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

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

Legislative Developments

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

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

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

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

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

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

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

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

Court Decisions

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

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

lGeneral Antiavoidance Rule or “GAAR”.

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

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

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

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

Other Court Decisions

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Limitation on Use of Dual Consolidated Loss

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

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

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

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

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

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

Exceptions to Dual Consolidated Loss Rule.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Article XVof the Treaty provides:

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

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

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

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

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

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Under §116 of The Canadian Income Tax Act (“CITA”), non-residents who dispose of certain taxable Canadian property, a/k/a “Canadian Taxable Property”, must notify the Canada Revenue Agency (“CRA”) of the pending sale either prior to the disposition or within 10 days after the closing. In addition, where the CRA has received either an amount to cover the tax on any gain the non-resident seller  may realize upon the disposition of property, or appropriate security is provided for the tax, the CRA will issue a certificate of compliance to the seller-non-resident and a copy of the certificate is also delivered to the purchaser.

Where the purchaser does not receive such certificate, the purchaser is required to remit a specified amount, i.e., 25% of the gross sales price,  to the Receiver General for Canada and is entitled to deduct the amount from the purchase price. Any payments or security provided by the non-resident seller and/or purchaser will be credited to the seller's account. A final settlement of tax will be made when the non-resident's income tax return for the year is assessed.

Canadian Taxable Property (“CTP”)

Canadian Taxable Property includes: (1) real property situated in Canada; (2) property used or held in, or eligible capital property in respect of, a business carried on in Canada;(3) designated insurance property of an insurer; (4) privately issued stock of a corporation resident in Canada; (5) shares of a non-resident, privately owned corporation that are not listed on a prescribed stock exchange if, at any time during the last sixty months(i) more than 50% of the fair market value of all the property of the non-resident corporation was made up of CTP, Canadian resource property, a timber resource property, an income interest in a trust resident in Canada, or an interest or option in such properties; and (ii) more than 50% of the fair market value of the shares was derived directly or indirectly from real property situated in Canada, Canadian resource properties or timber resource properties, or any combination of such properties; (6) publicly traded shares in a Canadian company if at any time during the last sixty months, 25% or more of the shares of the corporation belonged to the taxpayer and/or persons with whom the taxpayer did not deal at arm's length;(7) an interest in a partnership if, at any time during the last sixty months (i) more than 50% of the FMV of all property was of CTP, etc., and (ii) more than 50% of the FMV of the partnership interest was derived directly or indirectly from real property in Canada; (8) a capital interest in a Canadian resident trust (other than a unit trust; (9) a unit of a Canadian resident unit trust (other than a mutual fund trust); (10) a unit of a mutual fund trust if, at any time during the last sixty months, 25% or more of the units of the trust belonged to the taxpayer and/or persons with whom the taxpayer did not deal at arm's length; and (11) an interest in a non-resident trust if, at any time during the last sixty months, the trust  was essentially comprised by CTP. Certain types of Canadian property are excluded from the definition of CTP.

Section 116 does not provide for treaty exempt status. However, the CRA permits a non-resident taxpayer  to claim an exemption under a specific tax treaty at the time they file the notification of disposition. Non-resident sellers must state the applicable article and paragraph of the particular treaty that Canada has with their country of residence. To expedite the processing of the exemption, the necessary documentation to support the claim should be submitted along with the request. The documentation must be based on the particular tax treaty under which the exemption is claimed, and would include items such as proof of residency, or proof that the gain has been or will be reported in the vendor's country of residence.

Section 16 is a controversial part of the Canadian tax law since it is somewhat broad-sweeping in its application and imposes a substantial degree of notification, certification and advance tax requirements.

As recently reported in a just published Tax Notes article authored by Michael N. Kandev and Fred Purkey of Davies Ward Phillips & Vineberg LLP in Montreal, last year, the CRA attempted to limit the scope of §116, both on substantive and procedural rules. One new limitation is that “treaty exempt” property is no longer CTP.  See U.S.-Canadian Income Tax Treaty, Article XIII(3). Another new provision, this one effective March 4, 2010, narrowed the definition of CTP to certain Canadian real or business property and interests in entities that have substantial investments, based on value, in Canadian real property or mineral properties.  Under this narrowed framework, shares in a private Canadian corporation are CTP only to the extent that at any time during the five-year period preceding the disposition, they derived, directly or indirectly, more than 50% of their value from Canadian real property or Canadian resource properties.

Well-received by taxpayers and their advisers, the above changes were a significant change in the law in Canada. While the §116 reforms represented a favorable development for foreign investment in Canada, there are still certain rules that will continue to cause complexity and uncertainty. Among such problems noted by Messrs. Kandey and Purkey are the 5 year valuation lookback rule for shares and interests in partnerships and trusts

By far the main impediment to the intended results of the March 4, 2010, amendments has been the five-year valuation lookback for shares and interests in partnerships and trusts that is now the cornerstone of the amended definition of TCP.See Canadian Income Tax Act §248, ¶¶(d), (e). This 5 year lookback rule poses substantial uncertainty as to whether interests in private Canadian corporations holding ownership interests in real property are CTP or not period the business has not derived more than 50 percent of its value from Canadian real estate.

It is important to understand that a buyer of CTP from a non-resident, where the property is not “treaty exempt property”, still has potential liability in the transaction. As mentioned, the CRA must be notified of the sale, a tax clearance certificate must be obtained, and, in certain instances, the buyer must withhold and pay over within 30 days of the closing generally, 25%f the gross purchase price of the property.  Messrs. Kandey and Purkey warn that if the purchaser assumes incorrectly that the sale was exempt from tax on the erroneous belief that the subject property is not CTP, the CRA, in its view, is likely to turn first against the purchaser.  So, its “caveat emptor” to the purchaser of Canadian situs property from a non-resident. Reasonable cause does not appear to be a defense to the purchaser. Compounding this problem is that the purchaser’s liability, under CITA § 116(5), does not appear to be subject to a particular statute of limitations.  This can have major impacts on successor or transferee liability let alone buyers of companies which have purchased assets from Canadian non-residents.

Obviously, it is important to seek the advises of a Canadian tax advisor when this issue arises. There are also potential treaty issues involved, for example, if a U.S. owner of tax exempt property is trying to sell Canadian property and the buyer is resistant to accept such status for whatever reason. Witholding 25% of the gross sales price on an exempt sale (by treaty) where the buyer stubbornly refuses to accept a treaty exemption certificate statement will drive up the non-resident seller’s compliance costs. A U.S. tax adviser can advise U.S. persons on treaty issues that impact on the presence of tax exempt treaty property. Lurking  in the background for the U.S. seller of CTP are foreign tax credit issues.

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In preparing for a Senate Committee on Foreign Relations hearing held on June 7, 2011, the Joint Committee on Taxation issued comments on the Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Switzerland (JCX-31-11) (5/20/2011). The proposed protocol was signed on September 23, 2009, and is accompanied by official understandings implemented by an exchange of diplomatic notes (collectively, the “diplomatic notes”) carried out on that same day.

As with most bilateral tax treaties, the tax treaty with Switzerland is designed to reduce or eliminate double taxation of income earned residents of either country from sources within the other country and to prevent avoidance or evasion of the taxes of the two countries. The present treaty also is intended to promote close economic cooperation between the two countries and to eliminate possible barriers to trade and investment caused by overlapping taxing jurisdictions of the two countries.

The proposed protocol would modify several provisions to the U.S.-Switzerland Tax Treaty (October 2, 1996) and the Protocol signed in Washington on the same date. The proposed protocol sets forth rules that are similar to rules contained in recent U.S. income tax conventions, the 2006 U.S. Model Treaty and the 2010 OECD Model Treaty. The present treaty, as amended by the proposed protocol, however, includes certain substantive deviations from these treaties and models. Here are some of the more notable features of the new proposed protocol to the U.S.-Swiss Income Tax Treaty.

Article 10, pertaining to Dividends, would be, under the proposed protocol, to expand the prohibition on source country taxation of dividends beneficially owned by pension or other retirement arrangements resident in the other treaty country The present treaty generally allows full residence-country taxation and limited source-country taxation of dividends. The present treaty includes a generally applicable maximum rate of withholding at source of 15 % and a reduced five %  maximum rate for dividends received by a company owning at least 10% of the voting stock of the dividend-paying company. Special rules apply to dividends received from regulated investment companies (“RICs”) and real estate investment trusts (“REITs”).

Article 10, Paragraph 3 of the present treaty exempts from source-country taxation dividends paid to a pension plan or other retirement arrangement that is a resident in the other country if the pension plan or other retirement arrangement does not control the company paying the dividend.

Under the proposed protocol, the prohibition on source-country taxation also applies to dividends that are beneficially owned by an individual retirement savings plan set up in, and owned by a resident of, the other treaty country, so long as the competent authorities agree that the individual retirement savings plan generally corresponds to an individual retirement savings plan recognized in the other treaty country for tax purposes. The prohibition on source-country taxation of dividends is not available where the beneficial owner controls the company paying the dividend.

Under Article 25 (Mutual Agreement Procedure), the proposed protocol changes the voluntary arbitration procedure contained in Article 25 at present to a mandatory arbitration procedure a/k/a the “last best offer arbitration”, pursuant to which each of the competent authorities proposes one and only one figure for settlement, and the arbitrator must select one of those figures as the award. Under the proposed protocol, unless a taxpayer or other “concerned person” (in general, a person whose tax liability is affected by the arbitration determination) does not accept the arbitration determination, it is binding on the treaty countries with respect to the case. A mandatory and binding arbitration procedure is included in the U.S. income tax treaties with Belgium, Canada, France, and Germany. The details and applicable rules of the new mandatory arbitration procedure are set forth in the report.

Another proposed change is replacing Article 26 (Exchange of Information) and paragraph 10 of the 1996 protocol to rules that conform generally to the OECD standards. The proposed rules generally provide that, in response to specific requests, the two competent authorities will exchange such information as may be relevant in carrying out the provisions of the domestic laws of the United States and Switzerland concerning taxes covered by the treaty, to the extent the taxation under those laws is not contrary to the treaty. The information provisions are largely based on those contained in the OECD model and U.S. model treaty, with several exceptions. The United States and Switzerland agree to exchange such information as “may be relevant” in carrying out the provisions of the proposed protocol or in carrying out the provisions of the domestic laws of the two treaty countries concerning taxes that are imposed by a treaty country and subject to the treaty. Thus, the exchange of information is not restricted by paragraph 1 of Article 1 (Personal Scope) but instead is limited by Article 2 (Taxes Covered).

The limitation on taxes that may be the subject of an exchange of information is a significant departure from both the OECD Model and U.S. Model treaties. Information about persons who are residents of neither Switzerland nor the United States may be requested and provided under the proposed protocol. For example, a third country resident with a Swiss bank account that is reportable to the IRS may be the subject of a request by the competent authority for information with respect to the bank account.

Any information exchanged under the proposed protocol is regarded as secret in the same manner as information obtained under the domestic laws of the treaty country receiving the information. The exchanged information may be disclosed only to persons or authorities (including courts, administrative bodies and legislative bodies) involved in the administration, enforcement or oversight of the tax laws. Such functions include assessment, collection, civil and criminal prosecution, and the determination of appeals in relation to the taxes to which the proposed protocol applies. The authority to disclose information to persons involved in oversight of taxes includes authority to disclose to persons or authorities such as the tax-writing committees of the U.S. Congress and the Government Accountability Office. Such persons or authorities receiving the information may use the information only in the performance of their role in overseeing the administration of U.S. tax laws. Finally, exchanged information may be disclosed in public court proceedings or in judicial decisions.

A treaty country is not required to carry out administrative measures at variance with the laws and administrative practice of either treaty country, to supply information that is not obtainable under the laws or in the normal administrative practice of either treaty country, or to supply information that would disclose any trade, business, industrial, commercial, or professional secret or trade process, or information the disclosure of which would be contrary to public policy. The Technical Explanation notes, however, that if a treaty country is asked to provide information, it should provide the information even if its own statute of limitations period has expired for the issue to which the information relates. According to the Technical Explanation, the statute of limitations of the treaty country making the request should govern. The Technical Explanation also states that even if the limitations on information exchange mean that a treaty country is not obligated to supply information in response to a request from the other treaty country, the requested country may choose to supply the information if doing so does not violate its internal law.

The proposed protocol limits the ability of either country to decline a request for information based on the lack of need for such information in a domestic tax investigation, or the expiration of the limitations period in the requested treaty country. If the information may be relevant to the requesting treaty country, the limitations described immediately above will not support a refusal to exchange the information. .

In addition to replacing Article 26, as noted, the proposed protocol also amends the 1996 Protocol that was executed and ratified contemporaneously with the present treaty. Article 4 of  the proposed protocol replaces paragraph 10 of the 1996 Protocol. Under the 1996 Protocol, paragraph 10 detailed the understanding of tax fraud or related fraudulent conduct that would support an exchange of information of banking information. Neither the proposed Article 26 nor the proposed amendment to the 1996 Protocol requires that tax fraud or fraudulent behavior be established in order to permit exchange of information.

Subparagraph (a) of proposed paragraph 10 summarizes the understanding of the treaty countries about the information to be included in a specific request for exchange of information. The required information compromises five elements. They are: (1) information sufficiently specific to identify the person under examination or investigation; (2) the period of time for which information is requested; (3) the information that is sought, including the nature and form in which the information should be provided; (4) a statement of the tax purpose to which the information relates; and (5) the name of the person believed to be in possession of the requested information. With respect to the first described element, the proposed paragraph 10 includes an illustrative list of information that may be sufficient to identify a person, such as name, address, and account numbers.

Subparagraph (b) of proposed paragraph 10 explains the reasoning for requiring that the competent authority explain the purpose for which the information is needed. The treaty countries agree that the information requested need only meet a standard of “may be relevant” to tax matters in the requesting treaty country, to permit the “widest possible” production without authorizing “fishing expeditions.”.

Subparagraph (c) of proposed paragraph 10 provides that, upon specific request by the competent authority of a treaty country, the other competent authority must provide information in the form of depositions of witnesses and authenticated copies of unedited original documents (including books, papers, statements, records, accounts, and writings), to the same extent such depositions and documents can be obtained under the laws and administrative practices of the requested country with respect to its own taxes. A treaty country may request that responsive information be provided in an authenticated form that will facilitate use of that information in the administrative or judicial proceedings in the requesting country.

The proposed protocol commits the parties to honor only specific requests for exchange of information that comply with the requirements of subparagraph (a) of proposed paragraph 10. Subparagraph (d) of proposed paragraph 10 makes it clear that neither automatic nor spontaneous exchanges of information are required by the proposed protocol. Neither the treaty, the proposed protocol, nor the proposed paragraph 10 precludes such exchanges on a voluntary basis.

 Under Article 5 of the proposed protocol provides that the proposed protocol will enter into force upon the exchange of instruments of ratification, and it sets forth rules for when the provisions of the proposed protocol will take effect.

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Section 704(c) sets forth rules which govern  the allocation of the tax items of a partnership with respect to contributed property. More specifically, section 704(c)(1)(A) addresses the question of which partner or partners are to be allocated the unrealized appreciation or loss on property contributed to a partnership. The same principle applies with equal vigor to when additional property is contributed to the partnership or where property held by the partnership is distributed in exchange for a partnership interest. The same may be said for assets-over mergers of partnerships as well as revaluations of capital accounts. For a sampling of recent commentary on this subject see New York State Bar Association Tax Section, “Report on the Request for Comments of Section 704(c) Layers Relating to Partnership Mergers, Divisions and Tiered Partnerships”; See Pillow and Dance, "Notice 2009-70: A Focus on Complex Section 704(c) Netting vs. Layering Issues," 111 JTAX 336 (December 2009) . Other articles that have addressed issues raised in the Notice include: Abrams, ''Reverse Allocations: More Than Meets the Eye,'' 20 Tax Mgmt. Real Est. J. 2 (2004); Harris, ''Federal Taxation of Partnership Asset Revaluations,'' 14 Va. Tax Rev. 257 (1994).

Section 704(c)(1)(A) requires that income, gains, losses and deductions that are attributable to built-in gains or losses on contributed property are required to be allocated in a manner which takes into account the variation between the fair market value (FMV) and adjusted tax basis of the property at the time of the contribution. See Deficit Reduction Act of 1984, P.L. No. 98-369, §71(c). The regulations provide that a partnership must account for this “delta” amount or variance between basis and FMV by using “a reasonable method that is consistent with the purpose of section 704(c)”. Treas. Reg. §1.704-3(a)(1); Treas. Reg. §1.704-1(b)(2)(iv)(f)(“book-ups”).

There are three methods approved in the regulations for making section 704(c) allocations: (i) the traditional method, which is generally preferred by contributors of highly appreciated property; (ii) the traditional method with curative allocations, and (iii) the remedial allocation method. Other methods may be permitted. In general, many if not most partnership agreements will use the “traditional method” explained in Treas. Reg. §1.704-3(b) as modified, by a so-called “ceiling rule”, i.e., the total amortization, depletion, depreciation, or gain or loss allocated to the partners cannot exceed the total amount of the partnership's amortization, depletion, depreciation, or gain or loss. The ceiling rule also can create a lingering disparity between the noncontributing partners' section 704(b) capital account and tax capital account.

In Notice 2009-70, 2009-34 IRB 255, comments were solicited by the Treasury and IRS on section 704(c) and its application to revaluations, partnership mergers, divisions and tiered partnerships.

Where section 704(c) property contributed to a partnership is distributed to partners other than the contributor, i.e., in a so-called mixing bowl distribution, within seven years of its contribution, section 704(c)(1)(B) mandates that the contributing partner, or her successor in interest under a “step in the shoes” approach, is required to recognize gain or loss in an amount equal to the gain or loss that would have been allocated to the contributing partnership under section 704(c)(1)(B) had the property been sold to the distribute(s) at FMV at the time of distribution. Where gain or loss is recognized under section 704(c)(1)(B), the basis of the contributing partner’s interest in the partnership and basis of the distributed property are adjusted to reflect the recognized gain or loss. Such adjustment to basis is made prior to tax affecting the distribution. Treas. Reg. §1.704-4(e)(2).

Section 737 requires a contributing partner to recognize gain where the partnership distributes other property to the contributor of appreciated property within 7 years of that partner’s contribution. The gain recognized under section 737 by the distributee-contributing partner is the lesser of: (i) FMV of the distributed property less the adjusted basis of the partner’s interest in the partnership, or (ii) the ne precontribution gain of that partner. The net precontribution gain is gain that the contributing partner would recognize under section 704(c)(1)(B) had the partnership distributed the contributed property to a noncontributing partner within 7 years. §737(b). There are certain exceptions that will override application of section 704(c)(1)(B), such as the termination of a partnership under section 708(b)(1)(B). Moreover, in such instance there is no commencement of a new 7 year period for application of the mixing bowl provision.

Partnership Mergers and Deemed Liquidations: Another Exception to Triggering Section 704(c)(1)(B).

Where a partnership transfers all of its assets and liabilities to another partnership and liquidates or is deemed to liquidate, section 704(c)(1)(B) does not apply to the liquidation. Instead, it operates on the transferee partnership as a successor to the transferor partnership. Treas. Reg. §1.704-4(c)(4).  In this instance there is the commencement of a new 7 year period with respect to the difference between the section 704(b) book value and FMV of the transferred property. No new 7 year period is imposed with respect to the FMV and adjusted basis  spread existent on date of contribution. Treas. Regs. §§1.704-4(c)(4), 1.737-2(b)(1). The revaluation can result in a new level of section 704(c) gain. In Rev. Rul. 2004-43, 2004-1 C.B. 842, revoked by Rev. Rul. 2005-10, 2005-1 C.B. 492, the Service further stated that section 704(c) principles will apply to reverse section 704(c) allocations. It is noteworthy that the  the regulations under section 704(c)(1)(B) and section 737 do not provide a rule requiring both provisions to apply to reverse section 704(c) applications. See Treas. Reg. §1.704-3(a)(6)(i).

The Service in 2007 issued proposed regulations to section 704(c)(1)(B) and related provisions confirming and supplementing Rev. Rul. 2004-43, supra., that such provision would not apply to an assets-over merger where the transferor-partnership is terminated as a result of the merger. Still, Prop. Reg. §1.704-4(c)(4)(ii) states that section 704(c)(1)(B) applies to the transferee-partnership’s subsequent distribution of section 704(c) property contributed by the transferor partnership to the transferee partnership in an assets over merger under certain conditions. See Prop. Regs. §§1.704-4(c)(4)(iii)(A)-(D). In an assets over merger, a new 7 year period will not start for the initial section 704(c) gain or loss to the extent such difference has not be eliminated by remedial or curative allocations or by reporting section 704(c) gain or loss. Still, a distribution of contributed property to another partner after the completion of the assets over merger would tripper application of section 704(c) to the original contributor of the property if within the 7 year period. Of course a new section 704(c) amount and commencement of a new 7 year period would apply to booked-up gain or loss as a result of the merger. See Prop. Regs. §§1.704-4(c)(4)(ii)(D). The proposed regulations retain the rule in Rev. Rul. 2004-43 which provided that such rules would not apply to reverse section 704(c) gain or loss. See Treas. Reg. §1.704-3(a)(6)(i).

Application to Revaluations

Under Treas. Reg. §1.704-1(b)(2)(iv)(f), the partners in a partnership may agree, as part of the partnership agreement, to revalue the partnership’s property to current FMV on the happening of certain events such as contributions or distributions to or from the partnership. The re-valuation increases or decreases the book-tax differences in the partners’ capital accounts. This in turn re-vitalizes further application of section 704(c) which in such instance is referred to as a “reverse section 704(c) allocation”. Partnerships having reverse section 704(c) allocations do not need to employ the same allocation method used for “forward” section 704(c) allocations. If there are more than one reverse section 704(c) allocations caused by re-valuations, the allocations among the “reverse” allocations can vary as long as the method selected is reasonable. This provides the partnership and its members with flexibility on how to account for and adjust such book-tax differences in the asset pool held by the venture.

It is somewhat agreed by tax practitioners working in the partnership area that clearer and more definitive guidance is needed in this area. This “musing” serves simply as a reminder that this area continues to offer a great degree of flexibility but at the cost of a complex and uncertain landscape.

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 On July 15, 2011 the LB&I issued a directive (LB&I-04-0711-015) for industry directors and field specialists on when it is appropriate to raise the economic substance doctrine. IRM. 20.11, 20.1.5. The directive follows one issued in September 2010 (LMSB-04-0910-024) that advised IRS attorneys of the need to obtain approval from a field operations director before raising the issue.

Section 7701(o) , which was recently added to the Code as part of the Health Care and Education Reconciliation Act of 2010, sets forth a statutory definition of the economic substance doctrine.

The common law doctrine of “economic substance,” which continues to have application despite the enactment of Section 7701(o) , may be summarized as a principle applied by the courts to deny taxpayers tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in federal income taxes. It can be applied where the IRS and, if litigation ensues, the court believes that a transaction and its projected tax consequences, including associated costs and expenses, should be disregarded for tax purposes. underlying transaction or series is without economic substance.

Whether a transaction or series of transactions is “without economic substance” is debatable, as witnessed by the number of cases in which a taxpayer has asserted (presumably in good faith) that there was a real change in his or her economic position independent of federal income tax considerations. A “real change” in “economic position” invariably focuses on whether there is a realistic possibility that the taxpayer will derive a profit from the transaction.

The “business purpose” prong requires that the taxpayer, in entering into the transaction, was motivated by a bona fide business purpose and not simply by tax advantages or savings. The business purpose test involves an inquiry into the subjective motives of the taxpayer to determine whether the taxpayer intended the transaction to serve some useful nontax purpose. In making this determination, some courts bifurcate transactions in which activities with nontax objectives are combined with unrelated activities having only tax-avoidance objectives, resulting in the disallowance of the tax benefits of the overall transaction.

Under the new legislation, Section 6662(b)(6) imposes a penalty equal to 20% of the portion of any underpayment of tax attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. The penalty is based on the underpayment attributable to the economic substance failure; it is not imposed on the entire deficiency for the tax year.  In determining whether the penalty is applicable, Section 6662(i)(2) provides that amendments or supplements to an already-filed return are not taken into account if the amendment or supplement is filed after the date the taxpayer is first contacted by the IRS regarding the examination of the return (or an earlier date as specified by regulations). The new penalty provisions are effective for transactions entered into after 3/30/2010.

In addition, Section 6662(i) imposes an increase in the accuracy related penalty for nondisclosed noneconomic substance transactions. More specifically, where “any portion of an underpayment is attributable to one or more nondisclosed noneconomic substance transactions,” the accuracy related penalty with respect to that portion climbs to 40% instead. A "nondisclosed noneconomic substance transaction" means any portion of a transaction described in Section 6662(b)(6) with respect to which the relevant facts affecting the tax treatment are neither adequately disclosed in the return nor included in a statement attached to the return. Unless otherwise provided, an amendment or supplement to a return of tax will not be taken into account if the amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by the IRS regarding the examination of the return or another date as is specified by the IRS.

A third principal change made to the accuracy-related penalty rules under the “clarification” of the economic substance doctrine is found in new Section 6664(c)(2) , which provides that the “reasonable cause” exception does not apply to any portion of an underpayment that is attributable one or more transactions described in Section 6662(b)(6) —that is, any transaction lacking economic substance as defined in Section 7701(o).

For background on the judicial doctrines that oversee the tax law such as economic substance, the step transaction doctrine, substance over form, etc. and the recent “clarification” of the economic substance doctrine, See August,“The Codification of the Economic Substance Doctrine, Parts I and II,” Business Entities (WG&L), (Sep/Oct 2010) (Nov/Dec 2010). 

There is a fair amount of recent judicial commentary in this area dealing with different forms of tax motivated and tax abusive strategies. For a sampling of relevant case law, see Sala et ux, 106 AFTR 2d 2010-5406 , 2010-2 USTC ¶50527 (CA-10, 2010), rev'g and rem'g 101 AFTR 2d 2008-1843 , 2008-1 USTC ¶50308 , 552 F Supp 2d 1167 (DC Colo., 2008); ACM Partnership, 82 AFTR 2d 98-6682 , 157 F3d 231 , 98-2 USTC ¶50790 (CA-3, 1998), aff'g TC Memo 1997-115 , RIA TC Memo ¶97115 , 73 CCH TCM 2189 , cert. den. 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC, 99 AFTR 2d 2007-850 , 2007-1 USTC ¶50223 , 472 F Supp 2d 885 (DC Texas, 2007), aff'd 103 AFTR 2d 2009-2220 , 568 F3d 537 , 2009-1 USTC ¶50395 (CA-5, 2009); Coltec Industries, Inc., 98 AFTR 2d 2006-5249 , 454 F3d 1340 , 2006-2 USTC ¶50389 (CA-F.C., 2006), vac'g and rem'g 94 AFTR 2d 2004-6708 , 62 Fed Cl 716 , 2004-2 USTC ¶50402 (Fed. Cl. Ct., 2004), cert. den. 127 S. Ct. 1261 (2007); TIFD III-E, Inc. (“Castle Harbor”), 98 AFTR 2d 2006-5616 , 459 F3d 220 , 2006-2 USTC ¶50442 (CA-2, 2006), on remand 104 AFTR 2d 2009-6746 , 2009-2 USTC ¶50676 , 660 F Supp 2d 367 , 2009-2 USTC ¶50711 (DC Conn., 2009); BB&T Corporation, 99 AFTR 2d 2007-376 , 2007-1 USTC ¶50130 (DC N. Car., 2007), aff'd 101 AFTR 2d 2008-1933 , 523 F3d 461 , 2008-1 USTC ¶50306 (CA-4, 2008); Cemco Investors, LLC, 101 AFTR 2d 2008-768 , 515 F3d 749 , 2008-1 USTC ¶50178 (CA-7, 2008).There is a fair amount of recent judicial commentary in this area dealing with different forms of tax motivated and tax abusive strategies. For a sampling of relevant case law, see Sala et ux, 106 AFTR 2d 2010-5406 , 2010-2 USTC ¶50527 (CA-10, 2010), rev'g and rem'g 101 AFTR 2d 2008-1843 , 2008-1 USTC ¶50308 , 552 F Supp 2d 1167 (DC Colo., 2008); ACM Partnership, 82 AFTR 2d 98-6682 , 157 F3d 231 , 98-2 USTC ¶50790 (CA-3, 1998), aff'g TC Memo 1997-115 , RIA TC Memo ¶97115 , 73 CCH TCM 2189 , cert. den. 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC, 99 AFTR 2d 2007-850 , 2007-1 USTC ¶50223 , 472 F Supp 2d 885 (DC Texas, 2007), aff'd 103 AFTR 2d 2009-2220 , 568 F3d 537 , 2009-1 USTC ¶50395 (CA-5, 2009); Coltec Industries, Inc., 98 AFTR 2d 2006-5249 , 454 F3d 1340 , 2006-2 USTC ¶50389 (CA-F.C., 2006), vac'g and rem'g 94 AFTR 2d 2004-6708 , 62 Fed Cl 716 , 2004-2 USTC ¶50402 (Fed. Cl. Ct., 2004), cert. den. 127 S. Ct. 1261 (2007); TIFD III-E, Inc. (“Castle Harbor”), 98 AFTR 2d 2006-5616 , 459 F3d 220 , 2006-2 USTC ¶50442 (CA-2, 2006), on remand 104 AFTR 2d 2009-6746 , 2009-2 USTC ¶50676 , 660 F Supp 2d 367 , 2009-2 USTC ¶50711 (DC Conn., 2009); BB&T Corporation, 99 AFTR 2d 2007-376 , 2007-1 USTC ¶50130 (DC N. Car., 2007), aff'd 101 AFTR 2d 2008-1933 , 523 F3d 461 , 2008-1 USTC ¶50306 (CA-4, 2008); Cemco Investors, LLC, 101 AFTR 2d 2008-768 , 515 F3d 749 , 2008-1 USTC ¶50178 (CA-7, 2008).

The Field Directive of July 15, 2011

As mentioned, the recent legislation enacted a two part or conjunctive economic substance test in new section 7701(o). The new statute defines the economic substance doctrine as the common law doctrine under which certain tax benefits are not allowable if the transaction does not have economic substance or lacks a business purpose and states that "[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if [the legislation] had never been enacted." The statute further states that "[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if --

(A) first,  the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and

(B) second, the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction."

Passage of section 7701(o) resolved the longstanding conflict among various circuit courts of appeal regarding how the doctrine should be applied by codifying a two-part conjunctive test. It applies for transactions entered into and after March 30, 2010, which was the date of enactment of the 2010 Act.

Purpose of the Guidance

On September 14, 2010, an LB&I Directive, LMSB-20-0910-024, was issued relating to the codification of the economic substance doctrine in the 2010 Act. This directive stated that to ensure consistent administration of the strict liability penalty related to the application of the doctrine, any proposal to impose the doctrine (and implicate proposing to set forth the penalty) at IRS exam must be reviewed and approved by the Director of Field Operations (DFO).

The purpose of this LB&I Directive is to instruct examiners and their managers on the circumstances where it is appropriate to seek the approval of the DFO in order to raise the economic substance doctrine. Once an examiner determines that raising the doctrine may be appropriate, this directive sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

In addition, this LB&I Directive provides, as an important boundary line to LMSB and International, that, until further guidance is issued, the penalties provided in sections 6662(b)(6) and (i) and 6676 are limited to the application of the economic substance doctrine and may not be imposed due to the application of any other "similar rule of law" or judicial doctrine (e.g., step transaction doctrine, substance over form or sham transaction).

This LB&I Directive has four steps. First, an examiner should evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is likely not appropriate. Second, an examiner should evaluate whether the circumstances in the case are those under which application of the doctrine to the transaction may be appropriate. Third, if an examiner determines that the application of the doctrine may be appropriate, the guidance provides a series of inquiries an examiner must make before seeking approval to apply the doctrine. Fourth, if an examiner and his or her manager and territory manager determine that application of the economic substance doctrine is merited, guidance is provided on how to request DFO approval.

Generally, in applying this LB&I Directive, when a transaction involves a series of interconnected steps with a common objective, the term "transaction" refers to all of the steps taken together. However, in certain circumstances, it may be appropriate to apply this guidance separately to one or more steps that are included within a series of arguably interconnected steps. This may be appropriate in situations where an integrated transaction includes one or more tax-motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction. If an examiner wants to apply this guidance separately to one or more steps with a common objective, the examiner is required to seek guidance from their manager and consult with their local counsel before doing so.

An examiner should notify a taxpayer that the examiner is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins the analysis in the steps described below.

The Directive sets forth additional material under each of the four step process to determine if the issue should be raised under section 7701(o).

Many tax practitioners did not feel that it was necessary to codify the economic substance doctrine. Many more practitioners object to the 40% penalty as being too harsh. Perhaps the Service's directive will confirm that LMSB will tread lighly in this area to only go after abusive transactions that are patently obvious.

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In a recent commentary written by Trevor Johnson, which commentary  was published in International Tax Notes (July 11, 1011) the author describes the long-standing uncertainty surrounding the determining of "residency" for U.K. income tax purposes.

The issue is historical since it dates back over 200 years. Yet, the rules do not state explicitly who is and who is not a U.K. resident for tax purposes. While there is some guidance, the overall subject suffers from uncertainty.

The commentary quotes the Income Tax Act of 1842:

“Any subject of Her Majesty, whose ordinary residence shall have been in Great Britain, and who shall have departed from Great Britain and gone into any part beyond the sea for the purpose of occasional residence . . . shall be deemed, notwithstanding such temporary absence, a person charged with the duties granted by this Act as person actually residing in Great Britain. Provided always that no person who shall . . . actually be in Great Britain for some temporary purpose only, and not with any view or intent of establishing his residence therein, and who shall not actually have resided in Great Britain at one time or several times for a period equal in the whole to six months in any one year shall be charged with the duties mentioned in Schedule D as a person residing in Great Britain in respect of [foreign-source income] but nevertheless every such person shall, after such residence in Great Britain, for such space of time as aforesaid, be chargeable to the said duties for the year commencing on the sixth day of April preceding.”

The statutory language capturing the phrase “ordinary residency” should be clear, at least in certain instances, to be clear and predicable.  For example, we are told that a ordinary resident in the U.K. who temporary goes outside of the U.K. is still a resident. Visitors arriving in the U.K. for a temporary purpose without the intention of establishing residence, who spend less than 183 days in the U.K. in any tax year, are not regarded as resident for tax purposes. However, they will become resident for any year in which their presence exceeds 183 days. But as Mr. Johnson points out, there is much work to be done to arrive at a better set of applicable rules and principles.

While such rules sourced from the 1842 legislation were simply stated, additional ambiguous concepts were introduced such as the meaning of a “temporary purpose” and what was meant by “residence”. The commentator notes that when tax cases were first officially reported in 1875, one of the first was concerned with tax residence status. The second rule above also had limited application -- it only covered foreign-source income.

Since 1842’s version’s of residency was pronounced its principles have been restated in other tax acts and now is warehoused at section 829 and 831 of the Income Tax Act of 2007. Nevetheless, there are the same uncertainties present, which has, over time, led to various judicial decisions. The precedents from these cases are the basis from the current law is applied.

In recent years there has been a growing concern that that practice, as set out in publication HMRC6 (previously IR20), Residence, Domicile and the Remittance Basis, does not give certainty, has been changed without notice, and when it comes to the crunch, will not necessarily be supported by the courts. Thus, many in the UK want a more formal statutory definition of residency. The government has responding by forming a working group that will publish a consultative document.

Under current law in the U.K. and individual who spends 183 days or more in the U.S. is a resident for tax purposes. In Wilkie, 32 T.C. 485. Mr. Wilkie contended he was not “resident” by submitting evidence he was present in the UK for only 182 days and 20 hours. He was spared U.K. taxation by four hours. Where an individual moves to the U.K. with the intention either of living here permanently or working here for an extended period or for an indeterminate period then residency is also established. In Lysaght, 13 TC 511 (1928), the taxpayer was found to be resident in the U.K. because of his regular visits to carry out duties as a director of a U.K. company even though he had no definite place of residence here.

Where an individual comes to the U.K. on a temporary basis and is present for 91 or more days per year on the average over a four year period (based on the Lysaght decision) then he is resident. When an individual comes to the U.S. for a particular purpose and remains for at least two years, regardless of the number of days present in each year, i.e., a “settled purpose”, the such person is resident. See Cooper v. Cadwalader, 5 T.C. 101 (1904).

The object of the current consultation project  is to provide greater certainty when individuals determine their residence status under self-assessment, whether that be on arriving in the U.K. or leaving it. The consultation seeks views on a proposed statutory residence test, which would apply from April 6, 2012. It will have three parts:  (i) to determine whether the individual is clearly nonresident; (ii) to determine if the individual is clearly resident; (iii) to resolve the issue where application of the first two tests leads to a conflicting set of conclusions.

Under the first test of “clearly non-resident’, such would apply to an individual who is present in the U.K. for less than 45 days and was not a resident in any of the three immediately preceding tax years. If such person was resident in any of the 3 preceding years then he must be present for less that 10 days for the year in question. When an individual leaves the U.K. to work full-time abroad and is present in the U.K. for less than 90 days, of which no more than 20 are "working days", then he is non-resident.  In this context, full-time work, which includes self-employment, means work of 35 or more hours per week carried out over a complete tax year. A working day is one in which three or more hours of work are carried out.

Under the second part of the consultative prescription for residence, an individual will be treated as resident for the tax year when: (i) he is present in the U.K. for 183 days or more; (ii) his home is located in the U.K., or if he has more than one home, all of his homes are in the U.K.; and (iii) the individual is in the U.K. to carry out full-time work,i.e. work that is 35 or more hours per week carried out over a period of 9 months, wih no more than 25% of such person’s duties being carried on abroad.

Under the third part of the test or the tie-breaker provision, which apply if only if none of the tests in (i) or (ii) are met, factors are used to “connect” the individual to the U.K.  Such person will be “resident” in the year depending on the number of days present in the U.K. and one or more of these so called “connecting” factors: (i) the individual's spouse, civil partner, cohabitee, or minor children are resident in the U.K. for that year; (ii) for children, the individual must spend time with them for at least 60 days per year; (iii) the individual has accommodation in the U.K. which has actually occupied in that year other than hotels or temporary accomodations; (iv) the individual has done “substantive work” in the U.K. during the year of 40 days or 3 or more hours of work albeit not full time work in the U.K.; (v) the individual has spent 90 days or more in the U.K. in either of the immediately preceding 2 years; and (v) the individual has spent more time in the U.K. than elsewhere.

For individual arriving in and departing from the U.K., there are special rules or "tariffs" whereby the number of factors needed to make the individual resident for the year varies according to the number of days of presence in the U.K. in that year. The tariff for arrivals -- that is, someone who has not been resident in any of the three immediately preceding tax years -- is proposed to be as follows:

if present in the U.K. for less than 45 days -- none of the factors are taken into account (he would already be nonresident under Part (i));

if between 45 and 89 days -- resident if all four factors are satisfied;

if between 90 and 119 days -- resident if at least three factors are satisfied;

if between 120 and 182 days -- resident if at least two factors are satisfied; and

if 183 days or more -- he would already be resident under Part (ii)

In the case of an individual leaving the U.K. who has been resident in one or more of the three immediately preceding tax years, the tariff is as follows:

if present in the U.K. for less than 10 days -- none of the factors are taken into account (he would already be nonresident under Part (i));

if between 10 and 44 days -- resident if at least four factors are satisfied;

if between 45 and 89 days -- resident if at least three factors are satisfied;

if between 90 and 119 days -- resident if at least two factors are satisfied;

if between 120 and 182 days -- resident if at least one factor is satisfied; and

if 183 days or more -- he would already be resident under Part ii.

While the current rules tend to lead to an all or nothing by concession, "split-year" treatment is available in some situations whereby a different residence status can apply before and after the date of arrival or departure. This treatment is granted when the arrival or departure is for the purpose of taking up permanent residence in the U.K. or abroad or when the departure is in order to take up full-time employment abroad. The intention is to replicate, as far as possible, this treatment within the new statutory rules but to avoid the uncertainty inherent in the phrase "permanent residence." The proposal allows split-year treatment when the individual becomes U.K. resident because his only home is in the U.K., he starts full-time employment here, or he returns to the U.K. after working full time abroad. In the case of departures, the treatment will apply when the individual goes to work full time abroad or establishes his home in another country so as to become tax resident there.

A few years ago, special rules were introduced for capital gains tax to combat the practice of becoming nonresident for a period of a few years, during which the individual realized gains outside the U.K. tax net and then took up residence again.  In essence, those gains are stored up and taxed in the year in which the individual becomes resident again. The consultation document proposes that a similar rule be introduced for income tax purposes to target some forms of investment income. One example highlighted by Mr. Johnson is when profits of a privately owned company are accumulated and only paid out as dividends once the shareholder has become nonresident.

The U.K. is probably unique in that, in addition to the concept of residence, taxation is also levied according to the concepts of "ordinary residence," which is also covered in this document, and "domicile," which  will be the subject of a separate consultation document.

Are long-standing allies and friends in the U.K. might want to look at the rules we have under section 7701(b) in defining "resident" and "non-resident" for income tax purposes. Perhaps our approach is more sensible and predictable.

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In  IRS Announc. 2010-9, 2010-7 IRB 408 (the “UTP Announcement”),  the IRS announced that it was considering the adoption of an important addition to the income tax reporting requirements of corporations and certain business taxpayers. The new schedule would require certain business taxpayers to disclose annually uncertain tax positions (UTPs) by concisely describing the positions and providing information about their magnitude. Initially, the new schedule was to be filed beginning in tax years ending in 2010 by business taxpayers with total assets in excess of $10 million, provided the taxpayer had one or more uncertain tax positions of the type required to be reported on the new schedule. Eventually, however, the IRS decided to move forward with the UTP schedule and “softened” somewhat its initial approach on the asset threshold of  $10 million, starting with a $100,000,000 gross asset value threshold in 2010, which greatly reduced the number of required uncertain tax position schedules filing on 2010 returns. Now there is a phase of the asset threshold amount for corporations and certain business taxpayers until 2014 when the excess of $10 amount triggers the reporting requirement.  

It is clear that the IRS is trying to force corporate taxpayers to bring out into the open tax positions taken on their returns with which the IRS may not agree. Previously, taxpayers only were required to disclose uncertain tax positions to avoid accuracy-related penalties, and then only where there was not “substantial authority” or reasonable reliance on a tax advisor's “more likely than not” opinion (except in limited instances). Now, the IRS may take the view that a tax position having a significant degree of uncertainty must be disclosed and identified on the corporate tax return. This will inevitably lead to further litigation concerning the ability of the IRS to obtain workpapers, memoranda, legal opinions, and work product that are used to support the preparation and filing of Schedule UTP.

Various professional groups argued last Summer that the proposed Schedule UTP should be withdrawn as it forces taxpayers to either identify potential tax liability to fulfill its self-assessment requirements or face the possibility of a punishing rebuke should it fail to satisfy the IRS's increasing need for information. This obligation to disclose questionable or uncertain tax positions runs counter to time honored traditions between attorney-client communications, the work product doctrine as well as the relatively new federal tax practitioner privilege under section 7525 of the Internal Revenue Code.

While interim notices on the uncertain tax position schedule provided a limited form of mitigation, the present UTP form provides a roadmap for the IRS to efficiently audit a subject taxpayer by zeroing in on the taxpayer’s own concerns of what positions may be successfully challenged by the Service.  What happens when a taxpayer omits a item which the Service thought should have been disclosed as “uncertain”? Will penalties be imposed? Unless Congress acts, or a strong lobbying effort by professional groups ultimately is successful, it will be up to the courts to decide if the new burden of disclosing UTP is valid, even if promulgated under final regulations.

For further discussion on the background and implications of this new administrative rule, see August, “The Uncertain State of Uncertain Tax Positions”, Business Entities (WG&L), May/June 2011.

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In a decision that has wide-sweeping implications for companies that are doing business in the EU or otherwise become a party to a legal or administrative proceeding governed by the EU, as well as to American persons engaged, directly or indirectly such as through ownership of a controlled subsidiary or company in the EU, the Grand Chamber of the EU Court affirmed the decision of the Court of First Review (trial court) holding that various claims of legal privilege made by Akso Nobel Chemicals and Akcros Chemicals for communications made to the companies' in-house companies were not privileged and thus were discoverable under by the European Commission. Article 14 of Council Regulation 17 (anti-competitive practices; violations) of 6 February 1962, First Regulation implementing Articles [81] and [82] of the Treaty. The case was appealed  by the companies from the adverse decision rendered by the General Court in favor of the EU Commission.  The opinion was issued on September 14, 2010.

This Article 14 permits the EU Commission, through its officials, to investigate undertakings and associations of undertakings including: (1) examine books and other business records; (2) take copies or extracts of such business records; (3) ask for oral explanations “on the spot”; and (4) enter the premises (without prior notice), i.e., so called “dawn raids”

Factual Background

In early 2003, Commission officials assisted by representatives of the Office of Fair Trading of Great Britain, conducted a “dawn raid” at Akso Nobel’s and Akcros Chemical’s facilities in Manchester, England. During the investigation the Commission officials took copies of documents including documents, e.g., e-mails, asserted by the appellants as privileged communications between attorney and client.  The Commission officials explained they had to briefly examine the documents in question and form their own opinion of privilege.  Following a long discussion, and after the Commission officials and the OFT officials had reminded the applicants’ representatives of the consequences of obstructing investigations, it was decided that the leader of the investigating team would briefly examine the documents in question, with a representative of the applicants at her side. This ultimately led to a dispute as to 5 documents, including e-mails from employees of the company to and between its in-house counsel. In general, the legal issue was whether these documents were privileged and not subject to discovery as lawyer-client communications. The lawyer in question for Akso was in house lawyer licenced as an Advocaat of the Netherlands Bar. The Commission officials disagreed and would render a final decision on 8 May 2003 rejecting the privilege claims as to the e-mails and certain documents.

The appellants initiated actions before the General Court in Spring of 2003 to require the Commission to return certain documents seized and to order their return. The General Court dismissed the action on both grounds. (Case T-253/03).

The appellants filed with the Grand Chamber to set aside the judgment of the General Court which rejected the claim of legal professional privilege with Akzo’s in-house lawyer; set aside the judgment and cause the relevant privileged documents to be returned. Various groups intervened and filed claims in support of Akzo including the European Company Lawyers Association and the Association of Corporate Council Association (ACCA)-European Chapter, the International Bar Association, as well as the United Kingdom of Great Britain and Northern Ireland and the Kingdom of Netherlands.

The EU Commission contended that the relevant e-mails do not comply with the first condition for legal professional privilege in accordance with AM& S Europe v. Commission [1982] ECR 1575, whereby the legal advice (to be protected from discovery) must be requested and given for the purpose of the defence of the client’s rights. Neither e-mail, in the view of the Commission, met this foundational critierion. Moreover, the second condition of the AM&S Europe case would not be met since the in house lawyer is employed by the company and in-house counsel communications are not privileged under the decision of the EU Courts.

Recognizing that Akzo and Akcros both had a sufficient interest to appeal the case, they set forth various grounds for appeal and reversal of the holding of the Court below and of the Commission. The main attack made was the second requirement that in-house lawyers are excluded from legal professional privilege in the EU, even if such counsel is a member of the Bar of a EU country. The protection is only afforded under the AM&S Europe case to independent lawyers of member states of the EU.

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In opposition, the EU Commission contended that in AM & S Europe v Commission the Court placed lawyers in one of the following two categories: (i) employed salaried lawyers and (ii) lawyers who are not bound by a contract of employment. Only documents drafted by lawyers in the second category were regarded as being covered by legal professional privilege.

The Grand Chamber, in its analysis confirmed that the second condition of “indepence” is based on a conception of the lawyer’s role as collaborating in the administration of justice and as being required to provide, in full independence and in the overriding interests of that cause, such legal assistance as the client needs. The counterpart to that protection lies in the rules of professional ethics and discipline which are laid down and enforced in the general interest. Consequently, an in-house lawyer is less able to deal effectively with any conflicts between his professional obligations and the aims of his client.

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The Grand Chamber then stated that “It follows, both from the in-house lawyer’s economic dependence and the close ties with his employer, that he does not enjoy a level of professional independence comparable to that of an external lawyer.” Thus, the first ground of appeal asserted by the appellants failed.

The second argument pertained to the violation of “equal treatment” and that the position of in-house lawyers who are members of a Bar association is no different from that of external lawyers. The principal of equal treatment is a general principle of the EU law, contained in Articles 20 and 21 of the Charter of Fundamental Rights of the European Union. This argument was also rejected. The appellate court stated that in-house lawyers are in a fundamentally different position from external lawyers and therefore the General Court properly held there was no breach of the principle of equal treatment.

Regulation No 1/2003, contrary to the appellants’ assertions, does not aim to require in-house and external lawyers to be treated in the same way as far as concerns legal professional privilege, but aims to reinforce the extent of the Commission’s powers of inspection, in particular as regards documents which may be the subject of such measures. The principle of legal certainty of EU law is further not violated by the decision of the court below. Therefore, the principle of legal certainty does not require that identical criteria be applied as regards legal professional privilege in those two types of procedure. Accordingly, the fact that, in the course of an investigation by the Commission, legal professional privilege is limited to exchanges with external lawyers in no way undermines the principle relied on by Akzo and Akcros. A final argument claimed by the appellants is that the findings of the General court as a whole, violate the principle of national procedural autonomy and the principle of the conferred powers.

This principle of national procedural autonomy governs situations in which the courts and administrations of the Member States are required to implement European Union law, but does not apply where the legal limits of the actions of the institutions themselves are at issue. The Court responded that the regulation in question here was to be applied at the EU level and not at the level of the home jurisdiction under its national law. Here, the rules of procedure with respect to competition law, as set out in Article 14 of Regulation No 17 and Article 20 of Regulation No 1/2003, are part of the provisions necessary for the functioning of the internal market whose adoption is part of the exclusive competence conferred on the Union by virtue of Article 3(1)(b). In essence, neither the principle of national procedural autonomy nor the principle of conferred powers may be invoked against the powers enjoyed by the Commission in the area in question.The third ground set forth in the appeal also  failed.

Implications of Akso Nobel Chemical and Acros Chemicals Decision.

What is clear from the long-awaited decision in Akso Nobel is that the EU Courts will not accept a claim of attorney-client privilege with respect to in-house counsel situated in EU jurisdictions. Only external lawyers from EU countries, not foreign countries will qualify.

This in turn will lead to problems in the U.S. tax proceedings, including trials, where information gathered with respect to a U.S. taxpayer on its international business activities and tax compliance issues can be discovered far more easily. Upon discovery (and production) the waiver of such information and the subject matter is in play even in a U.S. tax proceeding. Moreover, despite the Supreme Court’s decision in Upjohn that in house communications to a ground of employees with in-house counsel as to the subject matter of an internal investigation are privileged, the same case in the EU would yield the opposite result as evidenced in Akso Nobel, supra. Could this lead to even a greater step that when talking to an in house lawyer in Europe such discussions can not be expected to be protected from disclosure in a US tax or other proceeding since there is no expectation of privacy, as the argument would presuambly go?

It is clear that the narrow attorney client privilege in the EU threatens the fabric of the attorney-client privilege in the States. I am sure there is more discussion, commentary from bar groups and acadmics, as well as from the courts, to follow.

This blogger will be the program moderator and speaker on the Attorney-Client, Work Product and Other Privilelges in Federal Tax Controversies and LItigation for ALI-ABA's National (and EU) webcast scheduled for Wednesday, June 29 at 12 noon (EST) from Philadelphia, Pa. Also speaking on the program is Ian Comiskey, of the Blank Rome law firm also of Philadelphia. Mr. Comiskey is a nationally recognized practitioner and legal authorities on tax procedure and tax litigation.

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The U.S. Department of the Treasury having announced on June 2, 2011 that it planned to begin formal negotiation of amendments to the existing bilateral income tax treaty with Japan, which Treaty was entered into force in 2004, commenced negotiations on June 8-10 in Washington, D.C. The amendments to the Treaty being discussed was the subject of some speculation in a tax publication, i.e., Tax Notes International, June 13, 2011. The topics for discussion should include, dividend exemption, mandatory arbitration procedures under the competent authority provision, and a more expansive exchange of information provision.

Zero Rate Withholding on Dividends

One area for discussion that reasonably should be on the agenda, at least that of Japan's agenda, is that the Japanese authorities want to lower the threshold for having a zero rate of withholding on dividends paid by a resident corporation of the other country. Under Article 10, 3(a), the current treaty provides an exemption from withholding tax where the beneficial owner of the dividend is a company that (i) is a resident of the other contracting state and has owned, directly or indirectly through one or more residents of either contracting state, more than 50% of the voting stock of the company paying the dividend for a period of 12 months, ending on the date in which the dividend is declared and (ii) such resident meets the special limitation on benefits provision under Article 22 of the Treaty.

Japan has recently been able to obtain a lower threshold for zero dividend withholding in other treaties such as the protocol it signed in 2010 with Switzerland and the new treaty it has with Netherlands, signed also in 2010 but both are not entered into forced as of yet. Under both the Swiss protocol and the new treaty with the Netherlands, the threshold is reduced to "more than 50% of the voting power" to "at least 50%" of the voting power, etc. ending on the date the dividend is declared. Thus, Japan wants a 50-50 joint venture company to qualify for zero rate withholding under the U.S. Treaty. The threshold in Japan’s treaty with Australia is "at least 80%" in contrast. Compare that result with the more liberal provision under the Japan-France income tax convention for zero withholding.

Mandatory Arbitration Procedures

The newswire also hinted that the Japanese negotiators want the adopt mandatory arbitration provisions into Article 25 of the Japan-U.S. Treaty. This was recently accomplished in the Netherlands treaty and in a "double tax agreement" recently signed by the Japanese government with Hong Kong in 2010, both of which are pending. This mandatory arbitration provision states that if under the competent authorities process there is no resolution of the case within 2 years of the presentation to the competent authority of the other contracting state, then any unresolved issues will go to arbitration is the petitioner requests but not if a decision on the issue(s) has already been rendered by a court or administrative body of either contracting state. Other special rules are incorporated in the proposals.

The U.S. model tax treaty of 2006 does not set forth a mandatory binding arbitration provision under the competent authority process. Still, the U.S. has MAP provisions with its treaties with Belgium, Canada and Germany. The Mexico and Netherlands treaties have adopted language that could establish a voluntary MAP approach. The Treasury’s approach to MAP can be said overall to be favorable and is viewed as a valuable aid in resolving competent authority disputes under tax treaties. Perhaps the current negotiations with Japan will include such an amendment for MAP.
 

Exhange of Information Amendment

It is further reported that the Japanese may want to update Article 26 of the Treaty, Competent Authorities, with respect to an evolving international standard on exchange of information. The thought it that one competent authority will have the right to request information from the other treaty country which the other may not use for its own tax purposes. The provision that Japan is believed to want in the Treaty by amendment is similar to if not identical with 4 and 5 of Article 26 of the 2006 U.S. Model Treaty.

Now, with respect to our country's "list" of amendments being sought, the Treasury did not, in its June 2 press release, issue such list of items for inclusion in the Treaty with Japan. It would be reasonable to assume, however,  that differences between the Treaty and the 2006 U.S. Model Treaty could be the subject of proposals requested by the U.S. Treasury.

Given the importance of our trading relationships with Japan, it is important that the Treaty can be amended in a manner that conforms with the policies each government feels is important for the sound tax administration of its countries tax laws and in a manner which fosters greater trading and investment in capital among the countries.

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In General: U.S. Efforts to Thwart Foreign Tax Credit Generator Arrangements

Several years ago a new tax avoidance (or “abusive” as the Service might phrase it) technique was identified by the Large and Mid-Size Business (LMSB) Division of the IRS in a field directive (LMSB-04-0208-003)(3/19/2008) on the subject of foreign tax credit (FTC) generators.

The FTC provisions in the Code  allow a U.S. taxpayer to claim a credit against its U.S. income tax liability for foreign taxes paid or accrued, directly or indirectly, with respect to its foreign source income. FTC generators are complex transactions that are designed to: (i) recover the foreign tax paid claimed as an FTC to avoid any foreign tax cost; or (ii) to eliminate the income that resulted in the FTC; or (iii) transactions which have elements of both (i) and (ii).  LMSB in its 2008 directive  noted that the FTC generator is causing a “significant drain” on the Treasury and also has resulted in the Treasury allocation substantial resources to combating transactions that are abusive. Such transactions are difficult to identify on a tax return including Schedule M-3 or Form 1118 (FTC-Corporations) but may be detected during an actual audit. The market for using FTC generators is strong in the financial services industry since these transactions “appear as a par of their general business operations” and are more difficult to identify. LMSB announced the formation of an issue management team to specifically address such transactions and coordinate their efforts throughout the Service and with the Appeals Division as well. On July 15, 2008, Treasury and the IRS issued final Regulations ( TD 9416 ) that were proposed in 2007  ("new Regulations") to address certain types of foreign tax credit generators. Two weeks earlier, on June 30,  2008, the IRS released CCA 200826036 (dated February 29, 2008), addressing a type of FTC transaction that was not specifically covered by the new Regulations.

The new Regulations to section 901 disallow FTCs (for foreign taxes paid), in connection with certain inappropriate “passive investment arrangements”, which arrangements, if they meet the six specified conditions contained in the regulations, artificially generate FTCs. See Treas. Reg. §1.901-2(e)(5). The final Regulations apply to foreign tax payments paid or accrued for tax years ending on or after the date of finalization (7/15/2008). Treas. Reg. §1.902-2(e)(5) provides that a FTC may only be claimed if it is involuntary within the criteria set in Treas. Reg. §1.901-2(a), which tests whether the payment of foreign taxes was still the produce of a  bona fide effort to minimize the impact of foreign taxes. 

The Regulations categorize three types of passive investment arrangements which involve a U.S. person and a foreign counterparty: (i) U.S. lender transactions; (ii) U.S. borrower transactions; and (iii) asset-holding transactions. In each situation the IRS claims that the U.S. person’s FTC benefit is shared by the parties through the pricing of the arrangement. See also CCA 200826036.

The six features that must be present to disallow the FTCs under the final Regulations are:

(1)  The transaction uses a "special purpose vehicle” (SPV) entity, the income and assets of which are substantially all passive (under an expansive definition) and the income of which is subject to taxation in a foreign country, other than a withholding tax on its owners (regardless of whether the income is taxed to the SPV or its owners).

(2) From a U.S. federal income tax perspective, a U.S. person has an equity interest in the SPV and is thus able to claim a credit for the SPV's foreign tax liability.

(3) The tax cost to the SPV is greater than the foreign tax expense that would have been imposed on the U.S. investor if the U.S. investor owned its interest in the SPV's assets directly.

(4) A foreign person participates in the transaction by (under foreign law) owning at least 10% of the SPV's equity or acquiring (directly or indirectly) 20% of the SPV's assets.

(5) The structure results in a foreign tax benefit to the foreign person through a credit, deduction, exemption of income, or disregarded payment.

(6) The foreign tax credit claim of the U.S. person results directly from tax arbitrage between the United States and another country involving (a) hybrid entities, (b) hybrid instruments, (c) inconsistent identity of tax ownership, or (d) inconsistent measurement of an entity's taxable income

Recent Attempts to Thwart Application of Foreign Tax Credit Generators in Canada.

A good example or illustration in this area is a transaction that starts with a loan by a Canadian resident corporation to a resident of the U.S..Had the Canadian taxpayer loaned the amount directly to the nonresident, the interest income would have been subject to Canadian tax without any foreign tax being paid by application of treaty reduction. 

The FTC generator inserts a third party, a special purpose entity or SPV, which is generally a flow thru entity for U.S. tax purposes. A  Canadian nonresident, i.e., U.S domiciled corporation, will also invest in the partnership. The partnership then loans an amount (including the amount invested by the Canadian resident) to another member of the nonresident's corporate group. The loan results in  interest income in the partnership and an offsetting interest deduction for the borrower, so there is no net tax to the U.S. nonresident's corporate group. Instead of receiving interest income with no offsetting credit, the Canadian resident receives an allocation of income from the partnership and claims an FTC for its share of the foreign (U.S.) tax paid by the partnership. The Canadian tax savings are divided between the Canadian lender and the nonresident borrower through a reduced yield being given to the Canadian resident taxpayer on what is in substance a loan with a tax receivable adjustment.

Adverse Impact of FTC Generators on Canadian Treasury; Apparantly Not to the Tax Court of Canada in Canada Liimited

In addition to the concerns expressed by the U.S. Treasury, the Canadian Department of Finance has stated that Canada risks losing billions of dollars in tax revenue from the use of FTC generators.  It therefore has proposed amendments to the ITA (Income Tax Act) to stop the FTC generators for tax years ending after March 4, 2010. Canada also has decided to challenge the FTC generator by taking the issue to the courts. The first judicial review of the subject was recently decided by the Tax Court of Canada in Canada Limited v. The Queen(Case 4145356). 2011 TCC 220, Apr. 21, 2011.

A summary of the facts involve a subsidiary (S) of the Royal Bank of Canada. In 2003, S invested in a Delaware limited partnership, Crown Point Investments LP, for $400 million.  The general partner of Crown Point, Gaskell Management LLC (GM) , and the other limited partner of Crown Point (CP), were subsidiaries of Bank of America.  The U.S. limited partner subsidiary, CP, invested $1.2 billion while the U.S. subsidiary general partner, GM, contributed $15 million to Crown Point Investments LP’s capital. While organized as a limited partnership, Crown Point elected to be taxed as a corporation for U.S. tax purposes.

The Royal Bank’s subsidiary S, and the limited partner (CP), entered into a “repo agreement under which S had the right to require CP to purchase its limited partnership units in Crown Point for $400 million (comprising approximately 25% of the capital in the limited partnership) and GM had the right as well to acquire S’s.  Because of the repo arrangement, S’s investment in Crown Point was treated for U.S. tax purposes as a loan by S (again a Canadian subsidiary to the Royal Bank of Canada) to CP (again a U.S. subsidiary of the Bank of America) . The limited partnership,  Crown Point, made a loan of approximately $1.6 billion to Mecklenberg Park Inc.(MP), another subsidiary of Bank of America.

Under the Crown Point partnership agreement, S was entitled to a cash distribution from Crown Point equal to 4.73%  of the $400 million advanced to Crown Point. In 2003 Crown Point distributed approximately $6.1 millionin  cash to S. Under the limited partnership agreement, the appellant's share of the partnership’s net profit was the lesser of: (i) its pro rata share of net profit of the partnership (that is, total net profit x 25%); and (ii) the total cash distributed to S divided by (1 - the applicable tax rate).

In computing its Canadian tax liability for 2003, S included in its income approximately $9.4 million as its distributive share of partnership income and claimed foreign tax credits of approximately $3.2 which was its share of the foreign tax paid by Crown Point to the U.S. total interest income earned on the MP loan. In 2003 Crown Point earned interest income of $28.7M (U.S.) from theMP loan and paid U.S. tax of approx. $10M (U.S.). The Canadian Revenue Department disallowed the FTC of S and did not reduce the amount of S’s distributive share of the limited partnership’s income.

The first issue was to determine whether the entire limited partnership structure would be respected for Canadian ITA purposes; it was a hybrid entity for Canadian tax purposes since it was a corporation for U.S. income tax purposes. While the partnership rules in Canada resemble the treatment of a flow thru entity for U.S. income tax purposes, even for foreign based partnerships such as Crown Point, While there is no specific rule on partnerships and FTCs under the ITA, in Interpretation Bulletin IT-183 and its replacement, IT-270R3, the Canada Revenue Agency allows a partner to include its distributive share of the foreign taxes paid by a partnership of which it was a member in the computation of its FTC.

Stating that Canadian tax law and not U.S. tax law, would be determinative and that as such, the limited partnership was a partnership for Canadian income tax purposes and that S would have potential liability for Canadian taxes. Therefore, S’s income for 2003 was its distributive share of partnership income or approximately $9.4M. The Canadian Revenue Agency’s argument that its income should be the amount of cash distributed to S or $6.1M, i.e., the fixed return that S was entitled to receive.

Under ITA section 126, a Canadian taxpayer is entitled to claim a foreign tax credit for taxes “paid” to a foreign country on foreign source income. The government argued that because the taxpayer was not personally liable for the U.S. tax, i.e., the U.S. corporation (limited partnership) was, it could not claim FTCs in Canada. The Court rejected the idea that ITA section 126 required actual liability. The Court instead viewed, in accordance with the Supreme Court of Canada’s direction that the courts not interpret the ITA in a restrictive manner but to also consider the context or purpose for which the provision was adopted, that no actual liability requirement is implied on the use of the word “paid”  in section 126.

Since S was subject to U.S. tax as an economic matter on its U.S. source income, and even though CP was taxed as a separate entity for U.S. tax purposes, S should be treated as having the foreign taxes charged against the amount that was distributed to it. The Court viewed this outcome as consistent with a strong policy in avoiding double taxation.

The decision may be fair it does not directly address the FTC generator issue and would have been addressed presumably by a U.S. court were the facts of the case inverted. It is noteworthy that Canada’s GAAR provision was not addressed by the Court.

Stay tuned as to whether the Canadian Revenue Agency appeals Canada Limited to the Federal Court of Appeal. 

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France for years has imposed an annual tax of 3% of the value of immovable property situated in France when that property was owned, directly or indirectly, by a legal person. France law provided an exemption from this excise  for those legal persons whose seat of management was situated in a country or territory that had a TIEA or income tax treaty containing a nondiscrimination clause, provided, however, that the identities and addresses of the legal persons’ shareholders were disclosed annually as of a certain date. The exemption also was extended to legal persons that had their effective center of management in France or another EU member state, again provided the identity and addresses of the ultimate shareholders were provided.

Prunus, a company organized under the laws of France, was a wholly owned subsidiary of a Luxembourg holding company, Polonium. Polonium was owned 50% each by two companies organized and established in the British Virgin Islands. Prunus owned, directly or indirectly, a number of properties situated in France, but under the French tax rules, Prunus and Polonium were exempt from the 3% immovable property tax. Nevertheless, the two BVI companies were subject to the 3% tax as the BVI and had not entered into a qualifying tax treaty or TIEA designed to combat tax evasion.  The French taxing authority assessed the 3% tax against the French company, Prunus,  who was, under the provision, jointly and severally liable for the tax owed by the two BVI companies. Prunus and Polonium argued that the French rules at issue were contrary to article 63 (free movement of capital) of the Treaty on the Functioning of the European Union (TFEU).

The European Court of Justice, on May 5, 2011, in its landmark decision, Prunus SARL v. France (C-384/09) held against Prunus and upheld the assessment. Noting that the companies in the BVI are not entitled to EU membership benefits derived from EU law, the French anti-avoidance rules were upheld, i.e., the tax may be imposed if the legal person is established in a country that there is no tax information exchange agreement or an income tax treaty containing a nondiscrimination provision between the BVI and France.

An English  commentator on the case noted that the decision has “major implications for similar companies established in so-called overseas countries and territories such as Bermuda and the Cayman Islands.

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The Financial Accounting Standards Board's oversight organization announced May 20 that it will test a new review process for existing standards with an analysis of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes."

FIN 48, which was promulgated in November 2006,  clarified the guidelines for accounting of uncertainty in income taxes on financial statements of enterprises per FASB Statement No. 109, Accounting for Income Taxes, and removes uncertain income tax positions from the guidance provided under FAS 5, Accounting for Contingencies. See August, “Understanding FIN 48: Accounting for Uncertainty in Income Taxes,” Business Entities (WG&L), May/Jun 2008.

It also applies to purchase accounting in connection with a business combination. Use of a valuation allowance described in FASB Statement 109, therefore, was eliminated as an appropriate substitute for the derecognition of a tax position. The requirement to assess a valuation allowance for deferred tax assets based on the sufficiency of future taxable income was left unchanged by FIN 48. This situation would arise, for example, where a company with a large NOL carryforward is not likely to produce a sufficient level of future taxable income to fully utilize the NOL within the applicable carryover period.

When a position is taken on a tax return that reduces the amount of income taxes payable even though another interpretation of current law can be made that would not reduce current income taxes payable, the enterprise realizes an immediate economic benefit. Under FIN 48, this benefit of a favorable tax position can be recognized in the current period when the position has a more likely than not (MLTN) chance of being upheld through court review despite the presence of contrary interpretations, and the benefit to ultimately be realized can be measured in accordance with applicable rules. Only the difference between the measured benefit and the reported benefit on the tax return is required to be added to the tax reserve. On the other hand, if the position on a particular item, i.e., a so-called “unit of account,” is determined to be less likely than not correct, the full amount of the tax liability, as well as projected interest and possible penalty, must be included in the reserve as a current liability (or reduction in the NOL carryforward or claimed tax refund) where the company anticipates making payment within one year or within the company's next operating business cycle. Non-current liabilities for fully or partially unrecognized tax positions are treated as a deferred tax liability to the extent unrecognized. Such book-tax adjustments will, in certain instances, affect the tax basis of one or more assets thereby differentiating book from tax depreciation - during the applicable recovery periods.

In many instances, partial or totally unrecognized tax positions may not later be derecognized, i.e., reduce the amount of the reserve or liability for uncertain taxes, until the statute of limitations has expired for the year in which the position was taken and the position has not been challenged by the taxing authority. Conversely, previously recognized tax positions that subsequently fail the MLTN recognition standard due to an intervening change in the law are required to be derecognized and charged to liabilities in the first subsequent financial reporting period in which such determination is made.

Where the MLTN standard is not satisfied (as discussed below), no economic benefit may be claimed and recognized for financial accounting purposes, i.e., a liability is booked or reflected on the financial balance sheet for the total amount of tax due, plus associated interest and penalties.

The Financial Accounting Foundation (FAF), the private-sector organization that oversees FASB, had determined over the last few years that the board required a formal process to monitor and address the issues that can arise after implementation of new accounting standards. The review will determine whether FIN 48 is accomplishing its purpose of providing useful financial information for management’s decision making process and evaluating the standard’s implementation and associated compliance costs. 

Many companies filing GAAP financial statements have had to seek legal opinions from tax counsel on issues that present a degree of uncertainty as to wehter the position taken on the tax return can be recognized, and if so, what is its proper "measurement". Such opinions in turn raise questions of attorney-client privilege and work product protection. FIN 48 schedules are reported on financial statements as an aggregate account and adjustment, its the schedules and opinions that contain much more information that the IRS in the event of an audit may want to have the taxpayer produce.

The adoption of FIN 48 has not been without its detractors and perhaps those who want to see more relaxed standards re-introduced into GAAP are trying to gain a foothold to causing a return to the former standard used under FAS 109 for reporting uncertain tax liabilities. It may also be something that the International Accounting Standards Board wants to see eliminated so that conversion of GAAP into IFRS can be effectuated.

For a related development see August, "The Uncertain State of Uncertain Tax Positions", Business Entities (May/June 2011).

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Chinese tax authorities have been aggressively enforcing the application of  its GAAR and are likely to scrutinize exit tax residency and permanent establishment issues as they relate to nonresident funds and management companies. This trend is also accompanied by a set of recent tax changes in China. Moreover, China has recently renegotiated treaties with Barbados, Mauritius, and Singapore, and continue to introduce new rules to address potentially abusive structures or transactions aimed at mitigating Chinese capital gain tax, particularly those based on double tax treaty claims or indirect transfers. These rules include general anti-avoidance rules  (GAARs)reflected in various pronouncements, i.e., Guoshuifa [2009] 2 ("Circular 2"), 3 Guoshuihan [2009] 698 ("Circular 698"), 4 Guoshuihan [2009] 601 ("Circular 601"), 5 Guoshuifa [2009] 124 ("Circular 124"), 6 and Guoshuihan [2010] 290 ("Circular 290").

As most tax practitioners who work with outbound investment into China, there are several structures for effectuating cross-border investments by non-Chinese resident funds in China. One approach is to set up an investment fund in the Cayman Islands as an investment holding company which fund would adopt as its tax residence a jurisdiction which has a tax treaty with China, such as Hong Kong, Ireland or Mauritius. As a holding company, the Caymanian fund would invest in companies doing business in China. A management company could either set up a subsidiary ("wholly foreign owned enterprise" (WFOE) or a representative office in China.

The corporate Income tax law, as revised, in China (CITL) has included several GAAR rules. Such anti-avoidance provisions permit the taxing to make adjustments when enterprises enter into business arrangements that give rise to a reduction of taxable income and are not supported by a reasonable business purpose. Under Chinese tax regulations, business arrangements without a bona fide business purpose refer to arrangements the primary purpose of which is to reduce, avoid, or defer tax payments. Guidance in this areas has been issued by the Chinese tax authorities which are very broad and cover a variety of contexts, including abuse of tax incentive policies, tax treaty provisions, legal vehicle forms or structures, tax havens, and other arrangements without bona fide business purposes. The Chinese have also adopted principles tax lawyers in the States are familiar with including, step transaction, substance over form, and book-tax differences.

The GAAR rules provide the Chinese tax authorities with the power to make adjustments to certain transactions or deny tax benefits, and allow local tax bureaus to disregard legal entities that are deemed to lack substance. These rules are being used to examine back-to-back loan or financing structures made by off-shore investment funds.

In Circulars 601 and 698 the Chinese taxing authorities will attack structures that exploit tax treaties, such as prohibited treaty shopping, and tax avoidance. combating tax treaty shopping and tax avoidance. These Circulars were preceded by some high-profile cases (citations omitted)and the issuance of other guidance aimed at strengthening the taxation of nonresidents.

In Circulars 124, the Chinese tax authorities introduced detailed administrative rules for treaty residents to claim treaty benefits, with an effective date of October 1, 2009. The rules provide that nonresidents will not be automatically granted the benefits under DTAs, and will be required to comply with administrative rules to receive them. Income derived by nonresidents is divided into two categories and is subject to different procedures for claiming treaty benefits.

For benefits attributable to passive income, including dividends, interest, royalties, and capital gains, nonresidents must adhere to an "application-approval" procedure. For active income, such as business income of permanent establishments, independent personal services, and dependent personal services, nonresidents must satisfy the "record-filing" procedure.

Different documentation is required with respect to  the two procedures. Once the application for treaty benefits is approved, the nonresident does not have to reapply to the tax authority to be entitled to benefits for three calendar years (including the year in which the initial application is made) with respect to (1) dividends derived from the same equity investment in the same enterprise; (2) interest derived from the same debt and due from the same debtor; and (3) royalties derived from granting the same right to the same person or enterprise. Eligible nonresidents under the DTAs that fail to apply for approval may cure this failure by filing an application within three years from the date of the tax payment to obtain a refund. Approval may be revoked by the Chinese tax authorities in certain circumstances and the nonresident may be required to pay the taxes plus surcharges, interest, or penalties. Query, how would a US based company issuing GAAP financials set up appropriate reserves under FIN 48 for such procedures and the risk of facing tax assessments in China?

In Circular 290, supplementary rules pertaining to local PRC tax authorities were promulgated including subjects on the timing of internal review procedures, tax filing requirements, and tax residency certificates for nonresidents seeking tax benefits under DTAs. Circular 290 requires a withholding tax agent to complete tax filing procedures regardless of whether the taxpayer has submitted related documents to the tax authority. Circular 290 clarifies that to obtain DTA benefits, a tax residency certificate must be issued exclusively for that purpose or in accordance with the requirements of Circular 124.

Additional Circulars Issued after 2008

Additional Circulars were issued by the PRC in 2009. For example, in Circular 601, rules for determining the "beneficial owner" for the purpose of claiming DTA benefits by treaty residents with respect to dividends, interest, and royalties. Agents and conduit companies (i.e., companies established to avoid or reduce tax or shift profits) are not beneficial owners for purposes of Circular 601. In Circular 698, the PRC addressed issues related to gains from equity sales (i.e., capital gains), specifically to increase the administration and taxation of direct and indirect capital gains derived by nonresidents. The Circular provides that the substance-over-form approach extends to capital gains derived indirectly by nonresidents on share or equity transactions and highlights the willingness of the Chinese tax authorities to disregard certain entities under GAAR if they were established to avoid tax and lack a business purpose and commercial rationale. The rules cover both direct and indirect equity or share transfers by nonresidents, the nonresidents' obligation to report and the Chinese tax authorities' jurisdiction over such gains, subject to certain conditions for indirect equity or share transfers.

The "share transfer" under Circular 698 refers to nonresidents transferring shares of a Chinese resident enterprise or company. Nonresidents are generally exempt from the Circular 698 reporting requirement for the disposal of listed shares of Chinese companies that were purchased and sold on a public stock exchange. For an indirect sale, Circular 698 asserts the Chinese tax authorities' right to invoke GAAR to disregard one or more intermediate holding companies if their existence serves no business purpose except avoidance of Chinese tax liabilities, thus effectively treating the indirect sale as a direct disposition of the Chinese company or enterprise.

There have been several cases that were prosecuted by the Chinese tax authorities under its GAAR Circulars in attacking transactions which the PRC taxing authorities believe does not comport with commercial substance. In the area of treaty shopping, a case arose in Tianjin (2010). The Tianjin case involved a Mauritius nonresident enterprise (MCo) that transferred its direct equity interest in a PRC non-land-equity joint venture (EJV) to another nonresident shareholder in Bermuda (BCo). The PRC tax authorities denied treaty benefits on capital gains derived by MCo from the direct disposal of equity interest in the EJV based on the following points: (i) MCo was merely a conduit company and was effectively managed by the U.S. parent company (USCo); and (ii) USCo is the beneficial owner of the capital gain in question. The PRC tax authorities determined , based on all facts and circumstances, that USCo had absolute control over MCo based on facts including: (i) the majority of EJV's sales were conducted through USCo; (ii) USCo sent its technical personnel into China to conduct product testing on EJV's products; (iii) EJV paid a royalty fee to USCo; (iv) USCo exercised substantial control over the production and operation of the EJV; and (v) USCo controlled the production, operation and funding of EJV.

In another recent case, Fujian (citation omitted), that was issued last year, the Fuzhou State Tax Bureau successfully assessed and collected taxes from a Hong Kong holding company after denying it a tax exemption under the China-Hong Kong DTA for capital gains on its transfers of the stock of a Chinese resident company. The disposing Hong Kong company alone owned less than 25% of the shares in the Chinese resident company and thus was otherwise eligible for relief under the DTA. However, its shareholder, a Hong Kong individual, owned additional shares in the same Chinese resident company through another intermediary Hong Kong holding company such that, in aggregate, the Hong Kong individual owned indirectly more than 25% of the shares in the Chinese resident company. The view of the Fuzhou State Tax Bureau was that the Hong Kong individual shareholder was the ultimate beneficial owner of the income and imposed a 10% withholding tax on the capital gains.

Practitioners working with outbound investments into China through an offshore holding company should review recent protocols entered into force under the China-Mauritius Treaty, the China-Barbados Treaty and the Singapore Treaty.

These developments in the PRC will cause tax practitioners and their clients investing in China to re-assess their tax structures and assess their present tax risk to challenge under the GAAR rules being enforced by the PRC. There are a host of potential problems in this area including the proper use of management entities, tax consequences of equity sales, eligibility for treaty protection, transfer pricing issues, permanent establishment issues, and location for the exercise of corporate governance.

It seems like the "economic substance doctrine", "business purpose", "substance over form", "step transaction", "sham transaction"., improper treaty shopping and related issues are now part of the tax landscape in the PRC.

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Canadians seeking to make investments in U.S. based private equity funds do face a challenging landscape attributable to the multitude of U.S. taxing authorities, federal, state and local governmental taxing authorities, as well as a somewhat counterintuitive home country tax regime, in reporting their U.S. operations back home in Canada. This is because U.S. private equity funds are frequently organized as limited partnerships which has the consequence that each non-resident U.S. partner is allocated his or its pro rata share of partnership income and is subject to U.S. income tax on such portion. More specifically, with respect to a non-resident investor who is a partner in the fund, its distributive share of partnership income is treated as income attributable to the conduct of a trade or business in the U.S. ("effectively connected income" or "ECI") if the equity fund is so engaged. §875(1). Treas. Reg. §1.875-1. Johnston v. Comm’r, 24 T.C. 920 (1955)(Canada-U.S. Income Tax Treaty: Unger v. U.S. 936 F.2d 1316 (CA-D.C., 1991); Rev. Rul. 90-80, 1990-2 C.B. 170.

The Canadian (or non-resident) partners sale of an interest in the partnership also generates ECI, at least that is the Service’s publicly stated position. See Rev. Rul. 91-32, 1991-1 CB 107 . Where the non-US. Investor in the fund is a foreign corporation, the branch tax is implicated but at a reduced treaty rate. §884 ; Canada-U.S. Tax Treaty, Article X, para. 6. Where the US limited partnership operative a private equity fund has ECI, it must withhold at a 35% rate on each non-resident’s share of ECI. §1446.

In order to mitigate these tax impacts, it is common for a foreign investor to own its interest in a private equity fund in the U.S. through a U.S. corporation. The insertion of such entity, frequently referred to as a "blocker" company , is either a de jure U.S. corporation or a de facto corporation for tax purposes which occurs, in the latter instance, through forming, for example, a single member LLC which makes a reverse default election under the CTB regulations to be treated as a corporation. This results in the blocker corporation being subject to U.S. tax on its share of the fund’s income and is the entity responsible for filing U.S. tax returns and payment of U.S. tax. Profits are distributed to the non-resident owner of the blocker as either dividends or a liquidating distribution. As to dividends, if no treaty is involved the withholding tax is 30% but a Canadian investor may qualify for an exemption or a reduced withholding rate under the Treaty. Canada -U.S. Tax Treaty, Article X, para. 2(b). If the Canadian owner holds 10% or more of the U.S. subsidiary’s voting stock, the rate on dividend withholding is reduced to 5%. A special relief rule applies to liquidating distributions.

A special concern for Canadian investors with use of a "corporate" blocker to hold its interest in a U.S. limited partnership is that that the partnership will still be treated as a pass through entity for Canadian tax purposes. Therefore, for Canadian investors, a problem arises when a U.S. fund uses as a blocker a U.S. limited partnership that elects to be treated as a corporation for U.S. tax purposes. The partnership still will be treated as a pass-through partnership for Canadian tax purposes. See §96 of the Canadian Income Tax Act .

The 2007 Protocol to the Canada-U.S. Tax Treaty, which addressed problems associated with the use of hybrid entities for investing in both Canada and the U.S., also impacts blocker structures for Canadians investing in the U.S. First problem pertains to tax reporting. The U.S. K-1 will go to the U.S. blocker entity (corporation) and not to the Canadian investors who will need the same information provided on a K-1 in order to fulfill their Canadian income tax reporting and tax payment obligations since the blocker is treated as fiscally transparent. More critical is the tax consequences in Canada attributable to the use of the blocker structure itself. Generally a dividend paid to a non-U.S. shareholder is subject to a U.S. 30% withholding tax, subject to applicable treaty reduction. Where a private equity limited partnership makes a distribution to a U.S. blocker taxable as a corporation, the corporation, already subject to income tax on ECI and other U.S. source income includible in taxable income, which them makes a distribution from its earnings and profits to its non-resident partners, is required to withhold 30% of the dividend subject to treaty override. A Canadian resident that otherwise qualifies for benefits under the U.S.-Canadian Treaty can reduce this rate to 15% and 5% if he or it owns 10% or more of the subsidiary’s voting stock. Qualified pensions in Canada are entitled to 0% withholding.

Under the 2007 U.S.-Canadian Treaty Protocol pertaining to hybrid entities, paragraph 7(b), Article IV states:

"An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State [Canada] where ...

"(b) The person is considered under the taxation law of the other Contracting State [U.S.] to have received the amount from an entity that is a resident of that other State [U.S.], but by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State [Canada], the treatment of the amount under the taxation law of that State [Canada] is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State [Canada]."

Under this provision, for Canadian income tax purposes, a U.S. "blocker" corporation is still treated as a pass through entity and the income of the U.S. limited partnership is still allocated as ECI to the Canadian owner of shares in the blocker company. The transfer of funds by the "blocker" to Canadian residents is not taxable. (Were the U.S. blocker treated as a corporation for Canadian income tax purposes, then the payments by the blocker would be considered to be a dividend which is the U.S. treatment of the payment). Still, there would seem to be a withholding obligation of 30% by the U.S. blocker on cash funds distributed to the Canadians. In other words, treaty benefits presumably are to be denied to the Canadian investors on the dividends. See Technical Explanation of the 2007 Protocol. As a result, paragraph 7(b) of the 2007 Protocol would apply to provide that the dividends are not considered to be paid to or derived by either the Canadian corporation or the Canadian pension fund.

So direct investment by the Canadian in the U.S. limited partnership (private equity fund) results in ECI on its distributive share of the income and is subject to withholding subject to treaty reduction. Investment in a U.S. blocker corporation doesn’t change the result and perhaps could inspire another level of withholding on dividends paid by the blocker to its non-resident shareholders.

The potential solution to this "whipsaw" situation is the use of a U.S. limited liability company (instead of a limited partnership) to perform the role of the blocker, i.e., the use of a domestic LLC that elects to be treated as a corporation for U.S. income tax purposes. Canada views the LLC as a corporation. See, e.g., CRA Document Nos. 9729780 (11/14/97) and 9713120 (5/20/97); Income Tax Technical News No. 29 (10/30/02); CRA Interpretation Bulletin IT-343R, "Meaning of the Term ‘Corporation’" (9/26/77), at para. This offers the benefits of the U.S. blocker structure and reduction of withholding levels on distributions made by the LLC to Canadian residents.

Caution: This BLOG does not in any way render legal advice to persons reading the material contained in this or any other filing made on this site and may not be relied upon as legal advice. If you have this issue described in this submission to resolve you must consult with your tax counsel in reviewing the options that you may consider and their impacts.

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The Service has just issued Rev. Proc. 2011-13, 2011-3 I.R.B.1, which updates Rev. Proc. 2010-15) as to whether whether disclosure of a position taken on a tax return is adequate for purposes of the section 6662(d) accuracy-related penalty and the section 6694(a) tax return preparer penalty.  The guidance updates the Service’s position to new section 6662(i) which provides an enhanced accuracy related penalty for  non-disclosed noneconomic substance transactions; the section 6662(j) increased accuracy-related penalty for undisclosed foreign financial asset understatements; and the Schedule UTP that must be filed by some corporations. The revenue procedure applies to any income tax return filed on 2010 tax forms for a tax year beginning in 2010 and to any income tax return filed on 2010 tax forms in 2011 for short tax years beginning in 2011.

Background

This revenue procedure updates Rev. Proc. 2010-15, 2010-7 I.R.B. 404, and identifies circumstances under which the disclosure on a taxpayer's income tax return with respect to an item or a position is adequate for the purpose of reducing the understatement of income tax under section 6662(d) and for the purpose of avoiding the tax return preparer penalty under section 6694(a) (understatements due to unreasonable positions on any income tax returns). The new procedure does not apply with respect to any other penalty provisions (including the disregard provisions of the section 6662(b)(1) accuracy-related penalty, the section 6662(i) increased accuracy-related penalty in the case of nondisclosed noneconomic substance transactions, and the section 6662(j) increased accuracy-related penalty in the case of undisclosed foreign financial asset understatements). This revenue procedure has been updated to include reference to: (i) the section 6662(i) increased accuracy-related penalty in the case of nondisclosed noneconomic substance transactions; (ii) the section 6662(j) increased accuracy-related penalty in the case of undisclosed foreign financial asset understatements; and (iii) the Schedule UTP, Uncertain Tax Position Statement, a new schedule required of certain corporations.

Section 6662

Section 6662 imposes a 20% accuracy related penalty with respect to  any portion of an underpayment of tax required to be shown on a return. The penalty is increased 100% to 40% of the underpayment of tax attributable to gross valuation misstatements under section 6662(h), nondisclosed noneconomic substance transactions under section 6662(i), or undisclosed foreign financial asset understatements under section 6662(j)). Section 6662(b)(2) applies to the portion of an underpayment of tax that is attributable to a substantial understatement of income tax.  See §6662(d)(1) for definition of substantial understatement of income tax. See also §6662(d)(1)(B) for corporations. Understatement is defined in section 6662(d)(2), i.e., the excess of the amount of tax required to be shown on the return for the taxable year over the amount of the tax that is shown on the return reduced by any rebate (within the meaning of section 6211(b)(2)).

Section 6694

Section 6694(a) imposes return preparer penalty on a return or claim for refund which reflects an understatement of liability due to an "unreasonable position" if the tax return preparer knew (or reasonably should have known) of the position. A position (other than a position with respect to a tax shelter or a reportable transaction to which section 6662A applies) is generally treated as unreasonable unless (i) there is or was substantial authority for the position, or (ii) the position was properly disclosed in accordance with section 6662(d)(2)(B)(ii)(I) and had a reasonable basis. If the position is with respect to a tax shelter (per §6662(d)(2)(C)(ii)) or a reportable transaction (per §6662A), it is more difficult to have the penalty lifted for reasonable cause. See Notice 2009-5, 2009-3 I.R.B. 309.

The Notice announces that an accurate disclosure of a tax position on the appropriate year's Schedule UTP, Uncertain Tax Position Statement, will be treated as if the corporation filed a Form 8275 or Form 8275-R regarding the tax position. The filing of a Form 8275 or Form 8275-R, however, will not be treated as if the corporation filed a Schedule UTP.

Operative Provisions

The Procedures addresses the quality and quantity of information required to make an adequate disclosure For example, the Procedure addresses how much factual information is sufficient and requires that the money amounts entered on the forms must be verifiable, i.e., if on audit, the taxpayer can prove the origin of the amount (even if that number is not ultimately accepted by the Internal Revenue Service) and the taxpayer can show good faith in entering that number on the applicable form. Special scrutiny is given to understatements arising from transactions involving related parties. The relationship must be disclosed on Form 8275 or Form 8275-R. Parts of the Procedure are quite detailed as to what is required to be stated on the disclosure. As set forth in the regulations, a properly or adequately disclosed position still does not have a “reasonable basis” per Treas. Reg. §1.6662-3(b)(3) or is attributable to a tax shelter (per §§6662(d)(2) or (d)(3), or is not properly substantiated or the taxpayer failed to keep adequate books and records with respect to the item or position. The Procedure warns that disclosure will not avoid a tax return preparer penalty where the position is taken with respect to a tax shelter (per §6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies.

A separate section of the Procedure addresses the required information needed for taxpayers itemizing deductions, claiming charitable contributions,  casualty and theft losses, certain expenses related to the ownership of rental property, the reasonableness of officers compensation claimed on Form 1120 and other specific items. The Procedure addresses information required to be shown on Forms M-1 or M-3, partnership returns and other return information.  As to foreign tax items, the Procedure provides information related to international boycott transactions as well as treaty based return positions.

 
Effective Date

This revenue procedure applies to any income tax return filed on a 2010 tax form for a taxable year beginning in 2010, and to any income tax return filed on a 2010 tax form in 2011 for a short taxable year beginning in 2011.

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A frequently raised issue in tax planning for U.S. companies engaged in business operations overseas is the proper employment type relationship that should be used for the business person who is going to be rendering services in one or more foreign jurisdictions. There are at least four general ways that such relationshipo could be structured: (i) the service provider is treated as an employee of the foreign employer; (ii) the service provider is retained as the employee of the U.S. employer with a secondary relationship with the foreign affiliate; (iii) the service provider serves "two masters" by being employed by both the U.S. employer and foreign employer; or (iv) the service provider is treated as an employee of a special services company and then the special services company loans out the services the service provider to the foreign company.

The following is a short explanation of the various options present. No legal advice is being rendered in this summary and a reader may not rely or act upon this explanation as such. In all events the reader must consult with his company’s lawyer or law firm on the points discussed.

Service Provider Works as an Employee of the Foreign Company

This form of arrangement is good for long-term projects or working on a permanent basis. The foreign employer places the service provider on its payroll and such worker's proper immigration status must be obtained. The foreign employee may be paid in foreign currency (see section 988) and is permitted to participate in employee benefit plans, including share option agreements and other emoluments of service. The problem with this arrangement is that the U.S. individual may no longer be able to continue to participate in the U.S. employer's employee benefit plans. It is also possible that the foreign "wages" will not be counted for FICA purposes. But see §3121(l). Since the service provider is an employee of the foreign affiliate, it may not be possible for the U.S. company to expense the compensation and other deductible payments made. This could even apply to a bonus paid by the U.S. parent corporation for services rendered by the service provider to the foreign subsidiary. See Young & Rubicam, Inc. v. U.S., 410 F.2d 1233 (Ct. Cl. 1969). It could even extend to the employee’s exercise of previously issued (U.S. employer) stock options when the service provider is employed by the foreign subsidiary at the time of exercise. Some companies do permit foreign based employees to remain in U.S. employee benefit plans but again there may be issues on the deductibility of the contributions for services rendered through a foreign affiliate-employee relationship unless the foreign employer adopts the plan and is a member of the same controlled group.

Service Provider Remains Employee of U.S. Employer With Secondary Relationship with Foreign Affiliate

In this situation the employee is leased to the foreign employer by the U.S. employer with the contractual right retained by the U.S. employer to direct and control the service provider’s work regardless of where such services are being rendered. In general, such "secondary" arrangements are of relatively short duration. This arrangement keeps the U.S. employee as a participant in the U.S. employer’s qualified retirement programs and his compensation constitutes "wages" for FICA purposes. The U.S. employer can deduct the amounts of compensation paid in accordance with §162(a)(1). Frequently the employee will be "charged out" as a cost to the foreign based affiliate.

The problem with the "loan out" or "secondary arrangement" is that depending on the nature of the services rendered, especially where a key executive is involved, the foreign based services may give rise to a permanent establishment issue or engaged in a trade or business issue for the U.S. parent corporation. This possibility must be carefully evaluated in advance and monitored during the term or period that the foreign based services are rendered. There could also be awkward withholding and income tax rules based on the foreign taxing authorities possible approach that the income from the services rendered is taxable in the country in which the services are rendered and there is a withholding requirement. Pertinent treaty provisions must be reviewed.

Service Provider Serves "Two Masters" As Being Employed by a U.S. and Foreign Company

Under this form of arrangement, the executive is hired by both companies and has separate employment agreements with each. She is able to participate in both companies employee benefit plans. This arrangement will be used where there are also some tax benefits inuring to the employer or employee. While this arrangement may carry a greater administrative cost, depending on the jurisdictions involved, it could provide tax benefits for the three parties.

Service Provider is Hired by Services Management Company

Yet another variation is for the U.S. employer to establish a special management services company to hire service providers as employees and lease out such employees to foreign companies where and as needed. This is a well-used format for multinational companies having a pool of foreign service providers working in different companies. The practice has been to form the global service management company in a tax-haven or low tax jurisdiction to reduce the corporate income tax on profits earned by the leased employees. This arrangement may mitigate somewhat the risk of a permanent establishment issue for the U.S. employer. The risk with this arrangement is that it is subject to an "alter ego" attack based on all facts and circumstances by a foreign jurisdiction. The services management company must be a separate and profitable entity in its own right to reduce the risk. As with the foreign employee arrangement, the U.S. employer may lose the tax deduction associated with the compensation paid unless the management company is a domestic corporation.

The foregoing four options are by no means the exclusive means for establishing the relationship between a U.S. individual rendering services to a foreign affiliate. Other options such as a so-called "dormant contract" or even a joint venture could be considered. Moreover tax equalization clauses and calculations are important aspects of the employment agreement with a foreign based employer. In all cases it is important to assess the tax impacts and potential risks to the various parties.

Other Possibilities

The foregoing four options are by no means the exclusive means for establishing the relationship between a U.S. individual rendering services to a foreign affiliate. Other options such as a so-called "dormant contract" or even a joint venture could be considered. Moreover tax equalization clauses and calculations are important aspects of the employment agreement with a foreign based employer. In all cases it is important to assess the tax impacts and potential risks to the various parties.

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The Justice Department on October 22 dismissed criminal charges against the Swiss bank, UBS AG, which had been accused of helping thousands of Americans evade U.S. taxes in the billions of dollars by concealing their assets in foreign accounts , The dismissal of the criminal chargers is part of UBS’ complying with an 18-month deferred prosecution agreement , which required UBS to pay $780 million in fines and taxes, exit the U.S. cross-border banking business, and turn over over account information of about 250 American clients. Based on such compliance with the DPA, the prosecutors moved to dismiss the criminal charges. According to the motion, UBS has met all the conditions set forth in the DPA. 

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Under newly enacted 7701(o), This newly issued Notice provides interim guidance regarding the codification of the economic substance doctrine, for any transaction to which the economic substance doctrine is relevant, the transaction shall be treated as having economic only in instances where: (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position; and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

Section 7701(o)(5)(A) defines the “economic substance doctrine” as the common law doctrine under which income tax benefits (as well as corresponding costs) with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. Both tests have to be met. 

Section 7701(o)(5)(C) states that the determination of whether the economic

substance doctrine is relevant to a transaction shall be made in the same manner as if

section 7701(o) had never been enacted. With respect to individuals, however, section

7701(o)(5)(B) states that the two-prong analysis in section 7701(o)(1) applies only with respect to a transaction entered in as part of a trade or business or an activity engaged

in for the production of income. Transaction, per §7701(o)(5)(D), includes a series of transactions.

Section 7701(o)(2)(A) provides that a transaction’s potential for profit shall be

taken into account in determining whether the requirements of section 7701(o)(1) are

met only if the present value of the reasonably expected pre-tax profit is substantial in

relation to the present value of the claimed net tax benefits. For purposes of computing

pre-tax profit, §7701(o)(2)(B) provides that the Secretary shall issue regulations

treating foreign taxes as a pre-tax expense in appropriate cases.

The Act also added §6662(b)(6), which provides that the accuracy-related penalty imposed under §6662(a) applies to any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance (within the meaning of §7701(o)) or failing to meet any similar rule of law (collectively a § 6662(b)(6) transaction). The Act also added section 6662(i), that increases the accuracy related penalty from 20% to 40% for any portion of an underpayment that is attributable to one or more §6662(b)(6) transactions which were not adequately disclosed on the return or statement attached to the return. In addition, §6662(i)(3), also a new provision, provides that certain amended returns or any supplement to a return shall not be taken into consideration for purposes of section 6662(i).

The Act amended §6664(c) so that the reasonable cause exception for underpayments found in §6664(c)(1) shall not apply to any portion of any underpayment attributable to a § 6662(b)(6) transaction. The Act similarly amended  §6664(d) so that the reasonable cause exception found in § 6664(d)(1) shall not apply to any reportable transaction understatement (within the meaning of §6662A(b)) attributable to a § 6662(b)(6) transaction. The Act further revised §6676 so that any excessive amount (within the meaning of §6676(b)) attributable to any §6662(b)(6) transaction shall not be treated as having a reasonable basis.

After providing a summary of the new “clarification” of the economic substance test, the Notice states that for transactions entered into on or after March 31, 2010, the IRS will apply §7701(o)’s two-prong conjunctive test. In determining whether a transaction has a

sufficient nontax purpose to satisfy the requirements of §7701(o)(1)(B), the Service announced that it will apply cases under the common-law economic substance doctrine pertaining to whether the tax benefits of a transaction are not allowable because the transaction lacks a business purpose. The Service will therefore challenge transactions where the taxpayer asserts that either the business purpose test or economic tests are applicable.

As a second guideline, Notice 2010-62 provides that the IRS will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of §7701(o). Therefore, if legal authorities, prior to the enactment of §7701(o), provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the IRS will continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable. The IRS anticipates that the case law regarding the circumstances in which the economic substancedoctrine is relevant will continue to develop. Consistent with §7701(o)(5)(C), codification of the economic substance doctrine should not affect the ongoingdevelopment of authorities on this issue.

Third, Notice 2010-62 states that the Treasury Department and the IRS do not

intend to issue general administrative guidance regarding the types of transactions to

which the economic substance doctrine either applies or does not apply. Inotherwords, there will be no “angel list” of approved transactions as many tax professionals had hoped for.

Fourth, in calculating  the net present value of the reasonable expected pre-tax profit under §§7701(o)(1)(A) and (B), the IRS will take into account the taxpayer’s profit motive only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for Federal income tax purposes. In performing this calculation, the IRS will apply existing relevant case law and other published guidance. Query, however, what is the discounted rate in computing present value, and what costs are allowable as directly related?

Fifth, Notice 2010-62 restates that §7701(o)(2)(B) grants the Secretary with authority to issue regulations requiring foreign taxes to be treated as expenses in computing the pre-tax profit in certain appropriate instances. Until such regulations are issued, the Notice states that §7701(o) does not restrict the ability of the courts to consider the appropriate treatment of foreign taxes in economic substance cases.

Sixth, as to disclosure issues, the Notice declares that unless a transaction is a reportable transaction per Treas. Reg. §1.6011-4(b), the adequate disclosure requirements of §6662(i) will be met where disclosure is made on a timely filed original return (determined with regard to extensions) or a qualified amended return (as defined under Treas. Reg. § 1.6664-2(c)(3)) the relevant facts affecting the tax treatment of the transaction. If a disclosure would be considered adequate for purposes of §6662(d)(2)(B) (without regard to §6662(d)(2)(C)) prior to the enactment of codification of economic substance it will be deemed to be adequate for purposes of §6662(i). The disclosure will be considered adequate only if it is made on a Form 8275 or 8275-R, or as otherwise prescribed in forms, publications, or other guidance subsequently published by the IRS

consistent with the instructions and other guidance associated with those subsequent

forms, publications, or other guidance.

Disclosures made consistent with the terms of Rev. Proc. 94-69 also will be taken into account for purposes of  §6662(i). However, where a transaction lacking economic substance is a reportable transaction, as defined in Treas. Reg. § 1.6011-4(b), the adequate disclosure requirement under section 6662(i)(2) will be satisfied only if the taxpayer meets the disclosure requirements described earlier in this paragraph and the disclosure requirements under the §6011 regulations. In other words, a taxpayer will not meet the disclosure requirements for a reportable transaction under the  §6011 regulations by only attaching Form 8275 or 8275-R to an original or qualified amended return.

Finally, Notice 2010-62 states that the Service  will not issue a private letter ruling or determination letter regarding whether the economic substance doctrine is relevant to any transaction or whether any transaction complies with the requirements of section 7701(o).

The Notice is effective as of the enactment of §7701(o), March 10, 2010.

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Under § 108(i) , enacted into law in  2009, a taxpayer may elect to defer recognition of discharge of business indebtedness income resulting from a “reacquisition”, a technical term contained in the statute, with respect to an “applicable debt instrument” during the calendar year 2009 or 2010. An “applicable debt instrument” is a debt instrument issued by a C corporation or by “any other person in connection with the conduct of a trade or business by such person.”  A “reacquisition” is an acquisition of a debt instrument by the “debtor” that “issued (or is otherwise the obligor under) the debt instrument” or by a person related to the debtor. In addition, a total forgiveness of the debt by the holder or a contribution of the debt to capital are also treated as “reacquisitions”. Where a taxpayer elects under §108(i), any cancellation of indebtedness income arising from the reacquisition is including in gross income ratably over a five year period beginning in 2014. Stated differently, the  deferral period for a reacquisition during in 2009,  starts with the fifth taxable year following the taxable year during which the reacquisition occurs and for a reacquisition during in 2010, the  five year deferral period starts with the fourth taxable year following the reacquisition year. If the §108(i) election is made as to a particular debt, the taxpayer may not elect to exclude the same income under another exception contained in §108, including the insolvency exception, the qualified farm or real property business indebtedness exceptions. Where, for example, a partnership reacquires its debt with COD income, the partnership must elect under §108(i). In such case, the partnership allocates the deferred income among its partners immediately before the discharge in the manner that it would have allocated the income if it had not elected to defer the income. Each partner then  recognizes his or her distributive share of the deferred income over the relevant five-year period. Any decrease in a partner's share of partnership liabilities as a result of the discharge is disregarded at the time of the discharge to the extent it would cause the partner to recognize gain. This is to prevent whipsaw from occurring under the §752 rules for deemed distributions of cash resulting from the discharge of the debt. Instead, a partner must take into account any liability decrease so disregarded “at the same time, and to the extent remaining in the same amount, as [the deferred income] is recognized.” There are events which will cause the deferral to accelerate and be included in gross income. This will occur where the taxpayer dies or he sells substantially all of the assets of the business or ceases to operate the business.

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Background

Section 172(a) allows a taxpayer to claim a deduction in an amount equal to the aggregate of the NOL carryovers and carrybacks to the taxable year. Section 172(b)(1)(A)(i) provides that an NOL for any taxable year generally must be carried back to each of the 2 years preceding the taxable year of the NOL. Section 172(b)(3) provides that any taxpayer entitled to a carryback period under § 172(b)(1) may make an irrevocable election to relinquish the carryback period for an NOL for any taxable year.

Under the alternative minimum tax, adjustments are required to be made to taxable income under §56 in computing alternative minimum taxable income (AMTI). In the NOL area, §56(a)(4) provides that the alternative tax net operating loss (ATNOL) deduction applies in lieu of §172’s NOL deduction in computing AMTI. Section 56(d)(1) provides certain adjustments and limitations used in determining the ATNOL deduction for the taxable year. Under § 56(d)(1)(A)(i), the ATNOL deduction generally cannot exceed 90% of AMTI, determined without regard to the ATNOL deduction and the deduction under § 199 (deduction with respect to manufacturing expense attributable to U.S. production activities). 

Worker, Homeownership, and Business Assistance Act of 2009

Section 13 of the Worker, Homeownership, and Business Assistance Act of 2009 (“WHBAA”), P.L. 111-92 (Nov.6, 2009) amends §§ 172(b)(1)(H) and 810(b)(losses from operations of a life insurance company) permitting taxpayers to elect to carry back an applicable net operating loss (NOL) for 3, 4, or 5 years, or a loss from operations for 4 or 5 years, in claiming overpayments in tax in one or each of such preceding taxable years. The IRS, in providing guidance in this area, just released Notice 2010-58, 2010-37 IRB, 08/20/2010  to offset taxable income in those preceding taxable years.

This entry will not address the impact of §13 of WHBAA on life insurance companies.

American Recovery and Reinvestment Act of 2009

Section 1211 of the American Recovery and Reinvestment Tax Act of 2009, P.L. 111-5(2/17, 2009) (ARRA), amended § 172(b)(1)(H) to allow an eligible small business (ESB) to elect to carry back a 2008 applicable NOL for a period of 3, 4, or 5 years (ARRA election)(emphasis added). Unlike the § 172(b)(1)(H) election under the WHBAA (WHBAA election), the ARRA election is applicable only to an NOL attributable to an ESB. The ARRA election is irrevocable and may be made for only one taxable year. Rev. Proc. 2009-26, 2009-19 I.R.B. 935 (April 25, 2009), modifying and superseding Rev. Proc. 2009-19, 2009-14 I.R.B. 747 (March 16, 2009), advises taxpayers how to make the ARRA election. In contrast the election under §172(b)(1)(H)(i), as amended by WHBAA, i.e., the 3, 4 or 5 preceding taxable year rule, is not limited to ESBs. Under the WHBAA, the term “applicable net operating loss” is with respect to a taxpayer’s NOL for a taxable year ending after December 31, 2007 and beginning before January 1, 2010.

Revised Section 172(b)(1)(H)

 Section 172(b)(1)(H)(iii) provides that the election under § 172(b)(1)(H) is to be filed by the due date (including extensions) for filing the return for the taxpayer’s last taxable year beginning in 2009.  The election is irrevocable and, in general, may be made for only one taxable year. However, §172(b)(1)(H)(v) allows a taxpayer that made or makes an ARRA election also to make a WHBAA election.

Section 172(b)(1)(H)(iv) limits the amount of an applicable NOL that a taxpayer elects under § 172(b)(1)(H)(i) to carry back to the 5^th taxable year preceding the taxable year of the loss but subject to a limitation that the amount of the reduction to taxable income can not exceed 50% of the taxpayer's taxable income for such 5^th  preceding taxable year. The taxable income for the 5th preceding taxable year is computed without regard to the NOL for the loss year or any taxable year thereafter. The excess amount (for the 5^th year rule) may be carried to later taxable years. For the carryback of an ATNOL to the 5^th preceding taxable year, the 50% limitation is applied separately based on the AMTI. The limitation on the amount of an applicable NOL that may be carried back to the 5^th preceding taxable year does not apply to an NOL carryback under the ARRA election.

Section 13(b) of the WHBAA amends § 56(d)(1)(A)(ii) to remove the 90% limitation in computing ATNOL attributable to an  applicable NOL for which a taxpayer made an election under § 172(b)(1)(H).

Section 13(e)(4) of the WHBAA provides that a taxpayer who elects under § 172(b)(3) to forgo a carryback for a loss for a taxable year ending before the date of enactment of the WHBAA (11/6/2009) may revoke that election before the due date (including extensions) for filing the return for the taxpayer's last taxable year beginning in 2009. An application under § 6411(a) for the applicable NOL is treated as timely if filed before that due date.

Section 13(f) of the WHBAA provides that the election under § 172(b)(1)(H) is not available to certain taxpayers that receive benefits under the Emergency Economic Stabilization Act of 2008, Title I of Div. A of P.L. 110-343, and certain affiliates of these taxpayers.

Notice 2010-58, supra, adopts a question and answer format which should facilitate a more complete understanding of the new labyrinth of rules to wade through in a timely manner.

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Congress enacted §280G in 1984 over concern that contracts between a corporation and its employees providing golden parachutes directly (or indirectly) attributable to a takeover of a target company would have an adverse effect on takeover activity in general, elevate the concerns of the management of the target company beyond permitted boundaries, including the deflection of shareholder value from the target’s shareholders to key management and control shareholders of the target company. S280G applies to payments under agreements entered into or renewed after June 14, 1984. Section 280G also applies to certain payments under agreements entered into on or before June 14, 1984, and amended or supplemented in significant relevant respect after that date. This section applies to any payment that is contingent on a change in ownership or control and the change in ownership or control occurs on or after January 1, 2004.

 As a result, § 280G disallows any deduction for certain payments to a “disqualified individual” (whether or not incident to termination of the individual's employment) if the payment: (i) is contingent on a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of a corporation's assets, provided the present value of the payment exceeds 3 times a defined base amount, or (ii) is paid pursuant to an agreement violating any generally enforced securities laws or regulations. Any payment pursuant to an agreement or amendment thereof entered into within one year before a change of ownership or control is presumed to be contingent on the change unless the contrary is established by clear and convincing evidence. Stated in more technical language, a parachute payment means any payment (other than an exempt payment, as defined in the regulations), that is: (i) in the nature of compensation; (ii) is made or is to be made to (or for the benefit of) a disqualified individual; (iii) is contingent on a change—(a)in the ownership of a corporation; (b)in the effective control of a corporation; or (iii) in the ownership of a substantial portion of the assets of a corporation; and (iv) has an aggregate present value of at least 3 times the individual's base amount.

A “disqualified individual” includes an officer, shareholder, or highly compensated individual (including a personal service corporation or similar entity), as well as any employee, independent contractor, or other person who performs personal services for the corporation and is specified in regulations. A disqualified individual's “base amount” is defined by reference to the individual's average annual taxable compensation for a five-year base period preceding the change of control or ownership. The parachute payments that are compared with three times the base amount to determine the excess parachute payments are net of an allowance for amounts established as reasonable compensation for personal services that were rendered before the change (if not already compensated for) or that are to be rendered after the change. The definition of “base amount” not only determines whether § 280G will apply but also determines the amount of the deduction limitation, since only payments in excess of the portion of the base amount allocable to the payment are nondeductible.

While many compensation agreements will be, by statutory presumption, subject to § 280G because they were made or modified within one year before the change in ownership, others must be shown to be contingent on the change. The arrangement must also be pursuant to a prescribed “change in ownership” transaction. Generally, “change in ownership” means the acquisition of more than 50% of the corporate stock (tested by vote or value) by one person or by a group of persons acting in concert. A change in effective control is presumed to occur when one person or a group acting in concert acquires 20% or more of the total voting power or when a majority of the board is replaced during a twelve-month period against the wishes of a majority of the old board. See Square D Co and Subsidiaries v. Comm’r,  121 TC 168 (2003).

Section 280G applies whether a change in ownership or control is friendly or hostile and whether the corporation is closely held or publicly traded. There are, however, two important exceptions that cause the change of control transaction to be exempt from application of §280G and §4999: (i) a “small business corporation,” defined by § 1361(b) as a corporation that is eligible to elect S corporation status or ii) a corporation whose stock is not readily tradable (on an established securities market or otherwise), provided the parachute payment is approved by the owners of more than 75% of the corporation's voting stock after adequate disclosure of all material facts. The provision is also inapplicable if the acquirer enter into a separate and independent contract with an employee (otherwise a disqualified person) after the change of ownership.

When §280G applies, there is also imposed on the recipient of the payment an excise tax under §4999(a) equal to 20% of an “excess parachute payment” . For this purpose, an “excess parachute payment is defined under the golden parachute rules, which deny a deduction to a corporation for any excess parachute payment that it makes §4999(b) .

The disallowance of the target corporation’s deductions under §280G will have a direct economic impact on the target shareholders. Such shareholders will bear the economic cost by the additional corporate level tax that will be imposed as well as the required withholding on the 20% excise tax. See §4999(c). Unfortunately, a disallowance of the corporation's deductions under § 280G will increase the loss suffered by the target shareholder group. This is because the target group bears the ultimate burden of both the golden parachute payments and the additional corporate tax attributable to § 280G , even if the shareholders sell out, because the well-advised buyer of stock will discount the value of the corporation by this dual burden on the corporation.

Congress again, also provided in §4999, to impose a 20% excise tax on the recipient of the parachute payment. Some  insiders will require the corporation to reimburse them if subject to the excise which in turn will increase the excess payment and in turn the excise payment. reimbursements will be additional parachute payments, creating a pyramid effect. On the other hand, corporations may attempt to write caps into parachute agreements to avoid excess payments or may attempt to characterize such excess amounts as loans. But see Yocum v. U.S., 96 AFTR2d 2005-5030 (Ct. Fed. Cl. 2005)(§4999 penalty imposed on retired CEO/president for payments received under restrictive stock agreement in  connection with corporation’s asset transfer to new co./joint venture: change in ownership occurred under §280G(b)(2)(A)(i)(II) triggering excise tax upon stock that became vested as result). See CCA 200923031 (June 5, 2009).

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At the present time the good people of the Swiss Federal Tax Administration are sorting out which of the thousands of requested names of US persons and account numbers with UBS will be turned over to the United States shortly in accordance with the U.S.-Swiss agreement.

In 2008 the Department of Justice and the Internal Revenue Service filed a court action in Federal District Court for the Southern District of Florida seeking to obtain information on UBS account holders through a John Doe summons. This led eventually to a February 2009 deferred prosecution agreement between the Department of Justice and UBS in which the bank accepted responsibility for a charge of conspiracy to defraud the United States admittedly perpetrated by its bankers and account managers. What some consider to be tantamount to a “slap on the wrist”,UBS agreed to pay $780 million in fines, penalties, interest, and restitution; close down its private wealth pitch to US persons from  its foreign based executives and disclose the names of U.S. clients. The agreement requires UBS to present to the IRS the remaining 4,500 names of U.S. clients of UBS AG owning or having beneficial interests in Swiss Accounts. The US government is moving forward beyond the UBS scandal to pursue other jurisdictions which have bank secrecy rules which are utilized by US persons and others to avoid detection and to potential evade the payment of income tax.

The Internal Revenue Service has indicated that it will use more John Doe summonses to identify U.S. taxpayers and others who are using offshore accounts and entities in tax haven and bank secrecy jurisdictions to evade U.S. tax as well as failing to report foreign financial accounts under the FBAR reporting requirements. Under § 7609(f) , a so-called John Doe summons is one that does not identify the person under investigation. It may be issued after a federal magistrate or district court judge determines: (i) the summons relates to the investigation of a particular person or ascertainable group or class of persons, (ii) there is reason to believe that the person, group, or class may fail or may have failed to comply with the tax laws, and (iii) the information sought and the identity of the persons whose liability is involved cannot be readily obtained from other sources. See. e.g., US v. Samuels, Kramer & Co., 712 F2d 1342 (9th Cir. 1983) .

Whistleblowers have also played an important role in assisting the U.S. investigations of offshore accounts, both inside and outside UBS, including former UBS banker Bradley Birkenfeld.   See §7623(b).

Under the limited amnesty program offered last year, it has been reported that 14,700 returns were filed under this special voluntary disclosure program for taxpayers with unreported income from offshore accounts. Under limited amnesty, taxpayers coming forward and reporting past omissions were required to pay either a 20% accuracy related penalty or a delinquency penalty on up to 6 years of non-compliance covered under the program plus a 20% penalty on the amount in the foreign bank account (FBAR penalties) in the year with the highest aggregate account or asset value, in lieu of all other applicable penalties.

It is presently uncertain as to how the IRS will generally treat those who decide to come forward and make a disclosure after the limited amnesty period has ended. The Service will obviously decide each of those disclosures on a case by case basis and decide which of the disclosures are appropriate for criminal prosecution as well. They already have.

More updates on this area in the future.

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The United States has entered into approximately 50 income tax treaties with various countries, including most of all the economically developed countries. Most tax treaties or tax conventions are negotiated using as a guide patterns established by a model treaty promulgated by the Organisation for Economic Cooperation and Development (OECD) , an organization of the developed countries of the world. The United States has its own model treaty which is used in general as a starting place for negotiations but  the U.S. Model  generally follows the OECD Model. Special provision is contained in the OECD Model as in most tax treaties for the treatment of nonresident income of athletes and entertainers. See OECD Model Treaty, Article 17.

The OECD Committee on Fiscal Affairs published a discussion draft on April 23, 2010 on the present uncertainty as to whether certain persons should be treated as entertainers or athletes (“artistes and sportsmen”) for purposes of Article 17 and is proposing a clarification by adding a ¶9.1 to the official Commentary on Article 17.

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Under Article 17, the country in which a nonresident entertainer or sportsman performs  may tax the income from these activities.  This special rule varies from that applied to the treatment of services rendered by non-residents in general. Thus, whether the personal services or activities of an entertainer or sportsman are involved must be determined and then the source and and allocation rules for activities performed in one or more countries of non-residence. The April draft proposal would clarify that contained within the definition of an entertainer or sportsman is anyone who acts as one, even for a single event, which of course is a very broad and somewhat all encompassing approach. Thus, one hockey game played in Canada by a U.S. citizen who resides in the U.S. would be sufficient or, as applied to entertainers, a U.K. actress permanently resident in England who receives a one-time fee for making a cameo appearance in a movie which was filmed in Spain.   Activities covered under Article 17 also include income from advertising or interviews derived by an entertainer or sportsman in the other state that are directly or indirectly related to an entertainment or sports event. The draft provides as an exception to the wide net set under the draft is for reporting or commenting on an entertainment or sports event where the reporter does not participate. In such instance the draft provides that such activity is not that of an entertainer or sportsman and is not covered under Article 17. Presumably coaching is not the same as reporting or commentating and presumably is within the scope of Article 17. The draft also addressed the source and allocation rules for activities performed in various countries as well as special categories of payments.  

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In LMSB-4-0510-017 (7/26/2010), the Deputy Commissioner International (LMSB) of the IRS set forth guidance under IRM: 4.51.5 with respect to certain gain recognition agreements ("GRA"). Section 367(a) or §367(d) may require a U.S. person to recognize gain on the transfer of property, including intangibles, to a foreign corporation unless one of several statutory exemptions is applicable, several of which require the filing of a GRA. The Treasury Department and the IRS issued final regulations under section 367(a) and on GRAs in February, 2009 (T.D.9446), replacing temporary regulations (T.D. 9311) that were issued in 2007, which final regulations increased the list of exceptions to §367(a).

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After an hour long television special last Thursday night, the "Decision" was announced on national television. LeBron James told the basketball world that he is taking his talents to South Beach and will play for the Miami Heat, joining superstars Dwayne Wade and Chris Bosh. The Miami Heat will be paying James over $100 Million over a 6 year period. As with many highly paid athletes and corporate executives, some of the compensation to be received by James may be deferred. Quite frankly, none of us at this time really know what the exact payment terms and schedule of payments were agreed to.

The deferral of compensation generally provides an advantageous tax result by delaying the taxation of such amounts. But to achieve this advantageous result, the requirements of Section 409A must be satisfied assuming, of course, that there is no income trigger resulting from application of the economic benefit or constructive receipt doctrines.

As the ink dries on James’ new employment agreement, as well as those of Dwayne Wade and Chris Bosh, the Miami Heat and James’ attorneys will have inevitably contemplated and believed, in good faith, to have satisfied the requirements contained in the statute and in the accompanying regulations. .

Section 409A enacted by Congress as part of the American Jobs Creation Act of 2004. The somewhat "over the top" provision was what Congress felt was necessary to respond to corporate excess and perceived abuses of Enron, WorldCom, and others. Also targeted were off shore deferred compensation arrangments.

Section 409A generally provides that if, at any time during a taxable year, a nonqualified deferred compensation plan such as an employment agreement fails, in form or in operation to meet certain requirements, then all compensation deferred under the plan for that taxable year, and all preceding taxable years, will be immediately included in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. To add insult to injury, in addition to the immediate taxation of the deferred compensation, when compensation is required to be included in gross income under Section 409A, an additional tax of 20% and interest, will be imposed on the amount included by the employee.

The application of Section 409A is surprisingly broad so as to include any delayed payment of compensation such as sign-on bonuses and certain severance benefits and payments. For example, if James is entitled to a sign-on bonus of $10 million from the Miami Heat that is paid over five years and James’ employment agreement does not comply with the requirements of Section 409A, then James in year 1 would receive $2 million in actual compensation but be responsible for payment of overover $5 million in taxes. James would most likely be unhappy with this result.

Earlier this year the IRS issued a notice which allows nonqualified deferred compensation plans to be corrected for certain Section 409A document failures with reduced current income inclusion and additional taxes. Fortunately, as part of the notice, the IRS provided a transition period so that the employee may avoid both income inclusion and additional taxes if the Section 409A document failures are corrected before December 31, 2010.

Section 409A essentially requires nonqualified deferred compensation plans to comply with three design and operational requirements to avoid immediate inclusion and additional taxation. First, the plan may not allow any deferred compensation to be distributed earlier than the occurrence of certain permissible distribution events such as a separation from service, disability, death, a time or a fixed schedule specified under the plan, a change in control, or an unforeseeable emergency. Second, except as otherwise provided, the plan may not permit the acceleration of the time or form of the payment of the deferred compensation. Finally, elections to defer compensation must be made within certain time periods that are set forth under the Section and its related regulations.

While I doubt LeBron focused on the Section 409A requirements in coming to terms with the Heat,  I am fairly certain his tax advisors were "right there" making sure the plan and payout requirements were satisfied for any deferrals agreed upon or timing for severance payments in the event of a termination.

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We are on notice that a significant increase in the number of transfer pricing examinations will be initiated by the IRS, both inbound and outbound. It is also expected that the Service will be asserting more frequently additions to tax under section 6662(e) for faulty transfer pricing practices. Taxpayers can expect additional penalty assertions, even if they have contemporaneous documentation. On the treaty side, Competent Authority personnel are increasingly available to field examiners to make sure that the proper documentation is provided and work on a coordinated basis in negotiating issues with foreign governments. Also expect a up-tick in information sharing with tax treaty countries. In this regard, it is reported that the process for IRS examiners to obtain information from foreign jurisdictions has been significantly streamlined, which has resulted in increased activity. Moreover, as recently mentioned in this blog, the United States is also working on a protocol to conduct joint audits with some U.S. tax treaty partners.

The IRS has recently announced that it will continue to emphasize transfer pricing issues as a key element in its efforts to foster international tax compliance. It is obvious that such renewed vigor is required due to the enormous and continuing growth in foreign based operations and foreign source income realized by U.S. multinational corporations. A second problem area is the continuation of efforts by taxpayers to engage in earnings stripping strategies employed by foreign based companies doing business in the United States. Some of these strategies violate arms length pricing standards and are in certain instances abusive and unsupportable on any level, particularly in the financing area. A third trend is the aggressive approach taken by some taxpayers who are residents of countries in which the U.S. has a tax treaty. To meet these challenges the IRS has embarked on a program of increasing LMSB staffing, selecting transfer pricing issue specialists, expand the number of economists in LMSB, and form a new LMSB transfer pricing practice, i.e, a nationwide group of transfer pricing experts. Thus, transfer pricing, together with withholding taxes and treatment of hybrid entities will be key facets of the international tax compliance initiatives of Commissioner Shulman.

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The Swiss parliament has finally given its approval to the settlement reach with the United States in attempting to resolve the UBS dispute for discovery of information related to US persons holding undisclosed bank accounts in Switzerland. The parliament has renounced a call to put the settlement for a voter referendum which had been called for by the lower house.Now, the agreement had been passed by both houses of the parliament, following a meeting last week of a settlement conference convened to work out differences between the two houses. In breaking the impasse, the lower house agreed to drop its demand for a referendum. In the end, many members of parliament abstained from the vote allowing the resolution for approval without a referendum to pass by a vote of 81 to 63 with 47 abstentions.

The August 19, 2009 settlement agreement, authorized the disclosure of client data, including client identiy, of 4,450 UBS accounts to resolve and settle the John Doe summons enforcement action pending in the Federal District for the Southern District of Florida. The deal required UBS make such disclosure. Parliamentary approval of the agreement became necessary following a January 21, 2010 adverse decision by the Swiss Federal Administrative Court holding that the agreement was insufficient to change the interpretation of "tax fraud and the like" as contained in the Switzerland-U.S. tax treaty.

Parliamentary approval of the agreement gives it the legal force of a treaty in Switzerland, allowing authorities to follow through with the disclosure of data on 4,450 UBS client accounts that was blocked by a January decision of the Federal Administrative Court. The court objected to the government's claim that the agreement could expand the definition of the treaty term "tax fraud and the like" to include long-term tax evasion.

Internal Revenue Service Commissioner Shulman stated in a press release that he was very pleased with the Swiss parliament’s decision and promised the IRS would "vigorously enforce the law" against offshore tax evaders.

The Swiss government said that following the approval of the agreement, "nothing stands in the way of UBS client details being disclosed" and that 1,200 cases are ready for immediate delivery. The Swiss Federal Tax Administration (SFTA) has also issued final decisions on 400 cases, with another 650 to follow shortly. Once a final decision has been issued, the subject individual is permitted to file an appeal within 30 days with the Federal Administrative Court.

It is reported that 500 disclosures have been made where U.S. clients of UBS consented to the release of their bank information. The remaining 1,450 cases are being processed by the Swiss taxing and should be completed by the agreement's August deadline.

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With the ever-increasing size of the global economy, more privately owned American companies are engaging in business operations outside of the United States. Whether the particular activity being set up outside of the US is capital and/or labor intensive, frequently the legal and tax advisors for the US company will recommend the formation of a foreign corporation be established in each jurisdiction in which the company intends to carry on business operations through a permanent establishment.  There may be a variety of reasons offered for such recommendation. Still, in some instances use of a foreign partnership or "hybrid" entity may be more suitable.

Still where a foreign corporation is the desired entity choice, the first issue is to what extent materials, capital and labor will be used in the foreign location.  Transfers of assets to a controlled foreign corporation does not always have a tax-free consequence. Ineed, the transfer of appreciated assets to a foreign corporation must run through the requirements under section 367 in order to determine whether and to what extent the transfers are non-taxable.

Section 367(a)(1) provides, subject to certain exceptions, that transfers of appreciated property to a foreign corporation will not qualify as a tax-free exchange for stock under section 351. Instead, gain must generally be recognized where the transferee is a foreign corporation. Exceptions are provided by the Code and in the regulations.

One of the more notable exceptions is made with respect to outbound transfers of stock or securities to a foreign corporation which is part of an overall reorganization or tax free exchange of stock. This is set forth under section 367(a)(2).

Another and perhaps broader exception is for transfers of property to a foreign corporation that will be used by the foreign corporation in the active conduct of a trade or business outside of the US. §367(a)(3). There are some types of property which will not qualify as part of the active trade or business exception. Such list includes inventory, installment obligations, accounts receivable, foreign currency intangible property, and property being leased by the transferor (except where leased to the transferee). Still, the incorporation of a foreign branch by transfer of its assets to a foreign corporation will result in the recapture of the excess foreign losses.

Section 367(a)(1) reaches out to tax transfers of appreciated property by a domestic partnership to a foreign corporation unless an exception can apply. This is treated as an indirect transfer of the assets by the partners.

Intangibles transferred to a foreign corporation present a major trap for the unwary. Generally, where a transfer of intangible assets is made to a foreign corporation, the transferor will generally be treated as having sold or transferred the intangible for payments which are contingent upon the productivity, use or disposition of the property. Thus, under section 367(d), the U.S. transferor of such intangibles must including in gross income each year over the useful life of the intangible or intangibles involved, an amount which reflects the amount which would have been received in the intangible(s) were sold. §367(d). In many instances it is far more preferable to license intangibles to the foreign based entity. Until regulations are issued, transfers of intangibles to entities taxable as partnerships do not run afoul of section 367(d).

Also under section 367(e) and accompanying regulations, gain is required to be recognized in two prescribed instances: (i) a US subsidiary corporation is required to recognize gain on the distribution of its assets to a foreign parent corporation and a foreign subsidiary which is also engage in a liquidation must also generally recognize gain in transferring its US business assets to its foreign parent corporation, subject to pertinent exceptions; and (ii) a US corporation which transfers the stock or securities of a controlled corporation recognizes gain to the extent such stock or securities are distributed to a foreign corporation.

The point being made in this short entry is that businesses seeking to expand their operations overseas must be advised from the inception of the expansion plan by tax counsel to ensure that the overall tax structure selected is sound, known in advance, and the associated costs are budgeted and predictable. The starting line in many cases is section 367. While this provision has many twists and turns that obviously could not be touched upon with any detail or completeness in this short message, it is also important to warn that there are indeed many other substantial tax considerations that touch upon planning for the expansion of business operations overseas.

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On June 8, 2010, Commissioner Douglas H. Shulman addressed members of the Organization for Economic Co-operation and Development (the "OECD") and leaders in the international tax and business community in Washington, D.C. The topic of his address was coordination of international tax compliance and tax administration. In starting off, Commissioner Shulman remarked that the "next rung in the evolutionary ladder of international tax administration is the progression from cooperation to coordinated action on global tax issues. This is a gradual process that will not take place in a day and a night. It will take time and deliberate and focused action".

This need for global cooperation on the audit level has become required due to an ever increasing globalization of capital markets, cross border flow of funds, technology advancements and off shore investment. This not only affects the US, Shulman noted, but the entire world. As Chair of the Forum on Tax Administration (FTA), the Commissioner acknowledged that he has been working with his international counterparts to build greater cooperation between tax authorities both domestically and internationally. Among the critical matters that need to be addressed with a "unified voice" include offshore compliance, corporate governance, high net worth individuals, coordinated joint audits and early competent authority resolution. Indeed, Shulman announced, the IRS is working on a protocol for joint audits with other countries. A joint audit does not necessarily mean a simultaneous exam but instead is a process where two or more countries join together to carry out a single audit of a company with cross-border business activities. The intended objective is increasing international tax compliance and perhaps reduce audit costs while increasing the level of service.

Benefits are also foreseeable in the competent authority Shulman added. Now and in prior years it could take years to resolve double-tax cases through the CA process. With a joint audit, identification of issues and assembling the material facts may be expedited and accelerate the time that the CA process needs to play itself out.

In moving forward with the joint audit approach, Shulman revealed that the FTA is developing a guide that would provide a how-to, practical approach that highlights pitfalls to avoid, and possible best practices to employ.

Commissioner Shulman also spoke of the updates on enforcement efforts pertaining to the Swiss government on the release of information on U.S. account holders of UBS and the number of individuals, approximately 15,000, who made timely disclosures under the VDP program initiated last year in response to the UBS crisis. Shulman noted that 97% of those who filed were accepted into the program.

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It is a generally accepted axiom of international income taxation that a U.S. tax treaty will prevent the taxation of the business profits of a resident of a treaty county, unless the profits in question are attributable to a "permanent establishment" that is maintained by that resident in the United States. See, e.g., U.S. treaties with Canada art. 7(1) ; Japan art. 8(1) ; Netherlands art. 3(1) ; United Kingdom art. 7(1) . Thus, in planning for a foreign person’s inbound investment in the U.S., and based on such foreign person’s status as a resident of a treaty country, the critical terms will be evaluating whether the foreign persons’ activities constitute a "permanent establishment" and the definition of "business profits". As to the latter term, see See, e.g., Japan art. 8(5) (manufacturing, mercantile, insurance, agricultural, fishing, or mining activities); Netherlands art. 3(5) (active conduct of trade or business); United Kingdom art. 7(7) (manufacturing, mercantile, banking, insurance, agricultural, fishing, or mining activities).

Where a permanent establishment is maintained in the U.S. the source country can tax the the business profits of the foreign person but only to the extent that the business profits that are attributable to the permanent establishment. If a taxpayer has a permanent establishment, a U.S. treaty does not exempt the resulting business profits but may limit the U.S. taxation. Typically, the treaty allows U.S. taxes to apply only to the business profits that are "attributable" to the permanent establishment. See, e.g., Canada art 7(1) ; Japan art. 8(1) ; Netherlands art. 3(1) ; United Kingdom art 7(1).

Where U.S. business type activities are conducted through a pass through entity such as a partnership, the character of the income passes through to any foreign partner. Therefore if the partnership maintains a permanent establishment in the U.S., any foreign partner will be treated as so engaged. Rev. Rul. 85-60, 1985-1 CB 187 (U.S. tax applied to foreign beneficiary of foreign trust that was limited partner in partnership with U.S. permanent establishment). Rev. Rul. 91-32, 1991-1 CB 107 (situation 3). See also Donroy, Ltd. v. United States, 301 F2d 200 (9th Cir. 1962), aff'g 196 F. Supp. 54 (ND Calif. 1961); WC Johnston v. Comm'r, 24 TC 920 (1955) (Canadian individual was taxable on his share of income of general partnership with a U.S. permanent establishment); Robert Unger v. Comm'r, P-H TC Memo. ¶ 90,015 (1990), aff’d 936 F.2d 1316 (DC Cir. 1991

While there are various formulations of the term "permanent establishment" under our tax treaties, generally it means a "fixed place of business" through which the business is carried on. See, e.g., Canada art. 5(1) ; Japan art. 9(1) ; Netherlands art. 2(1)(i)(A) ; United Kingdom art. 5(1) . Some examples may be listed in the statute as falling within or outside of the definition. For example, a "branch, office, factory or workshop" may be a permanent establishment. Another term used is "place of management". Generally tax treaties consider a mine, oil and gas well, quarry, or other place of extraction of natural resources as a permanent establishment. It is generally understood that the Service he Service ordinarily will not rule whether a taxpayer has a U.S. permanent establishment.

A treaty may list certain activities that a taxpayer may perform in the United States without being treated as having a U.S. permanent establishment. A list of such exceptions include: (i) facilities used for storage, display, or delivery of goods or merchandise belonging to the foreign person; (ii) storing goods or merchandise belonging to the resident for storage, display, or delivery or for processing by another person; (iii) the purchase of merchandise or collection of information; and (iv) advertising, research activities or similar activities that are preparatory in nature.

A growing concern in this area is when an agent of the foreign person can cause the principal to be treated a maintaining a permanent establishment in the U.S. A principal generally will not be deemed to have a U.S. permanent establishment merely because of carrying on business through a broker, general commission agent, or other independent agent. However, where a principal conducts business in the U.S. through an agent that is not independent and has and habitually exercises its authority to conclude contracts in the name of the principal such can cause the activity to be treated as part of a permanent establishment. See, e.g., Canada art. 5(5) ; Japan art. 9(4); Netherlands art. 2(1)(i)(D); United Kingdom art. 5(4) . For example, in Frank Handfield v. Comm’r, 23 T.C. 633 (1955) a Canadian manufactured postal cards in Canada which were sold in the United States through an agreement with a news company. The Tax Court held that under the agreement, the news company was the petitioner's agent for distributing the cards in the United States. It therefore concluded that the petitioner was engaged in business within the United States and income from sales in this country is subject to income taxes. Taisei Fire & Marine Ins. Co. v. Comm’r, 104 TC 535 (1995), acq. 1995-2 CB 1 .

The foregoing provides an over-simplified view of the permanent establishment concept. If the IRS successfully determines that a foreign person (of a treaty country) does have a permanent establishment in the US, then the foreign person will be subject to full U.S. income tax on the attributable profits. Employees or service providers of the foreign entity may also fall into a US employment tax whole as well with withholding consequences for the employer. It is possible that a branch tax issue may arise if the foreign person is incorporated, subject to treaty rate reduction. These are  just a few of the major consequences of a permanent establishment finding.

Therefore, it is critical in planning for a non-U.S. person’s investment in a business operation in the U.S. to carefully analyze whether and to what extent a permanent establishment risk is present.

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Section 280G provides, in general, that the service provider receiving an excess parachute payment must incur a 20% nondeductible excise tax on the excess portion of the parachute payment which is usually associated with a payment triggered by virtue of "change of control" provision in an executive employment agreement. An executive for this purpose is generally a highly compensated employee (top 1%), a 1% or more employee-shareholder or an officer or director within a certain time frame before the change of control event.

While there are several methods to mitigate the imposition of the excise tax under section 280G, such exceptions have limited access for many public companies. Legal counsel for service providers have also negotiated for gross-up payments (including double-gross ups) for reducing the cost to the service provider. The tax gross-ups, which are a function of the incremental excise tax , have provided comfort to key executives whose parachute payments have an "excess" component and run outside of the less than three to one (average past years compensation).

In November 2008 RiskMetrics Group (RMG), formerly known as ISS, announced a policy that it would consider tax gross-up payment for golden parachute treatment a "poor pay practice." With this pronouncement it is speculated among commentators who specialize in executive compensation planning that shareholders will not be so willing to approve golden parachute payments particularly those with "excess" amount profiles. Indeed, on commentator recently reported a recent study by Pearl Meyer & Partners for the National Association of Corporate Directors found that 61 Fortune 500 companies made material alterations to change in control benefits from November 2008 to August 2009 and that more than 10 percent of these agreements eliminated excise tax gross-up provisions. If a tax gross-up payment is to be eliminated, a cap on payments may be beneficial in avoiding falling into the excess category.

Public companies are therefore evaluating whether payments triggered on a change of control can be deflected over to a noncompetition agreement. Still, the regulations provide for compliance with a covenant not to compete to be treated as the equivalent of providing services after a change in control. Post-control services generally fall outside of the section 280G provision where the value of the future services is substantial, the covenant not to compete is "real" and has a "reasonable likelihood" of being enforced. .

There are several other strategies that are available to public companies and their executives to increase the amount that may be paid under the tipping point. The base amount used to determine the tipping point can be increased by exercising stock options, electing not to defer amounts under a nonqualified deferred compensation plan, and paying bonuses during the five-year period ending before the year of a change in control.⁷ The value of payments for purposes of the tipping point calculation can also be reduced by cashing out options on a change in control, which limits the value to the cash-out amount (as opposed to a higher fair value associated with an unexercised option that could be exercised for a prolonged period after a change in control).²⁸ Also, reasonable compensation for services to be rendered after a change in control includes payments received by an executive as bona fide damages for breach of contract because of an involuntary termination without cause.²⁹ This exemption may apply when the payments do not exceed the present value of the compensation that would have been paid during the remainder of the contract term, the executive demonstrates a willingness to work that is rejected by the buyer, and the amounts to be paid as damages are reduced to the extent the executive has earned income from other sources during the remainder of the contract term.

Thus, the planning environment on highly compensated executives, officers and directors of public companies and other taxpayers subject to the excess parachute provisions may be tilting strongly towards dropping the gross-up concept in mitigating the service provider’s cost. This means that a more careful analytical and legal analysis must be made as to the package of compensation benefits a particular executive is presently receiving and what is required to be paid out on a change of control as defined in the regulations.

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A issue of some significance in international taxation is the distinction required to be made by the taxing authorities as to the character of income derived from “shrink-wrapped” software, i.e., whether it is income from the license of a copyright itself or is income from a copyrighted article.  This in turn leads to the interrelated question of whether related receipts constitute “royalty income” or “trade or business income”. 

The distinction is critical of course since royalties are generally subject to flat rate tax and withholding from the source country (or no source taxation under applicable treaty) whereas business income can be taxed on a net basis in the jurisdiction in which the foreign company maintains a permanent establishment.  

A recent article on this issue authored by S. P. Singh and Sharad Goyal which was published in the Journal of International Taxation, April 2010, briefly addressed the treatment given under the Indian domestic tax law and tax treaties, i.e., a royalty is taxed irrespective of whether the foreign company has any presence in India. Business income, in comparison, is only taxed under Indian tax treaty it is reported only if there is a permanent establishment in India. In contrast, business income is taxable in the hands of a foreign company only if it has a permanent establishment in India.

Messrs. Singh and Goyal report that Indian revenue authorities have consistently taken the position that payments from the sale of software, regardless of whether it is over the counter type shrink-wrapped software or customized software, are both royalty income. While neither the Supreme Court of India nor an appellate court has not addressed this issue, the Indian Tax Appellate Tribunal (ITAT) has held that the payments amount to business income and not royalties. This decision was reached in Infrasoft Limited, where the ITAT (Delhi Bench) held that the amount received by a nonresident under a license agreement for allowing the use of standard software was not a "royalty" under either the Indian Income Tax Act, 1961 (ITA) or the India-U.S. income tax treaty . Infrasoft Limited v. ADIT, Order of the Delhi Bench of ITAT, 2009-TIOL-21-ITAT-DEL (2009). As pointed out by the authors, the position taken by the Indian revenue authorities is not entirely consistent with the approach taken in other jurisdictions.

Shrink-wrapped computer software is usually sold under a licensing agreement whereby the buyer is granted limited right to use the program for business or personal purposes. The copyright or patent remains owned by the seller/manufacturer of the material. The buyer is precluded from transferring or altering the program. If all rights with respect to the copyright are not transferred to the buyer, the issue is whether the transaction is taxable as royalty income for the use of the copyright or involves the purchase of copyrighted material taxable as business income.

The Model Treaties, i.e., OECD Model and U.N. Model, treat the taxation of royalties differently. Under the OECD model, the country of residence alone has the right to tax royalty income whereas the U.N. Model permits taxation in the source country as well. With respect to “software”, the starting point is to determine if the transaction involved is in fact a software transaction as well as how the transfer of the intellectual property is made. Transactions in intangibles are usually either transfers of full ownership or limited transfers of rights. Transfers of full ownership are taxable as "business income," as the payment is not consideration for “the use of, or the right to use” the property. If the payment is for partial rights in the copyright, it will be considered a royalty. This approach is applicable as well with respect to transactions in software. See Article 12 (Royalties) of the 2008 OECD Model. Again, where only part of the rights in the copyrighted software material is transferred, the transaction is generally treated as a royalty.  Compare Article 7 (Business Profits).

The authors point out that one of the problem areas involves the taxation of software distributors who are generally granted the right to copy the material and re-sell the copyrighted material in certain locations. Does this right to copy convert royalty income into business income? Presumably receipts from such reproduction and sale constitutes  business income to the software distributor. But there are countries such as Canada, Spain, Korea, Portugal and Mexico that are reported to disagree with this approach and treat such receipts as royalty income and impose a concomitant withholding obligation.  The approach in the OECD commentary, however, is not acceptable to some tax jurisdictions, including Canada, Spain, Greece, Korea, Portugal, and Mexico, which impose withholding tax on royalty income. For U.S. income tax treatment of copyrighted materials see Treas. Reg. §1.861-18.

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IRS Notice 2010-44

The IRS, on May 17, 2010, released Notice 2010-44 as new guidance for small businesses in determining to what extent they are eligible for the new health care tax credit under Section 45R that was enacted as part of the Affordable Care Act, that was signed into law on March 23, 2010.

Section 45R provides a federal income tax credit for eligible small employers, including tax-exempt organizations, that make nonelective contributions towards their employees’ health insurance premiums. An "eligible" employer must have fewer than 25 full time equivalent (FTE) employees for a tax year; the average annual wages must be less than $50,000 per FTE and the employer must maintain a "qualifying arrangement" as defined in the Notice. Notice 2010-44 provides guidance for tax years beginning prior to January 1, 2014 and transition relief for tax years beginning in 2010. The Notice outlines steps which must be met in order to qualify for the credit. The credit is not reduced by the value of available state healthcare credits. The credit is available for limited scope health insurance programs such as dental and eye care where the employer provides at least 50% of those benefits. There are three methods set forth in the Notice for computing how many FTE employees the business has.

It should be noted that while the guidance was needed and is generally favorable, it is complicated in its content, including required calculations of FTEs.

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In a detailed and comprehensive review of the US-Canada Income Tax Convention, the recently issued Fifth Protocol, and the OECD Model Treaty and related Commentaries, as well as the domestic tax law treatment of single member limited liability companies, pass through entities and other organization, the Canadian Tax Court, in an opinion written by Patrick Boyle, on April 8, 2010, concluded that implicit in the clear intention of the OECD countries, including Canada and the US, that treaty benefits be enjoyed by TD LLC in the present circumstances, and given the context of the Canadian and US tax régimes and the text of the US Treaty : (i) TD LLC must be considered to be a resident of the US for purposes of the US Treaty otherwise the treaty could not apply; (ii) TD LLC must be considered to be liable to tax in the US by virtue of all of its income being fully and comprehensively taxed under the US Code albeit at the member level; and (iii) the income of TD LLC must be considered to be subject to full and comprehensive taxation under the US Code by reason of a criterion similar in nature to the enumerated grounds in Article IV, namely the place of incorporation of its member which is the very reason that TD LLC's income is subject to full taxation in the US. the Tax Court of Canada held that a single member US LLC was a US resident for the purposes of the Canada-US Tax Treaty. As "resident", the US LLC was entitled to branch tax relief on Article X (Dividends) under the U.S.-Canada Tax Treaty. The decision overrides the long-standing position adopted by the Canada-Revenue Agency that a US LLC is not"resident in the U.S." for treaty purposes on the rationale that income is not subject to the most comprehensive form of taxation in the U.S. at the entity level.

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The IRS recently startled the corporate tax community, which community stills is struggling to effectively deal  with, i.e., successfully block,  Textron type summonses for the production of tax accrual workpapers and FIN 48 workpapers, by announcing in Annoucement 2010-9, a proposal which would require, for the first time,  “large corporations” to  report uncertain tax positions on a new schedule to be filed with their annual tax returns. I

In Textron v. United States,  an en banc decision of the First Circuit Court of Appeals,  held  that the work-product privilege was not implicated with regard to the taxpayer's tax accrual workpapers, because it found that the workpapers were not prepared “for” litigation and were required to be produced pursuant to an IRS administrative summons. 104 AFTR 2d 2009-5719 , 577 F3d 21 , 2009-2 USTC ¶50574 (CA-1, 2009), vacating and remanding 100 AFTR 2d 2007-5848 , 2007-2 USTC ¶50605 , 507 F Supp 2d 138 (DC R.I., 2007), aff'd in part and remanded in part 103 AFTR 2d 2009-509 , 553 F3d 87 , 2009-1 USTC ¶50167 (CA-1, 2009), vac'd by 560 F.3d 513 , 103 AFTR2d 2009-1436 (CA-1, 2009). Compare, the Fifth Circuit's decision in El Paso Co., 50 AFTR 2d 82-5530 , 682 F2d 530 , 82-2 USTC ¶9534 (CA-5, 1982) (primary purpose test) with various circuits applying the broader “because of ... in anticipation of litigation” or “but for ... in anticipation of litigation” tests used in describing work product. See, e.g.,  Roxworthy, 98 AFTR 2d 2006-5964 , 457 F3d 590 , 2006-2 USTC ¶50458 (CA-6, 2006); Adlman, 76 AFTR 2d 95-7188 , 68 F3d 1495 , 95-2 USTC ¶50579 (CA-2, 1995) (memorandum containing opinion work product relating to potential tax litigation arising out of a proposed merger may be protected);  Binks Mfg. Co. v. Nat'l Presto Indus., Inc., 709 F2d 1109 (CA-7, 1983); Senate of Puerto Rico, 823 F2d 574 (DC D.C., 1987); In re Sealed Case, 146 F3d 881 (DC D.C., 1998); In re Grand Jury Proceedings, 604 F2d 798 (CA-3, 1979); Simon v. G.D. Searle & Co., 816 F2d 397 (CA-8, 1987); In re Grand Jury Subpoena, 357 F3d 900 (CA-9, 2004); National Union Fire Insurance Co. v. Murray Sheet Metal Co., Inc., 967 F2d 980 (CA-4, 1992). See, in general,  August & Grimes,  “The Discovery Status of Tax Accrual Workpapers After Textron”, Business Entities (WG&L), Jan/Feb 2010. See also  August and Grimes, “Ability of IRS to Discover Tax Accrual and FIN 48 Workpapers”, 10 BET 6 (November/December 2008); August “Attorney-Client Privilege and Work-Product Doctrine in Federal Tax Matters,” 10 BET 4 (July/August 2008); and August, “Understanding Fin 48: Accounting for Uncertainty in Income Taxes,” 10 BET 30 (May/June 2008). 

Inviting comments from the tax professional community, which deadline recently passed at the end of March and the tenor of which can be expected to be particularly critical of the proposed measure, the IRS should be expected to require such reporting.  Why? Because it bypasses litigation over summonses enforcement actions under §§7602 or 7609 (third party recordkeeper).  It’s the economical way to get to the taxpayer’s innermost thoughts and anxieties over which items on the return may not survive “sunshine” and challenge from the IRS and if challenged what is the “worst case” economic impact from the positions disclosed.   Because the prospect that the form request may in effect ask clients to waiver privileged information communicated with its outside or in-house tax or general counsel, federal tax practitioner or the work product , particularly mental impressions of its tax and financial advisers on the same subject, litigation  with respect  to the form should be anticipated. Yet, since the form initiative, if passed, would be required to constitute a return, the non-complying large business taxpayer may fail to disclose at the risk of an extended or no statute of limitations for such year and face the prospects of penalties. Tax return preparers who fail to make the required disclosure face the prospect of preparer penalties and possible charges for violation of Circular 230.

While the Service could yank its proposal over the overwhelming criticisms it will undoubtedly hear, its litigation position on required return information may pose to bid a formidable obstacle to challenge successfully.  See, e.g., litigation arising under §6050I. Yet, in its Annoucement the Service was undoubtedly concerned about its “image” in this effort and therefore backs off slightly, at least from an appearance standpoint,  by stating at the same time that it otherwise plans to continue its policy of restraint for requesting tax accrual workpapers during an examination. The schedule will require the annual disclosure of uncertain tax positions in the form of a concise description of those positions and information about their magnitude.

Let’s get more specific about what Annoucement 2010-9 would, in its present proposed form, require be filed by corporations that have more than $10 million in assets and one or more uncertain tax positions to disclose those positions to the IRS. The businesses would file a IRS form schedule with the corporate income tax return or other business tax return, i.e., if an unincorporated entity has one or more large corporations as partners or members. 

The schedule would require (1) a concise description of each uncertain position for which the taxpayer or a related entity has recorded a reserve in its financial statement and (2) the maximum amount of potential federal tax liability attributable to each uncertain position -- determined without regard to the taxpayer's risk analysis of its likelihood of prevailing on the merits.  Uncertain tax positions also would include any position related to the determination of any U.S. tax liability for which a taxpayer or related entity has not recorded a tax reserve because the taxpayer (1) expects to litigate the position or (2) has determined that the IRS has a general administrative practice not to examine the position. A related entity is any entity related to the taxpayer under §§ 267(b), 318(a), or 707(b).
 

The proposal does not require the taxpayer to disclose the taxpayer's risk assessment or tax reserve amounts, even though the Service can compel the production of this information through a summons. United States v. Arthur Young, 465 U.S. 805, 815 (1984). While the Service, again, intends to require the reporting of uncertain tax positions, the Service is proposing to otherwise retain its existing policy of restraint as described in Announcement 2002-63, 2002-2 C.B. 72, and IRM 4.10.20.
 

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Typically, the parent  corporation of a U.S. based consolidated group of corporations will act as the primary source of capital to members of the group. Thus, for example,  the parent corporation may borrow funds from a third party lender and then loan such funds to finance its subsidiaries' business operations. 

When the consolidated group engages in a sale of one of the debtor subsidiaries, frequently efforts will be made to pay back the parent corporation prior to the sale for obvious reasons, i.e., the buyer does not want the target subsidiary to owe funds to the seller (parent).  In many instances, however, the pay back or forgiveness of the indebtedness can result in offsetting income and deduction items to the members.  

In general, where  the intercompany receivable (held by the parent corporation for example) has a value worth less than face, the parent may claim a bad debt expense while the subsidiary recognizes cancellation of indebtedness income. While these amounts will frequently result in a "wash", the results are not entirely neutral. Where there is cancellation of indebtedness income, such amount will  increase the adjusted basis of the debtor subsidiary's stock under the consolidated return "investment adjustment" rules. If the parent recognizes a loss on the sale of the subsidiary's stock, some or all of the loss attributable to that last-minute stock basis increase may be disallowed.

The unified loss and investment basis adjustment regulations to the consolidated return rules must be carefully analyzed and applied when engaged in "cleaning up" a target subsidiary's balance sheet prior to a sale of its stock.

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As previously reported, the IRS published in June, 2009, temporary and proposed regulations to §7874 which modified an example contained in former Temp.Reg. §1.7874-2T(e)(5), Ex.3 that may have created an unintended or unforeseen method of avoiding the 80% stock ownership test under §7874(b).

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With baseball season in full swing this Spring, many following America’s favorite pastime may have overlooked the issue of important and final regulations on the taxation of corporate inversions under §7874. The IRS issued final regulations on May 19, 2008 on the taxation of corporate inversions in which U.S. companies effectively reincorporate offshore by merging into a foreign surrogate.

As background, during the 1990s and early 2000s, several large, public, domestic corporations, reincorporated as foreign corporations, i.e., by establishing a foreign parent holding company over the U.S. subsidiary group, without changing the mode of their business operations or management oversight conducted primarily within the U.S. Inversion transactions can be effectuate several ways, including asset inversions, stock inversions or a combination of the two. Thus, for example, a stock inversion is effectuated by a U.S. corporation forming a foreign (parent) corporation, which then organizes a domestic merger subsidiary. The U.S. merger subsidiary then merges into the U.S. corporation with the U.S. corporation surviving (reverse triangular merger). The U.S. shareholders exchange stock of the foreign corporation for their U.S. shares. As part of the inversion planning, the U.S. corporation may transfer some or all of its foreign subsidiaries directly into the new foreign parent corporation or other related foreign corporations. Additional features of the well-designed inversion included earnings stripping exercises such as payments of interest, rents, fees or royalties to the new foreign parent or other foreign affiliates.

Inversion transactions are typically not tax-free to all participants. U.S. shareholders generally must recognize gain (but not loss) under §367(a), upon exchanging stock of a domestic corporation for shares of the new foreign parent. A domestic corporation may also recognize gain on transferring stock of a foreign subsidiary or other assets to a foreign member of the newly constituted group. For example, a domestic corporation recognizes gain under § 367(b) on the exchange of stock of a controlled foreign corporation (“CFC”) for stock of another foreign corporation which is not a CFC.

What §7874 attacks, which generally applies to inversions occurring after March 4, 2003, is by providing that the foreign corporation following an inversion will still be considered as “domestic” corporation for U.S. tax purposes, even though it is organized under the laws of a foreign country, if at least 80% of its stock is owned by former shareholders of the inverted domestic corporation. Where ownership by former shareholders of the inverted corporation is less than 80% but 60% or more, special rules apply to ensure that the corporation pays U.S. tax on gains recognized in transactions carried out to effectuate the inversion. Recognizing that the U.S. shareholders were required to pay capital gains taxes on the exchange, Congress also decided to imposed a 15% excise tax on the value of options and other stock-based compensation outstanding when a corporation inverts. The statute sets forth a set of complex definitions and applicable rules pertaining to a so-called “expatriated entity” which includes a domestic corporation or partnership to which a foreign corporation is a “surrogate foreign corporation.”

The IRS issued final regulations (T.D. 9399) maintain much of the provisions set forth under the temporary regulations in determining the scope of the inverted company’s expanded affiliate group of subsidiaries. Many tax practitioners have been reported by the tax press to be concerned about the overbreadth of the final regulations, in particular, the failure for the Service to provide an exception for the issuance of plain vanilla preferred stock in apply the stock percentage tests. Yet, on the other hand, certain rules pertaining to ownership by affiliates seems to make it easier to avoid the inversion provision. The final regulations add that Treasury is aware some taxpayers may be attempting to avoid the application of §7874 by structuring the inversion of a U.S. entity into a foreign entity through the use of intervening partnerships, resulting in an ownership fraction of zero. The IRS announced it was considering publishing additional regulations to address end around inversion strategies that in substance fall within Congress intent as what would constitute an inversion transaction for purposes of §7874.

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Tax practitioners, and particularly tax lawyers drafting, reviewing and/or negotiating partnership or limited liability company agreements for clients engaged in a business or investment joint venture, know the importance of meeting the substantial economic effect test under the regulations to §704(b), which is a form of safe harbor contained in federal income tax regulations. But capital accounts, as determined for book purposes as compared to for tax purposes, are critically important in understanding the economics of the particular business venture or “deal” as many are prone to say. Clients may think percentage of ownership in the deal or cash flow preferences are critical to set forth in the document. Of course they are. But added to the mix is the idea that for liquidations or other asset bailout strategies, the joint venturers, be it as partners in a partnership, or as members in a limited liability company, must understand capital accounts and the requirement under the regulations that liquidating distributions must be made in accordance with positive capital account balances. Where a partner has a deficit capital account on liquidation, strict capital account rules require that the partner must be obligated to restore its deficit balance, etc., to meet the safe harbor test.

The safe harbor “substantial economic effect” test, set forth in substantial detail in the regulations, permits the partners to allocate tax items among the participants so that the allocations have a corresponding substantial economic effect. Otherwise, allocations of tax items which do not meet the requirements of the safe harbor are respected only if in accordance with the partner’s interest in the partnership. Treas. Reg. §1.704-1(b)(1)(i) . Where the applicable standards are left unsatisfied, i.e., where the partners are reluctant to put in deficit capital account restoration provision, the Service may reallocate tax items to reflect each partner’s economic interest in the partnership. Treas. Reg. §1.704-1(b)(3)(i). This analysis generally has the Service (or a court in review) looking at how would the sales proceeds be divided among the members if all of the partnership’s assets were sold and the partnership liquidated. While both tests essentially are evaluating the allocation of tax items within the context of their economic interests, the partner’s interest in the partnership method for testing allocations is certainly unpredictable.

The lack of client understanding or acceptance of the role of maintaining and distribution out assets (in liquidation) in accordance with capital accounts has, in certain instances, given thought to more creative methods for determining a partner’s interest in the venture. The thought is that the percentage of ownership in the venture, by analogy to corporate law concepts, should be paramount. Indeed, there may be various instances where clients sign a partnership type agreement and really do not understand the capital account concept and its impact on the rights and interests of the partners. Some have, in response to the criticisms leveled at the complex capital account maintenance rules, permit distributions of cash and other assets to lead the allocation of income and loss. If the draftsmen is not sufficiently sophisticated in drafting legal agreements of this type, it would be best to avoid using this architecture. Those who prefer such other formulas, including corporate type proportionate ownership formulas, run the risk that the Service will have a great degree of flexibility in reallocating tax items among the parties in the event of an audit which predictably would require a fair degree of involvement by tax counsel for the partnership and perhaps counsel for the partners in avoiding an adverse impact for their clients.

The overriding point to be made here is that lawyers drafting partnership and LLC agreements must clearly understand the terms of the deal, whether there are distributional preferences for net cash flow from operations, refinancings, sales and liquidating distributions and how income or loss allocations will be made and to what extent such allocations will effect the partners’ rights in the deal. In many instances a business lawyer may trust the language used in a form from another deal with differing economic formulas and allocations, and assume it will work in the current deal she or he is involved with as well as pass IRS muster. The suggestion here, go over the cash flow, allocation of tax items and distribution provisions, including liquidating distributions, so that clients understand the economics and sign off on the deal. It helps for the client to recognize that normal corporate share ownership norms can frequently vary from capital account rules and principles. Clients and their legal counsel must carefully evaluate whether or not to apply strict capital account based principals in entering into partnership and LLC agreements.

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The Fifth Circuit Court of Appeals, in a per curiam decision, affirmed the findings and holding of the Tax Court and upheld the imposition of an accuracy related penalty on a husband and wife based on the record before the court. The testimony proferred by each side was conflicting, which is frequently if not generally true in tax litigation proceedings, but the Tax Court found that the taxpayer had not met its burden of production that it acted in good faith and reasonable cause in relying on their accountant who prepared their returns. See §6664(c)(1). Tax Court held that the Prudhommes did not meet this standard because they provided their accountants with insufficient information to prepare the tax return accurately and did not make a reasonable effort to assess their proper tax liability.

After operating a family business for a period of years, the taxpayers sold the business for approximately $11M with approximately one half or $5.5M received in cash, the acquiring company’s stock, valued at $2M and a promissory note for $3.5M. The sale took place in 2003 and the Prudhommes long-standing accounting firm prepared the return which was timely filed after extensions were applied for. The tax return omitted substantial amount of the sales proceeds resulting in additional taxes that were assessed by the Service in the amount of $576,728 which was paid in November, 2005. The accounting firm admitted during the audit that the error was its error. The taxpayers challenged a 20 percent underpayment (accuracy related) penalty and small penalty for failure to pay the correct amount of estimate taxes. The IRS contended that the taxpayers failed to properly notify the accounting firm of the total amount of sales proceeds it received in the transaction, including a $3.2M dividend they received from the sale. A Tax Court petition subsequently followed on the issue of the penalties.

On appeal to the Fifth Circuit, the Prudhommes asserted that the lower court’s findings of a lack of reasonable cause or acting in good faith on the part of the taxpayers was clearly erroneous. The Fifth Circuit was faced, under its applicable standard of review under §7482(a)(1), as to whether the Tax Court’s fact findings were clearly erroneous.

The Treasury regulations provide that "[t]he determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances." Treas. Reg. § 1.6664-4(b). "Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Id. The regulations also state that a court must consider whether the taxpayer made "an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer." Id. That is, even if a taxpayer relies on an expert, the court still must take into account "[a]ll facts and circumstances" regarding whether that reliance was reasonable and in good faith, including the "taxpayer's education, sophistication and business experience."Treas. Reg. § 1.6664-4(c)(1). Case law reveals that the most important factor is "'the extent of the taxpayer's effort to assess [his] proper tax liability' is '[g]enerally[] the most important factor' in determining reasonable cause and good faith." Stanford v. Comm'r, 152 F.3d 450, 460-61 (5th Cir. 1998) (quoting Treas. Reg. § 1.6664-4(b)). In other words, reliance on a tax professional, however, must be reasonable, and simply relying on a professional is not dispositive. While a taxpayer in avoiding the penalty based on reliance on a tax professional does not require obtaining a second opinion, there is no good faith reliance wheref the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item." Treas. Reg. § 1.6664-4(c)(i); see Srivastava v. Comm'r, 220 F.3d 353, 367 (5th Cir. 2000) (rejecting argument that the taxpayers reasonably relied upon a professional because, inter alia, they never gave their accountant a copy of the settlement agreement subject to the tax).

The record established at trial, in the view of the Fifth Circuit, supported the Tax Court’s holding on the imposition of the penalties. First, the taxpayers did not fully reveal the details of the sale to the accounting firm. This included bank records, a large dividend distribution and other documents of the sale. Second, the court concluded that the Prudhommes did not make a good faith effort to assess their correct tax liability. The court noted that Richard Prudhomme did not even read or sign the return, that Cathy Prudhomme did not verify that all income from the sale of the company was on the return, and that both Prudhommes were not unsophisticated taxpayers but were successful business people.

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In SEC v. Microtune, Inc. (N.D. Tex. 6/4/09), the District Court for the Northern District of Texas held that documents, notes, memos and other material produced and maintained by a law firm and its agents for the purpose of conducting an internal investigation of alleged improper practices with respect to reporting stock options was discoverable by the SEC through the issuance of its subpoena over the company’s claims (motion to quash) of attorney client privilege and the work product doctrine.

The case involved an enforcement action by the Securities and Exchange Commission against the former Chairman and CEO, Bartek, and the former CFO, Richardson, for their role in an alleged backdating scheme involving stock options of Microtune.

In June 2006, Microtune hired outside counsel, Andrews Kurth law firm, to conduct an internal investigation into the company’s stock option practices. Such legal counsel hired an outside accounting, Grant Thornton LLP, to assist in its efforts. In February and July 2007, Andrews Kurth presented its findings to the SEC, in the process turning over hundreds of pages of documents and other information gathered during the internal investigation. Approximately one year later, the SEC filed civil charges against Microtune, Bartek and Richardson allegeding the perpetration of a fraudulent stock option backdating scheme that had as its intended effect the improper awarding the defendants and other employees of millions of dollars in undisclosed compensation. Bartek and Richardson caused Microtune to grant backdated options, cancelling those options after the company's stock price dropped precipitously, and subsequently re-granting the same options at a substantially lower exercise price. According to the SEC's complaint, the re-grants were not, as required, accounted for using variable accounting, in part because Richardson and Bartek allegedly concealed the nature of the re-grants from Microtune's outside auditors and others.

There were SEC financial disclosure violations caused by the scheme as the backdated options resulted in the filing of false and misleading financial statements with the SEC. In particular, the SEC alleged that “Bartek directed others to backdate employment records, including offer letters, to establish falsified start dates and grant dates that preceded the actual dates when the new hires began working for Microtune.” The SEC sought penalties and other relief under Section 304 of the 2002 Sarbanes-Oxley Act, in order to prevent corporate executives to profit from money wrongfully earned while their companies mislead investors with false financial statements. Microtune, without admitting or denying wrongdoing, agreed to a permanent injunction against violations of the antifraud, financial reporting, books and records, internal controls, and proxy provisions of the federal securities laws. The SEC sought injunctive relief, disgorgement of wrongful profits, civil monetary penalties, officer and director bars, and reimbursement of profits from stock sales pursuant to Section 304 of the Sarbanes-Oxley Act against Bartek and Richardson. The company settled its liability out separately with the SEC, which presumably is proceeding against Bartek and Richardson.

Now for the production request made by the SEC. During discovery, the SEC subpoenaed internal investigation documents from Microtune, Andrews Kurth, Grant Thornton, and other law firms that had provided services to Microtune. Microtune moved to quash the subpoena on grounds of attorney-client and work product privileges. The District Court ruled in favor of the SEC in its June 4, 2009 decision. The attorney-client privilege was waived by Microtune’s voluntarily disclosing the internal investigation documents to the SEC and others.

The work product argument was also rejected because the evidence did not suggest that litigation concerns were the “primary motivating purpose” behind the documents' creation. The work product doctrine, sourced from the Supreme Court’s decision in Hickman v. Taylor, 329 U.S. 495 (1947) and now settled in FRCP 26(b)(3), holds that the work of preparing for trial demands insulation from opposing counsel's inquiries on a lawyer's research, analysis, legal theories, and mental impressions. The courts have used two tests in determining what is work product, which does not necessarily have to be prepared by a lawyer. The broader test is the “because of” test, which widens substantially the scope of what is work product. See United States v. Textron Inc. & Subsidiaries, 103 AFTR2d 2009-509, 520-23 (1st Cir. 2009), pending rehearing en banc. The other standard is that announced in the El Paso decision rendered by the 5th Cir., 682 F2d 530 (5th Cir. 1982), cert. denied, (1984) which asks if the primary purpose or motivation for engaging in the analysis, here the internal investigation, was in anticipation of litigation. If not, the work product doctrine does not apply. In is obviously of great difference whether the court applies the “because of……litigation” test versus the “primary purpose of …..litigation” test.

The decision in Microtune is presumably one of the first cases to extend such an analysis to internal investigation documents such that the documents are not protected unless the primary motivation behind their creation was the anticipation of litigation. This case should stand as a sharp reminder to counsel engaged in internal investigations to earmark that their work, memos, e-mails, power points, etc., are documented as primarily engaged in anticipation of litigation. For further background and analysis see, August, the Attorney-Client Privilege and Work-Product Doctrine in Federal Tax Matters, Business Entities (WG&L), Jul/Aug 2008.

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On June 25, the U.S. Bankruptcy Court for the Southern District of New York, Bankr. S.D. N.Y. No. 09-50026 (REG) June 25, 2009, issued a final order under §§105(a) and 362 of the Bankruptcy Act setting forth notification procedures and transfer restrictions pertaining to the transfer of GM stock retroactive to the filing of the petition before the court. It also scheduled a final hearing on open issues under the Chapter 11 proceeding.

As part of its final order the Court held: (i) that the Debtors’ net operating loss carryforwards "NOLs", foreign tax credits and other excess credit carryforwards, inotherwords the Debtors’ aggregate tax attributes, were property of the Debtors’ estates and are protected by section 362(a) of the Bankruptcy Code; (ii) unrestricted trading in GM stock could, before the Debtors' emergence from chapter 11 could severely limit the Debtors' ability to use the tax attributes for purposes of the Internal Revenue Code of 1986, as amended (i.e., by application of section 382 ownership change of the Code and related provisions); and (iii) with a view to preserving the maximium benefit or use of such tax attributes, set out detailed share transfer notification procedures and restrictions viewed as necessary and proper to preserve the tax attributes and in the best interests of the Debtors, their estates, and their creditors.

As background, where a corporation possessed with carryovers, i.e., NOLs, excess business or foreign tax losses, etc., undergoes an ownership change, section 382(a) imposes prospective use of such tax attributes. More specifically, an ownership change occurs if, for example, the percentage of stock owned by one or more of the corporation's 5% shareholders increases by more than 50% points over 3 year "testing period" on the day of any owner shift involving a "5% shareholder" as defined. As is true with public companies, section 382(g)(4) provides that stock owned by all shareholders who are not 5% shareholders is generally treated as owned by one 5% shareholder group n determining whether an ownership change has occurred. However, unless the corporation elects otherwise, the section 382(a) limitation does not apply to an ownership change if the old loss corporation is under the jurisdiction of a court in a Title 11 or similar case and the shareholders and qualified creditors, as defined, of the old loss corporation (determined immediately before the ownership change) own, as a result of being shareholders or creditors immediately before the change, stock of the new loss corporation constituting at least 50% of the total voting power and 50% of the total value of stock of the new loss corporation. See also Treas. Reg. §1.382-9(d)(3)(i)(debt "as always" equity rule). This paragraph is an oversimplification of the breadth and depth of section 382 to a corporation with tax attributes both in bankruptcy and non-bankrupcty contexts.

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Chief Counsel’s Office Announces Standard of Review for Litigating Cases Involving Innocent Spouse Relief Under Section 6015(f). (CC-2009-021)(June 30, 2009), supplementing CC-2004-26 (July 12, 2004).

The subject of "innocent spouse" relief is not new to tax practitioners and to many individuals who have had to endure the situation where signing a joint income tax return exposed the "non-liable" spouse, so to speak, with the spectre of joint and several liability. Section 6015(a) provides three avenues for a spouse filing a joint return to obtain relief. Under § 6015(b) , innocent spouse relief is available if the understatement of tax is attributable to erroneous items of one individual and the other individual did not know, or have reason to know, of the understatement and, taking into account all the facts and circumstances, it would be inequitable to hold that spouse liable. Section 6015(c) provides, for taxpayers who are no longer married, are legally separated, or not living together, for the liability of each spouse to be computed separately as if the spouses had filed separate returns for the taxable year if certain pre-requisites can be met. Finally, § 6015(f) is a general equity or "catch-all" rule that taking into account all the facts and circumstances, it would be inequitable to hold the spouse claiming innocent spouse status liable.

Chief Counsel’s Office sets forth a short history of recent case law under the general equitable relief rule, §6015(f). In Porter v. Comm’r, 130 T.C. 115 (2008) ("Porter I"), the Tax Court, following its prior opinion in Ewing, 122 T.C. 32 (2004), vacated, 439 F.3d 1009 (9th Cir. 2006), held that in determining whether the Commissioner abused his discretion in denying the petitioner relief under section 6015(f), the court conducts a trial de novo and may consider evidence introduced at trial that was not included in the administrative record developed during the administrative consideration of the claim. In Porter v. Commissioner, 132 T.C. No. 11 (April 23, 2009) ("Porter II"), the court reconsidered the standard of review in section 6015(f) cases and concluded that a de novo standard of review is proper. Thus, the Tax Court now will make its own de novo determination regarding whether a requesting spouse is entitled to relief under §6015(f) and will not be limited to evidence in the administrative record. The proper standard for review if that of "abuse of discretion". The Chief Counsel’s Advisory directs that attorneys should, therefore, continue to argue that, under an abuse of discretion standard of review, the scope of the Tax Court's review is limited to issues and evidence presented before Appeals or Examination. Attorneys should raise the scope and standard of review arguments whenever appropriate (e.g., in the pre-trial memo, at trial, and on brief), noting the Service's disagreement with the holding in the Porter I and II opinions.

To preserve the Porter issues for appeal, attorneys should continue to work with the petitioner to stipulate to the administrative record and should continue to raise a continuing evidentiary objection if the petitioner attempts to testify or otherwise enter evidence into the record that was not made available to the Service's examiner or Appeals Officer. If the court denies the evidentiary motion, additional evidence outside of the administrative record that may strengthen the Commissioner's case should be introduced into evidence . Other information and guidance is set forth in the Advisory.

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There is no accountant-client privilege recognized by the common law. U.S. v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999); FREV 501. In 1998, Congress provided a limited shield of confidentiality between a federally authorized tax practitioner and his client. This privilege is no broader than the existing attorney-client privilege. This is set forth in §7525, and in particular §7525(a)(1), which provides that "…with respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney. This federally recognized privilege can only be asserted in any noncriminal tax matter before the Internal Revenue Service; and any noncriminal tax proceeding in Federal court brought by or against the United States. §7525(a)(2). Moreover, the relatively new privilege does not apply to the rendering of business advice, accounting advice or tax return preparation advice. On the other hand, communications on legal matters raised in litigation or in anticipation of litigation are privileged by application of the work product doctrine. See FRCP 26(b). On the other side of the spectrum, communications about legal questions raised in litigation (or in anticipation of litigation) are privileged. The policy rationales under the attorney client privilege and the work product doctrine are distinctly different. As to the former, the courts give a narrow construction to the scope of the attorney client privilege inasmuch as such privilege runs contra to the search for truth. See U.S. v. Evans, 113 F.3d 1457, 1461 (7th Cir. 1997).

The Seventh Circuit, in Valero Energy Corp. v U.S., affirmed the U.S. District Court’s for the Northern District of Illinois, Eastern Division, order partially granting enforcement of an IRS summons issued to a company's tax advisers and directing the company to produce documents previously withheld under the tax practitioner privilege, upholding the court's finding that the tax shelter exception to the privilege applies. The tax issue pertained to a merger of Valero Energy and a Canadian company in 2001. Arthur Andersen LLP rendered tax and accounting advice on the transaction, including structure a purchase and disposition of certain financial instruments or positions which would generate large foreign source tax losses to offset gain realized in the acquisition. After finding out about the strategy in the financial press reporting the strategy saved Valero approximately $46M in taxes, the IRS issued a third party administrative summons on Arthur Andersen under §7609. Valero moved to quash the enforcement of the summons.

The lower court held that the tax practitioner privilege applied to some documents and the government had failed to meet its burden of showing that the tax shelter exception to the privilege applied. In a second ruling, the same district court found the government had established that some documents were discoverable under the "promotion" of tax shelter exception. Valero appealed to the Seventh Circuit.

The Seventh Circuit affirmed the district court's ruling. First, it agreed that certain documents were not privileged on the grounds that such documents were in the nature of business or accounting advice. Moving to the more noteworthy aspect of its opinion, the Appeals Court found that the exception under §7525(b)(2) did apply to certain materials sought to be produced. The appellant-Valero argued that to apply §7525(b)(2) there had to be a finding that the documents pertained to the "promotion of the direct or indirect participation of the person in a tax shelter". Here, Valero argued, there was no promotion since Arthur Andersen presented the tax strategy to it alone in order to reduce the tax impact of the merger and not as part of a pre-packaged promotion to various persons.

The appeals court rejected Valero’s argument which it found to create a conflict as far as Congress’ intent in defining tax shelter in §6662(d)(2)(C)(ii). "Nothing in this definition limits tax shelters to cookie-cutter products peddled by shady practitioners or distinguishes tax shelters from individualized tax advice," the court wrote. "Instead, the language is broad and encompasses any plan or arrangement whose significant purpose is to avoid or evade federal taxes." It also distinguished the case from Textron, 507 F. Supp. 2d 138 (2007), on the basis that the tax accrual workpapers involved in that case were not to be evaluated in the same light as pre-transactional documents and written advises rendered by a tax practitioner in the case before it. The Seventh Circuit added additional ingredients to its holding by stating in its opinion that the summons power held by the IRS goes to the "flip side of [the] coin" of our country’s self-reporting system. The section 7525 privilege "chips away at the IRS's summons power: we will not broaden it by narrowly interpreting exceptions without clear direction from Congress," the court stated.

The Seventh Circuit’s decision in Valero Energy reaches an opposite conclusion from the Tax Court’s recent decision in Countryside Limited Partnership et al.,132 T.C. No. 17 (June 8, 2009). In Countryside, Tax Court Judge James Halpern held that the section 7525(b) privilege exception for tax shelter promotion while not clear perhaps on its face did find support for the thought that it was not intended to apply to "routine relationships" between advisers and taxpayers as present before the Court.

In short, Valero Energy Corp. provides the government with a clear victory in its continued efforts to obtain tax opinions and related materials issued to clients by federal tax practitioners through the use of its summons power. Since the various courts that have looked at this issue previously gave the §7525(b)(2) exception a more narrow read, it will be interesting to follow how the issue continues to be received by the courts.

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