Federal Taxation Developments Blog

Tax Notes Reports on Comments Made by the Director of the IRS Whistleblower Office at a OffshoreAlert Conference Recently Held in Miami Beach

Jerald David August — Wed, 16 May 2012 09:56:36 -0500

In the May 14^th issue of Tax Notes, it was reported that Stephen Whitlock, director of the IRS Whistleblower Office, had made an appearance along with other IRS participants at the OffshoreAlert conference which was held at the Ritz-Carlton Hotel in Miami Beach.

Marchant, the editor of the newsletter OffshoreAlert, was hosting the concluding cocktail hour at his annual conference. Taken from its website, “[t]he OffshoreAlert Conference is an independent, non-promotional event covering every aspect of the fast-paced, ever-changing, complex world of Offshore Financial Centers and how they are routinely used by the world's biggest corporations and High Net Worth Individuals to minimize risk and maximize protection.” But why was a head of IRS offshore enforcement at the conference? That was clearly on the mind of Senator Chuck Grassley (R-Iowa), who stated his objection to the presence of Whitlock and other IRS employees at the conference. Perhaps it was because lawyers who represent whistleblowers were also in attendance. After all, Grassley has been critical of the fact that the Whistleblower Office was not processing a sufficient number of cases. But Grassley further expressed his displeasure about Whitlock and other governmental officials appearance at the conference that he wrote a strongly worded letter informing Treasury Secretary Timothy Geithner and IRS Commissioner Douglas Shulman about Miami trip, and he used the opportunity to express his impatience with the handling of his earlier complaints about the whistleblower program.

Portions of the letter are reproduced here:

Dear Secretary Geithner and Commissioner Shulman:

It has been seven months since I last wrote to Commissioner Shulman regarding the implementation of the whistleblower program at the Internal Revenue Service (IRS). While I was encouraged by the IRS's plodding but steady progress, I am now writing to convey my extreme disappointment in the management of the program. It was brought to my attention that the Director of the IRS Whistleblower program is currently participating in the Offshore Alert Conference (Conference) at the Ritz-Carlton in Miami Beach.

It is not clear to me how his attendance at the Conference furthers the administration of the IRS whistleblower program. The panel in which he is participating is titled "Enticing the Top Echelon: How the IRS, SEC and CFTC Attract High-Level Whistleblowers". Yet, the conference itself does not seem to attract whistleblowers. Under the "Who Attends" section of the conference's website, the following are listed: Global Financial Experts and Leading Offshore Firms and under "Who Should Attend" the following are listed: Offshore Providers, Offshore Clients, and Investigators"….

Separately, the Conference agenda lists at least two other IRS employees as "featured speakers", one a special advisor to the Offshore Compliance Initiative (OCI) and another who is a Special Trial Attorney to the OCI. The IRS's Offshore Voluntary Disclosure Initiative (OVDI) and its corresponding successes with combating offshore tax evasion are the result of whistleblowers coming forward following the improved IRS whistleblower incentives I authored in 2006. Assuming that these two individuals are involved with the OVDI program, I would expect that they could speak on behalf of the IRS Whistleblower Office.

However, I am skeptical that it is even appropriate for these two individuals to attend. There is certainly no reason for nineteen IRS employees to attend the conference as was reported to me just this morning. Again, the target audience for the conference is not whistleblowers, and, in a challenging fiscal time, this is not the best use of IRS resources. As a result, I ask that you provide the following information. (emphasis added).

Grassley proceeded to ask for detail of each person, by position and title who is an employee of the IRS or Chief Counsel who attended the conference and to further explain their justification for their attendance. He continued his sharp rebuke….

“Moreover, as I indicated in my September, 2011, letter, data from the IRS's own annual whistleblower report to Congress, as well as reports from the Government Accountability Office (GAO), make clear that the IRS does not have a problem attracting whistleblowers. The IRS's current problem is processing and compensating whistleblowers in a timely manner. Since last writing to Commissioner Shulman, I have received even more correspondence from whistleblowers whose claims are not progressing at the IRS. Such correspondence, along with recent cases filed in the Tax Court and corresponding press coverage, indicate that my worst fears are coming true. The lack of progress is demoralizing whistleblowers so that I am now concerned that whistleblowers will stop coming forward. In my September, 2011, letter, I asked for monthly updates about the number of claims sitting in the Whistleblower Office for review. The IRS has completely ignored this request and I now ask that you provide an update immediately.”

"The Whistleblower Executive Board was created in July 2008 and meets periodically to address matters pertinent to administration of the Whistleblower Program within the IRS. The Board has not yet reviewed an award claim recommendation or determination."

The IRS Internal Revenue Manual (IRM), section 25.2.2.8.2 states the following: "Prior to communicating the preliminary recommendation to the Whistleblower, the Director will share the preliminary recommendation with the Whistleblower Executive Board for concurrence." However, it is not clear how often this board meets. Provide a detailed list of all such meetings for the past three years and indicate when the next one will occur.

In my September, 2011, letter to Commissioner Shulman, I requested that the IRS implement the GAO's recommendations as well as a few others before the IRS submitted its next whistleblower report to Congress. The IRS response to the GAO indicated that IRS did not have the resources to implement those recommendations. As I stated in my letter, the money recovered from whistleblowers should more than cover the costs of implementing those recommendations.”

The balance of Grassley’s letter chronicled the lack of progress overall that the Whistleblower office had made to date, and among the particulars that whistleblowers were coming to his office to complain about delays in processing their claims. He demanded a progress report on final whistleblower regulations. (Section 406(b) and (c) of Title IV of Division A of the Tax Relief and Health Care Act of 2006 requires an annual report.)

Grassley is presently cosponsoring the Incorporation Transparency and Law Enforcement Assistance Act (S. 1483), which would require states to collect beneficial ownership information for corporations and limited liability companies. Non-transparent entities are used as well for Medicare fraud in addition to tax evasion. For whatever reason, S.1483 is opposed by the American Bar Association, the American Bankers Association, and the U.S. Chamber of Commerce. Publicly traded companies and broker-dealers would be exempt. FinCEN also has issued a notice of proposed rulemaking using a risk-based approach to ownership verification and explicitly requiring continuous monitoring of the customer relationship. FinCEN's alternative definition of beneficial owner would look for the entity's largest equity owner and responsible manager. The agency also advocated identification of owners of the assets in an account in some circumstances. FinCEN wants to phase in the identification requirement for existing customers.

At the ABA tax section meeting in San Diego earlier this year, Whitlock remarked that the IRS had paid about $20M in whistleblower awards on tax collections of $461M in 2010. In 2011 the IRS paid $8M in whistleblower claims based on $48M of collections. At the OffshoreAlert conference, Whitlock announcedhe could not provide even aggregate figures for the numbers and amounts of larger-case awards made under his program, because that might identify a taxpayer and jeopardize the program itself. The False Claims Act, however, allows the Justice Department to publicize awards. Under the False Claims Act, whistleblowers may bring their own cases to court. see Doc 2011-19478 or 2011 TNT 178-51 .)

A whistleblower (IRS) case takes five to seven years to complete from the time of the whistleblower's initial complaint. The case must be analyzed and the taxpayer audited. The taxpayer has rights to appeal that must be exhausted. The IRS tries to get the statute of limitations extended, especially when the taxpayer's conduct is continuing. Each case must be analyzed on its own merits.

A whistleblower cannot receive an award until the IRS recovers the associated taxes (section 7623(b)(1) refers to the collected proceeds). Technically, a net operating loss can wipe out the taxpayer's liability and the whistleblower's reward along with it, Whitlock acknowledged. Grassley complained about the failure to address this problem, and the IRS is reexamining the pertinent part of the Internal Revenue Manual.

The IRS Whistleblower Office acknowledged receiving approximately 3,500 submissions per year, about 10% of which are for tax liabilities of $2 million or more.

The IRS does not involve whistleblowers in case analysis or audits. A whistleblower may be debriefed while the claim is being evaluated, before the audit has begun, Whitlock explained. After the audit has begun, it's hands off. The results of investigations or audits are not announced. Whistleblowers who are denied awards are not told why their claims were closed. The IRS has the power to contract for a whistleblower's services -- a power Kelton says has never been invoked. See IRC section 6103(n) and Proc. Reg. section 301.6103(n)-1(b)). It is up to the IRS field and audit functions to pursue the complaint and, importantly, to evaluate how the whistleblower's information aided their audit. Section 7623(b)(1) requires that the whistleblower's information make a "substantial contribution" to the IRS action.

The tax statute does not guarantee a whistleblower anonymity, unlike the statutes governing SEC and CFTC whistleblowers that were enacted as part of the Dodd-Frank Act. Whitlock said the IRS tries to protect the whistleblower's identity, but it has to be disclosed if the IRS relies on him as a witness. So the IRS tries to develop the case independently, especially in criminal cases, when the whistleblower's identity could be required to be disclosed. See, e.g., Whistleblower 14106-10W v. Comm’r, 137 T.C. No. 15 (2011).

Treasury and Internal Revenue Service Issue Final Regulations on the Reporting Requirements for Interests on Deposits Maintained at U.S. Offices of Financial Institutions Paid to Nonresident Aliens

Jerald David August — Fri, 27 Apr 2012 09:36:07 -0500

Effective April 19, 2012, the Treasury and IRS published final regulations (T.D. 9584) on the information reporting by financial institutions of interest paid to nonresident alien individuals on deposits held on U.S. offices of certain financial institutions. Proposed regulations had been issued on the subject in January, 2011. The 2011 proposed regulations withdrew proposed regulations that had been issued approximately 10 years before, i.e., August 2, 2002). The earlier set of proposed regulations would have imposed reporting of interest payments to nonresident alien individuals who are residents of certain listed countries. The 2011 proposed regulations provide that payments of interest aggregating $10 or more on a deposit maintained at a U.S. office of a financial institution and paid to any nonresident alien individual are subject to information reporting. The final regulations are applicable with respect to interest payments made after 2012. These regulations will affect commercial banks, savings institutions, credit unions, securities brokerages, and insurance companies that pay interest on deposits.

Prior Comments From The Financial Services Industry and Tax Practitioners on Bank Deposit Information Reporting and Potential for Improper Use of Information

Comments received by the Treasury on the 2011 proposed regulations raised concerns that the information required to be reported might be misused, e.g., that deposit interest information may be shared with a country that does not have laws in place to protect the confidentiality of the information exchanged or that would use the information for purposes other than the enforcement of its tax laws. Such concerns could affect where nonresident alien individuals seek to place their deposits. In response, the government stated that such concerns are addressed by existing legal limitations and administrative safeguards governing tax information exchange. Bank deposit information reported pursuant to these regulations will be exchanged only with foreign governments with which the U.S. has an agreement providing for the exchange and when certain additional requirements are satisfied. Even when such an agreement exists, the IRS is not compelled to exchange information, including information collected pursuant to these regulations, if there is concern regarding the use of the information or other factors exist that would make exchange inappropriate.

More particularly, information reported pursuant to these regulations is return information under §6103 which contains strict confidentiality rules with respect to all return information. Moreover, §6103(k)(4) limits information exchange with a foreign government by the IRS under the requirements of a TIEA to which such foreign government is a party or under a bilateral tax treaty under its exchange of information and mutual cooperation articles. Absent such an agreement, the IRS is statutorily barred from sharing return information with another country, and these regulations cannot and do not change that rule.

Second, consistent with established international standards, all of the information exchange agreements to which the United States is a party require that the information exchanged under the agreement be treated and protected as secret by the foreign government. In addition, information exchange agreements generally prohibit foreign governments from using any information exchanged under such an agreement for any purpose other than the purpose of administering, collecting, and enforcing the taxes covered by the agreement. Accordingly, under these agreements, neither country is permitted to release the information shared under the agreement or use it for any other law enforcement purposes.

Third, consistent with the international standard for information exchange and United States law, the United States will not enter into an information exchange agreement unless the Treasury Department and the IRS are satisfied that the foreign government has strict confidentiality protections. Specifically, prior to entering into an information exchange agreement with another jurisdiction, the Treasury Department and the IRS closely review the foreign jurisdiction's legal framework for maintaining the confidentiality of taxpayer information. In order to conclude an information exchange agreement with another country, the Treasury Department and the IRS must be satisfied that the foreign jurisdiction has the necessary legal safeguards in place to protect exchanged information and that adequate penalties apply to any breach of that confidentiality.

Finally, even if an information exchange agreement is in effect, the IRS will not exchange information on deposit interest or otherwise with a country if the IRS determines that the country is not complying with its obligations under the agreement to protect the confidentiality of information and to use the information solely for collecting and enforcing taxes covered by the agreement. The IRS also will not exchange any return information with a country that does not impose tax on the income being reported because the information could not be used for the enforcement of tax laws within that country.

In addition, the IRS has options regarding the appropriate form of exchange. For example, the IRS might exchange information with another jurisdiction only upon specific request. In the case of specific exchange requests, the IRS evaluates the requesting country's current practices with respect to information confidentiality. The IRS also requires the requesting country to explain the intended permitted use of the information and justify the relevance of that information to the permitted use. Alternatively, in appropriate circumstances, the IRS might exchange certain information on an automatic basis. The IRS currently exchanges deposit interest information on an automatic basis with only one jurisdiction (Canada). The IRS will not enter into a new automatic exchange relationship with a jurisdiction unless it has reviewed the country's policies and practices and has determined that such an exchange relationship is appropriate. Further, the IRS generally will not enter into an automatic exchange relationship with respect to the information collected under these regulations unless the other jurisdiction is willing and able to reciprocate effectively.

The Treasury Department and the IRS announced that the legal and administrative safeguards described in the preceding paragraphs regarding the use of information collected under these regulations should adequately address the concerns identified by the comments and, therefore, these regulations should not significantly impact the investment and savings decisions of the vast majority of nonresidents who are aware of and understand these safeguards and existing law and practice. Nevertheless, to enhance awareness and further address concerns, these final regulations revise the 2011 proposed regulations to require reporting only in the case of interest paid to a nonresident alien individual resident in a country with which the United States has in effect an information exchange agreement pursuant to which the United States agrees to provide, as well as receive, information and under which the competent authority is the Secretary of the Treasury or his delegate.

Operative Effect of New Regulations: Payor Obligated to File Annual Form 1042-S

Sections 1.6049-4(b)(5) and 1.6049-8 of the Income Tax Regulations, as revised

by TD 9584, require the reporting of certain deposit interest paid to nonresident alien

individuals, as defined in §7701(b)(1)(B), on or after January 1, 2013. The regulations provide that in the case of reportable interest aggregating $10 or more paid to a nonresident alien individual, the payor must make an information return on Form 1042-S for the calendar year in which the interest is paid. Reportable interest is interest described in §871(i)(2)(A) that relates to a deposit maintained at an office within the U.S. and paid to a nonresident alien individual who is a resident of a country identified, in an applicable revenue procedure (see Proc. Reg. §601.601(d)(2) of this chapter) as of December 31 prior to the calendar year in which the interest is paid, as a country with which the United States has in effect an income tax or other convention or bilateral agreement relating to the exchange of information per §6103(k)(4) whereby the U.S. agrees to provide, as well as receive, information and under which the competent authority is the Secretary of the Treasury or his delegate.

In Rev. Proc. 2012-24, §3, the Service set forth a list of countries to which the information reporting pertains:

Antigua & Barbuda

Aruba

Australia

Austria

Azerbaijan

Bangladesh

Barbados

Belgium

Bermuda

British Virgin Islands

Bulgaria

Canada

China

Costa Rica

Cyprus

Czech Republic

Denmark

Dominica

Dominican Republic

Egypt

Estonia

Finland

France

Germany

Gibraltar

Greece

Grenada

Guernsey

Guyana

Honduras

Hungary

Iceland

India

Indonesia

Ireland

Isle of Man

Israel

Italy

Jamaica

Japan

Jersey

Kazakhstan

Korea (South)

Latvia

Liechtenstein

Lithuania

Luxembourg

Malta

Marshall Islands

Mexico

Monaco

Morocco

Netherlands

Netherlands island territories: Bonaire, Curacao, Saba, St. Eustatius and

St. Maarten (Dutch part)

New Zealand

Norway

Pakistan

Panama

Peru

Philippines

Poland

Portugal

Romania

Russian Federation

Slovak Rep.

Slovenia

South Africa

Spain

Sri Lanka

Sweden

Switzerland

Thailand

Trinidad and Tobago

Tunisia

Turkey

Ukraine

United Kingdom

Venezuela

The Service is not required to exchange information, including information

collected pursuant to the regulations, if there is concern regarding the use of the

information or other factors exist that would make exchange inappropriate. This

revenue procedure will be updated as appropriate.

Prevening Evasion of U.S. Tax

While on the surface the publication of this set of regulations may appear non-controversial, the subject relates directly to the effective tax administration of U.S. tax laws, and in particular, the ability of Service to prevent and detect offshore tax evasion. One purpose of the information reporting required by these regulations is to impede efforts by some U.S. taxpayers with U.S. deposits to falsely claim to be nonresidents in order to avoid U.S. taxation on their deposit interest income.

As previously discussed, the identification of a country as having an information exchange agreement with the United States does not necessarily mean that the information collected under these regulations will be reported to such foreign jurisdiction. As an additional measure to further increase awareness among concerned nonresidents regarding the IRS' use of information collected under these regulations, the Revenue Procedure also will include a second list identifying the countries with which the Treasury Department and the IRS have determined that it is appropriate to have an automatic exchange relationship with respect to the information collected under these regulations. This determination will be made only after further assessment of a country's confidentiality laws and practices and the extent to which the country is willing and able to reciprocate.

In further response to comments, the final regulations eliminate the requirement in the 2011 proposed regulations for financial institutions to include in the information a statement provided to nonresident alien individuals informing the individual that the information may be furnished to the government of the country where the recipient resides. In addition, these final regulations clarify that a payor or middleman may rely on the permanent residence address provided on a valid Form W-8BEN, "Beneficial Owners Certificate of Foreign Status for U.S. Tax Withholding", for purposes of determining the country of residence of a nonresident alien to whom reportable interest is paid unless the payor or middleman knows or has reason to know that such documentation of the country of residence is unreliable or incorrect.

The final regulations also modify Prop. Reg. § 31.3406(g)-1 to clarify that, consistent with the backup withholding rules generally, a payment of interest described in § 1.6049-8(a) is not subject to withholding under §3406 if the payor may treat the payee as a foreign person, without regard to whether the payor reported such interest (although a payor may be subject to penalties if it fails to report as required). As under the prior regulations requiring the reporting of interest paid to Canadian non-resident alien individuals, the final regulations define interest subject to reporting to mean interest paid on deposits as defined under §871(i)(2)(A) (including deposits with persons carrying on a banking business, deposits with certain savings institutions, and certain amounts held by insurance companies under agreements to pay interest thereon).

Information Sharing Between the U.S. And Treaty Partners and Tax Information Exchange Parties

As described in the preamble to the final regulations, the U.S. has built a network of international agreements either in the form of tax treaties or information exchange agreements, to facilitate the exchange of information (TIEA) concerning tax enforcement. The underlying rationale for such agreements is to promote cooperation as well as reciprocity of information exchange among sovereign nations. The new U.S. bank deposit regulations, which require reporting of deposit interest to the IRS, are intended to allow the IRS to exchange such information with a treaty partner or TIEA counterpart where designated as appropriate under applicable revenue procedure..

The reporting requirements contained in the final regulations will further allow the Service to exchange information in certain instances with other countries to combat international tax evasion and help implement aspects of the Foreign Account Tax Compliance Act or “FATCA”, which was enacted into law as part of the Hiring Incentives to Restore Employment Act (HIRE) (§§1471-1474). P.L. 111-147 (3/18/2010). FATCA was enacted to combat tax evasion and central among the various reforms in the recent legislation, which is generally effective next year, is the mandatory 30% withholding required on all payments to “foreign financial institutions” and certain “non-financial foreign entities.

FATCA further requires international cooperation between the U.S. and foreign countries. More specifically, FATCA requires overseas financial institutions to identify U.S. accounts and report information (including interest payments) concerning such accounts to the Service. The regulations on bank deposits are designed to aid in the exchange of tax information with foreign governments for tax administration purposes.

International Standard for Transparency and Information Exchange: Seeking Global Transparency

The Organisation for Economic Cooperation and Development (OECD) is an international economic organization of 34 countries founded in 1961 for the purpose of facilitating world trade and economic development based on principles of market economies and democratic government. It publishes standards to identify good business and economic practices. Under the international standard for transparency and exchange of information, which is reflected in the Organisation for Economic Cooperation and Development (OECD) Model Agreement on Exchange of Information on Tax Matters, the OECD Model Tax Convention, and the United Nations Model Double Tax Convention between Developed and Developing Countries, exchange of tax information cannot be limited by domestic bank secrecy laws or the absence of a specific domestic tax interest in the information to be exchanged. The OECD’s global standard on transparency provides that a country cannot refuse to share tax information based on domestic laws that do not require banks to share the information. Moreover, a country cannot opt out of information exchange based on the fact that the country does not itself need the information to enforce its own tax rules. It is noted that countries that do not have a domestic income tax have still agreed to participate in TIEAs to provide information about the accounts of nonresidents.

Treasury Announcement of Intergovernmental Framework for FATCA Implementation

On February 8, 2012, The Treasury issued a Joint Statement from the United States, France, Germany, Italy, Spain and the United Kingdom on an intergovernmental framework for improving international tax compliance as well as implementing FATCA. In the Joint Statement the parties, while announcing their support for the underlying goals of FATCA, acknowledged that foreign financial institutions established their respective countries may not be able to comply with the reporting, withholding and account closure requirements because of legal restrictions. In this regard the United States announced its willingness to reciprocate in collecting and exchanging on an automatic basis information on accounts held in US financial institutions by residents of France, Germany, Italy, Spain and the United Kingdom. The approach under discussion, therefore, would enhance compliance and facilitate enforcement to the benefit of all parties. More guidelines were set forth in the Joint Statement. The details of the Joint Statement are indeed of great importance and worthy of separate discussion and analysis.

Third Circuit Reverses Tax Court And Holds Taxpayers Received Tax-Exempt Interest on Deferred Payments From the Pennsylvania Department of Transportation Negotiated as Part of an Out-of-Court Settlement

Jerald David August — Fri, 13 Apr 2012 19:28:09 -0500

The Third Circuit, in partially reversing the Tax Court, in DeNaples v. Commissioner, 109 AFTR 2d 2012-1419 in a three judge panel opinion filed on March 19, 2012, held that two couples were in receipt of tax-exempt interest income under §103 with respect to installment payments made under an out-of-court settlement agreement with the State of Pennsylvania that arose out of an eminent domain proceeding. The holding that the amount of stated interest representing “delay damages” was not within §103, which was also determined by the Tax Court, was affirmed by the Third Circuit based on the taxpayers’ failure to meet its required burden of proof.

Code Section 103 (26 U.S.C.)

Section 103(a) of the Internal Revenue Code holds in relevant part: “gross income does not include interest on any State or local bond.” A “State or local bond” is defined in §103(c)(1) as “an obligation of a State or political subdivision thereof.” Since the inception of the Code in 1913, interest on obligations of states and their political subdivisions has been excluded from the interest recpient’s gross income. The rationale for the exclusion was to avoid a perceived unconstitutional burden on the borrowing power of state and local governments Drew v. United States, 551 F.2d 85, 87 (5th Cir. 1977); Holley v. United States, 124 F.2d 909, 911 (6th Cir. 1942). As a tax exemption, which is true of any rule of income exclusion contained in the Code, the Courts have universally required the scope of the exclusion be narrowly construed. See, e.g., In re Hechinger Inv. Co. of Delaware, Inc., 335 F.3d 243, 259 (3d Cir. 2003) .

Factual Background in DeNaples v. Commissioner

The taxpayers, Dominick,Louis, Betty and Mary Ann DeNaples, through their ownership in several pass through entities, owned several parcels of real property in Pennsylvania that was condemned by the Pennsylvania Department of Transportation (DOT) to facilitate the construction of the Lackawanna Valley Industrial Highway. In 1993 and 1994, to permit construction to go forward, the State and the DeNaples entered into two rights of entry, which permitted the State to enter onto the land but did not alter the DeNaples' entitlement to just compensation. In 1998, the State initiated condemnation proceedings against the properties in the Pennsylvania Court of Common Pleas by filing a Declaration of Taking pursuant to former 26 Pa. Stat. § 1-402(a). The DeNaples objected, contending that the declaration did not adequately describe the property. The court agreed and dismissed some of the suits. On the remaining suits, a jury trial was commenced and then stayed when the parties indicated that they had settled.

On November 7, 2001, the parties signed a memorandum of intent to settle. The DeNaples agreed that, in exchange for all their ownership interest in all the parcels of land, they would receive compensation of approximately $40,900,000, of which $24,600,000 was allocated to principal, and $16,300,000 was allocated to interest (“settlement interest”). The condemnation proceeding record omitted how the allocation between principal and interest was determined and did not incorporate the settlement agreement. Instead the parties moved to dismiss the proceeding.

Payment was to be made in five annual payments, with the first payment of $8,100,000 plus accrued interest due by March 1, 2002, and the remaining four payments of $8,200,000 plus accrued interest due by March 1, 2003, 2004, 2005, and 2006. Interest accrued annually on the unpaid settlement amount at the rate set by (former) rule 238 of the Pennsylvania Rules of Civil Procedure (Pa. R. Civ. P. 238)(“interest on deferred payment amounts”).

The DOT paid the DeNaples each $10,111,193 in 2003, $9,289,353 in 2004, and $17,739,276 in 2005. The obligation was discharged in full a year earlier than required. On their 2003 through 2005 federal income tax returns, each taxpayer reported taxable interest income of $545,664, $545,664, and $1,091,328, respectively, and excluded from gross income $2,040,054, $1,629,134, and $2,838,545, respectively, as tax-exempt interest under §103 of the Code. More specifically, as to the settlement interest income, the DeNaples received approximately $4,300,000 for 2002 through 2004 and $8,700,000 for 2005. They excluded from gross income under §103 any interest received above 6% (the stated rate under former Pa. R. Civ. P. 238 on the stated interest amount of $16,700,000. As to the “interest on deferred payments”, the DeNaples excluded all of such interest income in computing gross income again based on Section 103.

The IRS, upon audit and review of the DeNaples returns for the years 2003 thru 2005, disagreed with the tax-exempt interest positions taken on the returns and issued a statutory notice of deficiency for $2,300,000 in underpayments in income tax against each couple for the years 2003 through 2005, comprised of $714,019 for 2003, $587,257 for 2004, and $1,023,299 for 2005.

Tax Court Memorandum Decision Issued by Judge Nims

After the case was fully stipulated and briefed before the Court, the Tax Court sided with the government and held that no part of the “settlement interest” or “interest on deferred payments” was excludable from gross income as tax-exempt interest under Section 103. See DeNaples v. Comm’r, T.C. Memo. 2010-171.

As to the “settlement interest”, the Tax Court concluded that the DeNaples had failed to demonstrate that they received interest income above and beyond what was legally required and therefore the settlement interest was not an obligation of the State described within §103 because it did not invoke the State's borrowing authority. It also found that the stated allocation to interest was excessive, i.e., the ratio of interest to principal approached 40%.

As to the “interest on deferred payments”, Judge Nims held again that no amount was excludable under §103 finding that the DeNaples were entitled to be compensated for agreeing to receive the settlement payments in installments where the "interest" on the deferred payments was part of their right to just compensation. Accordingly, the Tax Court entered an order affirming the IRS' deficiency calculations in full.

The DeNaples’ then filed a motion for reconsideration which was denied. Tax Court refused to reopen the record to allow the taxpayers to introduce evidence of the prevailing commercial rate of interest as proof that a portion of the settlement interest was excludable from gross income. It held that to recompute the deficiencies in tax for each year as part of a Rule 155 computation would inappropriately allow the taxpayers to introduce evidence that it failed to produce at trial. The Tax Court found that the DeNaples had therefore failed to meet their burden of proof that the deficiency was inaccurate with respect to the “interest on deferred payments”. T.C. Memo. 2011-46 (2011).

The taxpayers filed an appeal to the Third Circuit, which heard the case de novo as to the Tax Court’s findings of law and the construction and application of the Internal Revenue Code and under the clear error standard for factual findings and inferences drawn therefrom. PNC Bancorp, Inc. v. Comm'r, 212 F.3d 822, 827 (3d Cir. 2000)

The Third Circuit Court of Appeals Reverses In Part the Tax Court Memorandum Decision

The Third Circuit reversed in part and affirmed in part the lower court’s decision.

In reviewing applicable precedent in the area, the Third Circuit noted its reliance on a long-standing Supreme Court decision in Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 86-87, which requires for purposes of §103, an “obligation” of a state or local government should not be “extended to include interest upon indebtedness not incurred under the borrowing power”. Where, however, the state or local governmental authority’s borrowing power is the source for the obligation to pay interest, then interest on the underlying indebtedness falls within the exemption. In contrast, where, for example, a state’s obligation to pay interest arises by operation of law, the state’s borrowing power is not implicated and §103 is unavailable. Where the state’s obligation to pay interest is part of a voluntary negotiation, howeer, its obligation to pay interest does find as its source the state’s borrowing authority and may be excludable §103.

After laying out the ground rules for determining whether interest paid by a state or governmental body as part of a settlement of an eminent domain proceeding falls within §103, the Third Circuit focused on Pennsylvania law on eminent domain proceedings. It observed, that in many instances, the state’s obligation to pay interest in a condemnation proceeding arises by operation of law. This occurs where the state delays in making payment of the just compensation amount which entitles the condemnee to interest by operation of law. Hughes v. Dep’t of Transportation, 523 A.2d 747, 753 (1983)(where owner can prove under former law that the statutory 6% rate is insufficient, a higher rate of interest on delayed condemnation payments may be established as part of just compensation award). See Wasserott v. PennDOT, 13 Pa. D. & C. 4^th 593, 595 (Ct. Com. Pl. 1991). In Hughes, supra, the Supreme Court of Pennsylvania ruled, aligning itself with a majority of jurisdictions, that “ if the property owner produces evidence that the 6% rate is constitutionally insufficient, he should be entitled to a higher rate of return as just compensation”. Where interest is owed by the condemning authority by operation of law, the interest is not excludable under §103. See 26 Pa. Cons. Stat. §713 (2006)(interest rate for delay damages changed to prime plus 1%).

Interest on Deferred Payments

Resolving the question of whether §103 applied to interest on deferred payments received by the DeNaples would turn, in the view of the Third Circuit, on whether the DOT’s interest obligation arose by operation of law or was solely the product of voluntary bargaining. The record below established that the DOT and the DeNaples negotiated a complete arms-length settlement of Pennsylvania's claims. The DeNaples agreed, as part of the out-of-court settlement agreement, to receive a lower, variable interest rate for the purpose of extending credit to Pennsylvania and not a higher rate that would have applied under then statutory rule. Therefore, interest on the deferred payments under the facts of the case met the requirements under §103. This portion of the Tax Court’s decision was reversed. The Third Circuit noted that the same analysis was essentially adopted by the Ninth Circuit in Stewart v. United States, 739 F.2d 411, 414 (9th Cir. 1984).

In elaborating on its voluntary negotiation rationale, the Third Circuit looked at the DeNaples and the DOT as having entered into an arms-length settlement agreement, albeit in the “shadow of the ongoing condemnation proceeding with its attendant rights and obligations, including the DeNaples' right to interest for any payment delay.” However, the taxpayers agreed to a rate of interest on deferred payments as part of the bargain and that bargain implicated the State of Pennsylvania’s borrowing authority. Thus, the interest paid on the deferred payments was not part of a judicial award of just compensation which would fall outside of §103. In this case the State's obligation to pay interest at a fixed rate did not arise by operation of law but instead by a “freely-negotiated contract that contemplated no further judicial intervention.”

In distinguishing the case at bar from the government’s reliance on the Sixth Circuit’s decision in Holley v. United States, supra, the Third Circuit noted that in Holley a settlement agreement between the condemning authority and the condemnee was part of the court’s order or award whereas in this case DeNaples and Pennsylvania agreed to a total settlement which extinguished the condemnation proceeding. No court award of “interest” was made as the condemnation proceeding was “settled, discontinued and ended”. The Third Circuit viewed that this difference was critical to its reaching its conclusion. A quote from the Court’s opinion drives home this distinction:

“ To be clear, we do not hold that any interest payment made pursuant to a voluntary settlement agreement is automatically excludable under Section 103. Rather, it is excludable here because, given the nature of how and what the parties agreed to in the settlement agreement, it is clear that the obligation to pay interest at the Rule 238 rate arose not by operation of law but through the voluntary, arms-length negotiations between the DeNaples and Pennsylvania.”

Settlement Interest

The Tax Court’s holding on the “settlement interest” of $14,000,000 stated in the settlement agreement as not constituting tax exempt interest was affirmed. The Third Circuit also held that the Tax Court did not err when it refused to reopen the record by rejecting the taxpayers’ motion for reconsideration to receive evidence about the prevailing commercial loan rate.

The taxpayers argument was that the “settlement interest” agreed to by the parties compensated them for the delay between the time of the initial right of entry and the entering into the settlement agreement. Based on the former Rule 238's reference to a 6% rate under Pennsylvania law which Rule was applicable at the time, the DeNaples excluded from their gross income only the delay interest in excess of 6%. The taxpayers viewed that since the 6% rate was required by law for delay payments, interest above 6% was the product of voluntary bargaining.

The Third Circuit agreed with Judge Nims’ opinion on this issue on several grounds. First, it agreed with the fact finding that the allocation made by the parties between interest and principal was arbitrary and excessive. Second, it rejected the taxpayers efforts in its motion for reconsideration to recalculate what the proper amount of interest would be based on prevailing commercial rates of interest for the years in issue. Such evidence was not produced at trial. The taxpayers simply failed to meet their burden of proof that the amount of the deficiency was incorrect. Finally, it agreed that an effort to recompute the deficiency under the guise of a Tax Court Rule 155 recomputation was outside of the scope and purpose of such provision. Rule 155 does not permit either party to have what is in effect an opportunity for retrial of what was left off the record. Blonien v. Comm'r, T.C. Memo. 2003-308; Paccar, Inc. v. Comm'r, 849 F.2d 393, 400 (9th Cir. 1988).

Both the Tax Court as well as the Third Circuit left open the thought that if the State or governmental authority enters into a voluntary agreement awarding just compensation as well as delay damages, the interest representing the delay damages computation may implicate the condemning authority borrowing authority and fall within §103 if the interest amount is reasonable based on prevailing commercial rates, the parties voluntary negotiated the rate of interest as part of an arms length bargain, and the agreement, once reached, was not incorporated in a court order.

Treasury and Internal Revenue Service Issue New Temporary Regulations on "All Cash" Type D Reorganizations

Jerald David August — Wed, 11 Apr 2012 14:22:11 -0500

In TD 9558, issued late last year, Temporary Regulations were promulgated on the determination of the basis of stock or securities in a reorganization where no stock or securities of the issuing corporation are issued and distributed in the transaction, and, in particular, the treatment of “all cash D reorganizations”. Where no stock or securities of the issuing corporation (“acquiring corporation”) are issued and distributed in the transaction, the ability to designate the share of stock of the issuing corporation to which the basis, if any, of the stock or securities surrendered will be connected to applies only to a shareholder owning stock in the issuing corporation. This limits the ability to allocate basis in stock, for example, to members of lower-tier corporate chains which still have the same ultimate indirect shareholder(s).

Background

On December 19, 2006, the IRS and the Treasury Department published a notice of proposed rulemaking) that included regulations under section 368 (the Temporary Regulations) which set forth rules for determining whether the distribution requirement under §§368(a)(1)(D) and 354(b)(1)(B) is complied with where there is no actual distribution of stock or securities.

Three years later, final regulations were published which, in addition to providing guidance regarding the qualification of certain transactions as reorganizations within §368(a)(1)(D), amended Treas.Reg. § 1.358- 2(a)(2)(iii) to provide that in the case of a reorganization in which the property received consists solely of non-qualifying property equal to the value of the assets transferred (as well as a nominal share described in the final regulations), the shareholder or security holder may designate the share of stock of the issuing corporation to which the basis, if any, of the stock or securities surrendered will attach. Treas. Reg. §1.358-2(a)(2)(iii) as amended stated:

“If a shareholder or security holder surrenders a share of stock or a security in a transaction under the terms of Section 354 (or so much of Section 356 as relates to Section 354) in which such shareholder or security holder is deemed to receive a nominal share described in Reg. 1.368-2(l), such shareholder may, after adjusting the basis of the nominal share in accordance with the rules of Reg. 1.358-1, designate the share of stock of the issuing corporation to which the basis, if any, of the nominal share will attach.”

The National Office of the IRS and the Treasury Department became aware that existing rules could be construed as allowing an inappropriate allocation of basis by persons that do not own actual shares of stock in the issuing corporation, such as a lower-tier ownership chain of a consolidated group. More specifically, the rules could be interpreted to allow persons who do not own actual shares of stock of the issuing corporation to allocate the adjusted basis of the nominal share to an actual share of stock of the issuing corporation directly owned by someone else before the nominal share is deemed to be further transferred through the chains of ownership to reflect the actual ownership of the target and issuing corporations. Under this interpretation of the rules, the actual share to which the basis was allocated could then be sold to purposely recognize a loss, and taxpayers would avoid losing the nominal share's basis, which would otherwise be zero following its deemed transfer through the chains of ownership to the actual shareholder of the issuing corporation.

All Cash D Reorganization and Distribution Rule

Under Treas. Reg. §1.368-2(l)(1), to qualify as a “D” reorganization a transferor corporation (combining entity) must transfer all or part of its assets to another corporation (another combining entity) and immediately after the transfer, the transferor corporation, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, must be in control of the transferee corporation, but only if, in pursuance of the plan, stock or securities of the transferee are distributed in a transaction that qualifies under §§ 354, 355, or 356.

Treas. Reg. §1.368-2(l)(2)(i) provides that a transaction otherwise described in §368(a)(1)(D) will be treated as satisfying the requirements of §§ 368(a)(1)(D) and 354(b)(1)(B) even where there is no actual issuance of stock or securities of the transferee corporation provided the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions. Where no consideration is received or the value of the consideration received in the transaction is less than the fair market value of the transferor corporation's assets, the transferee corporation will be treated as issuing stock with a value equal to the excess of the fair market value of the transferor corporation's assets over the value of the consideration actually received in the transaction.

Treas. Reg. §1.368-2(l)(2)(i) also provides that if the value of the consideration received in the transaction is equal to the fair market value of the transferor corporation's assets, the transferee corporation will be deemed to issue a nominal share of stock to the transferor corporation in addition to the actual consideration exchanged for the transferor corporation's assets. The nominal share of stock in the transferee corporation will then be deemed to be distributed by the transferor corporation to the shareholders of the transferor corporation. When appropriate, the nominal share will be further transferred through chains of ownership to the extent necessary to reflect the actual ownership of the transferor and transferee corporations. Treatment similar to that in the preceding two sentences will apply where the transferee corporation is treated as issuing stock with a value equal to the excess of the fair market value of the transferor corporation's assets over the value of the consideration actually received in the transaction. Other rules are provided in the regulations. See Treas. Reg. §1.368-2(l)(2), 1.358-6(b)(2).

New Temporary Regulations

The preamble to the final regulation noted that the IRS and the Treasury Department believe the ability to designate any remaining basis is consistent with current law regarding basis determination, as a similar result would occur under Treas. Reg. § 1.358-2 if an amount of issuing corporation stock was actually issued. Where stock is actually issued in a lower-tier transfer, such stock would then be transferred through chains of ownership, and in the process, if basis in the stock exceeded value, the basis in the shares would be reduced to the fair market value of the shares in the hands of the distributee, under §301(d). Accordingly, in such a case, basis in excess of the value of the issuing corporation shares would generally be preserved only where the shareholder of the transferor corporation does not further distribute the stock of the issuing corporation in a transaction to which §301 applies.

The new temporary regulations clarify and amend the final regulations under Treas. Reg. § 1.358-2(a)(2)(iii) to provide that where an actual shareholder of the issuing corporation is deemed to receive a nominal share of stock of the issuing corporation per Treas. Reg. § 1.368-2(l), such shareholder must, after allocating and adjusting the basis of the nominal share in accordance with the rules of this section and Treas. Reg. § 1.358-1, and after adjusting the basis in the nominal share for any transfers described in Treas. Reg. § 1.358-1, designate the share of stock of the issuing corporation to which the basis, if any, of the nominal share will attach.

The new temporary regulation provides:

“Section 1.358-2T is added to read as follows:

§ 1.358-2T Allocation of basis among nonrecognition property (temporary). (a)(1) through (a)(2)(ii) [Reserved]. For further guidance, see § 1.358-2(a)(1) through (a)(2)(ii).

(iii) For purposes of this section, if a shareholder or security holder surrenders a share of stock or a security in a transaction under the terms of section 354 (or so much of section 356 as relates to section 354) in which such shareholder or security holder receives no property or property (including property permitted by section 354 to be received without the recognition of gain or “other property” or money) with a fair market value less than that of the stock or securities surrendered in the transaction, such shareholder or security holder shall be treated as follows.

((A)) First, the shareholder or security holder shall be treated as receiving the stock, securities, other property, and money actually received by the shareholder or security holder in the transaction and an amount of stock of the issuing corporation (as defined in § 1.368-1(b)) that has a value equal to the excess of the value of the stock or securities the shareholder or security holder surrendered in the transaction over the value of the stock, securities, other property, and money the shareholder or security holder actually received in the transaction. If the shareholder owns only one class of stock of the issuing corporation the receipt of which would be consistent with the economic rights associated with each class of stock of the issuing corporation, the stock deemed received by the shareholder pursuant to the previous sentence shall be stock of such class. If the shareholder owns multiple classes of stock of the issuing corporation the receipt of which would be consistent with the economic rights associated with each class of stock of the issuing corporation, the stock deemed received by the shareholder shall be stock of each such class owned by the shareholder immediately prior to the transaction, in proportion to the value of the stock of each such class owned by the shareholder immediately prior to the transaction. The basis of each share of stock or security deemed received and actually received shall be determined under the rules of this section.

((B)) Second, the shareholder or security holder shall then be treated as surrendering all of its shares of stock and securities in the issuing corporation, including those shares of stock or securities held immediately prior to the transaction, those shares of stock or securities actually received in the transaction, and those shares of stock deemed received pursuant to the previous sentence, in a reorganization under section 368(a)(1)(E) in exchange for the shares of stock and securities of the issuing corporation that the shareholder or security holder actually holds immediately after the transaction. The basis of each share of stock and security deemed received in the reorganization under section 368(a)(1)(E) shall be determined under the rules of this section.

((C)) If an actual shareholder of the issuing corporation is deemed to receive a nominal share of stock of the issuing corporation described in § 1.368-2(l), such shareholder must, after allocating and adjusting the basis of the nominal share in accordance with the rules of this section and § 1.358-1, and after adjusting the basis in the nominal share for any transfers described in § 1.368- 2(l), designate the share of stock of the issuing corporation to which the basis, if any, of the nominal share will attach. (a)(2)(iv) through (c),

Example 14 [Reserved]. For further guidance, see § 1.358-2(a)(2)(iv) through (c), Example 14.

Example 15. (i) Facts. Each of Corporation X and Corporation Y has a single class of stock outstanding, all of which is owned by J, an individual. J acquired 100 shares of Corporation X stock on Date 1 for $1.50 each. On Date 2, Corporation Y acquires the assets of Corporation X for $100 of cash, their fair market value, in a transaction described in § 1.368-2(l). Pursuant to the terms of the exchange, Corporation X does not receive any Corporation Y stock. Corporation X Rules and Regulations distributes the $100 of cash to J in liquidation. Pursuant to § 1.368-2(l), Corporation Y will be deemed to issue a nominal share of Corporation Y stock to Corporation X in addition to the $100 of cash actually exchanged for the Corporation X assets, and Corporation X will be deemed to distribute all of the consideration to J. J will have a basis of $50 in the nominal share of Corporation Y stock under section 358(a). (ii) Analysis. Under paragraph (a)(2)(iii) of this section, J is the actual shareholder of Corporation Y, the issuing corporation, deemed to receive the nominal share of Corporation Y stock described in § 1.368-2(l). Therefore, J must designate any share of Corporation Y stock to which the basis of $50 in the nominal share of Corporation Y stock will attach.

Example 16. (i) Facts. Each of Corporation X and Corporation Y has a single class of stock outstanding, all of which is owned by Corporation P. Corporation T has a single class of stock outstanding, all of which is owned by Corporation X. The corporations do not join in the filing of a consolidated return. Corporation X acquired 100 shares of Corporation T stock on Date 1 for $1.50 each. On Date 2, Corporation Y acquires the assets of Corporation T for $100 of cash, their fair market value, in a transaction described in § 1.368-2(l). Pursuant to the terms of the exchange, Corporation T does not receive any Corporation Y stock. Corporation T distributes the $100 of cash to Corporation X in liquidation. Pursuant to § 1.368-2(l), Corporation Y will be deemed to issue a nominal share of Corporation Y stock to Corporation T in addition to the $100 of cash actually exchanged for the Corporation T assets, and Corporation T will be deemed to distribute all of the consideration to Corporation X. Corporation X will have a basis of $50 in the nominal share of Corporation Y stock under section 358(a). Corporation X will be deemed to distribute the nominal share of Corporation Y stock to Corporation P. Corporation X does not recognize the loss on the deemed distribution of the nominal share to Corporation P under section 311(a). Corporation P's basis in the nominal share is zero, its fair market value, under section 301(d). (ii) Analysis. Corporation X is deemed to receive the nominal share of Corporation Y stock described in § 1.368-2(l). However, under paragraph (a)(2)(iii) of this section, Corporation X is not an actual shareholder of Corporation Y, the issuing corporation. Therefore, Corporation X cannot designate any share of Corporation Y stock to which the basis, if any, of the nominal share of Corporation Y stock will attach. Furthermore, Corporation P cannot designate a share of Corporation Y stock to which basis will attach because Corporation P receives the nominal share with a basis of zero. (d) Effective/applicability date. This section applies to exchanges and distributions of stock and securities occurring on or after November 21, 2011. (e) Expiration date. This section expires on or before November 18, 2014.”

Commissioner Prevails in Imposing Deficiency With Respect to At-Risk Recapture in Roy Zeluck, TC Memo 2012-98

Jerald David August — Sun, 08 Apr 2012 20:08:01 -0500

Taxpayer invested $310,000 in an oil and gas partnership in 2001 consisting of cash of $110,000 and a subscription note issued by the taxpayer obligating him to pay $200,000 at the stated maturity date of December 31, 2009. The oil and gas partnership used the taxpayer’s, as well as the other investors’ notes a security on a “turnkey note” it issued to a drilling company. The taxpayer had signed an “assumption agreement” which had the legal effect of making him personally liable on the turnkey note (and security) to the extent of the amounts he was required to pay under the subscription note. For 2001 and 2002, the taxpayer-partner was allocated deductions(losses) of close to $300,000 which reduced his capital account balance from from $310,000 to $32,407. In 2003 the partnership terminated and distributed $32,407 to the taxpayer.

The taxpayer had not made payment of the principal amount on the $200,000 subscription note and failed to meet certain other requirements of the subscription agreement for interest payments. In auditing the taxpayer’s return, the Service issued a notice of deficiency determining that the taxpayer’s liability on the subscription note and assumption agreement became unenforceable in 2003. As a result, the Service contended that the taxpayer must include $200,000 in income for 2003. The taxpayer argued that if no liability existed in 2003, then the taxpayer was not liable on the same indebtedness as "nongenuine" as well when issued in 2001. As a result, since the statute of limitations for 2001 had expired, the Service could not challenge the taxpayer’s 2001 return.

Judge Goeke, in issuing a Memorandum opinion, found for the Commissioner holding: (i) the taxpayer’s liability on the subscription note and related assumption agreement, after reviewing the evidence submitted by both parties at trial, first became “nongenuine” in 2003; (ii) the taxpayer must recognize a $200,000 gain for 2003 under §465(e), at-risk recapture; and (iii) the taxpayer was liable for an accuracy related penalty of 20% under §6662.

Factor reflected by the case law to determine whether a genuine debt exists includes: (i) whether the promise to repay is in writing; (ii) whether interest is charged (and paid); (iii) whether a fixed schedule of payments is required (and paid); (iv) the presence of collateral to secure repayment; (v) whether the borrower had the ability to repay the debt; and (vi) whether the “lender” expected repayment to corroborate that the debt was real.

Section 465(e) provides for the recapture of losses where a taxpayer’s amount at risk in an activity is less than zero at the close of any taxable year by distributions, changes in the status of a debt from recourse to nonrecourse, or as in this case, “nongenuine”, or other similar arrangement which reduces the taxpayer’s risk of loss. In such event §465(e)(1)(A) requires the taxpayer to include in gross income from the at-risk activity an amount equal to such negative at-risk amount. The amount recaptured, however, is limited to the excess of the losses previously allowed in the subject activity over any amounts previously recaptured. The negative-at-risk amount added to income may later be treated as a deduction allocable to the activity in the first succeeding year if and to the extent that the taxpayer's at-risk amount is increased.

Service and Treasury Still Waiver on the Final Content of Additional Regulations To Be Issued Under Section 7874 On When Stock of a Foreign Corporation is Properly Disregarded For Whether An Inversion Transaction Has Occurred.

Jerald David August — Sun, 01 Apr 2012 05:45:32 -0500

At a recent tax ALI-ABA corporate taxation conference held in Washington on March 30, Brenda Zent, a lawyer from the Office of International Tax Counsel, U. S. Treasury, was quoted as stating that many decisions remain to be answered under the corporate inversion regulations under Section 7874, including points raised in IRS Notice 2009-78, 2009-40 IRB 452. Temporary regulations on surrogate foreign corporations are scheduled to sunset on June 8 and therefore it should be anticipated that the Treasury will produce final regulations in this area prior to the sunset. Problem areas include the use surrogate stock in a foreign corporation, the use of third-party transfers for cash, the treatment of options t acquire stock of the target corporation and the rules pertaining to public offerings of stock and their impact on applying the stock ownership tests under Section 7874. Although the rules currently treat all options to acquire the stock of the target corporation as stock of the foreign acquiring corporation, Treasury is considering whether it should provide an "angel list," Zent said. "We're looking at whether it's appropriate to perhaps carve out certain options” in response to some concerns that certain aspects of transactions found objectionable in the 2009 Notice may not be as problematic as first thought.

Taxing Corporate Inversions Described Under Section 7874

Section 7874 provides rules for expatriated entities and their surrogate foreign corporations. An “expatriated entity” is a domestic corporation (or domestic partnership) with respect to which a foreign corporation (which includes certain publicly traded foreign partnerships) is a “surrogate foreign corporation”, and any United States person related to such domestic corporation (or domestic partnership) (within the meaning of Sections 267(b) or 707(b)(1)). Section 7874(a)(2)(A).

A foreign corporation constitutes a surrogate foreign corporation if three conditions are satisfied.

First, the foreign corporation completes, after March 4, 2003, the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation. Section 7874(a)(2)(B)(i).
Second, after the acquisition at least 60 percent of the stock of the foreign corporation (by vote or value) is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation (the Ownership Condition). Section 7874(a)(2)(B)(ii).
Third, after the acquisition the expanded affiliated group (defined in section 7874(c)(1)) that includes the foreign corporation does not have substantial business activities in the foreign country in which, or under the law of which, the foreign corporation is created or organized, when compared to the total business activities of the expanded affiliated group. Section 7874(a)(2)(B)(iii).
Similar provisions apply if a foreign corporation acquires substantially all of the properties constituting a trade or business of a domestic partnership.

Under Section 7874(c)(2), certain stock of the foreign corporation is not taken into account in determining whether the Ownership Condition is satisfied: (1) stock of the foreign corporation held by members of the expanded affiliated group that includes the foreign corporation, and (2) stock of the foreign corporation sold in a public offering related to the acquisition described in section 7874(a)(2)(B)(i).Regulations addressing the Ownership Condition were published in the Federal Register on May 20, 2008, and June 12, 2009 (TD 9399, 73 FR 29054; TD 9453, 74 FR 27920).

Under Section 7874(c)(4) a transfer of properties or liabilities (including by contribution or distribution) shall be disregarded if such transfer is part of a plan a principal purpose of which is to avoid the purposes of Section 7874.

Section 7874(g) grants the Secretary broad authority to provide regulations necessary to carry out section 7874, including regulations adjusting the application of Section 7874 as necessary to prevent the avoidance of the purposes of Section 7874. More specifically, section 7874(c)(6) grants the Secretary authority to prescribe regulations as may be appropriate to determine whether a corporation is a surrogate foreign corporation, including regulations to treat stock as not stock.

In TD 9453, the IRS and Treasury modified Treas. Reg. § 1.7874-2T(e)(5), Example 3, to eliminate an unintended implication as to the scope or application of the public offering rule of section 7874(c)(2)(B). The preamble to this rulemaking provides that the IRS and Treasury are considering issuing guidance concerning the scope and application of the public offering rule and request comments in this regard.

Enter Notice 2009-78

In Notice 2009-78 the Treasury and the Service announced that regulations will be issued under Section 7874 providing whether certain shares of stock in a foreign corporation can be disregarded in determining the ownership of the foreign corporation for purposes of Section 7874(a)(2)(B)(ii). This project was presumably prompted by the tax administrations awareness that certain transactions have been designed to avoid Section 7874 which involve the transfer of cash or other property to a foreign corporation in a transaction related to the acquisition identified by Section 7874(a)(2)(B)(i). The transaction is designed, presumably, to minimize the former shareholders’ ownership in the foreign corporation in testing for retained percentage of ownership. This type of transaction may also occur with a reorganization in bankruptcy. The government is of the view that this type of structure improperly “end runs” Section 7874.

Another area of concern held by the Treasury and the IRS is the public offering provision contained in Section 7474(c)(2)(B) which applies to all public issuances of stock by a foreign corporation, regardless of the property exchanged for the stock. In the preamble to the 2009 regulations in this area (T.D. 9453), the government requested comments on the public offering rule.

A Closer Look At Notice 2009-78

The transactions of concern. Consider a domestic corporation attempts to avoid application of Section 7874 making a transfer of cash (or certain other assets) to the foreign corporation in a transaction related to the acquisition described in Section 7874(a)(2)(B)(i), which reduces the former shareholders' ownership in the foreign corporation for purposes of the Ownership Condition.

Example. Shareholders of a domestic corporation (X) transfer all their X stock to a newly-formed foreign corporation (New FC) in exchange for 79 percent of the stock of New FC and, in a related transaction, an investor transfers cash to New FC in exchange for the remaining 21 percent of the New FCo stock. The parties to the transaction take the position that the New FCo stock issued to the investor is not "sold in a public offering" and thus not subject to Section 7874(c)(2)(B). The parties also assert that the transfer of cash from the investor to New FCo was not part of a plan a principal purpose of which is to avoid the purposes of Section 7874 such that Section 7874(c)(4) does not apply to disregard the investor's transfer of cash to New FC in exchange for New FC stock.

The argument that the parties to the transaction would make is that assert the investor's New FC stock would be taken into account for purposes of the Ownership Condition. Thus, the former shareholders of X would hold only 79 percent of the stock of New FC by reason of holding stock of DC, whereby Section 7874(a)(1) would apply to X (and any other expatriated entity) but Section 7874(b) would not apply to treat New FC as a domestic corporation for purposes of the Code. The IRS and Treasury understand that similar transactions may be structured with respect to the acquisition of a domestic corporation in a title 11 or similar case (as defined in Section 368(a)(3)) or a domestic partnership. The Notice states that such transactions are inconsistent with the purposes of Section 7874.

Notice 2009-78 also stated that concern has been raised over the proper interpretation of the public offering rule of Section 7874(c)(2)(B) and whether it applies to all public issuances of stock by a foreign corporation, regardless of the property exchanged for the stock.

Example. Shareholders of a publicly-traded foreign corporation (FT) and a publicly-traded domestic corporation (DT) intend to transfer their FT and DT stock, respectively, to a newly-formed foreign corporation (FA) that will be publicly-traded. To effectuate the transaction, as part of a plan FA acquires all of the FT and the DT stock, respectively, from the FT and DT shareholders in exchange solely for newly-issued FA stock. If the FA stock issued to the FT shareholders is considered "sold in a public offering" and thus subject to section 7874(c)(2)(B), the former shareholders of DT would be treated as owning 100 percent of the stock of FA for purposes of the Ownership Condition, and FA would therefore be treated as a domestic corporation for purposes of the Code under Section 7874(b). A similar result would occur if instead FT merged with and into FA and the FT shareholders exchanged their FT stock for FA stock pursuant to the merger. The IRS and Treasury believe that such a result could be inappropriate in certain cases.

Notice 2009-78 announced the IRS and Treasury intended to issue regulations identifying stock of the foreign corporation that is not taken into account for purposes of the Ownership Condition. The regulations will identify stock of the foreign corporation that shall not be taken into account for purposes of the Ownership Condition, even if such stock may not otherwise be described in Section 7874(c)(2)(B). The regulations will also clarify that certain stock, which may be described in Section 7874(c)(2)(B), shall nonetheless be taken into account for purposes of the Ownership Condition.

The regulations issued pursuant to this notice shall provide that stock of the foreign corporation issued in exchange for "nonqualified property" in a transaction related to the acquisition described in Section 7874(a)(2)(B)(i) is not taken into account for purposes of the Ownership Condition, without regard to whether such stock is publicly traded on the date of issuance or otherwise. Subject to certain exceptions, the term "nonqualified property" shall generally mean: (1) cash or cash equivalents; (2) marketable securities as defined in Section 453(f)(2); and (3) any other property acquired in a transaction with a principal purpose of avoiding the purposes of Section 7874.

The Notice further commented that the term “marketable securities” for purposes of this rule generally will not include stock (or a partnership interest) issued by a member of the expanded affiliated group (per Section 7874(c)(1)) that after the acquisition includes the foreign corporation, unless a principal purpose of the issuance of the stock of the foreign corporation in exchange for such property was the avoidance of the purposes of Section 7874. For this purpose, a partnership shall be treated as a member of an expanded affiliated group if the partnership would be a member of the expanded affiliated group if it were a corporation.

The regulations expected to be issued will provide similar rules to address acquisitions of property by one or more members of the expanded affiliated group (that includes the foreign corporation after the acquisition) in exchange for stock of the foreign corporation, including, for example, pursuant to a triangular reorganization. For this purpose, a partnership shall be treated as a member of an expanded affiliated group if the partnership would be a member of the expanded affiliated group if it were a corporation.

Example 1. Stock issued in exchange for marketable securities. (i) Facts. Individual A wholly owns DT, a domestic corporation. FA, a newly formed foreign corporation, acquires all the DT stock from individual A in exchange solely for FA stock. In a transaction related to FA's acquisition of the DT stock, PRS transfers marketable securities (within the meaning of Section 453(f)(2)) to FA solely in exchange for FA stock.

(ii) Analysis. The FA stock issued to PRS in exchange for the marketable securities is not taken into account for purposes of the Ownership Condition.

Example 2. Stock issued with a principal purpose of avoiding Section 7874. (i) Facts. FA acquires all the DT stock in exchange solely for FA stock. In a transaction related to FA's acquisition of the DT stock, PRS transfers marketable securities (within the meaning of Section 453(f)(2)) to FT, a newly formed foreign corporation, solely in exchange for FT stock and then transfers the FT stock to FA in exchange solely for FA stock. The shares of FT stock do not constitute marketable securities within the meaning of Section 453(f)(2).

(ii) Analysis. The FA stock issued to PRS in exchange for the FT stock is not taken into account for purposes of the Ownership Condition because a principal purpose of such issuance is the avoidance of the purposes of Section 7874.

Example 3. (DT and DMS are domestic corporations while FT, FA and FMS are foreign corporations) Stock issued or exchanged for stock of a foreign corporation. (i) Facts. The stock of DT and FT is publicly traded. The following transactions are completed pursuant to a plan: FT forms FA, and FA forms DMS and FMS. FMS merges with and into FT, with FT surviving the merger. Pursuant to the FMS-FT merger, the FT shareholders exchange their FT stock solely for FA stock. Following the FMS-FT merger, DMS merges with and into DT, with DT surviving the merger. Pursuant to the DMS-DT merger, the DT shareholders exchange their DT stock solely for FA stock. After completion of the plan, FA wholly owns FT and DT.

(ii) Analysis. After the FMS-FT merger, FT is a member of the expanded affiliated group that includes FA. Therefore, the shares of FT stock are not treated as marketable securities and therefore do not constitute nonqualified property. Thus, the FA stock issued or exchanged for the FT stock is taken into account for purposes of the Ownership Condition.

(iii) Alternative facts. Assume the same facts as in paragraph (i) of this example except that, instead, FT merges with and into FA with FA surviving the merger. At the time of the merger, FT does not hold nonqualified property. Pursuant to the FT-FA merger, the FT shareholders exchange their FT stock solely for FA stock. Because the properties transferred by FT to FA pursuant to the FT-FA merger do not constitute nonqualified property, the FA stock issued in exchange for such properties pursuant to the merger will be taken into account for purposes of the Ownership Condition.

Effective Date of Notice 2009-70.The regulations described in this notice shall apply to acquisitions completed on or after September 17, 2009. Taxpayers may apply the rules described in this notice in their entirety to acquisitions completed on or after September 17, 2009, and before publication of the regulations described in this notice if the rules are applied consistently to all such acquisitions.No inference is intended as to the treatment of transactions described in this notice under current law and the IRS may, where appropriate, challenge such transactions under applicable provisions, including under section 7874(c)(4) or judicial doctrines (such as the substance-over-form doctrine).

New Regulations Under Section 108(e)(8); Creditor's Contribution of Debt to Debtor Partnership In Exchange For Equity Interest

Jerald David August — Tue, 20 Mar 2012 12:13:57 -0500

Last November 17^th, the Treasury and the Service issued final regulations (TD 9557) concerning the tax impact of a contribution of partnership indebtedness to a partnership in exchange for an interest in the partnership. These Regulations, effective for debt-for-equity exchanges occurring after 11/16/11, implement changes in Section 108(e)(8) that were adopted by Congress in the American Jobs Creation Act of 2004 (AJCA). Proposed Regulations had been issued on the subject in October 2008.

Section 108(e)(8)

Section 108(e)(8) provides that where an outstanding indebtedness is satisfied by a partnership interest (capital or profits interests) of the debtor-partnership (or stock of the debtor corporation) to a creditor in satisfaction of a recourse or nonrecourse debt, the partnership (corporation) is retreated as having satisfied the debt for an amount of money equal to the FMV of the partnership interest (or stock). For partnerships, the amount of COD income recognized under Section 108(e)(b) must be included in the distributive shares of the taxpayers which were partners in the partnership immediately before the discharge. See Section 108(e)(6)(debt contributed to capital by shareholders). See also Rev. Rul. 91-31, 1991-1 C.B. 19 (cancellation of recourse versus nonrecourse debt). The legislative history under AJCA provides that Section 108(e)(8) applies to an exchange of debt for a partnership interest whether the liability is recourse or nonrecourse.

Final Regulations: General Rule

The general rule previously recited under Section 108(e)(8) is repeated under Treas Reg. §1.108-8(a). Under Treas. Reg. § 1.108-8(b)(1) the FMV of a partnership interest transferred by a debtor partnership to a creditor in satisfaction of the partnership's indebtedness (a debt-for-equity exchange) is determined by taking into consideration all of the facts and circumstances. A safe harbor contained in Treas. Reg. §1.108-8(b)(2)(i) provides that FMV will be the liquidation value of the partnership interest if certain conditions are met; (i) the creditor, the debtor partnership, and its partners treat the FMV of the indebtedness as being equal to the liquidation value of the interest for purposes of determining the tax consequences of the exchange; (ii) the debtor partnership transfers more than one equity interest to a creditor in exchange for debt, then each creditor, the partnership and its partners treat the FMV of each such interest transferred by the partnership to such creditors as equal to its liquidation value; (iii) the debt-for-equity exchange is an arm's-length transaction; and (iv) any subsequent to the debt-for-equity exchange, neither the partnership redeems nor any person related to the partnership purchases the interest as part of a plan (at the time of the exchange) that has as a principal purpose the avoidance of COD income by the partnership. A prior requirement in the proposed regulations that the partnership had to maintain capital accounts in accordance with the substantial economic effect test to fall within the safe harbor was eliminated in the final regulations.

Related-party Transactions.

The final Regulations provide, as a clarification from the proposed regulations, that the liquidation-value safe harbor is available where the transaction involves related parties, provided that the debt-for-equity exchange has terms that are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests. On the other hand, under an anti-abuse rule contained in the final Regulations, the partnership cannot redeem and no person related to the partnership, i.e., under Sections 267 or 707(b), or to any partner, can purchase the debt-for-equity partnership interest as part of a plan at the time of the debt-for-equity exchange that has as a principal purpose the avoidance of COD income by the partnership.

Impact on Creditor

To the creditor swapping the debt instrument for a partnership interest, Section 721 will apply in general but the regulations acknowledge that Section 721 does not apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership's indebtedness for unpaid rent, royalties, or interest on indebtedness (including accrued OID), i.e., items that would have given rise to ordinary income to the creditor and a deduction by the partnership.

The creditor’s basis in its partnership interest is determined under Section 722, which will be the partner’s adjusted basis in the debt plus any gain recognized on the contribution. For holding period, see Section 1223. The final regulations rejected allowing the creditor to treat the cancelled debt for partnership interest to bifurcate the “note” into a note for interest exchange and a bade debt. The Treasury and the Service viewed bifurcation in this context was inconsistent with Section 721 as well as the results attributable to a debt for stock scenario under the corporate rules. Still, it may be possible, i.e., consult your tax advisor, to claim a bad debt deduction prior to and separate from the exchange of debt for stock particularly if the debt can qualify for partial worthlessness.

Debt Cancelled for Deductible Items Such as Rent, Interest or Royalties

Under a Section 721 model, the issuance of a partnership interest for the cancellation of previously expensed items would be treated generally as ordinary income to the creditor and generate a deductible expense to the partnership.. The final Regulations change the model for reporting this exchange of consideration. A debtor partnership will not recognize gain on the transfer of a partnership interest to a creditor in a debt-for-equity exchange for unpaid rent, royalties, or interest that accrued on or after the beginning of the creditor's holding period for the indebtedness.

Minimum Gain Chargeback Impact

The final regulations provide that COD income from a discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes.

Treatment of Cancelled Installment Obligations

Section 453B generally provides that if an installment obligation of a taxpayer is satisfied at other than its face value or the taxpayer distributes, transmits, sells, or otherwise disposes of an installment obligation, the taxpayer recognizes any deferred gain or loss. Treas. Reg. §1.453-9(c)(2) provides that the contribution of an installment obligation to a partnership under Section 721 does not constitute a disposition. The Treasury and Service announced that this exception should not apply to a creditor who disposes of an installment obligation of a partnership by contributing it to the debtor partnership, even if the transaction qualifies under Section 721. The creditor must instead recognize gain or loss under Section 453B. This would parallel treatment for the disposition of a ISO to a corporation for stock in a Section 351 transaction. This subject will be addressed in proposed regulations to be issued.

Special Allocation Rules for COD Income

While the proposed regulations did not address this area, it was the subject of prior rulings issued by the Service. First, in Rev. Rul. 92-97, 1992-2 C.B. 124, the Service held that an allocation of COD income that differs from the share of cancelled debt has substantial economic effect if (1) the deficit restoration obligations covering any negative capital account balances resulting from the COD income allocations can be invoked to satisfy other partners' positive capital account balances, (2) the requirements of the economic effect test are otherwise met, and (3) substantiality is independently established. In Rev. Rul. 99-43, 1999-2 C.B. 506 the Service warned that special allocations lack substantiality when the partners amend the partnership agreement to specially allocate COD income and book items from a related revaluation after the events creating such items have occurred, if the overall economic effect of the special allocations on the capital accounts does not differ substantially from the original allocations. The Service and Treasury were of the same view that based on the existing guidance no additional guidance on this subject was necessary in the final regulations pertaining to a debt in exchange for equity exchange.

French Parliament Recently Enacts Legislation for Tax and Disclosure Obligations on Trusts: France's Version of FATCA

Jerald David August — Tue, 20 Mar 2012 10:05:57 -0500

Legislation passed by the French Parliament in July 2011 imposes a new set of tax and disclosure obligations on trusts which have some connection to France. The legislation was passed by the Parliament on July 5 and published July 30.

Changes in Frances Wealth and Gift and Inheritance Taxes: An Overview

The legislation made significant changes to the wealth tax and to gift and inheritance taxes, abolished the tax shield, and introduced an exit tax on unrealized capital gains. As of 2011 the tax threshold or exemption has been increased from €800,000 to €1.3 million and the current tax brackets will change in 2012. For estates of French domiciliaries valued at €1.3 million to €3 million, the tax rate will be 0.25 percent, and for estates valued above €3 million, the tax rate will be 0.50 percent. To reduce the threshold effect, tax relief is available for estates valued at €1.3 million to €1.4 million and for estates worth €3 million to €3.2 million. For example, the tax will be reduced by €1,500 for net assets valued at €1.3 million, and by €7,500 for net assets valued at €3 millions.

The elimination of the wealth tax for estates worth less than €1.3 million will apply in 2011. Starting in 2012, for estates worth €1.3 million to €3 million, the tax reporting will be made directly on the income tax return, and a detailed statement will be required only for estates worth at least €3 million. The wealth tax ceiling (which covers as much as 85%of the income received during the previous year) will be eliminated in 2012. Other reforms include relaxation of the wealth tax exemption for professional athletes and valuation of shares in a real estate company in which nonresidents own interests indirectly in French real estate and eased rules pertaining to the Dutreil agreement that allows a partial exemption from the wealth tax and the gift and inheritance tax for company shares where a collective undertaking holds such shares for at least 6 years. . Other changes were made to taxation of gifts and inheritances. For example, the new legislation all transfers made through a trust will be subject to inheritance tax and gift tax. If the transfer is in the form of a gift or inheritance, the tax rules on gifts and inheritances will apply. For transfers that cannot be classified as a gift or inheritance, the goods, rights, or revenues put into the trust will be taxed under the rules applicable to inheritance at the time of death of the settlor, regardless of whether the goods are immediately transferred to the beneficiaries (even if they are not included in the taxable inheritance of the settlor) or remain in the trust. In such situations, the tax rate is determined by the beneficiaries' relationship to the settlor, with rates ranging from 5 to 60%. If the beneficiaries of the trust are not individually identified, they are taxed at the marginal rate of the scale (that is, 45% for a direct kinship or 60% for an indirect kinship). A rate of 60 percent also will apply if the law applicable to the trustee is the law of an uncooperative state or if the trust was set up after May 11, 2011, by a settlor who is not a French tax resident.

Exit Tax on Unrealized Capital Gains

A new exit tax on unrealized capital gains will apply retroactively from March 3, 2011, to all French tax residents who move abroad. The tax will apply to: all underlying capital gains relating to shares that represent at least 1% of the capital of a company, or to a direct or indirect stake evaluated at more than €1.3 million, if the taxpayer was a French tax resident during at least six of the 10 years preceding the transfer of residence outside of France; all capital gain on shares for which taxation has been postponed; and all sums payable under an earn-out provision, if the taxpayer was a French tax resident during at least six of the 10 years preceding the transfer of residence outside France.

The rate of the exit tax will be the capital gains tax rate, plus social contributions, in force at the time of the transfer. However, an automatic tax deferral is granted to French tax residents who transfer their tax residence to another EU member state or to a European Economic Area member state that has entered into an administrative assistance agreement with France to fight fraud and tax evasion, and a mutual assistance agreement for the collection of taxes. For other states, a tax deferral can be granted upon a specific request by the taxpayer.

New Compliance and Reporting Rules on French Situs or French RelatedTrusts

Commencing January 1, 2012, trusts, which term presumably includes foundations and similar entities are subject to stringent reporting rules. For example, the new disclosure regime applies even if no French wealth tax (ISF) is payable on the assets. The regime introduces a standard annual 0.5 per cent withholding tax that substitutes and overrides wealth tax. The trustee is responsible for the filing and payment of this tax (which is not however due if the relevant assets have been declared as part of the settlor's or beneficiary's wealth that is subject to the ISF tax, and if the disclosure obligations have been complied with).

The trustee must also disclose the creation and amendment of the trust, its main terms, and the market value of the assets on January 1 of each year, starting in 2012. Returns must be provided to the French tax authority by June 15 with corresponding tax payment requirements. An add-on penalty of 5% of the trust’s worldwide assets may be imposed where assets are not reported. There is a minimum penalty of 10,000 Euros for non-disclosure. The penalty would be imposed on the trustees, but the settlor and beneficiaries are also jointly and severally liable. The French authorities can seize the trusts's French assets to secure the fine. There is provision for criminal charges, including imprisonment, where the trustee is within the jurisdiction. Many believe the new law is unfair and is incompatible with France’s tax treaties and the EU rules on the free movement of capital.

The legislation is unusual in that it creates a regime for the definition and taxation of trusts even though France doesn't recognize the concept of a trust. (France signed the 1985 Hague Convention on the Recognition of Trusts but never ratified it.) A trust is defined in the French legislation as the legal rights created under the law of a country other than France by a "constituant" (settlor), either inter vivos or upon death, who transfers assets to an administrator (trustee) in the interests of one or more beneficiaries or for a defined objective. Observers say that wording is broad and likely covers fixed and discretionary trusts.

The legislation introduces a specific annual 0.5% withholding tax on trusts that is intended to act as an incentive on the settlor or beneficiaries to comply with any wealth tax declaration obligations. The withholding tax will apply when the settlor or one of the beneficiaries is a French tax resident or when the trust holds an asset or a right located in France. The tax applies to worldwide assets if the parties are tax resident in France, but only to French assets if the parties are not French tax residents. The trustee is responsible for the filing and payment of the withholding tax.

The withholding tax will not apply if the settlor or beneficiary declares the trust assets as part of his annual wealth tax return, or if new disclosure obligations have been fulfilled. Under the new disclosure regime, trustees will have to report annually on assets held in trusts if the settlor or one of the beneficiaries is a French tax resident or if any trust asset is situated in France. The trustee must disclose the setting up, modification, and, when applicable, the termination of a trust; the main terms of the trust; and the fair market value as of January 1 of the trust's assets that fall within the scope of the 0.5% withholding tax. If the settlor or a beneficiary of the trust is a French tax resident, the reporting requirement includes worldwide assets in trust, including assets that are exempt from the French wealth tax or are otherwise reported for wealth tax purposes; when there are no French resident settlors or beneficiaries, the reporting requirement applies only to French situs assets. The disclosure must be filed by June 15 each year.

Why the Strong Measures by the French Government?

It is fairly well understood that many French taxpayers had used trusts or offshore foundations or other entities to hide money in Swiss banks or other tax haven jurisdictions. The new legislation equates, if you will, the use of trusts as a tool for tax evasion. There are various comments and criticisms about the new legislation.

The new disclosure obligations also pose potential conflicts under local law if the trustee resides in a jurisdiction that forbids such disclosure. "In Singapore, for example, trustees cannot by application of Singapore law disclose any information regarding trusts to a foreign authority, unless they get the consent of a settlor or the beneficiary," "So clearly we have a conflict between French law, which wants to be extraterritorial, and the local law of the trustee. The new trust reporting rules could make trust companies somewhat resistant to dealing with French residents.

Relation To FATCA?

The new trustee and trust rules of France are similar to the FATCA rules that require foreign financial institutions to provide information to the IRS about U.S. citizens holding accounts in those institutions. The Foreign Account Tax Compliance Act (FATCA), enacted in 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act, is an important development in U.S. efforts to combat tax evasion by U.S. persons holding investments in offshore accounts.

Under FATCA, certain U.S. taxpayers holding financial assets outside the United States must report those assets to the IRS. In addition, FATCA will require foreign financial institutions to report directly to the IRS certain information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest.

FATCA requires certain U.S. taxpayers holding foreign financial assets with an aggregate value exceeding $50,000 to report certain information about those assets on a new form (Form 8938) that must be attached to the taxpayer’s annual tax return. Reporting applies for assets held in taxable years beginning after March 18, 2010. For most taxpayers this will be the 2011 tax return they file during the 2012 tax filing season. Failure to report foreign financial assets on Form 8938 will result in a penalty of $10,000 (and a penalty up to $50,000 for continued failure after IRS notification). Further, underpayments of tax attributable to non-disclosed foreign financial assets will be subject to an additional substantial understatement penalty of 40 percent.

Reporting by Foreign Financial Institutions Under FATCA

FATCA will also require foreign financial institutions (“FFIs”) to report directly to the IRS certain information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. To properly comply with these new reporting requirements, an FFI will have to enter into a special agreement with the IRS by June 30, 2013. Under this agreement a “participating” FFI will be obligated to: (i) undertake certain identification and due diligence procedures with respect to its accountholders; (ii) report annually to the IRS on its accountholders who are U.S. persons or foreign entities with substantial U.S. ownership; and (iii) withhold and pay over to the Service 30% of any payments of U.S. source income, as well as gross proceeds from the sale of securities that generate U.S. source income, made to (a) non-participating FFIs, (b) individual accountholders failing to provide sufficient information to determine whether or not they are a U.S. person, or (c) foreign entity accountholders failing to provide sufficient information about the identity of its substantial U.S. owners. See Notice 2011-53 for phase-in periods for FATCA implementation. See also proposed regulations issued on February 8, 2012.

United States Department of Justice Files Indictments Against Switzerland's Oldest Private Bank And Employees of Other Swiss Banks

Jerald David August — Tue, 20 Mar 2012 09:16:20 -0500

The Department of Justice is moving forward with several new prosecutions of a Swiss bank and employees of other Swiss banks in separate indictments that were filed recently. In an information release issued on February 2, 2012, the DOJ issued an indictment against Wegelin & Co., the oldest private bank in Switzerland which was founded in 1741. At all times relevant to the (superseding) indictment, Wegelin provided private banking, asset management and other services to clients throughout the world, including U.S. taxpayers living in the Southern District of New York. Wegelin had no branches outside of Switzerland, but accessed the U.S. banking system through a correspondent bank account it held at UBS AG in Stamford, Conn. This is the first time that a foreign bank operating outside of the United States has been criminally indicted by the United States for facilitating and concealing tax fraud committed by U.S. persons. The indictment alleges that Wegelin Bank conspired with certain U.S. citizens or residents to conceal $1.2 billion from the IRS through the use of secret accounts. The income generated from such secret accounts was also not reported to the IRS.

In response to the indictment and publication of the scandal, Wegelin was immediately sold to a competitor bank, the Raiffessen Group. At the same time that the indictment was filed, a civil forfeiture complaint was filed and asset seizure warrant issued against Wegelin’s correspondent bank account in the U.S. The government reportedly seized over $16 million from the account. Wegelin is charged in a superseding indictment with three client advisers of the bank,

Michael Berlinka, Urs Frei and Roger Keller, who were previously charged with the same conspiracy. From 2002 through 2011, Wegelin, Berlinka, Frei and Keller allegedly conspired with various U.S. taxpayers and others to hide the existence of bank accounts held with Wegelin and the income generated from such accounts. During 2008 and 2008, Wegelin, Berlinka, Frei and Keller opened and serviced many persons with secret accounts in an effort to obtain clients lost by UBS in light of the UBS investigation since by mid-2008, UBS ceased servicing undeclared accounts for U.S. taxpayers. Thus, Wegelin’s senior management allegedly purposely and knowingly wanted to capture the illegal business that had been operated by UBS. Both the criminal and civil forfeiture cases are pending with the United States District Court for the Southern District of New York.

The following allegations are based on the Superseding Indictment and civil forfeiture Complaint unsealed today in Manhattan federal court: Wegelin, founded in 1741, is Switzerland’s oldest bank. At all times relevant to the superseding indictment, Wegelin provided private banking, asset management and other services to clients around the world, including U.S. taxpayers living in the Southern District of New York. Wegelin had no branches outside Switzerland, but it directly accessed the U.S. banking system through a correspondent bank account that it held at UBS AG in Stamford, Conn. As of December 2010, Wegelin had approximately $25 billion in assets under management. Berlinka, Frei and Keller began working as client advisers at the Swiss bank in 2008, 2006 and 2007 respectively. From 2002 through 2011, Wegelin, Berlinka, Frei and Keller conspired with various U.S. taxpayers and others to hide the existence of bank accounts held at Wegelin and the income generated in those secret accounts from the IRS. Among other things, in 2008 and 2009, Wegelin, Berlinka, Frei and Keller opened and serviced dozens of undeclared accounts for U.S. taxpayers in an effort to capture clients lost by UBS in the wake of widespread news reports that the IRS was investigating UBS for helping U.S. taxpayers evade taxes and hide assets in Swiss bank accounts. By mid-2008, UBS had stopped servicing undeclared accounts for U.S. taxpayers.

Due to the scandal, members of Wegelin’s senior management affirmatively decided to capture the illegal business that UBS exited. To capitalize on the business opportunity this presented and to increase the assets under management, along with the fees earned from managing those assets, Berlinka, Frei, Keller and others, acting on behalf of Wegelin, told various U.S. taxpayer-clients that their undeclared accounts would not be disclosed to U.S. authorities because the bank had a long tradition of secrecy. They also persuaded U.S. taxpayer-clients to transfer assets from UBS to Wegelin by emphasizing, among other things, that unlike UBS, Wegelin did not have offices outside of Switzerland and was therefore less vulnerable to U.S. law enforcement pressure. Members of the Swiss bank’s senior management approved efforts to capture the clients who were leaving UBS and also participated in some meetings with U.S. taxpayer-clients who were fleeing UBS. In February 2009, UBS entered into a deferred prosecution agreement with the Justice Department on charges of conspiring to defraud the United States by impeding the IRS. As part of the deferred prosecution agreement, UBS paid $780 million in fines, penalties, interest and restitution.

To further the goals of the conspiracy, Wegelin, acting through Berlinka, Frei, Keller and/or others, took steps that included: (i) opening and servicing undeclared accounts for U.S. taxpayer-clients in the names of sham corporations and foundations formed under the laws of Liechtenstein, Panama, Hong Kong and other jurisdictions for the purpose of concealing some clients’ identities from the IRS;(ii) accepting, as part of Wegelin’s client files, documents that falsely declared that the sham entities were the beneficial owners of certain accounts, when in fact the accounts were owned by U.S. taxpayers; (iii) allow certain U.S. taxpayer-clients to open and maintain undeclared accounts at Wegelin using code names and numbers to minimize references to the actual names of the U.S. taxpayers on Swiss bank documents;(iv) ensure that account statements and other mail for U.S. taxpayer-clients were not mailed to them in the United States; (v)communicate with some U.S. taxpayer-clients using their personal email accounts to reduce the risk of detection by law enforcement; and (vi) have checks drawn on, and executing wire transfers through, its U.S. correspondent bank account for the benefit of U.S. taxpayers with undeclared accounts at Wegelin and at least two other Swiss banks. In doing so, the bank sometimes separated the transactions into batches of checks or multiple wire transfers in amounts that were less than $10,000 to reduce the risk that the IRS would detect the undeclared accounts. U.S. taxpayers are required to report the existence of any foreign bank account on their federal income tax returns if it holds more than $10,000 at any time during a given year, as well as any income it earns. By 2010, the collective maximum value of the assets in undeclared accounts beneficially owned by U.S. taxpayer-clients of Wegelin was more than $1.2 billion, with many accounts holding more than $10,000 in any one year.

The civil forfeiture complaint and the related seizure warrant arise out of Wegelin’s use of its correspondent bank account to help U.S. taxpayers with undeclared accounts repatriate money that they had hidden at the Swiss bank. This was often done in a manner designed to evade detection by U.S. authorities. For example, U.S. taxpayers routinely asked Wegelin to issue and send them checks, which were drawn off the bank’s correspondent bank account, that represented funds held in their secret accounts at the bank. Further, Wegelin permitted at least two other Swiss banks to issue checks drawn on its correspondent bank account for the benefit of U.S. taxpayers holding undeclared accounts at these other Swiss banks. The sheer volume of transactions in Wegelin’s correspondent bank account served to conceal the repatriation of money from U.S. taxpayers’ undeclared accounts at Wegelin and the other banks. “As alleged, Wegelin Bank aided and abetted U.S. taxpayers who were in flagrant violation of the tax code,” said Preet Bharara, U.S. Attorney for the Southern District of New York. “And they were undeterred by the crystal clear warning they got when they learned that UBS was under investigation for the identical practices. The indictment makes clear that we will seek to punish not only those U.S. taxpayers who violate the law in an effort to avoid paying their fair share of taxes, but also the individuals and entities who facilitate their crimes.” Joining in was IRS Commissioner Douglas Shulman who was quoted as saving that the indictment “[i]s another step in our ongoing effort to pursue hidden offshore assets – no matter where they are located. We are continuing our work to crack down on offshore tax evasion. Through our efforts, we are gaining access to more and more information on institutions and individuals involved in offshore tax evasion, and you can expect us to pursue all avenues to stop this abuse.”

President Obama Announces Corporate Income Tax Reform Proposal: Rate Reduction

Jerald David August — Wed, 22 Feb 2012 11:05:48 -0500

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

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

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

Argentina 35%

Australia 30%

Austria 25%

Brazil 34%

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

PRC (China) 25%

Denmark 25%

France 33.3%

Germany 29.8% (approx.)

Hong Kong 16.5%

India 33.2175%

Ireland 12.5%-25%-10%

Italy 31.4%

Japan 40.69%

Mexico 28%

Netherlands 20/25%

New Zealand 28%

Norway 28%

Poland 19%

Portugal 25%

Russia 20%-13%

South Africa 28%

South Korea 10%,20%,22%

Sweden 26.3%

Switzerland 13-25%

Taiwan 17%

United Kingdom 20%-25%

Venezuela 15%/22%/34%

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

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

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

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

[1] In November 2005, President Bush's Advisory Panel on Federal Tax Reform published its report. The Panel recommended the adoption of a simplified income tax plan (SITP) that included a “straightforward territorial method for taxing active foreign income.” Under the SITP:

“Active business income earned abroad in foreign affiliates (branches and controlled foreign subsidiaries) would be taxed on a territorial basis. Under the system, dividends paid by a foreign affiliate out of active foreign earnings would not be subject to corporate level tax in the United States. Payments from a foreign affiliate that are deductible abroad, however, such as royalties and interest would generally be taxed in the United States. Reasonable rules would be imposed to make sure that expenses incurred in the United States to generate exempt foreign income would not be deductible against taxable income in the United States.”

Facebook Founder, Mark Zuckerberg, Expected to Realize $6 Billion in Gross Income On Exercise of Nonqualified Stock Options in Facebook's Initial IPO

Jerald David August — Wed, 15 Feb 2012 17:21:00 -0500

Under Section 83, the transfer of property in connection with the performance of services, results in compensation to the service provider in the year in which the property received is non-forfeitable or transferable, and, if neither, if a timely election is made under Section 83(b). Where the “property” transferred consists of options of the employer’s stock, the options are currently includible in gross income as long as they have a “readily ascertainable fair market value” at the time of grant. But see §83(e)(3). The regulations, under Treas. Reg. §1.83-7(b)(2), provide a definition of “readily ascertainable value” if the subject options are actively traded on an established market. In the event that the options are not actively traded on an established market, an option still has a readily ascertainable fair market value where: (i) the option is transferable and is immediately excercisable in full; (ii) the option’s value is not significantly affected by any restriction on the option or the stock to be acquired on exercise, other than a lien or other condition to secure payment of the purchase price; and (iii) the fair market value of the “option privilege” can be measured with reasonable accuracy. See Cramer v. Comm’r, 64 F.3d 1406(9th Cir. 1995); Pagel, Inc. v. Comm’r, 91 T.C. 200 (1988), aff’d, 905 F.2d 1190 (8th Cir. 1990). In many instances the grant of a “nonqualified stock option” will not have a readily ascertainable fair market value. In such case the income tax event remains “open” until the option is exercised, even if the option obtains a readily ascertainable fair market value post-issuance. Comm’r v. LoBue, 351 U.S. 243 (1956). Thus, on exercise, the employee or service provider realizes compensation income to the extent that the value of the shares obtained through the exercise of the option on date of receipt exceeds the amount paid on the exercise. Of course, were the option holder to dispose of the options prior to exercise in a taxable transaction with an unrelated person, the income would be realized at such time. Treas. Reg. §1.83-7(a). Under Section 83(h), an employer is entitled to a deduction under Section 162 for amounts employees or service providers are required to include on grant or exercise of a stock option or other income triggering events. See Rev. Rul. 2003-98, 2003-34 IRB 379.

Now, on to Mr. Zuckerberg, who is expected to become a multi-billionaire shortly as a consequence of the IPO if one considers publicly traded shares to have greater value for achieving economic star status than mere ownership of a company of the same earnings capacity whose equity is not publicly traded. It is reported from the Form S-1 (registration statement) filed by the Company that Zuckerberg will exercise nonstatutory options to acquire 120 million shares of Facebook’s class B (voting) stock. It is presumed that the options, all of which have vested, were treated by the 2004 Harvard University graduate as “open” under Treas. Reg. §1.83-7 at time of grant. The options will expire in 2015.

What is presently uncertain will be the initial IPO price. Let’s assume a value of approximately $100 billion, yes, $100 billion. This results in a per share value for class B shares of approximately $50 per share. The exercise or strike price under the options is quite low, 6 cents per share. So, simple arithmetic would say that if Mr. Zuckerberg exercises options sufficient to realize $6 billion in value, in which he would have a strike price of $7.2 million, the federal income tax on the gain on exercise would exceed $2 billion. Undoubtedly, he would have to immediately dispose of some shares to pay this enormous tax liability although he is barred by certain securities laws from short-selling his shares. Perhaps a derivative “short position” or hedge or a prepaid variable forward contract, as some have suggested, would provide him with liquidity to pay taxes without running afoul of SEC rules. He might be wise to exercise much of his options now since despite the immediate tax cost, he can benefit from upside appreciation at capital gains rates then were he to wait and exercise a substantial portion later. Anyway, he can afford to bring in the “best” advisors to sort that out for him no doubt.

The Company may expect to be able to report a deduction under Section 83(h) for the amount of income realized by Zuckerberg as well as other executives exercising their NQSOs upon the issuance of the IPO. The registration statement mentions that such deductions could generate a tax refund of up to $500 million. Still, withholding would be required, perhaps as early as the day after exercise, which may be achieved in the form of a so-called “cashless exercise” but perhaps that would generate a problem under Section 402(a) of the Sarbanes-Oxley Act provisions as an improper extension of credit. A suggestion was made in the tax press that perhaps the market-maker (underwriter) could advance the withholding amount to the company before the market sale. More legal advisors necessary. As to the current deductibility of the compensation income, Treas. Reg. §1.83-6(a)(4) provides that no deduction is permitted under Section 83(h) to the extent that the expenditures (for receiving the services rendered) have to be capitalized. See Treas. Reg. §1.263A-1. There are also potential issues under Section 162(m) which applies compensation paid to highly compensated executives of public companies.

Congress has entered into the Facebook IPO news so to speak. On February 7^th, Senator Carl Levin (D-Mich), introduced the Cut Unjustified Tax Loopholes Act (S.2075) to limit the corporate deductibility of nonstatutory stock options to $1M and also expand the definition under Section 162(m) of “applicable employee remuneration” .

Another reform being kicked about is a proposed mark-to-market taxation system for publicly traded securities, including derivatives, held by the wealthiest and highest earning 1/10 of 1% of individuals. Under the proposal, all public companies, all private companies with $50 million or more of net assets, and all individuals and married couples with $1.6 million of adjusted gross income or $5 million of publicly traded property would be required to mark to market their publicly traded property, derivatives of publicly traded property, and some publicly traded debt and other liabilities. Mark-to-market gains of corporations would be taxed at the regular corporate rates and mark-to-market losses of corporations would be deductible against ordinary income or capital gains. For individuals, the tax rate on gains would be at long term capital gains rate and interest or other ordinary income at 35%. Individuals who are securities dealers or receive allocations of gains for performing investment services, i.e., carried interests, would be taxed at ordinary rates. All other taxpayers would remain on the realization system. This proposal has been coined the “Zuckerberg tax”. In this election year partisan bickering, perhaps these proposals are just "political amunition" and have little chance of being enacted into law.

Treasury Issues Proposed Regulations on FATCA: Joint Statement Issued with 5 European Nations Outlining an Alternative Approach

Jerald David August — Wed, 15 Feb 2012 11:38:46 -0500

Congress, in 2010, enacted a new set of rules on the required reporting and withholding with respect to foreign financial accounts and nonfinancial foreign entities in Pub. L. No. 111-147, §501 (2010)(the “HIRE ACT”). This legislation added Chapter 4 of Subtitle A of the Code which was originally introduced as part of the Foreign Account Tax Compliance Act of 2009 This Chapter consists of Sections 1471 through 1474.

The Service had previously issued preliminary guidance on Chapter 4. Notices 2010-60, 2010-37 I.R.B. 329, 2011-34, 2011-19 I.R.B. 765 and 2011-53, 2011-32 I.R.B. 124. See also Proc. Reg. §601.601(d)(2). Chapter 4 was enacted into law by Congress to extend the scope of the U.S. information reporting rules to include foreign financial institutions that maintain U.S. accounts. New disclosure obligations are imposed on certain nonfinancial foreign entities that present a high risk of tax avoidance. As an additional development, the Treasury Department and the IRS have been in consult with several foreign countries concerning the adoption of an alternative approach whereby an foreign financial institution could satisfy Chapter 4’s requirements if: (i) the foreign financial institution collects the information required under Chapter 4 and reports this to the residence country; and (ii) the residence country enters into an agreement to report such information annually to the IRS under Chapter 4, an income tax treaty, TIEA or other agreement with the U.S. The countries consulted with include France, Germany, Italy, Spain, and the United Kingdom.

The rules require foreign financial institutions (FFIs) as well as other foreign entities (nonfinancial foreign entities or NFFEs) to report to the Service information on financial accounts as well as other interests of U.S. persons. For foreign entities, where compliance with new reporting rules may prove difficult, Congress requires, under FATCA, payors to withhold tax at 30% with respect to U.S. source payments made to foreign entities, including interest, dividends, and royalties, and from the proceeds of sales of items producing interest or dividends from U.S. sources. The withholding tax applies whether the foreign entity receives the payments as beneficial owner or as agent for a client and whether the beneficial owner is a U.S. or foreign person. The special FATCA withholding tax of 30% is imposed on items that previously were not subject to withholding such as portfolio interest and capital gains of foreign investors. The special withholding rule overrides any treaty provision that the U.S. has entered into. A foreign financial institution (FFI) may avoid the obligation to make the 30% withholding by entering into an agreement with the IRS by which it agrees to make timely reports to the IRS on accounts of U.S. persons. A FFI may have previously entered into a qualified intermediary agreement (QI) for purposes of withholding on investment income, e.g., dividends, interest, royalties, and other fixed or determinable annual or periodical income. See §§1441, 1442. The FATCA withholding applies in addition to FDAP withholding under a QI agreement but provisionson the 30% FATCA withholding may be added to the agreement. Other foreign based entities (NFFEs) can avoid the 30% withholding tax by supplying required information as to their U.S. owners to U.S. withholding agents.

Generally, FATCA becomes effective for payments made after 2012. However, payments on an “obligation outstanding on” March 18, 2012, are exempt from withholding under FATCA as are the proceeds of a sale or other disposition of such an obligation but not for purposes of Sections 1441 or 1442. A “signification modification” of a debt instrument that was otherwise within the grandfather rule will trigger application of the FATCA provisions. A three year phase-in period was allowed by Congress to allow foreign entities to understand and implement compliance guidelines and procedures.

The summary to the proposed regulations incorporate the guidance already published under the FATCA Notices that had been issued and also provide guidance not previously addressed. Significant modifications and additions to the FATCA Notices listed included:

a. Expansion of Definition of “Grandfathered Obligations”. As mentioned, the HIRE Act grandfathers in and thus avoids FATCA withholding on obligations outstanding on or before March 18, 2012 or from the proceeds from the disposition of any such obligation. The proposed regulations exclude from the definition of “withholdable payment” and “passthru payment’ any payment made under an obligation outstanding on January 1, 2013 and any gross proceeds from the disposition of such an obligation.

b. Transitional Rules for Affiliates with Legal Prohibitions on Compliance. Section 1471(e) provides that the requirements of the FFI agreement shall apply to the U.S. accounts of the participating FFI and, except as otherwise provided by the Secretary, to the U.S. accounts of each other FFI that is a member of the same expanded affiliated group. Notice 2011-34 states that the Treasury Department and the IRS intend to require that each FFI that is a member of an expanded affiliated group must be a participating FFI or deemed-compliant FFI in order for any FFI in the expanded affiliated group to become a participating FFI. Recognizing that some jurisdictions have in place laws that prohibit an FFI's compliance with certain of chapter 4's requirements, the proposed regulations provide a two-year transition, until January 1, 2016, for the full implementation of this requirement. During this transitional period, an FFI affiliate in a jurisdiction that prohibits the reporting or withholding required by chapter 4 will not prevent the other FFIs within the same expanded affiliated group from entering into an FFI agreement, provided that the FFI in the restrictive jurisdiction agrees to perform due diligence to identify its U.S. accounts, maintain certain records, and meet certain other requirements. Similar rules apply to branches of FFIs that are subject to comparable restrictions.

c. Modification of Due Diligence Procedures for Account Identification. Section 1471(b) requires FFIs to identify their U.S. accounts. Guidance is provided in Noticies 2010-60 and 2011-34 on the subject. Comments received by the Treasury suggested modifications be made to that guidance, in particular with respect to preexisting accounts, to reduce the administrative burden on FFIs. In response, the proposed regulations rely primarily on electronic reviews of preexisting accounts. For preexisting individual accounts that are offshore obligations, manual review of paper records is limited to accounts with a balance or value that exceeds $1,000,000 (unless the electronic searches meet certain requirements, in which case manual review is not required). In addition, the proposed regulations provide detailed guidance on the precise scope of paper records required to be searched. Additionally, with respect to preexisting accounts, individual accounts with a balance or value of $50,000 or less, and certain cash value insurance contracts with a value of $250,000 or less, are excluded from the due diligence procedure. Other rules are set forth in the proposed regulations.

d. Guidance on Procedures Required to Verify Compliance. Section 1471(b)(1)(B) requires a participating FFI comply with issued verification procedures. Notice 2010-60 provides that the government is looking into possibly relying on written certifications by high-level management employees regarding the steps taken to comply with chapter 4, and Notice 2011-34 provides further guidance on the certifications to be provided by officers of a participating FFI. The proposed regulations modify and supplement the guidance in Notices 2010-60 and 2011-34 by providing that responsible FFI officers will be expected to certify that the FFI has complied with the terms of the FFI agreement.

e. Modification of Definition of Financial Account. Section 1471(d)(2) defines a financial account to mean, except as otherwise provided by regulation or notice, depository accounts, custodial accounts, and equity or debt interests in an FFI, other than interests that are regularly traded on an established securities market. The proposed regulations modify the definition of financial accounts to include traditional bank, brokerage, money market accounts, and interests in investment vehicles, and to exclude most debt and equity securities issued by banks and brokerage firms, subject to an anti-abuse rule.

f. Extension of the Transition Period for the Scope of Information Reporting. Notice 2011-53 provides for phased implementation of the reporting required under chapter 4 with respect to U.S. accounts. Pursuant to Notice 2011-53, only identifying information (name, address, TIN, and account number) and account balance or value of U.S. accounts would be required to be reported in 2014 (with respect to 2013). Recognizing the complexity and width of the various provisions, the proposed regulations provide that reporting on income will be phased in beginning in 2016 (with respect to the 2015 calendar year), and reporting on gross proceeds will begin in 2017 (with respect to the 2016 calendar year). In addition, the proposed regulations provide that FFIs may elect to report information either in the currency in which the account is maintained or in U.S. dollars.

g. Passthru Payments. Section 1471(b)(1)(D) requires participating FFIs to withhold on passthru payments made to nonparticipating FFIs and account holders. Notice 2011-53 states that participating FFIs will not be obligated to withhold on passthru payments that are not withholdable payments (foreign passthru payments) made before January 1, 2015. In response to complaints about the complexity of the rules as well as the effective date becoming closer, the proposed regulations provide that withholding will not be required with respect to foreign passthru payments before January 1, 2017. Instead, until withholding applies, to reduce incentives for nonparticipating FFIs to use participating FFIs to block the application of the chapter 4 rules, the proposed regulations require participating FFIs to report annually to the IRS the aggregate amount of certain payments made to each nonparticipating FFI. With respect to the scope and ultimate implementation of withholding on foreign passthru payments, the Treasury Department and the IRS request comments on approaches to reduce burden, for example, by providing a de minimis exception from foreign passthru payment withholding and a simplified computational approach or safe harbor rules to determine an FFI's passthru payment percentage.As mentioned the government is exploring the use of an alternative method or system for complying with FATCA for jurisdictions that enter into agreements to facilitate FATCA that provide a practical alternative approach to achieving the policy objectives of passthru payment withholding. In addition, where such an agreement provides for the foreign government to report to the IRS information regarding U.S. accounts and recalcitrant account holders, FFIs in such jurisdictions may not be required to withhold on any foreign passthru payments to non-compliant account holders.

Continued Work with Foreign Countries

The joint statement issued by the Treasury with France, Germany, Italy, Spain, and the United Kingdom has been applauded by one commentator, Alan Granwell, as "dramatic evidence of the intention of the participating countries to ultimately provide for automatic exchange of information on a broader basis….and reflects a continuation and expansion of the OECD's by-request exchange of information standard and the activities of the Global Forum on Transparency and Exchange of Information for Tax Purposes”. Still there a certain conflict of laws issues as well as other policy issues that must be addressed

Stay tuned. The FATCA regulations project is a big one for which there will be additional comments by bar associations and tax professionals.

Treasury Issues Final, Temporary and Proposed Regulations on Cost Sharing Agreements

Jerald David August — Sun, 12 Feb 2012 07:19:38 -0500

In December, 2011, the Treasury promulgated final, temporary, and proposed regulations to cost-sharing agreements (CSAs) which are effective on December 16, 2011. The final regulations adopt the effective date and transaction date rules under the 2009 temporary regulations (T.D. 9441) so that they are generally applicable for all CSAs, with transition rules for some arrangements which existed prior to January 5, 2009. The newly minted regulations substantially reflect the positions contained in the temporary and proposed regulations that had been issued in 2009 and adopt the “comparable uncontrolled transaction method” . The regulations addressed concerns and issues that were reflected in two Tax Court decisions, Veritas Software Corp., v. Commissioner, 133 T.C. 297 (2009) and Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005).

Cost Sharing Agreements In General: Section 482

Section 482 attempts to prevent income tax evasion by transactional allocations of value and cost made by controlled entities to ensure that taxpayers clearly reflect income relating to transactions between controlled entities. Section 482 allows the Commissioner to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among controlled entities if he determines that such distribution, apportionment, or allocation is necessary to prevent evasion of taxes or to clearly reflect the income of such entities. In determining the true taxable income, "the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer." Treas. Reg. §. 1.482-1(b)(1).

Section 482 provides that in the case of any transfer of intangible property the income with respect to the transfer shall be commensurate with the income attributable to the intangible. In a qualified cost-sharing arrangement (CSA), controlled participants share the cost of developing one or more items of intangible property. Treas Reg. §1.482-7(a)(1). When a controlled participant makes preexisting intangible property available to a qualified CSA, that participant is deemed to have transferred interests in the property to the other participant and the other participant must make a buy-in payment as consideration for the transferred intangibles. Treas. Regs. §§1.482-7(g)(1) and (2). The buy-in payment, which can be made in the form of a lump-sum payment, installment payments, or royalties, is the arm's-length charge for the use of the transferred intangibles. Treas. Regs. §§1.482 7(g)(2), (7) requires buy-in payments to be determined in accordance with Treas. Regs. §§1.482-1 and 1.482-4 through 1.482-6, and Treas. Reg. §1.482-4(a).

Section 1.482-4(a).

This provision requires that, in general, the arm's length amount charged in a controlled transfer of intangible property must be determined under one of the four methods listed in this paragraph (a). Each of the methods must be applied in accordance with all of the provisions of Treas. Reg. § 1.482-1, including the best method rule of Treas. Reg. § 1.482-1(c), the comparability analysis of Treas. Reg. § 1.482-1(d), and the arm's length range of Treas. Reg. § 1.482-1(e). The arm's length consideration for the transfer of an intangible determined under this section must be commensurate with the income attributable to the intangible. Treas. Reg. § 1.482-4(f)(2) (Periodic adjustments). The available methods are -- (1) The comparable uncontrolled transaction method, described in paragraph (c) of this section; (2) The comparable profits method, described in Treas. Reg. § 1.482-5; (3) The profit split method, described in Treas. Reg. § 1.482-6; and (4) Unspecified methods described in paragraph (d) of this section.

If the recipient of the intangibles fails to make an arm's-length buy-in payment, the Commissioner is authorized to make appropriate allocations to reflect an arm's-length payment for the transferred intangibles. Treas. Reg. §1.482-7(g)(1). Still, Commissioner's authority to make section 482 allocations is limited to situations where it is necessary to make each participant's share of costs equal to its share of reasonably anticipated benefits or situations where it is necessary to ensure an arm's-length buy-in payment for transferred preexisting intangibles. Treas. Reg. §1.482-7(a)(2).

Applicable Legal Standard for Judicial Review

When the Commissioner maintains a legal action against controlled entities in a Section 482 case, its 2 allocation will be sustained absent a showing of abuse of discretion. Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 353 (1991); Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582 (1989), affd. 933 F.2d 1084 (2d Cir. 1991).

For the taxpayer to prevail it must first demonstrate that the Commissioner’s section 482 allocation is arbitrary, capricious, or unreasonable. Sundstrand Corp. & Subs. v. Commissioner, supra at 353-354 (citing G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 359 (1987), and Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1131 (1985), affd. in part, revd. in part and remanded 856 F.2d 855 (7th Cir. 1988)). If petitioner proves that respondent's allocation is arbitrary, capricious, or unreasonable but fails to prove that the allocation it proposes meets the arm's-length standard, the Court must determine the proper allocation for the buy-in payment. Sundstrand Corp. & Subs. v. Commissioner, supra at 354.Respondent's determination as set forth in the notice of deficiency is presumptively correct. Id. at 353.

Overview of the Newly Issued CSA Regulations

The newly issued final regulations are intended to provide guidance to and determination of and compensation for economic contributions made by all controlled entities involved in a CSA under the arm’s length standard. This begins with the with the factual and functional analysis of the actual transaction or transactions among the controlled taxpayers. In a CSA, the controlled participants make economic contributions of two types:(i) mutual commitments to prospectively share intangible development costs in proportion to their reasonably anticipated benefits from exploitation of the cost shared intangibles (“cost contributions”); and (ii) to provide any existing resources, capabilities, or rights that are reasonably anticipated to contribute to developing cost shared intangibles (“platform contributions”). CSAs also involve economic contributions by the controlled participants of other existing resources, capabilities, or rights related to the exploitation of cost shared intangibles (“operating contributions”). The concepts of platform and operating contributions are intended to encompass any existing inputs that are reasonably anticipated to facilitate developing or exploiting cost shared intangibles at any time, including resources, capabilities, or rights, such as expertise in decision-making concerning research and product development, manufacturing or marketing intangibles or services, and management oversight and direction. Other prospective economic contributions consist of costs incurred to develop or acquire resources, capabilities, and rights that facilitate the exploitation of cost shared intangibles (operating cost contributions). The new regulations provide guidance in determining the arm's length charge for all such contributions to clearly reflect the incomes of the controlled participants.

The regulations attempts to facilitate the determination of the most reliable measure of arm's length results for the categories of economic contributions over the duration of the activity of developing and exploiting cost shared intangibles (CSA Activity). The combined effect of multiple contributions, potentially including controlled transactions outside of the CSA (e.g.,make-or-sell licenses, or intangible transfers governed by section 367(d)), may need to be evaluated on an aggregate basis, where that approach provides the most reliable measure of an arm's length result.

Suppose a taxpayer transfers, in a section 367(d) transaction, intangibles as part of a CSA, then the pricing of the intangibles under section 367(d) may need to be evaluated along with the pricing of all contributions in connection with the CSA on an aggregate basis, where that approach provides the most reliable measure of an arm's length result.

Under the principles of the investor model, the reliability of the analysis required must account for the degree of consistency of the valuation with the expectation that each controlled participant's net investment attributable to cost contributions, platform contributions, operating contributions, and operating cost contributions, is reasonably anticipated to earn a rate of return (which might be reflected in a discount rate used in applying a method) appropriate to the riskiness of the controlled participant's CSA Activity over the entire period of the CSA Activity. The duration of the CSA Activity may, or may not, correspond to the conventional concept of useful life with respect to any of the underlying economic contributions; it represents the period over which the controlled participants reasonably anticipate returns from the CSA Activity.

In determining the best method of measuring the arm's length results of a CSA, and any related controlled transactions, the regulations adopt the guidance included in the 2008 temporary regulations on assessing the potential applicability of the “comparable uncontrolled transaction” (CUT) method. The arm's length standard attempts to identify the results that would obtain had uncontrolled taxpayers engaged in the same transaction under the same circumstances. It is immaterial whether the arrangement among uncontrolled taxpayers is denominated as a "cost sharing arrangement," so long as the arrangement involves the same circumstances (or similar circumstances, assuming that reliable adjustments can be made to account for any differences). Thus, long-term licenses or research and development services contracts may provide CUTs, provided and to the extent they involve the same or similar scope and contractual terms, uncertainty of outcomes, profit potential, allocation of intangible development and exploitation risks, including allocation of the risks of existing contributions and the risks of developing future contributions, consistent with the actual allocation of risks under the CSA and through related controlled transactions.

A CSA may benefit from, and contribute to, a controlled group's own set of competitive advantages. Therefore, there may be no uncontrolled transactions that reliably reflects the same contributions by the parties, over a similar period of commitment, and with the same risk profile and profit potential. The arm's length standard requires application of the method that most reliably reflects the results that would have been realized had uncontrolled taxpayers engaged in the same transaction. Where comparable uncontrolled transactions are unavailable, these regulations, like other regulations under section 482, allow for reference to the results the controlled taxpayers could have realized by choosing a realistic alternative. The regulations adopt a specified income method included in the 2008 temporary regulations that represents an application of the realistic alternatives principle. These regulations adopt the 2008 temporary regulations' provision of a licensing alternative to the CSA that closely aligns with the economics of the CSA, but takes account of the licensor's commitment to bear the entire risk of the intangible development that would otherwise have been shared. The realistic alternatives analysis effectively constructs a comparable uncontrolled transaction that, depending on the facts and circumstances, may more reliably reflect the economics of the actual contributions to the CSA than can be derived from third party transactions. For cases where more than one controlled participant makes significant contributions to residual profits (including platform or operating contributions), the regulations adopt the guidance included in the 2008 temporary regulations on a specified residual profit split method (RPSM), which is also an application of the realistic alternatives principle.

The regulations further adopt guidance on the application of two other specified methods included in the 2008 temporary regulations -- the acquisition price method and the market capitalization method. The guidance regarding unspecified methods adopted from the 2008 temporary regulations reemphasizes that any such method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and enter into a particular transaction only if none of the alternatives is clearly preferable to it.

The newly issued regulations resolve issues that related back to the 1995 regulations. been raised under the 1995 regulations. Thus, where a controlled participant devotes, in whole or part, any existing resource, capability, or right to intangible development for the benefit of another controlled participant, whether by transfer or license to the other controlled participant, or by leveraging such resource, capability, or right within the context of the CSA, then the regulations require an arm's length charge for such platform contribution, in addition to the funding of intangible development costs.

The Preamble to the regulations recites that the regulations require an arm's length charge for one controlled participant's platform contribution commitment of a particular research team's experience and expertise to intangible development under a CSA, in addition to the controlled participants' sharing of the ongoing intangible development costs of the salaries of such researchers. To limit the arm's length charge in these circumstances to sharing the ongoing salary costs would ignore the value of having the particular research team already in place to undertake the intangible development with the benefit of its particular know-how. See Treas Reg. § 1.482-7(c)(5), Example 2. As another example, the contribution of core entrepreneurial functions such as product selection, market positioning, research strategy, and risk determinations and management requires an arm's length charge under these regulations. To omit charges for these or any other significant economic contributions one controlled taxpayer makes for another's benefit would fail to clearly reflect the incomes of such controlled taxpayers.

A unifying underpinning of the 482 regulations is that controlled transactions reflecting similar economics, regardless of the type of transaction (such as transfer of intangibles or provision of services), should be valued in accordance with similar principles and methods. See Treas.Reg. §§1.482-1(b)(2)(ii), 1.482-7, 1.482-4(g) and 1.482-9(m)(3). Under these provisions, the principles and methods for valuing platform and operating contributions under a CSA may also apply for purposes of determining the best method, which may be an unspecified method, for valuing similar contributions in connection with controlled transfers of intangibles or provisions of services.

Some Early Reflections on the New CSA Regulations

Perhaps one aspect of the new regulations that is controversial is the set of rules on when to compute a buy-in payment. These rules, as reflected in the final regulations, have been widened beyond normal cost-sharing applications. Another observation is that taxpayers who enter into ordinary or normal course licensing agreements may be unaware of the complexity of the new rules.

Contractual clauses in CSAs may allow the parties to make future adjustments. Such types of provisions are common. The final regulations, however, allows the IRS to ignore those clauses in valuing the transferred intangibles, especially where the provisions are vague or indefinite.

The regulations clarify the manner in which projections for financial benefits when valuing a buy-in payment are to be derived. The rules call for a single probability-weighted projection. The regulations also set forth rules regarding the use of pretax and post-tax calculations in applying specified valuation methods. Another provision proscribes making a retroactive adjustment of reasonably anticipated benefit shares for prior years based on new or updated information on expected benefits that wasn't available during the prior year, thus adopting a year-by-year approach. This provision was not included in the prior set of temporary regulations. Finally guidance is contained in the temporary and proposed regulations on the relationship between the discount rate used for the cost-sharing alternative and the discount rate for the licensing alternative. The temporary regulations, in general, test the reasonableness of the implied discount rate by comparing discount rates from CUPs with similar risk profiles.

The temporary regulations seek to police some of the ways that taxpayers have employed. The proposed regulations include a new specified application of the income method using the differential income stream in Treas. Reg. 1.482-7(g)(4)(v).

The regulations are quite detailed and complex as one would only expect.

Commissioner Issues Temporary and Proposed Regulations on Reporting Foreign Financial Assets For Individuals and Domestic Entities.

Jerald David August — Sun, 01 Jan 2012 19:58:00 -0500

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

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

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

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

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

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

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

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

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

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

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

Enactment of Code Section 6038D Under the HIRE Act

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

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

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

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

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

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

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

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

Other Related Reporting Requirements

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

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

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

Tax Notes International Highlights Year in Review for Foreign Countries: What Happened in Canada in 2011?

Jerald David August — Fri, 23 Dec 2011 14:51:55 -0500

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.

Final CFC Manufacturing Branch Regulations Released by IRS on Foreign Base Company Sales Income

Jerald David August — Fri, 23 Dec 2011 14:48:04 -0500

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

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

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

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

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

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

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

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

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

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

IRS Issues Fact Sheet Providing Information on Federal Income Tax Return and Foreign Bank Filing Requirements

Jerald David August — Wed, 21 Dec 2011 17:55:45 -0500

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

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

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

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

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

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

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

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

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

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

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

Tax Court Rules on Non-Resident, Professional Golfer's Treatment of U.S. Source Royalty and Personal Service Income in Goosen v. Commissioner, 136 T.C. No. 27 (6/9/2011).

Jerald David August — Tue, 06 Dec 2011 18:21:30 -0500

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

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

Petitioner Retief Goosen

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

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

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

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

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

Tax Court’s Analysis and Decision

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

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

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

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

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

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

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

Office of Chief Counsel Reports that Uncertain Tax Position Filings Were Lower Than Expected

Jerald David August — Tue, 06 Dec 2011 15:31:10 -0500

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.

Service Issues Favorable Ruling Permitting Satisfaction of the "All Events Test" for Accrual Method Taxpayer For Bonus Obligations Where Identity of Recipient and Amount of Bonus Not Yet Determined

Jerald David August — Thu, 01 Dec 2011 10:40:50 -0500

Background

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

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

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

Application to Year End Bonuses

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

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

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

Ruling Facts

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

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

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

Holding By Service

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

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