Thanks to Steve Suarez and Stephanie Wong with Borden Ladner Gervais LLP in Toronto who assembled the commentary which was published in Tax Notes International. I will only list in bullet form those developments in Canada that they highlighted. This Blog has previously featured tax developments in Canada from time to time.

Legislative Developments

l Effective January 1, 2011,  proposed amendments were made to the REIT rules to permit exemption from corporate income tax for qualifying flow through entities.

l Prposed amendments to eliminate the tax advantages of stapled securities (debt and equity securities "stapled" together), which will affect arrangements previously implemented by some corporations and REITs to avoid the specified investment flow-through tax.

l On March 16 the government announced draft legislative proposals in response to three Federal Court of Appeal decisions, including Collins v. The Queen (regarding reducible expenses) and Lehigh Cement Limited v. The Queen (regarding nonresident interest withholding tax).

l Proposed new business tax provisions as part of 2011 federal budget; including elimination of a corporation’s ability to defer taxation through a partnership with different fiscal year ends from that of the corporation (See IRC §§444 and 7519); reduction in tax incentives for Canadian oil shale expenditures; and the amendment or extension of various rules regarding flow-through shares.

l Outbound proposals for foreign affiliates of Canadian taxpayers. Includes provision for new upstream loan rules and “hybrid surplus” regime.

l Technical corrections provisions released, including proposals to expand the application of the shareholder benefit and debt rules to address partnerships and issues arising from foreign spinoffs, and to amend rules regarding the recognition of capital losses by Canadian beneficiaries of nonresident trusts and the treatment of nonresidents with Canadian service providers.

l Reportable transactions. Under the mandatory reporting regime for aggressive tax avoidance transactions, which was proposed in August 27, 2010, draft legislation, a reportable transaction entered into after 2010 (or that is part of a series of transactions that began before 2011 but is completed after 2010) must be reported by June 30 of the year after it first became a reportable transaction.

l Nine TIEA Agreements Executed. Canada's first nine tax information exchange agreements were entered into force (with the Netherlands Antilles, the Cayman Islands, Bahamas, Bermuda, St. Kitts and Nevis, St. Vincent and the Grenadines, Anguilla, San Marino, and the Turks and Caicos Islands). Canada also signed a protocol updating its 1980 income tax convention with Barbados to make it more consistent with current Canadian and international tax treaty policies.

Court Decisions

lTransfer Pricing. The Federal Court of Appeal upheld the Tax Court of Canada's decision in The Queen v. General Electric Capital Canada Inc. Guarantee fees the taxpayer paid to its indirect U.S. parent satisfied the arm's-length standard in Canada's transfer pricing rules. The Crown did not appeal.

In Alberta Printed Circuits Ltd. v. The Queen, the Tax Court substantially upheld the fees paid by the taxpayer to a non-arm's-length Barbadian corporation as representing arm's-length prices

lGeneral Antiavoidance Rule or “GAAR”.

The SCC heard the appeal of Copthorne Holdings Ltd. v. The Queen in January 2011 pertaiing to the proper computation of a corporation's paid-up capital following a horizontal reorganization. The SCC's decision remains pending.

The SCC granted the taxpayer in Garron Family Trust (Trustee of) v. The Queen leave to appeal the lower courts' decision, which applied a central management and control test to determine that a Barbadian trust was resident in Canada for tax purposes.

The Tax Court considered three artificial loss cases in which a series of transactions were implemented to generate a capital loss to offset a previously realized capital gain.

The general antiavoidance rule was applied in Triad Gestco Ltd. v. The Queen and 1207192 Ontario Limited v. The Queen for different reasons, while the GAAR was not applied in Global Equity Fund Ltd. v. The Queen. All three cases are being appealed.

Other Court Decisions

In Imperial Tobacco Canada Ltd. v. The Queen, the Federal Court of Appeal upheld the Tax Court's decision denying the taxpayer a deduction for employee stock option surrender payments made during its takeover, as the payments were capital outlays.

The Tax Court rejected the government's first challenge of so-called foreign tax credit generator arrangements in 4145356 Canada Limited v. The Queen.

In Sommerer v. The Queen (under appeal), the Tax Court found that a trust relationship existed and held that gains realized by a nonresident trust were exempt from Canadian taxation under the treaty and could not be attributed to the person who sold the property to the trust.

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On December 19, 2011, the Service issued final regulations (T.D. 9563) with respect to foreign base company sales income under §954(d) for situations involving the sale of personal property by a corporation foreign corporation (CFC) which is purchased, sold, manufactured, produced, grown, extracted, or constructed by one or more branches of the CFC. The final regulations adopt, for the most part, the set of proposed regulations that were issued on the same subject in 2008 and that were followed up with temporary regulations which were to expire on December 23.  The final regulations apply to tax years of CFCs commencing after June 30, 2009 and for tax years of U.S. shareholders in which the tax years of the CFCs end. The good news is that the final regulations only make minor modifications to the expiring temporary regulations in this area.

Under §954(d)(1), foreign based company sales income (FBCSI), which goes into the calculation of Subpart F income, means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where— (A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and (B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country. For purposes of this subsection, personal property does not include agricultural commodities which are not grown in the United States in commercially marketable quantities.

A special branch rule is contained in §954(d)(2) for CFCs which have a branch located outside of their country of incorporation. It applies where the CFC is engaged in purchasing, selling, manufacturing, producing, constructing, growing or extracting activities by or through the branch, and the carrying on of such activities has substantially the same effect were the branch a wholly subsidiary of the CFC. As a result, the branch and the CFC will be treated as separate corporations for purposes of determining the FBCSI of the CFC.

The "substantially same tax effect" determination is made pursuant to a tax rate disparity test set forth in Treas. Reg. § 1.954-3(b)(1)(i)(b) and  Treas. Reg. § 1.954-3(b)(1)(ii)(b). With respect to a sales or purchase branch, the tax rate disparity test requires comparing the rate of tax imposed on the income derived from the purchasing or selling activities of the branch with the rate of tax that would apply if the income were earned by the remainder of the CFC. With respect to a manufacturing branch, the tax rate disparity test is applied by comparing the rate of tax imposed on the income derived from the purchasing and selling activities of the CFC with the rate of tax that would apply to such income under the laws of the country in which the manufacturing branch is located.

These final regulations provide guidance on the application of the branch rule, in particular with respect to a CFC that has multiple branches. For example, the regulations set forth rules on how to determine whether a CFC earns FBCSI if purchase and sales activities are conducted by multiple branches and if multiple branches are involved in the manufacture of either a single or multiple items of personal property that is sold by the CFC. The final regulations, in changing the temporary regulations, omit the word “demonstrably” in determining whether the tested manufacturing location or tested sales located provided a greater contribution instead of a “demonstrably greater contribution”.

1. Demonstrably greater contribution . Treas. Reg. § .954-3T(b)(1)(ii)(c)(3)(iii) provides that if none of the branches or the remainder of a CFC independently satisfies the substantial contribution test, but the CFC as a whole made a substantial contribution, then for purposes of applying the tax rate disparity test, the location of manufacture, production or construction is the "tested manufacturing location" unless the "tested sales location" provided a "demonstrably greater" contribution. uncertainty, the word "demonstrably" has been deleted from § 1.954-3(b)(1)(ii)(c)(3)(iii).

2. Grouping of branches . Treas. Reg. § 1.954-3T(b)(2)(ii)(a) provides, in general, that for the grouping of branches which do not have tax rate disparity with a purchasing or selling branch, or with the remainder of the CFC treated as purchasing or selling on behalf of a manufacturing branch. This grouping rule applies for purposes of  Treas. Reg. § 1.954-3T(b)(2)(ii), which sets forth the rules that apply after it has been determined that a branch and the remainder of a CFC will be treated as separate corporations. The rules in Treas. Reg. § 1.954-3T(b)(2)(ii) allow a CFC to aggregate the activities of branches that do not have tax rate disparity with a sales or purchasing branch (or remainder) when applying the separate corporation analysis to determine whether the sales income of the sales or purchase branch (or remainder) is FBCSI. § 1.954-3(b)(1)(ii)(c)(3)(v), Example 1.  This change to add the phrase “the activities of” to Treas. Reg. §1.954-3(b)(2)(ii)(a) was made to clarify that the grouping rule for branches that don’t have tax rate disparities between manufacturing and sales locations applies only to the activities and not the income of the branches.

C. Deletion of  Treas. Reg. § 1.954-3(b)(2)(ii)(d)  The final regulations delete paragraph (d) of Treas. Reg. § 1.954-3(b)(2)(ii), which provided that income that is FBCSI as a result of the application of Treas. Reg. § 1.954-3(b)(1)(i) (purchasing or selling branch rules) is not again classified as FBCSI as a result of the application of Treas. Reg. § 1.954-3(b)(1)(ii) (manufacturing branch rules). This change was made because it was redundant.

D. Future Guidance .The IRS and the Treasury Department announced it would continue to study additional FBCSI issues, and are considering whether to issue additional guidance, including guidance regarding when a branch should be treated as a separate corporation under  §954(d)(2), and the scope of, and relationship between, FBCSI and foreign base company services income. Perhaps some may think that the guidance would extend to Treasury’s adding a definition of a “branch” for this purpose.

The final regulations for §954(d), contract manufacturing, for controlled foreign base company sales income included in Subpart F under the so-called branch rules, made relatively minor changes to previously issued temporary regulations that were to expire on December 23. Thus, some relief is in order that the final regulations did not take on new broad paths. Commentary on the final regulations welcomed however the change of the phrase “demonstrably greater” with using simply “greater” for purposes of Treas. Reg. §1.954-3(b)(1)(ii)(c)(3)(iii). There was concern that the additional word could be viewed by the courts as increasing the taxpayer’s burden of proof.

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Potential Penalties Applicable to Dual U.S. Citizens and Residents

The federal government has known for some time that taxpayers who are dual citizens or dual residents of the United States and another country may have knowingly or innocently failed to timely file U.S. federal income tax returns. This would occur, for example, where a U.S. citizen lived outside of the United States for an extended period of time without having formally expatriated both for U.S. immigration and tax law purposes. Such individuals may therefore have failed to file annual U.S. income tax returns, including quarterly estimated tax returns (and payments), and timely paid U.S. income taxes due, net after application of the foreign tax credit rules, other provisions in the Internal Revenue Code resulting in a reduction of U.S. income tax or by application of a pertinent income tax treaty or convention. The same problems could also arise with dual residents who, despite thinking they could be advantaged by a favorable tie-breaker provision in an applicable treaty, would still be accountable to file FBAR and other ownership disclosure forms despite holding a belief, in good faith, that they were “non-resident” for all purposes.

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U.S. Income Tax Treatment of Personal Service Income or Royalty Income of a Non-resident

Non-residents of the U.S. are subject to U.S. income tax on U.S. source fixed and determinable annual or periodic income, as described in Section 871(a), which income, subject to treaty override, is subject to a flat 30% tax rate without deductions. Such persons are further subject to U.S. income taxation on a “net” basis and at graduated rates with respect to income derived from the carrying on of a U.S. trade or business under Section 864(b).  As applied to a non-resident, professional athlete, engaging in a U.S. trade or business includes any  business activity in the United States that involves one's own physical presence. Treas. Reg. §1.864-2.  It is clear that earnings derived from Goosen’s playing in golf tournaments in the U.S. is income from carrying on a U.S. trade or business. On the other hand, U.S. source income from royalties is generally treated as fixed and determinable annual or period income (“FDAP”). Royalty income paid for the right to use intangible property generally is sourced where the property is used or is granted the privilege of being used. § 861(a)(4). Neither foreign source royalty income nor foreign source personal services income is subject to U.S. tax unless it is related to the conduct of a U.S. trade or business.

Petitioner Retief Goosen

This case involved Retief Goosen, the 2001 & 2004 U.S. Open Champion and considered by many to be one of the leading golfers in the world. His official website, www.retiefgoosen.com, highlights his many achievements in professional and amateur golf. 

IRS Issues Notice of Deficiency Issued Against Mr. Goosen for 2002 and 2003

Goosen’s U.S. income tax liability with respect to his U.S. source income for 2002 and 2003 was the subject of a challenge by the IRS and led to a decision by the Tax Court, J. Kroupa, finding for the Petitioner in part and for the Commissioner in part.  At the time the Tax Court Petition was filed, Goosen was a citizen of South Africa but a tax resident of the United Kingdom. His wife is a U.K. citizen and resident.

In a summary of the facts set forth in the Official Tax Court Syllabus, Goosen had entered into endorsement agreements with sponsors Acushnet, TaylorMade, Izod, Upper Deck, Electronic Arts and Rolex. He agreed to allow all sponsors to use his name, face, image and likeness in advertising and marketing campaigns worldwide. Goosen also agreed to perform some services for the sponsors. All endorsement agreements paid Mr. Goosen a base endorsement fee. Acushnet, TaylorMade and Izod prorated the base endorsement fee if he did not annually play in a specified number of golf tournaments, i.e., on-course endorsement fees. Moreover, Acushnet, TaylorMade and Izod provided bonuses to Goosen for achieving a specific finish in a PGA or European Tour tournament or a specified ranking on the World Golf Rankings.

Goosen characterized the endorsement fees and bonuses from Acushnet, TaylorMade and Izod as 50% personal services income and 50% royalty income on his nonresident Federal income tax returns (Forms 1040NR) for 2002 and 2003. He treated or characterized the endorsement fees from Upper Deck, Electronic Arts and Rolex as 100% royalty income. He reported approximately 7% of the total endorsement income as U.S.-source income. The Service asserted that Goosen should have characterized the endorsement fees and bonuses from Acushnet, TaylorMade and Izod as 100% from personal services income. It also reallocated a larger percentage of Goosen’s endorsement fees as U.S.-source income. The deficiency proposed by the Service was $20,224 for 2002 and $144, 474 for 2003.  Accuracy related penalties were set forth in the deficiency notice but were later conceded prior to trial by the Service.

Tax Court’s Analysis and Decision

First, the Court considered whether the endorsement income was, in whole or in part,  personal services income or royalty income. Both parties agreed that endorsement fees under the off-course endorsement agreements that Goosen had received were royalty income.  The issue then was whether endorsement income derived solely from  the on-course endorsement agreements,  which includes the TaylorMade, Izod and Acushnet agreements, was royalty income  (or personal service income) as well.  

The taxpayer’s argument for treating on-course endorsement payments as royalty income was that under such agreements he was paid for the right to co-market and co-brand the sponsors' products with petitioner's name and likeness. His counsel relied upon case law that supported the notion that such  payments are royalties because the person has an ownership interest in the rights granted. See Cepeda v. Swift & Co., 415 F.2d 1205 (8th Cir. 1969); Haelan Lab., Inc. v. Topps Chewing Gum, Inc., 202 F.2d 866 (2d Cir. 1953). Cf.  Boulez v. Commissioner, 83 T.C. 584 (1984) (intellectual property creator receives only personal services income if the creator lacks an ownership interest in the underlying property); Kramer v. Commissioner, 80 T.C. 768 (1983); Uhlaender v. Hendricksen, 316 F. Supp. 1277 (D. Minn. 1970).  The taxpayer adduced expert testimony to support the argument that the three companies primarily paid for his name and likeness rather than for the performance of services.

The IRS position as to the on-course endorsement income was that Goosen was primarily paid to perform personal services including playing golf and carrying or wearing the sponsors’ products and logos. The IRS relied upon the fact that the endorsement agreements provided for a proration (partial reduction) of the endorsement fees if Goosen did not play in a minimum number of golf tournaments. Therefore, any income received by Goosen from such on-course endorsements was only marginally for use of his name and likeness (royalty income). After review of the record, the Court  found that the income received from the on-course endorsement agreements was part royalty income and part personal services income citing  Kramer v. Commissioner,  80 T.C. 584 (1983). The Court allocated 50% of the on-course endorsement income as personal services income and 50% as royalty income.

The next issue was what portion of the on course endorsement income is sourced to the United States and whether any U.S. source royalty income was effectively connected to a U.S. trade or business.  §861(a)(4), §862(a)(4). The burden is on the taxpayer to demonstrate that he made a reasonable allocation of the royalty income between U.S. and foreign sources. The sponsors had the right to use Goosen’s name and likeness worldwide and the contracts allocated 25% of the royalty income as sourced to the United Kingdom and 75% to the rest of the world. No provision was contained in the agreement on how to source the royalty to the United States. The Tax Court rejected the contractual sourcing provision for determining U.S. source royalty income.  Where the contracting parties fail to make a reasonable allocation, the courts have generally allocated all of the royalty income to the U.S. unless the taxpayer can demonstrate a sufficient basis for making a proper allocation. A sufficient basis is present when a taxpayer establishes that he has property rights outside of the U.S. and furnishes evidence on the value of such rights. The Tax Court made fact findings on each endorsement agreement and the proper allocation of U.S. source royalty income from non-U.S. source royalty income. The allocations determined to be proper by the Court varied with each contract. For example, the Upper Deck endorsement agreement royalty payments were found to be 92% U.S. source income and the Electronic Arts royalty to be 70% U.S. source income.

The next issue was whether the non-U.S. source royalty income is effectively connected to a U.S. trade or business. It was undisputed that  Goosen was engaged in the U.S. trade or business of playing golf (“ECI”)  when playing in the U.S. and that his tournament earnings were to be taxed at regular graduated rates.   The IRS did not assert however, and the Court agreed, that  since Goosen did not maintain an office or fixed place of business in the U.S. his non-U.S. source royalty income is not part of his trade or business of playing golf.  The succeeding issue was to what extent the U.S. source royalty income should be treated as royalty income or personal services income.  Under Treas. Reg. §1.864-4(c)(3)(i), U.S. source royalty income is ECI where the activities of the trade or business are a material factor in realizing the royalty income.  

The Court ruled that Goosen’s U.S. source royalty income from on-course endorsement agreements was ECI but that that his U.S. source royalty income from off-course endorsement agreements was not ECI since the payments did not depend on whether he played in any golf tournaments in the U.S. Treas. Reg. §1.864-4(c)(3)(ii), Ex. (2). Thus, such U.S. source royalty income was FDAP and subject to a 30% flat rate.

The final issue was whether, as Goosen had argued, he was entitled to treaty protection in reducing the rate or avoiding the imposition of tax on his U.S. source royalty income by application of the U.S.-U.K. tax conventions. See §894(a)(1). Under the tax conventions, the U.K. will tax a U.K. resident, non-domiciliary on non-U.K. source income only to the extent the income is remitted to or received in the United Kingdom. See U.S.-U.K. tax treaty art. 1(7). The U.S. can not subject the same taxpayer to double taxation. Goosen failed to meet his burden of proof that his non-U.K. endorsement income was remitted to or received in the U.K. Therefore, the Tax Court held  that Goosen was not eligible for any treaty benefits.

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In 2010, the Service issued Announcments 2010-9, 2010-7 I.R.B. 408, 2010-17, 2010-13 I.R.B. 515 and 2010-30, I.R.B. 2010-19 stating that it was in the process of developing a schedule requiring certain business taxpayers to report uncertain tax positions in a separate schedule with their tax returns and requested comments both on the proposal and on a draft schedule and instructions. 

After the April 19, 2010 release of the first announcement and request for comments. The Service received a large number of comments on the overall proposal, including whether and how the Service should implement the requirement to file a schedule reporting uncertain tax positions, as well as the draft schedule and instructions.Many of the comments expressed concerns regarding how the Service would use the reported information, the interaction of the new reporting requirement with the existing policy of restraint, the additional burden the reporting requirement would place on affected corporations, and the impact the reporting requirement would have on the relationship between the corporation and the Service or the corporation and its advisors or independent auditors. Some commentators questioned the Service's authority to require reporting of uncertain tax positions with the corporation's tax return

The final schedule and instructions issued in Announcement 2010-75, issued on Septerm 24, 2010, removed several controversial proposals contained in the initially drawn UTP Schedule such as the elimination of the proposed maximum tax adjustment computation (which in many cases could exceed the taxpayer's financial statement reserves for uncertain taxes), elimination of requiring the reason and nature of the uncertainty to be set forth in a concise description of each uncertain position, the removal of reporting in reliance upon  administrative tax positions, and a five-year phase-in of the reporting requirement based on a corporation's asset size with the initial filings to be made for companies with over $100 million in assets starting with 2010 tax years. The requirement for filing applies to public or privately held corporation which issued audited financial statements and file Form 1120, 1120-F, 1120-L or 1120-PC. The total asset threshold is reduced to $50 million commencing in 2012 tax years and then to $10 million in asset value starting with 2014 tax years. The Service is considering extending the Schedule UTP reporting to other taxpayers including pass-through entities and tax exempt entities.

As reported in the December 6, 2011 issue of Tax Notes Today, the Associate Chief Counsel (Procedure and Administration) issued a somewhat surprising comment that only $1,500 corporate returns had an attached Schedule UTP with their return. The average number or items listed by the coordinated industry case (CIC) taxpayers was only 3.2 positions. Non CIC companies filing the Schedule UTP average only 1.8 items on the schedule. A representative of the Chief Counsel’s Office may have felt a sense of both frustration and skepticism when quoted with saying “People have very few uncertain tax positions these days”. The areas most frequently noted on the UTP schedules filed involved research tax credits, ordinary and necessary business deductions and quite expectedly, transfer pricing issues under Section 482.

The Chief Counsel and Commissioner can’t be pleased with this limited and unexpected luke-warm response. Perhaps the Service will be less willing to back off proposed accuracy related penalties in issuing notices of deficiency or conceding such issues prior to trial when the item(s) being challenged by the Service were not reflected on the Schedule UTP. From another perspective, perhaps the taxpayers first subject to filing the schedule did not want to provide the Service with a detailed set of road maps as to every potential issue that could be challenged by the Service upon audit. This will make for some interesting Q&As at audit as to why items were left off the UTP Schedule.

It is certain (not “uncertain”) that the 2010 filing results and those received by the Service for 2011 returns will result in the Commissioner’s possible reassessment of the Schedule UTP itself or whether further reforms are needed.

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Background

Taxpayers using the accrual method of income are required to recognize gross income in the taxable year in which “all the events which have occurred which fix the right to receive such income and the amount….can be determined with reasonable accuracy”. Treas.Reg. § 1.451-1(a).  Deductions are allowed to the accrual method taxpayer when “all the events have occurred which determine the fact of the liability,” the amount of the deductible item “can be determined with reasonable accuracy,” and economic performance has occurred with respect to the item. § 461(h); Treas. Reg. § 1.461-1(a)(2); Prop. Reg. § 1.461-1(a)(2). See U.S. v. Anderson, 269 US 422, 440–41 (1926)(adopted the “all events test” for accruing expenditures); Spring City Foundry Co. v. Comm’r, 292 U.S. 182, 184-185 (1934). Where an expenditure results in the creation of an asset whose tax life extends substantially beyond the close of the taxpayer year must be capitalized. Treas. Reg. § 1.461-1(a)(2).

Treas. Reg. §1.461-1(a)(2)(i) provides that, under an accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, in the taxable year in which: (i) all the events have occurred that establish the fact of the liability; (ii) the amount of the liability can be determined with reasonable accuracy, and (iii) economic performance has occurred for the liability (collectively, the “ all events test”). See also Treas. Reg. § 1.446-1(c)(1)(ii)(A).

Exceptions to strict application of the “all events test” have been carved into various portions of the Internal Revenue Code and set by case law.  For example, payments for goods and services to be supplied in future years are generally included in gross income under the accrual method when received and not when earned. Deductions are generally not allowed for estimates of costs of meeting contractual obligations under current sales or repair contracts. Special statutory rules injecting cash basis principles onto accrual method accounting taxpayers are applicable for charitable donations, medical expenses, contributions to qualified pension and profit sharing plans. In such instances the deduction is granted when paid and not when the liability to pay arises. See §§ 170(a)(1) (charitable contribution deduction); 213(a)(medical expenses “paid”), 404(a)(profit sharing and pension plans).

Application to Year End Bonuses

Where an accrual method taxpayer is obligated to pay a fixed amount of bonuses to a group of employees at the end of tax year in when the services were rendered but does not know either the particular recipients who will receive the bonuses or the amount each such service provider will receive until after the end of the tax year, the question arises as to whether such uncertainties prevent the accrual of such bonuses at the end of the current year.

In Rev. Rul. 76-345, 1976-2 C.B. 134, the Service announced that it would not follow the decision reached by the United States Court of Claims in Washington Post Company v. U.S., 405 F.2d 1279 (1969) that an accrual method taxpayer may deduct the full amount under a profit sharing plan established for its independent circulation dealers, for which its liability is fixed and certain with respect to the group as a whole, but for which the ultimate recipients, the time of actual payout, and the amount payable to each recipient cannot be ascertained in the year of accrual. In the Service’s view the “fact of the liability” under the first prong of the “all events test” is left unsatisfied where the identity of the recipient or the amount of the bonus payable to each is not determinable until after the end of the tax year.

In Rev. Rul. 2011-29, 2011-49 IRB (11/9/2011) the Service reached the opposite conclusion and announced it was revoking Rev. Rul. 76-345, supra. This should help facilitate the expensing of year end incentive bonuses without having to finalize the service providers entitled to receive bonuses or the amounts of the bonuses before year end.

Ruling Facts

As set forth in the Ruling, the taxpayer used the accrual method and pays bonuses to a group of employees under a bonus plan for services rendered during the current tax year. The minimum total amount of the bonuses under the program is determined: (i) by formula that is fixed prior to the end of the taxpayer year taking into account financial information of the company’s operations as of the end of the year; or (ii) by corporate action, such as a resolution of the board of directors or compensation committee made prior to the end of the year. Such action fixes the bonuses payable to the entire group. Bonuses are paid after the end of the taxable year but within 75 days of the succeeding year. If the employee entitled to the bonus is not working with the company at the time paid, the bonus is forfeited. Therefore, any forfeiture of the minimum total amount of the bonus is reallocated.

Under the first prong of the all events test an accrual method taxpayer must establish that “all events” have occurred which establish the fact of the liability. See Rev. Ruls. 2007-3, 2007-1 C.B. 350; 80-230, 1980-2 C.B. 169; Rev. Rul. 79-41-, 1979-2 C.B. 213, amplified by Rev. Rul. 2003-90, 2003-2 C.B 353. While an expense may be deductible before it is due and payable it is required that liability for the expense must first be firmly established. See, e.g., U.S. v. General Dynamics Corp., 481 U.S. 239, 243 (1987).

As mentioned, Rev. Rul. 76-345, supra, expressed disagreement with the holding in the Washington Post case issued by the U.S. Court of Claims that the first prong of the all events test may be met where the total amount of the liability was fixed at the end of the taxable year.

Holding By Service

Similar to the holding in Washington Post was the Supreme Court’s decision in U.S. v. Hughes Properties, Inc., 476 U.S. 593 (1986) that permitted a casino operator to deduct amounts guaranteed for payments to be made on slot machine jackpots that were not yet won by patrons by the end of the tax year. Critical to the Court was the that that a fixed obligation to pay was present regardless of which particular patron won. 476 U.S. @602. Therefore, in Rev. Rul. 2011-29, supra, the Service agreed that the liability for the taxpayer’s minimum amount of bonuses was established by the end of the year in which the services were rendered. This fact of liability satisfied the first prong of the all events test under Treas. Reg. 1.461-1(a)(2)(i).

The Ruling ends by declaring that accrual method taxpayers changing their prior practice on the treatment of bonuses to obtain the benefits of Rev. Rul. 2011-29 are instituting a change of accounting method that must meet the requirements of §§446 and 481 and applicable administrative procedures. See Rev. Proc. 2011-14, 2011-4 I.R.B. 330, §19.01(2).

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