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Tax Week in ReviewMonday, January 22, 2001 Deloitte & Touche OnLine
IRS Targets Two More Tax-Avoidance Transactions Even as they prepare for a change in administrations, Treasury and the IRS are continuing their war on abusive tax shelters. On January 18, the IRS issued notices that added intermediary transactions and contingent liability transactions to its list of tax-avoidance transactions. According to the Service, both of these transactions, along with transactions that are substantially similar, are "listed transactions" that are subject to the tax shelter registration, listing, and disclosure requirements. In addition, the Service may impose penalties on promoters of and participants in the transactions. The Service also has excepted certain lease transactions from the tax shelter regulations. Intermediary Transactions Tax Shelters -- In Notice 2001-16, the IRS states that it will challenge intermediary transactions. The notice describes these transactions as generally involving a seller who wants to sell the stock of a corporation, an intermediary, and a buyer who wants to purchase the corporation's assets but not its stock. The seller sells the company's stock to the intermediary and the company sells its assets to the buyer. The buyer claims a basis in the company's assets equal to the purchase price. In one form of the transaction, the company is included as a member of an affiliated group with the intermediary, and a consolidated return is filed in which the group claims losses or credits that offset the gain (or tax) resulting from the sale of assets. In another form of the transaction, the intermediary may be an entity that is not subject to tax, it liquidates the company, and there is no reported gain on the sale of the company's assets. Contingent Liability Tax Shelters -- The second transaction the Service targeted is one that was also addressed in the budget bill that President Clinton signed December 21. In Notice 2001-17, the IRS describes the transaction as one in which there is a transfer of a high basis asset to a transferee corporation in exchange for the transferee corporation's stock and the transferee corporation's assumption of a liability which the transferor has not yet taken into account for federal income tax purposes. The transferor typically remains liable for the underlying obligation. The basis and fair market value of the transferred asset are generally only marginally greater than the present value of the assumed liability. Therefore, the value of the transferee stock received by the transferor is minimal relative to the basis and fair market value of the asset transferred to the transferee corporation. The transaction is designed to qualify as an exchange under section 351 so that the basis of the stock that the transferor receives is equal to the basis of the transferred asset, unreduced by the assumed liability. The transferor then sells the stock of the transferee corporation for its fair market value shortly after the exchange and claims a loss in the amount of the present liability assumed by the transferee corporation. The Service states that any business purpose asserted for the transactions is "far outweighed" by the purpose of generating deductible losses for federal tax purposes. Therefore, it will disallow losses claimed by the transferor. Lease Exception to Tax Shelter Regulations -- The IRS has also announced that certain lease transactions will be exempted from the tax shelter registration, listing, and disclosure rules. The exception applies to lease transactions if (1) there is a lease or sale leaseback between an owner-lessor of tangible personal property and a lessee who is the user of the property; (2) the terms of the lease are consistent with customary commercial practice for the leasing of similar items of property; (3) the transaction qualifies as a lease for federal tax purposes; (4) the lessor and lessee agree to consistently report the transaction as a lease for federal tax purposes; and (5) the transaction is not the same as (or substantially similar to) a listed transaction under Treasury reg. section 301.6111-2T(b)(2). O'Neill Looks to Monetary Policy -- Not Tax Cuts -- to Rev Up Economy At his January 17 confirmation hearing before the Senate Finance Committee, Treasury Secretary-designate Paul O'Neill promised that the incoming Bush administration would deliver a detailed tax cut plan within six weeks. But while O'Neill expressed support for reforming both the corporate and individual alternative minimum tax -- which he labeled an example of the complexity that burdens the tax code -- he stopped short of endorsing tax cuts as an economic stimulus, citing Federal Reserve Board monetary policy as the best way to jump-start the slowing economy. President-elect George W. Bush's proposed 10-year, $1.6 trillion income tax cuts are affordable, even under the most conservative of the government's surplus projections, and should be the first tax cuts passed, because they would boost the economy, O'Neill said. Still, he downplayed the benefits of tax cuts, saying that monetary policy -- which he called it the "first line of action" in a faltering economy -- could do much more. O'Neill also noted that many of Bush's tax cuts would not start for several years, and would therefore help little now. In the short-term, he said, tax cuts would help the economy more if they were enacted retroactively -- through changing the withholding rates for instance. O'Neill indicated that Bush is studying that possibility. Committee Support for Cuts Mixed -- With the Finance Committee divided at 10 Democrats and 10 Republicans, and the full Senate split 50-50, Bush will need all of the help he can get to pass even a majority of his proposed cuts. Moreover, the president-elect has recently used the economic slowdown as his core argument for enacting a broad-based tax cut. At the hearing, several Democrats and some moderate Republicans, like Olympia Snowe of Maine, asked whether a slower consideration of tax cuts might not be okay, given their limited benefits. "We can ill afford a miscalculation" regarding the size and timing of tax cuts, Snowe said. Capital Gains, Social Security, Internet Taxes -- When Senate Majority Leader Trent Lott, R-Miss., -- a supporter of capital gains relief -- asked whether reducing capital gains tax rates would stimulate the economy, O'Neill said only that anything that lowers tax rates helps to reduce the cost of capital. In response to a question about whether enacting tax cuts too fast might be destabilizing for businesses, O'Neill said that Bush's proposed cuts target individuals, not businesses. Besides, he explained, companies collect taxes, but they do not ultimately pay them because taxes are passed on to consumers in the form of more expensive products and services. O'Neill indicated that he supports Bush's proposed Social Security investment accounts, noting that investing money will cause it to grow over time. He also said that he favors an extension of the Internet access tax moratorium, but cautioned that he currently knows little about Internet issues. Confirmation Likely -- Lawmakers from both sides of the aisle have indicated that the Senate will easily confirm O'Neill's nomination. Service Announces Relief on Stock Option Tax Withholding The IRS has announced (Notice 2001-14) that it will not assert liability for either income tax or FICA/FUTA withholding on the exercise of statutory options (section 422 incentive stock options and options provided under section 423 employee stock purchase plans) or on the disqualifying disposition of shares acquired by option exercise, provided the options are exercised before January 1, 2003. The vast majority of employers have not withheld income or payroll taxes on the exercise of statutory options or on disqualifying dispositions. Treasury and the IRS expect to issue administrative guidance clarifying current law with respect to the application of FICA tax, FUTA tax, and income tax withholding to statutory options. Comments regarding the guidance should be submitted to the IRS by May 7, 2001. Fifth Circuit Denies Interest Netting in Computing Combined Taxable Income for DISCs and FSCs The Fifth Circuit has held that the 1977 version of a Treasury regulation regarding the allocation and apportionment of interest expense deductions does not allow "interest netting" in computing the combined taxable income (CTI) for purposes of the Domestic International Sales Corporation and Foreign Sales Corporation provisions. The appeals court also held that a taxpayer's liability for deficiency interest is not eliminated when foreign tax credit carrybacks extinguish the deficiencies for the years to which the credits were carried. Dresser Industries Inc. v. United States, No. 99-11231 (5th Cir. Jan. 10, 2001). Although a 1990 decision by the Fifth Circuit allowed interest netting, that case (involving the same taxpayer) involved a prior version of the regulation. The court agreed with the government that the 1977 version expressly requires the allocation of gross interest expenses between DISC/FSC activities and non-DISC/FSC activities. The Fifth Circuit found this conclusion supported by Bowater Inc. v. Commissioner, 108 F.3d 12 (2d Cir. 1997). As to the deficiency interest issue, the Fifth Circuit held that although foreign taxes are deemed paid or accrued in the carryback year under section 904(c), the statute does not require that the credit reallocation be deemed to occur in the carryback year. The court then looked to section 6601 to conclude that a taxpayer remains liable for interest when an underpayment of tax is reduced or eliminated as a result of a carryback. Finally, the appeals court held that the deficiency interest continues to accrue until the filing date of the returns for the years in which the credits arose, not, as Dresser argued, until only the end of the tax year in which the carryback arises. Tax Court: Royalty Income From Foreign Parent Corp Was Passive Income The royalty income a domestic corporation received from its foreign parent corporation over the period 1989-91 was section 904 passive income for the purpose of calculating the domestic corporation's foreign tax credit, the Tax Court held in American Air Liquide Inc. v. Commissioner, 116 T.C. No. 3 (Jan. 16, 2001). The domestic corporation (AAL) argued that the royalty income was section 904(d)(1)(I) general limitation income, based on the look-through rule for controlled foreign corporations. But the Tax Court held that the rule did not apply to payments from foreign parents to domestic subsidiaries.
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