FIRPTA real estate tax reform continues its momentum with the recent release of bill text for H.R. 2128, the latest House bill introduced by Kevin Brady (R-Texas) and J Crowley (D-NY). In connection with the filing of the bill, Brady stated that H.R. 2128 is similar to the changes approved by the Senate Finance Committee and that he has previously proposed, but will now include a provision (like that supported by the Senate Finance Committee and the President) to eliminate the FIRPTA tax on foreign pension plans investing in U.S. real estate. The hope is that this will unlock material off-shore capital that could help fund infrastructure investments. Given the significant, bi-partisan support for these FIRPTA revisions in both houses of Congress and the Administration, we are optimistic that this is moving forward and on a possible path to enactment.
The bill defines a foreign pension plan qualifying for the proposed exemption to include any foreign pension plan or any other entity wholly-owned by a foreign pension plan. For this purpose, a foreign pension plan must (a) be organized under the law of a country other than the U.S., (b) provide benefits to present or former employees or their designees, (c) not have any single 5% participant or beneficiary, (d) be subject to governmental regulation and tax reporting in the country where established or organized, and (e) either (i) provide the employee with a tax deduction, exemption or reduced rate of tax for contributions, or (ii) be itself taxable on a deferred basis or at a reduced rate of tax.
The bill would also increase from 5% to 10% the maximum percentage that foreign holders of interests in publicly-traded REITs may hold and still qualify for exemption of REIT distributions and gain on sale of REIT stock from U.S. FIRPTA taxation. Further, the draft bill also tightens the definition of “domestic control” for REITs. This is relevant because of the FIRPTA tax exemption for the sale of stock in a domestically controlled REIT. The bill provides certain look through rules in determining whether an upper-tier REIT is consider domestic or foreign for purposes of testing domestic control over the lower-tier REIT.
The Treasury Department announced draft changes for the U.S. Model Income Tax Treaty — the baseline text used by the Treasury Department when it negotiates tax treaties. The current U.S. Model was last updated in 2006. The proposed changes in the draft provisions are intended to combat so-called Base Erosion or Profit Shifting (BEPS), which has been the subject of substantial debate in recent years. Treasury notes that treaties are designed to eliminate double taxation, but not to create opportunities for BEPS.
One set of draft provisions combats “special tax regimes” which provide low tax rates in certain countries, particularly to mobile income like royalties and interest. The second set of draft provisions is to combat corporate inversions by imposing full withholding taxes on key payments such as dividends and base stripping payments, including interest and royalties, made by U.S. companies that are “expatriated entities”. A third set of draft provisions makes revisions intended to prevent residents of third-countries from inappropriately obtaining the benefits of a bilateral tax treaty. The announcement also stated that Treasury intends to include in the next U.S. Model a new article to resolve disputes between tax authorities through mandatory binding arbitration.
In Comptroller v. Wynne, the Supreme Court ruled that individuals who earn income in states in which they do not reside may be entitled to refunds if the taxes they pay to the nonresident state are not fully creditable against their resident state taxes.
This case involved residents of Maryland who held interests in an S corporation that did business in a number of states. Maryland taxed the S corporation’s income to the individual shareholders and allowed a credit for taxes paid to other states. Maryland also imposed a county income tax in addition to its state income tax, but Maryland did not allow its residents to claim a corresponding credit against their county income tax liability.
The Supreme Court found that Maryland’s failure to give credit against the county tax for taxes paid to the nonresident state violated the Commerce Clause of the U.S. Constitution by imposing undue burdens on interstate commerce. The Court found the failure to give credit against the county tax violated the “internal consistency” test that courts use to evaluate the effect of state taxation regimes on interstate commerce. Applying this test, the court first assumed that every state had adopted Maryland’s personal income tax law. It then asked whether, if every state had Maryland’s law, income generated in interstate commerce would necessarily be taxed at higher rates than income earned entirely within Maryland. According to the Court’s analysis, Maryland’s tax system imposed a higher tax rate on interstate commerce.
In Wynne, the state collected both the state and county-level taxes. It is unclear whether the fact that the county tax was collected by the state (rather than by the county government) made a difference to the Court’s decision. If it did not, residents of other states and localities using a credit system may be due refunds if any taxes they pay to other state and local governments are not fully creditable against their resident state and local income tax liabilities.
Maryland taxpayers who paid nonresident taxes that were not fully creditable against their individual Maryland income tax liability should be contacting their income tax return preparers and looking into filing refund claims. The general due date for refund claims is to file them within three years of the due date (or, in the case of a validly extended return, the date of filing) of the relevant return or two years from the payment of tax, if later. Residents of other states using a credit system that does not fully eliminate double taxation (for example, residents of New York City who are not allowed a credit for out-of-state taxes against New York City personal income tax) may also consider contacting their income tax return preparers about the statute of limitations in their state and possibly file protective claims for refund.
The Tax Court recently ruled that a taxpayer was liable for self employment tax based on its status as a partner, even though the partnership had elected out of the partnership tax rules. Although the court in Methvin v. Commissioner respected the entity’s Section 761 election out of the Subchapter K partnership tax rules, it concluded that the entity was still a partnership for other purposes of the tax code.
The taxpayer owned a small percentage interest in oil and gas working interests through an operating agreement. Self-employment taxes apply to trade or business income earned directly or through being a partner in a partnership conducting such business. The taxpayer argued that he was not engaged in a trade or business and was not a partner in a partnership, asserting that his minority working interests were merely passive investments. The court disagreed, concluding that the taxpayer was liable as a partner in a partnership that conducted a business. The court cited its 1988 opinion in Cokes v. Commissioner for a similar conclusion that self-employment tax applied in this context, despite the fact that the taxpayer in Methvin had significantly less economic rights and control than the taxpayer in Cokes. The court further concluded that although the IRS had not challenged this issue on prior year audits, that did not prevent the IRS from challenging the issue in the year at issue.
The Methvin case is a warning to taxpayers that the Section 761 election out of Subchapter K does not turn off partnership status for all purposes, which could have implications well beyond self-employment taxes. The case is also a reminder that merely because an issue is not raised on a tax audit in a particular year, there is no precedential value to the prior audit.
The IRS recently issued final regulations under Section 162(m), which limits a public company’s deduction of executive compensation in excess of $1M. The Section 162(m) limits do not apply to performance-based compensation that meets certain qualifications. These final regulations released on March 30 solve two important riddles for practitioners:
- Per-Employee Limitations – To avoid the Section 162(m) limitations, plans that provide performance-based compensation must include a specific per-employee limit on the number of stock options or rights that may be granted during a specified period. Many practitioners were confused about whether this per-employee share limit applied to all types of equity-based awards offered under the plan, or only to certain kinds of awards named in the regulations (stock options and stock appreciation rights). The final regulations answer this question by giving plans wide berth, by allowing plans to name an aggregate maximum number of shares for most types of awards (stock options, stock appreciation rights, restricted stock, restricted stock units and other equity-based awards). The IRS noted that this was not intended to as a substantive change, which should give comfort to sponsors of plans that were already drafted broadly.
- Newly-Public Companies – The proposed regulations provided a transition relief period for companies that become publicly-traded. During the transition period, the limits of Section 162(m) do not apply to awards granted under plans or agreements that existed before the company became publicly-traded. With respect to restricted stock units (RSUs), the proposed regulations provided transition period protection only to RSUs that were paid during the transition period. In the final regulations, the IRS declined to extend transition relief to RSUs granted during the transition period. However, the IRS agreed to make the final regulations applicable to RSUs granted on or after the final regulations are published in the Federal Register.
Foreign asset reporting requirements are nothing new. US taxpayers have long been required to report worldwide income, and the FBAR filing requirements have been around since the 1970s. Congress and Treasury have increased the pressure in recent years, beefing up FBAR penalties, establishing additional foreign asset reporting requirements, and devoting significant resources to identifying and penalizing non-reporters.
Some taxpayers – especially expats who have not given up their U.S. citizenship – may not realize that opening a foreign bank account may trigger U.S. reporting requirements. Others have simply ignored these reporting requirements, perhaps assuming that their offshore accounts will escape notice.
Starting this year, non-reporters may be in for a rude shock. On March 31, 2015, under the Foreign Account Tax Compliance Act (FATCA), certain financial institutions began reporting to the U.S. government account information pertaining to U.S. taxpayers. Financial institutions in other jurisdictions will begin reporting this information in the coming months. More than 100 countries have either signed intergovernmental agreements or have reached agreements in substance with the U.S., facilitating FATCA reporting for financial institutions in those jurisdictions. Reporting and account review requirements for participating financial institutions will expand over the next few years, and foreign financial institutions that do not comply will be subject to a 30% withholding tax on certain payments of U.S. source income.
The IRS and Treasury offer voluntary disclosure programs for those with foreign accounts who are ready to come in from the cold. U.S. taxpayers who participate in these programs may avoid criminal penalties and may reduce financial penalties. Those who keep their heads in the sand may soon find that there is no place left to hide.
Of the many financial decisions a business faces in its life cycle, one of the most frequent (and certainly most important) is how best to fuel continued growth: should the business issue new debt or new equity? Debt and equity instruments can yield very different outcomes from a tax planning perspective, and so advisors consider a number of factors in determining what instruments to use. Once the “debt or equity” decision has been made, the instrument must be structured so that it is categorized appropriately for tax purposes. To do this, tax planners consider the terms of the relevant instrument in light of a variety of factors set forth in case law and legislative authority. The significant majority of existing authority, however, concerns debt or equity instruments issued by a corporate entity. Increasingly, businesses are operated through partnerships or other pass-through entities, and the question addressed in our recent article becomes whether the test for debt or equity is different in a partnership.
In most cases where equity is desired, it will be clear that holding a partnership instrument denominated as equity is sufficient to make the holder a “partner” for tax purposes. This analysis gets blurry, however, when considering the use of blended arrangements such as equity that has a lot of debt-like features (debt-like equity) or debt with many equity-like features (equity-like debt). In these instances of “blended” equity and debt, the determination of partner status becomes more difficult, as does any analysis of the tax implications of the instrument.
There have been recent court cases that attempt to clarify the how the classification of debt and equity might apply in the context of partnership issuers. The factors and analyses set forth in historical case law (even cases that specifically consider partnerships), however, do not cleanly apply to the complicated debt-like equity.
For example, in the 1960s, the Tax Court held in Hambuechen v. Commissioner of Internal Revenue that the traditional debt-equity tests used for corporations also applied to partnerships. The analysis in Hambuechen did not sufficiently address the complexities in partnership structures (or the types of “blended” instruments discussed above), however, and in subsequent years courts attempted to clarify the debt-equity analysis in light of the many different structures used by taxpayers.
Ultimately, the best structure for any business (and the preferred method of raising capital and fueling new growth) will depend on the applicable facts. Given the many different nuances between equity-like debt and debt-like equity, it is essential to consider the business’s short- and long-term financial goals in close consultation with a team of skilled financial, tax and legal advisors.
It is important to ask the question whether debt is different in a partnership. The short answer is clearly “no,” if you have something that is debt for a corporation it is also debt in a partnership. The longer answer is that the question of debt is integrally tied into the question of what is equity, as most believe you must be either debt or equity (since there are not tax rules governing an “other” category). This debt-like equity complexity is particularly true in partnerships, in part because the analysis of what qualifies as “equity” in a partnership is more difficult (and significantly more restrictive) than in a corporate setting. For now, each situation (and each instrument) must be evaluated on an individual, “facts and circumstances” basis. It remains to be seen whether there will be regulatory or legislative guidance on this issue. For a deeper exploration of this topic, visit our recent article.
The IRS announced that it has made significant progress on its publicly traded partnership (“PTP”) guidance and is lifting its moratorium on private letter rulings that started in 2014. It is reported that the IRS plans to release guidance in the near future to cover what is qualifying income from the exploration, development, mining and production, processing, refining, transportation, and marketing of minerals and natural resources. This item had been on the IRS business plan.
Although Section 7704 generally requires a separate corporate-level tax to apply to PTPs, a significant exception exists for “qualifying income”, largely including the natural resources industry. The growth of this PTP industry and its frequent request for IRS rulings prompted the IRS to explore a more streamlined guidance process, similar to what has happened in the REIT industry.
Yesterday the 5th circuit reversed the Tax Court and held in Pilgrim’s Pride that a taxpayer could receive an ordinary loss on the abandonment of a stock interest. In 2004 the taxpayer affirmatively abandoned their stock interest and declined an offer to sell the underlying stock because a $98.6M ordinary loss on abandonment was worth greater than the $20M offer it had to sell the stock. However, the IRS and Tax Court disagreed, citing Section 1234A for the proposition that an abandonment of a capital asset was treated as a capital loss. Noting this was a novel issue, the 5th circuit court disagreed with the IRS and Tax Court reading of Section 1234A to indirectly cover abandonments, concluding that Section 1234A(1) only applies to the termination of contractual or derivative rights, and not to the abandonment of capital assets. This case is quite significant and is the latest and most determinative authority on whether abandonment of an asset results in a capital versus an ordinary loss.
In new Rev. Proc. 2015-20, the IRS permits a “small business taxpayer” to use a simplified procedure to change its method of accounting under the final tangible property regulations for tax years beginning on or after January 1, 2014. This rule allows these small taxpayers to change to certain accounting methods without the burden of filing Form 3115. The guidance also modifies Rev. Procs. 2015-14 and 2015-13.
Who is a Small Business Taxpayer?
A small business taxpayer is a taxpayer with one or more separate and distinct trades or businesses that has either (1) total assets of less than $10 million as of the first day of the taxable year in which the change of accounting method is made under the tangible property regulations or (2) average annual gross receipts of $10 million or less for the prior three tax years.
What are the alternate procedures?
Certain accounting changes can be made on the taxpayer’s federal tax return without including any separate statement. To qualify the change must be to an accounting method listed in the Rev. Proc. and must include an adjustment under section 481(a) that takes into account only amounts paid or incurred, and dispositions, by the trade or business in taxable years beginning after January 1, 2014.
No Audit Protection
Most voluntary accounting method changes are granted by the IRS with “audit protection,” which means that the IRS will not require the taxpayer to change its method of accounting for the same item if impermissibly used for a taxable year prior to the year of change. Rev. Proc. 2015-20 specifies, however, that a small business taxpayer changing accounting methods under the simplified procedure will not receive any audit protection for taxable years beginning before January 1, 2014.