Monthly Tax Roundup (Volume 1, Issue 6)
After a brief summer break, we're back with the sixth edition of our Monthly Tax Roundup. Since the last issue in July, all branches of government have been busy from a tax perspective with the passage of the CHIPS and Science Act and the Inflation Reduction Act (IRA), a number of interesting court decisions, and developments on the tax administration front.
Tax Fact: According to the Organisation for Economic Cooperation and Development (OECD), the U.S. ranked 32nd out of 38 OECD countries in terms of tax-to-GDP ratio in 2020. The U.S.'s 2020 tax-to-GDP ratio was 25.5 percent compared with the OECD average of 33 percent.
"Congress can raise taxes because it can persuade a sizable fraction of the populace that somebody else will pay." – Milton Friedman, American economist
New Corporate Taxes Enacted in Inflation Reduction Act
A new corporate alternative minimum tax (AMT) or book minimum tax and a new excise tax on stock buybacks were put into place to fund the clean energy and health care provisions in the Inflation Reduction Act, which was signed into law on August 16, 2022. The corporate AMT imposes a 15 percent minimum tax on financial statement income of corporations whose average annual financial statement income exceeds $1 billion. A detailed discussion of the corporate AMT can be found in our recent alert. The new tax on stock buybacks is a one percent excise tax on the fair market value of stock repurchased by a publicly traded domestic corporation. The tax also applies to repurchases by an affiliate and by a foreign corporation that is a "surrogate foreign corporation" under the anti-inversion rules. There are exceptions, including for certain tax-free reorganizations and for stock repurchased for employee plans, as well as an adjustment for stock issued by the corporation during the taxable year.
IRS Enforcement and the IRA: What Will $45.6 Billion Buy?
For several years, the IRS has stated that its enforcement activities have been hampered by resource constraints. The Inflation Reduction Act (IRA) includes a significant increase in funding for the IRS. In particular, the IRA earmarks $45.6 billion dollars over the next 10 years for "necessary expenses for tax enforcement activities of the Internal Revenue Service," over and above the amounts already budgeted for IRS enforcement.
The additional funding in the IRA will ameliorate the IRS' resource constraints. While the IRS has not officially stated how it will spend this money, Treasury Secretary Janet L. Yellen wrote to IRS Commissioner Charles P. Rettig to "confirm the commitment that has been a guiding precept of the planning that [he] and [his] team are undertaking: that audit rates will not rise relative to recent years for households making under $400,000 annually."
With Secretary Yellen's comments in mind, one can make some educated predictions based on current enforcement trends. The IRS will certainly ramp up hiring of revenue agents and Chief Counsel attorneys, among others. Earlier this year, the IRS announced plans to hire up to 200 additional attorneys to help with cases involving syndicated conservation easements, abusive micro-captive insurance arrangements, and "other tax schemes." It would not be surprising if some of the newly appropriated money is devoted to this effort as well. In line with Secretary Yellen's comments and in response to criticism of the agency's decreased audit rates of large corporations over the past decade, it is likely that many of those new IRS employees will be assigned to the Large Business & International Division (LB&I). The complexity of the international tax changes in the Tax Cuts and Jobs Act (TCJA), plus the IRA's resurrection of the corporate alternative minimum tax, will provide grist for audits of large businesses for years to come. Similarly, one can expect some of the additional funding to support recent IRS efforts to increase audits of large partnerships and the application of the new partnership audit rules adopted in the Bipartisan Budget Act (BBA) of 2015.
In addition to focusing on large businesses (whether in corporate or partnership form), the IRS will likely increase the audit activity of high-net-worth families. Historically the IRS maintained silos between each of its divisions, e.g., LB&I would have little overlap with the Tax Exempt/Government Entities Division. The IRS rolled out a Global High Wealth program designed to foster communication and cooperation between IRS divisions to allow a holistic examination of all aspects of a high-net-worth family's economic footprint. It has also emphasized multi-division cooperation, including increased Criminal Investigations Division involvement, in its coordinated campaigns against syndicated conservation easement and micro-captive transactions. Additional funding would allow the IRS to use these initiatives as a template for audits of large businesses as well.
It is also likely that the IRS will make a considerable investment in data analytics tools. The IRS turned to data analytics over the past several years to mitigate the lack of resources. As the repository of the tax and financial data of hundreds of millions of taxpayers, the IRS has a rich source of data that could be mined to identify potential audit targets and potentially abusive transactions. That potential could be unlocked by applying additional funding to cutting-edge analytical tools.
In a second memorandum from Secretary Yellen to Commissioner Rettig, the Secretary directed the IRS to produce a six-month operational plan detailing how these resources will be deployed over the next decade. The report is directed to be delivered to Secretary Yellin six months from August 17. It will remain to be seen how this resource deployment plan meshes with the operational and structural planning already in progress in response to the Taxpayer First Act.
Commissioner Rettig announced on August 19 the establishment of a new office in the IRS – the IRA 2022 Transformation & Implementation Office – as a centralized office to coordinate across all IRS functions for the implementation of the IRS-related provisions of the new legislation. In addition to addressing new substantive tax law provisions, this office will focus on "taxpayer services transformation, tax compliance transformation, human capital transformation, and communications and outreach efforts." Nikole Flax, the current Commissioner of LB&I who also held high-level positions in other parts of the IRS, will head the new office.
President Biden Signs Semiconductor Manufacturing Investment Tax Credit
On August 9, 2022, President Biden signed the Advanced Manufacturing Investment Tax Credit into law. The new ITC allows a 25 percent tax credit for investment in domestic semiconductor manufacturing facilities. The credit is effectively refundable as taxpayers may elect to treat the credit as a direct payment of income tax for the year in which they determine their credit. The ordinary basis reduction and recapture rules in section 50 apply. In addition, taxpayers are subject to a special recapture rule if they invest in expansions of semiconductor manufacturing capacity in the People's Republic of China or other foreign countries of concern. See our alert for a more detailed discussion of the new ITC.
A Split-Decision in Medtronic and a Taxpayer Win in Eaton
In August, we had two important opinions in the transfer pricing context. First, the Tax Court issued its second opinion in Medtronic, adopting a new unspecified method to benchmark related-party royalties and split profits between U.S. and Puerto Rico affiliates. For more on Medtronic, see our coverage here. Then, on August 25, the Sixth Circuit Court of Appeals issued its opinion in Eaton Corp. v. Commissioner, a long-running dispute over whether the IRS wrongfully canceled two advance pricing agreements (APAs). The Sixth Circuit sided with Eaton on all fronts, holding that the IRS did not carry its burden under contract-law principles of proving that cancelation of the APAs was authorized, marking a win for taxpayers who seek certainty in their transfer pricing through APAs. Stay tuned for a more detailed analysis of Eaton in a forthcoming alert.
Update on Pending Challenges to Treasury and IRS Guidance
Here is a summary of recent significant developments in our closely watched cases involving challenges to Treasury regulations and IRS guidance under the Administrative Procedure Act (APA) and administrative law principles progressing through the courts.
Challenges to TCJA Regulatory Rules: Liberty Global, KYOCERA AVX, and FedEx
In Liberty Global, a federal district court ruled earlier this year that a temporary regulation issued to implement the section 245A dividends received deduction enacted as part of TCJA is invalid for failure to comply with the APA's notice-and-comment requirements. See Liberty Glob., Inc. v. United States, No. 1:20-cv-03501, 2022 U.S. Dist. LEXIS 62482 (D. Colo. Apr. 4, 2022). But that ruling does not resolve the case entirely because there are factual issues that bear on Liberty Global's eligibility for its claimed section 245A deductions. The government will not seek an interlocutory appeal of the district court's ruling and has noted that it will pursue substance-over-form arguments, including arguments under the economic substance doctrine codified at section 7701(o)(1). See Joint Status Rep. ¶¶ 7-8, Liberty Glob., Inc., No. 1:20-cv-03501, ECF No. 50 (D. Colo. July 1, 2022). Liberty Global may move for summary judgment on the question whether the economic substance doctrine is relevant and applicable to the transactions at issue, and a trial is likely to be scheduled for late 2023. See id. ¶¶ 9-13; Liberty Glob., Inc., No. 1:20-cv-03501, ECF No. 51.
The validity of another regulation related to the availability of the section 245A dividends received deduction is in dispute in KYOCERA AVX Components Corp. v. United States, No. 6:22-cv-02440 (D.S.C. filed July 28, 2022). Section 78 treats foreign taxes paid by foreign subsidiaries and deemed paid by the domestic parent corporation as a dividend received by the domestic parent corporation. In the TCJA, Congress amended section 78 to exclude those deemed dividends from the section 245A deduction. This exclusion was effective for tax years of foreign corporations beginning after December 31, 2017, which left a period of time during which section 78 dividends from foreign corporations with a fiscal year beginning in 2017 may have been eligible for the section 245A deduction. To fix a perceived gap in the statute, Treasury promulgated a regulation excluding section 78 dividends from the section 245A deduction for tax years beginning before January 1, 2018. KYOCERA AVX's fiscal year at issue in this matter ran from April 1, 2017, to March 31, 2018. KYOCERA AVX asserts that the section 78 amendment is inapplicable and therefore, it filed a refund claim in part based on claiming the section 245A deduction with respect to section 78 dividends during the fiscal year at issue. Further, KYOCERA AVX argues that the section 78 regulation is inapplicable because it is invalid on both substantive and APA procedural grounds.
In November 2020, FedEx filed suit in federal district court in Tennessee challenging the validity of final regulations Treasury issued under section 965, which imposed a one-time transition tax on deemed repatriated offshore earnings. See FedEx Corp. & Subsidiaries v. United States, No. 2:20-cv-02794 (W.D. Tenn. filed Nov. 2, 2020). FedEx argues that it was entitled to credits for foreign taxes paid on foreign earnings distributed to the U.S. and that Treasury's attempt to limit those foreign tax credits is contrary to the plain and precise language of the statute. In July, FedEx moved for partial summary judgment, asking the court to find that the regulation is invalid because it runs afoul of administrative law principles and its promulgation is procedurally defective. See Pl.'s Mot. Partial Summ. J., ECF No. 42. The government's cross-motion for partial summary judgment is due on September 9.
Regulatory Challenges in the Context of Conservation Easements
The U.S. Court of Appeals for the Eleventh Circuit's decision in Hewitt v. Commissioner, 21 F.4th 1336 (11th Cir. 2021), became final when the government declined to petition the U.S. Supreme Court for a writ of certiorari. As previously reported, in Hewitt the Eleventh Circuit invalidated the "proceeds regulation," which provides a formula for allocating proceeds after the extinguishment of a conservation easement, because Treasury failed to consider and respond to significant comments when promulgating the regulation as required by the APA.
Following Hewitt, the Eleventh Circuit also recently vacated in part the Tax Court's decision in Glade Creek Partner, LLC v. Commissioner. See T.C. Memo. 2020-148, vacated in part and remanded, No. 21-11251 (11th Cir. Aug. 22, 2022). The Eleventh Circuit concluded that the Tax Court, which entered its decision in Glade Creek before the Eleventh Circuit's decision in Hewitt, relied on the now invalid proceeds regulation in reaching its decision, and therefore the appellate court remanded the case "for reconsideration without reliance on the regulation."
The validity of the proceeds regulation is the subject of a circuit split given the Sixth Circuit's ruling in Oakbrook Land Holdings, LLC v. Commissioner upholding the validity of the regulation under the APA. See 28 F.4th 700 (6th Cir. 2022) (covered here). On July 6, 2022, the Sixth Circuit denied Oakbrook's request for rehearing en banc concluding that the issues raised in Oakbrook's petition were fully considered in the court's original decision in the case. Oakbrook may still seek Supreme Court review.
Other Ongoing Regulatory Challenges
The validity of the research and development (R&D) credit regulation defining "funded research" under section 41 is at issue in a dispute currently pending in the Tax Court on cross-motions for summary judgment. See Perficient, Inc. v. Commissioner, No. 7600-18 (Tax Court filed Apr. 19, 2018) (Perficient and the government filed cross-motions for partial summary judgment in March 2022 and May 2022, respectively). Taxpayers are not allowed a credit for research expenses to the extent the research was "funded" by another person. The regulations provide two tests, both of which must be met, to show that research was not funded: (1) the taxpayer must have taken on the financial risk of failure of the research, and (2) the taxpayer must retain substantial rights in the research performed. See Treas. Reg. § 1.41-4A(d). Perficient asserts that the second test — the substantial rights standard — is procedurally invalid because Treasury failed to address significant comments or to include a concise statement of basis and purpose as required by the APA. Perficient also argues that the substantial rights standard is substantively invalid because it is contrary to the unambiguous definition of "funded research" in section 41 or, in the alternative, contrary to congressional intent.
The long-running APA dispute between CIC Services and the government continues. As previously reported, earlier this year a federal district court in Tennessee vacated IRS Notice 2016-66 because the government improperly failed to follow the APA notice-and-comment requirements when issuing the Notice. See CIC Servs., LLC v. IRS, No. 3:17-cv-110, 2022 U.S. Dist. LEXIS 63545 (E.D. Tenn. Mar. 21, 2022). The court then scaled back the injunctive relief it granted in its original opinion, ruling that the government did not have to return information and documents obtained from taxpayers and material advisors other than those that were parties to the case. See CIC Servs., LLC v. IRS, No. 3:17-cv-110, 2022 U.S. Dist. LEXIS 105376 (E.D. Tenn. June 2, 2022). The parties have filed cross-appeals to the Sixth Circuit. CIC Services is appealing the district court's recent ruling limiting the remedy, while the government plans to appeal the merits of the district court's decision that the IRS violated the APA when it issued Notice 2016-66. The first brief in the appeal is due at the end of the month.
Partnership Status Upheld in Absence of Pre-Tax Profit
Kevin Kenworthy and Colin Handzo*
In Cross Refined Coal, LLC v. Commissioner, No. 20-1015, the U.S. Court of Appeals for the DC Circuit recently upheld a taxpayer's claim of partnership status finding that even if a partnership has no potential for pre-tax profit, it may still have a legitimate non-tax business purpose and be a valid partnership.
The taxpayer in Cross Refined Coal was formed as a limited liability company to build and operate a facility to produce coal eligible for refined coal credits under Section 45. Given the economics of the enterprise, the taxpayer expected to generate a profit only after accounting for the refined coal tax credits. In other words, the taxpayer would inevitably produce a pre-tax loss. The taxpayer originally only had one owner — a sponsor that could only utilize a portion of the refined coal credits the taxpayer was expected to produce each year. Shortly after the taxpayer built the necessary refining facility and began operations, two other investors — both of whom could readily make use of the tax credits — joined the enterprise. The taxpayer was profitable over several years, but the partnership ended after two lengthy shutdowns.
The IRS issued a notice of final partnership administrative adjustment asserting that the taxpayer was not a partnership for federal tax purposes "because it was not formed to carry on a business or for the sharing of profits and losses" but instead "to facilitate the prohibited transaction of monetizing 'refined coal' tax credits." Thus, the IRS asserted only the original partner could claim credits. Affirming the Tax Court's decision, the DC Circuit ultimately disagreed with the IRS and held that the partners intended to "'carry on business as a partnership.'" In so holding, the court noted that the investor-partners were no doubt motivated by the prospect of refined coal tax credits, but they also became legitimate partners in the enterprise because they reviewed daily production reports, signed off on major decisions, communicated regularly with the taxpayer's management, and made monthly contributions to cover the taxpayer's operating expenses. The court also noted that the partnership allowed the sponsor-partner to spread its investment risk over many projects and to raise additional capital.
The court squarely rejected the IRS's chief argument — that the taxpayer's partners did not intend to carry on a business together because the taxpayer did not pursue business activity to obtain a pre-tax profit and the tax credits were the sole profit driver. In addition, the DC Circuit rejected the IRS's alternative argument that a partnership can only be bona fide if it expects to make a pre-tax profit "at some point in time." The Circuit Court stated that a partnership's pursuit of after-tax profit can be a legitimate business activity, and "[t]his is especially true in the context of tax incentives, which exist precisely to encourage activity that would not otherwise be profitable." The court held that the taxpayer was a bona fide partnership, noting that the taxpayer engaged in business activity with "practical economic effect" (i.e., the production of cleaner burning coal, which Congress sought to encourage with credits) and did not "simply engage in 'wasteful activity,' which is typical of sham partnerships that merely manufacture tax losses."
Tax Court Considers the Effect of a Written but Unpaid Check
The U.S. Tax Court recently held that a decedent's gross estate included the value of checks that were validly written before the decedent's death but paid by the drawee bank after the decedent's death. Although the transfer-tax context may have justified this result, the court's holding is nevertheless somewhat surprising insomuch as it seems to conflict with the well-established income tax principle that a check constitutes payment upon delivery.
In Estate of DeMuth v. Comm'r, T.C. Memo. 2022-72, the decedent's son held a power of attorney authorizing him to make gifts to the decedent's issue. Several days before the decedent died, the son wrote 11 checks from the decedent's investment account to various family members. One check was deposited at a payee bank and paid by the decedent's bank before the decedent died, three checks were deposited at payee banks on the day the decedent died but paid by the decedent's bank after the decedent died, and the remaining seven checks were deposited at payee banks and paid by the decedent's bank after the decedent died. The estate excluded all 11 checks from the decedent's gross estate but the court concluded that 10 of these checks — those that the decedent's bank paid after the decedent died — were includable in the decedent's gross estate. However, the court held the IRS to its concession that the three checks deposited on the day the decedent died but paid by the decedent's bank after the decedent died were excludable.
Citing the Internal Revenue Code and Treasury regulations, the court began by observing that "the value of any check written by a decedent that still belongs to them at their death is includible in their gross estate; however, the funds from such a check no longer belong to a decedent at their death if they executed a completed gift of the check during their life." Thus, the court viewed the issue as whether the checks were completed gifts. The court then cited Treas. Reg. § 25.2511-2(b), which provides that a gift is not complete until a donor has "parted with dominion and control as to leave him no power to change its disposition." Turning to applicable state law, the court concluded that on the day the decedent died a stop-payment order could have prevented the decedent's bank from paying any of the 10 unpaid checks, which in turn meant that a completed gift had not yet occurred. And without a completed gift, the court concluded that the 10 unpaid checks were includable in the decedent's gross estate.
Estate of DeMuth stands in stark contrast to longstanding case law holding that for income tax purposes a check constitutes payment upon delivery. For example, in Estate of Spiegel, 12 T.C. 524 (1949), the Board of Tax Appeals held that a check written and delivered to a charity at the end of one year but paid by the drawee bank in the following year supported an income tax deduction in the first year. Citing existing authorities, the court reasoned that "upon the issuance and delivery of the checks in question, [the taxpayer] made a conditional payment of charitable contributions which, upon the presentation and payment of the checks, became absolute and related back to the time when the checks were delivered." Treasury regulations have since adopted this rule. See Treas. Reg. § 1.170A-1(b) ("The unconditional delivery or mailing of a check which subsequently clears in due course will constitute an effective contribution on the date of delivery or mailing").
As Estate of DeMuth focused only on whether there had been a completed gift for estate tax purposes, the case should have little bearing on the longstanding principle that a check constitutes payment upon delivery for income tax purposes.
New Draft Form 1040 Updates Crypto Reporting Question
On July 27, the IRS issued a draft Form 1040 for the 2022 tax year. One welcome amendment was the expansion of the cryptocurrency question on page one of the form, which now asks: "At any time during 2022, did you: (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)." (Emphasis added). The key difference from 2021's Form 1040 is the addition of the phrase "as a reward, award, or compensation," which appears aimed at ensuring that an affirmative response encompasses as broad a spectrum of crypto transactions as possible. The introduction of a virtual currency question on Form 1040 for 2019 and the recent changes reflect the IRS's heightened interest in proper reporting of digital assets and increased focus on crypto tax audits.
Form 1040's yes-or-no question has, since its inception, raised many questions regarding, for instance, what the IRS considers to be an event triggering tax liability. The IRS has issued informal guidance, such as the IRS's FAQ on virtual currencies, and some limited administrative guidance, such as Rev. Rul. 2019-24, which clarified the tax treatment of certain crypto transactions such as "hard forks" and "airdrops." But such guidance is not sufficient to answer the myriad questions taxpayers have surrounding cryptocurrency and its transactions.
It is therefore important to note the added phrase, "reward, award, or compensation," on the new draft Form 1040 and to file correctly. Simply holding cryptocurrency, without more, does not trigger income tax liability. However, the safe path is to report any increase in your holdings unless it is crystal clear that reporting is not required. For example, informal IRS guidance provides that taxpayers may respond "no" if the crypto asset was received through a bona fide gift. Ideally, taxpayers will see additional guidance that provides clear examples illustrating the types of digital asset transactions and that explains how each should be treated and reported for federal income tax purposes.
Post-Inflation Reduction Act of 2022: What's Next on the Tax Policy Agenda?
After almost a year of consideration, the Inflation Reduction Act of 2022 (IRA) was signed into law by President Biden on August 16, 2022. With the IRA now the law of the land, Treasury and the IRS will now turn to developing regulatory guidance on the corporate book income minimum tax and the one percent stock buyback excise tax before they go into effect at the beginning of next year. And although the prospects for any tax legislation before the November mid-term elections remain slim, congressional focus will soon turn to a potential year-end lame duck package that would address a number of priorities, including the Section 174 R&D amortization fix, retirement legislation, tax extenders, and TCJA-related items (such as the section 163(j) EBITDA fix and the pending phase-out of 100 percent bonus depreciation).
*Former Miller & Chevalier attorney
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