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The Internal Revenue Service has just published a first set of temporary regulations (T.D. 9567) under section 6038D requiring foreign financial assets of U.S. persons to be reported to the IRS for federal income tax purposes for tax years beginning after March 18, 2010. The text of the temporary regulations also serves as the text of concurrently issued proposed regulations applicable to domestic entities (REG-130302-10). Proposed regulations were also issued for application of section 6038D to domestic entities.

Effective December 19, 2011, the temporary regulations provide guidance regarding the requirement in section 6038D that individuals attach a statement to their income tax return to report required information on foreign financial assets in which they have an interest. The regulations affect individuals who must file Form 1040, "U.S. Individual Income Tax Return," and some individuals required to file Form 1040-NR, "Nonresident Alien Income Tax Return." The collection of information required by the regulations is generally satisfied by filing Form 8938, "Statement of Specified Foreign Financial Assets."

Again, as mentioned, the proposed regulations  address the reporting requirements of domestic entities under section 6038D, i.e., certain domestic corporations, partnerships and trusts (but not estates), which are to be effective for taxable years beginning after December 31, 2011.

Form 8938 must be filed when the total value of specified foreign assets exceeds prescribed thresholds, but the thresholds for taxpayers who reside abroad are higher that those for taxpayers who reside in the United States. The instructions in Form 8938 are supposed to reflect the provisions in the temporary regulations on when is reporting required, what is a foreign financial asset, how to determine the total value of subject assets, exemptions and other information. The Form 3938 does not preempt or replace a taxpayer’s obligation to file an FBAR report. Still, a Form 8938 is not required to be filed by an individual is not required to file an income tax return.  

The regulations should be carefully reviewed by tax counsel and tax professionals as well as return preparers. While this posting does not address the specific provisions contained in the temporary and proposed regulations, it does contain background information on the enactment of section 6038D which requires FBAR type disclosures to be made with annual income tax returns.

Congress’ Recent Move to Compel Tax Return Disclosure of Information Concerning Foreign Financial Assets in the Hiring Incentives to Restore Employment Act (“HIRE Act”), P.L. 111-147 (3/18/2010)

Prior to the HIRE Act,  our domestic laws required U.S. persons who transfer assets to, and hold interests in, foreign bank accounts or foreign entities to be subject to self-reporting requirements contained under the Internal Revenue Code (26 U.S.C.) and under the Bank Secrecy Act of the United States Code (31 U.S.C.).  While the Bank Secrecy Act,  31 U.S.C. §5311, originally targeted the reporting of large currency transactions for use in criminal, tax or regulatory investigations or proceedings, its reach has expanded to impose reporting obligations on both financial institutions and account holders. See,  e.g., Title III of the USA PATRIOT Act, Pub. L. No. 107-56 (October 26, 2001) (sections 351 through 366 amended the Bank Secrecy Act as part of a series of reforms directed at international financing of terrorism).

With respect to account holders, a U.S. citizen, resident, or  possibly a person doing business in the United States is required to keep records and file reports, as specified by the Secretary, when that person enters into a transaction or maintains an account with a foreign financial agency. 31 U.S.C. §5314. Regulations promulgated pursuant to broad regulatory authority granted to the Secretary in the Bank Secrecy Act provide additional guidance regarding the disclosure obligation with respect to foreign accounts which involves the filing of annual foreign bank and financial account statements.  

Treasury Department Form TD F 90-22.1, “Report of Foreign Bank and Financial Accounts,” (the “FBAR”) must be filed by June 30 of the year following the year in which the $10,000 filing threshold set forth in the regulations is satisfied. 31 C.F.R. § 103.27(c). The $10,000 threshold is the aggregate value of all foreign financial accounts in which a U.S. person has a financial interest or over which the U.S. person has signature or other authority.  The FBAR is filed with the Treasury Department at the IRS Detroit Computing Center. Failure to file the FBAR is subject to both criminal and civil penalties.  See 31 U.S.C. §322 which provides that failure to willful failure to file the FBAR is punishable by a fine up to $250,000 and imprisonment for five years, which may double if the violation occurs in conjunction with certain other violations. Since 2004, the civil penalties are not to exceed (1) $10,000 for failures that are not willful and (2) the greater of $100,000 or 50% of the balance in each account for willful failures. 31 U.S.C. §5321(a)(5).

Although the FBAR is received and processed by the IRS,  it is neither part of the income tax return filed with the IRS nor filed in the same office as that return. As a result, for purposes of Title 26, the FBAR is not considered “return information,” and its distribution to other law enforcement agencies is not limited by the nondisclosure rules of Title 26. The Bank Secrecy Act specifies only that such disclosure contain the following information “in the way and to the extent the Secretary prescribes”: (1) the identity and address of participants in a transaction or relationship; (2) the legal capacity in which a participant is acting; (3) the identity of real parties in interest; and (4) a description of the transaction.

Although the obligation to file an FBAR is not part of the Internal Revenue Code, the individual income tax return makes reference to this requirement, i.e., At any time during (tax year), did you have an interest in or signatory or any other authority over a financial account in a foreign country, such as a bank account, securities account, or other financial account?” Then reference is made to Form TD F 90-22.1 and filing requirements. The Form 1040 instructions advise individuals who answer “yes” to this question to identify the foreign country or countries in which such accounts are located.

Enactment of Code Section 6038D Under the HIRE Act

Section 6038D was enacted by section 511 of the HIRE Act. Section 6038D(a) requires an individual who holds any interest in a specified foreign financial asset during the taxable year to attach a statement to that individual's income tax return to report the information identified in section 6038D(c), where the aggregate value of the specified foreign financial assets in which the individual holds an interest exceeds $50,000 for the taxable year, or such higher dollar amount as the Secretary may prescribe by regulation or other pronouncement.

Section 6038D(b) defines specified foreign financial assets for this purpose as any financial account maintained by a foreign financial institution and, to the extent not held in an account at a financial institution: (i) any stock or security issued by any person other than a United States person; (ii) any financial instrument or contract held for investment that has an issuer or counterparty that is not a United States person; and (iii) any interest in a foreign entity.

Section 6038D(c) sets forth the information an individual must include on the statement reporting specified foreign financial assets. For a financial account, the name and address of the financial institution in which the account is maintained  as well as the account number must be reported. As to stock or securities, the name and address of the non-U.S. issuer, as well as information necessary to identify the class or issue of which the stock or security is a part, must be reported. In the case of any other instrument, contract, or interest, the names and addresses of all issuers and counterparties must be reported, together with the information necessary to identify the instrument, contract, or interest. The maximum value of each specified foreign financial asset during the taxable year also must be reported.

An individual who fails to disclose the information required to be reported by section 6038D(c) is subject to a $10,000 penalty under section 6038D(d)(1). Section 6038D(d)(2) provides that if the failure to comply continues for more than 90 days after receipt of notice of such failure, the individual must pay an additional penalty of $10,000 for each 30 day period (or fraction thereof) during which the failure to disclose continues after the expiration of the 90-day period up to a maximum of $50,000 with respect to any such failure.

Under section 6038D(e), the aggregate value of any specified foreign financial assets in which an individual has an interest is presumed to exceed the reporting thresholds set forth in section 6038D(a) if the Secretary determines that the individual has an interest in one or more specified foreign financial assets and has not provided sufficient information to demonstrate the aggregate value of the assets. This presumption applies for purposes of assessing the penalties imposed under section 6038D.

Section 6038D(f) authorizes the Secretary to issue regulations or other guidance applying the provisions of section 6038D to any domestic entity as if the domestic entity were an individual, if the domestic entity is formed or availed of for the purposes of holding, directly or indirectly, specified foreign financial assets. (italics added for emphasis).

Section 6038D(g) provides that no penalty will be imposed by section 6038D for any failure to report that is shown to be due to reasonable cause and not due to willful neglect. A foreign law restriction, whether civil or criminal, on disclosing the information required to be reported is not reasonable cause. This means that an U.S. individual may not use the rationale of a foreign bank secrecy statute or similar provision to excuse non-filing.

Section 6038D(h) authorized the Secretary to issue regulations or other guidance as may be necessary or appropriate to carry out the purposes of section 6038D which is reported in this post. This guidance may include appropriate exceptions from reporting for nonresident aliens, bona fide residents of U.S. possessions, and classes of assets identified by the Secretary. Section 6038D is effective for taxable years beginning after March 18, 2010 (the date of enactment of the HIRE Act). IRS Notice 2011-55, 2011-29 IRB 53 (July 18, 2011), provides that an individual that has a taxable year that begins after March 18, 2010, and is required to attach a statement of specified foreign financial assets to an annual return to be filed prior to the issuance of Form 8938, "Statement of Specified Foreign Financial Assets," is to satisfy his or her obligation under section 6038D for such taxable year by attaching Form 8938 for such taxable year to his or her next annual return required to be filed after the issuance of Form 8938.

Other Related Reporting Requirements

In addition to the FBAR requirements, additional reports are required by the Internal Revenue Code to be filed with the IRS by U.S. persons engaged in foreign activities, directly or indirectly, through a foreign business entity. Upon the formation, acquisition or ongoing ownership of certain foreign corporations, U.S. persons that are officers, directors, or shareholders must file a Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations.” IRS Form 8865, “Return of U.S. Persons with Respect to Certain Foreign Partnerships,” must be filed with respect to certain interests in a controlled foreign partnership. IRS Form 3520, “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts,” must be filed with respect to certain foreign trusts. IRS Form 8858, “Information Return of U.S. Persons With Respect To Foreign Disregarded Entities” must be filed with respect to a foreign disregarded entity. To the extent that the U.S. person engages in such foreign activities indirectly through a foreign business entity, other self-reporting requirements may apply. In addition, a U.S. person that capitalizes a foreign entity generally is required to file an IRS Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation.

The section 6038D filings will presumably be closely monitored and compared with the foreign financial institution and foreign non-financial institution reporting and witholding requirements to become operative in accordance with Chapter 4 of HIRE otherwise known as the FATCA provisions.

CAVEAT. THE INFORMATION CONTAINED IN THIS POSTING IS INTENDED FOR INFORMATIONAL PURPOSES ONLY AND NEITHER CONSTITUTES, NOR MAY BE RELIED UPON AS, LEGAL ADVICE. PERSONS READING THIS POST WHO ARE POTENTIALLY SUBJECT TO THE REPORTING REQUIREMENTS UNDER TITLE 26 OR TITLE 31 OF THE UNITED STATES CODE REFERRED TO HEREIN ARE STRONGLY ENCOURAGED TO SEEK THE ADVICE OF A QUALIFIED TAX LAWYER

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

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

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

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

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

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

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

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

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

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

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In May, 2008, temporary and proposed regulations were issued under §367(b) to address the Service’s concern about the tax impacts arising from certain triangular reorganizations involving foreign corporations, a/k/a “Killer B” transactions, in which a subsidiary purchases, in connection with the reorganization, stock of its parent corporation in exchange for property, and exchanges the parent corporation’s stock for the stock or property of a target corporation. This problem area had been on the Service’s radar screen for some time. See Notices 2006-85 and 2007-48. The reason for the concern was that the Service felt that such transactions involved the repatriation of earnings in the form of a tax-free reorganization that in many cases would escape U.S. income taxation on dividend repatriations.

The 2008 regulations contained in Temp. Reg.§ 1.367(b)-14, are now issued in final form in Treas. Reg. § 1.367(b)-10 and apply to transactions occurring after May 16, 2011. The final regulations require that adjustments be made as part of such a reorganization, i.e., subsidiary exchanges property for stock of its parent to acquire target stock (and/or securities) in a reorganization. The adjustments are deemed to be a dividend from the subsidiary  to the parent of the property transferred to the parent in exchange for its stock (and securities). Where the subsidiary purchases parent stock from another party, however, the parent is also treated as having contributed to the subsidiary the property deemed distributed to the parent.

Background.

Section 367(a)(1) provides in connection with a generally non-taxable liquidation of a controlled subsidiary, tax-free incorporation under §351 or non-taxable reorganization, involving a U.S. person’s transfer of appreciated property to a foreign corporation, such foreign corporation shall not be treated as a domestic corporation. This means that gain on the transfer of appreciated property will be recognized unless an exception to §367(a)(1) applies to the transfer. In addition, §367(b)(1) provides that in the case of any exchange that is entitled to non-recognition treatment, e.g., liquidation of a controlled subsidiary, non-taxable reorganization, etc., where there is no transfer of property described in §367(a)(1), such as in a  exhange of stock solely for voting stock in a Type B reorganization, a foreign corporation will be treated as a corporation except to the extent provided in regulations.  

Section 367(a)(1) (and the regulations under that section) and the 2008 regulations could each potentially apply to certain triangular reorganizations. For example, §367(a)(1) and the 2008 regulations could each potentially apply to a triangular reorganization described in  §368(a)(1)(B) if the subsidiary acquires parent corporation stock for property and each corporation involved in a triangular B reorganization, including the target corporation, are foreign corporations and the target corporation stock is held by a U.S. person who realizes gain on the exchange.  See Treas. Reg. § 1.367(a)-3(d)(1)(iii)(A) (providing that there is an indirect transfer by the U.S. person of the target stock to the subsidiary). Under a priority rule, §367(b)(1) will not apply to an exchange if gain is required to be recognized under §367(a)(1) unless an exception is provided by regulation.

Priority Rules

The 2008 regulations included a “priority rule” that provided, in general,  that if the amount of gain in the U.S. person’s disposition of target  stock that would otherwise be recognized under §367(a)(1) (absent an exception) is less than the adjustment treated as a dividend under the 2008 regulations, then the 2008 regulations, and not §367(a)(1), would apply to certain triangular reorganizations. See Treas. Reg. §1.367(a)-3(c). A comment received in response to the 2008 regulations was that the “priority rule” may not always yield the correct result at least from a tax policy standpoint, i.e., the “greater” dividend amount (over the gain amount) may be insulated from U.S. income taxation by a favorable tax treaty.  

While rejecting a full U.S. tax liability impact analysis as had been suggested by a commentator, the final regulations to Treas. Reg. §1.367(b)-10 will not apply (and therefore §367(a)(1) will apply) where the parent and subsidiary corporations in the triangular B reorganization are foreign corporations and neither corporation is a controlled foreign corporation (per Treas. Reg. §1.367(b)-2(a)) immediately before or immediately after the triangular reorganization. As a second exception to application of the  “priority rule”, the final regulations under Treas. Reg. §1.367(b)-10 do not apply if: (1) the parent is a foreign corporation; (2) the subsidiary is a domestic corporation; (3) the  parent’s receipt of a dividend from subsidiary  would not be subject to U.S. income tax under either §881 (for example, by reason of an applicable treaty) or  §882; and (4) the parent’s stock in the subsidiary is not a United States real property interest. See §897(c) .

The final regulations add a protective rule which includes the acquisition by the subsidiary, in exchange for property, of the parent corporation’s securities that are used to acquire the stock, securities, or property of the target corporation in the triangular reorganization, but only to the extent the parent’s securities are treated by the target’s shareholders or security holders as "other property" under §356(d).  Finally, the final regulations modify the “priority rule” by: (1) including exchanges of target securities as well as target corporation stock; (2) comparing the amount of gain that would be recognized under §367(a)(1) with not only the amount of the deemed dividend but also the amount of any gain (per §§301(c)(1) and (3), respectively); and (3) by providing  separate priority rules in  Treas. Regs. § 1.367(a)-3(a) and  Treas. Reg. § 1.367(b)-10.

Under Treas. Reg. § 1.367(a)-3(a)’s  priority rule, as modified, if the amount of gain in the target’s stock or securities that would otherwise be recognized by the target’s shareholders or security holders under §367(a)(1) (without regard to any exceptions to §367(a)(1)) is less than the sum of the amount of deemed dividend and the amount of gain (applying §§301(c)(1) and (3), respectively) under the final regulations, §367(a)(1) does not apply to the §§354 or 356 exchange by the target shareholders or security holders.  Stated in the opposite manner, under Treas. Reg. §1.367(b)-10’s priority rule, if the amount of gain recognized by the target shareholders or security holders under §367(a)(1) (taking into account any exception to §367(a)(1) that is applied) on the §354 or §356 exchange of target stock or securities exceeds the sum of the amount of deemed dividend and the amount of gain (applying §§ 301(c)(1) and (3), respectively) if the final regulations otherwise applied to the triangular reorganization, then the final regulations will not apply.

Priority Rules Apply Where Target is Unrelated to the Parent or Subsidiary Corporations

While commentators to the 2008 regulations posited that the 2008 regulations should not apply where the target is not related to either the parent or subsidiary, the final regulations did not adopt such proposal. The Treasury and IRS felt that even in such situation the potential for inequitable tax avoidance was still present.

Adjustments Having the Effect of a Distribution or Contribution

The final regulations clarify that adjustments are made based on a distribution or contribution of a notional amount, and therefore without the recognition of any built-in gain or loss on the distribution of such notional amount. The notional amount is equal to the amount of money transferred and liabilities assumed plus the fair market value of other property transferred, in connection with the triangular reorganization, by the subsidiary in exchange for the parent corporation’s stock or securities used to acquire the stock, securities or property of the target corporation.  The final regulations clarify that the adjustments that have the effect of a deemed distribution or deemed contribution do not affect the characterization of the actual transaction. For example, where the subsidiary corporation uses  property with a built-in gain to acquire parent corporation stock, its exchange of the property for parent stock is not affected by the regulations. Instead, the regulations require adjustments based on a deemed distribution and deemed contribution of the notional amount that occur apart from, and in addition to, the subsidiary corporation’s exchanging the built-in gain property for the  parent corporation stock. Under this example, the subsidiary would not recognize gain under §311(b) as to the notional amount and the subsidiary’s exchange of property would continue to be treated as an exchange subject to §1001 in which the subsidiary recognizes the built-in gain.

The final regulations apply to transactions occurring on or after May 17, 2011. For transactions that occur prior to May 17, 2011, see  Treas. Reg. § 1.367(b)-14T as contained in 26 CFR part 1 revised as of April 1, 2011.

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On March 4, 2011, the Treasury issued T.D.9515, containing final regulations on the treatment of certain intercompany gains with respect to stock owned by members of a consolidated group. The regulations provide for the redetermination of intercompany gain excluded from gross income in certain transactions involving stock transfers between members of a consolidated group. The temporary regulations portion of T.D. 9515 were included solely for the purpose of retaining the portion of the existing temporary regulations that are not being promulgated as final regulations at this time.  As background, on March 7, 2008, the IRS and the Treasury Department published temporary regulations § 1.1502-13T. See TD 9383, 2008-15 IRB 738. Also on March 7, 2008, the IRS and the Treasury Department published a notice of proposed rulemaking cross-referencing those temporary regulations. See REG-137573-07, 2008-15 IRB 750.

The 2008 temporary regulations addressed the treatment of certain intercompany gain with respect to consolidated group member stock. Treas. Reg. Section 1.1502-13 provides rules governing the timing and characterization of items resulting from transactions between consolidated group members. Treas. Reg. Section 1.1502-13(c) provides general rules under which the timing and character of those items can be deferred or recharacterized to clearly reflect the taxable income (and tax liability) of the group as a whole. These rules, in general, require application of a  “matching” principle under which the timing of inclusion of gain on the sale of property by the seller is linked to the buyer's recovery of its basis in the property and the seller’s and the buyer’s characterization are subject to redetermination in order to treat both seller and buyer as divisions of a single corporation.

The proposed regulations provide that intercompany gain with respect to member stock may be permanently excluded from gross income following certain stock basis elimination transactions such as in a tax-free spin off or section 332 liquidation. The IRS and the Treasury Department, in issuing the final regulations, reconsidered the requirement contained in the proposed regulations that, immediately before intercompany gain would otherwise be taken into account, the common parent  must be the member that holds the member stock with respect to which the intercompany gain was realized, and that the gain must be common parent’s intercompany item. Given the other requirements of the regulation, namely that (i) the group has not and will not derive any Federal income tax benefit from the intercompany transaction; and (ii) the excluded gain will not be treated as tax-exempt income for purposes of the investment adjustment regulations—it is appropriate to provide relief where a member other than the common parent holds the subject stock. The final regulations, therefore,  allow the exclusion of gain where a member holds the target member stock with respect to which the intercompany gain was realized, and the holding member is either (i) the buyer or seller, as a successor to the other party (either buyer or seller); or (ii) a third member that is the successor to both the buyer and seller corporate members.  

Previously, the preamble to the proposed regulations requested comments as to whether the “Commissioner's Discretionary Rule” ( Treas. Reg. Section 1.1502-13(c)(6)(ii)(D)) should be retained. The preamble also stated that the IRS and Treasury Department were considering eliminating the Commissioner's Discretionary Rule. Upon further consideration, T.D. 9515 states there may be circumstances where application of such discretion is warranted. Thus, for example, the final regulations do not provide automatic relief for transactions involving property other than member stock (such as the stock of non-members), but relief may be available after review by the IRS under the Commissioner's Discretionary Rule. The final regulations retain the Commissioner's Discretionary Rule in a form revised to describe the conditions to be satisfied for that discretion to be exercised, and to indicate that relief is available only through a request for a letter ruling. Finally, the final regulations provide that excluded gain is not treated as tax exempt income for purposes of  Treas. Reg. Section  § 1.1502-32 and does not increase earnings and profits.

An example from the final regulations is quoted.

 

“ Example 16. Intercompany stock distribution followed by section 332 liquidation. (a) Facts. P owns all of the stock of S, S owns all the stock of T, a member of the P group, and T owns all of the stock of T1, also a member of the P group. On January 1 of Year 1, S distributes all of the T stock to P in a distribution to which section 301 applies. At the time of this distribution, the value of the T stock is $100 and S has a $40 basis in the T stock. Under section 311(b), the distribution creates $60 of intercompany gain to S. Under section 301(d), P's basis in the T stock is $100. S will take its $60 intercompany gain into account under the matching rule. On January 1 of Year 4, in an independent transaction, S distributes all of its assets to P in a complete liquidation to which section 332 applies, and, under paragraph (j)(2) of this section, P succeeds to S's $60 gain. On January 1 of Year 7, T distributes all of its T1 stock to P in a transaction to which  section 355 applies. At the time of this distribution, P has a basis in the T stock of $100, the value of the T stock (without regard to T1) is $75, and the value of the T1 stock is $25. Under section 358, P allocates $25 of its $100 basis in the T stock to the T1 stock, and, under paragraph (j)(1) of this section, the T1 stock becomes a successor asset to the T stock. On January 1 of Year 9, in an independent transaction, T distributes all of its assets to P in a complete liquidation to which section 332 applies.

(b) Analysis. Under paragraphs (b)(1) and (f)(2) of this section, S's distribution in Year 1 of the T stock to P is an intercompany transaction, S is the selling member, and P is the buying member. In Year 9 when T liquidates, P has no gain or loss under section 332. Under paragraph (b)(3)(ii) of this section, P's $0 gain or loss with respect to the T stock under section 332 is a corresponding item. P takes $45 (75/100 × $60) of its intercompany gain into account under the matching rule in Year 9 to reflect the difference between P's $0 of unrecognized gain and P's $45 of recomputed unrecognized gain. (If P and S were divisions of a single corporation, P would have had a $40 basis in the T stock, and, after the Year 7 distribution of the T1 stock, would have held the T stock with a $30 basis.) However, paragraph (c)(6) of this section does not prevent the redetermination of P's intercompany gain as excluded from gross income provided P succeeds to S's intercompany item; P and S are a single entity; P's basis in the T stock that reflects the $45 intercompany gain taken into account is eliminated without the recognition of gain or loss (and this eliminated basis is not further reflected in the basis of any successor asset); the group has not derived and no taxpayer will derive any Federal income tax benefit from the basis in the T stock and will not derive any Federal income tax benefit from a redetermination of this portion of the gain; and the effects of the intercompany transaction have not previously been reflected, directly or indirectly, on the P group's consolidated return. (See paragraph (c)(6)(ii)(C) of this section.) Accordingly, under paragraph (c)(6)(ii)(C) of this section, the $45 intercompany gain that P takes into account is redetermined to be excluded from gross income. P's basis in its T1 stock continues to reflect $15 of intercompany gain.”

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 On January  6, 2011, the Treasury and the Internal Revenue Service proposed regulations (REG-146097-09) that would require U.S. banks to file annual reports of interest income paid to nonresident alien individuals. Current regulations, set forth in §6049, only require U.S. banks to report bank deposit interest paid to a U.S. person or to a non-resident alien who is a resident of Canada. The new proposed regulations resurface a prior proposed regulation project issued by the Clinton Administration that would have required U.S. banks to annually report to the IRS all U.S. bank deposit interest paid to any non-resident alien individual.  This proposal was strongly opposed by various business groups and such strong renewed opposition should be anticipated.

The stated rationale of the Service for the reissuance of this reporting is that it will foster global information exchange with other countries. It "will further strengthen the United States exchange and information program, consistent with adequate provisions for reciprocity, usability, and confidentiality in respect of this information..”. Moreover, the proposal is aimed at improving voluntary compliance by U.S. persons who attempt to avoid U.S. information reporting by making false claims of foreign status.

The banking industry in light of the reporting requirements imposed under the recent FATCA reporting and withholding regimes, along with this new rule, should be expected to lobby the Congress to have such proposal and reforms substantially cut-back or repealed. Stay tuned.
 

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On September 13, 2010, the Service, in REG-119921-09, issued somewhat landmark  proposed regulations concerning the classification for Federal tax purposes of a series of a domestic series limited liability company (LLC), a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business. The proposed regulations provide that, whether or not a series of a domestic series LLC, a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business is a juridical person for local law purposes, for Federal tax purposes it is treated as an entity formed under local law. Classification of a series or cell that is treated as a separate entity for Federal tax purposes generally is determined under the same rules that govern the classification of other types of separate entities.

Background

Certain states, including Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah and Puerto Rico,have statutes providing for series LLCs. A series LLC statute allow an LLC to establish separate series. Although series of a series LLC generally are not treated as separate entities for state law purposes and, thus, cannot have members, each series has “associated” with it specified members, assets, rights, obligations, and investment objectives or business purposes. Assuming the series LLC is properly documented, the debts, liabilities, and obligations of one series generally are enforceable only against the assets of that particular series and not against assets of other series or of the series LLC.

Certain jurisdictions have enacted statutes providing for entities similar to the series LLC. For example, certain statutes provide for the chartering of a legal entity (or the establishment of cells) under a structure commonly known as a protected cell company, segregated account company or segregated portfolio company (cell company). A cell company may establish multiple accounts, or cells, each of which has its own name and is identified with a specific participant, but generally is not treated under local law as a legal entity distinct from the cell company. The assets of each cell are statutorily protected from the creditors of any other cell and from the creditors of the cell company.

Prior to the issuance of the proposed regulations, the Service acknowledged that little guidance exists as to whether for Federal tax purposes a series (or cell) is to be treated as an entity separate from other series or the series LLC (or other cells or the cell company, as the case may be), or whether the company and all of its series (or cells) should be treated as a single entity. In response to a request for comments, the Service and the Treasury were, in general, in agreement that series and cells should be treated as separate entities for Federal tax purposes where established under a statute with provisions similar to the series LLC statutes currently in effect in several states.

Treas. Reg. §301.7701-1(a)(1) provides that the determination of whether an entity is separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law. Treas. Reg. §301.7701-1(a)(2) provides that a joint venture or other contractual arrangement may create a separate entity for Federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.

However, a joint undertaking merely to share expenses does not create a separate entity for Federal tax purposes, nor does mere co-ownership of property where activities are limited to keeping property maintained, in repair, and rented or leased.

Classification as a Separate Entity for Federal Tax Purposes

Whether an organization is an entity separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law.  Treas. Reg. §301.7701-1(a)(1). In Moline Properties, Inc., 319 U.S. 436 (1943) , the Supreme Court opined that where a corporation was formed for a purpose that is the equivalent of business activity or the corporation actually carries on a business, the corporation remains a taxable entity separate from its shareholders. Although entities that are recognized under local law generally are also recognized for Federal tax purposes, a state law entity may be disregarded if it lacks business purpose or any business activity other than tax avoidance. See Bertoli, 103 T.C. 501 (1994) ; Aldon Homes, Inc., 33 T.C. 582 (1959) . In the landmark partnership tax cases, Culbertson, 337 U.S. 733 (1949) and Tower,327 U.S. 280 (1946) , a partnership exists for Federal tax purposes where  the parties in good faith and acting with a business purpose intended to join together to conduct an enterprise and share in its profits and losses. See also Madison Gas & Elec. Co., 633 F.2d 512, 514 (7th Cir. 1980); Luna,  42 T.C. 1067, 1077-78 (1964) . On the other hand, the Service has ruled that a co-ownership does not rise to the level of an entity for Federal tax purposes if the owner employs an agent whose activities are limited to collecting rents, paying property taxes, insurance premiums, repair and maintenance expenses, and providing tenants with customary services. See Rev. Rul. 75-374, 1975-2 CB 261; Rev. Rul. 79-77 1979-1 CB 448; Rev. Proc. 2002-22, 2002-1 C.B. 733 (ruling guidelines on co-ownership of property as not constituting a partnership).  See also National Securities Series-Industrial Stocks Series, 13 T.C. 884 (1949), acq. 1950-1 C.B. 4. Compare. Union Trusteed Funds , 8 T.C. 1133 (1947) (series funds organized by a state law corporation could not be treated as if each fund were a separate corporation). See also §851(g)(rules for series funds of a RIC) and §§816(a) and 831(c) for definitions of an “insurance company”.

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On August 11, 2010, the Service issued temporary regulations (T.D. 9498) under §108(i)’s election to defer cancellation of indebtedness income for  corporations, partnerships and S corporations. The provision was enacted as part of the American Recovery and Reinvestment Act of 2009 and was intended by Congress to allow business to defer COD income ratably over a five hear period. The election is irrevocable. The IRS on August 11 released a set of temporary regulations providing rules for the section 108(i) election to defer cancellation of debt (COD) income for partnerships and corporations. The provision sunsets at the end of 2010 which limits the time that eligible taxpayers can restructure reacquisitions of debt to take advantage of the deferral. See also Rev. Proc. 2009-37, 2009-36 IRB 309.

This post reviews a few of the more noteworthy aspects of the rulemaking. A careful reading of the language contained in section 108(i) and the temporary regulations is a must.

Application to Corporations

Where a debtor corporation liquidates and dissolves or disposes of its assets connected with deferred COD income, an acceleration of the entire balance of deferred income is required. While the thought is that the scope of the acceleration provision should be narrow, the regulations provide for acceleration events for electing corporations which change their tax status or go out of existence. Exception is provided for section 332 and section 381 transactions but includes situations where the electing corporations files a Title 11 bankruptcy. Another acceleration event is where the corporation takes part in a transaction which might impair its ability to pay the related COD income tax liability, i.e., an impairment transaction. The regulations note that while a sale of substantially all assets results in an acceleration event for electing partnerships, it does not constitute an acceleration for electing corporations.

If a corporation engages in an impairment transaction under section 108(i), the regulations provide a net value acceleration rule that identifies when the electing corporation must accelerate its remaining deferred COD income. Acceleration is required only if immediately after the transaction, the gross value of the corporation's assets is less than 110% of its liabilities plus the related deferred COD tax. To avoid an acceleration under the impairment rule, the corporation must restore a certain amount of assets, i.e., either the amount removed in the impairment transactions or the difference between the gross value of its assets and the sum of its liabilities plus the related deferred COD tax, in a timely manner. This requires that corporations have a 10% equity base over liabilities, including deferred taxes in applying this rule. Still, this rule may prove to be a problem for heavily leveraged corporations.

For consolidated groups, the temporary regulations provide that an electing member has engaged in an impairment transaction if the transaction impairs the group's ability to pay the tax on the group's deferred COD. Groupwide treatment ensures that intercompany transactions do not qualify as impairment transactions. An impairment transaction does occur, however, when an electing member ceases to be a group member or moves to another group, although application of the net value acceleration rule is applied on a separate-entity basis (in the case of a cessation) or by reference to the members of the acquiring group (in the case of a transfer). The regulations further permit an electing member of a consolidated group to elect to accelerate in full the inclusion of its remaining deferred COD.

Dividends and charitable contributions are generally not treated as impairment transactions. Special rules in this area are also set out for regulated investment companies and REITs.

Earnings and profits of an electing corporation will increase in the year in which a §108(i) election is made and a corresponding decrease in earnings and profits when the deferred OID deduction is permitted. See §312(n).

Acceleration Events Involving Partnerships and S Corporations

Where the electing partnership or S corporation liquidates, disposes of substantially all of its assets, files for Title 11 bankruptcy, or otherwise dissolves, any COD income deferred under section 108(i) is accelerated and must be taken into account in the year of the triggering event. Similarly, where a partner or S corporation shareholder sells (or exchanges, redeems, transfers, gifts, or abandons) his interest in the electing entity, or he dies or liquidates, the deferred COD income allocated to that partner or shareholder is accelerated, and any gain must be recognized. There may not be, however, a requirement that the other partners or shareholders treat the deferred income as acceleration. The disposition of part but not all of a partner’s or S shareholder’s interest in the entity will result in only a corresponding percentage of acceleration of deferred COD income.  

As to what constitutes “substantially all” of the assets of a partnership, the regulations borrow from the safe harbor rule applied by the Service for certain reorganizations, including Type C reorganizations. Accordingly, the regulations provide that for acceleration purposes, "substantially all" assets means at least 90% of the fair market value of the net assets and at least 70% of the fair market value of the gross assets as of the date prior to the sale. In a tiered partnership structure, where a lower-tier partnership undergoes a triggering event, that event will not generally result in an acceleration event for the upper-tier electing partnership. However, if before the triggering event the upper-tier electing partnership transferred property to the lower-tier partnership under §721, the electing partnership could be treated as having sold substantially all of its assets, which would of course result in an acceleration event.

As to redemptions of partnership interests and interests in pass thru entities, the regulations provide that liquidating distributions of cash or other property by a partnership to a partner only count as redemptions giving rise to an acceleration event where the distribution represents a complete liquidation of the partner's interest. In addition, the regulations  provide that several types of transactions would not generally cause an acceleration event, including transactions described in §721, like kind exchanges under §1031 and terminations under §708(b)(1)(B).  

The regulations also set forth five safe harbors for partnerships and S corporations to meet the trade or business requirement in making the §108(i) election. Temp. Reg. section 1.108(i)-2T(d)(1) states that if at least 95% of the interest paid or accrued on the issued debt instrument was allocated to a trade or business expense under Treas. Reg. §1.163-8T, the instrument is deemed issued in connection with the partnership’s or S corporation's trade or business. The regulations also provide that a disregarded entity may take advantage of the election by treating any debt instrument issued by it as having been issued by the person treated as owning its assets for federal income tax purposes.

Allocation of COD Income Problems.

The regulations provide  that a partnership must first allocate all of the COD income connected to a reacquired applicable debt instrument to those persons who were partners immediately before the reacquisition under the rules of §704 without regard to §108(i). Then it determines which portion of each partner's allocable share of the COD income is deferred and which portion is included in the partner's distributive share of partnership income for the year. The regulations apply the pro rata allocation method to electing S corporations. Treas. Reg. §1.108(i)-2T(c)(1).

Outside basis is not increased under §705 or §1367 until the deferred COD income is recognized. he basis adjustment rules in the regs make clear that a partner's basis in its partnership The regulations further  address how to compute a partner's deferred section §752 amount, how capital accounts are effected and the consequences under the at-risk rules in §465.

Deferral of OID Deductions

Where the reacquisition causes a debt instrument to be issued or deemed issued, §108(i) provides for the deferral of related OID expense deductions ratably over the statutory inclusion period. The regulations provide that if a debt instrument is issued and the proceeds of it are used by the issuer or a person related to the issuer to reacquire the issuer's applicable debt instrument, such instrument is treated as having been issued for the reacquired applicable debt instrument. The phrase "or a person related to the issuer" was designed to prevent related parties from avoiding the rules for deferred OID deductions.

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On June 8, 2010, the Service issued final regulations providing that the section 704(c) anti-abuse rule takes into account the tax liabilities of both the partners in the partnership as well as certain direct and indirect owners of the partnership. T.D. 9485 (Treas. Reg. §1.704-3). The regulations apply to tax years commencing after June 9, 2010.

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When the terms of a debt instrument (e.g., mortgage, note or bond) are modified by agreement, the modification may be significant enough to result in a deemed taxable exchange of the original debt instrument for a “new” debt instrument.  This outcome, which has tax impacts on both the lender and the borrower, was announced in the Supreme Court’s decision in Cottage Savings v. Commissioner, 499 U.S. 554 (1991), and regulations which were issued thereafter under Treas. Reg. §1.1001-3. Under §1001, gain or loss is recognized by the lender and the debtor may find itself with cancellation of indebtedness income which then must be tested under §108 to see if there is a way to exclude the result from the borrower’s gross income.  

Treas. Reg. § 1.1001-3(c)(2)(ii) generally provides that a modification to a debt instrument occurs if an alteration changes the instrument to an instrument or property right that is not debt for federal income tax purposes, even if the alteration occurs by operation of the original terms of the debt instrument. Treas. Reg. § 1.1001-3(e)(5)(i) provides that a modification of a debt instrument that results in an instrument or property right that is not debt for federal income tax purposes is a significant modification. For purposes of this regulation,  any deterioration in the financial condition of the issuer between the issue date of the unmodified debt instrument and the date of modification (as it relates to the issuer's obligation to repay the debt instrument) is not taken into account, unless there is a substitution of a new obligor or the addition or deletion of a co-obligor.
The rule in Treas. Reg. § 1.1001-3(e)(5)(i) to disregard the worsening (or improving) financial condition of the issuer was originally intended to soften the potential for an adverse income tax impact to a financially troubled issuer. Thus, where a debt instrument is modified to accommodate the borrower in a troubled financial situation context, a hidden tax on the modification would place an additional burden on the borrower and would run adverse as well to the lender’s interest in seeing the adjusted obligated repaid in full. Despite this intent, the regulations can be viewed as imposing a taxable modification of a troubled borrower under certain instances. See  Treas. Reg. § 1.1001-3(c)(2)(ii) .

IRS has just issued proposed regulations which clarify the extent to which the deterioration in the financial condition of a debt instrument's issuer is taken into account in determining whether a modified debt instrument is recharacterized as an instrument or property right that is not debt. 

Under the proposed regulation, an analysis of all of the factors relevant to a debt determination of the modified instrument are to be analyzed at the time of the modification.  However, in making this determination, any deterioration in the financial condition of the issuer between the issue date of the debt instrument and the date of the alteration or modification (as it relates to the issuer's ability to repay the debt instrument) is not taken into account ( Prop. Reg § 1.1001-3(f)(7)(ii)(A) ) unless there is a substitution of a new obligor or the addition or deletion of a co-obligor. ( Prop. Reg § 1.1001-3(f)(7)(ii)(B) ) For example, any decrease in the fair market value of a debt instrument (whether or not publicly traded) between the issue date of the debt instrument and the date of the alteration or modification is not taken into account to the extent that the decrease in FMV is attributable to the deterioration in the financial condition of the issuer and not to a modification of the terms of the instrument. ( Prop. Reg § 1.1001-3(f)(7)(ii)(A) ). Where a debt instrument is significantly modified and the issue price of the modified debt instrument is determined under Prop. Reg § 1.1273-2(b) or Prop. Reg § 1.1273-2(c) (relating to a FMV issue price for publicly traded debt), then any increased yield on the modified debt instrument attributable to this issue price generally is not taken into account to determine whether the modified debt instrument is debt or some other property right for federal income tax purposes. However, any portion of the increased yield that is not attributable to a deterioration in the financial condition of the issuer, such as a change in market interest rates, is taken into account. ( Preamble to Prop Reg 06/03/2010 ). Effective date. The proposed regs apply to alterations of the terms of a debt instrument on or after the date the regs are finalized, but taxpayers may rely on them for alterations of the terms of a debt instrument occurring before that date. ( Prop Reg § 1.1001-3(h)(2) ).
 

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