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

In Henry Samueli et al v. Commissioner, 132 T.C. No. 4 (2011), the Tax Court, per Judge Kroupa’s opinion for the majority, in response to the petitioners and respondent (IRS) filing of cross motions for summary judgment in a consolidated proceeding, upheld the Service’s deficiencies in income tax for denying the taxpayers interest deductions claimed on the underlying “margin loans” used to acquire the securities, were disallowed on the basis the purported payments of “interest” were not made with respect to an actual debt. Instead the arrangement was treated as a stock sale and immediate repurchase and the issuance of a forward contract to the taxpayers to later acquire (and sell) the same securities.

Section 1058 In General

Section 1058 provides that where an owner of “securities”, as such term is defined under §1236(c), loans securities to another person, such as a broker or investor engaging in a short sale, the owner is not treated as having engaged in a “sale” in which gain or loss is recognized, either when the securities are transferred to the borrower or when they are later returned to the taxpayer. §1058(a).

In order to qualify for non-recognition treatment, certain agreement provisions must be satisfied in accordance with 1058(b): (i) the agreement provides for the return to the lender of securities that are identical to those transferred; (ii) payments must be made to the transferor of the shares for amounts equivalent to all interest, dividends and other distributions which the owner of the securities is entitled to receive during the period beginning with the transfer of the securities by the transferor and ending with the transfer of identical securities back to the transferor; (iii) the agreement doesn’t reduce the transferor (owner’s) risk of loss or opportunity for gain with respect to the securities transferred; and (iv) the agreement complies with the requirements set forth under the regulations. The third element was of direct consequence in the Samuelis case as discussed below which the Court ruled was not satisfied.

Where the borrower returns to the taxpayer securities which are different from those transferred by the taxpayer, or, if the borrower fails to deliver anything to the taxpayer, gain or loss is recognized at the time of the borrower's default.

According to the proposed regulations, the payments compensating the taxpayer for interest, dividends, and other distributions are treated as “a fee for the temporary use of property,” not as interest or dividend income. Where the equity holder is a tax-exempt organization, such payments are exempt from unrelated business taxable income as if the interest and dividends were received. For purposes of §1058, “securities” includes corporate stock, a “certificate of stock or interest in any corporation,” a bond or other debt instrument, and “any evidence of an interest in or right to subscribe to or purchase any of the foregoing.”

Recent Tax Court Decisions on Section 1058

In a recent decision of the Tax Court, Anshutz Co. v. Comm’r, 135 T.C. No. 5 (2010), the Court characterized “share-lending agreements” as contracts which are frequently entered into by equity holders of stock who have taken a “long” position with respect to such shares and plan on holding the stock for an extended period of time. The equity owner may contract to “lend” the stock to a counterparty, who can use the borrowed shares to increase market liquidity and facilitate stock sales. For example, the equity owner can lend shares to an investment bank, which could then use the loaned shares to execute short sales on behalf of its clients.

In another recent Tax Court decision, Calloway v. Commissioner, 135 T.C. No. 3 (2010), the Court held that a purported securities lending arrangement was in fact a disguised sale. The arrangement involved the equity owner’s transfer of shares of stock to another party in exchange for “”loan payments” for the use of the lender’s funds for an agreed amount. The owner of the stock had retained the right to pay off the loan and require the return of the same stock after 3 years had elapsed. The Tax Court analyzed this agreement as a disguised sale since the purported borrower couldn't repay the “loan” and demand return of his stock before the end of the three year period, he didn't retain the benefit of being able to sell his interest in the stock during that period, and also bore no risk of loss if the stock's value decreased. As such, the transaction failed to meet the requirements under §1058(b)(3) and was not a qualified securities lending agreement.

The Samuelis Case

Two couples were the petitioners in the case, the Samuelis’ (S) and the Rickses’ (R). S and R entered into a structured securities transaction in which they owned a 99.5% interest with S and his wife holding 10% interests indirectly through their operating company, a pass thru entity, and the balance of the same interests in an limited liability company, H&S Ventures, LLC (H&S Ventures) and the balance of the interests in a grantor trust holding interests in H&S Ventures. R owned the remaining .5% along with another individual. Mr. Samuelis, as noted in the Court’s opinion, is a billionaire who co-founded Broadcom Corporation, a publicly traded company listed on the NASDAQ Exchange.

The agreement involved S and R, through H&S Ventures, acquiring securities, i.e., $1.64 billion in value, from their securities broker Refco Securities LLC (RS LLC), on margin and then immediately loaning the securities back to RS LLC in 2001. Under the arrangement, RS LLC promised to transfer identical securities to H&S Ventures on Jan. 15, 2003. The securities consisted of a $1.7 billion principal STRIP of the $5.7 billion principal on an unsecured fixed-income obligation issued by Freddie Mac. The maturity date of the obligation was February 15, 2003, and the yield to maturity on October 17, 2001, at which the securities accrued interest, was fixed at 2.581 percent. The agreement allowed for an earlier transfer of the same or identical between H&S Ventures and RS LLC which permitted the “lender” to require an earlier transfer of the identical securities by termination on July 1, or December 2, 2002. H&S Ventures sold the securities back to RS LLC on January 15, 2003.

H&S Ventures, and therefore S and R to the extent of their proportionate interest in the limited liability company, reported the transaction under §1058 as a securities lending arrangement. H&S Ventures reported approximately $50.6 million in long-term capital gain on the sale in 2003. H&S Ventures also deducted millions of dollars of interest with respect to the transaction which was allocated among its various members. The petitioners also deducted as interest, payments made or accrued with respect to the initial margin loan with RS LLC in acquiring the securities.

The Service challenged the taxpayers’ reporting of the transaction contending that H&S Ventures purchased the securities from RS LLC and immediately sold the securities back to RS LLC in 2001 for no gain or loss and then repurchased from a deemed forward contract the same securities in 2003 realizing an approximate $13.5 million short term capital gain. The transaction was not, in the eyes of the Service, a securities lending transaction or arrangement per §1058. The Service further disallowed all of H&S Ventures’ interest expense reported since there was no true debt obligation present under the facts. Respondent also disallowed all of the petitioners’ interest deductions because the corresponding debt that petitioners claimed was related to the transaction did not exist. Inotherwords, despite the “margin loan” documentation, there was no actual debt to RS LLC as part of the arrangement.

Tax Court Rules in Favor of Respondent-IRS

Acknowledging that the issue presented in the case was one of “first impression”, the Tax Court upheld the Service’s position finding that the agreement under which S and R, through H&S Ventures, transferred the securities was not an agreement described in §1058(b)(3) since the agreement did reduce their opportunity for gain because there were only 3 days during the transaction period where S and R could have the securities transferred back to them to sell for a gain. The taxpayers arguments that their opportunity for gain was not reduced, a requirement under §1058(b)(3), was therefore rejected by the Court.

Responding to the parties filing cross motions for summary judgment in accordance with Tax Court Rule 121 (FRCP 56), the Tax Court, in an opinion issued by Judge Diane Kroupa, noted that not only were the requirements under §1058(b)(3) not established but the arrangement did not coincide with the legislative intent in enacting this provision. Indeed, the Court opined that the legislative history to §1058 provides that a securities loan agreement should result in the lender of the securities being placed in the same economic position the lender would have been in absent the agreement. Since the transaction was a sale, S (and R), through H&S Ventures, were not entitled to their claimed interest deductions made to RS LLC in 2001 and 2003 because an “actual debt” did not exist. The Court upheld the proposed deficiencies in income tax of $2,177,532 deficiency for 2001 and a $171,026 deficiency for 2003 in the Federal income taxes of Henry and Susan F. Samueli and a $6,126 deficiency for 2001 in the Federal income tax of Thomas G. and Patricia W. Ricks.

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 On July 15, 2011 the LB&I issued a directive (LB&I-04-0711-015) for industry directors and field specialists on when it is appropriate to raise the economic substance doctrine. IRM. 20.11, 20.1.5. The directive follows one issued in September 2010 (LMSB-04-0910-024) that advised IRS attorneys of the need to obtain approval from a field operations director before raising the issue.

Section 7701(o) , which was recently added to the Code as part of the Health Care and Education Reconciliation Act of 2010, sets forth a statutory definition of the economic substance doctrine.

The common law doctrine of “economic substance,” which continues to have application despite the enactment of Section 7701(o) , may be summarized as a principle applied by the courts to deny taxpayers tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in federal income taxes. It can be applied where the IRS and, if litigation ensues, the court believes that a transaction and its projected tax consequences, including associated costs and expenses, should be disregarded for tax purposes. underlying transaction or series is without economic substance.

Whether a transaction or series of transactions is “without economic substance” is debatable, as witnessed by the number of cases in which a taxpayer has asserted (presumably in good faith) that there was a real change in his or her economic position independent of federal income tax considerations. A “real change” in “economic position” invariably focuses on whether there is a realistic possibility that the taxpayer will derive a profit from the transaction.

The “business purpose” prong requires that the taxpayer, in entering into the transaction, was motivated by a bona fide business purpose and not simply by tax advantages or savings. The business purpose test involves an inquiry into the subjective motives of the taxpayer to determine whether the taxpayer intended the transaction to serve some useful nontax purpose. In making this determination, some courts bifurcate transactions in which activities with nontax objectives are combined with unrelated activities having only tax-avoidance objectives, resulting in the disallowance of the tax benefits of the overall transaction.

Under the new legislation, Section 6662(b)(6) imposes a penalty equal to 20% of the portion of any underpayment of tax attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. The penalty is based on the underpayment attributable to the economic substance failure; it is not imposed on the entire deficiency for the tax year.  In determining whether the penalty is applicable, Section 6662(i)(2) provides that amendments or supplements to an already-filed return are not taken into account if the amendment or supplement is filed after the date the taxpayer is first contacted by the IRS regarding the examination of the return (or an earlier date as specified by regulations). The new penalty provisions are effective for transactions entered into after 3/30/2010.

In addition, Section 6662(i) imposes an increase in the accuracy related penalty for nondisclosed noneconomic substance transactions. More specifically, where “any portion of an underpayment is attributable to one or more nondisclosed noneconomic substance transactions,” the accuracy related penalty with respect to that portion climbs to 40% instead. A "nondisclosed noneconomic substance transaction" means any portion of a transaction described in Section 6662(b)(6) with respect to which the relevant facts affecting the tax treatment are neither adequately disclosed in the return nor included in a statement attached to the return. Unless otherwise provided, an amendment or supplement to a return of tax will not be taken into account if the amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by the IRS regarding the examination of the return or another date as is specified by the IRS.

A third principal change made to the accuracy-related penalty rules under the “clarification” of the economic substance doctrine is found in new Section 6664(c)(2) , which provides that the “reasonable cause” exception does not apply to any portion of an underpayment that is attributable one or more transactions described in Section 6662(b)(6) —that is, any transaction lacking economic substance as defined in Section 7701(o).

For background on the judicial doctrines that oversee the tax law such as economic substance, the step transaction doctrine, substance over form, etc. and the recent “clarification” of the economic substance doctrine, See August,“The Codification of the Economic Substance Doctrine, Parts I and II,” Business Entities (WG&L), (Sep/Oct 2010) (Nov/Dec 2010). 

There is a fair amount of recent judicial commentary in this area dealing with different forms of tax motivated and tax abusive strategies. For a sampling of relevant case law, see Sala et ux, 106 AFTR 2d 2010-5406 , 2010-2 USTC ¶50527 (CA-10, 2010), rev'g and rem'g 101 AFTR 2d 2008-1843 , 2008-1 USTC ¶50308 , 552 F Supp 2d 1167 (DC Colo., 2008); ACM Partnership, 82 AFTR 2d 98-6682 , 157 F3d 231 , 98-2 USTC ¶50790 (CA-3, 1998), aff'g TC Memo 1997-115 , RIA TC Memo ¶97115 , 73 CCH TCM 2189 , cert. den. 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC, 99 AFTR 2d 2007-850 , 2007-1 USTC ¶50223 , 472 F Supp 2d 885 (DC Texas, 2007), aff'd 103 AFTR 2d 2009-2220 , 568 F3d 537 , 2009-1 USTC ¶50395 (CA-5, 2009); Coltec Industries, Inc., 98 AFTR 2d 2006-5249 , 454 F3d 1340 , 2006-2 USTC ¶50389 (CA-F.C., 2006), vac'g and rem'g 94 AFTR 2d 2004-6708 , 62 Fed Cl 716 , 2004-2 USTC ¶50402 (Fed. Cl. Ct., 2004), cert. den. 127 S. Ct. 1261 (2007); TIFD III-E, Inc. (“Castle Harbor”), 98 AFTR 2d 2006-5616 , 459 F3d 220 , 2006-2 USTC ¶50442 (CA-2, 2006), on remand 104 AFTR 2d 2009-6746 , 2009-2 USTC ¶50676 , 660 F Supp 2d 367 , 2009-2 USTC ¶50711 (DC Conn., 2009); BB&T Corporation, 99 AFTR 2d 2007-376 , 2007-1 USTC ¶50130 (DC N. Car., 2007), aff'd 101 AFTR 2d 2008-1933 , 523 F3d 461 , 2008-1 USTC ¶50306 (CA-4, 2008); Cemco Investors, LLC, 101 AFTR 2d 2008-768 , 515 F3d 749 , 2008-1 USTC ¶50178 (CA-7, 2008).There is a fair amount of recent judicial commentary in this area dealing with different forms of tax motivated and tax abusive strategies. For a sampling of relevant case law, see Sala et ux, 106 AFTR 2d 2010-5406 , 2010-2 USTC ¶50527 (CA-10, 2010), rev'g and rem'g 101 AFTR 2d 2008-1843 , 2008-1 USTC ¶50308 , 552 F Supp 2d 1167 (DC Colo., 2008); ACM Partnership, 82 AFTR 2d 98-6682 , 157 F3d 231 , 98-2 USTC ¶50790 (CA-3, 1998), aff'g TC Memo 1997-115 , RIA TC Memo ¶97115 , 73 CCH TCM 2189 , cert. den. 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC, 99 AFTR 2d 2007-850 , 2007-1 USTC ¶50223 , 472 F Supp 2d 885 (DC Texas, 2007), aff'd 103 AFTR 2d 2009-2220 , 568 F3d 537 , 2009-1 USTC ¶50395 (CA-5, 2009); Coltec Industries, Inc., 98 AFTR 2d 2006-5249 , 454 F3d 1340 , 2006-2 USTC ¶50389 (CA-F.C., 2006), vac'g and rem'g 94 AFTR 2d 2004-6708 , 62 Fed Cl 716 , 2004-2 USTC ¶50402 (Fed. Cl. Ct., 2004), cert. den. 127 S. Ct. 1261 (2007); TIFD III-E, Inc. (“Castle Harbor”), 98 AFTR 2d 2006-5616 , 459 F3d 220 , 2006-2 USTC ¶50442 (CA-2, 2006), on remand 104 AFTR 2d 2009-6746 , 2009-2 USTC ¶50676 , 660 F Supp 2d 367 , 2009-2 USTC ¶50711 (DC Conn., 2009); BB&T Corporation, 99 AFTR 2d 2007-376 , 2007-1 USTC ¶50130 (DC N. Car., 2007), aff'd 101 AFTR 2d 2008-1933 , 523 F3d 461 , 2008-1 USTC ¶50306 (CA-4, 2008); Cemco Investors, LLC, 101 AFTR 2d 2008-768 , 515 F3d 749 , 2008-1 USTC ¶50178 (CA-7, 2008).

The Field Directive of July 15, 2011

As mentioned, the recent legislation enacted a two part or conjunctive economic substance test in new section 7701(o). The new statute defines the economic substance doctrine as the common law doctrine under which certain tax benefits are not allowable if the transaction does not have economic substance or lacks a business purpose and states that "[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if [the legislation] had never been enacted." The statute further states that "[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if --

(A) first,  the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and

(B) second, the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction."

Passage of section 7701(o) resolved the longstanding conflict among various circuit courts of appeal regarding how the doctrine should be applied by codifying a two-part conjunctive test. It applies for transactions entered into and after March 30, 2010, which was the date of enactment of the 2010 Act.

Purpose of the Guidance

On September 14, 2010, an LB&I Directive, LMSB-20-0910-024, was issued relating to the codification of the economic substance doctrine in the 2010 Act. This directive stated that to ensure consistent administration of the strict liability penalty related to the application of the doctrine, any proposal to impose the doctrine (and implicate proposing to set forth the penalty) at IRS exam must be reviewed and approved by the Director of Field Operations (DFO).

The purpose of this LB&I Directive is to instruct examiners and their managers on the circumstances where it is appropriate to seek the approval of the DFO in order to raise the economic substance doctrine. Once an examiner determines that raising the doctrine may be appropriate, this directive sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

In addition, this LB&I Directive provides, as an important boundary line to LMSB and International, that, until further guidance is issued, the penalties provided in sections 6662(b)(6) and (i) and 6676 are limited to the application of the economic substance doctrine and may not be imposed due to the application of any other "similar rule of law" or judicial doctrine (e.g., step transaction doctrine, substance over form or sham transaction).

This LB&I Directive has four steps. First, an examiner should evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is likely not appropriate. Second, an examiner should evaluate whether the circumstances in the case are those under which application of the doctrine to the transaction may be appropriate. Third, if an examiner determines that the application of the doctrine may be appropriate, the guidance provides a series of inquiries an examiner must make before seeking approval to apply the doctrine. Fourth, if an examiner and his or her manager and territory manager determine that application of the economic substance doctrine is merited, guidance is provided on how to request DFO approval.

Generally, in applying this LB&I Directive, when a transaction involves a series of interconnected steps with a common objective, the term "transaction" refers to all of the steps taken together. However, in certain circumstances, it may be appropriate to apply this guidance separately to one or more steps that are included within a series of arguably interconnected steps. This may be appropriate in situations where an integrated transaction includes one or more tax-motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction. If an examiner wants to apply this guidance separately to one or more steps with a common objective, the examiner is required to seek guidance from their manager and consult with their local counsel before doing so.

An examiner should notify a taxpayer that the examiner is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins the analysis in the steps described below.

The Directive sets forth additional material under each of the four step process to determine if the issue should be raised under section 7701(o).

Many tax practitioners did not feel that it was necessary to codify the economic substance doctrine. Many more practitioners object to the 40% penalty as being too harsh. Perhaps the Service's directive will confirm that LMSB will tread lighly in this area to only go after abusive transactions that are patently obvious.

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In a recent commentary written by Trevor Johnson, which commentary  was published in International Tax Notes (July 11, 1011) the author describes the long-standing uncertainty surrounding the determining of "residency" for U.K. income tax purposes.

The issue is historical since it dates back over 200 years. Yet, the rules do not state explicitly who is and who is not a U.K. resident for tax purposes. While there is some guidance, the overall subject suffers from uncertainty.

The commentary quotes the Income Tax Act of 1842:

“Any subject of Her Majesty, whose ordinary residence shall have been in Great Britain, and who shall have departed from Great Britain and gone into any part beyond the sea for the purpose of occasional residence . . . shall be deemed, notwithstanding such temporary absence, a person charged with the duties granted by this Act as person actually residing in Great Britain. Provided always that no person who shall . . . actually be in Great Britain for some temporary purpose only, and not with any view or intent of establishing his residence therein, and who shall not actually have resided in Great Britain at one time or several times for a period equal in the whole to six months in any one year shall be charged with the duties mentioned in Schedule D as a person residing in Great Britain in respect of [foreign-source income] but nevertheless every such person shall, after such residence in Great Britain, for such space of time as aforesaid, be chargeable to the said duties for the year commencing on the sixth day of April preceding.”

The statutory language capturing the phrase “ordinary residency” should be clear, at least in certain instances, to be clear and predicable.  For example, we are told that a ordinary resident in the U.K. who temporary goes outside of the U.K. is still a resident. Visitors arriving in the U.K. for a temporary purpose without the intention of establishing residence, who spend less than 183 days in the U.K. in any tax year, are not regarded as resident for tax purposes. However, they will become resident for any year in which their presence exceeds 183 days. But as Mr. Johnson points out, there is much work to be done to arrive at a better set of applicable rules and principles.

While such rules sourced from the 1842 legislation were simply stated, additional ambiguous concepts were introduced such as the meaning of a “temporary purpose” and what was meant by “residence”. The commentator notes that when tax cases were first officially reported in 1875, one of the first was concerned with tax residence status. The second rule above also had limited application -- it only covered foreign-source income.

Since 1842’s version’s of residency was pronounced its principles have been restated in other tax acts and now is warehoused at section 829 and 831 of the Income Tax Act of 2007. Nevetheless, there are the same uncertainties present, which has, over time, led to various judicial decisions. The precedents from these cases are the basis from the current law is applied.

In recent years there has been a growing concern that that practice, as set out in publication HMRC6 (previously IR20), Residence, Domicile and the Remittance Basis, does not give certainty, has been changed without notice, and when it comes to the crunch, will not necessarily be supported by the courts. Thus, many in the UK want a more formal statutory definition of residency. The government has responding by forming a working group that will publish a consultative document.

Under current law in the U.K. and individual who spends 183 days or more in the U.S. is a resident for tax purposes. In Wilkie, 32 T.C. 485. Mr. Wilkie contended he was not “resident” by submitting evidence he was present in the UK for only 182 days and 20 hours. He was spared U.K. taxation by four hours. Where an individual moves to the U.K. with the intention either of living here permanently or working here for an extended period or for an indeterminate period then residency is also established. In Lysaght, 13 TC 511 (1928), the taxpayer was found to be resident in the U.K. because of his regular visits to carry out duties as a director of a U.K. company even though he had no definite place of residence here.

Where an individual comes to the U.K. on a temporary basis and is present for 91 or more days per year on the average over a four year period (based on the Lysaght decision) then he is resident. When an individual comes to the U.S. for a particular purpose and remains for at least two years, regardless of the number of days present in each year, i.e., a “settled purpose”, the such person is resident. See Cooper v. Cadwalader, 5 T.C. 101 (1904).

The object of the current consultation project  is to provide greater certainty when individuals determine their residence status under self-assessment, whether that be on arriving in the U.K. or leaving it. The consultation seeks views on a proposed statutory residence test, which would apply from April 6, 2012. It will have three parts:  (i) to determine whether the individual is clearly nonresident; (ii) to determine if the individual is clearly resident; (iii) to resolve the issue where application of the first two tests leads to a conflicting set of conclusions.

Under the first test of “clearly non-resident’, such would apply to an individual who is present in the U.K. for less than 45 days and was not a resident in any of the three immediately preceding tax years. If such person was resident in any of the 3 preceding years then he must be present for less that 10 days for the year in question. When an individual leaves the U.K. to work full-time abroad and is present in the U.K. for less than 90 days, of which no more than 20 are "working days", then he is non-resident.  In this context, full-time work, which includes self-employment, means work of 35 or more hours per week carried out over a complete tax year. A working day is one in which three or more hours of work are carried out.

Under the second part of the consultative prescription for residence, an individual will be treated as resident for the tax year when: (i) he is present in the U.K. for 183 days or more; (ii) his home is located in the U.K., or if he has more than one home, all of his homes are in the U.K.; and (iii) the individual is in the U.K. to carry out full-time work,i.e. work that is 35 or more hours per week carried out over a period of 9 months, wih no more than 25% of such person’s duties being carried on abroad.

Under the third part of the test or the tie-breaker provision, which apply if only if none of the tests in (i) or (ii) are met, factors are used to “connect” the individual to the U.K.  Such person will be “resident” in the year depending on the number of days present in the U.K. and one or more of these so called “connecting” factors: (i) the individual's spouse, civil partner, cohabitee, or minor children are resident in the U.K. for that year; (ii) for children, the individual must spend time with them for at least 60 days per year; (iii) the individual has accommodation in the U.K. which has actually occupied in that year other than hotels or temporary accomodations; (iv) the individual has done “substantive work” in the U.K. during the year of 40 days or 3 or more hours of work albeit not full time work in the U.K.; (v) the individual has spent 90 days or more in the U.K. in either of the immediately preceding 2 years; and (v) the individual has spent more time in the U.K. than elsewhere.

For individual arriving in and departing from the U.K., there are special rules or "tariffs" whereby the number of factors needed to make the individual resident for the year varies according to the number of days of presence in the U.K. in that year. The tariff for arrivals -- that is, someone who has not been resident in any of the three immediately preceding tax years -- is proposed to be as follows:

if present in the U.K. for less than 45 days -- none of the factors are taken into account (he would already be nonresident under Part (i));

if between 45 and 89 days -- resident if all four factors are satisfied;

if between 90 and 119 days -- resident if at least three factors are satisfied;

if between 120 and 182 days -- resident if at least two factors are satisfied; and

if 183 days or more -- he would already be resident under Part (ii)

In the case of an individual leaving the U.K. who has been resident in one or more of the three immediately preceding tax years, the tariff is as follows:

if present in the U.K. for less than 10 days -- none of the factors are taken into account (he would already be nonresident under Part (i));

if between 10 and 44 days -- resident if at least four factors are satisfied;

if between 45 and 89 days -- resident if at least three factors are satisfied;

if between 90 and 119 days -- resident if at least two factors are satisfied;

if between 120 and 182 days -- resident if at least one factor is satisfied; and

if 183 days or more -- he would already be resident under Part ii.

While the current rules tend to lead to an all or nothing by concession, "split-year" treatment is available in some situations whereby a different residence status can apply before and after the date of arrival or departure. This treatment is granted when the arrival or departure is for the purpose of taking up permanent residence in the U.K. or abroad or when the departure is in order to take up full-time employment abroad. The intention is to replicate, as far as possible, this treatment within the new statutory rules but to avoid the uncertainty inherent in the phrase "permanent residence." The proposal allows split-year treatment when the individual becomes U.K. resident because his only home is in the U.K., he starts full-time employment here, or he returns to the U.K. after working full time abroad. In the case of departures, the treatment will apply when the individual goes to work full time abroad or establishes his home in another country so as to become tax resident there.

A few years ago, special rules were introduced for capital gains tax to combat the practice of becoming nonresident for a period of a few years, during which the individual realized gains outside the U.K. tax net and then took up residence again.  In essence, those gains are stored up and taxed in the year in which the individual becomes resident again. The consultation document proposes that a similar rule be introduced for income tax purposes to target some forms of investment income. One example highlighted by Mr. Johnson is when profits of a privately owned company are accumulated and only paid out as dividends once the shareholder has become nonresident.

The U.K. is probably unique in that, in addition to the concept of residence, taxation is also levied according to the concepts of "ordinary residence," which is also covered in this document, and "domicile," which  will be the subject of a separate consultation document.

Are long-standing allies and friends in the U.K. might want to look at the rules we have under section 7701(b) in defining "resident" and "non-resident" for income tax purposes. Perhaps our approach is more sensible and predictable.

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Enactment of Section 304(b)(5)(B) in 2010

In The Education Jobs and Medicaid Assistance Act (P.L. 111-226, August 10, 2010), Congress amended §304(b)(5) by adding, in §304(b)(5)(B), to deny dividend reduction from earnings and profits  for a purchase of stock by a controlled foreign corporation through a chain of ownership that “hopscotches” over the U.S. person under §951(b). While §304 is itself an substance over form provision to avoid dividend inclusion, U.S. corporations have structured brother-sister or parent-subsidiary stock purchases to avoid foreign withholding taxes that would have otherwise been imposed on a direct dividend distribution and to also obtain deemed paid foreign tax credits under §902.  Congress, in 1996 and now recently in the Education Jobs Act last year, has tried to put a stop on “gaming” the withholding and controlled foreign corporation dividend impacts by stock purchases between a non-CFC or U.S. shareholder of a CFC.

Redemptions of Stock Through Related Corporations: Section 304

As a starting point, §304(a) provides that where a “related corporation” (other than a subsidiary, i.e., two corporations in which one or more persons are in control, as defined, of both, and in return for property, one of the corporations acquires stock in the other corporation from the person or person in “control” of both, then (unless §304(a)(2) applies), such property received is treated as a distribution in redemption of the stock of the corporation acquiring such stock. To the extent the described distribution is taxable as a dividend under §301, the transferor and the acquiring corporation shall be treated as if the transferor had transferred the stock so acquired in exchange for to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction controlled by §351(a), and then the acquiring corporation redeemed the stock it treated as having issued in the transaction.

Under §304(a)(2), which applies to the acquisition of stock in a related corporation by a subsidiary, where in return for property the stock of a parent corporation is acquired by a controlled subsidiary, then such property is treated as a distribution in redemption of the stock of the issuing (parent) corporation. If a subsidiary corporation (the controlled or acquiring corporation) acquires stock of its parent (the issuing corporation) from a shareholder of the parent, § 304(a)(2) provides that for purposes of § 302 or § 303, any “property” paid for the stock must be treated as a distribution in redemption of the parent corporation's stock.

The definition of the term “property” for purposes of § 304 is the same as for purposes of § 302.  Since the definition includes everything of value other than the corporation's own stock or stock rights, it normally causes little confusion; however, in the context of a parent-subsidiary redemption, the issue can arise as to which party is “the corporation,” particularly since § 304(a)(2) states that the transaction will be treated as a redemption of the stock of the issuing corporation. The Tax Court has held that a shareholder's transfer of parent stock to a subsidiary in exchange for stock of the latter is not a § 304 distribution of “property,” because it is a distribution of stock of the corporation referred to by § 317(a), the subsidiary in this case. See. Bhada, 89 TC 959 (1987) , aff'd sub nom. Caamano v. Comm’r, 879 F2d 156 (5th Cir. 1989) , and Bhada v. Comm’r, 892 F2d 39 (6th Cir. 1989). Section 304(a)(2) transmutes a sale of the parent's stock to the controlled subsidiary into a deemed redemption of the stock  by the parent but not for purposes of applying the non-equivalent tests under §302(b). The subsidiary's basis in the purchased parent stock is its cost basis under § 1012 regardless of whether the transaction is treated as a sale or a dividend to the selling shareholder. Where  the selling shareholder is treated as having received a §301 distribution, its basis in the parent corporation’s stock will generally be added to the basis of remaining shares.

Section §304(b) sets forth special rules for making sale or exchange determination under §302(b). Under §304(b)(1), where stock of a corporation is acquired under §304(a), whether the distribution is in part or full payment in exchange for the stock is made by looking at the “before” and “after” impacts by reference to the stock of the issuing corporation.  In applying the constructive ownership rules in §318 with respect to §302(b), §§318(a)(2)(C) and 318(a)(3)(C) are applied without regard to the 50%  limitation contained in those provisions.

The amount and source of the “dividend” portion of the redemption proceeds, i.e., in an acquisition of stock described under §304(a), is determined “as if the property were distributed” by the acquiring corporation to the extent of its earnings and profits and then by the issuing corporation to the extent of its earnings and profits. In applying the §351 construct in §304(a), unless otherwise provided, §304(a) (and not §351 and §§357 and 358 as they related to §351), shall apply to any property received in a distribution described in subsection (a) . To the extent the dividend is sourced from the earnings and profits of the acquiring corporation, the transferor is considered to receive the dividend directly from the acquiring corporation. Commentors have referred to this as “hopscotching” since the dividend essentially bypasses any intermediary shareholders, which in the context of this note would be a U.S. shareholder under §951(b). See H.R. Rep. No. 98-861 (1984) (Conf. Rep.), 1222-1224; Rev. Rul. 80-189 , 1980-2 C.B. 106. Other applicable rules with respect to liability assumptions, distributions incident to the formation of a bank holding company and treatment of certain intragoup transactions.

The Taxpayer Relief Act of 1997 Addressed Sales of CFC Stock Abuse

Section 304(b)(5) was enacted by Congress in 1997,  and shortly thereafter amended, in an effort to limit certain earnings and profits of a foreign acquiring corporation from being  taken into account for §304 purposes. The target of abuse of that legislation was to prevent a U.S. corporation from claiming a §902 foreign tax credit for taxes paid by a foreign acquiring corporation in instances where  an actual dividend paid by the foreign acquiring corporation would have been received by a foreign parent corporation and no foreign tax credit would have been available to the U.S. corporation. For example, if a foreign-controlled domestic corporation sells the stock of a subsidiary to a foreign sister corporation, the domestic corporation may claim it can  credit the foreign taxes that were paid by the foreign sister corporation. See Rev. Rul. 92-86, 1992-2 C.B. 199 ; Rev. Rul. 91-5, 1991-1 C.B. 114 . Where the foreign sister corporation actually distributed its earnings and profits to the common foreign parent, no foreign tax credits would have been available to the domestic corporation.

Under the Taxpayer Relief Act of 1997, P.L. 105-34 (8/5/97) bill, the earnings and profits of the acquiring foreign corporation, i.e., a CFC,  that are taken into account in applying §304. Such earnings and profits taken into account by the CFC will not exceed the portion of such earnings and profits that (1) is attributable to stock of such acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) and who is a U.S. shareholder (within the meaning of § 951(b)) of such corporation, and (2) was accumulated during periods in which such stock was owned by such person while such acquiring corporation was a controlled foreign corporation. For purposes of this rule, except as otherwise provided by the Secretary of the Treasury, the rules of §1248(d) (relating to certain exclusions from earnings and profits) would apply. See also §1442 which  generally requires a 30-percent gross basis tax to be withheld on dividend payments to foreign persons unless reduced or eliminated pursuant to an applicable income tax treaty.

Prior to the Education Jobs Act, enacted in 2010, a CFC group could repatriate the earnings and profits of the CFC group free from U.S. income tax where the acquiring corporation, the CFC, purchased the stock of the issuing corporation that resulted in a deemed distribution from the CFC directly to the foreign shareholder. This could occur, for example, if a CFC group which included a US holding company and a subsidiary CFC purchased  stock of its subsidiary CFC, a purchase by the CFC of stock of the issuing corporation held by a non-CFC foreign corporation in a transaction described §304(a)(1). This strategy resulted in a  dividend that bypassed the U.S. holding company and avoided the U.S. income tax that would have been otherwise payable by the U.S. holding company. In addition, because the dividend was treated as a distribution out of the earnings and profits  of acquiring, a foreign corporation, the constructive redemption resulted in a distribution of foreign source dividend income when paid to the foreign parent or other tax indifferent foreign member that was not subject to U.S. withholding tax. The earnings of an Issuing U.S. member of a foreign controlled group could also be constructively distributed to a foreign parent or  a tax indifferent entity in a constructive redemption. In that case, however, to the extent the dividend was deemed to be from the earnings of the domestic issuing corporation, it was generally be subject to U.S. withholding tax (at 30%, or for a lower rate under applicable treaty). Note the inapplicability of §367(a)(outbound transfers of property, including inventory from the U.S.) or §367(b)(foreign to foreign transfers) to §351 type transactions that are part of a deemed redemption under §304(a)(1).

“The Problem” Which Resulted in Passage of Section 304(b)(5)(B): A Hypothetical

Assume that FHC is a publicly traded foreign corporation and, by definition, is not a CFC. Assume further that  FHC does not maintain a U. S. trade or purpose directly but owns all the stock of US Sub. US Sub is the parent of a wholly owned foreign subsidiary, FS. All of FS’s earnings and profits are not previously taxed, i.e., earnings and profits described in §959(c)(3) that would also be described in §304(b)(5) and §304(b)(5)(A). FHC sells part of its share holdings in US Sub. to FS for cash in an amount equal to FS’s earnings and profits.

The “problem”  transaction is described in §304(a)(2) with the acquiring corporation being FS and the issuing corporation US Sub., and the shareholder of the issuing corporation FHC. Prior to the Act, FHC, per §304(b)(2)(A), would maintain its receipt of a dividend from FS for the full amount of cash received as a direct dividend from FS to FHC and not through US Sub. FHC would therefore contend it had no U.S. tax liability resulting from the deemed dividend, i.e., the dividend sourced from FS’s earnings would “hopscotch” over US Sub. But see §902 (for direct chain of ownership dividends from a CFC to its US parent corporation). After the transaction, FS would own stock of USP that generally would be a cost basis investment in U.S. property for purposes of §956 . This potentially could result in an income inclusion to US Sub. under §951(a)(1)(B) as the U.S. shareholder (per §951(b) ) of FS, a CFC. However, were FS’s earnings and profits eliminated in the stock purchase from FHC, the income inclusion under the CFC to US Sub. would be substantially reduced.

Enactment of Section 304(b)(5)(B) in 2010 Education Jobs Act

For §304 redemptions occurring after July 8, 2010, The 2010 Education Jobs Act, P.L. 111-226, under amended §304(b)(5)(B) imposes an additional limit on the earnings and profits of a foreign acquiring corporation that may be taken into account in determining the amount (and source) of a distribution treated as a dividend in a constructive redemption. Under the Act earnings and profits of an acquiring foreign corporation in a.§304(a) related party stock purchase are not taken into account in determining the amount treated as a dividend under §304(b)(2)(A) if more than 50% of the dividends arising in connection with the acquisition would neither (i) be subject to U.S. income tax for the year in which the dividends arise, §304(b)(5)(B)(i); or (ii) be included in earnings and profits of a CFC, per §957, without regard to §953(c) (§304(b)(5)(B)(ii)).  The limitation generally applies when more than 50% of the issuing corporation is acquired from a foreign person that is not a CFC, in which case none of the foreign acquiring corporation's earnings and profits is taken into account and just the target corporation’s earnings and profits are so accounted for in computing the amount of the dividend. The new provision effectively prevents the foreign acquiring corporation's earnings and profits from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign person (i.e., the transferor) without an intermediate distribution to a domestic corporation in the chain of ownership between the acquiring corporation and the transferor corporation. Generally, if the transferor is a foreign corporation (and not a CFC) and the acquiring corporation is a CFC, it is not relevant whether the target corporation is a domestic or a foreign corporation. However, if the target is a U.S. corporation, the 30-percent gross basis withholding tax applies to the amount constituting a dividend from the target, unless reduced or eliminated by treaty.

Revisiting the Hypothetical “Problem” After Passage of Section 304(b)(5)(B)

In applying §304(b)(5)(B) to the “Problem”, i..e, the stock sale occurred after August 10, 2010, then none of the FS’s earnings and profits would be used to fund a deemed dividend per §304(b)(2)(A). The requirements for §304(b)(5)(B) would be met, i.e., more than 50% of the dividends arising from such acquisition (without regard to §304(b)(5)(B)) would neither be subject to U.S. income tax either directly or through the CFC provisions. The gain FHC recognizes would not be subject to US tax.

Postscript. Regulations are expected to be issued that will provide a series of anti-avoidance provisions, including through the use of partnerships, options, or other arrangements to cause a foreign corporation to be treated as a CFC. The provision applies to transactions occurring after thedate of enactment, August 10, 2010.

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In  IRS Announc. 2010-9, 2010-7 IRB 408 (the “UTP Announcement”),  the IRS announced that it was considering the adoption of an important addition to the income tax reporting requirements of corporations and certain business taxpayers. The new schedule would require certain business taxpayers to disclose annually uncertain tax positions (UTPs) by concisely describing the positions and providing information about their magnitude. Initially, the new schedule was to be filed beginning in tax years ending in 2010 by business taxpayers with total assets in excess of $10 million, provided the taxpayer had one or more uncertain tax positions of the type required to be reported on the new schedule. Eventually, however, the IRS decided to move forward with the UTP schedule and “softened” somewhat its initial approach on the asset threshold of  $10 million, starting with a $100,000,000 gross asset value threshold in 2010, which greatly reduced the number of required uncertain tax position schedules filing on 2010 returns. Now there is a phase of the asset threshold amount for corporations and certain business taxpayers until 2014 when the excess of $10 amount triggers the reporting requirement.  

It is clear that the IRS is trying to force corporate taxpayers to bring out into the open tax positions taken on their returns with which the IRS may not agree. Previously, taxpayers only were required to disclose uncertain tax positions to avoid accuracy-related penalties, and then only where there was not “substantial authority” or reasonable reliance on a tax advisor's “more likely than not” opinion (except in limited instances). Now, the IRS may take the view that a tax position having a significant degree of uncertainty must be disclosed and identified on the corporate tax return. This will inevitably lead to further litigation concerning the ability of the IRS to obtain workpapers, memoranda, legal opinions, and work product that are used to support the preparation and filing of Schedule UTP.

Various professional groups argued last Summer that the proposed Schedule UTP should be withdrawn as it forces taxpayers to either identify potential tax liability to fulfill its self-assessment requirements or face the possibility of a punishing rebuke should it fail to satisfy the IRS's increasing need for information. This obligation to disclose questionable or uncertain tax positions runs counter to time honored traditions between attorney-client communications, the work product doctrine as well as the relatively new federal tax practitioner privilege under section 7525 of the Internal Revenue Code.

While interim notices on the uncertain tax position schedule provided a limited form of mitigation, the present UTP form provides a roadmap for the IRS to efficiently audit a subject taxpayer by zeroing in on the taxpayer’s own concerns of what positions may be successfully challenged by the Service.  What happens when a taxpayer omits a item which the Service thought should have been disclosed as “uncertain”? Will penalties be imposed? Unless Congress acts, or a strong lobbying effort by professional groups ultimately is successful, it will be up to the courts to decide if the new burden of disclosing UTP is valid, even if promulgated under final regulations.

For further discussion on the background and implications of this new administrative rule, see August, “The Uncertain State of Uncertain Tax Positions”, Business Entities (WG&L), May/June 2011.

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