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Compensation & Benefits Alert - March 2017

Thu, 03/09/2017 - 12:00am
Tax Free Accumulation of DISC Dividends in Roth IRA Upheld by Sixth Circuit Court of Appeals   Summary The United States Court of Appeals for the Sixth Circuit unanimously ruled against the Internal Revenue Service (IRS) on February 16, 2017, in Summa Holdings, Inc. v. Commissioner, No. 16-1712, 2017 U.S. App. LEXIS 2713 (6th Cir.) and held that the taxpayer’s combination of a domestic international sales corporation (DISC) and Roth Individual Retirement Accounts (Roth IRA) was proper, even though the structure resulted in the avoidance of income tax.

In the United States Tax Court proceedings in Summa, the IRS was successful with its “substance-over-form” argument, which would have reclassified the deductible DISC commissions from Summa Holdings, Inc. (Summa) as non-deductible dividends distributed directly to Summa’s shareholders. These reclassified distributions would have been fully taxable to Summa’s shareholders.

In addition to the lost tax exclusion, the stripping of the DISC’s income would have eliminated the subsequent distribution to the DISC’s sole owner, a C Corporation, that in turn paid dividends to its ultimate owners, the Roth IRAs. Under the Roth IRA rules, these dividends avoided taxation even upon distribution to the Roth IRA owners.  However, the IRS’s position would have stripped the Roth IRAs of its dividends and deemed the cash inflow to the Roth IRAs as contributions that were disallowed because the Roth IRA owners did not satisfy the requirements to make a contribution. Accordingly, the excess contributions would have to be withdrawn, and the earnings taxed to the Roth IRA owners.  

While binding on the Tax Court only in the Sixth Circuit, the opinion highlights the federal courts’ reluctance to close tax loopholes created by a complicated and intricate Internal Revenue Code and limits the IRS’s ability to use the “substance-over-form” doctrine at its leisure to avoid a tax consequence that it believes is unintended.  In addition, the opinion defers to Congress the task of closing unintended loopholes while suggesting that taxpayers may take advantage of tax savings so long as they fully comply with the “printed and accessible words of the tax laws.”  
BDO Observations IRS Notice 2004-8 designates Abusive Roth IRA Arrangements as “listed transactions.” Fact patterns similar to Summa may require disclosure to the IRS, thus inviting IRS scrutiny.
  Factual Background A family owned a manufacturing company, Summa.  In 2001, two sons each established and contributed to a Roth IRA. Subsequently, each Roth IRA paid $1,500 for 1,500 shares of stock in JC Export, a newly formed DISC.[1] The family formed another corporation, JC Holding, which purchased the shares of JC Export from the Roth IRAs to prevent the Roth IRAs from incurring any tax-reporting or shareholder obligations by owning JC Export directly. Between 2002 and 2008, each Roth IRA owned a 50-percent share of JC Holding, the sole owner of JC Export.

Under this structure, Summa paid commissions to JC Export, which distributed money as a dividend to JC Holding, the sole shareholder. JC Holding paid a 33-percent income tax on the dividends, then distributed the balance as a dividend to its shareholders, the two Roth IRAs. From 2002 to 2008, the family transferred over $5 million from Summa to the Roth IRAs. By 2008, each Roth IRA had accumulated over $3 million.

The Commissioner informed Summa that the “substance-over-form” doctrine would be applied to reclassify the payments to JC Export as dividends from Summa to its major shareholders. Consequently, the transfers would not count as commissions from Summa to JC Export, meaning that Summa had to pay income tax on the DISC commissions. Additionally, the Commissioner determined that each Roth IRA received a contribution in excess of the Roth IRA contribution limit, and since each son made over $500,000 in 2008, they were ineligible to contribute anything to their Roth IRAs.
Court Analysis The Court of Appeals reasoned that the Code expressly permits the transaction at issue; consequently, these transactions, as consummated, fully complied with the Code. The Commissioner asserted that the “substance-over-form” doctrine grants him the authority to reclassify Code-compliant transactions to “respect overarching…principles of federal taxation.” The Court disagreed and concluded that, although the Commissioner is permitted to recharacterize the economic substance of a sham transaction, it is another matter to allow the Commissioner “to recharacterize the meaning of the statutes—to ignore their form, their words, in favor of his perception of their substance.”

Furthermore, the Court of Appeals reasoned that the Code authorizes companies to create DISCs as shell corporations that can receive commissions, pay dividends that have no economic substance, and defer corporate income tax. Consequently, DISCs are all form and no substance, making it inappropriate for the Commissioner to utilize the “substance-over-form” doctrine with respect to Summa’s use of DISCs. Moreover, Roth IRAs are also designed for tax-reduction purposes, and the family used them for their intended purpose.
Finally, the Court of Appeals concluded that the Commissioner cannot, under the guise of the “substance-over-form” doctrine, invalidate a transaction just because taxpayers undertook it to reduce their tax liability. Congress established the DISC regime to for the purpose of lowering taxes. Moreover, Roth IRAs were established with the authority to own shares in DISCs for the purpose of reducing taxes. Consequently, “[t]he Commissioner cannot place ad hoc limits on them by invoking a statutory purpose (maximizing revenue) that has little relevance to the text-driven function of these portions of the Code (minimizing revenue).”
 
For more information please contact Peter Klinger or Joan Vines.
  [1]  DISCs incentivize companies to export their goods by deferring and lowering their taxes on export income. The exporter reduces its corporate income tax by paying the DISC “commissions” of up to 4 percent of gross receipts or 50 percent of net income from qualified exports. The DISC pays no tax on its commission income of up to $10 million. However, DISC shareholders must pay an annual interest charge on their share of the deferred tax liability on the DISC’s accumulated earnings. See IRC §§ 991, 995(b)(1)(E), 995(f); see also Treas. Reg. § 1.991-1(b).
 

Compensation & Benefits Alert

Thu, 03/02/2017 - 12:00am
Reduce Employee Stock Option Expense by Introducing Different Entry Levels and Forfeiture Techniques
Companies have adjusted over the years since the days of APB 25 to account for the expense of its employee stock options. And ever since, companies have adjusted the different variables within the traditional Black-Scholes-Merton pricing model to reduce the expense (e.g., reducing the once standard 10-year term to 7-years or less, premium pricing the strike/grant price above the underlying asset price, or using an annual risk of forfeiture rate to discount the option valuation). These minor measures do little to reduce the stock expense to a company's books and do little to further support its overall rewards programs.

There are, however, three other techniques that can significantly reduce the total stock option expense which accounts for stock option grant practices already in place, or practices that are philosophically practiced but are not accounted for in the current pricing of a company's stock options. The three techniques in this three-part article series are: Down and Out, Up and In, and Forward Start. Each one of the techniques, when applied to employee stock options, will have their own discounts, features, and drawbacks. Each one of these techniques uses a pricing model that is compliant with today's ASC 718 requirements (formerly FAS 123R), so we'll cover the necessary base calculations for each one of these before we discuss each of the different techniques. This article will focus on Down and Out options.
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State and Local Tax Alert - February 2017

Fri, 02/24/2017 - 12:00am
Illinois Extends Sunset Date for EDGE Income Tax Credit until April 30, 2017   Summary On January 20, 2017, Illinois Governor Rauner signed S.B. 513, which extended the sunset date of the Illinois Economic Development for a Growing Economy (“EDGE”) credit from December 31, 2016, to April 30, 2017.
The EDGE credit is the primary incentive tool used by the State of Illinois and the Illinois Department of Commerce and Economic Opportunity (“DCEO”) to attract expansion projects to the State by new and existing businesses that commit to creating jobs and making capital investment in Illinois.
  Details The EDGE income tax credit program was established to help encourage job creation and capital investment in Illinois.  The credit is available to qualified businesses that can provide evidence that, but for the EDGE credit, Illinois would not have been selected as the site for the expansion project.

Successful businesses can receive an annual corporate income tax credit worth a percentage of the personal income taxes withheld for qualifying jobs.  The credit can be claimed annually for up to 10 years, and unused credit can be carried forward five years. 

In order to qualify for the credit, eligible businesses must commit to:
  • Creating at least 25 new, full-time jobs at a project location in Illinois and making a capital investment of at least $5 million; or
  • Creating at least five new, full-time jobs and making a capital investment of at least $1 million, for businesses with fewer than 100 employees. 
The job creation and capital investment must be made within a two-year period.  Capital investment includes the purchase or lease of buildings, structures, equipment, land and furnishings.
The extension of the sunset date to April 30, 2017, means agreements may not be executed beyond that date.  In order to satisfy this requirement, DCEO has advised taxpayers that EDGE applications must be received no later than March 31, 2017.
  BDO Insights There is a limited amount of time for companies that are considering Illinois for the site of an expansion project to apply for benefits under the EDGE program.  Companies creating jobs and making capital investment are encouraged to apply for EDGE benefits as well as pursue other State and local incentives available for competitive expansion projects.
   

For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Managing Director
  Paul McGovern
Tax Managing Director   Jonathan Liss
Tax Managing Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Managing Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Managing Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Managing Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Managing Director
    Richard Spengler
Tax Managing Director
  Tony Manners
Tax Managing Director






   
Southwest:
Gene Heatly
Tax Managing Director

Tom Smith
Tax Partner
 

Federal Tax Alert - February 2017

Wed, 02/15/2017 - 12:00am
Final Regulations Issued Conforming REIT Built-in-Gain Recognition Period to Five Year Recognition Period, Applicable to S Corporations
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On January 17, 2017, the Treasury Department issued final regulations (T.D. 9810) that conform the built-in-gain recognition period for real estate investment trusts (“REITs”) and regulated investment companies (“RICs”) to five years, the same period for S corporations.  The regulations issued under Code Section 337(d) provide for a five-year built-in-gain recognition period during which a REIT or RIC may be subject to corporate-level tax on certain dispositions of property acquired from a C corporation in a conversion transaction.  The final regulations adopt, with modifications, a portion of the temporary regulations published on June 8, 2016 (TD 9770).

Treasury Regulation Section 1.337(d)-7 generally provides that if a C corporation property becomes property of a REIT or a RIC through either the C corporation’s conversion to such an entity or the C corporation’s transferring of assets to a REIT or RIC, the REIT or RIC will be subject to built-in-gains tax under IRC Section 1374 on the property.  This recognition period rule does not apply if the C corporation transferor makes a deemed sale election to recognize gain or loss as if it sold the property to an unrelated person at the fair market value of such property at the time of conversion or transfer.  Historically, the built-in-gain recognition period was 10 years.
Details In December 2015, Congress enacted the Protecting Americans Tax Act (“PATH”) which permanently set the built-in-gain recognition period under IRC Section 1374(d)(7) for C corporations becoming or merging into S corporations at 5 years. Since 2008 and prior to the PATH Act, the standard 10-year recognition period had been reduced annually to 5 years in extenders bills. Legislative history demonstrated and acknowledged that the built-in-gain recognition period had consistently been the same between S corporations, REITs and RICs. As a result, the Joint Committee on Taxation’s technical explanation of the PATH Act confirmed that the new 5-year recognition period applied to REITs and RICs as well as S corporations.

On June 8, 2016, Treasury issued temporary regulations, and proposed regulations cross referencing the temporary regulations, under IRC Section 337(d) and announced that the built-in-gain recognition period for REITs and RICs would revert to 10 years for REIT conversions and acquisitions occurring on or after August 8, 2016. These temporary regulations also called for deemed sale treatment, without the ability to elect IRC Section 1374 treatment for any C corporation that engages in a conversion transaction within 10 years of a tax free spin off. This deemed treatment applied to any situation in which a C corporation converted to REIT or RIC status, for which there was no private letter ruling submission prior to December 7, 2015, or spin offs that occurred prior to the change. These proposed regulations therefore seemingly overruled Congress and reinstated the 10-year recognition period rule.

The Treasury Department and the IRS received one written comment after the issuance of the temporary regulations. The comment requested a public hearing, and such hearing was held on November 9, 2016. The comment requested that the temporary and the proposed regulations with respect to the recognition period be immediately withdrawn and the recognition period with respect to REITs and RICs be defined with reference to the recognition period of IRC Section 1374(d)(7), which is currently a 5-year period as a result of the PATH Act. The comment asserted that the recognition period applicable to REITs and RICs as provided in the temporary and proposed regulations was not consistent with Congress’s intent in the PATH Act and prior administrative guidance. After the public hearing, a Treasury official stated that “we anticipate issuing final regulations that would modify the recognition period for REITs and RICs to confirm to the 5-year period that applies to S corporations.”

On January 17, 2017, the Treasury issued the final regulations under IRC Section 337(d). The regulations provide that the term “recognition period” means the recognition period as described in IRC Section 1374(d)(7), the 5-year period, beginning on the first day of the REIT or RIC’s taxable year, in the case of an election to be taxed as such, and in the case of other conversion transactions, on the day the REIT or RIC acquires the property. It should be noted that the final regulations do not address the “Automatic Deemed Sale Rule.” The preamble to the regulations indicates that the Treasury Department and the IRS continue to study this and other issues addressed in the temporary and proposed regulations, including other issues raised by comments. Comments are still being taken on these issues.

Based on the effective date as outlined in the final regulations, the regulations were to be effective and apply prospectively from February 18, 2017, 30 days after the publication of the regulations in the Federal Register, but taxpayers may choose to apply the definition of recognition period in the final regulations instead of the 10–year period as contained in the temporary regulations, for all conversion transaction or property acquisitions occurring on or after August 8, 2016, and on or before February 18, 2017. However, it should be noted that since the regulations are effective 30 days after publication, the final regulations are subject to the Presidential regulatory freeze that was issued on January 22, 2017. Under this freeze, regulations that have been published in the Office of the Federal Register but have not taken effect are subject to a 60-day postponement.
BDO Insights The final regulations are consistent with the intent of Congress to keep the built-in-gain recognition period for REITs and RICs the same as S corporations, which has historically been the case.

There does not appear to be policy concerns that would result in modification of the regulations as a result of the regulatory freeze. However, it should be noted that the effective date is subject to the freeze and must be taken in consideration.
For more information, please contact one of the following practice leaders: 
  Tanya Thomas Jeffrey N. Bilsky Julie Robins

International Tax Alert - February 2017

Wed, 02/15/2017 - 12:00am
Overview of Potential U.S. Corporate Tax Reform:  A Guide to the GOP House Blueprint
In June 2016, Ways and Means Republicans led the effort to unveil a “Better Way for Tax Reform.” This GOP House Blueprint (“the Blueprint”) identifies several problems with the United States current tax system and proposes several changes to such system as it relates to taxation of individuals, pass-through entities and corporations.  This Tax Alert focuses on some of the significant aspects of the Blueprint relating to corporations.1
  The Global Impact of the Current Tax Code In discussing the current tax system, the Blueprint notes that the United States has one of the highest corporate tax rates and such rates have encouraged businesses to move overseas.  The corporate tax rate represents an important factor in a company’s decision whether to invest and locate jobs in the United States or overseas. As evidence, the Blueprint highlights that, in 1960, 17 of the 20 largest global companies located their headquarters in the U.S. However, by 2015, only six of the top 20 were located in the United States.  The Blueprint states that one of the consequences of the relatively high U.S. corporate tax rate is that the number of corporate “inversions”—e.g., where a larger American company acquires a smaller foreign company, but locates the headquarters of the new company outside the United States—has accelerated dramatically in recent years. From 2003 through 2011, corporations completed only seven such transactions, or less than one per year on average. But from 2012 through 2015, corporations completed 27 inversions, a pace of almost seven per year. At the same time, an increasing number of U.S. companies are being acquired by foreign companies.

The Blueprint contrasts the U.S. tax system with those of the United States’ trading partners around the world. It notes that the United States uses a worldwide tax system, which means it generally taxes the earnings of U.S. companies overseas when those earnings are brought back to the United States and provides a credit for foreign taxes paid on those earnings. Meanwhile, virtually all of the United States’ major trading partners have adopted territorial tax systems, under which these governments generally do not tax the active business income earned overseas by companies headquartered in their countries. Currently, U.S.-based multinational companies hold more than $2 trillion in capital overseas.
  The GOP House Blueprint’s Plan to Address Global Competitiveness To address the recent wave of corporate inversions and make the United States more competitive, the Blueprint proposes reducing the corporate tax rate to 20 percent, switching to a territorial system, and implementing “border adjustments.” The Blueprint seeks to eliminate the existing self-imposed export penalty and import subsidy by moving to a destination-basis tax system. According to the Blueprint, under a destination-basis approach, the tax jurisdiction of income follows the location of consumption rather than the location of production. The Blueprint attempts to achieve this by providing for “border adjustments,” which effectively exempt exports from U.S. tax while taxing imports. Simply put, border adjustments mean that it does not matter where a company is incorporated; sales to U.S. customers are taxed and sales to foreign customers are exempt, regardless of whether the taxpayer is foreign or domestic. The Blueprint also ends the worldwide tax approach of the United States, replacing it with a territorial tax system that is consistent with the approach used by the United States’ major trading partners. The Blueprint states that these structural changes are an attempt to simplify and streamline the international tax rules and to encourage businesses to access “trapped cash” overseas.
  a. Treatment of Cross-Border Sales, Services and Intangibles  The Blueprint notes that today, all of the United States’ major trading partners raise a significant portion of their tax revenues through value-added taxes (“VATs”). These VATs include “border adjustability” as a key feature. This means that the tax is rebated when a product is exported to a foreign country and is imposed when a product is imported from a foreign country. These border adjustments reduce the costs borne by exported products and increase the costs borne by imported products. When the country is trading with another country that similarly imposes a border-adjustable VAT, the effects in both directions are offsetting and the tax costs borne by exports and imports are in relative balance. However, the Blueprint states that balance does not exist when the trading partner is the United States. The Blueprint argues that in the absence of border adjustments, exports from the United States implicitly bear the cost of the U.S. income tax while imports into the United States do not bear any U.S. income tax cost. This amounts to what the Blueprint describes as a “self-imposed unilateral penalty” on U.S. exports and “a self-imposed unilateral subsidy” for U.S. imports.
 
Because the Blueprint reflects a move toward a cash-flow tax approach for businesses, which attempts to reflect a consumption-based tax, the Blueprint argues that the United States will be able to compete on a level playing field by applying border adjustments within the context of a transformed business and corporate tax system. This cash-flow based approach that is proposed to replace the United States’ current income-based approach for taxing both corporate and non-corporate businesses will be applied on a destination basis. This means, according to the Blueprint, that products, services and intangibles that are exported outside the United States will not be subject to U.S. tax regardless of where they are produced. It also means that products, services and intangibles that are imported into the United States will be subject to U.S. tax regardless of where they are produced. This seeks to eliminate the incentives to move or locate operations outside the United States, while allowing U.S. products, services, and intangibles to compete on a more equal footing in both the U.S. market and the global market.
 
The Blueprint also discusses the border adjustments mentioned above and the rules of the World Trade Organization (“WTO”).  It notes that the WTO includes longstanding provisions regarding the use of border adjustments. Under these rules, border adjustments upon exports are permitted with respect to consumption-based taxes, which are referred to as indirect taxes. However, under these rules, border adjustments upon export are not permitted with respect to income taxes, which are referred to as direct taxes. Under WTO rules, the Blueprint notes that the United States has been precluded from applying the border adjustments to U.S. exports and imports necessary to balance the treatment applied by the United States’ trading partners to their exports and imports. By moving toward a consumption-based tax approach, in the form of a cash-flow focused approach for taxing business income, the Blueprint seeks to create the opportunity for the United States to incorporate border adjustments in the new tax system consistent with the WTO rules regarding indirect taxes.2
  b. Territorial Taxation of U.S.-Based Multinationals  In an attempt to allow U.S.-based companies to compete in global markets on an equal footing, the Blueprint replaces the existing worldwide tax system by allowing for a 100 percent exemption for dividends from foreign subsidiaries. It also seeks to eliminate the “lock-out effect” of current law, allowing U.S.-based companies to bring home their foreign earnings to be reinvested in United States without additional tax cost.
 
As part of the move to the modern territorial approach to international taxation, the Blueprint will provide rules that will allow foreign earnings that have accumulated overseas under the old system to be brought home. Accumulated foreign earnings will be subject to tax at 8.75 percent to the extent held in cash or cash equivalents and otherwise will be subject to tax at 3.5 percent (with companies able to pay the resulting tax liability over an eight-year period). The Blueprints basically seeks to free up the more than $2 trillion in foreign earnings that have been locked out of the United States under the current tax rules and attempts to reduce the build-up of such earnings.
  c. Simplification of the International Tax Rules  According to the Blueprint, the destination-based, territorial approach for international taxation reflected in the Blueprint would allow the subpart F rules of the current international tax regime to be significantly streamlined and simplified.   The Blueprint argues the destination-based approach for cross-border transactions should help level the playing field and eliminate the tax incentives for moving jobs and profits offshore.  As a result, the bulk of the subpart F rules (specifically the foreign base company income rules)—which were designed to counter tax incentives to locate overseas—could be rolled back.  Only the foreign personal holding company rules, which were designed to counter the potential for truly passive income to be shifted to low-tax jurisdictions, will continue to play a role in addressing potential abuse according to the Blueprint.  In addition to these reforms, the Committee on Ways and Means will also consider the appropriate treatment of individuals living and working abroad in today’s globally integrated economy.
  Summary of Some of the Key Aspects of Corporate/International Tax Reform in the Blueprint
  • Reduces the corporate tax rate to a flat 20 percent.
  • Repeals corporate Alternative Minimum Tax.
  • Allows Net Operating Losses (“NOLs”) to be carried forward indefinitely (no carry back) with adjustments for inflation; NOL carryforwards limited to 90 percent of net taxable income for such year.
  • Allows businesses to immediately write off the full cost of new investments (both tangible and intangible) in the first year.
  • Creates a territorial international tax system.
  • Provides for “border adjustments” as discussed above.
  • Subjects repatriations of accumulated foreign earnings to a tax of 8.75 percent (cash and equivalents) and 3.5 percent (non-cash and equivalents).
  • Limits the application of the Subpart F regime to the Foreign Personal Holding Company rules.
  • Only allows interest expense to be deducted to the extent of interest income; remaining net interest expense would be carried forward indefinitely to offset future net interest income.
  • Provides for a business credit to encourage research and development.
  • Preserves the last-in-first-out method of inventory accounting.
  • Eliminates nearly all other credits/deductions. 

BDO Insights If the approach to corporate and international tax reform in the Blueprint moves forward in Congress, it would represent a dramatic change to our current worldwide tax system.  There have been several proposals over the last several years to move from a worldwide tax system to a territorial tax system and such a change seems to have momentum in Congress.  However, one of the more controversial items in the Blueprint relates to border adjustments.  There are questions relating to whether such adjustments, as proposed in the Blueprint, would violate the WTO rules. Additionally, it appears that such border adjustments can have a disparate impact on certain taxpayers and industries (e.g., the border adjustments appear to be beneficial for U.S. companies that are net exporters while being detrimental to U.S. companies that are net importers).  However, more details relating to these border adjustments is necessary before determining the full impact they will have. 
 
For more information, please contact one of the following practice leaders:

  Joe Calianno
Partner and International Tax Technical Practice Leader           Brad Rode
Partner     Robert Pedersen
Partner and International Tax Practice Leader   William F. Roth III
Partner, National Tax Office    Scott Hendon
Partner    Jerry Seade
Principal     Annie Lee
Partner    Sean Dokko
Senior Manager    Monika Loving
Partner    Ryan Thomas
Senior Manager    Chip Morgan
Partner   Kevin Ainsworth
Senior Manager   
1 For a full discussion of the proposals in the Blueprint (along with the proposals to reform the rules relating to individuals and pass-through entities that are not discussed in this Tax Alert), please see “A Better Way: Our Vision for a Confident America,” published June 22, 2016.   

2 Based on language in the Blueprint, it does not appear that the GOP House Republicans view the border adjustments discussed in the Blueprint as a VAT. The Blueprint states the following: “This Blueprint represents a dramatic reform of the current income tax system. This Blueprint does not include a VAT, a sales tax, or any other tax as an addition to the fundamental reforms of the current income tax system.” “A Better Way: Our Vision for a Confident America,” page 15.

Expatriate Tax Newsletter - February 2017

Wed, 02/15/2017 - 12:00am
BDO's Expatriate Newsletter covers timely tax-related updates and regulations from countries around the globe. The February 2017 issue highlights developments in Hong Kong, Italy, United Kingdom, and more.

Topics include:
  • Hong Kong: The MPF Default Investment Strategy for enhancement of the Hong Kong Mandatory Provident Fund system
  • Italy: Flat tax regime for new residents
  • United Kingdom: Changes to the United Kingdom non-domicile tax rules

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China Tax Newsletter - February 2017

Wed, 02/15/2017 - 12:00am
The February 2017 edition of BDO China's China Tax Newsletter features recent tax-related news and developments in China, including the announcement of the following topics and more:
 
  • Revising Two Normative Documents Concerning Enterprise Income Tax
  • Supplementary Circular on Issues concerning Value-added Tax Policies for Asset Management Products
  • Execution of the Third Protocol to the Arrangement for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
  • Execution of the Agreement for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion

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International Tax Alert - February 2017

Fri, 02/10/2017 - 12:00am
Transfers of Certain Property by U.S. Persons to Partnerships with Related Foreign Partners
Summary Recently, the Department of the Treasury and the Internal Revenue Service (hereinafter, collectively “Treasury”) issued temporary (T.D. 9811) and proposed (REG-127203-15) regulations that address transfers of appreciated property by U.S. persons to partnerships with foreign partners related to the transferor.  The regulations override the rules under Section 721(a) providing for non-recognition of gain on a contribution of property to a partnership in exchange for an interest in the partnership, unless the partnership adopts the remedial method and certain other requirements are satisfied.  The regulations affect U.S. partners in domestic or foreign partnerships.
 
The regulations largely adopt the rules provided in Notice 2015-54 with certain modifications. Some of the key modifications, as further discussed below, include:
  1. Modifying the requirement for the U.S. transferor and related foreign partners to have 80 percent or more of the interests in partnership capital, profits, deductions or losses, instead of 50 percent for “Section 721(c) Partnerships.”  See Overview Sections 1 and 2 below;
  2. Modifying the “gain deferral method” such that property that gives rise to income effectively connected with a U.S. trade or business is generally not subject to the remedial allocation method or the consistent allocation method.  See Overview Section 3 below;
  3. Modifying the remedial allocation method as to anti-churning property.  See Overview Section 3 below; and
  4. Exempting contributions of property by “unrelated” U.S. transferors (i.e., a U.S. transferor that does not, together with related persons with respect to it, satisfy the ownership requirement).  See Overview Section 2 below.

Background The Taxpayer Relief Act of 1997 (the “1997 Act”), P.L. 105-34, granted the Secretary regulatory authority in Section 721(c) to override the application of the non-recognition provision of Section 721(a) to gain realized on the transfer of property to a partnership (domestic or foreign) if the gain, when recognized, would be includible in the gross income of a person other than a U.S. person. In the 1997 Act, Congress also enacted Section 367(d)(3), which provides the Secretary regulatory authority to apply the rules of Section 367(d)(2) to transfers of intangible property to partnerships in circumstances consistent with the purposes of Section 367(d).  Congress enacted Section 367 (and its predecessor) in order to prevent U.S. persons from avoiding U.S. tax by transferring appreciated property to foreign corporations using non-recognition transactions.
 
Section 721(a) provides a general rule that no gain or loss is recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.  Because Section 367 applies only to the transfer of property to a foreign corporation, absent regulations under Section 721(c) or Section 367(d)(3), a U.S. person generally does not recognize gain on the contribution of appreciated property to a partnership with foreign partners.
 
On August 6, 2015, Treasury issued Notice 2015-54 (the “notice”), which describes regulations to be issued under Section 721(c).  The notice states that future regulations generally will override the application of the non-recognition rule in Section 721(a) to gain realized on the transfer of property to a partnership (domestic or foreign) in certain circumstances in which the gain, when recognized, ultimately would be includable in the gross income of a related foreign person.  The notice further states that future regulations will allow for the continued application of Section 721(a) to transfers to partnerships with related foreign partners when certain requirements intended to protect the U.S. tax base are satisfied.  The notice described these requirements, in addition to others, as the “gain deferral method.”  For a discussion of the notice, see our Tax Alert, “New Notice 2015-54 Addresses Certain Contributions Made to Partnerships,” dated August 2015.
  Overview of the Temporary Regulations The temporary regulations adopt the rules that were described in the notice, with certain modifications.  Some of the key items to the temporary regulations are summarized below.
 
  1. Definitions
The notice states that future regulations would provide that a partnership is a Section 721(c) partnership if a U.S. transferor contributes Section 721(c) property (as defined in the notice) to the partnership, and, after the contribution and any transactions related to the contribution, (i) a related foreign person is a direct or indirect partner, and (ii) the U.S. transferor and related persons own (directly or indirectly) more than 50 percent of the interests in partnership capital, profits, deductions, or losses.  The temporary regulations, however, increase the threshold from a “more than 50 percent” test to an “80 percent or more” test (ownership requirement).
 
Section 721(c) Partnership:  A partnership (domestic or foreign) is a Section 721(c) partnership if there is a contribution of Section 721(c) property to the partnership and, after the contribution and all transactions related to the contribution: (i) a related foreign person with respect to the U.S. transferor is a direct or indirect partner in the partnership; and (ii) the U.S. transferor and related persons own 80 percent or more of the interests in partnership capital, profits, deductions, or losses.[1]

Section 721(c) Property: The temporary regulations define Section 721(c) property as property, other than excluded property, with built-in gain that is contributed to a partnership by a U.S. transferor.[2]  In addition, the temporary regulations provide rules that deem certain property of a tiered partnership to be Section 721(c) property.[3]  When an interest in a partnership is contributed, the partnership interest, if it is not excluded property, is the Section 721(c) property.
 
Excluded Property: The temporary regulations define excluded property as (i) a cash equivalent; (ii) a security within the meaning of Section 475(c)(2), without regard to Section 475(c)(4); (iii) an item of tangible property with built-in gain that does not exceed $20,000 or with an adjusted tax basis in excess of book value (built-in loss); and (iv) an interest in a partnership that holds (directly, or indirectly, through interests in one or more partnerships that are not excluded property under this clause (iv)) property of which 90 percent or more of the value consists of property described in clauses (i) through (iii) (partnership interest exclusion).[4]
 
Remaining Built-in Gain: The temporary regulations include a new term, “remaining built-in gain.”  Section 1.721(c)-1T(b)(13)(i) generally defines remaining built-in gain, with respect to an item of Section 721(c) property that is subject to the gain deferral method, as the built-in gain, reduced by decreases in the difference between the property's book value and adjusted tax basis. However, subsequent increases or decreases to the property's book value due to a revaluation other than a revaluation required under these temporary regulations for tiered partnerships are not taken into account in determining remaining built-in gain. The temporary regulations also provide rules for determining remaining built-in gain in the case of tiered partnerships.[5]
 
  1. General Rule of Gain Recognition
Section 1.721(c)-2T(b) provides the general rule that non-recognition under Section 721(a) will not apply to gain realized upon a contribution of Section 721(c) property to a Section 721(c) partnership.  However, this general rule does not apply to a direct contribution by a U.S. transferor if the U.S. transferor and related persons with respect to the U.S. transferor do not own 80 percent or more of the interests in partnership capital, profits, deductions, or losses.  This 80 percent related ownership threshold is a significant departure from the notice that required only 50 percent related ownership.
 
Section 1.721(c)-2T(c) provides a de minimis exception to the general rule. Under the de minimis exception in the temporary regulations, contributions of Section 721(c) property will not be subject to immediate gain recognition if the sum of all built-in gain for all Section 721(c) property contributed to a Section 721(c) partnership during the partnership's taxable year does not exceed $1 million.
 
Section 1.721(c)-2T(d)(1) provides a look-through rule for identifying a Section 721(c) partnership in certain tiered-partnership structures.  Specifically, subject to an exception for a technical termination of a partnership, if a U.S. transferor is a direct or indirect partner in a partnership (upper-tier partnership) and the upper-tier partnership contributes all or a portion of its property to another partnership (lower-tier partnership), then, for purposes of determining if the lower-tier partnership is a Section 721(c) partnership, the U.S. transferor is treated as contributing to the lower-tier partnership its share of the property actually contributed by the upper-tier partnership to the lower-tier partnership.
 
  1. Gain Deferral Method
Section 1.721(c)-3T describes the gain deferral method, which generally must be applied in order to avoid the immediate recognition of gain upon a contribution of Section 721(c) property to a Section 721(c) partnership.  Section 1.721(c)-3T(b) provides the five general requirements for applying the gain deferral method to an item of Section 721(c) property:
  1. The Section 721(c) partnership adopts the remedial allocation method and allocates Section 704(b) items of income, gain, loss, and deduction with respect to the Section 721(c) property in a manner that satisfies the consistent allocation method (as described below);
  2. The U.S. transferor recognizes gain equal to the remaining built-in gain with respect to the Section 721(c) property upon an acceleration event, or an amount of gain equal to a portion of the remaining built-in gain upon a partial acceleration event or certain transfers to foreign corporations described in Section 367;
  3. Certain procedural and reporting requirements are satisfied;
  4. The U.S. transferor extends the period of limitations on assessment of tax; and
  5. The rules for tiered partnerships are satisfied if either the Section 721(c) property is an interest in a partnership or the Section 721(c) property is described in the partnership look-through rule in Section 1.721(c)-2T(d)(1).
The temporary regulations employ two general principles in applying the gain deferral method to tiered partnerships.  First, if the Section 721(c) property is an interest in a partnership, the contribution of that partnership interest, and not the indirect contribution of the underlying property of the lower-tier partnership, to a Section 721(c) partnership is subject to Section 721(c), and the gain deferral method applies to the contribution of the interest.  Second, the gain deferral method must also be adopted at all levels in the ownership chain.
 
The temporary regulations provide that a contribution of Section 721(c) property that gives rise to income effectively connected with a U.S. trade or business (“ECI property”) is subject to immediate gain recognition if the gain deferral method is not applied. However, the temporary regulations modify the gain deferral method such that ECI property is not subject to the remedial allocation method or the consistent allocation method provided certain conditions are satisfied.[6] All the other requirements of the gain deferral method apply with respect to ECI property. Thus, a U.S. transferor must recognize gain upon an acceleration event with respect to ECI property, including when property ceases to be ECI property, and satisfy the procedural and reporting requirements with respect to ECI property.[7]
 
The temporary regulations revise the remedial allocation method in Section 1.704-3(d) as to related partners when a Section 721(c) partnership is applying the gain deferral method with respect to Section 197(f)(9) intangible property (e.g., goodwill and going concern value that was non-amortizable before the enactment of Section 197).  The revised rule requires the partnership to amortize the portion of the partnership's book value in the Section 197(f)(9) intangible property that exceeds its adjusted tax basis in the property.  Accordingly, the allocation of book amortization to a noncontributing partner will result in a ceiling rule limitation to the extent of this allocation of book amortization.  If a noncontributing partner is a related person with respect to the U.S. transferor, the temporary regulations provide that, solely with respect to the related noncontributing partner, the partnership must increase the adjusted tax basis of the property by the amount of the difference between the book allocation of the item to the related person and the tax allocation of the same item to the related person and allocate remedial income in the same amount to the U.S. transferor.[8]
 
As noted above, in order to avoid immediate gain recognition, taxpayers are required to apply the remedial allocation method in a manner that satisfies the consistent allocation method.  The consistent allocation method, which is applied on a property by property basis, requires a Section 721(c) partnership to allocate the same percentage of each book item of income, gain, deduction, and loss “with respect to the Section 721(c) property” to the U.S. transferor.  A regulatory allocation of book income, gain, deduction, or loss with respect to Section 721(c) property will be deemed to satisfy the consistent allocation method if the allocation is (i) an allocation of income or gain to the U.S. transferor; (ii) an allocation of deduction or loss to partner other than a U.S. transferor; or (iii) treated as a partial acceleration event (as described below).  It should be noted that an allocation of a creditable foreign tax expenditure as defined in Section 1.704-1(b)(4)(viii)(b), is not subject to the consistent allocation method.
 
The consistent allocation method is intended to prevent a U.S. transferor from rendering the remedial allocation method ineffective by, for example, having the partnership allocate a higher percentage share of book depreciation to the U.S. transferor (which would reduce the U.S. transferor's remedial income inclusion) than the U.S. transferor's percentage share of income or gain with respect to the property, which would result in shifting the gain (and taxable income) to related foreign persons that are direct or indirect partners in the partnership.
 
  1. Acceleration Events
Section 1.721(c)-4T provides rules regarding acceleration events which apply on a property-by-property basis.  When an acceleration event occurs with respect to Section 721(c) property, remaining built-in gain in the property must be recognized and the gain deferral method no longer applies, subject to certain exceptions.
 
Subject to certain exceptions detailed below, an acceleration event with respect to Section 721(c) property is any event that either would reduce the amount of remaining built-in gain that a U.S. transferor would recognize under the gain deferral method if the event had not occurred or could defer the recognition of the remaining built-in gain.  An acceleration event includes a contribution of Section 721(c) property to another partnership by a Section 721(c) partnership and a contribution of an interest in a Section 721(c) partnership to another partnership.  The temporary regulations provide that an acceleration event will not occur because of a reduction in remaining built-in gain in an interest in a partnership that is a Section 721(c) property that occurs as a result of allocations of book items of deductions and loss, or tax items of income and gain.[9]
 
Under the temporary regulations, an acceleration event with respect to Section 721(c) property occurs when any party fails to comply with a requirement of the gain deferral method with respect to that property.[10]  An acceleration event will not occur solely as a result of a failure to comply with a procedural or reporting requirement of the gain deferral method if that failure is not willful and relief is sought under the prescribed procedures.[11]
 
Under the temporary regulations, a U.S. transferor may affirmatively treat an acceleration event as having occurred with respect to Section 721(c) property by recognizing the remaining built-in gain with respect to that property and satisfying the reporting required by Section 1.721(c)-6T(b)(3)(iv).[12]  In addition, certain basis adjustments generally must be made.[13]
 
  1. Acceleration Event Exceptions
Section 1.721(c)-5T identifies the following categories of exceptions to acceleration events, which, like acceleration events, apply on a property-by-property basis:
  1. Termination events,[14] in which case, the gain deferral method ceases to apply to the Section 721(c) property;
  2. Successor events,[15] in which case, the gain deferral method continues to apply to the Section 721(c) property but with respect to a successor U.S. transferor or a successor Section 721(c) partnership, as applicable;
  3. Partial acceleration events,[16] in which case, a U.S. transferor recognizes an amount of gain that is less than the full amount of remaining built-in gain in the Section 721(c) property and the gain deferral method continues to apply;
  4. Transfers described in Section 367 of Section 721(c) property to a foreign corporation, in which case, the gain deferral method ceases to apply and a U.S. transferor recognizes an amount of gain equal to the remaining built-in gain attributable to the portion of the Section 721(c) property that is not subject to tax under Section 367;[17] and
  5. Fully taxable dispositions of a portion of an interest in a Section 721(c) partnership, in which case, the gain deferral method continues to apply for the retained portion of the interest.[18]
 
  1. Procedural and Reporting Requirements
To comply with the gain deferral method, the notice described regulations that would be issued requiring reporting of a gain deferral contribution and annual reporting with respect to the Section 721(c) property to which the gain deferral method applies.  The temporary regulations implement the rules described in the notice and Section 1.721(c)-6T provides the procedural and reporting requirements.
 
  1. Effective/Applicability Dates
The applicability dates of the temporary regulations generally relate back to the issuance of the notice.
 
Accordingly, in general, the temporary regulations apply to contributions occurring on or after August 6, 2015, and to contributions occurring before August 6, 2015, resulting from an entity classification election made under Section 301.7701-3 that is filed on or after August 6, 2015 (the “general applicability date”).  However, new rules, including any substantive changes to the rules described in the notice, apply to contributions occurring on or after January 18, 2017, or to contributions occurring before January 18, 2017, resulting from an entity classification election made under Section 301.7701-3 that is filed on or after January 18, 2017. Taxpayers may, however, elect to apply those new rules and substantive changes to the rules described in the notice to a contribution occurring on or after the general applicability date.  The election is made by reflecting the application of the relevant rule on a timely filed or amended return.
 
The Temporary Regulations are scheduled to expire on January 17, 2020.
 
For dates of applicability, see Sections 1.197-2T(l)(5)(i), 1.704-1T(f), 1.704-3T(g)(1), 1.721(c)-1T(e), 1.721(c)-2T(e), 1.721(c)-3T(e), 1.721(c)-4T(d), 1.721(c)-5T(g), 1.721(c)-6T(g), and 1.6038B-2T(j)(4)(i).
  BDO Insights BDO can assist taxpayers with understanding the complexities of these rules. While the temporary regulations scale back the application of these rules as compared to the notice, taxpayers should continue to consider the application of these rules when transferring appreciated property to a partnership with a related foreign partner. 
 
For more information, please contact one of the following practice leaders:
  Robert Pedersen
Partner and International Tax Practice Leader          Chip Morgan
Partner    Joe Calianno
Partner and International Tax Technical Practice Leader    Brad Rode
Partner    William F. Roth III
Partner, National Tax Office   Jerry Seade
Principal    Scott Hendon
Partner    Monika Loving
Partner    Annie Lee
Partner   Sean Dokko
Senior Manager    David Patch
Managing Director, National Tax
Office    Julie Robins
Managing Director, National Tax Office        [1] See §1.721(c)-1T(b)(14)(i). [2] See §1.721(c)-1T(b)(15)(i). [3] See §1.721(c)-1T(b)(15)(ii). [4] See §1.721(c)-1T(b)(6). [5] See §1.721(c)-1T(b)(13)(ii). [6] See §1.721(c)-3T(b)(1)(ii). [7] See §§ 1.721(c)-6T(b)(2)(iii), (b)(3)(vii), and (c)(1). [8] See §1.704-3T(d)(5)(iii)(C). [9] See §1.721(c)-4T(b)(3). [10] See §1.721(c)-4T(b)(2)(i). [11] See §§1.721(c)-4T(b)(2)(ii) and 1.721(c)-6T(f). [12] See §1.721(c)-4T(b)(4). [13] See §§ 1.721(c)-4T(c)(1) 1.721(c)-4T(c)(2). [14] See §§ 1.721(c)-5T(b)(1)-(7). [15] See §§ 1.721(c)-5T(c)(1)-(5). [16] See §§ 1.721(c)-5T(d)(1)-(3). [17] See §§ 1.721(c)-5T(e). [18] See §1.721(c)-5T(f).

Partnership Taxation Alert - February 2017

Wed, 02/08/2017 - 12:00am
Final Regulations Bring Clarity to Qualifying Income for Publicly Traded Partnerships Download PDF Version
Summary On January 19, 2017, Treasury and the IRS issued final regulations (TD 9817) under Section 7704(d)(1)(E) of the Internal Revenue Code.  The regulations provide guidance on the types of activities that generate Qualifying Income for publicly traded partnerships (“PTPs”), define the term “mineral or natural resource,” provide rules for determining whether activities that are not Section 7704(d)(1)(E) activities are nonetheless qualifying “Intrinsic Activities,” and establish a transition period for certain PTPs.  The final regulations follow the basic approach of the proposed regulations while incorporating changes based on feedback received from public comments.
Details Background
Section 7704(a) provides that, as a general rule, PTPs will be treated as corporations for federal income tax purposes.  Section 7704(c) provides an exception to this rule if 90 percent or more of a PTP’s gross income is Qualifying Income.  Qualifying Income is generally passive-type income such as interest, dividends, and rent.  However, Section 7704(d)(1)(E) provides that income and gains derived from the exploration, development, mining or production, processing, refining, transportation, or the marketing of any mineral or natural resource (a “Qualifying Activity”) also constitutes Qualifying Income.

Prior to the issuance of proposed regulations on May 6, 2015, little guidance was available that defined the specific activities that generate Qualifying Income in the mineral and natural resource industries.  As a result, PTPs often sought opinion letters from law firms and private letter rulings (“PLRs”) from the IRS to obtain comfort that the income generated by a particular activity was Qualifying Income.  Treasury issued the proposed, and now these final regulations due to the increased demand for PLRs, the responsibility to treat all taxpayers equally, and the desire to apply Section 7704(d)(1)(E) consistent with congressional intent.

Overview
Treas. Reg. Section 1.7704-4 creates a framework for determining whether an activity is a Qualifying Activity.  Pursuant to the new regulations, Qualifying Activities include Section 7704(d)(1)(E) activities and Intrinsic Activities.

Section 7704(d)(1)(E) Activities:  Section 7704(d)(1)(E) activities are those activities specifically enumerated in the statute.  One of the fundamental differences between the proposed regulations and the final regulations is the removal of an exclusive list of operations that comprised Section 7704(d)(1)(E) activities.  Instead, the final regulations provide general definitions of each of the eight component activities described in Section 7704(d)(1)(E), followed by a non-exclusive list of examples of each.  Despite the lists provided being non-exclusive, Treasury and the IRS do not intend that the final regulations be interpreted and applied expansively.

Intrinsic Activities: Intrinsic Activities are support activities essential to Section 7704(d)(1)(E) activities.  According to the preamble of the proposed regulations, it is the belief of Treasury and the IRS that these activities also give rise to Qualifying Income because the income is “derived from” the Section 7704(d)(1)(E) activity.  Consistent with the proposed regulations, the final regulations adopt the following three requirements for a support activity to be considered intrinsic to a Section 7704(d)(1)(E) activity:
  1. The activity is specialized to support a Section 7704(d)(1)(E) activity;
  2. The activity is essential to the completion of the Section 7704(d)(1)(E) activity; and
  3. The activity requires the provision of significant services to support the Section 7704(d)(1)(E) activity.
Support activities must be analyzed on an activity-by-activity basis for these three requirements to determine if the activity is an intrinsic activity.  

Effective Date and Transition Period
The final regulations apply to income earned by a partnership in a taxable year beginning on or after January 19, 2017.  However, an exception applies for certain income earned during a transition period.  The transition period ends on the last day of the partnership’s taxable year that includes January 19, 2027.  The exception provides that a partnership may treat income from an activity as Qualifying Income during the transition period if one of the following conditions are met:
  1. The partnership received a PLR from the IRS holding that the income from that activity is Qualifying Income;
  2. Prior to May 6, 2015, the partnership was publicly traded, engaged in the activity, and treated the activity as giving rise to Qualifying Income under Section 7704(d)(1)(E), and that income was Qualifying Income under the statute as reasonably interpreted prior to May 6, 2015;
  3. Prior to May 6, 2015, the partnership was publicly traded and had entered into a binding agreement for construction of assets to be used in such activity that would give rise to income that was Qualifying Income under the statute as reasonably interpreted prior to May 6, 2015; or
  4. The partnership is publicly traded and engages in the activity after May 6, 2015, but before January 19, 2017, and the income from that activity is Qualifying Income under the proposed regulations (REG-132634-14) contained in the Internal Revenue Bulletin 2015-21.  
BDO Insights The final PTP regulations bring much needed clarity in determining which activities give rise to Qualifying Income.  Existing and prospective PTPs should analyze their activities to determine if they fall within the newly defined guidelines for Qualifying Activities, and if not, whether they qualify under the transition rules.  While the new regulations are intended to reduce the need for case-by-case guidance, companies developing new technologies and companies with activities not defined by the new regulations may still need to consider requesting a PLR.  
 
For more information, please contact one of the following practice leaders: 
  Jeffrey N. Bilsky Julie Robins David Patch Will Hodges

International Tax Alert - February 2017

Wed, 02/08/2017 - 12:00am
The Indian Tiffin XII A bi-monthly publication from BDO India, "The Indian Tiffin" brings together business information, facilitating decision-making from a multi-dimensional perspective. The unique name of this thought leadership piece is inspired most literally by Indian tiffins, referring to home cooked lunches delivered to the working population by 'dabbawalas' – people who deliver the packed lunches (tiffins). In that same sense, the purpose of “The Indian Tiffin” newsletter is to deliver a variety of news to satiate your palate, from domestic and cross-border updates to India business perspectives. This issue covers:
 
  • India Economic Update by Milind S.Kothari, Managing Partner, BDO India LLP on Prime Minister Narendra’s announcement of the withdrawal of high currency notes in November 2016, and the unparalleled disruption in the economy that followed.
  • Learn about deal announcements in the M & A Tracker from Rajesh Thakkar, Partner, Transaction Advisory Services.  Hear about deals that were completed between November 2016 and January 2017, with an aggregated value of $6.32 billion, the sectors the deals came from, and targeted companies.
  • In the Featured Story, Rajesh Thakkar reflects on 2016’s Brexit, Donald Trump’s Presidential win, the demonetization of high currency by Prime Minister Narendra, and how India has a favorable economy and sits poised to be the fastest growing market globally.
  • The Guest Column feature with Ameya Kunte, Executive Editor, and Co-founder of Taxsutra, will touch on the Indian Revenue Service demonstration of their emphasis on strengthening non-adversarial regime, Advance Pricing Agreements, Mutual Agreement Procedures and Tax certainty. 
  Read The Newsletter

State and Local Tax Alert - February 2017

Tue, 02/07/2017 - 12:00am
Delaware Landmark Unclaimed Property Legislation as Remedy to Holding in Temple Inland v Cook with Eye Towards Friendly and Fair Compliance
Summary On January 26, 2017, S.B. 13 was passed by both houses, and signed by Governor John Carney Jr. on February 3, 2017.  The bill makes numerous prospective changes to Delaware’s unclaimed property laws.  In essence, Delaware seeks to scrap its previous unclaimed property statute and replace it with a newer model act version with significant modifications.  Specifically, S.B. 13 enacts significant changes to Delaware’s unclaimed property audit and Voluntary Disclosure Agreement (“VDA”) program rules, including provisions permitting certain holders currently under audit to convert their audit to a Delaware Secretary of State (“SOS”) VDA filing or an expedited audit program.  S.B. 13 also changes the look-back periods for both audits and VDA filings.  The bill also authorizes the Delaware Department of Finance (“DOF”) to initiate compliance reviews upon receipt of unclaimed property reports and makes changes to the administrative review process for audit findings.  Finally, the bill adopts record retention requirements, enacts a statute of limitations period that matches the record retention period, includes due diligence letter requirements for holders, and directs the DOF and SOS to promulgate consistent regulations for unclaimed property administration, among other changes.
Details Significant Changes to Unclaimed Property Audits and VDAs
 
Audit Program:
 
Under S.B. 13, holders currently under audit with the DOF would be afforded several options which are highlighted in the chart below: 
  Option Audit Notice Issue Date Look-Back Period Time to Complete Penalty & Interest Notification
Requirement Notification Deadline Convert to SOS VDA On or before 7/22/15 10 report years prior to the year holder received original audit notice 2 years + extensions Waived SOS and DOF notification required 60 days from adoption date of regulations under 1180(b)
 
Expected date to be on or after 7/1/17 Enroll in DOF Expedited Audit Any examination authorized by the DOF up to the effective date of S.B. 13 10 report years prior to the year holder received original audit notice[1] 2 years Waived[2] DOF notification required 60 days from adoption date of regulations under 1180(b)
 
Expected date to be on or after 7/1/17 Remain in DE DOF Regular Audit N/A 10 report years prior to year holder received original audit notice[3] Ongoing DOF has discretion to waive 50% of interest and any penalties for “good cause” N/A N/A  
The conversion of audits to VDAs also presents certain unanswered questions that are important to the conversion process, and are expected to be answered by summer 2017.  For example, it is unclear whether a holder may convert in part, or must convert in whole.  This issue is of importance to holders that may be close to closing out audit examinations on certain property types, while other property types have not begun testing or are in preliminary stages of audit review.  The same question is also raised with respect to legal entities that are close to completion versus other entities that are in beginning stages of review. 
 
The second issue relates to the uncertainty regarding the process for securing and sharing full and complete data secured by third party audit firms in the course of the audit with the holder and SOS VDA representatives.  Some of these third party audit firms do not maintain records uploaded by holders to their portal sites after a certain period of time under their own firm record retention policies.  If this is the case, are these records available somewhere other than the auditor, or do holders have to reproduce all of this information?  Is this process automatic, or does a holder have to file a FOIA request to get the records?
 
Thirdly, holders that convert to VDA face another issue as to whether they will be required to follow the same process or rulings maintained by the auditor, or if there is flexibility for adjustments or changes in approach where appropriate?  This issue is of particular importance, especially with respect to base period years that in some cases were selected by the third party auditor, even though the holder could not research all records within that period. 
 
Finally,  holders that are in multi-state audits with a third party auditor face another issue on how they will handle other piggy-backed participating audit states as part of their decision to convert or not.  Logically, the holder would seek to comply with these state audits contemporaneously as they progress through the DE VDA they just converted into.  This begs the question whether such third party audit firms are even necessary for such compliance.  These and other questions will need to be addressed in evaluation of aforementioned options under S.B. 13.
 
VDA Program:
 
Similarly, S.B. 13 modifies the VDA look-back periods.  While the bill is somewhat convoluted in this regard, a representative of the SOS office confirmed the filing types and filing periods in summary fashion, below:
  Type VDA Look-Back Period Open VDA with SOS or DOF past 7/1/16 1/1/xx, 10 report years (10 plus 5 years for 15 transaction years) prior to the year in which the DE VDA-1 Form was accepted by DE SOS or DE DOF VDA Closed with SOS or DOF by 7/1/16 1/1/96 – forward (transaction years) DE DOF VDA Converted to DE SOS VDA
 
(permission required) 10 report years (10 plus 5 years for 15 transaction years) prior to the year in which the originally filed DE VDA-1 Form was accepted by DE DOF  
S.B. 13 generally would also provide that the SOS may not accept a VDA filing for holders that: (a) have previously withdrawn from the VDA program, (b) were previously removed from the VDA program by the SOS, or (c) received an audit notice. 
 
Additionally, S.B. 13 provides that “…the Secretary of State shall possess full and complete authority to determine and resolve all such claims consistent with this chapter and exercise such authorities as are granted to the State Escheator under this chapter…”  This language suggests that the SOS has the power to “settle” escheat issues and matters in its sole discretion so long as consistent with the law.  While the bill also seeks for consistency amongst the SOS and DOF, it may be possible now to get resolve on certain issues in the SOS VDA program that historically would have had to been approved by DOF before resolution.
 
Interest and Penalty Changes
 
S.B. 13 makes several interest and penalty provisions, including the following:
  Type of Interest/Penalty Details Discretionary Waiver Unpaid property interest (mandatory unless otherwise waived within the statute) 0.5% per month, maximum of 50% of unreported property Yes, up to 50%[4] Failure to report penalty 5% per month, maximum of 50% of unfiled amounts, or civil penalty of $100 per day not to exceed $5,000 Yes, in whole or in part Failure to pay penalty 0.5% per month, maximum of 25% of unfiled amounts Yes, in whole or in part Fraudulent filing penalty 75% of the amount not paid or filed due to fraud Yes, in whole or in part Evasion of unclaimed property law penalty Civil penalty of $1,000 per day, maximum of $25,000, plus 25% of the amount not filed due to the intent to evade unclaimed property laws Yes, in whole or in part  

Compliance Provisions
 
S.B. 13 also makes several compliance-related provisions that are important and could make compliance more burdensome for some holders in the future.  Particularly, the DOF compliance review process will permit the DOF to review the contents of a holder’s report or inquire regarding the non-filing of a report to determine if the holder underreported.  DOF must notify the holder of any deficiency in writing within one year from the authorization of the compliance review.  S.B. 13 permits the holder 90 days to pay the deficiency or risk DOF judicial action or referral to the SOS for entry into the SOS VDA program.   Moreover, holders will be required to comply with due diligence letter requirements.  Under the bill, holders are required to initiate due diligence if a holder maintains a valid mailing address for owners of unclaimed property where the amount is $50 or more (due diligences letters are required for unclaimed securities of all amounts).  Given the above, holders should review their process for unclaimed property compliance and adopt best practices for maintaining raw data to support filings, including A/R aging reports, check registers, etc. 
 
Statute of Limitations & Record Retention Periods
 
Additionally, the bill provides certain rules around the statute of limitations and record retention.   Holders are required to retain supporting records for 10 years after the date a report was filed.  Similarly, a statute of limitation period prohibits the DOF from initiating an audit more than 10 years after the duty to report the property arose (unless the holder is already under audit or filed a fraudulent report).  Accordingly, it is important to note that the Bill defines the term “record” as “…information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form.” 
 
Moreover, Section 1139 of the bill defines “address of owner to establish priority” as “…the last-known address of an owner is a description, code, or other indication of the location of the owner on the holder’s books and records which identifies the state of the last-known address of the owner.”
 
These two definitions should be read in tandem with Section 1179 of the bill, which establishes that the DOF need only show evidence of an unpaid debt or undischarged obligation and passage of the requisite period of dormancy or presumed abandonment as prima facie evidence of unclaimed property.  A holder may overcome the burden of proof by establishing by a preponderance of the evidence that the obligation is no longer owed under one of six criteria listed in the bill.
 
There are three important takeaways from the above: (a) the Delaware look-back period on audit would extend to 15 transaction years (ten year audit limitation period, plus five year dormancy period), (b) a “record” as defined may not have to be both “available and researchable,” and (c) “address of owner to establish priority” appears to only need be sufficient to indicate the state of the apparent owner, not the apparent owners full mailing address.  
 
Thus, holders incorporated in Delaware will need to review their corporate record retention policies and conform to a 15 year retention period, as appropriate.  Likewise, holders should pay particular attention to what records are provided to the state to ensure that they can be researched appropriately.  The “record” term as defined in the Bill may encourage stronger audit requests, demands, and potentially subpoenas for address based records for longer base periods.  The result of which, if not researchable, could create much higher Delaware extrapolation rates and higher exposures to other participating states in the audit.  Moreover, holders should ensure that electronic and manual records maintain at a minimum “state” field or related code, indicator or description relating to a “state” in order to establish most accurate first priority rule property. 
 
Program Administration, Estimation, & Appeal Provisions
 
In an effort to create predictability and consistency in administration of VDAs and audits, the bill requires that the DOF and SOS promulgate consistent regulations regarding the administration of unclaimed property on or before July 1, 2017.[5]  While it is unclear what the exact regulations will provide, it should be noted that the SOS has published Implementing Guidelines, dated February 11, 2014, that provide many of the guiding principles for the administration of current VDA program.  The provisions in the Implementing Guidelines could serve as the basis for such regulations in whole or in part. 
 
While certain aspects of estimation methodologies are addressed in S.B. 13, it appears to require the SOS and DOF to address more specifically which items are to be included in the numerator of the extrapolation fraction and those included in the denominator of the fraction.  It is expected that the “gross method” of extrapolation and corresponding indemnification provisions under 12 Del. Code Section 1203 that have been used in the past will continue to be used in current and prospective audits and VDAs. 
 
Finally, S.B. 13 repeals the current internal administrative appeals process and permits holders under audit to file an action against the State Escheator in Chancery Court within 90 days after the date on which a DOF statement of findings is mailed.  Depending on a holder’s position in the audit process, certain holders may be required to exhaust administrative remedies applicable under the former process repealed by S.B. 13, while others do not.[6]  
 
Additional Provisions Included in S.B. 13
 
S.B. 13 contains various other changes that are related but not limited to definitions, the administration of unclaimed property for insurance companies, rules on use of third party audit firms, and provisions on the issuance of a subpoena duces tecum (a legal demand for documents) to holders in the course of an audit.
  BDO Insights As holders review the potential impact of S.B. 13 as applied to their current Delaware escheat posture, there are many things to consider and a number of questions to be answered: 
  • Most importantly, within 60 days of the passing of the regulations (expected to be some time after July 1, 2017), holders that are currently under audit must consider their options, as laid out above, and determine what course of action fits best with their current escheat posture, risk profile, etc.  It appears that a holder does not forgo any of its legal remedies at law (e.g, protest assessment in court, etc.) should it disagree with the state under any option, unless a final settlement is executed in a VDA, expedited audit, or regular audit.
 
  • Conversely, for holders that are not currently under audit and are VDA eligible, S.B. 13 will limit the look-back period to 15 transaction years and will continue to provide Section 1203 indemnification against claims by others on paid in amounts.[7]  Moreover, the Implementing Guidelines that are likely to be further revised under the Bill should provide even clearer guidance with respect to VDA expectations and processes for holders.  A holder that has received an invitation to participate in the DE VDA program should evaluate doing so before the expiration of its 60 day period.  Otherwise, the holder risks an audit with associated penalties and interest. 
 
  • Finally, all holders that are incorporated in Delaware or engage in business there should evaluate new guidelines and procedures relating to their annual unclaimed property compliance program.  Given the new “compliance review” program, holders will need to get ready to support their annual Delaware unclaimed property filings with raw data sources to avoid burdensome annual compliance reviews or referral to the SOS VDA program for single year periods.
Notwithstanding the above, and while an exhaustive analysis of all potential issues or questions presented by S.B.13 cannot be addressed here, BDO’s National Unclaimed Property Team of 20 plus professionals have extensive experience working with countless companies under DOF audits and has assisted more than 75 holders reach reasonable settlements under the Delaware VDA program.  Please contact one of the BDO contacts listed below to discuss any questions you have concerning unclaimed property and escheatment, how S.B. 13 may impact your company, and best practices for dealing with your escheat issues. 
   

For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Managing Director
  Paul McGovern
Tax Managing Director   Jonathan Liss
Tax Managing Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Managing Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Managing Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Managing Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Managing Director
    Richard Spengler
Tax Managing Director
  Tony Manners
Tax Managing Director






   
Southwest:
Gene Heatly
Tax Managing Director

Tom Smith
Tax Partner
    [1] Upon effective date of S.B. 13. [2] All requests for records must be made by the auditor within 18 months, with an examination report provided within 2 years from the date the holder notified the DOF and SOS.  If the holder does not cooperate, the State Escheator can impose penalty and interest.  This DOF determination regarding holder cooperation is subject only to the review of the Secretary of Finance. [3] Upon effective date of S.B. 13. [4] S.B. 13 also specifically provides that interest shall be waived in full for property paid under SOS VDAs, and DOF audits and VDAs if paid by July 1, 2017.  For holders not covered by this group, the statute also provides for waiver where “good cause” is presented, however this term is not defined in the Act. [5] Regulatory process will allow for a public commenting on the regulations by holder community.  [6] It should be noted that notwithstanding the changes to the appeal process in S.B.13, holders may also have the option of directly filing an action in Federal District Court.  See Temple-Inland, Inc. v. Cook, No. 14-654-GMS (D. Del. June 28, 2016).  [7] Section 1203 should also apply in audits and expedited audits as well.

International Tax Alert - February 2017

Thu, 02/02/2017 - 12:00am
Recent International Tax Guidance for December 2016 and January 2017 Summary In December of 2016 and January of 2017, the Department of the Treasury and the Internal Revenue Service (hereinafter, collectively “Treasury”), released guidance and regulations related to:
  1. Passive foreign investment companies (“PFICs”);
  2. Withholding and the Foreign Account Tax Compliance Act (“FATCA”);[1] and
  3. Inversions under section 7874.
Below is a high level overview of certain key items discussed in the guidance and regulations.
  Key Highlights
  1. PFICs
Recent International Tax Guidance for December 2016 and January 2017
 
Generally, U.S. shareholders in a PFIC are subject to certain reporting requirements and subject to certain tax regimes on PFIC income.[2]
 
Recently, Treasury issued final regulations that provide guidance on determining ownership of a PFIC and on certain annual reporting requirements for shareholders of PFICs to file Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.”   In addition, the final regulations provide guidance on an exception to the requirement for certain shareholders of foreign corporations to file Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations.”
 
The final regulations affect U.S. persons that own interests in PFICs and certain U.S. shareholders of foreign corporations.
 
The final regulations adopt the proposed regulations published on December 31, 2013, with certain changes, including implementing the rules described in Notice 2014-28 and Notice 2014-51, and withdraw the corresponding 2013 temporary regulations.  Notice 2014-28 announced that the regulations under section 1291 would provide that a U.S. person that owns stock of a PFIC through a tax exempt organization or account is not treated as a shareholder of the PFIC with respect to the stock.  Notice 2014-51 announced that the regulations under section 1298 would provide guidance concerning U.S. persons that own stock in a PFIC that is marked to market under a provision of chapter 1 of the Internal Revenue Code other than section 1296.
 
For dates of applicability, see Treas. Reg. Secs. 1.1291-1(j)(3), 1.1291-9(k)(3), 1.1298-1(h), 1.6038-2(m), and 1.6046-1(l)(3).
  1. Withholding and FATCA
Recently, Treasury issued two revenue procedures and four sets of regulations dealing with withholding and FATCA.
 
In T.D. 9808, Treasury issued final and temporary regulations regarding withholding of tax on certain U.S. source income paid to foreign persons, information reporting and backup withholding with respect to payments made to certain U.S. persons, and portfolio interest paid to nonresident alien individuals and foreign corporations.  The final regulations finalize certain proposed regulations issued in March 2014 with minor changes, and withdraw corresponding temporary regulations.  In addition, temporary regulations providing additional rules under Chapter 3 of the Code were issued.  The regulations affect persons making payments of U.S. source income to foreign persons.
 
For dates of applicability, see Treas. Reg. Secs. 1.871-14(j), 1.1441-1(f), 1.1441-3(i), 1.1441-4(g), 1.1441-5(g), 1.1441-6(i), 1.1441-7(g), 1.1461-1(i), 1.1461-2(d),1.6041-1(j), 1.6041-4(d), 1.6042-2(f), 1.6042-3(d), 1.6045-1(q), 1.6049-4(h), 1.6049-5(g), 31.3406(g)-1(g), 31.3406(h)-2(i), and 301.6402-3(f).
 
In addition, Treasury released proposed regulations (REG-134247-16) cross referencing the temporary regulations (T.D. 9808) to revise regulations regarding withholding of tax on certain U.S. source income paid to foreign persons as well as requirements for certain claims for refund or credit made by foreign persons.
 
Also, in T.D. 9809, Treasury issued final regulations under FATCA regarding information reporting by foreign financial institutions (“FFIs”) with respect to U.S. accounts and withholding on certain payments to FFIs and other foreign entities.  The Treasury decision finalizes (with changes) certain proposed regulations issued in March 2014 under FATCA, and withdraws corresponding temporary regulations.  The Treasury decision also includes temporary regulations providing additional rules under FATCA.
 
For dates of applicability, see Treas. Reg. Secs. 1.1471-1(c), 1.1471-2(c), 1.1471- 3(g), 1.1471-4(j), 1.1471-5(l), 1.1471-6(i), 1.1472-1(h), 1.1473-1(f), 1.1474-1(j), and 1.1474-6(g).
 
In addition, Treasury released proposed regulations (REG-103477-14) under FATCA describing the verification requirements (including certifications of compliance) and events of default for entities that agree to perform the FATCA due diligence, withholding and reporting requirements on behalf of certain FFIs or the FATCA due diligence reporting obligations on behalf of certain non-financial foreign entities.  The proposed regulations also describe the certification requirements and procedures for IRS’s review of certain trustees of trustee-documented trusts and the procedures for IRS’s review of periodic certifications provided by registered deemed compliant FFIs.  In addition, the proposed regulations describe the procedures for future modifications to the requirements for certifications of compliance for participating FFIs.  The proposed regulations also describe the requirements for certifications of compliance for participating FFIs that are members of consolidated compliance groups.
 
Lastly, Treasury recently released Rev. Proc. 2017-15 and 2017-16. Rev. Proc. 2017-15 sets forth the final qualified intermediary (“QI”) withholding agreement.  In general, the QI agreement allows foreign persons to enter into an agreement with the IRS to simplify their obligations as withholding agents.  Rev. Proc. 2017-16 updates guidance on how FFIs should enter into agreement with the IRS to be treated as participating FFIs.  FFI agreement procedures provided in earlier guidance expired on December 31, 2016.  FFI agreement procedures in Rev. Proc. 2017-16 apply beginning January 1, 2017. 
 
  1. Inversions
Recently, Treasury issued final and temporary regulations under section 7874 relating to inversions.  These regulations affect certain domestic corporations and partnerships (and certain parties related thereto) and foreign corporations that acquire substantially all of the properties of such domestic corporations or of the trades or businesses of such domestic partnerships.
 
The final regulations identify certain stock of a foreign corporation that is disregarded in calculating ownership of the foreign corporation for purposes of determining whether it is a surrogate foreign corporation.  Prior temporary regulations under section 7874 included the “disqualified stock rule.”  Under this rule, subject to a de minimis exception, disqualified stock is excluded from the denominator of the section 7874 ownership fraction (i.e., the fraction used to calculate the percent of stock, by vote or value, of the foreign acquiring corporation that is held by former shareholders by reason of holding stock in the domestic corporation).  
 
Disqualified stock generally includes stock of the foreign acquiring corporation that, in a transaction related to the domestic entity acquisition, is transferred to a person other than the domestic entity in exchange for “nonqualified property.”  Nonqualified property means (i) cash or cash equivalents, (ii) marketable securities, (iii) certain obligations, and (iv) any other property acquired with a principal purpose of avoiding the purposes of section 7874, regardless of whether the transaction involves an indirect transfer of property described in clause (i), (ii), or (iii).
 
The final regulations finalize the disqualified stock rule in the temporary regulations with certain modifications and clarifications.  Some of the key modifications and clarifications are summarized below:
  1. The final regulations exclude from the definition of nonqualified property an obligation owed by a member of the expanded affiliated group (“EAG”) if the holder of the obligation immediately before the domestic entity acquisition and any related transaction (or its successor), is a member of the EAG after the domestic entity acquisition and all related transactions.[3]
  2. The final regulations include a de minimis rule to exclude from the definition of nonqualified property, an obligation owed by a person that is only a de minimis former domestic entity shareholder or former domestic entity partner.  The final regulations also exclude from the definition of nonqualified property, an obligation owed by a person that, before and after the domestic entity acquisition, owns no more than a de minimis interest in any member of the EAG.[4]  Nevertheless, the anti-abuse rule in section 7874(c)(4) may still apply to disregard transfers of stock in exchange for such obligations.
  3. The final regulations provide that an obligation for purposes of the disqualified stock rule includes any fixed or contingent obligation to make payment or provide value (such as through providing goods or services).[5]  No inference is intended regarding the treatment, under Treas. Reg. Sec. 1.752-1(a)(4)(ii) or the temporary regulations, of a contractual agreement by a person to provide goods or services.
  4. Under the “associated obligation rule,” disqualified stock also generally includes stock of the foreign acquiring corporation that is transferred by a person (the transferor) to another person (the transferee) in exchange for property (the exchanged property) if, pursuant to the same plan (or series of related transactions), the transferee subsequently transfers the stock in exchange for the satisfaction or assumption of one or more obligations associated with the exchanged property.  The final regulations make certain modifications to this associated obligation rule.[6]  In addition, the final regulations generally limit the amount of disqualified stock arising under the associated obligation rule to the proportionate share of obligations associated with the exchanged property that, pursuant to the same plan (or series of related transactions), is not assumed by the foreign acquiring corporation.[7]  
  5. The final regulations make certain modifications to the de minimis exception in Treas. Reg. Sec. 1.7874-4(d)(1)(ii) to address certain practical difficulties noted in the comments to the temporary regulations.
  6. The final regulations clarify that stock of the foreign acquiring corporation included in the numerator of the section 7874 ownership fraction is in all cases also included in the denominator of the fraction.
  7. The final regulations clarify that an interest in a partnership is nonqualified property only to the extent it is a marketable security or avoidance property (i.e., any property, other than specified nonqualified property, acquired with a principal purpose of avoiding the purposes of section 7874).
The final regulations also provide guidance on the effect of transfers of stock of a foreign corporation after the foreign corporation has acquired substantially all of the properties of a domestic corporation or of a trade or business of a domestic partnership.  The prior temporary regulations provided a rule (the “subsequent transfer rule”) pursuant to which stock of a foreign corporation that is described in section 7874(a)(2)(B)(ii) (that is, by reason of stock) does not cease to be so described as a result of any subsequent transfer of the stock by the former domestic entity shareholder or former domestic entity partner that received such stock, even if the subsequent transfer is related to the domestic entity acquisition.  The final regulations adopt the subsequent transfer rule as final without modification.
 
For dates of applicability, see Treas. Reg. Secs. 1.7874-4(k), 1.7874-5(e), 1.7874-7T(h), and 1.7874-10T(i).
  BDO Insights  
The above discussion is a high level overview of certain key international tax issues from recent Treasury regulations and guidance.  The rules discussed in this tax alert are complex with various exceptions and applicability dates.  BDO can assist with understanding the complexities of the above discussed rules and also advise on how these rules may impact taxpayers.  Please reach out to your BDO international tax services contact if you have questions on the above.  
For more information, please contact one of the following practice leaders:
  Robert Pedersen
Partner and International Tax Practice Leader          Chip Morgan    Partner    Joe Calianno
Partner and International Tax Technical Practice Leader    Brad Rode
Partner 
    William F. Roth III
Partner, National Tax Office   Jerry Seade
Principal    Scott Hendon
Partner    Monika Loving
Partner    Annie Lee
Partner   Sean Dokko
Senior Manager    [1] Sections 1471 through 1474 and the Treasury Regulations promulgated thereunder. [2] See sections 1291 through 1298 and the Treasury Regulations promulgated thereunder. [3] Treas. Reg. Sec. 1.7874-4(i)(2)(iii)(A). [4] See Treas. Reg. Secs. 1.7874-4(i)(2)(iii)(B) and (C) (providing a de minimis rule for a less than five-percent ownership interest). [5] Treas. Reg. Sec. 1.7874-4(i)(3). [6] See, Treas. Reg. Sec. 1.7874-4(c)(1)(ii)(A).  [7] See Treas. Reg. Sec. 1.7874-4(c)(1)(ii)(B).

State and Local Tax Alert - February 2017

Thu, 02/02/2017 - 12:00am
California Appellate Court Affirms that an Out-of-State Corporation with a Passive Investment in a California Limited Liability Company is Not "Doing Business" in California Summary On January 12, 2017, the California Court of Appeal, Fifth District, held that Swart Enterprises, Inc. (“Swart”) was not “doing business” in California by virtue of owning a 0.2% non-managing interest in a Limited Liability Company (“LLC”) that was doing business in California.  The Court of Appeal ruled that Swart’s LLC interest was a passive interest.
  Details Background
 
In 2007, Swart purchased a 0.2 percent non-managing interest in an LLC, which was doing business in California.  The LLC was formed in 2005 and was designated as a manager-managed limited liability company.  Swart had no physical presence in California, did not sell or market products or services in California, and was not registered with the California Secretary of State to transact business within the state.  Swart’s only connection to California was its ownership interest in the LLC doing business in the state.
 
For the 2009 and 2010 tax years, the LLC was treated as a partnership for federal and state tax purposes.  In 2010, the LLC was not required to pay the California LLC fee because it had insufficient income; however, based on Swart’s ownership interest in the LLC, the Franchise Tax Board (the “FTB”) demanded that it file a corporate franchise tax return and pay the $800 minimum tax due on the return.  Swart filed the return and paid the tax, penalties, and interest under protest and requested a refund.
 
Holding
 
The court held that holding a 0.2 percent passive ownership interest in an LLC, with no right of control over the business affairs of the LLC, does not constitute “doing business” in California under  Cal. Rev. & Tax. Code § 23101.  The court also held that Swart’s LLC interest was comparable to a limited partnership interest.  Further, the court rejected the state’s reliance on Legal Ruling 2014-01 (July 22, 2014), which was issued during the pendency of the case.
 
  • No Broad Interpretation of “Doing Business” in California.  For tax years prior to January 1, 2011, California defined “doing business” as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”[1]  The California Attorney General argued that the term “doing business” should be interpreted broadly to include Swart’s passive investment.  The Court of Appeal disagreed, holding that prior judicial precedent did not require a broad interpretation, but rather distinguished between engaging in active and passive business.
 
  • LLC Interests are not Equivalent to General Partnership Interests.  Swart argued that it was not “doing business” in California solely by virtue of holding an ownership interest in an LLC doing business in California.  As a passive investor, it had no right to manage or control the LLC’s business operations.  The court agreed, holding that Swart’s interest in the LLC was comparable to a limited partnership interest because Swart “had no authority to participate in the management and control of the [LLC], it was not liable for the debts and obligations of the [LLC], it did not own an interest in specific property of the [LLC], nor could it act on behalf of the [LLC].”  Therefore, Swart could not be deemed to be “doing business” in California. 
 
  • Legal Ruling 2014-01 Rejected. The Attorney General relied upon Legal Ruling 2014-01 (the “Ruling”) as support that members of an LLC are doing business in California solely by virtue of an ownership interest in a LLC, regardless of whether the LLC is a member or manager-managed LLC.  In the Ruling, the FTB concluded that a corporate member holding a 15 percent interest in an LLC must file a California corporation income and franchise tax return and pay all taxes and fees resulting from its membership interest.  The Ruling’s “doing business” conclusion did not change even though the corporate member was “not incorporated, organized, or registered to do business in California” and had “no presence in California other than its membership in the LLC.”  In addition, the Attorney General argued that Swart had the right to exercise control over the LLC, because it relinquished control to the manager.  The court disagreed and stated Swart could not relinquish a right that it never held.  In addition to having no right to control or influence the LLC’s business, the court noted that, even if Swart had such right, its 0.2 percent interest rendered any such influence minimal.  
  BDO Insights
  • By holding that a passive investor with a minority interest in a manager-managed LLC doing business in California cannot be deemed to be doing business in California, a Court of Appeal has rejected Legal Ruling 2014-01 and dispels the FTB’s position that LLC interests are equivalent to general partnership interests.  As the court did not establish a bright-line test regarding the point at which a minority interest holder’s influence would be considered more than minimal, it would appear that the materiality of the influence exerted by minority interest holders (i.e., those with a greater than 0.2 percent but less than 50 percent interest) would require a factual analysis on a case-by-case basis.  The FTB may file a petition for review by the California Supreme Court within 10 days after the Court of Appeal decision becomes final. 
 
  • Taxpayers with similar facts should consider filing protective refund claims pending an appeal.
 
  • For tax years beginning on or after January 1, 2011, California changed its “doing business” definition and adopted an economic factor-presence nexus statute.  The Court of Appeal’s decision in Swart Enterprises leaves open the issue of whether a passive interest holder in a pass-through entity can be deemed to be “doing business” in California by virtue of its share of the pass-through entity’s apportionment attributes.
 
  • The court’s emphasis on the active aspect of engaging in business transactions could also call into question other scenarios, such as whether an out-of-state company could be “doing business” in California if it drop ships goods into California at the request of its customers to an extent that the entity’s sales exceeds California’s sales threshold under the economic factor-presence nexus statute.  Specifically, it is unclear whether such activity, which is outside of the entity’s control, would be considered “actively” engaging in business transactions within the state.
 


For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Managing Director
  Paul McGovern
Tax Managing Director   Jonathan Liss
Tax Managing Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Managing Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Managing Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Managing Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Managing Director
    Richard Spengler
Tax Managing Director
  Tony Manners
Tax Managing Director






   
Southwest:
Gene Heatly
Tax Managing Director

Tom Smith
Tax Partner
    [1] Former Cal. Rev. & Tax. Code § 23101, now Cal. Rev. & Tax. Code § 23101(a).

BDO Knows: Federal Tax - Asset Management

Wed, 02/01/2017 - 12:00am
Recent Executive Actions by Trump Administration Cast Doubt on Tax Regulations Impacting Asset Management Industry Summary On January 20, 2017, the White House chief of staff communicated President Trump’s plan for managing the federal process at the outset of his administration.  As part of this plan, the president’s appointees or designees are to be provided with sufficient time to review pending regulations.  In order to provide sufficient time to complete their review, the Administration requested that pending federal regulations be postponed.  Tax regulations covered by the request are effectively frozen and subject to change or withdrawal. 

On January 30, 2017, President Trump issued an executive order intended to reduce overall government regulation.  Pursuant to this executive order, executive departments and agencies are required to identify at least two existing regulations to be repealed prior to the issuance of a new regulation.  The executive order also imposes annual limitations on the incremental costs of new regulations. 

The breadth of the regulatory request and executive order is not yet clear.  It is therefore unknown if guidelines are limited to Treasury Regulations published in the Federal Register or other regulatory guidance such as Revenue Rulings, Revenue Procedures, and Notices.

A number of tax regulation projects may be impacted by these developments.  Particularly relevant to the asset management industry are proposed regulations under the new uniform partnership audit rules and dividend equivalent withholding regulations under Section 871(m) of the Internal Revenue Code.  These regulation projects are described below.
Details Partnership Audit Rules
The Bipartisan Budget Act of 2015 included provisions that fundamentally alter the manner in which partnerships, such as hedge funds and private equity funds, are audited by the IRS.  The so-called “TEFRA” rules were replaced with a regime that allows the IRS to make assessments at the partnership level, subject to certain elections to either opt out of the law or push out the assessments to partners. The law is scheduled to be effective for tax years beginning in 2018.  There are many complexities and unresolved issues with the law, some of which the asset management industry was hoping would be clarified through technical corrections and regulations.  These issues include:
  • Determining whether funds will be required to create ASC 740 (FIN 48) reserves for positions that were previously partner-level as opposed to fund-level – e.g., wash sales;
  • Determining who will be the “partnership representative” for non-U.S. fund managers;
  • Determining how much pressure fund managers will receive from investors to make the opt-out and/or push-out elections;
  • Determining how the push-out election will work in tiered arrangements, such as master-feeder structures; and
  • Adopting and implementing the rules in the States.
The IRS had published regulations on January 24, 2017, but subsequently withdrew them pursuant to the January 20, 2017, freeze order.
 
Dividend Equivalent Withholding
Over the past decade, Congress and the Treasury Department repeatedly expressed concern over perceived abuses by foreign investors' use of swap contracts and other derivatives to avoid U.S. withholding on dividend income from investments in U.S. stocks.  In 2010, Congress enacted Section 871(m) to require U.S. withholding, in certain circumstances, on “dividend equivalents” from “specified” notional principal contracts, as well as “equity linked instruments.”  Compliance with these rules is highly complex and costly to the banking and asset management industries. 

On President Obama’s last day in office, the IRS released regulations that provide guidance on the rules.  Despite the fact that the Section 871(m) regulations were officially published on January 24, 2017, after the January 20, 2017, freeze order, the IRS did not withdraw them.  The IRS released a statement indicating that the regulations were approved by the Office of Management and Budget.  However, it is unclear whether the IRS received approval from the administration for this action in accordance with the freeze order.  It is possible that the IRS may need to withdraw them in the near future.
  BDO Insights The above regulations may remain in a state of limbo until President Trump assembles a team of tax policy officials that will give direction to the Treasury Department and IRS.  There are also larger questions of tax reform and whether the Partnership Audit Rules and Dividend Equivalent Withholding Rules will be targeted for repeal in connection with that reform or other actions of the Trump administration.

BDO’s Asset Management team will continue to monitor these issues and keep our clients apprised of future developments.
 
For more information on matters discussed above, please contact one of the following practice leaders:
  Joe Pacello
Partner, Core Tax Services   Jonathan Schmeltz
Partner, Core Tax Services            Todd Simmens
National Managing Partner, Tax Risk Management
Technical Practice Leader, Tax Controversy & Procedure   Jeffrey N. Bilsky
Partner, National Tax Office
Technical Practice Leader, Partnerships
   
 

BDO Transfer Pricing News - January 2017

Mon, 01/30/2017 - 12:00am
Transfer pricing is increasingly influencing significant changes in tax legislation around the world. This 22nd issue of BDO's Transfer Pricing Newsletter focuses on recent developments in the field of transfer pricing in Brazil, Canada, France, Japan, Spain and Vietnam. For transfer pricing developments in India please refer to the publication of Transfer Pricing Prism 2017, which can be found on www.bdo.in.  
  Download

International Tax Alert - January 2017

Mon, 01/16/2017 - 12:00am
Notice 2016-76 Announces Phase-In Application of Various Withholding Rules 
Summary In Notice 2016-76 (the “Notice”), the Department of the Treasury and the Internal Revenue Service (collectively, “Treasury”) announced the phase-in application of various withholding rules over the next several tax years.  An anti-abuse rule will apply during the phase-in years.
Background Section 871(m) treats dividend equivalent payments as U.S. source dividends for purposes of chapters 3 and 4 and sections 871(a), 881, and 4948(a).  As a result, dividend equivalent payments are amounts subject to withholding (as defined in section 1.1441-2(a)) for purposes of sections 1441 through 1443 and withholdable payments (as defined in section 1.1473-1(a)) for purposes of sections 1471 and 1472.  Accordingly, a withholding agent generally is required to deduct and withhold a tax equal to 30 percent on any dividend equivalent payment made to a foreign person unless an exception from, or lower rate of, withholding applies pursuant to the Code or regulations thereunder, or an applicable income tax treaty.

Treasury issued the final and temporary regulations under sections 871(m), 1441, 1461 and 1473 (collectively, the “section 871(m) regulations”) in several parts.  On December 5, 2013, final regulations (TD 9648) were published at 78 FR 73079.  On September 18, 2015, final regulations and temporary regulations (TD 9734) were published at 80 FR 56866 (the “2015 final regulations”).  Also on September 18, 2015, the Federal Register published a notice of proposed rulemaking by cross-reference to temporary regulations and a notice of public hearing at 80 FR 56415.  Correcting amendments to the 2015 final regulations were published on December 7, 2015, in the Federal Register at 80 FR 75946, and on December 7, 2015, in the Federal Register at 80 FR 75956.

On July 1, 2016, Treasury released Notice 2016-42, 2016-29 IRB 67, containing a proposed Qualified Intermediary (“QI”) agreement that describes requirements and obligations that will be applicable to Qualified Derivatives Dealers (“QDD”). Treasury received written comments on Notice 2016-42.  Treasury published a final QI agreement at the end of 2016 in Rev. Proc. 2017-15, taking into account these comments.  The final QI agreement will be effective on or after January 1, 2017.

Various comments to the section 871(m) regulations noted that taxpayers and withholding agents will face challenges complying with certain aspects of the section 871(m) regulations by their applicability date of January 1, 2017.  Those challenges include designing, building, and testing new withholding and reporting infrastructure for dealers, issuers, and other withholding agents; implementing new system requirements for paying agents and clearing organizations; and enhancing and developing data sources for determining whether transactions are section 871(m) transactions.  In addition, certain taxpayers may face additional challenges applying for status as a QDD under the QI agreement and implementing the QDD regime in a timely manner.

To orderly implement the section 871(m) regulations, the Notice provides guidance for complying with the section 871(m) regulations in 2017 and 2018, and explains how the Internal Revenue Service (“IRS”) intends to administer those regulations in 2017 and 2018.  The Notice does not apply to any transaction that is a section 871(m) transaction pursuant to section 1.871-15(d)(1) (i.e., a specified notional principal contract entered into before January 1, 2017).
Highlights of the Notice Some of the highlights of the Notice include:
  • For 2017, the IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the section 871(m) regulations in enforcing the section 871(m) regulations for any delta-one transaction;
  • For 2018, the IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the section 871(m) regulations in enforcing the section 871(m) regulations for any non-delta-one transaction;
  • For 2017, withholding agents may rely on a simplified standard for determining whether transactions are combined transactions pursuant to section 1.871-15(n);
  • For 2017, withholding agents may remit amounts withheld for dividend equivalent payments quarterly;
  • For 2017 and following years, a QDD's section 871(m) amount is to be determined by calculating the net delta exposure of the QDD;
  • For 2017, the IRS will take into account the extent to which the QDD made a good faith effort to comply with the QDD provisions in the QI agreement when enforcing those provisions;
  • Prospective QDDs may apply for QDD status on or before March 31, 2017, and, if accepted by the IRS, be treated as having QDD status as of January 1, 2017;
  • Before receiving a QI-EIN, QDDs may provide a statement on a Form W-8IMY that the QDD is “awaiting QI-EIN,” and withholding agents may rely on this statement, to the extent permitted in this notice;
  • The section 871(m) regulations will not apply to certain existing exchange-traded notes specifically identified in section III.D of the Notice until January 1, 2020; and
  • The anti-abuse rule provided in section 1.871-15(o) will apply during the phase-in years described in the Notice.  As a result, a transaction that would not otherwise be treated as a section 871(m) transaction (including as a result of the Notice), may be a section 871(m) transaction under section 1.871-15(o).
  BDO Insights The Notice provides additional details on the rules mentioned above.  BDO can assist our clients with understanding their withholding and reporting obligations under the section 871(m) regulations as modified by the rules provided for in the Notice.  Withholding agents affected by the section 871(m) regulations should take particular notice of the phase-in approach detailed in the Notice.
 
For more information, please contact one of the following practice leaders:
  Robert Pedersen
Partner and International Tax Practice Leader          Chip Morgan      Partner    Joe Calianno
Partner and International Tax Technical Practice Leader    Brad Rode
Partner 
    William F. Roth III
Partner, National Tax Office   Jerry Seade
Principal    Scott Hendon
Partner    Monika Loving
Partner    Annie Lee
Partner   Sean Dokko
Senior Manager 

China Tax Newsletter - January 2017

Tue, 01/10/2017 - 12:00am
The January 2017 edition of BDO China's China Tax Newsletter features recent tax-related news and developments in China, including the following topics and more: 
 
  • Value-added Tax Policies for Finance, Real Estate Development, Education Ancillary Service and Other Services
  • Enterprise Income Tax Refund Involved in the Settlement of Land Appreciation Tax by Real Estate Developers
  • Issues Concerning the Determination and Handling of Special VAT Invoices Issued by Evading (Unreachable) Enterprises

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BDO Knows: ASC 740 - December 2016

Thu, 12/22/2016 - 12:00am
Intra-Entity Transfers of Assets Other Than Inventory Download PDF Version
Summary The FASB issued ASU 2016-16[1] in October 2016 eliminating the existing exception in GAAP that prohibits the recognition of income tax consequences for most intra-entity asset transfers. The exception has been retained for intra-entity asset transfers of inventory only. As a result, entities will now be required to recognize current and deferred income tax consequences of intra-entity asset transfers (other than those of inventory) when the transfer occurs.

The new standard takes effect in 2018 for public companies and is available here. Early adoption is permitted in the first interim period of the annual period in which the ASU is adopted. On adoption, the unamortized deferred tax on intra-entity asset transfers would be charged to opening retained earnings, avoiding the income tax expense that would otherwise be recognized. Additionally, an unrecognized deferred tax asset from intra-entity asset transfers, net of any valuation allowance, would also be initially recognized through retained earnings. Reporting entities should begin to plan for transition.
Details

Background
Under current accounting, the income tax effects (i.e., current and deferred) from all intra-entity transfers of assets (i.e., transfers between members of a consolidated reporting entity)[2] are deferred and generally either amortized into income tax expense over the economic useful life of the asset, or recognized when the asset is sold outside the reporting entity or impaired. The entity transferring an asset (“seller”) records the net tax effect (i.e., current plus deferred) on the balance sheet as a prepaid tax,[3] and the tax basis step-up in the entity receiving the asset (“buyer”) is not recognized in the reporting entity’s consolidated financial statements.[4] Generally, intra-entity tax consequences arise in transfers between different tax paying entities or tax-paying components (an individual entity or group of entities that is consolidated for tax purposes)[5] included in the reporting entity’s consolidated financial statements. If a FIN 48 uncertain tax benefit liability arises from an intra-entity asset transfer, it is also required to be deferred and amortized into income tax expense over the economic useful life or until settlement is reached if sooner.

This rule is an exception to the comprehensive recognition principle of all income tax effects in ASC 740. The recognition exception effectively normalizes the tax rates when an asset is initially transferred and in subsequent periods as the related income is recognized.

Below is an example that illustrates the consolidated financial reporting implications from an intra-entity asset transfer under current accounting:

U.S. domestic entity A (“seller” or “A”) and foreign entity B (“buyer” or “B”) are members of the same consolidated reporting entity. A’s tax rate is 40% (federal and state) and B’s tax rate is 15% and both are taxpayers (i.e., no valuation allowance). Entity A has net operating loss (NOL) carryforwards of $150 million which it has been utilizing in recent years (i.e., A has had pre-NOL taxable income in all recent years). In the current period, A transfers to B a previously acquired amortizable intangible asset having a book value of $100 million and zero tax basis in a taxable transaction (the remaining book amortization period is 3 years). Entity A maintains a deferred tax liability of $40 million (taxable difference of $100 million times 40%). The transfer pricing is $120 million which reflects the current fair market value. Entity A has no current tax liability since its pre-NOL taxable gain (selling price of $120 million) is offset by an equivalent amount of NOL carryforwards. The transfer, however, results in a deferred tax benefit of $40 million (a deferred tax liability of $40 million is released) and a deferred tax expense of $48 million for the utilization of NOL carryforwards. Therefore, A’s net tax effect from the intra-entity transfer of the intangible asset is $8 million (a deferred expense of $48 less a deferred benefit of $40). Entity B is allowed a tax basis step-up in its jurisdiction for the purchase price of $120 million which yields a deferred tax benefit of $3 million (purchase price of $120 million less book basis of $100 million times 15%). The intra-entity transaction is considered sustainable (based on technical merits) at the more likely than not level of confidence.

Journal Entries (in ‘000,000):
Debit: Deferred Tax Expense  $48
Credit: Deferred Tax Asset                  $48

(Entry to recognize deferred tax expense in A’s jurisdiction for NOL utilization)
 
Debit:  Deferred Tax Liability  $40
Credit: Deferred Tax Benefit               $40

(Entry to recognize the release of the previously recorded deferred liability in A’s jurisdiction)
 
Debit: Prepaid Tax                   $8
Credit: Deferred Income Tax Expense             $8         

(Entry to apply the paragraph 740-10-25-3(e) exception and defer recognition of net tax effect)

Under the existing accounting exception, the deferred tax asset of $3 million resulting from the tax basis step-up in B’s jurisdiction of $120 million is not allowed to be recognized in the consolidated financial statements. Instead it is effectively tracked “off-balance sheet” while it is being utilized on B’s local income tax return (tax amortization is also assumed to be three years for simplicity).

Over the remaining recovery period of three years, the consolidated financial statements would reflect the amortization of the prepaid tax ($8 million) and the utilization of the off-balance sheet deferred tax benefit ($3 million) in the following manner:

Debit: Income tax Expense     $2.6
Credit: Prepaid Tax                              $2.6

(Entry to amortize 1/3 of the prepaid tax or $8 divided by 3)
 
Debit: Income Tax Payable      $1
Credit: Income Tax Expense (Benefit) $1

(Entry to recognize 1/3 of the tax basis step-up or $3 divided by 3 in the buyer’s jurisdiction)

Under current accounting, there is no impact on the effective tax rate in the period of transfer as the pretax income/gain of $20 million is eliminated and the net tax effect of $5 million is deferred in consolidation. This is changed by ASU 2016-16 as explained below.

History of ASU 2016-16
The FASB had twice considered eliminating the exception but eventually decided to retain the accounting due to significant concerns from various stakeholders. However, in 2014 the FASB decided to reconsider the exception as part of its Simplification Initiative. The initial proposal issued in early 2015 required recognition of both the current and deferred income tax consequences of all intra-entity asset transfers (i.e., including transfers of inventory) when the transfer occurs, which would conform U.S. GAAP to IFRS. However, after receiving many comments, the FASB reached a final decision in 2016 to retain the exception for inventory assets only, while eliminating it for all other assets.[6] 

BDO Observation: In our comment letter, we generally supported the FASB’s original proposal to eliminate the exception for intra-entity transfers of all assets including inventory, or alternatively to leave prior GAAP unchanged. However, under the ASU, retaining the exception for inventory transfers, but eliminating it for all other assets, will require detailed tracking, which may be challenging in practice. Reporting entities will need to closely monitor their intra-entity transfers of inventory to ensure they defer all income tax effects until the inventory is sold outside the group or impaired. See below for additional discussion on inventory transfers.   

ASU 2016-16 Main Provisions

Elimination of the Existing Exception for Non-Inventory Assets
The ASU eliminates the exception for intra-entity asset transfers other than inventory so that an entity’s consolidated financial statements reflect the current and deferred tax consequences of intra-entity asset transfers (other than those of inventory) when the transfer occurs. That is, intra-entity asset transfers including intangible assets, property, plant and equipment, real estate, and financial assets are subject to the change. Inventory, as defined in the ASC Master Glossary, is excluded. Generally, tax consequences arise in asset transfers between different tax paying entities (or different tax consolidation groups) of a consolidated reporting entity.[7]

While the tax effects are now required to be recognized, the pretax profit from all intra-entity transfers is still required to be deferred or eliminated under the consolidation procedures of Topic 810.
To account for these tax consequences:
  1. A current tax liability should be recognized for the estimated taxes payable on tax returns for the current year; and
  2. A deferred tax asset (DTA) should be recognized for the estimated future tax effects attributable to the temporary difference between the buyer’s tax basis in the asset and the book basis as reported on the consolidated financial statements (i.e., the seller’s book basis).
If the intra-entity transfer also results in an uncertain tax position, the associated FIN 48 uncertain tax benefit liability is required to be recognized (i.e., it is no longer deferred). 

The following example illustrates the change:
U.S. domestic entity X has a $10 million cost basis in an intellectual property asset for which the tax basis is zero. In the current period, Entity X transfers the asset in a cross-border intra-entity transaction to a related foreign entity (a different tax-paying component) for $20 million. Entity X’s tax rate is 40% (federal and state) and the foreign subsidiary’s tax rate is 10%. Entity X has a deferred tax liability of $4 million when the asset is transferred to the foreign subsidiary. Entity X’s tax liability is $8 million (transfer price of $20 million less zero tax basis times 40%). The foreign subsidiary obtains a tax basis of $20 million. The intra-entity transaction is considered sustainable (based on technical merits) at the more likely than not level of confidence.      

The following entries should be made when the transfer occurs (in ‘000,000):
Debit: Income Tax Expense                 $8  
Credit: Current Tax Payable                            $8

(Entry to recognize the estimated current U.S. tax liability)
 
Debit: Deferred Tax Liability               $4
Credit: Income Tax Expense                            $4

(Entry to release U.S. deferred tax liability) 
 
Debit: Deferred Tax Asset                   $1
Credit: Deferred Tax Expense                         $1

(Entry to recognize a foreign deferred tax asset)
 
As illustrated above, under ASU 2016-16, the net tax effect of an intra-entity asset transfer (except inventory) is required to be recognized in the period of transfer (i.e., it is no longer deferred).
 
The deferred tax asset, which under current accounting is not allowed to be recognized, is recognized under ASU 2016-16 for the difference between the buyer’s tax basis ($20 million in this example) and the consolidated book basis ($10 million in this example). The book basis is not affected by the intra-entity transfer (i.e., book basis in consolidated financial statements is unchanged).
 
Unlike the current accounting, under ASU 2016-16 the consolidated effective tax rate will be affected in the period of transfer, because the net tax effect is required to be recognized (instead of deferred), while the pretax gain is still required to be eliminated.
 
In this example, this intra-entity transfer results in a net tax expense of $3 million that increases the effective tax rate in the period of transfer (i.e., a permanent effect on the rate). In contrast, when the intra-entity profit is recognized in the consolidated income statement (in this example, there is an estimated profit of $10 million when the asset is consumed in the consolidated group), there will be no tax effect to match against the income since the net tax effect has already been recognized. However, a consolidated profit exceeding $10 million would result in a 10% tax effect. For example, if Entity X is able to generate $25 million revenue from customers, there would be additional profit of $5 million and a tax expense of $500 thousand (10% times $5 million) assuming foreign earnings are reinvested outside the U.S. This illustrates how the entity reduced its overall income tax by shifting excess profit to a lower tax jurisdiction.    
 
Public business entities will have to disclose these tax effects in the tax rate reconciliation disclosure and related MD&A discussion.  

Retention of Exception for Inventory Property
For intra-entity asset transfers of inventory only, recognition of current and deferred income tax consequences will continue to be deferred until the inventory has been sold to an outside party or otherwise has left the group (e.g., impaired and/or discarded). The FASB does not expect that entities will have substantial difficulty distinguishing those assets that meet the GAAP definition of inventory,[8] for which the exception is retained, versus those assets that are non-inventory in character and should be accounted for under the ASU’s new requirement.

When inventory is transferred in an intra-entity transaction involving two tax-paying entities, ASC 740-10-25-3(e) will continue to preclude the recognition of a DTA for the difference between the tax basis in the buyer’s tax jurisdiction and the cost as reported in the consolidated financials. The tax basis in the buyer’s jurisdiction must be tracked off-balance sheet. Similarly, ASC 810-10-45-8 will continue to preclude recognition of an expense incurred (or sometimes a tax benefit if inventory is transferred at below book and tax basis) as a result of the intra-entity inventory transfer. Rather, the tax expense to the seller would be deferred on the balance sheet in consolidation (as a “prepaid tax” or “deferred charge”) and recognized in income tax expense when the inventory is sold outside the group or is impaired.

The following example illustrates the application of the retained exception to intra-entity transfer of inventory between a U.S. parent of the consolidated reporting entity (“USC”) and its foreign subsidiary (“FC”): 
USC owns inventory with a cost basis of $10 million and tax basis of $12 million (excess tax basis due to tax requirement to capitalize certain costs that were expensed for book). In the current period, USC transfers the inventory to FC for $13 million. In the subsequent period, FC sells all of the inventory to customers in its jurisdiction for a 20% markup or a selling price of $15.6 million.

USC’s combined federal and state tax rate is 40%. USC is a current taxpayer (no losses or valuation allowance) and it maintains a deferred tax asset of $800 thousand for the excess tax-over-book basis in the inventory. FC’s tax rate is 10% and its tax basis in the inventory immediately after the transfer is the transaction’s transfer price of $13 million which is assumed to be a sustainable pricing position under U.S. and international transfer pricing rules.

The intra-entity inventory transfer triggers (1) a U.S. current tax expense of $400 thousand (selling/transfer price of $13 million less tax basis of $12 million times 40%), (2) a U.S. deferred tax expense of $800 thousand and (3) a foreign deferred tax benefit of $300 thousand (tax basis of $13 million in excess of book basis of $10 million times 10%). The subsequent sale to customers triggers a foreign tax expense of $260 thousand (selling price of $15.6 million less tax basis of $13 million times 10%).

USC would also recognize pretax income of $3 million in its separate general ledger. However, in consolidation the pretax income is eliminated pursuant to the consolidation requirements in Topic 810 (the recognition and elimination of pretax income is not illustrated in this example).       
 
The following tax adjustments should be made when the transfer occurs (in ‘000):
Debit: Income Tax Expense                 $400 
Credit: Current Tax Payable                            $400

(Entry to recognize the estimated current U.S. tax liability)
 
Debit: Deferred Tax Expense              $800
Credit: Deferred Tax Asset                              $800

(Entry to reverse U.S. deferred tax asset previously recorded) 
 
Debit: Prepaid Tax                               $1,200
Credit: Income Tax Expense                            $1,200
(Consolidation entry to defer recognition of USC’s net tax expense)[9] 
 
In this illustration, the intra-entity profit ($3 million) is eliminated and the related U.S. tax effect ($1.2 million) is deferred in consolidation.  Further, FC’s tax basis step-up is not allowed to be recognized in the consolidated financial statements (see footnote 8).
 
The following entries should be made in the subsequent period when FC sells the inventory to its customers (in ‘000):
 
Debit: Income Tax Expense                 $1,200 
Credit: Prepaid Tax                                          $1,200

(Entry to release the deferred charge to income tax expense)
 
Debit: Current Income Tax Expense    $260 
Credit: Current Tax Payable                            $260

(Entry to recognize the current foreign tax liability)
 
In the period the inventory is sold to customers, the reporting entity would recognize pretax profit of $5.6 million (selling price of $15.6 million less book basis of $10 million) and a total tax expense related to the sold inventory of $1.46 million (an effective tax rate of about 26%).[10] In this example, the intra-entity transfer of inventory resulted in tax savings due to booking incremental profit of $2.6 million in the foreign jurisdiction where the tax rate is 10% (assuming the intra-entity transfer pricing is acceptable under relevant transfer pricing rules and USC permanently reinvests accumulated foreign earnings).  
 
BDO Observation: While the recognition exception for intra-entity transfers of assets has been a long-standing U.S. GAAP rule, care should be exercised now that the FASB has decided to retain the recognition exception only for inventory. The inventory illustration above highlights the need to track the deferred tax charge and release it to income tax expense when the inventory is sold outside the group or is impaired. This could be challenging when the inventory disposal cycle straddles two or three accounting periods (i.e., tracking requirements for inventory would now be different than non-inventory). Reporting entities should have robust internal controls over this aspect of the income tax provision process. Another important aspect of retaining the recognition exception for inventory transfers is the consideration of valuation allowance accounting. One complexity that was supposed to be resolved with the elimination of the exception was whether the release of a valuation allowance concurrent with an intra-entity transfer of an asset which generates a taxable gain should also be deferred. The ASU does not address this complexity and therefore professional judgment will be required to determine whether the release of a valuation allowance due to taxable income from intra-entity transfers of inventory should also be deferred. 
    
Outbound Transfers of Intangible Property under Section 367(d)[11]
The ASU is responsive to increasingly common cross-border outbound transfers of intellectual property. U.S. tax rules governing cross-border transfers of intangible assets are complex and unique. For example a U.S. entity can elect to treat an outbound transfer of intellectual property as an outright sale or as a “delayed recognition” transaction for U.S. federal tax purposes. Outright sale treatment triggers taxable income recognition in the period of transfer, whereas a deferred gain transaction requires inclusion of U.S. taxable income in future periods. The latter treatment is governed by Internal Revenue Code section 367(d) which requires the U.S. entity to include “deemed royalties” throughout the economic useful life of the intangible asset. Furthermore, the “deemed royalties” must be “commensurate with income,” which generally means royalties must reflect the income producing capacity of the intangible asset. That is, the U.S. entity is taxed annually on deemed royalties which must reflect arm’s length transfer pricing.[12] 

A question arises as to how to account for the future income tax consequences of outbound transfers of intellectual property transactions governed by section 367(d). The ASU does not address this question and professional judgment is required as in many of these outbound transfers neither the book basis nor the U.S. tax basis changes.

One view is to accept the tax law construct of delayed recognition and recognize income tax expense in future periods as the deemed royalties are included in the U.S. tax return. That is, there would be no income tax accounting to record in the period of transfer since there is no taxable temporary difference to account for. This view is premised on the fact that for U.S. income purposes, the U.S. tax liability is not considered “fixed and determinable” at the time of the transfer. Under this view, income tax expense is matched with income generated from consumption of the asset and it requires no adjustment (unless deemed royalties in this situation are considered an uncertain tax position/benefit).

There might be other acceptable views. Reporting entities undertaking outbound transfers of intellectual properties should consult with their financial statement auditors and tax advisors to determine the most appropriate treatment when they adopt the ASU.    

Interim Reporting
The FASB indicated in the ASU’s basis for conclusions that reporting entities will be required to determine whether the income tax effects from intra-entity transfers should be included in the estimate of the annual effective tax rate from continuing operations or recognized as a discrete period tax effect. As such, reporting entities will need to consider the guidance in paragraphs 740-270-30-12 through 30-13 which require the exclusion of significant unusual or infrequently occurring items from the estimated annual effective tax rate from continuing operations and determine whether the income tax effects from intra-entity transfers qualify for exclusion and should be accounted for discretely. Due consideration should also be given to internal controls over income taxes to ensure these transactions are timely identified and evaluated to determine the appropriate treatment.    
 
Effective Date and Transition Method

Mandatory Effective Date
The ASU is effective for public business entities for annual reporting periods beginning after December 15, 2017 and interim reporting periods within those fiscal years. It is effective for private entities for annual reporting periods beginning after December 15, 2018 and interim periods within annual periods beginning after December 15, 2019.

Early Adoption
An entity may elect early adoption, but it must do so in the first interim period of an annual period if it issues interim financial statements. Therefore, calendar year public business entities cannot early adopt the ASU in calendar year 2016. Such entities can elect to early adopt in calendar year 2017. In contrast, a reporting entity with a September 30 fiscal year end can elect early adoption of the ASU since it can still apply it in the first interim period ending December 31. 
  
Transition Method
The ASU is applied on a modified retrospective basis in the period of adoption. This means the unamortized balance of a prepaid tax/deferred charge (seller’s tax) due to a prior intra-entity asset transfer is derecognized through an adjustment to opening retained earnings, avoiding the impact on income tax expense that would have resulted absent adoption of the ASU. Conversely, the remaining off-balance sheet deferred tax asset (from the buyer’s tax basis step-up) is recognized, net of any valuation allowance, through opening retained earnings. That is, if a valuation allowance is initially required on a newly recognized deferred tax asset, it is also recognized through opening retained earnings. However, subsequent release of a valuation allowance initially recognized through retained earnings is generally recognized as income tax benefit in the period of release. That is, the release is not allowed to be “traced” back to retained earnings.  

In summary, all of the effects of initial adoption are recognized through opening retained earnings as part of a cumulative-effect adjustment as of the beginning of the period of adoption. The comparative prior period’s financial statements should not be restated.

For example, a calendar year public entity which adopts the ASU in its 2018 annual period would adjust opening retained earnings (i.e., January 1, 2018) for any unamortized prepaid tax/deferred charge balance and any unrecognized deferred tax asset, net of valuation allowance. The 2016 and 2017 comparative periods would not be adjusted for the adoption of the ASU. If the entity elects to early adopt in calendar year 2017, it would adjust its opening retained earnings (i.e., January 1, 2017) for any unamortized prepaid tax/deferred charge balance and any unrecognized deferred tax asset, net of the valuation allowance. The 2015 and 2016 comparative periods would not be adjusted for the adoption of the ASU.

Transition Disclosure
All entities should provide the following transition disclosures in the annual period of adoption and the interim periods within that first annual period: (i) the nature of and reason for the change, (ii) the effect of the change on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), any other affected financial statement line item(s), any affected per-share amounts for the current period, and (iii) the cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the period of adoption.

Appendix:  Inventory - The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventory excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.”
   

For more information, please contact one of the following regional practice leaders:

Yosef Barbut
National Assurance Partner
         Jennifer Kimmel
National Assurance Senior Manager     Adam Brown
Partner – National Director of Accounting
          [1] Intra-Entity Transfers of Assets Other Than Inventory [2]  The ASC’s Master Glossary defines the term intra-entity as: “Within the reporting entity. This could be transactions or other activity between subsidiaries of the reporting entity, or between subsidiaries and the parent of the reporting entity. Also called intercompany.” [3] Prepaid tax or “deferred charge” is an asset representing a past tax event, and is thus not subject to revaluation for tax rate changes or to the realizability evaluations of ASC 740.  [4]  ASC 810-10-45-8 requires that taxes paid on intra-entity profits on assets remaining within the consolidated group be deferred and any intra-entity profits be eliminated in consolidation, while ASC 740-10-25-3(e) provides an exception to the general recognition rule for deferred tax assets for basis differences related to intra-entity asset transfers. [5] ASC 740-10-30-5 [6] The Board determined that eliminating the exception for inventory transfers would not have resulted in significantly more useful information for users of financial statements to justify the considerable implementation costs. [7] ASC 740-10-30-5 [8] The ASC’s Master Glossary defines the term inventory as: “The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale.”  See appendix for an expanded definition. [9] ASC 740-10-25-3(e).  Note that under this exception, the tax basis step-up in the foreign jurisdiction cannot be recognized in the accounts and hence the resulting $300 thousand deferred tax benefit is tracked off-balance sheet.  [10] The effective tax rate of 26% is comprised of (i) consolidated pretax income of $5.6 million, less (ii) US tax expense of $1.2 million, less (iii) foreign tax expense of $560 thousand minus unrecorded tax benefit from the tax basis step-up of $300 thousand for a total foreign tax expense of $260 thousand.   [11] Transfers of intangible property (within the meaning of Internal Revenue Code section 936(h)(3)(B)) by a U.S. person to a related foreign corporation in a non-recognition exchange described in section 351 or 361 are treated as a sale in exchange for payments contingent upon the productivity, use, or disposition of the asset. [12] U.S. transfer pricing rules under Internal Revenue Code section 482 apply to these transactions. 

Compensation & Benefits Alert - December 2016

Thu, 12/22/2016 - 12:00am
President Obama Signs Bill that Eliminates the ACA Penalty on Certain Health Care Premiums Reimbursed to Employees
Summary On December 13, 2016, President Obama signed the 21st Century Cures Act, which allows certain small employers to establish a new type of health reimbursement arrangement that reimburses for health insurance premiums without exposure to the $100 dollar per day penalty under the Affordable Care Act (“ACA”).  Under these new rules, small business owners are permitted to compensate employees for medical visits or the cost of individual insurance premiums up to an annual limit of $4,950 for individuals, or $10,000 for families.  These reimbursements are also excludible from the employee’s gross income.  

An employer is eligible to establish a small employer health reimbursement arrangement if that employer (i) is not subject to the employer mandate under the Affordable Care Act (i.e., less than 50 full time employees or full time equivalents) and (ii) does not offer a group health plan to any employees.

These rules are effective for plan years beginning after December 31, 2016, with retroactive transition relief from penalties to small employers who continued to reimburse employees for medical expenses, including premiums for individual health insurance since June 30, 2015, when the IRS Notice 2015-17 relief from the $100 day penalty under IRC Section 4980D expired.  This means that small employers who have continued to provide such reimbursements will not be subject to the potential penalties.
Background and Discussion After the passage of the ACA, the IRS released Notice 2013-54 and 2015-17, describing health reimbursement arrangements as employer payment plans; therefore, they are group health plans within the meaning of Code Section 5000(b)(1). Group health plans are subject to the ACA’s market reforms, including the prohibition on annual limits for essential health benefits and the requirement to provide certain preventive care without cost sharing. Failure to comply with the ACA’s market reforms triggers an excise tax under Code Section 4980D, up to $100 per day for each employee.

Section 18001 of the 21st Century Cures Act amends Code Section 9831 by adding subsection (d), “Exception for Qualified Small Employer Health Reimbursement Arrangements (QHRA).” These QHRAs are exempt from the ACA market reforms and its penalties, provided the following:
  1. The arrangement is offered to all employees on the same terms and waiting periods may not exceed ninety (90) days;

  2. It is funded solely by an eligible employer and no salary reduction contributions may be made under the arrangement;

  3. The arrangement provides, after the employee provides proof of coverage, for the payment of, or reimbursement of, an eligible employee for expenses for medical care (as defined in Code § 213(d)) incurred by the eligible employee or the eligible employee’s family members (as determined under the terms of the arrangement); and

  4. The amount of payments and reimbursements for any year do not exceed $4,950 per employee, or $10,000, in the case of arrangements providing payments or reimbursements for family members of the employee, as adjusted for cost of living and partial years.

Additionally, the employer must provide a notice of eligibility and terms to each eligible employee, any employee not excluded by the terms of the arrangement.  Furthermore, the employer must report the total amount of the permitted benefit received under the qualified small employer health reimbursement arrangement on the employee’s Form W-2 for the year. Any employer that fails to provide any employee with a written notice of eligibility and terms is subject to a $50 penalty per employee, with the maximum penalty for all failures not exceeding $2,500 in any calendar year.

These rules are applicable for all taxable years beginning after December 31, 2016.  The transition relief under IRS Notice 2015-17, as discussed above, shall be treated as applying to any plan year beginning on or before December 31, 2016.


BDO Insights

This bill effectively allows the premium reimbursement by small employers to be integrated with the individual’s health care policy to determine whether an annual limit was placed on the benefit provided by the employer. There is no change for Applicable Large Employers.  Therefore, Applicable Large Employers are still prohibited from reimbursing premiums purchased on the individual health care market.  
 


For more information please contact one of the following practice leaders: 
  Joan Vines
Managing Director, National Tax Office
Compensation & Benefits    Carl Toppin
STS GES Senior Manager,
Compensation & Benefits
    Kim Flett
Managing Director, Tax
Compensation & Benefits    Peter Klinger
Principal, National Tax - Compensation & Benefits

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