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

In AM-2011-002, the IRS evaluated the separate return limitation on loss provision or “SRLY” with respect to the dual consolidated loss of a foreign disregarded entity under the check the box regulations.  As discussed below, the dual consolidated loss rule contained in §1503(d) and corresponding regulations, is designed to prevent a single economic loss from reducing the taxable income base of more than one taxing system, which frequently arises in instances in which one base is used in computing taxable income for U.S. income tax purposes and the other base is used in computing taxable income on a foreign tax return not subject to tax in the United States. The comments set forth herein are limited in scope and analysis and do not cover all of the material rules and issues in this area.

The facts involved in AM-2011-022 involve a common domestic parent, A, of a consolidated group of corporations. A owns 100% of B, a corporate domestic subsidiary included in the AB consolidated group. B owns 100% of C,  an entity organized under the laws of a foreign jurisdiction, Country X . C is subject to Country X’s income tax on its worldwide income but is disregarded as an entity separate from B for U.S. federal income tax purposes, i.e., a hybrid entity. C carries on a business in Country X that, if carried on by a U.S. person would be a foreign branch within the meaning of Treas. Reg. §1.367(a)-6T(g)(1) . B’s interest in C consists of a hybrid entity separate unit, and B’s indirect interest in the business operations of C is a foreign branch separate unit.  These two individual separate units are combined and treated as a single separate unit.

In Year 1, B generates $120x of net income that is attributable to the C Separate Unit; in Year 2, B incurs a net loss of $100x that is attributable to the C Separate Unit. B has no other items of income or loss for Years 1 and 2. The taxable income attributable to the AB group (without taking into account the C Separate Unit) is $300x and $150x respectively. The $100x net loss attributable to the C Separate Unit is a dual consolidated loss. As an alternative, the administrative guidance release analyzes the results if in Year 1 C generates only $60x of net income that is attributable to the C Separate Unit.

In general, the regulations prohibit the domestic use of a dual consolidated loss, with certain exceptions (including a domestic use election). The domestic use of a dual consolidated loss is deemed to occur when the dual consolidated loss is made available to offset, directly or indirectly, the income of a domestic affiliate in the year in which the dual consolidated loss is recognized or in any other tax year. In addition, a domestic use occurs when the dual consolidated loss  is included in the computation of the taxable income of a consolidated group.

When a domestic use limitation applies, the dual consolidated loss is treated as subject to the SRLY limitation set forth in Treas. Reg. §1.1502-21(c), and as modified by Treas. Reg. §1.1503-4. In the event the consolidated group makes a domestic use election under Treas Reg. §1.1503(d)-6(d), the domestic use limitation rules are inapplicable or yield to the rules under the special election procedure.  

In general, a corporation’s net operating loss that is subject to the SRLY limitation cannot use such loss to reduce consolidated taxable income, i.e., the loss arises in a separate return limitation year. Accordingly, a net operating loss subject to SRLY can only be used as a carryback or carryforward to the corporation which generated the loss. Unlike the general SRLY limitation, a dual consolidated loss may occur or arise in any taxable year, including a year in which the member is included in a consolidated group are recited in the administrative memorandum. The memorandum issued by the Service addresses when a dual consolidated loss (subject to SRLY),  may be used to offset consolidated taxable income in the year the dual consolidated loss is realized despite the fact that under SRLY principles such loss could not be utilized.

The administrative memorandum looks to the current SRLY regulations and the concept known as the “cumulative register.” Under this rule, the consolidated group may use a separate return limitation year net operating loss to reduce consolidated taxable income to the extent the SRLY member has contributed to the cumulative consolidated taxable income during the consolidated return years, as computed under the cumulative register. Because the dual consolidated return regulations fully incorporate the SRLY limitation, the memorandum concludes that the cumulative register concept applies to a dual consolidated loss that is subject to the domestic use limitation. Thus, under the facts of the memorandum, because the C  Separate Unit has a positive cumulative register of $120x, the AB group can use the C Separate Unit loss  of $100 in determining the group's consolidated taxable income in Year 2. The administrative memorandum further provides it is not necessary for the AB group to make a domestic use election to use the C dual consolidated loss.

Under the alternative facts, the AB group may use the C dual consolidated loss in Year 2 only to the extent of C Separate Unit’s cumulative register amount of $60x. Where the dual consolidated loss is greater than C Separate Unit's cumulative register, the excess remains subject to the domestic use (SRLY) limitation rule. The memorandum notes that the AB group may not file a domestic use election for a portion of a dual consolidated loss; rather, a domestic use election may be filed for only the entire C Separate Unit dual consolidated loss. The AB group may use the C Separate Unit's cumulative register or file a domestic use election for the entire C dual consolidated loss amount but not both.

Limitation on Use of Dual Consolidated Loss

The United States generally allows a domestic corporation, which is taxable on gross income from sources both within and without the United States, is similarly allowed, in computing taxable income,  to deduct items, including losses,  regardless of where the corporation incurs those losses. Thus, subject to applicable limitations, a domestic corporation may offset its domestic source income by foreign-source losses. Under the consolidated return regulations, a domestic (eligible) corporation is permitted to file a consolidated tax return with other “affiliated domestic corporations”. §1504. Again, subject to certain limitations, the losses of one member(s) of a consolidated group may be used to offset the gross income of another member(s) in determining consolidated taxable income.

It is also possible for a corporation to be treated as a “domestic” corporation for U.S. income tax purposes while it is also treated as a “resident” of a foreign country for purposes of applying the domestic tax laws of such foreign jurisdiction. For example, the United States views as “domestic” any corporation which is formed or organized by a state situated in the U.S. On the other hand, some foreign countries also regard as “resident” a the place where management and control over the corporation is exercised. See Temp. Reg. § 1.1503-2T(b)(3)(“dual resident corporation”). Thus it is possible for a domestic corporation for U.S. federal income tax purposes to also be a resident of another country based on a differing definition of “resident”, such as in the United Kingdom or Australia. This is known as the concept of a “dual resident corporation”.  The application of a relevant tax treaty may avoid the issue or problem of double taxation by resolving a dual residency conflict.  

Where a dual consolidated corporation is operating on a deficit basis, it is possible that the same economic losses could be duplicated by being claimed in each jurisdiction of residence and despite the fact that double taxation of income may be avoided. Congress was concerned with the dual resident corporation phenomena and, as part of the Tax Reform Act of 1986, enacted §1503(d). A dual consolidated loss, which includes the net operating loss of a dual resident corporation or the net loss attributable to a separate unit, may not be used to reduce the taxable income of a domestic corporation, including the affiliated member of a consolidated group,  unless the loss does not reduce or offset the income of a foreign corporation. See Treas. Reg. §1.1503(d)-1 through Treas. Reg. § 1.1503(d)-7.  Final regulations under §1503(d) were promulgated in 1992 and again revised and issued in final form in 2007. What is important to recognize is that boundary of the dual consolidated loss regulations goes well beyond the consolidated return regulations. Indeed, the dual consolidated loss rules may apply to a U.S. corporation that simply owns an interest in a foreign partnership that incurs losses. The regulations also provide for an election to allow the current deduction of losses subject to certain limitations and a recapture provision. The revised regulations address the application of the dual consolidated loss regime with respect to the check-the-box entity classification regulations. The Service has a “no-ruling” position on §1503(d). See Rev. Proc. 2009-7, § 4.01(26), 2009-1 CB 226, 228; Rev. Proc. 2010-7, § 4.01(26), 2010-1 CB 231, 233; Rev. Proc. 2011-7, § 4.01(26), 2011-1 IRB 233, 235.

Illustration. X is a corporation formed in Pennsylvania and owns all of the stock of Y, a foreign corporation organized under the laws of Country A. X also has a wholly owned US subsidiary, Z. Y and Z are engaged in business operations in Country A and A is also the jurisdiction where management is sitused for both Y (foreign sub) and Z (domestic organized sub). Under the laws of Country A, Z is a dual resident corporation and its worldwide income is subject to tax in the U.S. and Country A. Both FS and DS conduct most of their business in Country X. Country X is also the place of effective management for both FS and DS. Under the laws of Country X, DS is a domestic resident and is taxable by Country X on its worldwide income. Thus, DS is a dual resident corporation, whose worldwide income is subject to tax in both the United States and Country X. In 2011, X has taxable income of $100M, Y has taxable income of $100M and Z has losses from operations of $100M. Country A’s tax law permits Z (domestic sub) loss of $100M to reduce Y (foreign sub) income of $100M to eliminate any tax owed to Country A. Under §§1503(d) and 1503(d)(2), domestic sub Z’s $100M net operating loss constitutes a “dual consolidated loss” and therefore such loss can not be used to reduce X’s income of $100M for U.S. income tax purposes. Y(foreign sub) can not join in the filing of a consolidated return with X since it is a foreign corporation. The consolidated taxable income of X and Y for the taxable year is $100.

For U.S. income tax purposes, Z (domestic sub)  has a $100M dual consolidated loss carryover which loss may be used to offset DS's future income which it realizes. This loss may not, however, offset the income of X or any other member of the affiliated group (except Z) in any future year. future year.

The disallowance rule  contained in §1503(d) applies only to a dual consolidated loss incurred by a “domestic corporation”. See §§7701(a)(3), 7701(a)(4). The term also includes “any corporation treated as a domestic corporation by the Internal Revenue Code.” See, e.g., §269B which may result in treating a foreign corporation as a domestic corporation if the foreign corporation and any domestic corporation are “stapled entities.”    It may also include a Canadian or Mexican corporation treated as domestic per §1504(d).  It is further important to recognize that under the regulations, a  “separate unit” or “branch” of a domestic corporation may be treated as a separate domestic corporation (and as a dual resident corporation) for purposes of §1503(d). See Treas. Reg. §1.367(a)-6T(g)(1). The regulations define “separate unit” as including an interest in a partnership, a trust, a foreign branch or an interest in an entity that is not taxable for U.S. corporation for U.S. purposes, but is subject to tax in a foreign country as a corporation either on its worldwide income or on a residence basis. This last category of a “separate unit” applies to a “hybrid entity separate unit” owned directly or indirectly by a domestic corporation.  A domestic reverse hybrid is not treated as a dual resident corporation.

Exceptions to Dual Consolidated Loss Rule.

If a foreign business operation is not a “permanent establishment” for treaty purposes or is not taxed on a net basis, it is not a separate unit provided the business is not carried on directly or indirectly by a hybrid or transparent entity. Treas. Regs. §§ 1.1503(d)-1(b)(4)(iii), 1.1503(d)-7(c). Other special rules are provided in the regulations.

Under section 1503(d)(2) and accompanying reulgations, section 1503(d) will not apply to a net operating loss, which, under the foreign income tax law, does not offset the income of any foreign corporation. In other words a “dual consolidated loss” does not include a net operating loss realized in a foreign country where such country’s income tax laws: (i) do not permit the dual resident corporation to use its losses to offset any other person's income that is recognized in the same taxable year; and (ii) do not permit the losses of the dual resident corporation to be carried over or back to offset the income of any other person in any other taxable years.

SRLY Treatment.  Generally, i.e., except as provided in Treas. Reg. §1.1503(d)-6, the domestic use of dual consolidated loss is not allowed except to offset, directly or indirectly, the income of a domestic affiliate (other than the dual resident corporation or separate unit which realized the loss) in the taxable year of the dual consolidated loss or any other year or when the dual consolidate loss is included in the computation of consolidated taxable income or the income of an unaffiliated owner. Where in a particular year in which a separate unit or dual resident corporation realizes a dual consolidated loss, such loss consists of a pro rata portion of each item of deduction and loss which is taken into account in computing the dual consolidated loss.

The dual consolidated loss is treated as incurred in a separate return limitation year (“SRLY”) by the dual resident corporation or separate unit. See Treas. Reg. §1.1502-21(c). It generally is eliminated in a §381 transaction except for Type F reorganizations involving a domestic corporation as the surviving entity. The SRLY limitation on remains in effect even after the loss corporation ceases to be a DRC. Other special rules apply.

Overall, this is a complex provision and requires much thought and evaluation in advising corporate clients engaged in domestic and international business operations.

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In Russian Recovery Fund, Ltd., 108 AFTR2d ¶2011-5494, the  Court of Federal Claims ruled that the Internal Revenue Service may proceed with a collection action against a partner in a lower-tier partnership or “indirect partner” provided such partner’s return was filed within three years of the issuance of a final partnership administrative adjustment (FPAA) to the upper-tier partnership with respect to partnership level items that were adjusted. The tax items finally resolved in the FPAA to the upper-tier partnership directly impacted on the tax liability of the lower-tier partner. The Court further held that the Internal Revenue Service was not allowed to proceed with collection action against an “indirect partner” who filed his individual return more than three years before the issuance of the final partnership administrative adjustment. 

In accordance with the entity level audit rules enacted into law as part of the Tax Equity and Fiscal Responsibility Act (“TEFRA”), 26 U.S.C. §§ 6221–6233 (2006), the case filed in this action is a petition for readjustment of partnership items brought under 26 U.S.C. § 6226(a) by Russian Recovery Advisors, LLC (“RRA”) as the tax matters partner for Russian Recovery Fund, LTD (“RRF”). Plaintiffs allege, inter alia, that the Internal Revenue Service's (“IRS”) issuance of a FPAA for the tax year ending December 31, 2000, was untimely and therefore invalid, and that the representative partners' 2000 and 2001 tax years are closed for adjustment and assessment. The Court of Federal Claims had previously held in this case it was improper for an FPAA to adjust an individual partner’s amount at-risk based on its distributive share of non-recourse partnership liabilities and that the remedy for improper adjustment of a non-partnership item set forth in an FPAA does not invalidate the FPAA. See Russian Recovery Fund Ltd. v. United States, 81 Fed. Cl. 793 (2008).

Entity Audit Rules under TEFRA

As announced by TEFRA, under the partnership audit rules, the tax treatment of any partnership item, including the applicability of any penalty, addition to tax or additional amount which relates to an adjustment to a partnership item, is generally determined at the partnership level. §6221. Where the Internal Revenue Services wants to adjust any  “partnership items,” it must notify the individual partners through issuing an FPAA. §6226. See also §§6229, 6501. For period of 90 days after the FPAA is issued, the tax matters partner of the entity level partnership (or LLC) has the exclusive right to  file a petition for readjustment of the partnership items in the Tax Court, the Court of Federal Claims, or a U.S. District Court. §6226(a). After this 90 exclusivity period expires, the other partners (members) are granted an additional period of 60 days to file a petition for readjustment. §6226(b)(1).  Any partner (member) whose individual tax liability might be affected by the outcome of the litigation of partnership items may participate in the proceeding. §6224. The Internal Revenue Service may assess additional tax liability against individual partners within one year of the final conclusion of the partnership's tax determination. §6229(d). A partner may challenge the tax liability so determined by paying the assessment and filing a refund suit in the Court of Federal Claims for example. The partner is prohibited from brining an action for a refund attributable to partnership items. See §7422(h).

Statutes of Limitation: Assessment of Income Tax

It is universally acknowledged that the general statutory period of limitations for the assessment of income tax may not be made more than three years after the later of the date the tax return was filed or the due date of the tax return. §6501(a). Subject to exceptions and special rules, similarly the period for assessing tax attributable to a partnership item (or affected item), for a partnership tax year won't expire before the date that is three years after the later of: (1) the date the partnership return was filed, or (2) the last day for filing the return for that year (without regard to extensions). §6229(a).

As the tax matters partner for the Russian Recovery Fund, LTD (“RRF”), Russian Recovery Advisors, LLC. (“RRA”), filed a petition with the U.S. Court of Federal Claims for readjustment of partnership items per §6226(a). It challenged the IRS on the basis that the FPAA that the Service issued on 10/15/2005 for the tax year ending 12/31/2000 was issued beyond the permitted statute of limitations and was invalid as it affected an indirect partner who had filed a return more than three years before the FPAA.  Accordingly, the Court of Federal Claims previously held it improper for an FPAA to adjust an individual partner's amount at-risk in its distributive share of nonrecourse partnership liabilities as part of such FPAA. A deposit issue was also involved. See §6226(e). RRF was a limited partnership of ten partners that specialized in distressed asset transactions. Two of its partners were RRA and FFIP, LP (FFIP).

RRF filed its 2000 income tax return on Aug. 14, 2001. In the 2000 tax year, RRF allocated $46,424,782 of net section 988 (foreign currency)  losses to FFIP. On Oct. 14, 2005, the Service  issued an FPAA to RRF for the 2000 tax year, proposing adjustments to RRF partnership items. In the 2000 FPAA, IRS proposed to characterize this $46,424,782 disallowed the entire claimed losses which were allocated to FFIP.

FFIP, a partner of RRF, and also a pass thru entity, filed its own 2000 partnership tax return on or before August 16, 2001. After netting the losses it received from RRF with its own losses, FFIP reported $4,205,838 in losses for the 2000 tax year and $25,272,185 in losses for the 2001 tax year. The original $46.4 million in foreign currency section 988 losses that were allocated from RRF make up a large portion of both of these loss figures.

Nancy Zimmerman was an indirect partner of RRF through FFIP. She filed her 2001 return on Oct. 15, 2002, which was less than three years before the FPAA was issued. She filed her 200 income tax return more than 3 years before the issuance of the 2000 FPAA to RRF.  James DiBiase was an indirect partner of RRF through FFIP. He filed his 2001 and 2000 returns more than three years before the FPAA.

On May 10, 2005, FFIP, through its TMP, entered into an extension agreement with the IRS on Form 872-P, Consent to Extend the Time to Assess Tax Attributable to Partnership. The extension effectively allowed the Service to assess additional federal income tax attributable to the partnership items of FFIP against any partner for the period ending December 31, 2001 through August 31, 2006. Beginning in 2005, the Service audited  FFIP's 2001 partnership return including a detailed review of RRF's net section 988 losses reported on FFIP's 2001 tax return. The IRS completed the review of FFIP's 2001 partnership return and issued a “no adjustments” letter to FFIP. This extension allowed IRS to assess any federal income tax attributable to the partnership items of FFIP against any partner for the period(s) ended Dec. 31, 2001 at any time on or before Aug. 31, 2006.

Conclusions of the Court

After setting forth a detailed analysis of the facts and the law on each issue that was the subject of cross motions for summary judgment, the Court of Federal Claims reached several conclusions.  

1. Statute of Limitations Affirmative Defense Raised by Indirect Partners. The IRS asserted that RRA, as TMP to RRF, lacked standing to assert the statute of limitations defense on behalf of indirect partners. The Court of Federal Claims held that §6226 permits partners other than the tax matters partner to raise the statute of limitation defense and yet such  in no way prevents the TMP from raising the defense of their behalf.  See, e.g., AD Global Fund, LLC. v. United States, 481 F.3d 1351 (Fed. Cir 2007); Blak Invs. v. Comm'r, 133 T.C. 431 (2009). It is noted in the Court’s analysis that when a partner attempts to raise the statute of limitations defense at a partner level proceeding, it is foreclosed because the defense must be raised in the partnership level proceeding. Prati v. United States, 603 F.3d 1301, 1307 (Fed. Cir. 2010);Chimblo v. Comm'r , 177 F.3d 119, 125 [83 AFTR 2d 99-2610] (2nd Cir. 1998).

In Keener v. United States, 551 F.3d 1358 (Fed. Cir. 2009), the Federal Circuit held that the subject of a statute of limitations defense is appropriately viewed as a partnership item and handled in a partnership proceeding as opposed to a partner-level proceeding. Section 6221 provides that “[e]xcept as otherwise provided in this subchapter, the tax treatment of any partnership item ... shall be determined at the partnership level.” 26 U.S.C. § 6221 (2006). The Court of Federal Claims read  Keener and section 6221 together to mean that it is necessary for a statute of limitations defense, as a partnership item, to be raised in the partnership-level proceeding. See §6226(d)(1)(B).  Thus, while the statute allows partners other than the tax matters partner to raise a statute of limitations defense, it does not prevent the tax matters partner from raising the defense on their behalf.

2. One Year Rule Under Section 6229(d). RRA contended that due to the running of the statutes of limitation under §§6229 and 6501, summary judgment should be granted to the petitioners since the FPAA in this case was issued more than 3 years after RRF filed its 2000 return FPAA. In accordance with §6229(d) the statute of limitation for assessing RRF’s (indirect partner) 2001 return for “any tax imposed . . . which is attributable to any partnership item (or affected item) for a partnership taxable year,” was suspended until one year after the Court's final decision. The  RRA argued that the Service could only have assessed the losses on RRA’s 2001 return by issuing an FPAA to FFIP for the 2001 tax year. The Service argued that such losses must be adjusted at their source, RRF, not at FFIP, a second-tier partnership. The Court said that IRS could have issued an FPAA to FFIP, but to adjust the losses, an FPAA had to be issued at their source (RRF). The issuance of the FPAA to RRF had the effect of disallowing the foreign currency section 988 losses in 2000. The Court then held that the losses reflected on Nancy Zimmerman’s  2001 individual return were “attributable to” the disallowed RRF 2000 losses.

3. Assessment Against Lower Tier Partner  Permitted.

The Court therefore concluded that RRF loss adjustments arising from the 2005 FPAA could result in the assessment of income taxes as to Zimmerman’s tax liability for 2001. Under §6229(d), the issuance of the FPAA to RRF on October 14, 2005 suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. Simply put, this means that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was  still open for assessment. Plaintiffs argue that the IRS could only have assessed the losses on Ms. Zimmerman's 2001 return by issuing an FPAA to FFIP for the 2001 tax year. Defendant responds that the losses must be adjusted at their source, RRF, not at FFIP, a second tier partnership. The question, therefore, is whether after FFIP carried the losses forward into 2001, they ceased to be RRF partnership items and moved beyond the reach of an RRF partnership proceeding.

The Service is permitted to issued multiple FPAAs in tiered partnerships. Since RRF was the source of the losses reported and allocated to FFIP, also a pass through entity, the issuance of an FPAA to the lower tier partnership, i.e., FFIP, would be inappropriate for disallowing the RRF losses. See Sente Investment Club Partnership v. Commissioner, 95 T.C. 243 (1990); Kligfield Holdings v. Commissioner, 128 T.C. 192, 202 (2007)(FPAA issued to adjust partnership items in a closed year in order to assess a deficiency in a partner's later year return). See also §6231(a)(6). from the source down to the indirect partners in order to consider whether individual partners owe any tax. Under TEFRA, losses must be disallowed at their point of origin.

The Court found the Plaintiffs' argument for the issuance of multiple FPAAs unconvincing. The IRS could have issued an FPAA to FFIP, but to adjust the §988 losses, an FPAA had to be issued at their source, which was RRF.   The issuance of the FPAA to RRF had the effect of disallowing the section 988 losses in 2000. The issuance of the FPAA to RRF on October 14, 2005, suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. This meant that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was, in the view of the Court, still open for assessment (but under the facts of the case, not for Ms. Zimmerman’s 2000 tax return). It does not matter if the disallowed losses are also FFIP partnership items in 2001 because that fact does not prevent the FPAA from disallowing the losses at the RRF origination point and then assessing Ms. Zimmerman's 2001 tax return through a computational adjustment. The Court held that the FPAA issued to RRF in 2000 validly suspended the limitation period for assessing Ms. Zimmerman's 2001 individual tax return relating to partnership tax items involving the upper-tiered partnership.

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Under 26 USC §897, which was adopted into law as part of the Foreign Investment in Real Property Tax Act (“FIRPTA”) in 1980, gain realized by a foreign person with respect to the disposition of  an interest in US real property (“USRPI”) is characterized as income effectively connected with the conduct of a U.S. trade or business and subjects the foreign person to U.S. income tax on the net income derived from such gain at normal U.S. income tax rates. In general, under §1445 a purchaser of a USRPI from a foreign person is required to withhold a tax equal to 10% of the amount realized (generally gross purchase price). §1445(c); Treas. Reg. §1.1445-1(a). See also §6039C.     

The person in control of the payment, usually the buyer, or the closing agent, is required to deduct and withhold such portion of the payment and pay it over to the IRS. The required withholding must be remitted to the IRS within 20 days. The foreign transferor must report the gain, e.g., for a non-resident by filing a U.S. income tax return on Form 1040NR, on which withheld amounts are credited against the liability. The law also permits individuals to reduce or eliminate the required withholding by obtaining prior to closing an exemption certificate from the IRS or submit a U.S. resident certificate (under penalty of perjury) containing the seller’s identification number and that the transferor is not a foreign person to the buyer or closing agent. If the transferee or other person required to withhold the §1445 tax fails to withhold or pay over the amount withheld, that person is liable for the tax required to be withheld, plus interest and potential penalties (to the extent that the transferor's tax liability on the transfer is not otherwise paid). §1461; Treas. Reg. §1.1445-1(e)(1).

A USRPI is an interest in real property located in the U.S. or the U.S. Virgin Islands and any interest (other than solely as a creditor) in a domestic corporation that is a U.S. real property holding corporation (USRPHC). §897(c)(1)(A). For this purpose “real property” includes land and unservered natural products of land such as minerals, oil and gas deposits, unharvested crops and uncut timber, buildings and permanent structures. Also included within the term “real property” is personal property associated with the use of such real property such as equipment used in farming, construction, forestry or mining, property used in lodging places or rented office space.

Under §897(c)(2), a USRPI also includes any  the stock of any corporation if the FMV of its USRPIs equals or is greater than 50% of the FMV of its USRPIs, its interests in real property situated outside of the US and including any other of its assets used in a trade or business. 

A USRPHC, i.e., US real property holding corporation, does not include any class of stock of a corporation which is regularly traded on an established securities market unless a foreign person who during the preceding 5 year period held more than 5% of such class of stock. Stocks in U.S. corporation are presumed to be USRPI unless it can be established otherwise. Taxpayers seeking to rebut this presumption must affirmatively certify that the stock is not USRPI no later than the date of the disposition.

Under §897(c)(4) in determining whether a USRPHC exists, a foreign corporation holding USRPIs is treated as a a domestic corporation (§897(c)(4)(A)) and under regulations assets held by a partnership, trust or estate are treated as held proportionately by its partners or beneficiaries. See §897(c)(4)(B). Under §897(c)(5)(A), under regulations, if any corporation holds 50% or more of the FMV of all classes of stock of a second corporation, then for purposes of determining whether the corporation is a USRPHC, the first corporation is treated as owning a portion of each asset of the controlled corporation equal to the percentage of the second corporation represented by the stock held by the first corporation.

Under §897(d)(1) a foreign corporation may be required to recognize gain on the distribution of a USRPI subject to an exception provided under §897(d)(2). Furthermore, §897(j) requires that a nonresident alien individual or a foreign corporation recognize gain on the contribution of a USRPI to a foreign corporation. The treatment of transfers of USRPIs and stock of a USRPHC in what otherwise would be treated as a nonrecognition transaction is set forth in §897(e). Section 897(e)(1) for starters explains that it overrides all the nonrecognition provisions set forth in the Code, at least in the absence of a specific exception. Therefore §897(e)(1) applies to an exchange of a USRPI for an interest the sale of which would be subject to tax. Under §897(d)(2) a foreign corporation may avoid gain recognition with respect to the distribution of a USRPI in certain instances such as under §337. Where §§897(e) and 897(d) are in conflict or overlap, §897(e)(1) requires that §897(d) control. In general, §897 will override any contrary treaty provision. But see Temp. Regs. §§1.897-5T(d)(2), 1.897-6T(a)(9).

As an illustration of the potential reach of §897 is with respect to transactions that would otherwise be entitled to nonrecognition treatment. See §§897(d), 897(e). Suppose FC, a foreign corporation sells shares of stock in a U.S. corporation which is not a USRPC. Nevertheless, the purchaser of the share would be required to withhold and remit to the IRS 10% of the gross sales price within 20 day of the closing. Then FC would be required to file a U.S. income tax return for the year of sale, report the gain, and pay the tax due, if any, with a credit for the amount withheld or apply for a refund. See §881(a). Alternatively, withholding could be avoided if prior to the date of sale the US corporation provided a certificate of non-USRPHC (based on the lack of USRPIs) to the seller and a copy is provided to the purchaser. Then after the closing, the U.S. corporation is required to provide the IRS with a notice of non-USRPI status and a copy of the statement of non-USRPI status within 30 days of providing the statement of non-USRPI status to the seller. 

To avoid the withholding, the seller could request a statement of non-USRPI status from U.S. Corp. no later than the date of the sale. Before that date, U.S. Corp. must provide the statement of non-U.S.RPI status to the seller and a copy must be provided to the buyer. Subsequently, U.S. Corp. must provide the IRS with a notice of non-USRPI status (i.e. a cover letter explaining non-USRPI status) and a copy of the statement of non-USRPI status within 30 days of providing the statement of non-USRPI to the seller.

Another illustration is also involves a U.S. corporation (USCorp1) which has no USRPIs. USCorp1 is owned 100% by FC which transfers its stock in USCorp1 to another wholly owned U.S. subsidiary USCorp2 as part of a non-taxable §351 transaction. In this case §351 will be overridden by the FIRPTA and USCorp2 would be required to withhold and remit to the IRS 10% of the FMV of USCorp1 on a timely basis unless the necessary exemption certificates were obtained and provided to USCorp2 prior to the transfer. See Treas. Reg. §1.897-6T(a)(3).

The regulations provide for an exception. In this regard, Treas. Reg. §1.897-6T(a)(1) provides that any nonrecognition provision , i.e., §351, shall apply to a transfer by a foreign person of a USRPI on which gain is realized only to the extent that the transferred property would be subject to U.S. taxation upon its disposition and the transferor complies with certain filing requirements. Treas. Reg. §1.897-5T. This exception is referred to as the “USRPI for USRPI” rule. The rationale for the exception is that the transferor would be subject to US income tax on the interest it receives back in the exchange, i.e., the US corporation is a USRPHC. See Treas. Regs. §§1.1445-2(d)(2)(iii); Temp. Reg. §1.897-5T(d)(1)(iii).

This is a short summary of the FIRPTA provisions which are quite detailed and complex. In certain instances, transactions which may look as falling outside of FIRPTA are clearly subject to its application. The up-swing in foreign investment in USRPI should spark renewed interest by the IRS in auditing taxpayers subject to these rules.

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A recent technical interpretation issued by the Canada Revenue Agency, Technical Interpretation 2011-0393411E5, provides that under Article XV of the Canada-U.S. Income Tax Convention, that after 2008, when a U.S. resident employee of a Canadian resident corporation acquires shares of the corporation on the exercise of employee stock options, the Canada Revenue Agency (CRA) would disallow that the income from the taxable amount would qualify for exemption from Canadian income tax under the Canada-U.S. Tax Treaty, even if the employer was not present in Canada for more than 183 days. The rationale of the CRA is that the income realized from the exercise of the Canadian stock option was "paid" to the employee by the Canadian resident corporation in applying Article XV(2)(b) of the Treaty.

Under the Canadian tax law, in general, the fair market value of the share of stock acquired by exercise of a compensatory stock option in excess of the amount paid to acquire the option is treated as income from employment. This is essentially the same result that is produced under Section 83 of the Internal Revenue Code and in particular, in accordance with Treas. Reg. §1.83-7 (non-qualified stock options not having a readily ascertainable fair market value on grant). ITA, ¶7(1). The basis of the acquired shares, referred to as the "adjusted cost base", is equal to the amount paid for the option, plus the strike price and the excess of the value of the shares acquired over the employees’s cost basis to acquire the stock. ITA, ¶53(1)(j). With respect to a nonresident employee, the spread between the value of the stock acquired by exercise of a compensatory option must be related to services rendered or performed of an employment in Canada. ITA ¶¶115, 2(3)(a). Unlike the deduction reported by the employer-issuer under IRC §83(h), in Canada the issuing corporation is not permitted to deduction the amount of the compensatory element of the exercised employment option. ITA, ¶7(3)(b).

Article XVof the Treaty provides:

The language under Article XV is fairly clear and unambiguous. Generally, income from services received by a resident of the U.S., for example, is not taxable in Canada unless the employment is exercised in Canada and then is taxable in Canada to the extent so derived. So much for XV(1). Then in XV(2) , and in particular, XV(2)(b), income for services rendered by a U.S. resident for employment exercised in Canada is only taxable in the U.S. where the service provider is present in Canada for a period(s) of time not exceeding 183 days for a 12 month period commencing or ending in the relevant fiscal year and the compensation is not paid by, or on behalf of a person who is a resident of Canada and is not economically borne by a permanent establishment of a nonresident employer situated in Canada.

The question present in the newly issued TI was whether the position the CRA previously took in TI 2002-0126537, was still the position of the CRA in light of the fifth protocol to the Treaty that was signed and entered into force in 2008 with respect to Article XV(2)(b). In Technical Interpretation 2002-0126537 the CRA opined that a resident U.S. for the purposes of the treaty who was employed in Canada for the purposes of the ITA and earned income from that employment under section 7 of the ITA would not be subject to Canadian tax on that income by virtue of Article XV(2)(b) of the treaty if: (1) the resident was not present in Canada for more than 183 days in the tax year; and (2) the stock option benefit was not available to the employer as a deduction in computing taxable income of either a Canadian resident employer or the permanent establishment of a nonresident employer.

In Technical Interpretation 2011-0393411E5, the CRA revised its position from the position taken in 2002. In particular, the CRA opined that under the new provision, the compensatory element of the exercise of a stock option realized by a U.S. resident that is included in the employee’s income under the Canadian ITA for a tax year beginning on or after January 1, 2009, as income from an office or employment will be exempt from tax in Canada per Article XV(2)(b) provided: (i) the U.S. resident is not present in Canada for more than 183 days in any 12-month period commencing or ending in the particular tax year; (ii) the stock option remuneration is not paid by, or on behalf of, a person who is a resident of Canada under the treaty; and (iii) the stock option remuneration is not borne by a permanent establishment in Canada. Remuneration is borne by a permanent establishment in Canada if the compensatory element is deductible in the computation of income attributable to the permanent establishment under Canadian ITA. Stock option compensation derived by a U.s. resident is not exempt under the Treaty where it is paid by, or on behalf of, a resident of Canada even where the compensatory element is not deducting in computing the income of the Canadian resident employer.

What seems to be controversial about the CRA’s position is that in light of the Fifth Protocol to the Treaty (2008), when a U.S. resident employee of a Canadian resident corporation acquires shares of the corporation on the exercise of employee stock options, the CRA would deny an exemption from Canadian tax under the treaty, even if the employer was not present in Canada for more than 183 days, since the amount of any resulting stock option remuneration will be paid to the United States-resident employee by the Canadian-resident corporation for the purposes of Article XV(2)(b). This result may produce discontinuities in the cross-border treatment of non-qualified stock options (NQSOs) and incentive stock options (ISOs). This is due to the fact that as to incentive stock options, the bargain element on exercise is not included in taxable income for regular tax purposes only for alternative minimum tax purposes. Instead, capital gain is realized when the stock is sold provided the sale occurs more than 2 years after the date of grant or 1 year after exercise. IRC §421(a)(1).

It is certain that this new TI issued by the CRA will generate some controversy and that the issue will ultimately by posited with the Canadian tax courts for review and interpretation.

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