capital investments, would not automatically cause recapture.

The final regulations did not include this suggestion because  the Treasury and Service stated that it might create a situation in which the proceeds of the NMTC investment may only be invested in a qualified active low-income community business for a brief period without any new markets tax credit restrictions on how a certified CDFI may use the proceeds.  This would be inconsistent with encouraging investments in qualified active low-income community businesses during the 7-year credit period.

The Treasury and IRS were also asked, in response to the proposed regulations, that the final regulations allow a CDE to invest returns of capital, equity, or principal into entities other than certified CDFIs under  Treas. Reg. § 1.45D-1(d)(9)(ii). Such entities would include non-profit and for-profit entities focused on economic and community development, funds that provide equity and loans to small and medium businesses, and funds that provide equity or loans to minority and women owned businesses. The final regulations rejected this request for as unworkable given the potential scope of  potential reinvestment vehicles. The final regulations allow investments in certified CDFIs because there are rules that ensure that a certified CDFI serves low-income communities. Such rules do not currently exist for other potential reinvestment entities. However, the final regulations provide that in the future the Secretary may designate other qualifying entities in the Internal Revenue Bulletin. See Proc. Reg.  §601.601(d)(2)(ii)(b).

Lines of Credit

A commentator requested that the final regulations consider the entire amount of a line of credit as outstanding loan principal for purposes of the substantially-all requirement under  Treas. Reg. § 1.45D-1(c)(5)(i). Lines of credit often serve the capital needs of non-real estate businesses better than fully disbursed loans with fixed terms, which may be more appropriate for real estate investments. The government announced that this proposal was being given further review.

Changes Made to the Proposed Regulations in the Final Regulations

While the preceding reflects the changes that were requested by commentators that were rejected by the Service, T.D. 9600 makes two changes to the proposed regulations. First, the final regulations provide that the Treasury may designate other qualifying entities in addition to reinvestments in certified CDFIs. The final regulations further clarify that an investment in a non-real-estate qualified active low-income community business may be made through one or more CDEs. The final regulations apply to equity investments made after September 27, 2012.  

Effective Date/Applicability

The IRS and the Treasury Department received a few comments during the rule-making period regarding whether the final regulations should allow a qualified equity investment made before the effective date of the final regulations to be eligible for designation as a non-real estate qualified equity investment. The majority of commentators recommended not adopting a look-back rule. The IRS and the Treasury Department agreed. Allowing CDEs to designate investments as non-real estate after the investments are made does not serve the purpose of incentivizing new investments in non-real estate projects. Treas. Reg. §1.45D-1(c)(1)(iii) requires that an investment in a non-real estate qualified equity investment must be designated as such for a CDE to qualify for benefits allowed under the final regulations. Again, the final regulations apply to equity investments made on or after the date the final regulations are published in the Federal Register.

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As reported by the tax press and news release by the Treasury, Japan's Ambassador to the United States, Kenichiro Sasae and U.S. Treasury Deputy Secretary Neal S. Wolin, on January 24 signed a new protocol to amend the existing Japan-U.S. income tax treaty (2003) and the accompanying protocol.

The proposed protocol is noteworthy in that it marks the first time that Japan will allow a general withholding tax exemption for interest paid to a U.S. person entitled to benefit under the treaty. The proposed protocol would also widen the scope of the withholding tax exemption for certain dividends, set forth a new binding arbitration procedure, facilitate tax administration, and bring the current treaty into greater conformity with model treaty provisions of the United States and tax policy directives of Japan. Revisions were also made to the treatment of directors’ fees, exchange of information, and assistance in tax collection. The proposed protocol would remove the current provision for teachers and researchers. The treaty also strengthened the reach of Code Section 897, FIRPTA, on Japaneese residents.

Deputy Secretary Woline stated the proposed protocol stating that "These amendments provide important clarity for investors and businesses and will help foster cross-border investment between our countries."

Dividends

The proposed protocol would lower the eligibility threshold for the withholding tax exemption for dividends found in Article 10, ¶3 by reducing the required ownership threshold from from "more than 50 percent" to "at least 50 percent" of the voting stock of the company paying the dividends. This would facilitate equal joint venture arrangements in a Japaneese corporation to qualify for dividend exemption if other requirements are met. The required minimum holding period for dividend relief would be reduced in half from the current 12 months to 6 months.  

The proposed amendments would align the threshold for the withholding tax exemption for dividends in the Japan-U.S. income tax treaty with some of the thresholds in Japan's other income tax treaties, such as its treaties with the Netherlands, Switzerland, and the United Kingdom but is still less favorable than Japan’s treaties with other countries, including France.  

Interest

Article 11 presently provides for a 10% withholding tax rate for interest that is paid to a beneficial owner that is a resident of the other contracting state and that satisfies the other conditions. However, a withholding tax exemption is available in some cases: for example, if the interest is beneficially owned by a specified governmental body, financial institution, or pension fund. The proposed protocol would bring the Japan-United States income tax treaty into closer conformity with the current treaty policies of both countries by generally exempting interest from source-country taxation. However, exceptions may apply in the case of  equity kicker type debt or contingent interest, interest paid in connection with ownership interests in an entity used for the securitization of real estate mortgages or other assets, interest that is effectively connected with a permanent establishment, or when the amount of interest is not at arm's length. The proposed protocol also includes anti-conduit rules that would deny treaty benefits in the case of some back-to-back financing arrangements in which financing is provided by a person who does not enjoy equivalent or more favorable treaty benefits and is not a resident of either contracting state.

Gains From Real Property

Article 13 ¶1 presently  provides that gains derived by a resident of a contracting state from the alienation of real property situated in the other contracting state may be taxed in that other contracting state. Article V of the proposed protocol allows both contracting states to tax gains from the alienation of real property situated in their respective states by inserting a new definition of the term "real property situated in the other Contracting State". This would be inserted as Article 13, ¶2. Under the new and more expansive definition, real property situated in Japan would include "shares or interests in a company, partnership or trust deriving the value of its property directly or indirectly principally from real property referred to in Article 6 and situated in Japan." The new definition is broader than the current provision because it refers to "a company" regardless of where it is resident. The current treaty, Article 13, ¶2 provides that the rule applies only to "a company that is a resident of the other Contracting State."

The proposed revised definition of subject real property subject to tax on disposition in the other contracting state is anticipated to result in a greater amount of taxable gain in some cases that involve a partnership or trust deriving the value of its property, directly or indirectly, principally from real property.  The idea is that the contracting state in which the real property is situated may be able to tax the entire amount of gain from the alienation of an interest in such a partnership or trust, whereas current Article 13, ¶2 would limit the tax to the extent gain is attributable to assets that consist of real property situated in Japan. By defining the term "real property situated in the other Contracting State" to include a U.S. real property interest in the case of the United States, Article V of the proposed protocol would allow Section 897 to apply in full.

The proposed protocol, since it does not define the term "principally," is unclear whether the current test based on 50% of a company's value, as set forth in Article 13, ¶2, at present would continue to apply. It is also unclear how the term "principally" should apply in the case of a partnership or trust. Perhaps this uncertainty will be address by the Treasury in the form of a technical explanation of the proposed protocol or other pronouncement. Japan does not issue technical explanations of its income tax treaties.

Directors' Fees

Paragraph 3 of the notes clarifies the tax treatment of remuneration received by executive officers and other employees who are residents of a contracting state from a company that is a resident of the other contracting state. Such remuneration would fall outside the scope of Article 15 of the treaty, as amended, unless the person in the first contracting state serves as a member of the board of directors of the company. This reduces the risk of double taxation attributable to a possible wider interpretation of the term "directors" and a wider scope of taxable income applicable to "directors" under Japanese tax law.

Teachers and Researchers

The proposed protocol would delete the two-year tax exemption for individuals who visit a contracting state temporarily for the purpose of teaching or conducting research at a university, college, school, or other educational institution under Article 20 of the current treaty.

Elimination of Double Taxation

Under the proposed protocol, Article 23, ¶1 of the present treaty would be amended to conform with the foreign dividend exemption system that was enacted in 2009 by Japan. Subject to the applicable provisions of Japan's domestic tax law, if dividends are paid by a U.S. resident company to a Japanese resident company that has owned at least 10% of the total shares or 25% of the voting stock issued by the U.S. resident company, during the six-month period immediately before the day when the obligation to pay dividends is confirmed, 95%  of the dividends would be excluded from the Japanese resident shareholder's taxable income for Japanese tax purposes. Accordingly, in such instance Japan would not provide a foreign tax credit for any U.S. withholding tax imposed on the dividends.

Mandatory Binding Arbitration

The proposed protocol would amend present Article 25 to set forth a mandatory binding arbitration procedures.  Where a person presents a case under Article 25 to the competent authority of a contracting state of which the person is a resident on the basis that the actions of one or both of the contracting states have resulted, for that person, in taxation that is not in accordance with the provisions of the Japan-U.S. income tax treaty, and the competent authorities are unable to reach an agreement to resolve the case within two years from the presentation of the case to the competent authority of the other contracting state, any unresolved issues generally would be submitted to arbitration if the person so requests. The provision is intended presumably to calm U.S. multinational companies  that may presently feel that the mutual agreement process under the current treaty is not working.

The move to mandatory binding arbitration under bilateral tax conventions is gaining momentum. This would be, when entered into force,  Japan's third tax treaty to include such provisions. The United States currently has income tax treaties that provide for mandatory arbitration procedures with four other countries (Belgium, Germany, Canada, and France); its pending protocols with Switzerland and Spain also include such provisions. U.S. income tax treaties with some other countries -- including Mexico and the Netherlands -- incorporate authority for establishing voluntary binding arbitration procedures.

Exchange of Information

Articles 26 and 27 of the current treaty would be revised under the proposed protocol to allow the full exchange of information between the competent authorities for the administration of each country's tax laws and to enable the competent authorities to assist each other in the collection of taxes. In the case of Japan, the scope of taxes covered under Article 27 would be expanded to include the national consumption tax, the inheritance tax, and the gift tax.

Effective Dates

Article XV of the proposed protocol provides that for withholding taxes, the proposed protocol would apply to dividends and interest paid or credited on or after the first day of the third month following the date on which the proposed protocol enters into force. For other taxes, the proposed protocol generally would apply to taxable years beginning on or after January 1 of the year following the date on which the proposed protocol enters into force. However, teachers and researchers who are entitled to the benefits of article 20 of the current treaty at the time of the entry into force of the proposed protocol would continue to enjoy such benefits until such time that the benefits would have expired if the proposed protocol had not entered into force.

The provisions regarding mandatory arbitration procedures would have effect for cases that are under consideration by the competent authorities as of the date on which the proposed protocol enters into force and also cases that subsequently come under consideration.

Articles 26 and 27 of the current treaty, as amended by the proposed protocol, would have effect from the date of entry into force.

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