IRS guidance on the codified economic substance doctrine

7 Nov

The Internal Revenue Service issued further guidance last fall on the codified economic substance doctrine and related penalties. Notice 2014-58 amplifies the original Notice 2010-62. The new Notice provides guidance regarding: (i) the definition of a “transaction” for economic substance purposes; and (ii) the meaning of “a similar rule of law” in the accuracy-related penalty provisions of Internal Revenue Code section 6662(b)(6). Notice 2014-58 also addresses the reasonable cause exceptions under Code sections 6664(c) and (d), and the reasonable basis exception under section 6676. These exceptions are inapplicable to transactions described in Code section 6662(b)(6).

The economic substance doctrine is a partly-evolved judicial doctrine that was purportedly codified by the Health Care and Education Reconciliation Act of 2010. Code section 7701(o)(5)(A) attempts to define the “economic substance doctrine” as the common-law doctrine that disallows income tax benefits, if the transaction that produces those benefits lacks economic substance or a business purpose. This is a rather simplistic statement, and ignores the low threshold for business purpose, for transactions that involve a lot of money and paperwork.

Under section 7701(o)(1), a transaction (or series of transactions) has economic substance if: (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position; and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction. The legislative history explained: “The provision does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the [economic substance] doctrine. For example, the provision reiterates the present-law ability of the courts to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only tax-avoidance objectives in order to disallow those tax-motivated benefits.” H.R. Rep. No. 111-443(I), at 296-297, P.L. 111-152, Health Care and Education Reconciliation Act of 2010.

The term “transaction” has been defined by Treasury in the analogous context of reportable transactions, as “all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement and also includes any series of steps carried out as part of a plan.”

Code section 6662(b)(6) imposes a penalty on an underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance (within the meaning of section 7701(o)) or fails to meet the requirements of any “similar rule of law”. A penalty was intended by Congress for a transaction that is disregarded as a result of the application of the same factors and analysis required under section 7701(o) for an economic substance analysis, even if a different term is used to describe the doctrine. H.R. Rep. 111-443(I), at 304.

Code sections 6664(c)(2) and (d)(2) provide that the reasonable cause and good faith exception to a section 6662 or 6662A penalty does not apply to an underpayment attributable to transactions described in section 6662(b)(6).

For purposes of the penalty for an erroneous claim for refund or credit of an excessive amount, Code section 6676(c) provides that any excessive amount (within the meaning of section 6676(b)) that is attributable to a section 6662(b)(6) transaction is not treated as having a reasonable basis.

Notice 2014-58 provides that, for purposes of determining whether the codified economic substance doctrine applies, a “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any of the steps carried out as part of a plan. Facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction.

Generally, when a plan that generated a tax benefit involves a series of interconnected steps with a common objective, the “transaction”includes all of the steps taken together: an aggregation approach. When a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, an aggregation approach may not be appropriate. In that case, the “transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals: a disaggregation approach. For example, if transfers of multiple assets and liabilities occur and the transfer of a specific asset or assumption of a specific liability was tax-motivated and unnecessary to accomplish a non-tax objective, then the economic substance doctrine may be applied solely to the transfer or assumption of that specific asset or liability. Separable activities may include the use of an intermediary. These situations are neither exhaustive or comprehensive.

For purposes of section 6662(b)(6), “a similar rule of law” means a rule or doctrine that disallows the tax benefits under subtitle A of the Code related to a transaction because: (1) the transaction does not change a taxpayer’s economic position in a meaningful way (apart from Federal income tax effects); or (2) the taxpayer did not have a substantial purpose (apart from Federal income tax effects) for entering into the transaction. In other words, a “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o) for an economic substance analysis, even if different terms (e.g., “sham transaction”) are used. H.R. Rep. 111-443, at 304. The Service will not apply a penalty under section 6662(b)(6) (or otherwise argue that a transaction is described in section 6662(b)(6)), unless it also raises section 7701(o) to support the underlying adjustments. If the IRS does not raise section 7701(o) and relies upon other judicial doctrines (e.g., substance over form or step transaction), the Service will not apply a section 6662(b)(6) penalty (or otherwise argue that a transaction is described in section 6662(b)(6)), because the Service will not treat the transaction as failing to meet the requirements of a similar rule of law. Code sections and Treasury regulations, other than section 7701(o) and the regulations under that section, that disallow tax benefits are not similar rules of law for purposes of section 6662(b)(6).

Guidance against double-dipping with depreciation and foreign tax credits on certain foreign acquisitions

23 Aug

The Internal Revenue Service issued last year guidance on upcoming regulations under Internal Code Section 901(m), introduced in 2011, dealing with the denial of the foreign tax credit for certain foreign stock acquisitions. The proposed rules described in Notice 2014-44 seek to deny the dual benefit of a basis step-up and a foreign tax credit, for certain transactions that are treated as a stock acquisition abroad, and as an acquisition of the underlying assets in the United States. The provision denies credit for a portion of the foreign tax paid by the foreign target.

These types of transactions effectively allow a form of “double-dipping”. The U.S. acquiror obtains depreciation write-offs based on purchase cost. The foreign target pays relatively more foreign tax, by reason of not obtaining a step-up and extra write-offs. This foreign tax normally would be creditable by the US acquiror against US tax on other income in the same income group, or basket.

Under the upcoming regulations, in the case of a “covered asset acquisition”, the disqualified portion of any foreign income tax determined with respect to gain attributable to relevant foreign assets is not taken into account in determining the allowable foreign tax credit, either the direct credit, or the credit for foreign taxes paid by certain foreign subsidiaries.

A “covered asset acquisition” is

– a qualified stock purchase to which Code section

338(a) applies, i.e., a stock acquisition treated for tax purposes as the acquisition of the underlying assets, or

– any other transaction treated as (i) an acquisition of assets for U.S. tax purposes, and as (ii) the acquisition of stock (or disregarded) for foreign income tax purposes. The term also includes the acquisition of an interest in a partnership which has an election in effect under Code section 754, to raise or lower the tax basis of the partnership assets to match the basis of the partners in their partnership interests. A “covered asset acquisition” can also include any other similar transaction by regulation.

Under Code section 338, the purchaser is deemed to form a subsidiary corporation that acquires the assets of the target corporation. This construct results in an increased tax basis for the target’s assets and the elimination of the historic tax attributes associated with the assets.

The “disqualified portion” of the foreign tax means, with respect to any covered asset acquisition, the ratio of

(i) the aggregate basis differences (but not below zero) allocable for the year with respect to all relevant foreign assets, using the applicable cost recovery method, divided by (ii) the income on which the foreign income tax is determined. If the taxpayer fails to substantiate such income to the satisfaction of the Service, the income is determined by dividing the foreign tax by the highest marginal tax rate in the relevant jurisdiction.

Except as otherwise provided by regulation, if there is a disposition of any relevant foreign asset, the basis difference allocated to the taxable year of the disposition is the excess of the basis difference of such asset over the aggregate basis difference of such asset that has been allocated to all prior taxable years (Unallocated Basis Difference).

“Basis difference” means the adjusted basis of the relevant foreign asset immediately after the covered asset acquisition, over the basis before. If the asset has a built-in loss, the negative amount is taken into account.

The disallowed taxes are allowed as a deduction, free from the general limitations in Code sections 275 and 78.

While Code Sec. 901(m) reduces the amount of creditable foreign taxes, a Code Sec. 338(g) election can continue to provide some excess foreign tax credits, just reduced. The effective tax rate generally would be still lower without the election, lower than the US rate, resulting in incremental US tax on a dividend. The 338(g) election also eliminates the foreign target’s tax attribute history, simplifying computations, potentially avoiding subpart F gains or section 1248 deemed dividends. For the seller, the earnings resulting from the target’s deemed sale of assets is taken into account in determining the gain recharacterized as dividend under section 1248. The additional may dilute the seller’s deemed paid foreign

tax credits accompanying the deemed dividend.

Sometimes it is helpful for the foreign target to retain its historic tax attributes, e.g., previously taxed income, which includes amounts taxable to a U.S. seller under section 1248; or a high-taxed earnings pool or a deficit of a foreign target.

Notice 2014-44 announces that the Internal Revenue Service and the Department of the Treasury will issue regulations addressing the application of Code section 901(m) to dispositions of assets following covered asset acquisitions (CAAs), and to CAAs described in section 901(m)(2)(C) (regarding section 754 elections).

The future regulations will emphasize the term Relevant Foreign Assets (RFA). RFA means, with respect to a CAA, any asset with respect to such acquisition, if income or loss attributable to such asset is taken into account in determining the foreign income tax referenced in section 901(m)(1).

Notice 2014-44 provides guidance on the upcoming regulatory exception to the statutory disposition rule. The Code rule is that, if there is a disposition of any relevant foreign asset, the basis difference allocated to the taxable year of the disposition is the excess of (i) the basis difference of the asset, over (ii) the aggregate basis difference allocated to prior years (Unallocated Basis Difference).

Treasury finds that, applying the statutory disposition rule to the disposition of an RFA is appropriate in fact patterns in which the gain or loss is fully recognized for both U.S. and foreign income tax purposes. In certain cases, it may not be the appropriate time for all, or any, of the Unallocated Basis Difference to be taken into account. Section 901(m) should continue to apply to the remaining Unallocated Basis Difference. This includes cases in which the gain or loss from the disposition is recognized for purposes of U.S. tax, but not for foreign tax purposes, or cases in which no gain or loss is recognized for U.S. or foreign tax purposes.

Certain taxpayers are engaging in transactions shortly after a CAA, which are intended to invoke application of the statutory disposition rule under section 901(m)(3)(B)(ii), to avoid the purpose of section 901(m). An example is the target becoming disregarded as an entity separate from its owner, pursuant to an entity classification election under Treas. Reg. § 301.7701-3. The foreign target is deemed for U.S. tax purposes to distribute its assets and liabilities to FSub in liquidation (deemed liquidation) the day before the election is effective. No gain or loss is recognized. The taxpayers take the position that the deemed liquidation constitutes a disposition of the RFAs, and claim all of the basis difference in the final taxable year of the target that occurs by reason of the deemed liquidation.

Treasury is offended that: (i) the disparity in basis of the assets of the foreign target for U.S. and foreign tax purposes continues to exist after the deemed liquidation; and (ii) because no gain is recognized for foreign income tax purposes as a result of the deemed liquidation, there is no foreign income tax subject to disqualification under section 901(m).

Taxpayers have engaged in other variations of this transaction, also offensive to Treasury. Hence, regulations will be issued to create exceptions to the statutory disposition rule.

Treasury opines that, for purposes of section 901(m), a disposition means an event that results in gain or loss being recognized with respect to an RFA for purposes of U.S. income tax or a foreign income tax, or both, thus not including the tax-free deemed liquidation arising upon the foreign target’s entity classification election.

The portion of a basis difference with respect to an RFA that is taken into account as a result of a disposition will be determined under one of two rules.

If a disposition is fully taxable for both U.S. and foreign income tax purposes, the Disposition Amount is equal to the Unallocated Basis Difference.

If a disposition is not fully taxable for both U.S. and foreign income tax purposes, to the extent that the disparity in the U.S. Basis and the Foreign Basis is reduced as a result of the disposition, all or a portion

of the Unallocated Basis Difference is taken into account.

In the case of a positive basis difference, a reduction in basis disparity generally will occur if (i) gain is recognized for foreign tax purposes (Foreign Disposition Gain), which generally results in an increase in the Foreign Basis of the RFA, or (ii) loss is recognized for U.S. tax purposes (U.S. Disposition Loss), which generally results in a decrease in the U.S. Basis of the RFA.

If the RFA has a positive basis difference, the Disposition Amount equals the lesser of:

(i) any Foreign Disposition Gain plus any U.S. Disposition Loss (expressed as a positive amount), or

(ii) the Unallocated Basis Difference.

In the case of a negative basis difference, a reduction in basis disparity generally will occur if (i) loss is recognized for foreign tax purposes (Foreign Disposition Loss), which generally results in a decrease in the Foreign Basis of the RFA, or (ii) gain is recognized for U.S. income tax purposes (U.S.

Disposition Gain), which generally results in an increase in the U.S. Basis of the RFA.

If the RFA has a negative basis difference, the Disposition Amount equals the greater of the following amounts:

(i) any Foreign Disposition Loss plus any U.S. Disposition Gain (solely for this purpose, expressed as a negative amount), or

(ii) the Unallocated Basis Difference.

Special rules are proposed for a section 743(b) CAA.

Section 901(m) continues to apply to an RFA until the entire basis difference in the RFA has been taken into account using the applicable cost recovery method or as a Disposition Amount (or both), even if there is a change in the ownership of an RFA.

The Internal Revenue Service and Treasury continue to ponder whether and to what extent section 901(m) should apply to an asset received in exchange for an RFA if basis is determined by reference to the basis of the RFA transferred.

Mid-Year Amendments to Safe Harbor Pension Plans Following Windsor Decision

4 Jul

Internal Revenue Service Notice 2014-37 addresses mid-year amendments to “safe harbor” pension plans, clarifying the earlier Notice 2014-19. Notice 2014-19 provided guidance on the application of U.S. v. Windsor, 133 S.Ct. 2675 (2013), which struck down the Defense of Marriage Act.

“Safe harbor” plans allow business owners to maximize personal contributions to the company’s retirement account, receive the benefit of company matching contributions, and reduce some of the limitations associated with non-discrimination testing. The employer either must make a matching contribution for all participating employees, on the first 4% of each employee’s compensation, or contribute 3% of the employee’s compensation for each eligible employee, regardless of whether the employee participates in the plan. Under a traditional plan, if too few employees participate, a formula limits the amount that the business owner can personally contribute.

Following the Windsor decision in June 2013, the Service adopted Rev. Rul. 2013-17, holding that, for Federal tax purposes, the terms “spouse,” “husband and wife” etc., include an individual married to a person of the same sex, if the individuals are lawfully married under state law. The couple may be domiciled in a state that does not recognize such marriages. Not covered are individuals (of the same or opposite sex) who have entered into a registered domestic partnership or civil union that is not denominated as a marriage under the laws of that state.

The Service is authorized to prescribe the extent to which any judicial or administrative decision is to be applied without retroactive effect. Rev. Rul. 2013-17 is applied prospectively as of September 16, 2013. Taxpayers may rely on the ruling retroactively with respect to any employee benefit plan, for limited purposes with respect to certain health coverage and fringe benefits.

Several Code provisions provide special rules with respect to married participants in qualified retirement plans.

(i) Certain qualified retirement plans must provide a qualified joint and survivor annuity (QJSA) upon retirement to married participants (and generally must provide a qualified preretirement survivor annuity (QPSA) to the surviving spouse of a married participant who dies before retirement). The QJSA (or QPSA) may be waived by a married participant only with spousal consent. If such a plan permits loans to participants, the plan must obtain the consent of the spouse before making a loan to the participant.

(ii) Certain qualified defined contribution retirement plans are exempt from the QJSA and QPSA requirements, provided that a married participant’s benefit is payable in full to the participant’s surviving spouse, unless the spouse consents to the designation of a different beneficiary.

(iii) Under the required minimum distribution rules and the rollover rules, additional alternatives are provided for surviving spouses that are not available to non-spousal beneficiaries.

(iv) Generally a spouse is treated as owning shares owned by the other spouse, for purposes of determining whether corporations are members of a controlled group.

(v) Generally a spouse is treated as owning shares owned by the other spouse, for purposes of determining whether an employee is a key employee, including whether an employee is considered a 5% owner.

(vi) An employee stock ownership plan (ESOP) that acquires certain employer securities generally must prohibit the allocation of those securities for the benefit of certain individuals, including the spouse of the seller and of any individual who owns 25% or more of the securities.

(vii) No portion of the assets of an ESOP attributable to employer securities consisting of S corporation stock generally may accrue during a nonallocation year for the benefit of any disqualified person or certain family members (including spouse).

(viii) The anti-alienation rules do not apply to the recognition of an alternate payee’s right to receive a portion of the benefits payable to a participant under a plan pursuant to a qualified domestic relations order (QDRO). An alternate payee who is a spouse or former spouse of the participant is treated as the distributee under a QDRO.

Notice 2014-37 provides guidance on plan amendments to reflect the outcome of the Windsor decision, which are adopted after the beginning of a plan year, and which apply to a 401(k) or 401(m) safe harbor plan. These amendments were first addressed in Q&A-8 of Notice 2014-19.

Notice 2014-19 addressed the deadline to adopt a plan amendment pursuant to that Notice. The deadline is the later of (i) the end of the plan year in which the change is first effective, (ii) the due date of the employer’s tax return for the year that includes the date the change is first effective, or (iii) December 31, 2014. In the case of a governmental plan, any amendment need not be adopted before the close of the first regular legislative session of the body with the authority to amend the plan that ends after 2014.

A 401(k) safe harbor plan must be adopted before the beginning of the plan year and generally must be maintained throughout a full 12-month plan year. Treas. Reg. § 1.401(k)-3(e)(1).  Similar rules apply to § 401(m) safe harbor plans.  Following Notice 2014-19, the Service was asked whether a safe harbor plan may adopt a mid-year amendment.  The Service responds affirmatively in Notice 2014-37: a plan will not fail to satisfy the requirements to be a safe harbor plan merely because the plan sponsor adopts a mid-year amendment under Notice 2014-19.


The Wolf Growls ….. The Sheep Howl ….. New IRS Notice on Foreign Account Compliance (FATCA)

19 May

IRS Notice 2014-33 announces that calendar years 2014 and 2015 will be regarded as a transition period, for purposes of enforcement of the dreaded Foreign Account Tax Compliance Act (FATCA) by withholding agents and foreign financial institutions (FFIs).

The Hiring Incentives to Restore Employment Act of 2010 added section 1471 through 1474 to the Internal Revenue Code (Chapter 4 of Subtitle A). Chapter 4 generally requires agents to withhold at a 30 percent rate on certain payments to an FFI, unless the FFI has entered into an agreement to obtain status as a participating FFI and to report information with respect to accounts held by or for U.S. persons.

Chapter 4 also imposes on withholding agents certain withholding, documentation, and reporting requirements with respect to payments made to non-financial foreign entities (NFFEs).

In 2013, Treasury and the Service published final regulations under chapter 4, and issued Notice 2013-43 to preview a revised timeline for implementation of the FATCA requirements. In February 2014, Treasury and the Service released temporary regulations that clarify and modify the final regulations.

The temporary chapter 4 regulations require that withholding agents (including participating FFIs, qualified intermediaries, withholding foreign partnerships, and withholding foreign trusts) begin withholding with respect to payments on or after July 1, 2014, unless the withholding agent can reliably associate the payment with documentation to treat the payment as exempt from withholding under chapter 4 (as opposed to general tax withholding on certain payments to non-residents).

Treasury has released Model 1 and Model 2 intergovernmental agreements (IGAs) to facilitate the implementation of FATCA and to avoid legal impediments under local law that would otherwise limit an FFI’s ability to comply. IRS Announcement 2014-17 provides that the jurisdictions treated as having an IGA in effect would include jurisdictions that, before July 1, 2014, have reached agreements in substance with the United States on the terms of an IGA, and that have consented to be included on the Treasury/IRS lists of such jurisdictions, in addition to jurisdictions that have already signed IGAs. An FFI that is resident in, or organized under the laws of, a jurisdiction that is included on the lists, is permitted to register on the FATCA registration website and certify to a withholding agent its status as an FFI covered by an IGA. As of May 1, 2014, Treasury had signed 30 IGAs, and had agreements in substance with 29 jurisdictions.

2014 and 2015 will be regarded as a transition period for purposes of IRS enforcement and administration of the chapter 4 due diligence, reporting, and withholding provisions, and certain other provisions modified by the temporary coordination regulations. The Service will take into account the extent to which a participating or deemed-compliant FFI, direct reporting NFFE, sponsoring entity, sponsored FFI, sponsored direct reporting NFFE, or withholding agent, has made good faith efforts to comply with the requirements of the regulations.

For example, the Service will take into account whether a withholding agent has made reasonable efforts during the transition period to modify its account opening practices and procedures to document the chapter 4 status of payees, apply the standards of knowledge provided in chapter 4, and, in the absence of reliable documentation, apply the presumption rules. The Service will also consider the good faith efforts of a participating FFI, registered deemed-compliant FFI, or limited FFI to identify and facilitate the registration of each other member of its expanded affiliated group as required.
Entity obligations issued on or after July 1, 2014

Under the chapter 4 regulations, withholding agents (other than participating FFIs and registered deemed-compliant FFIs) are generally required to implement new account opening procedures beginning on July 1, 2014. A participating FFI is required to implement new account opening procedures on the later of July 1, 2014, or the effective date of its FFI agreement. A registered deemed-compliant FFI is required to implement new account opening procedures on the later of July 1, 2014, or the date on which the FFI registers as a deemed-compliant FFI and receives a global intermediary identification number (GIIN).

Comments, growls and howls have disclosed practical problems in implementation. Treasury and the Service intend to amend the chapter 4 regulations, to allow a withholding agent or FFI to treat an obligation held by an entity that is issued, opened, or executed on or after July 1, 2014, and before January 1, 2015, as a preexisting obligation for purposes of implementing chapter 4. A withholding agent would otherwise be required to document the entity by the earlier of the date a withholdable payment is made, or within 90 days of the date the obligation is issued.

The proposed amendments will not be available for obligations held by individuals, because the procedures for documenting individual accounts are “less complex” than those for documenting entities, and Form W-8BEN (for withholding agents to document individuals) has been published in final form.
Intergovernmental agreements

The Model 1 and Model 2 IGAs contain a provision that allows a partner jurisdiction that has entered into an IGA to receive the benefit of certain more favorable terms that are set forth in a later signed IGA or Annex.

Annex I of future Model 1 and Model 2 IGAs will, for an entity account opened on or after July 1, 2014, and before January 1, 2015, allow an FFI to treat such an account as a preexisting entity account, but without permitting application to such accounts of the $250,000 exception for accounts that are not required to be reviewed, identified, or reported.

Prior to the publication of the proposed amendments to the chapter 4 regulations, a partner jurisdiction may rely on the Notice to permit a reporting Model 1 or 2 FFI to apply the due diligence procedures for documenting entity accounts.
Modification of the standards of knowledge rules

The temporary coordination regulations revised the reason-to-know standard under the general withholding tax regulations, to provide that a withholding agent will have reason to know that documentation establishing the foreign status of a direct account holder is unreliable or incorrect, if the withholding agent has a current telephone number for the account holder in the United States and no telephone number for the account holder outside the United States, or has a U.S. place of birth for the account holder. Treas. Reg. § 1.1441-7(b). The addition of rules concerning a U.S. telephone number and a U.S. place of birth was made to coordinate with chapter 4. The temporary coordination regulations provide a transitional rule to allow a withholding agent that has previously documented the foreign status of a direct account holder for general withholding tax purposes, prior to July 1, 2014, to continue to rely on such documentation without regard to the telephone number or place of birth. The withholding agent would, however, have reason to know that the documentation is unreliable or incorrect, if the withholding agent is notified of a change in circumstances.

Treasury and the Service intend to amend the temporary coordination regulations to provide that a direct account holder will be considered documented prior to July 1, 2014, without regard to whether the withholding agent obtains renewal documentation for the account holder afterwards. Therefore, a withholding agent that has documented a direct account holder prior to July 1, 2014, is not required to apply the new reason to know standards relating to a U.S. telephone number or U.S. place of birth until the withholding agent is notified of a change in circumstances or reviews documentation that contains a U.S. place of birth.
Revision of definition of reasonable statement

A withholding agent may rely on the foreign status of an individual account holder for general withholding tax purposes, irrespective of certain U.S. indicia, if, in certain cases, the account holder provides a reasonable explanation supporting the account holder’s claim of foreign status. A reasonable explanation supporting a claim of foreign status for general withholding tax purposes can be a written statement prepared by an individual, or a checklist provided by a withholding agent stating that the individual meets the regulatory requirements.

The FATCA regulations also describes a reasonable explanation supporting a claim of foreign status. It is substantially similar to the description in the general withholding tax regulations, except that it limits the contents of a reasonable statement to the explanations permitted on the checklist, and does not permit an individual to provide a written explanation other than an explanation that the individual meets the requirements described in the regulations. Treasury and the Service intend to amend the final chapter 4 regulations, to adopt the broader description of a reasonable explanation of foreign status provided in the temporary coordination regulations.
Limited FFIs and limited branches

For any member of an “expanded affiliated group” to obtain status as a participating FFI or registered deemed-compliant FFI, each FFI member must have a chapter 4 status of a participating FFI, deemed-compliant FFI, exempt beneficial owner, or limited FFI. The final regulations also provide that an FFI or branch of a participating FFI must be registered with the Service and agree to certain conditions in order to be treated as a limited FFI or limited branch. Conditions include that the FFI or branch must not open accounts that it is required to treat as U.S. accounts, or accounts held by nonparticipating FFIs, including accounts transferred from any member of its expanded affiliate group.

The Service’s FATCA registration website serves as the primary way for FFIs to register as a participating FFI, registered deemed-compliant FFI, or limited FFI. FFIs that are members of an expanded affiliated group may designate a lead financial institution (Lead FI) to identify member FFIs that will register as participating FFIs, registered deemed-compliant FFIs, or limited FFIs and to perform certain functions with respect to member FFIs.

Howls and moans were heard from jurisdictions that are slow to engage in IGA negotiations and that have legal restrictions impeding their ability to comply with FATCA, including the conditions for limited FFI or limited branch status. The restrictions imposed by the regulations hinders the ability of an FFI to agree to the conditions of limited status due, for example, to requirements under local law to provide individual residents with access to banking services, or to the business needs of the FFI to secure funding from another FFI in the same jurisdiction with similar impediments to complying with the requirements of FATCA.

Treasury and the Service intend to amend the final chapter 4 regulations to permit a limited FFI or limited branch to open U.S. accounts for persons resident in the jurisdiction where the branch or FFI is located, and accounts for nonparticipating FFIs that are resident in that jurisdiction, provided that the FFI or branch does not solicit U.S. accounts from persons not resident in, or accounts held by nonparticipating FFIs that are not established in, that jurisdiction. The FFI (or branch) must not be used by another FFI in its expanded affiliated group to circumvent the regulations.

Certain jurisdictions are explicitly prohibiting an FFI resident in, or organized under the laws of, the jurisdiction, from registering with the Service and agreeing to any status, including as limited FFI. Treasury and the Service intend to amend the final chapter 4 regulations to provide that such a prohibition will not prevent the members of its expanded affiliated group from obtaining status as participating FFIs or registered deemed-compliant FFIs, if the ill-fated FFI is identified as a limited FFI on the FATCA registration website by a member of the expanded affiliated group that is a U.S. financial institution or an FFI seeking status as a participating FFI. If the Lead FI is prohibited from identifying the limited FFI by its legal name (why and by whom??), it will be sufficient if the Lead FI uses the term “Limited FFI” in place of its name and indicates the FFI’s jurisdiction of residence or organization.


Residence of Mr. Conrad Black

30 Apr

Poor Conrad Black, Baron Black of Crossharbour ! As though the assault and psychological horror inflicted on him by the authorities were not enough (disregarding legal and ethical considerations). He has now had the shame of having his affairs paraded before the Tax Court of Canada, for no apparent valid reason. The Court found his arguments to have no support in precedent or common sense, and it is unclear how the poor man was induced to file in court at all. G Conrad Black v The Queen 2008-2896 (IT) (TCC), January 14 2014.

In the tax year 2002, the taxpayer was resident of both Canada and the United Kingdom, under the domestic law of each country. Since his centre of vital interests was in the United Kingdom, the Canada-U.K. income tax treaty deemed him to be U.K. resident for purposes of the treaty.

Since the taxpayer did not establish a U.K. domicile, he was taxed in the United Kingdom under the fabled remittance system, which allows individuals ordinarily U.K. resident, but lacking a U.K. domicile, to pay U.K. tax only on income remitted to the United Kingdom, not income remitted or maintained offshore. The tax treaty specifies that any treaty relief from Canadian tax is granted only in respect of income that is subject to U.K. tax under the remittance regime, i.e., treaty benefits do not apply to income maintained offshore.

The taxpayer was induced to argue that, on the above basis, he should be treated as not resident in Canada for domestic law purposes. Thus, the taxpayer argued that he should be free from Canadian tax on non-Canadian employment income (approximately $2.8 million), on various shareholder benefits (approximately $2 million) and on investment income from non-Canadian sources (approximately $350K).

The only authority that the taxpayer could cite for his position, was a provision in the treaty-enabling statute, to the effect that the treaty prevailed to the extent of any inconsistency with domestic law. The taxpayer tried to argue that there was an inconsistency between Canadian domestic law treating him as resident, and the treaty, which treated him as U.K. resident. The Court properly found that there was no conflict whatsoever. In order for the treaty-tie breaker rule to apply, the taxpayer has first to be resident in Canada (and the United Kingdom) under domestic law. There is no authority under the treaty for concluding that taxpayer becomes not resident of Canada for any domestic law purpose, other than those purposes covered by the treaty. The treaty deals with specified items of income only, and none of the items in issue was regulated by the treaty.

The taxpayer was once advised by Canada’s leading tax law firm. It is difficult to believe that this firm would have led him into court over these issues. He was represented in this case by a Queen’s Counsel from Davis LLP, which is a good firm but not as prominent in tax. Still, even this firm is deemed to understand elementary tax treaty principles. Perhaps taxpayer was misled by accountants or other advisors, and found himself in a position that he and counsel decided had to be asserted, for better or worse.

Internal Revenue Service Notice on Bitcoins and Other Virtual Currencies

27 Mar

Internal Revenue Service Notice 2014-21, March 25, 2014, describes how existing general tax principles apply to transactions using virtual currency. Virtual currency is described as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. It operates like “real” currency but does not have legal tender status in any jurisdiction.

The Service answers frequently-asked questions on bitcoin status and solicits comments.  The Notice is uncontroversial, trendy and answering idiotic theories.

For federal tax purposes, virtual currency is treated as property. General tax principles are applicable. A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. The basis of the currency in the recipient’s hands is determined the same way.

If a virtual currency is listed on an exchange, and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.

If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer, and ordinary gain or loss if the virtual currency is not a capital asset, e.g., inventory and other property held mainly for sale to trade customers.

Virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.

When a taxpayer successfully mines virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. If a taxpayer’s mining constitutes a business, and the mining activity is not undertaken as an employee, the net earnings are subject to the self-employment tax. The fair market value of virtual currency paid as wages is subject to federal withholdings. A payment made using virtual currency is subject to information reporting to the
same extent as any other payment made in property.

A person who in the course of a trade makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment on Form 1099-MISC. A third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third party settlement organization (TPSO), required to report payments made to a merchant on a Form 1099-K, Payment Card and Third Party Network Transactions, if certain thresholds are met.

No clear answer was provided to the question whether taxpayers would be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with the Notice, prior to March 25, 2014.


Capitalized interest on defaulted policy loans includible in taxable amount

21 Mar

In Black v. Commissioner of Internal Revenue, Docket No. 6406-12. Feb. 12, 2014, the U.S. Tax Court has determined that capitalized interest accrued on taxpayer’s loans against his life insurance policy, is includible in determining the gross distribution and the taxable amount arising from the termination of the policy. The taxpayer borrowed against a life insurance policy but failed to repay the loans. The policy was terminated, and the loans were satisfied by policy proceeds and extinguished.

In June 1989, the husband of the taxpayer couple acquired an insurance policy on his life from Northwestern Mutual Life Insurance Co. (Northwestern). The policy was a whole life policy, having both cash value and loan features.

Taxpayer was permitted to borrow against the policy. “Policy debt” consisted of outstanding loans and accrued interest. Unpaid interest was added to loan principal. Taxpayer could surrender the policy and receive as a distribution the cash value of the policy, minus any outstanding policy debt. The policy terminated, if policy debt exceeded the cash value.

Over time, taxpayer borrowed $103,548 against the policy, which he did not repay. In 2009, the policy was terminated. The combined balance of the loans, including principal and interest, was $196,230, and taxpayer’s investment in the contract (aggregate premiums paid) was $86,663.

Northwestern issued to taxpayer a Form 1099-R, Distributions From Pensions, Annuities, etc. reflecting a gross distribution of $196,230 and a taxable amount of $109,567. The latter represented the difference between the combined balance of the loans, and taxpayer’s investment in the contract, i.e., $86,663.

Taxpayers did not report any part of the taxable income on Form 1099-R, nor did they acknowledge the policy on their return.

In 2011, taxpayers nervously amended their 2009 return, to reflect an increase in income of $16,885, attributable to the difference between the principal of the policy loans less premiums paid. The amended return was not accepted. The Service issued a notice of deficiency of $30,571 and assessed an accuracy-related penalty.

The parties agreed that the taxable amount of the gross distribution that arose on termination of the policy did not include taxpayer’s investment in the contract of $86,663, and that the taxable amount takes into account the outstanding loans totaling $103,548. The Service contended that the taxable amount also takes into account capitalized interest.

Internal Revenue Code section 61 specifically includes in gross income, income from life insurance contracts and from discharge of indebtedness.

The Court regarded taxpayer’s policy loans as true loans. Taxpayers would not have had to recognize these loan proceeds as taxable income upon receipt. When an insurance policy is terminated and the proceeds are used to satisfy a policy loan, the transaction is treated as if the taxpayers received the proceeds and applied them against the outstanding loan.

Under Code section 72, an amount received in connection with a life insurance contract, which is not received as an annuity, generally constitutes gross income to the extent that the amount exceeds the investment in the insurance contract. The investment in the contract is defined generally as the premiums or other consideration paid, less amounts received under the contract, to the extent excludable from gross income.

The Court held that the capitalized interest was properly treated as part of the principal of the indebtedness. Capitalized interest is includible in determining the amount of a taxpayer’s gross distribution when an insurance policy is terminated. The policy loans, including capitalized interest, were charged against the available proceeds at that time. This satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to taxpayers, and constituted income to them. A contrary result would permit policy proceeds, including previously untaxed investment returns, to escape tax altogether and found no basis in the law.

Taxpayers argued that the termination of the life insurance policy gave rise to a discharge of indebtedness. The Court could not so characterize the source of taxpayers’ income. The loans to taxpayer were not discharged; rather, they were extinguished after Northwestern applied the cash value of the insurance policy toward the debt owed. Even if the income were discharge of indebtedness income, taxpayers did not allege that any exception under Code section 108 applied to exclude the amount from gross income.

Code section 6662(a) imposes an accuracy-related penalty equal to 20% of the amount of any underpayment of tax that is attributable to a substantial understatement of income tax. An understatement of income tax is “substantial”, if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. There is an exception to the accuracy-related penalty with respect to any portion of an underpayment, if the taxpayer establishes that there was reasonable cause for such portion, and the taxpayer acted in good faith with respect to such portion. Taxpayers self-prepared their 2009 Federal income tax return, and nothing in the record suggests that they consulted with a professional adviser in connection therewith. Taxpayer is an attorney, yet failed to cite any case holding that interest on loans made against an insurance policy is not includible in the gross distribution when the policy is terminated for nonpayment. The only authorities taxpayers cited were Code sections and Treasury regulations that were inapposite. The Court held therefore that taxpayers failed the reasonable cause exception, nor could they invoke the “substantial authority” provision to reduce the amount of the understatement for penalty computation purposes.


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