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

Section 280G provides, in general, that the service provider receiving an excess parachute payment must incur a 20% nondeductible excise tax on the excess portion of the parachute payment which is usually associated with a payment triggered by virtue of "change of control" provision in an executive employment agreement. An executive for this purpose is generally a highly compensated employee (top 1%), a 1% or more employee-shareholder or an officer or director within a certain time frame before the change of control event.

While there are several methods to mitigate the imposition of the excise tax under section 280G, such exceptions have limited access for many public companies. Legal counsel for service providers have also negotiated for gross-up payments (including double-gross ups) for reducing the cost to the service provider. The tax gross-ups, which are a function of the incremental excise tax , have provided comfort to key executives whose parachute payments have an "excess" component and run outside of the less than three to one (average past years compensation).

In November 2008 RiskMetrics Group (RMG), formerly known as ISS, announced a policy that it would consider tax gross-up payment for golden parachute treatment a "poor pay practice." With this pronouncement it is speculated among commentators who specialize in executive compensation planning that shareholders will not be so willing to approve golden parachute payments particularly those with "excess" amount profiles. Indeed, on commentator recently reported a recent study by Pearl Meyer & Partners for the National Association of Corporate Directors found that 61 Fortune 500 companies made material alterations to change in control benefits from November 2008 to August 2009 and that more than 10 percent of these agreements eliminated excise tax gross-up provisions. If a tax gross-up payment is to be eliminated, a cap on payments may be beneficial in avoiding falling into the excess category.

Public companies are therefore evaluating whether payments triggered on a change of control can be deflected over to a noncompetition agreement. Still, the regulations provide for compliance with a covenant not to compete to be treated as the equivalent of providing services after a change in control. Post-control services generally fall outside of the section 280G provision where the value of the future services is substantial, the covenant not to compete is "real" and has a "reasonable likelihood" of being enforced. .

There are several other strategies that are available to public companies and their executives to increase the amount that may be paid under the tipping point. The base amount used to determine the tipping point can be increased by exercising stock options, electing not to defer amounts under a nonqualified deferred compensation plan, and paying bonuses during the five-year period ending before the year of a change in control.⁷ The value of payments for purposes of the tipping point calculation can also be reduced by cashing out options on a change in control, which limits the value to the cash-out amount (as opposed to a higher fair value associated with an unexercised option that could be exercised for a prolonged period after a change in control).²⁸ Also, reasonable compensation for services to be rendered after a change in control includes payments received by an executive as bona fide damages for breach of contract because of an involuntary termination without cause.²⁹ This exemption may apply when the payments do not exceed the present value of the compensation that would have been paid during the remainder of the contract term, the executive demonstrates a willingness to work that is rejected by the buyer, and the amounts to be paid as damages are reduced to the extent the executive has earned income from other sources during the remainder of the contract term.

Thus, the planning environment on highly compensated executives, officers and directors of public companies and other taxpayers subject to the excess parachute provisions may be tilting strongly towards dropping the gross-up concept in mitigating the service provider’s cost. This means that a more careful analytical and legal analysis must be made as to the package of compensation benefits a particular executive is presently receiving and what is required to be paid out on a change of control as defined in the regulations.

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In Container Corp., 134 TC No 5 , Tax Ct Rep (CCH) 58131, 2010 WL 571831 (2010), a case of first impression, the Tax Court, per the opinion of Justice Holmes, held that payments received by Vitro, S.A., a Mexican corporation, from its US subsidiary for the guarantee of the subsidiary's debt obligations was not income from sources within the U.S. under Section 861 , and, therefore, was not subject to withholding under Section 1442.

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A issue of some significance in international taxation is the distinction required to be made by the taxing authorities as to the character of income derived from “shrink-wrapped” software, i.e., whether it is income from the license of a copyright itself or is income from a copyrighted article.  This in turn leads to the interrelated question of whether related receipts constitute “royalty income” or “trade or business income”. 

The distinction is critical of course since royalties are generally subject to flat rate tax and withholding from the source country (or no source taxation under applicable treaty) whereas business income can be taxed on a net basis in the jurisdiction in which the foreign company maintains a permanent establishment.  

A recent article on this issue authored by S. P. Singh and Sharad Goyal which was published in the Journal of International Taxation, April 2010, briefly addressed the treatment given under the Indian domestic tax law and tax treaties, i.e., a royalty is taxed irrespective of whether the foreign company has any presence in India. Business income, in comparison, is only taxed under Indian tax treaty it is reported only if there is a permanent establishment in India. In contrast, business income is taxable in the hands of a foreign company only if it has a permanent establishment in India.

Messrs. Singh and Goyal report that Indian revenue authorities have consistently taken the position that payments from the sale of software, regardless of whether it is over the counter type shrink-wrapped software or customized software, are both royalty income. While neither the Supreme Court of India nor an appellate court has not addressed this issue, the Indian Tax Appellate Tribunal (ITAT) has held that the payments amount to business income and not royalties. This decision was reached in Infrasoft Limited, where the ITAT (Delhi Bench) held that the amount received by a nonresident under a license agreement for allowing the use of standard software was not a "royalty" under either the Indian Income Tax Act, 1961 (ITA) or the India-U.S. income tax treaty . Infrasoft Limited v. ADIT, Order of the Delhi Bench of ITAT, 2009-TIOL-21-ITAT-DEL (2009). As pointed out by the authors, the position taken by the Indian revenue authorities is not entirely consistent with the approach taken in other jurisdictions.

Shrink-wrapped computer software is usually sold under a licensing agreement whereby the buyer is granted limited right to use the program for business or personal purposes. The copyright or patent remains owned by the seller/manufacturer of the material. The buyer is precluded from transferring or altering the program. If all rights with respect to the copyright are not transferred to the buyer, the issue is whether the transaction is taxable as royalty income for the use of the copyright or involves the purchase of copyrighted material taxable as business income.

The Model Treaties, i.e., OECD Model and U.N. Model, treat the taxation of royalties differently. Under the OECD model, the country of residence alone has the right to tax royalty income whereas the U.N. Model permits taxation in the source country as well. With respect to “software”, the starting point is to determine if the transaction involved is in fact a software transaction as well as how the transfer of the intellectual property is made. Transactions in intangibles are usually either transfers of full ownership or limited transfers of rights. Transfers of full ownership are taxable as "business income," as the payment is not consideration for “the use of, or the right to use” the property. If the payment is for partial rights in the copyright, it will be considered a royalty. This approach is applicable as well with respect to transactions in software. See Article 12 (Royalties) of the 2008 OECD Model. Again, where only part of the rights in the copyrighted software material is transferred, the transaction is generally treated as a royalty.  Compare Article 7 (Business Profits).

The authors point out that one of the problem areas involves the taxation of software distributors who are generally granted the right to copy the material and re-sell the copyrighted material in certain locations. Does this right to copy convert royalty income into business income? Presumably receipts from such reproduction and sale constitutes  business income to the software distributor. But there are countries such as Canada, Spain, Korea, Portugal and Mexico that are reported to disagree with this approach and treat such receipts as royalty income and impose a concomitant withholding obligation.  The approach in the OECD commentary, however, is not acceptable to some tax jurisdictions, including Canada, Spain, Greece, Korea, Portugal, and Mexico, which impose withholding tax on royalty income. For U.S. income tax treatment of copyrighted materials see Treas. Reg. §1.861-18.

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Section 45D provides a new markets tax credit (NMTC) for qualified equity investments made to acquire an equity position in a corporation or partnership that is a "qualified community development entity ("CDE"). This credit was enacted as part of the Community Renewal Tax Relief Act of 2000, P.L. No. 106-554 (2000). A qualified CDE is any domestic corporation or partnership: (i) whose primary objective is providing investment capital for low-income communities or persons; (ii) maintains accountability to residents of such communities by providing them with a required level of representation on any governing board of or any advisory board to the CDE; and (iii) is certified by the Treasury as a qualified CDE.

Substantially all the investment proceeds must be used by the CDE to make qualified low-income community investments including: (i) capital or equity investments in, or loans to, qualified active low-income community businesses; (ii) certain financial counseling and other services to businesses and residents in low-income communities; (iii) the purchase from another CDE of any loan made by such entity that is a qualified low-income community investment; or (iv) an equity investment in, or loan to, another CDE. A "low-income community" is a population census tract with either: (i) has a poverty rate of at least 20% or (2) median family income which does not exceed 80% of the greater of metropolitan area median family income or statewide median family income (for a non-metropolitan census tract, does not exceed 80 percent of statewide median family income). In the case of a population census tract located within a high migration rural county, low-income is defined by reference to 85% instead of 80% of statewide median family income. A high migration rural county is any county that, during the 20-year period ending with the year in which the most recent census was conducted, has a net out-migration of inhabitants from the county of at least 10% of the population of the county at the beginning of such period.

The amount of the credit allowable to the investor (either the original purchaser or a subsequent holder) is (i) 5% for the year in which the equity interest is purchased from the CDE and for each of the following two years, and (ii) 6% for each of the following four years. The credit is determined by applying the applicable percentage to the amount paid to the CDE for the investment at its original issue, and is available for a taxable year to the taxpayer who holds the qualified equity investment on the date of the initial investment or on the respective anniversary date that occurs during the taxable year. The credit is recaptured if, at any time during the seven-year period that begins on the date of the original issue of the qualified equity investment, the issuing entity ceases to be a qualified CDE, the proceeds of the investment cease to be used as required, or the equity investment is redeemed. The Service has issued proposed regulations on the recapture issue. See also section 45D(g)(3).

The maximum annual amount of qualified equity investments is capped at $3.5 billion per year for calendar years 2006 through 2009. Lower caps applied for calendar years 2001 through 2005. For calendar years 2008 and 2009, Congress increased the maximum amount of qualified equity investments by $1.5 billion (to $5 billion for each year).

The Treasury must allocate these amounts among qualified CDEs, giving "priority" to CDEs "with a record of having successfully provided capital or technical assistance to disadvantaged businesses or communities" and CDEs intending to invest substantially all of their assets in equity interests in or loans to businesses owned by unrelated persons.

Over the 7 years for which the credit is claimed, an investor gets a total credit equal to 39% (5% for each of the first three years plus 6% for each of the next four years) of his investment. Basis in a qualified equity investment is reduced by the amount of the credit determined under Section 45D. However, basis reduction is not required for purposes of reporting the exclusion of gain with respect to small business stock under section 1202.

Although financing for real estate projects has  over the past year or so substantially dried up or become too expensive, the NMTC may provide opportunities for financing real estate projects that may not have otherwise taken seed. Indeed, the NMTC targets borrowers, nonprofits, and projects that otherwise cannot obtain conventional financing. It requires that "but for" the NMTC financing, the project would not be completed. The majority of CDEs are affiliates of banks, large nonprofit organizations, cities and other municipalities and bonding authorities.

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IRS Notice 2010-44

The IRS, on May 17, 2010, released Notice 2010-44 as new guidance for small businesses in determining to what extent they are eligible for the new health care tax credit under Section 45R that was enacted as part of the Affordable Care Act, that was signed into law on March 23, 2010.

Section 45R provides a federal income tax credit for eligible small employers, including tax-exempt organizations, that make nonelective contributions towards their employees’ health insurance premiums. An "eligible" employer must have fewer than 25 full time equivalent (FTE) employees for a tax year; the average annual wages must be less than $50,000 per FTE and the employer must maintain a "qualifying arrangement" as defined in the Notice. Notice 2010-44 provides guidance for tax years beginning prior to January 1, 2014 and transition relief for tax years beginning in 2010. The Notice outlines steps which must be met in order to qualify for the credit. The credit is not reduced by the value of available state healthcare credits. The credit is available for limited scope health insurance programs such as dental and eye care where the employer provides at least 50% of those benefits. There are three methods set forth in the Notice for computing how many FTE employees the business has.

It should be noted that while the guidance was needed and is generally favorable, it is complicated in its content, including required calculations of FTEs.

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While the government has for the most part successfully attacked tax products or tax-motivated strategies that were in vogue in the late 1990s and in the 2000s, there were many cases that the Service did not get the chance to audit and thereby escaped unscathed by passage of the statute of limitations and there were also some instances where the  Service suffered a judicial defeat.

Frequently, the client investing in a particular tax solution or tax-motivated transaction, was primarily driven by tax savings and, in the event the strategy was audited and successfully challenged by the IRS, to still avoid penalties by obtaining a "more likely than not" standard tax opinion from a reputable law firm or accounting firm . The tax opinion, in the eyes of the Service and some skeptical commentators on the tax law, was nothing more than a purchase of insurance acquired by the investor to avoid a 20% (or higher) penalty. Owing back taxes and interest for the use of the money until the taxes were repaid  from a "flaky" deal was not enough "skin in the game" for the taxpayer to be adverse to investing in the tax solution in the first place.

In an effort to provide uniformity to the tax law, Congress enacted section 7701(o) codifying the economic substance doctrine. The Congress adopted the Service’s approach, i.e., a two part conjunctive test which requires both (objective) economic substance and (subjective) substantial business purpose. The legislative history notes that the codification was not intended to replace or surplant existing precedent. Under the economic substance doctrine, first the transaction under evaluation must result in a meaningful change in the taxpayer's nonfederal-income-tax economic position and, second, the transaction must also have a substantial nonfederal-income-tax purpose. Both prongs must be satisfied based on the taxpayer’s generally required burden of proving its position by a preponderance of the evidence. The taxpayer is not required, per se, to establish a pretax profit to establish economic substance but can use this standard to meet the statutory requirement by demonstrating that the present value of the anticipated pretax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed from the transaction. Presumably guidance will be issued by the Service on examining the pretax profit test and how to compute the pretax profit, etc. Under section 7701(o)(4), accounting benefits cannot be taken into account in testing for whether the transaction has a substantial nonfederal-income-tax effect where the origin of the financial accounting benefit is a reduction in federal income tax. The reason for this rule is straightforward: If reduction of federal tax was the origin of the accounting treatment and the accounting treatment could be relied on in applying the conjunctive test, the test would become circular and cease to have meaning. Beyond this simple case, however, the circumstances in which the origin of the accounting benefit is federal tax reduction should be specified by Treasury and the IRS in future guidance. Foreign taxes are not treated as expenses per se under the pretax profit test subject to further guidance to be issue by the Service.

The term "transaction" is defined in section 7701(o)(5)(E) as including a series of transactions, i.e., see Treas. Reg. §1.6011-4(b)(1) "transaction includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement, and includes any series of steps carried out as part of a plan."

As far as the second prong, i.e., the taxpayer’s non-tax purpose for entering into the transaction, the purpose must be "substantial" and a "reasonable means" of satisfying such purpose. This requires that the transaction have a reasonable nexus to the taxpayer’s normal business operations or investment activities.

Congress has definitely imposed a "skin in the game" requirement for taxpayers that fail to meet the economic substance test. New section 6662(b)(6) imposes a strict liability penalty without an out for reasonable cause or good faith. The penalty is imposed on an "underpayment", per §6664(a) and is based on the amount of tax due were the transaction reported correctly. The penalty is 20% of the underpayment for disclosed transactions and 40% for undisclosed transactions.

Guidance will be forthcoming on this "new world" of section 7701(o) of statutory economic substance. Perhaps the Service will reduce the anxiety level of tax practitioners and there clients by publishing  an "angel list" of transactions or parts of larger transactions that will not be challenged by the Service under section 7701(o).

President Obama signed into law on March 30, 2010, the HIRE Act. Section 1409 of the Act sets adopts long-standing principle of the federal income tax law, that of the doctrine of economic substance, and not only codified the rule, which itself is controversial, but imposes a new strict liability penalty for its violation.

There are several judicial doctrines which are used to test the efficacy and purpose of the particular transactions being reviewed as well as sorting out those transactions that are primarily or solely motivated by tax savings from those transactions which have a substantial business purpose or economic motive that requires that the taxpayer changes position or risk with respect to the transaction viewed on a "before the transaction" and "after the transaction" basis. Several of the noted doctrines resorted to by the courts as aides are the "step transaction doctrine", the "sham transaction" doctrine" and the "business purpose doctrine". A fourth judicial overlay is that of the "economic substance" doctrine. Over the past ten years or so the courts have invoked the underlying calculus of each of these doctrines, which frequently overlap or are applied in an inconsistent manner, in determining whether or not to deny the tax benefits designed to flow from tax-motivated transactions.

The legal standard for applying the economic substance doctrine has been approached differently by various circuit courts of appeals.  Some have required that the transaction have either economic substance (from an objective standpoint) or a substantial business purpose (from a subjective standpoint). Other courts have required both prongs be present, i.e., both economic substance and substantial business purpose. Yet other courts have applied an overall approach drawing upon both business purpose and economic substance in evaluating the transaction as a whole.

The courts also did not always apply the same reasoning on the type of nontax economic benefit a taxpayer must establish to satisfy the economic substance requirement. Some courts denied tax benefits where a perceived business benefit was not in fact obtained. Other courts denied tax benefits on the judicial view that the transaction lacked profit potential. Still other courts disallowed tax benefits in instances where the transaction had a profit motive and the taxpayer was exposed to risk but the economic risks and profit potential were insignificant compared with the size of the tax benefits derived from the transaction

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With the repeal of the General Utilities doctrine to the taxation of corporate liquidations as part of the 1986 Tax Reform Act, Congress, in preventing avoidance of corporate level taxation for liquidations, with the exception of liquidations of controlled (and solvent) subsidiaries, block safe passage from corporate level tax for C or regular corporations converting to Subchapter S. While there are several provisions which embody this thought, the main provision is section 1374. Section 1374 imposes a tax on built-in gains, i.e., unrealized appreciation, while an asset is held by a C corporation which later makes a Subchapter S election. The tax applies generally for a period of 10 years although a recent revision to section 1374 permits it to expire at the end of 7 years.

An S corporation's gain upon disposition of an asset generally is treated as recognized built-in gain under section 1374 to the extent that the fair market value of that asset on the first day of the first taxable year for which the corporation's subchapter S election is in effect exceeds that asset's adjusted basis on such date. §1374(d)(1). If an asset with built-in gain is sold during the 10-year period beginning on such date, the S corporation will be taxed on the built-in gain. §§1374(a), 1374(d)(7). The tax is then treated as a "loss" or reduction in gain for pass through purposes. §1366(f)(2).

In Ringgold Telepone, supra, the corporation, which provided telecommunications services to customers, converted to Subchapter S status effective January 1, 2000. On such date it owned a 25% partnership interest in Cellular Radio of Chattanooga (CRC). The other 25% partners were Bell South, Trenton Telephone Co. and Beldsoe Telephone Co. CRS’s primary asset was in turn a 29.54% limited partnership interest in Chattanooga MSA limited partnership (CHAT), a wireless service provider. At all times between January 1 and November 27, 2000, petitioner indirectly owned a 7.385% interest in CHAT as a result of petitioner's 25% interest in CRC and CRC's 29.54% limited partnership interest in CHAT. The partnership interests in CHAT were not publicly traded.

The petitioner’s accounting firm valued the CRC (25%) interest based on 1998 financial data at approximately $4.6M. This report was issued on September, 1999. This valuation was updated on February 20, 2000 based on 1999 financial data to $2.6M. In March, 2000, petitioner hired an investment banking firm to sell its 25% interest at $7M which included a sales incentive to the investment banker and thus it could be inferred the asking price exceeded an objective assessment of value. Finally, on July 6, 2000, BellSouth offered to purchase the CRC interest for an amount slightly in excess of $5M subject to working capital adjustments to the date of closing. The transaction closed on November 27, 2000 for a $5.2M sales price.

On its 2000 Form 1120S, petitioner reported the amount of recognized built-in gain attributable to the CRC interest using a fair market value as of January 1, 2000 (the valuation date), of $2,600,000, the amount determined by the February 2000 report. Petitioner used the valuation of the CRC interest contained in the February 2000 report on the advice of Stephen Henley, a certified public accountant petitioner consulted to review its 2000 Federal income tax return. The IRS disagreed and contended that the corporation had a deficiency in income tax of $925,260 under section 1374 and an accuracy related penalty of 20% or $185,052. The issue was whether the FMV of the partnership interest owned by the petitioner as of the effective date of the conversion, January 1, 2000, was $2.98M as the taxpayer argued, or $5.220M as the IRS asserted was the amount paid by BellSouth. At trial the parties each submitted the report and expert testimony of valuation experts with each report supporting its respective position. In addition, the Service argued that an arms length sale reasonably close in time to the valuation event should be treated as the best evidence of value. Here the sale contract was signed 6 months after the effective date of the conversion. The taxpayer argued that the sale price should not be controlling as BellSouth paid a premium to acquire its 25% interest and should therefore not be treated as the "average hypothetical buyer" since it already owned a controlling interest in CHAT, the primary asset of CRC.

Finding the sale to be highly probative of value and negotiated at arms length, Judge Wells stated that the Court, based on special circumstances surrounding the buyer, the seller and the transaction, may have skewed the purchase price from the hypothetical fair market value of the interest. The opinion cited Epic Associates 84-III v. Commissioner, T.C. Memo. 2001-64; Hansen v. Commissioner, TCM 1952, and Treas. Reg. §20.2031-2(e). The seller-taxpayer argued that BellSouth paid a control premium for its 25% interest. The IRS argued that BellSouth already controlled CHAT prior to the acquisition of the 25% interest in CRC and did not gain any additional measure of control over CHAT by virtue of its purchase of the CRC interest. In other words, the purchase price paid by Bell South according to the IRS reflected a discount for lack of control.

After considering the sales price and terms that were close in time to the valuation date, and the expert testimony and reports submitted, the Court concluded that the fair market value of the CRC interest as of the valuation date was $3.727M. The Court used a weighted average of: (i) business enterprise analysis ($2.718M); distribution yield analysis ($3.243M) and the BellSouth sales price ($5.22M), weighted equally, in arriving at its value.

The Court rejected the government’s claim for the imposition of a 20% substantial understatement penalty finding that record reflected that the taxpayer acted in a reasonable manner and with good faith. §6664(c)(1).

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In Robinson Knife Manufacturing Company and Subsidiary v. Commissioner, __F.3d__(3/19/2010), the Second Circuit,  as set forth in the opinion of Judge Calabresi, held that the petitioner-appellant should be allowed to deduct sales-based trademark royalty payments instead of being required to capitalize such costs as was the decision of the Tax Court below, T.C. Memo 2009-9 and the government’s position throughout. See 26 USC §263A.  The taxpayer had deducted the royalties under §162(a) as ordinary and necessary business expenses.  The Second Circuit held  that where  a producer's royalty payments (1) are calculated as a percentage of sales revenue from inventory and (2) are incurred only upon the sale of that inventory, they are immediately deductible as a matter of law because they are not "properly allocable to property produced" per Treas. Reg. § 1.263A-1(e). 

 
In comments cited in the tax press, a representative of the Treasury Office of Tax Legislative Counsel, acknowledged that it has two concerns with the holding in Robinson Knife which it intends to address in regulations on pre-production period costs. The first is that even though Treasury received a number of comments requesting that sales-based costs be deductible, the final  §263A regulations only provided for the exclusion for commissions to authors. In contrast, the Second Circuit accepted the argument that sales based royalties were deductible and read into the regulations what the Treasury intentionally omitted in finalizing the regulations.  The second concern involves separating the cost from the underlying right received.  The Second Circuit merely looked at the cost, i.e., if the cost is triggered at sale, it’s not capitalizable. 
 

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