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The Service has just issued Rev. Proc. 2011-13, 2011-3 I.R.B.1, which updates Rev. Proc. 2010-15) as to whether whether disclosure of a position taken on a tax return is adequate for purposes of the section 6662(d) accuracy-related penalty and the section 6694(a) tax return preparer penalty.  The guidance updates the Service’s position to new section 6662(i) which provides an enhanced accuracy related penalty for  non-disclosed noneconomic substance transactions; the section 6662(j) increased accuracy-related penalty for undisclosed foreign financial asset understatements; and the Schedule UTP that must be filed by some corporations. The revenue procedure applies to any income tax return filed on 2010 tax forms for a tax year beginning in 2010 and to any income tax return filed on 2010 tax forms in 2011 for short tax years beginning in 2011.

Background

This revenue procedure updates Rev. Proc. 2010-15, 2010-7 I.R.B. 404, and identifies circumstances under which the disclosure on a taxpayer's income tax return with respect to an item or a position is adequate for the purpose of reducing the understatement of income tax under section 6662(d) and for the purpose of avoiding the tax return preparer penalty under section 6694(a) (understatements due to unreasonable positions on any income tax returns). The new procedure does not apply with respect to any other penalty provisions (including the disregard provisions of the section 6662(b)(1) accuracy-related penalty, the section 6662(i) increased accuracy-related penalty in the case of nondisclosed noneconomic substance transactions, and the section 6662(j) increased accuracy-related penalty in the case of undisclosed foreign financial asset understatements). This revenue procedure has been updated to include reference to: (i) the section 6662(i) increased accuracy-related penalty in the case of nondisclosed noneconomic substance transactions; (ii) the section 6662(j) increased accuracy-related penalty in the case of undisclosed foreign financial asset understatements; and (iii) the Schedule UTP, Uncertain Tax Position Statement, a new schedule required of certain corporations.

Section 6662

Section 6662 imposes a 20% accuracy related penalty with respect to  any portion of an underpayment of tax required to be shown on a return. The penalty is increased 100% to 40% of the underpayment of tax attributable to gross valuation misstatements under section 6662(h), nondisclosed noneconomic substance transactions under section 6662(i), or undisclosed foreign financial asset understatements under section 6662(j)). Section 6662(b)(2) applies to the portion of an underpayment of tax that is attributable to a substantial understatement of income tax.  See §6662(d)(1) for definition of substantial understatement of income tax. See also §6662(d)(1)(B) for corporations. Understatement is defined in section 6662(d)(2), i.e., the excess of the amount of tax required to be shown on the return for the taxable year over the amount of the tax that is shown on the return reduced by any rebate (within the meaning of section 6211(b)(2)).

Section 6694

Section 6694(a) imposes return preparer penalty on a return or claim for refund which reflects an understatement of liability due to an "unreasonable position" if the tax return preparer knew (or reasonably should have known) of the position. A position (other than a position with respect to a tax shelter or a reportable transaction to which section 6662A applies) is generally treated as unreasonable unless (i) there is or was substantial authority for the position, or (ii) the position was properly disclosed in accordance with section 6662(d)(2)(B)(ii)(I) and had a reasonable basis. If the position is with respect to a tax shelter (per §6662(d)(2)(C)(ii)) or a reportable transaction (per §6662A), it is more difficult to have the penalty lifted for reasonable cause. See Notice 2009-5, 2009-3 I.R.B. 309.

The Notice announces that an accurate disclosure of a tax position on the appropriate year's Schedule UTP, Uncertain Tax Position Statement, will be treated as if the corporation filed a Form 8275 or Form 8275-R regarding the tax position. The filing of a Form 8275 or Form 8275-R, however, will not be treated as if the corporation filed a Schedule UTP.

Operative Provisions

The Procedures addresses the quality and quantity of information required to make an adequate disclosure For example, the Procedure addresses how much factual information is sufficient and requires that the money amounts entered on the forms must be verifiable, i.e., if on audit, the taxpayer can prove the origin of the amount (even if that number is not ultimately accepted by the Internal Revenue Service) and the taxpayer can show good faith in entering that number on the applicable form. Special scrutiny is given to understatements arising from transactions involving related parties. The relationship must be disclosed on Form 8275 or Form 8275-R. Parts of the Procedure are quite detailed as to what is required to be stated on the disclosure. As set forth in the regulations, a properly or adequately disclosed position still does not have a “reasonable basis” per Treas. Reg. §1.6662-3(b)(3) or is attributable to a tax shelter (per §§6662(d)(2) or (d)(3), or is not properly substantiated or the taxpayer failed to keep adequate books and records with respect to the item or position. The Procedure warns that disclosure will not avoid a tax return preparer penalty where the position is taken with respect to a tax shelter (per §6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies.

A separate section of the Procedure addresses the required information needed for taxpayers itemizing deductions, claiming charitable contributions,  casualty and theft losses, certain expenses related to the ownership of rental property, the reasonableness of officers compensation claimed on Form 1120 and other specific items. The Procedure addresses information required to be shown on Forms M-1 or M-3, partnership returns and other return information.  As to foreign tax items, the Procedure provides information related to international boycott transactions as well as treaty based return positions.

 
Effective Date

This revenue procedure applies to any income tax return filed on a 2010 tax form for a taxable year beginning in 2010, and to any income tax return filed on a 2010 tax form in 2011 for a short taxable year beginning in 2011.

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Transfers of appreciated property to foreign estates and to non-grantor foreign trusts are subject to federal income tax to the transferor as if disposed in a taxable transaction. Gain recognized is the fair market value of the property less its adjusted basis. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), P.L. 107-16, §542(e)(1) amended the applicable provision, §684, and extended its reach to transfers of appreciated  property made in 2010 that were (1) transfers made or taking effect at death, to nonresident aliens, and (2) transfers made to a foreign grantor trust, i.e., to the extent a trust is wholly or partially treated as  owned by a non-U.S. person . Since EGTRRA had its own “sunset” rule, the expansion of §684 to transfers at death to non-resident aliens and to foreign grantor trusts was, by design, only effective for transfers occurring during 2010. See EGTRRA §§ 901, 542(f)(2).

The Tax Relief Act of 2010 repeals (retroactively) the amendments to §684 made by EGTRRA. However, the gain recognition requirement will still apply if the executor of a decedent dying in 2010 elects, in accordance with the Tax Relief Act of 2010, to treat the estate tax as repealed for 2010 and applies the modified carryover basis rules in §1022. Thus, the repeal of the extension of §684 in 2010 to non-resident alien beneficiaries and foreign grantor trusts contained in TRA 2010 applies where the taxpayer (estate) treats the one year phase out of the estate tax under EGTRRA as not taking effect. See TRA §301(a). This is another factor to consider, therefore, in whether the executor for a decedent dying in 2010 should elect “in” for not applying the federal estate tax. Accordingly, subject to this 2010, §684 will not apply to a transfer made to a nonresident alien or foreign grantor trust during or after 2010. Transfers of appreciated property to foreign estates and to non-grantor foreign trusts will still be subject to income tax under §684. 
 

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A U.S. partnership, trustee of a U.S. trust, or executor of a U.S. estate must deduct and withhold income tax on distributions attributable to the disposition of a U.S. real property interest (“USRPI”) to the extent it is includible in the income of a foreign partner, foreign beneficiary, or, in the case of a trust, a foreign person under the grantor trust rules per §671 et seq. For amounts paid after May 28, 2003, the Service was authorized to issue regulations to reduce the amount of income tax required to be withheld on a foreign person's gain from the disposition of an interest in U.S. real property from 35% to 15%. Since the Service had not issued regulations providing for the 15% rate,  domestic partnerships, estates, and trusts had to withhold tax at 35%.

Under section 303 of the 2003 Jobs and Growth Act (JGTRRA, Sec. 303, PL 108-27, 5/28/2003 ), as amended by section 102 of the 2005 Tax Increase Prevention Act (TIPRA, Sec. 102, PL 109-222, 5/17/2006 ), the Service’s authority to provide for a reduced 15% withholding rate by regulation was to expire for payments made in tax years beginning after Dec. 31, 2010 (in which case the rate reduced rate would have reverted to the earlier 20%).  Under the Act, the IRS has been granted authority to provide a 15% withholding rate on a distribution from a partnership, trust or estate attributable to the disposition of a USRPI for two additional years, i.e., tax years beginning before Jan. 1, 2013.
 

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Under the controlled foreign corporation rules, i.e., a foreign corporation defined under §957(a) as owned more than 50% of its combined voting power or value is owned by 10% (or such higher percentage) by U.S. shareholders on any day of the taxable year that is involved. A “U.S. Shareholder” per §951(b) is a U.S person, i.e., a citizen or resident of the U.S., a domestic partnership or corporation or a nonforeign trust or estate that owns 10% or more of the corporation’s combined voting power. See also §958.  U.S. shareholders of a CFC are required to include in gross income their share of the CFC’s subpart F income currently regardless of whether the income is distributed to the shareholders.

Subpart F income includes foreign base company income. One category of foreign base company income is foreign personal holding company income. For subpart F purposes, foreign personal holding company income generally includes dividends, interest, rents, and royalties, among other types of income. There are several exceptions to these rules. For example, foreign personal holding company income does not include dividends and interest received by a CFC from a related corporation organized and operating in the same foreign country in which the CFC is organized, or rents and royalties received by a CFC from a related corporation for the use of property within the country in which the CFC is organized. Interest, rent, and royalty payments do not qualify for this exclusion to the extent that such payments reduce the subpart F income of the payor. In addition, subpart F income of a CFC does not include any item of income from sources within the United States that is effectively connected with the conduct by such CFC of a trade or business within the United States (“ECI”) unless such item is exempt from taxation (or is subject to a reduced rate of tax) pursuant to a tax treaty.

Under the “look-thru rule” contained in §954(c)(6), dividends, interest (including factoring income per §954(c)(1)(E) ), rents, and royalties received by one CFC from a related CFC are not treated as foreign personal holding company income to the extent attributable or allocable to income of the payor that is neither subpart F income nor treated as ECI. For this purpose, a related CFC is a CFC that controls or is controlled by the other CFC, or a CFC that is controlled by the same person or persons that control the other CFC. Ownership of more than 50% of the CFC's stock (by vote or value) constitutes control for these purposes. The Secretary is authorized to prescribe regulations that are necessary or appropriate to carry out the look-thru rule, including such regulations as are appropriate to prevent the abuse of the purposes of such rule.

The look-thru rule is effective for taxable years of foreign corporations beginning before January 1, 2010, and for taxable years of U.S. shareholders with or within which such taxable years of such foreign corporations end. The 2010 Tax Relief Act extends for two years the application of the look-thru rule, to taxable years of foreign corporations beginning before January 1, 2012, and for taxable years of U.S. shareholders with or within which such taxable years of such foreign corporations end.

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Under the Subpart F rules, §§951-964, 10% or greater U.S. shareholders of a controlled foreign corporation (“CFC”), i.e.,foreign corporations where more than 50% of the stock of the foreign corporation is owned, directly or indirectly, by U.S. shareholders, are required to currently report in taxable income their share of the CFC’s Subpart F income  regardless of whether such income is distributed to the 10% or more shareholders,  In particular, Subpart F income also includes insurance income and foreign base company income. Foreign base company income includes, among other things, foreign personal holding company income and foreign base company services income (i.e., income derived from services performed for or on behalf of a related person outside the country in which the CFC is organized).

Under pre-2010 Tax Relief Act law, certain income from the active conduct of a banking, financing or similar business, or from the conduct of an insurance business (collectively referred to as “active financing income”) was temporarily excluded from Subpart F income, but only for tax years of foreign corporations beginning after Dec. 31, 1998 and before Jan. 1, 2010, and for tax years of U.S. shareholders with or within which any such tax year of the foreign corporation ended. Under pre-2010 Tax Relief Act law, for tax years of foreign corporations beginning after Dec. 31, 2009 (and tax years of U.S. shareholders ending with or within any such tax year), the insurance income exemption rules of §953(a), were to be applied in the same manner as if the tax year of the foreign corporation began in '1998. Thus, for tax years beginning after Dec. 31, 2009 in which the temporary exception for insurance income was not in effect, the same-country exception from Subpart F insurance income was to apply as under pre-'99 law.

The new law extends the active financing rules for an additional two years. This will allow banks, finance, insurance and similar revenue generating CFCs to continue to defer current taxation with respect to foreign source financing and insurance income under Subpart F. See §§953(e)(10), 954(h)(9).
 

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