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In preparing for a Senate Committee on Foreign Relations hearing held on June 7, 2011, the Joint Committee on Taxation issued comments on the Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Switzerland (JCX-31-11) (5/20/2011). The proposed protocol was signed on September 23, 2009, and is accompanied by official understandings implemented by an exchange of diplomatic notes (collectively, the “diplomatic notes”) carried out on that same day.

As with most bilateral tax treaties, the tax treaty with Switzerland is designed to reduce or eliminate double taxation of income earned residents of either country from sources within the other country and to prevent avoidance or evasion of the taxes of the two countries. The present treaty also is intended to promote close economic cooperation between the two countries and to eliminate possible barriers to trade and investment caused by overlapping taxing jurisdictions of the two countries.

The proposed protocol would modify several provisions to the U.S.-Switzerland Tax Treaty (October 2, 1996) and the Protocol signed in Washington on the same date. The proposed protocol sets forth rules that are similar to rules contained in recent U.S. income tax conventions, the 2006 U.S. Model Treaty and the 2010 OECD Model Treaty. The present treaty, as amended by the proposed protocol, however, includes certain substantive deviations from these treaties and models. Here are some of the more notable features of the new proposed protocol to the U.S.-Swiss Income Tax Treaty.

Article 10, pertaining to Dividends, would be, under the proposed protocol, to expand the prohibition on source country taxation of dividends beneficially owned by pension or other retirement arrangements resident in the other treaty country The present treaty generally allows full residence-country taxation and limited source-country taxation of dividends. The present treaty includes a generally applicable maximum rate of withholding at source of 15 % and a reduced five %  maximum rate for dividends received by a company owning at least 10% of the voting stock of the dividend-paying company. Special rules apply to dividends received from regulated investment companies (“RICs”) and real estate investment trusts (“REITs”).

Article 10, Paragraph 3 of the present treaty exempts from source-country taxation dividends paid to a pension plan or other retirement arrangement that is a resident in the other country if the pension plan or other retirement arrangement does not control the company paying the dividend.

Under the proposed protocol, the prohibition on source-country taxation also applies to dividends that are beneficially owned by an individual retirement savings plan set up in, and owned by a resident of, the other treaty country, so long as the competent authorities agree that the individual retirement savings plan generally corresponds to an individual retirement savings plan recognized in the other treaty country for tax purposes. The prohibition on source-country taxation of dividends is not available where the beneficial owner controls the company paying the dividend.

Under Article 25 (Mutual Agreement Procedure), the proposed protocol changes the voluntary arbitration procedure contained in Article 25 at present to a mandatory arbitration procedure a/k/a the “last best offer arbitration”, pursuant to which each of the competent authorities proposes one and only one figure for settlement, and the arbitrator must select one of those figures as the award. Under the proposed protocol, unless a taxpayer or other “concerned person” (in general, a person whose tax liability is affected by the arbitration determination) does not accept the arbitration determination, it is binding on the treaty countries with respect to the case. A mandatory and binding arbitration procedure is included in the U.S. income tax treaties with Belgium, Canada, France, and Germany. The details and applicable rules of the new mandatory arbitration procedure are set forth in the report.

Another proposed change is replacing Article 26 (Exchange of Information) and paragraph 10 of the 1996 protocol to rules that conform generally to the OECD standards. The proposed rules generally provide that, in response to specific requests, the two competent authorities will exchange such information as may be relevant in carrying out the provisions of the domestic laws of the United States and Switzerland concerning taxes covered by the treaty, to the extent the taxation under those laws is not contrary to the treaty. The information provisions are largely based on those contained in the OECD model and U.S. model treaty, with several exceptions. The United States and Switzerland agree to exchange such information as “may be relevant” in carrying out the provisions of the proposed protocol or in carrying out the provisions of the domestic laws of the two treaty countries concerning taxes that are imposed by a treaty country and subject to the treaty. Thus, the exchange of information is not restricted by paragraph 1 of Article 1 (Personal Scope) but instead is limited by Article 2 (Taxes Covered).

The limitation on taxes that may be the subject of an exchange of information is a significant departure from both the OECD Model and U.S. Model treaties. Information about persons who are residents of neither Switzerland nor the United States may be requested and provided under the proposed protocol. For example, a third country resident with a Swiss bank account that is reportable to the IRS may be the subject of a request by the competent authority for information with respect to the bank account.

Any information exchanged under the proposed protocol is regarded as secret in the same manner as information obtained under the domestic laws of the treaty country receiving the information. The exchanged information may be disclosed only to persons or authorities (including courts, administrative bodies and legislative bodies) involved in the administration, enforcement or oversight of the tax laws. Such functions include assessment, collection, civil and criminal prosecution, and the determination of appeals in relation to the taxes to which the proposed protocol applies. The authority to disclose information to persons involved in oversight of taxes includes authority to disclose to persons or authorities such as the tax-writing committees of the U.S. Congress and the Government Accountability Office. Such persons or authorities receiving the information may use the information only in the performance of their role in overseeing the administration of U.S. tax laws. Finally, exchanged information may be disclosed in public court proceedings or in judicial decisions.

A treaty country is not required to carry out administrative measures at variance with the laws and administrative practice of either treaty country, to supply information that is not obtainable under the laws or in the normal administrative practice of either treaty country, or to supply information that would disclose any trade, business, industrial, commercial, or professional secret or trade process, or information the disclosure of which would be contrary to public policy. The Technical Explanation notes, however, that if a treaty country is asked to provide information, it should provide the information even if its own statute of limitations period has expired for the issue to which the information relates. According to the Technical Explanation, the statute of limitations of the treaty country making the request should govern. The Technical Explanation also states that even if the limitations on information exchange mean that a treaty country is not obligated to supply information in response to a request from the other treaty country, the requested country may choose to supply the information if doing so does not violate its internal law.

The proposed protocol limits the ability of either country to decline a request for information based on the lack of need for such information in a domestic tax investigation, or the expiration of the limitations period in the requested treaty country. If the information may be relevant to the requesting treaty country, the limitations described immediately above will not support a refusal to exchange the information. .

In addition to replacing Article 26, as noted, the proposed protocol also amends the 1996 Protocol that was executed and ratified contemporaneously with the present treaty. Article 4 of  the proposed protocol replaces paragraph 10 of the 1996 Protocol. Under the 1996 Protocol, paragraph 10 detailed the understanding of tax fraud or related fraudulent conduct that would support an exchange of information of banking information. Neither the proposed Article 26 nor the proposed amendment to the 1996 Protocol requires that tax fraud or fraudulent behavior be established in order to permit exchange of information.

Subparagraph (a) of proposed paragraph 10 summarizes the understanding of the treaty countries about the information to be included in a specific request for exchange of information. The required information compromises five elements. They are: (1) information sufficiently specific to identify the person under examination or investigation; (2) the period of time for which information is requested; (3) the information that is sought, including the nature and form in which the information should be provided; (4) a statement of the tax purpose to which the information relates; and (5) the name of the person believed to be in possession of the requested information. With respect to the first described element, the proposed paragraph 10 includes an illustrative list of information that may be sufficient to identify a person, such as name, address, and account numbers.

Subparagraph (b) of proposed paragraph 10 explains the reasoning for requiring that the competent authority explain the purpose for which the information is needed. The treaty countries agree that the information requested need only meet a standard of “may be relevant” to tax matters in the requesting treaty country, to permit the “widest possible” production without authorizing “fishing expeditions.”.

Subparagraph (c) of proposed paragraph 10 provides that, upon specific request by the competent authority of a treaty country, the other competent authority must provide information in the form of depositions of witnesses and authenticated copies of unedited original documents (including books, papers, statements, records, accounts, and writings), to the same extent such depositions and documents can be obtained under the laws and administrative practices of the requested country with respect to its own taxes. A treaty country may request that responsive information be provided in an authenticated form that will facilitate use of that information in the administrative or judicial proceedings in the requesting country.

The proposed protocol commits the parties to honor only specific requests for exchange of information that comply with the requirements of subparagraph (a) of proposed paragraph 10. Subparagraph (d) of proposed paragraph 10 makes it clear that neither automatic nor spontaneous exchanges of information are required by the proposed protocol. Neither the treaty, the proposed protocol, nor the proposed paragraph 10 precludes such exchanges on a voluntary basis.

 Under Article 5 of the proposed protocol provides that the proposed protocol will enter into force upon the exchange of instruments of ratification, and it sets forth rules for when the provisions of the proposed protocol will take effect.

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Petitioners, husband and wife, were shareholders in an S corporation which provided wireless cellular service. The IRS asserted a deficiency in tax for approximately $16 million for the 5 years in issue (1996-2001) . At the heart of the dispute was the length in years of the recovery period that the S corporation was required to use in computing its annual cost recovery allowance for the wireless cellular assets, i.e., including antenna support structures, cell site equipment and leased digital equipment, used in the corporation's businss operations. Such class period recovery was set forth based on different asset class by the Service in Rev. Proc. 87-56, 1987-2 C.B. 674, which was in effect for the years in issue. The Tax Court agreed that the antenna  support structures fall within asset class 48.14 and have a recovery period of 15 years per Rev. Proc. 87-56, supra. The cell site equipment, excluding the switch, and the leased digital equipment, were held to fall within asset class 48.12 with a recovery period of 10 years. In contrast, the taxpayers’ reported the antenna support structures as under “Telegraph, Ocean Cable, Satellitte Communications Activity category and Asset Class 48.32 and recoverable over a shorter 7-year period.

The Tax Court, per the opinion of Judge Kroupa, held that the structures were more appropriately within the Telephone Communications activity category and therefore per Rev. Proc. 87-56, supra, Similarly, taxpayers' classification of a wide variety of cell site equipment, including base station and switch, as computer-based telephone central office switching equipment coming under Asset Class 48.121 with 5-year recovery period was, except for switch, also inappropriate; instead, and despite presence of some computerized components, remaining cell site equipment had to be classified under Asset Class 48.12 with 10-year life because radio was key component. Also, no depreciation was available for other/ leased digital equipment until year it was placed in service/year corp. switched from analog to digital service.

The authority to set forth class live periods by the IRS is granted by Congress. §167(m). Such guideline classes and lives or periods are established, supplemented and revised where necessary. Treas. Reg. §1.167(a)-11(b)(4)(ii). The Secretary has the authority to prescribe class lives for each class of property. The revenue procedure in effect for the years at issue was Rev. Proc. 87-56, 1987-2 C.B. 674.

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Section 704(c) sets forth rules which govern  the allocation of the tax items of a partnership with respect to contributed property. More specifically, section 704(c)(1)(A) addresses the question of which partner or partners are to be allocated the unrealized appreciation or loss on property contributed to a partnership. The same principle applies with equal vigor to when additional property is contributed to the partnership or where property held by the partnership is distributed in exchange for a partnership interest. The same may be said for assets-over mergers of partnerships as well as revaluations of capital accounts. For a sampling of recent commentary on this subject see New York State Bar Association Tax Section, “Report on the Request for Comments of Section 704(c) Layers Relating to Partnership Mergers, Divisions and Tiered Partnerships”; See Pillow and Dance, "Notice 2009-70: A Focus on Complex Section 704(c) Netting vs. Layering Issues," 111 JTAX 336 (December 2009) . Other articles that have addressed issues raised in the Notice include: Abrams, ''Reverse Allocations: More Than Meets the Eye,'' 20 Tax Mgmt. Real Est. J. 2 (2004); Harris, ''Federal Taxation of Partnership Asset Revaluations,'' 14 Va. Tax Rev. 257 (1994).

Section 704(c)(1)(A) requires that income, gains, losses and deductions that are attributable to built-in gains or losses on contributed property are required to be allocated in a manner which takes into account the variation between the fair market value (FMV) and adjusted tax basis of the property at the time of the contribution. See Deficit Reduction Act of 1984, P.L. No. 98-369, §71(c). The regulations provide that a partnership must account for this “delta” amount or variance between basis and FMV by using “a reasonable method that is consistent with the purpose of section 704(c)”. Treas. Reg. §1.704-3(a)(1); Treas. Reg. §1.704-1(b)(2)(iv)(f)(“book-ups”).

There are three methods approved in the regulations for making section 704(c) allocations: (i) the traditional method, which is generally preferred by contributors of highly appreciated property; (ii) the traditional method with curative allocations, and (iii) the remedial allocation method. Other methods may be permitted. In general, many if not most partnership agreements will use the “traditional method” explained in Treas. Reg. §1.704-3(b) as modified, by a so-called “ceiling rule”, i.e., the total amortization, depletion, depreciation, or gain or loss allocated to the partners cannot exceed the total amount of the partnership's amortization, depletion, depreciation, or gain or loss. The ceiling rule also can create a lingering disparity between the noncontributing partners' section 704(b) capital account and tax capital account.

In Notice 2009-70, 2009-34 IRB 255, comments were solicited by the Treasury and IRS on section 704(c) and its application to revaluations, partnership mergers, divisions and tiered partnerships.

Where section 704(c) property contributed to a partnership is distributed to partners other than the contributor, i.e., in a so-called mixing bowl distribution, within seven years of its contribution, section 704(c)(1)(B) mandates that the contributing partner, or her successor in interest under a “step in the shoes” approach, is required to recognize gain or loss in an amount equal to the gain or loss that would have been allocated to the contributing partnership under section 704(c)(1)(B) had the property been sold to the distribute(s) at FMV at the time of distribution. Where gain or loss is recognized under section 704(c)(1)(B), the basis of the contributing partner’s interest in the partnership and basis of the distributed property are adjusted to reflect the recognized gain or loss. Such adjustment to basis is made prior to tax affecting the distribution. Treas. Reg. §1.704-4(e)(2).

Section 737 requires a contributing partner to recognize gain where the partnership distributes other property to the contributor of appreciated property within 7 years of that partner’s contribution. The gain recognized under section 737 by the distributee-contributing partner is the lesser of: (i) FMV of the distributed property less the adjusted basis of the partner’s interest in the partnership, or (ii) the ne precontribution gain of that partner. The net precontribution gain is gain that the contributing partner would recognize under section 704(c)(1)(B) had the partnership distributed the contributed property to a noncontributing partner within 7 years. §737(b). There are certain exceptions that will override application of section 704(c)(1)(B), such as the termination of a partnership under section 708(b)(1)(B). Moreover, in such instance there is no commencement of a new 7 year period for application of the mixing bowl provision.

Partnership Mergers and Deemed Liquidations: Another Exception to Triggering Section 704(c)(1)(B).

Where a partnership transfers all of its assets and liabilities to another partnership and liquidates or is deemed to liquidate, section 704(c)(1)(B) does not apply to the liquidation. Instead, it operates on the transferee partnership as a successor to the transferor partnership. Treas. Reg. §1.704-4(c)(4).  In this instance there is the commencement of a new 7 year period with respect to the difference between the section 704(b) book value and FMV of the transferred property. No new 7 year period is imposed with respect to the FMV and adjusted basis  spread existent on date of contribution. Treas. Regs. §§1.704-4(c)(4), 1.737-2(b)(1). The revaluation can result in a new level of section 704(c) gain. In Rev. Rul. 2004-43, 2004-1 C.B. 842, revoked by Rev. Rul. 2005-10, 2005-1 C.B. 492, the Service further stated that section 704(c) principles will apply to reverse section 704(c) allocations. It is noteworthy that the  the regulations under section 704(c)(1)(B) and section 737 do not provide a rule requiring both provisions to apply to reverse section 704(c) applications. See Treas. Reg. §1.704-3(a)(6)(i).

The Service in 2007 issued proposed regulations to section 704(c)(1)(B) and related provisions confirming and supplementing Rev. Rul. 2004-43, supra., that such provision would not apply to an assets-over merger where the transferor-partnership is terminated as a result of the merger. Still, Prop. Reg. §1.704-4(c)(4)(ii) states that section 704(c)(1)(B) applies to the transferee-partnership’s subsequent distribution of section 704(c) property contributed by the transferor partnership to the transferee partnership in an assets over merger under certain conditions. See Prop. Regs. §§1.704-4(c)(4)(iii)(A)-(D). In an assets over merger, a new 7 year period will not start for the initial section 704(c) gain or loss to the extent such difference has not be eliminated by remedial or curative allocations or by reporting section 704(c) gain or loss. Still, a distribution of contributed property to another partner after the completion of the assets over merger would tripper application of section 704(c) to the original contributor of the property if within the 7 year period. Of course a new section 704(c) amount and commencement of a new 7 year period would apply to booked-up gain or loss as a result of the merger. See Prop. Regs. §§1.704-4(c)(4)(ii)(D). The proposed regulations retain the rule in Rev. Rul. 2004-43 which provided that such rules would not apply to reverse section 704(c) gain or loss. See Treas. Reg. §1.704-3(a)(6)(i).

Application to Revaluations

Under Treas. Reg. §1.704-1(b)(2)(iv)(f), the partners in a partnership may agree, as part of the partnership agreement, to revalue the partnership’s property to current FMV on the happening of certain events such as contributions or distributions to or from the partnership. The re-valuation increases or decreases the book-tax differences in the partners’ capital accounts. This in turn re-vitalizes further application of section 704(c) which in such instance is referred to as a “reverse section 704(c) allocation”. Partnerships having reverse section 704(c) allocations do not need to employ the same allocation method used for “forward” section 704(c) allocations. If there are more than one reverse section 704(c) allocations caused by re-valuations, the allocations among the “reverse” allocations can vary as long as the method selected is reasonable. This provides the partnership and its members with flexibility on how to account for and adjust such book-tax differences in the asset pool held by the venture.

It is somewhat agreed by tax practitioners working in the partnership area that clearer and more definitive guidance is needed in this area. This “musing” serves simply as a reminder that this area continues to offer a great degree of flexibility but at the cost of a complex and uncertain landscape.

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