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From Grant Thornton's Washington National Tax Office

Feb. 21, 2011 | THT 2011-04

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Contents

Grant Thornton insights
• Webcast: Potential efficiencies in your tax audit
• Webcast: 2011 Tax legislative outlook
• Webcast: Taking advantage of IC-DISC opportunities

Accounting methods and periods
• IRS issues statement of non-acquiescence in sales based royalties decision

Corporate transactions and operations
• IRS rules loss qualifies for 10-year carryback
• IRS rules on treatment of consent fees related to alteration of debt

International tax
• IRS announces a second offshore voluntary disclosure initiative

State and local tax
• Wisconsin enacts tax incentives to encourage businesses to relocate to state
• Washington Supreme Court holds sales reps created nexus for B&O tax
• New Jersey enacts expanded grant program, with more legislation awaiting
• North Carolina Superior Court upholds forced combination of returns
• SEC settlement warns taxpayers to maintain adequate sales and use tax records
• States follow trend of adopting bright-line nexus standards in 2010
• Preliminary injunction granted against Colorado’s sales tax reporting regime

Tax legislative updates
• President unveils updated tax agenda in the 2012 budget
• Legislation repealing new Form 1099 reporting advances

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GRANT THORNTON INSIGHTS

Webcast: Potential efficiencies in your tax audit
Wednesday, Feb. 23, 2011 ~ 3:00-4:00 p.m. Eastern ~ 1 CPE
A joint webcast with Thomson Reuters
Join Grant Thornton tax professionals Debbie Schleicher and April Little as they explore the types of provision information that your auditors will be looking for and show how ONESOURCE Tax Provision can provide the reports and level of detail your auditor requires. Visit our website for more information.

Webcast: 2011 Tax legislative outlook
Thursday, Feb. 24, 2011 ~ 3:00–4:30 p.m. Eastern ~ 1.5 CPE
This webcast will cover the tax legislative outlook for 2011, including the prospects and scenarios for corporate tax reform; what's new and what's important among the tax priorities in the president's latest budget proposal; and the likelihood of repeal for new Form 1099 requirements and other health care provisions. Visit our website for more information.

Webcast: Taking advantage of IC-DISC opportunities
Thursday, March 3, 2011 ~ 2:00-3:00 pm Eastern ~ 1 CPE
The Interest Charge-Domestic International Sales Corporation (IC-DISC) is one of the last remaining export initiatives available to U.S. exporters. In this Grant Thornton International Thinking webcast, we will discuss how you can benefit from the IC-DISC incentive. We will be covering the background of the program, the structure and set-up, the commission computation, the annual maintenance and other issues that may arise. Visit our website for more information.

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ACCOUNTING METHODS AND PERIODS

IRS issues statement of non-acquiescence in sales based royalties decision
The IRS recently released an action on decision (AOD 2011-01) announcing that it will not acquiesce to the Second Circuit’s decision in Robinson Knife Manufacturing Co. v. Commissioner (No. 09-1496 ).

In Robinson Knife, the Second Circuit delivered a taxpayer-favorable decision that reversed a Tax Court decision and held that sales-based royalties were not capitalizable because they do not benefit the production process. Robinson Knife enters into licensing agreements for the right to use trademarks on the kitchen tools that it manufactures. Under the agreements royalty payments were due when the tools were sold rather than at the time they were manufactured. The court reasoned that the royalties were incurred “by reason of” the sale of the tools and not by reason of the production of the tools. Therefore, the sales-based royalty costs were not treated as production costs under Treas. Reg. Sec. 1.263A-1(e)(3)(i).

Subsequent to the Second Circuit decision, the IRS released proposed regulations under Section 263A related to sales-based royalties. The proposed regulations provide that a sales-based royalty is a fee, payment or royalty described in Treas. Reg. Sec. 1.263A-1(e)(3)(ii)(U) that is incurred (within the meaning of Section 461) only upon the sale of property produced or acquired for resale and the cost is required to be capitalized under this paragraph (e)(3). The preamble to the proposed regulations refers to the holding in Robinson Knife. However, the IRS stated in the preamble that — rather than determining that the costs are inherently non-production-related as the second circuit did — the proposed regulations provide that otherwise capitalizable sales-based royalty costs are properly allocable to property sold during the taxable year (i.e., allocable to cost of goods sold). Accordingly, the proposed regulations take the position that sales-based royalties are production costs under Section 263A. However, the proposed regulations also provide that the costs that a taxpayer incurs upon the sale of property (such as a sales-based royalty) are allocable only to the property that has been sold or, for inventory property, deemed to be sold under the inventory cost flow assumption.

The IRS non-acquiescence, like the regulations, states that the IRS disagrees with the Second Circuit’s analysis in Robinson Knife. Specifically, the IRS stated that “the [Second Circuit] confused the timing with the purpose of the payments.” The IRS stated that it agreed with the Tax Court’s holding that the royalties were incurred “by reason of” the production process. The non-acquiescence refers to the favorable proposed regulations (which will not be effective until published as final regulations) but states that it will only follow the Second Circuit decision in cases appealable to the Second Circuit. It is not clear from the non-acquiescence whether the IRS is willing to apply the proposed regulations to cases pending in appeals and exam, or whether it will continue to challenge taxpayers with sales-based royalties until the regulations are finalized. Guidance is expected from the IRS Large Business and International Division (LB&I, formerly LMSB) addressing the IRS’s approach to pending cases with this issue.

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CORPORATE TRANSACTIONS AND OPERATIONS

IRS rules loss qualifies for 10-year carryback
The IRS has ruled (PLR 201105009) that certain losses incurred by an oil and gas exploration company qualifed for a 10-year carryback as specified liability losses (“SLLs”) under Section 172(f).

The S corporation (“S Corp”) addressed by the private letter ruling was engaged in oil and gas exploration and production business and conducted its activities on federal property (the “Federal Property”) that it leased from the U.S. government. Pursuant to federal regulation, upon beginning its activities on Federal Property in year 1, S Corp was obligated to perform certain decommissioning activities that would restore the Federal Property to its prior condition (the “Decommissioning Liabilities”). The Decommissioning Liabilities included that S Corp was obligated to:

  • permanently plug and abandon wells drilled from the platform located on the Federal Property;

  • remove the deck and flare boom from the platform;

  • clear the sea floor of all obstructions;

  • remove decommissioned pipelines; and

  • remove contaminated soil.

However, S Corp would not have to satisfy the Decommissioning Liabilities until S Corp’s abandonment of its operations on the Federal Property.

Subsequent to S Corp commencing its activities in year 1, S Corp merged with and into a limited liability company (“LLC”). LLC was classified as a partnership for federal income tax purposes. In years 3 and 4, LLC satisfied the Decommissioning Liabilities.

Section 172(b)(1)(C) provides a 10-year carryback to a taxpayer for SLLs, and Section 172(f)(1)(B)(i) provides that an SLL may be any amount allowable as a deduction (other than such amounts pursuant to Sections 468(a)(1) or 468A(a)) that is in satisfaction of a liability under a federal or state law requiring the following (a “Specified Liability”):

  • the reclamation of land;

  • the decommissioning of a nuclear power plant;

  • the dismantlement of a drilling platform;

  • the remediation of environmental contamination; or

  • a payment under any workers compensation act (within the meaning of Section 461(h)(2)(C)(i)).

Notwithstanding that a liability constitutes a Specified Liability under Section 172(f)(1)(B)(i), the satisfaction of a Specified Liability may constitute a SLL only if:

  1. the act (or failure to act) giving rise to such liability occurs at least three years before the beginning of the taxable year (the “3 Year Test”); and

  2. the taxpayer used an accrual method of accounting throughout the period or periods during which such act (or failure to act) occurred.

The IRS ruled that LLC’s losses related to the Decommissioning Liabilities constitute SLLs that qualified for the 10-year carryback. Despite the fact that the Decommissioning Liabilities accrued in year 1 (i.e., upon S Corp commencing activities on the Federal Property), LLC was successor to the Decommissioning Liabilities. Because the Decommissioning Liabilities were satisfied in years 3 and 4, the losses related to the Decommissioning Liabilities satisfied the 3 Year Test.

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IIRS rules on treatment of consent fees related to alteration of debt
The IRS has ruled (PLR 201105016) that a consent fee paid by a debtor to its creditors, which related to an alteration of the terms of certain debt, constituted a payment on such debt.br class="listspacing"> The taxpayer (“Taxpayer”) addressed by the private letter ruling was a debtor that desired to complete a business restructuring transaction in which it transferred assets to a limited partnership in exchange for cash and an interest in such partnership (the “Dropdown Transaction”).

In connection with the Dropdown Transaction, Taxpayer announced a tender offer to purchase certain of its outstanding debt (the “Tender Offer”) from the holders (the “Noteholders”) of such debt (the “Notes”). At the same time as the Tender Offer, Taxpayer also solicited the consent of the Noteholders to certain amendments to the terms of the Notes (the “Amendments”) in exchange for a fee (the “Consent Fee”). Taxpayer believed that the Dropdown Transaction could have been completed without the Amendments, but believed that it was desirable to eliminate uncertainty related to the completion of the Dropdown Transaction by entering into the Amendments. Taxpayer represented that the payment of the Consent Fees did not constitute a “significant modification” related to the Notes pursuant to Treas. Reg. Sec. 1.1001-3(e)(2).

Treas. Reg. Sec. 1.446-2(e)(1) provides that, subject to certain exceptions, a payment related to a debt (other than payments of additional interest or similar charges provided with respect to amounts that are not paid when due) is treated as a payment of interest to the extent of the accrued and unpaid interest. Similarly, Treas. Reg. Sec. 1.1275-2(a) provides that a payment under a debt instrument is treated first as a payment of original issue discount (“OID”) to the extent that OID is accrued and unpaid, and second as a payment of principal.

The analysis in PLR 201105016 interprets Treas. Reg. Sec. 1.1001-3(e)(2)(iii) to provide that payments made to modify a debt instrument are treated as payments under such debt instrument. Thus, the IRS ruled that the Consent Fees were treated as payments related to the Notes subject to Treas. Reg. Sec. 1.446-2(e)(1). Because the Consent Fees were additional payments related to the Notes, Taxpayer could deduct “repurchase premium” under Treas. Reg. Sec. 1.163-7(c) upon the retirement of the Notes because the total payments made by Taxpayer related to the Notes would exceed the principal and interest related to the Notes by the amount of the Consent Fee.

Despite that the Consent Fees were paid in connection with the Dropdown Transaction, the IRS ruled that Section 263 did not affect the treatment of the Consent Fee (i.e., the Consent Fee was not required to be treated as a transaction cost related to the Dropdown Transaction).

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INTERNATIONAL TAX

IRS announces a second offshore voluntary disclosure initiative
The IRS has announced a new offshore voluntary disclosure initiative designed to bring offshore money back into the U.S. tax system and help taxpayers with undisclosed income from hidden offshore accounts get current with their taxes.

The disclosure initiative will be available through Aug. 31, 2011, and presents an excellent opportunity to address offshore compliance issues. This includes issues relating to offshore assets and accounts, Report of Foreign Bank and Financial Account (FBAR) filings and other foreign information reporting requirements. In light of all the information that must be submitted to take advantage of the initiative by the deadline of Aug. 31, 2011, taxpayers who want to participate will need to act quickly.

For complete details, read Tax Flash 2011-05 from our Washington National Tax Office.

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STATE AND LOCAL TAX

Wisconsin enacts tax incentives to encourage businesses to relocate to state
The Wisconsin governor has approved legislation that provides a new corporate income tax credit for businesses that relocate to the state from another state or country. The legislation also adds a related personal income tax deduction from business income earned by an individual, or that passes through to an individual, from a partnership, limited liability company or S corporation. Read more in our SALT Alert.

Washington Supreme Court holds sales reps created nexus for B&O tax
The Washington Supreme Court has held that an out-of-state manufacturer that sent sales representatives to meet with its customers within Washington had substantial nexus for purposes of the business and occupation (B&O) tax. The taxpayer’s practice of sending the representatives to Washington was associated significantly with its ability to establish and maintain its market. Read more in our SALT Alert.

New Jersey enacts expanded grant program, with more legislation awaiting
In January, the New Jersey legislature passed the majority of 20 bills included in a “Back-to-Work-NJ” package, which is intended to create jobs and spur economic development. However, to date, the governor has only approved legislation that revises and expands the state’s Business Retention and Relocation Assistance Grant Program (BRRAG). Read more in our SALT Alert.

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North Carolina Superior Court upholds forced combination of returns
A North Carolina Superior Court upheld the Department of Revenue’s ability to order a combined return, but denied the DOR’s right to order a 25 percent penalty. This is the latest case in North Carolina to address the DOR’s ability to mandate combined reporting on taxpayers. The high-profile case involving Wal-Mart has received enormous publicity and the results could have broad implications for taxpayers that file in North Carolina, particularly those that have been forced to file a combined return under audit. Read more in our SALT Alert.

SEC settlement warns taxpayers to maintain adequate sales and use tax records
On Jan. 10, 2011, the Securities and Exchange Commission found that inadequate internal controls and accounting software leading to a company’s sales and use tax compliance deficiencies resulted in securities laws violations. The SEC decision stands as a warning to other publicly traded companies that have significant sales and use tax obligations to ensure their own accounting systems, processes and controls are adequate to protect against a finding of such non-compliance. Read more in our SALT Alert.

States follow trend of adopting bright-line nexus standards in 2010
During 2010, states continued to follow the trend of revising nexus standards to broaden the scope of out-of-state companies that are subject to their tax. Perhaps the most significant nexus development in 2010 was the adoption of factor presence (bright-line) nexus standards by several states with corporation income taxes. Read more in our SALT Alert.

Preliminary injunction granted against Colorado’s sales tax reporting regime
On Jan. 26, 2011, a U.S. District Court judge in Colorado issued a preliminary injunction against the Colorado Department of Revenue, preventing the enforcement of recently enacted sales and use tax notice and reporting requirements imposed on out-of-state retailers. Read more in our SALT Alert.

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TAX LEGISLATIVE UPDATES

President unveils updated tax agenda in the 2012 budget
The Obama administration has released its 2012 budget proposal, which includes many proposed tax changes. The budget does not include proposals that would make fundamental changes to the income tax system, nor does it discuss the changes to entitlement systems such as social security or Medicare and the taxes supporting them.

The administration made several changes to last year's budget proposal, including the following:

  • Scaling back a proposed fee based on the assets of financial institutions
  • Refining a proposal to tax excess returns connected to offshore intangible transfers
  • Converting the energy-efficient commercial building deduction to a credit
  • Proposing an increase in unemployment insurance taxes
  • Adding a proposal to limit the duration of the generation-skipping tax exemption
  • Proposing a permanent 100% gain exclusion for qualified small business stock
  • Proposing a partial repeal of new expanded Form 1099 reporting requirements

Many of the tax proposals are highly controversial, and there is no guarantee of enactment. The Republican majority in the House is expected to publish a competing set of budget priorities. The Senate will consider its own version. A presidential budget proposal is important, but far from the last word. Some of the tax proposals will be examined carefully by Congress, while others may not be considered this year, or ever.

For full details, read the latest Tax Legislative Update from our Washington National Tax Office.

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Legislation repealing new Form 1099 reporting advances
The House and Senate have both advanced legislation that would repeal the expanded Form 1099 information reporting requirements enacted as part of the 2010 health care reform legislation.

The full Senate on Feb. 17, 2011, voted 87 to 8 to pass a bill (S. 223) carrying an amendment that would repeal the reporting requirements. The underlying legislation is a reauthorization of the Federal Aviation Administration (FAA), which includes an extension of aviation fuel excise taxes through Sept. 30, 2013, and an increase in the tax on noncommercial aviation use of aviation-grade kerosene to 35.9 cents a gallon.

The provision to repeal the new Form 1099 reporting requirements was added to the bill as an amendment in an overwhelming 81 to 17 vote. The amendment’s cost was covered by $44 billion in rescinded discretionary spending, and it would completely reverse the health care bill provision that expanded reporting requirements to include payments made for property and payments made to corporations.

The House has also made progress toward repeal of the provisions. The House Ways and Means Committee on Feb. 17 passed two stand-alone bills to repeal new reporting requirements. The first (H.R. 4) was approved by voice vote after House Ways and Means Chair Dave Camp, R-Mich., said procedural rules prevented any amendments. It would completely repeal the reporting expansions in the health care bill, but included no revenue offset. The committee then voted 21 to 15 approve a bill (H.R. 705) that would repeal both the expanded reporting requirements from the health care bill and the new reporting requirements for landlords enacted as part of a 2010 small business bill. It was paid for by a provision that would increase limits on the amount of overpayments of the premium assistance tax credit that taxpayers must include in income.

The health care reform legislation included two expansions of reporting requirements that are scheduled to take effect beginning in 2012 (for reporting in 2013). Current rules generally only require information reporting (typically on a Form 1099) on payments in connection with a trade or business to a vendor of over $600 per year for services, and the regulations generally exempt payments made to a corporation. Beginning in 2012, the health care bill expands the rules to require reporting on both payments made for property and payments made to corporations. “Payments made for property” has been interpreted broadly to include payments for any kinds of goods.

The Small Business Jobs and Credit Act of 2010 (H.R. 5297) added separate rental expense reporting requirements. Previously, passive rental activity would not have been considered a trade or business for purposes of reporting, and payments in connection with this activity would not have required reporting on Form 1099. The small business bill amended the law to require reporting on any payments made in connection with earning rental income. These rules have already taken effect and payments made after Dec. 31, 2010, must be reported when 2011 Form 1099s are due in 2012.

Several disagreements need to be resolved before any repeal legislation can be enacted. The president in his budget blueprint proposed repealing only the provision that expanded reporting to include payments made for property, while leaving intact the new reporting for payments to a corporation (for services) or in connection with rental income. House and Senate lawmakers of both parties support the full repeal of reporting on payments for property and payments to corporations, but it is less clear whether there is enough support to repeal the new rental income reporting provisions, which are less controversial. The House and Senate will also need to agree on a revenue offset and a legislative vehicle. The Senate prefers using the FAA bill and spending cuts, while House Republicans appear to support using stand-alone legislation.

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This document supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document we encourage you to contact us or an independent tax advisor to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, specific circumstances or needs, and may require consideration of non-tax factors and tax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.


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