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

On September 19, 2011 the President submitted to the Joint Select Committee on Deficit Reduction a limited number of international tax reform proposals which the Administration “scored” for budgetary purposes as reducing the deficit by approximately $112 billion over a 10 year period. The changes proposed were essentially the same ones that were part of the President’s 2012 budget proposal announced last February. Some tax commentators were disappointed that there is no real comprehensive reform, such as shifting from a worldwide system of taxation to a territorial or sourcing based system as some had advocated.

The idea of enacting wide ranging reforms in this area would first require a consensus of what such new or revised system would look like, perhaps with or without a value added tax being part of the mix as many treaty partners have added. Then, the conceptual reforms or policy reforms reflected in such new or revised system would undoubtedly  require a rethinking of many rules contained in or otherwise directly linked with the foreign tax provisions in the Code, including the subpart F rules for current inclusion of such income to U.S. shareholders of controlled foreign corporations, the passive foreign investment company or PFIC provisions,  reorganization provisions, dividend treatment from foreign based subsidiaries would be just several of a host of provisions that would have to be addressed. Such reforms would undoubtedly have treaty impacts which treaties might require revision or at least negotiations as to whether revisions were necessary.

So perhaps massive reforms in this area are not appropriate at this time given the uncertain economic times we are living through. Reshuffling the deck chairs of the "ship" of our international tax system might add to the uncertainties we currently face. Still, a simple reduction in the corporate tax rate to a rate competitive in the worldwide market might be quite attractive to inspire increased investment  and employment in the U.S. by both multinationals and U.S. based companies. For the “reformers” the President’s proposals have been criticized as unattractive and simply broadening the base of (foreign source) income that is subject to current taxation.

The International Tax Reforms Being Proposed by the Obama Administration At This Time

Defer deduction of interest expense related to deferred income. Under current law, a taxpayer that incurs interest expense properly allocable and apportioned to foreign-source income may be able to deduct that expense even if some or all of the foreign source income is not subject to current U.S. taxation. To provide greater matching of the timing of interest expense deductions and recognition of associated income,the proposal would defer the deduction of interest expense properly allocable and apportioned to foreign-source income to the extent the U.S. taxation of such income is deferred. This would reduce the deficit by $36 billion over 10 years.

Determine the foreign tax credit on a pooling basis. Under the proposal, a taxpayer would be required to determine foreign tax credits from the receipt of a dividend from a foreign subsidiary on a consolidated basis for all its foreign subsidiaries. Foreign tax credits from the receipt of a dividend from a foreign subsidiary would be based on the consolidated earnings and profits and foreign taxes of all the taxpayer's foreign subsidiaries. This would reduce the deficit by $53 billion over 10 years.

Tax excess returns associated with transfers of intangibles offshore currently. The IRS has broad authority to allocate income among commonly controlled businesses under section 482 of the Internal Revenue Code. Notwithstanding the transfer pricing rules, there is evidence of income shifting offshore,including through transfers of intangible rights to subsidiaries that bear little or no foreign income tax. Under the proposal, if a U.S parent transfers an intangible to a controlled foreign corporation (CFC) in circumstances that demonstrate excessive income shifting from the United States, then an amount equal to the excessive return would be treated as subpart F income. This would reduce the deficit by $19 billion over 10 years.

Limit shifting of income through intangible property transfers. The definition of intangible property for purposes of the special rules relating to transfers of intangibles by a U.S. person to a foreign corporation (section 367(d) of the Internal Revenue Code) and the allocation of income and deductions among taxpayers (section 482) would be clarified to prevent inappropriate shifting of income outside the United States. This would reduce the deficit by $1 billion over 10 years.

Limit earnings stripping by expatriated entities. Under the proposal, the rules that limit the deductibility of interest paid to related persons subject to low or no U.S. tax on that interest would be amended to prevent inverted companies from using foreign-related party and certain guaranteed debt to reduce inappropriately the U.S. tax on income earned from their U.S. operations. This would reduce the deficit by $4 billion over 10 years.

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Section 6662 imposes an accuracy-related penalty for various types of infractions in tax, including underpayments attributable to negligence or disregard of rules or regulations (§6662(b)(1)) or a “substantial understatement of income tax” (§6662(b)(2)). A substantial understatement of income tax exists where the amount of the understatement for a taxable year exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. For a regular or C corporation a substantial understatement of income tax is present where the amount of the understatement for the tax year exceeds the lesser of $10,000 or $10,000,000. The substantial understatement penalty is reduced by the portion of the understatement attributable to the tax treatment of any item contributing to the understatement for which there is or was “substantial authority”, or, alternatively where the questionable item was adequately disclosed on the tax return. This relief rule does not apply to “tax shelters” which term is broadly defined for purposes of this provision. Other accuracy-related penalties are imposed on valuation misstatements, substantial estate or gift tax valuation understatements or substantial overstatement of pension liabilities. More recently, Section 6662(b)(6) imposes a special accuracy related penalty of up to 40%, generally accuracy-related penalties are limited to 20% of the resulting tax caused by the violation, for claimed tax benefits that are undisclosed on the return which are disallowed by application of the economic substance doctrine under Section 7701(o). Penalties for the failure to comply with the reportable transaction rules also subjects a taxpayer to a separate penalty under Section 6662A.

Under Section 7491(c), the Commissioner bears the burden of production and must produce sufficient evidence that the imposition of the penalty is appropriate in a given case. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets this burden, the taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect. Tax Court Rule 142(a).

Mitigation of the Accuracy-Related Penalty

It is only natural that when the particular treatment of an item on a tax return runs the risk of being challenged by the Service, including the assertion of an accuracy-related penalty, the tax advisor will consult with its client and discuss the risks involved in taking what might be labeled as “aggressive” position and whether a penalty can be avoided if the item in question generates a deficiency in tax. As mentioned, in some cases the presence of “substantial authority” for the treatment of a particular item on the return (which treatment is ultimately determined to be incorrect) or the filing of an adequate disclosure statement giving the Service notice of the particular item in question and its treatment on the return, will, in many instances, avoid the imposition of the penalty.  In addition, there is always the idea that the taxpayer’s reliance on its tax advisor(s) in taking the questionable position on the return provides a sufficient basis to avoid the penalty. More specifically, Section 6664(c)(1) provides that "[n]o penalty shall be imposed under section 6662 ... with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion." Under Treas. Reg. §1.6664-4(b)(1), reliance on professional advice can meet the requirements of “reasonable cause” and “good faith” provided, under all circumstances, such reliance was reasonable and the taxpayer in fact acted with good faith. Treas. Reg. §1.6664-4(c)(1) states that "[a]ll facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer ... under Federal tax law.” The presence of actual reliance on a qualified professional tax advisor may not assure a successful defense to an accuracy-related penalty will be the outcome although dictum from the Supreme Court’s decision in Boyle might be persuasive that a “per se” rule is proper. In United States v. Boyle, 469 U.S. 241, the Supreme Court stated: "When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.... ‘Ordinary business care and prudence’ does not demand such actions." 

Under Treas. Reg. §1.6664-4(c)(2), “advice” is “any communication *** setting forth the analysis or conclusion of a person, other than the taxpayer”. (emphasis added). See §7701(a)(14). The determination of whether a taxpayer acted with reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer's efforts to assess its proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor.   The Tax Court recently addressed the reasonable cause defense in Seven W. Enterprises, Inc. v. Commissioner, 136 T.C. No. 26 (2011) and in Woodsum v. Commissioner, 136 T.C. No. 29 (2011). 

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Under §116 of The Canadian Income Tax Act (“CITA”), non-residents who dispose of certain taxable Canadian property, a/k/a “Canadian Taxable Property”, must notify the Canada Revenue Agency (“CRA”) of the pending sale either prior to the disposition or within 10 days after the closing. In addition, where the CRA has received either an amount to cover the tax on any gain the non-resident seller  may realize upon the disposition of property, or appropriate security is provided for the tax, the CRA will issue a certificate of compliance to the seller-non-resident and a copy of the certificate is also delivered to the purchaser.

Where the purchaser does not receive such certificate, the purchaser is required to remit a specified amount, i.e., 25% of the gross sales price,  to the Receiver General for Canada and is entitled to deduct the amount from the purchase price. Any payments or security provided by the non-resident seller and/or purchaser will be credited to the seller's account. A final settlement of tax will be made when the non-resident's income tax return for the year is assessed.

Canadian Taxable Property (“CTP”)

Canadian Taxable Property includes: (1) real property situated in Canada; (2) property used or held in, or eligible capital property in respect of, a business carried on in Canada;(3) designated insurance property of an insurer; (4) privately issued stock of a corporation resident in Canada; (5) shares of a non-resident, privately owned corporation that are not listed on a prescribed stock exchange if, at any time during the last sixty months(i) more than 50% of the fair market value of all the property of the non-resident corporation was made up of CTP, Canadian resource property, a timber resource property, an income interest in a trust resident in Canada, or an interest or option in such properties; and (ii) more than 50% of the fair market value of the shares was derived directly or indirectly from real property situated in Canada, Canadian resource properties or timber resource properties, or any combination of such properties; (6) publicly traded shares in a Canadian company if at any time during the last sixty months, 25% or more of the shares of the corporation belonged to the taxpayer and/or persons with whom the taxpayer did not deal at arm's length;(7) an interest in a partnership if, at any time during the last sixty months (i) more than 50% of the FMV of all property was of CTP, etc., and (ii) more than 50% of the FMV of the partnership interest was derived directly or indirectly from real property in Canada; (8) a capital interest in a Canadian resident trust (other than a unit trust; (9) a unit of a Canadian resident unit trust (other than a mutual fund trust); (10) a unit of a mutual fund trust if, at any time during the last sixty months, 25% or more of the units of the trust belonged to the taxpayer and/or persons with whom the taxpayer did not deal at arm's length; and (11) an interest in a non-resident trust if, at any time during the last sixty months, the trust  was essentially comprised by CTP. Certain types of Canadian property are excluded from the definition of CTP.

Section 116 does not provide for treaty exempt status. However, the CRA permits a non-resident taxpayer  to claim an exemption under a specific tax treaty at the time they file the notification of disposition. Non-resident sellers must state the applicable article and paragraph of the particular treaty that Canada has with their country of residence. To expedite the processing of the exemption, the necessary documentation to support the claim should be submitted along with the request. The documentation must be based on the particular tax treaty under which the exemption is claimed, and would include items such as proof of residency, or proof that the gain has been or will be reported in the vendor's country of residence.

Section 16 is a controversial part of the Canadian tax law since it is somewhat broad-sweeping in its application and imposes a substantial degree of notification, certification and advance tax requirements.

As recently reported in a just published Tax Notes article authored by Michael N. Kandev and Fred Purkey of Davies Ward Phillips & Vineberg LLP in Montreal, last year, the CRA attempted to limit the scope of §116, both on substantive and procedural rules. One new limitation is that “treaty exempt” property is no longer CTP.  See U.S.-Canadian Income Tax Treaty, Article XIII(3). Another new provision, this one effective March 4, 2010, narrowed the definition of CTP to certain Canadian real or business property and interests in entities that have substantial investments, based on value, in Canadian real property or mineral properties.  Under this narrowed framework, shares in a private Canadian corporation are CTP only to the extent that at any time during the five-year period preceding the disposition, they derived, directly or indirectly, more than 50% of their value from Canadian real property or Canadian resource properties.

Well-received by taxpayers and their advisers, the above changes were a significant change in the law in Canada. While the §116 reforms represented a favorable development for foreign investment in Canada, there are still certain rules that will continue to cause complexity and uncertainty. Among such problems noted by Messrs. Kandey and Purkey are the 5 year valuation lookback rule for shares and interests in partnerships and trusts

By far the main impediment to the intended results of the March 4, 2010, amendments has been the five-year valuation lookback for shares and interests in partnerships and trusts that is now the cornerstone of the amended definition of TCP.See Canadian Income Tax Act §248, ¶¶(d), (e). This 5 year lookback rule poses substantial uncertainty as to whether interests in private Canadian corporations holding ownership interests in real property are CTP or not period the business has not derived more than 50 percent of its value from Canadian real estate.

It is important to understand that a buyer of CTP from a non-resident, where the property is not “treaty exempt property”, still has potential liability in the transaction. As mentioned, the CRA must be notified of the sale, a tax clearance certificate must be obtained, and, in certain instances, the buyer must withhold and pay over within 30 days of the closing generally, 25%f the gross purchase price of the property.  Messrs. Kandey and Purkey warn that if the purchaser assumes incorrectly that the sale was exempt from tax on the erroneous belief that the subject property is not CTP, the CRA, in its view, is likely to turn first against the purchaser.  So, its “caveat emptor” to the purchaser of Canadian situs property from a non-resident. Reasonable cause does not appear to be a defense to the purchaser. Compounding this problem is that the purchaser’s liability, under CITA § 116(5), does not appear to be subject to a particular statute of limitations.  This can have major impacts on successor or transferee liability let alone buyers of companies which have purchased assets from Canadian non-residents.

Obviously, it is important to seek the advises of a Canadian tax advisor when this issue arises. There are also potential treaty issues involved, for example, if a U.S. owner of tax exempt property is trying to sell Canadian property and the buyer is resistant to accept such status for whatever reason. Witholding 25% of the gross sales price on an exempt sale (by treaty) where the buyer stubbornly refuses to accept a treaty exemption certificate statement will drive up the non-resident seller’s compliance costs. A U.S. tax adviser can advise U.S. persons on treaty issues that impact on the presence of tax exempt treaty property. Lurking  in the background for the U.S. seller of CTP are foreign tax credit issues.

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The Tax Court, in a consolidated case involving a distressed asset/debt tax shelter, held that several partnerships’ basis in purchased consumer debt acquired from a Brazilian company was zero and that the transfer to the partnerships and subsequent redemption of the Brazilian company's partnership interests were a sale of receivables. The Service’s imposition of accuracy related penalties was upheld.

The transaction in issue has been referred to as a “DAD” or distressed asset debt transaction. In contrast to a Son-of Boss transaction, which exploited the narrow definition of partnership liability under §752 to deny liability assumption for a contingent debt obligation which is still reflected in outside basis, the DAD deal is far more pedestrian in the sense that it does not rely on hyper-technical interpretations of the Code and regulations. As to the Son-of-Boss basis plays see, e.g., Cemco Investors LLC v. United States, 515 F.3d 749, 752 (7th Cir. 2008); New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 185 (2009), affd. 408 Fed. Appx. 908 (6th Cir. 2010); Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007), revd. on other grounds 598 F.3d 1372, 1376 (Fed. Cir. 2010).  

In a DAD transaction, the loss is claimed by application of §§723 and 704(c) from the alleged contribution of a built-in loss asset by a tax indifferent party to a partnership However, this loss is preordained to be nullified by a matching gain upon the dissolution of the venture. Consequently, the tax benefits sought by the tax sensitive party are, absent other factors, confined to timing gains. Moreover, claiming these benefits requires sufficient "outside basis", which, in turn, entails an investment of real assets.

In a consolidated Tax Court proceeding, the facts of the case focused to a large extent on the business dealings between Warwick Trading LLC and Lojas Arapua, S.A., (“Arapua”) a Brazilian retail company in a bankruptcy proceeding/reorganization. In particular, Arapua transferred its troubled consumer receivables to Warwick in exchange for a membership or ownership interest in Warwick and an expectation to receive a cash distribution within a relatively short period of time. 

Warwick next transferred the low value or trouble consumer debt several trading companies, and investors acquired interests in those companies through several holding companies that were all organized as LLCs. The various LLCs elected partnership treatment and claimed bad debt deductions related to the Brazilian consumer receivables. The investors claimed the deductions on their tax returns. Warwick also claimed losses related to the receivables.

The IRS issued notices of final partnership administrative adjustments (“FPAA”) denying the members of the LLCs, including Warwick losses on the worthless debt and applied accuracy related penalties for lack of economic substance, violation of the partnership anti-abuse regulation, and disguised sales provisions.   

The various LLCs subject to the FPAA filed petitions with the Tax Court and the cases were consolidated. In a full opinion of the Court, per Judge. Wherry Jr., the Tax Court upheld the proposed deficiiencies in income tax set forth in the FPAAs, finding that two necessary conditions for allocation of the built-in losses of the distressed debt contributed among the various LLCs were not met. The Court first denied that the alleged partnership that Arapua formed with the managing member or Warwick was not a partnership for federal income tax purposes. Instead, Arapua wanted cash from the receivables and Warwick wanted the receivables to generate deductible tax losses. The Tax  court also found that the second condition for allocation of the built-in losses, that there had been a bona fide contribution of the distressed receivables, had not been met.

The Tax Court recharacterized the contributions as disguised sales under  §707(a)(2)(B) since Arapua received money within two years of the transfer of the receivables. As a purchase, Warwick’s cost basis in the receivables was the amount of cash paid and there was no transferred or exchanged basis for which built in losses could be claimed. Applying the step transaction as a judicial aide or rule of construction, the several steps were joined into a single transaction, i.e., Arapua’s sale of receivables to Warwick for the amount of cash paid. Therefore, the losses are measured against a zero basis as a factual matter and not deductible. The gross valuation misstatement penalty under §6662(h) was imposed since the taxpayers failed to show that they acted with reasonable cause and in good faith in their reporting of the losses.

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