Tax Court Relies on APA to Invalidate the Cost-Sharing Regulation Governing Stock-Based Compensation
October 2, 2015
We present here a guest post from our colleagues Patricia Sweeney and Andrew Howlett. A longer version of this post is published here.
In Altera Corp. v. Commissioner, 145 T.C. No. 3 (July 27, 2015), the Tax Court put the IRS and Treasury on notice that, when promulgating regulations premised on “an empirical determination,” the factual premises underlying those regulations must be based on evidence or known transactions, not on assumptions or theories. Otherwise, the regulations do not comply with the requirements of the Administrative Procedure Act (“APA”), 5 U.S.C. § 551 et seq. Applying the arm’s-length standard of Code section 482, the Altera decision provides another example of transfer-pricing litigation being decided on the basis of evidence of actual arm’s-length dealings rather than economic theories. Looking more broadly beyond the section 482 context, the decision is an important reminder to the IRS and Treasury that, in the wake of the Supreme Court’s decision in Mayo Foundation (562 U.S. 44 (2011), see our prior reports on the decision and oral argument in that case here and here), tax regulations are subject to the same APA procedures as regulations issued by other federal agencies. As a result, Treasury cannot ignore the evidence and comments submitted during the rulemaking process. If it is to reject that evidence, Treasury must engage in its own factfinding, and it must explain the rationale for its decision based upon the factual evidence.
Because of its specific impact on the regulation of cost-sharing agreements and, more generally, because it could open the door to APA challenges to other regulations, including but not limited to other transfer pricing rules, the government will strongly consider an appeal of this decision to the Ninth Circuit. A notice of appeal will be due 90 days after the Tax Court enters its final decision, but there is not yet a final, appealable order in Altera.
The Context for the Dispute. Code section 482 authorizes the Commissioner to allocate income and expenses among related parties to ensure that transactions between them clearly reflect income. Treas. Reg. § 1.482-1(b)(1) provides that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” In 1986, Congress amended section 482 to provide that, “in the case of any transfer (or license) of intangible property . . ., the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” As noted by the Tax Court, Congress enacted this amendment to section 482 in response to concerns regarding the lack of comparable arm’s-length transactions, particularly in the context of high-profit-potential intangibles. Congress did not intend, however, to preclude the use of bona fide cost-sharing arrangements under which related parties that share the cost of developing intangibles in proportion to expected benefits have the right to separately exploit such intangibles free of any royalty obligation. See H.R. Conf. Rep. No. 99-841 (Vol. II), at II-637 to II-638 (1986).
In 1995, Treasury issued detailed new cost-sharing regulations that generally authorized the IRS “to make each controlled participant’s share of the costs . . . of intangible development under the qualified cost sharing arrangement equal to its share of reasonably anticipated benefits attributable to such development.” In Xilinx, Inc. v. Commissioner, 598 F. 3d 1191 (9th Cir. 2010), the Ninth Circuit affirmed the Tax Court’s holding that the regulations did not require the taxpayer to include employee stock options (“ESOs”) granted to employees engaged in development activities in the pool of costs shared under the cost-sharing arrangement. The court reasoned that the term “costs” in the regulation did not include ESOs because that would not comport with the “dominant purpose” of the transfer pricing regulations as a whole, which is to put commonly controlled taxpayers at “tax parity” with uncontrolled taxpayers. Because of the overwhelming evidence that unrelated parties dealing at arm’s length in fact do not share ESOs in similar co-development arrangements, the court concluded that such tax parity is best furthered by a holding that the ESOs need not be shared. (For a more detailed examination of Xilinx, see our contemporaneous analysis here.)
In 2003 (prior to the Xilinx decision), Treasury had amended the transfer pricing regulations that were applicable to the years at issue in Xilinx. The amended regulations explicitly address the interaction between the arm’s-length standard and the cost-sharing rules, as well as the treatment of ESOs. Treas. Reg. § 1.482-1(b)(2)(i) now states that “Treas. Reg. § 1.482-7 provides the specific methods to be used to evaluate whether a cost sharing arrangement . . . produces results consistent with an arm’s length result.” Contrary to Xilinx, Treas. Reg. § 1.482-7(d)(2), as amended, specifically identifies stock-based compensation as a cost that must be shared.
Altera did not include ESOs or other stock-based compensation in the cost pool under the cost-sharing agreement it entered into with a Cayman Islands subsidiary. In accordance with the 2003 regulations, the IRS asserted that those costs should be included in the pool, and that, as a result, Altera’s income should be increased by approximately $80 million in the aggregate.
The Tax Court’s Analysis. Ruling on cross motions for summary judgment, the Tax Court, in a 14-0 decision reviewed by the full court, agreed with the taxpayer that the 2003 amendments to the cost-sharing regulations were invalid under the APA because Treasury did not adequately consider the evidence presented by commentators during the rulemaking process that stock-based compensation costs are not shared in actual third-party transactions.
The Tax Court first addressed the threshold issue of whether the 2003 regulations were governed by the rulemaking requirements of section 553 of the APA. To that end, it analyzed whether the regulations were “legislative” (regulations that have the force of law promulgated by an administrative agency as the result of statutory delegation) or “interpretive” (mere explanations of preexisting law). (This legislative/interpretive distinction under the APA is different from the distinction between legislative and interpretive Treasury regulations that was applied for many years in tax cases, but rendered largely obsolete by the Supreme Court’s Mayo decision.) Relying on Hemp Indus. Ass’n v. DEA, 333 F.3d 1082 (9th Cir. 2003), the Tax Court found that the 2003 cost-sharing regulations were legislative because there would be no basis for the IRS’s position that the cost of stock-based compensation must be shared under section 482 absent the regulation and because Treasury invoked its general legislative rulemaking authority under Code section 7805(a) with respect to the regulation.
APA section 553 generally requires the administrative agency to publish a notice of proposed rulemaking in the Federal Register, to provide interested persons an opportunity to participate in the rulemaking through written comments, and to incorporate in the adopted rules a concise general statement of their basis and purpose. APA section 706(2)(A) empowers courts to invalidate regulations if they are “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.” The Tax Court cited Motor Vehicles Mfrs. Ass’n v. State Farm, 463 U.S. 29 (1983), as holding that this standard requires “reasoned decisionmaking” and that a regulation may be invalidated as arbitrary or capricious if it is not based on consideration of the relevant factors and involves a clear error of judgment.
The Tax Court found that the stock-based compensation rule did not comply with the reasoned decisionmaking standard because the rule lacked a factual basis and was contrary to evidence presented to Treasury during the rulemaking process. The Tax Court stated that, although the preamble to the 2003 rule stated that unrelated parties entering into cost-sharing agreements typically would share ESO costs (thereby relating the regulation to the arm’s-length requirement of section 482), Treasury had no factual basis for this assertion. Commentators had provided substantial evidence that stock-based compensation costs were not shared in actual third-party agreements, which the Tax Court itself had found (and which the government conceded) in Xilinx. Treasury could draw no support from any of the submitted comments nor did it engage in any of its own factfinding to support its position. Absent such factfinding or other evidence, the Tax Court concluded that “Treasury’s conclusion that the final rule is consistent with the arm’s-length standard is contrary to all of the evidence before it.”
The Tax Court also stated that Treasury’s failure to respond to any of the comments submitted was evidence that the regulation did not satisfy the State Farm standard, stating “[a]lthough Treasury’s failure to respond to an isolated comment or two would probably not be fatal to the final rule, Treasury’s failure to meaningfully respond to numerous relevant and significant comments certainly is [because m]eaningful judicial review and fair treatment of affected persons require an exchange of views, information and criticism between interested persons and the agencies.” As a result, the final rule failed to satisfy State Farm’s reasoned decisionmaking standard.
Challenges for Treasury. The Altera decision highlights the limitations of the Treasury Department’s rulemaking authority when the regulation is based on a factual determination. In that situation, the deference normally given to Treasury because of its expertise as an administrative agency carries little weight unless it is supported by specific factfinding Treasury has done with respect to the rule at issue. In other words, Treasury cannot expect tax regulations that seek to implement a fact-based standard to be upheld simply because Treasury believes that they reach the right theoretical result. Instead, Treasury must explicitly cite the evidence and explain how that evidence provides a rational basis for the regulation.
The Altera decision should motivate Treasury to incorporate responses to submitted comments in its descriptions of final regulations. By specifically citing Treasury’s failure (1) to respond to comments or (2) to engage in independent factfinding as being important components of judicial review under the APA, the Tax Court’s decision effectively directs Treasury to spend more resources during the rulemaking process.
More broadly, the Altera decision underscores the constraints placed on Treasury and other administrative agencies under the APA. Although Mayo announced that Chevron deference principles would apply to Treasury regulations in the future, that was not a radical shift in the law because Treasury regulations had always been subjected to a deference analysis that bore considerable similarity to Chevron. By contrast, as the Tax Court noted, Treasury regulations have not traditionally been measured by APA standards, and Treasury’s notice-and-comment procedures have not been analyzed under State Farm. The Tax Court’s unanimous decision in Altera shows that judicial review under the State Farm standard is more than a mere paper tiger; where Treasury does not demonstrate that it adequately considered the relevant factors, including submitted comments, its regulation is at risk of being overturned. Although Altera as of now is binding authority only in Tax Court cases, challenges to Treasury regulations in other forums likely will cite its reasoning with respect to what constitutes reasoned decisionmaking for purposes of judicial review under the APA.
Considerations for Taxpayers. Absent reversal on appeal, Altera will have an impact on all related-party cost-sharing agreements. Although cost-sharing agreements governed by the 2003 regulations typically have provided for a sharing of stock-based compensation, they often have provided for a retroactive adjustment back to the start of the agreement if there is any relevant change in law. Taxpayers with cost-sharing agreements should carefully review their agreements and tax positions to determine whether their agreement provides for an adjustment mechanism or whether if claims for refund for open years are appropriate based on the Altera holding.
In addition, taxpayers should consider whether Altera has opened the door for additional regulatory challenges, both in the transfer pricing arena and elsewhere, in contexts where the regulations were premised on factual or theoretical assumptions by Treasury that lack sufficient evidentiary support. The Altera case already has been brought to the attention of the district court handling the Microsoft summons litigation in the Western District of Washington as relevant to determining whether the Treasury regulations at issue there are valid, and the case will likely also be cited in cases involving the validity of other transfer pricing regulations, such as the regulations currently under review by the Tax Court in 3M Co. et al. v. Commissioner; No. 005816-13. In addition, the transfer pricing regulations governing services transactions, which were developed following the regulations at issue in Altera, also define the term “cost” to include stock-based compensation and therefore may be vulnerable to reasoning similar to that in Altera.
Finally, taxpayers and other commentators should consider the Tax Court’s reasoning in Altera in developing comments to proposed regulations. Altera demonstrates that such comments can be important in laying a foundation for future judicial challenge even if the commentators are not successful in persuading Treasury to adopt their position.
March 17, 2015
The Fifth Circuit reversed the Tax Court’s decision in BMC Software yesterday. As we speculated that it might at the outset of the case here, the Fifth Circuit’s decision hinged on how far to take the legal fiction that the taxpayer’s accounts receivable created under Rev. Proc. 99-32 were deemed to have been established during the taxpayer’s testing period under section 965(b)(3). While the Tax Court treated that legal fiction as a reality that reduced the taxpayer’s section 965 deduction accordingly, the Fifth Circuit treated that legal fiction as just that—a fiction that had no effect for purposes of section 965: “The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period.” The Fifth Circuit based its decision on a straightforward reading of the plain language of the related-party-indebtedness rule under section 965, holding that for that rule “to reduce the allowable deduction, there must have been indebtedness ‘as of the close of’ the applicable year.” And since the deemed accounts receivable were not created until after the testing period, the Fifth Circuit held that the taxpayer’s deduction “cannot be reduced under § 965(b)(3).”
The Fifth Circuit also rejected the Commissioner’s argument that his closing agreement with the taxpayer mandated treating the deemed accounts receivable as related-party indebtedness. Here, the Fifth Circuit found that the interpretive canon that “things not enumerated are excluded” governed in this case. Because the closing agreement “lists the transaction’s tax implications in considerable detail,” the absence of “a term requiring that the accounts receivable be treated as indebtedness for purposes of § 965” meant that the closing agreement did not mandate such treatment.
November 5, 2014
The Second Circuit did not make the parties wait very long to learn the outcome of the Barnes Group’s appeal from the Tax Court’s imposition of dividend treatment on its multi-step transaction that enabled it to use in the United States cash that was located in Singapore. See our prior reports here and here. Little more than a month after oral argument, the court of appeals today issued a summary order affirming the Tax Court in all respects. The first page of such unpublished orders recites that they “do not have precedential effect,” but they can be cited in future cases pursuant to Fed. R. App. P. 32.1 (albeit only in limited circumstances in the Second Circuit, see 2d Cir. Local Rule 32.1.1). In any event, the court issued a nine-page opinion briefly touching on the issues.
First, the court of appeals quickly agreed with the Tax Court that the IRS had not run afoul of the principle that it should not argue against its own revenue rulings. Even though Barnes had relied on Rev. Rul. 74-503 in determining the tax consequences of a key step in the transaction, the court of appeals accepted the Tax Court’s explanation that Rev. Rul. 74-503 could be disregarded because it “addressed the tax treatment of an isolated exchange of stock, and therefore provided no guidance on when the individual steps in an integrated series of transactions will be disregarded under the step transaction doctrine.”
The court then upheld the application of the step-transaction doctrine, agreeing with the Tax Court that the intermediate steps would have been fruitless unless they were part of a single integrated plan. The court rejected the taxpayer’s argument that the doctrine should not apply because the steps had a valid business purpose, finding that the Tax Court’s contrary finding of no valid business purpose was not clearly erroneous. Specifically, the court of appeals stated that “any non-tax benefit of including the financing subsidiaries was, at best, a mere afterthought.” Similarly, the court held that the Tax Court did not clearly err in premising its constructive dividend conclusion on a finding that Barnes failed to show that certain interest or preferred dividend payments were ever made.
Finally, the court of appeals upheld the imposition of the 20% accuracy-related penalty. It ruled that its previous distinction of Rev. Rul. 74-503 as not applying to a situation involving multiple steps also made that ruling unavailable as “substantial authority” that could eliminate the penalty. And it ruled that Barnes had no “reasonable cause and good faith” defense because the PwC opinion on which it had relied “does not advise as to the tax consequences of the entire series of transactions transferring funds from ASA to Barnes.”
June 16, 2014
All of the briefs have now been filed in the Barnes case. The government’s response brief defends the Tax Court’s decision as a run-of-the-mill application of substance over form principles. Quoting from True v. Commissioner, 190 F.3d 1165 (10th Cir. 1999), it argues that the step-transaction doctrine applies because the “Bermuda/Delaware exchanges did not ‘make[ ] any objective sense standing alone’ without contemplation of the other steps.” In arguing that these steps served no business purpose, the government relies heavily on evidence that the “reinvestment plan” was based on tax planning that the taxpayer’s accountants had previously done for another client. The government asserts that “Barnes and PwC went to great lengths to create out of whole cloth a business purpose for a tax-avoidance plan that originated in PwC’s database.” Rather than a legitimate business plan, the government alleges that “the entire repatriation scheme consists of essentially nothing more than a circular flow of funds among Barnes and its wholly owned subsidiaries.”
The government’s brief also notes that, if the court of appeals is unpersauded by the Tax Court’s opinion, it should remand for additional factual determinations to resolve two alternative government arguments that were not reached by the Tax Court: 1) that the transaction had the principal purpose of tax evasion and therefore deductions could be disallowed under Code section 269; and (2) that the Delaware preferred stock was held under the anti-abuse rule of Treas. Reg. § 1.956-1T(b)(4).
With respect to the issue discussed in our previous post regarding the taxpayer’s argument that the government was prohibited from disavowing Rev. Rul. 74-503, the brief largely tracks the Tax Court’s discussion. In other words, the government does not question the soundness of the principle stated in Rauenhorst that the IRS cannot argue against its Revenue Rulings. Rather, the brief simply doubles down on the step-transaction point and argues that the taxpayer could not reasonably rely on that ruling here because this case does not involve “bona fide § 351 exchanges.”
With respect to the penalty issue, the government again criticizes PwC’s role, arguing that PwC had a “conflict of interest” in issuing an opinion regarding the transaction because it had an interest in a favorable tax result that would allow PwC to “market [the tax plan] to other corporations seeking to repatriate funds from a controlled foreign corporation.” Accordingly, the government argues that the taxpayer could not reasonably rely on the PwC letter for “objective advice.” The government also argues that the taxpayer could not reasonably rely on the opinion because “PwC did not opine on the integrated repatriation scheme as a whole.”
The taxpayer’s reply brief argues that the government’s brief “mischaracterizes the substance of the plan” because the Bermuda and Delaware subsidiaries did not operate as conduits for a dividend payment. Instead, it accuses the government of making a policy-based argument that would “impermissibly convert Section 956 into an anti-abuse rule.” The brief then disputes in detail the government’s description of the transaction and underlying facts.
With respect to the penalty issue, the reply brief states that the government “essentially rewrites the Tax Court’s factual findings” in criticizing reliance on the PwC opinion. The brief notes that PwC was Barnes’ long-time tax advisor and did not market the transaction to Barnes. It also states that the Tax Court held that the PwC advisor “was a competent professional who had sufficient expertise to justify reliance” and that Barnes “provided necessary and accurate information to the advisor.” In particular, the reply brief responds to the government’s “conflict of interest” accusation against PwC by noting that the Tax Court specifically observed that there was nothing “nefarious” about PwC keeping tax planning ideas in a database and by asserting that “the government’s unfounded assertions that PwC did not provide an adverse opinion in order to sell the transaction to others is ludicrous and without any factual basis.” The reply brief also argues that the government is incorrect in stating that the PwC opinion did not address the entire transaction, quoting the PwC opinion itself as stating that it “is premised on all steps of the proposed transaction.”
Oral argument has not yet been scheduled.
May 5, 2014
The taxpayer filed its reply brief in the BMC Software case last week. As in its opening brief, BMC cites Fifth Circuit precedent for the tax law definition of “indebtedness” as an “existing unconditional and legally enforceable obligation to pay.” BMC argues that it is undisputed that the accounts receivable created under Rev. Proc. 99-32 do not meet that definition—they neither existed nor were legally enforceable during the testing period for related-party indebtedness under section 965. (BMC observes that instead of disputing this point, the Commissioner tried to distinguish that case law, much of which comes from the debt-equity context. And BMC points out that the Commissioner’s argument implies different definitions of “indebtedness” may apply depending on the posture of the case.) In our first post on this case, we speculated that the outcome in this case may depend on whether the Tax Court took the legal fictions in Rev. Proc. 99-32 too far. That issue lurks beneath this definitional dispute: That the accounts receivable are deemed to have arisen during the testing period does not settle whether those accounts were “indebtedness” during the testing period.
BMC then turns to the closing agreement, which makes no mention of section 965 or the term “indebtedness.” BMC therefore relies on the legal principle that closing agreements must be construed to bind the parties “only to the matters expressly agreed upon.” BMC also addresses the Commissioner’s other arguments based on the closing agreement.
Finally, BMC makes a strong policy argument against the result in the Tax Court. BMC observes that the Commissioner concedes that the clear purpose of the related-party-indebtedness rule in section 965 is that it is meant to ensure “that a dividend funded by a U.S. shareholder, directly or indirectly, and that does not create a net repatriation of funds, is ineligible for the benefits” of section 965. Of course, no taxpayer could fund a dividend by way of deemed accounts receivable created after the dividend was paid. Therefore, BMC concludes, the case does not implicate the underlying purpose of the related-party-indebtedness rule under section 965.
We will provide updates once oral arguments are scheduled.
April 4, 2014
The Commissioner filed his brief in the BMC Software case last week. The brief hews closely to the Tax Court’s decision below. The brief primarily relies on the parties’ closing agreement and trumpets the finality of that agreement.
The Commissioner argues that BMC’s problem is of BMC’s own making—BMC chose to avail itself of the relief available under Rev. Proc. 99-32 and signed a closing agreement under which the accounts receivable were deemed established during the relevant testing period for the related-party indebtedness rule under section 965. And as if to suggest that BMC deserves the reduction in its section 965 deduction, the Commissioner repeatedly asserts that the underlying adjustments that precipitated BMC’s use of Rev. Proc. 99-32 resulted from BMC’s “aggressive” transfer-pricing strategies.
The Commissioner briefly addresses BMC’s primary argument on appeal, which is that the relevant definition of “indebtedness” for purposes of section 965 is the definition established in case law and not—as the Tax Court had found below—the Black’s Law definition. The Commissioner’s brief argues that most of the cases on which BMC relies for a definition of “debt” are inapplicable because they arise in the context of debt-equity disputes or other settlements where the Commissioner was challenging the taxpayer’s characterization of an amount as debt. According to the Commissioner’s brief, those cases address whether the underlying substance of an instrument or payment was truly debt but that “[f]actual inquiries to ascertain whether, and when, debt was created by the parties’ dealings are irrelevant here.”
The brief also addresses BMC’s arguments that the Tax Court misinterpreted the closing agreement. The Commissioner argues that parol evidence is irrelevant because the agreement is unambiguous and that in any event, the extrinsic evidence does not support BMC’s position.
BMC’s reply brief is due April 28.
Briefing Underway in Barnes as Second Circuit Considers Application of Step-Transaction Doctrine to Impose Dividend Treatment on Movement of Foreign Cash
February 21, 2014
In Barnes Group v. Commissioner, the Tax Court (Goeke, J.) looked askance at the taxpayer’s strategy for minimizing the tax consequences of a movement of foreign cash to U.S. affiliates. As the taxpayer explained it, its foreign subsidiary in Singapore had excess cash and borrowing capacity that Barnes wanted to use to finance international acquisitions. For the time being, however, there was no suitable acquisition target, and the cash was earning only 3% in short-term deposit accounts while it could have been used more profitably in the U.S. to reduce Barnes’s expensive long-term debt. Barnes hired PricewaterhouseCoopers to help it develop an approach to allow the foreign cash to be used in the U.S. without incurring the adverse U.S. tax consequences of a direct loan or distribution to the U.S. parent.
The resulting “reinvestment plan” involved the creation of two new subsidiaries, one in Bermuda and one in Delaware, and two successive contributions of cash in section 351 exchanges – first from Singapore to Bermuda and second from Bermuda to Delaware. The Delaware subsidiary then loaned the cash to Barnes. Feel free to examine the opinion linked below for the details of the transaction, but suffice it to say here that a linchpin of the tax planning was reliance on Rev. Rul. 74-503, which concluded that when two corporations exchange their own stock under circumstances similar to the section 351 exchange between the Bermuda and Delaware subsidiaries, they take a zero basis in the stock received. (Rev. Rul. 74-503 was revoked by Rev. Rul. 2006-2, but the earlier ruling is still relevant in this case because Rev. Rul. 2006-2 is prospective and provides that the IRS will not challenge positions already taken by a taxpayer that reasonably relied on Rev. Rul. 74-503.) Although Bermuda’s ownership of stock in its Delaware affiliate was an investment in U.S. property under section 956 and therefore would typically result in adverse U.S. tax consequences similar to a distribution, Barnes argued that Bermuda’s basis was zero and therefore that its section 956 inclusion should be zero.
The Tax Court disagreed, holding that the U.S. tax consequences of the transaction were different from those anticipated by Barnes. The court first determined that Rev. Rul. 74-503 did not preclude the IRS from challenging the taxpayer’s position, giving two reasons. First, the court briefly stated that, because it believed that “the substance of the reinvestment plan was a dividend from [Singapore] to Barnes” (as it would explain later in the opinion), the court did not “respect the form of the reinvestment plan” and therefore the ruling was irrelevant. Second, the court said that the ruling was irrelevant in any event because of the “substantial factual differences” between the ruling and this case. The court acknowledged that the section 351 exchanges, “considered alone, do have factual similarities to the revenue ruling,” but noted that they also were different in that they involved new subsidiaries, including a controlled foreign corporation. In addition, the Tax Court emphasized that the Barnes transaction was more complex than the one described in the ruling and listed seven “vast factual disparities” between the two situations. The court, however, devoted little attention to explaining why these factual differences were material to whether the principle of the ruling should apply here. Instead, the court simply recited the factual differences and then concluded that, “because the reinvestment plan far exceeded the scope of the stock-for-stock exchange addressed in Rev. Rul. 74-503,” the IRS was not precluded from challenging the taxpayer’s position.
The court then applied a step-transaction analysis to support its holding that “the substance of the reinvestment plan was a dividend” from Singapore to Barnes and should be taxed as such. According to the court, the step-transaction doctrine provides that “a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly but instead included the step for no other purpose than to avoid tax liability.” The court stated that the doctrine applies if any of three tests are satisfied: (1) the binding commitment test; (2) the end result test; and (3) the interdependence test. Finding the third test to be the most appropriate, the Tax Court concluded that the various steps were “so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps.” The key premise underlying that ultimate conclusion was the court’s determination that there was no “valid and independent economic or business purpose . . . served by the inclusion of Bermuda and Delaware in the reinvestment plan.” This analysis is an aggressive application of the step-transaction doctrine, taking it beyond its usual sphere, given that the steps ignored by the court were not transitory and that the characterization of the transaction as a dividend did not leave the parties in an economic position consistent with their legal rights and obligations following the actual transaction.
The court further found that Barnes did not “respect the form of the reinvestment plan” as Barnes made no interest payments to Delaware on the loan (even though interest had been accrued) and did not provide sufficient evidence that Delaware made any preferred dividend payments to Bermuda.
Finally, the court rejected the taxpayer’s contention that the reinvestment plan was intended to be a temporary structure under which the Singapore funds would ultimately be invested overseas when the right target appeared, noting that Barnes did not return any funds to Singapore.
The Tax Court also upheld the government’s imposition of a 20% accuracy-related penalty. The taxpayer raised two defenses to the penalty, arguing that its position was based on “substantial authority” and that it reasonably and in good faith relied on the PwC opinion letter. The court gave the “substantial authority” argument short shrift, simply repeating that Rev. Rul. 74-503 was “materially distinguishable” and hence should be afforded little weight. In response to the taxpayer’s additional citation of a 1972 General Counsel Memorandum, the court stated that GCMs “over 10 years old are afforded very little weight.” Given that taxpayers are generally invited to rely on the legal principles set forth in revenue rulings as precedent (see Treas. Reg. § 601.601(d)(2)(v)(d)), the court’s perfunctory dismissal of the taxpayer’s reliance on Rev. Rul. 74-503 as substantial authority – and consequent imposition of a penalty – appears fairly harsh.
With respect to reliance on the PwC opinion, the court rested its decision on its finding that Barnes and its subsidiaries did not respect the structure of the reinvestment plan by failing to pay loan interest or preferred stock dividends. In the court’s view, “by failing to respect the details of the reinvestment plan set up by PwC, . . . [the taxpayer] forfeited any defense of reliance on the opinion letter.”
The taxpayer’s opening brief contends that all of these determinations by the Tax Court are erroneous. The first and longest section of the brief criticizes the court’s step-transaction analysis and ultimate conclusion that the transactions simply amounted to a dividend from Singapore to Barnes. In the taxpayer’s view, the court’s analysis “invent[s] a new step” of a constructive dividend that “fails to account for all of the commercial realities that continue to this day for the four legally separate corporate entities.” For example, the taxpayer argues that the evidence showed that Barnes intended to repay the loans and therefore it could not be a constructive dividend. Much of this portion of the taxpayer’s brief argues that the Tax Court’s key factual findings were clearly erroneous – namely, that the two new subsidiaries lacked a non-tax business purpose; that Barnes paid no interest to Delaware; that no preferred dividends were paid; and that the reinvestment plan was not intended to be temporary.
Second, the brief argues that the government impermissibly disavowed Rev. Rul. 74-503. The taxpayer points to Rauenhorst v. Commissioner, 119 T.C. 157 (2002), for the proposition that the IRS cannot challenge the legal principles set forth in its own revenue rulings. It then argues that the factual differences identified by the Tax Court are irrelevant to the rationale for Rev. Rul. 74-503 and thus provide no basis for the government’s failure to abide by that rationale.
It will be interesting, and instructive for other cases, to see how the government deals with this point. If it is true that revenue rulings are supposed to provide guidance on legal principles on which taxpayers can rely, and if the IRS is constrained to some extent by its own rulings, it would seem apparent that merely identifying factual differences is not enough of a justification for disregarding the legal principles articulated in a revenue ruling. There are always going to be factual differences, especially when the ruling at issue contains only a brief and generic description of the facts, like Rev. Rul. 74-503. Will the government question the premise of the taxpayer’s argument in any way? Or will it accept the taxpayer’s statements about Rauenhorst and limit itself to defending the Tax Court’s position that the facts at issue are so materially different that the rationale of Rev. Rul. 74-503 cannot reasonably be applied here? Will it try to buttress the Tax Court’s reliance on the “vast factual disparities” between the two situations or will it simply focus on the argument that the tax effect of any individual step viewed in isolation is irrelevant (and therefore so is the ruling) because the transactions in substance amounted to a dividend?
Third, the taxpayer contests the court’s penalty determination. With respect to “substantial authority” the taxpayer relies primarily on the earlier discussion in the brief and maintains that it was reasonable to rely on the revenue ruling. With respect to the good faith argument, the taxpayer repeats its earlier discussion disputing the Tax Court’s finding that it did not respect the form of the transaction. It also argues that the PwC opinion, in any event, did not even address the loan and preferred dividend details on which the Tax Court rested its findings, and therefore the taxpayer’s alleged failures regarding those details do not undermine its claim of reasonable reliance on the PwC opinion. Finally, the taxpayer argues broadly that the Tax Court could not rest its good cause determination “on events that occurred after the returns were filed.”
The government’s brief is due May 15.
January 28, 2014
The taxpayer filed its opening brief in the Fifth Circuit appeal of BMC Software v. Commissioner. As we described in our earlier coverage, the Tax Court relied on the legal fiction that accounts receivable created pursuant to Rev. Proc. 99-32 in a 2007 closing agreement were indebtedness for earlier years (2004-06) in order to deny some of the taxpayer’s section 965 deductions. There are three main avenues of attack in the taxpayer’s brief.
First, the taxpayer argues that the Tax Court incorrectly treated those accounts receivable as “indebtedness” as that term is used in the exception to section 965 for related-party indebtedness created during the testing period. The taxpayer contends that the Tax Court looked to the Black’s Law definition of “indebtedness” when it should have looked to the tax law definition. And the taxpayer argues that the tax law definition—that “indebtedness” requires “an existing unconditional and legally enforceable obligation to pay”—does not include the fictional accounts receivable created under Rev. Proc. 99-32. The taxpayer argues that those accounts did not exist and were not legally enforceable until 2007 (after the section 965 testing period) and therefore did not constitute related-party indebtedness during the testing period for purposes of section 965.
Second, the taxpayer argues that the Tax Court was wrong to interpret the 2007 closing agreement to constitute an implicit agreement that the accounts receivable were retroactive debt for purposes of section 965. The taxpayer observes that closing agreements are strictly construed to bind the parties to only the expressly agreed terms. And the taxpayer argues that the parties did not expressly agree to treat the accounts receivable as retroactive debt for section 965 purposes. Moreover, the taxpayer argues that the Tax Court misinterpreted the express language in the agreement providing that the taxpayer’s payment of the accounts receivable “will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustments.” The taxpayer then makes several other arguments based on the closing agreement.
Finally, the taxpayer makes some policy-based arguments. In one of these arguments, the taxpayer contends that the Tax Court’s decision is contrary to the purpose of section 965 and the related-party-indebtedness exception because the closing agreement postdated the testing period and therefore cannot be the sort of abuse that the related-party-indebtedness exception was meant to address.
October 25, 2013
In BMC Software v. Commissioner, 141 T.C. No. 5, the Tax Court was faced with considering the effect that some legal fictions (created under a Revenue Procedure regarding transfer pricing adjustments) have on the temporary dividends-received deduction under section 965. And while both the section 965 deduction and the legal fictions under the Revenue Procedure appear to have been designed to benefit taxpayers by facilitating tax-efficient repatriations, the Tax Court eliminated that benefit for some repatriated amounts. The taxpayer has already appealed the decision (filed on September 18) to the Fifth Circuit (Case No. 13-60684), and success of that appeal may hinge in part on whether the Tax Court took the legal fictions in the Revenue Procedure too far.
First, some background on the section 965 deduction: In 2004, Congress enacted the one-time deduction to encourage the repatriation of cash from controlled foreign corporations on the belief that the repatriation would benefit of the U.S. economy. To ensure that taxpayers could not fund the repatriations from the United States (by lending funds from the U.S. to the CFC, immediately repatriating the funds as dividends, and then later treating would-be dividends as repayments of principal), Congress provided that the amount of the section 965 deduction would be reduced by any increase in related-party indebtedness during the “testing period.” The testing period begins on the earliest date a taxpayer might have been aware of the availability of the one-time deduction—October 3, 2004—and ends at the close of the tax year for which the taxpayer elects to take the section 965 deduction. Congress thus established a bright-line test that treated all increases in related-party debt during the testing period as presumptively abusive, regardless of whether the taxpayer had any intent to fund the repatriation from the United States.
BMC repatriated $721 million from a controlled foreign corporation (BSEH) and claimed the section 965 deduction for $709 million of that amount on its 2006 return. On that return, BMC claimed that there was no increase in BSEH’s related party indebtedness between October 2004 and the close of BMC’s 2006 tax year in March 2006. In the government’s view, however, this claim became untrue after the IRS reached a closing agreement with the IRS in 2007 with respect to BMC’s 2003-06 tax years.
That agreement made transfer pricing adjustments that increased BMC’s taxable income for the 2003-06 tax years. The primary adjustments were premised on the IRS’s theory that the royalties BMC paid to its CFC were too high. By making those primary adjustments and including additional amounts in income, BMC was deemed to have paid less to its CFC for tax purposes than it had actually paid.
The typical way of conforming BMC’s accounts in this circumstance is to treat the putative royalty payments (to the extent they exceeded the royalty agreed in the closing agreement) as deemed capital contributions to BSEH. If BMC were to repatriate those amounts in future, they would be treated as taxable distributions (to the extent of earnings and profits). But Rev. Proc. 99-32 permits taxpayers in this circumstance to elect to repatriate the funds tax-free by establishing accounts receivable and making intercompany payments to satisfy those accounts. The accounts receivable created under Rev. Proc. 99-32 are, of course, legal fictions—the taxpayer did not actually loan the funds to its CFC. BMC elected to use Rev. Proc. 99-32 and BSEH made the associated payments.
To give full effect to the legal fiction, Rev. Proc. 99-32 provides that each account receivable is “deemed to have been created as of the last day of the taxpayer’s taxable year for which the primary adjustment is made.” So although BMC’s accounts receivable from BSEH were not actually established until the 2007 closing agreement, those accounts receivable were deemed to have been established at the close of each of the 2003-06 tax years. Two of those years (those ending March 2005 and March 2006) fell into the testing period for BMC’s section 965 deduction. The IRS treated the accounts receivable as related-party debt and reduced BMC’s section 965 deduction by the amounts of the accounts receivable for those two years, which was about $43 million.
BMC filed a petition in Tax Court, arguing (among other things) that the statutory rules apply only to abusive arrangements and that the accounts receivable were not related-party debt under section 965(b)(3). The government conceded that BMC did not establish the accounts receivable to exploit the section 965 deduction, but argued that there is no carve-out for non-abusive transactions and the accounts receivable were indebtedness under the statute.
The court held that the statutory exclusion of related-party indebtedness from the section 965 deduction is a straightforward arithmetic formula devoid of any intent requirement or express reference to abusive transactions. The court also held that the accounts receivable fall under the plain meaning of the term “indebtedness” and therefore reduce BMC’s section 965 deduction under section 965(b)(3). So even though both the section 965 deduction and Rev. Proc. 99-32 were meant to permit taxpayers to repatriate funds with little or no U.S. tax impact, the mechanical application of section 965(b)(3) and Rev. Proc. 99-32 eliminated that benefit for $43 million that BMC repatriated as a dividend.
This does not seem like the right result. And here it seems the culprit may be the legal fiction that the accounts receivable were established during the testing period. The statute may not expressly address abusive intent, but that is because Congress chose to use the testing period in the related-party-debt rule as a blunt instrument to stamp out all potential abuses of the section 965 deduction. This anti-abuse intent is baked into the formula for determining excluded related-party debt because the opening date of the testing period coincides with the earliest that a taxpayer might have tried to create an intercompany debt to exploit the section 965 deduction. BMC did not create an intercompany debt during the testing period; the accounts receivable were not actually established until after the close of the testing period. Perhaps the court took the legal fiction that the accounts receivable were established in 2005 and 2006 one step too far. And perhaps the Fifth Circuit will address this legal fiction on appeal.
July 12, 2013
The Fifth Circuit has issued its opinion in Rodriguez, unanimously affirming the Tax Court in an opinion authored by Judge Prado. As forecasted in our earlier report on the oral argument (see here), the Court saw no way for the taxpayer to get around the technical obstacle that a section 951 inclusion is neither an actual dividend nor expressly denominated by Congress to be a “deemed dividend.” On the first point, the court stated that “actual dividends require a distribution by a corporation and receipt by the shareholder; there must be a change in ownership of something of value.” Hence, “Section 951 inclusions do not qualify as actual dividends because no transfer occurs.” On the second point, the court stated that the taxpayers’ “deemed dividends” argument was “unpersuasive . . . because, when Congress decides to treat certain inclusions as dividends, it explicitly states as much,” pointing to several provisions where Congress has explicitly stated that certain amounts should be treated as dividends.
The court did not express much angst over the unfairness argument made by the taxpayers — namely, that they could have obtained qualified dividend treatment through the formal declaration of a dividend had they only known that Congress was going to implement a more favorable rate for such dividends. The court recognized that fact, but did not agree that it led to a “harsh and unjust result.” To the contrary, the court said that the taxpayers had the opportunity to declare a dividend, or take other steps with the accumulated earnings, and those would have carried different tax implications. But they could not “now avoid their tax obligation simply because they regret the specific decision they made.” The court also gave short shrift to the taxpayers’ reliance on language in earlier legislative history and IRS pronouncements that described “a conceptual equivalence” between section 951 inclusions and dividend income.” The court said that these pronouncements carried little weight because the distinction between these inclusions and formal dividends “was treated loosely at the time because it did not carry tax implications” until 2003 when the preferential rate for qualified dividends was implemented.
The taxpayers have 45 days from the July 5 date of decision to seek rehearing, and 90 days to seek certiorari, though there is no reason to believe that either of those avenues for further review would prove to be fruitful.
June 28, 2013
The Fifth Circuit held oral argument in the Rodriguez case before Circuit Judges DeMoss, Dennis, and Prado. As we have previously reported here and here, the issue in this case is whether the taxpayers can receive qualified dividend income treatment for amounts included in their income under section 951. Taxpayers’ counsel stated that he had three main arguments: (1) section 951 is just an anti-deferral statute, not concerned with characterizing the income as dividend or ordinary income; (2) Private Letter Rulings and other Executive Branch announcements had previously characterized section 951 inclusions as “deemed dividends”; and (3) it was unfair, akin to a penalty, to deny dividend treatment to these income inclusions when the taxpayers concededly would have received qualified dividend treatment if they had actually made the distribution that was being imputed.
The court’s questioning at first focused on challenging the taxpayers’ basic point that the section 951 inclusion is essentially indistinguishable from a dividend. The court pointed out that at best what was involved was something “similar” to a dividend, not an actual dividend, noting that there was no actual distribution. When taxpayers’ counsel argued that the Code deems other kinds of income to be dividends even in the absence of a distribution, the court rejoined that these examples were distinguishable because they involved explicit statutory language providing that the income should be treated as a dividend. The taxpayers’ argument appeared to get more traction on the fairness point. The court observed that the taxpayers probably received legal advice and ought to suffer the consequences if they failed to make a dividend distribution and instead allowed the money to stay in the CFC and be subject to section 951 inclusion. But this position appeared to soften when taxpayers’ counsel explained that this choice would not have been apparent at the relevant time because it was not until the Bush-era tax cuts were enacted (including the reduced tax rate for qualified dividends) that it made any difference whether the inclusion was treated as a dividend or not.
Government counsel was met with questions as soon as she took the podium and overall had to entertain more questions than did taxpayers’ counsel. The court initially focused on the fairness point, remarking that the taxpayers had just done what was normally done at the time (before the Bush-era tax cuts) and wondering why they ought not to get the same treatment as if they had actually distributed the dividend. Government counsel acknowledged that Congress had no specific intent to impose a penalty on people in the taxpayers’ situation, but maintained that there was no basis for giving the taxpayers the relief they seek. Congress wanted to establish a reduced rate for dividends, but this was not a dividend nor any kind of distribution; it was just imputed income. Later, government counsel emphasized that there were other respects (apart from the reduced qualified dividend rate) in which the income included under section 951 is not treated as a dividend, such as the effect on earnings and profits. In response to a question about Congress’s understanding, she argued that Congress did understand that section 951 inclusions were not being treated as dividends and chose not to change that, pointing to a bill that did not get very far that would have explicitly treated them as dividends. Before the government’s argument concluded, however, the court returned to its starting point, and government counsel conceded that the taxpayers would have received the reduced tax rate if they had just formally distributed the included amount as a dividend.
On rebuttal, the court suggested to taxpayers’ counsel that the taxpayers perhaps ought to live with the consequences of their failure to take advantage of the option of declaring a dividend. The court also confirmed that the taxpayers could not cite to any binding precedent on point, but instead relied primarily on district court decisions from other jurisdictions.
Given the relative balance in the court’s questioning, neither affirmance nor reversal would be startling. If I were to hazard a guess, however, the most likely outcome appeared to be the conclusion that the reduced rate applies to “dividends,” and section 951 inclusions, while they may be similar, are not technically “dividends” nor have they been deemed dividends by statute. If so, the taxpayers may be out of luck.
May 20, 2013
[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]
The Supreme Court this morning unanimously ruled in favor of PPL in its case involving the creditability of the U.K. Windfall tax. See our prior coverage here. The opinion was authored by Justice Thomas, with Justice Sotomayor adding a separate concurring opinion.
The Court’s opinion is fairly succinct. Viewing the government’s position as more formalistic, the Court stated that it would “apply the predominant character test [of the foreign tax credit regulations] using a commonsense approach that considers the substantive effect of the tax.” The Court stated that the regulatory test looks to “the normal manner is which a tax applies,” and “the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis.”
Applying this approach, the Court held that “the predominant character of the windfall tax is that of an excess profits tax,” which makes it creditable. By contrast, the Court found that the government’s attempt to characterize the tax as being imposed on the difference between two values was unrealistic, noting that the U.K. statute’s “conception of ‘profit-making value’ as a backward-looking analysis of historic profits is not a recognized valuation method,” but instead “is a fictitious value.” The Court agreed with PPL’s argument that the equivalency of the tax with a more typical excess profits tax could be demonstrated through an algebraic reformulation of the formula for computing the tax. The Court addressed this point in some detail, putting this opinion near or at the top of the rankings in the category of most algebraic formulas found in a single Supreme Court opinion. Declaring that it must look at “economic realities, not legal abstractions,” the Court concluded that it must “follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.”
Justice Sotomayor’s separate concurring opinion focused on an issue that featured prominently in the oral argument (see our report here) — namely, how the analysis is affected by the way the tax applied to a few “outlier” taxpayers who did not operate for the full four-year period governed by the tax. Echoing the position taken in an amicus brief filed by a group of law school professors, Justice Sotomayor stated that the treatment of these outliers indicated that “the windfall tax is really a tax on average profits” and ought to be viewed as a tax on a company’s value, not net income. Justice Sotomayor acknowledged, however, that her position “cannot get off the ground” unless the Tax Court was wrong in stating in Exxon Corp. v. Commissioner, 113 T.C. 338, 352 (1999), that “a tax only needs to be an income tax for ‘a substantial number of taxpayers’ and does not have to ‘satisfy the predominant character test in its application to all taxpayers.'” Since the government indicated at oral argument that it did not disagree with the Tax Court on that point, Justice Sotomayor concluded that she should not base her analysis of the case on her “outlier” argument and instead would join the Court’s opinion. Interestingly, Justice Kagan did not join the concurrence even though she was the Justice who appeared at the oral argument to advocate most strongly for the “outlier argument” made in the amicus brief.
For its part, the majority briefly noted this argument in a footnote at the end of its opinion, and stated that it would “express no view on its merits” since the government had not preserved the argument. Notwithstanding that disclaimer, the body of the Court’s opinion provides ammunition for persons who might wish to oppose Justice Sotomayor’s position in future cases. The Court stated that the predominant character test means that “a foreign tax that operates as an income, war profits, or excess profits tax in most instances is creditable, even if it may affect a handful of taxpayers differently.” Another item in the opinion that could find its way into briefs in future foreign tax credit cases is the Court’s observation that the 1983 regulation at issue “codifies longstanding doctrine dating back to Biddle v. Commissioner, 302 U.S. 573, 578-79 (1938).” In its court of appeals briefing in PPL, the government had denigrated the relevance of pre-regulation case law, stating that the regulations merely “incorporate certain general standards from those cases,” and arguing that PPL “cannot rely on pre-regulation case law—to the exclusion of the specific regulatory test—to make its case.” The Court’s opinion will lend support to litigants who want to rely on pre-regulation case law in future foreign tax credit cases.
The Court’s opinion in PPL effectively resolves the Entergy case as well. As we have reported, the government filed a protective petition for certiorari in Entergy, but it has never suggested that PPL and Entergy should be decided differently. Thus, in the near future, probably next Tuesday, the Court can be expected to issue an order denying that certiorari petition and thereby finalizing Entergy’s victory in the Fifth Circuit.
May 7, 2013
As a follow-up to our posts on the Goosen case regarding sourcing of a golfer’s income from sponsors (see here), we provide this update on the case involving golfer Sergio Garcia. While they were not technically related cases, the significant overlap in issues and facts—not to mention witness testimony—meant that the outcome in Goosen partially determined the outcome in Garcia.
Both cases involved the character of the golfers’ endorsement income. Coincidentally, the golfers each had an endorsement contract with the same brand—TaylorMade. The golfers both argued that the lion’s share of the endorsement income was royalty income (i.e., paid for the use of the golfer’s name and likeness) and not personal services income (which is typically subject to a higher tax rate than royalties because of tax treaties).
Garcia had sold the rights to his image to a Swiss corporation (of which Garcia owned 99.5%) that in turn assigned the rights to a Delaware LLC (of which Garcia owned 99.8%). Garcia’s amended endorsement agreement assigned 85% of the contract payments to the LLC as payments for the use of his image rights. So Garcia argued that at least 85% of the endorsement payments were royalty income by virtue of the terms of the endorsement agreement. The Service originally argued that none of endorsement payments were royalty income and that all of the payments were for personal services. But the Service later tempered its position and argued that the “vast majority” of payments were for personal services.
Thanks to some testimony by the TaylorMade CEO that undermined the allocation in the agreement, the Tax Court declined to follow the 85/15 allocation in the amended endorsement agreement. But the Tax Court also rejected the Service’s argument that the “vast majority” of payments were for personal services. And the Tax Court determined that a 50/50 split was unwarranted.
In rejecting the 50/50 split, the Court tied the outcome in Garcia directly to the outcome in Goosen. As we wrote before, the Court opted for a 50/50 split between royalties and personal services for Goosen’s endorsement income. But expert testimony in Goosen contrasted Goosen’s endorsement income with Garcia’s. The expert in Goosen (Jim Baugh, formerly of Wilson Sporting Goods) had testified that, while Goosen had better on-course results than Garcia, Garcia had a bigger endorsement deal because of Garcia’s “flash, looks and maverick personality.” Consequently, the Court found that Garcia’s endorsement agreement “was more heavily weighted toward image rights than Mr. Goosen’s” and decided on a royalty/personal services split of 65/35.
The Tax Court also rejected the Service’s argument that Garcia’s royalty income was taxable in the U.S. under the U.S.-Swiss treaty. Perhaps the IRS will appeal that legal issue. Will Garcia appeal? The Tax Court’s decision is a victory for Garcia relative to the outcome in Goosen. On the other hand, if Garcia’s brand hinges on his “maverick personality,” then perhaps the “maverick” thing to do is to roll the dice with an appeal. Decision has not yet been entered under Rule 155, so we will wait to see whether there is an appeal.
February 25, 2013
[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]
Seven Justices (all but Justices Thomas and Alito) asked questions in the oral argument in PPL on February 20, but they did not obviously coalesce around any particular view of the case. Even in cases where the questioning can be more neatly categorized, it is always hazardous to try to predict the outcome based on the questioning at oral argument. At this point, the parties’ work is done, and they are reduced to waiting for a decision, which is likely to come down in May or June — certainly no later than the end of June.
Former Solicitor General Paul Clement argued first on behalf of PPL. Justice Sotomayor began the questioning of Mr. Clement and asked him the most questions. She pressed him on why the tax could not be regarded as a tax on value. She also expressed “fear” over what she saw as the breadth of the taxpayer’s position, characterizing PPL as seeking a rule that a tax is creditable “anytime a tax uses estimates of profits.” Mr. Clement responded that this “emphatically” was not the taxpayer’s position, explaining that normal valuation is prospective and hence taxes that use future estimates for valuation will always fail the realization requirement for creditability. In response to Justice Sotomayor’s suggestion that using actual profits was a reasonable way to “find the original flotation value,” Mr. Clement responded that “you would never do that in any normal valuation” because “the first rule of thumb” for those kinds of historical valuations “is to avoid hindsight bias.”
Several other Justices also asked questions of Mr. Clement, focusing on different issues of interest to them. Justice Kennedy asked a series of questions exploring the significance of the tax being labeled as a tax on value, or reasonably viewed in part as “a tax on low value,” notwithstanding that it is also logically seen as a tax on profits. Mr. Clement responded that the substance of the tax is “exactly like a U.S. excess profits tax” but did not “look at a normal rubric of value” because “the only measure of value here is by looking at retrospective earnings over a 4-year period.” Justice Ginsburg asked whether there were other examples of taxes like the U.K. Windfall Tax. Justice Breyer asked a series of questions exploring the operation and rationale of the tax as it applied to companies that had not been in operation for the full four-year period in which historical profits were measured. Mr. Clement stated that even these companies did not pay an amount of tax that exceeded their profits and, moreover, that creditability is to be determined by the “normal circumstances in which it applies,” not by the outliers.
One perhaps surprising aspect of the argument was the attention paid to the amicus brief filed by a group of law professors. Justice Kagan’s extensive questioning of Mr. Clement focused on an argument introduced by that amicus brief – namely, that the tax should not be treated as an income tax because of the way it treats the “short-period” outliers by looking to their average profits, not total profits, in determining the amount of the taxable “windfall” received. Specifically, the tax rate on those few companies who did not operate for the entire four-year period was higher than for the vast majority of the companies. Mr. Clement noted that the reason for this was because the taxing authorities “were trying to capture the excess profits during a period in which there is a particular regulatory environment” conducive to excess profits; for the short-period taxpayers the way to do this was to “hit them with a reasonably tough tax in year one but year two, three, and four they were in a favorable regulatory environment and they get no tax at all.” (Justice Breyer later stated that, “because time periods vary, rates will vary, but I don’t know that that matters for an income tax.”) Mr. Clement also emphasized here, as he did later to Justice Breyer, that the outlier case does not control creditability, which is determined based on the normal circumstances in which the tax applies. The amicus brief was also mentioned briefly by Justice Sotomayor.
After Assistant to the Solicitor General Ann O’Connell took the podium, Chief Justice Roberts engaged her on the amicus brief as well, pointing out that the argument discussed by Justice Kagan was “not an argument that you’ve made.” When Ms. O’Connell agreed, but pointed to the amicus brief, the Chief Justice remarked that “I don’t think we should do a better job of getting money from people than the IRS does.” In response to Justice Sotomayor, Ms. O’Connell sought to clarify the government’s position by distinguishing between two different points made in the amicus brief. With respect to the “aspect of the amicus brief that says if it’s bad for one, it’s bad for all,” that is not the government’s position; the government agrees with PPL that outliers do not control credibility. But with respect to the argument of the amicus that Justice Kagan had discussed in connection with the outliers – namely, that “it taxes average profits, not total profits” – Ms. O’Connell maintained that she was not saying that the argument was wrong, only that the government’s “principal argument” was that the predominant character of the tax “is not an income tax because of the way that it applies to everybody else.” Justice Kagan took the opportunity to state that she believed the argument developed in the amicus that had formed the basis for her questioning was “the right argument.”
Apart from the amicus brief discussion, Ms. O’Connell was questioned by Justices Scalia and Breyer on whether true valuations are based on historical profits, rather than direct market evidence of value. She responded that this was a good way to determine the value of the companies at the time of flotation. In response to questioning from the Chief Justice about how to treat a tax laid on income, Ms. O’Connell stated that a tax just “based on last year’s income” would be an income tax regardless of its label, but if the income were multiplied by a price/earnings ratio, it would be a tax on value. The topic of deference also made a brief appearance, with Justice Breyer suggesting that deference might be owed to the experts at the Tax Court and Justice Ginsburg wondering whether deference was owed to the government’s interpretation of its own regulations. The Chief Justice responded to the latter point by remarking that there did not appear to be a major dispute about the meaning of the regulatory language and hence that sort of deference “does not seem to move the ball much.”
Justice Breyer chimed in with a detailed discussion of the mechanics of the tax, suggesting that this indicated that the “heart of the equation in determining this so-called present value is nothing other than taking average income over the four-year period.” Ms. O’Connell disagreed, and after considerable back-and-forth, Justice Breyer remarked that he had “said enough” and he would go back and study the transcript to decide who was right.
Towards the end of the argument, Justice Ginsburg asked whether the regulation could be changed “so it wouldn’t happen again” if the taxpayer prevailed. Ms. O’Connell said that perhaps it could be made “even more clear than it already is,” but Justice Breyer wondered why it should be changed to make American companies “in borderline cases have to pay tax on the same income twice.” Ms. O’Connell disputed that characterization, stating that the taxpayer did get a foreign tax credit for payments it made of the standard British income tax and it would still get a deduction for the U.K. Windfall Tax payments if the government prevailed. Ms. O’Connell closed her argument by stating that the tax was “written as a valuation formula, and it’s not just written that way, but that’s the substance of what it’s trying to do.”
February 13, 2013
[Note: Miller & Chevalier filed an amicus brief in this case on behalf of American Electric Power Co. in support of PPL.]
PPL has filed its reply brief in the Supreme Court, thus completing the briefing. The brief responds at length to the government’s contention that the U.K. Windfall Tax should be viewed as a tax on value because it assertedly resembles “familiar” and “well-established” methods of measuring value. In fact, the reply brief maintains, the tax “is a tax on value in name only.” The reply brief observes that the tax involves “a backward-looking calculation driven entirely by actual, realized profits” and that it is “imposed on the income-generating companies themselves,” rather than on “the holder of the valuable asset.” The reply brief then states that the rest of the government’s arguments “all depend on the flawed premise that form trumps substance when it comes to the base of a foreign tax.” The difficulties with that premise were addressed extensively in PPL’s opening brief and are further addressed in the reply brief.
Oral argument is set for February 20.
February 3, 2013
[Note: Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in support of PPL in both the Third Circuit and the Supreme Court.]
A group of legal academics, led by Professor Michael Graetz of Columbia who authored the brief, has filed an amicus brief in PPL in support of the government. The brief argues that the UK tax should be treated as a tax on value, in line with the labels attached to it by Parliament, because it “was designed to redress both undervaluation at privatization . . . and subsequent lax regulation.” Maintaining that adopting PPL’s position “would open the door to claims of foreign tax credits for foreign levies based on value, not income,” the brief advances a somewhat creative policy rationale for affirming the Third Circuit that goes beyond anything argued by the government. Taking a perhaps unduly optimistic view of the political process, the brief claims that a reversal by the Supreme Court “would provide a road map to foreign governments, encouraging them to shift the costs of privatization to U.S. taxpayers by initially undervaluing public assets and companies sold to private interests and subsequently imposing a retroactive levy to compensate for the previous undervaluation.”
Although he has spent most of his career in academia (serving stints at Treasury from 1969-72 and 1990-92), Professor Graetz is not without Supreme Court experience. He briefed and argued Hernandez v. Commissioner, 490 U.S 680 (1989) on behalf of the taxpayer, arguing (unsuccessfully) for the position that adherents of the Church of Scientology were entitled to a charitable contribution deduction for payments made to the Church for “auditing” and “training” services.
Also linked below is the amicus brief filed by Patrick Smith, et al., which was noted in an earlier post, but was not available in an electronic version at the time.
January 15, 2013
[Note: Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in support of PPL in both the Third Circuit and the Supreme Court.]
The government has filed its response brief in the Supreme Court in PPL. The arguments in the brief do not closely track the analysis of the Third Circuit’s opinion. Indeed, the government pointedly distances itself from the Third Circuit’s heavy reliance on Treas. Reg. § 1.901-2(b)(3)(ii), Ex. 3. The Third Circuit had suggested that PPL’s position was foreclosed by Example 3, but the government’s Supreme Court brief suggests only that the example provides a “useful analogy,” while acknowledging that “the example is not directly applicable because it analyzes imputed gross receipts rather than actual gross receipts.” [See our prior observations on Example 3 here.]
Instead, the government’s brief asks the Supreme Court to accept the characterization of the U.K. Windfall Tax as “a tax on value,” rather than an income tax. According to the government, “[t]hat is so both because the U.K. government wrote it as a tax on value and because a company’s windfall tax liability is determined pursuant to a method of valuing property that is familiar to U.S. tax law,” where “it is common to calculate the value of property by taking into account the property’s ability to generate income.” The brief stops short of declaring that the label attached to the tax by Parliament is “determinative,” but asserts that “the ‘labels’ and ‘form’ that a foreign government uses to formulate a tax are relevant.”
PPL’s reply brief is due February 13, with oral argument scheduled for February 20.
January 4, 2013
[Note: Miller & Chevalier filed amicus briefs in this case on behalf of American Electric Power Co. in both the Third Circuit and the Supreme Court.]
The taxpayer has filed its opening brief in the Supreme Court in PPL Corp. v. Commissioner, No. 12-43, a foreign tax credit case that we have covered extensively on its journey to the Court. PPL’s brief heavily criticizes the formalism of the government’s position, stating that “the Commissioner would have the labels and form a foreign country employs, and not the substance of the tax it imposes, determine how the tax should be treated for purposes of U.S. tax law.” Once that formalistic approach is rejected, PPL argues, this becomes an “easy case” because “[t]here is no real dispute that the U.K. windfall tax is, in substance, an excess profits tax in the U.S. sense.”
Two other companies with current disputes regarding the creditability of the U.K windfall tax — Entergy Corp. and American Electric Power Co. — filed amicus briefs in support of PPL. The Entergy brief contains a detailed description of how the U.K. windfall tax came to be enacted in its particular form, and it states that the Third Circuit decision “disregards the real operation of the tax at issue.” The AEP brief contains a detailed description of the prior administrative treatment of excess profits taxes and argues that the operation and effect of the U.K. windfall tax is akin to that of a traditional U.S. excess profits tax that has always been regarded as creditable.
Another amicus brief was filed by the Southeastern Legal Foundation, the Chamber of Commerce, the Cato Institute, and the Goldwater Institute. That brief criticizes the government’s position as “opportunistic and inconsistent with the government’s usual emphasis on substance over form.” Patrick Smith also filed an amicus brief focusing on the operation of the regulations.
The government’s brief in response is due January 14. Oral argument has been scheduled for February 20.
November 21, 2012
The parties have now filed their opening briefs in the Fifth Circuit in Rodriguez, an appeal from the Tax Court’s decision that section 951 inclusion income is not to be taxed at the lower rate applicable to qualified dividends. See our prior report here.
As they argued in the Tax Court, the taxpayers emphasize a policy argument, stating that “Subpart F’s general purpose and mechanics should govern” and “Subpart F treats the amount included in the U.S. shareholder’s gross income essentially like a dividend.” The taxpayer also invokes substance vs. form principles and statements in the legislative history of Subpart F characterizing section 951 inclusions as deemed dividends. The taxpayers also point to GCMs, private letter rulings, and Internal Revenue Manual sections that support deemed dividend treatment.
The government’s response, like the Tax Court, focuses mostly on the text of the Code. It argues that the section 951 inclusion income is not literally a dividend; that the Code decrees that it should be treated as a dividend for other purposes but makes no such provision concerning the qualified dividend tax rate; and that there are some contexts in which section 951 inclusion income is not treated as a dividend, such as the earnings and profits calculation.
With respect to policy, the government asserts that the policy underlying enactment of the favorable tax rate for qualified dividends was to provide “an incentive for corporations to distribute their earnings to shareholders instead of retaining them.” Accordingly, the government argues, it does not advance that policy to provide the preferential tax rate in a situation where the corporation did not distribute the earnings.
Finally, the government urges the court to ignore the taxpayers’ argument that the IRS had previously treated section 951 inclusions as dividends in prior pronouncements. It states that those pronouncements did not specifically address the preferential tax rate question at issue here and that they are not the kind of IRS pronouncements that can be cited as authoritative precedent. In any event, the government states, the Commissioner “may change an erroneous administrative interpretation if he determines that such a position is incorrect.”
October 29, 2012
The Supreme Court this morning granted PPL’s petition for certiorari and will decide the question of the availability of the foreign tax credit for payments of the U.K. Windfall Tax on which we have reported extensively before. See here and here. The Court took no action on the government’s petition for certiorari in the companion Entergy case from the Fifth Circuit. That is a common practice for the Court when two cases present the same issue. The Court will “hold” (that is, continue to take no action on it) the Entergy petition until it issues a decision in PPL, and then it will dispose of the Entergy petition as appropriate in light of the PPL decision.
PPL’s brief is due December 13. The case likely will be argued in February or March, and a decision can be expected before the end of June.
(In case you are wondering why the Court is issuing orders on a day when the rest of Washington is shut down because of a hurricane, it is something of a Court tradition to stay open when the rest of the government is closed. In 1996, the Court heard oral arguments (as it is also doing today) on a day when the city was hit with a paralyzing blizzard. The Court sent out four-wheel drive vehicles to bring the Justices to the Court.)
October 4, 2012
In our previous post discussing the pending requests for Supreme Court review of the question of the creditability of the U.K. Windfall Tax, we noted that the Court had scheduled consideration of the PPL cert petition for its October 5 conference. The Court has now postponed that consideration until its October 26 conference. The reason for the change is to allow the Court to consider the PPL petition in tandem with the government’s petition in Entergy.
This postponement allows the Court to consider the issue with the benefit of an adversarial presentation. As you will recall, the government “acquiesced” in PPL’s cert petition on the theory that the Court should resolve the circuit conflict, and therefore there are no briefs in that case arguing that the Court should deny certiorari. The same is not true in Entergy, where the taxpayer vigorously argues that the Court should deny certiorari in both cases because the issue is not sufficiently significant to warrant Supreme Court review. Entergy notes that there are only three taxpayers directly affected by the Windfall Tax issue and asserts that the Third Circuit and Fifth Circuit, though reaching different outcomes on the specific issue, do not disagree “on matters of fundamental principle” regarding the foreign tax credit provisions. Rather, Entergy characterizes the circuit conflict as reflecting “an exceedingly narrow and technical disagreement” limited to how those principles should apply to the U.K. Windfall Tax. In its reply brief, the government acknowledges that there are only three directly affected taxpayers, but argues that there is a difference between the two circuits on the “proper analytical approach” to foreign tax credit issues that could potentially lead to disparate results in cases involving other foreign taxes.
As a result of the schedule change, the Court will likely announce whether it will review the issue on its October 29 order list. It is possible, if certiorari is granted, that the Court would make that announcement on October 26 in order to give the parties a head start on the briefing.
September 5, 2012
As previously reported here a few weeks ago, PPL filed a petition for certiorari asking the Supreme Court to review the Third Circuit’s decision denying a foreign tax credit for U.K. Windfall Tax payments. Given that the Fifth Circuit had decided the same issue in the opposite way in the Entergy case, there was a significant possibility that the government would not oppose certiorari, but instead would urge the Court to resolve the circuit conflict.
The government has now decided that its interests in resolving the conflict and potentially securing a reversal in Entergy outweigh its interest in preserving its victory in PPL, and accordingly it has filed an “acquiescence” in PPL urging the Court to hear the case. In that brief, the Solicitor General makes his case for why he believes PPL was correctly decided and also for why the issue is sufficiently important to justify Supreme Court review.
On the first point, the government’s brief rejects the characterization of the U.K. Windfall Tax as an “excess profits” tax. Instead, the government says, it is “a tax on the difference between the price at which each company was sold at flotation and the price at which it should have been sold, based on its ability to generate income.”
On the latter point, the government acknowledges both that the “specific question presented in this case is . . . unlikely to recur or to have significance for a large number of U.S. taxpayers” and that, “[b]y their nature, issues regarding the regulatory tests set forth in 26 C.F.R. 1.901-2(b) will necessarily arise in cases involving specific foreign tax laws that are unlikely to affect a large number of Americans.” But the government concludes that, “[n]evertheless, this Court’s guidance on the correct analytical approach for evaluating foreign taxes under Section 901 and the Treasury regulation may have significant administrative importance beyond the specific foreign tax law at issue here” and that the interest in uniform enforcement of the tax laws further justifies Supreme Court review.
Concurrent with its filing in PPL, the government filed a “protective” petition for certiorari in Entergy. In accordance with the Solicitor General’s common practice in situations where two different cases present the same issue, that document does not ask the Court to take immediate action. Instead, it asks the Court to hold the petition and to dispose of it as appropriate in light of the final disposition of the PPL case. The Court is likely to follow that advice, which means that if the PPL petition is denied, or if the decision is overturned, the Court will just deny the Entergy petition. If the PPL decision is affirmed, the Court would then grant the Entergy petition, vacate the Fifth Circuit’s decision, and remand the case for reconsideration in light of the Court’s intervening decision in PPL.
But that is getting ahead of things. First, the Court must decide whether to hear the issue at all. It has no obligation to do so, even though both parties recommend certiorari. Presumably, the Justices have not been dreaming about the opportunity to wade through the foreign tax credit regulations, and their inherent interest (or lack thereof) in the subject matter could tip the balance if they believe the question of importance of Supreme Court review is a close call.
The PPL petition is scheduled to be considered at the Court’s October 5 conference. An announcement of whether certiorari will be granted will most likely issue either on that date or on October 9.
August 6, 2012
The taxpayers have appealed to the Fifth Circuit from the Tax Court’s decision in Rodriguez v. Commissioner, No. 13909-08 (Dec. 7, 2011), which rejected qualified dividend treatment for certain amounts included in their income pursuant to Code Section 951. In 2003, Congress established a preferential tax rate for “qualified dividend income,” which includes dividends received from a qualified foreign corporation. Separately, section 951 contains provisions designed to limit tax deferrals by a “controlled foreign corporation” (CFC). Section 951 requires a taxpayer to include in income earnings of a CFC that are derived from investments in U.S real estate. The taxpayers in this case included such earnings in their income but sought to have them taxed at the favorable qualified dividend rate. In a comprehensive opinion, the Tax Court held that they were not “dividends” and hence should be taxed as ordinary income.
The taxpayers’ position was largely policy-based, arguing that the effect of the income inclusion was similar to that of a dividend, but their argument lacked strong direct support in the statutory text. As the Tax Court noted, legislative history and case law had described the section 951 inclusions as substantially equivalent to receiving dividends. See, e.g., Gulf Oil Corp. v. Commissioner, 87 T.C. 548, 571 (1986) (“Subpart F treats the amount of the increased investment much like a constructive dividend to the U.S. shareholders”). But the Tax Court concluded that this similarity did not resolve the case, observing that “to say that section 951 treats a CFC’s investments in U.S. property ‘much like’ a constructive dividend is a far cry from saying that such amounts actually constitute dividends.”
Instead, the Tax Court focused on a textual analysis. First, the court said that the section 951 inclusion did not meet the statutory definition of a dividend (Code section 316(a)) because there was no “distribution” by the corporation; a distribution cannot occur unless there is a “change in ownership of corporate property.” The court noted that the Code expressly provides that section 951 inclusions should be treated as a dividend for certain other purposes, but there is no such express provision for qualified dividend rates. See I.R.C. §§ 851(b), 904(d)(3)(G), 960(a)(1). The court also pointed to several provisions directing that other kinds of non-dividend income, such as redemptions and undistributed foreign personal holding company income, should be treated as dividends. See, e.g., I.R.C. §§ 302(a), 551(b). Given these examples of explicit dividend treatment elsewhere in the Code, the Tax Court concluded that the lack of an explicit textual basis for dividend treatment was a fatal flaw in the taxpayers’ position.
The Tax Court acknowledged that the taxpayers’ position drew support from the original 1962 Senate Report, which explained that, under Subpart F, “earnings brought back to the United States are taxed to the shareholders on the grounds that this is substantially the equivalent of a dividend being paid to them.” S. Rep. No. 1881, 87th Cong., 2d Sess. 794 (1962). But the court found that this sentence was not controlling, pointing to other ways in which treatment of section 951 inclusions differs from dividends (for example, effect on earnings and profits). The court added that affording qualified dividend treatment would not advance the stated legislative purpose for the preferential interest rate.
The impact of this decision is not necessarily confined to the context of qualified dividends. Rather, its reasoning seems applicable to other contexts in which one might argue that section 951 inclusions should be treated as dividends, but where there is no explicit provision to that effect. And the shoe might be on the other foot. For example, the new health care surtax on investment income for taxpayers earning more than $250,000 defines “net investment income” as including “income from interest, dividends, annuities, royalties, and rents.” I.R.C. § 1411(c)(1)(A)(i). If the IRS would like to impose the surtax on section 951 inclusion income, its victory in Rodriguez would appear to pose an obstacle to that position.
August 1, 2012
[Note: Miller & Chevalier filed an amicus brief on behalf of American Electric Power in the PPL case.]
We have fallen behind in updating the progress of the litigation concerning the creditability of the U.K. Windfall Tax that was imposed on British utilities in the 1990s. As we previously reported, the Tax Court held in two companion cases that this tax was equivalent to an income tax in the U.S. sense of the term and hence creditable. The government took two appeals — to the Third Circuit in PPL and to the Fifth Circuit in Entergy. Those courts reached opposite conclusions, and PPL has now asked the Supreme Court to grant certiorari to resolve the conflict. (See here and here for previous posts on the parties’ briefing in these cases.)
The Third Circuit was first to rule, in December 2011, and it rejected the Tax Court’s decision in an opinion that rested in large part on arguments not made in the government’s brief. The Third Circuit focused heavily on the details of the three-part test set forth in the regulations, stating that, in focusing on the “predominant character” language in those regulations, the Tax Court had errroneously suggested that the regulation “appl[y] a ‘predominant character standard’ independent of the three requirements.” In that connection, the Third Circuit dismissed the relevance of case law that predated those regulations, notwithstanding language in the preamble indicating that Treasury did not intend to depart from that prior case law. The Third Circuit also criticized PPL’s position that the “flotation value” component of the calculation was not relevant to the three-part test because it merely defined what part of the company’s profits would be taxed as “excess.” The Third Circuit did not deny that this approach would appear to prevent any “excess profits” tax from meeting the test, but it explained that “this argument merely suggests that the regulation misinterprets the statute,” and it was too late for PPL to argue that the regulation is invalid. Finally, the court surprisingly held that the Tax Court’s decision could not be squared with Treas. Reg. § 1.901-2(b)(3)(ii), Ex. 3, an example that illustrates how the gross receipts part of the regulatory test applies in a situation where the tax base is derived indirectly from a quantity that is “deemed” to reflect gross receipts. This example is of dubious relevance to the Windfall Tax, which was based on actual profits, not a “deemed” quantity; the example was not raised in the Tax Court proceedings and was mentioned only tangentially in the government’s brief.
The Fifth Circuit had heard oral argument in Entergy a couple of months before PPL was decided, but did not issue its opinion until June 2012. The Fifth Circuit stated that “the Commissioner’s assertion that we should rely exclusively, or even chiefly, on the text of the Windfall Tax” was contrary to settled case law establishing that the form of the foreign tax is not determinative. “Viewed in practical terms,” the court continued, “the Windfall Tax clearly satisfies the realization and net income requirements.” With respect to the gross receipts part of the test, the Fifth Circuit was “persuaded by the Tax Court’s astute observations as to the Windfall Tax’s predominant character” – namely, to claw back the utilities’ excess profits.
The Fifth Circuit then addressed itself directly to the Third Circuit’s PPL decision, characterizing the latter court’s reasoning as exemplifying “the form-over-substance methodology that the governing regulation and case law eschew.” The example in the regulations relied upon by the Third Circuit is “facially irrelevant,” the Fifth Circuit observed, because “[t]he Windfall Tax relies on no Example 3-type imputed amount, nor indeed on any imputation, for calculating gross receipts.” Thus, although noting that it is “always chary to create a circuit split,” the Fifth Circuit concluded that it had to disagree with the Third Circuit and find the Windfall Tax creditable.
After its petition for rehearing en banc was denied, PPL filed a petition for certiorari on July 9. The petition emphasizes the need to resolve the circuit conflict in order to achieve uniform administration of the tax law and heavily criticizes the Third Circuit for elevating the form of the tax over its substance. For its part, the government has chosen not to seek rehearing in Entergy, bringing the schedules of the cases closer together again. A petition for certiorari in Entergy is now due on September 4. The government’s response to PPL’s cert petition is currently due August 8, but a 30-day extension is likely, which would make the response due on September 7.
The position that the government decides to take in these cases is an important factor in assessing the prospects for a grant of certiorari. Most federal tax cases heard by the Supreme Court involve clear conflicts in the circuits, and it is impossible to deny the existence of such a conflict here. But the Court does not hear every tax case that involves a circuit conflict. Rather, it agrees to hear a case only when it believes that resolution of the conflict is sufficiently important, particularly to the uniform administration of the tax laws. Historically, the Court has afforded considerable deference to the government’s advice on the question of importance. As a repeat litigant at the Court, the government is very selective in asking for Supreme Court review, on the theory that if it does not ask too often, the Court is more likely to grant its requests when it really matters. And the Court does grant a high percentage (in the neighborhood of 70%) of the government’s petitions for certiorari. Thus, in deciding whether to ask the Court to resolve this conflict, the government will weigh its own interests, including estimating its prospects for success if the Court hears the case, and make a judgment about whether it views this issue as important enough to tax administration or to the government’s bottom line to justify using one of its precious “chits.”
Although one might think that the government’s monetary interests could induce it to oppose certiorari in PPL even if were to file a cert petition in Entergy, the Solicitor General’s long-term interest in maintaining credibility with the Supreme Court would trump those short-term monetary interests. Thus, there are two likely courses of action open to the government. Either it will oppose PPL’s petition and not push for Supreme Court review in Entergy or it will file a certiorari petition in Entergy and not oppose PPL’s petition. Unless there are additional extensions, we should know in early September how the government will approach the conflict. The Supreme Court will give its answer several weeks after that.
January 4, 2012
We posted in November 2011 about the Tax Court’s decision on the character and source of golfer Retief Goosen’s endorsement income. The Service appealed that decision to the D.C. Circuit in December. The D.C. Circuit case number is 11-1478. We’ll post updates as the appeal progresses.
November 1, 2011
In what appears may be the first in a series of cases on the endorsement income of non-resident aliens, the Tax Court was tasked with characterizing and sourcing the endorsement income for golfer Retief Goosen. The court’s decision may impact how other athletes and entertainers structure their endorsement deals and indicates how taxpayers should expect the IRS to source royalty income in similar cases.
Goosen, a native South African who is a U.K. resident, is subject to U.S. tax because playing professional golf in the U.S. amounts to engaging in a U.S. trade or business. He had endorsement agreements with Acushnet (which makes Titleist golf balls), TaylorMade, and Izod to use or wear their products while playing golf (these are the “on-course” endorsements). He also had endorsement agreements with Rolex, Upper Deck, and Electronic Arts (the “off-course” endorsements).
There were three main issues before the Tax Court:
(1) Was Goosen’s on-course endorsement income personal services income or royalty income or some combination of the two? (The parties agreed that all of the off-course endorsement income was royalty income.) The personal services income of nonresident aliens is subject to regular U.S. tax rates; they typically owe less U.S. tax on royalty income under tax treaties.
(2) What portion of Goosen’s royalty income was U.S.-source income? Under section 872, the gross income of nonresidents includes U.S.-source income.
(3) What portion, if any, of that U.S.-source royalty income was effectively connected to a U.S. trade or business? While U.S.-source royalties are generally subject to a flat 30% withholding tax, if royalties are effectively connected to a U.S. trade or business, they are subject to the graduated rates that apply to U.S. residents.
On the first issue, Goosen argued that the on-course endorsements were paid for the use of his name and likeness, which is classic royalty income. The IRS argued that because the on-course endorsement agreements required Goosen to make personal appearances and to play in a minimum number of golf tournaments (all while using Titleist balls and TaylorMade clubs and wearing Izod), the on-course endorsements were paid for personal services. The court split the difference, deciding that the sponsors paid for both the use of Goosen’s image and likeness and for personal services.
On the one hand, the court found that the sponsors were paying for more than just Goosen’s golfing—that the sponsors wanted to be associated with Goosen’s image. The court cited the morals clause in a couple of Goosen’s endorsement agreements as evidence that the sponsorship was about more than just golfing. (This morals-clause discussion enabled the court—and, conveniently, this blog entry—to meet the requirement that anything written about golf must mention Tiger Woods.)
The court also cited expert testimony from Jim Baugh (formerly of Wilson Sporting Goods) for the proposition that image is sometimes more important than performance. Baugh testified that while Goosen has won more and consistently been ranked higher than golfer Sergio Garcia, the two have effectively identical endorsement agreements with TaylorMade. Baugh attributed this to Garcia’s “flash, looks and maverick personality.” This is notable testimony because Garcia has his own Tax Court case pending, which is set for trial in Miami in March 2012. By detailing this testimony, the court gifts Garcia with a tailor-made argument that, relative to Goosen, a greater portion of Garcia’s TaylorMade endorsement income is royalty income.
On the other hand, the court held that the endorsement income could not be solely attributable to Goosen’s image. After all, the on-course endorsements required Goosen to make personal appearances and to play in a specified number of tournaments, all while wearing or using the sponsors’ products. Acknowledging that precision in allocating between royalty and personal service income was unattainable, the court settled on a straightforward 50-50 split.
As for the second issue, the court was left to decide what portion of Goosen’s royalty income was U.S.-source income. Generally, the source of royalty income from an intangible is where the property (in this case, Goosen’s image) is used. With respect to the Upper Deck and EA endorsements, the court looked to the relative U.S.-to-worldwide sales percentages of Upper Deck’s golf cards (92% in the U.S.) and EA’s video games (70% in the U.S.) and then sourced Goosen’s royalty income accordingly. For the three on-course endorsements and the Rolex endorsement, the court determined that while Goosen was marketed worldwide, the U.S. constitutes about half of that worldwide golf market. The court therefore treated half of the income from those four endorsements as U.S.-source income.
Finally, the court had to decide whether any of that U.S.-source income was effectively connected to a U.S. trade or business. The court held that only the on-course endorsement royalty income was effectively connected to a U.S. trade or business. The court found that since the off-course endorsements didn’t require Goosen to play golf tournaments or to be physically present in the U.S., that royalty income was not effectively connected to the U.S.
The aspect of the decision that seems to have scared some practitioners (other than the existence of a worldwide market for collectible golf cards, which maybe scares only this practitioner) was how the court sourced royalty income according to the U.S.-to-worldwide sales percentages. The fear is that the IRS will simply apply those percentages in every case, and taxpayers will have no room to negotiate a more favorable allocation.
We’ll keep an eye on where this case heads and will post updates on the Sergio Garcia case.
July 7, 2011
[Note: Miller & Chevalier represents amicus curiae American Electric Power Co. in this case.]
The PPL case is now fully briefed in the Third Circuit and ready for oral argument, which has been tentatively scheduled for September 22. PPL’s response brief addresses in detail the considerable evidence presented to the Tax Court regarding the operation and effect of the U.K. windfall tax, arguing that the evidence conclusively shows that the tax operated like a typical U.S. excess profits tax and therefore should qualify for a foreign tax credit. Amerian Electric Power Co. filed an amicus curiae brief in support of PPL that focuses primarily on discussing the precedents that call for courts to consider the kind of extrinsic evidence introduced by PPL. The government’s reply brief, like the one it filed in the companion Entergy case (see here), backs away from its previous argument that the court cannot ever consider extrinsic evidence. The government maintains, however, that PPL’s evidence was not probative and that the Tax Court should have denied creditability because the UK windfall tax describes the tax as being on “value.”
June 14, 2011
The government has filed its reply brief in the Fifth Circuit in Entergy. (See our initial report on the case here.) The reply brief puts forth a somewhat less disapproving attitude towards the examination of extrinsic evidence in foreign tax credit cases than previously advanced, stating as follows: “The Commissioner does not contend (as he did below) that extrinsic evidence has no relevance in determining creditability under Treas. Reg. § 1.901-2(b). Rather, our argument is that it was improper for the Tax Court to supplant an analysis of the windfall-tax statute with an analysis of extrinsic evidence.”
The bottom line, however, is the same. The government maintains that the text of the U.K. Windfall Tax statute, by describing the tax using the term “value,” conclusively establishes that the tax is not an “income” tax in the U.S. sense and therefore is not creditable.
The case will now await an order from the Fifth Circuit setting a date for the oral argument, which is likely a few months away.
May 23, 2011
The government has filed its brief in the Third Circuit in PPL. The brief is virtually identical to the brief filed a few weeks ago in the Fifth Circuit in Entergy that addresses the same issue of the creditability of the U.K. Windfall Tax under Code section 901. See our initial report here. The only significant differences are addressing PPL’s facts instead of Entergy’s and placing more weight on Third Circuit precedent instead of Fifth Circuit precedent. The essence of the government’s argument is that the section 901 determination should be based entirely on the text of the foreign statute, and therefore the Tax Court erred in considering extrinsic evidence of how the tax operates. Because the U.K. statute uses the term “profit-making value,” the government says that it is a tax on “value,” not an “income” tax, and therefore it should not be creditable.
PPL’s brief is due June 9.
May 13, 2011
The taxpayer has filed its answering brief in Entergy defending the Tax Court’s decision that the U.K. windfall tax is a creditable tax for purposes of the foreign tax credit under Code section 901. See our original report here. According to the taxpayer, the essence of the government’s argument is that “the creditability of a foreign tax can be determined only by the literal text of the foreign tax statute, and that the consideration of any other evidence is legal error.” This position, the taxpayer argues, is rebutted by “overwhelming authority establishing that the predominant character of a foreign tax is measured by its intent and effect,” which requires resort to evidence beyond the text of the foreign statute.
The taxpayer also argues that the government has mischaracterized the Tax Court’s decision in stating that the court ignored the three-part regulatory test for creditability. Instead, the Tax Court correctly heard evidence of the intent and effect of the U.K. tax to determine its predominant character — namely, a tax on excess profits — and then applied the three-part test to that predominant character.
The government’s reply brief is due May 31.
May 3, 2011
The Fifth Circuit yesterday issued a short, unpublished opinion affirming the Tax Court’s decision in Container. As discussed in more detail in our earlier post, the issue is the sourcing of guarantee fees charged by a Mexican parent to guarantee notes issued by its U.S. subsidiary. The Fifth Circuit ruled that the issue turned to a considerable extent on the Tax Court’s factual findings concluding that the fees were payments for services, which it found were not clearly erroneous. The Fifth Circuit concluded that the Tax Court’s ultimate characterization of the fees as foreign-source income was correct because they were payments for a service that was performed in Mexico — namely, the parent’s provision of the guarantee. The government had argued that the guarantee fees were more in the nature of interest that should be sourced to the United States.
This decision is of limited significance going forward. As we previously noted, Congress has already acted to reverse the result of this case for future years by enacting legislation specifically providing that a guarantee fee paid by a U.S. company is U.S.- sourced income. And the opinion resists making broad pronouncements about sourcing analysis, largely confining the discussion to the facts of the case. Indeed, by declining to publish the opinion, the Fifth Circuit has deliberately sought to minimize its precedential value. Under Fifth Circuit Rule 47.5.4, unpublished decisions may be cited, but they “are not precedent, except under the doctrine of res judicata, collateral estoppel or law of the case.”
A petition for rehearing, should the government choose to file one, would be due on June 16.
April 14, 2011
The government has filed its opening brief in the Fifth Circuit in Entergy, seeking reversal of the Tax Court’s holding that the U.K. windfall tax is a “creditable” tax for purposes of the U.S. foreign tax credit. See our previous report here. The government argues that the Tax Court misapplied a three-part test set forth in the regulations for determining whether a foreign tax is creditable. That test assesses whether the foreign tax has the “predominant character” of an income tax by examining whether it satisfies each of three requirements — relating to “realization,” “gross receipts,” and “net income.” According to the government, the U.K. windfall tax did not meet any of the three requirements because the tax was imposed on “value,” not realized “income,” and because gross receipts and expenses were not “components of the tax base.” The brief goes on to criticize the Tax Court for investigating the legislative purpose of the tax, rather than restricting its inquiry to the text of the statute.
The taxpayer’s brief is due May 16.
March 3, 2011
The Third Circuit has now issued a briefing schedule in the PPL case that makes the government’s opening brief due on April 5. This schedule should have the case marching along in fairly close parallel with Entergy, the companion case presenting the same UK tax creditability issue to the Fifth Circuit. (See our previous post here.) In Entergy, the government recently requested an extension to file its opening brief. The court granted an extension, but for less time than requested. The brief is now due April 13, after a 30-day extension. That date will likely hold, since the court has already cut back an unopposed extension request. In PPL, by contrast, it is quite possible that the government will get some additional time.
February 8, 2011
We present here a guest post from our colleague Kevin Kenworthy, who has considerable experience representing taxpayers on the issue of creditable foreign taxes.
The Tax Court’s two companion decisions in PPL Corp. v. Commissioner, 135 T.C. No. 8 (Sept. 9, 2010) and Entergy v. Commissioner, T.C. Memo 2010-166 (Sept. 9, 2010), raise an important question concerning whether a 1997 Windfall Tax imposed by the U.K. government on previously privatized industries is a creditable income tax under U.S. rules. The cases were tried separately before Judge Halpern and addressed in companion opinions issued simultaneously that ruled for the taxpayer (with the analysis contained in the PPL opinion). The opinions are linked below. The government has now appealed these cases to the Third and Fifth Circuits respectively. (The Tax Court cases, in opinions issued a few weeks earlier, also addressed an issue concerning the appropriate recovery period for depreciation of an electric utility’s lighting assets, but it appears at this point that the government does not plan to contest that issue on appeal.)
Under section 901 of the Code and related provisions, a U.S. taxpayer can elect to credit, rather than deduct, qualifying income taxes paid to a foreign country. Only income taxes are eligible for this credit; non-income taxes can only be deducted in computing taxable income. In determining whether a foreign tax is creditable, the ultimate inquiry is whether the levy is an income tax in the U.S. sense of the term. The governing regulations provide a specific framework for assessing whether a foreign tax meets this test, including requirements that the foreign tax meet a three-part test aimed at determining whether the tax will reach net gain in the ordinary circumstances in which it applies. Treas. Reg. § 1.901-2.
The U.K. Windfall Tax is an unconventional levy in some respects, resulting in part from its unique origins in British politics. In the early 1990s, Conservative governments continued a policy of privatizing what had previously been government-owned monopolies, including regional electricity companies, through a series of public stock offerings. The privatizations were anathema to traditional Labour Party tenets. Moreover, the newly privatized entities, although they continued to be subject to price regulation, proved to be quite profitable in the years following privatization. In 1997, the new Labour government announced a tax aimed at “windfall profits” previously realized by the formerly government-owned enterprises. The tax was justified by assertions that windfall profits resulted from the prior government’s decision to sell off the companies at too low a price, compounded by its failure to subject the privatized companies to adequate regulation.
The Windfall Tax was designed as a one-time, retrospective tax imposed on the privatized utilities. The new tax was imposed on the basis of a unique formula that started with the average book profits of these enterprises over the first four years following privatization multiplied by nine, an amount characterized by the statute as the “value in profit-making terms.” Tax at a rate of 23% was then imposed on the excess of this artificial earnings multiple over the initial market capitalization (the “flotation value”) of the shares. The tax was imposed on the companies directly, rather than on the initial private shareholders, many of whom had long ago sold their shares.
The taxpayers argued that the creditability of the Windfall Tax could be established by examining the actual operation and effect of the tax. The taxpayers showed that the statutory formula could be restated algebraically to reveal that the Windfall Tax operated in almost all cases equivalently to a tax imposed at a rate of roughly 50% on profits realized over a four-year period. Based in large part on this equivalence, the taxpayers argued that the Windfall Tax was essentially an income tax and satisfied the regulatory test for creditability. The IRS countered that the creditability of the Windfall Tax could be evaluated only by reference to the statutory language and that resort to extrinsic evidence of the type offered by the taxpayers was inappropriate. Further, the IRS argued that the statute’s apparent reference to valuation principles, rather than to conventional measures of net income, leads to the conclusion that the Windfall Tax is not creditable. Drawing ample support from the regulations themselves and from prior court decisions, the Tax Court refused to limit the creditability inquiry in this manner and found the Windfall Tax to be creditable.
The government’s opening brief in Entergy is due March 14, 2011. No briefing schedule has yet been established in PPL.
January 20, 2011
The Fifth Circuit has scheduled the oral argument in Container for Thursday March 3, 2011, in New Orleans. The identity of the three-judge panel will be announced at a future time.
December 6, 2010
Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (2009) was the first cost sharing buy-in case to go to trial. The question before the court was the value to place on the transfer by Veritas to its Irish subsidiary of the right to use technical and marketing intangibles related to software development. Veritas argued that the valuation should be based on an adjusted comparable uncontrolled transaction (CUT) analysis (involving licenses of the same or similar property). The IRS argued that it should be based on an aggregate discounted cash flow (DCF) analysis that valued the hypothetical transfer of a portion of Veritas’ business to the Irish sub; i.e., an “akin to a sale” theory.
The Tax Court held for the taxpayer in substantial part. Finding that the IRS’s “akin to a sale theory was akin to a surrender,” it rejected the IRS position that the “synergies” supposedly effectuated by considering as an aggregate various finite-lived intangibles (many of which were not even transferred) caused the whole to live forever. This is Gunnery Sergeant Hartman’s valuation method:
Marines die, that’s what we’re here for. But the Marine Corps lives forever. And that means you live forever. Full Metal Jacket (1987).
Rejecting this method, the Court dismantled the IRS’s DCF valuation which, through the application of unrealistic useful lives, growth rates, and discount rates, purported to value the transfer of assets as if it was valuing the sale of a business enterprise.
The Tax Court is correct. The Gunny’s method doesn’t work in IP valuation and, although it sounds good, it doesn’t really work with respect to the Marine Corps either. The whole doesn’t become everlasting simply because of the very important, historic sacrifices made by its earlier parts. Current and future success depends on the valor (or value) of the current parts as much as, and often more than, that of the former. Showing an understanding of this principle, the Tax Court found that a significant contributor to the anticipated future success of the Irish business was old-fashioned hard work by Veritas Ireland and its foreign affiliates. Accordingly, the Court held that the taxpayer’s CUT method, with certain adjustments, properly reflected the value of the transferred intangibles based on their expected useful lives.
In the ordinary course, one would expect the IRS to appeal a decision where it believed the factual and legal conclusions were fundamentally erroneous. However, like the schoolyard bully who gets beat up by the first nerdy kid he picks on, the IRS has kept its tactics but changed its victim. The IRS declined to appeal Veritas, while setting out its plan to take someone else’s lunch money in an Action on Decision that refuses to acquiesce in the Tax Court decision and indicates that it will challenge future transactions under the same aggregate value method rejected in Veritas. The AOD states that the IRS is not appealing Veritas because the Tax Court’s decision allegedly turns on erroneous factual findings that would be difficult to overturn on appeal.
This attempt by the IRS to use an AOD to continue to harass taxpayers should fail. The Tax Court’s opinion did not conclude that the useful life of the pre-existing IP could never survive later technology developments. And it did not exclude the possibility of future product value flowing from that original IP. Rather, it rejected the view that synergies allow the IRS to turn a specific asset valuation into a global business valuation and, while they are at it, include in that valuation non-compensable goodwill and going-concern value. The “head-start” IP provides is indeed valuable, but it is properly valued as part of a specific asset and not in some “synergistic” stew of assets, goodwill, going concern value and business opportunity. (While we are at it, Hospital Corp. of America v. Commissioner, 81 T.C. 520 (1983)) did not bless the valuation of a business opportunity; it held that while proprietary systems, methods and processes are compensable, the mere business opportunity to engage in R&D is not.) IP does give competitive advantages that do not necessarily disappear in next generation product developments. However, one cannot treat an IP transfer as the segmentation and transfer of an entire living, breathing business. This ignores the transaction that happened but, more importantly, the real and substantial risks assumed by the parties in developing the future IP, risks that drive the real value of those future products, products that are but one part of the value of that continuing business. Contra Litigating Treas. Reg. § 1.482-7T.
The AOD acknowledges that “[t]he facts found by the Court materially differed from the determinations made by the Service” but does not accept the consequences. The Tax Court disagreed with the IRS’s view of “the facts” because those “facts” were entirely inconsistent with the business realities of IP transfers. If it does not believe its position merits an appeal, the IRS should accept its loss. Instead, it is pushing around other taxpayers by foisting the same untenable “factual” story on them. As former British Prime Minister Benjamin Disraeli once said, “courage is fire and bullying is smoke.” The Veritas AOD is nothing but smoke.
December 4, 2010
We previously mentioned the IFA “Great Debate,” held on the campus of Stanford University on October 27, 2010, where the debaters squared off on the debatable utility of the Temporary Cost Sharing Regulations Income Method in valuing intangible transfers for transfer pricing purposes. As forecast, the debate was extremely well-attended (notwithstanding the conflicting start of the first game of the World Series just up the road in San Francisco). Bob Kirschenbaum and Clark Chandler drew the “pro” (i.e., you should never use the Income Method) while Jim O’Brien and Keith Reams drew the “con.” After the debate, Bob and I kicked around his presentation, how things went, and how he feels about the issue generally. The discussion seemed interesting enough to formalize and post.
Did you enjoy arguing the “pro” position? Would you have preferred to have the “con” position?
We were prepared for either and I think Clark and I did a good job advocating. However, I actually would have preferred the “con” position. It is more interesting analytically because you get to drill down on how the Code and Regulations might be read to permit an income method analysis that would fairly measure the value of the IP actually transferred.
With most taxpayers fighting the income method at Exam, wasn’t the “pro” position easier?
It is easier in the sense that the argument can be made very simply. That is true. The argument goes like this: The existing cost sharing regulatory construct already enabled the evaluation of rights to the anticipated income stream without essentially disregarding the transaction as actually structured by the parties. The “con” position, on the other hand, requires a more nuanced understanding of transfer pricing principles, what they are trying to achieve, and how one might go about constructing a set of variable inputs that could be used to indirectly derive the value of the IP transferred.
Personally, do you think the income method has a place in transfer pricing practice?
I think it does. However, Clark made a very persuasive argument that the Income Method as constituted in the Temporary Regs, while not to be discarded out of hand, becomes much more tenuous: (i) if the Regulations are read as mandating a counterfactual perpetual useful life of transferred IP (see Veritas v. Commissioner), and (ii) when coupled with the Periodic Trigger look-back provisions of the Temporary Regulations. If fairly applied, and in the right circumstances, the Income Method can be a powerful convergence tool for valuing IP. We have proven that in our dealings with Exam on cases where the IRS seeks to require CIP-compliant outcomes. Obviously, it will never be as good as a valid CUT, but it can be useful and does have a place in the practice.
What does the Tax Court’s recent decision in Veritas tell us about the viability of the Income Method?
At the end of the day, probably not much. Veritas was a gross overreach by the IRS; ultimately, the decision is just Bausch & Lomb revisited. Taxing a neutral transfer of business opportunity is not going to fly, nor is the imposition of a perpetual life for IP that produces premium profits for some limited number of years. That dog just will not hunt against a sophisticated and well-advised taxpayer. But it certainly doesn’t mean that the Income Method, properly applied, is never useful.
What do you see as the biggest errors the IRS makes in applying the Income Method?
(1) The perpetual useful life edict, and (2) the implicit presumption of unlimited sustention of competitive advantage. Technology progresses and, the fact is, legacy technology often doesn’t persist for multiple generations. You could not find too many people in Silicon Valley—where I do a fair amount of my work—who would take the other side of that proposition. Even where technology does persist for an extended period, the IRS at times contends that fundamentally new products, developed at great risk under Cost Sharing, owe their genesis entirely to foundational IP. You cannot assume large growth rates decades out and try to allocate all of that value to the original IP. At some point the competitive advantage associated with the pre-existing IP will dissipate. This is very basic finance theory. There are certainly other concerns but these are the most glaring weaknesses in the application of the Income Method.
November 22, 2010
The government has filed its reply brief in Container, and the parties will now await an order assigning a date for oral argument. The parties’ respective arguments were well delineated in the opening briefs, and the reply brief does not shed much additional light on the issue. The government emphasizes that it has never argued that guarantee fees are interest; instead it argues that they are more analogous to interest than to a payment for services. And, disputing the taxpayer’s argument, the government reiterates that this analogy is supported by the two most relevant cases, Bank of America and Centel.
The reply brief notes that Congress addressed this issue for future years in the Small Business Jobs Act of 2010. (This legislation is briefly discussed in our first post on the Container case.) Quoting the Blue Book, the reply brief asserts that the new legislation “‘effect[s] a legislative override’ of the Tax Court’s opinion in this case,” providing that a guarantee fee paid by a domestic corporation “is now expressly considered to be income from a United States source.”
We note that the practical implications of the new statute and the Container decision can differ from country to country depending on treaty provisions. The November 8 edition of Tax Analysts’ Tax Notes Today reported on a speech given by Robert Driscoll, a technical adviser at the IRS Large Business and International Division. It quoted Mr. Driscoll as saying that withholding and taxation of guarantee fees could depend on treaty provisions if the guarantor is a qualified resident of a treaty country. Specifically, if the guarantee fee can be categorized as “other income” under the treaty, Mr. Driscoll is quoted as saying, the payment “from a U.S. [subsidiary] to its foreign parent guarantor would not be U.S.-source income and thus would not be subject to withholding.” That statement is imprecise since “other income” provisions of treaties typically do not directly address sourcing. What Mr. Driscoll appears to be indicating is the IRS’s view that the “other income” provisions of treaties could preclude the U.S. from taxing guarantee fee income, even if that income is technically characterized as U.S.-source income under the new law (or, presumably, under prior law if the government prevails in Container). That would lead to the same tax result as a practical matter as a determination that the fees are not U.S.-source income.
October 28, 2010
The taxpayer has filed its answering brief in Container (attached below), arguing that guarantee fees paid to its Mexican parent were properly analogized to a payment for services and therefore sourced to Mexico. The taxpayer reasons that the government’s analogy to interest on a loan is misdirected because the guarantor does not advance any funds. All it does is “stand[ ] by to pay,” which is in the nature of a service, and it is the Mexican parent’s assets – located in Mexico – that give it the ability to serve as a guarantor. The taxpayer also maintains that the government’s position conflicts with the Tax Court’s factual findings to the extent that the government argues that the parent was a lender in substance because it expected the U.S. subsidiary to default.
The taxpayer disputes the government’s assertion that the relevant precedents support the interest analogy. With respect to the commissions paid for letters of credit in the Bank of America case, the taxpayer argues that “Bank of America was not being paid for substituting its credit for that of the foreign bank, but for substituting its money.” Accordingly, the taxpayer reasons, the commissions in Bank of America were logically analogized to interest, but a different result is called for in Container where the guarantor did not furnish any money. The taxpayer also distinguishes the Centel decision involving stock warrants as resting on factual findings specific to that case. It further contends that the Fifth Circuit should disregard the observation in Centel that Bank of America rejects analogizing guaranties to services, because that observation is “both dicta and incorrect.”
September 20, 2010
The government has filed its opening brief (attached below) in the Fifth Circuit in Container, challenging the Tax Court’s decision to treat loan guarantee fees as foreign-source income. As discussed in our previous post, the Tax Court concluded that such guarantee fees are best analogized to compensation for services.
The brief is unusually concise, using barely half of the maximum available pages. As it argued in the Tax Court, the government maintains on appeal that the fees are better analogized to interest, which would result in treating them as U.S.-source income. It emphasizes three elements of the fees in urging this position: the guarantee fees payments (1) “were made to [the Mexican parent] for the use of its credit”; (2) “to compensate it for putting its assets at risk;” and (3) “for its assistance in enabling [the U.S. sub] to meet its obligations under the Notes.”
The government’s brief criticizes the Tax Court’s approach for failing to recognize that: (1) there was no evidence that the sub had rendered any services to the parent in exchange for the fees; and (2) the amount of the fees was calculated as a percentage of the loan amount and, indeed, was a standard percentage charged by the parent to guarantee loans of its various subs irrespective of any services provided. The government also argues that the two most relevant precedents — Centel Comm. Corp. v. United States, 920 F.2d 1335 (7th Cir. 1990) (involving stock warrants), and Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982) (involving commissions paid in connection with letters of credit) — strongly support its position.
The taxpayer’s answering brief is currently due on October 18, 2010.
September 8, 2010
Practitioners interested in the more interesting conceptual aspects of transfer pricing should mark October 27th on their calendars. On that day, the International Fiscal Association is sponsoring a debate on the usefulness of the income method to value intangibles in the transfer pricing context. Dubbed “The Great Debate” by IFA, this year’s event will pit the best transfer pricing practitioners in the world (including Miller & Chevalier’s Bob Kirschenbaum and Baker & McKenzie’s Jim O’Brien) against each other. Neither will know which position they are arguing prior to a coin toss. The gloves will surely come off and our current understanding is that the only thing missing will be a steel cage. Attendance is limited to IFA members and special guests (which you can become by being sponsored by an IFA member). Information is available here.
August 13, 2010
On July 28, 2010, the IRS released AOD 2010-33; 2010-33 IRB 1. The AOD acquiesces in the result but not the reasoning of Xilinx, Inc. v. Comm’r, 598 F.3d 1191, 1196 (9th Cir. 2010) which held that stock option costs are not required to be shared as “costs” for purposes of cost sharing agreements under old Treas. Reg. §1.482-7. For prior analysis of Xilinx see this. The AOD in and of itself is relatively unsurprising. New regulations (some might say “litigating regulations”) have been issued that explicitly address the issue, and those regulations will test the question of whether Treasury has the authority to require the inclusion of such costs. The IRS surely realized that from an administrative perspective it was smart to let this one go. The best move for most taxpayers is likely to grab a bucket of popcorn and watch the fireworks as a few brave souls test Treasury’s mettle by challenging the validity of the new regulations. Including a provision in your cost sharing agreements that allow adjustments in the event of a future invalidation of the regulations might go well with the popcorn.
The only really interesting item in the AOD is the gratuitous bootstrap of the Cost Sharing Buy-In Regs “realistic alternatives principle.” The still warm “realistic alternatives principle” – the IRS assertion that an uncontrolled taxpayer will not choose an alternative that is less economically rewarding than another available alternative – “applies not to restructure the actual transaction in which controlled taxpayers engage, but to adjust pricing to an arm’s length result.” AOD, 2010 TNT 145-18, pp.4-5. That assertion appears to ignore that “arm’s length” is not some obscure term of art cooked up by the IRS, but rather an established concept that lies at the heart of most countries’ approach to international taxation.
Still clinging to the withdrawn Ninth Circuit opinion, the AOD offers in support of this premise that “the Secretary of the Treasury is authorized to define terms adopted in regulations, especially when they are neither present nor compelled in statutory language (such as the arm’s length standard), that might differ from the definition others would place on those terms.” Xilinx, Inc. v. Comm’r, 567 F.3d 482, 491 (9th Cir. 2009).
In short, the IRS appears to have dusted off the rule book of the King in Alice and Wonderland:
The King: “Rule Forty-two. All persons more than a mile high to leave the court.”
“I’m not a mile high,” said Alice.
“You are,” said the King.
“Nearly two miles high,” added the Queen.
“Well, I shan’t go, at any rate,” said Alice: “besides, that’s not a regular rule: you invented it just now.”
“It’s the oldest rule in the book,” said the King.
“Then it ought to be Number One,” said Alice.
Alice’s Adventures in Wonderland at 125 (Giunti Classics ed. 2002). The IRS has often been disappointed with the real rule Number One (the arm’s length principle) when the results of real-world transactions do not coincide with the results the IRS desires. Now the IRS looks to magically transform that rule into one that replaces those real-world transactions with the IRS’s revenue-maximizing vision. Tax Wonderland is getting curiouser and curiouser.
August 6, 2010
The parties are poised to brief the appeal of Tax Court’s decision in Container Corp. v. Commissioner, 134 T.C. No. 5 (Feb. 17, 2010), in the Fifth Circuit. The issue concerns the “sourcing” of income earned by a Mexican corporation from loan guarantee fees paid by its U.S. subsidiary. Code sections 861-63 identify certain items of income and specify whether they should be treated as U.S-source or foreign-source income. But there are items of income not specified in those sections, like loan guarantee fees, and it falls to the courts to determine how to source them, using analogies to items that are listed.
In Container, a U.S. subsidiary had to raise capital to finance corporate acquisitions, but needed the larger Mexican parent to guarantee the notes in order to make them marketable. The parent charged a standard 1.5% annual fee for providing the guarantee. The companies treated the fees as foreign-source income, analogizing them to “compensation for labor or personal services,” which are generally sourced to the location where the services are performed. I.R.C. §§ 861(a)(3), 862(a)(3). Therefore, the U.S. subsidiary did not withhold 30% from the fees, as would have been required if the fees were U.S.-source income. I.R.C. §§ 881(a), 1442(a). The IRS objected, arguing that the fees were better analogized to interest, which is sourced to the location of the interest payor. I.R.C. §§ 861(a)(1), 862(a)(1). The IRS also relied on one of the leading precedents, Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982), which had ruled that acceptance and confirmation commissions paid in connection with letters of credit should be treated like interest for sourcing principles.
The Tax Court opted for the taxpayer’s analogy. It distinguished Bank of America and the interest analogy by stating that the Mexican parent did not put its money “directly at risk”; it “was augmenting [the sub’s] credit, not substituting its own.” The Tax Court’s reasoning seems strained, as the proffered distinction does not come to grips with the reasoning in Bank of America or obviously relate to the policy underlying the sourcing rules. Although the guarantee fees are not identical to interest, they have some similarities and also serve the same function of facilitating the subsidiary’s ability to obtain capital. Without the guarantee, the subsidiary would surely have had to pay more interest to obtain the financing, and the guarantee fee thus is in some sense a substitute for interest. Conversely, while the parent can be said to have provided a service in promising “to possibly perform a future act” through the guarantee, the Tax Court’s approach appears to approve a much broader reading of the concept of performing “labor or personal services” than did the Bank of America case.
Congress has introduced legislation to reverse the outcome of the case by specifically providing that guarantee fees are to be sourced like interest. That legislation, contained in a provision of the Small Business Jobs Act that the Senate is expected to take up when it returns in September, would operate prospectively and is estimated to raise $2 billion over ten years. The legislation is not intended to provide any inference for the treatment of guarantee fees before the date of enactment; the appeal in Container is the government’s route to relief for those earlier years. And the Fifth Circuit’s decision may well provide more guidance beyond guarantee fees for how courts should approach the problem of sourcing analogies. The government’s opening brief is currently due September 15, 2010.