In CCA 201501013, the IRS found that an offshore fund making loans to U.S. borrowers was engaged in a U.S. trade or business where multiple loans owned by the fund were originated by an agent of the fund. This conclusion is consistent with an earlier 2009 memorandum that similarly found that the activities of agents were attributed to the lending company.
The discussion in the CCA puts foreign investors in loan funds on notice that the IRS intends to apply heightened scrutiny to these funds, where agents of the fund are involved in loan origination activities. If those activities are sufficiently extensive, the IRS is expected to contend that the portfolio interest exception (eliminating withholding taxes) and treaty rate reductions will not be available and the interest income will be subject to taxation in the U.S. at graduated income tax rates (i.e., effectively connected income, or “ECI”).
- Increased Risk of IRS Audit. In the CCA, the IRS has encouraged its agents to pursue on audit the issue of whether the lending activities of an offshore fund constitute a U.S. trade or business taxable as ECI and to obtain guidance from the IRS National Office to assist in case development. Although the facts in the CCA did not appear to include common “seasoning” of loans by another party, this is likely to be an area of focus for U.S. tax auditors.
- Protective Tax Return Filing. An offshore fund that raises capital from foreign persons to acquire interests in loans to U.S. borrowers typically tries to operate so as to avoid U.S. trade or business treatment and, as a result, does not file U.S. income tax returns. This means that the statute of limitations for assessment does not run. Further, where the foreign fund or its partners are treated as corporations under U.S. tax law, the IRS can disallow any deductions related to the fund’s income, unless an IRS Form 1120-F is filed within 18 months of the due date of the normal annual corporate return. See Treasury Regulation 1.882-4(a)(3). To protect against the loss of all deductions where there is an ECI risk, foreign entities taxed in the U.S. as corporations should consider filing protective U.S. corporate income tax returns, which also starts the running of the statute of limitations.
The CCA also offers a detailed analysis to support the IRS conclusion that the lending and underwriting activities of the foreign fund did not qualify under the exception for “trading in stocks or securities” under Code Section 864(b).
In the annual ritual of last minute legislative action, the Senate has passed the renewal of nearly all of the so-called Extenders legislation by a vote of 76 to 16, which will make the tax incentives applicable to calendar year 2014 if signed by the President. As is all too common, the Tax Increase Prevention Act of 2014 (H.R. 5771), merely resurrects provisions that expired January 1, 2014, but which will again expire on January 1, 2015. The bill includes popular incentives in areas such as affordable housing, conservation contributions, charitable contributions using IRA funds, “new markets” tax credit, “bonus” depreciation , faster leasehold improvement depreciation, small business stock, and various renewable energy incentives. This one-year extension is costly, at $41.6 billion over 10 years according to the JCT. Excerpts from the CRS summary are below.
Subtitle B: Business Tax Extenders – Extends through 2014:
- the tax credit for increasing research activities;
- the low-income housing tax credit rate for newly constructed non-federally subsidized buildings;
- the Indian employment tax credit;
- the new markets tax credit; the tax credit for qualified railroad track maintenance expenditures;
- the tax credit for mine rescue team training expenses;
- the tax credit for differential wage payments to employees who are active duty members of the Uniformed Services;
- the work opportunity tax credit;
- authority for issuance of qualified zone academy bonds;
- the classification of race horses as three-year property for depreciation purposes;
- accelerated depreciation of qualified leasehold improvement, restaurant, and retail improvement property, of motorsports entertainment complexes, and of business property on Indian reservations;
- accelerated depreciation of certain business property (bonus depreciation);
- the special rule allowing a tax deduction for charitable contributions of food inventory by taxpayers other than C corporations;
- the increased expensing allowance for business assets, computer software, and qualified real property (i.e., leasehold improvement, restaurant, and retail improvement property);
- the election to expense advanced mine safety equipment expenditures;
- the expensing allowance for film and television production costs and costs of live theatrical productions;
- the tax deduction for income attributable to domestic production activities in Puerto Rico;
- tax rules relating to payments between related foreign corporations and dividends of regulated investment companies;
- the treatment of regulated investment companies as qualified investment entities for purposes of the Foreign Investment in Real Property Tax Act (FIRPTA);
- the subpart F income exemption for income derived in the active conduct of a banking, financing, or insurance business;
- the tax rule exempting dividends, interest, rents, and royalties received or accrued from certain controlled foreign corporations by a related entity from treatment as foreign holding company income;
- the 100% exclusion from gross income of gain from the sale of small business stock;
- the basis adjustment rule for stock of an S corporation making charitable contributions of property;
- the reduction of the recognition period for the built-in gains of S corporations;
- tax incentives for investment in empowerment zones;
- the increased level of distilled spirit excise tax payments into the treasuries of Puerto Rico and the Virgin Islands; and
- the tax credit for American Samoa economic development expenditures.
Amends the Housing Assistance Tax Act of 2008 to extend through 2014 the exemption of the basic military housing allowance from the income test for programs financed by tax-exempt housing bonds.
Subtitle C: Energy Tax Extenders – Extends through 2014:
- the tax credit for residential energy efficiency improvements;
- the tax credit for second generation biofuel production;
- the income and excise tax credits for biodiesel and renewable diesel fuel mixtures;
- the tax credit for producing electricity using Indian coal facilities placed in service before 2009;
- the tax credit for producing electricity using wind, biomass, geothermal, landfill gas, trash, hydropower, and marine and hydrokinetic renewable energy facilities;
- the tax credit for energy efficient new homes;
- the special depreciation allowance for second generation biofuel plant property;
- the tax deduction for energy efficient commercial buildings;
- tax deferral rules for sales or dispositions of qualified electric utilities; and
- the excise tax credit for alternative fuels and fuels involving liquefied hydrogen.
Subtitle D: Extenders Relating to Multiemployer Defined Benefit Pension Plans – Extends through 2015 the automatic extensions of amortization periods for multiemployer defined benefit pension plans and for multiemployer funding rules under the Pension Protection Act of 2006.
In Mingo v. Comm’r the 5th Circuit upheld a Tax Court decision and denied installment sale treatment to the extent the partnership interest sold related to underlying unrealized receivables. The taxpayer sold its interest in a service partnership for an installment note. The court denied installment sale treatment to the extent that the purchase price related to customer receivables inside the partnership. The 5th Circuit court concluded that if the underlying receivables had been sold directly, they would not have qualified for installment sale treatment. The court then applied an aggregate treatment to the partnership based on the notion that since the unrealized receivables were so-called “hot assets” under Section 751, the court could then extend Section 751 look-through principles to the installment sale area. The IRS has made such arguments before, but now the Tax Court and 5th Circuit agree. Although there has been some disagreement in the bar with the IRS’s extrapolation of Section 751 principles in this way, the Mingo case gives the IRS something to point to beyond its own rulings. The case further gave the IRS a win by using the concept of a Section 481 adjustment to push the adjustment through even though the underlying tax year was closed.
In reversing the Tax Court, the 11th Circuit in Long v. Comm’r allowed a real estate developer favorable capital gain treatment upon the sale of its rights to a land purchase contract for a condominium development, even though sale of the condo units themselves would have been ordinary income.
The taxpayer originally had a contract to buy land that it was going to use to develop luxury condominiums. When the seller backed out, the taxpayer sued for specific performance and won. While the seller was appealing the decision, the taxpayer sold its position in the litigation and reported capital gain on the sale. The IRS disagreed and said the income should be ordinary income under the “substitution for ordinary income doctrine” (since the taxpayer would have recognized ordinary income had it actually developed the condominium and sold individual condo units). The taxpayer disagreed.
The Tax Court concluded that the income should be ordinary because the taxpayer would have ultimately recognized ordinary income had it been able to complete its original plan to sell condos. In reversing the Tax Court, the 11th Circuit Court of Appeals concluded that the Tax Court erred in not recognizing that the taxpayer never owned the land, but merely had a contract to acquire land. The court observed that the taxpayer never entered into the land purchase contract with an intent to sell that contract right in the ordinary course of business. Rather, the taxpayer had always intended to fulfill the terms of the contract and develop the project itself. Further the court found that the “substitute for ordinary income doctrine” did not apply since receipt of the lump sum payment for the taxpayer’s lawsuit rights was not a substitute for ordinary income that was already earned. Instead the taxpayer was selling a right to develop the condo.
The IRS published taxpayer-favorable proposed regulations to help minimize unnecessary tax under the Section 751(b) “hot asset” rules when a partnership makes a disproportionate distribution. The hot asset rules are designed to prevent a shifting of higher-tax ordinary income gain assets between partners. Thus if a partnership has a mix of capital gain and ordinary income assets, the rules prevent the partnership from distributing tax-free all of the ordinary income assets to one partner and capital gain assets to another. However, these rules had an intrinsic flaw in that they tracked the hot assets based on the gross value of the assets and not the net gain inherent in the assets. This disconnect resulted in the potential application of a deemed taxable hot asset exchange in many instances where it was not warranted.
The proposed regulations follow the general construct the IRS suggested in Notice 2006-14, Specifically, the proposed regulations adopt the hypothetical sale approach as the method by which the partners must measure their respective interests in Section 751 property for the purpose of determining whether a distribution reduces a partner’s interest in the partnership’s Section 751 property. Because this approach relies on Section 704(c) locking in a partner’s share of hot asset gain, the proposed regulations make so-called “bookups” mandatory under Reg. §1.704-1(b)(2)(iv)(f) in a distribution that would implicate the Section 751(b) hot asset rules. The proposed regulations also contain a special revaluation rule for distributing partnerships that own an interest in a lower-tier partnership and describe how basis adjustments under Sections 734(b) and 743(b) affect the computation of partners’ interests in Section 751 property.
The regulations are proposed to apply to distributions occurring in any taxable period ending on or after the date of publication of the regulations as final.
In consolidated cases known as Kenna Trading LLC, the Tax Court shut down an attempt to contribute foreign currency losses into a US partnership and syndicate the losses to investors by selling partnership interests followed soon by the partnership selling the loss assets. According to the court, the persons contributing loss assets did not qualify as partners under the traditional “Culbertson” test. The transaction also failed under the disguised sale rules as well as lacked economic substance.
The Tax Court found the transaction subject to significant penalties including the high “listed transaction” penalty for one of the years at issue based on it being substantially similar to the distressed asset trust shelter. Further the case was analogized to the recent IRS victory in Superior Trading. Note that 2004 legislation has since changed the law to more clearly prevent the syndication of losses imported into a partnership. The taxpayer tried to use state-law trusts in 2005 to avoid this law change. The Tax Court analyzed that such state-law trusts did not meet the tax definition of trusts, nor did they meet the tax definition of partnership, and regardless they lacked economic substance and were shams.
Notice 2014-58 adds some clarity to when the IRS will assert the strict-liability economic substance penalties and how they will determine the “transaction” that is disregarded under the Section 7701(o) economic substance doctrine. The new guidance amplifies Notice 2010-62 and also formalizes some of the unofficial guidance in the 2011 IRS LB&I field directive.
IRS reserves the ability to aggregate or disaggregate transaction steps when defining “transaction”, depending on the facts
The question of what is the “transaction” is critical to the economic substance analysis, particularly when testing the overall motivations for a broader business transaction with certain tax-motivated steps. The Notice clarifies that the term “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan. However, the IRS will apply a facts and circumstances approach and may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals — a disaggregation approach.
IRS provides some clarity on when other tax doctrines are subject to strict liability economic substance penalties under “similar rule of law” rule
The economic substance doctrine “strict liability” penalties under section 6662(b)(6) apply to underpayments attributable to any disallowance of a claimed tax benefit under the section 7701(o) economic substance doctrine “or if the transaction fails to meet the requirements under any “similar rule of law”. The Notice clarified that “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o), even if a different term or terms are used to describe the rule or doctrine. The IRS referred to the sham transaction doctrine as one such example. On the helpful side, the IRS stated that it will not apply the section 6662(b)(6) penalty unless it also raises section 7701(o) to support the underlying adjustments. Further, the IRS stated that if tax benefits are denied under Code sections and regulations other than section 7701(o), they are not similar rules of law for purposes of the section 6662(b)(6) penalty.
Earlier this week, the Treasury Department and the IRS announced that they would issue regulations that substantially limit the U.S. tax benefits of corporate inversions (and certain post-inversion transactions). The regulations described in Notice 2014-52 and in the IRS “Fact Sheet” will make it more difficult for U.S. corporations to satisfy the ownership thresholds necessary to avoid subjecting the inverted company to continued U.S. taxation, and will also significantly impact a new foreign parent’s ability to access offshore earnings free of U.S. tax after an inversion (including through tax-free decontrol of CFCs). Specifically, the regulations will:
- Restrict inversions with foreign corporations that have substantial passive assets (including cash and marketable securities).
- Restrict the U.S. company’s ability to satisfy the applicable ownership tests by making “skinny-down” distributions (i.e., pre-inversion “extraordinary” dividends).
- Restrict the U.S. company’s ability to engage in so-called “spinversions” under the internal group restructuring exception to the inversion rules.
- Prevent inverted companies from accessing earnings of existing CFCs using “hopscotch” loans, stock sales, or de-controlling transactions (such as tax-free transfers of stock of a CFC to the new foreign parent).
While new restrictions announced in Notice 2014-52 strike a substantial blow to U.S. companies hoping to gain U.S. tax benefits from inverting, there is still more to come. Treasury has indicated that future guidance will impose further limitations on the benefits of post-inversion tax avoidance transactions as well as inversion transactions that are contrary to the purposes of Section 7874. Earnings-stripping structures (which were not targeted by Notice 2014-52) are also under consideration by Treasury and may be the subject of future guidance. Further, there are also separate legislative proposals by Sen. Schumer and Sen. Levin that target earnings-stripping structures as well as more general proposed legislation to prevent corporate inversions.
Notice 2014-52 is generally applicable to transactions completed on or after September 22, 2014. There is no grandfathering provision for signed but not yet completed transactions.
In new Rev. Proc. 2014-54, the IRS modified the procedures to obtain the IRS consent to a change in method of accounting for dispositions of tangible depreciable property. This relates to the ”repair regulations“ finalized last year. The new guidance includes procedures to (i) obtain automatic IRS consent in certain contexts, (ii) to allow a late partial disposition election under Reg. § 1.168(i)-8 to be treated as a change in method of accounting for a limited period of time, and (iii) to modify the Appendix of Rev. Proc. 2011-14 regarding a change to the method of accounting described in Rev. Proc. 2014-16, for amounts paid to acquire, produce, or improve tangible property.
75% of a REIT’s assets must be real estate. When a REIT owns a debt secured by both real estate and non-real estate, the regulations create an apportionment formula that, although typically favorable, creates an inappropriate bias against real estate classification for distressed debt. The IRS previously published Rev. Proc. 2011-16 to provide taxpayers with an “Asset Test Safe Harbor” to avoid inappropriately classifying distressed debt as a non-real estate asset. However, the IRS has become aware of “anomalous results” with this safe harbor if the underlying asset begins to regain its value after the REIT originates or acquires the loan. Therefore in new Rev. Proc. 2014-51 the IRS modified the safe harbor test and related examples to avoid this anomaly. In a particularly helpful fashion, the new guidance is effective for all calendar quarters and all taxable years.