The November 8th elections will result in significant changes in Washington with a new President, a possible change of control in the Senate, and a possible decrease in the Republican majority in the House. The policymaking agenda in Washington will be determined by these changes with clear impacts on developments in the area of tax policy and the future of comprehensive tax reform.
The primary issue facing Congress when they return after the elections will be to address the funding of the Federal government, since the current Continuing Resolution expires on December 9th. Republicans would like to move a plan that includes long-term bills for certain departments, such as defense, and cover the rest of the government with another Continuing Resolution. Democrats have indicated that they prefer an omnibus bill that covers the entire government.
If Republicans win the White House, there will likely be a push from Capitol Hill Republicans for full-scale tax reform, while a Clinton presidency would more likely focus on a narrower discussion of international tax reform linked to infrastructure spending. Senator Chuck Schumer (D-NY), who would become Senate Majority Leader if control of the Senate flips, is a proponent of this approach and has stated that he believes this is an area in which he could find common ground with House Speaker Paul Ryan (R-WI) with a Clinton presidency. There could be opposition, however, from Ryan and other House Republicans to the infrastructure spending and from the progressive wing of the Democratic Party who are not on board with the tax reform proposals. Many in the Washington tax community are convinced that 2017 will see a renewed interest in moving comprehensive tax reform, and there is certainly likely to be more activity on this issue, but the question remains as to whether the focus of tax reform would be comprehensive or more targeted at business tax reform.
Specific tax issues that could be addressed in the lame duck session include extenders and a package of renewable energy provisions, but there is some opposition to addressing these issues, and House and Senate leadership have made no commitments. If the extender package gets some traction, it could draw other miscellaneous tax issues such as changes to the nuclear power production tax credit and legislation to defer stock options, and all of these issues would be a candidate for inclusion in an omnibus spending bill should it move forward.
The US Supreme Court denied certiorari in Gillette v. Franchise Tax Board, the leading case on whether an out-of-state business can elect to apportion its business income under the Multistate Tax Compact’s evenly weighted three-factor formula. The Court’s decision not hear the case means that the California Supreme Court’s 2015 holding will stand, where the court held that the state could enforce its statutory apportionment formula instead of the compact’s formula, despite the state’s adoption of the compact.
Prior to leaving Washington for the election recess, the House passed the Mobile Workforce State Income Tax Simplification Act, which would restrict states from imposing income tax on nonresidents, unless the individual works in that state for more than 30 days during the year. A similar version of this bill passed the House in 2012, but was never voted on in the Senate. A current and identical companion bill in the Senate has more support than the 2012 legislation, but challenges remain to passage in the Senate especially from Senators representing states who may lose revenue under the proposed regime.
Regulations on Partnership Disguised Sales and Liability Allocations
The IRS issued a package of regulations related to disguised sales under Code section 707(a)(2)(B) and the characterization of partnership liabilities as recourse or non-recourse under Code section 752. The package includes final regulations, temporary regulations, proposed regulations, and re-proposed regulations.
The first regulation provides final rules under Code section 707 covering disguised sales of property to or by a partnership and final rules under Code section 752 on allocations of excess nonrecourse liabilities of a partnership to partners for disguised sale purposes. Also released were final and temporary regulations on the allocation of liabilities for purposes of Code section 707 and when certain obligations are recognized for purposes of determining if a liability is a recourse partnership liability under Code section 752. Finally, the IRS released a proposed rule that addresses when certain obligations to restore a deficit balance in a partner’s capital account are disregarded under Code section 704 and when partnership liabilities are treated as recourse liabilities under Code section 752.
The most notable change with respect to disguised sales is included in the temporary and proposed regulations and requires the allocation of a partnership liability to be made in accordance with the manner in which the partners share profits of the partnership, regardless of whether such liability otherwise meets the definition of a recourse liability that is allocable in any other manner. With respect to the general partnership liability allocation rules under Code section 752, the proposed regulations had introduced a set of contractual and net worth factors to be satisfied in order for a partnership liability to be classified a recourse liability and allocable to a specific partner under the “risk-of-loss” test, but these proposed regulations were withdrawn and re-proposed with those factors becoming a new facts and circumstances anti-abuse rule.
The IRS issued final regulations clarifying the disallowance of the research and development credit for software that is developed by a taxpayer primarily for internal use. The rules narrow the definition of internal use software to be defined as software used for human resources, support services, and financial management, but also covering a broad range of issues including the list of general and administrative functions, dual functions, interactions and connectivity with third parties, and software that is commercially sold, leased, licensed or otherwise marketed to third parties. The final rules include 18 examples illustrating its application.
The IRS issued proposed regulations providing guidance relating to the income test and asset diversification requirements that are used to determine whether a corporation may qualify as a regulated investment company (RIC) for federal income tax purposes.
The IRS issued final and temporary regulations that extend the due date (by six months) by which a taxpayer may elect under Code section 165(i) to treat a loss attributable to a federally declared disaster as sustained in the prior tax year. The temporary regulations were made effective immediately because the federal government expect a significant number of casualty losses due to recent flooding events. The IRS also issued Revenue Procedure 2016-53 specifying how to make this election and how to take consistent return positions.
The IRS released a new International Practice Unit (IPU) that instructs auditors on identifying foreign goodwill or going concern (FGWGC). IPUs are drafted by the Large Business and International (LB&I) Division of the IRS and are intended to serve as both job aids and training materials. Generally, FGWGC describes the residual value of business operations outside of the US after other tangible and intangible assets have been identified and tallied. This IPU notes that the identification of FGWGC (or determination that it cannot exist) is critical in applying Code section 367(d) treatment to the outbound transfer of intellectual property, and it identifies a four-step process for making a determination of whether FGWGC exists.
The IRS also released other IPUs covering sourcing multi-year compensation under foreign tax credit (FTC) limitations, as well as comparing the use of the arm’s length standard with other valuation approaches to regulate inbound and outbound income shifting.
Treasury issued a report called “Reducing Income Inequality through Progressive Tax Policy: The Effects of Recent Tax Changes on Inequality” on the Administration’s efforts to increase the progressivity of the tax code and the overall effect of these changes. The study reviewed the changes to tax laws during the Obama Presidency and attributes positive changes to increases in the Earned Income Tax Credit (EITC) and the Child Tax Credit, as well as enactment of the American Opportunity Tax Credit, which defrays college tuition costs for low and middle-income families. It also cites more progressivity from increased rates on upper-income taxpayer individuals, higher estate taxes, new limits on itemized deductions for high-income individuals and a higher top rate on long-term capital gains and dividends.
The Defense Department, General Services Administration and National Aeronautics and Space Administration finalized a rule to prohibit Federal purchases from corporations with a delinquent Federal tax liability or a felony conviction, adopting without changes an interim rule issued in December 2015. The rule requires all bidders on Federal contracts to make a “representation regarding whether the offeror is a corporation with a delinquent tax liability or a felony conviction under Federal law, and an affirmative answer to these conditions bars the contractor from further consideration unless the agency has considered suspension or debarment of the corporation and has made a determination that this further action is not necessary to protect the interests of the Government.”
The OECD issued a new report outlining several mechanisms that member nations will implement to resolve treaty-related disputes in a timely, effective and efficient manner. These documents form the basis of the Mutual Agreement Procedure (MAP) peer review and monitoring process under Action 14 of the BEPS Action Plan. Recognizing that the actions to counter BEPS must be complemented with actions that ensure certainty and predictability for business, Action 14 calls for effective dispute resolution mechanisms to resolve tax treaty-related disputes. The compilation includes the Terms of Reference which translate the minimum standards approved in the final Action 14 report into a basis for peer review; the Assessment Methodology for the peer review and monitoring process and the MAP statistics reporting framework which reflects the collaborative approach competent authorities will take to resolve MAP cases and which will ensure greater transparency on statistical information relating to the inventory, types and outcome of MAP cases through common reporting of MAP cases going forward; and Guidance on information and documentation to be submitted with a MAP request.
As a further step to implement the OECD Common Reporting Standard (CRS), the first series of bilateral automatic exchange relationships were established among the first group of jurisdictions committed to exchanging information automatically as of 2017. With a year to go before the first exchanges of information on financial accounts pursuant to the OECD CRS, there are now more than 1000 bilateral relationships in place globally, most of them based on the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information (the CRS MCAA).
As part of a broader package of corporate tax reforms, the European Commission (EC) published a proposal for a Council Directive on a Common Consolidated Corporate Tax Base (CCCTB) which would apply to all groups of companies with total annual turnover in excess of EUR 750 million and a taxable presence in at least one European Union (EU) Member State. The CCCTB includes a tool for attributing income to where the value is created, through a formula based on three equally weighted factors (i.e., assets, labor, and sales). The proposal states that a new framework is needed for a fair and efficient taxation of corporate profits in light of Europe’s priority to promote sustainable growth and investment within a fair and integrated market.
The EC also proposed a Council Directive on Double Taxation Dispute Resolution Mechanisms in the EU. Under the proposal, current dispute resolution mechanisms would be adjusted to meet the needs of businesses more effectively. In particular, a wider range of cases would be covered and EU Member States would have clear deadlines to agree on binding solutions to cases of double taxation. The EC also released its proposal to extend the rules against hybrid mismatches to hybrid mismatches involving non-EU countries.
Earlier this year, the Treasury Department and IRS proposed sweeping regulations to address “earnings stripping,” which is a method by which a US company borrows money from a foreign affiliate, thereby shifting income from the US to a jurisdiction with lower tax rates. The proposed regulations under Code section 385 were designed to treat certain instruments that were purportedly debt as stock in order to address this perceived erosion of the US tax base.
On October 13th, Treasury and the IRS issued final, temporary and proposed regulations replacing the earlier proposed rules. The original proposed regulations had garnered significant comment and criticism, and the final regulations, which are significantly narrower in scope, reflect changes that appear to respond to comments received by the Government from taxpayers. At a background briefing, Treasury officials estimated that the final rules will raise from $600-700 million annually.
In commenting on the final rules, Treasury Secretary Lew stated that problems like inversions and earnings stripping cannot be solved by administrative action alone and that the “real solution is for Congress to enact comprehensive business tax reform with specific anti-inversion and earnings stripping provisions.” He indicated that for the remainder of the Obama Administration, Treasury would continue to make the case for business tax reform, and that recent developments, such as the European Commission’s State aid investigations, have brought “additional attention to this issue.”
A senior IRS official has commented that the agency expects there will be legal challenges to the final regulations. The preamble includes material responding to nearly 150 comments about specific issues in the regulations in an effort to address legal challenges.
House Ways & Means Committee Chair Kevin Brady (R-TX) reacted to the final rules by stating that, “American businesses and Members of Congress from both sides of the aisle have repeatedly asked the Administration to slow down and do the work necessary to ensure that final regulations under section 385 will not damage our economy and hurt American workers. By rushing the review process – despite the extensive comments received – and finalizing these regulations so quickly, it appears that the Obama Administration has ignored the real concerns of people who will be most impacted by these far-reaching rules. I am going to carefully review these final regulations in the days ahead and hear directly from people across America about how these rules will impact our workers, our job creators, and our communities.”
Senate Finance Committee Chair Orrin Hatch (R-UT) also released a statement indicating that he would have preferred Treasury re-propose the rules. “Since the day the regulations were first proposed, the Treasury Department has heard pointed concerns from both Republicans and Democrats, and from numerous American job creators and a wide variety of sectors across the US economy that proceeding with the rules would be ill-advised and lead to unintended consequences for America’s innovators. While the final regulations will need to be scrutinized closely, it is immensely concerning that, despite stark bipartisan concern, the Obama Administration moved forward with completing rules that could jeopardize American businesses and the economy here at home. While Treasury has indicated they have attempted to address some of the major concerns such as cash pooling transactions, foreign subsidiary-to-foreign-subsidiary transactions, and Subchapter S Corporation financing, among others, the devil’s in the details. And, we’ll now have to carefully examine whether the regulations will make the policy less intrusive on some categories of legitimate business transactions.”
The final regulations drew support from the Ranking W&M Democrat, Sander Levin (D-MI), who commented that “these regulations are another significant step the Administration has taken to restore fairness to the tax system and ensure multinational corporations pay their fair share of taxes.” In a statement, he said “For years, companies have been inverting and engaging in earning stripping to unfairly lower their tax bills. In the absence of Republican action on tax reform, Treasury has used its Administrative authority to help bring fairness to the tax system. Today’s regulations from Treasury – which took into account extensive comments from the public and intensive meetings with Republicans and Democrats in Congress – go straight to the core of that fairness issue by strongly limiting a company’s ability to use this tax avoidance strategy, which involves disproportionately leveraging a US company with debt and ‘stripping’ the US tax base through deductible interest payments.”
SFC Ranking Democrat Senator Ron Wyden (D-OR) also praised the final Treasury regulations, but agreed that Congress needs to act. In a statement, he said “These final rules on Section 385 clearly reflect a lot of input and careful study, and in my view they will go a long way to protecting our corporate tax base. What this does not change is the need for tax reform. For too long Congress has sat on a broken and outdated tax system, which is why the US has resorted to rule changes to respond to wave after wave of tax avoidance. The answer is for Congress to reform the tax code on a bipartisan basis.”
The general reaction from business has been cautious, perhaps in light of the fact the 518 pages of rules will take some time to review. A representative of the S Corporation Association praised the new rules, saying “This is a big win for Main Street businesses,” and thanking Treasury for listening to the group’s concerns. He commented that “S corporations were the hardest hit by the proposed rules, yet they are the least likely to engage in base erosion. The final rule recognizes that disconnect and fixes it.”
On the other hand, the president of the Organization for International Investment (OFII), stated that they would “continue to analyze the final regulations, but remain concerned that they may harm the ability of the US to attract global investment and limit opportunities for American workers.”
Revisions in the Final Rules
A major revision in the final 518 page rule eliminates the “bifurcation rule,” which would have given the IRS broad discretion to treat certain interests in a corporation as debt in part and stock in part. The Treasury Department and the IRS will continue to study this issue.
Many taxpayers who commented on the proposed regulations, including some Members of Congress, urged Treasury to re-propose the regulations instead of finalizing them, but Treasury declined to take that approach. Instead, most of the proposed regulations were finalized, others were issued as temporary regulations, while others were reserved for further consideration. Specifically, the rules applicable to partnership and disregarded entities, the rules applicable to consolidated groups, and the new exception for cash pooling and short-term debt instruments were issued in temporary and proposed form, which means that these rules have immediate effect, but Treasury has additional time to receive comments and make modifications prior to finalizing them in three years.
An area that received significant comment was the effective date of the regulations, with the final regulations generally following the proposed regulations applicability to debt issued after the date the proposed regulations were issued, i.e. April 4, 2016, with a general effective date 90 days after the final regulations are published in the Federal Register. Treasury revised the effective dates to apply only to taxable years ending on or after 90 days after the publication of the final and temporary regulations, which means that any covered debt instrument issued after April 4, 2016, and before the 90-day window after publication will not be recharacterized until 90 days after the publication date. Also, the effective date for the documentation rules is extended until January 1, 2018.
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