Monthly Tax Roundup (Volume 2, Issue 2)
Welcome to this month's tax roundup, which focuses on recent important developments at the Internal Revenue Service (IRS) and in the courts. The IRS continues to be very active, releasing a slew of guidance addressing previously taxed earnings, the research credit, and the new stock buyback excise tax. In the courts, we take a close look at developments in the Liberty Global case and the Supreme Court's latest actions on attorney-client privilege and the validity of the conservation easement regulations.
Tax Fact: Next year is unique in that no federal tax provisions are currently set to expire in 2024, according to the Joint Committee on Taxation.
"Death, taxes, and childbirth! There's never any convenient time for any of them." – Margaret Mitchell, American novelist
IRS Rules on Basis Consequences of Mid-Year Distribution of Previously Taxed Earnings
On January 27, 2023, the IRS released a private letter ruling (PLR 202304008) addressing the basis consequences of a mid-year repatriation of previously taxed earnings and profits (PTEP). For the transaction at issue, the ruling favorably answers a longstanding question of whether a mismatch exists in the timing of upward and downward basis adjustments associated with the creation and distribution of PTEP. The ruling may represent the first step toward resolving a nettlesome issue which has hindered cross-border cash management.
Under section 961(a), a U.S. shareholder increases its basis in stock of a controlled foreign corporation (CFC) by amounts the shareholder has been required to include in gross income under section 951(a), but which the CFC has not yet distributed. The upward basis adjustment ensures that the U.S. shareholder is not taxed on phantom gain if the shareholder sells the CFC before the previously taxed earnings are distributed. When a CFC distributes PTEP, the distribution is excluded from gross income of the U.S. shareholder under section 959(a), thereby preventing double taxation of the same earnings. When the U.S. shareholder receives a distribution of PTEP, the U.S. shareholder must reduce its basis in the CFC stock by the amount excluded from income under section 959(a). If the amount excluded from gross income exceeds the U.S. shareholder's adjusted basis, the shareholder must recognize gain under section 961(b)(2).
If a taxpayer distributes PTEP before the end of the taxable year, it may risk triggering the downward basis adjustment (including potential gain recognition) before the offsetting upward basis adjustment becomes available. Under 1965 final regulations, the U.S. shareholder increases its basis in the CFC to account for subpart F and global low-taxed intangible income (GILTI) inclusions "as of the last day of the taxable year." Treas. Reg. § 1.961-1(a). By contrast, the U.S. shareholder decreases its basis in the CFC at the time it "receives such excluded amount." Treas. Reg. § 1.961-2(a).
Proposed regulations published in 2006 would have resolved the potential timing mismatch, but the Department of the Treasury (Treasury) and the IRS formally withdrew those proposed rules in October 2022. Treasury and the IRS also provided limited relief in the context of the transition tax, through the "gain reduction rule" in Treas. Reg. § 1.965-2(g), but expressly cabined that relief to section 965 PTEP.
Summary of the January 2023 Ruling
In the January 2023 ruling, a U.S. shareholder includes subpart F and GILTI amounts in gross income and adjusts its PTEP accounts with respect to the associated CFC. The CFC distributes those earnings to the U.S. shareholder before the end of the taxable year in which the earnings were generated. Although the distribution occurs before the end of the taxable year, the IRS ruled that the U.S. shareholder accounts for the upward basis adjustment under section 961(a) when determining the basis reduction required under section 961(b). As a result, the ruling confirms that section 961 will not apply to trigger non-economic gain.
As always, the ruling is directed only to the taxpayer that requested it, and section 6110(k)(3) precludes unrelated taxpayers from relying on the ruling as precedent. However, the ruling represents the IRS's current approach to this longstanding question and may signal that the Office of Chief Counsel would rule favorably on similar transactions.
IRS Issues Draft Instructions for Research Credit Refund Claims
On January 11, 2023, the IRS issued a draft of revised instructions to the Form 6765, on which taxpayers report research and experimentation (R&E) credits. The proposed revisions incorporate additional documentation requirements for a refund claim for R&E credit first articulated in a 2021 IRS memo. See our prior coverage here, here, and here.
On October 15, 2021, the IRS announced its view of the requirements for valid R&E credit refund claims and simultaneously issued a Chief Counsel Memorandum (the R&E Memo) setting out its legal case for the requirements. The R&E Memo takes the position that a valid R&E credit refund claim must include the following requirements:
- All business components in connection with which the taxpayer is claiming the R&E credit
- For each business component:
- All research activities performed
- All individuals who performed each research activity
- All the information each individual sought to discover
- Total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses
The IRS has issued, and subsequently revised, frequently asked questions (FAQs) that elaborate on the requirements and attempt to address taxpayers' concerns with its view of a valid R&E credit refund claim. In particular, the IRS has extended the transition period, during which it will notify a taxpayer that it has determined that the taxpayer filed a deficient R&E credit refund claim and give the taxpayer 45 days to cure its claim.
The IRS has now taken its first step toward formalizing the requirements in the R&E Memo by proposing revisions to the instructions to Form 6765 that require taxpayers making R&E credit claims on an amended return (or, in the case of Bipartisan Budget Act of 2015 (BBA) partnerships, an administrative adjustment request) to meet the documentation requirements. Neither the proposed instructions nor the R&E Memo is legally binding and there continues to be controversy as to the procedural and substantive correctness of the IRS position that a valid refund claim for the R&E credit must meet the documentation requirements.
The IRS has not, to this point, proposed any changes to Form 6765 itself, and the draft instructions do not specify in what form taxpayers must submit the required information. But IRS officials have signaled that they intend to issue a revised Form 6765 in time for filing 2023 returns.
Treasury's Preliminary Guidance on Stock Buyback Excise Tax Expands Applicability to Foreign-Parented Companies
An anti-abuse rule, announced in guidance issued by Treasury and the IRS on December 27, 2022, would sweep foreign-parented groups into the stock buyback excise tax in a manner inconsistent with the language and intent of the statute. Although section 4501 has limited application to foreign-parented groups, the interim guidance announced in Notice 2023-2 introduces a per se rule that subjects the repurchase of publicly traded foreign parent stock to the excise tax to the extent it is "funded" (other than by distribution) by a U.S. affiliate within a two-year period. The breadth of this "funding rule" has the potential to penalize routine transactions. Comments to Notice 2032-2 are due March 20.
In general, the stock buyback excise tax applies only to publicly traded U.S. corporations. Under section 4501(d), if a U.S. affiliate purchases stock of its publicly traded foreign parent, then the U.S. affiliate is treated as a covered corporation and the hook stock is treated as a repurchase of the U.S. affiliate's own stock. When issuing Notice 2023-2, Treasury and the IRS were concerned that taxpayers could avoid the "hook stock" rule in section 4501(d) by funding a foreign affiliate to then repurchase the stock of the publicly traded foreign parent.
Notice 2023-2 establishes a "principal purpose" rule, under which a stock repurchase by a foreign corporation that is funded "by any means," including by distribution, debt, or capital contribution, from a U.S. affiliate could trigger the excise tax if the funding has a "principal purpose of avoiding the stock repurchase excise tax." Under the second prong of the rule (the per se rule), if a U.S. affiliate funds by any means, other than a distribution, a foreign affiliate, and the foreign affiliate repurchases stock of the publicly traded foreign parent company within two years of the funding, a principal purpose is deemed to exist and the excise tax rules are triggered. If the funding rule applies, it appears that the "netting rule" that permits stock buybacks to be offset by stock issuances only applies to the extent foreign parent stock was issued or provided to employees of the U.S. affiliate. There are no examples or other guidance illustrating the scope of the cavernous language "funds by any means."
In public comments, Treasury officials have noted that the per se rule is similar to rules in section 385 regulations and was driven by the assumption that events that happen close in time are connected. The government has signaled receptivity to comments on the funding rule, potentially including comments requesting exceptions for routine business transactions. These public comments do not address the core criticism of the interim guidance that a broad funding rule was never contemplated by Congress and is grossly overbroad if intended to target abusive avoidance transactions.
The funding rule, if promulgated as described in the Notice, would apply to repurchases and acquisitions of stock made after December 31, 2022, that are funded on or after December 27, 2022.
Liberty Global Files Motion to Dismiss Over Government Suit
Liberty Global, Inc. (LGI) has moved to dismiss a case brought by the government to collect $284 million in tax and accuracy-related penalties. LGI asserts that the government's complaint fails to state a valid claim because it never issued LGI a notice of deficiency, which LGI asserts is a statutory prerequisite for any government suit to collect unpaid income taxes. The government has not yet filed its opposition, but the district court has expressed skepticism towards LGI's position.
LGI originally sought a refund of $109 million in connection with a December 2018 transaction in which it sought the dividends received deduction under section 245A. Under temporary regulations issued in June 2019, most of the section 245A deduction was prohibited. On LGI's motion for partial summary judgment, the U.S. District Court for the District of Colorado ruled in April 2022 that the temporary regulations were invalid for failure to comply with requirements under the Administrative Procedure Act (APA). Rather than seeking interlocutory appeal, the government filed a separate complaint in October 2022, alleging that the December 2018 transaction lacked economic substance and that LGI owed additional tax. As a result of the government's complaint, there are two parallel cases in federal district court in Colorado addressing LGI's 2018 tax year — LGI's refund suit and the government's collection action.
In its motion to dismiss, LGI argues that section 6213(a) plainly requires that a notice of deficiency must precede any government collection action. LGI observes that courts have unanimously held that a notice of deficiency is required before any collection action, even where the government initiates suit outside of the administrative process. Furthermore, LGI contends that the cases cited by the government are inapposite because they address notices of assessment under section 6303, which serve to notify taxpayers of an assessment of tax against them, rather than a notice of deficiency before assessment, which provides taxpayers with the opportunity to petition the United States Tax Court. Finally, LGI argues that the three-year statute of limitations for assessment has now expired and therefore the government is barred from curing its failure by belatedly issuing a notice of deficiency.
The district court had discouraged LGI from filing its motion, stating in a recent order that "it appears based upon our review of the law cited in your letters that the motion to dismiss would very likely be denied." The court reiterated its position in a subsequent order, shortly before LGI filed the motion to dismiss. In any case, the government may still issue a notice of deficiency to LGI. It has signaled that it believes a six-year statute of limitations applies under section 6501(e)(1)(C) because LGI omitted subpart F income from its 2018 return.
The Supreme Court Steers Clear of Tax Issues: In re Grand Jury and Oakbrook Land Holdings
As we previously reported, the Supreme Court had granted a petition for a writ of certiorari to review a Ninth Circuit Court of Appeals decision involving the application of the attorney-client privilege to dual-purpose communications in the tax context. In re Grand Jury, 23 F.4th 1088 (9th Cir. 2022), cert. granted, No. 21-1397 (S. Ct.). On January 9, 2023, the Supreme Court heard oral arguments in the case. Then, in an unusual move, on January 23, 2023, the Court issued an order that the writ of certiorari is dismissed as improvidently granted, otherwise known as a "DIG."
A DIG is basically a Supreme Court do-over. It means that the Court changed its position and decided that it does not want to rule on the case. The procedure is rarely invoked, and the Supreme Court typically does not explain its reasoning, as was true here. All we know is that after hearing oral arguments, the Supreme Court decided that it did not want to address the merits of the case. As a result, the Ninth Circuit's decision in In re Grand Jury will remain the governing law for that circuit. Thus, in that circuit, the "primary purpose" test will continue to apply to determine if dual-purpose communications are subject to the attorney-client privilege.
Although we will not know what led the Court to change its thinking on this case, the Justices' questions during oral argument provide some insights. Perhaps most tellingly, Justice Kagan asked petitioner's counsel if they could comment on "the ancient legal principle, if it ain't broke, don't fix it." The Justices raised questions about whether it was appropriate for the Court to address the standard for determining privilege in a federal context, when the Federal Rules of Evidence explain that state law governs for privilege determinations. In addition, the Justices probed whether the "significant purpose" test is, in fact, the right test to apply, noting that most courts have historically applied a "primary purpose" test. Justice Sotomayor was skeptical and stated that she did not believe it was so hard to administer the existing test, while raising questions about the administrability of the test being proposed by petitioner. Based on the questions raised, it seems possible that the Court decided that any divergence in approach that might exist at the lower courts to determine the privilege status of dual-purpose communications may not be so significant to require the Supreme Court's review, or that this is just an area better left to the lower courts.
We will also not be hearing from the Supreme Court on the validity of a Treasury regulation dealing with charitable contribution deductions for the donation of a conservation easement. The Court denied Oakbrook Land Holdings' petition for writ of certiorari asking the Court to resolve a conflict between the Sixth and Eleventh Circuits on the validity of a conservation easement regulation. The Sixth Circuit held in a 2-1 split decision in Oakbrook Land Holdings, LLC v. Commissioner that the regulation at issue was procedurally and substantively valid under the APA and administrative law principles. See 28 F.4th 700 (6th Cir. 2022). By contrast, in Hewitt v. Commissioner, the Eleventh Circuit set aside the regulation as procedurally invalid for failing to respond to significant comments as required by the APA. 21 F.4th 1336 (11th Cir. 2021). Given the Court's decision to decline to hear this issue, the circuit split remains and may lead to additional challenges to the conservation easement regulation in other courts.
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