Monthly Tax Roundup (Volume 1, Issue 5)
Welcome to the fifth edition of Miller & Chevalier's Monthly Tax Roundup. We greatly appreciate your readership and the thoughtful and enthusiastic feedback we have received so far. Our goal is to provide a quick overview of the most significant legislative, administrative, and judicial tax developments from the past month. This month is no different – although the tax legislative agenda is on a bit of a pause as Build Back Better Act (BBBA) negotiations continue, the Internal Revenue Service (IRS), the Treasury Department, and the courts have been quite active with a slew of interesting guidance and judicial decisions to report on.
"What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin." - Mark Twain, author
"It is a way to take people's wealth from them without having to openly raise taxes. Inflation is the most universal tax of all." -Thomas Sowell, economist
District Court Pulls Back APA Relief in Micro-Captive Case
In a long-running challenge under the Administrative Procedure Act (APA), a U.S. federal district court in CIC Services, LLC v. IRS, No. 3:17-cv-110 (E.D. Tenn.), has scaled back the remedy it previously granted when it held micro-captive transaction reporting requirements triggered under Internal Revenue Service (IRS) Notice 2016-66 could not be enforced. As previously reported, the district court ruled in March that the government had improperly failed to follow the APA notice-and-comment requirements. Under the APA, the court was required to "hold unlawful and set aside" agency actions that are "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law." On that basis, the court vacated Notice 2016-66 and issued an injunction requiring the IRS to return to taxpayers and material advisors all information and documents collected pursuant to the notice. The court has now granted the government's motion for reconsideration of this injunctive relief.
In its motion for reconsideration, the government did not challenge the court's finding that Notice 2016-66 must be set aside for failure to follow APA procedures. Rather, the government argued that the district court lacked the authority to order the IRS to return information and documents obtained from taxpayers and material advisors other than those that were parties to the case. Noting that the plaintiff in CIC Services did not seek to file their case as a class action, the court concluded it was not authorized to grant injunctive relief on behalf of non-parties.
Based as it was on the Sixth Circuit's recent decision in Mann Construction, Inc. v. United States, 27 F.4th 1138 (6th Cir. 2022) (covered here), the underlying ruling that Notice 2016-66 is invalid is unlikely to be disturbed on appeal, but interesting questions remain for taxpayers and material advisors in other jurisdictions seeking to challenge the notice or penalties imposed for noncompliance. As things stand, the IRS can continue to assert penalties for failure to report micro-captive transactions against taxpayers and material advisors outside the Sixth Circuit. Unless the IRS concedes the invalidity of Notice 2016-66 for all, taxpayers and advisors in other jurisdictions may decide to bring additional pre-enforcement challenges to Notice 2016-66, or file claims for refund for any penalties already assessed and paid. In any event, given its well-known skepticism about many micro-captive transactions, the IRS is unlikely to give these transactions a pass.
Other APA Developments
The unlikelihood of the government conceding the invalidity of IRS notices like those at issue in Mann Construction and CIC Services for all taxpayers and material advisors is evidenced in the ongoing dispute in GBX Associates LLC v. United States. There, a real estate firm is challenging the validity of Notice 2017-10 (which designates syndicated conservation easements as "listed transactions") because the IRS did not follow the APA notice-and-comment procedures. No. 1:22-cv-00401 (N.D. Ohio filed Mar. 11, 2022). While the government conceded in its answer that Notice 2017-10 is unlawful in the Sixth Circuit for failure to comply with the APA under Mann Construction, the parties disagree on the proper relief, which is the subject of cross-motions for summary judgment filed last month. See No. 1:22-cv-00401, ECF Nos. 17 and 18. The plaintiff contends that the notice should be vacated in whole, while the government argues that the proper relief is for the court to set aside the notice as to GBX only, maintaining that the government should still be able to argue in cases outside the Sixth Circuit that Mann Construction was wrongly decided and that the notice is valid. The government has raised those arguments in federal district court in the Eleventh Circuit where the validity of Notice 2017-10 is also in controversy. See Green Rock, LLC v. IRS, No. 2:21-cv-1320, ECF No. 31 (N.D. Ala. June 13, 2022).
In other news relating to recent APA challenges in the tax context, the petitioner-appellant in Oakbrook Land Holdings, LLC v. Commissioner petitioned the Sixth Circuit for an en banc rehearing following the court's March opinion upholding the validity of a conservation easement regulation under the APA. See 28 F.4th 700 (6th Cir. 2022) (covered here). The two-judge majority opinion in Oakbrook reached a different conclusion than the Eleventh Circuit which held in Hewitt v. Commissioner, 21 F.4th 1336 (11th Cir. 2021), that the regulation at issue in Oakbrook is procedurally invalid under the APA. Warning that the Sixth's Circuit "panel majority set an unprecedentedly low bar for APA compliance" that "threatens to embolden Treasury and the IRS to issue rules without providing explanations and without considering public feedback," Oakbrook is requesting consideration by the full court.
Tax Court Questions Statutory Authorization for Decades-Old Revenue Procedure on Software Development Costs
In Kellett v. Commissioner, T.C. Memo. 2022-62, the Tax Court held that certain costs an individual incurred in developing a website for a new business venture predated an active trade or business and so constituted start-up expenditures for which Section 195 precludes a current deduction. In reaching this conclusion, the Tax Court rejected the taxpayer's attempt to rely on Rev. Proc. 2000-50, which provides that the IRS "will not disturb" a taxpayer's deduction of software development costs that closely resemble the type of costs that would be deductible as a research and experimentation expenditure under Section 174 (as it existed before amendment by the Tax Cuts and Jobs Act (TCJA)).
The IRS did not dispute that certain of the taxpayer's expenses fit within Rev. Proc. 2000-50 but insisted that such expenses were nevertheless not currently deductible because the taxpayer incurred them before starting a trade or business. The Tax Court summarily rejected this argument, observing that nothing in Rev. Proc. 2000-50 limits its application to software development costs that a taxpayer incurs after a taxpayer commences an active trade or business.
However, the court went on to reject the taxpayer's reliance on the revenue procedure. The court said that "to the extent Rev. Proc. 2000-50 purports to establish a taxpayer's entitlement to a deduction, petitioner has not demonstrated that the Code authorizes any such deduction." And because the petitioner had the burden of establishing his entitlement to the claimed deduction, the court "assume[d] without deciding that the Rev. Proc. 2000-50 deduction lacks statutory authorization." This left the court with the taxpayer's argument that the IRS is "estopped" from taking a position contrary to its own guidance. The court rejected this argument on the grounds that (1) revenue procedures generally "do not create substantive rights in the public," (2) in the absence of a statutory predicate for a deduction, there is no discretion for the IRS to abuse, and (3) the Tax Court, as a court of law rather than a court of equity, has no authority to impose equitable estoppel against the IRS.
Taxpayers across industries have relied on Rev. Proc. 2000-50 for decades. While Kellett purports not to invalidate Rev. Proc. 2000-50, the case raises questions about a taxpayer's ability to prevail in any Tax Court litigation where the taxpayer's position depends on the revenue procedure. More generally, taxpayers that incur costs before commencing an active trade or business should consider whether the IRS's arguments in Kellett create risk when relying on other sub-regulatory guidance that provides for an immediate deduction without expressly conditioning such a deduction on the existence of an active trade or business.
In CCA, IRS Characterizes Termination Fees as Capital Losses Under Section 1234A
In the latest foray regarding the character of termination fees in a failed acquisition, a recently issued Chief Counsel Advice Memorandum (CCA) concluded that such contractual break-up fees constituted capital losses, rather than ordinary expenses, in the hands of the payor.
Under the redacted facts, the taxpayer had entered into two agreements with stipulated termination fees if the transaction fell through: a merger agreement with a target corporation (Target) and an agreement with a purchaser interested in acquiring the taxpayer. After the merger with the Target was determined to be impracticable if not impossible, both agreements were terminated and the taxpayer paid out a termination fee to the Target and a termination fee to the attempted purchaser. The taxpayer deducted the termination fees as Section 162 expenses.
The IRS rejected the taxpayer's position and instead concluded that the termination fees resulted in losses under Section 165, and that under Section 1234A, the character of such losses was capital. The IRS disputed the taxpayer's reliance on authorities that had held that break-up fees were currently deductible (rather than capitalized) and concluded that even though the termination fees were not required to be capitalized under Section 263, they were deductible as Section 165 losses and not as Section 162 ordinary and necessary business expenses.
The application of Section 1234A to different types of contractual terminations has evolved over time and can be fact dependent. The CCA does not describe the terms of the taxpayer's terminated agreements, but it suggests that the IRS's position is that a break-up fee in a mergers and acquisitions (M&A) context will generally be considered to terminate rights "with respect to a capital asset" for purposes of Section 1234A. Taxpayers paying or receiving termination fees in connection with M&A transactions should carefully evaluate the impact of the CCA on the deductibility of such payments.
OECD Global Minimum Tax: Delayed Implementation and GILTI Co-Existence
The Organization for Economic Cooperation and Development's (OECD) Pillar Two project, which seeks to establish a 15 percent global minimum tax rate for multinationals through a series of top-up tax rules, has faced significant setbacks in implementation in the U.S. and around the world. Notwithstanding the delay, U.S. companies should be considering the potential implications of Pillar Two implementation regardless of whether U.S. legislation meant to conform the global intangible low-taxed income (GILTI) to the income inclusion rule (IIR) set forth under the Pillar Two framework moves forward or not.
While the OECD has developed model rules and commentary and is currently working through several technical and administrative issues in the Implementation Framework phase, it remains to be seen whether any jurisdictions will implement the rules in 2023 as the OECD has envisioned. In the EU, a directive to implement Pillar Two has not yet been approved, with Hungary becoming the latest holdout preventing unanimous adoption of the rules. Recently, public statements from EU officials have indicated that the body could consider other mechanisms for implementing Pillar Two despite opposition from a single country.
Prospects for U.S. legislation are also cloudy, as they are tied to the fortunes of a slimmed down Build Back Better Act (BBBA) being passed by Congress sometime this year. Even if the pending legislative changes to GILTI that would allow it to be recognized as a qualified IIR are enacted, there are concerns that a number of domestic, nonrefundable tax credits will operate to deflate the effective tax rate calculated at the U.S. parent level, resulting in additional top-up tax liability on U.S. income despite a conforming 15 percent GILTI rate. As a part of the Implementation Framework, the OECD is considering proposals put forth by Treasury Department officials to treat nonrefundable credits in a more favorable manner, such that they do not negatively impact effective tax rates.
If current-law GILTI remains in effect, it is Treasury's (and ostensibly, the OECD's) position that GILTI would instead be treated as a controlled foreign corporation (CFC) regime for purposes of Pillar Two. The effect of treating GILTI as a CFC regime is that GILTI taxes must be pushed down to the CFCs whose earnings comprise the GILTI inclusion at the U.S. shareholder level to determine the effective tax rates in each constituent CFC's jurisdiction (mechanisms for allocating GILTI taxes assessed at the U.S. shareholder level to CFCs are currently under consideration as part of the Implementation Framework effort). If those CFCs' effective tax rates still fall below 15 percent after considering both the local country covered taxes and GILTI taxes, Pillar Two top-up taxes could apply. Under Pillar Two, any top-up taxes due may be imposed by the jurisdiction of any holding company that directly or indirectly owns the low-taxed subsidiary, or the jurisdictions of other affiliated companies, or the source jurisdiction itself under a qualified domestic minimum top-up tax.
Moreover, the availability of a U.S. foreign tax credit in the event a U.S. company pays Pillar Two taxes in another jurisdiction remains unclear. The Pillar Two framework does not contemplate a credit for Pillar Two taxes (to prevent circularity issues) and these taxes may not satisfy the attribution rule under the final foreign tax credit regulations. Notably, the preamble to the final foreign tax credit regulations indicates that Treasury is willing to revisit some of the rules once the OECD's work is complete.
While the OECD has consistently stated that the Pillar Two model rules are final, the fact that several key technical issues have arisen from the operation of these rules means that they will likely be revisited during the Implementation Framework. Affected taxpayers are well-advised to stay abreast of any advancements with implementation efforts, as the impacts will attach whether or not there is any U.S. action to do the same.
New Crypto Regulation Bill Includes Industry Favorable Tax Provisions
It has been a busy few weeks for cryptocurrency with the market tumbling and a new bill in Congress proposing much-needed updates to the government's treatment of digital assets. On June 7, Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) proposed the bipartisan Responsible Financial Innovation Act (RIFA), which contains a myriad of measures that seek to "provide for responsible financial innovation and to bring digital assets within the regulatory perimeter" (i.e., provide certainty and clarity to the growing cryptocurrency industry). Measures include those impacting the IRS, Treasury, and various other agencies. The bill would provide much-needed definitions related to crypto, add tax exemptions, and create a detailed regulatory framework for digital assets.
One taxpayer friendly provision in the proposed bill would amend Section 451 (the general rule for taxable year of including any item of gross income) to state that digital asset rewards created in relation to mining or staking will not cause income recognition until the assets are sold. This proposal is at odds with the IRS's position in Jarrett et al. v. United States of America, No 3:2021cv00419 (M.D. Tenn.) (which we are following), and it would provide certainty in an area where uncertainty has been troubling many taxpayers.
Another key proposal in RIFA is the addition of new Section 139J. This new section would provide for a de minimis exclusion from the calculation of gross income for gains or losses of up to $200 from the disposition of virtual currency in a personal transaction for the purchase of goods and services. The $200 limitation applies on a per transaction basis. An aggregation rule is designed to prevent taxpayers from using related transactions to double up on the $200 limit. This provision is thus aimed at protecting people from gathering records to report small personal transactions for their taxes each year. Significantly, up to $200 of losses are excluded from impacting gross income as well, which is a change from the proposed version of section 139J introduced in H.R. 6582, the Virtual Currency Tax Fairness Act of 2022.
RIFA would also narrow the definition of "broker" for tax information reporting — a term defined broadly in the Infrastructure Investment and Jobs Act, which was signed into law on November 15, 2021. Under current law, the term "broker" could be interpreted to sweep those who mine or stake to validate crypto transactions into extensive reporting obligations (which start in 2023) that appear to have been meant for U.S. crypto asset exchanges and other similar players. Treasury indicated in February that its view was that ancillary parties (such as miners and stakers) were not meant to be subjected to the reporting requirements. The new bill would define broker much more narrowly as "any person who (for consideration) stands ready in the ordinary course of a trade or business to effect sales of digital assets at the direction of their customers."
RIFA, which includes many other provisions that would impact other government agencies, would classify most digital assets as commodities and would empower the Commodity Futures Trading Commission (CFTC) to regulate most of the industry.
Finally, we note that RIFA directs Treasury and the IRS to adopt guidance on five specific crypto topics "not later than one year after the date of enactment." The one-year mandate is unusual. One of the topics on which guidance is requested is the classification of "forks, airdrops, and similar subsidiary value as taxable, contingent upon the affirmative claim and disposition of the subsidiary value by a taxpayer." Readers may recall that Rev. Rul. 2019-24 provides that hard forks are generally taxable at the time of receipt, regardless of whether the token is disposed of. RIFA would appear to be directing Treasury and the IRS to change its current guidance.
We do not expect RFIA to become law anytime soon in its current form, but we do believe it will serve as a template against which future pieces of legislation are drafted and negotiated. Stay tuned for updates as we continue to monitor developments in crypto legislation.
IRS Releases Guidance on Superfund Chemical Excise Tax
In anticipation of the July 1 effective date for the newly reenacted Superfund chemical excise tax, the IRS has released an FAQ covering the basics of this excise tax and Rev. Proc. 2022-26 outlining the process for adding to or removing from the list of taxable substances.
Last year's Infrastructure Investment and Jobs Act (Pub. L. 117-58) reinstated and doubled the Superfund chemical excise tax, effective July 1, 2022. The excise tax applies to Section 4661 "Taxable Chemicals" sold by a manufacturer, producer, or importer and Section 4671 "Taxable Substances" sold or used by an importer. Taxable Chemicals are taxed at statutory "per ton" rates and Taxable Substances (which, by definition, contain Taxable Chemicals) are generally taxed rates based on the Taxable Chemicals used in their production.
The IRS has published an initial list of additional Taxable Substances in Notice 2021-66 and it may add other substances in which Taxable Chemicals constitute more than 20 percent of the weight or value.
The latest guidance confirms that a Taxable Substance may be added or removed to the list only by (1) the IRS, in consultation with the Environmental Protection Agency (EPA) and Customs and Border Protection (CBP), making the 20 percent weight or value determination or (2) an exporter, importer, or "interested party" petitioning to add or remove the substance from the list.
Rev. Proc. 2022-26 sets forth the procedures for making such a petition and provides several clarifications. It defines an "exporter" as the person named as shipper or consignor in the export bill of landing. It also confirms, consistent with prior guidance, that Taxable Substances do not include certain items finished into end-use products.
After a petition is filed, the IRS will publish a notice in the Federal Register with 60 days for public comment. The Secretary will make a determination within 180 days after the date the petition is filed (unless that period is extended by agreement between the petitioner and the IRS). Taxpayers will have at least 90 days' notice of a determination before it goes into effect. For exporters claiming a refund, the determination is deemed effective as of the day the petition was filed (per a transition rule, for petitions made before January 1, 2023, the deemed effective date is July 1, 2022).
Finally, the FAQ notes that the IRS is working on calculating tax rates for Taxable Substances in accordance with the statute and will release the tax rates as they become available. Importers are not required to use the IRS-prescribed tax rates for the tax on Taxable Substances and may calculate their own rates based on the composition of the substance.
BBBA Remains in a Holding Pattern as Mid-Term Elections Loom
Although June was marked by significant tax legislative activity, including Secretary Yellen's testimony before both tax-writing committees and the advancement of retirement legislation by the Senate Finance Committee, little progress was made on the Build Back Better Act (BBBA). Senate Majority Leader Chuck Schumer (D-NY) and Senator Joe Manchin (D-WV) continue to negotiate on a package that could address climate change, prescription drug pricing, deficit reduction, Affordable Care Act (ACA) premiums, and associated tax increases to fund these initiatives, but other legislative priorities and continuing concerns regarding inflation have prevented any real progress. Although the underlying budget reconciliation instructions do not expire until September 30, it is widely believed that Democrats need to pass the BBBA (in at least some form) before the August Congressional recess. Given that once any deal is struck, it will take the Congress the better part of a month to draft, score, and process a bill, we anticipate that the next few weeks will be crucial to the fate of the BBBA.
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