Monthly Tax Roundup (Volume 2, Issue 6)
This month's Tax Roundup is focused on administrative guidance as we summarize several important recently released guidance packages in the international space, as well as highlight the annual request for new projects for the Priority Guidance Plan (PGP). We also analyze the Supreme Court's grant of certiorari in an administrative law case, the resolution of which may have significant impact on the administrative guidance process going forward.
Tax Fact: The Congressional Budget Office (CBO) projects that corporate income tax receipts will decrease steadily in relation to Gross Domestic Product (GDP) from 2023 to 2033, "reflecting the net effects of scheduled changes in tax rules."
"Death and taxes may be inevitable, but unjust taxes are not." –Ronald Reagan
Proposed Regulations Favorably Address Repatriation of Intangible Property
On May 2, 2023, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released proposed regulations addressing the tax consequences under section 367(d) of repatriating certain intangible property (IP). The proposed rules would eliminate potential obstacles to the return of IP to the U.S.
Under section 367(d), when a U.S. person transfers IP to a foreign corporation in a nonrecognition transaction, the transaction is treated as a taxable sale of the IP in exchange for deemed royalties over the useful life of the IP. Under existing rules for subsequent transfers, it is unclear whether repatriation of the IP would terminate the annual deemed inclusions under section 367(d). The preamble to the proposed rules acknowledges that "[c]ontinued application of section 367(d) in these situations could result in excessive U.S. taxation and may disincentivize certain repatriations of intangible property." Accordingly, Treasury and the IRS propose to terminate deemed royalties arising from a prior outbound transfer of IP if the IP is repatriated to certain qualified U.S. persons.
Under the proposed rules, the application of section 367(d) is terminated if the foreign IP owner subsequently disposes of the IP to a "qualified domestic person," and the original U.S. transferor satisfies certain reporting requirements. Qualified domestic persons generally include related U.S. corporations, related U.S. individuals, and the original (or successor) U.S. transferor. However, partnerships, regulated investment companies (RICs), real estate investment trusts (REITs), and S corporations are excluded from the definition of qualified domestic persons. In declining to treat domestic partnerships as qualified domestic persons, Treasury and the IRS refrained from providing rules treating a partnership as an aggregate of its partners, based on the concern that an aggregate approach "could allow taxpayers to circumvent the purposes of these proposed regulations[.]"
Upon a qualified disposition, the original U.S. transferor recognizes a final partial deemed royalty payment and depending on the transaction, may recognize gain. Whether (and how much) gain is recognized depends on whether the IP is "transferred basis property" as a result of the subsequent disposition.
For transferred basis property, the gain recognized is the amount the transferee foreign corporation would recognize if its adjusted basis in the IP equaled the U.S. transferor's former adjusted basis in the property. Thus, no gain would be recognized on the repatriation of IP arising from the complete liquidation of the transferee foreign corporation in a transaction described in sections 332 and 337. This is because a transferee foreign corporation does not recognize gain in the liquidation, "regardless of the adjusted basis in the intangible property."
For IP that is not transferred basis property, the gain recognized is the excess of the fair market value of the IP over the U.S. transferor's former adjusted basis in the IP. Thus, if the IP is repatriated through a distribution of built-in gain property described in section 311(b), the U.S. transferor would recognize gain equal to the difference between the fair market value and the U.S. transferor's adjusted basis at the time of the original outbound transfer.
The proposed regulations provide rules for determining the qualified domestic person's adjusted basis in the repatriated IP. In drafting those rules, Treasury and the IRS declined to address longstanding "uncertainty regarding the treatment of adjusted basis in intangible property subject to section 367(d) while section 367(d) applies" (that is, before the IP is repatriated).
The proposed regulations do not contain a rule allowing taxpayer reliance prior to finalization. Comments must be received by July 3, 2023.
IRS Formalizes Process for Evaluating Advance Pricing Agreement Requests
The IRS has issued interim guidance on the process the Advance Pricing and Mutual Agreement Program (APMA) will follow in determining whether to accept a taxpayer's request for an advance pricing agreement (APA). Existing guidance already states that APMA has discretion to reject an APA request and identifies some circumstances in which APMA may do so. See Rev. Proc. 2015-41, 2015-35 I.R.B. 263, § 4.02(1). The interim guidance formalizes the process APMA follows when exercising this discretion and, for the first time, explicitly provides a role for non-APMA IRS transfer-pricing personnel in that process. The stated goal is to provide an "early mechanism for identifying potential roadblocks to successfully concluding a proposed APA and opportunities for other paths to certainty," not to limit or decrease the number of APA requests that APMA accepts. Nevertheless, taxpayers and tax practitioners have been wary about the extent to which the interim guidance will cause APMA to refer requests away from the collaborative APA function and toward the more adversarial IRS examination function for processing.
An APA is a mechanism for taxpayers to coordinate with one or more tax authorities to resolve transfer pricing issues on a voluntary and prospective basis. The U.S. has had a formal APA program for over 30 years and has executed over 2,200 APAs during that time. In recent years, APMA has seen its inventory of pending APA requests rise and the average time for executing an APA lengthen. Recent APMA statements have also referenced instances where APMA has worked on an APA request for years only to have a treaty partner ultimately refuse to accept the APA request or otherwise terminate the process, an outcome APMA considers "an utter failure and a waste of everybody's time and resources."
Against this backdrop, the interim guidance observes that there are multiple procedural mechanisms for obtaining certainty for transfer pricing issues and an APA might not always be the most "successful," a concept the interim guidance asserts is based "not only on reaching agreement but also doing so with an appropriately commensurate commitment of financial and human resources for both the taxpayer and the tax administrations involved." Other procedural mechanisms specifically called out in the interim guidance are the International Compliance Assurance Process (ICAP), joint audits by multiple tax authorities, and conventional transfer pricing examinations. Taxpayer views on and experiences with these mechanisms, which are invariably retrospective in nature, have been mixed.
Broadly speaking, the new APMA review process has two stages. First, APMA will provide optional pre-submission review to taxpayers that wish to submit a prefiling memorandum to APMA before submitting a formal APA request. In this pre-submission review, APMA — in consultation with IRS transfer pricing personnel responsible for risk assessment — will give a preliminary opinion on whether an APA or an alternative mechanism is best suited for successfully achieving the desired certainty. Second, APMA — again, in consultation with other IRS transfer pricing personnel — will formally review all APA requests to determine whether to accept the request in full or in part. In both contexts, APMA will consider the facts and circumstances underlying the request based on several criteria, none of which is dispositive. These criteria relate to the experience APMA may have with the type of request or treaty partner to be involved, as well as the materiality and complexity of the transfer pricing issues proposed to be covered by the APA. These procedures and criteria apply to all APA requests filed with APMA after April 24, 2023, whether unilateral, bilateral, or multilateral and whether for a new APA or a renewal APA.
APMA review of prefiling memoranda and APA requests and discussions between taxpayers and APMA regarding the prospects for achieving a successful APA are not new. Rev. Proc. 2015-41 currently contemplates both. What is new, however, are the requirements that APMA conduct such review in consultation with IRS transfer pricing personnel responsible for risk assessment and discuss the outcome of that review with the taxpayer. Evaluating these developments against the backdrop of limited APMA resources, APMA's growing APA request inventory and processing time, and references to alternative treatment streams like ICAP, joint audits, and conventional transfer pricing examinations have led to taxpayer and tax practitioner concern over the extent to which the interim guidance is a wolf in sheep's clothing that will restrict taxpayers' access to the APA program. APMA leadership have resoundingly rejected this characterization, asserting that the interim guidance is a formalization of existing processes and procedures and caters to what should be a mutual desire by taxpayers and the IRS to obtain transfer pricing certainty as efficiently and effectively as possible. Time and experience operating under the interim guidance are needed to determine its practical effect. In the meantime, taxpayers may glean additional insights to the extent APMA incorporates the formalized review process in the pending revision to Rev. Proc. 2015-41, which has been on the IRS's PGP since September 2021.
IRS Releases Guidance on Portfolio Investor Exception in FIRPTA
On May 19, 2023, the IRS Office of Associate Chief Counsel (International) released a Generic Legal Advice Memorandum (AM 2023-003, the GLAM) addressing an exception from U.S. taxation under section 897 for portfolio investors in regularly traded stock in a U.S. real property holding company (URPHC), and in particular the application of this "regularly traded exception" to stock held through a partnership. Under section 897(c)(3), stock in a U.S. corporation that is regularly traded on an established securities market may only be treated as a U.S. real property interest (USRPI) if a person beneficially owns more than five percent of the corporation's total value during a specified period. The GLAM concludes that if stock in a publicly traded USRPHC is held by a partnership, the five percent ownership threshold must be tested both at the level of the partnership and at the level of the partners.
The GLAM applies an "entity approach" to partnerships to analyze a situation (Situation 1) in which a nonresident alien owns a 25 percent interest in a partnership, which in turn owns eight percent of the stock of a publicly traded USRPHC. The GLAM concludes that the nonresident alien cannot qualify for the regularly traded exception because the partnership owns more than five percent of the stock of the USRPHC. This is the case even though the nonresident alien economically has only a two percent indirect interest in the USRPHC and therefore might otherwise be considered a portfolio investor. In reaching its conclusion that an entity approach is appropriate, the GLAM points to several statutory schemes in which the activities or nexus of a partner are tested at the partnership level. It observes that a partnership is a "collective investment vehicle" and that a partnership can determine whether a corporation whose stock it owns is a USRPHC and to file returns.
The GLAM makes clear, however, that this entity approach does not protect a foreign investor from U.S. tax under section 897 in a case where the foreign investor owns more than five percent of the stock of a USRPHC, whether directly or constructively through a partnership. In the second situation presented in the GLAM (Situation 2), a nonresident alien owns a 25 percent interest in a partnership, which in turn owns four percent of the stock of a publicly traded USRPHC. In addition, the individual directly owns 4.5 percent of the same USRPHC. The GLAM concludes in Situation 2 that the stock does not qualify for the regularly traded exception because the nonresident alien owns 5.5 percent of the stock of the USRPHC (4.5 percent directly, plus one percent constructively). The GLAM states that this result is dictated by the section 318 attribution rules, which are referenced in section 897(c)(6).
The IRS position in the GLAM will affect foreign portfolio investors who might otherwise have expected that the regularly traded exception would apply to their investments so long as they do not own more than a five percent economic interest in a USRPHC. The IRS's application of an entity approach in Situation 1 is notable in light of the policy of excluding portfolio investments in publicly traded stock from taxation, which Congress articulated when enacting the Foreign Investment in Real Property Act (FIRPTA). See H.R. Rep. No. 96-1167, at 513 (1980).
Notice 2023-36 Provides an Opportunity to Highlight Issues of Concern Through Priority Guidance Plan Recommendations
On May 4, 2023, the IRS issued Notice 2023-36, 2023-21 IRB 855, requesting public recommendations for items to be included on the 2023-2024 PGP. The 2023-2024 PGP will identify guidance projects that Treasury and the IRS intend to actively work on as priorities during the period from July 1, 2023, through June 30, 2024.
Given limited IRS resources and the flood of recently enacted legislation requiring administrative guidance, the PGP has taken on increased importance in focusing the IRS' efforts on those guidance items most important to taxpayers and tax administration. In reviewing recommendations and selecting additional projects for inclusion on the 2023-2024 PGP, Treasury and the IRS will consider the following:
- Whether the recommended guidance resolves significant issues relevant to a broad class of taxpayers
- Whether the recommended guidance reduces controversy and lessens the burden on taxpayers or the IRS
- Whether the recommended guidance relates to recently enacted legislation
- Whether the recommendation involves existing regulations or other guidance that is outdated, unnecessary, ineffective, insufficient, or unnecessarily burdensome and that should be modified, streamlined, expanded, replaced, or withdrawn
- Whether the recommended guidance promotes sound tax administration
- Whether the IRS can administer the recommended guidance on a uniform basis
- Whether the recommended guidance can be drafted in a manner that will enable taxpayers to easily understand and apply the guidance
In our experience, recommendations for the PGP have become an effective and efficient mechanism for highlighting issue of concern and in need of guidance to the IRS. That being said, competition for slots on the PGP is high given a conscious effort by the IRS to reduce the number of projects on the PGP to focus the plan on those projects that can reasonably be completed within the plan year and the priority given to guidance projects related to the large amount of recently enacted legislation. As a result, taxpayers often resubmit their recommendations multiple times over a period of years before a project is included in the PGP. In some instances, the IRS may propose an alternative mechanism, such as a private letter ruling (PLR), to address important issues that cannot find a home on the PGP. Furthermore, because the recommendations are publicly available on regulations.gov (and typically published in the tax press), PGP recommendations can also be an effective mechanism for identifying other impacted taxpayers who would be supportive of the recommendation.
Recommendations in response to Notice 2023-36 are due by June 9, 2023.
Supreme Court to Revisit Chevron Doctrine
On May 1, 2023, the U.S. Supreme Court granted certiorari in Loper Bright Enterprises v. Raimondo, No. 22-451 (S. Ct.), a challenge to a regulation requiring the fishing industry to pay for the costs of observers who monitor compliance with fishery management plans. The crux of the dispute in Loper is a doctrine of statutory interpretation called Chevron deference. This doctrine has been a fixture of administrative law since the Supreme Court decided Chevron v. Natural Resources Defense Council, 467 U.S. 837 (1984). That decision established a two-part test for evaluating whether a regulation is invalid. In Step One, the court examines whether the regulation unambiguously contravenes the language of the statute. If so, the regulation is invalid. If the statute is ambiguous, however, the court moves to Step Two, which defers to the agency's interpretation of the statute unless it is unreasonable. Few challenges to regulations succeed at Chevron Step Two.
When the Supreme Court agreed to hear Loper, it indicated it would consider "[w]hether the Court should overrule Chevron or at least clarify that statutory silence concerning controversial powers expressly but narrowly granted elsewhere in the statute does not constitute an ambiguity requiring deference to the agency." As Miller & Chevalier's ERISA and Employee Benefits Litigation practice recently noted, while certain conservative justices on the Supreme Court have repeatedly criticized Chevron, the lower courts have continued to apply the doctrine because it remains binding precedent. The implications of the Supreme Court chiseling away at Chevron, or outright reversing it, may go far beyond the fishing industry and may have a dramatic impact on regulatory challenges to Treasury regulations.
Chevron currently applies to Treasury regulations as well as regulations by other federal agencies. Over the past several years, taxpayers have increasingly challenged the validity of Treasury regulations. While many of those challenges succeed on procedural grounds, such as Treasury's failure to follow the rules of the Administrative Procedures Act, substantive challenges to Treasury regulations must contend with Chevron deference. Because the Internal Revenue Code is often silent on important questions, Treasury seeks to fill in those gaps with regulations. The IRS relies heavily on Chevron deference to defend those regulations from substantive court challenges. If the Supreme Court abolishes the Chevron doctrine, the IRS will have to defend Treasury regulations on the merits based on traditional statutory interpretation principles, rather than relying on Chevron deference to carry the day.
The Supreme Court may not take the dramatic step of overruling Chevron completely. The Court could merely set limits on the applicability of the doctrine or could even reaffirm Chevron's holding. Whatever the Supreme Court does, it will have a direct impact on the tax world, and taxpayers should monitor Loper closely.
*Katherine Lewis is a summer associate.
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