Tax Executives Institute--U.S. Department of Treasury Office of Tax Policy liaison meeting February 8, 2005.
II. 2004 Act Guidance
TEI commends the IRS and Treasury Department for their outreach in respect of guidance under the American Jobs Creation Act of 2004 (Pub. L. No. 108-357). The new law requires the government to issue clarifying rules within a tight timeframe and the collaborative approach helped ensure that the resulting guidance dealt with taxpayers' real-world concerns. We appreciate the government's efforts to issue guidance expeditiously and to draw TEI and its members into the process.
b. Repatriation Guidance:
New section 965 of the Internal Revenue Code provides that a U.S. shareholder may elect an 85-percent dividends-received deduction with respect to certain cash dividends received from the shareholder's controlled foreign corporation.
Based on the feedback we have received, taxpayers are generally pleased with Notice 2005-10, which was issued on January 13, 2005, and provides guidance concerning section 965. The Notice provides specific guidance on domestic reinvestment plans and investments in the United States under section 965(b)(4)(B). TEI is still reviewing the Notice, but we have identified the following issues that need clarification:
Section 5.02 provides that, other than expenditures for executive compensation, expenditures incurred in connection with the funding of worker hiring and training are permitted investments under the statute, including expenditures incurred for hiring new workers and training both existing and new workers, as well as "expenditures incurred on compensation and benefits." The latter phrase seemingly is very broad and encompasses compensation and benefit expenditures for new and existing workers. TEI recommends that the government clarify that this interpretation is correct.
Section 5.05 (b) provides that a dividend reinvestment plan may include funding for a qualified plan, as long as, in the taxpayer's business judgment, such funding improves the financial stability of the U.S. company. Consider the following example:
A U.S. parent has an underfunded foreign pension plan in CFC 1 and is ultimately responsible for curing that underfunding. May a dividend from CFC 2 that is then contributed to CFC 1 to cure the underfunded pension plan qualify as a dividend reinvestment plan if funding from the U.S. company would otherwise impair the financial stability of the U.S. company? In other words, if the U.S. company must borrow to fund CFC 1's pension plan, is its financial stability considered to be impaired?
In addition, would the payment of retiree medical expenses be considered an item that improves the financial stability of the company?
Section 5.07 provides that expenditures incurred on advertising or marketing with respect to trademarks, trade names, and brand names or "similar intangible property" are permitted investments. TEI recommends that the government clarify that the advertising and marketing expenditures are not limited to intangible property, but include tangible property as well.
Further Guidance. Sections 965(d) and (e) provide special rules limiting foreign tax credits and expense deductions and limiting the attributes available to offset the nondeductible portion of dividends. There is confusion about whether the tax on the income inclusion of 15 percent of a qualified distribution can be offset in whole or part by foreign tax credits that are carried over from prior years. What is Treasury's position on this issue?
Acquisitions. If a Target does not pay a dividend in 2005, must the Purchaser's base period be modified by Target's prior year dividends?
PTI. Will there be further guidance on the tracing of previously taxed income (PTI) on distributions from lower-tier subsidiaries? Consider, for example, a transaction that begins with a distribution from CFC 2 to CFC 1 creating subpart F income, which would be eligible for the 85-percent exclusion if it were ultimately distributed to the U.S. parent. If CFC 1 has PTI from prior years, however, is that earlier PTI separated from the PTI created in 2005 to permit tracing of the repatriation amount?
Expense Allocations. Finally, when will further guidance be issued on the allocation and apportionment of expenses to section 965 dividends?
Domestic Manufacturing Deduction:
Section 199 of the Internal Revenue Code provides a deduction for a percentage of income attributable to a taxpayer's qualified production activities income (QPAI), which is the excess of the taxpayer's domestic production gross receipts (DPGR) over allocable production expenses. Section 199(c)(4)(A) defines DPGR as including the taxpayer's gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States.
On January 19, 2005, the IRS and Treasury issued Notice 2005-14, which provides interim guidance on an extraordinarily broad set of issues relating to section 199. TEI commends the IRS and Treasury for acting so expeditiously and comprehensively in issuing guidance. We are still reviewing the Notice, but note the following issues:
Section 3.04(7)(d) provides that software sold to customers who take delivery of the software by downloading the software from the Internet qualifies for the domestic manufacturing deduction under section 199. On the other hand, gross receipts from software that is "merely offered for use to customers online for a fee are not DPGR.... These receipts are not DPGR because these receipts are attributable to the provision of a service and are not derived from the lease, rental, license, sale, exchange, or other disposition of the software."
The guidance makes an artificial distinction based on the amount of end use of the product. Software that is provided for use through the Internet can be, and often is, licensed, regardless whether the user downloads the software or uses it on the Internet.
Section 4.03 provides rules for determining a taxpayer's QPAI, noting that QPAI is determined on an item-by-item basis (and not, for example, on a division-by-division, product-line-by-product-line, or transaction-by-transaction basis). Subsection (1) provides that if a taxpayer manufactures a shirt and a hat in the United States and the QPAI derived from the manufacture of the shirt is $3 and from the hat is ($1), the taxpayers's QPAI is $2.
TEI finds the use of the term "item-by-item" confusing. The Notice implies that an item is equivalent to a product, identified by a model number or a part number or perhaps the stock keeping unit (SKU) for inventory purposes. Is this interpretation correct?
Section 4.04(4) provides that in contract manufacturing situations, if one taxpayer performs activities that qualify for the deduction under a contract with an unrelated party, then only the taxpayer that has the benefits and burdens of ownership of the property during the period the qualifying activity occurs is treated as engaging in the qualifying activity. The approach has raised concern among companies that structure their contract manufacturing arrangements to have title pass after the manufacturing stage (since it is often simpler to buy the finished goods rather than engage in a tolling process); for these companies, the contractor is producing the products using the companies' know how and specifications. Are any changes to this approach contemplated? Would the government consider deferring the effective date of the requirement to own raw materials and work-in-process inventory for one year?
Sections 4.04(5)(a) and (b) provide definitions of "in whole or significant part" and "substantial in nature." Subsection (c) provides a safe harbor that permits taxpayers to be treated as having MPGE property if, in connection with the property, conversion costs (direct labor and related factory burden) to MPGE property are incurred by the taxpayer within the United States and the costs account for 20 percent or more of the total cost of goods sold (CGS).
For purposes of determining whether the conversion costs of the MPGE property are substantial in nature, are design and development activities, packaging, repackaging, labeling, and minor assembly operations included in the total cost of goods sold and thus included in the denominator of the fraction of the 20-percent safe harbor test? TEI believes that these costs should be excluded from CGS.
Section 4.05(3) addresses other deductions allocable or apportionable to DPGR. How are the Extraterritorial Income Exclusion (EIE) and section 199 deduction treated for purposes of the allocation and apportionment of other deductions under section 861? Both the EIE and manufacturing deduction are determined at the taxable income level and require that all other deductions be allocated and apportioned under section 861 as a part of their respective computations. Because both provisions are in effect for the 2005 and 2006 tax years, each amount seemingly requires a simultaneous calculation.
TEI believes it is inequitable to further reduce each benefit if each is required to reduce the taxable income of the other before applying the applicable rate. Thus, the section 199 regulations could deem EIE to be one of the "deductions not attributable to the actual conduct of a trade or business" under section 4.05(3)(iv), and thus allocable or apportionable to DPGR for purposes of calculating the manufacturing deduction. Similarly, since the 2004 Act and legislative history refer to the "otherwise-applicable ETI benefits" under the prior law for the 2005 and 2006 transition calculations--which contained no provision for a domestic manufacturing deduction--it follows that the section 199 manufacturing deduction should not be allocated or apportioned to the taxable income used in the EIE calculation.
d. Mixed Use of Corporate Aircraft by Specified Individuals:
Section 907 of the 2004 Act amended section 274(e)(2) to overturn the result in Sutherland Lumber-Southwest, Inc. v. Commissioner, 255 F. 3rd 495 (8th Cir. 2000). For expenses incurred after October 22, 2004, the amount of the deduction for the cost of entertainment, amusement, or recreation facilities (including company-owned aircraft) used by specified individuals for nonbusiness purposes is limited to the amount of expenses treated as compensation or includible in income. Specified individuals include officers, directors, and 10-percent owners subject to the requirements of section 16(a) of the Securities and Exchange Act of 1934.
TEI urges the Treasury Department and IRS to issue guidance implementing this provision, especially for allocating costs for a mixed use of covered facilities by the specified individuals. For example, assume a company determines that a specified individual's use of a corporate aircraft after October 22, 2004, is entirely business related, but cannot establish that the travel of the specified individual's spouse (who accompanied the individual) is business related. Where the individual and spouse are the only passengers, the incremental operating cost of the aircraft for the spouse's travel is zero. Hence, the full cost of operating the aircraft should be deductible, notwithstanding the spousal travel.
There are many other cases of mixed uses of corporate aircraft where guidance is required in respect of determining the amount of the disallowed corporate deductions or income inclusions to the specified individuals.
Guidance is also needed concerning what expenses are to be included in the "disallowed pool" of expenses. For example, does the pool include expenses related to the aircraft only or does it include hanger expenses or the total cost of the aviation department?
III. Tax Shelters
a. Circular 230:
In December, the Treasury Department and IRS issued final and proposed regulations relating to Circular 230, which governs the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, tax return preparers, and other persons representing clients before the IRS. Section 10.33 of Circular 230 now provides certain "best practices" or "aspirational standards" for rendering tax advice, including "establishing the facts, determining which facts are relevant, evaluating the reasonableness of any assumptions or representations, relating the applicable law ... to the relevant facts, and arriving at a conclusion supported by the law and the facts" and "acting fairly and with integrity in practice before the IRS." The changes to Circular 230 are aimed at enhancing professionalism by emphasizing the importance of aspirational standards.
The new rules modify the standards applicable to practitioners who provide covered opinions concluding that the tax treatment of a federal tax item is at least more likely than not the proper treatment. Similarly, the new rules propose a standard for a "marketed" opinion, i.e., an opinion (including a "more likely than not" opinion) that a practitioner knows, or has reason to know, will be used or referred to by someone other than the practitioner, or someone at his firm, in promoting, marketing, or recommending a "tax shelter" to a taxpayer.
The relationship between TEI members and their "client," i.e., employer, is different from that of private practitioners and the rules must recognize that difference. Circular 230 is not easily applied to a taxpayer's self-representation without straining the definitions used by the Circular, which are generally aimed at tax practitioners employed by law and accounting firms. Clarification is needed concerning the effect and application of these rules on in-house tax professionals.
Although the rules are aimed at "tax shelter" transactions, TEI is concerned that their application to any "written statement," including emails, may adversely affect the ability of in-house tax professionals to efficiently provide or obtain high-quality tax advice. We invite a discussion whether these rules may be overbroad and counterproductive to enhancing compliance, especially in respect of routine tax planning.
In addition, in-house corporate tax professionals have substantial capabilities and seek only limited assistance from outside tax practitioners. For example, tax department personnel may themselves analyze and provide an opinion on a particular transaction and seek only confirmation of their analyses from outside practitioners. In these circumstances, the rules permit the tax adviser to issue a "limited scope" opinion whereby the taxpayer and adviser can agree that the scope of the opinion and the taxpayer's reliance on the opinion for purposes of avoiding penalties are limited to the federal tax issues addressed in the opinion.
The new accuracy related penalty in section 6662A does not apply to any portion of a reportable transaction understatement if the taxpayer demonstrates that it has reasonable cause and acts in good faith. Under Notice 2005-12, a taxpayer does not have reasonable cause and act in good faith unless (1) the facts affecting the transaction are adequately disclosed, (2) the taxpayer's position is or was supported by substantial authority, and (3) the taxpayer reasonably believed that its treatment of the item was more likely than not correct. An opinion of a tax adviser may not be relied upon to establish reasonable cause if the adviser or the opinion is disqualified. An opinion is disqualified if the opinion (1) is based on unreasonable factual or legal assumptions; (2) unreasonably relies on representations from the taxpayer (or any other person); (3) does not identify and consider all relevant facts; or (4) fails to meet any other requirements the Secretary may prescribe.
We are uncertain whether a "limited scope" opinion on reportable transaction issues discussed by the taxpayer with outside advisers will ever satisfy the requirement that the opinion identify "all relevant facts" or not "unreasonably rely on representations of the taxpayer." In nearly all cases involving routine tax advice for a reportable transaction, the taxpayer will be the source of the adviser's information for the facts and issues to be addressed. If the outside adviser relies on the taxpayer to supply the facts, does any opinion in respect of a reportable transaction that has "a significant purpose of tax avoidance" require a full-scope "reliance" opinion in order to afford the taxpayer with penalty protection?
We understand that the Treasury Department and IRS intend to revise Circular 230 to take into account the changes made by the 2004 Act. We also understand that the principles in Notice 2005-12 will be incorporated in the reportable transaction penalty regulations. We encourage the Treasury Department and IRS to ensure that the provisions defining reasonable belief for purposes of the reasonable cause and good faith relief mesh with the Circular 230 provisions on opinion standards, especially for "limited scope" opinions or for routine tax-planning advice.
b. Reasonable Cause and Good Faith
The 2004 Act revised the rules for satisfying the reasonable cause and good faith requirements of section 6664. Under the statute as interpreted in Notice 2005-12, an opinion of a tax adviser may not be relied upon to establish the reasonable belief of a taxpayer that the treatment of an item is more likely than not correct if the adviser or the opinion is disqualified. The Act applies to taxable years ending after the date of enactment (October 22, 2004).
Taxpayers may have engaged in one or more reportable transactions prior to the Act's effective date and obtained an opinion that, under the provisions and definitions of the Code as amended by the 2004 Act, would be considered disqualified. Under what circumstances, if any, are taxpayers required to obtain a new opinion--i.e., one not considered "disqualified"--in order to maintain the reasonable belief that the tax treatment of an item in a return filed prior to or after the date of enactment is more likely than not correct? In other words, when is a taxpayer required to "re-opinion an opinion" in order to maintain its reasonable belief that the treatment of the item is more likely than not correct?
Under Notice 2005-12, a taxpayer's reasonable belief is determined based on the law and facts that exist at the time of filing its return. If a return with a reportable transaction that was the subject of a "disqualified" opinion is filed before the effective date of the Act, is the opinion still valid for purposes of establishing a reasonable belief at the time of filing? What if the transaction occurs and the opinion is obtained before the effective date of the Act, but the return is filed subsequently?
In addition, if a transaction occurred in a prior year, but has continuing effect in a return subject to the Act's amendments, is the determination of the taxpayer's reasonable belief for positions in returns filed subsequently dependent on obtaining a new opinion for the prior transaction? Finally, would an amended return filed after the date of enactment that includes a reportable transaction require a new "qualified" opinion for the previously reported transactions?
IV. Tax Reform
On January 7, 2005, President Bush established the President's Advisory Panel on Federal Tax Reform, which is charged with producing a report "with revenue neutral policy options" that simplifies the Internal Revenue Code, reflects appropriate progressiveness, and promotes long-run economic growth and job creation. The report is due by July 31, 2005.
This appears to be a daunting task, particularly in light of the time and revenue neutrality constraints. What role will Treasury play in the tax reform debate? What steps should be taken to ensure that the final report is balanced and the proposed reforms administrable?
V. Status Reports
a. Withholding on Stock Options:
In a Field Directive dated March 14, 2003, IRS examiners were instructed, solely for penalty purposes, not to challenge the timeliness of employment and withholding tax deposits exceeding $100,000 that arise from the exercise of the stock options, as long as the deposits are made within one day of the settlement date of the option. In comments filed in June 2003, TEI urged that the Treasury Department and IRS issue rules of administrative convenience for FICA, FUTA, and income tax withholding related to NQSO exercises that are similar to those set forth in Notice 2001_73. Most NQSO plans are administered through stock brokers and the cash for the exercise price and employment and withholding taxes is not available to the employer on the date of exercise. We also suggest that employers be permitted to make the requisite tax deposits within a reasonable period of time following the settlement date. A reasonable period of time for making the deposit following the employer's receipt of notice from the broker that an option has been exercised would, at a minimum, be no earlier than the deposit date for the employer's next regularly scheduled payroll processing period for "cash" wages.
Is further guidance anticipated in this area?
b. Transfer Pricing Issues:
Please provide a report on the status of the cost-sharing regulations. Will they be issued before the section 482 services regulations become final? Will they be issued in temporary or proposed form?
What is the status of the transfer pricing study mandated by the 2004 Act?