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 Tax Hot Topics From Grant Thornton's National Tax Office Jan. 28, 2009 No. 2009-02
Contents
Tax
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Recent developments
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The taxpayer addressed by the TAM was an electrical utility company that incurred costs to repair and replace certain items of electrical transmission and distribution equipment damaged by two storms. The taxpayer was not reimbursed by insurance for its losses and calculated its loss under Section 165 using the “cost of repairs” method. Under Section 165, a taxpayer’s loss is limited to the lesser of the change in the fair market value of the asset or the taxpayer’s unrecovered basis in the asset. Because some of the utility’s assets had been fully depreciated, the basis limitation in Treas. Reg. Sec. 1.165-7(b)(1)(ii) came into play, and it became important to identify the proper “unit of property.” In determining the basis limitation, the taxpayer proposed that its entire transmission and distribution system was the “single, identifiable property” that was damaged by the storms. Alternatively, the taxpayer proposed that its entire transmission system constituted one unit of property for this purpose, and that its distribution system should be grouped into the assets in each of its three operating divisions. The taxpayer was subject to Federal Energy Regulatory Commission (FERC) regulations. The IRS examination team proposed that the “single, identifiable property” damaged or destroyed by the storms was each a FERC retirement unit, which generally corresponded to the individual asset. Alternatively, the IRS examination team proposed that each transmission line and distribution circuit is a separate unit of property for this purpose. The IRS examined a number of cases analyzing the phrase “single, identifiable property.” The IRS specified several factors to consider, such as whether: (1) the unit chosen is reasonable in relation to the nature and scope of the casualty; (2) it reflects all the physical damage caused by the casualty; (3) it remains constant and identifiable for tax purposes and has a cost or adjusted basis that is not changed except by elimination of an asset or by injection of capital; (4) it is consistent with the taxpayer’s other tax accounting practices (e.g., depletion in the timber cases); (5) it is accounted for and identifiable as a unit for non-tax accounting purposes; (6) it is a unit whose utility derives from its functioning as a whole; (7) it is separately treated for operational and management purposes; (8) it is a “commercially segmentable” unit likely to be bought or sold as such; and (9) whether it is consistent with industry practice. The IRS rejected the taxpayer’s position that its entire transmission system constituted one unit of property for this purpose and concluded that the unit of property used to quantify loss was unreasonably large. Likewise, the IRS refused to use the individual retirement unit or asset as proposed by the examination team. Accordingly, the IRS adopted the examination team’s alternate position, in which each line, circuit and substation is treated as a single, identifiable property. Therefore, for transmission property, the single, identifiable properties are each transmission line and each transmission substation. For distribution property, the single, identifiable properties are each distribution circuit and each distribution substation.
Tax Court addresses the
application of Section 263A to sales-based royalties The taxpayer used the simplified production method to capitalize certain inventoriable costs to ending inventory under Treas. Reg. Sec. 1.263A-2(b). After designing certain kitchen tools, the taxpayer entered into contracts with companies owning well respected, trademarked brand names. The contracts allowed the taxpayer to use certain trademarks on products designed by the taxpayer. The contracts were entered into prior to production commencing. However, no payment of royalties began until products were sold. The taxpayer was not capitalizing the royalty costs through its Section 263A computation, but rather expensing them in the period incurred. The IRS claimed that the costs were indirect costs of production, arguing that the taxpayer could not have manufactured the products legally with the trademark if not for the agreement. Treas. Reg. Sec. 1.263A-1(e)(3)(ii)(U) includes licensing and franchising costs in the non-exclusive list of indirect costs that must be capitalized to the extent that such costs are properly allocable to property produced. The taxpayer argued that these costs were not licensing and franchising costs as described in that code section, but were marketing expenses exempt from capitalization under Treas. Reg. Sec. 1.263A-1(e)(3)(iii)(A). The court agreed with the IRS that these costs are licensing and franchising costs that qualify as indirect costs of production and are subject to Section 263A. The taxpayer argued that, even if the royalty costs were indirect production costs, such costs should not be associated with ending inventory since the costs were incurred only in connection with sold items. However, because the taxpayer uses the simplified production method described in Treas. Reg. Sec. 1.263A-2(b) to allocate other additional Section 263A costs, the court agreed with the IRS that the taxpayer is required to use the simplified production method for all direct and indirect costs subject to Section 263A, which would include the indirect licensing and franchising costs. The court acknowledged that because the simplified production method is intended to ease the administrative burdens of Section 263A, by its nature it may result in an allocation that is not as precise as other specific cost allocation methods. Therefore, the Tax Court rejected the taxpayer’s claim that including these costs in the simplified production method distorted income because, in fact, these costs were attributable to items that were no longer in ending inventory (sold items). The IRS has taken the position consistently on exam that all royalties, regardless of whether they were incurred by reason of the sale or of the production, should be capitalized under Section 263A. The Treasury, realizing that taxpayers needed some official guidance in this area, has this issue on the Business Plan for 2008-09.
COMPENSATION
AND BENEFITS Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund, replaces a somewhat confusing and cumbersome process that employers had to undertake previously when adjusting employment taxes for a refund or to pay an additional amount due. This process was beneficial to employers as it resulted in no interest and (generally) no penalties assessed. However, it involved waiting until the end of the quarter to file either a Form 941c, Supporting Statement to Correct Information, along with the regular Form 941, Employer’s Quarterly Federal Tax Return, when making a payment or filing the 941c with Federal Form 843, Claim for Refund and Request for Abatement if a refund was being requested. When third-party payroll providers were involved, the process was further complicated by their rules, deadlines and timelines. This is no longer necessary with the Form 941-X, which will be used to claim refunds of overpaid employment taxes or to make adjustments for underpaid employment taxes. Starting in January 2009, when employers and payers need to correct previously filed employment tax returns, the new Form 941-X will replace both the Form 941c and Form 843. Form 941-X is a stand-alone form corresponding to, and relating line-by-line with, the employment tax return it is correcting. The employer will be able to file Form 941-X when an error is discovered, rather than having to wait to file it at the end of the quarter with the next employment tax return. The only feature that is not as simple as the original 941c is that a Form 941-X must be filed for each quarter that is being adjusted, while one Form 941c would cover all four quarters in a particular calendar year. However, Form 941-X and new procedures should make adjusting incorrect wages and employment taxes a much simpler and more straightforward process.
IRS issues interim guidance
and transition relief under Section 457A Section 457A was added by the Emergency Economic Stabilization Act of 2008 and imposes significant restrictions on the deferral of management and incentive fees by managers of offshore hedge funds. The restrictions may also apply more broadly to deferral arrangements covering U.S. taxpayers employed by some foreign corporations, including subsidiaries of U.S corporations, and by partnerships with exempt organizations or foreign partners. Highlights of the guidance include:
Until further guidance is issued, taxpayers may rely on Notice 2009-8, and taxpayers may apply Notice 2009-9 retroactively to Oct. 3, 2008.
IRS issues guidance on
reporting 2009 required minimum distributions
CORPORATE TRANSACTIONS AND OPERATIONS
INDIVIDUAL AND FAMILY WEALTH PLANNING Entitled the “Certain Estate Tax Relief Act of 2009,” H.R. 436 would freeze the estate tax regime currently in place for 2009 and make it permanent. Thus, the legislation would make permanent the current $3.5 million estate tax applicable exclusion amount and the maximum estate tax rate of 45 percent. This provision would be effective for estates of decedents dying, and gifts made, after Dec. 31, 2009. For gift and estate tax purposes, the bill would also disallow lack-of-marketability discounts for non-business assets when there is a transfer of an interest in an entity that is not publicly traded. A non-business asset is defined as an asset that is not used in the conduct of a trade or business. Specifically, the bill would require that non-business assets be treated as if the transfer of such assets had occurred between the buyer and the seller outside the transfer of the interest in the entity. The interest in the entity would then be valued as if the non-business assets had been included in the entity. For example, suppose a mother and father contributed their diversified portfolios to a family limited partnership (FLP) in return for a one percent general interest and a 49 percent limited interest each in the FLP. Next, assume the mother and father each gifted their 49 percent limited interests in the FLP to their daughter. Under the bill, the mother and father would be treated as if they had transferred interests in their diversified portfolios directly to their daughter without regard to the fact that the diversified portfolios were assets of the FLP. If the FLP had contained other assets that were used in a trade or business conducted by the FLP, the bill would have no affect on the valuation of the limited interests of the FLP transferred to the daughter except that the diversified portfolio would not be considered in the valuation of the transferred limited interests. The bill contains certain exceptions for certain passive assets, as well as assets that are considered working capital of an active trade or business. It also contains certain look-through rules for non-business assets that consist of interests in another entity. Finally, the bill disallows any minority discount for gift and estate purposes for interests in an entity if such discount is due to the fact that the transferee does not have control of the entity if the transferee and his or her family members have control of the entity. The disallowance of lack-of-marketability discounts and minority interest discounts would apply to transfers after the date of enactment of the bill.
INTERNATIONAL TAX Generally, an investment in U.S. property by a controlled foreign corporation (CFC) can result in an income inclusion to certain U.S. shareholders of the CFC under Section 951(a)(1)(B). An obligation of a U.S. person is generally considered U.S. property for this purpose subject to certain exceptions. During 2008, the IRS issued two items of guidance intended to broaden the application of some of these exceptions to provide relief to taxpayers during the economic downturn. Notice 2008-91 allowed taxpayers to elect to treat U.S. obligations held by a CFC, but collected within 60 days of being incurred, as not being U.S. property under Section 956(c) as long as the CFC does not hold U.S. obligations for 180 or more calendar days during the tax year. The previous rule under Notice 88-108 (which taxpayers may still elect to use) was for obligations repaid within 30 days as long as U.S. obligations were not held for 60 or more calendar days during the tax year. Notice 2008-91 was originally applicable for two years beginning with tax years ending after Oct. 3, 2008, and on or before Dec. 31, 2009, but has now been extended by Notice 2009-10 to apply for an additional consecutive year of a CFC (including any short year) that ends after Oct. 3, 2008, and that ends on or before Dec. 31, 2009. For more information on Notice 2008-91 see Tax Flash 2008-09. Rev. Proc. 2008-26 provides guidance on whether securities are “readily marketable” for purposes of Section 956(c)(2)(J) for any day during calendar years 2007 and 2008 for which it is relevant whether securities are readily marketable for purposes of that section. The revenue procedure stated that the IRS would not challenge whether a security was readily marketable for purposes of Section 956(c)(2)(J) as long as the securities in question were readily marketable at any time during the three-year period ending on the effective date of Rev. Proc. 2008-26. Notice 2009-10 extends the application of Rev. Proc. 2008-26 to any day during the calendar year of 2009 for which it is relevant whether securities are readily marketable for purposes of Section 956(c)(2)(J) (in addition to any day during calendar years 2007 and 2008).
U.S. and France sign protocol to 1994
income tax treaty Significant provisions of the protocol include:
A memorandum of understanding signed the same day as the protocol details the rules and procedures for implementing the arbitration provision. In general, the protocol will have effect for taxes withheld at source for amounts paid or credited on or after the first day of January of the year in which the protocol enters into force (i.e., Jan. 1, 2009, if the protocol enters into force during 2009). In respect to other taxes, the protocol will be effective for taxable periods beginning on or after the first day of January following the date on which the protocol enters into force. Some special rules apply in the case of the Mutual Agreement Procedure. The United States and France must notify each other when their respective constitutional and statutory requirements for ratification have been satisfied. The protocol will enter into force on the date of receipt of the later of such notifications.
Letter ruling holds RICs eligible
for foreign functional currency Each Fund was part of a Delaware statutory trust registered under the Investment Company Act of 1940 as an open-ended series investment company and was treated as a separate corporation for federal tax purposes under Section 851(g). In seeking to achieve their investment objectives, each Fund will invest substantially all of its assets in short-term instruments denominated in a single non-USD currency.
IRS PRACTICE
AND PROCEDURE Brokers and other reporting entities are required by Section 6045 to give their costumers certain information in annual information statements, such as the Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.” The recently enacted Energy Improvement and Extension Act of 2008 changed the deadline for issuing these information reports from Jan. 31 to Feb. 15. The IRS has set this deadline as Feb. 17 in 2009 because Feb. 15 is a Sunday and Feb. 16 is a holiday.
PARTNERSHIPS/PASS-THROUGH ENTITIES The proposed regulations sought to amend the existing regulations for disguised sales of property by adding rules for disguised sales of partnership interests and by revising the rules relating to disguised sales of partnership property. The proposed regulations had been broadly criticized.
STATE AND LOCAL TAX
New York trial court dismisses
challenges to “Amazon Rule”
Sales factor for services: Two
state courts provide guidance
Maryland Comptroller publishes
final corporate reporting regulations
Pennsylvania provides guidance
on loss deductions, state tax addbacks and apportionment
TAX LEGISLATIVE
UPDATE The Senate Finance Committee has also unveiled their version and has scheduled a markup for Jan. 27. Congressional leadership and President Obama are pledging to enact a final stimulus bill before President’s Day on Feb. 16. The House tax title includes temporary tax credits for individuals, a five-year net operating loss carryback period, extension of bonus depreciation to 2009, enhancements to existing energy tax incentives and loosened tax-exempt bond rules. Several important provisions have been modified since they were proposed, and there are likely to be more significant changes before a final bill is enacted. The Senate tax title also contains $275 billion in tax relief, but there are key differences between the House and Senate versions. For businesses, the Senate Finance Committee legislation has a slightly modified net operating loss provision. It would also allow general business credits to be carried back five years instead of one, allow individuals to exclude more income from gains on small business stock, and allow income from the repurchase of a taxpayer’s own debt at a discount to be spread over four years. Our National Tax Office has compiled a summary of the details of the major tax provisions in the House Ways and Means Committee bill and an explanation of the differences contained in the Senate Finance Committee version. Read more in Tax Legislative Update 2009-02.
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