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Service Issues Favorable Private Letter Ruling on Reverse Parking Exchange Transaction Involving Multiple Related Parties

Posted in Federal Tax Rulings


In PLR 201416006 (4/18/2014)  the Service ruled that a taxpayer could successfully effectuate a reverse like-kind exchange under §1031, and in accordance with the safe harbor guidance issued in  Rev. Proc. 2000-37, 2000-2 C.B. 308,  even though the taxpayer and two related parties entered into a separate qualified exchange accommodation arrangements (QEAAs) for “parking” the same property held by an exchange accommodation titleholder (EATX).


Section 1031 provides that a taxpayer will not recognize gain or loss on the exchange of property held for use in a trade or business or held for investment for property of “like-kind” that is also held for use in the taxpayer’s trade or business or held for investment. There are certain types of property that fall outside the scope of §1031 and there are instances in which the exchange will be partially taxable due to the presence of a limited form of non-like kind consideration or “boot”.

The replacement property that is to be part of the exchange  must be identified by the taxpayer within 45 days after the date that the property given up in the exchange is relinquished. In addition, the taxpayer must actually receive the replacement property no later than: (i) 180 days after the date the relinquished property is transferred; or (ii) the due date (with regard to extensions) for the taxpayer’s return for the taxable year in which the relinquished property is transferred, whichever occurs first. See §1031(a)(3). In some cases more than one property may be acquired as qualifying replacement property provided such meets the requirements under the regulations.

Where a direct and simultaneous exchange of like-kind property isn’t possible, the taxpayer seeking non-recognition treatment will attempt to structure a deferred exchange using a third party and if necessary a fourth party. In some instances, a deferred exchange may involve the seller transferring the relinquished property before acquiring the replacement property. In order to satisfy the requirements under §1031, the taxpayer must carefully navigate the regulations and other guidance promulgated by the Service in successfully engaging in a reverse multi-party, like-kind exchange.

A reverse parking transaction describes an arrangement designed where the transferor or seller may acquire the replacement property through an accommodation party and “park” the desired replacement property until such time that the taxpayer arranges for the transfer of the relinquished property to the ultimate transferee in either a simultaneous or deferred exchange. After such a transfer is arranged, the taxpayer-seller  transfers the relinquished property to the accommodation party in exchange for the replacement property, and the accommodation party then transfers the relinquished property to the ultimate transferee. A variation of this strategy is that an accommodation party may acquire the replacement property on behalf of the taxpayer, immediately exchange such property with the taxpayer for the relinquished property, and then hold the relinquished property until the taxpayer arranges for a transfer of such property to the ultimate transferee.

Due to the uncertainty surrounding the status of reverse-parking transactions in general, the Service issued a safe harbor procedure in 2000 for qualifying reverse like-kind exchanges permitting the accommodation party to be treated as the owner of the property for federal income tax purposes for the interim period until the accommodation party can obtain the replacement property.  If the taxpayer rather than the accommodation party were treated as the owner of the property, the requisite “exchange” would be absent and the taxpayer would be taxed on the gain from the disposition of the relinquished property.

Revenue Procedure 2000-37, 2002-2 C.B. 308

The Service, in Rev. Proc. 2000-37, supra, announced a safe harbor for reverse parking transactions in applying the regulations under §1031(a)(3). In this guidance the Service announced that it “will not challenge” the previously acquired property’s qualification as a “replacement property” or otherwise impose gain on the transfer of the relinquished property if the exchange is effectuated via a “qualified exchange accommodation arrangement” (QEAA). A QEAA must meet all of the following requirements:

(i) “Qualified indicia of ownership” of property, which may be replacement property or relinquished property, must be held by a person (the “exchange accommodation titleholder”) other the taxpayer or a “disqualified person” at all times from when the person acquires the indicia of ownership until the replacement property is transferred to the taxpayer or the other party to the exchange with respect  to the  relinquished property.

(ii) The exchange accommodation title holder (EATX) must either be subject to federal income tax or be a partnership or S corporation, more than 90% of the interests in which are held by taxable persons.

(iii) When the EATX acquires the property, the taxpayer must have a “bona fide intent” that the property be either replacement or relinquished property in an exchange qualifying for nonrecognition of gain under § 1031.

(iv)  The taxpayer and the EATX must agree in writing not later than five business days after the latter acquires qualified indicia of ownership that (1) the exchange accommodation titleholder is holding the property for the taxpayer to facilitate a § 1031 exchange and will be treated as beneficial owner of the property for all federal tax purposes and (2) both parties’ tax returns will be consistent with the agreement on beneficial ownership.

(v) The relinquished property, if it is not the property transferred to the EATX, must be identified not later than 45 days after the exchange accommodation titleholder receives qualified indicia of ownership of the replacement property.

(vi)  Within 180 days after the EATX  receives qualified indicia of ownership, the property must be transferred to the taxpayer as replacement property or the other party to the exchange as relinquished property.

(vii) “The combined time period” that the EATX holds title to the relinquished and replacement property may not exceed 180 days.

(viii)  The taxpayer or a disqualified person may guarantee obligations of the EATX, including secured and unsecured debt incurred to acquire the property, may lend or advance funds to the exchange accommodation titleholder, may indemnify the EATX for costs and expenses, or may manage or supervise improvement of the property, act as contractor, or provide other services to the EATX.

(ix) The EATX may lease the property to the taxpayer or a related person.

(x)  The guidance allows the taxpayer and the EATX titleholder to make arrangements (or agreements) relating to the purchase or sale of the property, including puts and calls at fixed or formula prices,” which may be “effective” for not more than 185 days after the exchange accommodation titleholder acquires the property. They also may agree that if the value of the relinquished property varies from the estimated value agreed upon when it is transferred to the EATX, any shortfall or excess will be paid by or to the taxpayer. An arrangement does not fail to qualify “merely because that accounting, regulatory, or state, local, or foreign tax treatment of the arrangement” differs from the federal income tax treatment.

Transactions falling outside of the safe-harbor are not automatically deemed to involve a taxable event with respect to the relinquished property.

PLR 201416006

Facts.  Taxpayer and Affiliates 1 and 2 each owned separate commercial office buildings, and each was interested in acquiring Property as replacement property through transactions separately structured to qualify as non-taxable reverse like-kind exchanges. Each entered into a QEAA with the same unrelated exchange accommodation party, identified as EATX. Taxpayer and its Affiliates represented that each complied with the requirements of Rev Proc 2000-37, including the requirement that taxpayer and each Affiliate had a bona fide intent to acquire Property as replacement property in a §1031 like-kind exchange when EATX acquired QIO in Property.

In its QEAA, the taxpayer acknowledged that the EATX had entered into a concurrent QEAA for Property with each Affiliate, giving each rights to acquire Property, in whole or part, to complete like-kind exchanges. Also, taxpayer’s right to acquire Property is subject to its giving notice to EATX of its intention to acquire the Property, in whole or part. The agreement stated that the taxpayer’s rights would terminate upon prior delivery of such notice by either Affiliate. The agreement also provided that if an Affiliate gave prior notice of its intent to acquire Property, EATX had no further obligation to transfer Property to the taxpayer, whether in connection with the exchange described in the agreement or otherwise.

As per the QEAA and under the facts for the ruling request, the taxpayer stated that it will assign its right in the contract to buy Property to EATX, which will thereafter acquire title to Property using funds that taxpayer, Affiliate 1, Affiliate 2, or any related entity advances. Within 45 days thereafter, taxpayer, Affiliate 1, and Affiliate 2 will each identify property that each proposes to transfer as relinquished property according to the terms of its respective QEAA with EATX. Taxpayer and EATX will enter into an exchange agreement under which taxpayer will assign to EATX its right under the QEAA to acquire the Property. Within 180 days from the time that EATX acquires title to the Property, EATX will transfer title to the Property to the taxpayer in exchange for taxpayer’s relinquished property, consistent with Treas. Reg. § 1.1031(k)-1(g)(4).

The private letter ruling is factually unique in the sense that it involves multiple related parties each attempting to acquire the same property using a reverse-like kind exchange format under §1031 and Rev Proc 2000-37, 2000-2 CB 308.

The Service ruled that the taxpayer could indeed successfully consummate the reverse like-kind exchange under §1031, even though it and two related parties entered into separate qualified exchange accommodation arrangements for “parking” the same property held by an exchange accommodation titleholder (i.e., the same swap facilitator).   The reason that the taxpayer went through the gyrations of qualifying one of three taxpayers to engage in a reverse like-kind exchange may have been to allow the owner of the relinquished property to presently consummate a sale before it was decided which taxpayer would relinquish its replacement (like-kind) properties as part of a multi-party exchange.

The private letter ruling concludes that Rev Proc 2000-37, supra, does not bar an accommodation party from serving as an EATX to multiple taxpayers, including related parties, under multiple and simultaneously entered into QEAAs with respect to the same parked property. Taxpayer’s QEAA is not invalid merely because Taxpayer’s right to acquire property terminates upon prior notice by either of its Affiliates to EATX of its intent to acquire property.

Thus, the Service concluded that based on the information submitted, and each representation made (including the representation that taxpayer and Affiliates 1 and 2 had a bona fide intent to acquire Property pursuant to each of its QEAAs), taxpayer’s QEAA to acquire Property in whole or in part is a QEAA as defined in Rev Proc 2000-37, separate and distinct from the QEAAs entered into by each of the Affiliates, (with separate application of the identification rules of Treas. Reg. § 1.1031(k)-1(c)(4)).

Congress Debating Whether to Change the Tax Rules Governing Passive Foreign Investment Companies

Posted in Uncategorized


As recently reported by the tax press (See TNT 4/14/2014), two sets of proposals for reforming the taxation of PFICs have been submitted for consideration by House Ways and Means Committee Chair, Dave Camp, R-Mich., which makes only a single change to the PFIC rules, and a set of PFIC reforms  offered by former Senate Finance Committee Chair Max Baucus.


The PFIC rules were enacted into law in 1986 by Congress for the purpose of limiting the ability of U.S. persons to make investments in foreign corporations and defer current income taxation through indirect holdings in passive investment assets. Congress addressed two issues in the PFIC rules. First in requiring a U.S. shareholder in a PFIC to be subject to current income taxation on his share of PFIC income and, second, to avoid having U.S. persons  convert ordinary income into capital gains through the use of foreign passive investment corporations.  Congress permitted, however,  some U.S. shareholders, who did not have adequate information about the earnings of foreign corporations and could not compel the foreign corporation to make distributions, to defer the realization of U.S. income taxes until actual distributions were received but at the cost of imposing an interest charge on the ultimate receipt of the distribution.

Two sets of rules or regimes were adopted under the PFIC template. One set applies to a PFIC that one or more U.S. shareholders makes a “qualified electing fund” election.  Under the elective QEF regime, the electing shareholder (or shareholders) includes in gross income a pro rata share of the foreign corporation’s earnings. The second set of rules applies to a PFIC which is not a QEF as to a particular U.S. shareholder.  In such case the U.S. shareholder is not currently taxed on his share of PFIC income until he either receives a taxable distribution from the foreign corporation or directly  engages in a taxable disposition of his stock. Under the non-QEF provisions, income is characterized as ordinary in nature and there is an added interest charge  to the U.S. shareholder when income inclusion occurs in order to reflect the time value of the deferral for the time period that the earnings attributable to the distribution or taxable disposition were deferred.  Because the rules on passive foreign investment companies under either regime arguably produce the economic equivalent of current taxation, Congress did not see any need to apply penalty taxes at the corporate level. Accordingly, the accumulated earnings tax does not apply to a passive foreign investment company.

Need for Reform Of PFIC Identified

The current discussion in Washington on PFICs reflect another round of criticisms leveled on the use of PFICs  to accumulate passive income  for U.S. shareholders and thereby defer U.S. taxes on the income. Other regimes included the rules on (1) foreign personal holding companies (adopted in 1937 and repealed in 2004); (2) controlled foreign corporations (adopted in 1962); and (3) foreign investment companies (adopted in 1962 and repealed in 2004).

The PFIC provisions are broader than the other anti-deferral provisions since the definition of a PFIC, unlike the CFC, FPHC, etc., provisions, do not have a stock ownership test. Therefore, a corporation may be a PFIC even where it has a few U.S. shareholders who hold a small or even nominal position in foreign corporation’s stock.    By contrast, the rules on controlled foreign corporations and the former rules on foreign personal holding companies and foreign investment companies apply or applied only to corporations that meet the applicable stock ownership test.

In 1997, Congress introduced two major changes to the PFIC rules. First, the 10% U.S. shareholders of a CFC may be able to avoid PFIC rules entirely by recognized pre-emption of CFC rules over PFIC rules, subject to a grandfather provision. Second, where a foreign corporation’s shares are publicly traded or marketable, a U.S. shareholder may elect mark-to-market reporting each year (e.g., including the unrealized appreciation in the stock in income) and avoid the regular rules on passive foreign investment companies.

What to Do With The PFIC Rules?

One of the open questions in international tax reform is what to do about the passive foreign investment company regime. As tax reform may gather some momentum, there may be renewed interest on changing the PFIC provisions. It is well documented that the purpose of the PFIC provisions was to level the playing field between U.S. persons investing in passive assets through offshore mutual funds and those who invest in the same assets via domestic mutual funds (whose investment income is taxed currently at ordinary rates even if not distributed).

A reform to the PFIC rules was suggested approximately 21 years ago by the New York State Bar Association (NYSBA). It proposed the adoption  of a mark-to-market set of rules for most U.S. shareholders owning stock in a PFIC. This proposal announced that such reform would be consistent with the recognized policy objectives of creating playing field neutrality between those engaged in passive investments within the U.S.  and those U.S. persons making investments in offshore mutual funds, and, at the same time, greatly simplify the PFIC rules and thereby achivieving greater levels of tax compliance than the three sets of rules potentially applicable under the PFIC provisions then and still currently in place.

In particular, the NYSBA recommended taxing shareholders who own 25% or more of a PFIC, own stock in a PFIC that meets a §552(a)(2)-type stock ownership test, or own stock in a PFIC that is a controlled foreign corporation under the QEF rules. Most other shareholders would be taxed under the mark-to-market regime, as long as their stock was considered marketable.

The 1993 NYSBA report is important because, in his tax reform option paper on international competitiveness that later evolved into the Finance Committee’s discussion draft on international tax  Baucus cited it as his sole source regarding moving to a mark-to-market regime for PFICs with marketable stock. Baucus’s option paper referred to a 1963 bill as a source for taxation of nonmarketable PFIC stock.

Some have suggested that the problems with PFIC are largely attributable to the statutory definition. The thought is that some PFICs, by definition, should not be included under this regime. In other words, let’s narrow the definition of PFIC to not force essentially operating companies offshore to conform to a PFIC regime for its U.S. shareholders.

The current definition of a PFIC includes both an  income and asset test. The asset test is eliminated in the Baucus version. The income test provides that where 75% or more of the foreign corporation’s gross income is passive, then the corporation is a PFIC.  Former Senator Baucus’ proposal reduces the passive income percentage test from 75% to 60%. So perhaps this is some “good news” on the elimination of the asset test, but some “bad news” in the form of reducing the passive income threshold.

On the mark-to-market regime for PFICs whose stock is “marketable” there is some thought  currently being given to broaden the definition beyond stock that is traded on an established exchange. Alternatively, if a stock is not widely traded but the holder can dispose of it at a determinable price on short notice,  some have suggested that the PFIC stock should still be considered marketable

One area in which the Baucus proposals vary from the Camp version is the proposed change to the active insurance exception. The proposals replace the current test based on whether a corporation is predominantly engaged in an insurance business by application of a gross receipts test. This suggested revision is thought to be necessary to prevent U.S. investors in hedge funds  from using the insurance exception to avoid taxes.  The proposal includes quantitative requirements such as sufficient premium income so that more than 50% of  gross receipts are insurance premiums. Also, insurance liabilities, including reserves, must, under the Baucus proposal, be at least 35% of  total assets.  The Camp version has the same provision. Obviously, this issue will be a controversial if not contentious subject with certain members of the insurance industry. Expect some “in-fighting” by lobbyists on this aspect of the proposed reforms to PFICs.

More Guidance on PFICs Needed

Even if legislation in the short term is not forthcoming, it is a commonly held view by tax practitioners working with PFICs and their shareholders, that more guidance in the form of regulations, rulings or other pronouncements by the Service is desirable. Indeed, the proposed regulations issued in 1992 remain in proposed form. Among the areas in need for well-thought out guidance are:

  • The “look-through” rule in §1297(c) which treats a pro rata share of the income and assets of a subsidiary as owned by the parent if the parent owns more than 25% of the value of the subsidiary.
  • Whether the activities of the employees of a subsidiary, in addition to the subsidiary’s income and assets, can be attributed or imputed to the parent  in determining whether income of the subsidiary is passive or active.
  • Application of the PFIC rules to trusts, including grantor trusts, and its beneficiaries. There are a host of potential issues that need guidance in this particular area including the computation of undistributed net income with respect to foreign trusts owning stock in a PFIC.
  • Application of the foreign tax credit rules to PFICs. Currently, only withholding taxes are creditable in the U.S. on excess distributes received from a PFIC.

While there are various international tax issues that could be included in a tax bill that Congress may decide to push forward, including as part of a budget reconciliation bill, it is still anyone’s guess whether the PFIC will be streamlined in its form and operation.

Deemed Asset Sales Under Section 336(e), An Overlooked Planning Technique In Acquiring Stock of a Domestic Corporation?

Posted in Federal Tax Regulations


Enacted As Part of the Repeal of the General Utilities Doctrine in the Tax Reform Act of 1986

Section 336(e) of the Code authorizes the issuance of regulations whereby a domestic corporation which owns a controlling interest, per §1504(a)(2), in the stock of another domestic corporation, is permitting to treat the taxable disposition of its stock as a deemed asset sale of the target-subsidiary’s assets. While §336(e) was enacted into law as part of the Tax Reform Act of 1986, among the set of corporate tax provisions under Part II of Suchapter C which repealed the General Utilities Doctrine, the provision was not operative under final regulations were issued. H.R. Conf. Rep. No. 8411, 99th Cong., 2d Sess., Vol 11, 198, 204 (1986), 1986-3 C.B., Vol. 4, 198-207.

Enabling Regulations Issued Last Year

In T.D. 9619 (5/15/2013), the Service issued enabling elections for certain transactions under §336(e). Proposed regulations were issued in 2008 (REG-143544-04).

While a §336(e) election results in a deemed sale of the target’s assets as with the sale of target stock in a §338(g) or §338(h)(10) transaction, the scope of a §336(e) is broader and can extend to other types of stock transfers of stock in a controlled domestic corporation. Moreover, unlike the limitation set forth for a “qualified stock purchase” under §338(d)(3) which can only be made by a purchasing corporation, the acquirers or purchasers of subsidiary stock can include individuals and noncorporate entities as well.  The regulations also permit S corporations to take advantage of a §336(e) election which will yield similar results to a §338(h)(10) election as to the sale of 80% or more of the stock of an S corporation provided all shareholders of the target S corporation consent.

In order to make an  § 336(e) election, the seller(s), or in the case of an S corporation target, all of the S corporation shareholders, and the target must enter into a written, binding agreement to make an § 336(e) election. An § 336(e) election statement must be attached to the relevant income tax or informational return. Where the seller(s) and the 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 § 336(e) election statement to the target on or before the due date (including extensions) of the group’s consolidated Federal income tax return.

Where the target is an S corporation, the election statement is filed on the S corporation’s timely filed return. If the seller and the 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 the seller’s and the target’s timely filed returns. By (1) requiring the seller(s) or all of the S corporation shareholders and target to enter into a written, binding agreement, (2) in the case of a consolidated group, requiring the common parent of the group to provide a copy of the election statement to the target, and (3) in the case where the seller and the target are members of an affiliated group but do not join in the filing of a consolidated return, requiring both the seller and the target to file the election statement on their respective returns, the IRS and the Treasury Department indicated in the preamble the belief that the final regulations significantly reduce the potential for unwanted results or unfair surprise.

Unlike an election under section 338(h)(10), which is available only if target stock is acquired by a corporate purchaser, the proposed and final  regulations do not require an acquirer of target stock to be a corporation, or even necessarily a purchaser. Also unlike § 338(h)(10), which generally requires that a single purchasing corporation acquire the stock of a target, the proposed (and final) 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.

Two Different Models for Treating Deemed Transactions Under Section 336(e)

The proposed regulations provided two models for the deemed transactions where a §336(e) election  is made; (i) the Basic Model; and (ii) the Sale-to-Self Model.

The Basic Model: Seller Realizes Gain/Loss From Sale

The first  or “basic” model generally follows the same structure used for the deemed transactions resulting from the making of a  § 338(h)(10) election (basic model) and applies to all qualified stock dispositions (including taxable distributions of target stock) other than distributions described in §§355(d)(2) or 355(e)(2).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).

The party recognizing the gain is the deemed seller of asset. Therefore, “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. Then, after taking into account the gain or loss realized from 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 §§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.

Basic Model for Non-Section 355(d)(2) or (e)(2) Transactions

The final regulations generally follow the rules contained in the proposed regulations with respect to the deemed transactions under the basic model. 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 § 351.


The Sale-to-Self Model: Sale by Old Target to New Target; Retention of Tax Attributes

The second model adopted by the proposed (and final)  regulations for the deemed sale transactions resulting from a § 336(e) election applies to §§355(d)(2) and (e)(2) transactions  is the “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.

In the Preamble to the final regulations noted some conceptual problems with the sale-to-self model but decided that the sale-to-self model should be retained. While the deemed transactions resulting from the making of  § 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 §355.  In as much as a deemed sale of assets to a new target cannot actually be undertaken in a §§ 355(d)(2) or (e)(2) transactions, and Service views the predominant feature of the §336(e) election with respect to a §§ 355(d)(2) or (e)(2) transaction is the § 355 transaction, the  final regulations adopt the sale-to-self model and treat the transaction as the distribution of old target stock.

The Preamble to the final regulations further notes that the Service and Treasury Department, in responding to other criticisms with the “sale-to-self” model, do not believe that adoption of the sale-to-self model should cause the anti-churning rules in § 197(f)(9) or  wash sale rule in §1091 to apply to a §336(e) election with respect to a section 355(d)(2) or (e)(2) transaction. Therefore, the final regulations provide that for purposes of § 197(f)(9), § 1091, and any other provision designated in the Internal Revenue Bulletin by the IRS, old target, in its capacity as seller of assets in the deemed asset disposition, is treated as a separate and distinct taxpayer from, and unrelated to, old target in its capacity as acquirer of assets in the subsequent deemed purchase and for subsequent periods.

The Disallowed Loss Rule: Application to “Net Losses”

The proposed regulations disallowed 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 rationale for this rule was conformity with §311 and §355(c). The Service and Treasury received many complaints on the loss disallowance rule and that the policy reasons under §336(e) for permitting loss recognition were valid. In response, the final regulations generally permit target’s realized losses in the deemed asset disposition to offset sthe amount of target’s realized gains. Thus, the 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 percent 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 (1) target stock distributed at any time within the 12-month disposition period, and (2) 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. Accordingly, under the disallowed loss rule of the final regulations, if a §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.

While some had suggested that any non-recognized net loss be applied to increase the target’s asset basis after the deemed asset disposition, the final regulations rejected this thought as falling outside of the purpose of §336(e), i.e., to avoid two levels of taxation rather than to also preserve the use of built-in losses.

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

The time and manner of making § 336(e) election provided in the proposed regulations also differed from those for making an election under §338(h)(10). Noting that a joint election may be burdensome in cases with multiple purchasers, the proposed regulations provide that a §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 final regulations provide, however, that order to make a § 336(e) election, seller(s), or in the case of an S corporation target, all of the S corporation shareholders, and target must enter into a written, binding agreement to make a §336(e) election and a §336(e) election statement must be attached to the relevant return. If 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 §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. By (1) requiring seller(s), or all the S corporation shareholders, and target to enter into a written, binding agreement, (2) in the case of a consolidated group, requiring the common parent of the consolidated group to provide a copy of the election statement to target, and (3) in the case in which seller and target are members of an affiliated group but do not join in the filing of a consolidated return, requiring both seller and target to file the election statement on their respective returns, the IRS and Treasury Department believe that the final regulations significantly reduce the potential for unwanted results or unfair surprise.

The final regulations retain the rule that the election must be made by the due date of the relevant tax return. The IRS and Treasury Department believe that a due date of the 15th day of the ninth month after the disposition date will add administrative burden to both taxpayers and the IRS. Such due date would generally require that the election be made prior to the filing of the tax return, rather than on a tax return.  The government’s stated experience in administering §338 has shown that some taxpayers miss the due date for making a § 338 election because they wrongly believe that the election is due with the income tax return of the taxpayer. Further, except with respect to the election statement filed by seller if seller and target are members of the same affiliated group but do not join in the filing of a consolidated return, the due date for filing the election statement now coincides with the due date of the return that includes the deemed disposition tax consequences.

The final regulations provide detailed requirements to assist taxpayers in making a § 336(e) election for an eligible subsidiary of target (target subsidiary). See Treas. Regs. §§ 1.336-2(h)(4) and (5).  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 § 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 § 336(e) election for target subsidiary requires that a § 336(e) election statement 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.

Modifications to Form 8883 (“Asset Allocation Statement Under Section 338”) or a new form will accommodate the §336 election. Form 8883 should continue to be filed until a special form fir §336(e) events is issued. See also Form 8023.

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

Where the stock of a corporation is sold or distributed within an affiliated group and then is transferred outside the affiliated group, a §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 § 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. § 1.1502- 13(f)(5)(ii)(C) provides an election (a ”§ 1.1502-13(f)(5) election”) in the case of §338(h)(10) and comparable transactions. A § 1.1502-13(f)(5) election allows taxpayers to treat the deemed liquidation as the result of a §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 allow a taxpayer to make a § 1.1502-13(f)(5) election to treat the deemed liquidation of target into seller as a result of a § 336(e) election as a taxable liquidation. Treas. Reg. § 1.1502-13(f)(5)(ii)(C).

The final regulations further provide that in the case of a §§355(d)(2) or (e)(2) transaction that is preceded by an intragroup transaction, for the limited purpose of a § 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

Consistent with the legislative history under the TRA ’86, the final regulations permit a  §336(e) election to be made for S corporation targets and provide additional and special rules to allow §336(e) elections to be made with respect to S corporation targets.

Where a § 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 § 336(e) election, the final regulations provide the same requirement for purposes of making a §336(e) election. While S corporation shareholders consent to a section 338(h)(10) election by signing Form 8023, to make a § 336(e) election, the S corporation shareholders do not file a §336(e) election statement. Instead, consent to make a §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 §336(e) election statement for an S corporation target is filed with the income tax return of the S corporation target. If a §336(e) election is made for an S corporation target, old target’s S election continues in effect through 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 § 1361(b) and wants to be an S corporation, a new election for new target under § 1362(a) must be made. This rule poses a trap for the unwary no doubt.

Determination of AGUB (Adjusted Gross-Up Basis) and ADADP (Aggregate Deemed Asset Disposition Price)

The final regulations continue to adhere to the position that sellers selling costs or purchaser acquisitions costs do not reduce old targets ADADP or buyer’s AGUB. With regard to grossing up the selling costs and acquisition costs over all target stock, this issue was specifically addressed in the preamble to the proposed section 338 regulations in 1999 (”Grossing-up the selling shareholders’ selling costs or the purchasing corporation’s acquisition costs would result in costs not actually incurred reducing old target’s amount realized for the assets or increasing new target’s cost basis in the assets. . . . [T]here is no evidence that the purchasing corporation’s costs to acquire an amount of target stock sufficient for there to be a qualified stock purchase would increase proportionately if it acquired all of the target stock . . .”). 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 §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 § 338 apply the same rule in determining grossed-up amount realized. The IRS and the Treasury Department believe that it is appropriate to use the same computation for purposes of a section 336(e) election. Accordingly, the final regulations retain the rule of the proposed regulations.

Gain Recognition Elections

The proposed §336(e) regulations provided that the holder of nonrecently disposed stock may make a gain recognition election, similar to the gain recognition election under § 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 §318(a), other than §318(a)(4)), 80-percent or more of the voting power or value of target stock. Once made, a gain recognition election is irrevocable. This rule was retained in the final regulations.

Anti-Related Party Rule

The proposed regulations provided that a transaction is not a disposition (and therefore is ineligible to count towards a qualified stock disposition) if target stock is sold, exchanged, or distributed to a related person. The proposed regulations, like the §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 §318(a), other than § 318(a)(4). In the Preamble to the final regulations, after reviewing many comments that were submitted on the related party aspects, that the anti-related party rule should not be prohibited if cross ownership is minimal. The best manner for addressing the commenters’ concerns is to 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 §336(e), the attribution rules of  §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 five-percent threshold is within the range suggested by comments for limiting upstream and downstream attribution under § 318(a) between partners and partnerships, and is consistent with the five-percent threshold of constructive ownership rules under §§267(e)(3) and 1562(e)(2) relevant to partners and partnerships.

Scope of Regulations: Application to Non-recognition Transactions

The final regulations do not permit an election to be made in non-taxable transfers of target stock. However, the IRS and Treasury Department will continue to study this issue and may address the issue in future guidance.

International Provisions: Application to Acquisitions of Foreign Targets

The final regulations retain the requirement that the seller and the target both must be domestic corporations. However, the IRS and Treasury stated it will continue to study the issue.

Allocation of Foreign Taxes Paid

The proposed regulations provide that if a §336(e) election is made and target’s taxable year under foreign law (if any) 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). See Treas. Reg. §1.338-9(d) for allocating foreign tax paid by a target that is acquired in a transaction that is treated as an asset acquisition pursuant to an election under § 338 if the foreign taxable year of target does not close at the end of the acquisition date. In addition, regulations under §901, which were published on February 14, 2012, provide foreign tax allocation rules, consistent with § 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 § 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 tax imposed at the entity level on the income of such entities. The IRS and Treasury Department intend to issue future guidance that will make similar modifications to Treas. Reg. § 1.338-9(d).

Covered Asset Acquisition Rules: Section 901(m)

Section 901(m)(1), enacted into law as part of the Education Jobs and Medicaid Assistance Act of 2010, P.L. 111-226 (8/10/2010),  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 shall not be taken into account in determining the foreign tax credit allowed under §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. Since a §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 § 336(e) elections) for foreign tax purposes, a §336(e) election for a target corporation is a covered asset acquisition. 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

The proposed regulations to §336(e) provided that where the 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. Under the proposed regulations, if seller 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 regulations are silent as to 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. In the Preamble to the final regulations, it was announced that the rule in the 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 ¶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 structure and policies of §338(h)(10), including the application of the consistency rules of Treas. Reg. § 1.338-8. In general,  Treas. Reg. § 1.338-8 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 § 338 election), then the purchasing corporation is required to take a carryover basis in the acquired asset. The final regulations, in response to comments made during the proposed rule-making period, provide that for purposes of §336(e), 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.

Section 338 Elections With Respect to Stock Acquisitions of Foreign Corporations In Light of Section 901(m)

Posted in Federal Taxation Developments


Where a U.S. corporation purchases stock of a foreign corporation and makes a §338(g) election, generally the election provides the U.S. corporation a tax-free step up in basis with respect to the target corporations foreign based assets. The assets would not be stepped-up, however, for foreign income tax purposes. Therefore, gains on the subsequent disposition of one or more of the target’s foreign based assets in a taxable transaction would generate foreign tax credits where the basis step up with respect to the same assets produced no U.S. income tax.

For foreign tax credit purposes,   a §338 election also eliminates the foreign target corporation’s pre-acquisition pools of post-1986 E&P and post-1986 foreign taxes which are used for computing the indirect foreign tax credit under §902 (and §§960 and 962) thereby simplifying future calculations of E&P for Subpart F and foreign tax credit purposes.  The inside basis increase of the foreign target’s assets to fair market value will presumably for used for GAAP financial accounting purposes,  The §338 election could therefore provide a potential cost savings to the purchasing corporation from having  to undertake a time consuming and potentially expensive  historical E&P and foreign tax study of the foreign target.

The Education Jobs and Medicaid Assistance Act of 2010 enacted Section 901(m) which disallows a foreign tax credit for the disqualified portion of any foreign tax paid or accrued in connection with a “covered asset acquisition.”  A covered asset acquisition includes a qualifying purchase of a corporation’s stock in a §338 election. See §338(d)(“purchasing corporation). It also includes the purchase of a partnership interest where the partnership has previously made or makes for the taxable year in which the sale occurs a §754 election resulting in a basis increase for with respect to foreign based assets of the partnership. In general, §901(m) includes any transaction treated as the purchase of an entity’s assets for U.S. tax purposes but for foreign tax purposes is a stock acquisition.  See also §§338(h)(10) and 336(e) which will also trigger application of §901(m) with respect to the stock of a foreign target in a deemed asset sale transaction.

Section 901(m) goes directly to the  base broadening problem where the foreign tax base on the target’s asset pool exceeds the U.S. tax base with respect to the same assets. This difference between the two bases, or “delta” factor, can result in an overabundance on foreign tax credits . Since the principal purpose of the foreign tax credit is to avoid double tax on the U.S. tax base, §901(m) prevents the U.S. purchaser of foreign target stock from claiming the foreign tax credit with respect to foreign income that avoids U.S. taxation in a  ”covered asset acquisition”.

Section 901(m) requires the isolation of the  “disqualified portion” of foreign income taxes as credits (not deductions) determined with respect to income or gain attributable to the “relevant foreign assets” arising in connection with a covered asset acquisition. The “disqualified portion” of the foreign income taxes for a particular tax year is equal to the ratio of (1) the aggregate basis differences allocable to such taxable year with respect to all relevant foreign assets, divided by (2) the income on which the foreign income tax is determined. For purposes of determining the aggregate basis difference allocable to a taxable year, the term “basis difference” means, with respect to any relevant foreign asset, the excess of (1) the adjusted basis of such asset immediately after the covered asset acquisition, over (2) the adjusted basis of such asset immediately before the covered asset acquisition. The tax basis for U.S. tax purposes is the basis for making these determinations and not the basis under foreign tax law.

There is an anti-competitive aspect to §901(m). It adversely affects the U.S. corporate purchaser of a foreign target. What is the actual source of the problem is not just §901(m), which as mentioned denies foreign tax credits for the asset basis increase for U.S. income tax purposes, but the added fact that the U.S. income tax rate on U.S. corporations is 35% which is substantially higher than the corporate tax rates worldwide.  Whether one supports the rationale for the enactment of §901(m) or not, it seems fairly clear that §901(m) represents a potential added cost to U.S. corporations bidding with non-U.S. companies to acquire the stock of a  foreign target.

Section 901(m) is generally effective for transactions that occur after December 31, 2010.

CAVEAT: The information set forth in this post simply describes the terrain and does not dig into the core of the mechanical rules and computations required for a §338 election, which comes in three species or forms, as well as for §901(m). The subject of  §338 and §901(m) is indeed a detailed and lengthy topic. Add to the mix deemed asset sale provisions under §336(e) or via a §754 election as well and you have quite a lot of ground to cover. GAAP rules also enter into the equation. This posting is not intended to provide legal advice. Consult with your tax advisor to determine the impact of §901(m) or §338.


IRS Criminal Investigation Report For Fiscal 2013 Announces Gains in Enforcement, Penalties

Posted in Federal Taxation Developments


The Criminal Investigation Division of the Internal Revenue Service recently issued its Annual Business Report for 2013. This post highlights notable portions of the Annual Report.

Among the most publicized actions initiated by CID and law enforcement officials in the Justice Department and various AUSA offices, including the indictments and/or convictions of Kwame Kilpatrick, Liberty Reserve, HSBC bank, Rashia Wilson, the so-called “Queen of ID Theft,” who was sentenced to nearly 20 years in prison, Tim Turner, the self-proclaimed “President” of the sovereign citizen tax evasion movements, was sentenced to 216 months in prison, and the Los Zetas drug cartel. In total, the CID worked on 5,300 cases for 2013, recommended over 4,300 for prosecution and supported prosecutors with over 3,800 indictments of individuals. Guilty pleas or convictions were realized over 93% during fiscal year 2013.

Stated Investigative Priorities for Fiscal Year

As stated in the report, CID focused on 10 primary areas of criminal activity: (i) Identity Theft Fraud; (ii) Return Preparer Fraud & Questionable Refund Fraud; (iii) International Tax Fraud; (iv) Fraud Referral Program; (v) Political/Public Corruption; (vi)  Organized Crime Drug Enforcement Task Force (OCDETF); (vii) Bank Secrecy Act and Suspicious Activity Report (SAR) Review Teams: (viii) Asset Forfeiture; (ix) Voluntary Disclosure Program; and (x) Counterterrorism and Sovereign Citizens.

Stated Accomplishments for Fiscal Year 2013.

  • CID investigations (5,314)
  • CID investigations completed (5,557) a 12.5% increase over FY 2012
  • CID prosecution recommendations (4,364) an increase of 17.9% from FY 2012
  • Convictions (3,311) an increase of 25.7% from FY 2012
  • Conviction rate 93.1% which is .1% greater than FY 2012

Examples of CID Enforcement Actions for General Tax Fraud Adjudicated in FY 2013

  • Accountant Sentenced for Tax Fraud:  An accountant was sentenced to 63 months in prison and ordered to make restitution of $1.786M to the IRS. The accounting was the managing partner of an accounting firm in Chicago. A large client of the accountant was a family owned a group of plumbing wholesale supply companies. The accountant was givensole authority to sign checks, transfer funds and sign tax returns for the trusts he managed. He used his unlimited access to embezzle more than $4.3M over a four year period by writing checks to himself or his firm. He also stole money from a family investment partnership account and an account of the estate of a deceased family member. Rome spent the money he stole to pay personal expenses.
  • Pyramid Scheme:  Two women from Hartford, Conn. Were sentenced to 72 months and 54 months in prison, respectively. In addition, Bello and Platt were ordered to pay restitution to the several victims of the pyramid scheme. They were convicted of conspiracy to commit wire fraud and conspiracy to defraud the IRS, multiple counts of wire fraud and filing false tax returns, including omitting income they generated from the scheme.
  • Former Pilot Sentenced in Tax Fraud Scheme Involving Fuel Taxes:  In Atlanta, GA, a former pilot was sentenced to 7 years in prison and order to pay $5.6M in restitution to the U.S. Treasury. The defendant plead guilty to two counts of filing false claims against the United States. According to court documents, from 2009 through 2012, the defendant filed, or caused to be filed, over 100 fraudulent corporate tax returns, claiming $35M in refunds for fuel taxes falsely claimed to have been paid on fuel purchased for off-road company vehicles. The false claims were made in the names of corporations and shell companies, none of which used off-road vehicles or paid the fuel tax claimed for refund.
  • Home Builder Sentenced for Tax Evasion. In Boise, Idaho, a general contractor who operated a construction company to build homes evaded tax during 2005 thru 2008 by concealing receipts. Certain checks made payable to the defendant at his requests were cashed in lieu of being deposit. The defendant received 27 months in prison and order to pay $429,436 in restitution.
  • Racing Fuel Company Founder and Owner Pleads Out to Making False Claims Against United States and Bank Fraud.  Last November, a federal district judge in Grand Rapids, Mich. Sentenced the owner and founder of a successful racing fuel and motor sports business to over 22 years in prison and order to pay $83M in restitution to the Service for filing false refund claims applicable to federal “excise taxes”. The false claims resulted in the defendant’s receipt of refund payments over $80M.

Identity Theft Prosecutions

  • Ohio Woman Sentenced in Identity Theft and Tax Refund Scam. Defendant sentenced by federal district court in  Cincinnati, Ohio, to 61 months in prison and ordered to pay $477,490 in restitution to the IRS.  Defendant pleaded guilty to one count of conspiracy to submit false claims for federal income tax refunds with the IRS and to one count of aggravated identity theft. According to court documents, between January 2011 and September 2012, defendant conspired with others to obtain false claims for income tax refunds from the IRS by electronically filing false 2010 and 2011 federal income tax returns claiming at least $654,550 in refunds that they knew they were not entitled. Defendant’s  primary role was to prepare and submit false returns to the IRS using stolen identities. The co-conspirator unlawfully obtained the individual names, dates of birth, and social security numbers used to prepare and file the false income tax returns.
  • Woman Sentenced for Running Stolen Identity Tax Fraud Scheme. Essentially the same general facts of stolen identities of more than 400 individuals, many of whom were deceased, to file fraudulent tax returns using their social security numbers and claimed refunds in tax. Woman was sentenced to 12 years in prison and ordered to pay $835,883 in restitution to the IRS.
  • Self-Proclaimed “First Lady” of Tax Fraud Sentenced: A Tampa federal district court judge, on July 16, 2013, sentenced a woman to 234 months in prison on wire fraud and aggravated identity theft charges stemming from her scheme to defraud the IRS, and to a consecutive 18 months in prison for being a felon in possession of a firearm. She was also ordered to forfeit $2,240,096. The case involved identity theft and the file of fraudulent income tax returns seeking refunds. Her co-conspirator was sentenced to 174 months in prison.

Examples of Prosecutions Involving Return Preparers

  • Kansas Tax Preparer Sentenced for Filing False Tax Returns: A Wichita, Kansas federal district court judge sentenced the convicted defendant to 3 years in prison after being found guilty of 19 counts  of preparing false income tax returns for a total of 17 people during tax years 2007, 2008 and 2009. According to trial evidence, in the tax returns the return preparer falsely stated deductions for depreciation, home improvements, business repairs, contract labor, legal fees, home repairs, medical expenses, advertising, insurance, car and truck expenses, hay and grain expenses, cell phones and care of dependents.
  • North Carolina Woman Sentenced for Preparing False Tax Returns:  Return preparer who prepared false tax returns for hundreds of clients in order to obtain larger tax refunds for the clients, sentenced last Fall in Greensboro, N.C., to 70 months in prison and ordered to pay $92,910 in restitution to the IRS.
  • Tennessee Man Sentenced for Tax Fraud for Preparing False Tax Returns. Return preparer sentenced to 33 months in prison for tax fraud. His co-conspirator was also sentenced in 2013 but for a period of 26 months. The defendants operated several tax preparation businesses in Memphis. They routinely filed false federal income tax returns for their clients which falsely reflected losses and expenses arising from fictitious home-based businesses, such as cutting hair and landscaping.
  • Pennsylvania Man Sentenced for Fraudulent Tax Refund Scheme:  A defendant was sentenced by a federal district court  in Philadelphia, Pa., to 144 months in prison and ordered to pay $1,751,809 in restitution to the IRS. The defendant was convicted in March, 2013 of committing a series of tax refund schemes that defrauded the United States. A federal jury found him and his co-conspirators guilty of multiple counts of both conspiracy and filing false claims/tax returns to the IRS.  Defendant and co-conspirators solicited claimants whose personal information was used to file false tax returns claiming the Telephone Excise Tax Refund (TETR) in 2007 and the First Time Homebuyer Credit in 2009. Several other co-conspirators were sentenced in this scheme, one for 216 months in prison (and restitution) and another, a former IRS employee, to 228 months in prison (and restitution).

Examples of  Prosecutions Involving Abusive Tax Schemes

  • South Dakota Surgeon Sentenced for Tax Evasion Involving Offshore Trusts and Bank Accouts.  A surgeon from South Dakota was sentenced, in May, 2013, to  60 months in prison after a long trial. He was convicted of deflecting his earnings through a complex maze of organizations formed under the laws of Ireland, Hungary, Cyprus, Isle of Man, Jersey, and Guernsey. The funds ultimately were deposited into various foreign accounts that the defendant controlled through a New Zealand trust, in the name of a corporation set up for him in Nevis, a Caribbean island. Through these offshore transactions, defendant attempted to hide his income and evade over $1 million in taxes.
  • Former Bank Broker Sentenced for Promoting Illegal Tax Schemes. Defendant sentenced to 42 months in prison and pay restitution of over $115M and forfeit $1M. The defendant-broker and investment representative at a bank between 1997 and 2003. Over that 6 year period, he worked with members of a law firm, an accounting firm and bank representatives to design, market and implementhigh-fee tax strategies for individual clients. Those strategies, or “tax shelters,” were designed to allow high-net-worth clients to eliminate, reduce, or defer taxes on significant income or gains. Among the fraudulent tax shelters designed, marketed, and implemented by Parse and his co-conspirators were “Short Sales,” “Short Options Strategy” (SOS), and “Swaps.” The Short Sale tax shelter was marketed and sold from 1994 through 1999 to at least 290 wealthy individuals and generated at least $2.6 billion in false and fraudulent tax losses. The SOS tax shelter was marketed and sold from 1998 through 2000 to at least 550 wealthy individuals, and generated at least $3.9 billion in false and fraudulent tax losses. The Swaps tax shelter was marketed and sold in 2001 and 2002 to at least 55 wealthy individuals, and generated more than $420 million in false and fraudulent tax losses. In addition, defendant directed his own bank clients to the fraudulent shelters, and was given a free tax shelter opinion letter by the attorneys, which he used to evade hundreds of thousands of dollars of his own income taxes. Defendant was paid over $3 million in commissions by the bank attributable to the fraudulent tax shelters. He also took part in the illegal back-dating of certain tax shelter transactions. The attorneys worked with defendant to create documents and effectuate securities transactions at the bank after the close of the tax year and back-dated them using “as of” dates, which treated the documents as if they had been signed prior to the close of the tax year, in violation of tax accounting rules.
  • Owner of California Law Firm Sentenced for Tax Fraud. A Los Angeles attorney and owner of a law firm in Santa Monica, Calif., was sentenced to 36 months in prison and ordered to pay $2,056,879 in restitution in December, 2012. On January 25, 2012, the lawyer entered a plea of guilty to  willfully subscribing and filing false tax returns. According to court documents, the defendant-lawyer used  shell entities and trusts to hide over $900,000 in client fees and assets from the IRS. He also  submitted a false offer in compromise form by mail and filed false tax returns with the IRS in attempts to evade over $1 million in tax.

Examples of Prosecutions of Non-Filing Investigations

  • Economist Sentenced for Failure to File Tax Returns.  A Manhatten, NY economist was sentenced to 48 months in prison and ordered to pay $1.67 million in restitution and $2,500 in the costs of prosecution. He was convicted of tax evasion and mail fraud in January, 2013. The defendant failed to file income tax returns and pay income taxes on over $1.7 million in consulting income from 1989 through 2010. He justified his failure to pay taxes by claiming that he could not identify a provision in the tax code that made him liable for the payment of income taxes. Defendant evaded his taxes by providing a false social security number to one employer. In addition, he provided false withholding forms to employers that claimed that he was exempt from taxes.
  • Nevada Physician Sentenced on  Fraudulent Failure to File Income Tax Returns. A physician was sentenced by a Las Vegas federal district court to 27 months in prison and ordered to pay $306,171. Earlier last year, the defendant  pleaded guilty on April 22, 2013 to income tax evasion and failing to file income tax returns. According to court documents, from 1999 through 2008, defendant-physician failed to file income tax returns from 1999 through 2008 and did not pay tax on fees generated from his medical practice and expert witness fees.  The defendant is a Canadian citizen and U.S. permanent resident alien, closed all of his personal bank accounts and used a third party business to cash his paychecks. He made extensive use of cash to pay personal expenses in an effort to avoid detection.
  • Washington Businessman Sentenced for Fraudulent Failure to File Returns and  Report Income.  Last May a federal district court judge sentenced a businessman to 2 years in prison and order to make restitution of approximately $1M to the government. Other fines and penaltes were imposed. The individual was convicted on four counts of failing to file federal income tax returns for the years 2004 through 2007. According to court records, the defendant, an independent insurance agent licensed to sell employee benefits, health insurance and other insurance products, earned over $2.6M from 2004 through 2007 but failed to file federal tax returns reporting his income.

Examples of Prosecutions Involving Employment Taxes

  • Former Owner of Employee Leasing Company Sentenced for Failing to Pay Payroll Taxes.  A Utah federal district court in July, 2013 sentenced the former owner of an employee staffing company to 51 months in prison and ordered to pay $541,513 in restitution to the IRS. Pleading guilty for failing to account and pay over employment taxes for a five year period relating to three different employee leasing companies, the tax evaded totaled more than $2.3M.
  • Japanese Restaurant Owner  Sentenced for Filing False Returns.  A San Francisco owner of a Japanese Restaurant was sentenced to 33 months in prison and ordered to pay $459,105 in restitution after being convicted by a jury on March 27, 2012, for filing false tax returns, failure to file tax returns, and mail fraud. The evidence presented by the prosecution is interesting to note: (i) the defendant maintained detailed records of the restaurant’s daily receipts in 26 boxes marked “Seasoned Octopus”; (ii) the gross receipts boxes were stored in a crawl space beneath the restaurant floor; (iii) cash sales shown on the gross receipts records stored in the crawl space were not reported to the IRS; and  (iv) the defendant maintained an encrypted Excel spreadsheet documenting $1,910,803 in sales, while he reported $65,738 in sales to the IRS. The defendant also paid employees cash wages of  $548,919 for the 2004 through 2006 tax years. Employees received cash wages in white envelopes each payday. The defendant failed to include these cash wages on the quarterly payroll tax returns (Forms 941) filed with the IRS.
  • Owner of Washington Roofing Company Sentenced for Employment Tax Evasion: A roofing company owner in Seattle, Wash., was  sentenced to 24 months in prison and ordered to pay $1,179,761 to the IRS. In July 2012, defendant  pleaded guilty to paying a portion of his employees’ wages in cash from 2005 through 2008 and to not collecting employment taxes including Social Security, Medicare and income tax withholding from the cash wages. According to his plea agreement, Defendant  informed his employees in early 2005 that they would receive a portion of their wages in cash. The cash payroll was about 50%  of each employee’s pay. No payroll taxes were collected on the cash portion of the employees’ pay. By paying in cash and not reporting the wages, defendant avoided approximately $1,179,761 in employment taxes for 2006 through 2008. Even as he was failing to collect and pay over the employment taxes, defendant took  more than $3.9 million in wages and profits from the business for 2005 through 2008.
  • Founder and Former Chief Executive Officer of Body Armor Company Sentenced on Federal Charges. A CEO of a public company which supplied body armor to the military and law enforcement agencies was sentenced, on August 15, 2013, in Central Islip, N.Y., to 204 months in prison and ordered to pay a $8.7 million fine and to forfeit approximately $65 million. According to trial evidence, the defendant with others conspired to loot the company for person gain. He concealed his control of a related company in order to funnel more than $10M from the company to support a thoroughbred horse-racing business and to finance a lavish lifestyle. To cover up his theft, the defendant created, and directed others to create, fictitious documents and misclassified these personal expenses as business expenses on the company’s books and records. He also falsely inflated inventory to artificially boost reported profits, and then lied to auditors in an effort to cover up the schemes. He further engaged Brooks also engaged in accounting fraud schemes designed to increase the net income and profits that the company filed in press releases and filings with the SEC by  falsely inflating the value of the company’s existing inventory, adding non-existent inventory to the company’s books and records, and fraudulently reclassifying expenses. Although the defendant was initially released on bail conditions requiring that he account for and repatriate all foreign assets, he was re-arrested and bail was revoked in January 2010 after the government discovered that he had concealed millions of dollars in accounts in the tax haven principality of San Marino as well as in London, England.


Examples of Prosecutions Involving International Operations

Comment: The Criminal Investigation Division  has special agent attachés strategically stationed in 10 foreign countries. Criminal Investigation attachés are especially focused on promoters from international banking institutions which facilitate United States taxpayers in evading their United States tax requirements. Current oversea offices include: Beijing, China; Bogota, Colombia; Bridgetown, Barbados; Frankfurt, Germany; Hong Kong, China; London, England; Mexico City, Mexico, Ottawa, Canada; Panama City, Panama; Sydney, Australia; and The Hague, the Netherlands. The International Lead Development Center (ILDC) is specifically tasked with conducting research on potential international criminal investigations. In addition, CI has personnel assigned to Interpol and the International Organized Crime Intelligence and Operations Center (IOC-2) to combat the threats posed by international criminal organizations, assist in joint investigations and the apprehension of international fugitives.

  • Man Sentenced for Fraud Committed Against a Children’s Charity:  Defendant, a citizen of Zimbabwe, was sentenced to 72 months in prison and order to make restitution of over $629,000 and over $79,000 in back taxes. Defendant was convicted of money laundering and filing a false tax return. According to court documents, while Defendant was being investigated for his role in a scheme to obtain fraudulent United States passports, agents discovered evidence that he received large wire transfers from bank accounts held by a children’s foundation in the Republic of South Africa. The children’s foundation has its headquarters in Michigan and is one of the world’s largest children’s charities. The investigation revealed that defendant was part of a scheme to submit bogus invoices for payment to the charity. The charity paid members of the scheme a total of nearly $800,000 between 2006 and 2008 before learning that it was being swindled. Defendant  did not report to the IRS any of the money he received from the charity during those years.
  • Illinois Businessman Sentenced for Tax Evasion In UBS Bank Account Case. In July, 2013, a federal district court ordered defendant to serve 12 months and one day (felony): On July 16, 2013, in Chicago, Ill., the defendant was sentenced to 12 months and one day in prison and ordered to pay a $32,500 fine. He had already paid $1,039,343 in back taxes to the IRS, as well as a civil penalty of approximately $3.75 million. In entering a guilty plea as part of an agreement to present to the court for sentencing consideration, the defendant admitted he had transferred hundreds of thousands of dollars from the United States to his individual offshore UBS account for the sole purpose of evading domestic income taxes. He maintained at least one offshore UBS account between 1981 and 2009, while maintaining at least one additional joint account. He managed both accounts with the assistance of a UBS personal banker based on the Island of Jersey. In addition to failing to report interest income, defendant admitted that he intentionally failed to report all of his income from his monument business and his rental properties. He had also knowingly gave “no” responses on his tax to whether he had foreign bank accounts. checked the box “no” on his returns.
  • Businessman Sentenced for Hiding Income in Undeclared Bank Accounts: On July 9, 2013, in Newark, N.J., defendant was sentenced to 19 months in prison and ordered to pay a $20,000 fine. As part of his plea agreement, defendant paid to a one time FBAR penalty of $260,000. He also had plead guilty in February, 2013, to one count of tax evasion in connection with his diverting funds from his wholesale merchandise business to undisclosed foreign accounts at HSBC in India, among other places. Defendant evaded taxes on $1,198,054 in income for 2006 through 2009. He also failed to file FBARs for 2006 through 2008.
  • Ohio Attorney Sentenced on Tax Fraud Charges: In November, 2012, an Ohio lawyer was sentenced to 85 months in prison and ordered to pay a $265,000 criminal fine, $388,000 in restitution to the IRS and $24,069 in restitution to a client. He was convicted by a jury in 2012  on one count of a corrupt endeavor to obstruct and impede the IRS; 15 counts of aiding and assisting in the preparation of false and fraudulent tax returns, that related to five different trusts; one count of willfully failing to file a FBAR; one count of conspiracy to obstruct justice, commit perjury and make false statements; two counts of witness tampering; one count of submitting a false statement; and one count of obstruction of justice. His mother and a co-defendant was sentenced to three years of probation and ordered to pay a $150,000 criminal fine for her role in the conspiracy with her son to obstruct justice, commit perjury and make false statements. The lawyer created and operated several nominee entities in order to disguise and conceal his income and assets from the IRS. The false trust return charges relate to filings for at least five separate trust entities during the tax years 2003 to 2005. Evidence produced at trial showed that he had been filing similarly false returns for the trusts dating back to 1990. Each of the trusts reported receiving significant amounts of interest income each year, yet no income tax was ever reported as due because the trust tax returns fraudulently claimed deductions for distributions purportedly paid annually to a foreign beneficiary. The trusts’ purported foreign beneficiary was located in the Netherlands and testified that she was not the beneficiary of the trusts. FBAR violations were also committed.

Recent Statements of IRS Deputy Commissioner (International), IRS Large Business and International Division Suggest Possible Changes to the Offshore Voluntary Disclosure Initiative And Greater Cooperation Among Foreign Treaty Partners

Posted in Uncategorized


In comments made at the Pacific Rim Institute conference in Palo Alto, CA on January 30, 2014, Deputy Commissioner Michael Danilack responded to criticisms of the OVDI program currently in place. In fact, the National Taxpayer Advocate, Nina Olsen, filed criticisms of the initiative in her recent annual report. Ms. Olson, as reported by Tax Notes, criticized how the IRS has implemented the OVDP regarding foreign bank account report information returns and said the disproportionate penalties for small accounts versus large accounts mark the program as unfair.

One recurring criticism lobbied at the government is the “catch 22” phenomena where a participant is initially accepted and then is subsequently disqualified. The participant goes forward and files, submits a set of admissions against interest, waives Fifth Amendment rights and then is rejected. That’s obviously not an equitable process. Others have similarly been critical of the OVDP, with practitioners recently criticizing it as inflexible and participants complaining of being disqualified from the program after being previously accepted.  In picking up on Ms. Olsen’s criticism, the fines imposed also seem to be excessive especially if the Department of Justice wants to pursue a 50% penalty per year approach which results in liability in excess of the highest amount contained in the “tainted” account.

It was reported in Mr. Danilack’s remarks that more than 43,000 disclosures have been made under the three UBS initiatives which has resulted in $6.5 billion in collections.

The Director of the Competent Authority Services Division at the Canada Revenue Agency, Sue Murray, noted that Canada has offered a voluntary disclosure program for many years but that the recent publicity of offshore evasion and enforcement is increasing the number of disclosures north of the border to new highs. Another participant on the same panel, Mark Konza, Deputy Commissioner of Corporate Tax Erosion and International Division of the Australian Taxation Office, mentioned that Australia will be embarking on an off-shore initiative program in 2014. The Deputy Commissioner for International Affairs in Japan’s National Tax Agency, stated that Japan is “very eager” to adopt a voluntary disclosure program for offshore bank and investment accounts.

Information Exchange Under FACTA

Deputy Danilack also voiced optimism that putting into place a multilateral legal platform in fostering greater automatic information exchange would enhance tax administration goals in connection with fighting tax evasion effectuated through off-shore banking. With the FACTA rules going into effect this year and various countries entering into Model IGA agreements with the United States or still in the negotiation process, governments will be stepping up disclosures of foreign residents having bank and financial accounts within their sovereign territory under  FACTA and IGA Agreements. This will be particularly helpful to the Service with respect to  non-treaty countries complying with FACTA, including entering into IGAs and TIEA agreements.

Danilack, as further reported by Tax Notes, voiced enthusiasm for The Joint International Tax Shelter Information Centre (JITSIC) as an excellent vehicle for exchanging information quickly and informally, Danilack said, noting that similar forums may become more prevalent in the future. JITSIC currently includes only a small number of countries, but there are many more countries with which the United States would like to engage in close cooperation, he said. Officials are in the early stages of considering how to expand participation, he added.

Enhanced International Cooperation on Joint Audits

Danilack further stated a welcomed change would involve countries increasing their level of mutual cooperation to determine which companies present the highest amount of international risk. Danilack wants tax authorities to consider company risk profiles in a more global context and then “compare notes” with their counterparts from other countries on how they reached their conclusions. Danilack believes that engaging in joint efforts to review a multinational would yield a common understanding of international risk  and would be preferable than individual conclusions.  Obviously, the joint audit approach would be particularly helpful in curbing base erosion strategies and transfer pricing abuse. At present, the employment of  joint audits may stay at their current low levels. But the idea is to foster greater use of the joint audit and competent authority protocols. Deputy Director Murray of  Canada agreed that more joint audits and competent authority reviews should be pursued.

Canada and the United States Enter into FATCA Agreement

Posted in Federal Tax Legislation

After much discussion and commentary  echoing for months from both sides of the border, the United States and Canada executed, on February 5, 2014, an intergovernmental agreement (IGA) to implement the Foreign Account Tax Compliance Act. The Canada-United States IGA entered into is based on the Treasury’s Model 1 reciprocal exchange of information provisions.  

Under FACTA, which was enacted into law by the 2010 HIRE Act, §501(a), foreign financial institutions must cooperate with U.S. tax administrators  by supplying information with respect to U.S. reportable account holders in order to avoid 30% withholding on certain payments.  The withholding is triggered if a withholdable payment doesn’t meet the requirements under §1471(b) as to reporting and other requirements. Withholdable payments will, in general, be treated as U.S. source fixed or determinable annual or periodical (FDAP) income and gross proceeds from the disposition of property that generates interest and dividends.

Under §1471(b), a foreign financial institution will meet the requirements, and therefore avoid FACTA withholding, if an agreement is in effect between the FFI and the IRS under which the financial institution agrees: (i) to obtain information for each holder of each account maintained by the financial institution in determining which accounts are U.S. accounts; (ii) to meet verification and due diligence procedures for identifying U.S. accounts; (iii) for any U.S. account maintained by the institution, to report annually certain information required under §1471(c); (iv) to deduct and withhold a 30% tax on any “passthru payment” made by the institution to a “recalcitrant account holder” or to another FFI which does not meet the §1471(b) requirements; and so much of any passthru payment made by the financial institution to another FFI that has a §1471(b)(3) election in effect for the payment, as is allocable to accounts held by recalcitrant holders or FFIs that do not meet the §1471(b) requirements; (v) to comply with IRS requests for additional information on any U.S. account; and (vi) where foreign law would prevent disclosure of the required information, to attempt to obtain a waiver of such law and make the required disclosure.

Due to issues related to bank secrecy laws in many foreign jurisdictions, the Treasury adopted an alternative  approach to achieving transparency for foreign financial accounts owned by U.S. persons. This was achieved through the process of negotiating intergovernmental agreements (IGAs) with foreign countries to “soften” to  some extent the breadth and depth of the FACTA rules. The Model 1 IGA has two species, reciprocal (Model 1A) and non-reciprocal (Model 1B).  There is one main type of Model 2 IGA which has two versions, based on countries which the United States have and does not have an existing exchange-of-information agreement.  

Canada’s Reaction to FACTA

Following passage of FATCA in 2010, Canadian financial institutions and wealthy individuals and their advisors had expressed  reservations about the nature of the FATCA legislation and its heavy handed approach reflected by the U.S. law’s  crossing-over jurisdictional boundaries to compel foreign financial institutions and non-financial foreign companies to  foreign financial information and non-foreign financial entity information involving U.S. persons. The 2012 development of the IGA framework by the Treasury, admittedly designed to reduce financial institutions’ compliance costs and resolve local law conflicts, did not immediately assuage the rumblings heard from north of the border. It did not appear that Canada did not like IGAs as well.

In December, the Canadian Department of Finance acknowledged that it had received comments from a leading constitutional law expert in which he stated that an IGA negotiated under the terms of the model IGA would violate Canada’s Charter of Rights and Freedoms. When this development was reported by the tax press, it was suggested that perhaps Canada would resist falling in line with other foreign countries in agreement to enter into an IGA. Well, the issue has been put to rest by both governments entering into the IGA.

Under Article 4 of the Canada-U.S. IGA, each reporting Canadian Financial Institution will be treated as complying with §1471 (26 U.S.C.) if Canada complies with certain other portions of the IGA (Articles 2 and 3) and the Reporting Canadian Financial Institution: (i) identifies U.S. Reportable Accounts and timely reports annually to the Canadian Competent Authority the information required under Article 2, subparagraph 2(a); (ii) for 2015 and for 2016, reports annually to the Canadian Competent Authority the name of each Nonparticipating Financial Institution to which it has made payments and the aggregate amount of such payments; (iv) meets registration requirements on the IRS FATCA registration website, and meets other requirements, including making the required withholding on any U.S. Source Withhodable Payment payable to any Nonparticipating Financial Institution.

Another recent Model 1 mutual exchange of information  IGA was entered into with Hungary on February 4.  Including Canada and Hungary, the United States has entered into 22 IGAs.  


U.S. Based Parent Corporations With Foreign Branch Operations Need to Take Into Account Potential Application of the Overall Foreign and Domestic Loss Rules

Posted in Legal

For U.S. taxpayers planning to engage in business operations in foreign countries, especially in start-up type situations,  consideration must be given as to what are the potential tax consequences, including timing differences, for reporting built-in losses and anticipated foreign losses from operations overseas. The melding of the expected tax impacts are also important in projecting the effective rate of tax for GAAP or foreign financial accounting purposes. For example a loss incurred by a wholly owned foreign-based subsidiary is frequently required to be consolidated with income of other controlled subsidiaries or affiliates in computing consolidated financial income of the U.S. parent corporation even if such foreign losses cannot be currently used to reduce the U.S. parent’s taxable income. A loss which is realized by a foreign based affiliate that is not deductible in such year for U.S. income tax purposes will still be a factor in increasing the overall effective tax rate of the consolidated group (for financial accounting purposes).

Example. US Parent Corp. owns four foreign based subsidiaries which all meet the definition of a foreign controlled foreign corporation. Three of the foreign based CFCs have taxable income for 2013 of $300x (all of which is Subpart F income) while the fourth CFC for the same year realizes a taxable loss of $500x. Overall, the foreign based CFCs have a book loss for 2013 of ($200). However, the CFC loss with respect to the fourth CFC cannot be currently used to reduce the CFC income of the other three CFCs or otherwise reduce the US Parent Corp’s worldwide income. Thus, the effective tax rate with respect to foreign operations will be as high as 35% (U.S. federal) on the $300x of Subpart F income.

Use of Branch Operations For Conducting Business Operations Overseas

Because of the potential lock-in effect of foreign source losses from controlled foreign subsidiaries, consideration should be given to operating a foreign base as a “branch” which can be accomplished, for example, by conducting foreign based operations through a hybrid (“eligible entity” under the check-the-box regulations) entity or pass thru single member limited liability company.

Of course, consideration must first be given to whether the prior and current activities of the foreign branch will give rise to income and VAT tax in the foreign jurisdictions in which the branch is engaged in business operations. Any applicable income tax convention must also be taken into account is assessing the potential tax obligations of a foreign based operation. See, e.g., 2006 U.S. Model Income Tax Treaty for exceptions to the permanent establishment rules for business operations conducted  in the other Contracting State. Such exceptions include: (1) maintenance of a stock of goods or merchandise solely for display, storage, or delivery; (2) maintenance of a stock of goods for processing by another enterprise; (3) maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or collecting of information for the business; (4) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; (5) the maintenance of a fixed place of business solely for any combination of the activities mentioned in (1) through (4), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character. Also important to consider are the application of withholding rules in the foreign jurisdiction with respect to various sources of income, including dividends and interest.

Expected Losses From Foreign Based Operations

Where a new or existing base of foreign operations is currently expected to generate losses, the use of a foreign branch will facilitate the current use of such foreign based losses by the U.S. parent corporation in computing its worldwide taxable income and in using the overall worldwide  tax rate as the effective rate for GAAP purposes.  Thus, in some instances, the use of a foreign branch may be preferred over that of a foreign based subsidiary for including current years’ losses in reducing the U.S. company’s tax on its worldwide income.

Another factor to be considered in evaluating the benefits of  a foreign branch versus foreign subsidiary, is the potential impact on foreign tax credits (FTC). Foreign branch losses from active business operations, for example, are generally allocated to foreign source income of the U.S. parent corporation and therefore reduce the “numerator” in computing the FTC limitation under §904. Foreign tax credits of a foreign subsidiary may only be used in accordance with §§902 and 960 which may suspend or defer the timing for reporting the foreign taxes accrued or paid.

Where anticipated foreign source losses, such as anticipated losses from start-up operations overseas, exceeds the U.S. parent corporation’s foreign source income, the result will also generate an “overall foreign loss” (OFL). The presence of an OFL limits  the U.S. corporation’s current use of  FTCs generated from other foreign operations.

Overall Foreign Losses

An overall foreign loss (“OFL”), for purposes of §904(f), occurs when gross income for a tax year from foreign sources is exceeded by the sum of deductions properly apportioned or allocated to foreign sources, without accounting for any net operating loss (NOL) allowable for such year and certain other items.  Where a U.S. corporate taxpayer has an OFL usable to offset U.S. source income, the U.S. effective tax rate on U.S. source income is reduced, sometimes substantially.  If there were no recapture rule with respect to the OFL, succeeding years’ foreign source income could  be used by the same taxpayer to load up on  FTCs.  To avoid this “double benefit”, under §904(f), a portion of foreign source taxable income earned after an OFL year (a/k/a “excess foreign loss”) is required to be recharacterized as U.S. source taxable income for FTC limitation purposes.  This results in some foreign-source income being reclassified as U.S.-source income to make up for the foreign losses that had been previously been “converted” and taken against U.S.-source income.  If the foreign-source income exceeds the amount of the foreign-source loss previously deducted against U.S.-source income, the excess will be allocated in proportion to the foreign-source income baskets against which the foreign-source loss had been deducted.

Recapture of Foreign Source Losses

Section 904(f) therefore is a recapture rule whereby a U.S. taxpayer, who has previously used OFLs in reducing its worldwide taxable income subject to U.S. income tax, is required to treat a portion of foreign source income earned after an OFL year as U.S. source taxable income for FTC purposes. Where the foreign source income is greater than the OFL previously deducted against U.S. source income, the excess will be allocated in proportion to the foreign source income baskets against which the foreign source loss was deducted. Under §904(f) the amount of OFL recapture is an amount equal to the lesser of: (i) 50% of taxable income from foreign sources; or (ii) the OFL not recaptured in prior years. §904(f)(1)(B). The taxpayer may elect to include as U.S. source income OFLs in excess of the 50% of foreign source taxable income.

The §904(f) recapture rule applies separate for each basket of foreign source income, i.e., the general limitation basket and the passive income basket. Accordingly, an OFL account must be established for each FTC limitation basket. Treas. Reg. § 1.904(f)-1(c). Since losses realized in either foreign source “basket” are first allocated against income from the other “basket”, a taxpayer will not have an OFL in either basket unless, overall, deductions allocated and apportioned to gross income from foreign sources exceed that income. §904(f)(5). For example, if a foreign branch of a U.S. corporation has $10,000x of general category income in 2013 and $1,000x of investment loss, then the U.S. corporation’s OFL account for 2013 will be $9,000x.

Where an OFL is part of an NOL carryback, it must first be applied to reduce taxable income from foreign sources in the first carryback year.  Treas. Reg. § 1.904(g)-3(b). Accordingly, a carryback is added to an OFL account to the extent that the foreign portion of the NOL for the carryback year exceeds foreign source (taxable) income prior to the carryback. Therefore, if an OFL that becomes part of an NOL carryover, it is added to an OFL account if and when this portion of the carryback reduces taxable income from U.S. sources.  Treas. Reg. § 1.904(f)-1(d)(3); § 904(f)(2)(A) (NOL not included in initial computation of OFL).

In the “recapture year”, foreign source income is computed for each FTC “basket” and the OFL account within a basket is recaptured to the extent of foreign source income with respect to such “basket”.  Treas. Reg. § 1.904(f)-2(b). The recapture amount is therefore charged to the relevant basket.  Treas. Reg. § 1.904(f)-1(e)(2).

As mentioned, a taxpayer is required to recapture an OFL, in a year in which the taxpayer elects the FTC, by recharacterizing foreign source income realized in a subsequent year. § 904(f)(1); Treas. Reg. § 1.904(f)-2(a). As mentioned, the recharacterized foreign source income is the lesser of: (i) 50% of foreign source taxable income; or (ii) the OFL not recaptured in prior years. §904(f)(1)(B).   A taxpayer may also elect to raise the 50% limitation to up to 100%.  Treas. Reg. § 1.904(f)-2(c)(2). A taxpayer may make or amend such an election by attaching a statement to its annual Form 1116 or Form 1118 stating: (i) the percentage elected, (ii) the dollar amount of foreign source taxable income that the taxpayer is recharacterizing as U.S. source income, and (iii) the dollar amounts in the OFL accounts before and after recapture.

Dispositions of Assets of Foreign Trade or Business or Stock of a Controlled Foreign Corporation

There is a recapture of OFL, without regard to the 50% of foreign source taxable income rule, with respect to gain recognized on dispositions of property used in a foreign trade or business of from the sale of CFC stock in which the taxpayer owns a majority of its stock, by vote or value. Where the disposition of assets of a foreign trade or business or a majority interest in CFC stock, it still must recognize gain up to the full amount of the unrecaptured loss.

Example. US Corp. has an OFL of a foreign branch and transfers the branch’s assets to a new, wholly owned foreign subsidiary (or by a check-the-box election of a foreign “eligible entity”). The foreign operations turn profitable. By deflecting the foreign branch’s profits to a foreign subsidiary, even a CFC, it is possible that the income of the CFC or foreign subsidiary could be deferred. Section 367(a)(3)(C) requires a  OFL recapture at the time of the transfer of the branch assets in a § 351 transfer.

These rules apply to a disposition of foreign business assets, including a §721 transaction or of CFC stock. § 904(f)(3)(D)(i). Special provisions are set forth in the consolidated return regulations pertaining to consolidated OFLs or COFLs. See T.D. 8884 (5/25/2000). See also pertinent parts of  Treas. Regs. §§1.1502-3, -4, -21.

Overall Domestic Loss Rule

In the American Jobs Creation Act of 2004, Congress enacted new §904(g)(1) which provides for income recharacterization (from a “domestic loss” to a “foreign loss”) for any taxpayer who sustains an overall domestic loss (ODL) for any tax year beginning after 2006, if certain conditions are met, again, for purposes of applying the FTC rules.  An ODL is any domestic loss to the extent such loss offsets foreign source taxable income for the current tax year or for any preceding tax year by reason of a carryback.  A “domestic loss” is the amount by which the gross income for the tax year from U.S. sources is exceeded by the sum of the deductions properly apportioned or allocated thereto (determined without regard to any carryback from a subsequent tax year).  §904(g)(2).  Under §904(g)(1) , the amount of ODL required to be  recharacterized as “foreign loss” is the lesser of: (i) the amount of the unrecharacterized ODL for years prior to such succeeding tax year; or (ii) 50% of the taxpayer’s U.S. source taxable income for such succeeding tax year.  Other special rules apply.  See generally Treas. Regs. §§1.904(g)-1, -2; Preamble, T.D. 9371, 72 Fed. Reg. 72592 (12/21/07), removed by T.D. 9595, 77 Fed. Reg. 37576 (6/22/12).

Example.  T generates a $100x U.S. source loss and earns $100x of foreign source income in year 1, and pays $30 of foreign tax on the $100x of foreign source income. Since T has no net taxable income in year 1, no FTC can be claimed in year 1 with respect to the $30 of foreign taxes. If the taxpayer then earns $100x of U.S. source income and $100x of foreign source income in year 2, pre-AJCA law did not allow the recharacterization of any portion of the $100x of U.S. source income as foreign source income to reflect the fact that the previous year’s $100 U.S. source loss reduced the taxpayer’s ability to claim the FTC. Under §904(g), T may recharacterize $50x of year 2 income as foreign source income for purposes of applying the FTC limitation rules. The rule applies for tax years commencing after 2006.

Comment: The foregoing explanation merely is an effort to inform the reader, in summary form, of one part of the complex maze of intersecting rules and computations affecting the foreign tax credit provisions. Therefore, the commentary,  as with all postings on this Federal Taxation Developments Blog, can not be relied upon as legal advice by anyone reading this blog post either by Jerry August, or the law firm Fox Rothschild LLP.

United States Supreme Court Determines that Partnership Determinations Affecting Outside Basis of a Partner Are Subject to the TEFRA Entity Level Audit Rules in United States v. Woods

Posted in Federal Tax Case Law Decisions

On December 3, 2013, a unanimous Supreme Court, in an opinion written by Justice Scalia, held that whether a gross valuation misstatement penalty with respect to a partnership tax item could be imposed was to be determined in a partnership level proceeding under the TEFRA audit rules.  112 AFTR 2d  2013-6974 (2013),  In reversing the Fifth Circuit, the Court upheld the imposition of a 40% gross valuation misstatement as to the inflated claimed outside basis of partners holding partnership interests in an abusive tax scheme who claimed large tax losses based on such erroneously inflated basis.


Prior to 1982, the Service was precluded from making adjustments in correcting a partnership’s informational return and resolving a dispute about such proposed partnership-level adjustments in a single, unified proceeding. Instead, auditing and adjusting partnership tax items were resolved at the individual partner level, i.e., through deficiency proceedings at the individual-taxpayer level. See generally §§ 6211-6216.  Under a deficiency proceeding, the IRS is required to timely issue, prior to the running of the statute of limitations on assessments, including extensions, a separate notice of deficiency to each taxpayer under §6212(a) in which case the taxpayer has a 90 day period to file  a petition in the United States Tax Court to challenge the alleged deficiency before the tax can be assessed. See §6213(a).  It is also possible for the TMP to decide in proceeding before the Federal District Court having venue of the matter or with the Court of Federal Claims. These procedures applied as well to partnership income tax adjustments prior to the enactment of the partnership entity level audit rules in the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. 96 Stat. 648 (26 U.S.C. §§6221-6232].  The need for partnership level determinations was enacted into law by Congress to remove the cumbersome and difficult process faced by the Service in chasing down each partner based on his or its place of residence. The potential always existed for inconsistent determinations among different partners, most particularly where the partners in question resided in different circuits.

Under TEFRA, partnership-related tax matters are involved in a two part process. First, the IRS commences the audit at the partnership level to adjust “partnership items,” as defined. See §§ 6221, 6231(a)(3).  Where the treatment of certain partnership items is contested by the party acting on behalf of the partnership, e.g., the tax matters partner, the Service is required to issue a final partnership audit adjustment report or FPAA notifying the partners of the unresolved adjustments to partnership items. The partners may seek judicial review of those adjustments, §§ 6226(a)-(b). Once the adjustments to partnership items have become final, the IRS may undertake further proceedings at the partner level to make any resulting “computational adjustments” in the tax liability of the individual partners. § 6231(a)(6). Most partnership level “computational adjustments” may be directly assessed against the partners, bypassing deficiency proceedings and permitting the partners to challenge the assessments only in post-payment refund actions. §§ 6230(a)(1), (c). Deficiency proceedings are still available, however, for certain computational adjustments that are attributable to “affected items,” that is, items that are affected by (but are not themselves) partnership items. §§ 6230(a)(2)(A)(i), 6231(a)(5).

A partnership item under TEFRA includes “the applicability of any penalty . . . which relates to an adjustment to a partnership item.” § 6226(f). A determination that a partnership lacks economic substance, for example, is such an adjustment.  Under the TEFRA formula, the court in a partnership-level proceeding may provisionally determine the applicability of any penalty that could result from an adjustment to a partnership item, even though actual assessment of the penalty requires a subsequent, partner-level proceeding. At the partner-level proceeding, each partner may raise any arguments or affirmative defense as to why the penalty should not be imposed. In the Woods case, the question was whether the partnership level proceeding tribunal had jurisdiction to determine the applicability of the valuation-misstatement penalty.

The valuation misstatement penalty applies to the portion of any underpayment that is “attributable to” a “substantial” or “gross” “valuation misstatement.” A “substantial” or “gross” valuation misstatement is present where “the value of any property (or the adjusted basis of any property) claimed on any return of tax” exceeds by a specified percentage “the amount determined to be the correct amount of such valuation or adjusted basis.” §§ 6662(a), (b)(3), (e)(1)(A), (h). The accuracy-related penalty applies to any portion of an underpayment that is attributable to a “substantial valuation misstatement” if the underpayment for the year from all such misstatements exceeds $5,000 ($10,000 for a C corporation that  is not a personal holding company).The normal penalty rate of 20% for a substantial valuation misstatement is increased to 40% with respect to a gross valuation misstatement.  Although the valuation overstatement penalty, like all other aspects of the accuracy-related penalty, may be avoided by a showing of reasonable cause, a return disclosure of an overstatement does not negate the penalty. Overstatements of value or adjusted basis have been subject to penalties of one sort or another since 1982.

Facts in Woods Case

Respondent Woods and his employer, McCombs, participated in an offsetting-option tax shelter which was designed to generate large paper losses that they could use to reduce their taxable income. Under the scheme, each purchased from Deutsche Bank a series of currency-option spreads. Each spread consisted of a “long-option,” in which each purchased at a premium, and a “short option” which each sold to Deutsche Bank for which each received a premium. Since the premium paid for the long option was largely off-set by the premium received for the short option, the net cost of the package to Woods and McCombs was substantially less than the cost of the long option alone. Woods and McCombs contributed the spreads, along with cash, to two partnerships, which used the cash to purchase stock and currency.  In determining their “outside” basis in their partnership interests, Woods and McCombs treated only the long component of the spreads (the investors’ obligation to buy which were transferred to the partnerships subject to such investors’ obligations) and disregarded the nearly offsetting short component. As a result, when the partnerships’ assets were disposed of for modest gains, Woods and McCombs claimed huge losses attributable to their unrecovered and gross inflated  outside “basis” which  basis they asserted had to fully reflect their obligations under the long-option contributed to the partnerships.   Although they had contributed only  roughly $3.2 million in cash and spreads to the partnerships, they later claimed losses of more than $45 million which was due to the unrecovered outside basis in liquidation of their partnership interests.

Service’s Challenge to the Claimed Outside Basis and Losses Claim by the Partners

The Internal Revenue Service timely issued a FPAA to each partnership. The FPAA took the following positions: (i) the Service felt that the partnerships were a sham and should be disregarded for federal income tax purposes; and (ii)  the Service disallowed  the related losses. It concluded that the partnerships were formed for the purpose of tax avoidance and  lacked “economic substance and were shams.” Tax shelters of this type were solely  designed to generate large paper losses that a taxpayer could use to reduce taxable income. They had no economic substance in the eyes of the Service.   See IRS Notice 2000-44, 2000-2 Cum. Bull. 255 (describing offsetting-option tax shelter as a “listed transaction”).

As there were no valid partnerships for tax purposes, the IRS determined that the partners could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments would be subject to a 40% penalty for gross valuation misstatements. Woods, as the TMP,  filed for judicial review. §6226(a). The District Court held that the partnerships were properly disregarded as shams but that the valuation-misstatement penalty did not apply.  The Government appealed the decision on the penalty to the Court of Appeals for the Fifth Circuit. While the appeal was pending, the Fifth Circuit held in a similar case that, under Circuit precedent, the valuation-misstatement penalty does not apply when the relevant transaction is disregarded for lacking economic substance. Bemont Invs., LLC v. United States, 679 F. 3d 339, 347-348 (2012). In a concurrence joined by the other members of the panel, Judge Prado acknowledged that this rule was binding Circuit law but suggested that it was mistaken. A different tribunal subsequently affirmed the District Court’s decision in this case in a one-paragraph opinion, declaring the issue “well settled.” 471 Fed. Appx. 320 (per curiam), reh’g denied (2012).The Fifth Circuit affirmed the determination that the valuation misstatement penalty did not apply.

Prior to the Woods case, two  Courts of Appeals, the Federal Circuit and the DC Circuit, held that District Courts lacked jurisdiction to consider the valuation misstatement penalty in similar circumstances see Jade Trading, LLC v. United States, 598 F. 3d 1372, 1380 (CAFed. 2010); Petaluma FX Partners, LLC v. Commissioner, 591 F. 3d 649, 655-656 (CADC 2010). The government filed for a writ of certiorari based on the existing split in the circuits on the question as to whether the penalty was a partnership item that could be addressed by a court in review of a FPAA.

Supreme Court Rules in Favor of the United States

The Supreme Court, in a unanimous decision in which Justice Antonin Scalia wrote the opinion, reversed the Fifth Circuit and  held that a district court had jurisdiction in a partnership-level proceeding under TEFRA  to determine the applicability of a valuation misstatement penalty and that the penalty applied to a tax underpayment that resulted from an (outside) basis-inflating transaction that was disregarded for lack of economic substance. Scalia stressed, however, that the partnership level penalty determination is “provisional” in that the partnership proceeding tribunal can determine only whether the partnership-level determination results in a penalty and the imposition of the penalty itself requires a separate partner-level proceeding.

The Appellant-United States argued that the District Court had jurisdiction to determine whether the penalty could be imposed on the basis that as a matter of law a partner can not have an outside basis in a sham partnership so that any claim of an outside basis in a partnership that does not exist is, by definition, constitutes a gross valuation misstatement. The TMP had argued that because outside basis is not a partnership item, but an “affected item”, a penalty that would rest on a misstatement of outside basis cannot be considered at the partnership level. He maintains that a penalty does not relate to a partnership-item adjustment if it “requires a partner-level determination,” regardless of “whether or not the penalty has a connection to a partnership item.”

The Supreme Court looked to the plain language of the gross valuation-misstatement penalty in §6662(e)(1)(A) in support of its position. Under the facts of the case, once the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in his partnership interest greater than zero. Any underpayment resulting from use of a non-zero basis would therefore be “attributable to” the partner’s having claimed an “adjusted basis” in the partnerships that exceeded “the correct amount of such . . . adjusted basis.” See § 6662(e)(1)(A). And under the relevant Treasury Regulation, when an asset’s adjusted basis is zero, a valuation misstatement is automatically deemed to be a gross valuation misstatement. The valuation-misstatement penalty encompasses misstatements that are based on legal as well as factual errors, so it is applicable to misstatements that rest on the use of a sham partnership.


The United States Securities and Exchange Commission Judge Suspends Units of “Big Four” Accounting Firms Over Audit Secrecy

Posted in Legal

As reported recently from various news media outlets, on January 22, 2014 SEC Administrative Law Judge, Cameron Elliot, issued a cease-and-desist order and suspended the Chinese subsidiaries of Deloitte & Touche, Ernst and Young, KPMG, and PricewaterhouseCoopers, for six months holding that the subsidiaries had “willfully violated” U.S. laws.  SEC Act of 1934, Release No. 71390/ January 24, 2014; Adm. Proceeding File No. 3-15687.  The Chinese based affiliates, which also include BDO’s Chinese subsidiary, refused to present data, e.g., accounting workpapers, about companies based in China and listed on U.S. securities exchanges based on the need to comply with Chinese secrecy laws. The accounting firms felt it was up to Congress and the PRC to resolve the dispute.  The United States Public Company Accounting Oversight Board (PCAOB) has been negotiating with Chinese authorities to gain access to the audit documents.

Judge Elliot went out of his way, in the 112 page ruling, to censure the Chinese affiliates of KPMG, PricewaterhouseCoopers, Ernst and Young and Deloitte and Touche.  Another firm, Dahua, previously a member of the BDO network international, was censured but did not  receive a 6 month suspension. Forbes reported that Chinese stocks listed in the U.S. “got hammered on January 22, and the bloodshed continued on January 23, led by the internet and solar stocks”. A 3.5% drop in the Bloomberg China-US Equity Index (of most traded U.S.-listed Chinese stock). It is reported that there are 425 Chinese companies with a market capitalization of $185 billion trade in the New York exchange. Will the affected companies now be unable to timely file 2013 annual reports as required by U.S. law? Will the problem continue to affect the market value of the Chinese companies?

China’s response was somewhat predictable. It warned of “consequences” from barring the Big 4 accounting firms from conducting audits of U.S. listed Chinese Companies.

Chief Litigation Counsel in the SEC’s Enforcement Division, Matthew Solomon, stated he was “gratified by the decision” and felt that the decision was proper and necessary and that the production of such records is critical to the SEC’s ability to investigate potential securities law violations and to protect investors. There have been reports to claims of fraud and inefficent auditing standards at the units of the Big Four situated in China. In December 2012, the SEC charged the China units of the Big Four with violating the Securties Exchange Act and the Sarbanes-Oxley Act, which demands foreign public accounting firms turn over to the SEC upon request, information on any firm publicly traded on US markets. This information, including access to work papers, permits the SEC to test the quality of the audits and protect investors from accounting fraud.

While the ruling does not go into effect immediately, there are concerns that audits of U.S. companies doing business in China as well as Chinese companies listed on U.S. stock exchanges could complicate the audit process. Still, the ruling is being appealed by the sanctioned firms, which process could take some time. Will the Big 4 be able to sign the audits in the interim?  Presumably not but this thought is made from a “distance” no doubt.

Prior to this problem surfacing there was a recent wave of new IPO listings from China in the United States.  Moreover, the censure would presumably also affect, also in accordance with rules set by PCAOB and Sarbanes-Oxley, multinational public firms using Big 4 firms for current SEC compliance work, including audits, with a substantial presence in China.

While the ruling does not go into effect immediately, there are concerns that audits of U.S. companies doing business in China as well as Chinese companies listed on U.S. stock exchanges could complicate the audit process. Still, the ruling is being appealed by the sanctioned firms, which process could take some time, and therefore the recent ruling does not go immediately. Will the Big 4 be able to sign the audits? What would happen if they refuse?  Prior to this problem surfacing there was a recent wave of new IPO listings from China in the United States.  Moreover, the censure would presumably affect, under rules set by PCAOB, multinational public firms using Big 4 firms for current SEC compliance work, including audits, with a substantial presence in China.