TEI comments on Section 482 penalty, notional principal contracts, earnings stripping, and information reporting penalties.

As prospects for a tax bill ebbed during the last two months of 1991, Tax Executives Institute turned its attention to a tidal wave of IRS regulatory issues. That there has been an increase in the number of published regulations cannot be denied. According to Associate Chief Counsel (Domestic) Stuart Brown, in fiscal year 1990 the IRS issued 50 sets of regulations; in fiscal year 1991, the number rose to 113.

Specifically, the Institute filed comments on four regulatory subjects: the section 482 valuation misstatement penalty, information-reporting penalties, notional principal contracts, and so-called earnings stripping. On the administrative side, TEI responded to an IRS request for comments on the efficacy of a proposal to exclude dormant foreign subsidiaries from certain reporting requirements. In addition, the Institute followed up on its August 28 meeting with IRS and Treasury representatives with supplemental comments on the proposal to use U.S. generally accepted accounting principles in computing the earnings and profits of foreign corporations.

Finally, at the end of October, the Institute convened its 46th Annual Conference in Seattle. The conference is the subject of a separate story elsewhere in this issue.

Section 482 Penalty

According to comments submitted by TEI to the IRS on October 11, the IRS should issue immediate guidance to its field personnel not to assert the section 482 penalty until final "post-White Paper" regulations under section 482 are issued. The Institute's comments relate to a project recently opened by the IRS to develop regulations under section 6662(e) of the Code. The comments on the application of the valuation misstatement penalties to net section 482 transfer price adjustments expand on an earlier TEI submission relating to the accuracy-related penalties under section 6662 and the reasonable-cause exception under section 6664. (The accuracy-related penalty comments were reprinted in the May-June issue of The Tax Executive.)

In its written comments, TEI said that the 1986 Tax Reform Act changes to section 482 and the subsequent Treasury-IRS White Paper on transfer pricing have caused a significant controversy over the standards underlying section 482. Hence, it would be inequitable to assert the penalty until the basic standard is redefined. TEI explained that the fact-driven nature of section 482 transfer price disputes raises serious concerns over the propriety of imposing penalties in an area where the standard of conduct is not known or knowable in advance.

Under the 1990 Omnibus Budget Reconciliation Act, the IRS is to submit a report to Congress by March 1, 1992, on measures designed to "improve compliance" with section 482. TEI recommended that IRS endorse repeal of section 6662(e) as an ad hoc, ill-conceived appendage to the integrated penalty reform enacted in 1989.

Absent repeal of the statute, TEI proposed a number of safe-harbor categories that could be incorporated in forthcoming proposed regulations as standards of taxpayer conduct in the "reasonable-cause" and "good-faith" exception to imposition of the penalty. In particular, TEI advocated that reasonable cause existed where (1) there is a voluntary self-assessment of an adjustment through an amended return or otherwise; (2) the adjustment amount, though in excess of $10 million, is de minimis and, therefore not culpable, if less than 10 percent of the volume of intercompany transactions; (3) there was a lack of a tax avoidance purpose in setting the transfer price used (as evidenced by a high rate of tax on both sides of a transaction or the existence of competent authority procedures); (4) the taxpayer can demonstrate it relied on a prior audit result in setting its transfer prices; (5) there is adequate documentation of the pricing policy and its determination; (6) the foreign jurisdiction has an "arm's-length" transfer price standard and the foreign government has accepted the price used; or (7) the taxpayer engages competent, independent advisers to establish the transfer price.

During the week of October 14, TEI held preliminary discussions with Robert Culbertson, Acting Associate Chief Counsel (International), and other IRS representatives about its recommendations. TEI is preparing a response to questions raised by the IRS concerning its section 482 pending submission.

TEI's written comments, which are reprinted in this issue beginning on page 414, were developed under the aegis of the International Tax Committee, whose chair is Raymond G. Rossi of Intel Corporation. Also participating materially in the preparation of the comments were Lisa Norton of Ingersoll-Rand Corporation and Karen A. Radtke of General Motors Corporation.

Information Reporting

Regulations

The administration of the Code's penalty provisions continued in the vanguard of TEI's activities with the October 24 filing of comments with the IRS on the temporary and proposed regulations under sections 6721 through 6724 of the Code. These regulations pertain to the imposition of penalties for failure to comply with information reporting requirements. The regulations implement the 1989 reforms to the civil penalty provisions of the Code.

In its comments, TEI expressed concern about the exclusive nature of the proposed regulations with respect to the objective criteria for determining whether reasonable cause exists for a waiver of a penalty. Specifically, the Institute discussed the high burden of proof necessary for a filer to secure relief. TEI urged the IRS to temper the unduly stringent slant of the reasonable cause provision by revising the regulations to confirm that the examples of "mitigating factors," "events beyond the filer's control," and the description of "acting in a responsible manner" in the regulations are just that -- examples.

The Institute also criticized a rule that a filer may not establish reasonable cause for a failure owing to the unavailability of relevant business records unless the records have been unavailable for at least a two-week period prior to the due date of the return. Calling the two-week standard "arbitrary," TEI stated that "[i]t blithely ignores the fact that a supervening event preventing the availability of records could occur far less than two weeks before the due date of the return but nevertheless preclude timely filing." The Institute recommended that the regulations be revised to provide that no penalty will be imposed when, for example, a filer suffers a fire that destroys all business records one week before the due date.

TEI also commented on section 6721's time-sensitive tiered penalty structure, the exception for inconsequential errors or omissions, and the de minimis rule for failures to include correct information.

TEI's comments were prepared under the aegis of its Federal Tax Subcommittee on Payroll and Other Taxes, whose chair is Clifford H. Omo of Mobil Administrative Services Company Inc. Michael J. Nesbitt of Paychex, Inc. materially contributed to the preparation of the comments. The comments are reprinted in this issue beginning on page 420.

Earnings Stripping Regulations

On October 11, the Institute filed comments with the IRS on the proposed regulations issued under section 163(j) of the Code, relating to the deductibility of interest paid by a U.S. affiliate to a related entity where no or very little tax is paid (so-called earnings stripping). The provision limits the U.S. interest deduction when (1) a corporation's debt-to-equity ratio exceeds 1.5 to 1; (2) the interest is paid to a related party who is exempt from U.S. taxation; and (3) the corporation has "excess interest expense," i.e., its net interest expense exceeds 50 percent of its adjusted taxable income plus the excess limitation carryforward.

The Institute made recommendations concerning two areas upon which the IRS had requested comments: interest equivalents and loan guarantees. TEI said that the definition of interest equivalents should be limited to items that predominantly reflect the time value of money or in substance represent payments for the use or forbearance of money. The Institute also recommended that loan guarantees merely securing more favorable interest rates or other loan terms not subject the interest to the earnings stripping rules. This determination should be based on the facts and circumstances that exist at the time the guarantee is made, TEI said.

Other areas addressed by the Institute included: (1) the adjustments for accounts receivable and payable required in computing adjusted taxable income; (2) the treatment of adjusted taxable losses; (3) the one-way nature of the anti-abuse and anti-stuffing rules; (4) the definition of affiliated group; and (5) the fixed stock write-off method.

The Institute's written comments were prepared under the aegis of its International Tax Committee, whose chair is Raymond G. Rossi of Intel Corporation and its Non-U.S. Owned Multinational Corporations Subcommittee, whose chair is Robert L. Ashby of Northern Telecom Inc. Byron Furseth of Shell Oil Co. and Alan Getz of Mitsui & Co. (USA) contributed materially to the preparation of the submission. The comments are reprinted in this issue beginning on page 425.

Comments on Notional

Principal Contracts

On November 4, TEI filed comments on proposed regulations under section 446 concerning the accounting treatment for notional principal contracts (NPCs). In its comments, TEI commended the IRS for providing guidance on the issue of the timing of income and deductions related to periodic and nonperiodic payments for notional principal contracts. TEI encouraged the IRS to provide further guidance on the integrated accounting for NPCs used as hedges of assets and liabilities.

TEI criticized the accounting requirements for lump-sum payments, suggesting that the required use of option pricing models was incredibly complex. TEI suggested that the regulations should adopt a "rough justice," simplified straight line method of amortizing such payments. TEI also criticized the trap for the unwary caused by the requirement that the non-assigning party recognize gain or loss when a termination payment is made to assign an NPC.

Proposed regulations under section 1092, dealing with straddles, were also issued in conjunction with the accounting rules for NPCs. Under these rules, NPCs are classified as interests in "actively traded personal property" subject to the section 1092 loss deferral rules. TEI explained that the terms of NPCs are affected by the creditworthiness of the counter-parties and are characterized by negotiation of each contract (even if under an umbrella agreement). As a result, NPCs are not "actively traded" in the sense of standardized stock, options, commodity, or futures contracts. TEI also requested the IRS to defer characterizing gains or losses on NPCs as capital in nature until it resolves, by further regulatory guidance, the implications for business hedges raised by the Supreme Court in the Arkansas Best decision.

TEI's comments, which begin on page 433, were prepared under the aegis of TEI's Federal Tax Committee, whose chair is David F. Nitschke of Amerada Hess Corporation. Also contributing substantially to TEI's submission were Donald N. Adler of Dean Witter Financial Services Group and Philip G. Cohen of Unilever United States.

Form 5471:

Dormant Subsidiaries

On September 12, TEI commented on the development of a revenue procedure that would exempt U.S. corporations from filing a Form 5471 (Information Return of U.S Persons with respect to Foreign Corporations) with respect to "dormant subsidiaries." The comments took the form of a letter from TEI President Reginald W. Kowalchuk to David I. Bower of the Office of Associate Chief Counsel (International).

In its comments, TEI endorsed the issuance of a revenue procedure that would exempt U.S. parents from the requirement to file a Form 5471 for their inactive controlled foreign corporations. In lieu of the Form 5471, TEI suggested that a U.S. corporation be permitted to attach a list to its tax return of those companies to which the exemption applied. The Institute also propose a definition for the term "dormant subsidiary."

The Institute's comments were prepared under the aegis of its International Tax Committee, whose chair is Raymond G. Rossi of Intel Corporation.

Use of U.S. GAAP to

Compute E&P

Following up on a prior submission, TEI on October 21 filed comments with the IRS on the use of U.S. generally accepted accounting principles (GAAP) to compute the earnings and profits (E&P) of foreign corporations. The comments, which took the form of a letter from TEI President Reginald W. Kowalchuk to IRS Commissioner Fred T. Goldberg, Jr., are reprinted in this issue beginning on page 431. (The Institute's March 27 comments on this issue were reprinted in the March-April issue of The Tax Executive.)

In this latest submission, the Institute urged the IRS to recognize and sanction "the 'real world' compliance procedures that taxpayers may already be employing." While recognizing that the adoption of the U.S. GAAP E&P proposal was not a "perfect solution" to the interaction of the E&P calculation with Subpart F, the Institute nevertheless stated that "the proposal constitutes 'rough justice' for both the IRS and taxpayers" by reducing compliance burdens without violating sound tax policy goals.

Other issues addressed in TEI's comments included the effect of the U.S. GAAP E&P proposal on the sale or disposition of a capital asset and the availability of GAAP financial statements. The comments were prepared under the aegis of its International Tax Committee, whose chair is Raymond G. Rossi of Intel Corporation.