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

On June 11, 2010, the Federal Circuit Court affirmed the application of the judicial economic substance doctrine (as compared with newly enacted section 7701(o) version of the economic substance doctrine) to a Son of BOSS tax shelter that was marketed as the Jenkins & Gilchrist law firm strategy and affirmed the imposition of accuracy related penalties in Stobie Creek Investments LLC v. U.S., Fed. Cir., No. 2008-5190 (6/11/2010).

The Son of BOSS (Bond and Option Sales Strategy) shelter attempted to take advantage that assets and contingent liabilities were treated differently for tax purposes when contributed to a partnership, thus facilitating, it was thought or planned, to permit the investor to benefit from an artificial tax loss to offset substantial realized gains of the same taxpayer. The "artificial loss" was the tax product so to speak used to offset the large gains. The government has been highly successful in defeating the Son of BOSS strategy in various lawsuits and as part of an overall national policy for inviting taxpayer concessions.

The facts involved members of a family that had a highly successful family owned business that they were in the process of selling (assets) and realizing a substantial capital gain. They approached a lawyer with Jenkins & Gilchrist in January 200. The goal of the J & G strategy was to reduce the capital gain resulting from the sale of assets.

The strategy reduced a taxpayer's capital gain by increasing, or "stepping up," the basis in the asset the taxpayer wanted to sell. Because a partnership does not pay taxes, the resulting stepped-up basis passes through to the partners, thereby reducing the partner's capital gain and attendant capital gains tax when the asset is sold. To create a stepped-up basis in the assets, the J & G strategy required the contribution of assets to a partnership followed by the distribution of the partnership's assets to the taxpayers. The goal of realized a large capital loss was to be achieved through a six step process: (i) investment in foreign currency options through a single-member LLC; (ii) formation of a partnership with a third party or wholly-owned S corporation; (iii) contribution of the foreign currency options to the partnership; (iv) recognition of an economic gain or loss by the partnership when the options expired or were exercised; (v) termination and liquidation of the partnership through contribution of the taxpayer's partnership interest to an S corporation;  and the (vi) sale of the partnership's assets by the S corporation or taxpayer.

Among the various steps, step 3 is important for the success of the tax strategy. The idea was to make a substantial investment in foreign currency option spreads, whereby the LLC sells a short option and purchases a long option in the same currency. As contributed (i.e., the options) to the tax partnership, i.e., Stobie Creek, the partners basis in his partnership interest is increased by the cost (or adjusted basis) of the purchase made in the long option, but not decreased by the short option obligation. Under the J & G strategy, the short option's contribution has no effect on the taxpayer's basis because it is not treated as a "liability" section 752 when calculating the taxpayer's basis in his partnership interest. When the partnership is liquidated during step 5, the tax basis in the partnership's assets is "stepped up" to match the partner's outside basis. This stepped-up basis allows the taxpayer to recognize less capital gain when the asset is sold during step 6.

The family involved agreed to embark on the J&G strategy, including a fee to J&G of 2% of the gain to be sheltered or approximately $4.1M. Another promoter’s fee was $2M yielding total fees of in excess of $6M. The Welles family decided to pursue the J & G strategy. To obtain help implementing the strategy,

Then, with the formation of the LLC and execution of the plan, J & G stated it would be issuing a tax opinion for the Welleses similar to the one attached to the letter, which would opine that it was "more likely than not" that the transactions would be respected for federal income tax purposes.

The IRS issued a FPAA for Stobie Creek's 2000 tax year in March 2005. The IRS issued a FPAA for Stobie Creek's 2000 stub year in February 2007. The FPAAs disregarded Stobie Creek for tax purposes as a sham and disallowed the partnership's stated basis in the closely held stock, finding it attributable to transactions entered into for the purpose of tax avoidance. As a result, the FPAAs increased Stobie Creek's capital gain income from the sale of the closely held stock and assessed over $4.2 million in additional taxes. The FPAAs also imposed accuracy-related penalties per § 6662.

Stobie Creek and the other plaintiffs filed this action in the Court of Federal Claims in July 2005. The complaint sought readjustment of partnership items for the 2000 tax year and 2000 stub year,as well as a tax refund of the $4.2 million assessed in the FPAAs.

In this case, Stobie Creek Investments LLC, JFW Enterprises Inc., and JFW Investments LLC used the Son of BOSS strategy to inflate the basis of their stock in a family business, thereby eliminating over $200 million in capital gains realized from the sale of that stock. Upon audit, the IRS disallowed the losses in their entirety charging that the Stobie Creek Investments LLC strategy was a sham. Based on this determination, the IRS disallowed the partnership's stated basis in the stock, increased the partnership's capital gain from the sale of the stock, and assessed additional taxes.

In March, 2005 a notice of final partnership administrative adjustmentFPAA Issued a Notice of Final Partnership Administrative Adjustment (FPAA) for Stobie Creek's 2000 tax year was issued in March 2005. A second FPAA for the 2000 stub year was issued in February 2007.

The FPAAs disregarded Stobie Creek as a sham and disallowed the partnership's stated basis in the stock, finding it attributable to transactions entered into for the purpose of tax avoidance. The Service increased the entity’s capital gain from the sale of stock and assessed over $4.2M in additional taxes as well as accuracy related penalties per section 6662.

Tax Refund Suit Filed by Taxpayers in the Court of Federal Claims 

The plaintiffs filed an action in the Court of Federal Claims in July 2005, seeking a refund of the increased taxes and penalties. The trial court found that the plaintiffs failed to show the underlying foreign exchange digital options transactions,  which were the economic investments that would facilitate and leverage the amount of the loss realized to the U.S. transferors, had no business purpose beyond creating a tax advantage. It further lacked economic substance. The trial court also found that Stobie Creek was liable for the accuracy-related penalties.

[As an aside, under the entity level audit procedures, the IRS must mail an FPAA to the designated "tax matters partner", all notice partners, and representatives of notice groups. The primary mailing of the FPAA, which is used for notice of deficiency purposes, is the mailing to the TMP. The mailing to the other partners must occur within 60 days after the mailing to the TMP. An FPAA is equivalent to a notice of deficiency (90-day letter) in regular audits. A deficiency attributable to a partnership item cannot be assessed until the notice of an FPAA has been mailed and 150 days have elapsed after the mailing. Where a Tax Court petition is filed within 150 days after the FPAA notice, no deficiency attributable to a partnership item may be assessed until the Tax Court's decision on the matter becomes final.]

At the trial, the court found that Stobie Creek's basis calculations complied with the literal requirements of the tax code. It declined, therefore, to retroactively apply Treas. Reg. §1.752-6. The trial court nonetheless disregarded the transactions implementing the J & G strategy under the economic substance, step transaction, and end result doctrines. 4 Had the trial court applied Treas. Reg. § 1.752-6 retroactively, plaintiff's refund action would fail under the literal application of the tax code and treasury regulations because the short options would constitute liabilities for the purpose of § 752, reducing the LLCs’ basis in their partnership interests. The government did not appeal the trial court’s determination not to apply Treas. Reg. §1.752-6 retroactively. It simply ruled against the taxpayers under the economic substance doctrine.

The trial court further held that the accuracy penalty was appropriate and that reasonable cause was not present through the argued reliance on the opinion of the J&G law firm. See §6664(c)(1). Reliance on the law firm’s opinion was not reasonable due to their clear conflict of interest.

 

On appeal to the Federal Circuit, the Court examined the economic substance doctrine as applied by the trial court. The court of appeals noted that the purpose of this rule is to separate a transaction that should be respected as legitimate and a transaction principally designed to generate a tax benefit, which is a sham. In this case, the appellants argued that the foreign exchange digital options should not be treated as shams or lacking in economic substance since there were bona fide business transactions, designed to generate an economic profit from investing in foreign currencies. See section 988.

Such argument was rejected at the trial court and by the Federal Circuit based on the facts related to the investments and through the introduction of expert testimony.

 

The economic substance doctrine distinguishes between a real transaction in a particular way to obtain a tax benefit, which is legitimate, and creating a transaction to generate a tax benefit, which is illegitimate. A transaction could meet the literal terms of the Code but still lack "economic reality". See, e.g., Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84 (1978). Such transactions include those that have no business purpose beyond reducing or avoiding taxes, regardless of whether the taxpayer's subjective motivation was tax avoidance. Transactions shaped solely by tax-avoidance are also disregarded. Under an "objective" test, the Federal Circuit stated that whether a transaction lacks "economic reality," has no bona fide "business purpose" or was shaped solely by tax-avoidance features is an objective inquiry, evaluated prospectively. Coltec Industries Inc v. U.S., 454 F3d 1340 (Fed. Cir. 2006), vacg & remg 62 Fed. Cl. 716 (Ct. Fed. Cl. 2004). The objective test of economic substance requires that the transaction be evaluated based on information available to a prudent investor at the time the taxpayer entered into the transaction, not what may (or may not) have happened later. If this test is failed, then the transaction fails as well, as to its designed tax benefits, regardless of the taxpayer’s subjective motivation was (or was not) tax avoidance.

The Appeals Court, after evaluating the transcript of the proceedings below, reached the same conclusion as the trial court that the transactions did not reflect economic reality and were not motivated by a business purpose. The Court stated that the trial court properly treated the options as part of a separate, unified transaction, that were part of determining the taxpayer’s basis in Stobie Creek LLC. The options were also found to have lacked economic substance since there was not reasonable possibility that the options would return a profit. There also was no bona fide business purpose other than to generate tax benefits. This was evidenced, in part, by the fee structure. All the fees were computed by the amount of the gain to be shelter by the tax strategy.

Reasonable Cause Defense to Accuracy Related Penalties Rejected

As to the partnership level assertion of reasonable cause, to avoid the accuracy related penalty on partnership level determinations (i.e., for stepping up the basis in the closely held stock), the Court reviewed and affirmed the lower court’s determination that the penalties were to be imposed. See §6664(c). Temp. Treas. Reg. § 301.6221-1T(d). The taxpayers claimed that the TMP, Jeffrey Welles, had reasonable cause, reliance on advice from the promoter and J&G law firm, on the merits of its reporting position. Section 6664(c)(1) provides a narrow defense to § 6662 penalties if the taxpayer proves it had (1) reasonable cause for the underpayment and (2) acted in good faith. See also Treas. Reg. § 1.6664-4(c)(1). The taxpayer bears the burden of showing this exception applies. The most important of these factors contained in the regulations is "the extent of the taxpayer's effort to assess the taxpayer's proper tax liability," judged in light of the taxpayer's "experience, knowledge, and education." Treas. Reg. § 1.6664-4(b)(1).

Reliance is not reasonable, however, where, as was the case here, the adviser has an inherent conflict of interest about which the taxpayer knew or should have known. Treas. Reg. § 1.6664-4(c). This was a finding made by the trial court and the Appeals Court affirmed.Circuit Court of Appeals Affirms

 

 

 

Evaluation on Appeal of the Economic Substance Doctrine

Taxpayers Appeal to the Federal Circuit After Losing on Economic Substance; Penalties Imposed

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We are on notice that a significant increase in the number of transfer pricing examinations will be initiated by the IRS, both inbound and outbound. It is also expected that the Service will be asserting more frequently additions to tax under section 6662(e) for faulty transfer pricing practices. Taxpayers can expect additional penalty assertions, even if they have contemporaneous documentation. On the treaty side, Competent Authority personnel are increasingly available to field examiners to make sure that the proper documentation is provided and work on a coordinated basis in negotiating issues with foreign governments. Also expect a up-tick in information sharing with tax treaty countries. In this regard, it is reported that the process for IRS examiners to obtain information from foreign jurisdictions has been significantly streamlined, which has resulted in increased activity. Moreover, as recently mentioned in this blog, the United States is also working on a protocol to conduct joint audits with some U.S. tax treaty partners.

 

The IRS has recently announced that it will continue to emphasize transfer pricing issues as a key element in its efforts to foster international tax compliance. It is obvious that such renewed vigor is required due to the enormous and continuing growth in foreign based operations and foreign source income realized by U.S. multinational corporations. A second problem area is the continuation of efforts by taxpayers to engage in earnings stripping strategies employed by foreign based companies doing business in the United States. Some of these strategies violate arms length pricing standards and are in certain instances abusive and unsupportable on any level, particularly in the financing area. A third trend is the aggressive approach taken by some taxpayers who are residents of countries in which the U.S. has a tax treaty. To meet these challenges the IRS has embarked on a program of increasing LMSB staffing, selecting transfer pricing issue specialists, expand the number of economists in LMSB, and form a new LMSB transfer pricing practice, i.e, a nationwide group of transfer pricing experts. Thus, transfer pricing, together with withholding taxes and treatment of hybrid entities will be key facets of the international tax compliance initiatives of Commissioner Shulman.

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In PLR 201016048 (4/23/2010) the Service held that the issuance of a share of stock of a foreign parent corporation issued as consideration to cancel a debt obligation of the wholly owned domestic subsidiary would not trigger cancellation of indebtedness income even though the issued share as cancelled shortly thereafter.

Filing the PLR request was the common parent of an affiliated group of U.S. corporations which filed a consolidated U.S. corporate income tax return. The common parent was the wholly owned subsidiary of its foreign parent corporation. The common parent had borrowed a substantial amount of funds from the foreign parent for conducting business operations. It was stipulated that the foreign parent did not carry on a trade or business within the U.S. or maintain a fixed base or permanent establishment within the U.S. It did not file a U.S. income tax return. 

As part of a prior acquisition transaction, a portion of the debt which had been used to finance the operations of a domestic subsidiary, was cancelled by the foreign parent in exchange for the taxpayer’s stock in the subsidiary. Still, the taxpayer, despite this cancellation, was still in debt to its foreign parent.

To improve the common parent’s balance sheet, the foreign parent wanted to cancel the balance of the debt. For purposes of the foreign parent corporation’s domestic tax position, the cancellation was made in exchange for stock of the U.S. subsidiary (common parent of the consolidated group) with the value of the stock estimated to be equal to the value of the cancelled debt. The cancellation would occur before year end at which time the common parent intended to enter into a rescission agreement pursuant to which (i) the debt cancellation would be voided, with interest paid accordingly, and (ii) the transferred shares of the taxpayer's stock would be cancelled. Subsequent to the rescission, the debt and the interest would revert back to their original amounts as if the transaction never occurred.

Following the rescission of the original cancellation agreement, the taxpayer intended to enter into an agreement with the foreign parent pursuant to which (i) solely for purposes of its foreign taxes, the foreign parent would purchase a single share of the taxpayer's stock in exchange for cancellation of an amount of the debt intended to be equal to the FMV of the single share, (ii) the foreign parent would cancel the aforementioned amount of the debt as a capital contribution to the taxpayer, and (iii) the single share, which was issued solely for foreign tax reasons, would be cancelled. 

Based on the facts provided and a number of taxpayer representations, the IRS ruled that: 

(1) The original cancellation of the debt and issuance of the shares of taxpayer stock pursuant to the transaction would be disregarded for U.S. federal income tax purposes (i.e., the rescission would be respected).

(2) The taxpayer's transitory single share would be disregarded for U.S. federal income tax purposes.

(3) The taxpayer would be treated as having satisfied the debt with an amount of money equal to the foreign parent's adjusted basis in the debt for purposes of determining income from discharge of indebtedness under Section 108(e)(6). 

The Service accepted as immaterial the taxpayer’s having to issue a share and cancel it for foreign tax purposes without muddying the waters so to speak and adversely affect the favorably ruling that it was seeking to obtain. Thus, the Service may have looked at the stock issuance and cancellation as being controlled by section 108(e)(6) based on the foreign parent’s 100% stock ownership instead of section 108(e)(8). Were the latter to apply to the transaction, the debt cancellation would result in COD income since the value of a single share by the common parent would have been less than the face amount of the debt cancelled by the foreign parent.

 

 Under section 108(e)(6) where a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, such corporation is treated as having satisfied the indebtedness with an amount of money equal to the shareholder's adjusted basis in the indebtedness. Section 108(e)(8) provides that where a debtor-corporation transfers stock to a creditor to satisfy the repayment of an indebtedness, the corporation-debtor is viewed as satisfying the debt in an amount of money equal to the value of the stock. 

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The Swiss parliament has finally given its approval to the settlement reach with the United States in attempting to resolve the UBS dispute for discovery of information related to US persons holding undisclosed bank accounts in Switzerland. The parliament has renounced a call to put the settlement for a voter referendum which had been called for by the lower house.Now, the agreement had been passed by both houses of the parliament, following a meeting last week of a settlement conference convened to work out differences between the two houses. In breaking the impasse, the lower house agreed to drop its demand for a referendum. In the end, many members of parliament abstained from the vote allowing the resolution for approval without a referendum to pass by a vote of 81 to 63 with 47 abstentions.

The August 19, 2009 settlement agreement, authorized the disclosure of client data, including client identiy, of 4,450 UBS accounts to resolve and settle the John Doe summons enforcement action pending in the Federal District for the Southern District of Florida. The deal required UBS make such disclosure. Parliamentary approval of the agreement became necessary following a January 21, 2010 adverse decision by the Swiss Federal Administrative Court holding that the agreement was insufficient to change the interpretation of "tax fraud and the like" as contained in the Switzerland-U.S. tax treaty.

Parliamentary approval of the agreement gives it the legal force of a treaty in Switzerland, allowing authorities to follow through with the disclosure of data on 4,450 UBS client accounts that was blocked by a January decision of the Federal Administrative Court. The court objected to the government's claim that the agreement could expand the definition of the treaty term "tax fraud and the like" to include long-term tax evasion.

Internal Revenue Service Commissioner Shulman stated in a press release that he was very pleased with the Swiss parliament’s decision and promised the IRS would "vigorously enforce the law" against offshore tax evaders.

The Swiss government said that following the approval of the agreement, "nothing stands in the way of UBS client details being disclosed" and that 1,200 cases are ready for immediate delivery. The Swiss Federal Tax Administration (SFTA) has also issued final decisions on 400 cases, with another 650 to follow shortly. Once a final decision has been issued, the subject individual is permitted to file an appeal within 30 days with the Federal Administrative Court.

It is reported that 500 disclosures have been made where U.S. clients of UBS consented to the release of their bank information. The remaining 1,450 cases are being processed by the Swiss taxing and should be completed by the agreement's August deadline.

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With the ever-increasing size of the global economy, more privately owned American companies are engaging in business operations outside of the United States. Whether the particular activity being set up outside of the US is capital and/or labor intensive, frequently the legal and tax advisors for the US company will recommend the formation of a foreign corporation be established in each jurisdiction in which the company intends to carry on business operations through a permanent establishment.  There may be a variety of reasons offered for such recommendation. Still, in some instances use of a foreign partnership or "hybrid" entity may be more suitable.

Still where a foreign corporation is the desired entity choice, the first issue is to what extent materials, capital and labor will be used in the foreign location.  Transfers of assets to a controlled foreign corporation does not always have a tax-free consequence. Ineed, the transfer of appreciated assets to a foreign corporation must run through the requirements under section 367 in order to determine whether and to what extent the transfers are non-taxable.

Section 367(a)(1) provides, subject to certain exceptions, that transfers of appreciated property to a foreign corporation will not qualify as a tax-free exchange for stock under section 351. Instead, gain must generally be recognized where the transferee is a foreign corporation. Exceptions are provided by the Code and in the regulations.

One of the more notable exceptions is made with respect to outbound transfers of stock or securities to a foreign corporation which is part of an overall reorganization or tax free exchange of stock. This is set forth under section 367(a)(2).

Another and perhaps broader exception is for transfers of property to a foreign corporation that will be used by the foreign corporation in the active conduct of a trade or business outside of the US. §367(a)(3). There are some types of property which will not qualify as part of the active trade or business exception. Such list includes inventory, installment obligations, accounts receivable, foreign currency intangible property, and property being leased by the transferor (except where leased to the transferee). Still, the incorporation of a foreign branch by transfer of its assets to a foreign corporation will result in the recapture of the excess foreign losses.

Section 367(a)(1) reaches out to tax transfers of appreciated property by a domestic partnership to a foreign corporation unless an exception can apply. This is treated as an indirect transfer of the assets by the partners.

Intangibles transferred to a foreign corporation present a major trap for the unwary. Generally, where a transfer of intangible assets is made to a foreign corporation, the transferor will generally be treated as having sold or transferred the intangible for payments which are contingent upon the productivity, use or disposition of the property. Thus, under section 367(d), the U.S. transferor of such intangibles must including in gross income each year over the useful life of the intangible or intangibles involved, an amount which reflects the amount which would have been received in the intangible(s) were sold. §367(d). In many instances it is far more preferable to license intangibles to the foreign based entity. Until regulations are issued, transfers of intangibles to entities taxable as partnerships do not run afoul of section 367(d).

Also under section 367(e) and accompanying regulations, gain is required to be recognized in two prescribed instances: (i) a US subsidiary corporation is required to recognize gain on the distribution of its assets to a foreign parent corporation and a foreign subsidiary which is also engage in a liquidation must also generally recognize gain in transferring its US business assets to its foreign parent corporation, subject to pertinent exceptions; and (ii) a US corporation which transfers the stock or securities of a controlled corporation recognizes gain to the extent such stock or securities are distributed to a foreign corporation.

The point being made in this short entry is that businesses seeking to expand their operations overseas must be advised from the inception of the expansion plan by tax counsel to ensure that the overall tax structure selected is sound, known in advance, and the associated costs are budgeted and predictable. The starting line in many cases is section 367. While this provision has many twists and turns that obviously could not be touched upon with any detail or completeness in this short message, it is also important to warn that there are indeed many other substantial tax considerations that touch upon planning for the expansion of business operations overseas.

 

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On June 8, 2010, the Service issued final regulations providing that the section 704(c) anti-abuse rule takes into account the tax liabilities of both the partners in the partnership as well as certain direct and indirect owners of the partnership. T.D. 9485 (Treas. Reg. §1.704-3). The regulations apply to tax years commencing after June 9, 2010.

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On June 8, 2010, Commissioner Douglas H. Shulman addressed members of the Organization for Economic Co-operation and Development (the "OECD") and leaders in the international tax and business community in Washington, D.C. The topic of his address was coordination of international tax compliance and tax administration. In starting off, Commissioner Shulman remarked that the "next rung in the evolutionary ladder of international tax administration is the progression from cooperation to coordinated action on global tax issues. This is a gradual process that will not take place in a day and a night. It will take time and deliberate and focused action".

This need for global cooperation on the audit level has become required due to an ever increasing globalization of capital markets, cross border flow of funds, technology advancements and off shore investment. This not only affects the US, Shulman noted, but the entire world. As Chair of the Forum on Tax Administration (FTA), the Commissioner acknowledged that he has been working with his international counterparts to build greater cooperation between tax authorities both domestically and internationally. Among the critical matters that need to be addressed with a "unified voice" include offshore compliance, corporate governance, high net worth individuals, coordinated joint audits and early competent authority resolution. Indeed, Shulman announced, the IRS is working on a protocol for joint audits with other countries. A joint audit does not necessarily mean a simultaneous exam but instead is a process where two or more countries join together to carry out a single audit of a company with cross-border business activities. The intended objective is increasing international tax compliance and perhaps reduce audit costs while increasing the level of service.

Benefits are also foreseeable in the competent authority Shulman added. Now and in prior years it could take years to resolve double-tax cases through the CA process. With a joint audit, identification of issues and assembling the material facts may be expedited and accelerate the time that the CA process needs to play itself out.

In moving forward with the joint audit approach, Shulman revealed that the FTA is developing a guide that would provide a how-to, practical approach that highlights pitfalls to avoid, and possible best practices to employ.

Commissioner Shulman also spoke of the updates on enforcement efforts pertaining to the Swiss government on the release of information on U.S. account holders of UBS and the number of individuals, approximately 15,000, who made timely disclosures under the VDP program initiated last year in response to the UBS crisis. Shulman noted that 97% of those who filed were accepted into the program.

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It is a generally accepted axiom of international income taxation that a U.S. tax treaty will prevent the taxation of the business profits of a resident of a treaty county, unless the profits in question are attributable to a "permanent establishment" that is maintained by that resident in the United States. See, e.g., U.S. treaties with Canada art. 7(1) ; Japan art. 8(1) ; Netherlands art. 3(1) ; United Kingdom art. 7(1) . Thus, in planning for a foreign person’s inbound investment in the U.S., and based on such foreign person’s status as a resident of a treaty country, the critical terms will be evaluating whether the foreign persons’ activities constitute a "permanent establishment" and the definition of "business profits". As to the latter term, see See, e.g., Japan art. 8(5) (manufacturing, mercantile, insurance, agricultural, fishing, or mining activities); Netherlands art. 3(5) (active conduct of trade or business); United Kingdom art. 7(7) (manufacturing, mercantile, banking, insurance, agricultural, fishing, or mining activities).

Where a permanent establishment is maintained in the U.S. the source country can tax the the business profits of the foreign person but only to the extent that the business profits that are attributable to the permanent establishment. If a taxpayer has a permanent establishment, a U.S. treaty does not exempt the resulting business profits but may limit the U.S. taxation. Typically, the treaty allows U.S. taxes to apply only to the business profits that are "attributable" to the permanent establishment. See, e.g., Canada art 7(1) ; Japan art. 8(1) ; Netherlands art. 3(1) ; United Kingdom art 7(1).

Where U.S. business type activities are conducted through a pass through entity such as a partnership, the character of the income passes through to any foreign partner. Therefore if the partnership maintains a permanent establishment in the U.S., any foreign partner will be treated as so engaged. Rev. Rul. 85-60, 1985-1 CB 187 (U.S. tax applied to foreign beneficiary of foreign trust that was limited partner in partnership with U.S. permanent establishment). Rev. Rul. 91-32, 1991-1 CB 107 (situation 3). See also Donroy, Ltd. v. United States, 301 F2d 200 (9th Cir. 1962), aff'g 196 F. Supp. 54 (ND Calif. 1961); WC Johnston v. Comm'r, 24 TC 920 (1955) (Canadian individual was taxable on his share of income of general partnership with a U.S. permanent establishment); Robert Unger v. Comm'r, P-H TC Memo. ¶ 90,015 (1990), aff’d 936 F.2d 1316 (DC Cir. 1991

 

While there are various formulations of the term "permanent establishment" under our tax treaties, generally it means a "fixed place of business" through which the business is carried on. See, e.g., Canada art. 5(1) ; Japan art. 9(1) ; Netherlands art. 2(1)(i)(A) ; United Kingdom art. 5(1) . Some examples may be listed in the statute as falling within or outside of the definition. For example, a "branch, office, factory or workshop" may be a permanent establishment. Another term used is "place of management". Generally tax treaties consider a mine, oil and gas well, quarry, or other place of extraction of natural resources as a permanent establishment. It is generally understood that the Service he Service ordinarily will not rule whether a taxpayer has a U.S. permanent establishment.

 

A treaty may list certain activities that a taxpayer may perform in the United States without being treated as having a U.S. permanent establishment. A list of such exceptions include: (i) facilities used for storage, display, or delivery of goods or merchandise belonging to the foreign person; (ii) storing goods or merchandise belonging to the resident for storage, display, or delivery or for processing by another person; (iii) the purchase of merchandise or collection of information; and (iv) advertising, research activities or similar activities that are preparatory in nature.

A growing concern in this area is when an agent of the foreign person can cause the principal to be treated a maintaining a permanent establishment in the U.S. A principal generally will not be deemed to have a U.S. permanent establishment merely because of carrying on business through a broker, general commission agent, or other independent agent. However, where a principal conducts business in the U.S. through an agent that is not independent and has and habitually exercises its authority to conclude contracts in the name of the principal such can cause the activity to be treated as part of a permanent establishment. See, e.g., Canada art. 5(5) ; Japan art. 9(4); Netherlands art. 2(1)(i)(D); United Kingdom art. 5(4) . For example, in Frank Handfield v. Comm’r, 23 T.C. 633 (1955) a Canadian manufactured postal cards in Canada which were sold in the United States through an agreement with a news company. The Tax Court held that under the agreement, the news company was the petitioner's agent for distributing the cards in the United States. It therefore concluded that the petitioner was engaged in business within the United States and income from sales in this country is subject to income taxes. Taisei Fire & Marine Ins. Co. v. Comm’r, 104 TC 535 (1995), acq. 1995-2 CB 1 .

The foregoing provides an over-simplified view of the permanent establishment concept. If the IRS successfully determines that a foreign person (of a treaty country) does have a permanent establishment in the US, then the foreign person will be subject to full U.S. income tax on the attributable profits. Employees or service providers of the foreign entity may also fall into a US employment tax whole as well with withholding consequences for the employer. It is possible that a branch tax issue may arise if the foreign person is incorporated, subject to treaty rate reduction. These are  just a few of the major consequences of a permanent establishment finding.

Therefore, it is critical in planning for a non-U.S. person’s investment in a business operation in the U.S. to carefully analyze whether and to what extent a permanent establishment risk is present.

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When the terms of a debt instrument (e.g., mortgage, note or bond) are modified by agreement, the modification may be significant enough to result in a deemed taxable exchange of the original debt instrument for a “new” debt instrument.  This outcome, which has tax impacts on both the lender and the borrower, was announced in the Supreme Court’s decision in Cottage Savings v. Commissioner, 499 U.S. 554 (1991), and regulations which were issued thereafter under Treas. Reg. §1.1001-3. Under §1001, gain or loss is recognized by the lender and the debtor may find itself with cancellation of indebtedness income which then must be tested under §108 to see if there is a way to exclude the result from the borrower’s gross income.  

Treas. Reg. § 1.1001-3(c)(2)(ii) generally provides that a modification to a debt instrument occurs if an alteration changes the instrument to an instrument or property right that is not debt for federal income tax purposes, even if the alteration occurs by operation of the original terms of the debt instrument. Treas. Reg. § 1.1001-3(e)(5)(i) provides that a modification of a debt instrument that results in an instrument or property right that is not debt for federal income tax purposes is a significant modification. For purposes of this regulation,  any deterioration in the financial condition of the issuer between the issue date of the unmodified debt instrument and the date of modification (as it relates to the issuer's obligation to repay the debt instrument) is not taken into account, unless there is a substitution of a new obligor or the addition or deletion of a co-obligor.
The rule in Treas. Reg. § 1.1001-3(e)(5)(i) to disregard the worsening (or improving) financial condition of the issuer was originally intended to soften the potential for an adverse income tax impact to a financially troubled issuer. Thus, where a debt instrument is modified to accommodate the borrower in a troubled financial situation context, a hidden tax on the modification would place an additional burden on the borrower and would run adverse as well to the lender’s interest in seeing the adjusted obligated repaid in full. Despite this intent, the regulations can be viewed as imposing a taxable modification of a troubled borrower under certain instances. See  Treas. Reg. § 1.1001-3(c)(2)(ii) .

IRS has just issued proposed regulations which clarify the extent to which the deterioration in the financial condition of a debt instrument's issuer is taken into account in determining whether a modified debt instrument is recharacterized as an instrument or property right that is not debt. 

Under the proposed regulation, an analysis of all of the factors relevant to a debt determination of the modified instrument are to be analyzed at the time of the modification.  However, in making this determination, any deterioration in the financial condition of the issuer between the issue date of the debt instrument and the date of the alteration or modification (as it relates to the issuer's ability to repay the debt instrument) is not taken into account ( Prop. Reg § 1.1001-3(f)(7)(ii)(A) ) unless there is a substitution of a new obligor or the addition or deletion of a co-obligor. ( Prop. Reg § 1.1001-3(f)(7)(ii)(B) ) For example, any decrease in the fair market value of a debt instrument (whether or not publicly traded) between the issue date of the debt instrument and the date of the alteration or modification is not taken into account to the extent that the decrease in FMV is attributable to the deterioration in the financial condition of the issuer and not to a modification of the terms of the instrument. ( Prop. Reg § 1.1001-3(f)(7)(ii)(A) ). Where a debt instrument is significantly modified and the issue price of the modified debt instrument is determined under Prop. Reg § 1.1273-2(b) or Prop. Reg § 1.1273-2(c) (relating to a FMV issue price for publicly traded debt), then any increased yield on the modified debt instrument attributable to this issue price generally is not taken into account to determine whether the modified debt instrument is debt or some other property right for federal income tax purposes. However, any portion of the increased yield that is not attributable to a deterioration in the financial condition of the issuer, such as a change in market interest rates, is taken into account. ( Preamble to Prop Reg 06/03/2010 ). Effective date. The proposed regs apply to alterations of the terms of a debt instrument on or after the date the regs are finalized, but taxpayers may rely on them for alterations of the terms of a debt instrument occurring before that date. ( Prop Reg § 1.1001-3(h)(2) ).
 

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On May 14, 2010, the IRS and Treasury announced in Notice 2010-41, that they will issue regulations classifying certain domestic partnerships as foreign partnerships for the purpose of identifying the US shareholders of a CFC with respect to income inclusions (for Subpart F income) in accordance with §951(a). This announcement continues to reflect the Service’s concern, as set forth in Notice 2009-7, 2009-1 C.B. 312, identifying the following transaction (and substantially similar transactions) as a "transaction of interest" for purposes of Treas. Reg. § 1.6011-4(b)(6) and §§ 6111 and 6112.  Notice 2009-7 continues in effect.

Basic Scenario Under Question by Service

. The transaction of interest in question is where a US taxpayer (A) wholly owns two CFCs, i.e, CFC 1 and CFC 2, each of which owns 50% of another CFC, i.e., CFC 3 through a domestic partnership. A foreign corporation is a CFC for a particular taxable year if more than 50% of its stock is held by U.S. shareholders at any time during the year. A U.S. shareholder is a U.S. person (citizen, resident, or domestic corporation, partnership, trust, or estate) owning at least 10% percent of the corporation's voting stock. In applying the 50% test, proportionate shareholdings are measured by voting power or value, whichever gives the higher percentage for U.S. shareholders.

CFC3 has amounts described in § 951(a)(1). Taxpayers have taken the position that this structure avoids the flow through of Subpart F income under §951(a) with respect to CFC 3Taxpayer takes the position that it does not have an income inclusion under § 951(a) with respect to CFC3 because the domestic partnership is the first United States person in the chain of ownership of CFC3. This argument finds substance in a literal application of the Code. For starters, §957(c) defines a United States person by reference to § 7701(a)(30). Section 7701(a)(30)(B) defines a US person to include a domestic partnership. Section 7701(a)(5) defines the term "foreign" as applied to a corporation or partnership as a corporation or partnership that is not domestic. Section 7701(a)(4) provides that the term domestic when applied to a corporation or partnership means created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations. So far so good for the "literalists" view. However, § 7701(a) provides that any general definition included therein does not apply where such definition is manifestly incompatible with the intent of the relevant Code provision.

Notice 2009-7, supra, states, in challenging this construct, that the taxpayer’s argument of avoiding CFC status for CFC 3 is contrary to the purpose and intent of §951 and that regulations will be issued requiring the domestic partnership to be treated as a foreign partnership thereby requiring the Subpart F income of CFC 3 to be passed up with character intact to the CFC 1 and CFC 2. Thus, the Treasury is taking the view that the definition of a domestic partnership under §7701(a)(4), for certain partnerships wholly or partly owned by foreign corporations, is contrary to the legislative intent of §951. As set forth in the recent Notice 2010-41, which also announced that the regulations will apply for tax years of domestic partnerships ending after May 13, 2010, will treat domestic partnerships as foreign if certain conditions are met. Guidance will also address tiered partnership structures.

On December 29, 2008, the Treasury Department and the IRS issued Notice 2009-7, 2009-1 C.B. 312, identifying the following transaction (and substantially similar transactions) as a transaction of interest for purposes of § 1.6011-4(b)(6) and §§ 6111 and 6112 of the Code. A United States taxpayer (Taxpayer) wholly owns two controlled foreign corporations (CFC1 and CFC2), each of which owns 50 percent of another controlled foreign corporation (CFC3) through a domestic partnership. CFC3 has amounts described in § 951(a)(1). Taxpayer takes the position that it does not have an income inclusion under § 951(a) with respect to CFC3 because the domestic partnership is the first United States person in the chain of ownership of CFC3. As stated in Notice 2009-7, the Treasury Department and IRS believe that Taxpayer's position is contrary to the purpose and intent of § 951 of the Code.

The recent notice specifies that the regulations will treat a domestic partnership as foreign where:

1. The partnership is a US shareholder of a CFC per §§957(a) or 953(c); and

2. If the partnership were treated as foreign: (i) the FC would continue to be a CFC; and (ii)at least one United States shareholder of the CFC; (a) would be treated under § 958(a) as indirectly owning stock of the CFC owned by the partnership that is indirectly owned by a foreign corporation; and (b) it would be required to include an amount in gross income under § 951(a) with respect to the CFC.

The regulations to be issued will provide similar results in the case of tiered-partnership structures.

It should be noted that Notice 2009-7, supra, continues in effect treating the above structure, or one substantially similar to the structure, as a "transaction of interest". As further stated in Notice 2009-7, the IRS may challenge the positions taken by taxpayers with respect to such transactions, including under the provisions of subpart F and subchapter K of the Code, or under judicial doctrines including the sham transaction, substance over form, and economic substance doctrines. Note recent codification of §7701(o) and related strict liability penalty provision.

 

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