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

 

Chinese tax authorities have been aggressively enforcing the application of  its GAAR and are likely to scrutinize exit tax residency and permanent establishment issues as they relate to nonresident funds and management companies. This trend is also accompanied by a set of recent tax changes in China. Moreover, China has recently renegotiated treaties with Barbados, Mauritius, and Singapore, and continue to introduce new rules to address potentially abusive structures or transactions aimed at mitigating Chinese capital gain tax, particularly those based on double tax treaty claims or indirect transfers. These rules include general anti-avoidance rules  (GAARs)reflected in various pronouncements, i.e., Guoshuifa [2009] 2 ("Circular 2"), 3 Guoshuihan [2009] 698 ("Circular 698"), 4 Guoshuihan [2009] 601 ("Circular 601"), 5 Guoshuifa [2009] 124 ("Circular 124"), 6 and Guoshuihan [2010] 290 ("Circular 290").

Potential Investment Fund Structures in China

As most tax practitioners who work with outbound investment into China, there are several structures for effectuating cross-border investments by non-Chinese resident funds in China. One approach is to set up an investment fund in the Cayman Islands as an investment holding company which fund would adopt as its tax residence a jurisdiction which has a tax treaty with China, such as Hong Kong, Ireland or Mauritius. As a holding company, the Caymanian fund would invest in companies doing business in China. A management company could either set up a subsidiary ("wholly foreign owned enterprise" (WFOE) or a representative office in China.

Chinese GAAR Provisions

The corporate Income tax law, as revised, in China (CITL) has included several GAAR rules. Such anti-avoidance provisions permit the taxing to make adjustments when enterprises enter into business arrangements that give rise to a reduction of taxable income and are not supported by a reasonable business purpose. Under Chinese tax regulations, business arrangements without a bona fide business purpose refer to arrangements the primary purpose of which is to reduce, avoid, or defer tax payments. Guidance in this areas has been issued by the Chinese tax authorities which are very broad and cover a variety of contexts, including abuse of tax incentive policies, tax treaty provisions, legal vehicle forms or structures, tax havens, and other arrangements without bona fide business purposes. The Chinese have also adopted principles tax lawyers in the States are familiar with including, step transaction, substance over form, and book-tax differences.

The GAAR rules provide the Chinese tax authorities with the power to make adjustments to certain transactions or deny tax benefits, and allow local tax bureaus to disregard legal entities that are deemed to lack substance. These rules are being used to examine back-to-back loan or financing structures made by off-shore investment funds.

China Treaty Circulars: A Brief Summary

 

In Circulars 601 and 698 the Chinese taxing authorities will attack structures that exploit tax treaties, such as prohibited treaty shopping, and tax avoidance. combating tax treaty shopping and tax avoidance. These Circulars were preceded by some high-profile cases (citations omitted)and the issuance of other guidance aimed at strengthening the taxation of nonresidents.

In Circulars 124, the Chinese tax authorities introduced detailed administrative rules for treaty residents to claim treaty benefits, with an effective date of October 1, 2009. The rules provide that nonresidents will not be automatically granted the benefits under DTAs, and will be required to comply with administrative rules to receive them. Income derived by nonresidents is divided into two categories and is subject to different procedures for claiming treaty benefits.

For benefits attributable to passive income, including dividends, interest, royalties, and capital gains, nonresidents must adhere to an "application-approval" procedure. For active income, such as business income of permanent establishments, independent personal services, and dependent personal services, nonresidents must satisfy the "record-filing" procedure.

Different documentation is required with respect to  the two procedures. Once the application for treaty benefits is approved, the nonresident does not have to reapply to the tax authority to be entitled to benefits for three calendar years (including the year in which the initial application is made) with respect to (1) dividends derived from the same equity investment in the same enterprise; (2) interest derived from the same debt and due from the same debtor; and (3) royalties derived from granting the same right to the same person or enterprise. Eligible nonresidents under the DTAs that fail to apply for approval may cure this failure by filing an application within three years from the date of the tax payment to obtain a refund. Approval may be revoked by the Chinese tax authorities in certain circumstances and the nonresident may be required to pay the taxes plus surcharges, interest, or penalties. Query, how would a US based company issuing GAAP financials set up appropriate reserves under FIN 48 for such procedures and the risk of facing tax assessments in China?

In Circular 290, supplementary rules pertaining to local PRC tax authorities were promulgated including subjects on the timing of internal review procedures, tax filing requirements, and tax residency certificates for nonresidents seeking tax benefits under DTAs. Circular 290 requires a withholding tax agent to complete tax filing procedures regardless of whether the taxpayer has submitted related documents to the tax authority. Circular 290 clarifies that to obtain DTA benefits, a tax residency certificate must be issued exclusively for that purpose or in accordance with the requirements of Circular 124.

Additional Circulars Issued after 2008

Additional Circulars were issued by the PRC in 2009. For example, in Circular 601, rules for determining the "beneficial owner" for the purpose of claiming DTA benefits by treaty residents with respect to dividends, interest, and royalties. Agents and conduit companies (i.e., companies established to avoid or reduce tax or shift profits) are not beneficial owners for purposes of Circular 601. In Circular 698, the PRC addressed issues related to gains from equity sales (i.e., capital gains), specifically to increase the administration and taxation of direct and indirect capital gains derived by nonresidents. The Circular provides that the substance-over-form approach extends to capital gains derived indirectly by nonresidents on share or equity transactions and highlights the willingness of the Chinese tax authorities to disregard certain entities under GAAR if they were established to avoid tax and lack a business purpose and commercial rationale. The rules cover both direct and indirect equity or share transfers by nonresidents, the nonresidents' obligation to report and the Chinese tax authorities' jurisdiction over such gains, subject to certain conditions for indirect equity or share transfers.

The "share transfer" under Circular 698 refers to nonresidents transferring shares of a Chinese resident enterprise or company. Nonresidents are generally exempt from the Circular 698 reporting requirement for the disposal of listed shares of Chinese companies that were purchased and sold on a public stock exchange. For an indirect sale, Circular 698 asserts the Chinese tax authorities' right to invoke GAAR to disregard one or more intermediate holding companies if their existence serves no business purpose except avoidance of Chinese tax liabilities, thus effectively treating the indirect sale as a direct disposition of the Chinese company or enterprise.

There have been several cases that were prosecuted by the Chinese tax authorities under its GAAR Circulars in attacking transactions which the PRC taxing authorities believe does not comport with commercial substance. In the area of treaty shopping, a case arose in Tianjin (2010). The Tianjin case involved a Mauritius nonresident enterprise (MCo) that transferred its direct equity interest in a PRC non-land-equity joint venture (EJV) to another nonresident shareholder in Bermuda (BCo). The PRC tax authorities denied treaty benefits on capital gains derived by MCo from the direct disposal of equity interest in the EJV based on the following points: (i) MCo was merely a conduit company and was effectively managed by the U.S. parent company (USCo); and (ii) USCo is the beneficial owner of the capital gain in question. The PRC tax authorities determined , based on all facts and circumstances, that USCo had absolute control over MCo based on facts including: (i) the majority of EJV's sales were conducted through USCo; (ii) USCo sent its technical personnel into China to conduct product testing on EJV's products; (iii) EJV paid a royalty fee to USCo; (iv) USCo exercised substantial control over the production and operation of the EJV; and (v) USCo controlled the production, operation and funding of EJV.

In another recent case, Fujian (citation omitted), that was issued last year, the Fuzhou State Tax Bureau successfully assessed and collected taxes from a Hong Kong holding company after denying it a tax exemption under the China-Hong Kong DTA for capital gains on its transfers of the stock of a Chinese resident company. The disposing Hong Kong company alone owned less than 25% of the shares in the Chinese resident company and thus was otherwise eligible for relief under the DTA. However, its shareholder, a Hong Kong individual, owned additional shares in the same Chinese resident company through another intermediary Hong Kong holding company such that, in aggregate, the Hong Kong individual owned indirectly more than 25% of the shares in the Chinese resident company. The view of the Fuzhou State Tax Bureau was that the Hong Kong individual shareholder was the ultimate beneficial owner of the income and imposed a 10% withholding tax on the capital gains.

Practitioners working with outbound investments into China through an offshore holding company should review recent protocols entered into force under the China-Mauritius Treaty, the China-Barbados Treaty and the Singapore Treaty.

These developments in the PRC will cause tax practitioners and their clients investing in China to re-assess their tax structures and assess their present tax risk to challenge under the GAAR rules being enforced by the PRC. There are a host of potential problems in this area including the proper use of management entities, tax consequences of equity sales, eligibility for treaty protection, transfer pricing issues, permanent establishment issues, and location for the exercise of corporate governance.

It seems like the "economic substance doctrine", "business purpose", "substance over form", "step transaction", "sham transaction"., improper treaty shopping and related issues are now part of the tax landscape in the PRC.

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In U.S. v. Fort, 107 AFTR 2d ¶2011-739 (11^th Cir. 4/19/2011) a three-judge panel of the Eleventh Circuit upheld a federal district court's (Northern District of Georgia) decision, granting the Department of Justice, Civil Tax Division, summary judgment on that issue that under the constructive receipt doctrine, a consulting partner's sale of an interest in Ernst & Young was a fully taxable in the year the interest was sold to Cap Gemini in exchange for the stock. The lower court rejected the taxpayer’s argument that since he was subject to a five year contractual restriction on selling the shares received in the exchange and was subject to a forfeiture provision for certain conditions based on the post-sale profitability of the consulting company operated by E&Y, such limitation and restrictions did not postpone the year in which a taxable realization occurred for federal income tax purposes. The government brought the action against the taxpayer, Danny C. Fort, to recover a tax refund of over $300,000 which it argued was erroneously refunded.

Constructive Receipt Doctrine In General

A fundamental principle of federal income taxation is that, in general, the receipt of property and/or cash for services rendered or to be rendered or as part of a sale or other disposition of property the amount includible in gross income is the year in which such property is received. §451(a). Where the taxpayer utilizes the cash method of accounting, income must be reported in the year in which the taxable receipts are "actually" or "constructively" received, whichever first occurs. Treas. Reg. §1.451-1(a). In addition, items of gross income are taxable in the year in which the taxpayer is in receipt of an "economic benefit" even if there is earlier no actual or constructive receipt. See also §409A (acceleration of year of gross income realization plus 20% surcharge for deferred compensation that violates the contract requirements contained in the regulations).

As to the constructive receipt doctrine, the courts have determined that the following conditions are required to cause income realization: (1) the amount must be due; (2) the amount must be appropriated on the books of the obligor; (3) the obligor must be willing to pay; (4) the obligor must be solvent and able to pay; and (5) the obligee must have knowledge of the foregoing facts. Moreover the constructive receipt doctrine requires that an amount be credited to an individual's account and be subject to unqualified demand. Robinson v. Commissioner, 44 T.C. 20 (1965); Basila v. Commissioner, 36 T.C. 111 (1961) acq., 1962-1 C.B. 3; Oates v. Commissioner, 18 T.C. 570 (1952), aff'd, 207 F.2d 711 (7th Cir. 1953). See Treas. Reg. § 1.446-1(c)(1)(I).

Factual Background

In early 2000, Ernst & Young ("E&Y") prepared to spin off and sell its information-technology consulting business to Cap Gemini, S.A. ("Cap Gemini"), a French corporation. At this time, Fort was a partner in that consulting business. On February 28, 2000, E&Y and Cap Gemini executed a Master Agreement that detailed the terms of the transaction. Under the Master Agreement, the proceeds of the sale were divided among E&Y's partners. For consulting partners who qualified as accredited investors under SEC rules, such as Fort, the consulting partner agreed to terminate his or her interest in E&Y, and in exchange, received a distribution of Cap Gemini shares. Additionally, these partners would begin working at a new entity, Cap Gemini Ernst & Young ("CGE&Y"), under employment agreements containing noncompete clauses. There were limitations imposed on the receipt of Cap Gemini. Cap Gemini shares would not be distributed outright to each partner. Instead, 25% of each partner's shares would be sold immediately to cover that partner's income taxes incurred as a result of this transaction, and the other 75% of the shares (the "Restricted Shares") were placed into an individual account in the partner's name at Merrill Lynch. There were limitations placed on the Restricted Shares. They could not be withdrawn from the partner's account at Merrill Lynch immediately, and therefore, the Merrill Lynch accounts were like escrow accounts. For four years and 300 days following the closing, partners could only sell portions of the Restricted Shares at scheduled times. After the four-year, 300-day period, the partners could withdraw all remaining Restricted Shares from the Merrill Lynch account. The former tax director of E&Y's consulting practice, who helped structure this transaction, stated that the reason for these restrictions was to prevent all of the partners from selling too many Cap Gemini shares at once, thereby diminishing the value of the shares.

The Restricted Shares were also subject to forfeiture as "liquidated damages" if a partner (1) breached his employment agreement; (2) voluntarily left his employment; or (3) was terminated. The amount of forfeitable shares decreased with each anniversary of the closing date that the partner remained at CGE&Y, so, generally, the longer a partner worked for CGE&Y, the fewer shares he or she would forfeit if the forfeiture provision were triggered. In addition, the termination forfeiture requirement applied to only two types of termination, and the number of Restricted Shares forfeited upon termination depended on under which type a partner was terminated. If a partner was terminated "for cause," the partner forfeited the full amount of the forfeitable Restricted Shares. However, if a partner was terminated for "poor performance," the partner forfeited at least 50% of the forfeitable Restricted Shares, but could keep a percentage of the remaining 50%, as determined by a review committee.

Partners also would have dividend and voting rights in the Restricted Shares. The dividends paid on the Restricted Shares were not subject to forfeiture, and partners could withdraw these dividends shortly after they were declared. As for voting, Merrill Lynch's French affiliate would vote a partner's shares "as instructed by [the partner] as beneficial owner." Because of the restrictions placed upon the Restricted Shares, the Master Agreement stated that, for tax purposes, the Restricted Shares would be valued at 95% of the closing price of Cap Gemini stock on the closing date. Fort subsequently signed the Partner Agreement, making him a party to the Master Agreement.

The transaction closed on May 23, 2000. Twenty-five percent of Fort's shares were sold at closing and the proceeds turned over to Fort, to cover taxes due based on receipt of the full value of all the stock in 2000. The remaining 75%, the Restricted Shares, were deposited into Fort's Merrill Lynch account.

 

Fort reported gross proceeds of $1,759,097 from this transaction on his 2000 income tax return. At this time, the Cap Gemini stock was worth approximately $156 per share. In other words, the entire value of the Cap Gemini stock received was included in the amount realized on the sale in 2000. Fort’s basis in his interest in E&Y would then be reduced from the amount realized in arriving at taxable income. The characterization of the gain would be determinate in accordance with §§741 and 751.

In September 2003, Fort was terminated as part of a downsizing. At this time, the value of the Cap Gemini shares had declined substantially

The District Court Grants the Government's Motion for Summary Judgment

The district court granted the government's motion for summary judgment and awarded it the disputed amount. 105 AFTR 2d 2010-2559, (N.D. Ga. 5/10/2010) at 3 (N.D. Ga. May 20, 2010). The court stated that taxable income during a given taxable year includes all income from whatever source derived that is "actually" or "constructively" received during that year. While the court assumed that Fort did not actually receive the Restricted Shares, it concluded that he constructively received them, because: he alone stood to gain or lose money based on the stock's performance. He received the benefit of the dividends paid on the shares, and he had the right to direct how the shares would be voted. Moreover, he knowingly agreed to the sale restriction and the forfeiture provision. He also agreed to the amount of the discount.The district court also rejected Fort's argument that the forfeiture provision prevented him from constructively receiving the Restricted Shares in 2000. The court explained that "the fact that the partners risked having to return some of their shares at a later time does not mean that they did not constructively receive the shares in the first place."Id.

Fort Appeals to the Eleventh Circuit

In review of the district court’s grant of summary judgment de novo, i.e., viewing the moving party’s evidence and all factual inferences arising from it in the light most favorable to such party, there is nevertheless, no genuine issue of any material fact and the moving party is entitled to judgment as a matter of law. Fort has appealed the grant of summary judgment in the government's favor, arguing that he did not "receive" the escrowed shares of stock in the year 2000 for tax purposes, and, therefore, was not taxable for their value in that year.

Government’s Danielson Rule Argument Rejected.

The government used the Danielson doctrine or rule in challenging that Fort’s ability to amend his 2000 return is limited because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income in 2000. See Comm’r v. Danielson, 378 F.2d 771 (3^rd Cir. 1967). The government argues, citing to Danielson, that Fort's ability to challenge his 2000 tax return is limited, because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income received in 2000. Fort responds that the Danielson rule is inapplicable to this case. The Court agreed. The taxpayer argued that the agreed upon form of the transaction had particular tax consequences and since the form of the transaction was not in dispute, the Danielson doctrine did not apply. See, e.g., United States v. Fletcher, 562 F.3d 839, 842–43 (7th Cir. 2009) (in a case dealing with this same transaction and materially identical facts as the one at bar, the Seventh Circuit rejected reliance on the Danielson rule, writing that "because [the former E&Y partner] does not try to recharacterize the transaction, doctrines that limit or foreclose taxpayers' ability to take such a step are beside the point"); United States v. Nackel, 686 F. Supp. 2d 1008, 1019 [105 AFTR 2d 2010-474] (C.D. Cal. 2009) (in another case involving this same transaction, the District Court for the Central District of California wrote: "The government impermissibly conflates case law concerning a party's effort to look through and re-characterize the form of a transaction with that which addresses what the parties intended would be the tax consequences of a transaction. The former is subject to the heightened scrutiny sought now by the government, the latter is not."). The Eleventh Circuit panel of judges agreed that the Danielson rule was inapplicable in resolving the case.

 

The district court below had held that in the year 2000 Fort did not actually receive the income from the Restricted Shares but was in constructive receipt of the Restricted Shares and therefore the value of such stock should be includible in gross income to the extent of the agreed value of such Shares in 2000.

The Eleventh Circuit observed that in general,, when assets are placed in escrow as security or otherwise and the taxpayer receivesno right to control or otherwise enjoy those assets, the courts and the Service have held that income is not realized until such time as the contingency is satisfied and the funds are paid over to the taxpayer. On the other hand, the courts and the Service have generally held ... that income is presently realized notwithstanding that the taxpayer lacks an absolute right to possess the escrowed assets. Consistent with the IRS's position, courts have held that a taxpayer presently realizes income when he or she possesses sufficient indicia of control over the assets held within an escrow account or escrow-type arrangement.

In a case involving the legendary comedian and actor, Charles Chaplin v. Commissioner, a company delivered shares of stock to Charlie Chaplin in 1928, who then was required to place the shares in escrow, only to be released when he delivered photoplays to the company in later years. 136 F.2d at 300. The Ninth Circuit held that the shares were income to Chaplin at the time of the initial delivery in 1928, not later, when Chaplin delivered the photoplays and the shares were released. Id. The Ninth Circuit emphasized that Chaplin possessed the following indicia of control over the shares in escrow: (1) the contract at issue vested ownership immediately in Chaplin and the shares were issued in his name; (2) Chaplin had voting rights in the shares; (3) dividends on the shares were declared and paid to an escrow agent who held them for Chaplin's benefit; and (4) Chaplin was considered the owner of the shares.

 

In Bonham v. Commissioner, also cited above, a taxpayer and a company agreed that the taxpayer would receive title in 750 shares of stock, but the shares would be deposited with the company "as a guarantee for [his] performance." The Eighth Circuit held that the taxpayer realized immediate income when he initially received the 750 shares, not when the shares were later withdrawn.

In the case at bar the Eleventh Circuit was impressed with the fact that it could look at other courts which addressed the same issue arising from the same transaction.. In each of these cases, the courts held that the receipt of the Restricted Shares constituted income in the year 2000.United States v. Bergbauer , 602 F.3d 569, 581] (4th Cir. 2010), cert. denied, 131 S. Ct. 297 (2010);Fletcher , 562 F.3d at 845; Nackel, 686 F. Supp. 2d at 1026; United States v. Berry, 2008 WL 4526178 [102 AFTR 2d 2008-6447], at 7 (D.N.H. Oct. 2, 2008);United States v. Culp , 2006 WL 4061881 [99 AFTR 2d 2007-618], at 1 (M.D. Tenn. Dec. 29, 2006).

Of those related decisions, the lower court placed emphasis on the Fletcher decision out of the Seventh Circuit. In Fletcher the court stated that "a taxpayer's willingness to defer consumption does not defer taxation." 562 F.3d at 843. The court concluded that the CGE&Y agreement was merely a deferral of consumption, not income, for three reasons: (i) the partners bore the market risk that the Restricted Shares would appreciate or depreciate from the date of the closing, because the market price of the Restricted Shares could rise or fall while the shares were in the Merrill Lynch account; (ii) Cap Gemini had already paid the Restricted Shares into the partners' Merrill Lynch accounts, the partners merely agreed to postpone unrestricted access to the stock, rather than to allow Cap Gemini to pay them later; and (iii) the partners agreed to value the Restricted Shares at a discount—95% of the market price of the underlying shares on the closing date—which reflects "not only illiquidity but also the risk that [Cap Gemini] would use its power over the account in an unauthorized way, or that Merrill Lynch might fail in its duty as a custodian." The Eleventh Circuit concurred with the lower court that the Fletcher Court’s decision and supporting analysis was persuasive and that the case involved a mere "delay in consumption" and not a "delay of income".

After weaving through the various restrictions and limitations under the master purchase agreement, the Eleventh Circuit held that the lower court’s grant of summary judgement was affirmed. In sum, Fort constructively received the Restricted Shares in 2000. The fact that Fort could not access the shares immediately was merely a postponement of consumption, not income: CGE&Y paid the full consideration of the shares into Fort's Merrill Lynch account on the closing date, and therefore, Fort bore the market risk of share appreciation or depreciation beginning on the closing date. This conclusion is buttressed by the fact that Fort possessed indicia of control over the shares: he had dividend and voting rights in the shares, and the shares were held in an individual account in Fort's name. Additionally, constructive receipt was not impossible simply because Fort was required to forfeit the shares upon the occurrence of certain conditions, because Fort had sufficient control over whether those conditions would occur. Therefore, Fort realized income at the time the Restricted Shares were transferred into his Merrill Lynch account in 2000.

Constructive Receipt Doctrine . Cap Gemini did not require Fort to forfeit any of his Restricted Shares. Shortly after his termination, Fort learned that several former E&Y consulting partners had filed amended year 2000 tax returns, claiming that they did not realize income from the Restricted Shares in that year. Fort followed suit, filing his own year 2000 amended return, asserting that he did not realize income in 2000 from the then-value of the Restricted Shares. The IRS initially accepted Fort's amended return and granted him a refund for his 2000 tax return. Subsequently, however, the IRS determined that the refund to Fort was in error, and the government filed this suit to recover the refund.

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In Historic Boardwall Hall, LLC. V. Commissioner, 136 T.C. No. (2011) the Tax Court ruled that a LLC which was formed to facilitate a corporation's, i.e, Pitney Bowes, investment in the rehabilitation of an historic government building, East Hall, a National Historic Landmark property in Atlantic City, New Jersey had business purpose and was not a sham.The investment was designed to earn the controlled entity of Pitney Bowes, Historic Boardwalk Hall, LLC, rehabilitation credits under section 47. The Tax Court ruled, therefore, that the corporate partner was entitled to its distributive share of the claimed rehabilitation tax credits.

 

The Tax Court determined that the LLC that was formed by New Jersey Sports and Exposition Authority (NJSEA) and investment corp. (corp. partner), to allow corp. partner investment in rehabilitation of historic hall/governmentally-owned building and obtain §47 rehabilitation tax credits, had objective economic substance based on fact that corporate partner did not enter into transaction solely for tax credits but also to invest with a realistic possibility of realizing economic gain or profit and that corporate partner’s investment provided NJSEA  with more money than it otherwise would have had, that development fee involved was legitimate expense, and that there were real risks involved. Court also viewed the legislative purpose to the rehabilitation credit provision and found that the evidence in the case was not inconsistent with such purpose.  The Court rejected arguments lobbied by the government that the corporate partner never obtained partner status, the benefits and burdens of the hall’s ownership were never transferred in a sale to the partnership, and that the purchase option, under which NJSEA could buy back the hall did not cause the taxpayer’s reporting of the rehabilitation credits to be erroneous. The Tax Court further rejected the IRS’s determination under the anti-abuse regulation, Treas. Reg. §1.701-2(b), to recast the transaction so as to deny the corporate partner its desired allocation of the §47 rehabilitation credits.

 

Economic Substance of Transaction Upheld.

 

The Court found that there was both an objective profit motive and subject business purpose present under the facts. See CM Holdings, Inc., 90 AFTR 2d 2002-5850 , 301 F3d 96 ,  2002-2 USTC ¶50596 (CA-3, 2002)(conjunctive two part test applied by 3rd Circuit). The IRS argued that Boardwalk Hall had no possibility of earning a profit apart from a 3% fixed return and the benefits related to the rehabilitation credits. For the subjective test, the IRS argued that Boardwalk Hall had no business purpose because it was intended solely to facilitate NJSEA's sale of rehabilitation tax credits to Pitney Bowes.

 

The Tax Court dismissed the arguments by noting that section 47 is intended to encourage taxpayers to participate in what would otherwise be an unprofitable activity. The court added that when the rehabilitation tax credits were taken into account, the objective profit test was adequately satisfied. Further, because Boardwalk Hall pursued the risk-laden objective of rehabilitating a landmark convention center for use as a special events center, the court found that the subjective business purpose requirement was also met. In sum, the Tax Court concluded that Boardwalk Hall had economic substance and was not a sham.

 

Partnership Status

 

The IRS also argued that Pitney Bowes was not a partner in Boardwalk Hall because it had no meaningful stake in its success or failure and its interest in Boardwalk Hall was more like debt than equity. The Tax Court dismissed these arguments, stating that Pitney Bowes and NJSEA joined together in a transaction with economic substance to allow Pitney Bowes to invest in the East Hall rehabilitation. Further, the court noted that the decision to invest provided a net economic benefit to Pitney Bowes through its 3% preferred return and rehabilitation tax credits.

 

Rejection of Application of Partnership Anti-Abuse Regulation

 

Finally, the IRS argued that it was necessary to recast the transaction under Treas. Reg. §1.701-2(b), the anti-abuse transaction. Because of its finding that the transaction had economic substance, the Court held it was inappropriate to then hear the case under the filter of this GAAR rule for partnerships.  

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In PLR 201051019 (12/23/2010), the Service ruled that in computing a consolidated group’s §382 limitation after filing for bankruptcy relief, all of its outstanding liabilities before the ownership change should be taken into account at the adjusted issue price, regardless of whether the obligations were subsequently discharged in whole or in part during the recognition period. Accordingly, unless the parent of the consolidated group of corporations elected application of §382(l)(6), then under §382(l)(5), there is no §382 limitation on pre-change losses or built-in losses of the parent consolidated group and each of its members as a result of the ownership change that took place under the facts.

Facts. Parent (P) is the common parent of a consolidated group (Parent Consolidated Group) engaged in Business A. On Date 1, P and X, a disregarded entity of Subsidiary Y, filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. The subsidiaries of Parent (other than X), including Subsidiary Y, did not file for bankruptcy protection. Later, under a plan or reorganization approved by the Bankruptcy Court: (i) each electing holder of an allowed claim arising under a Note 1 or any holder of an allowed claim arising under a Note 2 received its pro rata share of New Notes 1 and a specified percentage of P's new common stock; (ii) each non-electing holder of a claim under Note 1 had its current claim reinstated and retained the Note; (iii) each holder of a claim under Loan 1 or 2 received its pro rata share of New Notes 1 and specified percentage of P’s new common stock; (iv) each holder of an allowed claim under Note 3 or 4 received its pro rata share of a specified percentage of P’s new common stock plus contingent value righs; (v) each holder of certain notes issued by X received its pro rata share of New Notes 2 issued by X and guaranteed by P; (vi) the holders of equity interests in P cancelled those interests however preferred stock holders of P received contingent value rights. The only debt of P debt that was exchanged for stock was debt of P.

Under the plan or reorganization approved by the Bankruptcy Court in a Title 11 case, P would experience an ownership change under §382, immediately after the ownership change at least 50% of the value and voting power of the common stock of P would become owned by “qualified creditors” per §382(l)(5)(3) and Treas. Reg. §1.382-9(d)(1).

The affiliated group of corporations, of which P is the common parent, is a “loss group” per Treas. Reg. §1.1502-91(c). All members of the consolidated group were eligible to be included in the determination of whether the loss group were eligible to be included in determining whether the loss group had a net unrealized build in loss per Treas. Reg. §1.1502-91(g)(2)(ii).

The ruling identified two alternative methods by which to calculate the §382 limitation Where §382(l)(5) applies, the amount of pre-change losses or built-in losses of the taxpayer to be used to offset taxable income of any new loss corporation for any post-change year would not be limited by §382 as a result of an ownership change. Conversely, if §382(l)(6) was applied, the value of the old loss corporation would reflect the increase in value resulting from any surrender or cancellation of creditors' claims in the transaction, pursuant to Treas. Reg. 1.382-9 .

If Section 382(l)(6) were elected, the consolidated group would calculate its net unrealized built-in gain or loss, pursuant to Section 382(h) and in conjunction with the guidance provided in Notice 2003-65 , under the deemed Section 338 approach. In holding that all liabilities should be considered, the Service specified that amounts realized should be allocated to the stock and obligations of the group notwithstanding that gain or loss might not be taken into account under Reg. 1.1502-91 .

In this situation since no election was made under §382(l)(6), then under §382(l)(5) the Service ruled that no §382 limitation on pre-change losses or built-in losses of the P consolidated group and each member resulted as a result of the ownership change. See §382(h). Notice 2003-65, 2003-2 CB 747 , provides two alternative approaches—the §338 approach and the §1374 approach—to applying §382(h) that should be considered when calculating recognized built-in gain and recognized built-in loss.   P also  takes into account the increase in the value of P resulting from the surrender of certain creditor claims per Treas. Reg. §1.382-9. On the other hand, were the P consolidated group to apply §382(l))(6) to the change in ownership, then in applying Notice 2003-65 to the calculation of net unrealized built-in gain or loss, as modified by Notice 2003-65, the P consolidated group may compute the deemed sale and allocation rule for determining the aggregate deemed sale price under Treas. Regs. §§ 1.338-4 and 1.338-6. Amounts realized should be allocated to the stock and obligations of members of the P consolidated group regardless of whether such gain or loss might not be taken into account under Treas. Reg. §1.1502-91.

Liabilities often are discharged coincident with an ownership change, resulting in cancellation of indebtedness income. PLR 201051019 is helpful in clarifying how to apply the §382 limitation in this situation by clarifying that, under the described fact pattern, all liabilities—including those discharged as part of a bankruptcy filing—should be included in any net unrealized built-in gain or loss calculation.

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