This past year has seen a number of important developments in the areas of Tax Court procedure, federal court procedure, and privilege and non-disclosure. As the below cases and posts demonstrate, taxpayers’ reliance on experts, their efforts to protect privileged information, and their efforts to limit sweeping government discovery requests continue to be tested and closely scrutinized.
Section 385(a) provides that Treasury is authorized to issue regulations to determine whether an interest in a corporation is to be treated for purposes of the Code as stock or indebtedness. On April 4, 2016, Treasury and the Service issued proposed regulations (Proposed Regulations, found here) under section 385 that treat certain purported debt between related entities as stock for US federal income tax purposes. Treasury stated specifically that the regulations under section 385 had been issued to “address the issue of earnings stripping” in three ways – (1) “[t]argeting transactions that increase related-party debt that does not finance new investment in the United States”; (2) “[a]llowing the IRS on audit to divide a purported debt instrument into part debt and part stock”; and (3) “[r]equiring documentation for members of large groups to include key information for debt-equity tax analysis[.]”
Once the Proposed Regulations were issued, practitioners and industry groups of affected companies (among others) questioned whether the Proposed Regulations were narrowly tailored to serve these stated purposes, and observed that the Proposed Regulations represented a significant departure from past practice. The Proposed Regulations received widespread attention, and practitioner groups and others submitted numerous detailed formal comments before the regulations were finalized. Among the most important critiques, practitioners criticized the Proposed Regulations for their potential overbreadth in their application to foreign-to-foreign transactions, for their lack of a de minimis exception for smaller companies, and for the anticipated burden of the contemporaneous documentation requirements.
Treasury and the Service released final and temporary section 385 regulations (Final 385 Regulations, available here), which are effective as of October 21, 2016, the date of publication in the Federal Register. The Final 385 Regulations provide several exceptions not contained in the Proposed Regulations, including that the Final 385 Regulations apply only to debt instruments issued by a covered member, which is defined as a domestic corporation, to members of its expanded group. The Final 385 Regulations were accompanied by an unusually lengthy Preamble which purports to address major comments received during the notice-and-comment process.
Like the Proposed Regulations, the Final 385 Regulations contain the documentation rules that require specific substantiation in order to treat related-party instruments as debt. These rules are not effective for debt instruments issued prior to January 1, 2018. The Final 385 Regulations contain several modifications to the documentation rules. For example, the Proposed Regulations automatically recharacterized a purported debt instrument as equity in the event of a documentation failure. Under the Final 385 Regulations, if an expanded group is otherwise highly compliant with the documentation rules, then the Final 385 Regulations apply a rebuttable presumption with respect to a purported debt instrument under which a taxpayer can rebut an equity presumption by satisfying specific enumerated tests.
The Final 385 Regulations contain the recast rules issued in Prop. Treas. Reg. §1.385-3, but with significant modifications. In general terms, the Final 385 Regulations reduce the debt issuance to the extent the [...]
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Transfer pricing, the allocation of income or loss between members of a controlled group, (TP) continues to be the critical taxation issue in the cross-border world (international, federal or state), whether in planning, controversy or other purposes. Why is this case? Because the tax consequences of each entity begins with its income or loss posture.
On November 2, 2015, the Bipartisan Budget Act of 2015, (the Act), H.R. 1314, 114 Congress/Public Law No. 114-74, made significant changes to the rules governing US federal income tax audits of partnerships (New Audit Rules). The New Audit Rules are codified at Internal Revenue Code Sections 6221 through 6241. On August 4, 2016, the IRS released temporary and proposed regulations relating to certain aspects of the New Audit Rules. And, on December 6, 2016, technical corrections to the New Audit Rules (Technical Corrections) were introduced in both the House of Representatives, H.R. 6439, and in the Senate, S. 3506.
On December 2, 2016, the US District Court for the Central District of California found that taxpayers who failed to file a Report of Foreign Bank and Financial Accounts (FBARs) for three foreign accounts, one of which, in the court’s view, was intentionally kept secret from all persons except their children, for over a decade were “at least recklessly indifferent to a statutory duty.” Read more about the case here. The court found that the taxpayers were “sophisticated,” pointing to evidence that they ran a successful camera shop, and that they lacked credibility having made several misrepresentations on their failed attempt to apply to the Offshore Voluntary Disclosure Program (OVDP) and for making unbelievable assertions at trial. The court did not apply the heightened standard of willfulness applicable to criminal trials, a violation of a known legal duty, finding that civil trials apply the lesser standard of reckless disregard of a statutory duty. Additionally, the court rejected the defendants’ argument that the government had to show willfulness under the clear and convincing standard of proof and applied the typical civil preponderance of the evidence standard of proof. The taxpayers’ lawyer has stated that they will appeal the decision.
Practice note: Ensuring that OVDP applications are complete and truthful is crucial to their acceptance and, as demonstrated here, can and will be used against the taxpayer in any later proceedings. The taxpayers in this case had a number of factors working against them, and, as shown here, offshore reporting cases will often turn on their own specific facts. As more and more FBAR enforcement cases are being docketed around the country, it will be interesting to see whether reviewing courts will apply a uniform standard for willfulness under the FBAR statute.
The Internal Revenue Service (IRS) has finalized regulations that tax transfers of certain property, including goodwill and going concern value, to foreign corporations in nonrecognition transactions described in Internal Revenue Code Section 367. The final regulations replace proposed regulations published on September 16, 2015 and temporary regulations published in 1986.
We previously discussed the 2015 proposed regulations and why they were viewed as controversial when issued given the elimination of favorable tax treatment for transfers of foreign goodwill and going concern value to foreign corporations. The final regulations followed the proposed regulations on this point, which may lead to future litigation over the validity of the final regulations. Taxpayers should carefully review these final regulations and be aware of potential arguments that may exist for challenging the positions taken by the IRS.
In tax litigation, there are often (at least) two important categories of issues to consider: (1) substantive; and (2) procedural. A great deal of tax litigation will be focused on the substance of the Internal Revenue Service’s (IRS) adjustments (e.g., was a taxpayer entitled to a particular deduction?). But the procedural aspects should not be ignored. If the IRS did not abide by its procedural requirements before making a tax adjustment, consideration should be given to whether the IRS’s adjustment is procedurally invalid. Sometimes taxpayers win on these issues; other times they do not. The United States Tax Court’s (Tax Court) recent case, Graev v. Commissioner, is an example of the latter.
In Graev, an IRS Revenue Agent determined that a 40 percent gross valuation misstatement penalty should apply. The Revenue Agent prepared a “Penalty Approval Form” in accordance with Internal Revenue Manual (I.R.M.) procedures and submitted it to his immediate supervisor. The supervisor checked the form’s “Approved” box and initialed the form in its space for “Group Manager Initials.” The Revenue Agent then prepared a proposed notice of deficiency determining the 40 percent penalty and no other penalties.
The proposed notice of deficiency was referred to the IRS Office of Chief Counsel (Chief Counsel) for review, pursuant to I.R.M. procedures. The Chief Counsel attorney assigned to the case prepared a memorandum back to the Revenue Agent’s office with proposed revisions to the notice of deficiency. Specifically, the Chief Counsel attorney instructed the inclusion of an alternative 20 percent accuracy-related penalty. The Chief Counsel attorney signed the memorandum and his immediate supervisor initialed it.
The Revenue Agent revised the notice of deficiency to include the alternative 20 percent penalty, but his immediate supervisor did not approve it in writing. The IRS ultimately issued the revised notice of deficiency, which included a signature by an IRS Technical Services Territory Manager and a page on which the penalties were computed. Under the Internal Revenue Code (Code), the 20 percent and 40 percent penalties cannot be stacked. As a result, the computation for the 40 percent penalty was shown fully, but the computation for the 20 percent penalty was calculated as zero.
On November 17, 2016, the US Department of the Treasury’s Community Development Financial Institutions Fund (CDFI Fund) announced the largest single round award of New Market Tax Credit (NMTC) allocations since the program’s creation in 2001. One hundred twenty organizations, headquartered in 36 states, the District of Columbia and Puerto Rico, were awarded a total of $7 billion of NMTC allocations.
In an apparent response to coordination questions raised by comments to proposed regulations under Code Section 871(m) (relating to certain cross-border dividend equivalent payments), the US Department of the Treasury issued proposed regulations on April 12, 2016, (the Proposed Regulations) addressing deemed distributions of stock and stock rights under Code Section 305(c). Among other stated goals, the Proposed Regulations attempt to “resolve ambiguities concerning the amount and timing of deemed distributions that are or result from adjustments to rights to acquire stock.” The Proposed Regulations also provide guidance to withholding agents regarding the current withholding and information reporting obligations under chapters three and four with respect to such deemed distributions.
In the latest issue of the Journal of Taxation of Financial Products, we have published an article outlining the Proposed Regulations, describing the types of transactions, including adjustment events, giving rise to deemed distributions with respect to stock rights, as well as describing the amount and timing thereof. A companion article in this issue of the Journal addresses the related withholding and information reporting considerations.
As discussed in the article, the Proposed Regulations, while not answering all pertinent questions, attempt to provide clarity on the question of whether certain adjustments with respect to stock rights result in deemed distributions for purposes of Code Sections 305(b) and 301. It will be interesting to see whether the regulations are finalized in their current form or will be subject to extensive comments and potentially re-proposed. It is worth noting that a number of comments to the Proposed Regulations have already been submitted, largely seeking clarifications on certain aspects of the Proposed Regulations. However, some of the comments submitted to date suggest that the regulations are inappropriate and should not be adopted, based largely on the notion that the adjustments at issue do not result in an accretion to wealth in many instances, and thus should not result in taxable income. A critical question regarding the timing and content of final regulations may ultimately depend on the views of withholding agents as to the withholding and reporting provisions.
We have previously written about Judge Mark V. Holmes’ dislike of the Internal Revenue Service’s (IRS) practice of issuing subpoenas to non-parties without informing the taxpayer. To recap, Tax Court Rule 147 allows a party to issue a subpoena to a non-party but does not specifically require that prior notice be given to the other side of the issuance of the subpoena. Rather, the subpoena is enforceable as of the beginning of the court’s trial session. In contrast, Fed. R. Civ. Proc. 45 requires notice to other parties before service of non-party subpoenas for the production of documents, information or tangible things. In two prior orders, Judge Holmes ordered that the IRS must serve on taxpayers all non-party subpoenas together with all responses and documents that the non-parties produced have been in the form of unpublished orders. In his orders, Judge Holmes adopted the notification requirement of Fed. R. Civ. Proc. 45, and explained his rationale for his orders.
Unfortunately for taxpayers, Tax Court orders are not to be treated as precedent under Tax Court Rule 50(f), and therefore are not binding on any other Judge of the Tax Court. This point is illustrated by Judge Carolyn P. Chiechi’s December 2, 2016, orders in six related cases (see, e.g., Tangel v. Commissioner), where she stated that “[a] party that issues a subpoena under Rule 147(a) and/or (b) is not required to give prior notice to the other party.” Judge Chiechi further noted that under the facts and circumstances presented the IRS did not issue the subpoenas to harass, annoy, embarrass, oppress or cause an undue burden on the taxpayers. (more…)
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