Federal Taxation Developments Blog

Special Deferral of Cancellation of Indebtedness Income Under Section 108(i) Continues Through This Year

Jerald David August — Mon, 30 Aug 2010 13:36:32 -0500

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

Service Issues Preliminary Guidance on Expanding Information Reporting Requirements for Foreign Financial Institutions And U.S. Accounts On Withholding, Reporting and other Requirements for Certain Payments Made to Foreign Entities in Notice 2010-60; 2010

Jerald David August — Sun, 29 Aug 2010 11:50:12 -0500

FATCA Background

FATCA (originally called the Stop Tax Haven Abuse Act in a bill introduced on 2/17/07 by Sen. Levin (D-Mich.), then chair of the Senate Permanent Subcommittee on Investigations, Sen. Coleman (R-Minn.), then the ranking Republican on the subcommittee, and Sen. Obama (D-Ill.), then a member of the subcommittee), is designed to deter the use of tax havens for committing acts of tax evasion. A later version was submitted by Senators Baucus (D-Mont.), chair of the Senate Finance Committee, Sen. Kerry (D-Mass) and Reps. Rangel (D-NY), then chair of the House Ways and Means Committee and Neal(D-Mass), chair of the Ways and Means Subcommitee on Select Revenue Measures.

FATCA provides for: (i) increased levels of mandatory disclosure of offshore investments; (ii) an extended applicable statute of limitations; (iii) increased penalties for related compliance failures and (iv) sets forth rebuttable presumptions to enhance the government’s ability to impose sharp sanctions and penalties in prosecuting tax cases involving offshore compliance. The FATCA provisions will also have a direct impact on the tax treatment of foreign trusts, certain dividend equivalent payments and certain foreign targeted obligations. A prior version contained a provision requiring "material advisors" who structured and/or worked on a foreign entity transaction to disclose the transaction . This controversial provision, that was to be reflected in new §6116, was dropped from FATCA. FATCA was employed as a revenue offset for the Hiring Incentives to Restore Employment Act (HIRE; P.L. 111-92, 3/18/10), of which it is a part.

Information Returns—Increased Disclosure of Information About Foreign Entities

The default rule is that there will be a 30% withholding tax by the U.S. payor on the payment of certain income earned from U.S. sources to foreign financial institutions and foreign nonfinancial entities. The default rule can be avoided if the foreign entities provide the government with information regarding U.S. taxpayers. In addition, taxpayers are required to file disclosures reporting (1) the existence of foreign financial assets when the aggregate value of all such assets exceeds $50,000, (2) investments in passive foreign investment companies (PFICs), and (3) interests or involvements with foreign trusts.

Financial Financial Institution Disclosure

In addition, after 3/18/10 Treasury can issue Regulations requiring foreign financial institutions and foreign nonfinancial institutions to file on magnetic media all returns to report taxes withheld. This requirement applies equally to withholding pursuant to Section 1441 or new Section 1474(a) . Treasury also can require financial institutions to electronically file returns for taxes they withhold regardless of how many returns the institutions file during the year. Consequently, the IRS may assert a failure-to-file penalty under Section 6721 on financial institutions that fail to comply with these new electronic filing requirements.

Section 1471

Institutions are required to file this information annually with respect to all of their U.S. account holders. Under §1471(c)(1), actual disclosure includes: (i) the identifying number of the U.s. account holder or U.S. owner of a foreign entity holding an account at the institution; (ii) the account number; (iii) account balances; and (iv) the gross deposits and withdrawals from the account, i.e., account activity.

If a foreign financial institution can prove to the IRS that it does not have any U.S. customers and agrees to adhere to further IRS reporting pronouncements, it will be exempt from §1471(b) withholding and §1471(c) disclosure provisions. Such institution also may be exempt if Treasury determines that it is one of a class for which the new rules are not necessary.

A foreign financial institution also may agree to the §1471 withholding and bypass the §1471(c)(1) disclosure if it makes an election under §1471(c)(2) to be subject to the same reporting requirements as a U.S. financial institution under §§6041 , 6042 , 6045 , and 6049 .

Under §1471(b)(3) a foreign financial institution making U.S. source payment to another FFI which does not comply with FATCA, it may reject serving as a withholding agent for U.S. source payments. Where an election under §1471(b)(3) is filed, the required withholding will apply with respect to any payment made to the electing foreign financial institution to the extent the payment is allocable to accounts held by foreign financial institutions that do not enter into an agreement with Treasury or to payments made to recalcitrant account holders (i.e. an account holder that refuses to provide required information). A foreign financial institution making the election under §1471(b)(3) must notify the withholding agent of the election and provide information necessary for the withholding agent to correctly determine the amount of the withholding. Special rules apply with respect to tiered FFIs.

The effective date of §1471 is for payments made after 2012, and will not apply to any obligation or disposition of an obligation made prior to 3/18/12.

Section 1472

These rules do not apply to any payment beneficially owned by a publicly traded corporation, a corporation that is a member of an expanded affiliated group that includes a publicly traded corporation, any foreign government, any international organization or instrumentality or any foreign central bank.

U.S. persons who buy U.S. securities from a foreign entity are obligated to obtain the certification or else withhold the 30% tax on the purchase. Consequently, it is not just U.S. institutions that are required to withhold. The obligation is imposed on all U.S. withholding agents. The rules described above do not apply to any class of payments later identified by Treasury as posing a low risk of tax evasion.

Foreign Accounts and Assets

The FBAR report is generally required to be filed by a U.S. person with a financial interest, signature authority, or other authority over foreign financial accounts if at any point during the calendar year the aggregate value of all such foreign accounts equaled or exceeded $10,000, even if only for one day. Section 6038D disclosure is required to report "specified foreign financial assets" when the aggregate value exceeds $50,000. Section 6038D(b) defines a "specified foreign financial asset" to include ownership of: (i) a financial account maintained by a foreign financial institution; (ii) a stock or security issued by a non-U.S. person; (iii) a financial interest or contract held for investment that has a non-U.S. issuer or counterparty; and (iv) an interest in a foreign entity. Under §6038D, a "foreign entity" includes any entity that is not a U.S. person. This last category is extremely broad in application. The filing requirement under §6038D is directed toward U.S. individuals although the Treasury has the ability to require "any domestic entity which is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets," to file the disclosure as if it were an individual. Regulations exempting nonresident aliens and bona fide residents of any U.S. possession from the disclosure. Are anticipated. Certain assets may also be exempt from disclosure.

The information to be disclosed under new Section 6038D includes: (i) the name and address of the financial institution in which the account is maintained; (ii)account number; (iii) for any stock or security, the name and address of the issuer and other information necessary to determine the ownership; (iv) as to an "instrument", the names and addresses of all issuers and counterparties; and (v)the maximum value of the asset during the tax year.

The minimum penalty for failing to submit the required disclosure is $10,000, and it increases by $10,000 for each 30-day period following notification from Treasury, with the maximum penalty being $50,000. There is, however, a 90-day grace period following notification from the Treasury before the additional $10,000 penalties accrue. This is similar to the penalty for failure to file Form 5471 and Form 3520. As with those information returns (relating to foreign corporations and foreign trusts or foreign gifts, respectively), the penalty may be waived if the taxpayer is able to demonstrate that the failure to file was due to reasonable cause.

Foreign companies

Penalties.

Expanded Statute of Limitations.

Foreign Trusts and Certain Grantor Trusts.

Taxable Distributions

Notice 2010-60, supra, identifies entities excluded from the financial institution definition or that are otherwise exempt from some or all of the obligations imposed by the offset provisions. Generally, these include some insurance companies and holding and startup companies. The notice describes the scope of collection of information and identification of persons by financial institutions under sections 1471 and 1472, and the information FFIs must report to the IRS regarding their U.S. accounts. The notice also outlines the IRS's intention to require all or most financial institutions to electronically file their returns regarding tax for which the institutions are liable under the foreign tax compliance offset provisions. A detailed review of the Notice is not set forth in this information capsule. Anyone having questions about FATCA, the Notice 2010-60, the relevant statutory provisions involved, etc., must consult with their legal advisor who is competent to render advice in this area of the tax law. Therefore this release is for informational purposes only and may not be relied upon by anyone reading this post or in advising clients.

. Before FATCA was enacted, §643(i) provided that a loan of cash or marketable securities from a foreign trust to a U.S. grantor, U.S. beneficiary, or another other U.S. person who was related to a U.S. grantor or U.S. beneficiary was generally required to be treated as a distribution (potentially from DNI and interest surcharge) by the foreign trust to such grantor or beneficiary. FATCA amends §643(i)(1) in setting forth that any use of trust property after March 18, 2010 by a U.S. grantor, U.S. beneficiary, or any U.S. person related to a U.S. grantor or U.S. beneficiary is treated as a distribution. This rule does not apply to the extent that the foreign trust is paid the fair market valuefor the use of the property within a reasonable time following the use. A subsequent return of the property to the foreign trust is disregarded for tax purposes §643(i)(3) . But see §§679 and 6048. Form 3520. Special rules apply with respect to foreign trusts and grantor trusts . See §679. Under §679(c)(1), amounts accumulated in a foreign trust as treated as being held for the benefit of a U.S. person even if the U.S. person's interest in a foreign trust is contingent on a future event. Under §679(c)(4), where any person has discretion to make a distribution from a foreign trust to, or for the benefit of, any person, the trust will be treated as having a U.S. beneficiary unless the terms of the trust specifically identify the class of persons to whom the distributions may be made and none of those persons can be U.S. persons during the tax year. Furthermore, §679(c)(5) provides where any U.S. person who directly or indirectly transfers property to a foreign trust is directly or indirectly involved in any agreement or understanding that may result in the trust's income or corpus being paid or accumulated for the benefit of a U.S. person, the agreement or understanding will be treated as a term of the trust. In essence, any discretion held by a trustee or protector to make a distribution or accumulate income for a U.S. person will be deemed to have been exercised. New §679(c)(6) provides that any loan of cash or marketable securities (or the use of any other trust property) directly or indirectly to or by any U.S. person will be treated as paid or accumulated for the benefit of such U.S. person. Where, however, the U.S. person repays the loan at a market rate of interest or pays the FMV for the use of the property within a reasonable time the provision will be avoided. Finally, under new §679(d) where a U.S. person transfers (directly or indirectly) property to a foreign trust, the trust will be presumed to have a U.S. beneficiary unless the transferor submits information, as requested by Treasury, to demonstrate that no part of the income or trust may be paid or accumulated to or for the benefit of a U.S. person. Instead of the general 3 year rule for assessing an income tax within 3 years of filing a return, which expands to 6 years where a taxpayer omits 25% or more of the income that should have been reported in gross income, FATCA §6501(e) to extend application of the six-year period where a taxpayer omitted more than $5,000 of income attributable to one or more assets required to be reported under §6038D . In addition, the 3 year and 6 year statutes of limitation will be suspended until the information required to be reported under Section 6038 , 6038B , 6046A , or 6048 , or new §6038D is provided to the IRS. The extended limitations periods are applicable to: (i) returns filed after March 18, 2010; and (ii) returns filed on or before that date if the limitations period under § 6501 has yet to expire. For FATCA filing failures, new §6662(j) increases the standard 20% accuracy related penalty to a 40% penalty on any portion of an underpayment attributable to an undisclosed financial asset that should have been reported under §§ 6038 , 6038B , 6046A , or 6048 , or new § 6038D The increased penalty regime is effective as of the tax year beginning after the date of enactment (i.e., after 2010 for calendar-year taxpayers). . Generally, a foreign corporation will qualify as a passive foreign investment company or PFIC where: (i) 75% or more of its gross income in the tax year is passive income, or (ii) on average during the tax year at least 50% of the assets held by the corporation produce passive income or are held for the production of passive income. FATCA section 521 adds new §1298(f) subjecting persons owning shares in a PFIC to file an annual information return disclosing their ownership of the PFIC. This replaces current law under which disclosure was required only when the taxpayer made a QEF election or disposed of the interest in the PFIC. The PFIC disclosure requirement became effective as of 3/18/10. See, however, Notice 2010-34, 2010-17 IRB. . FATCA imposes a second filing requirement (in addition to the FBAR filing requirements) on U.S. taxpayers with foreign accounts and assets. FATCA §511 creates new §6038D , which requires U.S. taxpayers with foreign accounts and assets to report these investments on an information return when the aggregate value of the investments exceeds $50,000. Section 6038D applies to assets held during tax years beginning after 3/18/10. The new reporting requirement is broader than the current FBAR, so it is possible that individuals who do not have an FBAR filing obligation presently may still be subject to the new reporting requirement. For example, FATCA requires taxpayers with investments in foreign entities, such as foreign hedge funds and private equity funds, to report the existence of these investments. Currently the FINCEN FBAR regulations issued in February, 2010, exempt these types of assets from FBAR reporting. There are separate penalties for failures under each provision although the FBAR penalties are more severe. The required information is to be attached Form 1040. This additional form of disclosure does not replace the FBAR filing requirement which is filed with the Detroit Service Center. . New §1472 imposes a 30% withholding tax on any payment made to a nonfinancial foreign entity from a U.S. payor where: (i) the beneficial owner of the payment is a nonfinancial foreign entity and (ii) all of the following requirements are not met with respect to the beneficial owner: (1) the beneficial owner or payee provides the "withholding agent" with either (a) a certification that the beneficial owner does not have any substantial U.S. owners (i.e., more than a 10% direct or indirect interest), or (b) the name, address, and TIN of each substantial U.S. owner of the beneficial owner; (2) the withholding agent does not know, or have reason to know, that any information provided as described above is incorrect; and (3) the withholding agent provides the information described above to Treasury in the manner provided for by Treasury. . Foreign financial institutions (FFIs) include, but are not limited to, banks, brokerages, and investment funds. Furthermore, non-publicly-traded equity and debt interests in FFIs are deemed to be accounts for purposes of this section. Such foreign financial institutions have the option of disclosing their U.S. account holders to the IRS. Failure to comply with the disclosure requirement will subject the institution to financial penalties in the form of a 30% withholding tax by U.S. payors on payments of certain U.S. source income. FFIs desirous of complying with the disclosure requirement must agree to the conditions set forth in §1471(b): (i) obtain information from each holder of an account at the financial institution to determine if any of its accounts is a U.S. taxpayer account; (ii) comply with any due diligence procedures required by the Service in relation to a U.S. taxpayer account; (iii) provide an annual report to Treasury on any U.S. taxpayer accounts maintained by the institution; (iv) deduct and withhold 30% from certain pass-through payments made to recalcitrant U.S. taxpayer account holders or certain other foreign financial institutions; (v) comply with any information requests by the IRS with respect to any U.S. taxpayer account; and (vi) procure a waiver of any foreign law from each U.S. taxpayer with an account, where such foreign law would prohibit the financial institution from disclosing information. . Under FATCA §501 a new withholding regime is contained in new §§1471 and 1472 which are generally applicable to payments made after 2012. These rules require foreign financial institutions with U.S. customers and foreign nonfinancial entities with substantial U.S. owners to disclose information regarding U.S. taxpayers. Failure to disclose the information to the Service will result in a U.S. payor's being required to withhold a 30% tax on certain U.S. source income. The withholding will occur on income normally subject to U.S. taxation, such as dividends, as well as to income that is generally excluded under §871 such as bank interest and capital gains. Failure to comply will subject the U.S. withholding agents to financial penalties.

Service Issues Notice 2010-58 In Providing Guidance Under Longer Net Operating Loss Carryback Periods Recently Granted by Congress

Jerald David August — Thu, 26 Aug 2010 09:15:13 -0500

Background

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

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

Worker, Homeownership, and Business Assistance Act of 2009

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

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

American Recovery and Reinvestment Act of 2009

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

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

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

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

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

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

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

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

Anticipated Up-tick in Merger and Acquisition Activity; Don't Forget About the Change of Control Provision, Section 280G

Jerald David August — Mon, 23 Aug 2010 09:03:42 -0500

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

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

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

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

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

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

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

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

Service Recently Issues Favorable Continuity of Business Interest Private Letter Ruling on R&D Activities

Jerald David August — Tue, 17 Aug 2010 16:50:54 -0500

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

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

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

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

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

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

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

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

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

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

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

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

Update on Offshore Bank Secrecy Directives by the United States and the Internal Revenue Service: "Mining the UBS Lake" for US Tax Evaders

Jerald David August — Tue, 17 Aug 2010 15:52:48 -0500

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

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

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

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

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

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

More updates on this area in the future.

Service Issues Temporary Regulations Under Section 108(i), Election to Defer Cancellation of Indebtedness Income for Corporations and Partnerships

Jerald David August — Mon, 16 Aug 2010 11:37:52 -0500

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

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

Application to Corporations

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

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

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

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

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

Acceleration Events Involving Partnerships and S Corporations

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

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

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

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

Allocation of COD Income Problems.

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

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

Deferral of OID Deductions

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

Review of Incorporation of a Partnership: Rev. Rul. 84-111, 1984-2 C.B. 88.

Jerald David August — Mon, 09 Aug 2010 14:20:08 -0500

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

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

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

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

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

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

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

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

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

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

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

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

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

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

IRS Issues Action on Decision and Nonacquiescence to the Fifth Circuit Court of Appeals Recent Decision in Tidewater, Inc. and Subsidiaries.

Jerald David August — Tue, 03 Aug 2010 07:05:24 -0500

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

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

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

The Organisation for Economic Co-Operation and Development ("OECD") Issues Discussion Draft on Athletes and Entertainers Under OECD Model Treaty

Jerald David August — Tue, 03 Aug 2010 06:47:01 -0500

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

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

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

Service Issues Guidance to Examination Division On Deferred Gain Recognition Agreements Involving Outbound Transfers of Stocks and Securities to Foreign Corporations

Jerald David August — Sat, 31 Jul 2010 11:27:48 -0500

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

Brief Overview of Section 367(a)

Section 367(a) applies to appreciated property transferred to a controlled foreign corporation and §367(d) carves out as a special rule with respect to transfers "intangible property" to a foreign corporation. Section 367(a)(1) imposes a gain (but generally not loss) recognition requirement on the transfer of appreciated property to a foreign corporation that would otherwise be part of an exchange of property for stock as part of a tax-free exchange under §351. As far as contributions to capital, §367(c)(2) provides applicable rules. See Rev. Rul. 76-240, 1976-1 CB 101 . For transfers of intangible property, e.g., rights to a patent, to a controlled foreign corporation, §367(d) may tax the U.S. transferors on an imputed stream of "deemed royalty" payments for a period of up to twenty years. See, e.g., Du Pont de Nemours & Co. v. U.S., 471 F2d 1211 (Ct. Cl. 1973).

Section 367(a)(1) is subject to several exceptions. One applicable exception is a transfer of stock or securities of a foreign corporation by a U.S. person to a foreign corporation where: (i) the U.S. person, directly or indirectly, owns less than 5% of both the total voting power and value of stock of the transferee foreign corporation immediately after the transfer; or (ii) immediately after the transfer the U.S. person ends up owning at least 5% of either the total voting power or the total value of the stock of the transferee foreign corporation provided such U.S. person enters into a five year GRA. §367(a)(2); Treas. Reg. §1.367(a)-3(b)(1).

Another exception applies for transfers of stock or securities of a U.S. corporation by a U.S. person to a foreign corporation that would otherwise be taxable under §367(a)(1) unless four conditions are satisfied: (i) 50% or less of the total voting power and total value of the stock of the transferee foreign corporation is received in the exchange, in the aggregate, by U.S. transferors; (ii) 50% or less of each of the total voting power and the total value of the stock of the transferee foreign corporation is owned, in the aggregate, immediately after the transfer by U.S. persons that are either officers or directors of the U.S. target company or 5% target shareholders; (iii) either (a) the U.S. person is not a 5% transferee shareholder, or (b) the U.S. person is a 5% transferee shareholder and enters into a five-year GRA with respect to the U.S. target company stock or securities it exchanged; and (iv) the foreign corporation is actively engaged in a trade or business.

The preceding paragraphs represent two instances whereby the gain recognition requirement provision "turns off" so to speak gain recognition under section 367(a)(1) where the U.S. transferor properly and timely elects to enter into a five year GRA with the Service. Deferred gain under a GRA is required to be accelerated for certain events including a disposition of part or all of the stock or securities previously transferred by the foreign corporation, a disposition of substantially all of the assets of the transferred corporation, a complete or partial disposition of the stock of the transferee foreign corporation received by the U.S. transferor in the initial transfer, the U.S. transferor becomes a member of a consolidated group or ceases to be a member of a consolidated group in certain instances, where the U.S. transferor is an individual, the death, expatriation or termination of a resident’s "long term U.S. residence" and where the U.S. transferor materially breaches the terms of the GRA (or any requirement of §367), including the failure to file an annual certification, occurs within the five year period. See Treas. Regs. 1.367(a)-8(k)(1) through (k)(13) . But see, in general, §367(b), which must also be considered for transfers that may also fall within the purview of this section.

The new directive applies to any timely filed document that "purports" to be a GRA with respect to the original transfer, any new GRA required as a result of a triggering event, a waiver of the period of limitations on assessment, an annual certification statement and any other information required per Treas. Reg. §1.367(a)-8. For example, if in lieu of providing required information (such as the basis or FMV of the transferred stock or securities) taxpayer provides that such information is"available upon request." For example, if in lieu of providing required information (such as the basis or fair market value of the transferred stock or securities) taxpayer provides that such information is available upon request.This memorandum does not, however, apply to any original GRA required to be filed with respect to an initial transfer, where that original GRA (or document purporting to be an original GRA) was not timely filed. The Service, in setting forth its Directive, acknowledged that this subject was still under study.

Generally, where gain is required to be recognized under a GRA it must be reported (and the taxes paid) on an amended federal income tax return for the tax year of the initial transfer, which must be filed on or before the 90th day following the triggering event. An election is available, however, that allows the U.S. transferor to report any gain recognized under the GRA on its federal income tax return for the tax year during which the triggering event occurs. Interest must be paid under either filing option on any additional tax due, for the period between the due date of the initial federal income tax return for the year of the transfer and the date on which the additional tax due is paid

The Directive

Effective as of the date of this memorandum, July 26, 2010, until further notice is provided, IRS agents are directed to treat any failure to correctly or timely file a document subject to this memorandum as nevertheless satisfying the timeliness requirement under the regulations if, the taxpayer files an amended return for the taxable year to which the failure relates that includes: (i) the complete and accurate filing that should have been included with the original return for such taxable year; (ii) the statement "Filed pursuant to Directive of Examination Action with respect to Certain Gain Recognition Agreement" on the firstpage of the amended return and (iii) the amended return must be filed with the applicable Internal Revenue Service Center with which the U.S. transferor filed its original return for such taxable year; (iv) the taxpayer files with the amended return a Form 8838 "Consent to Extend the Time To Assess Tax Under Section 367- Gain Recognition Agreement" extending the period of limitations on assessment of tax with respect to the gain realized but not recognized on the initial transfer to the later of (1) the close of the eighth full taxable year followingthe taxable year during which the initial transfer occurs or (2) three years from the date the required information is provided to the IRS under this section II; and (v) the taxpayer complies with the notice requirements set forth in §1.367(a)-8(p)(2)(ii)(A) and (B).

Under the Directive, a taxpayer is not required to provide an explanation of the reasons for the failure to timely file or comply. Where the taxpayer submitted a request for reasonable cause relief under § 1.367(a)-8(p) prior to the issuance of this Directive that was denied, taxpayer will be subject to the procedures under this Directive provided that taxpayer meets all of the other requirements in this Directive. If, however, taxpayer submitted a request for reasonable cause relief under Treas. Reg. § 1.367(a)-8(p) prior to the issuance of this Directive that is pending, taxpayer must withdraw its request for reasonable cause to become subject to the procedures under this Directive. Under these circumstances, the amended return submitted by the taxpayer under § 1.367(a)-8(p) will be deemed to satisfy the requirement described in paragraph 1 above. Examples are provided in illustrating the applicable principles involved.

The Service cautions that the Directive is not an official pronouncement of the law or the position of the IRS and cannot be used or relied upon as such. More specifically, the memorandum recites that it sets forth no legal conclusion as to whether taxpayers have complied with the requirements in Treas. Reg. §1.367(a)-8 or other demonstrated that the failure to comply was due to reasonable cause and not willful neglect.

Caution to Reader. The foregoing description of LMSB-4-0510-017 and certain aspects of §367 and background material to aide in understanding the Directive are in no way intended to be construed or relied upon as advisory material for which any reliance may be given by anyone reading this entry. This area of the tax law is quite complex and reading the foregoing "current event" in no way is a substitute for seeking the advises of a competent tax advisor familiar with this area of the Internal Revenue Code.

LeBron James, the Miami Heat and Section 409A of the Internal Revenue Code

Jerald David August — Thu, 15 Jul 2010 13:38:36 -0500

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

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

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

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

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

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

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

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

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

Tax Court Rules on Jurisdiction to Hear Denial of Whistleblower Claim Under Section 7623 in William P. Cooper, III v. Comm'r, 135 T.C. No. 4, July 8, 2010

Jerald David August — Sat, 10 Jul 2010 16:21:25 -0500

So, stay tuned to see if the IRS investigates the case further and Mr. Cooper ultimately is successful in his efforts in filing his claims.

The Petitioner-Cooper in this case, filed 2 claims for a whistleblower award with the IRS pursuant to §7623(b)(4) appealing an adverse determination by the Service. Petitioner then filed with the Tax Court to which the government responded by seeking a dismissal based on lack of jurisdiction because the Service had not issued a determination notice as required under §7623(b)(3). Petitioner claimed that a letter that the Service sent to him was a valid "notice" of denial sufficient to give the Tax Court jurisdiction. The Tax Court, per Judge Diane L. Kroupa, first addressed the jurisdictional issue and found in favor of the Petitioner, i.e., the letter of denial by the IRS constitutes a "determination" for purposes of establishing jurisdiction.

Background

Petitioner, an attorney, submitted two Forms 211, Application for Award for Original Information, to the Internal Revenue Service (IRS) in 2008 concerning alleged violations of the Internal Revenue Code. He alleged in the two claims that certain parties had failed to pay millions of dollars in estate and generation- skipping transfer tax. Petitioner alleged in one claim that a trust having over $102 million in assets was improperly omitted from the gross estate of Dorothy Dillon Eweson (Eweson), resulting in a possible $75 million underpayment in Federal estate tax. He learned of the alleged omission by representing the widow of Ms. Eweson's grandson, who is also the guardian of a purported beneficiary of the trust. He verified the information by examining the public records and the records of his client.

Petitioner alleged in the other claim that Eweson impermissibly modified two trusts as part of a scheme to avoid the generation-skipping transfer tax. The trusts at issue had a combined value of over $200 million at the time of Ms. Eweson's death in 2005. Again, Petitioner learned of the alleged violation through his representation of the widow of Ms. Eweson's grandson. Petitioner submitted additional information to support the allegation several months after filing the claim. He provided newly discovered filings from a New York Surrogate Court proceeding in which a corporate trustee challenged the trust modifications as designed primarily to evade taxation. Petitioner also provided a legal memorandum and draft legal documents from Ms. Eweson's attorneys that indicated the trusts were modified as part of a scheme to avoid the generation- skipping transfer tax.

The IRS Whistleblower Office (Whistleblower Office) notified Petitioner that it had received the whistleblower claims, would investigate and then determine whether his information could meet the requirements for payment of an award. Petitioner was not contacted again until 9 months later when he received a letter denying the claims on the ground that an award was not warranted for either claim because petitioner's information did not "result in the detection of the underpayment of taxes."

Petitioner filed two separate petitions with the Tax Court to which the Service moved to dismiss for lack of jurisdiction since no determination was issued.

The Tax Court derives its jurisdiction from statute, as authorized by Congress. Judge v. Comm’r, 88 T.C. 1175, 1180-1181 (1987); Naftel v. Comm’r, 85 T.C. 527, 529 (1985). As with courts in general, the Tax Court has long held it has jurisdiction to determine whether it can hear a particular case. Hambrick v. Comm’r, 118 T.C. 348 (2002); Pyo Jurisdiction. v. Comm’r, 83 T.C. 626, 632 (1984); Kluger v. Comm’r, 83 T.C. 309, 314 (1984).

Background of Whistleblower Award Program

The Service has long held the ability, i.e., the discretion, to pay an award to a person that aids in: (i) detecting underpayments of tax and (ii) detecting and bringing to trial and punishment persons guilty of violating the internal revenue laws. §7623(a). The discretionary whistleblower awards have been arbitrary and inconsistent, however, because of a lack of standardized procedures and limited managerial oversight. Prior to recent statutory revision, the Court observed that it took an average of 7½ years for a discretionary award to be paid and a slightly shorter period for being rejected. Claims that were rejected did not have to provide a specific reason for the denial on the rationale that such would potentially involving disclosure of confidential return information.

As part of the Tax Relief and Health Care Act of 2006, P.L. 109-432, Congress amended §7623 to require the Secretary to pay nondiscretionary whistleblower awards and granted the Tax Court jurisdiction to review such rewards. Under current law, a whistleblower can receive a minimum nondiscretionary award of 15% of the collected proceeds where the Service proceeds with administrative or judicial action using information provided in a whistleblower claim. Under §7623(b)(4), the whistleblower has 30 days from the issuance of a non- discretionary award determination to file a petition in this Court. Guidance in this area was issued by the Service in Notice 2008-4, 2008-1 C.B. 253. Whistleblowers must file Form 211 which the Whistleblower Office must acknowledge its receipt. The Whistleblower Office will send correspondence to the whistleblower once a final determination regarding the claim has been made. Final Whistleblower Office determinations regarding awards may beappealed to this Court. Id. Awards will not be paid, however, until there is a final determination of the tax liability and the amounts owed are collected. The Commissioner also issued procedural guidance on how whistleblower claims will be processed. See IRM 25.2. 2 (Dec. 30, 2008). In general, whistleblower claims will be denied where the information provided does not: (i) identify a Federal tax issue upon which the IRS will act; (ii) result in the detection of an underpayment of taxes; or (iii) result in the collection of proceeds. The whistleblower will be notified by the Whistleblower Office once an award decision has been made.

The Tax Court Addresses the Jurisdictional Issue Merits of the Service’s Denial of the Two

The IRS argued that there can be a determination for jurisdictional purposes only if the Whistleblower Office undertakes an administrative or judicial action and thereafter "determines" to make an award. Respondent incorrectly interprets §7623(b)(4). The statute expressly permits an individual to seek judicial review in this Court of the amount or denial of an award determination to the United States Tax Court *** within 30 days of such determination.". Accordingly, The Tax Court held that its jurisdiction is not limited to the amount of an award but extends to any determination to deny an award.

The Court further rejected the government’s claim that its letter(s) were not a "determination". Craig v. Comm’r, 119 T.C. 252 (2002) (form decision letter issued after an "equivalent hearing" constituted a "determination" for conferring jurisdiction under §6330(d)(1)); Lunsford v. Comm’r, 117 T.C. 159, 164 (2001) (written notice to proceed with the collection action constitutes a "determination"); Offiler v. Comm’r, 114 T.C. 492, 498 (2000) (determination notice is the jurisdictional equivalent of a deficiency notice pursuant to §6212). Finding there is no dispute that the letter put Mr. Cooper on sufficient notice to file a petition with this Court as he did so timely. Respondent's letter is therefore a determination because it constitutes a final administrative decision regarding petitioner's whistleblower claims in accordance with the established rocedures. Accordingly, we find that we have jurisdiction to review the denial of the claims.

This issue was reported by Forbes Magazine (December 14, 2009) pertaining to several large whistleblower cases in process, including UBS informant Bradley Birkenfeld in Boston. While he may be in federal prison for some time, it is reported he could leave prison with millions in reward money having filed numerous whistleblower claims against clients of UBS he knew held accounts in Switzerland and the beneficial owners had allegedly evaded billions of dollars in US taxes. Here, as perhaps a litigation tactic, heirs of the Eweson estate were turning in other heirs. It is uncertain whether Mr. Cooper filed the claims on his own behalf or on behalf of his client, an 11 year old great grandson of Dorothy Dillon Eweson. Presumably Mr. Cooper filed the claims on behalf of his client. The Forbes article reported that Mr. Cooper hopes his Tax Court actions will prompt the IRS to take a new look at the situation and generate some money for the heirs he's helping. "This was taken as a step of last resort," he says. However, experts doubt the 2006 whistleblower law created a legal right for someone to challenge an IRS decision not to pursue a Form 211 tip.

Tax Court, in a Fully Reviewed Opinion, Holds That 90% Stock Loan Tax Scheme Program Was a Disguised Sale Lizzie W. Calloway, et vir. v. Commissioner, 135 T.C. No. 3, July/8/2010

Jerald David August — Sat, 10 Jul 2010 15:29:04 -0500

Factual Background

In August 2001, Calloway ("Petitioner") entered into an agreement with Derivium Capital, LLC whereby Petitioner transferred 990 shares of his IBM common stock to Derivium in exchange for the sum of $93,586.23. The agreement recited that the transaction was a loan of 90% of the value of the IBM stock pleged as collateral. The program was promoted by a company that engaged in some 1,700 similar transactions involving approximately $1 .25 billion. More on Derivium below.

The purported loan was nonrecourse and precluded Petitioner from making any payments of interest or principal during the 3 year term of the loan arrangement. Under the agreement Derivium was permitted to sell the stock, which it did as soon as the transaction was entered into. The loan's terms were as follows: nonrecourse as to borrower (recourse against collateral only); dividends to be received as cash payments against interest due, with the balance of interest owed to accrue until maturity date; noncallable before maturity; no prepayment allowed before maturity; interest at 10.5% compounded annually; balloon payment at loan maturity equal to the loan principal plus accrued interest. At maturity of the "loan", Petitioner Calloway was granted the option of: (i) paying the balance due on the note and having an equivalent amount of IBM stock returned to him; (ii) renewing the purported loan for an additional term; or (iii) satisfy the "loan" by surrendering any right to receive IBM stock. At maturity in August 2004 the balance due was $40,924.57 in excess of the then value of the IBM stock. Petitioiner elected to satisfy his purported loan by surrendering any right to receive IBM stock. P was not required to and did not make any payments toward either principal or interest on the purported loan.

Prior to entering into the loan arrangement, the Petitioner relied upon the advises of Robert Nagy, who was purportedly a certified public accountant to the president of Derivium. Nagy claimed that while there was no guaranty the transaction would be treated as a "sale", there was a "solid basis for the position that these transactions are, in fact, loans." Calloway testified that a loan versus a sale transaction made economic sense to him because the loan proceeds given to him were 90% of the value of the IBM stock whereas if he had sold the stock he would have had to pay 20% capital gains taxes under the then applicable rate. The taxpayer did not report the transaction on his 2001 return holding the belief that the transaction was a loan. The Service disagreed and asserted a failure to timely file penalty as well as an accuracy related penalty.

In the opinion of the Court authored by Judge Ruwe, the proposed assessment of income tax of $30,911 by the Internal Revenue Service in its notice of deficiency was upheld. The Court found that the transaction, in substance, was a sale of Petitioner’s IBM stock to Derivium in August 2001 for the "loan" amount of $93,586.23. resulting from the transfer of all of the burdens and benefits of ownership. The Court distinguished the facts at bar to the securities lending arrangement described in Rev. Rul 57-451, 1957-2 CB. 295 or otherwise equivalent to a securities lending arrangement under §1058. The Petitioner was further held liable for a late filing penalty of $6,583 under §6651(a)(1) as well as an accuracy-related penalty of $6,182 under §6662.

The central issue in the case was whether the Derivium "master agreement" loan was to be treated as a loan or instead as a sale for Federal income tax purposes. It is somewhat universally accepted that a "sale" for Federal income tax purposes is given its ordinary meaning as a transfer of property for money or a promise to pay money." Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221, 1237 (1981) (citing Comm’r v. Brown, 380 U.S. 563, 570-571 (1965)). Since the economic substance of a transaction, rather than its form, controls for tax purposes, the question for the court to determine at bar was whether the benefits and burdens of ownership of the IBM stock passed from petitioner to Derivium. This is a question of fact for which generally the taxpayer has the burden of proving by a preponderance of the evidence. See §7491. See also Arevalo v. Comm’r, 124 T.C. 244, 251-252 (2005), affd. 469 F.3d 436 [98 AFTR 2d 2006-7676] (5th Cir. 2006). Factors the courts have considered in making this determination include: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest in the property is acquired; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property.

In the majority opinion by Ruwe, in which 10 judges joined and one additional judge concurring in result only, the Tax Court was critical of the taxpayer’s "loan" position on various grounds, including:

Petitioner did not treat the transaction consistent as a loan. For example, he did not include dividends pain on the stock as income from 2001 through 2004. He failed to report the "sale" of the shares on his 2004 return and further failed to alternatively report any cancellation from indebtedness income in 2004 for the balance of the "loan" left unpaid and discharged.
Petitioner did not retain any property interest in the stock. He retained, in the eyes of the Court, no more than an option to purchase an equivalent number of IBM shares after 3 years at a price equivalent to $93,586 plus "interest." The effectiveness of the option depended on Derivium's ability to acquire and deliver the required number of IBM shares in 2004.
Derivium obtained title to, possession of, and complete control of the IBM stock from Calloway. It immediately exercised those rights and sold the stock.
Upon receipt of the $93,586.23 from Derivium in 2001, Calloway bore no risk of loss in the event that the value of the IBM stock decreased. He was entitled to retain all the funds transferred to him regardless of the performance of the IBM stock in the financial marketplace.

The Court opined that at best the agreement with Derivium provided the Petitioner with an option to repurchase IBM stock at the end of 3 years however this option depended on Derivium’s ability to acquire IBM stock at that time. The Tax Court pointed out that two other Federal courts recently considered whether the transfer of securities to Derivium under its 90%-stock-loan program was a sale for Federal tax purposes (one case, dealing with Mr. Nagy, dealt with §6700 promoter penalties; the other, dealing with Mr. Cathcart, enjoined him from marketing the 90% stock loan program). In those cases, the courts, using essentially the same facts and applying the same legal standards that are found in well established cases, found that the 90%-stock-loan-program transactions were sales of securities and not bona fide loans.

The Tax Court also held that the transaction was not analogous to the securities lending arrangement in Rev Rul 57-452, 1957-2 CB 295 , nor was it equivalent to a securities lending arrangement under Code Sec. 1058 .

Petitioner was held liable for the accuracy related penalty under §6662 because he was found not to have acted with reasonable cause and in good faith because he didn't report the transaction on his returns consistent with his characterization of it. He couldn't avoid liability for the penalty by showing reliance on a competent professional adviser (i.e., his financial adviser) because he made no effort to establish that adviser's credentials or qualifications nor did he establish whether the adviser had any relations to Derivium. Finally, Calloway admitted that he knew nothing about Mr. Nagy other than that he apparently wrote an opinion letter addressed to Mr. Cathcart concerning another 90%-stock-loan transaction. In like manner there the Petitioner failed to establish "reasonable cause" or the absence of "willful neglect" in not timely filing his 2001 return which was filed more than 21 month after its due date.

On November 24, 2009, Judge Phyllis J. Hamilton, for the U.S. District Court for the Northern district of California, ordered a permanent injunction against the principal of Derivium, Charles Cathcart of Tuxedo Park, N.Y., from promoting a complex tax scheme involving numerous entities located around the globe and sales of over $1.25 billion in securities, the Justice Department announced today. The record indicated that Cathcart, a Ph.D. economist, developed a scheme called the "90% Loan Program" and promoted it throughout the United States through companies he controlled-including Derivium Capital LLC and Derivium USA.The 90% Loan Program falsely claimed customers could exchange their appreciated stock for loan payments equal to 90% of the stocks’ value without paying income tax on their capital gains. It also purported to allow the tax-free return of those customers’ stocks at maturity if the customers repaid the "loans." The customers’ stocks were sold immediately, with 90% of the sale proceeds going to make the purported "loans" to the customers, and the other 10% being retained by the promoters. Customers were told the loans were made by independent third-party lenders, but in fact the supposed loans were made through sham companies that Cathcart created and controlled. The sham companies never functioned as genuine lenders, never held or maintained any assets or reserves, and were located throughout the world in such far-flung places as the Isle of Man, Ireland and Hong Kong.

The Federal district court record reflected that Cathcart, through the 90% Loan Program, sold more than $1.25 billion worth of customers’ stock in some 3,100 transactions, leaving more than $100 million for himself and the other promoters after payment of 90% of the sale proceeds to customers as purported loans. The government complaint in the case alleged that the scheme cost the U.S. Treasury an estimated $230 million or more. Judge Hamilton previously ruled that Cathcart’s customers were not receiving loans, because the transactions were in fact sales. Thus, Cathcart’s representations to customers that they were receiving loans were false statements about the scheme’s tax benefits. The same court earlier barred Cathcart’s son, Scott, Robert Nagy, and other members of the team from promoting the 90% Loan program. A representative of the Department of Justice stated that the government wanted to shut down complex tax schemes that falsely claim to eliminate income tax on capital gains, a scheme directed towards the more affluent.

By the time that Mr. Calloway had his 2001 case heard and decided by the Tax Court, the numerous legal proceedings and investigative efforts undertaken by the Department of Justice working with the SEC and IRS made the outcome to this civil tax case before the Tax Court forseeable as well as anticlimactic. One can't help but wonder why the Petitioner still pressed forward with his case and furthermore, why it took the full Court to decide it. Perhaps the answer to the latter question was to prevent other adventurous and predatory "lenders" from falsely promoting a bad tax scheme employing a "loan" strategy.

Promoters and Principals of Derivium Subsequently Face SEC and IRS Charges

Tax Court’s Underlying Analysis

The Tax Court Finds in Favor of the Service

Tax Court's Decision in Xilinx Affirmed by the Ninth Circuit Court of Appeals

Jerald David August — Tue, 06 Jul 2010 17:09:07 -0500

In an en banc decision, the Ninth Circuit Court of Appeals, reversed its prior 2-1 panel decision, and affirmed the Tax Court's determination in Xilinx, 105 AFTR2d 2010-638 (3/22/ 2010), ruling that that under pre-2004 Regulations to section 482, employee stock options (ESOs) did not have to be included in the costs shared between related companies under a bona fide, cost-sharing arrangement (CSA).

The central issue in the case was whether, under the pre-2004 Regulations to section 482, related companies that engaged in a joint venture to develop intangible property must include the value of certain ESOs in the pool of costs to be shared under a CSA, regardless of whether companies operating at arm's length would fail to do so.

Xilinx, Inc., was engaged in researching, developing, manufacturing, marketing, and selling field programmable logic devices. During the tax years initially in issue (1996-1999) it was the parent corporation of a group of affiliated subsidiaries including Xilinx Ireland (XI). Xilinx and XI entered into a cost-sharing arrangement to develop intangibles. Each party was required to pay a percentage of the total research and development based on its respective anticipated benefits from the intangibles, and to share direct costs, which included salaries, bonuses and other payroll costs, indirect costs, and acquired intellectual property rights costs.

Under the plans, Xilinx offered incentive stock options (ISOs), nonstatutory stock options (NSOs), and employees stock purchase plans (ESPPs). All ISOs and NSOs were issued at prices that were at-the-money whereas ESPP purchase rights were issued with an exercise price equal to 85% of the stock's market price.The options generally were subject to a five-year vesting period.

In 1996, Xilinx and XI entered into an agreement permitting XI employees to acquire stock in Xilinx. The agreement required XI to pay Xilinx the cost associated with the exercise of the options. Cost equaled the stock's market price on the exercise date over the exercise price. During the years in issue, generally accepted accounting principles (Accounting Principles Board Opinion 25 (APB 25)), required that the issuing company not incur expense related to options granted at-the-money.

After auditing the group’s return, the IRS issued notices of deficiency under the cost-sharing regulations, i.e., Treas. Reg. 1.482-7(d) , that the spread (stock's market price over exercise price on exercise date), or the grant date value, relating to compensatory stock options, should have been included as a research and development cost. Under the Service’s approach, Xilinx’s taxable income was substantially increased.

The Tax Court Sides with the Petitioner

The Tax Court, 125 TC 37 (2005), rejected the IRS’s interpretation under Treas. Reg. §1.482-7(d) by holding that such analysis violated the arm’s length standard under Treas. Reg. §1.482-1(b) where it was uncontroverted that unrelated parties would not explicity share such amounts. The IRS was attempting to circumvent the arm's length standard, arguing that Treas. Reg. §1.482-7's application automatically produced the required arm's length result was in its view disingenuous and erroneous in light of Treas. Reg. §1.482-1(b)’s explicit language and history. Thus, the IRS's reallocation was arbitrary and capricious. In contrast, taxpayers' allocation, excluding any ESO-related costs from research and development expenses, satisfied the arm's length standard and was upheld. Accordingly, it held that IRS's allocations were arbitrary and capricious and that Xilinx's allocations met the arm's-length standard mandated by Treas. Reg. 1.482-1(b) .

The Ninth Circuit’s Panel Decision Reverses

In May 2009, the Ninth Circuit reversed the Tax Court, 2-1 (Judges Fisher and Reinhardt in the majority, Judge Noonan in dissent). However, Xilinx’s requesting for rehearing en banc was granted and the panel decision was withdrawn in January, 2010.

The en banc decision reversed the panel’s conclusion . In the March 2010 decision by a three-judge panel of the Ninth Circuit, Judge Raymond Fisher, who wrote the court's 2009 opinion, changed his mind. On the second try, Judge Fisher noted that while Xilinx viewed Treas. Regs. §§1.482-1(b)(1) and 1.482-7(d)(1) as irreconcilable, the IRS interpreted Treas.Reg. §1.482-7(d)(1) 's “all costs” requirement as consistent with Treas.Reg. §1.482-7(b)(1) 's arm's-length standard. In other words, the more narrowly drawn specifics contained in the CSA regulation should be controlling.

The Ninth Circuit disagreed and concluded that the taxpayer’s position that Treas. Reg. §1.482-1(b) was controlling where another part the of the regulations appeared to be in conflict. This was based on analyzing the legislative history of §482, the drafting history of the regulations, and authoritative comments under various tax treaties. Judge Noonan, who wrote the new opinion, held that where the two Regulations were "hopelessly ambiguous" and that the ambiguity should be resolved in light of the commonly held understanding of the arm's-length standard prior to the case's litigation. If the standard of arm's length is trumped by [Treas. Reg. §1.482-]7(d)(1), the Ninth Circuit opined that the purpose of the statute is frustrated." "If Xilinx cannot deduct all its stock option costs, Xilinx does not have tax parity with an independent taxpayer."

Noonan also noted that with respect to the Ireland-U.S. income tax treaty , "[i]t is enough that our foreign treaty partners and responsible negotiators in the Treasury thought that arm's length should function as the readily understandable international measure."

Ways and Means Chair Speaks on Carried Interest Compromise

Jerald David August — Thu, 01 Jul 2010 07:37:26 -0500

Perhaps one of if not the most controversial pieces of the extenders bill winding its way though Congress is the carried interest provision. Taking on its term from the hedge fund industry, a "carried interest" translated into tax parlance is a profits interest in an entity taxable as a partnership. Under current IRS pronouncements that set forth a safe harbor when issuing such interests, taxable income (ordinary service type) can be avoided while subsequent gains allocable to the dispositions of such interests can qualify for long term capital gain treatment. This substantial tax advantage has caught the attention of the Democratic side of the Congressional tax-writing committees and proposals to reverse this favorable treatment have been introduced during the past year or so.

More recently, on May 11, House Ways and Means Committee Chairman Sander Levin (D-Mich.) stated that a compromise proposal being floated is to allow a phased-in change to the tax treatment of carried interest to be a main offset for the tax extenders legislation moving toward the House floor. Still, the primary legislative vehicle, H.R. 4213, to the disappoint of many, does not carve out the carried interest reform to exempt particular industries as was hoped for by the real estate and private equity industries as well as others. Levin also said lawmakers still are discussing whether to include a provision from the small business tax bill that would raise $7.7 billion by stopping companies from using subsidiaries to channel deductible payments through U.S. tax treaty countries before earnings are repatriated to a tax haven.

Federal Imposition of Accuracy-Related Penalties on Son of BOSS Tax Shelters in Stobie Creek Investments

Jerald David August — Wed, 30 Jun 2010 09:12:38 -0500

On June 11, 2010, the Federal Circuit Court affirmed the application of the judicial economic substance doctrine (as compared with newly enacted section 7701(o) version of the economic substance doctrine) to a Son of BOSS tax shelter that was marketed as the Jenkins & Gilchrist law firm strategy and affirmed the imposition of accuracy related penalties in Stobie Creek Investments LLC v. U.S., Fed. Cir., No. 2008-5190 (6/11/2010).

The Son of BOSS (Bond and Option Sales Strategy) shelter attempted to take advantage that assets and contingent liabilities were treated differently for tax purposes when contributed to a partnership, thus facilitating, it was thought or planned, to permit the investor to benefit from an artificial tax loss to offset substantial realized gains of the same taxpayer. The "artificial loss" was the tax product so to speak used to offset the large gains. The government has been highly successful in defeating the Son of BOSS strategy in various lawsuits and as part of an overall national policy for inviting taxpayer concessions.

The facts involved members of a family that had a highly successful family owned business that they were in the process of selling (assets) and realizing a substantial capital gain. They approached a lawyer with Jenkins & Gilchrist in January 200. The goal of the J & G strategy was to reduce the capital gain resulting from the sale of assets.

The strategy reduced a taxpayer's capital gain by increasing, or "stepping up," the basis in the asset the taxpayer wanted to sell. Because a partnership does not pay taxes, the resulting stepped-up basis passes through to the partners, thereby reducing the partner's capital gain and attendant capital gains tax when the asset is sold. To create a stepped-up basis in the assets, the J & G strategy required the contribution of assets to a partnership followed by the distribution of the partnership's assets to the taxpayers. The goal of realized a large capital loss was to be achieved through a six step process: (i) investment in foreign currency options through a single-member LLC; (ii) formation of a partnership with a third party or wholly-owned S corporation; (iii) contribution of the foreign currency options to the partnership; (iv) recognition of an economic gain or loss by the partnership when the options expired or were exercised; (v) termination and liquidation of the partnership through contribution of the taxpayer's partnership interest to an S corporation; and the (vi) sale of the partnership's assets by the S corporation or taxpayer.

Among the various steps, step 3 is important for the success of the tax strategy. The idea was to make a substantial investment in foreign currency option spreads, whereby the LLC sells a short option and purchases a long option in the same currency. As contributed (i.e., the options) to the tax partnership, i.e., Stobie Creek, the partners basis in his partnership interest is increased by the cost (or adjusted basis) of the purchase made in the long option, but not decreased by the short option obligation. Under the J & G strategy, the short option's contribution has no effect on the taxpayer's basis because it is not treated as a "liability" section 752 when calculating the taxpayer's basis in his partnership interest. When the partnership is liquidated during step 5, the tax basis in the partnership's assets is "stepped up" to match the partner's outside basis. This stepped-up basis allows the taxpayer to recognize less capital gain when the asset is sold during step 6.

The family involved agreed to embark on the J&G strategy, including a fee to J&G of 2% of the gain to be sheltered or approximately $4.1M. Another promoter’s fee was $2M yielding total fees of in excess of $6M. The Welles family decided to pursue the J & G strategy. To obtain help implementing the strategy,

Then, with the formation of the LLC and execution of the plan, J & G stated it would be issuing a tax opinion for the Welleses similar to the one attached to the letter, which would opine that it was "more likely than not" that the transactions would be respected for federal income tax purposes.

The IRS issued a FPAA for Stobie Creek's 2000 tax year in March 2005. The IRS issued a FPAA for Stobie Creek's 2000 stub year in February 2007. The FPAAs disregarded Stobie Creek for tax purposes as a sham and disallowed the partnership's stated basis in the closely held stock, finding it attributable to transactions entered into for the purpose of tax avoidance. As a result, the FPAAs increased Stobie Creek's capital gain income from the sale of the closely held stock and assessed over $4.2 million in additional taxes. The FPAAs also imposed accuracy-related penalties per § 6662.

Stobie Creek and the other plaintiffs filed this action in the Court of Federal Claims in July 2005. The complaint sought readjustment of partnership items for the 2000 tax year and 2000 stub year,as well as a tax refund of the $4.2 million assessed in the FPAAs.

In this case, Stobie Creek Investments LLC, JFW Enterprises Inc., and JFW Investments LLC used the Son of BOSS strategy to inflate the basis of their stock in a family business, thereby eliminating over $200 million in capital gains realized from the sale of that stock. Upon audit, the IRS disallowed the losses in their entirety charging that the Stobie Creek Investments LLC strategy was a sham. Based on this determination, the IRS disallowed the partnership's stated basis in the stock, increased the partnership's capital gain from the sale of the stock, and assessed additional taxes.

In March, 2005 a notice of final partnership administrative adjustmentFPAA Issued a Notice of Final Partnership Administrative Adjustment (FPAA) for Stobie Creek's 2000 tax year was issued in March 2005. A second FPAA for the 2000 stub year was issued in February 2007.

The FPAAs disregarded Stobie Creek as a sham and disallowed the partnership's stated basis in the stock, finding it attributable to transactions entered into for the purpose of tax avoidance. The Service increased the entity’s capital gain from the sale of stock and assessed over $4.2M in additional taxes as well as accuracy related penalties per section 6662.

Tax Refund Suit Filed by Taxpayers in the Court of Federal Claims

The plaintiffs filed an action in the Court of Federal Claims in July 2005, seeking a refund of the increased taxes and penalties. The trial court found that the plaintiffs failed to show the underlying foreign exchange digital options transactions, which were the economic investments that would facilitate and leverage the amount of the loss realized to the U.S. transferors, had no business purpose beyond creating a tax advantage. It further lacked economic substance. The trial court also found that Stobie Creek was liable for the accuracy-related penalties.

[As an aside, under the entity level audit procedures, the IRS must mail an FPAA to the designated "tax matters partner", all notice partners, and representatives of notice groups. The primary mailing of the FPAA, which is used for notice of deficiency purposes, is the mailing to the TMP. The mailing to the other partners must occur within 60 days after the mailing to the TMP. An FPAA is equivalent to a notice of deficiency (90-day letter) in regular audits. A deficiency attributable to a partnership item cannot be assessed until the notice of an FPAA has been mailed and 150 days have elapsed after the mailing. Where a Tax Court petition is filed within 150 days after the FPAA notice, no deficiency attributable to a partnership item may be assessed until the Tax Court's decision on the matter becomes final.]

At the trial, the court found that Stobie Creek's basis calculations complied with the literal requirements of the tax code. It declined, therefore, to retroactively apply Treas. Reg. §1.752-6. The trial court nonetheless disregarded the transactions implementing the J & G strategy under the economic substance, step transaction, and end result doctrines. 4 Had the trial court applied Treas. Reg. § 1.752-6 retroactively, plaintiff's refund action would fail under the literal application of the tax code and treasury regulations because the short options would constitute liabilities for the purpose of § 752, reducing the LLCs’ basis in their partnership interests. The government did not appeal the trial court’s determination not to apply Treas. Reg. §1.752-6 retroactively. It simply ruled against the taxpayers under the economic substance doctrine.

The trial court further held that the accuracy penalty was appropriate and that reasonable cause was not present through the argued reliance on the opinion of the J&G law firm. See §6664(c)(1). Reliance on the law firm’s opinion was not reasonable due to their clear conflict of interest.

On appeal to the Federal Circuit, the Court examined the economic substance doctrine as applied by the trial court. The court of appeals noted that the purpose of this rule is to separate a transaction that should be respected as legitimate and a transaction principally designed to generate a tax benefit, which is a sham. In this case, the appellants argued that the foreign exchange digital options should not be treated as shams or lacking in economic substance since there were bona fide business transactions, designed to generate an economic profit from investing in foreign currencies. See section 988.

Such argument was rejected at the trial court and by the Federal Circuit based on the facts related to the investments and through the introduction of expert testimony.

The economic substance doctrine distinguishes between a real transaction in a particular way to obtain a tax benefit, which is legitimate, and creating a transaction to generate a tax benefit, which is illegitimate. A transaction could meet the literal terms of the Code but still lack "economic reality". See, e.g., Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84 (1978). Such transactions include those that have no business purpose beyond reducing or avoiding taxes, regardless of whether the taxpayer's subjective motivation was tax avoidance. Transactions shaped solely by tax-avoidance are also disregarded. Under an "objective" test, the Federal Circuit stated that whether a transaction lacks "economic reality," has no bona fide "business purpose" or was shaped solely by tax-avoidance features is an objective inquiry, evaluated prospectively. Coltec Industries Inc v. U.S., 454 F3d 1340 (Fed. Cir. 2006), vacg & remg 62 Fed. Cl. 716 (Ct. Fed. Cl. 2004). The objective test of economic substance requires that the transaction be evaluated based on information available to a prudent investor at the time the taxpayer entered into the transaction, not what may (or may not) have happened later. If this test is failed, then the transaction fails as well, as to its designed tax benefits, regardless of the taxpayer’s subjective motivation was (or was not) tax avoidance.

The Appeals Court, after evaluating the transcript of the proceedings below, reached the same conclusion as the trial court that the transactions did not reflect economic reality and were not motivated by a business purpose. The Court stated that the trial court properly treated the options as part of a separate, unified transaction, that were part of determining the taxpayer’s basis in Stobie Creek LLC. The options were also found to have lacked economic substance since there was not reasonable possibility that the options would return a profit. There also was no bona fide business purpose other than to generate tax benefits. This was evidenced, in part, by the fee structure. All the fees were computed by the amount of the gain to be shelter by the tax strategy.

Reasonable Cause Defense to Accuracy Related Penalties Rejected

As to the partnership level assertion of reasonable cause, to avoid the accuracy related penalty on partnership level determinations (i.e., for stepping up the basis in the closely held stock), the Court reviewed and affirmed the lower court’s determination that the penalties were to be imposed. See §6664(c). Temp. Treas. Reg. § 301.6221-1T(d). The taxpayers claimed that the TMP, Jeffrey Welles, had reasonable cause, reliance on advice from the promoter and J&G law firm, on the merits of its reporting position. Section 6664(c)(1) provides a narrow defense to § 6662 penalties if the taxpayer proves it had (1) reasonable cause for the underpayment and (2) acted in good faith. See also Treas. Reg. § 1.6664-4(c)(1). The taxpayer bears the burden of showing this exception applies. The most important of these factors contained in the regulations is "the extent of the taxpayer's effort to assess the taxpayer's proper tax liability," judged in light of the taxpayer's "experience, knowledge, and education." Treas. Reg. § 1.6664-4(b)(1).

Reliance is not reasonable, however, where, as was the case here, the adviser has an inherent conflict of interest about which the taxpayer knew or should have known. Treas. Reg. § 1.6664-4(c). This was a finding made by the trial court and the Appeals Court affirmed.Circuit Court of Appeals Affirms

Evaluation on Appeal of the Economic Substance Doctrine

Taxpayers Appeal to the Federal Circuit After Losing on Economic Substance; Penalties Imposed

Renewed Emphasis By Internal Revenue Service in Auditing International Concerns and Policing Transfer Pricing Requirements

Jerald David August — Tue, 22 Jun 2010 16:52:10 -0500

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

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

Service Rules that Cross-Border Debt Cancellation Between Related Parties Did Not Result in Cancellation of Indebtedness Income

Jerald David August — Tue, 22 Jun 2010 16:12:12 -0500

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

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

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

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

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

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

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

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

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

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

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

UBS UPDATE: SWISS PARLIAMENT GIVES FINAL APPROVAL TO RELEASE 4,450 BANK DEPOSIT INFORMATION OF US PERSONS

Jerald David August — Tue, 22 Jun 2010 15:37:35 -0500

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

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

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

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

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

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