Monthly Tax Roundup (Volume 1, Issue 4)
Welcome to the fourth edition of Miller & Chevalier's Monthly Tax Roundup, providing you a quick overview of the most significant tax developments from the past month. In addition to a slew of developments at the IRS and on Capitol Hill, there have been a number of interesting judicial decisions to highlight.
"A tax loophole is something that benefits the other guy. If it benefits you, it is tax reform."
-Russell B. Long, former U.S. Senator
Tax Fact: According to the Tax Foundation, the average statutory corporate income tax rate across 180 jurisdictions, is 23.54 percent. Among OECD nations, the average is slightly lower at 23.04 percent.
Tax Court Rejects Section 199 Online Software Claim
The section 199 deduction for domestic production activities (DPAD), continues to be a source of controversy notwithstanding its repeal in 2017. Taxpayers claiming the deduction for online software have frequently been challenged by the IRS, often with the assertion of penalties. In BATS Global Markets Holding, Inc. v. Commissioner, 158 T.C. No. 5 (Mar. 31, 2022), the Tax Court issued the first court decision concerning online software under section 199. BATS addressed whether fees the taxpayer charged for access to its online software qualified for the section 199 deduction under the online software regulations set forth in Treas. Reg. § 1.199-3(i)(6).
For background, section 199 provided a deduction based on income derived from the disposition of qualifying production property. Congress intended the section 199 deduction to apply to the production of tangible personal property, not the provision of services. Section 199 explicitly includes the production of "any computer software" as qualifying production property. IRC § 199(c)(5)(B). Notably, the statute does not indicate any limitation on the deduction based on whether the software is provided online as opposed to on a tangible medium like a disk. But notwithstanding the general language in the statute, Treasury decided to impose restrictions on the applicability of section 199 to online software. Specifically, Treas. Reg. § 1.199-3(i)(6)(ii) excludes income from "online services (such as Internet access services, online banking services, providing access to online electronic books, newspapers, and journals), and other similar services" from qualifying for the section 199 deduction. Treas. Reg. § 1.199-3(i)(6)(iii) creates an exception for online access to software if the taxpayer also sells the same software on a tangible medium or via download or if a third party sells "substantially identical software" in that fashion. The dispute in BATS focused on these regulatory provisions.
BATS operated exchanges for national securities markets and claimed section 199 deductions for three categories of fees related to software it developed to operate those exchanges. Logical port fees were charged to provide access to the BATS communications network, which validated customer orders and forwarded those orders to a matching engine. Routing fees were charged for the routing and trade execution services performed for customers. Transaction fees were charged for participation in electronic markets facilitated by BATS software. BATS did not sell its software on a tangible medium or via download but identified third parties who used those methods to sell trading software that BATS contended was substantially identical to its own software. The IRS contended that BATS merely provides access to online software and that the third-party software on which BATS relied was not substantially identical. The court found in favor of the IRS on both grounds.
The court held that Treas. Reg. § 1.199-3(i)(6)(ii) precluded these fees from qualifying for the section 199 deduction and that the taxpayer "did not provide its customers direct access to its software as defined in the Code and the regulations." Rather, the fees were charged for "access to [BATS's] communications network." Analogizing to examples in the regulations concerning access to online auction software or telecommunications services, the court said that the fees were paid for trade execution services, not the disposition of software, and therefore did not qualify for the section 199 deduction.
In the alternative, the court held that the third-party software on which BATS relied were not "substantially identical" to the BATS software and therefore did not satisfy the exception in Treas. Reg. § 1.199-3(i)(6)(iii)(B). The court held that for purposes of the "substantially identical" standard, the functionality of the third-party software must be evaluated from the perspective of the customer. The court determined, based on the facts before it, that BATS "had fundamentally different relationships with their customers with regard to the operation of a securities exchange" than the third parties did via their software products. Those third-party products were therefore not "substantially identical" to the BATS software and BATS could not satisfy the Treas. Reg. §1.199-3(i)(6)(iii)(B) exception.
While the BATS decision is noteworthy as the first court decision on a section 199 online software dispute, its effect on other such cases is unclear. Section 199 disputes turn on the specific facts and circumstances of each particular taxpayer. Different facts, elicited through fact and expert testimony at trial, may result in different outcomes even when the different taxpayers seem to be similarly situated. Compare, e.g., ADVO, Inc. v. Comm'r, 141 T.C. 298 (2013) (denying section 199 deduction for publisher) with Meredith Corp. v. United States, 447 F. Supp. 3d 805 (S.D. Iowa 2020) (allowing section 199 deduction for publisher). Thus, as a practical matter, BATS may have little effect on other pending cases with different facts, particularly if those cases are litigated in a refund forum as opposed to the Tax Court. Further, no court has considered whether the regulatory distinction between online software and software on a tangible medium, which appears nowhere in the statutory text of section 199, may be invalid. The obsolescence of the regulatory framework, designed for a time when most software was sold on disks rather than accessed online, may lend support to such an argument. While the IRS will doubtlessly assert that every section 199 online software dispute is exactly like BATS, taxpayers should be careful to emphasize their particular facts that differentiate them from that decision.
In FDII Advice Memorandum, IRS Reverses Course in the Treatment of Deferred Compensation Expense
The IRS recently issued a Chief Counsel Advice Memorandum in which it concluded that a taxpayer's foreign-derived intangible income (FDII) deduction must be reduced by deferred compensation expense attributable to services provided in years prior to the effective date of FDII. This analysis in the memorandum reflects a change of course for the IRS, which had concluded in prior guidance in 2009 and 2017 that expenses that related to years prior to the effective date of prior law section 199 were allocated and apportioned based on a factual relationship between the prior year expense and the taxpayer's section 199 income in the current year. Companies that claim the FDII benefit and have these types of expenses need to evaluate the impact of the new IRS position. For more information, see our Tax Alert.
Tenth Circuit Affirms Harsh Tax Court Decision in Micro-Captive Case
In Reserve Mechanical Corp. v. Commissioner, No. 18-9011 (10th Cir. May 13, 2022), the Tenth Circuit Court of Appeals affirmed a Tax Court decision holding that Reserve Mechanical was not qualified for tax-exempt status as a small insurance company under section 501(c)(15) because it was not engaged in the business of insurance. In an extraordinarily detailed opinion, the court upheld the Tax Court's decision concluding that Reserve Mechanical had not adequately distributed risk among a group of insureds and that the reinsurance pooling arrangement was not insurance. In addition, the court found that the policies issued by Reserve Mechanical were not insurance in the commonly accepted sense. Rather, the court held that Reserve Mechanical, which was incorporated in Anguilla, British West Indies, was a foreign corporation subject to the 30 percent tax on fixed, determinable, annual, or periodical (FDAP) income from within the United States under section 881(a).
Reserve Mechanical argued that its participation in an insurance pool arrangement resulted in the distribution of risk among multiple insureds. Reserve Mechanical was managed by Capstone Associates, Ltd. (Capstone), which also managed PoolRe Insurance Corp. (PoolRe). PoolRe sold stop-loss coverage to the insureds that also bought direct coverage from the captive insurance companies managed by Capstone and coinsured vehicle-service insurance contracts with another insurance company. Reserve Mechanical participated in the PoolRe insurance pool by reinsuring the stop-loss coverage provided by PoolRe and PoolRe's risk under the coinsurance contracts. The court affirmed the Tax Court's holding that Reserve Mechanical did not distribute risk through its participation in the pool arrangement. The court held that Reserve Mechanical's reinsurance of PoolRe's stop-loss coverage was not bona fide insurance because the terms of the reinsurance agreement were such that Reserve Mechanical bore no meaningful risk of loss. Similarly, the court held that Reserve Mechanical's reinsurance of PoolRe's coinsured vehicle-service contracts was not bona fide insurance because Reserve Mechanical assumed a de minimis amount of risk too small to constitute actual risk.
The Tenth Circuit also affirmed the Tax Court's ruling that Reserve Mechanical's policies were not insurance in the commonly accepted sense. In particular, the court addressed three challenges raised by the taxpayer on appeal. On each point, the court affirmed the conclusions of the Tax Court. First, the court held that the Tax Court did not err in concluding that the policies provided only excess coverage. Second, the court held that Reserve Mechanical's premiums were unreasonable and not negotiated at arm's length. And third, the court held that there were irregularities in the operations of Reserve Mechanical, including in the processing of its only claim, and seemed troubled by some inconsistencies in the testimony regarding the involvement and knowledge of Reserve Mechanical's management.
Finally, the court rejected Reserve Mechanical's alternative argument that, if it is not an insurance company, the payments it received should not be FDAP income but should be nontaxable contributions to capital. The court stated that the most important factor in determining whether a payment should be treated as a contribution to capital is the motive of the payor. The court held that there was no dispute that the insureds did not intend their payments to Reserve Mechanical to be contributions to capital.
While the court noted that the Tax Court's ruling was limited to the facts of this case and that the Tax Court did not criticize risk pools as a general matter, the decision is not favorable for taxpayers. The court's ruling that Reserve Mechanical must include the payments in income notwithstanding the fact that it did not provide insurance is a particularly harsh result. While the IRS concession in the Puglisi case at the end of 2021 signaled a willingness on the part of the IRS to accept that micro-captive arrangements can be valid for federal tax purposes, this decision does very little to advance the position of other micro-captive insurance transactions in future controversies. See Puglisi v. Comm'r, Docket No. 4796-20, 4799-20, 4826-20, 13487-20, 13488-20, 13489-20 (U.S. Tax Court Nov. 5, 2021).
Tax Court Order Wrestles with Subject Matter Waiver
In a recent pre-trial order in Anadarko Petroleum Corp. v. Commissioner, Dkt. 23018-18, 23019-18 (May 13, 2022), the Tax Court ruled that the previous disclosure of privileged communications did not result in a subject matter waiver that would extend to undisclosed privileged communications. The taxpayer had previously submitted privileged communications in an earlier bankruptcy proceeding believing them to be covered by a protective order. The IRS argued that this disclosure effectively waived privilege for other communications concerning the same subject matter. In ruling on the question, the Tax Court looked to Federal Rule of Evidence (FRE) 502, which narrows the circumstances in which a disclosure of privileged communications triggers a subject matter waiver. Under FRE 502(a), when there is a disclosure of a privileged communication in a federal proceeding or to a federal agency like the IRS that results in a waiver, such waiver will extend to other undisclosed communications only if the waiver is intentional, the undisclosed communications concern the same subject matter, and fairness requires that they be considered together. The Tax Court ruled here that the disclosure of privileged communications in the prior bankruptcy case was not an intentional waiver of the subject matter covered by those documents. Therefore, the subject matter waiver did not apply to the undisclosed communications at issue in the proceeding. FRE 502 offers significant protection from the traditional rules governing the waiver of privilege and the company was successful in invoking it here, but this case is a useful reminder of its scope.
In Person Appeals Conferences Returning Soon
IRS Appeals personnel are expected to return to the office starting June 25, 2022, although some flexibility will remain for some telework. At the recent meetings of the American Bar Association (ABA) Tax Section, Chief of the IRS Independent Office of Appeals Andy Keyso confirmed that in-person conferences will be available for any taxpayer that requests one after that date. At one point, the policy of Appeals was to offer an in-person conference only if certain requirements were met. Even before the pandemic, Keyso had changed the policy so that a taxpayer could have an in-person conference if desired. The Internal Revenue Manual (IRM) currently reflects that the setting for an Appeals conference is at the option of the taxpayer: "Taxpayers have multiple conference options including holding the conference by telephone, correspondence, in person or virtually (for example, WebEx videoconferencing software and Virtual Service Delivery (VSD)). Appeals may use other technologies as they become available." IRM 188.8.131.52.1(1).
IRS Issues Updated Guidance on Economic Substance, Lowering Bar for Exam to Assert Doctrine During Exams
On April 22, 2022, the IRS Large Business & International Division (LB&I) issued updated guidance (effective immediately) to all LB&I and Small Business/Self-Employed (SB/SE) examiners and managers on the assertion of the economic substance doctrine and related penalties. Section 7701(o), which was codified in 2010, clarifies that transactions "to which the . . . doctrine is relevant" must have economic substance and a business purpose. If either condition is not met, the taxpayer will be subject to a 20 percent strict liability penalty on any underpayment attributable to the disallowed tax benefit claimed (or 40 percent if the transaction is not disclosed). See also Section 6662(b)(6), (i).
Since the codification of the doctrine, IRS executive approval has been required before Exam could raise the economic substance doctrine and assert economic substance penalties under sections 6662(b)(6) and 6662(i). The IRS updated guidance removes these requirements with the stated goal of aligning the economic substance penalties with other assessable penalties that do not require executive approval. The new guidance did not, however, remove the requirement under section 6751(b) that the penalties must be personally approved in writing by the immediate supervisor of the person who initially determines the penalty.
The updated guidance is being incorporated into the IRM. For instance, old IRM Exhibit 4.46.4-4 included a four-step process for determining whether to assert the doctrine. This process included submission of a written request to the Director of Field Operations (DFO) and a requirement that the DFO provide the taxpayer an opportunity to explain their position. The updated IRM exhibit removes these requirements (as well as the four-step process), though it states that an examiner must still consult with local field counsel before proceeding in making an economic substance argument if the issue is novel, significant and/or will require significant resources to address. Updated IRM Exhibit 4.46.4-4 also removes some considerations (which were listed in the old exhibit) that indicate when application of the doctrine is "likely not appropriate," including, for instance, if the transaction is related to the choice between capitalizing a business with debt or equity or the choice to utilize a related-party entity in a transaction, provided that section 482's arm's length standard is satisfied.
The new IRS guidance appears to lower the bar for exam to make economic substance arguments, though it is yet to be seen if agents will raise economic substance arguments or assert related penalties with increased frequency and with less taxpayer interaction.
Wyden and Portman Introduce Legislation to Deny Foreign Tax Credits and Other Tax Benefits for Companies Operating in Russia and Belarus
On May 12, Senators Ron Wyden (D-OR) and Rob Portman (R-OH) introduced the "Support Ukraine Through Our Tax Code" Act to the Senate to deny foreign tax credits and deductions for taxes paid to Russia or Belarus. Largely mirroring the draft language circulated in April, the bill amends section 901(j) to deny foreign tax credits for taxes paid to Russia or Belarus until normal trade relations resume under the Suspending Normal Trade Relations with Russia and Belarus Act. In a change from the prior draft proposal, the denial of credits will be imposed 90 days, as opposed to 30 days, after the bill's enactment. The bill also specifically amends section 275 to deny a foreign tax deduction for taxes paid to Russia or Belarus, also effective 90 days after the bill's enactment.
Under the bill, income earned in Russia or Belarus would be treated as subpart F income and taxed at the full corporate rate under section 952(a)(5) and taxes paid to Russia or Belarus would be included in a U.S. shareholder's income under the section 78 gross-up. The bill provides for a transition rule for taxpayers exiting Russia and Belarus, whereby income derived in Russia or Belarus is not treated as per se subpart F income (and therefore losses can be used to offset GILTI income), provided that the taxpayer meets certain gross receipts tests (requiring that the gross receipts of the taxpayer and affiliates derived from Russia and Belarus decline by at least 85 percent in 2022 and 95 percent in 2023 and later compared to gross receipts earned in Russia or Belarus in 2021).
Consistent with the draft legislation released in April, the bill also denies certain tax benefits denied to persons already sanctioned in relation to the invasion of Ukraine, including denial of tax treaty benefits, the exemption from withholding for foreign governments or portfolio interest, exemption of shipping and Foreign Investment in Real Property Tax Act (FIRPTA) income, the availability of the trading safe harbor under section 864(b), and (in a new addition to the list) the exemption from withholding for a foreign central bank under section 895.
The bill provides that these provisions would apply without regard to any treaty obligations of the United States.
Companies would be well advised to consider the potential impact of the proposed legislation, in particular the scope of relief under the transition rule for companies exiting Russia and Belarus.
Consideration Turns to a Lame Duck Tax Package Given Legislative Uncertainty
As both houses of Congress return from the Memorial Day recess next week, consideration of a potential tax title for the China competition bill as well as some revised form of the Build Back Better Act (BBBA) will continue – although it is unclear what the future holds for both pieces of legislation at this time. Given this uncertainly, policymakers have started to consider a potential path forward on a lame duck tax package. Such a package has the potential to attract a number of tax provisions, including Tax Cuts and Jobs Act-related changes (such as the popular research and development (R&D) amortization fix), retirement savings legislation, tax extenders and other items that enjoy bipartisan support.
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