International Tax Blog

Famous Tax Quote #13 - Anticipatory Assignment

Famous Tax Quotes includes quotations from court opinions with language that is colorful or that concisely states an important tax principle. Readers are encouraged to send suggestions for upcoming Famous Tax Quotes.

Continuing our series on Famous Tax Quotes, today's Famous Tax Quote is:

There is no doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements . . . .

Lucas v. Earl, 281 U. S. 111 (1930).

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Famous Tax Quote #12 - Income Is Taxed to The Earner

Today's Famous Tax Quote is:

"[T]he first principle of income taxation: . . . income must be taxed to him who earns it.”

Commissioner v. Culbertson, 337 U. S. 733, 739-740 (1949).

Overseas Inheritance Scam: Tax Certificate for Wire Transfer

A story.

Let’s say you receive an email notifying you about an inheritance of US$6 million (or Euros or Pounds) that you are about to receive.  The inheritance is coming from someone (the “decedent”) that lived outside the U.S.  You are not related to the decedent.  In fact, you had never heard of the decedent before receiving the email.  However, for some reason, the decedent wanted to leave his fortune to you.  The dollar signs are so big in your eyes that you bite.

Let’s say you are confused by lots of legal mumbo jumbo going on, but after all, the cash is coming from a foreign country where they have strange customs.  After you have dished out some cash for various fees associated with the decedent's estate (that for some reason could not come out of the cash you will inherit), the money is about to be wire transferred to you (or to a foreign corporation that you will control, etc.).

Unfortunately, you are told, a wire transfer of this magnitude requires that you need to get a “tax certificate” to wire transfer the money.  Obtaining the tax certificate, you are told, will cost you an additional US$2,000.  Receiving this inheritance is starting to drain your pocketbook.  You wonder if it might be cheaper to get this tax certificate from someone else.

You search around and find the phone number of an international tax attorney.  You call the attorney and ask about getting one of these so called tax certificates so the money can be wire transferred.  After providing a little background to the attorney, he states point blank that you are involved in a scam and that you should not have any further contact with these crooks.

Do you believe the attorney?  Is the prospect of receiving US$6 million, the fact that you have already dished out some cash, and the potential embarrassment too much to overcome for you to see the truth?  Will you continue sending good cash after bad?  One can only wonder.

See also international money transfer tax scam.

FBAR Reporting for Foreign Mutual Funds

Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (hereinafter referred to as the “FBAR”), generally must be filed by June 30th of each year to report financial interests in, or signature authority over, foreign financial accounts held during the prior calendar year.

In October 2008, the I.R.S. revised the FBAR and its accompanying instructions.  The instructions were modified in several controversial ways.  This blog posting only discusses the changes with respect to U.S. citizens or U.S. residents that own interests in foreign commingled funds, including foreign mutual funds.

Both the old and the new instructions to the FBAR provide that a financial account includes “any bank, securities, securities derivatives, or other financial instruments account.”  The revised FBAR instructions, however, add an embellishment to the definition of financial account.  The revised instructions provide that financial accounts:

generally also encompass any accounts in which the assets are held in a commingled fund and the account owner holds an equity interest in the fund (including mutual funds).

On its face, the instructions would now appear to require every U.S. citizen and U.S. resident with an interest in a foreign mutual fund, or commingled fund, to file the FBAR.  Given the potential civil penalty of $10,000 per year for nonwillful failure to file the FBAR, this is an important change to the instructions.

Unfortunately, the instructions do not provide a definition of an “account.”  Further, there does not appear to be any other authority to provide additional guidance as to what is meant by an account.

If a U.S. person directly acquires stock in a foreign corporation, it is difficult to see how the shares of stock themselves constitute an “account.”  Clearly, if the shares are in a foreign brokerage account, then the foreign brokerage account could trigger the FBAR filing requirement.  However, not all shares in foreign corporations are acquired through foreign brokerage accounts.  The following discussion assumes that a U.S. person’s direct ownership of shares of a typical foreign corporation that has active business operations does not rise to the level of an “account” for purposes of the FBAR.

Many, if not most, foreign mutual funds would be treated as corporations for U.S. tax purposes.  In fact, the passive foreign investment company (“P.F.I.C.”) rules are specifically targeted at foreign mutual funds.  In order to be a passive foreign investment company, the foreign entity must be a corporation under U.S. tax principles.  If the FBAR instructions apply to foreign corporations that are treated as mutual funds, each time a U.S. person acquires shares of stock in a foreign corporation (a mutual fund or otherwise), a determination would need to be made as to whether the foreign corporation was a “commingled fund,” such as a mutual fund.

The instructions to the FBAR do not provide a definition of a commingled fund or of a mutual fund, and it is unclear what these terms are intended to mean.  For instance, if a foreign holding company has one wholly owned subsidiary and no other assets, presumably the holding company would not be a commingled fund.  On the other hand, if the foreign holding company owns a small percentage of many different companies (just like a mutual fund), the holding company may be a commingled fund.  It is unclear where on this spectrum a non-commingled fund becomes a commingled fund (and therefore causes the shares to become an “account”).

After receiving comments from U.S. tax practitioners, the Treasury Department last month (August 2009) issued Notice 2009-62.  This notice provides an extension to file an FBAR until June 30, 2010 for the 2008 year and earlier years with respect to foreign commingled funds.  In the interim, the Treasury Department is expected to provide additional guidance.

Interestingly, if the forthcoming definition of a commingled fund is not simple and clear, it may be easier (read less expensive) to file protective FBARs for all foreign shareholdings.  If U.S. tax return preparers must investigate the activities of each foreign corporation in which their client owns shares (to determine the entity’s status as a commingled fund or not), it may be easier, cheaper, and safer (penalty wise) to complete the FBAR for all foreign shareholdings.

Andrew Mitchel is a U.S. international tax attorney who advises businesses and individuals with cross-border activities.

Three Manufacturing Tests Under Code § 954(d) & the Manufacturing Branch Rules

In December 2008, the I.R.S. and the Treasury Department published T.D. 9438, which included new regulations under Code § 954(d).  These regulations became effective on July 1, 2009, and are generally applicable to tax years of controlled foreign corporations (“C.F.C.s”) beginning after June 30, 2009.

As with the prior regulations, foreign base company sales income (“FBCSI” or “subpart F income”) generally does not include income of a C.F.C. derived in connection with the sale of personal property manufactured, produced, or constructed (“manufactured”) by such corporation.  Under the new regulations, a C.F.C. will have manufactured personal property which the corporation sells only if the corporation satisfies one of the following tests through the activities of its own employees:

--- 1.954-3(a)(4)(ii) - Substantial Transformation Test (“STT”),

--- 1.954-3(a)(4)(iii) - Substantive Manufacturing Test (“SMT”), or

--- 1.954-3(a)(4)(iv) - Substantial Contribution Test (“SCT”).

When a C.F.C. purchases product from related parties or sells product to related parties, the C.F.C. may be able to avoid FBCSI under one of the above noted manufacturing tests (often referred to as the “manufacturing exception”).  Consequently, manufacturing activities are generally useful in avoiding subpart F income.

Manufacturing Branch Rules

However, if the C.F.C. performs the manufacturing activities through a branch (or similar establishment) in a country other than the country in which it is created or organized, the manufacturing activities can create subpart F income under complex manufacturing branch rules.  Under these rules, subpart F income can occur even if there are no related party purchases and no related party sales.  If the branch rules apply, certain activities are deemed to have occurred on behalf of deemed related parties.

Deemed Activities & Deemed Entities

With regard to the deemed activities, certain purchasing and selling activities are deemed to occur on behalf of a related manufacturing entity.  With regard to the deemed related parties, the manufacturing branch is deemed to be a separate entity and the location of the sales activities (the home office of the C.F.C. or a sales branch) is also deemed to be a separate entity.  This fictional construct may or may not create FBCSI, depending upon the circumstances.

Manufacturing Activities Not Treated As Manufacturing

The manufacturing branch rules do not apply if the C.F.C. as a whole does not meet one of the manufacturing tests noted above (STT, SMT, or SCT).  Thus, where a C.F.C. is engaged in some manufacturing activities (see the indicia of manufacturing in Treas. Reg. § 1.954-3(a)(4)(iv)(b)(1) - (7)) within or outside its country of formation, but not enough to be meet the manufacturing tests, the manufacturing branch rules do not apply.  If a C.F.C. does not have related party purchases and does not have related party sales, but does have some manufacturing activities outside its country of formation, and if the C.F.C. can limit those manufacturing activities to avoid meeting the manufacturing tests, the C.F.C. can avoid FBCSI under the manufacturing branch rules.

Of course, if purchasing and/or selling activities occur outside the C.F.C.’s country of formation, then the sales branch rules must be applied to determine whether FBCSI exists.  Similar to the manufacturing branch rules, subpart F income can be triggered under the sales branch rules even if there are no related party purchases and no related party sales.

Green Card Holders Living Outside the U.S.

It is not unusual for Green Card holders to move outside the U.S. permanently or indefinitely.  Often individuals will work in the U.S. for many years and then decide to retire or semi-retire to their country of origin.  If those individuals do not formally relinquish their Green Cards, they generally continue to be treated as residents for U.S. tax purposes.

Green Card Test for U.S. Tax Residency

Code § 7701(b)(1)(A) provides in part that an alien individual who is lawfully admitted for permanent residence (i.e., a Green Card holder) at any time during a calendar year shall be treated as a resident of the United States with respect to that calendar year.  For tax purposes, an individual is a lawful permanent resident of the United States at any time if:

(A) such individual has the status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws, and

(B) such status has not been revoked (and has not been administratively or judicially determined to have been abandoned).

Code § 7701(b)(6).  Stated another way, an individual ceases to be a resident under this rule if the lawful permanent residence status has been revoked or if it has been administratively or judicially determined to have been abandoned.

Immigration Law

A green card holder may formally abandon his/her status by filing an USCIS (formerly the INS) Form I-407 (Abandonment of Lawful Permanent Resident Status).  For immigration law purposes, an alien’s status as a permanent resident may cease without a formal determination that an alien has abandoned his/her permanent residence.  The formal determination may not occur until some time later, such as when the alien tries to return to the United States, claiming to be a permanent resident.  Thus, for purposes of the immigration laws, a determination of abandonment may not take place until many years after the actual abandoning act.  This reflects the fact that the USCIS does not need to know the alien’s status until he/she tries to return to the United States.

Tax Law

For tax purposes, however, Congress intended an alien to be treated as a lawful permanent resident under Code § 7701(b)(6) until there has been a formal determination that his/her status has been abandoned.  This fact is evidenced in the Joint Committee on Taxation’s General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 463 (1984), where it stated:

The Act defines “lawful permanent resident” to mean an individual who has the status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws, if such status has not been revoked or administratively or judicially determined to have been abandoned.  Therefore, an alien who comes to the United States so infrequently that, on scrutiny, he or she is no longer legally entitled to permanent resident status, will be a resident for tax purposes. The purpose for this requirement of revocation or determination is to prevent aliens from attempting to retain an apparent right to enter or remain in the United States while attempting to avoid the tax responsibility that accompanies that right.

Treaties

Although U.S. tax law continues to treat lawful permanent residents as tax residents until there has been a formal determination that his/her status has been abandoned, income tax treaties may be available to override this rule.  An individual who would be treated as a resident alien under this rule might be treated as a nonresident alien under the so-called “tiebreaker” rules of the income tax treaties to which the United States is a party. 

For instance, an individual who is considered a resident of the United States pursuant to the internal laws of the United States and also a resident of a treaty country pursuant to the treaty partner’s internal laws may be able to claim under the treaty that he/she is a nonresident of the United States.  See Treas. Reg. § 301.7701(b)-7(a)(1).

These rules can create a tension between U.S. tax law and U.S. immigration law.  An individual may want to claim the benefits of a treaty to be treated as a nonresident of the U.S. for tax purposes.  However, such a claim might adversely impact their U.S. immigration status.

Schering-Plough Corp. v. U.S.

I finally finished reading Judge Katherine S. Hayden’s 91 page opinion of Schering-Plough Corp. v. U.S. that came out last week.  I must say that the opinion is a tour de force.  The Court held that certain “swap-and-assign” transactions should not be respected as sales of future income streams.  Instead, the transactions should be treated, in substance, as loans.

In arriving at this conclusion, the Court analyzed various topics, including:

• interest rate swaps,
• assignment of one of the legs of the swaps for an up-front payment,
• testimony from experts,
• testimony from Schering-Plough employees,
• substance over form principles,
• subpart F income and section 956,
• conduit theories,
• sales of future streams of income versus loans,
• step transaction doctrine, and
• economic substance doctrine.

A number of cases in the past have had more success with economic substance arguments at the appellate level.  I have no idea whether Schering-Plough plans to appeal.  If they do, however, I would not give good odds of an overturn on appeal.  Having said that, the weakest area for the government would seem to be in the area of a taxpayer being able to rely on a notice published by the I.R.S. (discussed on pages 88 to 90 of the opinion), under a detrimental reliance argument.

Famous Tax Quote #11 - Exalting Form Over Substance

Today's Famous Tax Quote is from a U.S. District Court case that came out last week:

Permitting a taxpayer to control the economic destiny of a transaction with labels would . . . exalt form over substance, thereby perverting the intention of the tax code.

Schering-Plough Corp. v. U.S., ___ F. Supp. ___ (U.S. Dist. Ct. 2009).

I.R.S. Extends Due Date for Late Check-the-Box Elections

Today the I.R.S. issued Revenue Procedure 2009-41 which allows certain late entity classification (“check-the-box”) elections to be filed retroactively for a period of 3 years and 75 days.

Entity Classification Elections Generally

Treas. Reg. § 301.7701-3(a) provides in part that a business entity that is not a per se corporation under Treas. Reg. § 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8) (i.e., an eligible entity) can elect its classification for federal tax purposes as provided in Treas. Reg. § 301.7701-3.  An eligible entity with at least two members can elect to be classified as either a corporation or a partnership, and an eligible entity with a single owner can elect to be classified as a corporation or as a disregarded entity.

Treas. Reg. § 301.7701-3(b) provides a default classification for an eligible entity that does not file an entity classification election.  Thus, an entity classification election is necessary only when an eligible entity chooses to be classified initially as other than its default classification or when an eligible entity chooses to change its classification.

Form 8832

Entity classification elections are made by filing Form 8832, Entity Classification Election.  Treas. Reg. § 301.7701-3(c)(1)(iii) provides that an entity classification election will be effective on the date specified by the entity on Form 8832 or on the date filed if no such date is specified on the election form.  The effective date specified on Form 8832 cannot be more than 75 days prior to the date on which the election is filed and cannot be more than 12 months after the date on which the election is filed. 

9100 Relief

Under Treas. Reg. § 301.9100-1(c) the I.R.S. may grant a reasonable extension of time to make certain elections.  Treas. Reg. § 301.9100-3 provides that the I.R.S. will grant an extension of time when the taxpayer provides the evidence to establish to the satisfaction of the I.R.S. that the taxpayer has acted reasonably and in good faith and the grant of relief will not prejudice the interests of the government.

Revenue Procedure 2002-59

Revenue Procedure 2002-59 provides guidance for entities newly formed under local law to request relief for a late initial classification election filed by the due date for the first federal tax return (excluding extensions) of the entity’s desired classification for the year of the entity’s formation.

Extended to CHANGES in Classification

Revenue Procedure 2009-41 supersedes Revenue Procedure 2002-59.  Significantly, Revenue Procedure 2009-41 extends late entity classification relief to changes in classification elections.  Under Revenue Procedure 2002-59 relief was only available for initial classification elections.  This extension is important because it eliminates many questions related to late entity classification elections, for instance where “off-the-shelf” entities are used.

No Retroactive Election for Per Se Corporations Until Conversion

One must remember, however, that no entity classification elections can be made for per se corporations.  Consequently, even if an entity converts from being a per se corporation to being an eligible entity, the effective date of the entity classification election cannot be prior to the date of the conversion.

S Corporations

An eligible entity may qualify for alternative relief under Treas. Reg. § 301.7701-3(c)(1)(v)(C), which treats an entity as having made a classification election to be treated as a corporation when it timely elects to be an S corporation under Code § 1362(a)(1).  Also, see Revenue Procedure 2004-48 and Revenue Procedure 2007-62 for special rules applicable to late S corporation elections and late entity classification elections.

Private Letter Rulings

An entity that does not satisfy the requirements for relief under Revenue Procedure 2009-41 may request relief by applying for a letter ruling.  However, the I.R.S. user fees (not to mention advisor fees) for private letter rulings can be significant.

Importance for Foreign Entities

This new relief is very helpful for many taxpayers that form entities outside the United States without first obtaining thorough U.S. tax advice.  Often it is beneficial to make entity classification elections for foreign entities, but taxpayers may not be immediately made aware of the benefits of such an election.  Importantly, however, certain requirements must be met to obtain relief under Revenue Procedure 2009-41 and not all taxpayers may qualify for such relief.

Famous Tax Quote #10 - Meaningless Gesture

Today's Famous Tax Quote is:

The issuance of further stock would have been a meaningless gesture, and we cannot conclude that the statute requires such a vain act. We conclude, therefore, that there was in substance an exchange of stock . . . .

James Armour, Inc. v. Commissioner, 43 T.C. 295 (1964).

Famous Tax Quote #9 - Origin of All Events Test

Famous Tax Quotes includes quotations from court opinions with language that is colorful or that concisely states an important tax principle. Readers are encouraged to send suggestions for upcoming Famous Tax Quotes.

Continuing our series on Famous Tax Quotes, today's Famous Tax Quote is:

[A]ll the events . . . which fix the amount of the tax and determine the liability of the taxpayer to pay it.

U.S. v. Anderson, 269 U.S. 422, 441 (1926)

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Widely Held vs. Closely Held

In our last blog posting, we discussed that it is useful to conceptually divide cross-border taxation into the categories of “inbound” and “outbound.”  Inbound refers to non-U.S. persons with U.S. income and/or U.S. activities, and outbound refers to U.S. persons with non-U.S. income and/or non-U.S. activities.

Another useful classification for dealing with cross-border transactions is that of widely held companies and that of closely held companies.  These categories are useful for both inbound and outbound transactions.  Thus, inbound and outbound can be sub-divided as follows:

 

Widely Held Companies

Widely held companies have certain advantages and certain disadvantages in both the inbound and outbound contexts.  In the inbound context, if the widely held company is publicly traded, then one of its advantages is that it may more easily qualify for the limitation on benefits provisions included in most U.S. income tax treaties.  This qualification may allow it to be subject to lower tax rates on U.S. withholding taxes or, in some circumstances, to avoid U.S. taxation entirely.  One of the disadvantages of a widely held company in the inbound context is that it is more difficult to avoid branch profits taxes and/or dividend withholding taxes.

In the outbound context, a disadvantage is that widely held companies (typically “C” corporations) are subject to two levels of taxation - one tax at the corporate level as profits are earned and another tax at the shareholder level when profits are distributed.  Several other countries have “integrated” tax systems that allow shareholders to claim credits against their own income tax liabilities for taxes paid at the corporate level.  The U.S. does not have such an integrated tax system.  Consequently, profits earned by widely held corporations in the U.S. are generally subject to two levels of taxation.

An advantage of a widely held company in the outbound context is that foreign income taxes paid by foreign subsidiaries of the U.S. parent can generally be claimed as foreign tax credits in the U.S. when the foreign profits are distributed (or deemed distributed) to the U.S. parent.  These foreign tax credits are sometimes called “indirect” or “deemed paid” foreign tax credits.  If widely held U.S. parent companies were not allowed to claim deemed paid credits, profits earned by foreign corporate subsidiaries would ultimately be subjected to three levels of taxation: foreign corporate taxation, U.S. corporate taxation, and U.S. shareholder taxation.

Closely Held Companies

As with widely held companies, closely held companies have certain advantages and disadvantages in both the inbound and outbound contexts.

In the inbound context, an advantage of a closely held company is that it may be able to structure its U.S. operations to avoid branch profits taxes and dividend withholding taxes.  A disadvantage of a closely held company is that, depending on the structure, there may be U.S. estate taxation risks.

A brief discussion of the taxation of U.S. closely held companies is helpful to understand the advantages and disadvantages in the outbound context.  U.S. closely held companies are often structured to avoid entity level taxation.  This is typically achieved with the use of “S” corporations or partnerships.  Without an entity level tax, only the shareholders/partners are subject to U.S. income tax.

NB: Limited liability companies (“LLCs”) formed in the U.S. are often treated as partnerships for U.S. tax purposes.  However, LLCs can also be treated as S corporations, C corporations, or disregarded entities.

In the outbound context, a disadvantage is that a closely held U.S. parent company which is not structured as a “C” corporation does not qualify for deemed paid foreign tax credits.  Consequently, profits of foreign subsidiaries of closely held U.S. parent companies may be subject to two levels of taxation (foreign entity level tax and U.S. shareholder level tax).  However, an advantage of a closely held company is that it may be able to structure the operations of its foreign subsidiaries to be subject to only one level of worldwide taxation.

Complex U.S. Tax Rules for Both

Both widely held and closely held companies are subject to some of the same complex U.S. tax rules.  For instance, in the inbound context, some of the rules that apply to both types of companies include:

• Earnings stripping,
• Transfer pricing,
• U.S. withholding taxes, and
• Special U.S. tax reporting obligations.

In the outbound context, some of the rules that apply to both types of companies include:

• Deemed distributions as subpart F income,
• Interest charges and ordinary income characterization under the passive foreign investment company (“PFIC”) regime,
• Recharacterization of capital gain as ordinary income on sales or exchanges of stock in certain foreign corporations under Code § 1248,
• Transfer pricing,
• Foreign withholding taxes,
• Special rules for outbound transfers of property under Code § 367, and
• Special U.S. tax reporting obligations.

This blog posting touches on many issues and is not intended to cover any of the issues in depth.  Each of the sub-categories of cross-border taxation has many intricate rules that should be analyzed in detail with respect to each specific taxpayer.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

“Inbound” & “Outbound”

Cross-border taxation can be subdivided into various categories based on the type of transaction being analyzed.  At the highest level, the categories include “inbound” and “outbound.”  These categories are useful because significantly different U.S. tax rules can apply to the different types of transactions.

Inbound

When viewed from the United States, “inbound” refers to non-U.S. persons (“persons” meaning both individuals as well as entities) with U.S. income and/or U.S. activities.  A typical inbound circumstance exists where a foreign corporation has income and/or activities in the U.S.  For instance, Toyota is a Japanese headquartered company.  However, Toyota sells its products in the United States.  Thus, Toyota is selling “into” the U.S., and Toyota would generally be considered in the inbound category.

In order for a transaction to be considered inbound, however, it is not necessary for product to be imported into the U.S.  Continuing the example above, Toyota may decide it is better to manufacture product in the U.S.  Consequently, Toyota may form a U.S. subsidiary and have the subsidiary manufacture and sell the product in the U.S.  In this circumstance, there has been no product imported into the U.S.  However, it is still an inbound transaction because the parent company is from outside the United States and its subsidiary has activities in the United States.

Typical cross-border tax issues related to inbound transactions can include: U.S. withholding taxes, transfer pricing, branch profits taxes, branch interest taxes, earnings stripping, income tax treaties, etc.

Outbound

“Outbound” refers to U.S. persons with NON-U.S. income and/or NON-U.S. activities.  A typical outbound circumstance exists where a U.S. headquartered corporation has income and/or activities in other countries.  For instance, Wal-Mart is an American publicly traded company.  However, Wal-Mart purchases many of its products from suppliers located outside the United States.  Further, Wal-Mart sells many of its products outside the United States (either through foreign subsidiaries or otherwise).  Thus, Wal-Mart is a U.S. headquartered company with activities “outside” the U.S., and Wal-Mart would generally be considered in the outbound category.

Typical cross-border tax issues related to outbound transactions can include: foreign withholding taxes, transfer pricing, foreign tax credits and foreign tax credit limitations, subpart F income, Code § 956 inclusions (a.k.a. investments in U.S. property), income tax treaties, etc.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Free Code § 302 Redemption Flowchart

On our sister website, Tax-Charts.com, we have published a flowchart of distributions in redemption of stock under Code § 302.  Redemptions of stock can be treated either as sales/exchanges or as Code § 301 distributions.  The flowchart leads the user, step-by-step, through the process of determining whether the redemption should be treated as a sale/exchange or as a Code § 301 distribution.

The flowchart covers the substantially disproportionate rules of Code § 302(b)(2) as well as the family attribution rules of Code §§ 302(b)(3) and 302(c), and more.

The flowchart is available for free.  Students taking corporate tax classes may be particularly interested in studying the flowchart.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Famous Tax Quote #8 - Tax Rules Don't Necessarily Make Sense

Continuing our series on Famous Tax Quotes, today's Famous Tax Quote is:

"[W]hat makes sense" does not necessarily dictate the definitive answer in the tax area; apparent conceptual niceties often must give way to the hard realities of statutory requirements.

United States Freight Co. v. U.S., 422 F.2d 887 (U.S. ct. of Cl. 1970)

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Famous Tax Quote #7 - Contingent Liabilities

Continuing our series on Famous Tax Quotes, today's Famous Tax Quote is:

The prudent business man often sets up reserves to cover contingent liabilities.  But they are not allowable as deductions.

Lucas v. American Code Co., Inc., 280 U.S. 445 (1930).

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Tax Chart Shape & Color Conventions

On our sister website (www.andrewmitchel.com) we have published over 700 tax charts.  Over 600 of these charts can be viewed onscreen at no cost.  The remaining 100+ charts (and printing capabilities for the 600+ onscreen charts) can be accessed with a $200 annual subscription (See chart orders).

Many shapes and colors are used in the charts.  Heretofore, we have not published a comprehensive legend of the shapes and colors we use.  In this blog posting, we explain many of the conventions that we use on our charts.  Of course, with over 700 charts there are exceptions to these general rules.

Shapes

Shapes are used in the charts primarily to designate various types of entities.  The following shapes are used:

1. Rectangles represent corporate / limited liability entities.

2. Triangles represent partnerships.
3. Pentagons represent trusts.
4. Trapezoids represent U.S. “S” corporations.
5. Ovals represent individuals, the public, and a “catch all” other.
6. Small pink circles with a, b, and c letters represent the order that several transactions take place within one box.
7. Small triangles within rectangles represent entities treated as a flow-thru entities for U.S. tax purposes.  Other international tax presentations often use a triangle within a rectangle to represent a partnership and an oval within a rectangle to represent a disregarded entity.  Our charts do not use two different shapes for these two types of entities.  Rather, in our charts the triangle represents flow-thru status and one must look to the percentage ownership in order to distinguish between partnership status and disregarded entity status.  A 100% owned flow-thru entity is a disregarded entity and any other flow-thru entity is a partnership.

Partnerships and S corporations are typically not subject to an entity level tax.  Trusts, similarly, are often not subject to an entity level tax.  We have attempted to utilize similar shapes for partnerships, S corporations, and trusts in order to reflect their similar nature.  Thus, the top two sides of the triangles for partnerships and the top two sides of the pentagons for trusts come to a point.  Think of these two sides, if you will, as “funneling” the earnings, profits, etc. up to the owner/beneficiary.  For S corporations, the two sides of the trapezoid turn inward, similar to the tops of the triangles and pentagons.  This shape is intended to represent the same upward funneling concept.

Lines & Outlines

1. Thick, colored, dashed lines generally represent action, an agreement, or a special type of ownership (e.g., preferred stock).  Typically, matching colored text describes these lines.

2. Outlines of shapes are typically thin, black, solid lines.
3. Shapes with outlines of thin, black, dashed lines represent either newly formed entities or non-entities (such as corporate divisions, property, etc.).

Background Colors for Shapes

Generally only two colors are used as background for shapes: white and blue.  White generally means that the entity is a U.S. entity.  Blue means that the entity is a non-U.S. (foreign) entity.

Loans Between Entities

Loans between entities are generally represented by a thick, colored, dashed line with matching colored text.  Further, the lending entity has a “+” next to it, and the borrowing entity has a “-” next to it.

Recently Created Conventions

We have recently begun creating a number of charts that include trusts.  As indicated above, these trusts are represented by pentagons.  Some of the trusts are grantor trusts and some of them are non-grantor trusts.  We believe that it would be useful to have a visual cue that distinguishes between grantor and non-grantor trusts.  In this regard, we tentatively plan to represent grantor trusts with an outline of a thick, red line and to represent non-grantor trusts with an outline of the normal thin, black line.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Famous Tax Quote #6 - Presumption of Correctness

Continuing our series on Famous Tax Quotes, today's Famous Tax Quote is:

[The Commissioner's] ruling has the support of a presumption of correctness, and the [taxpayer] has the burden of proving it to be wrong.

Welch v. Helvering, 290 U.S. 111 (1935).

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Foreign Deferral Matching Principle

The Obama administration has proposed to defer deductions for certain expenses incurred by U.S. multinationals with deferred foreign income.  This blog posting first discusses two other U.S. tax matching principles and then discusses the proposed Obama matching principle.

Exempt Income / Expense – Matching Principle

Expenses are often incurred in the process of generating taxable income.  These expenses are generally deductible for tax purposes, so that only the net profit is subject to income tax.

Certain types of income are exempt from income taxes.  Examples include municipal bond interest income and certain foreign earned income.  As would be expected, expenses related to the exempt income are generally not deductible for tax purposes.

The disallowance of expenses related to tax exempt income can be thought of as a matching principle: if the income is not taxable, the related expense should not be tax deductible.

Timing of Income / Expense – Matching Principle

Certain types of expenditures create assets or other long term benefits.  U.S. tax law generally requires that the cost of creating or purchasing assets, and expenditures that create long term benefits, be deducted for tax purposes over the useful life of the asset, or over the term of the benefit.

This deferral of deductions is based on an accounting matching principle which attempts to match the timing of expense deductions with the timing of income recognition.

Deferral of Foreign Income / Expense – Obama Proposed Matching Principle

U.S. based businesses with foreign subsidiaries are often able to defer U.S. taxation of foreign profits, sometimes for extended or even indefinite periods.

Expenses related to the foreign operations, however, are often incurred and deducted by the U.S. parent company on a current basis.  Thus, there is a mismatch with the timing of income recognition and the timing of deductions – income is deferred but expenses are not deferred.

The Obama administration has proposed to create a matching principle: foreign related expenses cannot be deducted until the foreign related income is subject to U.S. tax.  There are large dollar amounts at stake.

Example of Interest Expense

Interest expense is an example of the mismatch of income and expenses.  Say a U.S. parent company typically earns $100 of profit before income taxes on its U.S. operations.  Say also that the U.S. parent is considering expanding its operations by borrowing and investing $1,000.  The expanded operations can be located either in the U.S. or overseas.  Say also that labor and material costs are identical in the U.S. and in the proposed foreign country.  As long as the tax rate in the foreign country is lower than the tax rate in the U.S., the U.S. parent can reduce its current worldwide tax cost by expanding its operations outside the U.S. rather than inside the U.S.

This can be demonstrated as follows:  Assume the U.S. parent borrows $1,000 at 10% interest per annum in the U.S.  The U.S. parent invests the $1,000 as equity into a foreign subsidiary in a lower tax country with an active foreign business.  Assume also that the foreign subsidiary earns $150 per year and reinvests its earnings in the foreign business.

Under today’s tax rules, the U.S. parent can generally deduct the $100 of interest expense in the U.S. on a current basis.  This interest expense wipes out the U.S. parent’s U.S. taxable income ($100 pre-interest profit minus $100 interest expense).  The foreign income of $150, however, is not currently taxed in the U.S.

Incentive to Invest Overseas

The current deduction for the U.S. interest expense combined with the deferral of the foreign income creates an incentive for the U.S. parent to invest in new businesses overseas rather than to invest in the U.S.  The proposed matching principle would eliminate this incentive by deferring the $100 of interest expense until the $150 of foreign earnings were subject to U.S. tax.

Famous Tax Quotes #4 & #5 - No Patriotic Duty to Increase Taxes

Continuing our series on Famous Tax Quotes, today's Famous Tax Quotes are both from Judge Learned Hand:

#4  Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.

Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)

#5  Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

Commissioner v. Newman, 159 F.2d 848, 851 (2d Cir. 1947) - dissenting opinion

[Hat tip: Frank Santoro]

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Famous Tax Quote #3 - Deductions Legislative Grace

Continuing our series on Famous Tax Quotes, today's Famous Tax Quote is:

Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.

New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)

[Hat tip: Frank Santoro]

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Famous Tax Quote #2 - What Actually Occurred

Continuing our series on famous tax quotes, today's Famous Tax Quote is:

[A] transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred.  * * *

[W]hile a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not. 

Commissioner v. National Alfalfa Dehydrating, 417 U. S. 134 (1974).

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Famous Tax Quote #1 - Straight Path / Devious Path

I often come across court opinions with language that is colorful or that concisely states an important tax principle.  I feel like these should be “Famous Tax Quotes.”

Today I begin a series in which I will occasionally post “Famous Tax Quotes” on this blog.  The criteria for these quotations is that they are from court opinions (e.g., the Supreme Court, the Circuit Courts, the Tax Court, etc.) where a tax issue is being decided.  I encourage readers to send me suggestions for upcoming Famous Tax Quotes.

The first Famous Tax Quote is:

A given result at the end of a straight path is not made a different result because reached by following a devious path.  Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938).

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Qualified Business Units (QBUs)

Under U.S. tax rules, qualified business units (QBUs) are important for purposes of calculating certain transactions denominated in currencies other than the U.S. dollar.  This posting discusses what a QBU is.  However, this posting does not discuss the specific U.S. tax rules on how to report non-U.S. dollar denominated transactions for a QBU or a non-QBU.

In general, a QBU is any separate and clearly identified unit of a trade or business of a taxpayer, provided that separate books and records are maintained. 

Certain entities can constitute QBUs.  For instance, a corporation is a QBU.   Further, a partnership, trust, or estate is a QBU of a partner or beneficiary.

Certain activities can also qualify as a QBU.  In order for activities to create a QBU:

1. The activities must constitute a trade or business, and
2. A separate set of books and records must be maintained with respect to those activities.

The definition of a “trade or business” for this purpose is broader than most definitions of “trade or business.”  A trade or business for purposes of defining a QBU is:

[A] unified group of activities that constitutes (or could constitute) an independent economic enterprise carried on for profit, the expenses related to which are deductible under section 162 or 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).

Deductions for typical trade or business expenses are generally found in Section 162.  However, section 212 generally allows deductions for the production or collection of income, regardless of whether an actual trade or business exists.  Expenses typically fitting within section 212 include rental property deductions and investment-related expenses.

Thus, investment activities can create a QBU as long as they are a separate and clearly identified unit and separate books and records are maintained.  This principle is illustrated in Treas. Reg. § 1.989(a)-1(e), Example 6, which provides:

Taxpayer A, an individual resident of the United States, is engaged in a trade or business wholly unrelated to any type of investment activity.  A also maintains a portfolio of foreign currency-denominated investments through a foreign broker.  The broker is responsible for all activities necessary to the management of A’s investments and maintains books and records as described in paragraph (d) of this section, with respect to all investment activities of A.  A’s investment activities qualify as a QBU under paragraph (b)(2)(ii) of this section to the extent the activities engaged in by A generate expenses that are deductible under section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).

In certain circumstances, the existence of a QBU can allow for the deferral of recognition of currency gains and losses.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

IRS Additional FAQs Regarding Filing of FBAR and other Cross-Border Tax Forms

On June 24, 2009 the I.R.S. published an update to its frequently asked questions (FAQs) regarding the filing of FBARs (Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts) and other cross-border tax forms under the offshore account and entity voluntary disclosure program announced on March 23, 2009.

There are now 51 FAQs.

FAQ # 46 asks:

A taxpayer moved to the U.S. in 2007 and is now a permanent resident of the U.S.  The taxpayer had a requirement to file an FBAR for one year but failed to do so.  Is the taxpayer subject to a penalty equal to 20 percent of the account?

The answer to this FAQ is quite interesting ---

First, the taxpayer should confirm that the taxpayer had an FBAR filing requirement. Assuming that the taxpayer was required to report the interest earned on the account during the year the taxpayer was in the U.S. and failed to do so, the taxpayer is subject to a penalty based on the high account balance during the year. The penalty may be limited to five percent if the taxpayer did not avoid U.S. tax with respect to the deposits and if the account was passively held during the year the taxpayer was in the U.S. If there was no unreported taxable income related to the unreported foreign accounts that would have been reported on the FBAR, the taxpayer will not be subject to the 20 percent offshore penalty. In that case, the taxpayer should file delinquent FBARs attaching a statement explaining why the FBAR was not timely filed. For more information, see FAQ 9.

As mentioned in FAQ #50,

Taxpayers and practitioners trying to decide whether to simply file an amended return . . . or to make a formal voluntary disclosure . . . should consider the nature of the error they are trying to correct.

As mentioned in FAQ #15, the civil penalty for non-willfully failing to file the FBAR cannot exceed $10,000.  If the failure to file is non-willful and the bank account balance is greater than $50,000, the voluntary disclosure program would not seem to make sense.  Further, the I.R.S. has been lenient in assessing the $10,000 penalty for non-willful failures, especially under circumstances such as those described in FAQ #46.  If the taxpayer described in FAQ #46 did not willfully fail to file the FBAR, the taxpayer should consider whether filing the FBAR as part of the voluntary disclosure program is the best course of action.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

UBS Client Pleads Guilty to Filing False Tax Return

A UBS client pleaded guilty today to filing a false tax return for tax year 2004, the Justice Department and Internal Revenue Service (IRS) announced.  On April 1, 2009, the taxpayer, an accountant, was charged with filing a false tax return that intentionally failed to disclose the existence of a Swiss bank account maintained by UBS of which he was the beneficial owner and failed to report any income earned on that account.

The taxpayer had maintained a UBS bank account in the name of a nominee British Virgin Island corporation.  His tax return failed to report that he had an interest in, or signature authority over, a financial account at UBS in Switzerland.  Additionally, he failed to report the income he earned on any UBS Swiss bank accounts.

As part of his plea agreement, the taxpayer agreed to pay a 50% penalty for the year with the highest balance in the account as of June 30 in order to resolve his civil liability for failing to file FBARs for tax years 2001 through 2007.

The I.R.S. currently has a voluntary disclosure program in which taxpayers can file the prior 6 years of tax returns to declare unreported offshore accounts and unreported offshore entities.  Under the voluntary disclosure program, taxpayers generally must pay all taxes and interest on unreported income.  Further, certain penalties are imposed, including a penalty equal to 20% of the highest value in the foreign financial accounts during the past 6 years.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Branch Rule Complexity Continued

Stop reading if you are tired of hearing about long sentences.  The sentences with 165 and 173 words in the prior post were from regulations promulgated in 1964.  It appears that the Treasury is trying to out-do itself with long sentences.  Treasury Decision 9438, published December 24, 2008 [Merry Christmas], amends the regulations for the branch rules and includes a sentence with 235 words.  Here it is from Temp. Treas. Reg. § 1.954-3(b)(2)(ii)(a):

For purposes of applying the rules of this paragraph (b)(2)(ii) and §1.954-3(b)(2)(ii), a branch or similar establishment of a controlled foreign corporation treated as a separate corporation purchasing or selling on behalf of the remainder of the controlled foreign corporation under paragraph (b)(2)(ii)(b) of this section, or the remainder of the controlled foreign corporation treated as a separate corporation purchasing or selling on behalf of a branch or similar establishment of the controlled foreign corporation under §1.954-3(b)(2)(ii)(c), will include any other branch or similar establishment or remainder of the controlled foreign corporation that would not be treated as a separate corporation (apart from the branch or similar establishment of a controlled foreign corporation that is treated as performing purchasing or selling activities on behalf of the remainder of the controlled foreign corporation under paragraph (b)(2)(ii)(b) of this section or the remainder of the controlled foreign corporation that is treated as performing purchasing or selling activities on behalf of the branch or similar establishment under §1.954-3(b)(2)(ii)(c)) if the effective rate of tax imposed on the income of the purchasing or selling branch or similar establishment, or purchasing or selling remainder of the controlled foreign corporation, were tested under the principles of §1.954-3(b)(1)(i)(b) or (b)(1)(ii)(b) against the effective rate of tax that would apply to such income if it were considered derived by such other branch or similar establishment or the remainder of the controlled foreign corporation.

Further, I can't figure out any difference between "this paragraph (b)(2)(ii) and §1.954-3(b)(2)(ii)."  It appears to me that "this paragraph (b)(2)(ii)" is "§1.954-3(b)(2)(ii)."  Similar references are made twice in Temp. Treas. Reg. § 1.954-3T(b)(2)(i)(d).  Either I am missing something or the Treasury is trying to be redundantly confusing.

[UPDATE:  I realized that the difference between the two references is that the reference to "this paragraph" is for the temporary regulations and the other reference is for the final regulations.]

I haven't flowcharted this one yet.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Branch Rule Complexity

I have a habit of counting the number of words in a sentence when I come across a really long one.  Today I was creating a flowchart of the foreign base company sales income rules (one of the types of subpart F income), when I came across a particularly long sentence.  This sentence has 165 words.

My flowchart has 9 separate steps for the single sentence.  I like to create a citation to authority for each step in my flowcharts.  I realized how long the sentence was when I was trying to create the citations.  All 9 boxes cite to the same sentence.  I usually like to be as specific as possible in my citations, but I haven’t yet determined a method to cite to different items within a sentence.

The über sentence is found in the sales branch rules that apply to foreign base company sales income -- Treas. Reg. § 1.954-3(b)(1)(i)(b) [second sentence]:

The use of the branch or similar establishment for such activities will be considered to have substantially the same tax effect as if it were a wholly owned subsidiary corporation of the controlled foreign corporation if the income allocated to the branch or similar establishment under the immediately preceding sentence is, by statute, treaty obligation, or otherwise, taxed in the year when earned at an effective rate of tax that is less than 90 percent of, and at least 5 percentage points less than, the effective rate of tax which would apply to such income under the laws of the country in which the controlled foreign corporation is created or organized, if, under the laws of such country, the entire income of the controlled foreign corporation were considered derived by the corporation from sources within such country from doing business through a permanent establishment therein, received in such country, and allocable to such permanent establishment, and the corporation were managed and controlled in such country.

If you are interested in the 9 steps in the flowchart, shoot me an email and I will send them to you.

P.S. I just remembered that there is a similar sentence in the manufacturing branch rules.  It turns out that this sentence has even more words -- 173.  See Treas. Reg. § 1.954-3(b)(1)(ii)(b) [second sentence].

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Deemed Permanent Establishment, But Not Carrying On Business

The Australian Tax Office (“ATO”) recently held that a U.S. resident head lessor had a deemed permanent establishment in Australia under Article 5, paragraph 4(b) of the Australia-U.S. Income Tax Treaty (the “Treaty”).  However, because the U.S. resident was not carrying on business in Australia, Australia was precluded, under Article 7, paragraph 1 of the Treaty, from taxing the business profits of the U.S. resident.  See ATO Interpretive Decision 2009/21.

Permanent Establishment

Article 5, paragraph 4 of the Treaty provides in part:

[A]n enterprise of one of the Contracting States shall be deemed to have a permanent establishment in the other Contracting State if: . . . (b) it maintains substantial equipment for rental or other purposes within that other State (excluding equipment let under a hire-purchase agreement) for a period of more than 12 months.

The U.S. head lessor leased equipment to an Australian resident company who subleased the equipment to third parties in Australia.  The ATO held that the taxpayer was considered to be maintaining substantial equipment for rental purposes within Australia for a period of more than 12 months.  Accordingly, the taxpayer was deemed to have a permanent establishment in Australia in relation this equipment leasing activity.

Carrying On Business

Article 7, paragraph 1 of the Treaty provides in part:

The business profits of an enterprise of one of the Contracting States shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.

The ATO provided that where the lease contracts are entered into outside Australia and the activities of the lessor in Australia only consist of the drafting of the lease but not the receipt of lease rentals, the mere leasing of equipment by the U.S. lessor in Australia does not, of itself, constitute the carrying on of business in Australia through the deemed permanent establishment.  The ATO stated that for business to be carried on in Australia through the deemed permanent establishment, a US lessor would need undertake more activities within Australia, for example, undertaking inspection or maintenance checks on the equipment in Australia, or conducting lease negotiations in Australia.

As a result, Australia was precluded from taxing the business profits of the U.S. head lessor under the Treaty.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Offshore Asset Protection Misconceptions

There are many forms of asset protection.  There is no silver bullet and often multiple techniques are used.

Insurance

One of the best types of asset protection is purchasing insurance.  If your home burns to the ground, insurance protects you.  If you get in a car accident and injure someone, insurance protects you.  Insurance, however, has limitations on coverage - both on the amount that will be covered and on the type of activity covered.  Therefore, insurance is not always sufficient to protect your assets.

Limited Liability Companies

Another type of asset protection is operating your business activities through a company with limited liability - such as a corporation or a limited liability company.  If formalities are complied with and if business and personal assets are not commingled, a company with limited liability can be an effective means of asset protection for the shareholders of the company.  If the company is sued, the shareholders generally cannot be held liable for the debts of the company.

Divesting of Assets

If one member of a family is more likely to be sued than another, it may be helpful to have family assets held by other members of the family.  For instance, if one spouse engages in a high risk profession, it may be prudent to have the family home and other assets held by the other spouse.  It is important to note, however, that this approach merely shifts risk from one spouse to another.  If the low risk spouse is held liable for an action, the assets can still be lost.

Domestic asset protection trusts (“DAPT”) and offshore asset protection trusts (“OAPT”) are also included in this category.  Trusts can be created for the benefit of family members and property can be transferred to the trusts so that the property is beyond the reach of creditors.  In several U.S. states it is now even possible to create “self-settled” trusts, where the trust benefits the creator of the trust and may protect the property from creditors.

Obfuscation (Hiding Assets)

Making it difficult for creditors to find assets and/or to gain control of those assets is another technique of asset protection.  There are an unlimited number of techniques that can be used to hide assets.  This rationale is often one of the major selling points of offshore asset protection advisors.

One approach to hiding assets is to set up bank or other accounts in countries with bank secrecy laws.  Another approach is to set up foreign corporations, foreign trusts, foreign foundations, or other types of foreign entities where the owners or beneficiaries of those entities are kept secret.  This secrecy might be achieved by having the title to the shares held by one person, but the shares beneficially owned by another.  Sometimes, instead of keeping the owners or beneficiaries secret, the beneficiaries or owners are simply not yet determined (shares not officially issued for corporations, contingent beneficiaries for trusts, etc.).

U.S. Tax Issues With Obfuscation

The problem with obfuscation is that Congress has created numerous U.S. tax reporting requirements for offshore activities.  The penalties for failing to comply with the U.S. tax reporting requirements can be enormous.  For instance, if a U.S. citizen transfers $100,000 to a foreign trust and simply fails to tell the I.R.S. about the transfer, the penalty starts at 35% ($35,000) and goes up from there.  Code § 6677(a).  The comparable penalty for failing to disclose transfers to foreign corporations is 10%.  Code § 6038B(c). 

To learn more about U.S. tax reporting requirements (and the penalties) for offshore activities, speak with a qualified U.S. tax professional.

Obfuscation Increases U.S. Tax Advisor Fees

Even without obfuscation, it can cost thousands of dollars to hire a tax professional to help you prepare the necessary U.S. tax forms related to the offshore activities.  Many tax professionals don’t regularly deal with offshore tax reporting, and the ones that do may be hesitant to prepare the tax returns due to the potential for penalties.

Where there has been obfuscation, it can cost even more.  In the typical case, the U.S. citizen that has created the offshore asset protection structure may initially be tight-lipped about the details.  The conversation might go as:

Client:  "I don’t own the shares of the foreign corporation (to which I transferred assets)."
U.S. Tax Advisor: "Who owns the shares?"
Client: "My foreign attorney’s secretary holds title to the shares."
U.S. Tax Advisor: "Can you have the shares transferred into your name at any time?"
Client: "Well . . . "

U.S. tax law looks to the substance of the transaction.  If shares or assets are nominally owned by one person, but beneficially owned by another, U.S. tax law would treat the beneficial owner as the true owner.  Therefore, the beneficial owner would be required to report the ownership of the shares or assets.

Obfuscation techniques intentionally make transactions overly complex and unclear.  To meet the U.S. tax filing requirements, the complexity and uncertainty must be sorted through to determine the proper filings.  The time it takes the U.S. tax advisor to sort through the “mess” costs the client in additional fees.

U.S. Tax Reporting Undercuts Obfuscation

A properly prepared U.S. tax return will be a road map to where the assets went and to who controls the assets.  It is not recommended that the U.S. tax filings have any misleading information.  On the contrary, it is important that the U.S. tax filings be as complete and as accurate as possible.  The I.R.S. often has discretion in determining whether they will assert penalties.  If an I.R.S. agent perceives that the information provided is not complete or accurate, they may be more likely to impose penalties.

In essence, the obfuscation must be unwound for purposes of preparing the U.S. tax return.  Therefore, the complexity and uncertainty intended for asset protection purposes may not serve its purpose.

In summary, it is important for U.S. citizens and U.S. residents to understand all of the U.S. tax implications of setting up offshore asset protection structures, preferably prior to entering into such a structure.  However, if such a structure has already been set up and the U.S. tax reporting requirements for earlier years have not been complied with, it is important to get up to date with those filings.  While the I.R.S. generally waives penalties for reasonable cause, they are much less likely to find reasonable cause when they are the ones who discover the existence of the offshore structure.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

I.R.S. Finally Publishes 2008 Form 8804

Yesterday, March 21, 2009, the I.R.S. finally published Form 8804, Annual Return for Partnership Withholding Tax (Section 1446).  Form 8804 is used by partnerships with U.S. effectively connected income that is allocable to foreign partners.  Although the 2008 form is now completed, the instructions to this year’s form have not yet been released.

It is remarkable that the I.R.S. is still publishing forms for the 2008 year that are due April 15, 2009.  If a tax preparer uses software to complete Form 8804, he/she must now wait until the software provider updates its software to include the new form.  Presumably, updating the form should not take much time, given that there were no law changes this year related to the form and it is virtually identical to last year’s form.  Of course, this brings up the question as to why it took the I.R.S. so long to change the “2007” at the top of the form to “2008.”

On March 18, 2009, the I.R.S. also updated Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax.  Form 8805 is filed separately for each foreign partner, and if taxes have been withheld, the foreign partner must attach a copy of the Form 8805 to their U.S. income tax return to claim credit for the taxes paid on their behalf.

It is possible to extend the filing date for Forms 8804 and 8805.  However, it is astounding that the I.R.S. has delayed the publishing of these forms until less than one month before their due date.

Modifications to Section 367 in Outbound Section 304 Transactions

On February 10, 2009 the I.R.S. and Treasury Department issued temporary regulations in Treasury Decision 9444 regarding the application of Code § 367(a) and (b) with respect to Code § 304 transactions.

Code § 367(a)(1) generally provides that if a United States person transfers property to a foreign corporation in an exchange described in Code § 332, 351, 354, 356, or 361, the foreign corporation shall not be considered a corporation for purposes of determining the extent to which the United States person recognizes gain on such transfer.  Exceptions to the general rule are provided by section 367(a)(2) and (3).

Code § 367(b)(1) provides that in the case of an exchange described in section 332, 351, 354, 355, 356, or 361 in connection with which there is no transfer of property described in section 367(a)(1), a foreign corporation shall be considered to be a corporation except to the extent provided in regulations.  Regulations under Code § 367(b) generally provide that if the potential application of Code § 1248 cannot be preserved immediately following the acquisition of the stock or assets of a foreign corporation (foreign acquired corporation) by another foreign corporation in an exchange subject to Code § 367(b), then certain exchanging shareholders of the foreign acquired corporation must include in income as a dividend the Code § 1248 amount attributable to the stock of the foreign acquired corporation.

Code § 304(a)(1) generally provides that, for purposes of Code §§ 302 and 303, if one or more persons are in control of each of two corporations and in return for property one of the corporations (the acquiring corporation) acquires stock in the other corporation (the issuing corporation [i.e., the target corporation]) from the person (or persons) so in control, then such property shall be treated as a distribution in redemption of the stock of the acquiring corporation. 

To the extent Code § 301 applies to the distribution, the transferor and the acquiring corporation are treated as if (1) the transferor transferred the stock of the target corporation to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction to which Code § 351(a) applies, and (2) the acquiring corporation then redeemed the stock it is deemed to have issued.  Under section 304(b)(2), the determination of the amount of the property distribution that is a dividend (and the source thereof) is made as if the property is distributed by the acquiring corporation to the extent of its earnings and profits, and then by the target corporation to the extent of its earnings and profits.

On February 21, 2006, the IRS and Treasury Department issued final regulations (TD 9250) providing that Code § 367(a) and (b) do not apply to a deemed Code § 351 exchange resulting from a Code § 304(a)(1) transaction, stating:

The IRS and the Treasury believe that the interests of the government are protected, and the policies underlying section 367(a) and (b) are preserved, in a section 304(a)(1) transaction without regard to the application of section 367.  The IRS and Treasury believe that, in most or all cases, the income recognized in a section 304 transaction will equal or exceed the transferor's inherent gain in the stock of the [target] corporation transferred to the foreign acquiring corporation.
An underlying assumption in the 2006 final regulations was that the deemed redemption would provide basis recovery only with respect to the basis in the shares deemed issued in the deemed Code § 351 exchange.  The preamble to the 2009 temporary regulations acknowledges that certain taxpayers may be taking the position that basis recovery is allowed on the stock of the acquiring corporation other than the stock deemed issued in the Code § 304 transaction.

The I.R.S. and Treasury are currently studying whether such basis reduction is allowable.  If such basis recovery is allowable (or claimed), the 2009 temporary regulations provide that gain will be recognized.

Specifically, the 2009 temporary regulations provide an exception to the general rule of nonrecognition if the distribution is applied against and reduces (in whole or in part), pursuant to Code § 301(c)(2), the basis of stock of the foreign acquiring corporation held by the United States person other than the stock deemed issued to the United States person in the deemed Code § 351 exchange. 

The chart below depicts the deemed steps in a Code § 304 transaction.  If, in step 2b below, the taxpayer were to claim that the deemed redemption were to not only recover basis in the deemed issued shares (the blue dotted line between P and X in box 2b), but also were to recover basis in the pre-existing shares of Corp X owned by Corp P (the black solid line between P and X in box 2b), then gain would be recognized by Corp P on the outbound Code § 304 transaction.  The gain realized would reduced by the amount treated as a dividend to Corp P.

 

For a clearer image of the chart click on the chart or see  Outbound 304 Transaction

“Unrelated” Financial Institution Under U.S.-Australia Income Tax Treaty

In Interpretive Decision 2009/2, the Australian Tax Office ruled that an Australian resident taxpayer which is a payer of dividends on redeemable preference shares is “unrelated” to a U.S. resident financial institution for the purposes of Article 11(3)(b) of the U.S.-Australia Income Tax Treaty (the “Treaty”).  Article 11 of the Treaty deals with the payment of interest.  Therefore, the Australian Tax Office must have viewed the redeemable preference shares as debt for Australian tax purposes.

Under the facts of the ruling, the Australian company participated in a financing arrangement with a US financial institution in order to obtain funds at a lower cost for the Australian group of companies.  The Australian company issued redeemable preference shares to the US financial institution.

The redeemable preference shares were mandatorily redeemable 10 years after issue and included the following rights:

• the right to be paid preferential dividends, calculated by reference to an external benchmark interest rate;
• the right to exercise 10% of the voting power at the Australian company’s annual general meeting;
• the ability to appoint one member to the Australian company’s board of directors comprising five directors (with a quorum constituted by two directors). Each director ordinarily has one vote in the board’s meeting with board resolutions being passed by the majority of votes.

The Australian company makes dividend payments to the US financial institution.  Where specified events occur involving compliance with the terms of the redeemable preference shares, the director appointed by US financial institution has five votes on the board of the Australian company (with a quorum constituted by the one director appointed by US financial institution ) but only with respect to any decision or resolution to rectify the specified event.

Article 11(3) of the Treaty provides that Australia will not tax interest arising in Australia where a US financial institution is beneficially entitled to that interest (and satisfies other conditions).  Article 3(2) of the Treaty provides that any term not defined will have the meaning given under the laws of Australia relating to the taxes to which the Treaty applies, unless the context otherwise requires. The term “unrelated” is not defined in the Treaty or in Australian domestic tax law.

The Australian Tax Office ruled that, since the US financial institution has restricted voting and profit participation rights, the redeemable preference shares do not cause the Australian company and the US financial institution to be “related” within the meaning of Article 11(3)(b) of the Treaty.

It is interesting to note that the financing arrangement was structured as redeemable preference shares.  Presumably, the US financial institution was claiming that the redeemable preference shares should be treated as equity for U.S. tax purposes.

Treaty Limits on Reduced Dividend Withholding Rates for U.S. Mutual Funds

Dividend Withholding

The U.S. generally imposes a 30% withholding tax on dividends paid by U.S. corporations to nonresident aliens and foreign corporations.  This 30% rate is typically reduced to 15% under U.S. income tax treaties for residents of the treaty countries that beneficially own shares in the U.S. corporation.  Further, the withholding rate is often reduced to 5% for treaty country corporate residents that beneficially own at least 10% of the voting stock of the U.S. company paying the dividend.

Direct / Non-Direct Investments

The 10% threshold marks the dividing line used by the Department of Commerce in defining whether income from foreign assets is categorized as income from “direct investments” or income from “non-direct investments.”  The Department of Commerce defines an investment as direct when a single person owns or controls, directly or indirectly, at least 10 percent of the voting securities of a corporate enterprise or the equivalent interest in an unincorporated business.  Non-direct investments consist mostly of holdings of corporate equities and corporate and government bonds, generally referred to as “portfolio investments,” and bank deposits and loans.

Taxation of U.S. Mutual Funds

U.S. mutual funds are generally structured as “regulated investment companies” or “RICs.”  U.S. tax law generally treats a RIC as both a corporation and as an entity not subject to corporate tax to the extent it distributes substantially all of its income.  The purpose of a RIC is to allow investors to hold diversified portfolios of securities.  Dividends paid by a RIC generally are treated as dividends received by the payee, and the RIC generally pays no tax because it is permitted to deduct dividends paid to its shareholders in computing its taxable income.

Treaty Limitations on Dividends Paid by U.S. Mutual Funds

U.S. tax treaties generally deny the five-percent rate of withholding tax to dividends paid by U.S. RICs.  The 15% rate of withholding generally is allowed for dividends paid by a RIC.  This restriction is intended to prevent the use of a RIC to gain inappropriate U.S. tax benefits. 

For example, a company resident in the treaty country that wishes to hold a diversified portfolio of U.S. corporate shares could hold the portfolio directly and would bear a U.S. withholding tax of 15% on all of the dividends that it receives.  Alternatively, the company could hold the same diversified portfolio by purchasing 10% or more of the interests in a RIC.  If the RIC is a pure conduit, there may be no U.S. tax cost to interposing the RIC in the chain of ownership.  Absent the special rule, such use of the RIC could transform portfolio dividends, taxable in the U. S. at a 15% maximum rate of withholding tax, into direct investment dividends taxable at a 5% maximum rate of withholding tax.

Ireland - What’s Not to Like?

There are many reasons to like Ireland.  It is a beautiful place to visit and to live.  It has an educated, English-speaking population and many other valuable attributes.  From a tax perspective, many companies in Ireland enjoy a local income tax rate of no more than 12.5%.  This contrasts with combined U.S. federal and state corporate income tax rates of as much as 40% or more.

A low foreign income tax rate is especially attractive for publicly traded companies that can indefinitely keep their earnings outside the U.S.  For earnings per share (“EPS”) purposes, companies in these circumstances calculate tax expense on their foreign earnings based only on the foreign tax imposed. 

For instance, if $100 of pre-tax earnings is earned in the U.S., the federal and state tax expense could be $40 or more.  Thus, only $60 of earnings would be reported to shareholders for EPS purposes.  If it is possible to shift that $100 of pre-tax earnings to Ireland (and to indefinitely keep the earnings out of the U.S.), the tax expense for that income for EPS purposes declines to $12.5.  In this case, $87.5 of earnings would be reported to shareholders for EPS purposes.  By merely shifting the location of the income from the U.S. to Ireland, EPS for that item of income has increased by 46%.

The more profit that can be shifted to Ireland, the bigger the benefit.  Even better, some companies are able to shift profits to zero tax jurisdictions.  In these circumstances, the outsourcing of U.S. jobs provides a 67% increase in earnings per share for the profits outsourced.

Theoretically, the foreign earnings will be subject to U.S. tax (for book purposes and for tax purposes) when repatriated to the U.S.  However, there can be all sorts of ways to utilize the cash earned outside the U.S.  Foreign acquisitions is one example.  In fact, foreign acquisitions may be “cheaper” than U.S. acquisitions because U.S. acquisitions require the cash to be repatriated to the U.S., thereby triggering a tax cost.

Even with foreign acquisitions and other strategies to utilize the foreign cash, some companies build up large amounts of cash outside the U.S.  In 2004, however, Congress came to the rescue with the enactment of Code § 965.  Under this new provision, these companies were allowed to repatriate cash to the U.S. during a window period where they could deduct 85% of the dividends received.  During this window period, approximately $312 billion was repatriated to the U.S.

Undoubtedly, many of the same companies have again built up foreign cash and are yearning for another gift from Congress.

Foreign Bank Secrecy & Tax Evasion

On July 17, 2008, in conjunction with a hearing regarding Tax Haven Banks and U.S. Tax Compliance, the Permanent Subcommittee on Investigations of the U.S. Senate released a report (the “Subcommittee Report”) that reads like a spy novel.  The Subcommittee Report reviews the “global tax scandal” related to LGT Bank in Liechtenstein, and the “international tax scandal” related to UBS AG in Switzerland.

The LGT scandal erupted after a former employee of a Liechtenstein trust company provided tax authorities around the world with data on about 1,400 persons with accounts at LGT.  The UBS AG scandal broke when the U.S. arrested a private banker formerly employed by UBS AG on charges of having conspired with a U.S. citizen and a business associate to defraud the IRS of $7.2 million in taxes owed on $200 million of assets hidden in offshore accounts in Switzerland and Liechtenstein.

LGT Bank in Liechtenstein

LGT Bank in Liechtenstein is owned and controlled by the royal family in Liechtenstein.  According to the Subcommittee Report:

LGT employed practices that could facilitate, and in some instances have resulted in, tax evasion by U.S. clients.  These LGT practices have included maintaining U.S. client accounts which are not disclosed to U.S. tax authorities; advising U.S. clients to open accounts in the name of Liechtenstein foundations to hide their beneficial ownership of the account assets; advising clients on the use of complex offshore structures to hide ownership of assets outside of Liechtenstein; and establishing “transfer corporations” to disguise asset transfers to and from LGT accounts.  It was also not unusual for LGT to assign its U.S. clients code words that they or LGT could invoke to confirm their respective identities.  LGT also advised clients on how to structure their investments to avoid disclosure to the IRS . . . .

For many of its U.S. clients, LGT helped establish one or more Liechtenstein foundations.  Under U.S. tax law, the IRS generally views Liechtenstein foundations as foreign trusts.  U.S. persons with an interest in a foreign trust, including a Liechtenstein foundation, are required to disclose the existence of the trust to the IRS by filing Forms 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) and 3520-A (Annual Information Return of Foreign Trust With a U.S. Owner).  Financial penalties for failing to file these forms can be confiscatory.

The foundations provided strong secrecy protections and yet gave substantial control over the foundations to their beneficial owners.  In one case, a U.S. citizen pretended to sell his home in New York to what appeared to be an unrelated party from Hong Kong.  In fact, the buyer was a British Virgin Islands company with a Hong Kong address, and it was wholly owned by a Bahamian corporation which was, in turn, wholly owned by the U.S. citizen’s Liechtenstein foundation.

The foundations often would not name the grantor or his/her family members as beneficiaries.  Instead, the foundation instruments would include a complex mechanism providing for the naming of beneficiaries.  Despite these mechanisms, internal LGT documents were clear as to the the true beneficiaries of the foundation.

At times, LGT would set up for the foundation what LGT has sometimes referred to as a “transfer corporation” to help disguise asset flows into and out of a foundation’s accounts.  This transfer corporation acts as a pass-through entity that breaks the direct link between the foundation and other persons with whom it is exchanging funds, making it harder to trace those funds.

A strategy employed by LGT to enhance secrecy and client anonymity was to limit the ability of outside parties to trace client communications back to Liechtenstein.  To achieve this objective, LGT not only instituted a policy of retaining client mail at the bank in Liechtenstein, or sending mail to locations outside of a client’s home jurisdiction, but also undertook efforts to minimize the ability of outside parties to trace telephone calls back to the bank and even the country itself.  One LGT document, for example, providing information on how to contact a client, instructed that calls should be made only from public phone booths outside of Liechtenstein.

The Subcommittee Report stated:

These LGT accounts together portray a bank whose personnel too often viewed LGT’s role as, not just a guardian of client assets or trusted financial advisor, but also a willing partner to clients wishing to hide their assets from tax authorities, creditors, and courts.  In that context, bank secrecy laws have served as a cloak not only for client misconduct, but also for bank personnel colluding with clients to evade taxes, dodge creditors, and defy court orders.

UBS AG

UBS AG of Switzerland is one of the largest financial institutions in the world, and has one of the world’s largest private banks catering to wealthy individuals.  From at least 2000 to 2007, UBS made a concerted effort to open accounts in Switzerland for wealthy U.S. clients, employing practices that could facilitate, and have resulted in, tax evasion by U.S. clients.  These UBS practices included maintaining for an estimated 19,000 U.S. clients “undeclared” accounts in Switzerland with billions of dollars in assets that have not been disclosed to U.S. tax authorities, and assisting U.S. clients in structuring their accounts to avoid U.S. tax reporting requirements.

UBS assured its U.S. clients with undeclared accounts that U.S. authorities would not learn about them, because the bank is not required to disclose them; UBS procedures, practices and services protect against disclosure; and the account information is further shielded by Swiss bank secrecy laws.  In November 2002, for example, senior officials in the UBS private banking operations in Switzerland sent a letter to U.S. clients about their Swiss accounts which states in part:

“[W]e should like to underscore that a Swiss bank which runs afoul of Swiss privacy laws will face sanctions by its Swiss regulator … [I]t must be clear that information relative to your Swiss banking relationship is as safe as ever and that the possibility of putting pressure on our U.S. units does not change anything. . . .

The Subcommittee Report indicated that UBS also provided training to its client advisors on how to detect -- and avoid – surveillance by U.S. customs agents and law enforcement officers.  A UBS training document provides a series of scenarios designed to train its personnel.  An excerpt from one of the scenarios is as follows:

After passing immigration desk during your trip to USA/Canada, you are intercepted by the authorities. By checking your Palm, they find all your client meetings. Fortunately you stored only very short remarks of the different meetings and no names.

As you spend around one week in the same hotel, the longer you stay there, the more you get the feeling of being observed. Sometimes you even doubt if all of the hotel employees are working for the hotel. A lot of client meetings are held in the suite of your hotel.

One morning you are intercepted by an FBI-agent.  He looks for some information about one of your clients and explains to you, that your client is involved in illegal activities.

Question 1: What would you do in such a situation?

Question 2: What are the signs indicating that something is going on?

The document does not indicate UBS’ preferred responses to these questions.

The Subcommittee Report is 110 pages long and has many more details of the practices and procedures of LGT and UBS.  UBS is currently under investigation by the SEC, IRS, and Department of Justice.