In PLR 201322032 (5/31/2013), the National Office ruled that an ownership change under a plan of reorganization will constitute a Title 11 ownership change in accordance with Section 382(l)(5)(A) and therefore there will be no NOL cut-back or ownership change limitation resulting by virtue of application of Section 382(a).

Summary of Section 382(a): Application to Title 11 Proceedings

Section 382(a) provides that the taxable income of any “new loss corporation” with respect to any “post-change year” which may be offset by “pre-change losses” shall not exceed the Section 382 limitation for such year. Under Section 382(b)(1), generally, the Section 382 limitation for any post-change year will be an amount equal to (A) the value of the old loss corporation as of the change date, multiplied by (B) the long-term tax exempt rate. Under Section 382(b)(2), if the Section 382 limitation for any post-change year exceeds the taxable income of the “new loss corporation” for such year which was offset by “pre-change losses” the Section 382 limitation for the next post-change year is increased by the amount of such offsets. Where the new loss corporation does not carry on the business enterprise of the old loss corporations continuously for a minimum period of 2 years beginning with the change date, Section 382(c) provides that the Section 382(c) limitation will be zero.

The Section 382 limitation does not apply to an ownership change if the old loss corporation is a debtor in bankruptcy. Generally, where the bankruptcy rule under Section 382 applies, the pre-change net operating losses and excess credits that can be carried forward to a post-change year are reduced. A new loss corporation, however, may elect not to have the bankruptcy exception apply. More specifically, under Section 382(l)(5), Section 382(a) does not apply with respect to any ownership change where the old loss corporation is immediately prior to such ownership change under the jurisdiction of the court in a title 11 or similar case and the shareholders and creditors of the old loss corporation (determined just prior to such ownership change) own (immediately after such ownership change and as a result of being shareholders or creditors before such change) stock of the new loss corporation (or stock of a controlling corporation if also in bankruptcy) meets the requirements under Section 1504(a)(2) (substituting 50% for 80% each place it appears). Other special rules apply under Section 382(l)(5).

Facts In Private Letter Ruling

Taxpayer is a State corporation that files a federal income tax return on a calendar year basis. Taxpayer produces and sells products to customers. The customers serve as end users or that purchase Product at wholesale for resale. As of the date of the Proposed Transaction (described below), Taxpayer has a NOL carryover (the "Pre-Change Losses").

As of Date 2 (actual date redacted), Taxpayer's capital stock consisted of a outstanding shares of a single class of common stock. All of Taxpayer's common stock is owned by its [historic] Shareholders, each of which owns b%.

As of Date 1 [actual date redacted] Taxpayer had been named as a defendant in numerous lawsuits claiming damages for personal physical injury, physical sickness, or death from exposure to Item that was included in Product. On Date 1, Taxpayer filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in order to obtain the court-supervised reorganization process and the provisions of Section 524(g) of the Bankruptcy Code to resolve the liability for the Item-related personal injury claims. Currently, Taxpayer is operating its business and managing its properties as a debtor in possession subject to the provisions of the Bankruptcy Code.

On Date 3 [actual date redacted], Taxpayer filed a plan of reorganization (the "Plan") with the Bankruptcy Court. Under the Plan, the existing capital stock of Taxpayer, which is held by the Shareholders, will be cancelled and all of the newly issued common stock of reorganized Taxpayer will be transferred to Trust. Pursuant to the Plan, Trust will be created to resolve all present and future Item-related personal injury claims against Taxpayer, as well as certain present and future Item-related personal injury claims against the Shareholders that relate to Taxpayer's manufacture, sale, or distribution of Item. An Item-related personal injury claim includes, in general, any claim against Taxpayer existing now or arising in the future for, among other things, death, bodily injury, sickness, disease, medical monitoring, or other personal injuries (whether physical, emotional, or otherwise) to the extent caused by or allegedly caused, directly or indirectly, by the presence of or exposure to Item or Item-containing products. The Item-related personal injury claims do not include Item-related property damage claims.

The Item-related personal injury claims will be addressed through the funding of Trust, which will receive on the Effective Date, in complete settlement and satisfaction of the Item-related personal injury claims, the following assets: (i) insurance proceeds previously received by Taxpayer; (ii) Taxpayer's right to future payments from certain insurance policy settlements; (iii) * * * percent of the newly issued reorganized Taxpayer common stock, representing all of the outstanding stock of reorganized Taxpayer; (iv) dividend payments to be made by reorganized Taxpayer in the future; and (v) * * * contributions from the Shareholders (collectively, the "Trust Assets"). The value of the Trust Assets expected to be contributed to Trust is estimated to be less than the value of the Item-related personal injury claims that are expected to be filed with Trust during the life of the trust.

It is further stated that under the Plan, Trust will assume all liability and responsibility for all of the allowed personal injury claims and will be the sole recourse of the holder of an Item-related personal injury claim. Also, Trust will indemnify Taxpayer, reorganized Taxpayer, the Shareholders, and certain insurance companies so that they will have no further financial or other responsibility for such claims. In the event that any cash or Trust Assets remain in Trust after all of the Item -related personal injury claims have been satisfied, the trustees of Trust will transfer such remaining assets to an unrelated charitable organization exempt from federal income tax under Section 501(c)(3). However, Taxpayer does not anticipate that any assets will remain in Trust after satisfaction of all allowed Item-related personal injury claims.

Under the Plan, the Bankruptcy Court will retain exclusive jurisdiction over any matter arising in or relating to the Chapter 11 case or the Plan. This includes matters relating to interpreting, enforcing and administering the terms of the Trust Agreement.

The Proposed Transaction

In the "Proposed Transaction," pursuant to the Plan, * * * percent of the reorganized Taxpayer common stock, representing all of the outstanding stock of reorganized Taxpayer, will be issued to Trust (the "Ownership Change").

Representations Made in Private Letter Ruling Request

The following representations have been made in connection with the Proposed Transaction:

(a) Trust will be a qualified settlement fund as defined in Treas. Reg. § 1.468B-1(c). [1]

(b) Taxpayer will be a loss corporation as defined in Section 382(k)(1)[2] at the time of the Ownership Change.

(c) Immediately before the Ownership Change occurs, Taxpayer will be under the jurisdiction of the Bankruptcy Court in a Title 11 or similar case, within the meaning of Sections 382(l)(5)(G) and 368(a)(3)(A).

(d) The Proposed Transaction will be pursuant to a bankruptcy plan approved by the Bankruptcy Court.

(e) Immediately after the Proposed Transaction, at least 50% of the value and voting power of the stock of Taxpayer will be held by Trust.

(f) Pursuant to Section 382(l)(5)(B), the amount of Pre-Change Losses available for use by Taxpayer will be computed as if no deduction were allowable for interest paid or accrued by Taxpayer during (i) any taxable year ending during the three-year period preceding the taxable year in which the Ownership Change occurs, and (ii) the period of the taxable year in which the Ownership Change occurs on or before the change date, with respect to indebtedness which was converted into Taxpayer common stock pursuant to the Proposed Transaction.

(g) Taxpayer will not have made an election under Section 382(l)(5)(H) to forgo the application of section 382(l)(5) to the Ownership Change.

(h) Immediately after the bankruptcy proceeding, there will be no outstanding options, including interests that are treated as an option under Treas. Reg. §1.382-9(e)(1), that, if exercised or converted, would affect the ownership of a controlling interest by Trust.

(i) None of the holders of claims against Taxpayer that are qualified creditors are described in Treas. Reg.§1.382-9(d)(4)(i).

Rulings

Based on the foregoing, the private letter ruling reached the following conclusions:

1. The Proposed Transaction will result in an ownership change of Taxpayer within the meaning of Section 382(g).

2. Solely for purposes of Section 382(l)(5)(A), the qualified creditors of Taxpayer, within the meaning of Treas. Reg. §1.382-9(d), will be treated as owning at least 50% of the stock of Taxpayer on the date of the Proposed Transaction; therefore, the Ownership Change of Taxpayer will be an ownership change described in Section 382(l)(5)(A) (regardless of whether or not all the persons who are beneficiaries of Trust have been identified or are identifiable at the time of the Proposed Transaction). Accordingly, the general rule stated in section 382(a) will not apply by reason of the Ownership Change to limit the amount of post-change year taxable income of Taxpayer that may be offset by Pre-Change Losses of Taxpayer.

Caveats Set Forth in PLR

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. In particular, we express no opinion regarding whether, if another ownership change occurs within the two years immediately following the Ownership Change described above, Section 382(l)(5)(D) will cause the Section 382 limitation with respect to the second ownership change to be zero.

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[1]  A qualified settlement fund is an account, fund or trust qualified settlement fund a fund, trust, or account that is: (1) established by an order of (or approved by) a federal, state, or local government authority; (2) established in order to satisfy one or more contested or uncontested claims asserting liability for torts, breach of contract, environmental clean-up under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), or any violation of laws or claims identified in Revenue Rulings or Revenue Procedures; and (3) a trust under applicable state law, or whose assets are otherwise segregated from other assets of the transferor. Treas. Reg. § 1.468B-1(c). See U.S. v. Brown, 92 AFTR 2d 2003-6826, 348 F3d 1200 . Payments to such funds can be deducted despite the economic performance requirement of § 461(h).

[2]  Under §382(k)(1) a “loss corporation” means a corporation able to use a NOL carryover or having a NOL for the taxable year in which the ownership change occurs. Except as otherwise provided in the regulations, it includes any corporation with a net unrealized built-in loss as of the change date.

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In Notice 2012-39 the Service provided guidance on some transfers of intangible property by a U.S. corporation to a foreign corporation in an exchange that falls within Section 361(a) or Section 368(b) The Service’s motive in issuing the Notice was to thwart transactions intended to repatriate earnings from foreign corporation without recognition of income. A regulations projection on the same issue is pending. The effective date of the proposed regulations is announced as to transfers occurring after July 12, 2012.

 

Background: Section 367(a) and Section 367(d) and Outbound Transfers to Controlled Foreign Corporations

 

 

Subject to certain exceptions, section 367(a) generally applies to the transfer of property by a United States person to a foreign corporation in an exchange described in section 332, 351, 354, 356, or 361. Section 367(d)(1) provides that, except as provided in regulations, if a U.S. person transfers any intangible property (as described in section 936(h)(3)(B)) to a foreign corporation in an exchange described in section 351 or 361, section 367(d) (and not section 367(a)) applies to such transfer. Income or gain attributable to the transfer of property by a U.S. person to a foreign corporation in an exchange described in section 351 or 361 is taken into account either in accordance with section 367(d)(2)(A)(ii)(I) or (II), or possibly in accordance with section 367(a).

Section 367(d)(2)(A) provides where a U.S. person transfers intangible property is treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of such property, the transferor is treated as receiving amounts that reasonably reflect the amounts that would have been received: (1) annually in the form of such payments over the useful life of such property (section 367(d)(2)(A)(ii)(I)), or (2) in the case of a disposition of the intangible property following such transfer (whether direct or indirect), at the time of the disposition (section 367(d)(2)(A)(ii)(II)). For this purpose, an indirect disposition of the intangible property following the transfer includes a disposition of the transferor's interest in the transferee corporation. S. Rep. No. 169, 98th Cong., 2d Sess., at 367 (1984). The amounts taken into account under section 367(d)(2)(A)(ii) must be commensurate with the income attributable to the intangible. Section 367(d)(2)(A) (flush language).

 

Section 367(d)(2)(B) provides for federal income tax purposes, earnings and profits of a foreign corporation to which the intangible property was transferred are reduced by the amount required to be included in the income of the transferor of the intangible property. Section 367(d)(2)(C) provides that any amount included in gross income pursuant to section 367(d) is treated as ordinary income. For purposes of applying section 904(d), any amount included in income under section 367(d) is treated in the same manner as if such amount were a royalty. Section 367(d)(2)(C).

 

Treasury Regulation Section 1.367(d)-1T(c)(1) provides that if a U.S. person transfers intangible property that is subject to section 367(d) to a foreign corporation (transferee foreign corporation) in an exchange described in section 351 or 361, then such person is treated as having transferred that property in exchange for annual payments contingent on the productivity or use of the property. The regulation further provides that such person shall, over the useful life of the property, annually include in gross income an amount that represents an appropriate arm's-length charge for the use of the property. Treasury Regulation Section. 1.367(d)-1T(c)(1). See Section 482.

 

Treasury Regulation Section 1.367(d)-1T(d)(1) provides that a U.S. person who transfers intangible property subject to section 367(d) to a transferee foreign corporation in an exchange described in section 351 or 361 and, within the useful life of the intangible property, that U.S. transferor subsequently disposes of the stock of the transferee foreign corporation to a person that is not a related person (per Treasury Regulation Section 1.367(d)-1T(h)). the U.S. transferor is treated as having simultaneously sold the intangible property to the unrelated person acquiring the stock of the transferee foreign corporation. Treasury Regulation Section 1.367(d)-1T(d)(1). The U.S. transferor is required to recognize gain (but not loss) in an amount equal to the difference between the fair market value of the transferred intangible property on the date of the subsequent disposition and the U.S. transferor's former adjusted basis in that property.

 

Treasury Regulation Section 1.367(d)-1T(e)(1) provides that where a U.S. person transfers intangible property  per section 367(d) to a transferee foreign corporation in an exchange described in section 351 or 361 and, within the useful life of the transferred intangible property, the U.S. transferor subsequently transfers the stock of the transferee foreign corporation to U.S. persons that are related to the transferor (per Treasury Regulation 1.367(d)-1T(h)). These rules generally provide, in part, that the related U.S. persons, over the useful life of the property, annually include in gross income a proportionate share of the contingent annual payments that would otherwise be deemed to be received by the U.S. transferor under Treasury Regulations Sections 1.367(d)-1T(c) and 1.367(d)-1T(e)(1).

 

Treasury Regulation Section 1.367(d)-1T(g)(1)(i) provides that if a U.S. person is required to recognize income under certain provisions of the regulations under section 367(d), including Treasury Regulation Section 1.367(d)-1T(c), and the amount deemed to be received is not actually paid by the transferee foreign corporation, then the U.S. person may establish an account receivable from the transferee foreign corporation equal to the amount deemed paid that was not actually paid. Such account receivable may be established and paid without further U.S. income tax consequences to the U.S. transferor or the transferee foreign corporation. Treasury Regulation Section 1.367(d)-1T(g)(1)(i).

 

Notice 2012-39: Identifying What the Service Considers Abusive In this Area

 

 

One example that is targeted by the Notice involves a U.S. parent corporation and a wholly owned domestic as well as a foreign subsidiary. The only asset of the domestic subsidiary is a patent with a tax basis of zero that is transferred to the foreign subsidiary for cash. Then the U.S subsidiary turns around distributes the cash to its U.S. parent corporation and liquidations under Section 332. The Service notes that some taxpayers have taken the position that neither the parent nor the domestic subsidiary recognizes gain or dividend income on the receipt of the cash. The parent then applies the section 367(d) regulations to include amounts in gross income in subsequent years and to establish a receivable from the foreign subsidiary in the amount of the parent's aggregate income inclusion. The parent claims that the foreign subsidiary's repayment of the receivable does not give rise to income so that the parent effects a repatriation in excess of the amount of cash transferred while only recognizing income in the amount of the inclusions over time. The pending regulations are intended to ensure that for all outbound section 367(d) transfers, the total income taken into account is either included in income by the U.S. subsidiary (transferor) in the year of the reorganization or, when appropriate, over time by one or more qualified successors. Any income taken into account must be commensurate with the income attributable to the section 367(d) property transferred in the outbound transfer.

 

Specifically, the Notice states that the regulations will provide that in an outbound section 367(d) transfer, the U.S. transferor will take into account income under section 367(d)(2)(A)(ii)(I) regarding each qualified successor, if any, by treating as a prepayment of such income the product of the section 367(d) percentage multiplied by the sum of: (1) the money and fair market value of other property received by the qualified successor in exchange for, or in connection with, stock of the U.S. transferor, reduced by the portion of any U.S. transferor distributions received by the qualified successor; and (2) the product of the qualified successor's ownership interest percentage multiplied by the amount of non-qualifying liabilities that are either assumed by the transferee foreign corporation in the reorganization or satisfied by the U.S. transferor with money or other property provided by the transferee foreign corporation. As a prepayment of the income, the amount is included in income by the U.S. transferor in the year of the outbound section 367(d) transfer, regardless of the productivity of the transferred section 367(d) property in the year of the transfer or in subsequent years.

 

Income under section 367(d)(2)(A)(ii)(II) will be taken into account by the U.S. transferor in an amount equal to the product of: (1) the sum of the ownership interest percentages of all non-qualified successors, if any, multiplied by (2) the amount of gain realized on all the section 367(d) property transferred in the section 361 exchange.

 

Each qualified successor will generally take into account the income attributable to a proportionate share of the contingent annual payments that the U.S. transferor would have been treated as receiving had the U.S. transferor remained in existence and retained the qualified stock received in the reorganization (assuming for this purpose that the transfer continues to qualify as an exchange described in section 361), and had the U.S. transferor not recognized any income under the provisions of Notice 2012-39.

 

Stay tuned for the Proposed Regulations on this Subject.

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In Rev. Rul. 2012-19, 2012-28 IRB, which was issued on June 25, 2012, the Service issued an important ruling on whether dividends and dividend equivalents related to restricted stock and restricted stock units (“RSU”) can be treated as performance-based compensation for purposes of §162(m)(4)(c) provided that each must separately meet the requirements under that provision to qualify as performance-based compensation.

 

Section 162(m)(1) Limitation

 

Under §162(m)(1) a “publicly held corporation” is not permitted to deduct under §162(a) as an ordinary and necessary business expense, compensation paid to a “covered employee” to the extent such compensation exceeds $1 million. A “covered employee” includes a group of five or less of the company’s most highly compensated employees and  commissions and compensation conditioned on the meeting of clearly defined performance goals are generally excepted from the ceiling. Even if the excess compensation is non-deductible, it is still included in the employee’s gross income and and subject to federal income tax. The $1 million limitation is applicable only to the compensation of a “covered employee” which includes: (i) the CEO of the company as of the last day of the corporation’s taxable year or the person then acting in such capacity; and (ii) any other employee whose “total compensation” must be reported to shareholders under the Securities Exchange Act “by reason of such employee being among the four highest compensated officers for the taxable year.” § 162(m)(3). Treas. Reg. § 1.162-27(c)(6) Ex. 17. Where SEC rules require  require disclosure for fewer than four executives in addition to the chief executive officer, “then only those for whom disclosure is required are covered employees. HR Rep. No. 213, 103d Cong., 1st Sess. 585 (Conf. Rep. 1993). See IRS Notice 2007-49, 2007-1 C.B. 1429 (providing changes to the application of this provision based on changes in the Exchange Act compensation disclosure rules). See also Notice 2008-94, 2008-44 IRB (application of §§162(m)(5) and 280G(e) under the TARP legislation, PL 110-343, 10/3/2008).

 

Two Fact Patterns Contained in Rev. Rul. 2012-19

 

Corps. X and Y are publicly held corporations. §162(m)(2). Both have restricted common stock and RSU plans based on the common stock of each. The restricted stock and RSUs granted under the plans of both corporations vest upon reaching certain preestablished, objective performance goals and otherwise meet the requirements of  Treas. Reg. § 1.162-27(e). Therefore, compensation received due to the vesting of the restricted stock and vesting and payment of the RSUs is qualified performance-based compensation that is excluded from the applicable employee’s compensation subject to the §162(m) limitation.  

 

Situation 1:Dividends Subject to Performance Goals Being Satisfied. X Corp.’s plan provides that dividends and dividend equivalents otherwise payable to an employee during the period from grant through vesting with respect to performance-based restricted stock and RSU awards granted to the employee are accumulated and become vested and payable only if the related performance goals with respect to the restricted stock and RSUs are satisfied. All other requirements of § 1.162-27(e) are met with respect to the grant of rights to dividends and dividend equivalents.

 

Situation 2; Dividends Paid with Respect to Restricted Stock and RSU Awards Not Subject to Satisfaction of Performance Goals. Under the second scenario in the ruling, Corp. Y’s plan provides for payment to an employee during the period from grant to vesting of dividends and dividend equivalents with respect to performance-based restricted stock and RSU awards granted to the employee at the same time dividends are paid on common stock of Corporation Y regardless of whether the performance goals established with respect to the restricted stock and RSUs are satisfied.

 

Section 162(m)(4)(A) defines “ applicable employee remuneration,” with respect to any covered employee for any taxable year, subject to the overall limitation. Section 162(m)(4)(C) states that “applicable employee remuneration” does not include any remuneration payable solely on account of the attainment of one or more performance goals, but only if (i) the performance goals are determined by a compensation committee of the board of directors of the taxpayer which is comprised solely of two or more outside directors, (ii) the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before payment of such remuneration, and (iii) before any payment of such remuneration, the compensation committee certifies that the performance goals and other material terms were in fact satisfied. See Treas. Regs. §§1.162-27(e)(2)-(e)(5).

 

In particular, Treas. Reg. §1.162-27(e)(2)(i) requires that qualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals. Treas. Reg. §1.162-27-(e)(2)(ii) provides that a pre-established performance goal must state, in terms of an objective formula or standard, the method for computing the amount of compensation payable to the employee if the goal is attained. This is determined on a grant-by-grant basis. Treas. Reg. §1.162-27(e)(2)(iv). Treas. Reg. §1.162-27(e)(2)(iv) further provides that, except as provided in Treas. Reg. § 1.162-27(e)(2)(vi) (relating to stock options and stock appreciation rights), whether a grant of restricted stock or other stock-based compensation satisfies the performance goal requirements is determined without regard to whether dividends, dividend equivalents, or other similar distributions with respect to stock, on such stock-based compensation are payable prior to the attainment of the performance goal. (emphasis added) Dividends, dividend equivalents, or other similar distributions with respect to stock that are treated as separate grants under  Treas. Reg. § 1.162-27(e)(2)(iv) are not performance-based compensation unless they separately satisfy the performance goal requirements.

 

Service’s Analysis in Rev. Rul. 2012-19

 

The Service starts its analysis by citing Treas. Reg. § 1.162-27(e)(2)(iv), by citing the operative rule that the dividends and dividend equivalents under Corps. X’s and Y’s plans are grants of compensation that are separate and apart from the related restricted stock and RSU grants. Therefore, the grants of the dividends and dividend equivalents must separately satisfy the requirements of Treas. Reg. § 1.162-27(e) to be qualified performance-based compensation.

 

Situation 1; Dividends Subject to Performance Goals Being Satisfied. Under Corp. X’s plan, participants' rights to restricted stock and RSUs are subject to performance goals which satisfy the requirements of  Treas. Reg.§ 1.162-27(e) and are excluded from applicable remuneration for purposes of the limitation in § 162(m)(1). Under the same plan, participants' rights to dividends and dividend equivalents vest and become payable only if the same performance goals that apply to the related grants of restricted stock and RSUs are satisfied.  Based on the separate grant-by-grant test, the ruling concludes that the dividends and dividend equivalents under X's plan are excluded from applicable remuneration for § 162(m)(1) purposes and are excluded from the $1 million limitation. 

 

Situation 2; Dividends Paid with Respect to Restricted Stock and RSU Awards Not Subject to Satisfaction of Performance Goals.. The dividends and dividend equivalents under Corp. Y’s plan fail to satisfy the requirements under § 162(m)(4)(C) and Treas. Reg. § 1.162-27(e) since the rights to these amounts do not vest and become payable solely on account of the attainment of pre-established performance goals. Such amounts are not qualified-performance based compensation and are therefore included in “applicable employee remuneration” under §162(m)(1).

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

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

 

Therefore, dual citizens or residents may have failed to file timely Reports of Foreign Banks and Financial Accounts (FBARs) under the FINCEN regulations. The FBAR must be filed by any U.S. person by June 30 of the year following the calendar year in which the U.S. person has a financial interest in, or signature authority over, foreign financial accounts (FFAs) where the aggregate value of the FFAs exceeds $10,000 at any time during the calendar year. A "U.S. person" includes a U.S. citizen or U.S. resident, as well as a corporation, trust, partnership or limited liability company created, organized or formed under U.S. law. See 31 C.F.R.§1010.350(a); TD F 90-22.1 (Rev. 3-2011). "Signature authority" means the authority (alone or in conjunction with another) to control the disposition of money, funds or other assets held in a financial account by direct communication (in writing or otherwise) to the person with whom the financial account is maintained. "FFAs" include bank, securities and other types of accounts. 31 CFR §1010.350(c).

 

It is known that there are a large number of individuals who may have failed to meet their personal obligations under Title 26 (e.g., federal income tax) and Title 31 (FBAR reports) for a period of years. Now, in light of the increased scrutiny the IRS and Department of Justice is giving to those U.S. persons who are noncompliant in one or both of these areas, many of those individuals desire to come forward and disclose their unreported income as well as delinquent FBAR reports. In addition, Canadian government representatives have publicly noted their displeasure with the enhanced IRS scrutiny of tax and financial reporting failures of dual citizens since many dual Canadian-U.S. citizens have resided in Canada for most or a substantial portion of their lives. The problems associated with dual citizenship or residence are by no means, however, limited to those residing north of the border.

The fact sheet (FS-2011-13) released by the IRS on December 7, 2011, summarizes information about federal income tax return and FBAR filing requirements and how to file a federal income tax return or FBAR as well as potential penalties. Taxpayers who owe no U.S. income tax, perhaps as a result of available foreign tax credits or the availability of the foreign earned income exclusion under §911, may owe no U.S. income tax and therefore will not be subject to delinquency penalties for failure to file or pay. §§6651(a)(1), 6651(a)(2). For such individuals, no penalties will be imposed for delinquent returns and failure to timely pay. More importantly, the notice states that no FBAR penalty applies in the case of a violation that the IRS determines was due to reasonable cause.

The recent 2011 Offshore Voluntary Disclosure Initiative offered by the IRS allowed many taxpayers to disclose their previously undisclosed non-U.S. accounts (and assets) in exchange for some clarity as to the extent of penalties that may be imposed. However, the program ended on September 9, 2011, leaving those who did not participate, perhaps because they were unaware of the program, to face a difficult dilemma in light of the continuing and mounting efforts of the U.S. government to obtain U.S. account owner information from foreign banks and financial institutions.

Despite the official closure of the 2011 Offshore Voluntary Disclosure Initiative, the IRS’ standard voluntary disclosure practice remains a viable alternative for taxpayers who wish to correct prior non-reporting of foreign income, accounts and assets. Just this month, the IRS issued additional guidance for U.S. citizens and dual citizens residing outside the United States who may have not timely filed their U.S. federal income tax returns or reported their foreign accounts on an FBAR (Form TD F 90-22.1) despite having met the criteria for doing so. The guidance does not specifically describe a process by which to correct prior noncompliance. Methods of correction include consideration of making a “voluntary disclosure” as well as an alternative form of disclosure.

U.S. citizens, whether also citizens of a foreign country and irrespective of where they reside, are required to annually file U.S. federal income tax returns reporting their income from all sources (i.e., both U.S. and foreign income). Such persons may also be required to complete and file with the IRS specific forms reporting such items as foreign accounts (bank or investment accounts), the acquisition and disposition of interests in foreign entities, transfers of property to foreign entities or financial information of foreign entities controlled by the taxpayer. The guidance issued by the IRS in Fact Sheet 2011-13 does not present a new disclosure initiative but instead provides additional insight as to how the IRS may handle certain voluntary disclosures if specific criteria are met.

The Fact Sheet notes that where no U.S. tax is due with respect to unreported foreign income, those cases would not be subject to failure to file and failure to pay penalties under § 6651. For example, if a U.S. citizen derives income from a foreign source but does not report same on his or her U.S. return, no failure to file or failure to pay penalties would be imposed if as a result of the application of foreign tax credits, the taxpayer’s U.S. tax liability is eliminated. For situations where there is an outstanding U.S. tax liability, taxpayers may assert a reasonable cause argument that would have to be supported by the facts existing at the time of the noncompliance. A successful reasonable cause defense would allow the taxpayer to avoid the failure to file and failure to pay penalties. The delinquent taxes and interest on the underpayments of tax would remain outstanding liabilities of the taxpayer, however.1

The question of unfiled FBARs is also addressed in the guidance and demonstrates the sharp contrast between participation in one of the previous tailor-made offshore disclosure programs (2009 Offshore Voluntary Disclosure Program and 2011 Offshore Voluntary Disclosure Initiative) and the standard voluntary disclosure practice.2 Through the offshore disclosure programs, the IRS would impose a “miscellaneous Title 26 offshore penalty” of either 20 percent or 25 percent (for the 2009 and 2011 programs, respectively) with no consideration given to the extent of unpaid tax liability. In other words, even if the extent of unreported income from a foreign account was only one dollar and tax was due on that income, the flat-rate penalty would be imposed.

The guidance issued in the Fact Sheet describes a more reasonable approach based on the applicable statutes and explains that examiners have discretion in determining the extent of FBAR penalties, depending on the facts of the particular case. According to the guidance, penalties for failure to file FBARs can be avoided if, among other factors, there was “no tax deficiency (or there was a tax deficiency but the amount was de minimis).” Furthermore, a reasonable cause argument for failing to file FBARs may be asserted in seeking to eliminate potential FBAR penalties. While the guidance describes the potential for penalty relief under certain circumstances, each case should be carefully evaluated to determine the applicability of a reasonable cause defense for both income tax and FBAR penalty mitigation.

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Background

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

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

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

Application to Year End Bonuses

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

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

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

Ruling Facts

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

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

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

Holding By Service

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

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

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In PLR 201051019 (12/23/2010), the Service ruled that in computing a consolidated group’s §382 limitation after filing for bankruptcy relief, all of its outstanding liabilities before the ownership change should be taken into account at the adjusted issue price, regardless of whether the obligations were subsequently discharged in whole or in part during the recognition period. Accordingly, unless the parent of the consolidated group of corporations elected application of §382(l)(6), then under §382(l)(5), there is no §382 limitation on pre-change losses or built-in losses of the parent consolidated group and each of its members as a result of the ownership change that took place under the facts.

Facts. Parent (P) is the common parent of a consolidated group (Parent Consolidated Group) engaged in Business A. On Date 1, P and X, a disregarded entity of Subsidiary Y, filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. The subsidiaries of Parent (other than X), including Subsidiary Y, did not file for bankruptcy protection. Later, under a plan or reorganization approved by the Bankruptcy Court: (i) each electing holder of an allowed claim arising under a Note 1 or any holder of an allowed claim arising under a Note 2 received its pro rata share of New Notes 1 and a specified percentage of P's new common stock; (ii) each non-electing holder of a claim under Note 1 had its current claim reinstated and retained the Note; (iii) each holder of a claim under Loan 1 or 2 received its pro rata share of New Notes 1 and specified percentage of P’s new common stock; (iv) each holder of an allowed claim under Note 3 or 4 received its pro rata share of a specified percentage of P’s new common stock plus contingent value righs; (v) each holder of certain notes issued by X received its pro rata share of New Notes 2 issued by X and guaranteed by P; (vi) the holders of equity interests in P cancelled those interests however preferred stock holders of P received contingent value rights. The only debt of P debt that was exchanged for stock was debt of P.

Under the plan or reorganization approved by the Bankruptcy Court in a Title 11 case, P would experience an ownership change under §382, immediately after the ownership change at least 50% of the value and voting power of the common stock of P would become owned by “qualified creditors” per §382(l)(5)(3) and Treas. Reg. §1.382-9(d)(1).

The affiliated group of corporations, of which P is the common parent, is a “loss group” per Treas. Reg. §1.1502-91(c). All members of the consolidated group were eligible to be included in the determination of whether the loss group were eligible to be included in determining whether the loss group had a net unrealized build in loss per Treas. Reg. §1.1502-91(g)(2)(ii).

The ruling identified two alternative methods by which to calculate the §382 limitation Where §382(l)(5) applies, the amount of pre-change losses or built-in losses of the taxpayer to be used to offset taxable income of any new loss corporation for any post-change year would not be limited by §382 as a result of an ownership change. Conversely, if §382(l)(6) was applied, the value of the old loss corporation would reflect the increase in value resulting from any surrender or cancellation of creditors' claims in the transaction, pursuant to Treas. Reg. 1.382-9 .

If Section 382(l)(6) were elected, the consolidated group would calculate its net unrealized built-in gain or loss, pursuant to Section 382(h) and in conjunction with the guidance provided in Notice 2003-65 , under the deemed Section 338 approach. In holding that all liabilities should be considered, the Service specified that amounts realized should be allocated to the stock and obligations of the group notwithstanding that gain or loss might not be taken into account under Reg. 1.1502-91 .

In this situation since no election was made under §382(l)(6), then under §382(l)(5) the Service ruled that no §382 limitation on pre-change losses or built-in losses of the P consolidated group and each member resulted as a result of the ownership change. See §382(h). Notice 2003-65, 2003-2 CB 747 , provides two alternative approaches—the §338 approach and the §1374 approach—to applying §382(h) that should be considered when calculating recognized built-in gain and recognized built-in loss.   P also  takes into account the increase in the value of P resulting from the surrender of certain creditor claims per Treas. Reg. §1.382-9. On the other hand, were the P consolidated group to apply §382(l))(6) to the change in ownership, then in applying Notice 2003-65 to the calculation of net unrealized built-in gain or loss, as modified by Notice 2003-65, the P consolidated group may compute the deemed sale and allocation rule for determining the aggregate deemed sale price under Treas. Regs. §§ 1.338-4 and 1.338-6. Amounts realized should be allocated to the stock and obligations of members of the P consolidated group regardless of whether such gain or loss might not be taken into account under Treas. Reg. §1.1502-91.

Liabilities often are discharged coincident with an ownership change, resulting in cancellation of indebtedness income. PLR 201051019 is helpful in clarifying how to apply the §382 limitation in this situation by clarifying that, under the described fact pattern, all liabilities—including those discharged as part of a bankruptcy filing—should be included in any net unrealized built-in gain or loss calculation.

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In Field Service Advisory 2011110F, issued by Chief Counsel’s Office on March 18, 2011, the Service stated that  §197(f)(1) prohibits a worthless amortization deduction for a §197 intangible, in this case an automobile franchise contract, that was terminated by the manufacturer. Section 197(f)(1) prohibits a deductions for worthless §197 intangibles, including goodwill, where other amortizable §197 intangibles purchase as part of the same transaction remain in place. The amount of such worthless amortizable §197 intangible is included in the basis of the remaining §197 intangibles.

Under the facts of the FSA, a automobile dealership was granted a sales and services franchise under a franchise agreement. Then the dealership purchased certain assets of another auto dealer including the amount of $39x for goodwill related to such franchise rights (sales and servicing) for a particular make of automobile. The automobile dealer alleged that $4x of the amount was allocated to goodwill for the franchise agreement but such allocation was not contained in the agreement. Later, the automobile dealer was notified that the manufacturer was terminating its franchise to sell certain products and the sales franchise as well. The automobile dealer was paid 1.8% of $39x in consideration for the terminations as well as for certain releases, waivers and transfer to manufacturer of the dealership’s customer lists and service records. Thus, the automobile dealer claimed that the goodwill associated with the franchise rights became worthless.  

Section 197(a), which was enacted into the Code in 1993, permits a taxpayer to amortize an amortizable §197 intangible asset, generally acquired by purchase after August 11, 1993, ratably over a 15 year period regardless of the assets’ MACRS period or useful life. See Frontier Chevrolet Co. v. Comm’r, 329 F.3d 1131, 1135 (9^th Cir. 2003). In general, a §197 intangible includes goodwill and any franchise, trademark or trade name. See also §1253(b). Certain self-created intangibles are excluded from the definition of “an amortizable § 197 intangible”.

Under §1253(b)(1), a franchise includes an agreement that gives one of the parties the right to distribute, sell, or provide goods, services, or facilities within a specified area. Where there is a disposition of any §197 intangible or any such intangible becomes worthless, §197(f)(1) provides that in such instance were any one or more amortizable §197 assets acquired in such transaction or series of related transactions are retained: (i) no loss may be recognized, and (ii) appropriate basis adjustments must be made to the retained intangibles. See Treas. Reg. § 1.197-2(g)(1). The abandonment of an amortizable §197 intangible, or any other event rendering an amortizable §197 intangible worthless, is treated as a disposition of the intangible per §197(f)(1) and Treas. Reg. § 1.197-2(g)(1). See Treas. Reg. § 1.197-2(g)(1)(i)(B).

The taxpayer-automobile dealer contended that it was entitled to deduct the claimed amount of worthless goodwill based on two arguments. First that the asset purchase agreement separately stated a goodwill value for one of the franchises purchased and which one later became worthless. The Service felt that the evidence did not support this argument and that even if goodwill was separately stated for each franchise,  §197(f)(1) still applies, as all of the goodwill was acquired in a single transaction or series of related transactions.

The automobile dealer further argued that §197(f)(1) does not apply to its special situation and that the “spirit” of  §197(f)(1)(A)(i) did not contemplate automobile franchises.The Service found no indication in either the Code or the legislative history to §197 to support this thought or notion that automobile franchises were exempt from application of §197(f)(1).

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In PLR 201109003 (3/04/2011) the Service ruled, under the facts set forth in the request,  that the proposed issuance of two classes of stock by a corporation which intended to meet the requirements of a real estate investment trust (REIT) would not cause distributions to stockholders to be treated as “preferential dividends” under Section 562(c) or otherwise jeopardize the corporation’s qualification as a REIT.

A REIT and its shareholders are taxed in accordance with Sections 856-859 provided certain requirements are met. A REIT, generally organized as a corporation, trust or association,  generally results in federal income taxes being imposed on a current basis to its members through the form of dividend distributions. 

The general requirements of a REIT per Section 856(a) are: (i) the organization must be managed by one or more trustees or directors; (ii) beneficial ownership in the organization must be represented by transferable shares or certificates; (iii) the organization generally must be taxable as a domestic corporation ; (iv) the organization must be neither a financial institution per Section 582(c)(5) nor an insurance company subject to the provisions of Subchapter L; (v) the organization must be beneficially owned by at least 100 persons during a minimum of 335 days in a taxable year of twelve months (or during a proportionate part of a taxable year of less than twelve months); and (vi) the organization must not be closely held per Section 542(a)(2). Substantial amendments were made to the REIT provisions in 2004 which expanded the types of securities which will constitute “straight debt” for purposes of apply the 10% single issuer limitation in Section 856(m) as well as adding safe harbor rules for determining whether rents from a taxable REIT subsidiary are comparable to unrelated party rents. See Section 856(d)(8)(A).

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Back to the ruling. Under Section 857(a)(1) , a REIT's dividends-paid deduction must equal or exceed 90% of its REIT taxable income. For purposes of Section 561(a) , the deduction for dividends paid includes dividends paid during the tax year. A distribution is not qualified dividend if it is “preferential” in nature. Thus, under Section 562(c), a dividend for REIT deductibility purposes can not: (i) prefer any shares of stock in a class over other shares of stock within the same class; or (ii) prefer one class of stock over another (except to the extent that such a class is entitled to a preference).

In Rev Proc 99-40, 1999-2 CB 565 , the Service rule that in certain instances distributions made by a  regulated investment company (RIC) to its shareholders in varying amounts may still be deductible as dividends under Section 562. Where the varying distributions to different groups of shareholders differ on account of expense allocations relating to shareholder services, the distribution of shares, allocation of the benefit of a waiver or reimbursement of a fee, or variations resulting from the allocation of performance-based advisory fees,  will not be treated as nondeductible preferential dividends so long as such expenses are allocated to the group of shares for which the expenses were incurred and certain other requirements are met.

Under the facts of PLR 201109003 the taxpayer-corporation (intending to qualify as a REIT) . intends, through its operating partnership, to invest primarily in a diversified portfolio of commercial real estate properties located in major metropolitan markets and other real estate-related assets. Taxpayer's shares of common stock will not be publicly traded but liquidity for shares would be realized under a redemption plan. The plan would generally allow stockholders to request on a daily basis that Taxpayer redeem their shares at the net asset value (“NAV”) per share. Taxpayer's shares will be distributed a broker-dealer that will form a syndicate of participating broker-dealers to offer and sell the shares to the public.

Ttraditional non-listed REITs have been criticized for up front costs which will be avoided in this case through a reduced commission at closing but will pay dealer manager fees based on net asset value and a distribution fee.  In preliminary discussions with potential broker-dealers, Taxpayer was informed that its shares will not be attractive to investors with wrap accounts or registered investment advisors (RIAs) where investors pay their financial advisors an asset-based fee as an alternative to paying additional transaction fees. Specifically, although Taxpayer's selling commission could be waived for such investors, they would still bear a second level of distribution charges if Taxpayer charges a distribution fee with respect to such investors. So, to attract investors the Taxpayer proposed to issue: (i) one class of common stock that will be subject to the selling commission and annual distribution fee; and (ii) for investors with wrap accounts or RIAs, a class of common stock that will not be subject to any selling commission or allocation of the distribution fee. After shares are purchased, Taxpayer will pay certain quarterly and annual fees which are accrued on a daily basis for purposes of NAV calculation.

Taxpayer filed its registration statement on Form S-11 to register its shares of common stock to be offered to the public. Taxpayer now intends to amend its registration statement before its public offering to provide for two classes of common stock. The various fees Taxpayer proposes to charge for each class are as follows: (i) an advisory fee payable by Taxpayer to advisor for implementing Taxpayer's investment strategy and managing its day-to-day operations which will be charged at the same rate for each class of stock; (ii) a dealer manager fee, charged at the same rate for each class, paid in consideration of the distribution, marketing and stockholder services the Dealer Manager provides to Taxpayer in connection with the continuous offerings; (iii) a distribution fee, charged only to one class of stockholders, that will be entirely reallowed to participating broker-dealers selling such shares. This fee compensates those broker-dealers for their distribution services related to the shares.

Conclusion.

The PLR concluded that under the facts involved the  issuance of the two classes of shares won't: (i) cause the dividends paid by Taxpayer with respect to those shares to be preferential dividends under Section 562(c) ; or (ii) cause Taxpayer to fail to qualify as a REIT.

The Service  determined that, although Taxpayer didn't technically fall within the scope of Rev Proc 99-40 , sufficient common ground exists between REITs and RICs warranting similar treatment. Thus, the dual class structure the Service found was consistent with RIC requirements under Rev. Proc. 99-40 and therefore qualified for favorable treatment. The Service found significant the provision that the Taxpayer is subject to a continuous “merit review” process intended to ensure that the stockholders are treated fairly, in addition to many SEC, state, and other restrictions and regulations with respect to its stock offerings, its operations, and the rights of its stockholders.

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Now we can add Program Manager’s Technical Advice or “PMTA” to the list of administrative projects on tax matters that are open to FOIA and review by the tax practitioner community. One area that needs some help are investors in tenancy-in-common programs. On May 15, 2010, the Service issue PMTA 2010-05 which provides an legal analysis from Chief Counsel’s office directed to IRS program managers in the field. In addressing a bankruptcy in which TIC investors were involved, the PMTA concluded : (i) the short-term pooling of funds by TIC owners with a payment agent does not result in a partnership even if provided in a non-pro rata format; and (ii) the appointment of a communications agent by TIC owners to facilitate communication between the TIC owners and their counsel does not result in a partnership.

The  PMTA addressed a TIC offering in which A, the hypothetical TIC sponsor, or an affiliate of A, purchased rental property and then sold TIC interests in the property to TIC individual investors to complete section 1031 exchanges. The purchase price paid was (i) the amount of cash funded by a prior section 1031 exchange and (ii) the assumption of debt encumbering the property. The total number of investors (including the A affiliate) did not exceed 35 in any single property.

At the same time as the purchase of the TIC interests, the TIC owners leased the Property to a master tenant (an affiliate of A) under a master law. The TIC owners further entered into a TIC Agreement which contained the requirements for an (favorable) advance ruling under Rev. Proc. 2002-22. The Agreement required the TIC owners to share all revenues and fund all expenses related to the Property pro rata in proportion to their relative percentage TIC interests.

Under the facts, A and several of its affiliates owning the Property filed petitions for bankruptcy and as a direct result, the TIC owners undertook the following actions to protect their respective interests in the Property: (i) the TIC owners raised funds (initially on a non-pro rata basis) to pay legal fees and costs of the bankruptcy and make debt service payments on the Property; (ii) intended to file for reimbursements of such funds, costs and debt service payments in relation to their percentage TIC interests; (iii) one TIC owner was designated as a payment agent to collect funds and make required disbursements; and (iv) designated a point person for working with the various parties involved in the bankruptcy. The PMTA stated  indicates that in most cases, the TIC owners equalized the non-pro-rata pooling of funds in an amount of time in a “reasonable amount of time.”

The issue was whether the temporary pooling of funds on a non-pro rata basis and the appointment of the payment agent and communications agent, caused by the bankruptcy converted the TIC owners to become partners in a de facto partnership for federal income tax purposes. The PMTA concluded that the actions taken did not cause the TIC owners to become partners for federal income tax purposes.

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The Chief Counsel’s Office just released an advisory, CCA 201106007, which ruled that the sale of software products by a controlled foreign corporation to end-users situated in the United States was not an investment in the U.S. under section 956(c)(1)(D) requiring that the amount so invested be included in the U.S. shareholders’ gross income under section 951(a)(1)(B) based on the underlying facts.

The taxpayer is a U.S. entity involved in the distribution of information technology and services, including the development of software in the U.S. under a cost sharing arrangement with its wholly-owned foreign subsidiary, S (also CFC). Under the cost sharing arrangement, S acquired the rights to market the acquired copyrights in the U.S. When the taxpayer finishes the development of a software product intended for sale to end-user customers, the final version of the software “code” is transferred to a “gold master” disk and delivered to S. The wholly owned subsidiary then reproduces and sells copies of the software to unrelated, end-user customers in the United States.

 

Background

Under the CFC provisions, a U.S. shareholder is required to include in gross income her pro rata share of the CFC’s subpart F income and the increase in the CFC’s investment in U.S. property See §951(a)(1)(B). The underlying rationale for the investment in U.S. property provision is that such reinvestment is substantially equivalent to a dividend. See Sen. Rep. No. 1881, 87th Cong., 2d Sess., 1962-3 CB 703, 704. The term U.S. property is defined in section 956(c) (1) as a rule of inclusion and section 956(c)(2) as a rule of exclusion. (and excluded from the definition of the term in section 956(c)(2). U.S. property includes tangible property in the U.S., stocks and debt obligations of related domestic corporations, and patents, copyrights and other intangibles acquired or developed for use in the U.S. A CFC’s stock in a U.S. subsidiary is also U.S. property. See Tobin, “Double Taxing Sandwiches”, 39 Tax Mgmt. Int’l 273 (2010).

There are exceptions to U.S. property set forth in section 956(c)(2) which attempt to apply to property held temporarily in the United States as part of a “normal commercial transactions”. A U.S. shareholder claiming the benefit of any exception must file a statement with its return identifying the property covered by the exception. Treas. Reg. § 1.956-2(b)(2). Portfolio investments in stock and debt of unrelated U.S. companies are also excluded from the definition of U.S. property.

In addition to the myriad of rules of inclusion and exclusion contained in section 956(c) and the underlying regulations, property held by a foreign corporation controlled by the CFC is treated as owned by the CFC if avoidance of section 956 is “one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation.” The latter rule is intended to prevent taxpayers from circumventing section 956 by using a CFC with no earnings and profits to hold U.S. property that is effectively acquired with the earnings of a related CFC. Treas. Reg. § 1.956-1T(b)(4)(i). See, e.g., The Limited, Inc. v. Comm’r, 113 TC 169, 192 (1999) , rev'd on another issue, 286 F3d 324 (6th Cir. 2002).

 

Intangibles as U.S. Property

The CCA starts its analysis by noting “United States property” per section 956(a)(1)(D) includes any right to use intangible property in the U.S. that is acquired or developed by a CFC for use in the U.S. The operative word here is “right” to use in the U.S. Whether such right has been acquired or developed for use in the U.S. is based on examining all facts present. Treas. Reg. § 1.956- 2(a)(iv)(d). However, a right actually used principally in the U.S. will generally be considered to have been acquired or developed for use in the U.S. unless affirmative evidence shows the contrary.

Thus, both the statute and regulations to section 956 define U.S. property in relation to whether a CFC develops intangible property intended for use in the U.S. or acquires the right to use intangible property in the U.S.—not whether such right is actually exercised.

 

Resolution of the Issue in CCA 201106007

Here, S, a CFC, invested in U.S. property per section 956 when it acquired or developed the rights to use copyright rights in the U.S. pursuant to the cost sharing arrangement. However, the actual sales of the computer software copies from S to end-user customers in the U.S. do not in and of themselves constitute an investment in U.S. property within the scope of section 956(c)(1)(D). Furthermore, the actual transfer of copies of the software by S to the end-user U.S. customers does not affect the calculation of the inclusion amount, if any, under section 956 attributable to S’s original investment in U.S. property, because S did not acquire or develop additional rights (or relinquish any rights) to use the software in the U.S. merely as a result of the sale of copies to a U.S. person.

The CCA did find, as mentioned, that S made an investment in U.S. property for purposes of section 956(c)(1)(D) as a result of its acquisition or development of rights to use copyright rights in the U.S. under the cost sharing agreement. Still, the amount invested in the U.S. is based on S’s adjusted basis in the copyright rights. Where S’s costs were properly deducted in computed taxable income, it may have a $0 basis in U.S. property. The CCA then opined that further factual development is needed to determine whether and to what extent other aspects of Sub's activities with respect to the copyright rights constitute an investment in U.S. property within section 956.

 

CCA Conclusion

The CCA concluded, based on the preceding analysis, that the sale of software products by S (a CFC) to end-user customers in the U.S. did not constitute an investment in U.S. property under section 956(c)(1)(D) so as to require an income inclusion for its U.S. parent corporation. S, however, was viewed in the CCA as having made an investment in U.S. property when it acquired or developed rights to use copyrights in the U.S. under the cost sharing agreement. Still, the actual sales of the computer software copies from S to the U.S. end-user (customers) did not, per se, constitute an investment in the U.S.

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Taxpayers-mutual funds or RICs filed ruling request seeking favorable determination from the National Office of the Internal Revenue Service that income derived from each Fund's investments in a wholly-owned subsidiary that is a controlled foreign corporation (CFC) constitutes qualifying income under §851(b)(2).

Underlying Facts

Each Fund, a corporation using the accrual method of accounting, is a series of a business trust and is registered as an investment company under the Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq., as amended (the 1940 Act). Each Fund is a regulated investment company (RIC) under § 851(a) of the Code.

Fund A intends to form a wholly-owned subsidiary (Subsidiary A) incorporated as a Type A Company under the laws of Country . Fund B also intends to form a wholly- owned subsidiary (Subsidiary B) incorporated as a Type A Company under the laws of Country. Under the laws of Country, a Type A Company provides limited liability for all holders of shares. A shareholder's liability is limited to the amount, if any, unpaid with respect to the shares acquired by the shareholder. Subsidiary A and Subsidiary B intend to file elections on Form 8832, Entity Classification Election, to ensure that they will be treated as corporations for federal income tax purposes.

Each Fund represents that, although neither Subsidiary A nor Subsidiary B will be registered as an investment company under the 1940 Act, each Subsidiary will comply with the requirements of section 18(f) of the 1940 Act, Investment Company Act Release No. 10666, and related SEC guidance pertaining to asset coverage with respect to transactions in commodity swaps, commodity futures and other transactions in derivatives.

Each Fund will invest a portion of its assets in its Subsidiary, subject to the limitations contained in §851(b)(3). Each subsidiary is expected to invest primarily in commodities, commodity-linked swaps, commodity-linked futures, and other commodity-linked derivatives, including total return swaps and commodity-linked securities. Subsidiary A will be wholly-owned by Fund A, and Subsidiary B will be wholly- owned by Fund B, and both are thus expected to be classified as CFCs, as defined in § 957 of the Code. Each Fund will include its "subpart F" income attributable to its Subsidiary under the rules in the Code applicable to CFCs.

RIC Qualifying Income Requirement

Section 851(b)(2) states a corporation fails to be treated as a RIC for any taxable year unless it meets an income test whereby 90% or more of its gross income is derived from certain sources. Section 851(b)(2) defines qualifying income as dividends, interest, payments with respect to securities loans (per §512(a)(5)), and gains from the sale or other disposition of stock or securities (per §2(a)(36) of the 1940 Investment Act) or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to [the RIC's] business of investing in such stock, securities, or currencies which are defined in accordance therein. .

Under the flush language of § 851(b), for purposes of § 851(b)(2), dividends include amounts included in gross income under the controlled foreign corporation rule in §§ 951(a)(1)(A)(i) or 1293(a) for the taxable year to the extent that, under §§ 959(a)(1) or 1293(c) (as the case may be), there are distributions out of the earnings and profits of the taxable year which are attributable to the amounts so included.

Section 957 of the Code defines a controlled foreign corporation (CFC) as any foreign corporation in which more than 50 percent of (1) the total combined voting power of all classes of stock entitled to vote, or (2) the total value of the stock is owned by US shareholders on any day during the corporation's taxable year. A US shareholder is defined in § 951(b) as a US person who owns 10% or more of the total voting power of a foreign corporation. Each Fund represents that it will own 100% of the voting power of the stock of its Subsidiary. Each Fund is a United States person. Each Fund therefore represents that its Subsidiary will qualify as a CFC under these provisions as well as the other requirements under §951(a)(1).

Under § 954(a)(1), foreign base company income constitutes Subpart F income and includes foreign personal holding company income determined under § 954(c). Section 954(c)(1) defines foreign personal holding company income to include dividends, interest, royalties, rents, and annuities; gains in excess of losses from transactions in commodities (including futures, forward, and similar transactions but excluding certain hedging transactions and certain active business gains and losses); and, subject to certain exceptions, net income from notional principal contracts. Each Subsidiary's income from its investments in commodities and commodity- linked instruments may generate subpart F income. Each Fund therefore represents that it will include in income its Subsidiary's subpart F income for the taxable year in accordance with § 951.

Service Issues Favorable Ruling

:

Based on the facts set forth in the ruling, the Service ruled that the income derived from each Fund’s investing in stock of a CFC would constitute qualifying income under § 851(b)(2).

 

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In Announcement 2010-75, 2010-7 IRB 408, the Service announced that while it intends to retain its existing policy of "restraint" for requesting taxpayers to produce their tax accrual workpapers during an IRS audit examination, it stated it would be developing a schedule requiring certain business taxpayers to report uncertain tax positions ("UTPs") on their tax returns. The schedule would be required to be filed as part of the corporate income tax return, including consolidated income tax return, and would require a short and accurate description of each UTP for which the taxpayer or related entity has recorded a reserve on its financial statements and further requiring the taxpayer calculate the maximum amount of the potential federal tax liability attributable to each UTP (determined without regard to the taxpayer’s underlying risk analysis as to the likelihood of its prevailing on the merits). A notice of proposed rulemaking was issued on September 9, 2010 and sets forth a proposed rule explicitly authorizing the Service to require the filing of a Schedule UTP. See also IRS Announcs. 2010-76, 2010-41 IRB (9/24/2010), 2010-13 IRB 515, 2010-30, 2010-19 IRB 668.

In Annoucement 2010-75, which was issued on September 24, 2010, the Service stated that major changes would be made to the draft schedule for disclosure of UTPs. The Service will require certain corporations with audited financial statements to file Schedule UTP beginning with the 2010 tax year. The Service acknowledged it had received many comments on the overall proposal, including how the Service would use the reported information, the interaction of the new reporting requirement with the existing policy of restraint, the additional burden the reporting requirement would place on affected corporations, and the impact the reporting requirement would have on the relationship between the corporation and the Service or the corporation and its advisors or independent auditors. Some commentators questioned the Service's authority to require reporting of uncertain tax positions with the corporation's tax return. The Announcement states that the final schedule and instructions make a number of significant changes to the April draft in order to address burden and other concerns expressed by commentators. Some of the major changes include: (i) a five-year phase-in of the reporting requirement based on a corporation's asset size; (ii) no reporting of a maximum tax adjustment; (iii) no reporting of the rationale and nature of uncertainty in the concise description of the position; and (iv) no reporting of administrative practice tax positions.

 

Five-year phase-in period

In Announc. 2010-9, the Service proposed that the reporting requirement apply to business taxpayers with total assets of at least $10 million. The Service requested comments on whether transition rules should be used or criteria modified to either include or exclude certain business taxpayers, and the type of uncertain tax positions that should be reported by pass-through entities and tax-exempt entities.

In Announc. 2010-30, the Service stated the types of corporations initially required to file the UTP schedule and that such would be limited to corporations that issue audited financial statements (or that have tax positions for which a related party records a reserve in an audited financial statement) and file Form 1120, U.S. Corporation Income Tax Return; Form 1120-F, U.S. Income Tax Return of a Foreign Corporation; Form 1120-L, U.S. Life Insurance Company Income Tax Return; or Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return.

The final schedule and instructions generally retain the previously announced filing requirements regarding types of corporations required to complete the schedule for 2010 tax years. Accordingly, public or privately held corporations that issue audited financial statements and that file a Form 1120, Form 1120-F, Form 1120-L, or Form 1120-PC must file Schedule UTP if they satisfy the total asset threshold. In response to comments, however, the Service has implemented a five-year phase-in of the Schedule UTP for corporations with total assets under $100 million. Corporations that have total assets equal to or exceeding $100 million must file Schedule UTP starting with 2010 tax years. The total asset threshold will be reduced to $50 million starting with 2012 tax years and to $10 million starting with 2014 tax years. The Service will consider whether to extend all or a portion of Schedule UTP reporting to other taxpayers for 2011 or later tax years, such as pass-through entities and tax-exempt entities.

The final instructions do not exclude CAP or CIC taxpayers from the reporting requirement. With respect to CAP, the Service will address Schedule UTP compliance in upcoming CAP permanence guidance that is expected to be released shortly.

 

The draft schedule and instructions proposed that the corporation report a maximum tax adjustment for each tax position listed on the schedule, other than transfer pricing and other valuation positions. The maximum tax adjustment was defined in the draft instructions as the maximum United States federal income tax liability for the tax position if the position were not sustained upon examination by the Service. The draft instructions also provided the corporation a choice of ranking transfer pricing and other valuation positions based on the federal income tax reserve or an estimate of the adjustment to federal income tax that would result if the position were not sustained. These guidelines received a fair amount of criticism from tax professionals and professional organizations.

In response to the criticisms received in this area, the Service has removed the proposed requirement to report the maximum tax adjustment. Instead, the final schedule and instructions require a corporation to rank all of the reported tax positions (including transfer pricing and other valuation positions) based on the United States federal income tax reserve (including interest and penalties) recorded for the position taken in the return, and to designate those tax positions for which the reserve exceeds 10% of the aggregate amount of the reserves for all of the tax positions reported on the schedule. The ranking method relies on the reserve computations that corporations perform for audited financial statement purposes, but does not require disclosure of the actual amounts of the tax reserves.

In addition, commentators noted the difficulty of computing the maximum tax adjustment for tax positions for which no reserve was created based on an expectation to litigate the position. The instructions address this concern by providing that no size needs to be determined with respect to these tax positions and that these positions can be assigned any rank by the corporation.

 

Criticism was also received that the disclosure of the rationale for the disclosure of the UTP and the nature of the uncertainty when beyond the level of disclosure required under FIN 48 and that such disclosure went beyond the Service's policy of restraint and stated objective not to require that taxpayers disclose their assessment of the strength or weakness of their positions. In response, the new Annoucement conceded that the proposed requirement to include the rationale and nature of the uncertainty in the concise description has been eliminated. The instructions now require a concise description of the tax position, including a description of the relevant facts affecting the tax treatment of the position and information that reasonably can be expected to apprise the Service of the identity of the tax position and the nature of the issue. This is based upon and consistent with the information required to be reported on Form 8275. In addition, the final instructions expressly state that a corporation is not required to include an assessment of the hazards of a tax position or an analysis of the support for or against the tax position.

 

The proposal required that a corporation report on Schedule UTP tax positions for which no reserve was recorded because the corporation determined it was the Service's administrative practice not to raise the issue during an examination. In response to certain comments, the Service has eliminated the proposed requirement to report tax positions for which no reserve was created due to a widely-understood administrative practice, but will continue to explore ways to assess the impact of these tax positions on overall tax compliance.

 

The final instructions clarify that the schedule seeks the reporting of tax positions consistent with the reserve decisions made by the corporation for audited financial statement purposes. The instructions clarify that corporations are not required to report tax positions that are either immaterial under applicable financial accounting standards or are sufficiently certain so that no reserve is required under those standards. A tax position that a corporation would litigate, if challenged, but that is clear and unambiguous or is immaterial is therefore not required to be reported on Schedule UTP. The instructions require reporting of tax positions taken in a return for which reserves were created under applicable financial accounting standards or for which no reserve was created because of an expectation to litigate.

A number of commentators requested that the instructions regarding unit of account be clarified to more closely align the term with its meaning in FIN 48. The final instructions add an example to emphasize that the definition of unit account should be applied consistently with the guidance in FIN 48. The final instructions continue to provide that a corporation that uses its entire tax year as a unit of account under IFRS or another method of accounting may not do so for Schedule UTP reporting, but must identify a unit of account based on FIN 48 principles or by using any other level of detail that is consistently applied if that identification is reasonably expected to apprise the Service of the identity and nature of the issue underlying a tax position taken in the tax return.

2. A tax position is reported on Schedule UTP once (1) a reserve for a tax position is recorded and (2) a tax position is taken on a return regardless of the order in which those two events occur.

3. Corporations report their own tax positions on Schedule UTP and do not report the tax positions of a related party.

4. Tax positions taken in years before 2010 need not be reported in 2010 or a later year even if a reserve is recorded in audited financial statements issued in 2010 or later.

5. Reporting of recurring tax positions taken in multiple years.

6. Short Years. Schedule UTP need not be filed for short tax years ending in 2010.

7. Asset Filing Requirement. Worldwide assets are used to determine whether a corporation that files a Form 1120-F (including a protective return) must file Schedule UTP.

8. Definition of Audited Financial Statement. As revised, one on which an independent auditor expresses an opinion and that compiled or reviewed financial statements are excluded from the definition of audited financial statement.

9. The definition of record a reserve was revised to clarify that it includes the recording of a reserve for United States federal income tax, interest, or penalties and to reinforce that temporary differences must be reported on Schedule UTP.

10. Corporations included in multiple audited financial statements that the recording of a reserve in any audited financial statement in which the corporation is included triggers reporting of the tax position if the tax position is taken on a return filed by the reporting corporation.

 

 

The Service received a fair amount of criticism on the UTP filing requirement in that it unfairly asks taxpayers to volunteer and identify tax positions along with the taxpayer's views and assessments of those positions. Such "fall on one’s own sword" approach the UTP requires is, such persons argue, inconsistent with the attorney-client privilege, the work product doctrine, and the tax practitioner privilege, because it may require disclosure of information that is based upon the advice of counsel and tax return preparers and may require the sharing of the mental impressions of these advisers. Concern also is on whether disclosure of tax positions on Schedule UTP could enable adversaries to raise questions about subject-matter waiver with respect to confidential communications related to the disclosed tax positions.

In response, the instructions no longer require the rationale and nature of the uncertainty to be included in the schedule's concise description and further explain that the concise description should not include information related to the corporation's assessment of the hazards of a tax position or an analysis of the support for or against the tax position.

 

The Service is releasing, contemporaneously with the release of this announcement, Announcement 2010-76, which modifies the policy of restraint in response to these concerns. The Announcement set forth ground rules that the Service had embarked on for the first time.

1. If a document is otherwise privileged under the attorney-client privilege, the tax advice privilege in section 7525 of the Code, or the work product doctrine and the document was provided to an independent auditor as part of an audit of the taxpayer's financial statements, the Service will not assert during an examination that privilege has been waived by such disclosure. But such ground rules will not apply where: (i) the taxpayer has engaged in any activity or taken any action, other than those described in that paragraph, that would waive the attorney-client privilege, the tax advice privilege in section 7525 of the Code, or the work product doctrine; or (b) a request for tax accrual workpapers is made under IRM 4.10.20.3 because unusual circumstances exist or the taxpayer has claimed the benefits of one or more listed transactions.

2. Under current procedures, examiners request tax reconciliation workpapers as a matter of course. IRM 4.10.20.3. The taxpayer may redact the following information from any copies of tax reconciliation workpapers relating to the preparation of Schedule UTP it is asked to produce during an examination: (i) working drafts, revisions, or comments concerning the concise description of tax positions reported on Schedule UTP; (ii) the amount of any reserve related to a tax position reported on Schedule UTP; and (iii) computations determining the ranking of tax positions to be reported on Schedule UTP or the designation of a tax position as a Major Tax Position.

3. Other than requiring the disclosure of the information on the schedule, the requirement to file Schedule UTP does not affect the policy of restraint.

The final schedule and instructions announced in Announc. 2010-75 retain the requirement to report tax positions taken in a return for which no reserve was recorded because of an expectation to litigate the position and incorporate revised instructions to clarify the meaning of expectation to litigate. The final instructions clarify that a corporation may rely on the reserve decisions it made for financial statement purposes to complete Schedule UTP and thus is not expected to reassess at the time the schedule is completed those reserve decisions previously made for financial statement purposes.

 

 

The Service announced the issuance of a Directive concerning the use of Schedule UTP by the Service and its examination and research personnel. The Directive outlines the various uses for the information reported on the schedule and indicates that initial processing of Schedule UTP information will be centralized to ensure appropriate review to identify trends and areas requiring further guidance to address uncertainty in the law.

In addition, the Service will create a working group to study and revise the Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, to reduce duplicate reporting. The Service believes that the implementation of Schedule UTP is likely to reduce the need for some of the information currently reported on the Schedule M-3. The working group will begin its work in 2011 to develop appropriate revisions to the Schedule M-3.

The Service also will be expanding the Compliance Assurance Program (CAP) and making it permanent. The Service intends that the permanent CAP will consist of three phases: pre-CAP, which will allow a taxpayer to become current on the audit cycle while demonstrating the requisite transparency needed to be eligible for CAP; CAP, which will resemble the existing CAP pilot program; and CAP maintenance, which will call for the reduction of resources and taxpayer contact for those taxpayers in this phase as appropriate. Details will be contained in the upcoming CAP permanence guidance that is expected to be released shortly.

 

Concerns have been raised that the Service will automatically disclose information reported on the Schedule UTP to foreign governments. The Service intends to generally refrain from providing Schedule UTP information to other governments except in those circumstances in which there is a reciprocal arrangement with the foreign government regarding uncertain-tax-position information, such as where the foreign government collects similar information for its own tax administration purposes and agrees to make this information available to the Service in a similar manner. In addition, even if reciprocity did exist, the Service would consider other factors in determining whether to disclose the information, including the relevance of the information to the the identity and nature of those tax positions.

 

The final Schedule UTP instructions state that a complete and accurate disclosure of a tax position on the appropriate year's Schedule UTP will be treated as if the corporation filed a Form 8275 or Form 8275-R regarding the tax position and that a separate Form 8275 or 8275-R need not be filed to avoid certain accuracy-related penalties with respect to that tax position. Consistent with Notice 2010-62, issued September 13, 2010, in the case of a transaction that is not a reportable transaction, the Service will treat a complete and accurate disclosure of a tax position on Schedule UTP as satisfying the disclosure requirements of section 6662(i). The Service is studying other ways to reduce duplicate reporting and is considering whether complete and accurate disclosure on Schedule UTP would also, in appropriate circumstances, provide the information necessary to satisfy the reportable transaction disclosure requirements.

Relation to disclosure statements

Exchange of information with foreign governments

Internal Directive and related changes

IRS Announcement 2010-76

Privilege, work product doctrine, subject matter waiver, and policy of restraint comments

Additional areas of clarification made by the Service in Announc. 2010-75

1. Schedule UTP requires the reporting of U.S. federal income tax positions but not foreign or state tax positions. Under the general reporting instructions, however, a corporation is required to report a United States federal income tax position taken in a return that arises out of uncertainty with regard to a foreign tax position (e.g., foreign tax credits) if a reserve for United States federal income tax was recorded to reflect that uncertainty.

Consistency between Schedule UTP reporting and financial statement reserve decisions

No reporting required for which no reserve created due to widely-understood administrative practice

Removal of requirement to include rationale and nature of uncertainty in concise description of the position

No reporting of maximum tax adjustment

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In PLR 201034004, the National Office of the Internal Revenue Service issued a favorable ruling to the taxpayer’s proposed issuance of financial statements and supplemental information containing disclosures of a subsidiary's income on a LIFO and non-LIFO basis to the taxpayer's creditors and shareholders. Rulings requested and granted. Taxpayer plans to issue reviewed (as opposed to audited) consolidated financial statements with unique characteristics, and asked the National Office to rule that the LIFO conformity requirements wouldn't be violated under such circumstances. More specifically, The taxpayer asked for a favorable ruling that such financial disclosures will not violate the LIFO conformity rule under §472 and the corresponding regulations. The Service ruled favorably.

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  In Notice 2010-60, the Service has issued temporary guidance until proposed (and later final) regulations are issued, hopefully sometime in early 2011, on recent reforms law designed to attack U.S. tax evasion activities by certain U.S. and foreign persons. Notice 2010-60 addresses key provisions aimed at foreign tax compliance enacted as part of the Hiring Incentives to Restore Employment Act of 2010 (HIRE), which includes the Foreign Account Tax Compliance Act of 2009 (FATCA).  These new measures are designed to block U.S. citizens from using offshore accounts to avoid U.S. tax by imposing a 30% withholding tax obligation. A withholding provision applies with respect to payments made to a foreign entity that is either a foreign financial institution (FFI) or a nonfinancial foreign entity.  New rules on information reporting apply with respect to certain payments made to foreign entities . Enhanced penalties are imposed on disclosure failures and a special rule extending the statute of limitations is also part of FATCA. Special rules apply to foreign trusts, grantor trusts which are foreign trusts, deemed dividend equivalent payments and other provisions.  

 

 

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One of the various requirements to qualify an acquisitive transaction as a tax-free reorganization is the continuity of business enterprise requirement. A tax-free reorganization requires a “continuity of business under modified corporation forms”. (citation omitted). The courts have entered into this area from time to time dealing with such issues as post reorganization asset drop-downs (Standard Realization Co. v. Comm’r, 10 TC 708 (1948) (acq.)) or asset sales (Pridemark, Inc. v. Comm’r, 345 F2d 35 (4th Cir. 1965) . .(reorganization treatment denied under preconceived sale of assets where business operations had been suspended during the interim period). The reported cases in this area may be viewed as having turned on the specific facts in each case.

The COBE rule requires that there be a continuity of business activity of the historic business of the acquired entity. The regulations provide that in order to meet the COBE requirement, in general, the acquiring corporation must: (i) continue the target corporation’s historic business; or (ii)) continue the use of a “significant portion” of the target corporation’s historic business assets in a business. Logically the regulations state that the fact that the acquiring corporation is engaged in the same line of business as the target corporation should result in a finding that COBE is present. Where the target had been engaged in more than one business, COBE requires that the target only continue a significant line of its business. Another rule provides that the acquiring corporation may continue the “historic business” of the target which is the business most recently conducted.

While the COBE requirements applies to the various species of tax-free reorganizations, for insolvency (Type G) reorganizations, the COBE requirement may present a greater obstacle particularly where the historic business operations of the debtor-reorganized corporation have been substantially reduced in size of operation. Examples are contained in the regulations applying these principles.

Regulations adopted in 1998, liberalized the COBE requirements by permitting post-reorganization asset drop-downs to controlled subsidiaries or even partnership if certain conditions are met. Numerous examples are contained in the regulations. Additional changes to the COBE regulations were promulgated in 2007.

Another COBE rule is contained in section 382(c) pertaining to the portability of net operating losses in particular ownership change and equity structure shift events.

Against this backdrop in PLR 201015024 (4/16/2010) the National Office of the IRS ruled that using historic business assets to conduct research and development activities in order to perfect and protect patent rights satisfied the continuity of business enterprise (COBE) test.

The taxpayer-corporation seeking the ruling was had engaged in research and development activities in years one to three for one aspect of “Business A”. It applied for and/or received patents for this new technology; created a product based on this new technology; and brought this product to the commercial market. In year two an “ownership change” occurred per §382(g). The §382(c) 2 year testing period for COBE or the “COBE Period) began on Date A and ended on Date B. In year 3 Competitor A (as it was referred to in the ruling), an established company in the same line of business as Taxpayer), engaged in vigorous action to compete with the taxpayer’s commercial marketing of its product. Within the 2 year COBE Period, on Date C, as a result of the competition of Competitor A, taxpayer sold part of its business relating to the commercial marketing of its product to Acquiring-1. The taxpayer, however, retained all or part of its R&D department, its patents and patent applications and law suits or potential lawsuits against Competitor A for patent infringement and antitrust violations. In year 4, after the end of the COBE Period. Pm Date D. the taxpayer sold its R&D activities to Acquiring 2 for potential future payments. In year 5 the taxpayer received a payment from Competitor A in settlement of the patent infringement and antitrust lawsuits and for the right to the future use of Taxpayer's patents. The amount of the settlement payment was substantially more than the funds previously received by taxpayer for the part of its business it sold in year 2. 

In addition to certain other representations made by the taxpayer as set forth in the ruling request and recited in the ruling, the Service ruled: 

1. Taxpayer’s activities after the asset sale in developing and perfecting new technology; in applying for and/or perfecting patents; and negotiating with and litigating against Competitor A with regard to its business and patents and with regard to the patent infringement and antitrust lawsuits constitute the use of “historic business assets” by Taxpayer. See Treas. Reg. §1.368-1(d)(3)(ii).

2. The “historic business assets” with regard to which Taxpayer received the large settlement payment constitutes a “significant portion” of Taxpayer's pre–asset sale historic business assets.

3. Taxpayer's use of its “historic business assets” from DateC until the DateB end of the 2–year COBE Period constitutes a continued business use by Taxpayer of a significant portion of its historic business assets sufficient to meet the continuity of business enterprise requirement in Treas. Reg. § 1.368-1(d) and, accordingly, the DateC asset sale does not bring into effect the § 382(c) carryforward limitation (2 year COBE period).

As various corporate tax jocks would say, “what a ruling” this one is (and favorable at that). Note §6110(k)(3)’s warning: “Unless the Secretary otherwise establishes by regulations, a written determination [e.g., private letter ruling] may not be used or cited as precedent. The preceding sentence shall not apply to change the precedential status (if any) of written determinations with regard to taxes imposed by subtitle D of this title.”

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Incorporation of an Entity Taxable as a Partnership to a Corporation or Association Taxable as a Corporation

At times it may be desirable to convert an entity taxable as a partnership, such as a limited liability company having more than 1 member or a limited partnership, into a corporation for federal income tax purposes. There may be several reasons why this planning option should be considered including the possible IPO of the business entity although in such case the conversion of tax status should be dependent upon the successful offering.

As set forth in Rev. Rul. 84-111, supra, there are three methods by which an entity taxable as a partnership may convert to a corporation.

 

The first method is the “assets over” or “partnership asset transfer” approach. In such instance the tax partnership transfers its assets to the newly organized corporation in exchange for the stock and the assumption by the corporation of partnership liabilities, and the partnership then liquidates by distributing the corporate stock received in the incorporation transaction to the partners in accordance with their partnership proportions.

 

The second method is the “assets up” or “partner asset transfer” approach, where the tax partnership’s assets are first distributed in-kind to the partners who then transfer the assets to the corporation in exchange for the corporations's stock and the corporation assumes the liabilities of the partners which were just assumed by the partners from the distributing or liquidating partnership.

 

The third method is the “partnership interest transfer” approach, where the interests of the partners in the tax partnership are transferred to the corporation in exchange for the corporation's stock. This exchange will terminate the partnership (since only one “partner” will then hold interests in the former partnership). The partnership's assets and liabilities will become the assets and liabilities of the corporation.

 

The check-the-box regulations contain a rule whereby the partnership may elect to change from a tax partnership to an association taxable as a corporation. Treas. Reg. § 301.7701-3(g)(1)(i) sets forth the effects of the CTB election which takes the “assets over” or “partnership asset transfer” approach: (i) the partnership contributes all of its assets and liabilities to the association in exchange for stock in the association;  and (ii) immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners.

 

In Rev. Rul. 2004-59, 2004-1 CB 1050 the Service ruled that if an unincorporated state law entity that is classified as a partnership for federal tax purposes converts into a state law corporation under a state law conversion statute, the following (“assets over”)is deemed to occur: (i) the partnership contributes all its assets and liabilities to the corporation in exchange for stock in such corporation; and immediately thereafter, (ii) the partnership liquidates, distributing the stock of the corporation to its partners. In other words, the conversion is treated in the same manner as an election (without a state law conversion to corporate status) under Treas. Reg. § 301.7701-3(c)(1)(i) .

 

Impact of “Assets Over” Conversion.  The exchange under §351, as mentioned, is between the partnership and the corporation. The partnership then terminates through a liquidating distribution of the newly received stock. The basis of the assets received by the transferee corporation will be the partnership's basis per §362. The basis of the stock received by the partnership will be the basis of the partnership’s assets transferred to the corporation, reduced by liabilities assumed by the corporation or to which the transferred properties were subject. § 358 . This amount may vary significantly with the partners’ basis in their partnership interests which becomes the corporation’s basis in the acquired assets under the “Assets Up” method.  The basis of the transferee corporation's stock received by the partners in liquidation of the partnership is the adjusted or outside basis of the partners' interests in the partnership less the amount of the corporation's assumption of the partnership's liabilities in the incorporation transaction.

The holding period for the stock received in the exchange and distributed to the partners in liquidation receives “tacking” of the holding period of the partnership but only as to capital or §1231 assets. Ordinary income assets of the partnership are not entitled to tacking and the holding period for the stock begins on the day following the date of the exchange. §§ 1223(1), 1223(2). The “assets over” approach is considered by many tax advisors as the least complex method for incorporating a partnership.  

 

“Assets Up” Approach. Under this alternative, the partnership first liquidates by distributing its assets, subject to liabilities, to the partners. The second step is the transfer of assets received from the partnership to the transferee corporation in exchange for stock in accordance with §351(a). The basis of the distributed received in liquidation to the partners is the adjusted basis of each partner's interest in the partnership, less any money distributed or property treated as money. Each partner’s basis in the stock received in the exchange (or deemed exchange) will be equal to the basis of the assets received in the liquidating distribution, less liabilities assumed by the transferee. §358. The corporation’s basis in the transferred assets is equal the partners adjusted basis in the assets “contributed” up to the corporation. § 362 . Note again, that the outside basis in the partners’ interest in the partnership will become the corporation’s basis in its assets which may produce a different result then the “Assets Over” approach.

The partners' holding period in the assets received in liquidation includes the partnership’s holding period. The holding period in the stock received in the exchange includes the holding period for the capital assets and § 1231 assets.  Ordinary ncome assets receive no tacking of holding period. §1223(1) . The holding period for the corporation in assets received in the exchange includes the (former) partners' holding periods in the assets transferred to the corporation. § 1223(2) .

 

Transfer of Partnership Interests Approach.  As the third alternative, the partners transfer their partnership interests to a transferee corporation in exchange for shares of the corporation under §351. The partnership terminates since upon receipt by the corporation there will be only one “partner”. The partners basis in the stock received in the exchange will be the basis for their partnership interests, reduced by any liabilities assumed. §358. The corporation’s basis for the partnership assets will be each partner's basis in the partnership interest transferred. § 362 .  Tacking of holding period is permitted for the stock received holding period to the extent that the assets in the partnership are neither §751 or ordinary income assets. The corporation's holding period in the assets received in the exchange includes the holding period of the partnership in the assets transferred. § 1223(2) .

 

If the corporation-transferee is an S corporation, the Assets Up method may place jeopardy on the corporation’s S status as it will have, at least momentarily, a partnership as a shareholder. This is discussed briefly in Rev. Rul. 84-111, supra.

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In Tidewater, Inc. and Subsidiaries v. U.S., 565 F.3d 299 (4/13/2009), the Fifth Circuit affirmed the District Court’s  determination in a tax refund suit, reported at 100 AFTR2d 2007-6360 (DC LA 2007), which granted controlled group/oceangoing vessel owner-operators' refund of an overpayment of tax attributable to its claim that it could deduct, under the former foreign sales corporation provision, commissions paid to a foreign sales corporation on the portion of income allocated to the leasing component of time charters/mixed lease-service agreements. The Court agreed with the trial court below that time chartered vessels constituted qualified export property for purposes of former §927 and former Treas. Reg. § 1.927(a)-1T(f)(2) 's provision for leases to controlled group members of property that is held for sublease. The resolution of the issue hinged on whether the taxpayers' agreements with customers were in the  nature of service contracts or leases/subleases. This analysis required application of the factors set forth in §7701(e). The six factors in §7701(e) that the Fifth Circuit analyzed were (1) physical possession of the property; (2) control of the property; (3) significant possessory or economic interest in the property; (4) substantial risk of nonperformance; (5) concurrent use of the property; and (6) that the total contract price does not substantially exceed the rental value of the property for the contract period.

The Fifth Circuit held that the control factor was most important and therefore concluded that the agreements in issue in this case were more akin to lease/sublease agreements due to the significant control customers exercised over every aspect of  the vessels' use.

The AOD, (AOD 2010-01, posted on the IRS website May 17, 2010; 2010-22 IRB), states the Service’s disagreement with the the Fifth Circuit’s analysis and application of the factors test under §7701(e). The Service continues to hold its position that time charters should be treated as service contracts on the basis that the right to direct the destination and itinerary of boat trips for a specific period of time is not sufficient “control” or otherwise meets the requirements of a lease of property versus a contract for services.  

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In PLR 201016048 (4/23/2010) the Service held that the issuance of a share of stock of a foreign parent corporation issued as consideration to cancel a debt obligation of the wholly owned domestic subsidiary would not trigger cancellation of indebtedness income even though the issued share as cancelled shortly thereafter.

Filing the PLR request was the common parent of an affiliated group of U.S. corporations which filed a consolidated U.S. corporate income tax return. The common parent was the wholly owned subsidiary of its foreign parent corporation. The common parent had borrowed a substantial amount of funds from the foreign parent for conducting business operations. It was stipulated that the foreign parent did not carry on a trade or business within the U.S. or maintain a fixed base or permanent establishment within the U.S. It did not file a U.S. income tax return. 

As part of a prior acquisition transaction, a portion of the debt which had been used to finance the operations of a domestic subsidiary, was cancelled by the foreign parent in exchange for the taxpayer’s stock in the subsidiary. Still, the taxpayer, despite this cancellation, was still in debt to its foreign parent.

To improve the common parent’s balance sheet, the foreign parent wanted to cancel the balance of the debt. For purposes of the foreign parent corporation’s domestic tax position, the cancellation was made in exchange for stock of the U.S. subsidiary (common parent of the consolidated group) with the value of the stock estimated to be equal to the value of the cancelled debt. The cancellation would occur before year end at which time the common parent intended to enter into a rescission agreement pursuant to which (i) the debt cancellation would be voided, with interest paid accordingly, and (ii) the transferred shares of the taxpayer's stock would be cancelled. Subsequent to the rescission, the debt and the interest would revert back to their original amounts as if the transaction never occurred.

Following the rescission of the original cancellation agreement, the taxpayer intended to enter into an agreement with the foreign parent pursuant to which (i) solely for purposes of its foreign taxes, the foreign parent would purchase a single share of the taxpayer's stock in exchange for cancellation of an amount of the debt intended to be equal to the FMV of the single share, (ii) the foreign parent would cancel the aforementioned amount of the debt as a capital contribution to the taxpayer, and (iii) the single share, which was issued solely for foreign tax reasons, would be cancelled. 

Based on the facts provided and a number of taxpayer representations, the IRS ruled that: 

(1) The original cancellation of the debt and issuance of the shares of taxpayer stock pursuant to the transaction would be disregarded for U.S. federal income tax purposes (i.e., the rescission would be respected).

(2) The taxpayer's transitory single share would be disregarded for U.S. federal income tax purposes.

(3) The taxpayer would be treated as having satisfied the debt with an amount of money equal to the foreign parent's adjusted basis in the debt for purposes of determining income from discharge of indebtedness under Section 108(e)(6). 

The Service accepted as immaterial the taxpayer’s having to issue a share and cancel it for foreign tax purposes without muddying the waters so to speak and adversely affect the favorably ruling that it was seeking to obtain. Thus, the Service may have looked at the stock issuance and cancellation as being controlled by section 108(e)(6) based on the foreign parent’s 100% stock ownership instead of section 108(e)(8). Were the latter to apply to the transaction, the debt cancellation would result in COD income since the value of a single share by the common parent would have been less than the face amount of the debt cancelled by the foreign parent.

 

 Under section 108(e)(6) where a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, such corporation is treated as having satisfied the indebtedness with an amount of money equal to the shareholder's adjusted basis in the indebtedness. Section 108(e)(8) provides that where a debtor-corporation transfers stock to a creditor to satisfy the repayment of an indebtedness, the corporation-debtor is viewed as satisfying the debt in an amount of money equal to the value of the stock. 

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On May 14, 2010, the IRS and Treasury announced in Notice 2010-41, that they will issue regulations classifying certain domestic partnerships as foreign partnerships for the purpose of identifying the US shareholders of a CFC with respect to income inclusions (for Subpart F income) in accordance with §951(a). This announcement continues to reflect the Service’s concern, as set forth in Notice 2009-7, 2009-1 C.B. 312, identifying the following transaction (and substantially similar transactions) as a "transaction of interest" for purposes of Treas. Reg. § 1.6011-4(b)(6) and §§ 6111 and 6112.  Notice 2009-7 continues in effect.

Basic Scenario Under Question by Service

. The transaction of interest in question is where a US taxpayer (A) wholly owns two CFCs, i.e, CFC 1 and CFC 2, each of which owns 50% of another CFC, i.e., CFC 3 through a domestic partnership. A foreign corporation is a CFC for a particular taxable year if more than 50% of its stock is held by U.S. shareholders at any time during the year. A U.S. shareholder is a U.S. person (citizen, resident, or domestic corporation, partnership, trust, or estate) owning at least 10% percent of the corporation's voting stock. In applying the 50% test, proportionate shareholdings are measured by voting power or value, whichever gives the higher percentage for U.S. shareholders.

CFC3 has amounts described in § 951(a)(1). Taxpayers have taken the position that this structure avoids the flow through of Subpart F income under §951(a) with respect to CFC 3Taxpayer takes the position that it does not have an income inclusion under § 951(a) with respect to CFC3 because the domestic partnership is the first United States person in the chain of ownership of CFC3. This argument finds substance in a literal application of the Code. For starters, §957(c) defines a United States person by reference to § 7701(a)(30). Section 7701(a)(30)(B) defines a US person to include a domestic partnership. Section 7701(a)(5) defines the term "foreign" as applied to a corporation or partnership as a corporation or partnership that is not domestic. Section 7701(a)(4) provides that the term domestic when applied to a corporation or partnership means created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations. So far so good for the "literalists" view. However, § 7701(a) provides that any general definition included therein does not apply where such definition is manifestly incompatible with the intent of the relevant Code provision.

Notice 2009-7, supra, states, in challenging this construct, that the taxpayer’s argument of avoiding CFC status for CFC 3 is contrary to the purpose and intent of §951 and that regulations will be issued requiring the domestic partnership to be treated as a foreign partnership thereby requiring the Subpart F income of CFC 3 to be passed up with character intact to the CFC 1 and CFC 2. Thus, the Treasury is taking the view that the definition of a domestic partnership under §7701(a)(4), for certain partnerships wholly or partly owned by foreign corporations, is contrary to the legislative intent of §951. As set forth in the recent Notice 2010-41, which also announced that the regulations will apply for tax years of domestic partnerships ending after May 13, 2010, will treat domestic partnerships as foreign if certain conditions are met. Guidance will also address tiered partnership structures.

On December 29, 2008, the Treasury Department and the IRS issued Notice 2009-7, 2009-1 C.B. 312, identifying the following transaction (and substantially similar transactions) as a transaction of interest for purposes of § 1.6011-4(b)(6) and §§ 6111 and 6112 of the Code. A United States taxpayer (Taxpayer) wholly owns two controlled foreign corporations (CFC1 and CFC2), each of which owns 50 percent of another controlled foreign corporation (CFC3) through a domestic partnership. CFC3 has amounts described in § 951(a)(1). Taxpayer takes the position that it does not have an income inclusion under § 951(a) with respect to CFC3 because the domestic partnership is the first United States person in the chain of ownership of CFC3. As stated in Notice 2009-7, the Treasury Department and IRS believe that Taxpayer's position is contrary to the purpose and intent of § 951 of the Code.

The recent notice specifies that the regulations will treat a domestic partnership as foreign where:

1. The partnership is a US shareholder of a CFC per §§957(a) or 953(c); and

2. If the partnership were treated as foreign: (i) the FC would continue to be a CFC; and (ii)at least one United States shareholder of the CFC; (a) would be treated under § 958(a) as indirectly owning stock of the CFC owned by the partnership that is indirectly owned by a foreign corporation; and (b) it would be required to include an amount in gross income under § 951(a) with respect to the CFC.

The regulations to be issued will provide similar results in the case of tiered-partnership structures.

It should be noted that Notice 2009-7, supra, continues in effect treating the above structure, or one substantially similar to the structure, as a "transaction of interest". As further stated in Notice 2009-7, the IRS may challenge the positions taken by taxpayers with respect to such transactions, including under the provisions of subpart F and subchapter K of the Code, or under judicial doctrines including the sham transaction, substance over form, and economic substance doctrines. Note recent codification of §7701(o) and related strict liability penalty provision.

 

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Premiums Paid to Controlled Foreign Corporation Insurance  Company for Provisional Indemnification Receivables for Loss Reserves Must be Included in Subpart F Income under Sections 952 and 956 in TAM 201015030 (9/25/09).

In a technical advise memorandum issued last Fall, the National Office determined certain  provisional indemnification receivables (PIR) for incurred but non-reported loss reserves are includable in a foreign insurer's subpart F insurance income and are effectively to be included in the  of a U.S. shareholder of the foreign insurer on a pro rata basis under §§ 951 and 953.
Under the stated summary of the facts, the taxpayer  is a U.S. shareholder of a foreign insurer, which is a controlled foreign corporation (CFC), i.e., §957 defines a CFC as a foreign corporation where more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned by U.S. shareholders. A” U.S. shareholder” for this purpose, per §951, is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. 

The taxpayer has policies reinsured by the foreign insurer, including auto liability and general liability policies. The foreign insurer's shareholder agreement sets out a method to calculate a shareholder/insured's premium, depending on an actuarial firm estimating a shareholder/insured's predictable losses (Fund A) and other losses to the foreign insurer's retained limit (Fund B). The annual premium is the sum of the shareholder/insured's contributions to Fund A, Fund B, and the fixed costs of the program.

Loss and profit distribution rules as well as risk of loss allocations were contained among the shareholders/insured. More particularly, under the risk of loss rules, any  additional premium assessments against the taxpayer were anticipated and the foreign insurer calculated them, in part, based on the PIR for incurred but as of yet unreported losses. The foreign insurer's financial statements for the relevant years included in income the increase in the receivables for PIR, and the taxpayer's federal income tax return for the relevant years excluded the increase in receivables for PIR in computing the taxpayer's deemed dividend income from the foreign insurer under subpart F. However, the taxpayer deducted the increase in the actuarial estimated reserves for incurred but not reported losses on the same basis as book income.   This effectively resulted in a deduction without an income or revenue offset.

The taxpayer argued that changes in the PIR, representing potential assessments on shareholders/insureds , are reversed for the calculation of taxable earnings and profits for subpart F purposes because of their still contingent nature. The IRS maintained that under § 832  insurance company taxable income, a property and casualty insurance company must determine its gross income, in part, on an earned premium basis. Under that system, premiums are not earned when a policy is written or a premium collected, but the premium is earned over the period of coverage.

Technical Analysis
Neither the Code nor Regulations define the terms "insurance" or "insurance contract". The Supreme Court however that insurance involves both risk shifting and risk distribution.  Helvering v. LeGierse, 312 U.S. 531 (1941). The risk transfer must be the risk of economic loss. See, e.g., Allied Fidelity Corp. v. Commissioner, 572 F. 2d 1190 (7th Cir. 1978), cert. denied. The risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F. 2d 288, (2d Cir. 1950), and must not be merely an investment or business risk. Le Gierse, 312 U.S. at 542, Rev. Rul. 89-96, 1989-2 C. B. 114; Rev. Rul. 2007-47, 2007-2 C.B. 127. 
Section 957(b) provides  that for purposes only of taking into account income described in  §953(a) (relating to insurance income), the term CFC includes not only a foreign corporation as defined in subsection (a) but also one of which more than 25% of the total combined voting power of all classes of stock (or more than 25% of the total value of the stock) is owned (per §958(a))  or is considered as owned per §958(b), by U.S. shareholders on any day during the taxable year of such corporation, where the gross amount of premiums or other consideration in respect of the reinsurance or the issuing of insurance or annuity contracts described in §953(a)(1) exceeds 75% of the gross amount of premiums or other consideration in respect of all risks.

For certain insurance companies, §953(c)(1)(a) provides that  the term” U.S. shareholder “means with respect to any foreign corporation, a U.S. person (per §957(c)) who owns (within the meaning of § 958(a)) any stock of the foreign corporation. Under § 953(c)(1)(b) the term CFC  has the meaning given to such term by §957(a) determined by substituting 25% or more for more than 50%. Under §953(c)(1)(C) the reference to pro rata share in section 951(a)(1)(A)(i) shall be determined under section 953(c)(5). As a CFC, its U.S. shareholders must include in gross income their pro rata shares of the corporation's subpart F income, as defined in §952, and the amounts determined under §956, which are based on the U.S. property held by the CFC.  Section 951(a)(1)(A)(i) requires a U.S. shareholder of a CFC to include in gross income such shareholder's pro rata share of the CFC's subpart F income for the year.

Section 952(a) defines subpart F income to include, among other things, insurance income as defined in §953, and foreign base income, per § 954. In effect, § 951 provides for the inclusion in the taxable income of a U.S. shareholder its share of current earnings and profits of a foreign insurance company as "deemed dividends."  Section 953(a)(1) defines “insurance income”, including income that would be taxed under subchapter L (§§801-848) as if the company was a domestic insurance company.. Amounts includable as deemed dividends are computed on the same basis as a domestic insurance company's taxable income. See §832 and in particular §832(b)(3), which defines underwriting income as the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred. Section 832(b)(4) provides that the term premiums earned on insurance contracts during the taxable year means an amount computed as follows: (A) from the amount of gross written premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance; (B) to the results so obtained, add 80% of the unearned premiums on outstanding business at the end of the preceding taxable year and deduct 80% of the unearned premiums on outstanding business at the of the taxable year.  Section 832(b)(5) defines losses incurred during the taxable year on insurance contracts based on a series of calculations.  For meaning of “unearned premium” see Treas. Reg. §1.832-4(a)(8)(i) i.e., unearned premium for a contract, other than a contract described in §816(b)(1)(B,  is the portion of the gross premium written that is attributable to future insurance coverage during the effective period of the insurance contract. Unearned premiums do not include any additional liability established by the insurance company on its annual statement to cover premium deficiencies.  See also NAIC, Statements of Statutory Accounting Principles (SSAP) No. 53 (setting forth guidelines for the reporting of earned but unbilled premiums).

Taxpayer takes the position that the change in the PIR, which represents potential assessments on shareholder/insureds, on the books of Foreign Insurer, which is a CFC, are reversed for the calculation of taxable earnings and profits for subpart F purposes because of their contingent nature. When the assessments are actually determinable, they are included in the calculation of taxable earnings and profits of Foreign Insurer as claims indemnification. Taxpayer believes that the PIR are not contractually determinable with certainty at the close of the taxable year and therefore should not be includable under SSAP No. 53 as written premiums on a NAIC annual statement.

National Office’s Rejection of Taxpayer’s Return Position Argument
The National Office disagreed with the taxpayers' omitting the PIR payments from Subpart F income.  Its reasoning is set forth in steps.  First, section 832 requires a property and casualty insurance company to determine its gross income, in part, on an earned premium basis. Under this system, a premium is not earned when a policy is written or when the premium is collected. Rather, the premium is earned over the period of coverage.  Under § 832(b)(4), earned premiums are composed, in part, of gross written premiums during the taxable year less return premiums and premiums paid for reinsurance. The amount of written premiums is then converted to an earned basis by means of the reduction allowed with respect to the net increase in unearned premiums during the taxable year. The items taken into account under § 832(b)(4) closely track items reflected in calculating earned premiums. The determination of gross written premiums in section 832(b)(4) necessarily includes certain amounts that would not otherwise be accruable under general tax accrual principles because the insurance company either has not received the premium or does not have an enforceable right to collect these amounts.

The PIR estimates due to Foreign Insurer from the shareholder/insured based on estimated incurred but not reported losses must be included in Foreign Insurer's earned premiums under § 832(b)(4) without regard to whether the amounts would meet the all events test for accrual of income by a non-insurance company.  This is mandated by §446(b) in clearly reflecting underwriting income, i.e., premiums earned and losses incurred must be computed on the same basis. Thus, the deduction for unpaid loss reserves in excess of Fund A must be offset by the increase in PIR.

Here, pursuant to the shareholders/insureds agreement with the CFC Insurer, the shareholders are required to pay additional premiums based on incurred but not reported losses. Foreign Insurer has included these additional premiums in its financial income, but has excluded them from its computation of subpart F taxable income and earnings and profits. However, Foreign Insurer has included in financial and taxable income the expected premiums (CIR) from shareholder/insureds based upon its actuarially determined reserves for reported losses. There should be no distinction between these receivables and the additional receivables from shareholder/insured on incurred but not reported losses. Thus, Foreign Insurer must also include PIR in taxable subpart F income as it does with its financial income.

TAM Holding

The PIR is includable in the calculation of Foreign Insurer's earnings and profits. The changes to the Foreign Insurers subpart F income and earnings and profits to reflect the PIR are included in Taxpayer's income on a pro-rata basis under §§951 and 953.

 

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PLR 200952031 (12/24/2009) addressed the application of the dividends received deduction (DRD) in the foreign context where a foreign corporation is the parent of a U.S. subsidiary. As a comment before discussing the ruling, sometimes in structuring an acquisition of a target that engages in both U.S. and non-U.S. business enterprises, it may be better to restructure the target's business operations before the acquisition instead of afterwards which may be the normal course.

Under the general facts of the ruling, acquisition group ("A") owned a U.S. subsidiary which had purchased all of the stock of a domestic target corporation ("T"). T conducted business operations both within and outside of the U.S. After the acquisition, T reincorporated as a foreign corporation, FT, which contributed its domestic business to New U.S.T. Then A’s U.S. subsidiary liquidated which resulted in A’s owned new FT with FT owning New U.S. T. This U.S. parent, foreign subsidiary, wholly owned U.S. subsidiary structure has been referred to as the "foreign sandwich". How will this structure affect the flow of profits from the lowest tier US subsidiary up the change of command?

The taxpayer seeking the ruling did not ask about the domestic to foreign transaction. The IRS simply stated in the ruling that the outbound transfer was an F reorganization. But, consider the drop out or drop down into the New U.S.T. Can it really be said that it was a true F reorganization? Perhaps it was instead an F involving the U.S.T. and then a dividend up of the foreign based business to the foreign company? See Treas. Regs. §§1.368-1(k)(1). 1.368-2(m). The ruling did not dwell on the F reorganization issues or problems but instead focused on the treatment of dividends from New U.S.T. to the FT and then from FT to A.

The ruling held: of course, based on the FT’s status as a foreign corporation, it is ineligible to qualify under §§902 and 960 on foreign tax credits (and corresponding gross up). FT’s foreign base company income for dividends paid by New U.S.T. will be reduced by the 80% DRD (dividends received deduction). Dividends paid up to A can be sheltered by 80% DRD for the U.S. source portion of the dividends from FT citing Weyerhaeuser, 38 BTA 594 (1935). Thus, FT would increase its earnings and profits account by the gross amount of its dividends received from New U.S.T. despite using the DRD in determining subpart F income.

Example. Assume that New U.S.T. had has earnings and profits of $500 and pays a $500 dividend to FT. New Foreign Target receives $100 in foreign base company income, assuming the 80% dividends received deduction applies. Acquirer includes this $100 in income currently and gets step-up in basis of stock per §961(a). This $20 amount is not a “dividend” and does not qualify for the dividends received deduction. Section 964(a)(6) does not mitigate because New U.S. Target is not a CFC.) When A receives a dividend of $100 (previously taxed income) it will reduce its basis in FT stock. §961(b). For amounts above the $100 of PTI, if from the U.S. source earnings, Acquirer will be allowed an 80% DRD. Thus, on a subsequent distribution of the $100 from New Foreign Target (assuming no change in accumulated earnings and profit and no current earnings and profits), $100 will reduce basis, and $400 will be treated as a dividend, 80% of which will qualify for the DRD.

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Treas. Reg. §1.305-3(b)(3) provides, in relevant part, that: a distribution of property incident to an isolated redemption of stock, e.g., a tender offer, will not trigger application of §305(b)(2) even though the redemption distribution is treated as a distribution of property to which §301 applies. Thus, an isolated non-pro rata redemption of stock does not result in a deemed distribution of stock under §305(c) to the nonredeeming shareholders, thereby negating the application of §305(b)(2) when the redemption is either (1) not treated by the redeeming shareholder as a Section 301(c)(1) distribution, or (2) an "isolated redemption."

The regulations illustrate Congressional intent where a majority shareholder causes a corporation to redeem some of its stock in a single, one-time redemption.

Treas. Reg. §1.305-3(e) Example (10) P has 1,000 shares of stock outstanding. T owns 700 shares of the P stock and G owns 300 shares of the P stock. In a single and isolated redemption to which §301 applies, the corporation redeems 150 shares of T's stock. Since this is an isolated redemption and is not part of a periodic redemption plan, G is not treated as having received a deemed distribution under §305(c) to which §§305(b)(2) and 301 apply even though he has an increased proportionate interest in the corporation.

Finally, the regulations contain an example in which a series of non-pro rata redemptions does not result in a deemed distribution under §305(c) when the redemptions have some valid business purpose (e.g., to fund an employee benefit plan), provided that the redemptions were not in pursuance of a plan to increase the proportionate interests of some shareholders and to distribute property to other shareholders. Because the redemptions in the cited examples are not motivated by an intent to increase the proportionate interest of some shareholders, §305(b)(2) does not tax the increased interests as a dividend. See also Rev. Rul. 77-19, 1977-1 C.B. 83 (corporation’s redemption of stock from some minority shareholders for cash in a merger was not equivalent to a taxable dividend with respect to the continuing shareholders in the surviving corporation).

With that as a backdrop, in PLR 201002022 the Service hints a significant nontax business purpose for the redemption will support a conclusion that §305 is inapplicable even though the distributions increase the proportionate interests of nonredeeming shareholders, and even if the distribution of stock and other properties is part of a series of distributions. In addition, if the distributing corporation is publicly held, a strong argument can be made that any stock and property distribution policy or plan adopted by the corporation that results in changes in proportionate interest of the remaining shareholders is not intended as a device to bail out the corporation's E&P. This argument is particularly applicable where the change in proportionate interests among the shareholders is minor. But neither the statute nor the regulations specifically adopt these implicit and practical limitations on the finding of a Section 305(b)(2) dividend distribution in a non-pro rata redemption.

Unlike the examples in the regulations which set out the isolated redemption exception, neither the legislative history nor the preamble to the regulations make any reference to a business purpose exception. While the more typical isolated redemption avoids dividend equivalence for valid reason, the expanse of a business purpose exception could be limitless and perhaps is too optimistic. Redemptions by co. of Class B common stock held by described retirement plan will qualify as redemptions that aren't essentially equivalent to dividend within meaning of Code Sec. 302(b)(1); , and distributions in redemption of stock owned by retirement fund will be treated as distributions in full payment in exchange for stock owned by retirement plan as provided in Code Sec. 302(a); .

Under the facts of the PLR, the Company is a privately owned company engaged in a business and has 2 class of outstanding common stock, voting and non-voting. The Company has an ESOP which owns shares of the nonvoting stock. Prior to Date 1, in order to provide liquidity to the Retirement Plan and to help the Retirement Plan diversify its assets, Company's board of directors plan to annually redeem an amount of shares of Class B common stock held by the Retirement Plan. At the meeting, the board of directors approved a financial forecast that included a dedicated line item for the planned redemptions. Absent further redemptions, the Retirement Plan will have sufficient liquidity to meet its obligations for only the next 3 to 5 years.

On Date 1, Company redeemed e shares of Class B common stock from the Retirement Plan in exchange for cash, which reduced the Retirement Plan's ownership of Company's total shares of common stock outstanding . On or about Date 2, Company will redeem shares of Class B common stock from the Retirement Plan in exchange for cash which will reduce the Retirement Plan's ownership of Company's total shares of common stock outstanding. Barring unforeseen or unanticipated business circumstances regarding cash flow, Company plans additional annual redemptions from the Retirement Plan.

On or about Date 3, Company will redeem shares of Class B common stock from the Family Group in exchange for cash. Currently, there is no plan to offer any further redemptions to the Family Group.

The Service rule that the planned series of redemptions of Class B stock from the Retirement Plan will be treated as redemptions that are not essentially equivalent to a dividend per §302(b)(1). See United States v. Davis , 397 U.S. 301 (1970); Rev. Rul. 75-512, 1975-2 C.B. 112; Rev. Rul. 77-426, 1977-2 C.B. 87. It further ruled that the redemption of the family’s stock will constitute a single and isolated transaction and will not result in a deemed distribution under section 305 with respect to any of Company's shareholders, regardless of whether such shareholder has a portion of its stock redeemed in the transaction. See Treas. Reg. § 1.305-3(e), Examples (10) and (11). See also Rev. Rul. 77-19, 1979-1 C.B. 84.

 

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In a move designed to thwart efforts to have offshore loan originators and purchases of U.S. debt portfolios, such as consumer debt or subprime mortgages, from avoiding effectively connected income per §864(b), the Office of Chief Counsel addressed the question of whether interest income earned by a foreign corporation with respect to loans originated by an agent, whether dependent or independent, operating in the United States is attributable to "the U.S. office" through which the foreign corporation’s banking, financing or similar business activity is carried on, such that the interest income is "effectively connected income"?

The CCO Memorandum concludes that received by a foreign corporation with respect to loans that it originated to U.S. borrowers constitutes income effectively connected with such foreign corporation’s banking, financing or similar business when an agent, whether dependent or independent, performs origination activities described in the facts below on the foreign corporation’s behalf with respect to such loans in the United States.

 

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