Jerald David August's Recent Articles from LexMonitor

The Large Business and International Division of the Service Issues Directive on Raising the Economic Substance Doctrine

jaugust@foxrothschild.com (Jerald David August) — Mon, 18 Jul 2011 02:09:34 GMT

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

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

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

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

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

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

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

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

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

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

The Field Directive of July 15, 2011

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

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

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

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

Purpose of the Guidance

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

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

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

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

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

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

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

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

United Kingdom Still Weighing the Proper Standard for Tax Residency

jaugust@foxrothschild.com (Jerald David August) — Mon, 18 Jul 2011 01:56:21 GMT

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

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

The commentary quotes the Income Tax Act of 1842:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Congress Recently Amends Section 304 to Prevent Avoidance of U.S. Tax on Redemption of Stock Held By a Foreign Corporation from a Controlled Foreign Corporation

jaugust@foxrothschild.com (Jerald David August) — Sun, 10 Jul 2011 15:24:18 GMT

Enactment of Section 304(b)(5)(B) in 2010

In The Education Jobs and Medicaid Assistance Act (P.L. 111-226, August 10, 2010), Congress amended §304(b)(5) by adding, in §304(b)(5)(B), to deny dividend reduction from earnings and profits for a purchase of stock by a controlled foreign corporation through a chain of ownership that “hopscotches” over the U.S. person under §951(b). While §304 is itself an substance over form provision to avoid dividend inclusion, U.S. corporations have structured brother-sister or parent-subsidiary stock purchases to avoid foreign withholding taxes that would have otherwise been imposed on a direct dividend distribution and to also obtain deemed paid foreign tax credits under §902. Congress, in 1996 and now recently in the Education Jobs Act last year, has tried to put a stop on “gaming” the withholding and controlled foreign corporation dividend impacts by stock purchases between a non-CFC or U.S. shareholder of a CFC.

Redemptions of Stock Through Related Corporations: Section 304

As a starting point, §304(a) provides that where a “related corporation” (other than a subsidiary, i.e., two corporations in which one or more persons are in control, as defined, of both, and in return for property, one of the corporations acquires stock in the other corporation from the person or person in “control” of both, then (unless §304(a)(2) applies), such property received is treated as a distribution in redemption of the stock of the corporation acquiring such stock. To the extent the described distribution is taxable as a dividend under §301, the transferor and the acquiring corporation shall be treated as if the transferor had transferred the stock so acquired in exchange for to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction controlled by §351(a), and then the acquiring corporation redeemed the stock it treated as having issued in the transaction.

Under §304(a)(2), which applies to the acquisition of stock in a related corporation by a subsidiary, where in return for property the stock of a parent corporation is acquired by a controlled subsidiary, then such property is treated as a distribution in redemption of the stock of the issuing (parent) corporation. If a subsidiary corporation (the controlled or acquiring corporation) acquires stock of its parent (the issuing corporation) from a shareholder of the parent, § 304(a)(2) provides that for purposes of § 302 or § 303, any “property” paid for the stock must be treated as a distribution in redemption of the parent corporation's stock.

The definition of the term “property” for purposes of § 304 is the same as for purposes of § 302. Since the definition includes everything of value other than the corporation's own stock or stock rights, it normally causes little confusion; however, in the context of a parent-subsidiary redemption, the issue can arise as to which party is “the corporation,” particularly since § 304(a)(2) states that the transaction will be treated as a redemption of the stock of the issuing corporation. The Tax Court has held that a shareholder's transfer of parent stock to a subsidiary in exchange for stock of the latter is not a § 304 distribution of “property,” because it is a distribution of stock of the corporation referred to by § 317(a), the subsidiary in this case. See. Bhada, 89 TC 959 (1987) , aff'd sub nom. Caamano v. Comm’r, 879 F2d 156 (5th Cir. 1989) , and Bhada v. Comm’r, 892 F2d 39 (6th Cir. 1989). Section 304(a)(2) transmutes a sale of the parent's stock to the controlled subsidiary into a deemed redemption of the stock by the parent but not for purposes of applying the non-equivalent tests under §302(b). The subsidiary's basis in the purchased parent stock is its cost basis under § 1012 regardless of whether the transaction is treated as a sale or a dividend to the selling shareholder. Where the selling shareholder is treated as having received a §301 distribution, its basis in the parent corporation’s stock will generally be added to the basis of remaining shares.

Section §304(b) sets forth special rules for making sale or exchange determination under §302(b). Under §304(b)(1), where stock of a corporation is acquired under §304(a), whether the distribution is in part or full payment in exchange for the stock is made by looking at the “before” and “after” impacts by reference to the stock of the issuing corporation. In applying the constructive ownership rules in §318 with respect to §302(b), §§318(a)(2)(C) and 318(a)(3)(C) are applied without regard to the 50% limitation contained in those provisions.

The amount and source of the “dividend” portion of the redemption proceeds, i.e., in an acquisition of stock described under §304(a), is determined “as if the property were distributed” by the acquiring corporation to the extent of its earnings and profits and then by the issuing corporation to the extent of its earnings and profits. In applying the §351 construct in §304(a), unless otherwise provided, §304(a) (and not §351 and §§357 and 358 as they related to §351), shall apply to any property received in a distribution described in subsection (a) . To the extent the dividend is sourced from the earnings and profits of the acquiring corporation, the transferor is considered to receive the dividend directly from the acquiring corporation. Commentors have referred to this as “hopscotching” since the dividend essentially bypasses any intermediary shareholders, which in the context of this note would be a U.S. shareholder under §951(b). See H.R. Rep. No. 98-861 (1984) (Conf. Rep.), 1222-1224; Rev. Rul. 80-189 , 1980-2 C.B. 106. Other applicable rules with respect to liability assumptions, distributions incident to the formation of a bank holding company and treatment of certain intragoup transactions.

The Taxpayer Relief Act of 1997 Addressed Sales of CFC Stock Abuse

Section 304(b)(5) was enacted by Congress in 1997, and shortly thereafter amended, in an effort to limit certain earnings and profits of a foreign acquiring corporation from being taken into account for §304 purposes. The target of abuse of that legislation was to prevent a U.S. corporation from claiming a §902 foreign tax credit for taxes paid by a foreign acquiring corporation in instances where an actual dividend paid by the foreign acquiring corporation would have been received by a foreign parent corporation and no foreign tax credit would have been available to the U.S. corporation. For example, if a foreign-controlled domestic corporation sells the stock of a subsidiary to a foreign sister corporation, the domestic corporation may claim it can credit the foreign taxes that were paid by the foreign sister corporation. See Rev. Rul. 92-86, 1992-2 C.B. 199 ; Rev. Rul. 91-5, 1991-1 C.B. 114 . Where the foreign sister corporation actually distributed its earnings and profits to the common foreign parent, no foreign tax credits would have been available to the domestic corporation.

Under the Taxpayer Relief Act of 1997, P.L. 105-34 (8/5/97) bill, the earnings and profits of the acquiring foreign corporation, i.e., a CFC, that are taken into account in applying §304. Such earnings and profits taken into account by the CFC will not exceed the portion of such earnings and profits that (1) is attributable to stock of such acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) and who is a U.S. shareholder (within the meaning of § 951(b)) of such corporation, and (2) was accumulated during periods in which such stock was owned by such person while such acquiring corporation was a controlled foreign corporation. For purposes of this rule, except as otherwise provided by the Secretary of the Treasury, the rules of §1248(d) (relating to certain exclusions from earnings and profits) would apply. See also §1442 which generally requires a 30-percent gross basis tax to be withheld on dividend payments to foreign persons unless reduced or eliminated pursuant to an applicable income tax treaty.

Prior to the Education Jobs Act, enacted in 2010, a CFC group could repatriate the earnings and profits of the CFC group free from U.S. income tax where the acquiring corporation, the CFC, purchased the stock of the issuing corporation that resulted in a deemed distribution from the CFC directly to the foreign shareholder. This could occur, for example, if a CFC group which included a US holding company and a subsidiary CFC purchased stock of its subsidiary CFC, a purchase by the CFC of stock of the issuing corporation held by a non-CFC foreign corporation in a transaction described §304(a)(1). This strategy resulted in a dividend that bypassed the U.S. holding company and avoided the U.S. income tax that would have been otherwise payable by the U.S. holding company. In addition, because the dividend was treated as a distribution out of the earnings and profits of acquiring, a foreign corporation, the constructive redemption resulted in a distribution of foreign source dividend income when paid to the foreign parent or other tax indifferent foreign member that was not subject to U.S. withholding tax. The earnings of an Issuing U.S. member of a foreign controlled group could also be constructively distributed to a foreign parent or a tax indifferent entity in a constructive redemption. In that case, however, to the extent the dividend was deemed to be from the earnings of the domestic issuing corporation, it was generally be subject to U.S. withholding tax (at 30%, or for a lower rate under applicable treaty). Note the inapplicability of §367(a)(outbound transfers of property, including inventory from the U.S.) or §367(b)(foreign to foreign transfers) to §351 type transactions that are part of a deemed redemption under §304(a)(1).

“The Problem” Which Resulted in Passage of Section 304(b)(5)(B): A Hypothetical

Assume that FHC is a publicly traded foreign corporation and, by definition, is not a CFC. Assume further that FHC does not maintain a U. S. trade or purpose directly but owns all the stock of US Sub. US Sub is the parent of a wholly owned foreign subsidiary, FS. All of FS’s earnings and profits are not previously taxed, i.e., earnings and profits described in §959(c)(3) that would also be described in §304(b)(5) and §304(b)(5)(A). FHC sells part of its share holdings in US Sub. to FS for cash in an amount equal to FS’s earnings and profits.

The “problem” transaction is described in §304(a)(2) with the acquiring corporation being FS and the issuing corporation US Sub., and the shareholder of the issuing corporation FHC. Prior to the Act, FHC, per §304(b)(2)(A), would maintain its receipt of a dividend from FS for the full amount of cash received as a direct dividend from FS to FHC and not through US Sub. FHC would therefore contend it had no U.S. tax liability resulting from the deemed dividend, i.e., the dividend sourced from FS’s earnings would “hopscotch” over US Sub. But see §902 (for direct chain of ownership dividends from a CFC to its US parent corporation). After the transaction, FS would own stock of USP that generally would be a cost basis investment in U.S. property for purposes of §956 . This potentially could result in an income inclusion to US Sub. under §951(a)(1)(B) as the U.S. shareholder (per §951(b) ) of FS, a CFC. However, were FS’s earnings and profits eliminated in the stock purchase from FHC, the income inclusion under the CFC to US Sub. would be substantially reduced.

Enactment of Section 304(b)(5)(B) in 2010 Education Jobs Act

For §304 redemptions occurring after July 8, 2010, The 2010 Education Jobs Act, P.L. 111-226, under amended §304(b)(5)(B) imposes an additional limit on the earnings and profits of a foreign acquiring corporation that may be taken into account in determining the amount (and source) of a distribution treated as a dividend in a constructive redemption. Under the Act earnings and profits of an acquiring foreign corporation in a.§304(a) related party stock purchase are not taken into account in determining the amount treated as a dividend under §304(b)(2)(A) if more than 50% of the dividends arising in connection with the acquisition would neither (i) be subject to U.S. income tax for the year in which the dividends arise, §304(b)(5)(B)(i); or (ii) be included in earnings and profits of a CFC, per §957, without regard to §953(c) (§304(b)(5)(B)(ii)). The limitation generally applies when more than 50% of the issuing corporation is acquired from a foreign person that is not a CFC, in which case none of the foreign acquiring corporation's earnings and profits is taken into account and just the target corporation’s earnings and profits are so accounted for in computing the amount of the dividend. The new provision effectively prevents the foreign acquiring corporation's earnings and profits from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign person (i.e., the transferor) without an intermediate distribution to a domestic corporation in the chain of ownership between the acquiring corporation and the transferor corporation. Generally, if the transferor is a foreign corporation (and not a CFC) and the acquiring corporation is a CFC, it is not relevant whether the target corporation is a domestic or a foreign corporation. However, if the target is a U.S. corporation, the 30-percent gross basis withholding tax applies to the amount constituting a dividend from the target, unless reduced or eliminated by treaty.

Revisiting the Hypothetical “Problem” After Passage of Section 304(b)(5)(B)

In applying §304(b)(5)(B) to the “Problem”, i..e, the stock sale occurred after August 10, 2010, then none of the FS’s earnings and profits would be used to fund a deemed dividend per §304(b)(2)(A). The requirements for §304(b)(5)(B) would be met, i.e., more than 50% of the dividends arising from such acquisition (without regard to §304(b)(5)(B)) would neither be subject to U.S. income tax either directly or through the CFC provisions. The gain FHC recognizes would not be subject to US tax.

Postscript. Regulations are expected to be issued that will provide a series of anti-avoidance provisions, including through the use of partnerships, options, or other arrangements to cause a foreign corporation to be treated as a CFC. The provision applies to transactions occurring after thedate of enactment, August 10, 2010.

Large Corporations Required to File Statement Disclosing Uncertain Tax Positions with Annual Corporate Income Tax Return

jaugust@foxrothschild.com (Jerald David August) — Wed, 06 Jul 2011 15:34:46 GMT

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

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

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

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

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

Recent Decision of Judgment of the Court (Grand Chamber) of EU in Akzo Nobel Chemicals, et al v. European Commission Imperils Attorney Client Privilege for Foreign Based Subsidiaries, Including in U.S. Tax Proceeings and Non-Tax Proceedings

jaugust@foxrothschild.com (Jerald David August) — Sun, 26 Jun 2011 11:43:23 GMT

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

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

Factual Background

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

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

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

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

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

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

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

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

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

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

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

Implications of Akso Nobel Chemical and Acros Chemicals Decision.

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

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

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

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

Representatives of Japan and the United States Commence Negotiations on Amendments to the U.S.-Japan Income Tax Treaty

jaugust@foxrothschild.com (Jerald David August) — Mon, 20 Jun 2011 02:05:22 GMT

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

Zero Rate Withholding on Dividends

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

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

Mandatory Arbitration Procedures

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

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

Exhange of Information Amendment

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

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

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

Tax Court of Canada Approves of Foreign Tax Credit Generator Arrangement in Canada Limited v. The Queen (Case 4145358); Cross Border Impacts

jaugust@foxrothschild.com (Jerald David August) — Tue, 14 Jun 2011 01:40:49 GMT

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tax Court Examines Tax Consequences to Taxpayer's Sale of Conservation Easement State Income Tax Credits in George H. Tempel, 136 T.C. No. 15 (2001)

jaugust@foxrothschild.com (Jerald David August) — Mon, 13 Jun 2011 16:08:07 GMT

In Tempel, the taxpayers sold a portion of their newly received transferable Colorado state income tax credits, i.e., in the aggregate sum of $260,000, that resulted from a donation of a conservation easement on approximately 54 acres of the petitioners' land in Colorado.

In reporting two transactions in which the taxpayers subsequently sold $110,000 of their credits to separate unrelated buyers, the taxpayers claimed a cost basis in the tax credits equal in amount to an allocable portion of the professional fees incurred to make the donation. Also included was an allocable portion of land basis, on the rationale that the credits in substance constituted a separate property right that was part of the land.

The IRS, after reviewing the returns whereby the taxpayers reported the gain as short term capital gain after reducing the amount realized from the “costs” allocated to the credits, challenged both the basis computation and the character of the gain reported.

The Tax Court, per the opinion of Judge Wherry, rejected the taxpayers calculation of basis. First on the basis that the taxpayers did not “purchase” the credits. Next, their basis in the credits did not include a portion of their basis in the land. The credits were instead separate rights granted under state law and not a property right inherent in the land.

As to the character of the gain, which was essentially for the total amount realized, the Service argued that the gain was ordinary income since the credits were not capital assets. The Service cited the Gladden case as precedent, i.e., payments to relinquish water rights constituted ordinary income. See Gladden v. Comm’r, 112 T.C. 209 (1999), rev’d on a different issue, 262 F.3d 851 (9^th Cir. 2011). The Court rejected this position finding that the credits themselves were not income based on the fact that the credits wre not contractual in nature and could not be used by the taxpayers. Judge Wherry, in his opinion, relied on the Supreme Court’s opinion in National Railroad Passenger Corp. v. Atchison, Topeka & Santa Fe Railroad Co., 470 U.S. 451, 465-466 (1985). Here, the Court found, there was no clear indication that the legislature of Colorado intended to bind itself contractually; ergo the state tax credit did not create any private contractual rights. Furthermore, the gains are not ordinary income based on the rationale that the proceeds received were a substitute for ordinary income. There was no finding that the credits when received were an accession to wealth to support an inclusion under section 61(a).

After finding that the state credits were no non-capital assets or a substitute for ordinary income, the Court further held that the gain was properly reported as short term capital gain as the requisite holding period was less than one year, i.e, the credits could not be "tacked onto" the holding period with respect to the land.

European Court of Justice Decision in Prunus SARL v. France (C-384/09) Has Major Tax Implications for Companies Established in Certain Off Shore Tax Havens or Territories

jaugust@foxrothschild.com (Jerald David August) — Thu, 09 Jun 2011 19:55:12 GMT

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

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

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

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

Treasury and IRS Issue Final Regulations Under Section 367(b) For Certain Triangular Reorganizations: "The Killer B" Regulations.

jaugust@foxrothschild.com (Jerald David August) — Tue, 07 Jun 2011 13:58:03 GMT

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

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

Background.

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

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

Priority Rules

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

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

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

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

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

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

Adjustments Having the Effect of a Distribution or Contribution

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

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

New Final and Temporary Regulations on Treatment of Certain Intercompany Gains With Respect to Stock Owned by members of a Consolidated Group of Corporations

jaugust@foxrothschild.com (Jerald David August) — Mon, 23 May 2011 19:52:37 GMT

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

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

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

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

An example from the final regulations is quoted.

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

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

Financial Accounting Standards Board's Oversight Group Will Test a New Review Process for Existing Standards Under FIN 48

jaugust@foxrothschild.com (Jerald David August) — Mon, 23 May 2011 19:00:58 GMT

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

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

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

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

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

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

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

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

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

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

Obama Administration to Consider Imposing Corporate Income Tax on Certain Pass Through Entities

jaugust@foxrothschild.com (Jerald David August) — Fri, 06 May 2011 01:20:22 GMT

The tax press has recently informed the professional community that “in an April 29 e-mail briefing to its members, the National Association for Publicly Traded Partnerships cited an unnamed Treasury official who said the Obama administration is interested in a plan that would tax pass through entities with [annual] revenues [gross receipts] of $50 million or more as corporations”. White House spokeswoman Amy Brundage said the process is still unfolding and “no decisions have been made about the content of any specific reform proposal or the timing or manner in which the administration” will introduce a package of corporate tax reforms for the Congress to consider. .

The proposal on taxing large revenue pass through entities as well as prior comments to reduce the corporate income tax rate in general is sure to get more attention in the weeks ahead. It is clear that corporate tax reform is on the legislative “table” as our country’s federal corporate income tax rate of 35% is the second highest in the world next to Japan’s 39.5% rate which is presently anticipated to be reduced. Some countries, such as Ireland, have a corporate tax rate that is less than one-third of the U.S. rate and significantly higher than China or certain EU countries. While there is pressure on Congress to reduce the maximum marginal rate, a GEO study released in 2008 revealed that 55% of U.S. companies paid no federal income taxes during at least one year in a seven year period that it studied. Thus, part of the Obama Administration’s thinking is to reduce the corporate income tax rate but broaden the base by denying or deferral certain deductions or cost recovery allowances. There is expected to be a set of new base broadening provisions in the taxation of U.S. persons having foreign source income.

In going back to imposing corporate income tax on certain pass throughs, i.e., those having $50 million gross revenue partnerships and pass through entities, which amount will most likely be aggregated with the gross revenues of affiliated entities, perhaps both corporate and non-corporate, should be subject to corporate level income tax should be expected to be met with stiff opposition from the business community, including owners of closely held pass through companies that have high revenues, such as hedge funds and private equity firms. Presumably the proposal would affect the favorable treatment under current law of publicly traded limited partnerships that are eligible to avoid corporate level taxation based on the predominance of passive type income.

Taxing high revenue partnerships as corporations will also trigger a fair amount of business restructuring both from a tax and governance standpoint. Moreover, it again opens the door to discuss the benefits of integrating the double tax system of the corporate and shareholder level income tax by permitting dividend tax relief on in the form of a dividend deduction, imputed tax credit at the shareholder level for corporate income tax paid or elimination of taxes on dividends. It could further result in wholesale revisions to the entire set of corporate tax rules currently in place including the reorganization provisions. So it will be quite important to see whether the tax on pass throughs being discussed is a one item concept or whether it is based of a restructuring of the federal income taxation of U.S. business enterprises.

Perhaps in the haze of political bickering that is sure to follow on evaluating and commenting on the Obama Administration’s new and controversial test balloon to tax pass throughs, it would be nice if Congress would seize the opportunity to address our double-tax corporate income tax system and solve the integration issue once and for all so that there could be horizontal equity achieved by taxing corporate and non-corporate business enterprises on essentially the same basis. So much for editorial comments, at least for now.

Tax Strategies for Funds Investing In China: China Tax Authorities Aggressively Enforcing GAAR (General Anti-Avoidance Rules)

jaugust@foxrothschild.com (Jerald David August) — Fri, 22 Apr 2011 13:48:20 GMT

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

Potential Investment Fund Structures in China

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

Chinese GAAR Provisions

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

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

China Treaty Circulars: A Brief Summary

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

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

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

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

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

Additional Circulars Issued after 2008

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

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

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

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

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

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

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

Eleventh Circuit Affirms Lower Court's Holding that Consulting Partner's Sale of Ernst & Young Interest Was Taxable in Year of Sale Despite Temporary Limitations on Economic Enjoyment

jaugust@foxrothschild.com (Jerald David August) — Fri, 22 Apr 2011 12:26:54 GMT

In U.S. v. Fort, 107 AFTR 2d ¶2011-739 (11^th Cir. 4/19/2011) a three-judge panel of the Eleventh Circuit upheld a federal district court's (Northern District of Georgia) decision, granting the Department of Justice, Civil Tax Division, summary judgment on that issue that under the constructive receipt doctrine, a consulting partner's sale of an interest in Ernst & Young was a fully taxable in the year the interest was sold to Cap Gemini in exchange for the stock. The lower court rejected the taxpayer’s argument that since he was subject to a five year contractual restriction on selling the shares received in the exchange and was subject to a forfeiture provision for certain conditions based on the post-sale profitability of the consulting company operated by E&Y, such limitation and restrictions did not postpone the year in which a taxable realization occurred for federal income tax purposes. The government brought the action against the taxpayer, Danny C. Fort, to recover a tax refund of over $300,000 which it argued was erroneously refunded.

Constructive Receipt Doctrine In General

A fundamental principle of federal income taxation is that, in general, the receipt of property and/or cash for services rendered or to be rendered or as part of a sale or other disposition of property the amount includible in gross income is the year in which such property is received. §451(a). Where the taxpayer utilizes the cash method of accounting, income must be reported in the year in which the taxable receipts are "actually" or "constructively" received, whichever first occurs. Treas. Reg. §1.451-1(a). In addition, items of gross income are taxable in the year in which the taxpayer is in receipt of an "economic benefit" even if there is earlier no actual or constructive receipt. See also §409A (acceleration of year of gross income realization plus 20% surcharge for deferred compensation that violates the contract requirements contained in the regulations).

As to the constructive receipt doctrine, the courts have determined that the following conditions are required to cause income realization: (1) the amount must be due; (2) the amount must be appropriated on the books of the obligor; (3) the obligor must be willing to pay; (4) the obligor must be solvent and able to pay; and (5) the obligee must have knowledge of the foregoing facts. Moreover the constructive receipt doctrine requires that an amount be credited to an individual's account and be subject to unqualified demand. Robinson v. Commissioner, 44 T.C. 20 (1965); Basila v. Commissioner, 36 T.C. 111 (1961) acq., 1962-1 C.B. 3; Oates v. Commissioner, 18 T.C. 570 (1952), aff'd, 207 F.2d 711 (7th Cir. 1953). See Treas. Reg. § 1.446-1(c)(1)(I).

Factual Background

In early 2000, Ernst & Young ("E&Y") prepared to spin off and sell its information-technology consulting business to Cap Gemini, S.A. ("Cap Gemini"), a French corporation. At this time, Fort was a partner in that consulting business. On February 28, 2000, E&Y and Cap Gemini executed a Master Agreement that detailed the terms of the transaction. Under the Master Agreement, the proceeds of the sale were divided among E&Y's partners. For consulting partners who qualified as accredited investors under SEC rules, such as Fort, the consulting partner agreed to terminate his or her interest in E&Y, and in exchange, received a distribution of Cap Gemini shares. Additionally, these partners would begin working at a new entity, Cap Gemini Ernst & Young ("CGE&Y"), under employment agreements containing noncompete clauses. There were limitations imposed on the receipt of Cap Gemini. Cap Gemini shares would not be distributed outright to each partner. Instead, 25% of each partner's shares would be sold immediately to cover that partner's income taxes incurred as a result of this transaction, and the other 75% of the shares (the "Restricted Shares") were placed into an individual account in the partner's name at Merrill Lynch. There were limitations placed on the Restricted Shares. They could not be withdrawn from the partner's account at Merrill Lynch immediately, and therefore, the Merrill Lynch accounts were like escrow accounts. For four years and 300 days following the closing, partners could only sell portions of the Restricted Shares at scheduled times. After the four-year, 300-day period, the partners could withdraw all remaining Restricted Shares from the Merrill Lynch account. The former tax director of E&Y's consulting practice, who helped structure this transaction, stated that the reason for these restrictions was to prevent all of the partners from selling too many Cap Gemini shares at once, thereby diminishing the value of the shares.

The Restricted Shares were also subject to forfeiture as "liquidated damages" if a partner (1) breached his employment agreement; (2) voluntarily left his employment; or (3) was terminated. The amount of forfeitable shares decreased with each anniversary of the closing date that the partner remained at CGE&Y, so, generally, the longer a partner worked for CGE&Y, the fewer shares he or she would forfeit if the forfeiture provision were triggered. In addition, the termination forfeiture requirement applied to only two types of termination, and the number of Restricted Shares forfeited upon termination depended on under which type a partner was terminated. If a partner was terminated "for cause," the partner forfeited the full amount of the forfeitable Restricted Shares. However, if a partner was terminated for "poor performance," the partner forfeited at least 50% of the forfeitable Restricted Shares, but could keep a percentage of the remaining 50%, as determined by a review committee.

Partners also would have dividend and voting rights in the Restricted Shares. The dividends paid on the Restricted Shares were not subject to forfeiture, and partners could withdraw these dividends shortly after they were declared. As for voting, Merrill Lynch's French affiliate would vote a partner's shares "as instructed by [the partner] as beneficial owner." Because of the restrictions placed upon the Restricted Shares, the Master Agreement stated that, for tax purposes, the Restricted Shares would be valued at 95% of the closing price of Cap Gemini stock on the closing date. Fort subsequently signed the Partner Agreement, making him a party to the Master Agreement.

The transaction closed on May 23, 2000. Twenty-five percent of Fort's shares were sold at closing and the proceeds turned over to Fort, to cover taxes due based on receipt of the full value of all the stock in 2000. The remaining 75%, the Restricted Shares, were deposited into Fort's Merrill Lynch account.

Fort reported gross proceeds of $1,759,097 from this transaction on his 2000 income tax return. At this time, the Cap Gemini stock was worth approximately $156 per share. In other words, the entire value of the Cap Gemini stock received was included in the amount realized on the sale in 2000. Fort’s basis in his interest in E&Y would then be reduced from the amount realized in arriving at taxable income. The characterization of the gain would be determinate in accordance with §§741 and 751.

In September 2003, Fort was terminated as part of a downsizing. At this time, the value of the Cap Gemini shares had declined substantially

The District Court Grants the Government's Motion for Summary Judgment

The district court granted the government's motion for summary judgment and awarded it the disputed amount. 105 AFTR 2d 2010-2559, (N.D. Ga. 5/10/2010) at 3 (N.D. Ga. May 20, 2010). The court stated that taxable income during a given taxable year includes all income from whatever source derived that is "actually" or "constructively" received during that year. While the court assumed that Fort did not actually receive the Restricted Shares, it concluded that he constructively received them, because: he alone stood to gain or lose money based on the stock's performance. He received the benefit of the dividends paid on the shares, and he had the right to direct how the shares would be voted. Moreover, he knowingly agreed to the sale restriction and the forfeiture provision. He also agreed to the amount of the discount.The district court also rejected Fort's argument that the forfeiture provision prevented him from constructively receiving the Restricted Shares in 2000. The court explained that "the fact that the partners risked having to return some of their shares at a later time does not mean that they did not constructively receive the shares in the first place."Id.

Fort Appeals to the Eleventh Circuit

In review of the district court’s grant of summary judgment de novo, i.e., viewing the moving party’s evidence and all factual inferences arising from it in the light most favorable to such party, there is nevertheless, no genuine issue of any material fact and the moving party is entitled to judgment as a matter of law. Fort has appealed the grant of summary judgment in the government's favor, arguing that he did not "receive" the escrowed shares of stock in the year 2000 for tax purposes, and, therefore, was not taxable for their value in that year.

Government’s Danielson Rule Argument Rejected.

The government used the Danielson doctrine or rule in challenging that Fort’s ability to amend his 2000 return is limited because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income in 2000. See Comm’r v. Danielson, 378 F.2d 771 (3^rd Cir. 1967). The government argues, citing to Danielson, that Fort's ability to challenge his 2000 tax return is limited, because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income received in 2000. Fort responds that the Danielson rule is inapplicable to this case. The Court agreed. The taxpayer argued that the agreed upon form of the transaction had particular tax consequences and since the form of the transaction was not in dispute, the Danielson doctrine did not apply. See, e.g., United States v. Fletcher, 562 F.3d 839, 842–43 (7th Cir. 2009) (in a case dealing with this same transaction and materially identical facts as the one at bar, the Seventh Circuit rejected reliance on the Danielson rule, writing that "because [the former E&Y partner] does not try to recharacterize the transaction, doctrines that limit or foreclose taxpayers' ability to take such a step are beside the point"); United States v. Nackel, 686 F. Supp. 2d 1008, 1019 [105 AFTR 2d 2010-474] (C.D. Cal. 2009) (in another case involving this same transaction, the District Court for the Central District of California wrote: "The government impermissibly conflates case law concerning a party's effort to look through and re-characterize the form of a transaction with that which addresses what the parties intended would be the tax consequences of a transaction. The former is subject to the heightened scrutiny sought now by the government, the latter is not."). The Eleventh Circuit panel of judges agreed that the Danielson rule was inapplicable in resolving the case.

The district court below had held that in the year 2000 Fort did not actually receive the income from the Restricted Shares but was in constructive receipt of the Restricted Shares and therefore the value of such stock should be includible in gross income to the extent of the agreed value of such Shares in 2000.

The Eleventh Circuit observed that in general,, when assets are placed in escrow as security or otherwise and the taxpayer receivesno right to control or otherwise enjoy those assets, the courts and the Service have held that income is not realized until such time as the contingency is satisfied and the funds are paid over to the taxpayer. On the other hand, the courts and the Service have generally held ... that income is presently realized notwithstanding that the taxpayer lacks an absolute right to possess the escrowed assets. Consistent with the IRS's position, courts have held that a taxpayer presently realizes income when he or she possesses sufficient indicia of control over the assets held within an escrow account or escrow-type arrangement.

In a case involving the legendary comedian and actor, Charles Chaplin v. Commissioner, a company delivered shares of stock to Charlie Chaplin in 1928, who then was required to place the shares in escrow, only to be released when he delivered photoplays to the company in later years. 136 F.2d at 300. The Ninth Circuit held that the shares were income to Chaplin at the time of the initial delivery in 1928, not later, when Chaplin delivered the photoplays and the shares were released. Id. The Ninth Circuit emphasized that Chaplin possessed the following indicia of control over the shares in escrow: (1) the contract at issue vested ownership immediately in Chaplin and the shares were issued in his name; (2) Chaplin had voting rights in the shares; (3) dividends on the shares were declared and paid to an escrow agent who held them for Chaplin's benefit; and (4) Chaplin was considered the owner of the shares.

In Bonham v. Commissioner, also cited above, a taxpayer and a company agreed that the taxpayer would receive title in 750 shares of stock, but the shares would be deposited with the company "as a guarantee for [his] performance." The Eighth Circuit held that the taxpayer realized immediate income when he initially received the 750 shares, not when the shares were later withdrawn.

In the case at bar the Eleventh Circuit was impressed with the fact that it could look at other courts which addressed the same issue arising from the same transaction.. In each of these cases, the courts held that the receipt of the Restricted Shares constituted income in the year 2000.United States v. Bergbauer , 602 F.3d 569, 581] (4th Cir. 2010), cert. denied, 131 S. Ct. 297 (2010);Fletcher , 562 F.3d at 845; Nackel, 686 F. Supp. 2d at 1026; United States v. Berry, 2008 WL 4526178 [102 AFTR 2d 2008-6447], at 7 (D.N.H. Oct. 2, 2008);United States v. Culp , 2006 WL 4061881 [99 AFTR 2d 2007-618], at 1 (M.D. Tenn. Dec. 29, 2006).

Of those related decisions, the lower court placed emphasis on the Fletcher decision out of the Seventh Circuit. In Fletcher the court stated that "a taxpayer's willingness to defer consumption does not defer taxation." 562 F.3d at 843. The court concluded that the CGE&Y agreement was merely a deferral of consumption, not income, for three reasons: (i) the partners bore the market risk that the Restricted Shares would appreciate or depreciate from the date of the closing, because the market price of the Restricted Shares could rise or fall while the shares were in the Merrill Lynch account; (ii) Cap Gemini had already paid the Restricted Shares into the partners' Merrill Lynch accounts, the partners merely agreed to postpone unrestricted access to the stock, rather than to allow Cap Gemini to pay them later; and (iii) the partners agreed to value the Restricted Shares at a discount—95% of the market price of the underlying shares on the closing date—which reflects "not only illiquidity but also the risk that [Cap Gemini] would use its power over the account in an unauthorized way, or that Merrill Lynch might fail in its duty as a custodian." The Eleventh Circuit concurred with the lower court that the Fletcher Court’s decision and supporting analysis was persuasive and that the case involved a mere "delay in consumption" and not a "delay of income".

After weaving through the various restrictions and limitations under the master purchase agreement, the Eleventh Circuit held that the lower court’s grant of summary judgement was affirmed. In sum, Fort constructively received the Restricted Shares in 2000. The fact that Fort could not access the shares immediately was merely a postponement of consumption, not income: CGE&Y paid the full consideration of the shares into Fort's Merrill Lynch account on the closing date, and therefore, Fort bore the market risk of share appreciation or depreciation beginning on the closing date. This conclusion is buttressed by the fact that Fort possessed indicia of control over the shares: he had dividend and voting rights in the shares, and the shares were held in an individual account in Fort's name. Additionally, constructive receipt was not impossible simply because Fort was required to forfeit the shares upon the occurrence of certain conditions, because Fort had sufficient control over whether those conditions would occur. Therefore, Fort realized income at the time the Restricted Shares were transferred into his Merrill Lynch account in 2000.
Constructive Receipt Doctrine . Cap Gemini did not require Fort to forfeit any of his Restricted Shares. Shortly after his termination, Fort learned that several former E&Y consulting partners had filed amended year 2000 tax returns, claiming that they did not realize income from the Restricted Shares in that year. Fort followed suit, filing his own year 2000 amended return, asserting that he did not realize income in 2000 from the then-value of the Restricted Shares. The IRS initially accepted Fort's amended return and granted him a refund for his 2000 tax return. Subsequently, however, the IRS determined that the refund to Fort was in error, and the government filed this suit to recover the refund.

Tax Court Renders Favorable Decision on Rehabiliation Credits In Historic Boardwalk Hall, LLC. v. Commissioner

jaugust@foxrothschild.com (Jerald David August) — Mon, 11 Apr 2011 01:26:07 GMT

In Historic Boardwall Hall, LLC. V. Commissioner, 136 T.C. No. (2011) the Tax Court ruled that a LLC which was formed to facilitate a corporation's, i.e, Pitney Bowes, investment in the rehabilitation of an historic government building, East Hall, a National Historic Landmark property in Atlantic City, New Jersey had business purpose and was not a sham.The investment was designed to earn the controlled entity of Pitney Bowes, Historic Boardwalk Hall, LLC, rehabilitation credits under section 47. The Tax Court ruled, therefore, that the corporate partner was entitled to its distributive share of the claimed rehabilitation tax credits.

The Tax Court determined that the LLC that was formed by New Jersey Sports and Exposition Authority (NJSEA) and investment corp. (corp. partner), to allow corp. partner investment in rehabilitation of historic hall/governmentally-owned building and obtain §47 rehabilitation tax credits, had objective economic substance based on fact that corporate partner did not enter into transaction solely for tax credits but also to invest with a realistic possibility of realizing economic gain or profit and that corporate partner’s investment provided NJSEA with more money than it otherwise would have had, that development fee involved was legitimate expense, and that there were real risks involved. Court also viewed the legislative purpose to the rehabilitation credit provision and found that the evidence in the case was not inconsistent with such purpose. The Court rejected arguments lobbied by the government that the corporate partner never obtained partner status, the benefits and burdens of the hall’s ownership were never transferred in a sale to the partnership, and that the purchase option, under which NJSEA could buy back the hall did not cause the taxpayer’s reporting of the rehabilitation credits to be erroneous. The Tax Court further rejected the IRS’s determination under the anti-abuse regulation, Treas. Reg. §1.701-2(b), to recast the transaction so as to deny the corporate partner its desired allocation of the §47 rehabilitation credits.

Economic Substance of Transaction Upheld.

The Court found that there was both an objective profit motive and subject business purpose present under the facts. See CM Holdings, Inc., 90 AFTR 2d 2002-5850 , 301 F3d 96 , 2002-2 USTC ¶50596 (CA-3, 2002)(conjunctive two part test applied by 3rd Circuit). The IRS argued that Boardwalk Hall had no possibility of earning a profit apart from a 3% fixed return and the benefits related to the rehabilitation credits. For the subjective test, the IRS argued that Boardwalk Hall had no business purpose because it was intended solely to facilitate NJSEA's sale of rehabilitation tax credits to Pitney Bowes.

The Tax Court dismissed the arguments by noting that section 47 is intended to encourage taxpayers to participate in what would otherwise be an unprofitable activity. The court added that when the rehabilitation tax credits were taken into account, the objective profit test was adequately satisfied. Further, because Boardwalk Hall pursued the risk-laden objective of rehabilitating a landmark convention center for use as a special events center, the court found that the subjective business purpose requirement was also met. In sum, the Tax Court concluded that Boardwalk Hall had economic substance and was not a sham.

Partnership Status

The IRS also argued that Pitney Bowes was not a partner in Boardwalk Hall because it had no meaningful stake in its success or failure and its interest in Boardwalk Hall was more like debt than equity. The Tax Court dismissed these arguments, stating that Pitney Bowes and NJSEA joined together in a transaction with economic substance to allow Pitney Bowes to invest in the East Hall rehabilitation. Further, the court noted that the decision to invest provided a net economic benefit to Pitney Bowes through its 3% preferred return and rehabilitation tax credits.

Rejection of Application of Partnership Anti-Abuse Regulation

Finally, the IRS argued that it was necessary to recast the transaction under Treas. Reg. §1.701-2(b), the anti-abuse transaction. Because of its finding that the transaction had economic substance, the Court held it was inappropriate to then hear the case under the filter of this GAAR rule for partnerships.

Service Issues Letter Ruling on Application of Section 382(l)(5) For a Consolidated Group Which Filed for Bankruptcy Protection Under Title 11.

jaugust@foxrothschild.com (Jerald David August) — Mon, 11 Apr 2011 00:59:29 GMT

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

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

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

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

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

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

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

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

Recent Legislation Modifies Application of the Related Party Redemption Provision Contained in Section 304: In The Education Jobs and Medicaid Assistance Act of 2010, P.L. 111-226

jaugust@foxrothschild.com (Jerald David August) — Mon, 28 Mar 2011 19:55:53 GMT

Section 304 provides provides generally that, for purposes of §§302 and 303, if one or more persons are in control of each of two corporations and one such corporation (the “acquiring corporation”) acquires in exchange for property stock of the other corporation (the “issuing corporation”) from the person (or persons) so in control, then, unless §304(a)(2) applies, the property is treated as received in redemption of the stock of the acquiring corporation.

Section 304(a)(2) provides generally that, for purposes of §§302 and 303, if in exchange for property the acquiring corporation acquires stock of the issuing corporation from a shareholder of the issuing corporation and the issuing corporation controls the acquiring corporation, then the shareholder shall be treated as receiving the property in redemption of the stock of the issuing corporation.

“Control” for purposes of §304 means the ownership of stock possessing at least 50% of the total combined voting power of all classes of voting stock or at least 50% of the total value of shares of all classes of stock. With certain modifications, the constructive ownership rules of §318 are applied.

Under section 304(b)(2), the determination of the amount of the property distribution that is a dividend (and the source thereof) is made as if the property were distributed by the acquiring corporation to the extent of its earnings and profits, and then by the issuing corporation to the extent of its earnings and profits. If the acquiring corporation is foreign, §304(b)(5) limits the amount of earnings and profits of the acquiring corporation that are taken into account for this purpose.

Where and to the extent that the dividend is sourced from the E&P of the acquiring corporation, the transferor is considered to receive the dividend directly from the acquiring corporation;this outcome has been referred to by tax practitioners as “hopscotching” because the dividend bypasses any intermediary shareholders.

Special rules apply if the acquiring corporation is foreign under §304(b)(5). For purposes of determining the amount of the dividend to the transferor, the foreign acquiring corporation's E&P that is required to be taken into account is limited to the portion of such E&P that: (i) is attributable to stock of the foreign acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) of the target corporation and who is a U.S. shareholder per §951(b) of the foreign acquiring corporation and (ii) was accumulated while such stock was owned by the transferor (or a person related thereto) and while the foreign acquiring corporation was a controlled foreign corporation (“CFC”).

Where the redemption treated as a dividend is made with respect to stock held by a non-U.S. person, 30% withholding under §1441 is generally required on the dividend unless and to the extent that a treaty is applicable and provides for a lower rate of withholding.

Revision to Section 304.

Under the recent revision to §304 made in the Medicaid Assistance bill, an additional limitation on the E&P of a foreign acquiring corporation is taken into account in determining the amount (and source) of the distribution that is treated as a dividend. In particular, where more than 50% of the dividends arising from acquisition would (without taking into account the provision) not be: (i) subject to U.S. tax in the year in which the dividend arises, or (ii) includible in the E&P of a CFC per §957 (but without taking into account §953(c)), the E&P of the foreign acquiring corporation is not taken into account for this purpose. The new special rule generally applies if more than 50% of the target corporation is acquired from a foreign

Where the special rule applies, none of the foreign acquiring corporation's E&P is taken into account. In such case, the only E&P that is taken into account to determine the amount constituting a dividend is the target corporation's E&P. The provision is aimed to prevent the foreign acquiring corporation's E&P from permanently escaping U.S. taxation by being deemed to be distributed directly to a foreign person (i.e., the transferor) without “hopschotching” over” an intermediate distribution to a domestic corporation in the chain of ownership between the acquiring corporation and the transferor corporation. Generally, if the transferor is a foreign corporation (and not a CFC) and the acquiring corporation is a CFC, it is not relevant whether the target corporation is a domestic or a foreign corporation. However, if the target is a U.S. corporation, the 30-percent gross basis withholding tax applies to the amount constituting a dividend from the target, unless reduced or eliminated by treaty. See §1442. Regulations are to provide rules to prevent circumvention of the provision through the use of partnerships, options, or other arrangements to cause a foreign corporation to be treated as a CFC.

The revision applies to redemptions occurring after the date of enactment (8/10/2010).

Temporary Regulations setting forth anti-abuse rules to §304 were issued last year. See Treas. Reg. §1.304-4T.

Service Issues Field Service Advisory That Addresses A Failed Automobile Dealership's Inability to Claim Worthless Investment in Dealer's Franchise Rights

jaugust@foxrothschild.com (Jerald David August) — Mon, 28 Mar 2011 19:48:58 GMT

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

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

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

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

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

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

IRS Issues Favorable REIT Ruling On Preferential Dividends

jaugust@foxrothschild.com (Jerald David August) — Thu, 10 Mar 2011 20:27:51 GMT

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

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

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

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

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

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

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

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

Conclusion.

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

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