Monthly Tax Roundup (Volume 1, Issue 1)
Welcome to Miller & Chevalier's Monthly Tax Roundup, a monthly update designed to provide readers with a quick overview of the most significant recent tax developments. We'll provide highlights across the tax spectrum, including tax controversy, tax planning, and tax policy.
Final FTC Regulations Put Creditability of Foreign Taxes at Risk
New foreign tax credit regulations will lead to double taxation for U.S. taxpayers in many scenarios. These rules deny foreign tax credits for foreign taxes that were clearly creditable under prior law and raise practical and interpretive issues for taxpayers in routine fact patterns. Under the new rules, a foreign tax credit is available only for foreign income taxes that conform closely to U.S. tax law, including with respect to the application of the arm's length principle, the allowance of deductions, and the sourcing of income earned by non-residents. In particular, withholding taxes on services and royalties imposed on the basis of the residence of the payor or on a similar basis will not be creditable except when imposed directly on a U.S. taxpayer that benefits from a U.S. tax treaty that permits a credit. Such taxes are common outside of the U.S. tax treaty network. Taxpayers will have to evaluate the creditability of foreign taxes to which they are subject and consider whether it is possible to mitigate or avoid the negative outcomes under the rules. See our alert here.
IRS Takes New, Burdensome Position on R&D Credit Refund Claims
A recent Field Advisory Memo articulated a novel position on what constitutes a valid refund claim for the research and development (R&D) credit, asserting that taxpayers must provide voluminous records with the initial claim in order for the claim to even be considered. Read more about the memo here.
Internal Revenue Service (IRS) agents were instructed to enforce these standards on any amended return filed on or after January 10, 2022 and would give taxpayers a chance to perfect any deficient claims during one-year transition period. While the memo's guidance is limited to R&D credit claims, query whether the IRS will take a similar position with respect to other types of refund claims.
The memo's guidance has been supplemented by frequently asked questions (FAQs) posted to the IRS website, the most recent set being posted on February 8, 2022. More guidance should be expected and taxpayers would be prudent to monitor the FAQs for further developments. IRS officials defended the position at the recent American Bar Association Tax Section Meeting, arguing that the memo contained nothing new. Nevertheless, these requirements represent an onerous new burden on taxpayers that wish to claim an additional R&D credit on an amended return.
IRS Introduces Fast-Track PLR Program
The IRS recently announced a new pilot program for fast-track processing of corporate private letter ruling (PLR) requests, under which the IRS will aim to issue a ruling in 12 weeks. We are hopeful that the fast-track program will enable taxpayers to obtain certainty on the tax treatment of transactions in a timely manner.
The fast-track process is available for PLR requests that are solely under the jurisdiction of the Associate Chief Counsel (Corporate) (e.g., corporate reorganizations and spin-offs). Taxpayers may receive fast-track processing for PLR requests that are primarily under the jurisdiction of Corporate and that also include a ruling that falls under the jurisdiction of another Associate office if the other office agrees to fast-track processing. To apply for fast-track processing, a taxpayer must first request a pre-submission conference to address the substantive issues and the fast-track request. In determining whether to grant fast-track processing, the IRS will consider all facts and circumstances, including the complexity of the proposed transactions, the issues presented, and other obligations of the attorneys assigned to process the request.
Taxpayers in the fast-track program must comply with additional procedural requirements. For example, the PLR request itself must include a draft PLR that includes a legend of defined terms and a description of relevant facts, representations, requested rulings, and administrative matters. The taxpayer must also agree to provide any additional information requested by the IRS within seven business days of the request.
Although the fast-track procedures require the taxpayer to state its reasons for requesting fast-track processing, IRS officials have indicated that they do not intend to evaluate the sufficiency of these reasons. In addition, taxpayers may request a period shorter than 12 weeks for processing if there is "real business need" and if the IRS is able to accommodate the request. Taxpayers requesting a period shorter than 12 weeks, however, will be expected to substantiate a business exigency outside the taxpayer's control or adverse consequences to the taxpayer or other persons and must demonstrate that the request was submitted as promptly as possible after becoming aware of such circumstances. This fast-track program is similar to the 10-week expedited ruling pilot program that Corporate introduced in 2005.
Tax Court Considers Economic Performance and Deferred Compensation
The Tax Court recently sided with the IRS in a case involving the sale of a National Basketball Association (NBA) team — the Memphis Grizzlies — and the interaction of tax accounting rules and deferred compensation rules. See Hoops, LP v. Commissioner, T.C. Memo. 2022-9. The buyer had assumed certain player contracts with deferred compensation obligations. The seller had included the liability assumption in the amount realized and claimed an offsetting deduction based on Treas. Reg. § 1.461-4(d)(5), which provides that economic performance occurs with respect to a liability assumed in connection with the sale or exchange of a trade or business as the liability is included in the amount realized. The IRS conceded that economic performance had occurred and that the deferred compensation liability had been incurred for section 461 purposes. However, the IRS asserted that another Code provision — section 404(a)(5) — controls the way this incurred liability is taken into account for federal income tax purposes and defers a deduction until the taxable year in which the deferred compensation is included in the recipient's gross income.
In holding for the IRS, the Tax Court agreed that "it is the section 404(a)(5) limitation as to the amount deductible for any year that precludes deduction for the year of the 2012 sale, not any purported failure to satisfy the economic performance requirement." The Tax Court also rejected the petitioner's argument that in the absence of a current deduction for the deferred compensation liability, clear reflection principles and case law require excluding the liability assumption from the seller's amount realized.
A sale or exchange of a trade or business often raises issues regarding the deductibility of amounts for which economic performance has not yet occurred. Taxpayers facing these issues should remember that while Treas. Reg. § 1.461-4(d)(5) can provide for economic performance, other Code provisions or Treasury regulations may nevertheless defer or deny a current deduction.
Sixth Circuit Case in Whirlpool Has Implications for Branch Structures
The Sixth Circuit is currently considering the taxpayer's motion for rehearing en banc in Whirlpool Financial Corp. v. Commissioner. In December 2021, the Sixth Circuit in a 2-1 decision affirmed the Tax Court's opinion that income derived by a controlled foreign corporation (CFC) was foreign base company sales income (FBCSI) under the Subpart F branch rule. Whirlpool had claimed that income earned by its Luxembourg CFC from the sale of products was not FBCSI. The Luxembourg CFC owned a Mexican disregarded entity that manufactured those products for a service fee. Under the Luxembourg-Mexico tax treaty and the Mexico Maquiladora incentive regime, the Luxembourg CFC's income from selling the products was attributable to a permanent establishment in Mexico but was not taxed in Mexico. Whirlpool argued that the income of the Luxembourg CFC was not FBCSI under the branch rules of section 954(d)(2) because the manufacturing branch regulations promulgated under section 954(d)(2) either impermissibly interpreted the governing statute or by their terms did not apply.
In affirming the Tax Court's opinion, the Sixth Circuit's majority opinion surprisingly ignored the section 954(d)(2) regulations entirely. Instead, the majority held that under the terms of the statute, once it was determined that the income met the requirements of the statutory branch rule of section 954(d)(2), that income was FBCSI and no separate analysis of the rest of the statute or the governing regulations was necessary. As noted in the dissent, this interpretation is contrary to the regulations and the IRS's longstanding positions. Indeed, if applied literally and without context, the analysis in Sixth Circuit's majority opinion would result in FBCSI in many common fact patterns.
Taxpayer Sustains Deduction for Punitive Damages
In a recent district court decision, Altria Group, Inc. v. United States, the court upheld the taxpayer's deduction under the pre-2018 section 162(f) relating to relating to deductibility of fines and penalties. While the Tax Cuts and Jobs Act of 2017 (TCJA) meaningfully modified section 162(f) starting in 2018, pre-2017 section 162(f) continues to have relevance and the court helpfully relied on language in the 2017 amendment to section 162(f) that provides that the disallowance does not apply in suits in which no governmental entity is party.
As background to the case, a plaintiff had sued Altria's subsidiary in an Oregon court alleging misrepresentation and negligence. The jury awarded damages, including punitive damages relating to the misrepresentation claim. Under Oregon law, a portion of any punitive damages award must be paid to a state fund for crime victims. Therefore, in 2012, Altria paid over $47.7 million in punitive damages, $26.5 million of which went to Oregon. Altria deducted the entire amount of the punitive damages. On audit, the IRS disallowed the deduction for the $26.5 million that went to Oregon under section 162(f). Altria paid the resulting tax due and then sued for refund in District Court (E.D. Va.).
As in effect in 2012, section 162(f) denies a deduction for "any fine or similar penalty paid to a government for the violation of any law." In 2017, section 162(f) was expanded to deny a deduction for any amount arising from a violation (or potential violation) of the law and paid to the government. However, section 162(f)(3) now explicitly exempts amounts paid for suits "in which no government or governmental entity is a party."
The court held that the portion of the punitive damage award paid to the Oregon was not a fine or similar penalty for a violation of law (under pre-2018 version of section 162(f)). In its analysis, the court determined that "the origin of the liability" to the state was the split recovery statute, not "the punitive damage award made, and reflected in, the … jury verdict." The court also cited the 2017 amendments to section 162(f)(3), finding that the limitation is "implied in the 2012 version" of the statute as well.
The court also considered the purpose of split recovery statute and determined that purpose was to redirect amounts to the state crime victims' fund; although the punitive damages award is a "punishment," the split recovery statute itself does not act to punish the party against whom the punitive damage award was made.
Congress Moves to Other Priorities with Build Back Better Act on Hold
As the Biden administration and congressional Democrats continue to determine a path forward on the Build Back Better Act (BBBA), Congress has moved on to address a host of other legislative priorities. Congress has turned its attention to government funding (which currently expires on March 11) and the China competitiveness bill, as well as potential action on additional COVID-19 relief, postal reform, electoral college reform, and legislation addressing the situation in Ukraine. Also looming is the anticipated partisan battle over President Biden's nomination to the Supreme Court. While Congress addresses these important issues, it is hoped that policymakers will consider including time-sensitive tax legislation, such as extenders, the requirement to amortize R&D expenditures that went into effect at the beginning of this year, and the pending phase-out of 100 percent bonus depreciation in any moving legislative vehicle. Whether the continued consideration of BBBA, which may last throughout much of the year, tempers the willingness to do so is yet to be seen.
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