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

Many business companies have hit "hard times" the past several years in being able to maintain profit levels. This in turn has led to job layoffs, foreclosures and a sharp increase in bankruptcy proceedings. In many instances, companies, like individuals encumbered with "underwater debt" or "negative equity" debt, attempt to renegotiate or restructure one or more of its debt obligations in place.

Where such restructuring of an old debt into a revised debt is successful,  income tax impacts frequently result to both parties. Focusing on the borrower, frequently a restructured obligation will result in a partial cancellation of indebtedness income which is generally taxable in accordance with §61(a). A limited exclusion from gross income bor debt cancellation is available under §108(a) in four contexts, including the insolvency of the taxpayer. Where, however, one of the four categories qualifying for a partial or full exclusion from gross income are not applicable, the restructured debt will, as to the debtor, require tax payments on the income attributable to cancelled "principal" in the indebtedness.

Congress, as part of The American Recovery and Reinvestment Act of 2009, added new §108(i) which allows for a deferral of income resulting from an otherwise taxable cancellation of indebtedness for "indebtedness discharged by the reacquisition of the debt instrument" in 2009 and 2010. As set forth in the definition of a requisition in §108(i)(4), a "reacquisition" includes (A) any acquisition of the debt instrument by the borrower or a person related to the borrower, and (B) there is an "acquisition", i.e., acquisition of the debt instrument for cash, exchange of the debt instrument for another debt instrument, including by modification, the exchange of the debt instrument for stock or an interest in an entity taxable as a partnership, the contribution of the debt instrument to capital and the complete forgiveness of the debt by the holder of the debt instrument.

Where cancellation of indebtedness income is realized by the debtor in 2009 or 2010, the taxpayer may elect, under new §108(i), to defer the inclusion of the taxable income arising from the cancellation until 2014 at which time the income is reported ratably over a 5 year period extending through 2018. An election is made separately for each debt instrument. See Rev. Proc. 2009-37, 2009-36 IRB 309 (information required).

Taxpayers seeking to take advantage of this special relief rule should understand that the election is irrevocable and in making the election, the taxpayer must satisfy the disclosure requirements. The tax attributes of the taxpayer must also be taken into account particularly where there may be expiring net operating loss carryovers. The deferred income is required to be accelerated under §108(i)(5)(D) where the taxpayer dies, liquidates or sells substantially all of its assets, ceases to do business or in similar situations. The acceleration rule is in need of definitive regulations as support for avoiding an acceleration event could be made, for instance, where the taxpayer is acquired in a non-taxable reorganization described under §368.

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In a detailed and comprehensive review of the US-Canada Income Tax Convention, the recently issued Fifth Protocol, and the OECD Model Treaty and related Commentaries, as well as the domestic tax law treatment of single member limited liability companies, pass through entities and other organization, the Canadian Tax Court, in an opinion written by Patrick Boyle, on April 8, 2010, concluded that implicit in the clear intention of the OECD countries, including Canada and the US, that treaty benefits be enjoyed by TD LLC in the present circumstances, and given the context of the Canadian and US tax régimes and the text of the US Treaty : (i) TD LLC must be considered to be a resident of the US for purposes of the US Treaty otherwise the treaty could not apply; (ii) TD LLC must be considered to be liable to tax in the US by virtue of all of its income being fully and comprehensively taxed under the US Code albeit at the member level; and (iii) the income of TD LLC must be considered to be subject to full and comprehensive taxation under the US Code by reason of a criterion similar in nature to the enumerated grounds in Article IV, namely the place of incorporation of its member which is the very reason that TD LLC's income is subject to full taxation in the US. the Tax Court of Canada held that a single member US LLC was a US resident for the purposes of the Canada-US Tax Treaty. As "resident", the US LLC was entitled to branch tax relief on Article X (Dividends) under the U.S.-Canada Tax Treaty. The decision overrides the long-standing position adopted by the Canada-Revenue Agency that a US LLC is not"resident in the U.S." for treaty purposes on the rationale that income is not subject to the most comprehensive form of taxation in the U.S. at the entity level.

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The IRS recently startled the corporate tax community, which community stills is struggling to effectively deal  with, i.e., successfully block,  Textron type summonses for the production of tax accrual workpapers and FIN 48 workpapers, by announcing in Annoucement 2010-9, a proposal which would require, for the first time,  “large corporations” to  report uncertain tax positions on a new schedule to be filed with their annual tax returns. I

In Textron v. United States,  an en banc decision of the First Circuit Court of Appeals,  held  that the work-product privilege was not implicated with regard to the taxpayer's tax accrual workpapers, because it found that the workpapers were not prepared “for” litigation and were required to be produced pursuant to an IRS administrative summons. 104 AFTR 2d 2009-5719 , 577 F3d 21 , 2009-2 USTC ¶50574 (CA-1, 2009), vacating and remanding 100 AFTR 2d 2007-5848 , 2007-2 USTC ¶50605 , 507 F Supp 2d 138 (DC R.I., 2007), aff'd in part and remanded in part 103 AFTR 2d 2009-509 , 553 F3d 87 , 2009-1 USTC ¶50167 (CA-1, 2009), vac'd by 560 F.3d 513 , 103 AFTR2d 2009-1436 (CA-1, 2009). Compare, the Fifth Circuit's decision in El Paso Co., 50 AFTR 2d 82-5530 , 682 F2d 530 , 82-2 USTC ¶9534 (CA-5, 1982) (primary purpose test) with various circuits applying the broader “because of ... in anticipation of litigation” or “but for ... in anticipation of litigation” tests used in describing work product. See, e.g.,  Roxworthy, 98 AFTR 2d 2006-5964 , 457 F3d 590 , 2006-2 USTC ¶50458 (CA-6, 2006); Adlman, 76 AFTR 2d 95-7188 , 68 F3d 1495 , 95-2 USTC ¶50579 (CA-2, 1995) (memorandum containing opinion work product relating to potential tax litigation arising out of a proposed merger may be protected);  Binks Mfg. Co. v. Nat'l Presto Indus., Inc., 709 F2d 1109 (CA-7, 1983); Senate of Puerto Rico, 823 F2d 574 (DC D.C., 1987); In re Sealed Case, 146 F3d 881 (DC D.C., 1998); In re Grand Jury Proceedings, 604 F2d 798 (CA-3, 1979); Simon v. G.D. Searle & Co., 816 F2d 397 (CA-8, 1987); In re Grand Jury Subpoena, 357 F3d 900 (CA-9, 2004); National Union Fire Insurance Co. v. Murray Sheet Metal Co., Inc., 967 F2d 980 (CA-4, 1992). See, in general,  August & Grimes,  “The Discovery Status of Tax Accrual Workpapers After Textron”, Business Entities (WG&L), Jan/Feb 2010. See also  August and Grimes, “Ability of IRS to Discover Tax Accrual and FIN 48 Workpapers”, 10 BET 6 (November/December 2008); August “Attorney-Client Privilege and Work-Product Doctrine in Federal Tax Matters,” 10 BET 4 (July/August 2008); and August, “Understanding Fin 48: Accounting for Uncertainty in Income Taxes,” 10 BET 30 (May/June 2008). 

Inviting comments from the tax professional community, which deadline recently passed at the end of March and the tenor of which can be expected to be particularly critical of the proposed measure, the IRS should be expected to require such reporting.  Why? Because it bypasses litigation over summonses enforcement actions under §§7602 or 7609 (third party recordkeeper).  It’s the economical way to get to the taxpayer’s innermost thoughts and anxieties over which items on the return may not survive “sunshine” and challenge from the IRS and if challenged what is the “worst case” economic impact from the positions disclosed.   Because the prospect that the form request may in effect ask clients to waiver privileged information communicated with its outside or in-house tax or general counsel, federal tax practitioner or the work product , particularly mental impressions of its tax and financial advisers on the same subject, litigation  with respect  to the form should be anticipated. Yet, since the form initiative, if passed, would be required to constitute a return, the non-complying large business taxpayer may fail to disclose at the risk of an extended or no statute of limitations for such year and face the prospects of penalties. Tax return preparers who fail to make the required disclosure face the prospect of preparer penalties and possible charges for violation of Circular 230.

While the Service could yank its proposal over the overwhelming criticisms it will undoubtedly hear, its litigation position on required return information may pose to bid a formidable obstacle to challenge successfully.  See, e.g., litigation arising under §6050I. Yet, in its Annoucement the Service was undoubtedly concerned about its “image” in this effort and therefore backs off slightly, at least from an appearance standpoint,  by stating at the same time that it otherwise plans to continue its policy of restraint for requesting tax accrual workpapers during an examination. The schedule will require the annual disclosure of uncertain tax positions in the form of a concise description of those positions and information about their magnitude.

Let’s get more specific about what Annoucement 2010-9 would, in its present proposed form, require be filed by corporations that have more than $10 million in assets and one or more uncertain tax positions to disclose those positions to the IRS. The businesses would file a IRS form schedule with the corporate income tax return or other business tax return, i.e., if an unincorporated entity has one or more large corporations as partners or members. 

The schedule would require (1) a concise description of each uncertain position for which the taxpayer or a related entity has recorded a reserve in its financial statement and (2) the maximum amount of potential federal tax liability attributable to each uncertain position -- determined without regard to the taxpayer's risk analysis of its likelihood of prevailing on the merits.  Uncertain tax positions also would include any position related to the determination of any U.S. tax liability for which a taxpayer or related entity has not recorded a tax reserve because the taxpayer (1) expects to litigate the position or (2) has determined that the IRS has a general administrative practice not to examine the position. A related entity is any entity related to the taxpayer under §§ 267(b), 318(a), or 707(b).
 

The proposal does not require the taxpayer to disclose the taxpayer's risk assessment or tax reserve amounts, even though the Service can compel the production of this information through a summons. United States v. Arthur Young, 465 U.S. 805, 815 (1984). While the Service, again, intends to require the reporting of uncertain tax positions, the Service is proposing to otherwise retain its existing policy of restraint as described in Announcement 2002-63, 2002-2 C.B. 72, and IRM 4.10.20.
 

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Premiums Paid to Controlled Foreign Corporation Insurance  Company for Provisional Indemnification Receivables for Loss Reserves Must be Included in Subpart F Income under Sections 952 and 956 in TAM 201015030 (9/25/09).

In a technical advise memorandum issued last Fall, the National Office determined certain  provisional indemnification receivables (PIR) for incurred but non-reported loss reserves are includable in a foreign insurer's subpart F insurance income and are effectively to be included in the  of a U.S. shareholder of the foreign insurer on a pro rata basis under §§ 951 and 953.
Under the stated summary of the facts, the taxpayer  is a U.S. shareholder of a foreign insurer, which is a controlled foreign corporation (CFC), i.e., §957 defines a CFC as a foreign corporation where more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned by U.S. shareholders. A” U.S. shareholder” for this purpose, per §951, is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. 

The taxpayer has policies reinsured by the foreign insurer, including auto liability and general liability policies. The foreign insurer's shareholder agreement sets out a method to calculate a shareholder/insured's premium, depending on an actuarial firm estimating a shareholder/insured's predictable losses (Fund A) and other losses to the foreign insurer's retained limit (Fund B). The annual premium is the sum of the shareholder/insured's contributions to Fund A, Fund B, and the fixed costs of the program.

Loss and profit distribution rules as well as risk of loss allocations were contained among the shareholders/insured. More particularly, under the risk of loss rules, any  additional premium assessments against the taxpayer were anticipated and the foreign insurer calculated them, in part, based on the PIR for incurred but as of yet unreported losses. The foreign insurer's financial statements for the relevant years included in income the increase in the receivables for PIR, and the taxpayer's federal income tax return for the relevant years excluded the increase in receivables for PIR in computing the taxpayer's deemed dividend income from the foreign insurer under subpart F. However, the taxpayer deducted the increase in the actuarial estimated reserves for incurred but not reported losses on the same basis as book income.   This effectively resulted in a deduction without an income or revenue offset.

The taxpayer argued that changes in the PIR, representing potential assessments on shareholders/insureds , are reversed for the calculation of taxable earnings and profits for subpart F purposes because of their still contingent nature. The IRS maintained that under § 832  insurance company taxable income, a property and casualty insurance company must determine its gross income, in part, on an earned premium basis. Under that system, premiums are not earned when a policy is written or a premium collected, but the premium is earned over the period of coverage.

Technical Analysis
Neither the Code nor Regulations define the terms "insurance" or "insurance contract". The Supreme Court however that insurance involves both risk shifting and risk distribution.  Helvering v. LeGierse, 312 U.S. 531 (1941). The risk transfer must be the risk of economic loss. See, e.g., Allied Fidelity Corp. v. Commissioner, 572 F. 2d 1190 (7th Cir. 1978), cert. denied. The risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F. 2d 288, (2d Cir. 1950), and must not be merely an investment or business risk. Le Gierse, 312 U.S. at 542, Rev. Rul. 89-96, 1989-2 C. B. 114; Rev. Rul. 2007-47, 2007-2 C.B. 127. 
Section 957(b) provides  that for purposes only of taking into account income described in  §953(a) (relating to insurance income), the term CFC includes not only a foreign corporation as defined in subsection (a) but also one of which more than 25% of the total combined voting power of all classes of stock (or more than 25% of the total value of the stock) is owned (per §958(a))  or is considered as owned per §958(b), by U.S. shareholders on any day during the taxable year of such corporation, where the gross amount of premiums or other consideration in respect of the reinsurance or the issuing of insurance or annuity contracts described in §953(a)(1) exceeds 75% of the gross amount of premiums or other consideration in respect of all risks.

For certain insurance companies, §953(c)(1)(a) provides that  the term” U.S. shareholder “means with respect to any foreign corporation, a U.S. person (per §957(c)) who owns (within the meaning of § 958(a)) any stock of the foreign corporation. Under § 953(c)(1)(b) the term CFC  has the meaning given to such term by §957(a) determined by substituting 25% or more for more than 50%. Under §953(c)(1)(C) the reference to pro rata share in section 951(a)(1)(A)(i) shall be determined under section 953(c)(5). As a CFC, its U.S. shareholders must include in gross income their pro rata shares of the corporation's subpart F income, as defined in §952, and the amounts determined under §956, which are based on the U.S. property held by the CFC.  Section 951(a)(1)(A)(i) requires a U.S. shareholder of a CFC to include in gross income such shareholder's pro rata share of the CFC's subpart F income for the year.

Section 952(a) defines subpart F income to include, among other things, insurance income as defined in §953, and foreign base income, per § 954. In effect, § 951 provides for the inclusion in the taxable income of a U.S. shareholder its share of current earnings and profits of a foreign insurance company as "deemed dividends."  Section 953(a)(1) defines “insurance income”, including income that would be taxed under subchapter L (§§801-848) as if the company was a domestic insurance company.. Amounts includable as deemed dividends are computed on the same basis as a domestic insurance company's taxable income. See §832 and in particular §832(b)(3), which defines underwriting income as the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred. Section 832(b)(4) provides that the term premiums earned on insurance contracts during the taxable year means an amount computed as follows: (A) from the amount of gross written premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance; (B) to the results so obtained, add 80% of the unearned premiums on outstanding business at the end of the preceding taxable year and deduct 80% of the unearned premiums on outstanding business at the of the taxable year.  Section 832(b)(5) defines losses incurred during the taxable year on insurance contracts based on a series of calculations.  For meaning of “unearned premium” see Treas. Reg. §1.832-4(a)(8)(i) i.e., unearned premium for a contract, other than a contract described in §816(b)(1)(B,  is the portion of the gross premium written that is attributable to future insurance coverage during the effective period of the insurance contract. Unearned premiums do not include any additional liability established by the insurance company on its annual statement to cover premium deficiencies.  See also NAIC, Statements of Statutory Accounting Principles (SSAP) No. 53 (setting forth guidelines for the reporting of earned but unbilled premiums).

Taxpayer takes the position that the change in the PIR, which represents potential assessments on shareholder/insureds, on the books of Foreign Insurer, which is a CFC, are reversed for the calculation of taxable earnings and profits for subpart F purposes because of their contingent nature. When the assessments are actually determinable, they are included in the calculation of taxable earnings and profits of Foreign Insurer as claims indemnification. Taxpayer believes that the PIR are not contractually determinable with certainty at the close of the taxable year and therefore should not be includable under SSAP No. 53 as written premiums on a NAIC annual statement.

National Office’s Rejection of Taxpayer’s Return Position Argument
The National Office disagreed with the taxpayers' omitting the PIR payments from Subpart F income.  Its reasoning is set forth in steps.  First, section 832 requires a property and casualty insurance company to determine its gross income, in part, on an earned premium basis. Under this system, a premium is not earned when a policy is written or when the premium is collected. Rather, the premium is earned over the period of coverage.  Under § 832(b)(4), earned premiums are composed, in part, of gross written premiums during the taxable year less return premiums and premiums paid for reinsurance. The amount of written premiums is then converted to an earned basis by means of the reduction allowed with respect to the net increase in unearned premiums during the taxable year. The items taken into account under § 832(b)(4) closely track items reflected in calculating earned premiums. The determination of gross written premiums in section 832(b)(4) necessarily includes certain amounts that would not otherwise be accruable under general tax accrual principles because the insurance company either has not received the premium or does not have an enforceable right to collect these amounts.

The PIR estimates due to Foreign Insurer from the shareholder/insured based on estimated incurred but not reported losses must be included in Foreign Insurer's earned premiums under § 832(b)(4) without regard to whether the amounts would meet the all events test for accrual of income by a non-insurance company.  This is mandated by §446(b) in clearly reflecting underwriting income, i.e., premiums earned and losses incurred must be computed on the same basis. Thus, the deduction for unpaid loss reserves in excess of Fund A must be offset by the increase in PIR.

Here, pursuant to the shareholders/insureds agreement with the CFC Insurer, the shareholders are required to pay additional premiums based on incurred but not reported losses. Foreign Insurer has included these additional premiums in its financial income, but has excluded them from its computation of subpart F taxable income and earnings and profits. However, Foreign Insurer has included in financial and taxable income the expected premiums (CIR) from shareholder/insureds based upon its actuarially determined reserves for reported losses. There should be no distinction between these receivables and the additional receivables from shareholder/insured on incurred but not reported losses. Thus, Foreign Insurer must also include PIR in taxable subpart F income as it does with its financial income.

TAM Holding

The PIR is includable in the calculation of Foreign Insurer's earnings and profits. The changes to the Foreign Insurers subpart F income and earnings and profits to reflect the PIR are included in Taxpayer's income on a pro-rata basis under §§951 and 953.

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