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

In REG-13050-11, the Service issued, on November 30, 2012, proposed regulations providing guidance under Section 1411 of the Internal Revenue Code. Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, 124 Stat. 209,   (“HCERA”) enacted new Section 1411 established in new Chapter 2A of subtitle A (income taxes) effective for taxable years beginning after December 31, 2012.  The proposed regulations interpret Section 1411 with respect to subject individuals, estates and trusts.   The tax under Chapter 2A (Section 1411) does not apply to a nonresident alien (on passive U.S. source income) or to a trust all of the unexpired interests of which are devoted to one or more charitable purposes set forth in Section 170(c)(2)(B).    The tax imposed by Section 1411 is not deductible in computing any tax under subtitle A (income or alternative minimum tax). The government has also asked that comments be received on the proposed regulations by March 5, 2013. On November 29th, the Service also released guidance on Section 1411 in question and answer format (20 Q&As in total) which is posted on its webpage.

Section 1411 imposes on certain individuals an annual  3.8% tax on the lesser of a taxpayer’s “net investment income”, i.e., capital gains, dividends, annuities, royalties, interest, rents, and income from some trades or businesses, or the amount by which an individual's modified adjusted gross income exceeds $200,000 ($250,000 for joint filers and surviving spouses). The tax is assessed and collected in the same manner as income tax, in fact it is part of the income tax title in the Internal Revenue Code.

U.S. individuals frequently invest funds outside of the United States. Such investments can be in the form of time or money deposits, bonds issued by foreign persons, foreign stocks, including stocks in a “controlled foreign corporation” or “passive foreign investment company”. This submission briefly discusses the application of the Medicare Contribution tax to passive income derived from investments in controlled foreign corporations or from a passive foreign investment company.

Controlled Foreign Corporations and Passive Foreign Investment Companies

Section 1411(c)(1) provides that net investment income (NII) includes dividends and net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply. Accordingly, income from investments in foreign corporations generally is included in the calculation of net investment income for Section 1411 purposes. More specifically, dividends and gains derived with respect to the stock of a controlled foreign corporation (per Section 957(a)) (CFC) or a passive foreign investment company (within the meaning of Section 1297(a)) (PFIC) are taken into account in NII. Applicable rules are set out in Prop. Treas. Regs. §1.1411-5, -10, and other pertinent provisions.

Controlled Foreign Corporation (CFC) Rules.

Section 951 may require the U.S. shareholders of a controlled foreign corporation to include amounts in income without any corresponding receipt of cash or property under a "deemed" dividend construct. A foreign corporation is a CFC where more than 50% of either the total combined voting power of its stock entitled to vote or the total value of its stock is owned (or treated as owned) by “United States shareholders” on any day during the foreign corporation's taxable year.   CFC status is applied annually. A U.S. shareholder’s pro rata share of the CFC’s annual Subpart F income, as defined in Section 952, is includible in gross income to the extent of the earnings and profits of the CFC. See §§952(c), 964(a). See also §959 (previously taxed earnings and profits). A U.S.shareholder (as defined in Section 951(b)) of a CFC is required to include certain amounts in income currently under Section 951(a) (Section 951 inclusions). Unless a special election is made under -10(g) of the new proposed regulations, Section 951 deemed dividend  inclusions are not treated as dividends unless otherwise expressly provided for in the Code, and therefore are not within any of the categories of income items that comprise NII (unless the amount is derived from a trade or business to which the tax applies as provided in Section 1411(c)(1)(A)(ii) and Prop. Treas. Reg. §1.1411-4(a)(1)(ii)). 

Passive Foreign Investment Companies (PFIC). 

A PFIC is defined under Section 1296(a) as any foreign corporation that has either: (i) 75% of its gross income as “passive income” (defined in Section 1296(b)(1) by reference to the “passive income” definition under the § 904(d) separate-basket rules, but with an exception for “real” banks and insurance companies in Section 1296(b)(2)); or (2) 50% (by value) of its assets as passive assets (i.e., assets producing, or held for the production of, passive income). There is no threshold U.S. ownership rule as there is with the CFC provisions.

The PFIC rules look to the character of the income and assets. A U.S. shareholder of a PFIC incurs a deferral in tax interest charge on the deferral privilege available under Section 1291 which becomes assessable when he disposes of his PFIC stock (or when he receives substantial distributions thereon). Alternatively, if the PFIC elects qualified electing fund (QEF) status under Section 1295 (which election was converted to a shareholder-level election approximately 25 years ago), the U.S. shareholder is taxed currently under Section 1293 on the undistributed earnings of the PFIC (and the Section 1295 election is permanent). The U.S. shareholder, however, can defer payment of the tax on undistributed income imposed under Section 1293 (deemed distribution construct) by electing an extension of time to pay such tax under Section 1294, although failure to elect under Section 1295 will deny stepped-up basis at death for the investors under Section 1291(e), in a manner similar to the rules of Section 1246(e).

The net effect of these provisions is to remove the economic benefit attributable to tax deferral for those who choose to invest in passive foreign investment vehicles. A third option, enacted by Congress in 1997, added an elective mark-to-market regime for shareholders of a publicly traded PFIC. Where elected, a PFIC shareholder is required to treat “gains” as ordinary income and losses as ordinary losses but only to the extent of previously included gains. Basis is adjusted to reflect the reported gains and losses. The source of the income is determined under sale of personal property rules, i.e., the residence of the seller, and the Section 1296 election is binding.

            Net Investment Income (NII) and CFCs and PFICs.

As mentioned, a U.S. shareholder of a CFC is required to include certain amounts in income, i.e., Subpart F income to the extent of earnings and profits, under Section 951(a). The Preamble to the Section 1411 proposed regulations states that constructive or pass through income includible under Section 951 will generally not be treated as dividends in computing NII as dividend income unless expressly provided for in the Code. Still NII treatment will result to the extent the Subpart F income is derived from a trade or business to which the tax applies as provided in Section 1411(c)(1)(A)(ii)(trading trading in financial instruments or commodities) and Prop. Treas. Reg. § 1.1411-4(a)(1)(ii)). As to PFICs, a U.S. person is required to income in income amounts described under Section 193 if the taxpayer makes a QEF election under Section 1295.. Section 1293 inclusions also are not treated as dividends unless expressly provided for in the Code, and, therefore, also are not taken into account for purposes of calculating net investment income (unless the amount is derived from a trade or business to which the tax applies as provided in Section 1411(c)(1)(A)(ii) and Prop. Treas. Reg. §1.1411-4(a)(1)(ii)).  This difference in timing for reporting income for chapter 1 (regular income tax) and chapter 2A (Section 1411), as well as other overlapping provisions, will require a taxpayer to compute separate stock basis for chapter 1 and chapter 2A, subject to making an election under Prop. Reg. §1.1411-10(g) which seems to only be available after 2013 although the Preamble to the regulations when read with the proposed regulations is not entirely clear on this point, i.e., whether such election can be made for a taxable year beginning in 2013.

Another area of overlap and complexity will be the treatment of distributions of previously taxed income under the CFC or PFIC rules and their characterization for Section 1411 purposes. Both the Subpart F rules applicable to U.S. persons owning stock in a CFC and the PFIC rules as well provide rules that prevent amounts that have been included in income under Sections 951 and 1293 by a U.S. person from being subject to tax again when there is an actual distribution from the foreign corporation. Section 959(d) provides distributions from a CFC excluded from gross income for purposes of chapter 1 under Section 959(a) (earnings and profits attributable to Section 951 inclusions) are not dividends for federal income tax purposes but represent a tax-free recovery of previously taxed income. In like manner, Section 1293(c) provides that PTI distributions of a PFIC that were allocable to prior Section 1293 inclusions are not dividends for federal income tax purposes.

The Preamble to the proposed regulations to Section 1411 comments that in the absence of these previously taxed income rules under Sections 1293(c) and 959(d), actual distributions that would be taxable as dividends under general Code rules applicable to corporations and their shareholders. Moreover, as is the case with dividends, such actual distributions reduce the earnings and profits of the relevant CFC or PFIC. Accordingly, the proposed regulations take the position that a distribution of earnings and profits that were previously taxed and which is not a dividend for purposes of Section 959(d) or Section 1293(c), is still a dividend for chapter 2A purposes and therefore constitutes gross income from dividends under Section 1411(c)(1)(A)(i) and Prop. Treas. Reg. §1.1411-4(a)(1)(i). There are added applicable rules that are required to be made in determining previously tax income, adjustments to stock basis, and sourcing earnings and profits for distributions of PTI. No one will be able to say that these rules are easy to understand or once understood are simple to apply perhaps with one exception.

Proposed Regulations to Section 1411 Permit Consistency Election for CFC/PFIC and Section 1411 Purposes.

The Treasury and IRS recognize that the integrating the CFC and PFIC rules with Section 1411, including the required two sets of stock basis computations as well as the deemed sale rules and application of Section 1248, are complex and administratively burdensome.  Since these adjustments are complex and may add administrative burdens for certain taxpayers, Prop. Reg. §1.1411-10(g) permits individuals, estates, and trusts to make an election to include inclusions under Sections 951 and 1293 in net investment income in the same manner and in the same taxable year as such amounts are included in income for chapter 1 purposes. If an individual, estate, or trust makes the election, any Section 959(d) or Section 1293(c) PTI distributions that are not treated as dividends for chapter 1 purposes are not treated as dividends for Section 1411 purposes, and thus would not be included in NII. The separate computation of basis for Section 1411 purposes would not be required, and thus distributions under Sections 959(d) and 1293(c) would decrease the taxpayer's basis in its CFC or PFIC stock, and inclusions under Sections 951 and 1293 would increase the taxpayer's basis in its CFC or PFIC stock, in the same manner as the taxpayer's basis is adjusted for chapter 1 purposes.

This posting is limited to briefly discuss the nature of applying the CFC and PFIC rules to Section 1411. The proposed regulations on this subject are complex and contain many applicable rules. Therefore, this posting does not constitute the rendering of legal advice (tax advice) to anyone reading this post. It is simply issued for informational purposes  and as a brief summary of the proposed regulations and their application to CFCs and PFICs only. Tax advisors should be on notice of the proposed regulations and that they may rely on them this year along with the Q&A guidance. Expect final regulations to be issued by mid-Summer 2013.

            I will be submitting a more detailed article on this subject for publication in Business Entities (Warren,Gorham &LaMont) which I have been proud to serve as (the “outside”) Editor-in-Chief for many years and serve on the Board of Advisors for International Taxation.

• Print
• Comments
• Trackbacks
• Share Link

On January 1, the Senate, by a vote of 89-8, passed H.R. 8, the “American Taxpayer Relief Act of 2012” (“ATRA”). ATRA was then rushed to the House of Representatives which passed the bill by a more partisan vote of 257 to 167. On January 2nd, President Obama signed the bill into law. ATRA avoids the return to higher income tax rates for nearly all individuals based on the tax rates in effect prior to passage of The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16, 6/7/01; EGTRRA or the "2001 Act"). It further retains many favorable tax incentives that were due to expire at the end of 2012. ATRA will, however, increase income tax rates for high-income individuals. It will also increase the transfer tax rates but retain the existing exemption equivalent amount in effect during 2012.

ATRA Increases the Maximum Marginal Rates on Ordinary Income, Capital Gains and Dividend Income of High-Income Taxpayers

Although previously extended by Congress from expiring in 2010 for an additional two years, the 2001 Bush income tax rates expired on December 31, 2012. Under ATRA, for tax years beginning after 2012, the income tax rates for most individuals will remain at 10%, 15%, 25%, 28%, 33% and 35% instead of increasing to 15%, 28%, 31%, 36% and 39.6% as would have occurred if Congress failed to act. Without ATRA, all individuals’ marginal tax rate also would also increase the maximum tax rates on dividends and capital (long term) gains. In ATRA, the highest marginal income tax rate increases to 39.6% from 35% only as to high-income individuals, those having taxable income in excess of $400,000 per year ($450,000 for joint filers and $425,000 for heads of household). Dividends and capital gains(long term) will increase from a maximum marginal rate of 15% to 20% but again, only for high-income individuals. Certain rates of tax on gains from recapture of straight-line depreciation will remain at 25% as will gain from the taxable disposition of collectives at 28%.

Prior to the end of 2012, the anticipated increase in dividend and capital gains rates, especially among those who felt that the Congress would not be able to pass a tax bill having support from both houses of Congress, led many to realize gains or accelerate the issuance and receipt of dividends from closely held corporations before the close of the 2012 tax year. Dividends were subject to the threat of a 39.6 maximum income tax rate if Congress did not act. Congress also provides permanent relief from the harsh effects some taxpayers had suffered under the alternative minimum tax rules. Retroactive to tax years commencing after 2011, ATRA permanently increases the AMT exemption amounts for individuals based on filing category and further indexes the exemption amounts for inflation. ATRA also permanently allows an individual to offset her regular tax liability as well her AMT liability by certain nonrefundable personal credits.

The higher income tax rates on high income individuals from ordinary income, including interest and income from rents, as well as capital gains and dividends, may become a more significant factor in structuring the sale of a closely held business or the merger and acquisition between two companies. Thus, a privately owned company thinking of selling out at a good net-after tax” price, will have to reset its “net after tax” position. Consideration must also be given to passive income generated from the sale of a business operating as a partnership or limited liability company for federal income tax purposes. Again, as discussed below, the Medicate Contribution Tax of 3.8% is added onto the applicable marginal federal income tax rate. As also mentioned in our November 2012 Alert, the change in rate structure may also affect the preferred entity form for many businesses to engage in particularly if the much talked about reduction in the corporate income tax rate subsequently occurs. If the C corporation income tax rates were to be significantly reduced, there eventually could be a wide disparity between the highest rate of tax on a regular or C corporation in contrast with the higher individual rates on businesses conducted through S corporations or partnerships. 

            Extenders: Continuation of Certain Business Tax Incentives

ATRA extended parts of the credits and other tax incentives contained in the American Recovery and Investment Tax Act of 2009 which were due to expire at the end of 2012. The legislation also continue some personal tax provisions which were also due to expire including special rules for contributions of capital gain real property made for conservation purposes, the option to deduct state and local general sales taxes, and the exclusion for cancellation of debt income from qualified personal residents. ATRA extended the American Opportunity tax credit, which permits eligible taxpayers to claim a credit equal to 100% of the first $2,000 of qualified tuition and related expenses, and 25% of the next $2,000 of qualified tuition and related expenses (for a maximum tax credit of $2,500 for the first four years of post-secondary education); These changes operate through 2013 or 2014 so they are not permanent. There are also depreciation provisions for accelerated expensing and cost recovery allowances over shorter periods for certain eligible property that were extend by ATRA through 2014.

Permanent Retention of Federal Transfer Tax.

ATRA permanently retains the federal estate tax (and generation skipping transfer tax) at a maximum rate of 40%. The federal gift tax is also retained as part of the unified gift-estate tax system that is a long-standing feature of the federal transfer tax. The exemption amount will remain at $5 million per individual for lifetime taxable gifts and testamentary transfers for estates of decedents dying after December 31, 2012. ATRA also makes permanent the “portability” among spouses of any unused exemption amount of the first spouse to die provided an appropriate election is made. ATRA also extends the estate tax deduction for state estate taxes. The generation skipping tax provisions remain in effect and related provisions and technical rules under the GST which were due to expire are permanently retained.

Social Security Taxes, Medicare Tax and Self-Employment Taxes: Increase in Medicare Tax in 2013

Prior to the enactment of the recent healthcare legislation, social security benefits and certain Medicare benefits were primarily funded by payroll taxes on “covered” wages as well as self-employment taxes. As to the former, FICA imposes tax on employers based on the amount of wages paid to an employee during the year. The tax imposed is composed of two parts: (1) the OASDI tax equal to 6.2 percent of covered wages up to the taxable wage base ($110,100 for 2012), which generally increases annual in small increments; and (2) the Medicare hospital insurance (HI) tax amount equal to 1.45 percent of covered wages. In addition to the tax on employers, each employee is subject to social security taxes equal to the amount of tax imposed on the employer. The employee level tax generally must be withheld and remitted to the Federal government by the employer.

As a parallel rule to social security taxes on covered wages, the self-employment tax imposes taxes on the net income from self employment of self employed individuals. The rate of the self-employment taxes is equal to the combined employee-employer taxes on social security taxes up to the FICA taxable wage base. Similarly, the rate of the HI portion is the same as the combined employer and employee HI rates and there is no cap on the amount of self employment income to which the rate applies. For purposes of computing net earnings from self employment, taxpayers are permitted a deduction equal to the product of the taxpayer's earnings (determined without regard to this deduction) and one-half of the sum of the rates for combined social security taxes (12.4 percent) and HI tax (2.9 percent), i.e., 7.65 percent of net earnings. This deduction reflects the fact that the social security taxes on an employee's wages, do not include FICA taxes paid by the employer, whereas the self-employed individual's net earnings are economically equivalent to an employee's wages plus the employer share of FICA taxes.

The 2010 Health Care Act increases the employee portion of the HI tax after 2012 by an additional tax of 0.9 percent on wages received in excess of the applicable “threshold amount” to 3.8 percent. This added HI tax applies to net earnings from self-employment and wages in excess of $250,000 (per year) for taxpayers filing a joint return, $125,000 for married individuals filing separate returns and more than $200,000 for other taxpayers.

The New Medicare Contribution Tax of 3.8 percent on Net Investment Income

The New Medicare Contribution Tax, which was enacted in 2010 as part of The Health Care and Education Reconciliation Act of 2010, P.L. No. 111-152, effect on January 1, 2013. It closes the gap between Federal social security taxes imposed on “wages” or “self employment income” and investment income, which, of course, is not subject to social security tax. For the first time Congress imposes an income tax on investment income for funding Medicare. This new tax of 3.8 percent on net investment income from passive activities, contained in new Section 1411 of the Internal Revenue Code, and applies to individuals, trusts and estates. It also applies to income passed through to partners, members of a limited liability company or shareholders in an S corporation. The new tax does not apply to non-resident aliens or corporations subject to federal income tax.

For individuals, the New Medicare Contribution Tax, which is applied at a flat rate of 3.8 percent, and is imposed as an add-on to a taxpayer’s overall federal income tax liability, is imposed on the lesser of: (i) the taxpayer’s excess of modified adjusted gross income over a “threshold amount”, or (ii) such taxpayer’s net investment income.

For trusts and estates, the tax applies to the lesser of: (i) the excess of adjusted gross income over the amount where the highest income tax bracket begins ($11,650 in 2012); or (ii) “undistributed net investment income.” It is important to note that the “threshold amount” for married individuals filing joint returns is $250,000 ($125,000 for married couples filing separate returns) or $200,000 for other taxpayers. This “threshold amount” does not apply to (non-grantor) trusts and estates.

The term “net investment income” includes gross income from interest, dividends, annuities, royalties, and rents other than such income that is derived in the ordinary course of a trade or business. It follows that interest, dividends, annuities, royalties, and rents which pass through a partnership, LLC or S corporation to its partners, members or shareholders, will retain their character as net investment income and will be subject to the new 3.8 percent Medicare tax.

Additionally, the definition of net investment includes: (1) any other gross income derived from a trade or business if such trade or business is a “passive activity” with respect to the taxpayer within the meaning of the passive activity loss rules; and (2) any net gain (to the extent taken into account in computing taxable income) attributable to the taxable sale or disposition of property other than property held in a trade or business that is not a passive activity as to the taxpayer. The definition of net investment income, as mentioned, includes “interest, dividends, annuities, royalties and rents”, etc., but such items are not taken into account if “derived in the ordinary course of a trade or business,” as long as that trade or business (i) does not constitute a passive activity with respect to the taxpayer, and (ii) does not constitute “trading in financial instruments or commodities.” It is obvious that many capital gains and dividend income, as well as the pass through of passive types of income to investors in a pass through entity, will be subject to the 3.8% tax. Note that the threshold amounts for the 3.8% Medicare tax is set at $250,000, etc., which is considerably lower than the threshold level for the increased income and capital gains taxes.

Net investment income does not include any distribution from a qualified retirement plan or individual retirement account. Net investment income further does not include income that is taken into account in determining self-employment income eliminating the prospect of being double-taxed under both tax provisions.

Where an individual is actively engaged in a trade or business, then such individual’s profits or share of profits from such trade or business will generally not be included in “net investment income” for purposes of the 3.8 percent New Medicare Tax. Whether an individual is “active” or “passive” in a particular economic activity is determined annually in accordance with Section 469 of the Internal Revenue Code and applicable regulations. Generally, under Section 469 trade or business activities that are not rental activities or working interests in oil and gas properties are treated as passive activities unless the taxpayer materially participates in the activity. A taxpayer is not treated as materially participating in an activity unless his involvement in the operations of the activity is regular, continuous, and substantial.

The current regulations under passive activity loss rules in section 469 provide that a taxpayer materially participates, and therefore is not “passive”, in an activity if he or she can prove meeting one of seven applicable tests set forth in the regulations. See Treas. Reg. §1.469-5T(a). Moreover, the regulations contain an election whereby a taxpayer can “aggregate” his or her involvement in more than one business activity in order to satisfy the “active” participation requirement. The passive activity loss rules are also important in determining whether losses from a particular activity can only be used against passive income. What makes sense to a particular individual can only be determined by examining such individual’s tax profile both for prior years, the current year and as further projected into the future.

The new law will spawn a set of Service pronouncements in the form of rulings, notice and proposed regulations. Proposed regualtions have already been issued under Section 1411.

• Print
• Comments
• Trackbacks
• Share Link

Unless Congress can act decisively before the end of this year, the marginal federal income tax rates will increase for taxable years beginning on or after January 1, 2013. While the House and Senate had passed separate versions of extensions of the current tax rates through the end of 2013 to give the Congress some added time to resolve tax rate as well as other tax provisions, such actions have failed. It therefore is uncertain whether the extenders will be enacted into law or whether the Obama Administration will be able to work out a year end resolution of the “fiscal tax cliff” which includes, of course, the scheduled rate increases. If no progress is made before year end, then we are in for a significant tax increase on net investment income, including capital gains.

This Fox Rothschild Alert Focuses on three income tax rate increases generally affecting individuals as well as estates and trusts.  There are other significant impacts resulting from the expiration of the Bush tax cuts, and other tax legislation that has been enacted in the past few years. As an illustration, we have previously sent out a Fox Rothschild Alert (June 2012 and September 2012) on the substantial increase in federal gift, estate and generation skipping tax after 2012 and substantial reduction in the current $5 million exemption amounts to $1,000,000. There are also other important provisions in the tax code that are due to expire at the end of this year.  It is also reasonable to expect a major tax bill to be enacted by Congress this year.

Increase in Maximum Marginal Rates on Ordinary Income and Capital Gains

Although previously extended by Congress from expiring in 2010 for an additional two years, the 2001 Bush tax rate cuts will expire on December 31, 2012. On January 1, the top individual marginal income tax rate will increase from 35% to 39.6% and the 10% tax bracket will be eliminated. The maximum marginal tax rate on long term capital gains will increase from 15% to 20% (with “qualified 5 year (capital) gain” at a 18%/8% rate structure). There is no scheduled increase from the "cliff" for 25% taxable gains (e.g., recapture of straight line depreciation) and 28% taxable gains (e.g., gain from the sale of collectibles). Another important item is the increase in the rate of tax from 15% to as much as 39.6% for dividend income with respect to “qualified dividend income” received from domestic and qualified foreign corporations.

The significant increase in capital gains rates and taxes on dividend income have already resulted in taxpayers attempting to realize gains or accelerated the receipt of dividends from closely held corporations before the end of this year. If the rates do increase, i.e., Congress does not resolve the fiscal tax cliff in a manner that reduces or eliminates the anticipated tax rate hikes, then the new tax rates will certainly have a widespread and dramatic effect on future tax planning for all taxpayers, including closely held businesses and investors. For example, many owners of appreciated real property may prefer to engage in tax-free exchanges instead of having a preference for cash sales. From a merger and acquisition standpoint, privately owned companies looking to sell out may want to either postpone the sale of its business or consider being acquire in a tax-free reorganization or perhaps engage in a joint venture which could be partially taxed to the extent cash is received. With higher rates also brings along a greater tax benefit from depreciation and other tax deductions, including tax credits. The change in rate structure may also affect the preferred entity form for many businesses particularly if the much talked about reduction in the corporate income tax rate occurs. There could be a wide disparity then in the rate of tax a regular or C corporation pays instead of a flow through entity used by individuals in operating a closely held business or professional service organization causing the entity owners to reassess the best tax form for doing business.

Social Security Taxes, Medicare Tax and Self-Employment Taxes: Increase in Medicare Tax in 2013

Prior to the enactment of the recent healthcare legislation, social security benefits and certain Medicare benefits were primarily funded by payroll taxes on “covered” wages as well as self-employment taxes. As to the former, FICA imposes tax on employers based on the amount of wages paid to an employee during the year. The tax imposed is composed of two parts: (1) the OASDI tax equal to 6.2% of covered wages up to the taxable wage base ($110,100 for 2012) which generally increases annual in small increments; and (2) the Medicare hospital insurance (“HI”) tax amount equal to 1.45% of covered wages. In addition to the tax on employers, each employee is subject to social security taxes equal to the amount of tax imposed on the employer. The employee level tax generally must be withheld and remitted to the Federal government by the employer.

As a parallel to social security taxes on covered wages, the self-employment tax imposes taxes on the net income from self employment of self employed individuals. The rate of the self-employment taxes is equal to the combined employee-employer taxes on social security taxes up to the FICA taxable wage base. Similarly, the rate of the HI portion is the same as the combined employer and employee HI rates and there is no cap on the amount of self employment income to which the rate applies. For purposes of computing net earnings from self employment, taxpayers are permitted a deduction equal to the product of the taxpayer's earnings (determined without regard to this deduction) and one-half of the sum of the rates for combined social security taxes (12.4%) and HI tax (2.9%), i.e., 7.65% of net earnings. This deduction reflects the fact that the social security taxes on an employee's wages, do not include FICA taxes paid by the employer, whereas the self-employed individual's net earnings are economically equivalent to an employee's wages plus the employer share of FICA taxes.

The 2010 Health Care Act increases the employee portion of the HI tax after 2012 by an additional tax of 0.9% on wages received in excess of the applicable “threshold amount” to 3.8%.  This added HI tax applies to net earnings from self-employment and wages in excess of $250,000 (per year) for taxpayers filing a joint return, $125,000 for married individuals filing separate returns and more than $200,000 for other taxpayers. 

TheNew Medicare Contribution Tax of 3.8% on Net Investment Income

The New Medicare Contribution Tax, which was enacted in 2010 as part of The Health Care and Education Reconciliation Act of 2010, P.L. No. 111-152, effect on January 1, 2013.  It closes the gap between federal social security taxes imposed on “wages” or “self employment income” and investment income which, of course, is not subject to social security tax. For the first time Congress imposes an income tax on investment income for funding Medicare. This new tax of 3.8% on net investment income from passive activities, contained in new Section 1411 of the Internal Revenue Code, and applies to individuals, trusts and estates. It also applies to income passed through to partners, members of a limited liability company or shareholders in an S corporation. The new tax does not apply to non-resident aliens or corporations subject to federal income tax.  

For individuals, the New Medicare Contribution Tax, which is applied at a flat rate of 3.8%, and is imposed as an add-on to a taxpayer’s overall federal income tax liability, is imposed on the lesser of: (i) the taxpayer’s excess of modified adjusted gross income over a “threshold amount”, or (ii) such taxpayer’s net investment income.

For trusts and estates, the tax applies to the lesser of: (i) the excess of adjusted gross income over the amount where the highest income tax bracket begins ($11,650 in 2012); or (ii) “undistributed net investment income.” It is important to note that the “threshold amount” for married individuals filing joint returns is $250,000 ($125,000 for married couples filing separate returns) or $200,000 for other taxpayers. This “threshold amount” does not apply to (non-grantor) trusts and estates.

The term “net investment income” includes gross income from interest, dividends, annuities, royalties, and rents other than such income which is derived in the ordinary course of a trade or business. It follows that interest, dividends, annuities, royalties, and rents which pass through a partnership, LLC or S corporation to its partners, members or shareholders, will retain their character as net investment income and will be subject to the new 3.8% Medicare tax.

Additionally, the definition of net investment includes: (1) any other gross income derived from a trade or business if such trade or business is a “passive activity” with respect to the taxpayer within the meaning of the passive activity loss rules; and (2) any net gain (to the extent taken into account in computing taxable income) attributable to the taxable sale or disposition of property other than property held in a trade or business that is not a passive activity as to the taxpayer.

The definition of net investment income, as mentioned, includes “interest, dividends, annuities, royalties and rents”, etc.,  but such items are not taken into account if “derived in the ordinary course of a trade or business,” as long as that trade or business (i) does not constitute a passive activity with respect to the taxpayer, and (ii) does not constitute “trading in financial instruments or commodities.”

Net investment income does not include any distribution from a qualified retirement plan or individual retirement account.  Net investment income further does not include income which is taken into account in determining self-employment income eliminating the prospect of being double-taxed under both tax provisions. 

Where an individual is actively engage in a trade or business, then such individual’s profits or share of profits from such trade or business will generally not be included in “net investment income” for purposes of the 3.8% New Medicare Tax.  Whether an individual is “active” or “passive” in a particular economic activity is determined annually in accordance with Section 469 of the Internal Revenue Code and applicable regulations.  Generally, under Section 469 trade or business activities that are not rental activities or working interests in oil and gas properties are treated as passive activities unless the taxpayer materially participates in the activity.  A taxpayer is not treated as materially participating in an activity unless his involvement in the operations of the activity is regular, continuous, and substantial.

The current regulations under section 469 provide that a taxpayer materially participates, and therefore is not “passive”, in an activity if he or she can prove meeting one of seven applicable tests set forth in the regulations. See Treas. Reg. §1.469-5T(a). Moreover, the regulations contain an election whereby a taxpayer can “aggregate” his or her involvement in more than one business activity in order to satisfy the “active” participation requirement. The passive activity loss rules are also important in determining whether losses from a particular activity can only be used against passive income. What makes sense to a particular individual can only be determined by examining such individual’s tax profile both for prior years, the current year and as further projected into the future.

Impact of Tax Rate Hikes and New Medicare Contribution Tax

The remaining weeks to 2012 will determine whether Congress will act now to extend otherwise expiring tax benefits, including the employee 2% payroll tax reduction, and possibly reduce expected tax rate hikes on ordinary income and capital gains.  Perhaps the imposition of the New Medicare Contribution Tax of 3.8% is less likely to be reduced or eliminated in as much as the Supreme Court upheld its constitutionality and President Obama having won re-election.  As with prior major changes in tax rates, taxpayers and their advisors need to address the potential impacts.

• Print
• Comments
• Trackbacks
• Share Link

Under our current corporate income tax system, a corporation is subject to federal income tax on its taxable income at a maximum marginal rate of 35%. In the alternative, due to large write-offs for cost recovery allowances and similar items of tax preference in computing taxable income for the regular corporate income tax, a corporate alternative minimum tax is imposed under Section 55 at a rate of 20% times the alternative minimum taxable income (AMTI) in excess of $40,000 (which exemption phases out at $310,000 of AMTI), less the alternative minimum foreign tax credit.  In many instances there are items that reduce taxable income for the regular tax but do not in computing AMTI. A special AMT tax credit carryforward under Section 53 to guards against double inclusion of income. Certain “small corporations” are not subject to the corporate AMT.

The President's corporate income tax plan is designed to make Amercian companies more competitive in the global economy and to stimulate “in-sourcing” of jobs instead of “out-sourcing” and loss of American jobs. The proposal to reduce the U.S. corporate tax rate, here by 20%, is not a new proposal as the Bush Administration had floated the same idea in 2005 but with a corporate maximum tax rate of 25% .[1] However, for “manufacturing” (within the US), under the Obama proposal the highest rate of corporate income tax on taxable income from domestic manufacturing would also be set at 25%. Expect “everyone” to try to posture that is engaged in US manufacturing (in addition to the obvious case of being engaged in manufacturing) should this reform be enacted. See Section 199.

To see where the President’s proposal, if enacted, would place the US corporate income taxpayer in light of foreign corporate income tax rates, a few of the more notable corporate tax rates of foreign countries are listed:

Argentina 35%

Australia 30%

Austria     25%

Brazil        34%

Canada     15% (11% small business federal) 1-16% (provincial)

PRC (China) 25%

Denmark 25%

France     33.3%

Germany 29.8% (approx.)

Hong Kong 16.5%

India         33.2175%

Ireland     12.5%-25%-10%

Italy          31.4%

Japan       40.69%

Mexico   28%

Netherlands 20/25%

New Zealand 28%

Norway   28%

Poland     19%

Portugal 25%

Russia    20%-13%

South Africa 28%

South Korea 10%,20%,22%

Sweden 26.3%

Switzerland 13-25%

Taiwan  17%

United Kingdom 20%-25%

Venezuela 15%/22%/34%

In order to help “pay” for the reduction in corporate tax rate the idea, again, not new, is to broaden the base of the tax by eliminating tax “loopholes” (political speak for provisions which currently allow for proper tax minimization) and eliminating a number of tax subsidies. Job creation and investment in the U.S. would be incentivized. One example of base broadening would be revising the “blocker” rules which allow corporate affiliates to block foreign source income from current taxation of U.S. companies until there is dividend repatriation. Another related provision would be to defer expensing of foreign based operations. Another item for the chopping block is the liberal depletion allowance rules. President Obama has said that it was time end subsidies and tax breaks for the oil industry, which "rarely has been more profitable," while increasing tax credits for developing alternative energy sources.

The Republicans have also been carrying the ball for corporate income tax reform. Former Governor Mitt Romney has been quoted as wanting the corporate income tax rate to be reduced to 25%. Former House Speaker Newt Gingrich goes 50% better and suggests a maximum US corporate income tax rate of 12.5%. Former Senator Santorum would exempt domestic manufacturers from the corporate tax and halve the top rate for other businesses.

Details of the various proposals will be issued shortly. Also, expect the Obama Administration to propose reform of the carried interest rules (e.g., non-taxable issuance of profits interests for services in a partnership) by taxing income sourced from carried interests at ordinary rates.

In this election year, many don’t expect any legislation in this area to make it through Congress. It’s just political speak for some. Still, its out there and who knows, it might just happen since both parties want corporate tax reform.

• Print
• Comments
• Trackbacks
• Share Link

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.

• Print
• Comments
• Trackbacks
• Share Link

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

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

Redemptions of Stock Through Related Corporations: Section 304

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

• Print
• Comments
• Trackbacks
• Share Link

The tax press has recently informed the professional community that “in an April 29 e-mail briefing to its members, the National Association for Publicly Traded Partnerships cited an unnamed Treasury official who said the Obama administration is interested in a plan that would tax pass through entities with [annual] revenues [gross receipts] of $50 million or more as corporations”. White House spokeswoman Amy Brundage said the process is still unfolding and “no decisions have been made about the content of any specific reform proposal or the timing or manner in which the administration” will introduce a package of corporate tax reforms for the Congress to consider. .

The proposal on taxing large revenue pass through entities as well as prior comments to reduce the corporate income tax rate in general is sure to get more attention in the weeks ahead. It is clear that corporate tax reform is on the legislative “table” as our country’s federal corporate income tax rate of 35% is the second highest in the world next to Japan’s 39.5% rate which is presently anticipated to be reduced. Some countries, such as Ireland, have a corporate tax rate that is less than one-third of the U.S. rate and significantly higher than China or certain EU countries. While there is pressure on Congress to reduce the maximum marginal rate, a GEO study released in 2008 revealed that 55% of U.S. companies paid no federal income taxes during at least one year in a seven year period that it studied. Thus, part of the Obama Administration’s thinking is to reduce the corporate income tax rate but broaden the base by denying or deferral certain deductions or cost recovery allowances. There is expected to be a set of new base broadening provisions in the taxation of U.S. persons having foreign source income.  

In going back to imposing corporate income tax on certain pass throughs, i.e., those having $50 million  gross revenue partnerships and pass through entities, which amount will most likely be aggregated with the gross revenues of affiliated entities, perhaps both corporate and non-corporate, should be subject to corporate level  income tax should be expected to be met with stiff opposition from the business community, including owners of closely held pass through companies that have high revenues, such as hedge funds and private equity firms.  Presumably the proposal would affect the favorable treatment under current law of publicly traded limited partnerships that are eligible to avoid corporate level taxation based on the predominance of passive type income.  

Taxing high revenue partnerships as corporations  will also trigger a fair amount of business restructuring both from a tax and governance standpoint. Moreover, it again opens the door to discuss the benefits of integrating the double tax system of the corporate and shareholder level income tax by  permitting dividend tax relief on in the form of a dividend deduction, imputed tax credit at the shareholder level for corporate income tax paid or elimination of taxes on dividends. It could further result in wholesale revisions to the entire set of corporate tax rules currently in place including the reorganization provisions. So it will be quite important to see whether the tax on pass throughs being discussed is a one item concept or whether it is based of a restructuring of the federal income taxation of U.S. business enterprises.

Perhaps in the haze of political bickering that is sure to follow on evaluating and commenting on  the Obama Administration’s new and controversial test balloon to tax pass throughs, it would be nice if  Congress would seize the opportunity to address our double-tax  corporate income tax system and solve the integration issue once and for all so that there could be horizontal equity achieved by taxing corporate and non-corporate business enterprises on essentially the same basis. So much for editorial comments, at least for now.

• Print
• Comments
• Trackbacks
• Share Link

Section 304 provides provides generally that, for purposes of §§302 and 303, if one or more persons are in control of each of two corporations and one such corporation (the “acquiring corporation”) acquires in exchange for property stock of the other corporation (the “issuing corporation”) from the person (or persons) so in control, then, unless §304(a)(2) applies, the property is treated as received in redemption of the stock of the acquiring corporation. 

Section 304(a)(2) provides generally that, for purposes of §§302 and 303, if in exchange for property the acquiring corporation acquires stock of the issuing corporation from a shareholder of the issuing corporation and the issuing corporation controls the acquiring corporation, then the shareholder shall be treated as receiving the property in redemption of the stock of the issuing corporation.

“Control” for purposes of §304 means the ownership of stock possessing at least 50% of the total combined voting power of all classes of voting stock or at least 50% of the total value of shares of all classes of stock. With certain modifications, the constructive ownership rules of §318 are applied.

Under section 304(b)(2), the determination of the amount of the property distribution that is a dividend (and the source thereof) is made as if the property were distributed by the acquiring corporation to the extent of its earnings and profits, and then by the issuing corporation to the extent of its earnings and profits. If the acquiring corporation is foreign, §304(b)(5) limits the amount of earnings and profits of the acquiring corporation that are taken into account for this purpose.  

Where  and to the extent that the dividend is sourced from the E&P of the acquiring corporation, the transferor is considered to receive the dividend directly from the acquiring corporation;this outcome has been referred to by tax practitioners as “hopscotching” because the dividend bypasses any intermediary shareholders.

Special rules apply if the acquiring corporation is foreign under §304(b)(5). For purposes of determining the amount of the dividend to the transferor, the foreign acquiring corporation's E&P  that is required to be taken into account is limited to the portion of such E&P that: (i) is attributable to stock of the foreign acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) of the target corporation and who is a U.S. shareholder per §951(b) of the foreign acquiring corporation and (ii) was accumulated while such stock was owned by the transferor (or a person related thereto) and while the foreign acquiring corporation was a controlled foreign corporation (“CFC”).

Where the redemption treated as a dividend is made with respect to stock held by a non-U.S. person, 30% withholding under §1441 is generally required on the dividend unless and to the extent that a treaty is applicable and provides for a lower rate of withholding.

Revision to Section 304.

Under the recent revision to §304 made in the Medicaid Assistance bill, an additional limitation on the E&P of a foreign acquiring corporation is taken into account in determining the amount (and source) of the distribution that is treated as a dividend. In particular, where more than 50% of the dividends arising from acquisition would (without taking into account the provision) not be: (i) subject to U.S. tax in the year in which the dividend arises, or (ii) includible in the E&P of a CFC per §957 (but without taking into account §953(c)),  the E&P of the foreign acquiring corporation is not taken into account for this purpose. The new special rule generally applies if more than 50%  of the target corporation is acquired from a foreign corporation which is not a controlled foreign corporation.

Where the special rule applies, none of the foreign acquiring corporation's E&P is taken into account. In such case, the only E&P that is taken into account to determine the amount constituting a dividend is the target corporation's E&P. The provision is aimed to prevent the foreign acquiring corporation's E&P from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign person (i.e., the transferor) without “hopschotching” over” an intermediate distribution to a domestic corporation in the chain of ownership between the acquiring corporation and the transferor corporation. Generally, if the transferor is a foreign corporation (and not a CFC) and the acquiring corporation is a CFC, it is not relevant whether the target corporation is a domestic or a foreign corporation. However, if the target is a U.S. corporation, the 30-percent gross basis withholding tax applies to the amount constituting a dividend from the target, unless reduced or eliminated by treaty. See §1442. Regulations are to provide rules to prevent circumvention of the provision through the use of partnerships, options, or other arrangements to cause a foreign corporation to be treated as a CFC.

The revision applies to redemptions occurring after the date of enactment (8/10/2010).

Temporary Regulations setting forth anti-abuse rules to §304 were issued last year. See Treas. Reg. §1.304-4T.

• Print
• Comments
• Trackbacks
• Share Link

Transfers of appreciated property to foreign estates and to non-grantor foreign trusts are subject to federal income tax to the transferor as if disposed in a taxable transaction. Gain recognized is the fair market value of the property less its adjusted basis. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), P.L. 107-16, §542(e)(1) amended the applicable provision, §684, and extended its reach to transfers of appreciated  property made in 2010 that were (1) transfers made or taking effect at death, to nonresident aliens, and (2) transfers made to a foreign grantor trust, i.e., to the extent a trust is wholly or partially treated as  owned by a non-U.S. person . Since EGTRRA had its own “sunset” rule, the expansion of §684 to transfers at death to non-resident aliens and to foreign grantor trusts was, by design, only effective for transfers occurring during 2010. See EGTRRA §§ 901, 542(f)(2).

The Tax Relief Act of 2010 repeals (retroactively) the amendments to §684 made by EGTRRA. However, the gain recognition requirement will still apply if the executor of a decedent dying in 2010 elects, in accordance with the Tax Relief Act of 2010, to treat the estate tax as repealed for 2010 and applies the modified carryover basis rules in §1022. Thus, the repeal of the extension of §684 in 2010 to non-resident alien beneficiaries and foreign grantor trusts contained in TRA 2010 applies where the taxpayer (estate) treats the one year phase out of the estate tax under EGTRRA as not taking effect. See TRA §301(a). This is another factor to consider, therefore, in whether the executor for a decedent dying in 2010 should elect “in” for not applying the federal estate tax. Accordingly, subject to this 2010, §684 will not apply to a transfer made to a nonresident alien or foreign grantor trust during or after 2010. Transfers of appreciated property to foreign estates and to non-grantor foreign trusts will still be subject to income tax under §684. 
 

• Print
• Comments
• Trackbacks
• Share Link

A U.S. partnership, trustee of a U.S. trust, or executor of a U.S. estate must deduct and withhold income tax on distributions attributable to the disposition of a U.S. real property interest (“USRPI”) to the extent it is includible in the income of a foreign partner, foreign beneficiary, or, in the case of a trust, a foreign person under the grantor trust rules per §671 et seq. For amounts paid after May 28, 2003, the Service was authorized to issue regulations to reduce the amount of income tax required to be withheld on a foreign person's gain from the disposition of an interest in U.S. real property from 35% to 15%. Since the Service had not issued regulations providing for the 15% rate,  domestic partnerships, estates, and trusts had to withhold tax at 35%.

Under section 303 of the 2003 Jobs and Growth Act (JGTRRA, Sec. 303, PL 108-27, 5/28/2003 ), as amended by section 102 of the 2005 Tax Increase Prevention Act (TIPRA, Sec. 102, PL 109-222, 5/17/2006 ), the Service’s authority to provide for a reduced 15% withholding rate by regulation was to expire for payments made in tax years beginning after Dec. 31, 2010 (in which case the rate reduced rate would have reverted to the earlier 20%).  Under the Act, the IRS has been granted authority to provide a 15% withholding rate on a distribution from a partnership, trust or estate attributable to the disposition of a USRPI for two additional years, i.e., tax years beginning before Jan. 1, 2013.
 

• Print
• Comments
• Trackbacks
• Share Link

Under the controlled foreign corporation rules, i.e., a foreign corporation defined under §957(a) as owned more than 50% of its combined voting power or value is owned by 10% (or such higher percentage) by U.S. shareholders on any day of the taxable year that is involved. A “U.S. Shareholder” per §951(b) is a U.S person, i.e., a citizen or resident of the U.S., a domestic partnership or corporation or a nonforeign trust or estate that owns 10% or more of the corporation’s combined voting power. See also §958.  U.S. shareholders of a CFC are required to include in gross income their share of the CFC’s subpart F income currently regardless of whether the income is distributed to the shareholders.

Subpart F income includes foreign base company income. One category of foreign base company income is foreign personal holding company income. For subpart F purposes, foreign personal holding company income generally includes dividends, interest, rents, and royalties, among other types of income. There are several exceptions to these rules. For example, foreign personal holding company income does not include dividends and interest received by a CFC from a related corporation organized and operating in the same foreign country in which the CFC is organized, or rents and royalties received by a CFC from a related corporation for the use of property within the country in which the CFC is organized. Interest, rent, and royalty payments do not qualify for this exclusion to the extent that such payments reduce the subpart F income of the payor. In addition, subpart F income of a CFC does not include any item of income from sources within the United States that is effectively connected with the conduct by such CFC of a trade or business within the United States (“ECI”) unless such item is exempt from taxation (or is subject to a reduced rate of tax) pursuant to a tax treaty.

Under the “look-thru rule” contained in §954(c)(6), dividends, interest (including factoring income per §954(c)(1)(E) ), rents, and royalties received by one CFC from a related CFC are not treated as foreign personal holding company income to the extent attributable or allocable to income of the payor that is neither subpart F income nor treated as ECI. For this purpose, a related CFC is a CFC that controls or is controlled by the other CFC, or a CFC that is controlled by the same person or persons that control the other CFC. Ownership of more than 50% of the CFC's stock (by vote or value) constitutes control for these purposes. The Secretary is authorized to prescribe regulations that are necessary or appropriate to carry out the look-thru rule, including such regulations as are appropriate to prevent the abuse of the purposes of such rule.

The look-thru rule is effective for taxable years of foreign corporations beginning before January 1, 2010, and for taxable years of U.S. shareholders with or within which such taxable years of such foreign corporations end. The 2010 Tax Relief Act extends for two years the application of the look-thru rule, to taxable years of foreign corporations beginning before January 1, 2012, and for taxable years of U.S. shareholders with or within which such taxable years of such foreign corporations end.

• Print
• Comments
• Trackbacks
• Share Link

Under the Subpart F rules, §§951-964, 10% or greater U.S. shareholders of a controlled foreign corporation (“CFC”), i.e.,foreign corporations where more than 50% of the stock of the foreign corporation is owned, directly or indirectly, by U.S. shareholders, are required to currently report in taxable income their share of the CFC’s Subpart F income  regardless of whether such income is distributed to the 10% or more shareholders,  In particular, Subpart F income also includes insurance income and foreign base company income. Foreign base company income includes, among other things, foreign personal holding company income and foreign base company services income (i.e., income derived from services performed for or on behalf of a related person outside the country in which the CFC is organized).

Under pre-2010 Tax Relief Act law, certain income from the active conduct of a banking, financing or similar business, or from the conduct of an insurance business (collectively referred to as “active financing income”) was temporarily excluded from Subpart F income, but only for tax years of foreign corporations beginning after Dec. 31, 1998 and before Jan. 1, 2010, and for tax years of U.S. shareholders with or within which any such tax year of the foreign corporation ended. Under pre-2010 Tax Relief Act law, for tax years of foreign corporations beginning after Dec. 31, 2009 (and tax years of U.S. shareholders ending with or within any such tax year), the insurance income exemption rules of §953(a), were to be applied in the same manner as if the tax year of the foreign corporation began in '1998. Thus, for tax years beginning after Dec. 31, 2009 in which the temporary exception for insurance income was not in effect, the same-country exception from Subpart F insurance income was to apply as under pre-'99 law.

The new law extends the active financing rules for an additional two years. This will allow banks, finance, insurance and similar revenue generating CFCs to continue to defer current taxation with respect to foreign source financing and insurance income under Subpart F. See §§953(e)(10), 954(h)(9).
 

• Print
• Comments
• Trackbacks
• Share Link

• Print
• Comments
• Trackbacks
• Share Link

 Importance of Transfer Pricing Rules

 A critical concern for many multinational corporations, regardless of whether the parent company maintains its tax residence in the United States, Japan, the United Kingdom, or elsewhere, is the manner in which in which it prices goods, services, and intangibles, such as the results of research and capital transferred to its foreign affiliates. Transfer pricing rules and guidelines used to price goods transferred among affiliate companies and across jurisdictional boundaries have more impact on which governmental jurisdiction taxes the income generated from international transactions than any other aspect of the tax law. Transfer pricing rules and their consequences are drivers of tax collections for many industrial nations and a focal point of international taxation and international tax planning.

What this results in is a form of competition between countries on transfer pricing rules in an effort to increase international trade and deflect profits into each competitor’s tax coffers. The concern of many multinational companies, of course, is to avoid double taxation, tax penalties and rigorous transfer pricing protocols and pricing checks. The international tax mechanisms available to prevent double taxation generally require consultation at the government level, which is a slow and costly process and is not guaranteed to succeed in preventing double taxation.

In addition to transfer tax legislation, Levin also said the Senate needs to act first on a plan to extend the 2001 and 2003 tax cuts, but the outlook for getting a bill done remains uncertain. The debate on repealing the tax cuts for the upper 2% of taxpayers is repeated daily on our televisions.

Finally, Levin also said it is essential for Congress to take action on the estate tax before the end of the year and blamed Republicans for blocking progress on the legislation. "For Republicans to use their votes to essentially stalemate action, I think has led to a lot of turbulence," Levin said. "They talk about uncertainty, they are creating the uncertainty."

Levin Expects Transfer Pricing Bill

  Against this background, Sander Levin (D-Mich.), House Ways & Means Committee Chair, stated on October 7, that he expects to bring transfer pricing legislation to the House floor during the lame duck session of Congress in an attempt to prevent improper tax avoidance strategies employed by multinational companies in this area. The perception shared by many Democrat members is that the current rules are difficult to enforce and encourages the movement of jobs overseas, i.e., by shifting jobs and economic payments to lower tax jurisdictions. . So the target is outsourcing of jobs. Previously, President Obama had two transfer pricing provisions in his fiscal year 2011 budget proposal pertaining to the taxation of "excess returns" from transfers of intangibles outside of the U.S. and by limiting the shifting of income through intangible property transfers. There are other proposals in this area suggested by Representative Lloyd Doggett (D-Texas), per H.R. 5328, which would required companies take into account certain U.S. intangibles income under Subpart F. Doggett’s approach would attempt to block certain income shifting strategies in general. On the other side of Congress, the Republicans have argued, somewhat persuasively, that in order to attract capital and jobs in the U.S., Congress should lower the corporate tax rates. The U.S. has the second highest corporate tax rate among our tax treaty partners. Previously, the Bush Administration had recommended a reduction in the maximum  U.S. corporate tax rate to 25%. Perhaps the proper approach for Congress to take may be the broaden the base as the Democrats are contending while adopting the lower tax rate that Republicans want. Agreement on both sides in a compromise of that type would indeed be welcome.

• Print
• Comments
• Trackbacks
• Share Link

The bulk of the FATCA provisions go into effect with respect to payments made after 2012. There are two generally categories of payments: (i) those made to non-U.S. financial institutions; and (ii) those made to non-U.S. non-financial institutions. With respect to both payments, contained in §§1471 and 1472 respectively, there is a 30% withholding required on payments to the non-U.S. person unless such non-U.S. person meets certain disclosure and reporting requirements.

The new 30% required withholding is imposed regardless of applicable treaty provisions. This will require that in those instances where a non-U.S. payee is entitled to a more favorable treaty rate, such withholding will be recovered by the payee through a refund claim or credit against U.S. income taxes otherwise due. Withholding is required on interest on bonds or other obligations issued by state or local governments or with respect to portfolio debt (per §871(h)). Thus, for debt obligations issued after 3/18/2010, a tax-exempt organization will have to determine whether the holder is a non-U.S. person, and then if it is a financial institution or not, before interest is paid. See also §649. Section 6049 . In addition to establishing that the payee is a foreign person, the U.S. payee will need to determine whether the payee is a financial institution, whether the payee has entered into an agreement with the IRS, or whether the payee has substantial U.S. owners.

Where the payor of a withholdable payment is a tax-exempt (U.S.) organization, FATCA still applies as to “withholdable payments”. For this purpose, “withholdable payment” includes interest (including any original issue discount), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income, if such payment is from sources within the United States and proceeds from the sale or other disposition of any property of a type that can produce interest or dividends from sources within the United States.

Where the recipient is a non-U.S. person, the tax-exempt organization will have to determine whether the non-U.S. payee is a financial institution (§1471) or a non-financial institution (§1472)). Under FATCA, the term “financial institution”  is one which accepts deposits in the ordinary course of its business, holds financial assets on the account of others as a substantial portion of its business, or is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest (including a futures or forward contract or option) in such securities, partnership interests, or commodities.

The withholding obligation under FATCA extends to the purchase of U.S. stocks and bonds from non-U.S. persons.  There is no requirement that the gross proceeds represent income. If the seller is a non-U.S. entity, the FATCA provisions may still apply to the payment of the gross proceeds after 2012.

A non-U.S. exempt organization having business or investment dealings with U.S. persons may be subject to withholding at 30% as well unless an exception is present. The primary exception under FATCA is with respect to any " public international organization" or any wholly owned agency or instrumentality thereof. Under §7701(a)(18), a public international organization is one: (i) in which the United States participates pursuant to any treaty or under the authority of any Act of Congress authorizing such participation or making an appropriation for such participation, and (ii) os designated by the President through appropriate Executive Order as being entitled to enjoy the privileges, exemptions, and immunities provided in the International Organizations Immunities Act.

Where a non-U.S. exempt organization does fall within the public international organization exception it then needs to be determined whether such organization is a financial institution or is not. Most tax-exemption organizations should not fall within the definition of a financial institution although the definition is broad. For example, some organizations which have endowments held in separate entities may result in the endowment being treated as a financial institution. Perhaps that type of non-U.S. exempt organization may desire to enter into an agreement with the U.S. or otherwise disclose its U.S. accounts. Another option of course is to seek a refund under an applicable treaty provision if available.  As to a non-financial, non-U.S. exempt organization, it will have to disclose to the payor the identity of any substantial U.S. owners or represent that it has no substantial U.S. owners. For this purpose a "substantial U.S. owner" is a person holding more than 10% of the voting power of all the membership interests.

Finally, it is also possible for a non-U.S. organization to be treated as making withholdable payments. The first is that of the non-U.S. organization with a U.S. branch. If the branch is treated as being engaged in a U.S. trade or business, interest that is sourced as U.S. interest paid by the branch will be treated as U.S. source income. It therefore will be a withholdable payment if paid to a non-U.S. entity. The same result may apply with respect to royalties. Where a non-U.S. organization maintains a U.S. branch using property for which royalties or licensing fees are to be paid, the royalties may be withholdable payments. Again, a third form of withholdable payment would be a non-U.S. tax exempt organization’s sale of U.S. stocks or bonds to a non-U.S. person, subject to qualification in the regulations. 

• Print
• Comments
• Trackbacks
• Share Link

• Print
• Comments
• Trackbacks
• Share Link

Section 45D provides a new markets tax credit (NMTC) for qualified equity investments made to acquire an equity position in a corporation or partnership that is a "qualified community development entity ("CDE"). This credit was enacted as part of the Community Renewal Tax Relief Act of 2000, P.L. No. 106-554 (2000). A qualified CDE is any domestic corporation or partnership: (i) whose primary objective is providing investment capital for low-income communities or persons; (ii) maintains accountability to residents of such communities by providing them with a required level of representation on any governing board of or any advisory board to the CDE; and (iii) is certified by the Treasury as a qualified CDE.

Substantially all the investment proceeds must be used by the CDE to make qualified low-income community investments including: (i) capital or equity investments in, or loans to, qualified active low-income community businesses; (ii) certain financial counseling and other services to businesses and residents in low-income communities; (iii) the purchase from another CDE of any loan made by such entity that is a qualified low-income community investment; or (iv) an equity investment in, or loan to, another CDE. A "low-income community" is a population census tract with either: (i) has a poverty rate of at least 20% or (2) median family income which does not exceed 80% of the greater of metropolitan area median family income or statewide median family income (for a non-metropolitan census tract, does not exceed 80 percent of statewide median family income). In the case of a population census tract located within a high migration rural county, low-income is defined by reference to 85% instead of 80% of statewide median family income. A high migration rural county is any county that, during the 20-year period ending with the year in which the most recent census was conducted, has a net out-migration of inhabitants from the county of at least 10% of the population of the county at the beginning of such period.

The amount of the credit allowable to the investor (either the original purchaser or a subsequent holder) is (i) 5% for the year in which the equity interest is purchased from the CDE and for each of the following two years, and (ii) 6% for each of the following four years. The credit is determined by applying the applicable percentage to the amount paid to the CDE for the investment at its original issue, and is available for a taxable year to the taxpayer who holds the qualified equity investment on the date of the initial investment or on the respective anniversary date that occurs during the taxable year. The credit is recaptured if, at any time during the seven-year period that begins on the date of the original issue of the qualified equity investment, the issuing entity ceases to be a qualified CDE, the proceeds of the investment cease to be used as required, or the equity investment is redeemed. The Service has issued proposed regulations on the recapture issue. See also section 45D(g)(3).

The maximum annual amount of qualified equity investments is capped at $3.5 billion per year for calendar years 2006 through 2009. Lower caps applied for calendar years 2001 through 2005. For calendar years 2008 and 2009, Congress increased the maximum amount of qualified equity investments by $1.5 billion (to $5 billion for each year).

The Treasury must allocate these amounts among qualified CDEs, giving "priority" to CDEs "with a record of having successfully provided capital or technical assistance to disadvantaged businesses or communities" and CDEs intending to invest substantially all of their assets in equity interests in or loans to businesses owned by unrelated persons.

Over the 7 years for which the credit is claimed, an investor gets a total credit equal to 39% (5% for each of the first three years plus 6% for each of the next four years) of his investment. Basis in a qualified equity investment is reduced by the amount of the credit determined under Section 45D. However, basis reduction is not required for purposes of reporting the exclusion of gain with respect to small business stock under section 1202.

Although financing for real estate projects has  over the past year or so substantially dried up or become too expensive, the NMTC may provide opportunities for financing real estate projects that may not have otherwise taken seed. Indeed, the NMTC targets borrowers, nonprofits, and projects that otherwise cannot obtain conventional financing. It requires that "but for" the NMTC financing, the project would not be completed. The majority of CDEs are affiliates of banks, large nonprofit organizations, cities and other municipalities and bonding authorities.

• Print
• Comments
• Trackbacks
• Share Link

.

While the government has for the most part successfully attacked tax products or tax-motivated strategies that were in vogue in the late 1990s and in the 2000s, there were many cases that the Service did not get the chance to audit and thereby escaped unscathed by passage of the statute of limitations and there were also some instances where the  Service suffered a judicial defeat.

Frequently, the client investing in a particular tax solution or tax-motivated transaction, was primarily driven by tax savings and, in the event the strategy was audited and successfully challenged by the IRS, to still avoid penalties by obtaining a "more likely than not" standard tax opinion from a reputable law firm or accounting firm . The tax opinion, in the eyes of the Service and some skeptical commentators on the tax law, was nothing more than a purchase of insurance acquired by the investor to avoid a 20% (or higher) penalty. Owing back taxes and interest for the use of the money until the taxes were repaid  from a "flaky" deal was not enough "skin in the game" for the taxpayer to be adverse to investing in the tax solution in the first place.

In an effort to provide uniformity to the tax law, Congress enacted section 7701(o) codifying the economic substance doctrine. The Congress adopted the Service’s approach, i.e., a two part conjunctive test which requires both (objective) economic substance and (subjective) substantial business purpose. The legislative history notes that the codification was not intended to replace or surplant existing precedent. Under the economic substance doctrine, first the transaction under evaluation must result in a meaningful change in the taxpayer's nonfederal-income-tax economic position and, second, the transaction must also have a substantial nonfederal-income-tax purpose. Both prongs must be satisfied based on the taxpayer’s generally required burden of proving its position by a preponderance of the evidence. The taxpayer is not required, per se, to establish a pretax profit to establish economic substance but can use this standard to meet the statutory requirement by demonstrating that the present value of the anticipated pretax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed from the transaction. Presumably guidance will be issued by the Service on examining the pretax profit test and how to compute the pretax profit, etc. Under section 7701(o)(4), accounting benefits cannot be taken into account in testing for whether the transaction has a substantial nonfederal-income-tax effect where the origin of the financial accounting benefit is a reduction in federal income tax. The reason for this rule is straightforward: If reduction of federal tax was the origin of the accounting treatment and the accounting treatment could be relied on in applying the conjunctive test, the test would become circular and cease to have meaning. Beyond this simple case, however, the circumstances in which the origin of the accounting benefit is federal tax reduction should be specified by Treasury and the IRS in future guidance. Foreign taxes are not treated as expenses per se under the pretax profit test subject to further guidance to be issue by the Service.

The term "transaction" is defined in section 7701(o)(5)(E) as including a series of transactions, i.e., see Treas. Reg. §1.6011-4(b)(1) "transaction includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement, and includes any series of steps carried out as part of a plan."

As far as the second prong, i.e., the taxpayer’s non-tax purpose for entering into the transaction, the purpose must be "substantial" and a "reasonable means" of satisfying such purpose. This requires that the transaction have a reasonable nexus to the taxpayer’s normal business operations or investment activities.

Congress has definitely imposed a "skin in the game" requirement for taxpayers that fail to meet the economic substance test. New section 6662(b)(6) imposes a strict liability penalty without an out for reasonable cause or good faith. The penalty is imposed on an "underpayment", per §6664(a) and is based on the amount of tax due were the transaction reported correctly. The penalty is 20% of the underpayment for disclosed transactions and 40% for undisclosed transactions.

Guidance will be forthcoming on this "new world" of section 7701(o) of statutory economic substance. Perhaps the Service will reduce the anxiety level of tax practitioners and there clients by publishing  an "angel list" of transactions or parts of larger transactions that will not be challenged by the Service under section 7701(o).

President Obama signed into law on March 30, 2010, the HIRE Act. Section 1409 of the Act sets adopts long-standing principle of the federal income tax law, that of the doctrine of economic substance, and not only codified the rule, which itself is controversial, but imposes a new strict liability penalty for its violation.

There are several judicial doctrines which are used to test the efficacy and purpose of the particular transactions being reviewed as well as sorting out those transactions that are primarily or solely motivated by tax savings from those transactions which have a substantial business purpose or economic motive that requires that the taxpayer changes position or risk with respect to the transaction viewed on a "before the transaction" and "after the transaction" basis. Several of the noted doctrines resorted to by the courts as aides are the "step transaction doctrine", the "sham transaction" doctrine" and the "business purpose doctrine". A fourth judicial overlay is that of the "economic substance" doctrine. Over the past ten years or so the courts have invoked the underlying calculus of each of these doctrines, which frequently overlap or are applied in an inconsistent manner, in determining whether or not to deny the tax benefits designed to flow from tax-motivated transactions.

The legal standard for applying the economic substance doctrine has been approached differently by various circuit courts of appeals.  Some have required that the transaction have either economic substance (from an objective standpoint) or a substantial business purpose (from a subjective standpoint). Other courts have required both prongs be present, i.e., both economic substance and substantial business purpose. Yet other courts have applied an overall approach drawing upon both business purpose and economic substance in evaluating the transaction as a whole.

The courts also did not always apply the same reasoning on the type of nontax economic benefit a taxpayer must establish to satisfy the economic substance requirement. Some courts denied tax benefits where a perceived business benefit was not in fact obtained. Other courts denied tax benefits on the judicial view that the transaction lacked profit potential. Still other courts disallowed tax benefits in instances where the transaction had a profit motive and the taxpayer was exposed to risk but the economic risks and profit potential were insignificant compared with the size of the tax benefits derived from the transaction

• Print
• Comments
• Trackbacks
• Share Link

Many business companies have hit "hard times" the past several years in being able to maintain profit levels. This in turn has led to job layoffs, foreclosures and a sharp increase in bankruptcy proceedings. In many instances, companies, like individuals encumbered with "underwater debt" or "negative equity" debt, attempt to renegotiate or restructure one or more of its debt obligations in place.

Where such restructuring of an old debt into a revised debt is successful,  income tax impacts frequently result to both parties. Focusing on the borrower, frequently a restructured obligation will result in a partial cancellation of indebtedness income which is generally taxable in accordance with §61(a). A limited exclusion from gross income bor debt cancellation is available under §108(a) in four contexts, including the insolvency of the taxpayer. Where, however, one of the four categories qualifying for a partial or full exclusion from gross income are not applicable, the restructured debt will, as to the debtor, require tax payments on the income attributable to cancelled "principal" in the indebtedness.

Congress, as part of The American Recovery and Reinvestment Act of 2009, added new §108(i) which allows for a deferral of income resulting from an otherwise taxable cancellation of indebtedness for "indebtedness discharged by the reacquisition of the debt instrument" in 2009 and 2010. As set forth in the definition of a requisition in §108(i)(4), a "reacquisition" includes (A) any acquisition of the debt instrument by the borrower or a person related to the borrower, and (B) there is an "acquisition", i.e., acquisition of the debt instrument for cash, exchange of the debt instrument for another debt instrument, including by modification, the exchange of the debt instrument for stock or an interest in an entity taxable as a partnership, the contribution of the debt instrument to capital and the complete forgiveness of the debt by the holder of the debt instrument.

Where cancellation of indebtedness income is realized by the debtor in 2009 or 2010, the taxpayer may elect, under new §108(i), to defer the inclusion of the taxable income arising from the cancellation until 2014 at which time the income is reported ratably over a 5 year period extending through 2018. An election is made separately for each debt instrument. See Rev. Proc. 2009-37, 2009-36 IRB 309 (information required).

Taxpayers seeking to take advantage of this special relief rule should understand that the election is irrevocable and in making the election, the taxpayer must satisfy the disclosure requirements. The tax attributes of the taxpayer must also be taken into account particularly where there may be expiring net operating loss carryovers. The deferred income is required to be accelerated under §108(i)(5)(D) where the taxpayer dies, liquidates or sells substantially all of its assets, ceases to do business or in similar situations. The acceleration rule is in need of definitive regulations as support for avoiding an acceleration event could be made, for instance, where the taxpayer is acquired in a non-taxable reorganization described under §368.

• Print
• Comments
• Trackbacks
• Share Link

The Obama Administration set forth certain changes it will seek to have Congress adopt next year or beginning in 2011 as part of the 2010 budget proposals in the area of international taxation, particularly with respect to U.S. based multinational companies. See U.S. Dept. of Treasury, "General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals" (May 2009). Under U.S. federal income tax law principles, U.S. companies can generally defer paying U.S. tax on earnings of their foreign subsidiaries engaged in business operations outside of the United States until such earnings are repatriated. This results in a deferral of U.S. tax on such foreign earnings which is particularly attractive where the foreign based subsidiary is operating in a lower tax country or perhaps a tax haven jurisdiction. Under the controlled foreign corporation rules, such desired deferral of foreign earnings can be blocked by the required inclusion of a corporation’s Subpart F income of a controlled foreign corporation. While such rules have been in place for some time, allocation of expenses, interest and other items have been used to reduce Subpart F income or otherwise create timing differences to either reduce the pass through of Subpart F income or broaden the deferral. The Administration’s controversial budget proposals would effectively reduce the scope of deferral, increasing taxes on U.S. companies conducting foreign operations through foreign subsidiaries. The proponent of such legislation has been Chairman Charles Rangel (D-NY) of the House Ways and Means Committee. See H.R. 3970, "Tax Reduction and Reform Act of 2007," section 3201.

Deferral of Current Use of Foreign Related Deductions. The first major reform under the Obama Administration’s proposals would be to allow certain "foreign-related deductions" only to the extent that expenses (other than research and development expenditures) and losses are allocable or apportionable to currently taxed foreign income. The largest categories of foreign-related expenses likely to be deferred in some degree would be interest and stewardship/headquarters costs. Deferred expenses would be carried forward to subsequent years and would be combined with foreign-source expenses for that year before applying the proposal in that year.

Blended Deemed-Paid Foreign Tax Credits. The second major reform would be to adjust or blend the amount of deemed paid foreign tax credits under section to no more than the average rate of total foreign tax actually paid on total foreign earnings by the company's foreign subsidiaries (presumably earned after the effective date). This change is designed to eliminate the ability to manage high- and low-tax foreign income pools separately.

A third and still important change would be to treat a "defective entity" formed in a foreign jurisdiction to be treated as a separate corporation for U.S. tax purposes, except for foreign defective entities owned directly by: (i) companies incorporated in the same country; or (ii) U.S. entities (except in cases where U.S. tax avoidance is present). This reform will have the likely result of subjecting many U.S. companies to current taxation on Subpart F income.

• Print
• Comments
• Trackbacks
• Share Link