Monthly Tax Roundup (Volume 1, Issue 9)
Our November tax roundup reports on a flurry of activity at the Internal Revenue Service (IRS), including the release of the annual Priority Guidance Plan (PGP) and the highly anticipated proposed foreign tax credit (FTC) regulations. We'll also summarize an important development in the continuing conservation easement litigation and give a preview of next year's tax legislative agenda in light of the mid-term election results.
Happy holidays from Miller & Chevalier!
"Taxation is, in fact, the most difficult function of government and that against which their citizens are most apt to be refractory." – Thomas Jefferson
"In other words, a democratic government is the only one in which those who vote for a tax can escape the obligation to pay it." – Alexis de Tocqueville, Former Minister for Europe and Foreign Affairs of France
New Proposed Foreign Tax Credit Regulations Issued
The IRS and Department of the Treasury (Treasury) released proposed regulations on November 18 intended to address taxpayer concerns regarding the new attribution rules for royalty withholding taxes and the cost recovery requirements. The proposed rules permit foreign royalty withholding taxes to satisfy the source-based attribution rules if the taxpayer substantiates that the royalty is paid pursuant to a "single-country" license agreement that limits the use of intangible property to the country imposing the foreign tax, even if the foreign country's law otherwise imposes royalty withholding tax based on the residence of the payor. Additionally, the cost recovery rules are amended to require that a foreign tax permit recovery of "substantially all" significant costs or expenses and to provide a safe harbor if the foreign law disallows recovery of 25 percent or less of an item of significant cost or expense or limits certain deductions to a cap that is not less than 15 percent of gross receipts or not less than 30 percent of taxable income. A detailed discussion of the proposed regulations can be found in our recent alert. The new rules are proposed to apply to foreign taxes paid in taxable years ending on or after November 18, 2022. Comments on the proposed regulations are due by January 23, 2023.
Update to Draft Schedule UTP
As we reported last month, the IRS released draft changes to Schedule UTP. The period to submit comments has now closed, but two major questions remain. First, the precise amount that is to be reported, and second, which contrary positions will need to be reported.
Speaking at the American Institute of Certified Public Accountants National Tax Conference on November 1, Acting Commissioner of the IRS Large Business and International (LB&I) Division Holly Paz promised revised instructions that will give a more detailed description of the amount to be reported. The draft UTP Instructions require reporting "the location of the tax position and amount of the unrecognized federal income tax benefits." Paz posited that this amount was not the amount of the reserve, but rather the amount listed on the line of the return. However, this is akin to the maximum tax adjustment disclosure required by the 2010 draft Schedule UTP which was ultimately scrapped because the information was a misleading description of the position.
The other concern is how any contrary positions will be reported. The draft changes require reporting of private guidance issued by the IRS. While this type of guidance is useful in determining the 'IRS's position, a taxpayer cannot cite the ruling as precedent and is ultimately non-binding for any taxpayer that the guidance was not issued to.
Schedule UTP is intended to help the IRS identify issues during audit, but there is no penalty for failing to file a Schedule UTP, therefore, it is in the 'IRS's best interest to address the issues discovered in the comment period to improve compliance.
IRS Issues 2022-2023 Priority Guidance Plan Containing New Guidance Projects
Treasury and the IRS issued their initial 2022-2023 Priority Guidance Plan on November 4. The PGP lists 205 guidance projects that are priorities for Treasury and IRS during the July 1, 2022, through June 30, 2023, plan year and 71 items of more routine guidance that are generally published annually. The PGP does not provide target completion dates.
Guidance projects stemming from the Inflation Reduction Act (IRA) feature heavily in the PGP, including projects on the stock buyback excise tax under Section 4501, the new corporate alternative minimum tax, and the new or amended energy tax incentives which the PGP presents in a new "Energy Security" section. The IRS requested public comments on implementing these energy tax incentives in a series of nine notices in October and November.
The PGP also includes new projects on areas of recent IRS focus. A new project for "regulations" on research-credit substantiation under Section 41 could be an effort to formalize aspects of the IRS's October 2021 Chief Counsel Advice Memorandum that identified requirements for filing a valid refund claim based on Section 41 credits. Read our prior coverage here. Another new project exists for "guidance" under Section 170 regarding conservation easements, including facade easements, an area that has generated much tax controversy over the last several years. Most recently, the U.S. Tax Court invalidated Notice 2017-10, which designated syndicated conservation easement transactions as "listed transactions," under the Administrative Procedure Act (APA). See here for our latest coverage.
Another area of attention is "digital assets," i.e., cryptocurrency and nonfungible tokens (NFTs). The PGP includes new projects under Sections 6045 and 6045A (relating to returns of brokers) and Section 6050I (relating to returns for cash transactions). The 2021 Infrastructure and Investment Act expanded these provisions to encompass digital assets for returns required to be furnished after December 2023, so guidance from the IRS next year would be timely. The PGP also has a project dedicated to guidance on the tax treatment of digital assets generally. The digital-asset industry will be watching this project closely given the proliferation of digital-asset transactions in recent years, the uncertain treatment of so-called "staking rewards" (see here, here, and here for prior coverage), and potential loss claims relating to exchange collapses (e.g., FTX).
Treasury and the IRS have already addressed some PGP projects in the weeks immediately following its release. Rev. Proc. 2022-39 (released November 16) addressed the PGP project for guidance regarding special rules for qualified amended returns filed by certain large corporations. See here for our alert on this new revenue procedure. Proposed regulations from November 18 addressed the PGP project for regulations related to the foreign tax credit, including on the source-based attribution requirement for withholding taxes on royalties, the cost recovery requirement, and the allocation and apportionment of foreign income taxes. See our coverage on this here.
Taxpayers should review the PGP and consider submitting comments to Treasury and the IRS on existing guidance projects of relevance or potential new guidance projects to add to the list.
Tax Court Vacates Conservation Easement Notice for APA Violation
In a recent case, the Tax Court vacated Notice 2017-10, which designates syndicated conservation easement transactions as "listed transactions." In Green Valley Investors, LLC v. Commissioner, 159 T.C. No. 9 (2022), a 15-2 majority of the court held that the IRS was subject to the APA notice-and-comment requirements when it issued the notice and that the IRS failed to satisfy those requirements.
The taxpayers in Green Valley Investors each engaged in a syndicated conservation easement transaction. The taxpayers filed a motion for partial summary judgment on the issue of their liability for an accuracy-related penalty with respect to a reportable transaction under section 6662A. The taxpayers argued that Notice 2017-10 was procedurally invalid under the APA. The IRS first argued in response that Notice 2017-10 is not a legislative rule and, therefore, it is not subject to notice-and-comment rulemaking procedures under the APA. Second, the IRS argued that Congress had expressly exempted the IRS from APA procedures when designating listed or reportable transactions. The court agreed with the taxpayers and rejected both IRS arguments.
This case and its implications for other reportable transactions and future challenges to Treasury and IRS guidance under the APA are discussed in our recent alert.
IRS Continues Efforts to Identify and Respond to Latest International Tax Issues
November saw an uptick in informal guidance issued by the IRS Office of Associate Chief Counsel International (ACCI) in what appears to be a continued trend by the ACCI to announce legal positions and coordinate IRS response to identified international tax issues.
The first of these Chief Counsel Memoranda, AM 2022-004, addresses how the active trade or business (ATB) exception for outbound stock transfers applies in the case of foreign corporations that have not generated income in the requisite three-year period. Under section 367(a)(1) and Treas. Reg. § 1.367(a)-3(c), an outbound stock transfer is not subject to gain recognition if certain conditions are met, including the ATB test. The ATB test requires that the transferee foreign corporation be engaged in an active trade or business outside the U.S. for the entire 36-month period immediately before the transfer. The regulations provide that in order for a trade or business to be an ATB, it must "ordinarily" include the collection of income. In AM 2022-004, the IRS concluded that a foreign corporation in the "pre-revenue" and product development stage does not meet the ATB test because its activities have not "ordinarily" included the collection of income. In contrast, the memorandum concludes that the ATB test was met in the case of a foreign corporation that generated income in two of the prior three years but temporarily ceased to generate income due to the "exception situation" of an unexpected discovery of a product defect. The unfavorable treatment of pre-revenue corporations in the section 367(a) context stands in contrast to the direction taken by the IRS in the tax-free spin-off rules of section 355. In the section 355 context, the IRS is studying whether a business can qualify as an ATB if it conducts "entrepreneurial activities" with the purpose of generating income in the future and has issued favorable private letter rulings.
In AM 2022-005, the IRS concluded that foreign shareholders of a domestic international sales corporation (DISC) may not claim treaty benefits on the basis that a DISC distribution is not attributable to a permanent establishment and therefore is eligible for a reduced rate of U.S. tax under an applicable U.S. income tax treaty. Section 996(g) provides that in the case of a foreign shareholder of a DISC, DISC distributions are treated as "effectively connected with the conduct of a trade or business conducted through a permanent establishment." The IRS states that it is aware of taxpayers that have taken the position that U.S. income tax treaties ratified after the enactment of section 996(g) override this statute. The IRS asserts that this position is erroneous because it believes that tax treaties and the Code must be applied consistently such that taxpayers that avail themselves of the beneficial DISC regime must forgo treaty benefits with respect to DISC distributions. Although the IRS appears to acknowledge that the taxpayer position is supported by "literal interpretations of treaty text," it rejects such interpretations by claiming they produce "absurd results."
AM 2022-006 concludes that the tax consequences that would result from transfers of intangible property subject to section 482 or section 367(d), and from realistic alternatives to such transfers, may need to be considered to determine an arm's length result. The memorandum observes that uncontrolled parties generally consider tax consequences when negotiating a transaction price. The memorandum applies this principle to three scenarios in which a U.S. parent transfers intangible property to a controlled foreign corporation (CFC): (1) a license, (2) a contribution, and (3) a platform contribution transaction related to a cost sharing arrangement with the CFC. In each case, the memorandum examines the present value of expected pre-tax and post-tax income streams of each party pursuant to the transfer and to realistic alternatives to that transfer and discusses the application of the arm's length standard and realistic alternatives principle to determining the appropriate transfer price. In the view of the IRS, the price the U.S. transferor receives must be sufficient to provide the transferor with income with a post-tax present value at least equal to the post-tax present value the transferor would have realized had it not engaged in the transfer.
Finally, the IRS released PMTA 2022-08, which follows the approach of a memorandum released earlier this year regarding the allocation and apportionment of prior period expenses to deduction eligible income (DEI) and foreign-derived deduction eligible income (FDDEI) for purposes of the section 250 deduction for foreign-derived intangible income (FDII). Whereas the prior memorandum involved deferred compensation expense, the facts in PMTA 2022-08 involve legal expenses relating to a claim for damages resulting from an industrial accident that occurred in a year prior to the effective date of section 250. The IRS concludes the expenses must be apportioned to DEI and FDDEI and reduce the FDII deduction in 2018. PMTA 2022-08 states that a 2017 CCA that addressed a similar fact pattern in the section 199 context "no longer represents the position of the issuing Office." For prior coverage of this issues, see our alert.
Tax Legislation in the New Congress
The 2022 mid-term elections delivered a divided Congress with Republicans taking control of the House by a slim margin and Democrats keeping a slight majority in the Senate. Divided government is generally a recipe for legislative gridlock, particularly with respect to tax legislation. Nevertheless, an active tax policy agenda is anticipated – even if very little legislation is ultimately enacted.
House Republicans will likely focus on bills to (1) make the tax relief enacted as part of the Tax Cuts and Jobs Act (TCJA) permanent and (2) repeal tax increases included in the recently enacted IRA. Although these bills will not receive consideration in the Democratic-controlled Senate (and certainly would not be signed into law by President Biden), they will establish the Republican tax policy platform in advance of the 2024 Presidential and Congressional elections. This is particularly important given that several TCJA items, including the reduced individual rates and the section 199A pass-through deduction, are scheduled to expire at the end of 2025.
House Republican tax-writers will turn a critical eye on the IRS and its newly established 10-year, $80-billion funding boost. Expect early House action on legislation that would dial back that amount or repurpose it entirely for customer service rather than enforcement. House GOP leaders are expected to keep up the pressure on the IRS with close scrutiny of the new funding and how those funds will be deployed through a series of letters of inquiry, document requests, oversight hearings, and even subpoenas. Deployment of the new IRS funding will, over time, have a significant impact on taxpayers – funding targeted at improving customer service should result in reduced times for the processing of returns and refund claims, whereas funding targeted at enforcement will ultimately result in increased audit scrutiny of taxpayers.
Senate Democrats, by contrast, are likely to return to the themes of the Build Back Better Act (BBBA), proposing "social infrastructure" and other domestic spending programs financed by marginal rate increases and other revenue raisers targeted at high-income individuals and large businesses. Tax increases passed by the House as part of the BBBA but not enacted as part of the IRA will likely be proposed again. Similar to the reception that House Republican proposals will receive in the Senate, virtually any combination of spending and tax increases proposed by Senate Democrats is a dead letter to the House.
Setting aside the political messaging exercises of both parties, what tax legislation could actually reach the president's desk? There may be opportunities for tax proposals to be included in larger pieces of legislation in response to a sudden economic downturn or even a package providing relief from a natural disaster. In addition, Congress may consider farm and aviation authorization bills next year that could serve as vehicles for tax proposals. Popular tax provisions with strong bipartisan support, such as the extension of temporary tax relief provisions ("tax extenders") and bonus depreciation, may also get consideration – although the window of opportunity may close quickly given the pending 2024 elections.
Overall, a very modest tax legislative agenda is anticipated for the next Congress, one focused more on political messaging and oversight than on enacting tax legislation. While there may be some incremental tax legislation considered, there likely will be few (if any) major tax policy changes (and certainly no significant tax increases) in the next two years, as Congressional actions will be primarily directed at developing policy platforms for the 2024 elections. Nevertheless, it is important for taxpayers to remain engaged, as those policy platforms could soon be acted upon after the next elections.
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