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Tax laws are constantly evolving. In fact, the only thing you can count on is change—and industry-leading tax content from LexisNexis®. …

Tax laws are constantly evolving. In fact, the only thing you can count on is change—and industry-leading tax content from LexisNexis®.

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  • 1. LEXIS® FEDERAL TAX JOURNAL QUARTERLY September 2013 IN THIS ISSUE: Featured Articles Allison Christians on Reversal of Fortune: Did  PPL Corporation Get a Foreign Tax Credit  from the Wrong Government?    Dmitriy Kustov on Portfolio Interest:  Free  Money    Joel S. Newman on Deductions on a Higher  Plane:  Medical Marijuana Business Expenses    Special International Update Tim Sanders and Eric Sensenbrenner on U.S.  Inversions Through European Mergers  Practitioner’s Corner Robert S. Chase II, et al. on The End of an  Era: IRS Expands “No Rule” Policy for Spin‐ Offs and Other Common Corporate  Transactions    Adam B. Cohen, Vanessa A. Scott, Carol A.  Weiser, et al. on Fall of the DOMA‐n  Empire: Practical Employee Benefits  Implications Lexis Commentary Deanne B. Morton on The Medical Excise Tax:  Is  Repeal the Right Therapy?    Current Developments  CORPORATIONS  Final Treasury Regulations, TD 9619  EMPLOYMENT  Notice 2013‐17, 2013‐20 IRB 1082  HEALTH CARE  Revenue Procedure 2013‐25, 2013‐21 IRB 1  Notice 2013‐41, 2013‐29 IRB 60  Notice 2013‐42, 2013‐29 IRB 61  MEDICAL RELATED TAXES Proposed Regulations, 78 FR 27873‐27877  PARTNERSHIPS   Announcement 2013‐30, 2013‐21 IRB 1134   Final Treasury Regulations, TD 9623  PRACTICE & PROCEDURE   Final Treasury Regulations, TD 9618  Revenue Procedure 2013‐32, 2013‐28 IRB 55  REAL ESTATE  Revenue Procedure 2013‐27, 2013‐24 IRB 1243  SECURITIES TRANSACTIONS  Revenue Procedure 2013‐26, 2013‐22 IRB 1160  Notice 2013‐38, 2013‐25 IRB 1251  Notice 2013‐48, 2013 IRB LEXIS 355 
  • 2.   QUESTIONS ABOUT THIS PUBLICATION? _____________________________________________________________________ For questions about the Editorial Content appearing in this publication or for reprint permission, please call: Deanne B. Morton, J.D., LL.M. (in Taxation), at 1-800-424-0651 x3264 Email: For assistance with shipments, billing or other customer service matters, please call: Customer Services Department at 800-833-9844 Outside the United States and Canada, please call 518-487-3000 Fax number 518-487-3584 Customer Service Website For information on other LexisNexis® Matthew Bender® products, please call Your account manager or 800-223-1940 Outside the United States and Canada, please call 518-487-3000 _____________________________________________________________________ Cite to articles in this publication as: Author name, Article name, [vol. no.] Lexis® Federal Tax Journal Quarterly [Ch. no.], § [sec. no.] [Matthew Bender] Example: Allison Christians, Allison Christians on Reversal of Fortune: Did PPL Corporation Get a Foreign Tax Credit from the Wrong Government?, 2013-09 Lexis® Federal Tax Journal Quarterly 1, § 1.01 [Matthew Bender]. ____________________________________________ This publication is designed to provide authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other assistance is required, the services of a competent professional should be sought. LexisNexis, Lexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. Matthew Bender is a registered trademark of Matthew Bender Properties Inc. Copyright © 2013 Matthew Bender & Company, Inc., a member of LexisNexis® All rights reserved. No copyright is claimed in the text of statutes, regulations, and excerpts from court opinions quoted within this work. Permission to copy material exceeding fair use, 17 U.S.C. § 107, may be licensed for a fee of 25¢ per page per copy from the Copyright Clearance Center, 222 Rosewood Drive, Danvers, Mass. 01923, telephone (978) 750-8400. Editorial Offices 121 Chanlon Road, New Providence, NJ 07974 201 Mission Street, San Francisco, CA 94105  
  • 3. Table of Contents Featured Articles Allison Christians on Reversal of Fortune: Did PPL Corporation Get a Foreign Tax Credit from the Wrong Government? § 1.01 Introduction § 1.02 The Controversy § 1.03 The “Windfall Tax” § 1.04 The Claim of Right Doctrine § 1.05 Conclusion Dmitriy Kustov on Portfolio Interest: Free Money § 2.01 Introduction: Tax-Free Interest in a Financially Troubled World § 2.02 The Enactment of the Portfolio Interest Tax Exemption [1] Capital Formation and Balance of Payments [2] Tax Equity Arguments [3] Tax Avoidance and Evasion [4] Subsequent Developments § 2.03 Requirements of the Portfolio Interest Income Exemption [1] U.S. Person [2] Foreign Person [a] Required Statement Proving Foreign Residency [b] Foreign Bank [c] Controlled Foreign Corporation (CFC) [d] “10-Percent Shareholder” [3] Registered Form [a] Regulations C(1): Physical Form [b] Regulations C(2): Book Entry [4] Contingent Interest [5] Jurisdiction Not “Blacklisted” by the Secretary [6] Effectively Connected Income (ECI) [a] Asset Test [b] Activities Test [7] Side Kick: Estate Tax § 2.04 Conclusion Joel S. Newman on Deductions on a Higher Plane: Medical Marijuana Business Expenses § 3.01 Introduction § 3.02 Two Tax Court Cases [1] CHAMP v. Commissioner [2] Olive v. Commissioner [3] CHAMP and Olive Compared § 3.03 IRS Enforcement in Context
  • 4. § 3.04 Current Efforts [1] Harborside [2] Legislative Lobbying [3] Lobbying the Attorney General and the DEA [4] Litigation Strategy § 3.05 The Future Special International Update from Lexis Tax Journal Magazine Tim Sanders and Eric Sensenbrenner on U.S. Inversions Through European Mergers § 4.01 U.S. Inversions Through European Mergers Practitioner’s Corner Robert S. Chase II, et al. on The End of an Era: IRS Expands “No Rule” Policy for SpinOffs and Other Common Corporate Transactions § 5.01 The End of an Era: IRS Expands “No Rule” Policy for Spin-Offs and Other Common Corporate Transactions Adam B. Cohen, Vanessa A. Scott, Carol A. Weiser, et al. on Fall of the DOMA-n Empire: Practical Employee Benefits Implications § 6.01 Fall of the DOMA-n Empire: Practical Employee Benefits Implications Lexis Commentary Deanne B. Morton on The Medical Excise Tax: Is Repeal the Right Therapy? § 7.01 Introduction § 7.02 Defining the Tax [1] Generally [2] Definitions [a] Manufacturer, Producer, or Importer [b] Taxable Medical Device; Dual Use Device [c] Taxable Sales Price for Calculating the Tax § 7.03 Exemptions [1] Retail Exemption [a] Facts and Circumstances Test [b] Retail Exemption Safe Harbor [2] Other Exemptions § 7.04 Applicable Form and Payment Procedures § 7.05 Deposit Safe Harbor and Penalties § 7.06 Prospects for Repeal § 7.07 Conclusion
  • 5. Current Developments § 8.01 CORPORATIONS Final Treasury Regulations TD 9619 Final Treasury Regulations TD 9622 § 8.02 EMPLOYMENT Notice 2013-17 § 8.03 HEALTH CARE Revenue Procedure 2013-25 Notice 2013-41 § 8.04 MEDICAL RELATED TAXES Proposed Regulations 78 FR 27873-27877 § 8.05 PARTNERSHIPS Announcement 2013-30 Final Treasury Regulations TD 9623 § 8.06 PRACTICE & PROCEDURE Final Treasury Regulations TD 9618 Revenue Procedure 2013-32 § 8.07 REAL ESTATE Revenue Procedure 2013-27 § 8.08 SECURITIES TRANSACTIONS Revenue Procedure 2013-26 Notice 2013-38 Notice 2013-48                
  • 6. Featured Articles Allison Christians on Reversal of Fortune: Did PPL Corporation Get a Foreign Tax Credit from the Wrong Government? By Allison Christians § 1.01 Introduction In PPL Corp. v. Commissioner,1 the Supreme Court reminded us that a foreign government’s characterization of its own tax is not dispositive in deciding whether the tax ought to be creditable in the United States. This dismissal accords with the established doctrine around the creditability of a tax, which determines whether something is a tax at all, and, if so, whether it is an income tax, according to U.S. principles.2 But something important seems to have been lost in this approach; namely, that the tax in this case seems, in the words of Third Circuit Court Judge Ambros, “a bridge too far”3 from the kind of income tax that the foreign tax credit was designed to alleviate. The tax in question appears instead to force a disgorgement of profits in order to, in effect, re-price a preexisting sale of a company using the benefit of hindsight to determine the then-fair market value. The doctrine surrounding the creditability of a tax—which now, due to the PPL Corp. decision, expressly allows a re-configuration of a foreign tax to accord with U.S. income tax principles—does not seem to have a means of dealing with the distinction between an income tax qua income tax and an income tax qua disgorgement of profits. That is troubling because the end result in PPL Corp. is that the U.S. fisc bore the brunt of not one, but two foreign taxes imposed on the same income stream by the same foreign government. Instead, the U.S. could have borne no cost at all to the extent the second tax in effect wiped out profits that had been subject to the foreign income tax in the first place. To understand why this might have been so requires both an examination of the controversy that led to the Supreme Court decision in the first place, as well as another look at the U.K.’s intentions in enacting the tax in question. § 1.02 The Controversy The controversy between PPL Corp. and the IRS arose as a result of a law passed by the British Parliament in 1997, enacting what it called a “windfall tax” on 32 energy companies.4 PPL Corp. owned shares in one such company at the time the tax was levied, and it accordingly sought a credit against its U.S. tax liability for its share of the U.K. liability paid.5 The IRS had previously denied the creditability of the windfall tax in a private letter ruling issued in 2007 on the grounds that “[b]y its express terms, the                                                               Allison Christians is the H. Heward Stikeman Chair in Taxation Law at McGill University Faculty of Law. Special thanks to Montano Cabezas for excellence in research assistance with this article. 1 133 US 1897 (2013). The ruling reversed the judgment of the Third Circuit (665 F3d 60 (3d Cir 2011)), and settled a split with the Fifth Circuit in Entergy Corp v Commr, 683 F3d 233 (5th Cir 2012). 2 Treas Reg § 1.901-2(a)(2) (“A foreign levy is a tax if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes. …. [which] is determined by principles of U.S. law and not by principles of law of the foreign country.”), Biddle v Commr, 302 US 573 (1938). 3 PPL Corp v Commr, 665 F3d 60, 65 (3d Cir 2011). 4 Finance (No 2) Act 1997, c. 58, Pt I, clause 1 (Eng.). 5 PPL Corp v Commr, 135 TC 304 (2010).
  • 7. U.K. Windfall Tax … is a tax on the appreciation of the company above its flotation value.”6 Accordingly, the IRS denied PPL’s credit. But PPL viewed the tax as one on income because the terms of the foreign statute assessed “value” by reference to profits. PPL argued that the lawmakers used the term “value” in the statute for political reasons, and by reconfiguring the formula used to calculate value, it could be shown that, in effect, the statute imposed a 51.75 percent tax on “excess profits” earned by the taxpayer over a specified period of time. The case went to the Tax Court, along with an identical case brought by Entergy Corporation.7 The Tax Court decided in favor of the taxpayers in both cases, finding that the tax was creditable under IRC section 901 since it “did, in fact, ‘reach net gain’ as required by the applicable Treasury Regulation.”8 But on appeal, a circuit split ensued. The Third Circuit reversed the Tax Court, holding that the windfall tax failed the regulatory standards for creditability in the U.S., and rejecting the taxpayer’s algebraic reformulation of the statute on the grounds that accepting such a reformulation would virtually eliminate any limitation on creditability.9 Conversely, the Fifth Circuit affirmed the Tax Court, holding that the tax was, in substance, based on excess profits.10 The Supreme Court accepted the petition for writ of certiorari and resolved the split in the taxpayer’s favor, deciding that the windfall tax was in effect, if not necessarily in form, imposed on the basis of profits.11 The Supreme Court declined to spend much time on the U.K. government’s intentions in enacting the windfall tax, given the decision to treat such intentions as non-dispositive.12 Yet a reflection on the U.K. government’s intentions in adopting the tax reveals that any entitlement PPL Corp. had to a tax credit should have been against the government that imposed the forced disgorgement, and not against the United States. That is because an extraction that is a forced disgorgement of profits—which clearly seems to have been the purpose of the U.K. windfall tax—represents an undoing of an “error”, which in this case was carried out by the former U.K. government in its sale of the energy companies at a below-market price.                                                              6 Ltr Rul 200719011 (stating that “[t]he statutory language of the U.K. Windfall Tax … is clear and does not satisfy the net gain requirement of Treas Reg §1.901-2(b)”). 7 Entergy Corp v Commr, TC Memo 2010-166. 8 PPL Corp v Commr, 135 TC 304 (2010). 9 PPL Corp v Commr, 665 F3d 60, 67 (3d Cir 2011), “[a]ny tax on a multiple of receipts or profits could satisfy the gross receipts requirement, because we could reduce the starting point of its tax base to 100% of gross receipts by imagining a higher tax rate.”). 10 Entergy Corp v Commr, 683 F3d 233 (5th Cir 2012). 11 Petition for Writ of Certiorari, July 9, 2012, available at 12 It is perhaps of note that one of the original reasons to view foreign government intentions as non-dispositive was revenue-protective in nature: those who viewed the foreign tax credit mechanism as a gift of revenue to other countries feared that foreign governments would characterize their pre-existing taxes as income taxes in order to make them available for credit in the U.S. Focusing on their substantive nature would serve to thwart such formalistic efforts. For a discussion of this history, see Graetz & O'Hear, “The ‘Original Intent’ of U.S. International Taxation,” 51 Duke L J 1021 (1997). The PPL Corp decision thus presents an irony in that the foreign government did not intend the windfall tax to be considered an income tax for domestic purposes and even rejected their creditability for foreign income tax purposes, but the taxpayer’s substance-over-form argument ultimately led the U.S. government to sacrifice revenue anyway.
  • 8. § 1.03 The “Windfall Tax” That the U.K. tax was intended to be a disgorgement of profits is apparent from both the record of the PPL Corp. decisions and the public discussion surrounding the enactment of the law in 1997, even if not discussed in the Supreme Court decision. In the Tax Court decision, Judge Halpern states the details surrounding the enactment of the windfall tax. The main theme, repeated throughout the briefs of the parties and in the decisions of the various courts, is that the windfall tax was enacted as a political response to widespread public discontent over high consumer energy prices, which were juxtaposed against what were viewed as excessive profits being earned by energy companies and excessive salaries for their managers. These companies had been privatized under the Thatcher government, and it seems clear from Judge Halpern’s and others’ discussions of the context of the tax that “the public retained a strong feeling that the privatized utilities had unduly profited from privatization and that customers had not shared equally in the gains therefrom.”13 In some ways it makes sense to disregard the U.K. government’s characterization of the tax, given that the politics of tax policy are always shaped by emotional appeal rather than technical design. In this case, lawmakers repeatedly confused the base of the tax in explanations of their legislation to the public. Gordon Brown, then Chancellor of the Exchequer, called the legislation a tax on excess profits, but then characterized its substance as a clawback of value lost by the taxpayer when the prior government underpriced and under-regulated the energy companies.14 The U.K. tax authority similarly deemed the legislation a tax on excess profits, but then explained that the tax fell on the difference between two estimated values of the targeted companies: that initially determined by the former government and that recalculated by the current government.15 The U.K. Treasury, for its part, explained that the tax was required “because the companies were sold too cheaply and regulation … was too lax.”16 At the same time, the social and political context of a given tax seems particularly relevant when, as in this case, an argument could be made that the economic impact of the tax is not—or not only—imposed on the basis of profits, as the Supreme Court notes, but is in fact imposed for the purpose of clawing back the profits all together. There must be a difference between such a clawback and the act of imposing an income tax. That difference probably lies somewhere in the underlying policy goals of income taxation, which include, at their core, the requirement that income taxation be based on ability to pay.17                                                              13 PPL Corp v Commr, 135 TC 304, 310 (2010). Chancellor Brown explained that “I believe I have struck a fair balance between recognising the position of the utilities today and their under-valuation and under-regulation at the time of privatisation. The windfall tax will be related to the excessively high profits made under the initial regime. A company's tax bill will be based on the difference between the value that was placed on it at privatisation, and a more realistic market valuation based on its after-tax profits for up to the first 4 full accounting years following privatisation.” Id at 315 (2010). 15 According to Inland Revenue, the windfall tax was to be charged “on the difference between company value, calculated by reference to profits over a period of up to four years following privatisation, and the value placed on the company at the time of flotation.” Id. 16 Id at 340. 17 See, e.g., R Goode, The Individual Income Tax (1976); Dodge, “Theories of Tax Justice: Ruminations on the Benefit, Partnership, and Ability-to-Pay Principles,” 58 Tax L Rev 399 (2005); Fleming, Peroni & Shay, “Fairness in International Taxation: The Ability-to-Pay Case for Taxing Worldwide Income,” 5 Fl Tax Rev 299 (2001); Nancy Kaufman, “Fairness and the Taxation of International Income,” 29 Law & Pol’y in Int’l Bus 145 (1998). 14
  • 9. Various aspects of the U.K. tax legislation suggest that this tax was not designed to consider ability to pay as a fundamental matter. For example, the tax was a one-time levy; it applied only to the specified taxpayers, and could not and would not ever apply to any taxpayer other than those named specifically as a class; it was retroactive; it was specifically designed and formulated to raise a pre-determined amount of revenue, and it did raise that amount of revenue; and finally, its form was specifically chosen to ensure it would not be viewed as a tax on profits.18 The various U.S. courts dismissed each of these factors as nondispositive to the question of whether the “predominate character” of the tax was of an income tax in the U.S. sense, per U.S. regulations. Yet together, the factors paint a picture of a tax that is not, in qualitative terms, an income tax. Justice Thomas’s ultimate admonition was that we ought to assess the foreign tax in question from the perspective of common sense. That is a perilous proposition because the common sense of the Court had it crediting a tax that arguably does not look like an income tax in any sense other than under the formulaically reconfigured version presented by the taxpayer. Moreover, an alternative common sense interpretation of the tax could have employed the claim of right doctrine to explain that the tax credit sought by the taxpayer should have been applied not against its income for U.S. purposes at all, but rather against the income tax initially imposed by the U.K. on the income that later became subject to the windfall tax. § 1.04 The Claim of Right Doctrine In U.S. tax law, when a taxpayer has received income and later is determined not to have been legally entitled to it, she can take a credit against future income to, in effect, undo the inclusion of income in the prior year.19 Under this “claim of right” doctrine, the taxpayer is saved from permanently bearing an incorrect amount of tax solely because an administrative convention—namely, the tax year—had the taxpayer including income and paying tax on that income before the error was discovered. Obviously, [if the error and its discovery thereof] had happened in the same year, no error correction would be needed, since the taxpayer would simply refrain from including the income subsequently discovered to legally belong to another. But if the error and discovery happen in two different years, some mechanism is needed to right the administratively-produced wrong. That mechanism is a tax credit. Under IRC section 1341, “if an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item,” then the tax in the current year is reduced by the amount of the tax imposed in the prior year.20 In the present case, the taxpayer had a colorable claim of right case against the U.K. revenue authority. If the windfall tax was truly meant to disgorge profits and was not, as its designers scrupulously sought to avoid, a second tax on profits,21 then we might expect the taxpayer to have sought a credit against its U.K. income tax in the prior year for the amount of income disgorged via the 1997 windfall tax. If PPL Corp. had succeeded in making a claim of right argument in the U.K., this would have eliminated the original income to which the regular income tax had been applied. That, in turn, could have prompted a claim of                                                              18 PPL Corp v Commr, 135 TC 304, 312-314 (2010). See, e.g., North American Oil Consolidated v Burnet, 286 US 417 (1932); IRC § 1341 (computation of tax where taxpayer restores substantial amount held under claim of right). 20 IRC § 1341(a). 21 See PPL Corp v Commr, 135 TC 304, 312 (2010) (designers sought to avoid “a risk of criticism that it constituted a second tax on the same profits.”). 19
  • 10. right adjustment in the opposite direction in the United States, so as to undo any foreign tax credits that had been taken in the prior year with respect to taxes on income that were subsequently disgorged.22 Of course, the claim of right doctrine is a U.S. principle, so the question would be whether the U.K. has an equivalent regime and whether the taxpayer availed itself of it. But therein lies another issue in the PPL Corp. decision, which was neither discussed by the parties nor the Court; namely, the regulatory requirement that a U.S. taxpayer minimize its foreign tax liability in order to claim the foreign tax credit in the U.S.23 This foreign tax minimization rule suggests that if the windfall tax indeed gave rise to the disgorgement of profits its designers intended, then PPL Corp., Entergy Corp., and any other U.S. taxpayer that had been indirectly charged with the windfall tax should have made an effort (even if unsuccessful) to have the tax treated as a disgorgement under domestic U.K. law as well as under the U.S.-U.K. tax convention,24 in order to ensure the U.S. creditability of the original income tax on the profits when they were originally earned. Indeed, a convincing case has already been made that PPL Corp. improperly failed to avail itself of tax relief under the existing tax convention.25 The regulations under IRC section 901 suggest that the taxpayer’s failure to turn to the treaty to seek relief, including via its dispute resolution mechanism, could render the windfall tax not creditable even today, notwithstanding its now-undisputed character as an income tax under U.S. law. As such, even after the PPL Corp. decision—and maybe even because of the PPL Corp. decision, since that case cemented the windfall tax’ character as an income tax—the IRS has an avenue to renew its rejection of the tax credit relief sought by the taxpayer. Accordingly, if the U.K. windfall tax was a disgorgement of profits, then a series of events unfolds that would reverse the U.S. foreign tax credit not once but potentially twice, after the PPL Corp. decision. First, the income that had been earned by the energy companies in the period covered by the windfall taxes (between 1984 and 1996) would have been reduced by the amount calculated under the windfall tax statute. To the extent that a U.S. company owned shares in those companies during the years in question, such companies may have credited their U.S. tax liabilities by an amount of normal income taxes (not windfall taxes) paid to the U.K. tax authority in those years. As the underlying income would have been reduced by the windfall tax, so too would the foreign tax on such income and in turn the U.S. tax credit.                                                              22 See IRC § 1341(a)(2). Treas Reg § 1.901-2 (e)(5) (“An amount paid is not a compulsory payment, and thus is not an amount of tax paid, to the extent that the amount paid exceeds the amount of liability under foreign law for tax. An amount paid does not exceed the amount of such liability if the amount paid is determined by the taxpayer in a manner that is consistent with a reasonable interpretation and application of the substantive and procedural provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer’s reasonably expected liability under foreign law for tax, and if the taxpayer exhausts all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer's liability for foreign tax (including liability pursuant to a foreign tax audit adjustment.”). 24 Convention Between The Government Of The United States Of America And The Government Of The United Kingdom Of Great Britain And Northern Ireland For The Avoidance Of Double Taxation And The Prevention Of Fiscal Evasion With Respect To Taxes On Income And On Capital Gains, art. 10, TIAS 13161 (2001). 25 Cameron, “PPL Corp.: Where's the Treaty Argument?,” 138 Tax Notes 1117, reprinted in 69 Tax Notes Int’l 951 (2013). 23
  • 11. Thus the company would need to adjust its income tax for U.S. purposes under the claim of right rule, to reflect the amount of income, and the corresponding tax, based on the post-disgorgement amounts. Of course, this is all a rather complicated undoing of income, taxes, and income tax credits. Perhaps the common sense approach of the Court is compelling in its simplicity: viewing the windfall tax as an income tax allows a circumvention of the implications of a foreign government forcing a disgorgement of profits and the domino effect created by the subsequent unwinding. But the cost of this simplicity is that it is the U.S. fisc, and not the U.K. treasury, that ultimately bore the cost of the U.K. windfall tax at issue in the PPL Corp. decision. § 1.05 Conclusion It doesn’t seem obvious that the U.S. fisc ought to bear the kind of cost imposed by the U.K. windfall tax as if it involved a standard exercise of the foreign tax credit.26 Even if, as the petitioner successfully argued in PPL Corp., the tax can be reconfigured algebraically to resemble one on profits and therefore an income tax in the U.S. sense, it is not clear that the tax should be so reconfigured as a matter of coherent tax policy. The foreign tax credit was designed to eliminate duplicative taxes on the same income.27 In this case the foreign tax was, according to its own designers, not meant to be an iteration of a domestic income tax but rather was intended to perform a distinct and independent function; namely, the disgorgement of profits. If it nevertheless catches the same base as an income tax would in the United States, should the foreign tax credit really apply? The Supreme Court suggests that the answer is yes, under current law. But the result invites us to reconsider what the foreign tax credit is meant to accomplish as a policy matter, and whether these goals are in fact served when we dismiss evidence that the foreign government expressly intended the tax in question to accomplish a very different result than that normally sought through income taxation.                                                              26 The U.S. fisc bears the foreign tax credit as a cost in the sense that it represents revenue forgone. Thus, changes to the mechanism for claiming the foreign tax credit can have significant budgetary impacts. See Office of Management and Budget, Fiscal Year 2014, Analytical Perspectives, Budget of the U.S. Government, 187-190 (2013) available at The tax credit is not characterized as a tax expenditure because it is viewed as a structural component of the income tax rather than a deviation therefrom. See discussion of tax expenditures, id at 143, 241-258 (“tax expenditures refer to the reduction in tax receipts resulting from the special tax treatment accorded certain private activities.”). However, a too-generous tax credit, which credits things that are not duplicative of the income tax in nature, should be considered a tax expenditure. See, e.g., Fleming & Peroni, “Can Tax Expenditure Analysis Be Divorced from a Normative Tax Base?: A Critique of the ‘New Paradigm’ and Its Denouement,” 30 Va Tax Rev 135 (2010). 27 For a discussion and critique, see Shaviro, “The Case Against Foreign Tax Credits,” 3 J of Legal Analysis 65 (2011).
  • 12. Dmitriy Kustov on Portfolio Interest: Free Money By Dmitriy Kustov § 2.01 Introduction: Tax-Free Interest in a Financially Troubled World Following the world’s recent financial troubles, governments worldwide are seeking new sources of revenue, raising tax rates, promising (only, it seems) to close gaping tax loop holes, attempting to increase tax compliance generally, and actively fighting against bank secrecy jurisdictions and tax havens. In this financially troubled world, many U.S. taxpayers may well be surprised to learn that our government allows certain investors to pay absolutely no tax on interest they receive from some common forms of debt. In fact, most U.S.-based taxpayers are taxed at the highest applicable rates on the interest from these debt instruments while other persons receive the interest from the exact same debt instruments tax free. This tax free interest is the “Portfolio Interest” (PI) tax exemption. PI, broadly defined, is the interest on specified debt obligations paid to certain foreign persons. Since 1984, PI has been tax exempt, although interest in general had already been tax exempt for many foreign investors under various U.S. tax treaties. This article briefly discusses the enactment of the PI tax exemption, summarizes the policy and economic considerations behind the exemption, and then details the requirements under IRC Sections 871(h) and 881(c) for exempting non-resident aliens and corporations from taxation of PI. § 2.02 The Enactment of the Portfolio Interest Tax Exemption In 1984, the U.S. changed its game on certain interest income payments to non-residents. President Ronald Reagan signed into law the Deficit Reduction Act of 1984,1 repealing the tax on PI. Essentially, a pawn was sacrificed for bigger gains. On a closer look, it turned out to be an inexpensive move as Congress gave up only about $50 million in revenues due to the repeal.2 According to the 1977 statistics, roughly only about five percent of the total interest paid to nonresidents went to the coffers as most of the PI payments were already tax exempt under the provisions of various U.S. tax treaties. 3                                                               Dmitriy Kustov, CPA, EA, MS Tax (Golden Gate University) has more than fifteen years of experience in tax return preparation and tax consulting. He runs a boutique San Francisco accounting firm specializing in various tax issues concerning small and medium size businesses. 1 PL 98-369, 98 Stat 494 (July 18, 1984). 2 1977 projected statistics from HR 7553, Subcommittee on Selected Revenue Measures of the Committee on Ways and Means on June 19, 1980). 3 Compare this to the Deficit Reduction Act’s overall tax revenues increase of $18 billion per year coming on the heels of the Tax Equity and Fiscal Responsibility Act of 1982, PL 97-248, 96 Stat 324 (Sept 3, 1982), which raised taxes by $37.5 billion a year. See “Reagan was not a tax cutter, he was a tax raiser?” at
  • 13. Despite the minimal effect on tax revenues, the new law had its skeptics. A congressional committee had weighed in on the pros and cons of the measure four years before its enactment.4 The policy and economic factors the committee had considered included: 1) capital formation and balance of payments, 2) tax equity, and 3) tax avoidance and evasion. [1] Capital Formation and Balance of Payments Proponents of the repeal bet on a considerable infusion of foreign capital into the United States that would help the balance of payments, strengthen the dollar, assist in capital formation, and help create new jobs. Since this capital infusion would be in the form of debt and not equity, the inflow would also reduce the foreign ownership of U.S. businesses. As a result, U.S. owners would realize greater profits by leveraging debt from abroad. On the other hand, the opponents argued that the repeal of taxation on PI would merely substitute the PI-related obligations for other existing investment forms, rather than increase the total investment. Besides, the debt would need to be ultimately repaid, together with interest. These repayments would thus create a greater outflow of capital than the original infusion. Also, the increased debt would be directly contrary to the steps taken at that time to restrain the availability of credit in an attempt to reduce inflation.5 [2] Tax Equity Arguments Opponents of the PI tax exemption argued that it would be unfair to tax U.S. taxpayers and not to tax non-residents on the same type of income. Proponents countered that the proper comparison is not with the U.S. tax treatment of U.S. lenders but rather with the way in which other foreign countries tax similarly situated lenders from outside their borders. The second comparison is more appropriate because other countries’ tax regimes determine the environment in which U.S. borrowers must compete for foreign funds. For example, Australia, Denmark, France, Finland, Japan, the Netherlands, Norway, and Sweden do not impose withholding taxes, at least in the case of bonds issued in foreign currencies. Foreign lenders could always choose not to lend to U.S. companies and merely lend elsewhere.6                                                              4 “Every argument is like unto a dagger: two sharp and cutting sides” (Proverb). Inflation in January of 1980 was 14.38%, nearly at its highest level in recent history after it reached its peak in March of that year at 14.76%. 1980, however, saw a gradual reduction in inflation, which went uninterrupted through 1983 when it was rained in to the levels at around 3-4%. See Tim McMahon, “Historical Inflation Rate,” Apr 3, 2013, available at Perhaps, this victory over inflation paved the way for the portfolio interest tax repeal in 1984. If we ever see those inflation rates go up again, might the portfolio interest rules be tightened with an aim of combating inflation? This situation could probably depend on the amount of the capital borrowed versus GDP. The situation is very different now from when the tax was repealed. In 1981 the percent of U.S. debt of GDP was 32.5%, in 2012 it was 100.8% and growing. See United States Debt as a Percentage of GDP (1940-2012), available at The HIRE Act of 2010 (PL 111–147, 124 Stat 71 (Mar 18, 2010)) already excluded foreign targeted obligation from portfolio interest exemption. 6 Currently, the following countries assess zero tax on interest paid to non-residents: Austria, Cyprus, Finland, France, Germany, Gibraltar, Hong Kong, Hungary, Luxemburg, Malta, Netherlands, Norway, South Africa, and 5
  • 14. [3] Tax Avoidance and Evasion Opponents argued that the only effective way to prevent tax avoidance and evasion, especially in a world with tax havens and bank secrecy jurisdictions, is to withhold at the source. Those favoring the PI tax exemption responded by pointing out that taxpayers have virtually unlimited opportunities to avoid or evade taxes, if they intend to do so. As a result, the repeal of the U.S. tax on PI income was unlikely to increase tax avoidance or evasion.7 [4] Subsequent Developments Four years after the congressional committee’s analysis, the proponents’ arguments prevailed as the Deficit Reduction Act of 1984 was signed into law. The original law included the rule that a 10-percent or greater direct or indirect ownership of the creditor by the non-resident lender disqualified the PI income as tax exempt.8 The denial of exemption on contingent interest income came in 1993.9 The original provisions allowed bearer form obligations sold under procedures reasonably designed to prevent sale or resale to U.S. persons. With these bearer obligations, the interest had to be payable only outside the U.S., and the U.S. holders were subject to tax penalties.10 These so called “targeted foreign obligations” were disqualified in 2010 with the repeal of certain foreign exceptions to registered bond requirements, although allowing some transitional relief.11 § 2.03 Requirements of the Portfolio Interest Income Exemption A 30 percent tax is generally imposed on U.S. source Fixed or Determinable Annual or Periodic (FDAP) income not effectively connected with a U.S. trade or business (e.g., interest, dividends, and royalties) paid to non-resident aliens and corporations.12 The tax is reduced under most tax treaties. Under the right circumstances, and only if certain complicated rules are observed, the right non-residents can be exempt from the U.S. tax on FDAP interest income from U.S. sources without regard to the respective tax treaty.13 This unique vehicle is called “Portfolio Interest” (PI) and is described in IRC Sections 871(h) and 881(c) for the cases of non-resident aliens and corporations, respectively. The favorable treatment of this special kind of interest under the Internal Revenue Code also extends to the estate tax regime as the underlying loan instruments are exempt from the estate tax.14 PI is also exempt from the reporting requirements of IRC                                                                                                                                                                                                   Sweden; to a limited extent, the tax rates on interest are zero in Canada, Colombia, Denmark, Estonia, Ireland, Israel, Lithuania, Switzerland, and Turkey. See Deloitte Compare Rates Results 7 Remember, however, that in 1980, the U.S. still had zero tax on interest under the treaty with the Netherland Antilles that comprised 18.8% of the total debt outstanding to foreign creditors. See H.R. 7553, Subcommittee on Selected Revenue Measures of the Committee on Ways and Means on June 19, 1980, available at 8 See Section 2.02[2][e]. 9 Revenue Reconciliation Act of 1993, PL 103-66, 107 Stat 312 (Aug 10, 1993); see Section 2.03[4] discussing Contingent Interest. 10 Conference Report, '84 DRA, PL 98-369, 7/18/84 11 See Notice 2012-20, 2012-1 CB 574 (Mar 7, 2012); Hiring Incentives to Restore Employment Act, PL 111-147, 124 Stat 100 (Mar 18, 2010). See Section 2.03[3] discussing Registered Form. 12 IRC §§ 871(a), 881(a). 13 IRC §§ 871(h), 881(c). 14 The gift tax will still apply though, according to IRC § 2511(b).
  • 15. Section 6049, and the corresponding Treasury Regulation Section 1.6049-5(b)(8). No Form 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, or Form/1042(S) (Foreign Person’s U.S. Source Income Subject to Withholding) is necessary for PI. The rules for PI can, perhaps, be compressed into the following few statements, which will be discussed further below: 1. The issuer must be a U.S. person.15 2. The holder must be a foreign person that: a. provided proof of its foreign status,16 and that is: b. not a bank extending credit in the course of its ordinary trade or business (except if buying U.S. obligations);17 c. not related to the issuer, if the foreign person is a Controlled Foreign Corporation (CFC);18 and d. not a “10-percent shareholder” in the issuer at the time the interest is received.19 3. The underlying obligation must be in “registered form.”20 4. The interest must not be contingent interest (with some exceptions).21 5. Before the obligation is issued, the Secretary must not have determined in writing (and published a statement) that the foreign country of the creditor has inadequate information exchange with the U.S.22 6. The interest must be FDAP, and cannot be income “effectively connected” to the U.S. trade or business (ECI).23 The main goals of these provisions are to ensure that (1) U.S. persons do not benefit from the tax free interest, and (2) the underlying debt is not like equity in the hands of the holder.24                                                              15 IRC § 871(h)(2)(B)(ii)(I). IRC §§ 871(h)(2)(B)(ii)(I) & (II), 881(c)(2)(B)(ii)(I),(II), 871(h)(5). 17 IRC § 881(c)(3)(A). 18 IRC § 881(c)(3)(C). 19 IRC §§ 871(h)(3), 881(c)(3)(B). 20 IRC §§ 871(h)(2)(B)(i), 881(c)(2)(B)(i)) as defined by IRC §§ 163(f) (871(h)(7), 881(c)(7). 21 IRC §§ 871(h)(4), 881(c)(4) 22 IRC §§ 871(h)(6), 881(c)(6). 23 IRC §§ 871(a), 881(a), 871(h), 881(c). 24 The PI rule is to be distinguished from the general rule on deposits under IRC Section 871(i). The subsection exempts non-residents from tax on any interest not effectively connected with U.S. trade or business and paid on: 16 (A) deposits with persons carrying on the banking business, (B) deposits or withdrawable accounts with savings institutions chartered and supervised as savings and loan or similar associations under Federal or State law, but only to the extent that amounts paid or credited on such deposits or accounts are deductible under section 591 (determined without regard to sections 265 and 291) in computing the taxable income of such institutions, and (C) amounts held by an insurance company under an agreement to pay interest thereon.
  • 16. [1] U.S. Person Who can be an issuer of a PI obligation? The definition is quite broad. The main rules under IRC Section 871(h)(2)(B)(ii)(I) refer to a U.S. person as the one who “would otherwise be required to deduct and withhold tax from such interest under Sec. 1441(a).” The regulations under IRC Section 1441(a) clarify that “[a] U.S. person is a person described in section 7701(a)(30), the U.S. government (including an agency or instrumentality thereof), a State (including an agency or instrumentality thereof), or the District of Columbia (including an agency or instrumentality thereof).”25 IRC Section 7701(a)(30) lists the following as a “United States person”: “(A) a citizen or resident of the United States, (B) a domestic partnership, (C) a domestic corporation, (D) any estate (other than a foreign estate, within the meaning of paragraph (31)), and (E) any trust if – (i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States persons have the authority to control all substantial decisions of the trust.” The original guidance from the IRS for IRC Section 871 provided that interest is PI within the meaning of IRC Sections 871(h)(2)(B) or 881(c)(2)(B) if the underlying “obligation is a registration-required obligation within the meaning of section 163(f)(2)(A).”26 Since registration is not required for the obligations issued by individuals, such obligations were deemed ineligible for portfolio interest treatment. Many early private letter rulings implied that this guidance was to be followed.27 Final Treasury Regulation Section 1.871-14 does not have this particular restriction. [2] Foreign Person Generally, the term, Foreign Person, is also quite broad but has a few notable exceptions discussed below. According to Treasury Regulation Section 1.1441-1(c)(2) “[t]he term foreign person means a nonresident alien individual, a foreign corporation, a foreign partnership, a foreign trust, a foreign estate . . . . Solely for purposes of the regulations under chapter 3 of the Internal Revenue Code, the term foreign person also means, with respect to a payment by a withholding agent, a foreign branch of a U.S. person that furnishes an intermediary withholding certificate described in paragraph (e)(3)(ii) of this section. Such a branch continues to be a U.S. payor for purposes of chapter 61 of the Internal Revenue Code. See [Treasury Regulation] § 1.6049-5(c)(4).” [a] Required Statement Proving Foreign Residency No portfolio interest exemption is available unless either a timely statement is provided to the withholding agent proving the foreign status of the payee, or the Secretary has determined that                                                              25 Treas Reg § 1.1441-1(c)(2). See Temp Treas Regs § 35a.9999-5, Q&A (8) (The full text of these old regulations can be found in PLR 8611066.) 27 See e.g., PLR 8611066, 8703052, 8703068. 26
  • 17. no such statement is required.28 The statement can be made either by the beneficial owner or by a financial institution that holds customers’ securities in the ordinary course of its trade or business.29 The Secretary has the authority to determine that such statement from “any person (or any class including such person)” does not meet these requirements.30 The statement must be furnished before expiration of the beneficial owner's limitations period for claiming a refund of tax paid on the interest.31 Thus, as long as the statement is provided within the statute of limitations (normally three years after the original tax return was due), the U.S. tax return may be filed to claim a refund for the amounts withheld. The withholding certificate (Form W-8Ben) along with the “Foreign Person's U.S. Source Income subject to Withholding” (Form 1042-S) must be attached to the tax return.32 The ITIN (Individual Taxpayer Identification Number) or EFIN (Employer Federal Identification Number) is required to file the tax return to claim a refund (otherwise, the return will not be processed by the IRS) but neither ITIN nor EFIN is necessary on the statement to the withholding agent under IRC Section 871(h)(2)(ii).33 The beneficial owner can use the official Form W-8Ben and intermediary can use the official Form W-8IMY or a substitute form. The substitute form will be acceptable if it contains provisions that are substantially similar to those of the official form, if it contains the same certifications relevant to the transactions as are contained on the official form and these certifications are clearly set forth, and if the substitute form includes a signature-under-penaltiesof-perjury statement identical to the one stated on the official form. The substitute form is acceptable even if it does not contain all of the provisions contained on the official form, so long as it contains those provisions that are relevant to the transaction for which it is furnished.34 Thus, a taxpayer may be asked to fill out an alternative to the official IRS forms but the content of the statement would be the same. [b] Foreign Bank The PI exemption is not available to a foreign bank extending credit in its ordinary course of trade or business, except in the case of interest paid on an obligation of the United States.35 The discussion of a “bank” for these purposes is found in Technical Advice Memorandum 9822007.36 In the situation described in the memorandum, a foreign entity provided financing to a U.S. company under a complex “square trip financing” arrangement. In essence, this arrangement was a lease-buy back with a third party advancing the cash for the buy-back part. The District Director argued that the nature of the loan instrument, being, in effect, a loan that would                                                              28 IRC § 871(h)(2)(ii)(I), (II). IRC § 871(h)(5). 30 IRC § 871(h)(5). 31 Treas Reg § 1.871-14(c)(3)(i). 32 Treas Reg § 301.6402-3(e). 33 Preamble to TD 8734 (Oct 6, 1997). 34 Treas Reg § 1.1441-1(e)(4)(vi). 35 IRC § 881(c)(3)(A). 36 PLR 9822007 (Feb 10, 1998). 29
  • 18. ordinarily be generated by a bank while it is engaged in the business of banking, should be the decisive factor for determining what is a “bank.” The IRS counsel disagreed, however, siding with the taxpayer and narrowly construing the definition of a bank for the purposes of IRC Section 881(c)(3)(A). The IRS counsel acknowledged in the memo that neither the Code nor the Treasury Regulations specifically defined the term “bank” for the purposes of IRC Section 881. (These regulations still have not been issued as of July 2013). Because Congress frequently cross-references IRC Section 581 when it uses the term, “bank,” by itself (as opposed to the term, “banking, financing, or other similar business”) the same analysis should apply here. IRC Section 581 requires that a substantial part of the entity’s business consists of receiving deposits and making loans and discounts for it to be considered a “bank.” The foreign corporation in this instance did not accept deposits and therefore was not considered a “bank.” [c] Controlled Foreign Corporation (CFC) The foreign person can be a Controlled Foreign Corporation (CFC). The interest received by a CFC, however, must not be from a related person as defined by IRC Section 267(b): members of the immediate family, fiduciaries and beneficiaries of the trust, and by attribution of more than 50 percent ownership in entities. (See the detailed discussion of the related person rules under the Contingent Interest rules below). Additionally, any 10-percent shareholder of the corporation cannot be the issuer.37 CFC is defined in IRC Section 957(a) as a corporation more than 50 percent of which is owned by the U.S. persons. The 50 percent ownership can be by vote or value, directly or indirectly – the attributions rules of IRC Section 318(a) are applied with some modifications by IRC Section 958. [d] “10-Percent Shareholder” The non-resident lender must not be a “10-percent shareholder” in the debtor at the time the interest is received.38 A 10-percent shareholder is a person who owns either 10 percent or more of the total combined voting power of all classes of voting stock of a corporation or 10 percent or more of the capital or profits interest in a partnership.39 The direct and indirect ownership is taken into consideration under the Section 318(a) attribution rules with some modifications. Here is a brief description of the modified attribution rules:  Ownership by children (including those legally adopted), grandchildren, and parents is attributed to the individual.40 Reattribution among the family members is not allowed.41                                                              37 IRC §§ 881(c)(3)(A), 864(d)(4). IRC §§ 871(h)(3), 881(c)(3)(B). 39 IRC § 871(h)(3)(B)(i),(ii). 40 IRC § 318(a)(1). 41 IRC § 318(a)(5)(B). 38
  • 19.     [3] Ownership by partnerships is proportionately attributed to the partners,42 and ownership by a partner is attributed to a partnership.43 From trusts, the ownership is attributed to grantors and beneficiaries. In the case of the latter, the actuarial interest is used.44 Attribution from grantors and substantial beneficiaries (more than 5 percent of contingent actuarially computed interest) back to a trust is also proportionate.45 Ownership by a corporation is attributed proportionately to the shareholders based on the value of the stock owned in the corporation.46 Ownership by the 50 percent shareholders is attributed to a corporation,47 while for less than 50 percent shareholders the attribution is measured by the proportionate value owned by shareholders in the corporation.48 There is no attribution by the reason of option ownership to or from partnership, trust, or corporation.49 Registered Form The PI rules borrow its registered form definitions from Section 163(f) of the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. 50 Under TEFRA, there are two ways for an obligation to be considered registered: a) by requiring the obligation to be surrendered and reissued to effect its transfer to another holder;51 or b) through a “book entry.”52 Unless an obligation is in “registered” form, it is considered to be in “bearer” form,53 including an obligation that can be transferred at any time until its maturity by any means other than those consistent with the registered form.54 A term “bearer” is used throughout this article in a purely technical sense as physical securities are seldom issued.55 Nonetheless, the interest received on the obligation while it is in bearer form is disqualified from the PI tax exemption.                                                              42 IRC § 318(a)(2)(A). IRC § 318(a)(3)(A). 44 IRC § 318(a)(2)(B). 45 IRC § 318(a)(3)(B). 46 IRC §§ 318(a)(2)(C), 871(h)(3)(C)(i). 47 IRC § 318(a)(3)(C). 48 IRC § 871(h)(3)(C)(ii)(II). 49 IRC § 871(h)(3)(C)(iii). 50 PL 97-248, 96 Stat 324 (Sept 3, 1982). IRC § 871 itself only clarifies that the rules related to the book entry system under IRC § 149 (a)(3) can be used. According to these rules, “a book entry bond shall be treated as in registered form if the right to the principal of, and stated interest on, such bond may be transferred only through a book entry consistent with regulations prescribed by the Secretary.” IRC § 149 (a)(3)(A). The chain of nominees is allowed subject to the Secretary’s regulations. IRC § 149 (a)(3)(A). The actual portfolio interest regulations under Treas Reg § 1.871-14(c) refer taxpayers specifically to the conditions described in Treas Reg § 5f.103-1. (These regulations are now issued under IRC § 149). 51 Regulation C(1), TEFRA. 52 Regulation C(2), TEFRA. 53 Treas Reg § 5f.103-1(e)(1). 54 Treas Reg § 5f.103-1(e)(2). 55 See Stephen B. Land, “Bearer or Registered? Lingering Issues Under TEFRA,” 58 Tax Lawyer 3 (Spring 2005) for a very in depth discussion of the subject. 43
  • 20. [a] Regulations C(1): Physical Form This section concerns instruments issued in an old fashioned, physical form. A transfer of this type of obligation may be effected only by surrender of the old instrument and either the reissuance by the issuer of the old instrument to the new holder or the issuance of a new instrument by the issuer to the new holder.56 In addition, under a special rule, an obligation that, as of a particular time, is not in registered form under the above rules can be converted into registered form at a later time when the requirements of the registered form are satisfied.57 Example: Corporation C issues obligations in bearer form. A foreign person purchases a bearer obligation and then sells it to a U.S. person. At the time of the sale, the U.S. person delivers the bearer obligation to Corporation C and receives an obligation that is identical to the original, except that the obligation is now registered with the issuer or its agent as to both principal and any stated interest, and may be transferred at all times until its maturity only through a means described in Treasury Regulation Section 5f.103-1(c). Under Treasury Regulation Section 5f.103-1(e), the obligation is considered to be in registered form from the time it is delivered to Corporation C until its maturity.58 Example (4) of the Treasury Regulations59 describes a conversion to a bearer form. Corporation A issues an obligation that is registered with the corporation as to both principal and any stated interest. Transfer may be effected by the surrender of the old instrument and either the reissuance by the issuer of the old instrument to the new holder or the issuance by the issuer of a new instrument to the new holder. The obligation can be converted into a form in which the transfer of the right to the principal of, or stated interest on, the obligation may be effected by physical transfer of the obligation. Under Treasury Regulation Section 5f.103-1(c) and (e), the obligation is not considered to be in registered form and is considered to be in bearer form. The IRS has expressed its opinion on a sort of two-step arrangement where an obligation first is issued in bearer form and is later “immobilized” in a clearing system.60 The obligation is registered if: (1) the obligation is represented by one or more global securities in physical form that are issued to and held by a clearing organization (as defined in Treasury Regulation Section 1.163-5(c)(2)(i)(B)(4)) (or by a custodian or depository acting as an agent of the clearing organization) for the benefit of purchasers of interests in the obligation under arrangements that prohibit the transfer of the global securities except to a successor clearing organization subject to the same terms; and (2) the beneficial interests in the underlying obligation are transferable only through a book entry system maintained by the clearing organization (or an agent of the clearing organization). [b] Regulations C(2): Book Entry An obligation shall be considered transferable through a book entry system if the ownership of an interest in the obligation is required to be reflected in a book entry, whether or not physical securities are issued. A book entry is a record of ownership that identifies the owner of an                                                              56 Treas Reg § 5f.103-1(c)(1). Treas Reg § 5f.103-1(e)(3). 58 Treas Reg § 5f.103-1(f), Example 6. 59 Treas Reg § 5f.103-1(f). 60 Notice 2012-20, 2012-1 CB 574 (Mar 7, 2012). 57
  • 21. interest in the obligation.61 Thus, no physical form of the obligation is required. The rule is especially welcome in this day and age of efficient securities markets. Such dematerialized book-entry systems for holding and transferring bonds, as developed and now mandatory in some foreign countries, were highlighted by Notice 2006-99.62 The Notice confirmed that the registered form will be recognized if bondholders do not have the ability to withdraw bonds from the book-entry system and obtain physical certificates representing the bonds.63 The mere possibility of termination of the clearing organization’s business without a successor is not a disqualifying factor.64 Other situations that are not disqualifying factors are the default by the issuer (exception 2) and the issuance of definitive securities at the issuer’s request upon a change in tax law that would be adverse to the issuer, but for the issuance of physical securities in bearer form (exception 3).65 However, after the actual occurrence of one of the above events, any obligation with respect to which a holder has a right to obtain a physical certificate in bearer form will no longer be in registered form, regardless of whether any option to obtain a physical certificate in bearer form has actually been exercised. Treasury and the IRS requested comments regarding whether any exceptions should be provided to this general rule.66 Perhaps a “rollover period” could be introduced giving the holders time to move the securities. Note that in accordance with the Regulations C(1) above, as soon as an obligation is no longer in registered form, a holder can transfer it to another clearing organization and regain the registered form. Formerly, an exception to the registration requirement existed for certain “foreign targeted obligations.”67 The regulations featured a host of rules designed to ensure that the obligations were issued only to foreign persons, including the requirement that the instruments were issued only outside the U.S. and restrictions on the offer and sale, delivery, and certification of the instruments. The Hiring Incentives to Restore Employment (HIRE) Act of 201068 eliminated this exception for instruments issued after March 18, 2012, by repealing IRC Section 163(f)(2)(B). As international securities markets develop and the U.S. government becomes ever more persistent about the information exchange programs, the rules discussed here are most likely to evolve and be clarified further. We are especially looking forward to the regulations promised in Notice 2012-20.69 In conclusion, it is important to remember that both issuers and holders have other non-PI reasons to steer away from the bearer form. Under IRC Section 163(f), registration is required in all situations other than if the obligation (1) is issued by a natural person, (2) is not of a type offered to public, or (3) has a maturity of not more than one year.70 For the violators on the issuer side, the consequences are no interest deduction71 and an excise tax of one percent for                                                              61 Treas Reg § 5f.103-1(c)(2). 2006-2 CB 907 (Oct. 27, 2006). 63 Section 3 of Notice 2006-99, 2006-2 CB 907 (Oct. 27, 2006). 64 Section 3 (Exception 1) of Notice 2006-99, 2006-2 CB 907 (Oct. 27, 2006). 65 Section 3 of Notice 2012-20, 2012-1 CB 574 (Mar 7, 2012). 66 Id. 67 Referred to as Regulations “D.” See Treas Reg § 1.163-5(c)(2)(i)(D). 68 PL 111–147, 124 Stat 71 (Mar 18, 2010). 69 2012-1 CB 574 (Mar 7, 2012). 70 IRC § 163(f)(2). 71 IRC § 163(f)(1). 62
  • 22. each year till maturity.72 Holders lose the right to deduct any losses on the sale73 and must pay tax on any gain under ordinary rates.74 [4] Contingent Interest The portfolio interest exemption does not apply to certain contingent interest income received by foreign persons. The amount of interest paid on obligation may not be determined by: (i) reference to any receipts, sales, or other cash flow of the debtor or a related person; (ii) any income or profits of the debtor or a related person; (iii)any change in value of any property of the debtor or a related person; (iv) any dividend, partnership distribution, or similar payments made by the debtor or a related person.75 The Secretary may identify any other type of contingent interest to prevent avoidance of Federal income tax.76 No special regulations have been issued yet. The phrase “related person” under the above rules is rather inclusive.77 In addition to the relationships described in IRC Sections 267(b) and 707(b)(1), the Code provides that a party to any arrangement undertaken for a purpose of avoiding the application of the contingent interest rules can be deemed “related” for these purposes.78 However, some types of contingent interest are allowed, pursuant to a list of exceptions in IRC Section 871(h)(4)(C). In the case of an instrument on which a foreign holder earns both contingent and non-contingent interest, denial of the portfolio interest exemption applies only to the portion of the interest that is contingent.79 Assume that the interest rate on a debt instrument is stated as the greater of either of two amounts: 6 percent of the principal amount or 10 percent of gross profits. In such a case, only the gross-profits-based interest is contingent interest. The conference report clarified that, with respect to such an instrument, only the excess of the contingent amount, if any, over the minimum fixed interest amount is disqualified from PI treatment.80                                                              72 IRC § 4701(a). IRC § 165(j). 74 IRC § 1287(a). 75 IRC § 871(h)(4)(A)(i). 76 IRC § 871(h)(4)(A)(ii). 77 See IRC § 871(h)(4)(B) (with reference to IRC §§ 267(b) or 707(b)(1)). 78 IRC § 871(h)(4)(B). 79 Revenue Reconciliation Act of 1993, PL 103-66, 107 Stat 312 (Aug 10, 1993) (House Explanation). 80 Revenue Reconciliation Act of 1993, PL 103-66, 107 Stat 312 (Aug 10, 1993) (Conference Report). 73
  • 23. [5] Jurisdiction Not “Blacklisted” by the Secretary The IRS has the authority to name any jurisdiction as having inadequate information exchange with the U.S. and suspend the PI income tax exemption treatment for creditors from that country.81 More specifically, to disqualify a jurisdiction, the Secretary must provide in writing and publish a statement that the provisions of IRC Sections 871(h) and 881(c) shall not apply to payments of interest to any person within that foreign country during the period beginning and ending on the dates specified by the Secretary.82 Retroactive disallowance of deduction is not valid.83 This authority has not been exercised as of July 2013. [6] Effectively Connected Income (ECI) It is important to remember that PI exemption from tax merely works for FDAP interest income. If the tax is due under any other section of the Code (e.g., under IRC Sections 872 or 882 – tax on income connected with a U.S. trade or business), then the exemption is not available. The ECI rules refer to two ways in which FDAP can become ECI. In both of those tests, the primary weight is given to the accounting on the books of a given trade or business.84 [a] Asset Test The Asset Test determines whether the income, gain, or loss is derived from assets used in, or held for use in, the conduct of a trade or business.85 Assets will tend to be considered so used if they were held for the principal purpose of promoting the present conduct of the business,86 were acquired and held in the ordinary course of the U.S. trade or business (e.g., an account or note receivable arising from the business),87 or held in a “direct relationship” to the U.S. business.88 The “direct relationship” is measured by whether or not an asset is in the business to meet present (rather than future) need. For example, an asset is needed for this purpose if held to meet operating expenses, but it is not needed in this sense if it is held to provide for future diversification into a new business, to expand the business activities outside the U.S., to provide for future plant replacement, or to use for future business contingencies.89 The “direct relationship” presumption is raised if the asset was acquired with funds generated by the business, income from the asset is retained or reinvested in the business, and personnel who are                                                              81 IRC § 871(h)(6). IRC § 871(h)(6)(A). 83 IRC § 871(h)(6)(A). 84 IRC § 864(c)(2), Treas Reg § 1.864-4(c)(4). 85 IRC § 864(c)(2). 86 Treas Reg § 1.864-4(c)(2)(ii)(a). 87 Treas Reg § 1.864-4(c)(2)(ii)(b). 88 Treas Reg § 1.864-4(c)(2)(ii)(c). 89 Treas Reg § 1.864-4(c)(2)(iv)(a). 82
  • 24. present in the U.S. and actively involved in the conduct of the business exercise significant management and control over the investment of the asset.90 Such presumption can be rebutted if it can be shown that such assets are held for future, not present, business needs.91 Example: M, a foreign corporation that uses the calendar year as the taxable year, is engaged in industrial manufacturing in a foreign country. M maintains a branch in the United States that acts as the importer and distributor of the merchandise it manufactures abroad. By reason of these branch activities, M is engaged in business in the United States during 1968. The branch in the United States is required to hold a large current cash balance for business purposes, but the amount of the cash balance so required varies because of the fluctuating seasonal nature of the branch's business. During 1968 at a time when large cash balances were not required, the branch invests the surplus amount in U.S. Treasury bills. Since these Treasury bills are held to meet the present needs of the business conducted in the United States, they are held in a direct relationship to that business, and the interest for 1968 on these bills is effectively connected for that year with the conduct of the business in the United States by M.92 [b] Activities Test The Activities Test determines whether the activities of a trade or business were a material factor in the realization of the income, gain, or loss.93 The test usually applies to passive type income, gain, or loss that arises directly from the active conduct of the foreign corporation’s U.S. trade or business.94 Activities relating to the management of investment portfolios are not treated as activities of a trade or business conducted in the U.S. unless the maintenance of these investments is the principal activity of the trade or business.95 Example: Foreign corporation S is organized for the purpose of investing in stocks and securities. S is not a personal holding company or a corporation that would be a personal holding company if all of its outstanding stock were not owned by foreign persons during the last half of its taxable year. Its investment holdings consist of common stocks issued by both foreign and domestic corporations and a substantial amount of high grade bonds. The business activity of S consists of the management of its portfolio for the purpose of investing, reinvesting, or trading in stocks and securities. During the taxable year, S has its principal office in the U.S. and, by reason of its trading in the U.S. in stocks and securities, is engaged in business in the U.S. The dividends and interest derived by S during the year from U.S. sources, and the gains and losses from U.S. sources from the sale of stocks and securities from its investment portfolios, are effectively connected for the year with S’s conduct of business in the U.S.96                                                              90 Treas Reg § 1.864-4(c)(2)(iv)(b). Treas Reg § 1.864-4(c)(2)(v). 92 Treas Reg § 1.864-4(c)(2)(v), Example 1. 93 IRC § 864(c)(2)(B). 94 Treas Reg § 1.864-4(c)(3)(i). 95 Treas Reg § 1.864-4(c)(3)(i). 96 Treas Reg § 1.864-4(c)(3)(ii), Example 1. 91
  • 25. For the purposes of ECI, the business of “banking, financing, or other similar business” is a dangerous place. In the controversial Office of Chief Counsel Memorandum TAM 2009-010,97 the IRS put forward a somewhat convincing argument that, where a foreign entity is engaged in “banking, financing, or other similar business” and makes loans to the U.S. public through an agent (dependent or independent), this activity will render the taxpayer engaged in U.S. trade and business. The interest income thus will be partially taxable in U.S. (under certain rules described in the regulations) and PI treatment will not apply. The key is that Treasury Regulation Section 1.864-4(c)(5)(ii),(iii) does not require that the loan origination agent or its U.S. office be related to the taxpayer. Treasury Regulation Section 1.864-5 defines “banking, financing, or other similar business” for these purposes in the following manner: A nonresident alien individual or a foreign corporation shall be considered for purposes of this section and paragraph (b)(2) of [Treasury Regulation] § 1.864-5 to be engaged in the active conduct of a banking, financing, or similar business in the United States if at some time during the taxable year the taxpayer is engaged in business in the United States and the activities of such business consist of any one or more of the following activities carried on, in whole or in part, in the United States in transactions with persons situated within or without the United States (1.864- 4(c)(5)(i)): (a) Receiving deposits of funds from the public, (b) Making personal, mortgage, industrial, or other loans to the public, (c) Purchasing, selling, discounting, or negotiating for the public on a regular basis, notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness, (d) Issuing letter of credit to the public and negotiating drafts drawn thereunder, (e) Providing trust services for the public, or (f) Financing foreign exchange transactions for the public.98 Thus, if any foreign entity that is regularly involved in making loans hires a loan originator in the U.S. for obtaining the loan, this activity would subject the interest to a partial taxation in the U.S. The results would probably be different if the issuer paid the fee directly to the loan originator, instead of to the foreign entity lender.                                                              97 GLAM 2009-010; 2009 GLAM LEXIS 15 (Sept 22, 2009). This memorandum was published internally and obtained via FOIA.   98 Treas Reg § 1.864-4(c)(5).
  • 26. [7] Side Kick: Estate Tax As a general rule, for purposes of the estate tax, stock in U.S. corporations and debt obligations of United States’ persons, as well as debt obligations of the U.S. Government, the States or any provincial subdivision thereof, and the District of Columbia, are included in the taxable estate of the individual.99 IRC Section 2105 excludes from this rule PI-related obligations, if the interest from these obligations is considered PI.100 Even if the statement of foreign ownership described in IRC Section 871(h)(5) (or Form W-8Ben) is not provided and tax is being withheld on the payments of the interest, the estate tax still does not apply. If a portion of the interest on the underlying obligation is considered contingent under IRC Section 871(h)(4), then only that portion of the obligation (based on the reasonable calculations of the taxpayer) is subject to the estate tax.101 If the interest on the obligation, in addition to qualifying as PI, is exempt from tax under another Code section, then the underlying obligation is not excludable from the estate.102 Classic example used to be the United States Treasury Bills that matured in less than 183 days. These instruments are excluded from the “original issue discount obligations” making interest automatically not taxable to non-resident aliens.103 In 1997, Congress added provision excluding from estate tax short term (under 183 days) taxable original issue discount obligations (including U.S. Treasury Bills).104 These rules apparently leave state and municipal bonds includible in the estate.105 No exemption for PI obligations applies to the gift tax.106 Note that no estate tax applies to bank deposits, savings and loan associations deposits, and amounts held by an insurance company under an agreement to pay interest thereon.107 § 2.04 Conclusion Dogs bark, but the caravan goes on. (Proverb) For most of us, the news that non-resident aliens do not pay income tax on U.S. source interest income comes as a surprise, especially now, in the time of rising tax rates and precipitating sequestration. Hopefully, this article sheds some light on the origins of the PI income tax exemption and the various covenants for its availability under the Code.                                                              99 IRC § 2104. IRC § 2105(b)(3). 101 IRC § 2105(b). 102 PLR 9422001. 103 IRC §§ 871(g)(1)(B)(i), 871(a). 104 IRC § 2105(b)(4). 105 IRC §§ 103, 871(g)(1)(B)(ii), 2105(b)(4). 106 IRC § 2511(b). 107 IRC §§ 2105(b)(1); 871(i)(1),(3). 100
  • 27. The big picture summary of the PI rules above should be viewed as a snapshot in the dynamic process of tax policy and rulemaking. Barring some drastically evolving macroeconomic considerations, the policy most likely will stay in place for the foreseeable future. There is, however, an observable trend to tighten it, mainly in the direction of increasing U.S. (and worldwide, for that matter) tax compliance. The 2010 repeal of the foreign targeted obligations exception limited the PI universe and came in a package with a host of other “offset provisions” (i.e., revenue raisers) primarily addressing tax evasion.108 If the perception of compliance irregularities remains, the IRS might start taking more aggressive rulemaking steps to tighten the exemption further by using its broad authorities under the two PI Code sections. We shall see. One always hopes for the wise shepherds as the caravan enters new terrains.                                                              108 Taxes to enforce reporting on certain foreign accounts, Disclosure of information with respect to foreign financial assets, Modification of statute of limitations for significant omission of income in connection with foreign assets, Clarifications with respect to foreign trusts which are treated as having a U.S. beneficiary, etc. See HIRE Act of 2010, PL 111–147, 124 Stat 71 (Mar 18, 2010).
  • 28. Joel S. Newman on Deductions on a Higher Plane: Medical Marijuana Business Expenses By Joel S. Newman § 3.01 Introduction Imagine three sole proprietorships. The first, “Legal,” sells widgets, and is in complete conformity with all federal, state and local laws. The second, “Illegal,” is a gambling establishment, in violation of the laws of its state. The third, “MMJ,” dispenses marijuana, but only to those who can certify that it is necessary to alleviate their medical conditions. It has no other business. This dispensation of “medical marijuana”1 is legal under the laws of MMJ’s state, but illegal under federal law.2 Legal, Illegal, and MMJ all have identical income and expenses: Gross sales $100,000 --Cost of goods sold --$80,000 Gross profit $20,000 --Other operating expenses --$8,000 Operating income $12,000 Legal will have taxable income of $12,000. The cost of goods sold will be subtracted from gross sales, and the other operating expenses will be deductible. Illegal will be taxed exactly the same way. However, MMJ will have taxable income of $20,000. Cost of goods sold will be subtracted, but other operating expenses will not be deductible. Why is Illegal treated the same as Legal? Why is MMJ treated differently from the other two? Legal and Illegal are treated the same way because of Commissioner v. Sullivan.3 In Sullivan, the Commissioner denied salary and rent deductions to an illegal gambling enterprise. Justice Douglas wrote:                                                               Joel S. Newman is a Professor of Law at Wake Forest School of Law in North Carolina. Before teaching at Wake Forest, he taught as a visiting professor at the University of Hawaii, University of Florida, Notre Dame and Xiamen University, in the People's Republic of China. Professor Newman has also served as a consultant for CEELI, the ABA's rule of law initiative, for projects in Lithuania, Macedonia, Slovakia, Uzbekistan, Ukraine, and St. Petersburg, Russia. He has also been an Associate with Shearman & Sterling in New York, and with Frederickson, Byron, Colborn, Bisbee & Hansen, in Minneapolis. 1 For the remainder of this article, the term “medical marijuana” will be used to describe such marijuana usage. The specific requirements for medical marijuana vary according to the formulations of the state statutes that legalize it. See note 12, infra, for a list of the states in which medical marijuana has been legalized and citations to the relevant statutes. See also, Historical Timeline-Medical Marijuana, available at 2 21 USCS § 801. 3 356 US 27 (1958).
  • 29. If we enforce as federal policy the rule espoused by the Commissioner in this case, we would come close to making this type of business taxable on the basis of its gross receipts, while all other businesses would be taxable on the basis of net income. If that choice is to be made, Congress should do it.4 Thus, generally, the cost of goods sold, and other operating expenses (a.k.a. ordinary and necessary business expenses), are deductible, regardless of the underlying legality or illegality of the business. Legal and Illegal might be treated differently with respect to criminal law, but, for tax law, they are treated the same.5 Why, then, is MMJ treated differently? Recall that, in Sullivan, Justice Douglas conceded that Congress had the power to deny deductions to certain kinds of businesses, if it so chose.6 Congress made that choice in 1982. Congress was apparently reacting to the Tax Court decision in Edmondson v. Commissioner.7 In Edmondson, a drug dealer was busted, and then audited. The IRS wanted to tax him on the unreported income from his drug-related activities. He countered that, if he was to be taxed on the income, then he should be allowed to deduct his expenses, including travel expenses, and the purchase of an accurate scale. The Tax Court allowed the deductions. Congress was horrified. It enacted IRC Section 280E, which provides:                                                              4 Id at 29. Cases allowing deductions to illegal enterprises include: Cavaretta v Comm’r, TC Memo 2010-4; Blanning v Comm’r, TC Memo 2004-201 (2004); Nelson v Comm’r, TC Memo 2000-212 (2000); Steffen v US, 41 Fed Cl 134 (1998); Brizell v Comm’r, 93 TC 151 (1989); Raymond Bertolini Trucking Co v Comm’r, 736 F2d 1120 (6th Cir 1984); , Carter v Comm’r, TC Memo 1984-443 (1984); Edmondson v Comm’r, TC Memo 1981-623; Dukehart-Hughes Tractor & Equip Co v US, 341 F2d 613 (Ct Cl 1965); Stacy v US, 231 FSupp. 304 (SD Miss 1963); RCA Communications v US, 277 F2d 164 (Ct Cl 1960); Edwards v Bromberg, 232 F2d 107 (5th Cir 1956). On the same day that Sullivan was decided, the Supreme Court handed down Tank Truck Rentals v Comm’r, 356 US 30 (1958). That decision created the “public policy exception”: that deductions would be disallowed “…if allowance of the deduction would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.” 356 US at 33-34. The public policy exception has been codified in part in Sections 162(c) and (f), and the Foreign Corrupt Practices Act, 15 USCS § 78dd-1. However, there is also a case law component. For example, in part due to the public policy doctrine, the expenses incurred when assets of a criminal enterprise are forfeited or condemned are not deductible. McHan v Comm’r, TC Memo 2006-84; Ruddel v Comm’r, TC Memo 1996-125; Holt v Comm’r, 69 TC 75 (1977); Wood v US, 863 F2d 417 (5th Cir 1989); Pring v Comm’r, TC Memo 1989-340; Fuller v Comm’r, 213 F2d 102 (10th Cir 1954). However, legal fees in defending against criminal prosecution are usually deductible. Nelson v Comm’r, TC Memo 2000-212; Comm’r v Shapiro, 278 F2d 556 (7th Cir 1960); Comm’r v Tellier, 383 US 687 (1966); C Coat, Apron & Linen Serv, Inc, v US, 298 F Supp 1201 (SDNY 1969); O’Malley v Comm’r, 91 TC 352 (1988); Sundel v Comm’r, TC Memo 1998-78 (1998); Kent v Comm’r, TC Memo 1986-324. See Borek, “The Public Policy Doctrine and Tax Logic: The Need for Consistency in Denying Deductions Arising from Illegal Activities,” 22 U Balt L Rev 45 (1992). 6 Sullivan, 356 US at 27. See also, Commissioner v Tellier, 383 US 687 (1966): “Deduction of expenses falling within the general definition of s 162(a) may, to be sure, be disallowed by specific legislation, since deductions ‘are a matter of grade and Congress can, of course, disallow them as it chooses.’” 383 US at 693, quoting US v Sullivan. 7 Edmondson v Comm’r, TC Memo 1981-623 (1981). See generally, Joel S. Newman, “CHAMP: How the Tax Court Finessed a Bad Statute,” Tax Notes Today, 2007 TNT 172-39 (Sept. 3, 2007). 5
  • 30. No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.8 The Senate Finance Committee Report commented: To allow drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are allowed to other, legal, enterprises. Such deductions must be disallowed on public policy grounds. * * * To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill. 9 Thus, even though Legal and Illegal may deduct Cost of Goods Sold and other operating expenses, MMJ can subtract its costs of goods sold, but not other operating expenses, because Congress said so in IRC Section 280E. For many years, Section 280E was applied routinely.10 Other cases mentioned the section, without applying it.11 However, all of the cases involved the criminal drug trade. Then, things                                                              8 IRC § 280E; see Carrie F. Keller, “The Implications of I.R.C. § 280E in Denying Ordinary and Necessary Business Deductions to Drug Traffickers,” 47 St Louis U L J 157 (2003); Rutherford, “Taxation of Drug Traffickers’ Income: What the Drug Trafficker Profiteth, the IRS Taketh Away,” 33 Ariz L Rev 701 (1991); Peace and Messere, “Tax Deductions and Criminal Activities: The Effects of Recent Tax Legislation,” 20 Rutgers LJ 415 (1989). 9 S Rep 97-494, at 309 (1982). The Tax Court is convinced that the Senate was thinking of Edmondson. Californians Helping to Alleviate Medical Problems, Inc v Comm’r, 128 TC 14 (2007). Curiously, the same thing happened in Australia. In Commissioner of Taxation v La Rosa [2003] FCAFC 125 (5 June 2003), Mr. La Rosa was busted for drug dealing, and required to pay tax on his unreported income. He argued that, if he was to pay tax on his drug-related income, he should be allowed drug-related deductions, including the expense of a robbery which occurred during a drug deal. The Federal Court of Australia allowed the deductions. The Australian Parliament was horrified, and enacted Section 26-54 of the Income Tax Assessment Act of 1997, which disallows deductions for expenditures relating to illegal activities. See Gupta, “Taxation of Illegal Activities in New Zealand and Australia,” J Australasian Tax Teachers Assoc. 2008, V. 3, no. 2 ; Lund, “Deductions Arising from Illegal Activities,” v. 13 [2003] Revenue Law J, Iss. 1, Art. 7. See generally Edward J. Roche Jr., “Federal Income Taxation of Medical Marijuana Businesses,” Tax Lawyer (Spring 2013). 10 Peyton v Comm’r, TC Memo 2003-146; Sundel v Comm’r, TC Memo 1998-78; Franklin v Comm’r, TC Memo 1993-184; Browning v Comm’r, TC Memo 1991-93; Bratulich v Comm’r, TC Memo 1990-600; Caffery v Comm’r, TC Memo 1990-498; US v Petri, 917 F. 2d 1307 (9th Cir 1990) [unpublished] (prosecution for criminal tax evasion for violating §7201 by willfully violating IRC § 280E). 11 Bilzerian v US, 41 Fed Cl 134 (1998) (finding that the perceived need to enact IRC § 280E proves that Congress did not consider all of the expenses of illegal activity to be nondeductible); McHan, TC Memo 2006-84 (holding that IRC § 280E was not raised in a timely manner); Ruddel, TC Memo 1996-125 (forfeiture nondeductible; “see
  • 31. changed. A number of states enacted laws legalizing the dispensation of marijuana for medical purposes. Now at least eighteen states, plus the District of Columbia, have legalized medical marijuana.12 In addition, in the past year, two states have legalized the possession and sale of small amounts of recreational marijuana, even if no medical need can be shown.13 How have these state developments impacted IRC Section 280E? First, can the federal government continue to criminalize marijuana, even in states which have declared it to be legal for certain purposes? The Supreme Court says that it can. In Gonzalez v. Raich,14 the Court held that, under the Commerce Clause, the federal government can do just that.15 Second, should the deductibility of the expenses of the marijuana business be any different in those states in which such business is, to some extent, legal? Apparently, the answer is no, but it gets a bit complicated. The Tax Court has ruled on this question twice. § 3.02 Two Tax Court Cases [1] CHAMP v. Commissioner In Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner,16 the taxpayer (CHAMP), a nonprofit under state law but not tax-exempt under federal law,17 dispensed marijuana to its members pursuant to the California Compassionate Use Act of 1996.18 It also “provided caregiving services to its members.” In fact, the Tax Court found that this caregiving function was the taxpayer’s “primary purpose.”19 The caregiving services included massages, and weekly or biweekly support group sessions—for the HIV/AIDS group, the “wellness” group, the Phoenix group (for elderly members), the Force group (focusing on spiritual and emotional                                                                                                                                                                                                   also IRC § 280E”; Wood v US, 863 F 2d 417 (5th Cir 1989) (IRC § 280E cited to show a sharply defined public policy against deductibility of drug forfeitures); Ryan, TC Memo 1989-297 (IRC § 280E inapplicable to tax year in question); Vasta, TC Memo 1989-531 (court notes that IRS did not argue for the applicability of IRC § 280E); Styron, TC Memo 1987-25 (IRC § 280E inapplicable to tax year in question); Kent, TC Memo 1986-324 (legal expenses deductible; court cites IRC § 280E without commenting on its applicability); Bender, TC Memo 1985375 (IRC § 280E does not change the applicability of IRC § 1348). 12 17 Legal Medical Marijuana States and DC: Laws, Fees and Possession Limits. I. Summary Chart.; Six States with Pending Legislation to Legalize Medical Marijuana, 13 Colorado: to be become Colo. Constitution, Art 18, §16; See Denver Post Marijuana News Page, Washington: RCWA § 69.50, Brookes, “Pot Legalization is Coming,” Rolling Stone,; Dickinson, “The Next Seven States to Legalize Pot,” Rolling Stone, In case you’re interested, they are Oregon, California, Nevada, Rhode Island, Maine, Alaska, and Vermont. 14 545 US 1 (2005). 15 Id. See Mikos, “State Taxation of Marijuana Distribution and Other Federal Crimes,” 2010 Chi Legal F 223; Mikos, “On the Limits of Supremacy: Medical Marijuana and the States’ Overlooked Power to Legalize Federal Crime,” 62 Vand L Rev 1421 (2009). 16 128 TC 173 (2007). 17 See PLR 201013062, similarly denying tax exempt status to a provider of medical marijuana. 18 Cal Health & Safety Code § 11362.5; CHAMP, 128 TC at 174-175. 19 CHAMP, 128 TC at 174.
  • 32. development), and the women’s group. Low-income members also received daily lunches and hygiene supplies. One-on-one counseling was offered, as well as social events, including field trips, movies, guest speakers, and live music.20 The taxpayer argued that IRC Section 280E should not apply at all, because its activities with respect to medical marijuana were not “trafficking” within the meaning of the statute. However, the Tax Court disagreed. Quoting the dictionary, the Tax Court defined “trafficking” as “…to engage in commercial activity; buy and sell regularly.”21 The Tax Court held that CHAMP was engaged in two activities—the dispensation of medical marijuana, and caregiving. Only those expenses allocable to the medical marijuana activity were disallowed pursuant to IRC Section 280E. The Court allocated 18/25 of CHAMP’s salaries, payroll taxes, employee benefits, employee development training, meals and entertainment, and parking and tolls, to caregiving. Therefore, this 18/25 portion was fully deductible. Ninety percent of most of the taxpayer’s other expenses were similarly allocated to caregiving, and were also deductible.22 [2] Olive v. Commissioner In Olive v. Commissioner,23 taxpayer Martin Olive established the Vapor Room, a for-profit dispensary of medical marijuana. In addition to providing the marijuana, there were yoga classes, chess and other board games, movies with complimentary popcorn, and massages.24 However, the Tax Court characterized these as “… minimal activities and services as part of its principal business of selling medical marijuana.”25 Further, it noted that “[t]he Vapor Room’s sole source of revenue was its sale of medical marijuana and patrons did not specifically pay for anything else connected with or offered by the Vapor Room.”26 The Tax Court found that taxpayer had under-reported his income. It also rejected his calculations of cost of goods sold, and arrived at its own figure.27 Finally, as to expenses other                                                              20 Id. at 175. Id. at 182, quoting Webster’s Third New International Dictionary (2002). The court also cited US v Oakland Cannabis Buyers’ Cooperative, 532 US 483 (2001) for the proposition that the sale of medical marijuana is “trafficking.” Yet, the word “trafficking” cannot be found in Oakland Cannabis. That case stands only for the proposition that marijuana—even medical marijuana—is a Schedule I substance under the Controlled Substance Act. 22 Id. at 185. 23 Olive v Comm’r, 139 TC No 2 (2012). 24 Id. at 3. The Vapor Room provided an important service. Residents of Section 8 Housing in the San Francisco area could not use medical marijuana in their homes, for fear of being evicted. The Vapor Room not only provided them with the marijuana; it provided them with a safe place to use it. In fact, the shuttle busses from the local UC medical facility routinely took patients directly from their chemotherapy sessions to the Vapor Room, for marijuana therapy. Telephone conversation with Henry Wykowski, attorney for the petitioner in CHAMP and Olive, Feb. 1, 2013. 25 Id. at 1. 26 Id. at 3. 27 Despite rejecting the taxpayer’s COGS figures, the Tax Court still allowed a generous calculation of COGS, at 21
  • 33. than cost of goods sold, the Court refused to accept the taxpayer’s figures, instead accepting only those amounts which the Commissioner conceded. However, even these conceded amounts were disallowed under IRC Section 280E.28 Part of Mr. Olive’s problem was the lack of substantiation, of income, of cost of goods sold, and of other expenses. As to cost of goods sold: Petitioner, in fact, concedes in his posttrial brief that he “freely admitted” to the revenue agent that he had no receipts for COGS. Petitioner argues nonetheless that the ledgers alone are sufficient substantiation for taxpayers operating in the medical marijuana industry because, he states, that industry “shun[s] formal ‘substantiation’ in the form of receipts.”29 * * * * Petitioner consciously chose to transact the Vapor Room’s business primarily in cash. He also chose not to keep supporting documentation for the Vapor Room’s expenditures. He did so at his own peril.30 The lack of substantiation was exacerbated by the Court’s finding that the petitioner and his witnesses lacked credibility.31 The major finding of the Tax Court in Olive, however, was that the taxpayer was engaged in one business, not two. That one business was medical marijuana. Therefore, IRC Section 280E disallowed essentially all of the deductions. Finally, the court in Olive agreed with CHAMP that IRC Section 280E applied, because the taxpayer was “trafficking.”32 [3] CHAMP and Olive Compared CHAMP and Olive differ in three respects. First, CHAMP, though not federally tax-exempt, was a nonprofit under California law. The Vapor Room was for profit.33 It does not appear that this distinction made any difference. Second, CHAMP’s substantiation was accepted by the court; the Vapor Room’s was not. Curiously, despite Mr. Olive’s statements to the contrary,34 those in the new, medical marijuana                                                                                                                                                                                                   75.16% of gross receipts, minus an allowance for the marijuana that the taxpayer either gave away or consumed himself. Id. at 11. 28 Id. at 15. 29 Id. at 8-9. 30 Id. at 9. 31 Id. at 7. 32 Id. at 12. 33 Generally, medical marijuana dispensaries in California tend to be not for profit, while such dispensaries in Colorado tend to be for profit. The dispensaries in northern California tend to provide substantial caregiving services in addition to the marijuana; the dispensaries in southern California do not. Wykowski, supra note 24. 34 Olive, 139 TC at 8-9.
  • 34. business do keep careful records. However, those in the older, totally criminal drug trade typically do not. Criminals are loath to keep careful records; those records could later prove helpful to the prosecution. Moreover, drug dealers who were audited by IRS on their drug-related income typically had already been busted for the drug crime. By the time they got to court on the tax issue, it was already clear that they had lied about their drug-related income on their initial tax returns. Not surprisingly, such taxpayers had credibility problems.35 Both of these aspects of record-keeping in the drug industry are considerably less true for the recently established medical marijuana dispensaries. The new dispensaries are heavily regulated by the state.36 Therefore, they must, and do, keep careful records, for state tax purposes, at the very least. Also, they are totally open about their enterprise. There is no attempt to hide the details of their operations. As such, there is no reason to doubt their credibility. In this regard, Mr. Olive was an anomaly, perhaps harking back to a previous drug culture.37 The court-approved substantiation and credibility in CHAMP, and the opposite in Olive, must have mattered. However, the biggest impact was likely on the ability of the taxpayer to prove whether or not there was a business other than the dispensation of marijuana, and, if so, what the proper allocation of expenses to that other business would have been. The critical difference between the two cases, then, is the finding of two businesses in CHAMP, and one business in Olive. Once two businesses were found, the Tax Court in CHAMP was willing to make liberal allocations of expenses to the non-marijuana, and hence, deductible, category. In Olive, with essentially only one business, no such allocation was possible. The IRS reaction to CHAMP and Olive has been predictable. After CHAMP, IRS resolved medical marijuana tax disputes at the audit level. Generally, they would accept reasonable allocations of expenses between nondeductible, marijuana-related expenses and deductible, nonmarijuana-related expenses, often in the range of 20 percent allocations for nondeductible marijuana-related use, and 80 percent allocations for deductible, non-marijuana-related use. Allocations were typically done on the basis of such factors as square footage of floor space                                                              35 Perhaps some of the drug dealers were reluctant to report their illegal income, for fear that IRS would disclose their criminal activities to law enforcement personnel. They needn’t have worried. See IRS Disclosure & Privacy Law Reference Guide, IRS Publication 4639, Cat No 50891P (Rev’d 9-2011). Old and new, the marijuana business is a cash business. See notes 52-54, infra, and accompanying text. Recordkeeping is always more difficult in a cash business. 36 See, e.g., California State Board of Equalization, Special Notice: Important Information for Sellers of Medical Marijuana, February 2007,; California Department of Justice, Guidelines for the Security and Non-Diversion of Marijuana Grown for Medical Use, August, 2008. 37 The Court in Olive noted, “Petitioner was oblivious to the licensing requirement for his medical marijuana dispensary. He received the requisite license from San Francisco in or about July 2004.” Olive, 139 TC No 2, fn 4. Mr. Olive had opened the Vapor Room some six months earlier, in January of 2004.
  • 35. devoted to the various activities, time spent, revenues, and salaries.38 However, since Olive, IRS has placed the burden on the taxpayer. It is far more prone to disallow all deductions. The medical marijuana industry is now perceived as a good target for audits, since, more likely than not, the audits will generate substantial additional tax revenues.39 § 3.03 IRS Enforcement in Context Modern drug enforcement policy dates to the Nixon Administration’s War on Drugs, and the Controlled Substance Act of 1970.40 However, the legalization of medical marijuana changed everything. We soon knew that the federal government could enforce the Controlled Substance Act against the medical marijuana industry.41 Yet, whether it would actually choose to do so was another matter. In October 2009, U.S. Deputy Attorney General David Ogden sent a Memorandum to U.S. Attorneys in states that had legalized medical marijuana (the “Ogden Memorandum”).42 The Ogden Memorandum made it clear that, while the Department of Justice would continue to enforce the Controlled Substance Act in all states, it was also committed, “…to making efficient and rational use of its limited investigative and prosecutorial resources.”43 Accordingly, while the prosecution of “…significant traffickers of illegal drugs, including marijuana, and the disruption of illegal drug manufacturing and trafficking networks…” continued to be a “core priority,”44 the Department would not focus federal resources on “…individuals whose actions are in clear and unambiguous compliance with existing state laws providing for the medical use of marijuana.”45 The Memorandum went on to list the following characteristics as indicative of conduct not in clear and unambiguous compliance:    Unlawful possession or unlawful use of firearms; Violence; Sales to minors;                                                              38 Wykowski, supra note 24. Luigi Zamarra, CPA, formerly CFO of Harborside, and currently with Henry Levy & Co., CPAs, of Oakland, California, suggests a “transactional factor” which would produce allocations more favorable to the marijuana dispensaries. Mr. Zamarra suggests that, in allocating time to marijuana dispensing vs. other care-giving, the time spent on such things as discussing the medical effects of the marijuana is properly characterized as “medical advice”—not trafficking in marijuana. The only time properly allocable to “trafficking,” in his view, is the time it takes to ring up the sale. Mr. Zamarra can be reached at 39 Wykowski, supra note 24. 40 21 USCS § 801. 41 Gonzalez v Raich, 545 US 1 (2005); US v Oakland Cannabis Buyers’ Cooperative, 532 US 483 (2001). 42 US Deputy Attorney General David W. Ogden, Memorandum for Selected United States Attorneys. Subject: Investigations and Prosecutions in States Authorizing the Medical Use of Marijuana, Oct 19, 2009. 43 Id. 44 Id. 45 Id.
  • 36.    Financial and marketing activities inconsistent with the terms, conditions, or purposes of state law, including evidence of money laundering activity and/or financial gains or excessive amounts of cash inconsistent with purported compliance with state or local law; Illegal possession or sale of other controlled substances; or Ties to other criminal enterprises.46 However, in June 2011, the Department of Justice refined its policy. A new Memorandum by Deputy Attorney General James M. Cole stated, “The Department’s view of the efficient use of limited federal resources as articulated in the Ogden Memorandum has not changed.”47 But Cole went on: There has, however, been an increase in the scope of commercial cultivation, sale, distribution and use of marijuana for purported medical purposes. For example, within the past 12 months, several jurisdictions have considered or enacted legislation to authorize multiple large-scale, privately operated industrial marijuana cultivation centers. Some of these planned facilities have revenue projections of millions of dollars based on the planned cultivation of tens of thousands of cannabis plants. The Ogden Memorandum was never intended to shield such activities from federal enforcement action and prosecution, even where those activities purport to comply with state law.48 Cole urged that such activities be federally prosecuted, and concluded, “Those who engage in transactions involving the proceeds of such activity may also be in violation of federal money laundering statutes and other federal financial laws.49 Other U.S. Attorneys reacted to the Cole Memorandum with enthusiasm. U.S. Attorney Andre Birotte, Jr. of the Central District of California criticized medical marijuana as “the new                                                              46 Id. The policies of the Ogden Memorandum were a reiteration of the position taken by Attorney General Eric Holder at press conferences in February and March of 2009. Marijuana Policy Project, Federal Enforcement Policy De-Prioritizing Medical Marijuana: Statements from President Obama, his spokesman, and the Justice Department, updated August 2011. 47 US Deputy Attorney General James M. Cole, Memorandum for United States Attorneys, Subject: Guidance Regarding the Ogden Memo in Jurisdictions Seeking to Authorize Marijuana for Medical Use, June 29, 2011. Grim, “Memo: DOJ Cracks Down on Pot Shops,” Huffington Post, July 1, 2011, available at; Stern, “Obama Administration Clarifies Medical-Marijuana Stance—Sort Of; Reaffirms Lack of Interest in Busting Patients, but Warns of Possible Consequences for Commercial Activity,” Phoenix New Times, June 30, 2011, available at; Freedman, “Attorney general defends medical pot crackdown,” SFGate, available at; Martin A Lee, Smoke Signals: A Social History of Marijuana (2012), at 396. 48 Id. 49 Id.
  • 37. California gold rush.”50 Melinda Haag, U.S. Attorney for the Northern District of California, agreed: What we are finding, however, is that California’s laws have been hijacked by people who are in this to get rich and don’t care at all about sick people.51 The response to the Cole Memorandum was a federal crackdown on medical marijuana dispensaries, especially in California. Not surprisingly, the “money laundering” aspects, which were raised in both the Ogden and Cole Memoranda, were a major focus. In going after the possible money laundering, the federal government was simply treating the medical marijuana industry like any other illegal business. Banks generally do not deal with illegal businesses, lest they violate the banking regulations. Therefore, with a few exceptions in Colorado,52 banks are refusing to deal with the medical marijuana industry.53 Accordingly, most medical marijuana dispensaries can establish neither checking accounts nor credit card accounts.54 Of necessity, they deal in large amounts of cash. Naturally, that makes the federal government suspicious. Cash and properties have been confiscated.55 Additionally, large tax deficiencies have been found.56 Many dispensaries have been shut down, including Humboldt Medical,57 the Marin                                                              50 Miller, “US Attorneys Hold Press Conference on Federal Medical Pot Crackdowns,” High Times (Oct. 11, 2011); available at 51 Id.; Doug Fine, Too High to Fail: Cannabis and the New Green Economic Revolution (2012), at 230-231. 52 Telephone conversation with James Marty, CPA, Jim Marty & Assoc, LLC, Colorado, Jan 15, 2013; “Medical Marijuana Shops Struggle with Banks, Mounting Federal Pressure to Turn the Business Away,” Huffington Post, June 17, 2011,; Wyatt, “Colo. Considers banking for medical marijuana shops,” USA Today, Feb 14, 2012, 53 Huffington Post, supra note 52; “It’s Legal to Sell Marijuana in Washington, But Try Telling That to a Bank,” NPR Morning Edition, Nov. 16, 2012,; Ross, “Medical Marijuana sales becoming cash only,”; Kor, “Banks Say No to Medical Marijuana,” Arizona Journal, Banking is not the only problem. Insurance coverage is also difficult. Andrews, “When Your State Says Yes To Medical Marijuana, But Your Insurer Says No,” The suppliers of marijuana to the dispensaries have even more of a problem with the banks than the dispensaries do. Wykowski, supra note 24. 54 Matonis, “Credit Card Processors Discriminate Against Medical Marijuana,” Forbes, Sept. 29, 2012. 55 Hecht, “IRS seizes California medical marijuana provider’s bank account,” Sacramento Bee, June 15, 2012, 56 Allegedly, the IRS Abusive Tax Avoidance Transactions office (ATAT) is behind most of the IRS actions, at least in Colorado. Marty, supra, note 52. I have not been able to corroborate this information. See generally, Internal Revenue Manual 5.20.1, Abusive Tax Avoidance Transactions. However, it is possible that the Illegal Source Financial Crimes Program within the IRS Criminal Investigation Division is also involved. See Erb, “IRS Just Says No to Medical Marijuana Deductions,” Forbes (Oct 6, 2011), available at See generally, Investigation-(CI).
  • 38. Alliance for Medical Marijuana (with a tax bill of over one and a quarter million dollars),58 and the One Love Wellness Center.59 § 3.04 Current Efforts [1] Harborside The Harborside Health Center, of Oakland, California, serves 94,000 patients, and earns about $22 million in revenue. It keeps careful records, and provides substantial non-marijuana-related, caregiving services. It paid about $1.1 million in taxes to the city of Oakland, $2 million to California and $500,000 to the United States.60 However, the U.S. Attorney for the Northern District of California, claimed that Harborside, as a “superstore,” was more likely to be in violation of state law. She tried to get Harborside evicted from its premises,61 but failed.62 The IRS audited for tax years 2007 and 2008. It disallowed deductions pursuant to IRC Section 280E, and came up with an additional $2.5 million in back taxes. According to the facility’s chief executive, if they had been forced to pay the additional taxes, they would have gone out of business.63 However, it now appears that Harborside will settle its dispute with the IRS.64 [2] Legislative Lobbying A number of legislators have written to IRS, asking for a ruling that IRC Section 280E does not apply to medical marijuana. Not surprisingly, they failed. IRS has responded: Because neither section 280E nor the Controlled Substances Act makes exception for medically necessary marijuana, we lack the authority to publish the guidance                                                                                                                                                                                                   57 Onishi, “Cities Balk as Federal Law on Marijuana is Enforced,” NY Times (June 30, 2012), A14. Novack, “Owner of First U.S. Marijuana Pharmacy Now Broke and Fighting IRS,” Forbes (July 2012), available at; Carly Schwartz, “Medical Marijuana, California’s Oldest Pot Club, Closes,” Huffington Post (Dec 2, 2011), available at 59 “Facing Federal Scrutiny, Sacramento marijuana store shuts down,” See also, Nagourney, “In California, It’s U.S. vs. State Over Marijuana,” NY Times (Jan 14, 2013), A1. 60 Olson, “IRS ruling strikes fear in medical marijuana industry,” NBC News, available at 61 Romney, “Oakland protests U.S. attorney’s crackdown on large medical marijuana dispensary,” LA Times (July 13, 2012), available at Fine, supra note 51, 240-241. 62 Matthai Kuruvila, “Harborside Health Center eviction denied,” SFGate, 63 Olson, supra note 60 (quoting Steve DeAngelo); See also, “Millions at stake in IRS audit of Oakland medical marijuana dispensary,”; Wood, “Taxes Are Killing Medical Marijuana Like Roundup,” Forbes (Aug 3, 2012); Erb, supra note 56, Romney, supra note 61, Fine, supra note 51 at 240. 64 Interview with Henry Wykowski, April 12, 2013. 58
  • 39. that you request. The result you seek would require the Congress to amend either the Internal Revenue Code or the Controlled Substances Act.65 Accordingly, members of Congress are hoping to do just that. As the IRS letter points out, one could amend or repeal IRC Section 280E directly, or one could statutorily remove marijuana from Schedules I and II of the Controlled Substance Act, which would make IRC Section 280E inapplicable. The Small Business Tax Equity Act of 2013 would accomplish the former by removing medical marijuana from the coverage of IRC Section 280E.66 The Medical Marijuana Patient Protection Act would have done the latter.67 Senator Leahy, Chair of the Judiciary Committee, has written to the Director of the Office of National Drug Control Policy to suggest that the Controlled Substances Act be amended to allow possession of up to one ounce of marijuana, in those states in which marijuana is legal.68 Congressmen Blumenauer (D. Ore.) and Polis (D. Colo.) have introduced the Marijuana Tax Equity Act of 2013, also with a view toward legalization.69 The industry has organized to help lobby for these, and similar proposals.70 [3] Lobbying the Attorney General and the DEA Pursuant to the Controlled Substances Act, the Attorney General of the United States may remove a drug from the Controlled Substance schedules.71 The removal procedures are actually done by the Drug Enforcement Administration, which is part of the Department of Justice. Americans for Safe Access recently tried to force DEA to reclassify marijuana. To fit within Schedule I, it must be shown that the substance has “no currently accepted medical use in treatment in the United States.”72 It is hard to see how marijuana can be a Schedule I controlled substance, given that it is helpful in the treatment of cancer, glaucoma, and AIDS.73 However,                                                              65 Letters dated Dec. 16, 2010 from Andrew J. Keyso, IRS Deputy Associate Chief Counsel (Income Tax & Accounting) to Representatives Barney Frank, Raul Grijalva and Jared Polis. 66 HR 2240, 113th Cong., 1st Sess (2013). 67 HR 2835, 111th Cong., 1st Sess (2009). This legislation would essentially have prevented the federal government from banning the medical use of marijuana. See also, the Respect State Marijuana Laws Act of 2013, H.R. 1523, 113th Cong., 1st Sess. (2013). See generally, Caulkins, Hawken, Kilmer and Kleiman, Marijuana Legalization: What Everyone Needs to Know (2012). 68 Letter from Senator Patrick Leahy to Director R. Gil Kerlikowske (Dec. 5. 2012), available at 69 HR 501, 113th Cong., 1st Sess. See also, Mike Riggs, “Meet the Members Who Will Make Marijuana Reform an Issue in 2013,” 70 “IRS Threatens to Shut Down Medical Cannabis,” Some of the organizations include NORML (National Organization for Reform of Marijuana Laws) and the National Cannabis Industry Association, For a quick survey of international legislation decriminalizing marijuana and other drugs, see “Virtually Legal,” Economist, Nov 14, 2009, at 70. 71 21 USCS § 811(a), (b). For a prediction that marijuana will be completely descheduled only in the second Hilary Clinton administration, see Bill Keller, “How to Legalize Pot,” NY Times, May 20, 2013. 72 21 USCS § 812 (b)(1)(B). One would think that marijuana could be taken out of Schedule II as well because it does not have a “high potential for abuse.” 21 USCS§812(b)(2)(A). 73 See Randall and O’Leary, Marijuana Rx: The Patients’ Fight for Medicinal Pot (1998). Petitioners’Final Reply Brief, Americans for Safe Access, v DEA, No 11-1265, 2013 US App LEXIS 1407 (DC Cir Jan 22, 2013).
  • 40. although Americans for Safe Access was found to have standing, the D.C. Circuit Court ultimately refused to order the DEA to reclassify.74 [4] Litigation Strategy Olive is being appealed to the Ninth Circuit. At least six other dispensaries are in similar disputes with IRS.75 Olive will argue that IRC Section 280E does not apply to medical marijuana, in states where it has been legalized. Presumably, the argument would apply to recreational marijuana in Colorado and Washington as well. Clearly, Congress could not have contemplated legal medical and/or recreational marijuana when it enacted IRC Section 280E in 1982, because they did not exist at the time. Most of us would distinguish a criminal drug smuggler, who obtains his product somewhere in Central or South America and sells it in a state in which it is illegal under both state and federal law, from a medical marijuana dispensary. In fact, both the Ogden and Cole Memoranda clearly indicate that the Department of Justice recognizes the distinction between “significant traffickers of illegal drugs,” and “individuals whose actions are in clear and unambiguous compliance with existing state laws.”76 Can this distinction hold up in light of the language of IRC Section 280E? There can be no question that marijuana is listed as a “controlled substance,” in the Controlled Substance Act.77 One might question, however, whether the activities of the medical marijuana dispensaries constitute the “trafficking” of that substance. They do. CHAMP specifically held that “trafficking,” within the meaning of IRC Section 280E, applied to the medical marijuana industry.78 Olive held the same.79 Even if the dispensing of medical marijuana is “trafficking” within the meaning of IRC Section 280E, does the trade or business of a dispensary like the Vapor Room “consist” of such trafficking? Black’s Law Dictionary defines “consisting” as Being composed or made up of. This word is not synonymous with “including;” for the latter, when used in connection with a number of specified objects, always implies that there may be others which are not mentioned.80                                                              74 Americans for Safe Access, supra note 73. Wykowski, supra note 24. 76 Ogden Memorandum, supra note 42. 77 21 USCS § 812(b). 78 CHAMP, 128 TC at 182. 79 Olive, supra note 23, at 12. The most common use of “trafficking” in legal materials is “drug trafficking” in the Federal Sentencing Guidelines. e.g. USSG §2L.2 , 18 USCS However, there is nothing there to suggest that the dispensation of medical marijuana would not be “drug trafficking.” In fact, there is a federal statutory definition of “trafficking,” although, by its terms, it only applies within the meaning of that separate statute. The Computer Fraud and Abuse Act (CFAA) applies to anyone who “traffics … in any password…” The statute defines “traffic” as, “ to transfer, or otherwise dispose of, to another, or obtain control of with intent to transfer or dispose of.” 18 USCS § 1029(e)(5). See Atpac, Inc v Aptitude Solutions, Inc, 730 FSupp2d 1174 (EDCal 2010). 80 Black’s Law Dictionary 279 (5th ed 1979). See also, Parmelee Pharmaceutical Co v Zink, 188 FSupp 821 (DWD 75
  • 41. Accordingly, “consists of” necessarily means “consists only of.” Therefore, IRC Section 280E would apply to a facility which only traffics in marijuana, but would not apply to a facility which traffics in marijuana and provides other caregiving services.81 One might think that this interpretation would carry out the will of Congress. Legal, medical marijuana could not have been imagined when Congress enacted IRC Section 280E. Surely, they wanted to deny deductions to the “bad” drug smugglers who did nothing but drug smuggling. Surely, they would not have wanted to deny deductions to the “good” medical marijuana dispensaries which provided marijuana to their patients, but did so much more. And yet, this interpretation of “consists” would also have the curious result of denying deductions to those who only trafficked in marijuana (whether good or bad), while allowing deductions to those who trafficked in marijuana and provided hired assassins. If a judge believed, as I do, that IRC Section 280E is silly, and should be applied as narrowly as possible, he or she might go for the “consist” argument. Otherwise, I would not be optimistic. The industry’s best hopes lie in amending the statute, getting marijuana removed from the Controlled Substance schedule, or persuading the government to change its enforcement policy. Of course, anything short of winning in court will not help the Vapor Room at this point. § 3.04 The Future IRC Section 280E makes no sense. Those in the drug industry should be treated no worse than those in other illegal industries. If caught breaking the law, they should suffer the appropriate consequence. However, they should not be taxed on gross income. They should be allowed business deductions, just like everyone else. IRC Section 280E is hard to justify under the public policy doctrine. Admittedly, the Senate Finance Committee claimed a public policy justification when the statute was enacted in 1982.82 However, since then, there have been so many conflicting statements from the federal government, and such clear statements from the jurisdictions in which medical, and even recreational, marijuana have been legalized, that the “sharply defined” policy has become increasingly fuzzy. Arguably, those dispensing medical marijuana or recreational marijuana, in states where such dispensation is legal, should be treated better than other lawbreakers. Even Department of Justice policy pronouncements recognize that there is a difference between the good guys and the bad guys. In view of the increasing sentiment toward legalization of at least some, if not all, marijuana use,83 rigorous enforcement of anti-marijuana laws puts neither DOJ nor IRS in a good                                                                                                                                                                                                   Mo 1960). 81 Wykowski, supra note 24. 82 S Rep 97-494. Also, in Wood v US, 863 F2d 417 (5th Cir 1989), IRC § 280E was cited as evidence of a sharply defined public policy against the deductibility of drug forfeitures. 83 Edwards-Levy, “Pot Legalization Support at Record High, Poll Finds,” Huffington Post (Dec 4, 2012), available at
  • 42. light. Further, enforcement of a law which is supported by so few, risks harm to the rule of law in general.84 In December of 2012, President Obama was asked about legalizing marijuana. He replied, “I wouldn’t go that far.” * * * And, as it is, the federal government has a lot to do when it comes to criminal prosecutions. It does not make sense, from a prioritization point-of-view, for us to focus on recreational drug users in a state that has already said that, under state law, that’s legal. We’ve got bigger fish to fry…How do you reconcile a federal law that still says marijuana is a federal offense and state laws that say that it’s legal?85 For federal income tax purposes, Legal, Illegal and MMJ should be treated the same. If they earn income, they should report it, and be taxed on it. If they incur ordinary and necessary expenses in producing that income, they should be allowed to deduct them. It would be best if IRC Section 280E were amended or repealed, or, at least, if marijuana were removed from Schedules I and II. But, for the moment, IRS and DOJ should spend their enforcement resources in other ways. There are, indeed, bigger fish to fry.                                                                84 “Prohibition will work great injury to the cause of temperance. It is a species of intemperance within itself, for it goes beyond the bounds of reason in that it attempts to control a man’s appetite by legislation, and makes a crime out of things that are not crimes. Prohibition law strikes a blow at the very principles upon which our government was founded.” Attributed to Abraham Lincoln, Speech, 18 Dec. 1840, to Illinois House of Representatives. If he didn’t say it, he should have. 85 Vamburkar, “President Obama Responds to Question About Legalizing Marijuana…And His Own Past Drug Use.” See also, “David Axelrod Unaware of Any Plans For Obama To Change Drug Policy in Second Term,” Huffington Post (Sept 6, 2012), available at There is also no apparent change in White House drug control strategy. The 2012 National Drug Control Strategy: Building On a Record of Reform: Executive Summary. See also, Office of National Drug Control Policy, Marijuana Legalization (October 2012), available at
  • 43. Special International Update from Lexis Tax Journal Magazine Tim Sanders and Eric Sensenbrenner on U.S. Inversions Through European Mergers By Tim Sanders and Eric Sensenbrenner § 4.01 U.S. Inversions Through European Mergers Speed Read: The US corporate tax regime can put US-based multinationals at a competitive disadvantage, leading them to migrate. US anti-inversion rules have ceased to halt the trend. Changes made a year ago point towards migration through mergers with sizeable non-US corporations, which can reduce the impact of the anti-inversion rules. Such mergers are likely to involve a US forward or reverse triangular merger coupled, in the case of the UK, with a court scheme of arrangement which can reduce the tax costs of the combination to an acceptable level. US-based multinationals are increasingly looking to 'invert', that is become a multinational corporation incorporated outside the US, headed by a non-US parent. Some recent examples are Aon's move to London, Eaton Corporation's merger with Cooper Industries PLC, and Liberty Global's merger with Virgin Media. This article will explain the reasons why a US corporation may wish to migrate, the obstacles to it doing so and the structures one might see adopted in future, given recent changes in US law. Reasons to Invert A US company may wish to relocate for several reasons. First, US-based companies with significant non-US operations may find themselves at a competitive disadvantage, compared to their competitors headquartered in jurisdictions that impose a territorial tax system that exempts, or reduces, the tax burden on foreign income. By contrast, a US-headed corporation is subject to worldwide taxation and, under the US subpart-F regime, the earnings of its controlled foreign corporations (CFCs) may be subject to a US tax in advance of repatriation. A corporate migration, or inversion, enables the company to expand operations outside the US, either organically or through acquisitions, without the earnings being subject to US taxation, generally imposed at a higher rate than in most locations outside the US where it conducts business. In                                                               This article was first published in Tax Journal, dated 28 June 2013, and is reproduced with kind permission of the publishers. All rights reserved. The article is intended to give general guidance and is not a substitute for professional advice.  Tim Sanders is an English qualified tax lawyer and fellow of the Chartered Institute of Taxation. He heads Skadden, Arps, Slate, Meagher & Flom's European tax practice and specialises in corporate and finance taxation, with particular emphasis on cross-border matters. Eric Sensenbrenner is a US attorney and partner in the Washington DC office of Skadden, Arps, Slate, Meagher & Flom. He advises on a broad range of US and international tax matters, with a particular emphasis on transactional tax planning in the international context.
  • 44. addition, existing non-US operations can be moved 'out-from-under' the US company, albeit often at some tax cost, or effectively 'de-controlled' to avoid the US CFC regime. '[The merger will] allow us to potentially achieve a global effective tax rate comparable to that of our global competitors ... The UK currently has lower corporate tax rates than the US and generally has a more favourable tax regime with respect to non-UK earnings of companies repatriated in the form of dividends than the US has with respect to non-US earnings' (Source: ENSCO International Inc proxy statement, filed on 20 November 2009). A structure under a non-US parent can facilitate placing leverage into the group, often in connection with the inversion transaction itself. Under existing US tax law, the ability to deduct interest paid by a US company to its non-US parent on such debt is limited, effectively to 50% of its earnings before interest, taxes, depreciation and amortisation (EBITDA), although in recent years there have been proposals to tighten these limitations and further restrict the ability of inverted companies to deduct interest paid to foreign parent corporations. Hurdles The US has introduced a succession of legislative and regulatory changes designed to prevent a US corporation migrating without a significant tax cost. A brief analysis of the history of such changes is necessary to understand why, in future, US companies are more likely to migrate through merging with a sizeable European counterpart, rather than through internal reorganisations, as one has typically seen in the past. The history of US corporate inversion is broadly divided between inversions that took place prior to the introduction of s 7874 of the US Internal Revenue Code ('the code') and those that have taken place since. Prior to s 7874, it is sufficient to note for current purposes that there were relatively few hurdles to overcome if a US corporate wished to invert. (Although such inversions often resulted in gain being recognised by the US shareholders of the inverted company under s 367(a) of the code, market conditions and institutional shareholdings often meant shareholderlevel gain was not a significant impediment.) Throughout the 1990s US companies migrated, including well-known companies such as Triton Energy Corporation (Cayman, 1996), Tyco International (Bermuda, 1997), Fruit of the Loom (Cayman, 1999), Ingersoll-Rand (Bermuda, 2001) and Noble Corp (Cayman, 2002). The exit of such iconic US companies led to widespread concern and outrage. A member of the US Senate Finance Committee commented on Ingersoll-Rand's migration that 'it produced the jack hammers that were used to carve Mount Rushmore. It left the US for Bermuda last September and now pays less than $28,000 in taxes to Bermuda instead of its $40m tax tab to the United States government.'
  • 45. In response to this exodus, the S 7874 anti-inversion rule was introduced in the US Congress in 2002, and enacted as part of the American Jobs Creation Act of 2004. Under S 7874, as originally enacted, if:   a non-US corporation acquires, directly or indirectly, substantially all of the properties held, directly or indirectly, by a US corporation (or a US partnership); and former shareholders of the US corporation own 80% or more of the voting power or value of the non-US corporation by reason of their former shareholding in the US corporation; then the non-US corporation will be treated as a domestic corporation for US tax purposes, and so will continue to be fully subject to US tax. If 60% ownership continuity is present (but less than 80%), the expatriated US corporation is respected as being non-US for US tax purposes, but will be treated as a 'surrogate foreign corporation' whose 'inversion gains' are taxed under a special regime and whose corporate executives could be subjected to an excise tax on stock-based compensation. An inversion gain means income and gains recognised by the former US domestic corporation on the disposition of stock or other properties (including by licence) which would continue to be taxed for 10 years after the inversion, without the benefit of offset for losses or credits. However, the rules do not apply where there is less than 60% continuity of ownership or if the expanded affiliated group, that includes the non-US parent company, has substantial business activities in the non-US jurisdiction in which the non-US corporation is incorporated. Under the initial regulations issued by the US Treasury Department in 2006, there was a 'safe harbour' rule, which provided that the expanded affiliated group (EAG) would be regarded as having substantial business activity, if at least 10% of its employees, assets and sales were situated in the non-US corporation's country of incorporation. This test was supplemented by a general facts and circumstances test that looked at a range of factors to determine whether the substantial business activities test was met, including: n the historical conduct of continuous business activities in the non-US jurisdiction by the EAG;    the performance in the non-US jurisdiction of substantial managerial activities by locally based officers and employees; a substantial degree of ownership of the EAG by investors resident in the foreign country; and the conduct of business activities in the non-US jurisdiction that are material to the overall business objectives of the EAG. In 2009, the regulations were replaced by new regulations that removed the 10% safe harbour, leaving only a facts and circumstances test for determining substantial business activities. It was this facts and circumstances test that Aon relied upon when migrating to London in 2012:
  • 46. 'We believe that the activities the Aon Delaware expanded affiliated group conducts in the UK should satisfy the substantial business activities test set forth in the Applicable Regulations' (Source: Aon form s-4, filed 13 January 2012). Over the years that followed the introduction of s 7874, despite a number of regulations designed to tighten the regime, US companies continued to migrate out of the US. Across the range of continuity of interest from more than 80% to less than 60%, between 2004 and 2012 there were more than 20 migrations of large US corporations, including Aon and ENSCO International Inc's migrations to the UK. Finally, a more substantial change was introduced in the 2012 regulations, which are effective from 12 June 2012. The key change introduced by the 2012 regulations was that the then-existing facts and circumstances test was replaced with a strict bright line test as the sole means for satisfying the substantial business activities test. This new test requires that at least 25% of the expanded group's employees, assets and gross income is located in, or derived from, the single relevant non-US country. By this is meant not only that at least 25% of employees by number must be based in the relevant country but also that they must account for at least 25% of the total salary bill, which is designed to stop junior staff making up the 25% where all (highly paid) senior management and executives remain in the US. The asset test considers only tangible assets (not intangibles) located in the relevant non-US country. Finally, gross income is treated as derived from the country in which the customer is located and excludes income from related parties. These rules make it much more difficult to rely on the safe harbour, as even US corporations with large non-US operations, and even those with exclusively non-US but geographically diversified businesses, may not have a sufficient concentration of operations in any one country. For example, a US corporation that has 70% of its operations outside the US may split those operations between, say, the UK, Germany, France and Italy with minor operations in multiple jurisdictions, such that even though a number of such countries may exceed 20% and thus be larger than operations in the US, no one non-US country can cross the 25% threshold. Ironically, under this formulation of the test for substantial business activities, many US companies may not be treated as having substantial business activities in any country, including the US. However, the exclusion where there is less than 60% continuity of ownership remains and the worst effects of s 7874 can be avoided where there is less than 80% continuity. Thus, a US company that can tie up with a non-US company of comparable size can avoid the impact of s 7874 and even a tie up with a material but smaller non-US company that reduces continuity below 80% can eliminate the worst effects of s 7874. Structures Each structure is tailored to meet the particular facts and circumstances of each case but most share some core characteristics. Where a US corporation wishes to combine with an existing UK listed company, this would probably involve a court scheme of arrangement under the
  • 47. Companies Act 2006 Part 26. This would be coupled with a US forward or reverse triangular merger to merge the existing US corporation into the new structure. What is involved is best illustrated by example represented in the shaded box (above). A UK scheme of reconstruction To affect a merger of the UK company, a new UK company is formed (Newco PLC) and under a court scheme of arrangement, constituting a scheme of reconstruction under TCGA 1992 Sch 5AA, the ordinary shares of UK PLC held by the public shareholders are cancelled and reissued to Newco PLC. As an aside, assuming UK PLC is listed, it is likely to have a large number of shares in issue that are not needed once it is de-listed and becomes a wholly owned subsidiary of Newco PLC. Thus, as part of the arrangements there may be a (tax-free) share consolidation of UK PLC shares. In consideration of its acquisition of UK PLC, Newco PLC issues its shares to the former public shareholders of UK PLC in proportion to their former shareholdings in UK PLC.
  • 48. A court scheme treated as a reconstruction for UK tax purposes is generally used, rather than an on-market exchange offer falling within TCGA 1992 s 135. This is for non-tax reasons, principally the level of shareholder acceptance required to succeed and also the ability to squeeze out dissenting shareholders, or apathetic shareholders who fail to vote. In a market offer, 90% shareholder acceptance is required to compulsorily acquire the balance, whereas once a scheme is approved it binds all shareholders. The required majority to approve a scheme and so force a squeeze out of non-accepting shareholders is generally considerably easier to achieve than the 90% needed in an open market offer. A scheme can be approved by 75% by value and a majority by number of the target company's shareholders who actually vote (in person or by proxy) at the relevant shareholders' meeting. Although a court-sanctioned cancellation scheme is adopted for non-tax reasons, there is a beneficial tax consequence. A scheme allows one to mitigate stamp duty that would arise on an offer (or a court-approved exchange), as there is a cancellation and issue of shares but no transfer of shares. A problem used to be the issue of shares by Newco PLC to shareholders who hold, or wish to hold, shares through a clearing or a depository system, which led to a potential 1.5% SDRT charge under FA 1986 s 93 or s 96 on issue (or stamp duty under FA 1986 s 67 or s 70 if shares were transferred into such a system). US shareholders in a public company do not expect to pay stamp duty on their share dealings; typically shares would be issued into a depository/clearing system such as DTC so that future share dealings may be conducted free of stamp duty. This would result in the 1.5% SDRT charge to the extent that Newco PLC shares were issued to the US Inc shareholder base in the merger. Aon tackled this by transferring shares of Aon Global (effectively Newco PLC in our example) into a depository (EES) before the effective date of the scheme, at which point they were worth their nominal subscribed value, so reducing duty to a relatively low level, then subsequently moving such shares into DTC's nominee, so qualifying for the exemption for transfers between depositories and clearing systems in FA 1986 s 72A. However, recent changes in law mean that such types of structuring may no longer be required. On 1 October 2009, the CJEU held in HSBC Holdings PLC and Vidacos Nominees Ltd v HMRC (C-569/07) that it was illegal for EU Member States to charge stamp duty or SDRT on the issue or transfer of shares to a clearance service, on the basis that it was contrary to art 11 of Directive 69/335/ EEC and art 56 of the EC Treaty on free movement of capital. Following that case, there was a period of uncertainty as whilst HMRC confirmed it would apply the case to depositories as well as clearing systems, this was restricted to those based in the EU, leaving uncertainty in the case of an issue to an entity such as DTC in the US. However, the First-tier Tribunal judgment on 28 February 2012 in the case of HSBC Holdings PLC and The Bank of New York Mellon Corporation v HMRC [2012] UKFTT 163 (TC), held that the 1.5% entry charge on share and securities issues by an EU issuer to a depositary, wherever based, was unlawful. Following this, HMRC announced it would not appeal and would extend the treatment to all clearers and depositories wherever based, but also noted that this only applies to transfers that are an integral
  • 49. part of an issue of share capital. Thus, provided one is satisfied that DTC is a clearing system within FA 1986, which HMRC appears to have accepted in Aon, and provided there is an issue of shares on the cancellation scheme, prima facie, the 1.5% charge is capable of being avoided. On the cancellation, shareholders in UK PLC potentially qualify to roll-over gains inherent in their existing UK PLC shares into Newco PLC shares, to the extent they do not receive cash or other consideration. To qualify for this treatment under TCGA 1992 s 136, the scheme must qualify as a scheme of reconstruction under TCGA 1992 Sch 5AA. Schedule 5AA has four conditions, the first two of which must be satisfied along with one of the other two. The first two conditions require the issue of ordinary share capital of Newco PLC to shareholders of UK PLC ordinary share capital (or each class of ordinary share capital involved in the reconstruction) and that each member of a UK PLC share class has the same entitlement. This precludes shareholders in the same class in UK PLC being offered a mix and match alternative, as although they all have the same right to elect they will inevitably elect to accept different mixes, so at the time of the scheme they will have different rights and entitlements with, for example, some shareholders taking all shares of Newco PLC and some a mix of shares and cash. It is possible to cater for this by incorporating as a preliminary step a share reorganisation. In the example, all UK PLC shareholders wanting to take Newco PLC shares would be redesignated as A ordinary shares and those wanting a mix redesignated as B ordinary shares, so that at the effective date of the scheme each A shareholder and each B shareholder would receive exactly the same as each other member of that share class. In practice, given the US desire to reduce the continuity of US ownership, there may be limited scope to allow UK shareholders to take consideration other than shares of Newco PLC. The final condition that Newco PLC would rely upon, to qualify as a scheme of reconstruction under Sch 5AA in our example, would be that the scheme is carried out pursuant to Companies Act 2006 Part 26 and no part of the business of UK PLC is transferred under the scheme to any other person. The tax free roll-over treatment for shareholders under TCGA 1992 s 136 is subject to the scheme not being part of a scheme of tax avoidance, usually a relatively minor concern when two large unconnected entities combine but one that is normally dealt with through obtaining clearances under TCGA 1992 s 138 and ITA 2007 s 701 or CTA 2010 s 748. A US triangular Conditional upon the UK scheme and simultaneous with it in the US, Newco Inc, a subsidiary set up for the purposes of the merger, is merged with and into US Inc. The example we use illustrates a reverse triangular merger. Under a forward triangular merger, US Inc could be merged into Newco Inc under the provisions of US law (usually Delaware law, as many of the Fortune 100 have chosen to incorporate there, taking advantage of Delaware's generally corporation-friendly environment) and US Inc ceases to exist. Newco Inc would succeed to all the rights, duties and obligations of US Inc, including ownership of all its assets. The outstanding
  • 50. shares of US Inc would be cancelled and former shareholders in US Inc would receive merger consideration, which may be cash and/or shares in Newco PLC, at a set ratio. Newco PLC satisfies US Inc's obligation to provide shares in Newco PLC by issuing shares directly to them. In consideration of this, Newco Inc issues further shares to Newco PLC. This latter step is not required by US law but may be done for UK tax purposes (including ensuring the UK company has the appropriate tax basis, but given the availability of SSE, this may be regarded as unnecessary). A forward merger is treated as akin to a disposition of assets by the US Inc for US tax purposes but, provided that the cash element of the merger (boot in US terminology) does not exceed 50% to 60% of the total consideration, the merger should be tax free for US Inc US resident shareholders to the extent that they receive shares and US Inc is also not subjected to tax. This type of forward merger is not often used in a merger of large multinationals as, inter alia, the consents and approvals of third parties may be required to novate contracts, etc. (as in a standard asset purchase) and some US states will impose transfer taxes on the transfer of property located in that state. Importantly, also, from a US tax perspective, in the event that the merger should fail to qualify as a tax-free reorganisation for any reason, the US Inc would recognise a gain on its assets, in contrast to a reverse merger, in which only shareholder-level gain is at risk (and, in most cases, would otherwise be recognised in an inversion transaction). If the surviving corporation is US Inc, this is a reverse triangular merger. By operation of the relevant state merger law in the US, as a result of the merger, Newco PLC's shares in Newco Inc are automatically converted into shares of US Inc as the surviving corporation in the merger, and the existing shares of US Inc (owned by the public shareholders of US Inc) automatically are converted into a right to receive the merger consideration, e.g. shares of Newco PLC. Potentially UK shareholders in US Inc may qualify for roll-over treatment. The UK tax issues raised are the same as a forward triangular merger. However, for US tax reasons, there is a limit to the amount of cash (or debt) that can be introduced into a reverse triangular merger.
  • 51. Practitioner’s Corner Robert S. Chase II, et al. on The End of an Era: IRS Expands “No Rule” Policy for SpinOffs and Other Common Corporate Transactions By Robert S. Chase II, William R. Pauls, and Christopher W. Schoen § 5.01 The End of an Era: IRS Expands “No Rule” Policy for Spin-Offs and Other Common Corporate Transactions On June 25, the IRS expanded its “no-rule” policy with respect to spin-offs and other tax-free corporate separations, liquidations, contributions, and reorganizations. Effective for letter ruling requests received by the IRS after August 23, 2013, Rev. Proc. 2013-32, 2013-28 I.R.B. 1, provides that the IRS will no longer rule on an entire transaction under §332, §351, §355, §368, or §1036. Instead, the IRS will rule only on one or more “significant issues” arising in the context of such a transaction. Accordingly, taxpayers have a short window of time to send spinoff letter ruling requests to the IRS Office of Associate Chief Counsel (Corporate) if they would like to receive a letter ruling providing that no gain or loss will be recognized by the parties to such a transaction. In brief, Rev. Proc. 2013-32 also:  Potentially broadens the range of issues that may qualify as “significant” for letter ruling purposes.  Discontinues the IRS’s single-issue letter ruling pilot program under §355 (Rev. Proc. 2009-25, 2009-24 I.R.B. 1088), thereby eliminating the expedited treatment offered by the pilot program.  Continues in effect all pertinent no-rule policies described in Rev. Proc. 2013-3, 2013-1 I.R.B. 113, governing the IRS’s letter ruling practice. These and other notable aspects of Rev. Proc. 2013-32 are discussed in greater detail below. Sutherland Observation: The IRS’s decision to expand its no-rule policy likely will have the most significant impact on public spin-offs. Historically, many such transactions have been contingent upon the receipt of a letter ruling from the IRS addressing the transaction’s qualification under §355 and the ancillary tax consequences following from that determination. Upon the effectiveness of Rev. Proc. 2013-32, these types of transactions will have to proceed on the basis of an opinion of counsel. The ramifications of this new paradigm should be considered and closely followed.                                                               © 2013 Sutherland Asbill & Brennan LLP. All Rights Reserved. Robert S. Chase II, Christopher W. Schoen, and William R. Pauls are attorneys with Sutherland Asbill & Brennan LLP in the firm’s Washington, D.C. office. 
  • 52. Current IRS Letter Ruling Procedures Ordinarily, the IRS will not issue a letter ruling on only part of an integrated transaction. If, however, part of an integrated transaction falls under an area of the Internal Revenue Code (Code), including those under the jurisdiction of the IRS Office of Associate Chief Counsel (Corporate) (ACC Corporate), on which the IRS will not issue letter rulings (a so-called “no -rule issue” or “no-rule area”), the IRS nonetheless may issue a letter ruling on other parts of the transaction. In addition, the IRS ordinarily will not issue letter rulings with respect to an issue that is clearly and adequately addressed by a statute, regulations, a decision of a court, or authority published in the Internal Revenue Bulletin (i.e., comfort rulings). However, in its discretion, the IRS may decide to issue a ruling on such an issue if the IRS otherwise is issuing a letter ruling to the taxpayer on another issue arising in the same transaction. Prior to the effective date of Rev. Proc. 2013-32, the IRS generally will not issue letter rulings addressing:  Whether a transaction qualifies for nonrecognition treatment under §332, §351 (except for certain transfers undertaken before §355 transactions), or §1036;  Whether a transaction constitutes a reorganization within the meaning of §368(a)(1)(A) (including a transaction that qualifies under §368(a)(1)(A) by reason of §368(a)(2)(D) or §368(a)(2)(E)), §368(a)(1)(B), §368(a)(1)(C), §368(a)(1)(E), or §368(a)(1)(F); or  The tax consequences (such as nonrecognition and basis) that result from the application of the foregoing Code sections, unless the IRS determines that there is a “significant issue” within the meaning of Rev. Proc. 2013-3 (discussed below). If the IRS determines that there is a significant issue, and to the extent that the transaction is not described in another no-rule area, the IRS will rule on the entire transaction and not just the significant issue. In Rev. Proc. 2009-25, the IRS announced a pilot program for letter rulings on issues arising in the context of §355 transactions. Under this program, a taxpayer could request a letter ruling on part of a larger transaction or on a particular issue that a transaction presented. The IRS, in turn, would issue a letter ruling on the particular issue raised in the letter ruling request and not on any other issue (including, in some cases, qualification of the transaction under §355) or on any other aspect of the transaction. Updated IRS Letter Ruling Procedures Under Rev. Proc. 2013-32 In what is described as an effort to conserve IRS resources, Rev. Proc. 2013-32 restricts the scope of letter rulings that address issues with respect to transactions under §332, §351, §355, and §1036, and reorganizations within the meaning of §368. Specifically, the IRS will no longer rule on whether a transaction qualifies for nonrecognition treatment under §332, §351, §355, or § 1036, or on whether a transaction constitutes a reorganization within the meaning of §368 (collectively, the Applicable Provisions), regardless of whether the transaction presents a significant issue and regardless of whether the transaction is an integral part of a larger
  • 53. transaction that involves other issues upon which the IRS will rule. The IRS will rule, however, on one or more issues under the Applicable Provisions to the extent that such issue or issues are “significant.” For purposes of Rev. Proc. 2013-32, a “significant issue” is an issue of law that meets two requirements: (i) the resolution of the issue is not essentially free from doubt, and (ii) the issue is germane to determining the tax consequences of the transaction. Sutherland Observation: Rev. Proc. 2013-3, which is applicable prior to the effective date of Rev. Proc. 2013-32, defines a “significant issue” as an issue of law that meets three requirements: (i) the issue is not clearly and adequately addressed by a statute, regulation, decision of a court, tax treaty, revenue ruling, revenue procedure, notice, or other authority published in the Internal Revenue Bulletin; (ii) the resolution of the issue is not essentially free from doubt; and (iii) the issue is legally significant and germane to determining the major tax consequences of the transaction. Thus, with regard to the definition of the term “significant issue,” Rev. Proc. 2013-32 eliminates the requirement that the issue not be clearly and adequately addressed by a statute, regulation, or other substantial authority and modifies the “germaneness” requirement. In making these changes, the IRS potentially broadened the range of issues that may qualify as “significant” for letter ruling purposes. The IRS will rule on the tax consequences (such as nonrecognition and basis) that result from, or on another issue concerning, the application of the Applicable Provisions to the extent that a significant issue is presented. For example:  A §351 exchange that does not present any significant issues under §351 may present a significant issue regarding the application of §358 to the transferor in the exchange. In such a case, the IRS will rule only on the significant issue under §358.  The IRS will issue rulings addressing significant issues presented by the application of Treas. Reg. § 1.368-1(d) (concerning continuity of business enterprise in reorganizations) or Treas. Reg. § 1.368-2(k) (concerning certain transfers of assets or stock in reorganizations). Sutherland Observation: Rev. Proc. 2013-32 does not limit the number of significant issues that may be the subject of a single letter ruling request. Also, the IRS has reserved the right to rule on any other issue in, or that is a part of, a transaction described in a letter ruling request (including ruling adversely) if the IRS believes that so doing is in “the best interests of tax administration.” In brief, Rev. Proc. 2013-32 also notes the following points concerning the updated letter ruling process:  All pertinent no-rule policies described in Rev. Proc. 2013-3 governing the IRS’s letter ruling practice will govern letter ruling requests made pursuant to Rev. Proc. 2013-32. For example, §3.01(43) of Rev. Proc. 2013-3, which contains the no-rule policy
  • 54. regarding business purpose and “device” issues under §355 and “plan” issues under §355(e), continues in effect.  In preparing a letter ruling request under Rev. Proc. 2013-32, taxpayers should continue to consult other applicable revenue procedures (e.g., Rev. Proc. 81-60, 1981-2 C.B. 680 (§368(a)(1)(E)); Rev. Proc. 83-59, 1983-2 C.B. 575 (§351); Rev. Proc. 86-42, 1986-2 C.B. 722 (§368(a)(1)(A), (B), (C), (D), and (F) (acquisitive reorganizations)); Rev. Proc. 90-52, 1990-2 C.B. 626 (§332); and Rev. Proc. 96-30, 1996-1 C.B. 696 (§355)) and include in the letter ruling request the information and representations described in such revenue procedures, but only to the extent that such information and/or representations relate to the significant issue(s) described in the letter ruling request.  Before submitting a letter ruling request under Rev. Proc. 2013-32, a taxpayer should call ACC Corporate to discuss whether the IRS will entertain the letter ruling request.  Rev. Proc. 2013-32 applies to all letter ruling requests postmarked or, if not mailed, received by the IRS after August 23, 2013. Sutherland Observation: Given the effective date of Rev. Proc. 2013-32, taxpayers have eight weeks to send spin-off letter ruling requests to ACC Corporate if they would like to receive a letter ruling providing that no gain or loss will be recognized by the parties to such a transaction. Effect of Rev. Proc. 2013-32 on Supplemental Letter Rulings As provided in Rev. Proc. 2013-32, ACC Corporate will apply the same no-rule policy described above to supplemental letter ruling requests. Furthermore, with respect to supplemental letter rulings:  A change of circumstances arising after a transaction has been completed ordinarily will not present a significant issue with respect to the transaction;  An issue of fact (as opposed to an issue of law) does not present a significant issue; and  All pertinent no-rule policies governing the IRS’s letter ruling practice will govern supplemental letter ruling requests. Effect of Rev. Proc. 2013-32 on Other Revenue Procedures In order to effect the updated letter ruling process, Rev. Proc. 2013-32 modifies (or eliminates) the other revenue procedures that are referenced above and Rev. Proc. 2013-1, 2013-1 I.R.B. 1. Sutherland Observation: Rev. Proc. 2013-32 does not impact the provisions of Rev. Proc. 2013-3 pursuant to which the IRS announced that it would no longer issue rulings concerning socalled “North-South” transactions, recapitalizations into control, and stock-for-debt swaps (see § 5.01(9), §5.01(10), and §5.02(2), respectively, of Rev. Proc. 2013-3) because those areas are “under study.”
  • 55. Adam B. Cohen, Vanessa A. Scott, Carol A. Weiser, et al. on Fall of the DOMA-n Empire: Practical Employee Benefits Implications By Adam B. Cohen, Vanessa A. Scott, Carol A. Weiser, Mikka Gee Conway, and Joanna G. Myers § 6.01 Fall of the DOMA-n Empire: Practical Employee Benefits Implications On June 26, the U.S. Supreme Court decided United States v. Windsor, striking down Section 3 of the federal Defense of Marriage Act (DOMA) as unconstitutional and holding that same-sex marriages recognized under state law must also be recognized for federal law purposes. The Windsor case raised questions regarding federalism, equal protection of same-sex couples, due process and jurisdiction under Article III of the Constitution. While conclusively establishing that the federal government may not discriminate against same-sex married couples, Windsor leaves unresolved many issues regarding the recognition of spousal rights and the interaction of state and federal law. This Legal Alert supplements our earlier Legal Alert on the top 10 benefits issues raised by Windsor and includes a chart to aid employers in considering the broader implications of the case for their benefit plans. Windsor Overview Windsor was a federal tax refund case. The plaintiff, Edith Windsor, resided in New York with her longtime partner, Thea Spyer. In 2007, with Spyer in failing health and with no jurisdiction in the United States yet offering same-sex couples the right to marry, the couple married in Canada. New York recognized their marriage as valid under state law. Spyer died in 2009, leaving her entire estate to Windsor. Normally, a surviving spouse can inherit her deceased spouse’s estate free of federal estate tax, up to a certain dollar threshold. However, because Section 3 of DOMA defined “marriage” for federal purposes as “a legal union between one man and one woman,” the federal estate tax exemption applied only to opposite-sex spouses, and Windsor could not claim the exemption. Instead, Windsor owed federal estate taxes of $363,053—taxes she would not have owed if she were married to a man. Windsor paid the tax, and then sued for a refund, challenging DOMA’s definition of marriage as a violation of her Fifth Amendment equal protection rights. The district court, and the U.S. Court of Appeals for the Second Circuit on appeal, agreed that the challenged provision was unconstitutional and ordered the United States to issue a refund. In a 5-4 decision authored by Justice Anthony Kennedy, the Supreme Court first held that it had jurisdiction to consider the case despite the fact that the U. S. Department of Justice agreed with Windsor that the statute was unconstitutional and declined to defend it. On the merits, the Court affirmed the decision of the Second Circuit, holding Section 3 of DOMA unconstitutional as a                                                               © 2013 Sutherland Asbill & Brennan LLP. All Rights Reserved. The authors are attorneys with Sutherland Asbill & Brennan LLP in the firm’s Tax, Employee Benefits and Executive Compensation practice groups. 
  • 56. “deprivation of the liberty of a person protected by the Fifth Amendment of the Constitution.” In invalidating the federal statute, the Court acknowledged the traditional power of the states to define marriage, and confined its holding to marriages “lawful” under state law. In other words, same-sex couples are married for federal law purposes only to the extent that they are married for state law purposes. Employee Benefits Implications Windsor has significant implications for employee benefit plans. After Windsor, the definition of “spouse” under any federal law governing employee benefits must now be interpreted to include same-sex spouses recognized under state marriage laws. There are now 14 jurisdictions that issue (or will soon issue) marriage licenses to same-sex couples: California,1 Connecticut, Delaware, the District of Columbia, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Rhode Island, Vermont and Washington. Less clear is how the federal government will treat same-sex couples who were legally married in one state, but who reside in a state that does not recognize same-sex marriage, or a state that, like DOMA, defines marriage as between a man and a woman. Another issue not expressly addressed by the Windsor Court is the retroactive effect of the decision. Given the Court’s decision to grant retroactive tax relief to Windsor in this case, it is reasonable to assume that courts and government agencies will apply the ruling in Windsor retroactively, interpreting federal statutes and regulations as if Section 3 of DOMA was never enacted. Retroactive application of the decision could open the door to numerous ex-post-facto claims relating to employer-sponsored benefit plans, including claims made by:  Former employees currently receiving retirement plan distributions in the form of a single-life annuity, who may be entitled to a qualified joint and survivor annuity (QJSA) if they were married to a same-sex partner at the time of benefit commencement;  Surviving same-sex spouses, who may have the right under the Employee Retirement Income Security Act (ERISA) to challenge retirement plan distributions made in a form other than a QJSA or a qualified pre-retirement survivor annuity without spousal consent;  Divorced same-sex spouses who may seek to re-open divorce proceedings to request retroactive distribution of retirement benefits under a qualified domestic relations order;  Same-sex spouses or former same-sex spouses and their children seeking retroactive COBRA election rights; and  Employers and employees seeking a refund of income taxes and FICA taxes paid on income imputed on the value of health benefits previously provided to same-sex spouses.                                                              1 Also on June 26, the Supreme Court decided Hollingsworth v. Perry, which effectively reinstated California’s 2008 legalization of same-sex marriage.
  • 57. In addition to potential retroactive claims that could result from Windsor, the decision raises a variety of general plan administration issues, including:  Whether there will be relief from or a method of addressing disqualification concerns for retirement plans that did not treat same-sex spouses as spouses for QJSAs, spousal consent and other purposes;  Whether spousal rights for married same-sex couples will be determined based on the law of the state of residency or the law of the state of marriage (irrespective of the state of residency); and  Whether federal law will recognize as spouses same-sex couples married abroad, without regard to whether states recognize such a marriage. We anticipate receiving guidance from federal agencies – most notably, the Internal Revenue Service – in the coming weeks on these issues. (Both the Internal Revenue Service and the Department of Justice, among other agencies, have issued statements that guidance will be forthcoming.) Pending such guidance, however, certain employee benefits matters warrant early consideration by plan sponsors in anticipation of plan document amendments and changes to administrative systems. Attached is a chart that highlights some key considerations for specific employee benefit arrangements. For retirement plans, the implications, such as the treatment of same-sex spouses for purposes of the QJSA rules, flow directly from federal law, and the primary question is which state law applies to determine the validity of a same-sex marriage and not whether plan terms recognize same-sex marriage. The same is true for some welfare plan rules, such as COBRA and special enrollment rights, as well as the federal tax treatment of benefits provided to same-sex spouses and their children. For other welfare plan rules, however, such as coverage under a cafeteria plan, or the right to reimbursement under a dependent care or health care flexible spending account (FSA) or a health reimbursement account (HRA), the plan terms, any fiduciary interpretations of those terms and applicable protections of same-sex couples under state law may be relevant in determining the exact implications of DOMA for the plan.
  • 58.    
  • 59. Lexis Commentary Deanne B. Morton on The Medical Excise Tax: Is Repeal the Right Therapy? By Deanne B. Morton, J.D., LL.M., Lexis® Federal Tax Analyst § 7.01 Introduction One of the more controversial tax issues of the year has been the implementation of the medical device excise tax. Effective with respect to sales of applicable devices after December 31, 2012, the medical device excise tax was initially imposed pursuant to Section 1405(a) of the Health Care and Education Reconciliation Act of 20101 (the “Act”), in conjunction with the Patient Protection and Affordable Care Act (the “Affordable Care Act”).2 The tax is a manufacturers excise tax and the general manufacturers excise tax statutes and regulations provide important definitions and guidelines with respect to the application, operation, and payment procedures of this new tax. In addition, the Internal Revenue Service (IRS) has issued specific guidance related to the medical device excise tax.3 Almost immediately after the Act was signed into law, calls for repeal of the medical device excise tax began. Proposed repeal legislation has been introduced in both houses of Congress4 and much is at stake for the parties that support and oppose the new tax. Critics claim that the tax will adversely affect patient care, innovation, and job creation.5 Proponents note the lost revenue if the tax was repealed, and assert that challenges to the tax do not withstand scrutiny.6 This article will provide a general overview of the new medical device excise tax.7 We will explore to whom the tax applies, 8 how it is assessed,9 what sort of exemptions may be available,10 applicable forms and process for payment,11 and potential penalties in the case of                                                              1 PL 111-152, 124 Stat 1029 (Mar 30, 2010). PL 111-148, 124 Stat 119 (Mar 23, 2010). 3 See Treas Reg §§ 48.4191-1 and 48.4191-2; Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). See generally, Andrew Nolan, “CRS Examines Regulations for Medical Device Excise Tax,” Tax Notes Today, 2013 TNT 41-23 (Mar 1, 2013). 4 See Protect Medical Innovation Act of 2013, 2013 HR 523 (Feb 6, 2013) and Medical Device Access and Innovation Protection Act, 2013 S 232 (Feb 7, 2013). The Senate voted, in a non-binding resolution on March 21, 2013, to repeal the excise tax (79 voting in favor; 20 voting against). 5 The medical device industry has been one of the most outspoken critics of the tax. See Daniel B. Kramer, M.D., and Aaron S. Kesselheim, M.D., The Medical Device Excise Tax — Over before It Begins? N Engl J Med (May 9, 2013), available at 6 See, e.g., Paul N. Van de Water, Excise Tax on Medical Devices Should Not Be Repealed, Center on Budget and Policy Priorities (Mar 11, 2013), available at 7 See Section 7.02[1]. 8 See Section 7.02[2}. 9 Id. 10 See Section 7.03. 11 See Section 7.04. 2
  • 60. noncompliance.12 This article will also address the controversy created by the tax and examine the possibility of repeal.13 § 7.02 Defining the Tax [1] Generally The medical device excise tax is a 2.3 percent levy on the gross sales price14 of any “taxable medical device”15 by a medical device manufacturer, producer, or importer16 of such device. The tax applies to all sales17 of such devices after January 1, 2013.18 [2] Definitions [a] Manufacturer, Producer, or Importer It is the manufacturer that is liable for the medical device excise tax.19 Treasury Regulations define “manufacturer” broadly to include “any person who produces a taxable article from scrap, salvage, or junk material, or from new or raw material, by processing, manipulating, or changing the form of an article or by combining or assembling two or more articles.”20 Producer and importer are also included in the term manufacturer. An “importer” is defined as “any person who brings such an article into the United States from a source outside the United States, or who withdraws such an article from a customs bonded warehouse for sale or use in the United States.”21 [b] Taxable Medical Device; Dual Use Device A “taxable medical device” is a device, as defined under the Federal Food, Drug and Cosmetic Act’s (the “FFDCA”) Section 201(h), that is intended for humans.22 Section 201(h) of the FFDCA23 defines “device” as “an instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article.” 24 The definition includes components, parts, or accessories, which are “(1) recognized in the official National Formulary, or the United States Pharmacopeia, or any supplement to them, (2) intended for use in the diagnosis of disease or other conditions, or in the cure, mitigation, treatment, or prevention of                                                              12 See Section 7.05. See Section 7.06. 14 See Section 7.02[2][c] discussing Treas Reg §§ 48.4216(a)-1 through 48.4216(e)-3. 15 See Section 7.02[2][b] discussing IRC § 4191(b)(1) (defining “taxable medical device”); 21 USC § 321(h) (providing a full definition of device under the FDCA). 16 See Section 7.02[2][a]. 17 Treas Reg § 48.0-2(a)(5). 18 PL 11-152, Section 1405(c); Treas Reg § 48.4191-1(g). 19 Treas Reg § 48.4191-1(c) (referencing Treas Reg § 48.01-2(a)(4)). 20 Treas Reg § 48.0-2(a)(4)(i). The Treasury Regulations address some additional circumstances where the manufacturer may not be clearly identified. See Treas Reg § 48.0-2(a)(4)(ii) and (iii). 21 Treas Reg § 48.0-2(4)(i). 22 Treas Reg § 48.4191-2. 23 21 USC § 321(h). 24 21 USC § 321(h). 13
  • 61. disease, in man or other animals, or (3) intended to affect the structure or any function of the body of man or other animals,” and which do not “achieve their primary intended purposes through chemical action within or on the body of man or other animals and are not dependent upon being [metabolized] in order to achieve their primary intended purposes.” 25 Certain devices are specifically excluded from the new tax by IRC Section 4191(b)(2), including eyeglasses, contact lenses, hearing aids, and any other medical device determined to be of a type that is generally purchased by the public at retail for individual use.26 Exemptions are discussed in detail in Section 7.03 below. With respect to dual use devices, if a device has both a medical and a non-medical use, the classification of the device depends upon whether or not the device is listed with the Food and Drug Administration (FDA).27 If it is listed by the FDA, it will be considered a taxable medical device.28 Devices used only in research are not subject to the medical device excise tax. “The rational for this exclusion is that devices used in research, teaching or analysis that are not introduced into commercial distribution are exempt from the FDA registration and listing requirements under Section 510(g) of the FFDCA.”29 It is important to note that sales of devices listed by the FDA as suitable for human use are taxable even if sold for non-medical or veterinary use.30 It is important to recognize that taxability is based most significantly on whether a device is listed with the FDA.31 The regulations follow the rule of equating taxable devices with those listed by the FDA and also address the possibility of listing mistakes by the FDA.32 According to the regulations, if a device is erroneously omitted from the list, sales of the device are taxable beginning on the date when the FDA notifies the manufacturer that the device should have been                                                              25 21 USC § 321(h). See IRC § 4191(b)(2). The final regulations provide further guidance. See Treas Reg § 48.4191-2 and Section 7.03 discussion below. 27 See Treas Reg § 48.4191-2(b). 28 It is important to recognize that taxability is based most significantly on whether a device is listed with the FDA. See TD 9604, 77 FR 72924 (Dec 7, 2012) (enacting final regulations under IRC § 4191) The regulations follow the rule of equating taxable devices with those listed by the FDA and also address the possibility of listing mistakes by the FDA. Id. According to the regulations, if a device is erroneously omitted from the list, sales of the device are taxable beginning on the date when the FDA notifies the manufacturer that the device should have been listed. Id. Similarly, if a listed device is later de-listed, a credit or refund may be available for tax paid on sales of the device during the intervening period. Id. (citing IRC § 6416(a) and corresponding regulations). Where an FDA-listed item is combined with a pharmaceutical, the entire sales price is taxable, not just the portion attributable to the device. Id. Software incorporated into devices is similarly included 29 See “IRS Releases Proposed Regulations on Medical Device Excise Tax,” by Deloitte (available at 2.pdf). 30 Many comments on the proposed regulations suggested that only sales for actual human use should be taxed, but the IRS rejected that approach. See TD 9604, 77 FR 72924 (Dec 7, 2012) (enacting final regulations under IRC § 4191) See also Joseph DiSciullo, “IRS Releases Plenitude of Healthcare Reform Guidance,” Tax Notes, 137 Tax Notes 1179 (Dec 10, 2012) ; “Unofficial Transcript Available of IRS Hearing on Medical Device Excise Tax, “Tax Notes Today, 2012 TNT 96-30 (May 17, 2012). 31 See TD 9604, 77 FR 72924 (Dec 7, 2012) (enacting final regulations under IRC § 4191). 32 Id. 26
  • 62. listed.33 On the other hand, if a listed device is later de-listed, a credit or refund may be available for tax paid on sales of the device during the intervening period.34 Where an FDA-listed device is combined with a pharmaceutical drug, the entire sales price is taxable, not just the portion attributable to the device.35 Software sold together with, or incorporated into, devices is not bundled with the taxable device however, unless the entire bundle is listed by the FDA.36 Otherwise, the medical device excise tax attaches only to the sale of the devices within the bundle that are listed with the FDA.37 While existing rules do not directly address whether a donation of a taxable article constitutes a taxable use that is thus considered a sale,38 Notice 2012-77 provides interim rules that state the donation of a medical device by the manufacturer to an eligible donee will not constitute a taxable use.39 Eligible donee is defined as an entity described in IRC Section 170(c).40 It is important to note however that a subsequent sale of a donated article will trigger the medical device excise tax.41 In that case, the previously eligible donee would incur liability for the tax and would presumably be responsible for calculating and paying the tax itself.42 [c] Taxable Sales Price for Calculating the Tax The taxable sales price of a medical device, as with manufacturer’s excise taxes in general, is based on the price at which the item is sold to independent wholesalers.43 Applicable to manufacturers generally, Treasury Regulation Section 48.4216(a)-1(a) provides that the price for which a taxable article is sold includes the total consideration paid for the device, including money, services (e.g. warranty), or other things.44 The price includes the cost of tools and dies needed to manufacture the taxable article(s).45 The covering or containers that house the taxable item(s), as well as charges incident to packing and shipment preparation, are also included in the taxable sales price.46 Items excluded from the taxable sale price include 1) the manufacturers excise tax (whether billed as a separate charge or included in the sales price),47 2) actual transportation, delivery, insurance, or installation charges incurred by the manufacturer or                                                              33 Id. Id. (citing IRC § 6416(a) and corresponding regulations). 35 TD 9604, 77 FR 72924 (Dec 7, 2012). (stating that although the Affordable Care Act enacted both the medical device excise tax as well as a branded prescription fee, there is no coordination between the provisions and no exclusion is provided under IRC § 4191 for a combination product). 36 TD 9604, 77 FR 72924 (Dec 7, 2012); Treas Reg § 48.4216(a)-1(e). 37 Id. Interim rules under Notice 2012-77 also provide interim guidance with respect to medical convenience kits. See Section 5 of Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 38 IRC § 4218. 39 See Section (4)(c) of Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 40 IRC § 701(c) identifies organizations that qualify for charitable contribution deductions for federal income tax purposes, including organizations exempt under IRC § 501(c)(3). 41 See Section (4)(c)(2)(C) of Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 42 Further guidance on this issue is expected per Notice 2012-77, but the timing for that guidance is unknown. 43 Notice 2012-77 addresses how to determine wholesale price when the item is sold to consumers directly, to retailers or to persons who are not independent of the manufacturer. See Section 3 of Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 44 Treas Reg § 48.4216(a)-1(a). 45 Treas Reg § 48.4216(a)-1(b). 46 Treas Reg § 48.4216(a)-1(d). 47 Treas Reg § 48.4216(a)-2(a). 34
  • 63. importer in connection with the delivery of the article to a purchaser;48 3) local advertising charges;49 and 4) charges for warranty paid at the purchaser’s option.50 In Notice 2012-77, issued in conjunction with Final Treasury Regulations Sections 48.4191-1 and 48.4191-2, the IRS provided interim guidance on how taxpayers may utilize the constructive pricing rules in IRC Section 4216 for purposes of determining “price” where certain model distribution chains are employed by some manufacturers in the medical device industry. For example, when a manufacturer sells a taxable medical device to an independent wholesale distributor or reseller that only leases the device at resale. In the interim guidance, the IRS sets out various model distribution chains (identified through written comments on the proposed regulations and informal taxpayer inquiries) and explains how taxpayers may apply the constructive sale price rules to the distribution chain. 51 The general approach of the interim rules is to treat a percentage of the actual sales price as the “constructive sales price.”52 It is important to note that the interim rules provide only safe harbors (the proffered model distribution chains discussed in Notice 2012-77 are not an exclusive list), and manufacturers can use other methods of showing the fair market wholesale price.53 § 7.03 Exemptions [1] Retail Exemption As mentioned above, retail sales of medical items the public generally buys for individual use are excluded from the definition of “taxable medical devices” and thus not subject to the medical device excise tax. Eyeglasses, contact lenses and hearing aids are specifically exempt from the medical device excise tax.54 The Final Treasury Regulations also set forth a retail exemption facts and circumstances test55 and provide a specific safe harbor for certain delineated devices.56 [a] Facts and Circumstances Test Under the final regulations, “[a] device will be considered to be of a type that is generally purchased by the general public at retail for individual use if it is regularly available for purchase and use by individual consumers who are not medical professionals, and if the design of the device demonstrates that it is not primarily intended for use in a medical institution or office or by a medical professional.”57  The determination of whether a device meets these requirements is based on all the relevant facts and circumstances. The regulations provide a nonexclusive list of relevant factors and also provide specific examples of how to apply factors in determining whether a particular device is a taxable medical device.58                                                              48 Treas Reg § 48.4216(a)-2(b). Treas Reg § 48.4216(e)-1. 50 Treas Reg § 48.4216(a)-2. 51 See Section 3 of Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 52 Id. 53 Id. 54 IRC § 4191; Treas Reg § 48.4191-2(b)(1). 55 Treas Reg § 48.4191-2(b)(2)(i) & (ii). 56 Treas Reg § 48.4191-2(b)(2)(iii). 57 Treas Reg § 48.4191-2(b)(2) (emphasis added). 58 See Treas Reg § 48.4191(b)(2)(iv) (providing examples using the facts and circumstances retail exemption as well as the safe harbor). 49
  • 64. Factors relevant to the evaluation of whether an item is “regularly available for purchase and use by individual consumers” include: (1) whether consumers who are not medical professionals can purchase the device in person, over the telephone or internet in the types of forums listed;59 (2) whether consumers who are not medical professional can use the device safely and effectively for its intended purpose with minimal or no training from a professional;60 and (3) whether the device is classified by the FDA as a “Physical Medical Device.”61 Factors relevant to the determination of whether a device is “not primarily intended for use in a medical institution or office or by a medical professional” include: (1) whether the device generally must be implanted, inserted, operated or otherwise administered by a professional,62 (2) whether the cost to acquire, maintain and/or use the device requires a large initial investment and/or ongoing expenditure that is affordable for the average individual customer,63 (3) whether the device is a Class III FDA-classified device;64 (4) whether the device is classified by the FDA as one of the various devices identified in Treasury Regulation Section 48.4191-2(b)(ii)(D);65 and (5) whether the device qualifies as durable medical equipment, prosthetics, orthotics, and supplies for which payment is available on an exclusively renal basis under Medicare Part B payment rules and is an “item requiring frequent and substantial servicing” as defined in 42 CFR 414.222.66 [b] Retail Exemption Safe Harbor Treasury Regulation Section 48.4191-2(b)(2)(iii) provides a list of devices that “will be considered to be of a type generally purchased by the general public at retail for individual use.”67 The list includes: (1) devices included in the FDA’s online IVD Home Use Lab Tests (Over-the-Counter Tests) database;68                                                              59 Treas Reg § 48.4191-2(b)(2)(i)(A) (referencing purchases in drug stores, supermarkets, medical supply stores and from retailers that generally sell devices). 60 Treas Reg § 48.4191-2(b)(2)(i)(B). 61 Treas Reg § 48.4191-2(b)(2)(i)(C). 62 Treas Reg § 48.4191-2(b)(2)(ii)(A). 63 Treas Reg § 48.4191-2(b)(2)(ii)(B). 64 Treas Reg § 48.4191-2(b)(2)(ii)(C). 65 Treas Reg § 48.4191-2(b)(2)(ii)(D). 66 Treas Reg § 48.4191-2(b)(2)(ii)(E). 67 See Examples 6, 7, 8 & 11 of Treas Reg § 48.4191(b)(2)(iv) for specific illustrations of the application of the safe harbor exemption. 68 Treas Reg § 48.4191-2(b)(2)(iii)(A).
  • 65. (2) (3) (4) [2] devices described as "OTC" or "over the counter" in the relevant FDA classification regulation heading;69 devices described as "OTC" or "over the counter" devices in the FDA's product code name, the FDA's device classification name, or the "classification name" field in the FDA's device registration and listing database;70 Devices that qualify as durable medical equipment, prosthetics, orthotics, and supplies, as described in Subpart C of 42 CFR part 414 (Parenteral and Enteral Nutrition) and Subpart D of 42 CFR part 414 (Durable Medical Equipment and Prosthetic and Orthotic Devices), for which payment is available on a purchase basis under Medicare Part B payment rules, and are "prosthetic and orthotic devices," as defined in 42 CFR 414.202, that do not require implantation or insertion by a medical professional; "parenteral and enteral nutrients, equipment, and supplies" as defined in 42 CFR 411.351 and described in 42 CFR 414.102(b); "customized items," as described in 42 CFR 414.224; "therapeutic shoes," as described in 42 CFR 414.228(c); or supplies necessary for the effective use of durable medical equipment, as described in section 110.3 of chapter 15 of the Medicare Benefit Policy Manual (Centers for Medicare and Medicaid Studies Publication 100-02).71 Other Exemptions Under the general rules governing manufacturer excise taxes, sales of devices for further manufacture or export are also exempt from the medical device excise tax.72 The seller and purchaser must be specifically registered with the IRS for the exemption to apply, although foreign purchasers are generally exempt from the registration requirement.73 Components sold for further manufacture or for sale for resale for further manufacture are exempt as well.74 Finally, products intended for non-human use exclusively are exempt from the tax, although the dual use rules discussed above in Section 7.02[2][b] should be considered carefully before relying on an exemption.75 § 7.04 Applicable Form and Payment Procedures Medical device excise tax is reported on Form 720 (Quarterly Federal Excise Tax Return).76 When the form is filed, a deposit of tax for each semi-monthly period in which tax liability is incurred must also be                                                              69 Treas Reg § 48.4191-2(b)(2)(iii)(B). Treas Reg § 48.4191-2(b)(2)(iii)(C). 71 Treas Reg § 48.4191-2(b)(2)(iii)(D). 72 IRC § 4221(a)(2). 73 In the case of a foreign purchaser, the seller must obtain proof from the purchaser of the tax-free nature of the sale. Id. 74 IRC § 4221(a)(1). 75 Although the tax does not impact medical devices intended for exclusive use in veterinary medicine, if a device intended for human use is also intended for use in veterinary practice, the medical device excise tax would apply. See Victoria Broehm, “Congress Looks to Repeal the Excise Tax on Dual-Use Medical Devices” (Apr 15, 2013), available at See also Pharmaceutical and Life Sciences Industry Alert 3-2012 by PWC, available at 76 See IRS Publication 510, Chs. 11 & 12, available at 70
  • 66. made, but only if the manufacturer’s quarterly net tax liability exceeds $2,500.77 Each business entity with an employer identification number (EIN) must file its own Form 720, and a deposit (if applicable) is due by each entity.78 § 7.05 Deposit Safe Harbor and Penalties The deposit of medical device excise tax for each semimonthly period must not be less than 95 percent of the amount of net tax liability incurred during the semimonthly period unless the safe harbor provided in Treasury Regulation Section 40.6302(c)-1(b)(2)(ii) applies. Under the safe harbor, any person that filed a Form 720 for the second preceding calendar quarter is considered to have met the semimonthly deposit requirement for the current quarter if the following factors have been met: (1) the deposit for each semimonthly period in the current calendar quarter is not less than 1/6 of the net tax liability reported for the lookback quarter, (2) each deposit is made on time, (3) the amount of any underpayment is paid by the due date of the return, and (4) the person’s liability does not include any tax that was not imposed during the lookback quarter.79 If a person fails to make deposits as required, the IRS may withdraw the person’s right to use the safe harbor.80 Under IRC Section 6656, penalties apply for a failure to make required deposits.81 Penalties can be avoided if the taxpayer makes an affirmative showing that such failure is due to reasonable cause and not willful neglect.82 In Notice 2012-77,83 the IRS provided temporary relief from the penalties mentioned above and said that penalties for failure to make semimonthly deposits would not be imposed until September 2013, unless such nonpayment was due to willful neglect.84 The safe harbor would then be available beginning in the third quarter of 2013, and for purposes of the lookback quarter for deposits, the first calendar quarter of 2013 is the appropriate reference point.85 § 7.06 Prospects for Repeal Shortly after the medical device excise tax went into effect in January 2013, the calls for repeal began.86 Medical device manufacturers insist the tax will hinder job creation, innovation, and                                                              77 IRC § 6302; Treas Reg § 40.6302(c)-1(a). Id. 79 Section 6 of Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 80 Treas Reg § 40.6302(c)-1(b)(2)(v). 81 See Section 7.04, supra for a discussion of when a deposit is required. 82 See IRC § 6656 and accompanying regulations. 83 2012-2 CB 781 (Dec 5, 2012). 84 See IRC § 6656 and Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 85 See Notice 2012-77, 2012-2 CB 781 (Dec 5, 2012). 86 See Protect Medical Innovation Act of 2013, 2013 HR 523 (Feb 6, 2013); Medical Device Access and Innovation Protection Act, 2013 S 232 (Feb 7, 2013); First Responder Medical Device Tax Relief Act, 2013 HR 581 (Feb 6, 2013). 78
  • 67. have a negative effect overall on patient care.87 Opponents of the tax say that changes to the health care system as a result of the Affordable Care Act health insurance mandate88 will not generate the projected increased revenue to justify the new excise tax.89 The Senate voted 79-20 to repeal the tax, although the approved amendment was non-binding and would require a complete offset of the loss from repeal through new revenue from undetermined sources.90 With revenue from the tax projected of at least $30 billion over 10 years, the revenue loss is not insignificant if the tax is repealed. Alternatives for an offset introduced through legislation have included proposals to offset the tax by reducing subsidies for oil and gas companies91 and eliminating wind-power tax credits.92 Supporters of the medical device excise tax purport that the new tax does not adversely affect manufacturers in a greater proportion than other sectors in the health care industry. They assert that the expansion of health insurance coverage could in fact increase the demand for medical devices and offset the effect of the tax as projected, and that health care reform may stimulate medical device innovation by promoting more cost-effective ways of delivering care.93 In July 2013, the Obama administration announced a delay of the employer mandate for health insurance implemented under the Affordable Care Act.94 The “employer mandate” requires businesses with 50 or more workers to decide whether to provide insurance coverage to workers or pay a fine.95 Employers will now have an extra year to meet the mandate. The delay does not currently impact the medical device excise tax or any other taxes included under the Affordable Care Act to help fund the law, and the IRS called for employers to voluntarily comply with the mandate despite the delay.96                                                              87 Companies have already cited the tax as the impetus for employee lay-offs and for increased offshoring. See Ramesh Ponnuru, “Tongue-Depressor Tax Will Harm Jobs, Innovation,” Bloomberg News (Jan 2, 2012), available at See generally Kristina Peterson and Christopher Weaver, “Medical-Device Tax Repeal Faces Uphill Battle in Senate,” Wall Street Journal (Mar 22, 2013), available at 88 PL 111-148, 124 Stat 119 (Mar 23, 2010). 89 A study done by AdvaMad, a trade association for the medical device manufacturing industry states that profits make up less than 4% of sales in the industry and a levy of 2.3% on sales will be overly burdensome even with increased sales. See Ramesh Ponnuru, “Tongue-Depressor Tax Will Harm Jobs, Innovation,” Bloomberg News (Jan 2, 2012), available at 90 See Kristina Peterson and Christopher Weaver, “Medical-Device Tax Repeal Faces Uphill Battle in Senate,” Wall Street Journal (Mar 22, 2013), available at 91 Medical Device Tax Elimination Act, 2013 HR 1295 (Mar 20, 2013). 92 Medical Device Access and Innovation Protection Act, 2013 S 232 (Feb 7, 2013). 93 See Paul N. Van de Water, “Excise Tax on Medical Devices Should Not Be Repealed,” Center on Budget and Policy Priorities (Mar 11, 2013), available at 94 Notice 2013-45, 2013-31 IRB 1 (July 9, 2013); IRC § 4980H. Some legislators have called for a delay of the individual share responsibility provisions under IRC § 5000A as well for the sake of fairness. See Fairness for American Families Act, 2013 HR 2668 (July 11, 2013); “Individual Mandate Should be Delayed Out of Fairness, House Taxwriters Say,” Tax Notes Today, 2013 TNT 134-22 (July 12, 2013). 95 The fine is $2,000 for each full-time employee lacking coverage, although the first 30 employees are excluded from the fee. See IRC § 4980H. 96 Notice 2013-45, 2013-31 IRB 1 (July 9, 2013).
  • 68. § 7.07 Conclusion Finding an offset is perhaps the key to the repeal of the medical device excise tax, but reaching consensus on how an appropriate offset worth tens of billions of dollars is possibly an insurmountable challenge.97 Repeal may have greater potential if it is included in a larger tax reform package, but such reform is of course unpredictable at this point. In the meantime, compliance with the new tax remains a challenge for many taxpayers.98                                                              97 See “Finding an Offset for Medical Device Tax Repeal Presents Challenges, Tax Notes Today (Tax Analysts (April 17, 2013). 98 See generally, Matthew Dalton, “Compliance with Medical Device Tax a Work in Progress,” Tax Notes, 138 Tax Notes 1407 (Mar 25, 2013).
  • 69. Current Developments By Patricia A. Tyler, J.D., LL.M. (in Taxation), Lexis Federal Tax Analyst § 8.01 CORPORATIONS Final Treasury Regulations, TD 9619 IRS Issues Final Treasury Regulations on Deemed Asset Sale Elections Synopsis: The IRS has published final regulations that provide the terms, conditions and consequences for making an IRC Section 336(e) election to treat the sale, exchange, or distribution of at least 80 percent of the voting power and value of the stock of a corporation (target) as a sale of all its underlying assets. The final treasury regulations generally allow the target's realized losses in a deemed asset disposition to offset the amount of the target's realized gains. Also, under the disallowed loss rule, if an IRC Section 336(e) election is made and any stock of the target is distributed during the 12-month disposition period, whether or not as part of the qualified stock disposition, any net loss attributable to the stock distribution is disallowed. Disallowed losses are applied to increase the basis of the target's assets after the deemed asset disposition. Any excess losses are permanently disallowed. The final regulations generally retain the rules, including the sale-toself model, of the proposed regulations for deemed transactions under the basic model. The final regulations also provide that to make an IRC Section 336(e) election, sellers (or for an S corporation target, all of the S corporation shareholders) and the target must enter into a written, binding agreement to make an IRC Section 336(e) election, and an IRC Section 336(e) election statement must be attached to the relevant return. The election must be made by the return's due date. Provided in the regulations are detailed requirements to help taxpayers make an IRC Section 336(e) election for an eligible subsidiary of the target. An IRC Section 336(e) election can be made for S corporation targets. The final regulations provide additional and special rules to allow IRC Section 336(e) elections to be made for S corporation targets. Final Treasury Regulations, TD 9622 IRS Issues Final Regulations on Deferred Discharge of Indebtedness Income of Corporations and Deferred OID Deductions Synopsis: The IRS has issued final regulations under IRC Section 108(i) on the accelerated inclusion of deferred discharge of indebtedness income of corporations, the accelerated deduction of deferred original issue discount, and the calculation of earnings and profits resulting from an election under IRC Section 108(i).
  • 70. The Final regulations primarily affect C corporations and provide necessary guidance regarding the accelerated inclusion of deferred discharge of indebtedness (also known as cancellation of debt (COD)) income (deferred COD income) and the accelerated deduction of deferred original issue discount (OID) (deferred OID deductions) under IRC Section 108(i)(5)(D) (acceleration rules), and the calculation of earnings and profits as a result of an election under IRC Section 108(i). The regulations also provide rules applicable to all taxpayers regarding deferred OID deductions under IRC Section 108(i) as a result of a reacquisition of an applicable debt instrument by an issuer or related party. § 8.02 EMPLOYMENT Notice 2013-17, 2013-20 IRB 1082 IRS Provides ESPOS with Relief from Anti-Cutback Requirements Synopsis: The IRS has provided relief from the anti-cutback requirements of IRC Section 411(d)(6) for plan amendments that eliminate a distribution option described in IRC Section 401(a)(28)(B)(ii)(I) from an employee stock ownership plan that becomes subject to the diversification requirements of IRC section 401(a)(35). Generally, an ESOP must provide specified plan participants the opportunity to elect to direct the investment of at least 25 percent of the participant's account. IRC § 401(a)(28)(B)(i). An ESOP can satisfy this diversification requirement by distributing the portion of a participant's account that is covered by the election within 90 days after the period during which the election is made. IRC § 401(a)(28)(B)(ii). IRC Section 401(a)(35) provides diversification requirements that apply to some defined contribution plans that hold (or are treated as holding) publicly traded employer securities. However, the diversification requirements of IRC Section 401(a)(28)(B) do not apply to a plan that is subject to IRC Section 401(a)(35). Notice 2013-17 addresses circumstances in which an ESOP that satisfied the diversification requirements of IRC Section 401(a)(28)(B)(i) by allowing distribution of a portion of a participant's account has become subject to the IRC Section 401(a)(35) diversification requirements. Unlike IRC Section 401(a)(28)(B), the IRC Section 401(a)(35) diversification requirements cannot be satisfied by distributing a portion of the participant's account. Accordingly, an amendment to an ESOP that becomes subject to section 401(a)(35) to eliminate a distribution option previously provided to satisfy IRC Section 401(a)(28)(B)(i) does not cause the plan to fail to satisfy the requirements of IRC Section 411(d)(6), even if the amendment is adopted after the plan's section 1107 date, but only if the amendment satisfies the conditions for relief under Notice 2013-17. An amendment meets the conditions for relief under Notice 2013-17 if (1) the amendment is both adopted and put into effect under the plan by the last day of the first plan year beginning on or after January 1, 2013, or by the deadline for adopting an interim amendment to the plan to satisfy IRC Section 401(a)(35), if later, and (2) the section 1107 conditions are met regarding the
  • 71. amendment (other than the requirement that the amendment be adopted by the plan's section 1107 date). § 8.03 HEALTH CARE Revenue Procedure 2013-25, 2013-21 IRB 1 IRS Announces 2014 Inflation-adjusted Amounts for HSAS Synopsis: The IRS has announced the 2014 inflation-adjusted amounts for health savings accounts under IRC Section 223. Adjustments are made to the maximum annual contribution limits for HSAs and the out-of-pocket spending limits for high-deductible health plans. For 2014, the annual limitation on deductions under IRC Section 223(b)(2)(A) for an individual with self-only coverage under a high deductible health plan is $3,300. The annual limitation on deductions under IRC Section 223(b)(2)(B) for an individual with family coverage under a high deductible health plan is $6,550. For 2014, a high deductible health plan is defined under IRC Section 223(c)(2)(A) as a health plan with an annual deductible that is not less than $1,250 for self-only coverage or $ 2,500 for family coverage, and the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $6,350 for self-only coverage or $12,700 for family coverage. Notice 2013-41, 2013-29 IRB 60 IRS Issues Guidance on Eligibility for Minimum Essential Coverage under Some Government Health Programs Synopsis: The IRS provides guidance on whether or when, for purposes of the IRC Section 36B premium tax credit, an individual is eligible for minimum essential coverage under the Medicaid, Medicare, children's health insurance, and TRICARE government-sponsored health programs or under a student health plan or state high-risk pool. Beginning in 2014 the premium tax credit will be available to individuals who buy coverage under a qualified health plan through an affordable insurance exchange and are not eligible for other minimum essential coverage. The guidance lists rules that apply for purposes of determining eligibility for coverage in a qualified health plan subsidized by the premium tax credit. An individual who loses CHIP coverage because of nonpayment of premiums and is barred from re-enrolling during a lockout period is treated as eligible for CHIP and is not eligible for qualified health plan coverage subsidized by the premium tax credit during the lockout period. An individual may be eligible for premium-subsidized health plan coverage during the pre-
  • 72. enrollment waiting period for CHIP coverage. An individual is eligible for minimum essential coverage under Medicaid or Medicare only on receiving a favorable determination of eligibility when (1) Medicaid coverage requires a finding of disability or blindness or (2) Medicare coverage is based solely on a finding of disability or illness. The notice also provides information as to when an individual is eligible for minimum essential coverage under some programs only if the individual is enrolled in the coverage. Notice 2013-42, 2013-29 IRB 61 IRS Provides Relief from Shared Responsibility Payment Synopsis: The IRS provides relief from the IRC Section 5000A shared responsibility payment for specified individuals who are eligible to enroll in some eligible employer-sponsored health plans with a non-calendar plan year that begins in 2013 and ends in 2014. In Notice 2013-42, the IRS provides transitional relief by providing that during the first year that IRC Section 5000A applies to individual taxpayers, an employee, or an individual having a relationship to the employee, who is eligible to enroll in a non-calendar year eligible employersponsored plan with a plan year beginning in 2013 and ending in 2014 (the 2013-2014 plan year) will not be liable for the IRC Section 5000A shared responsibility payment for certain months in 2014. The transition relief begins in January 2014 and continues through the month in which the 2013-2014 plan year ends. The relief applies only for determining a taxpayer's IRC Section 5000A shared responsibility payment for not maintaining minimum essential coverage. Any month in 2014 for which an individual is eligible for the transition relief provided by this notice will not be counted in determining a continuous period of less than 3 months for purposes of the short coverage gap exemption described in IRC Section 5000A(e)(4). § 8.04 MEDICAL RELATED TAXES Proposed Regulations, 78 FR 27873-27877, REG-126633-12 IRS Issues Proposed Treasury Regulations on Computation and Application of Medical Loss Ratio Synopsis: The IRS has issued proposed regulations that provide guidance to Blue Cross and Blue Shield organizations on computing and applying the medical loss ratio under the Affordable Care Act. IRC Section 833 does not apply to an otherwise-eligible organization unless the organization's medical loss ratio (MLR) during the tax year is not less than 85 percent. IRC Section 833(c)(5). The proposed regulations state that the meaning of terms and the methodology used in the MLR computation under IRC Section 833(c)(5) should be consistent with the definition of those same
  • 73. terms and the methodology under section 2718 of the PHSA. The proposed regulations provide that the MLR numerator does not include costs for "activities that improve health care quality" but that the term "reimbursement for clinical services provided to enrollees" has the same meaning as provided in the PHSA. Further, the same exclusions that are permitted from total premium revenue under section 2718(b) of the PHSA are permitted exclusions from total premium revenue under IRC Section 833(c)(5) in the MLR denominator. The proposed regulations explain that these exclusions include assessments and fees imposed by the Affordable Care Act. However, an organization's operating costs or any administrative costs associated with taxes or fees are not part of a state or federal assessment and may not be deducted from total premium revenue for purposes of the MLR calculation. When computing the MLR for a tax year under IRC Section 833(c)(5), use the same three-year period that is used under the PHSA. § 8.05 PARTNERSHIPS Announcement 2013-30, 2013-21 IRB 1134 Some Partnerships Must Pay Withholding on ECTI Allocable to Foreign Partnerships at 2012 Rates Synopsis: For payments due in 2013, a 2012-2013 fiscal year partnership should pay withholding tax under IRC Section 1446 on effectively connected taxable income allocable to foreign individual partners at the rates in effect in 2012. Announcement 2012-30 provides that partnerships that have effectively connected taxable income (ECTI) allocable to a foreign partner must file a 2012 Form 8804, Annual Return for Partnership Withholding Tax (Section 1446), for any taxable year that begins in 2012. For payments due in 2013, a 2012-2013 fiscal year partnership should pay withholding tax under IRC Section 1446 on effectively connected taxable income allocable to foreign individual partners at the rates in effect in 2012. Foreign partners in a fiscal year partnership with a tax year ending in 2013 nonetheless must pay tax on their distributive share of the partnership's ECTI based on the tax rates in effect in the tax year of their inclusion as determined under IRC Section 706(a). Final Treasury Regulations, TD 9623 IRS Issues Final Regulations on Deferred Discharge of Indebtedness Income of Partnerships and S Corporations Synopsis: The IRS has issued final regulations under IRC Section 108(i), providing rules on the deferral of discharge of indebtedness income and original issue discount deductions by a partnership or an S corporation with respect to reacquisitions of applicable debt instruments in 2009 or 2010. The regulations provide basis adjustment rules whereby a partner's basis in its partnership and an
  • 74. S corporation shareholder's stock basis are not adjusted to account for their share of deferred items at the time of reacquisition but when deferred items are recognized. The regulations incorporate the rules in Rev Proc 2009-37 for determining a partner's deferred IRC Section 752 amount and provide additional computational rules and examples. For capital account maintenance purposes, the regulations provide that a partnership should treat deferred items as if no IRC Section 108(i) election were made. The regulations provide that a decrease in a partner's or shareholder's amount at risk in an activity resulting from a COD for which an IRC Section 108(i) election is made is not taken into account in determining the partner's or shareholder's amount at risk in that activity under section 465 in the tax year of the reacquisition. Instead, the decrease is taken into account at the same time, and to the extent remaining, in an amount equal to the deferred COD income the partner or shareholder recognizes. If a debt instrument is issued in a debt-for-debt exchange or a deemed debt-for-debt exchange and there is any OID on the debt instrument, the issuer of the new debt instrument must defer some or all of the deductions for such OID under IRC Section 108(i). The regulations provide that the aggregate amount of deferred OID is allowable as a deduction to the issuer of the debt instrument ratably over the inclusion period, or earlier upon the occurrence of an acceleration event. Also provided are rules on basis adjustments and adjustments to accumulated adjustments accounts for deferred OID deductions that apply to the issuing entity. § 8.06 PRACTICE & PROCEDURE Final Treasury Regulations, TD 9618 Final Treasury Regulations Expand Window for Submitting Return Disclosure Authorizations Synopsis: The IRS has issued final regulations that double the period for submission to the IRS of taxpayer authorizations allowing disclosure of returns and return information to third-party designees. Beginning on May 7, 2013, final treasury regulations extend the time period for submitting to the IRS a signed and dated authorization permitting disclosure of returns and return information to third-party designees. The time period has been extended from 60 days to 120 days. The time period is extended to assist third party designees that have had difficulty obtaining and submitting written authorizations within the 60-day time period. Revenue Procedure 2013-32, 2013-28 IRB 55
  • 75. IRS Issues Guidance on Updated IRC Section 355 Checklist Questionnaire Synopsis: The IRS is launching a one-year pilot program and has issued guidance providing an updated IRC Section 355 checklist questionnaire specifying the information and representations that must be included in a request for rulings under that section. Generally, the IRS refrains from issuing "comfort rulings" and letter rulings containing primarily factual issues. Rev Proc 2003-48. However, the IRS has not strictly applied its policies for letter ruling requests on transactions intended to qualify under IRC Section 355. Under a one-year pilot program, the IRS will not determine whether a proposed or completed distribution of a controlled corporation's stock is being carried out for one or more corporate business purposes, whether the transaction is used principally as a device, or whether the distribution and an acquisition are part of a plan under IRC Section 355(e), the IRS said. Rather, these determinations may be made on an examination of the taxpayer's return. Revenue Procedure 2013-32 requires taxpayers seeking a ruling under IRC Section 355 to submit representations on the business purpose and device requirement and whether there is a plan under IRS Section 355(e)(2)(A)(ii). The request for a letter ruling, including representations, must be accompanied by a penalties of perjury statement signed and dated by the taxpayer indicating that the submission contains all the relevant facts relating to the request and such facts are true, correct, and complete. § 8.07 REAL ESTATE Revenue Procedure 2013-27, 2013-24 IRB 1243 IRS Provides Median Gross Income Guidance Synopsis: The IRS has provided guidance on the U.S. and area median gross income figures needed by issuers of IRC Section 143(a) qualified mortgage bonds and IRC Section 25(c) mortgage credit certificates to compute the housing-cost-to-income ratio of IRC Section 143(f)(5). Revenue Procedure 2013-27 provides that when computing the IRC Section 143(f) income requirements, issuers must use the median gross income for the United States, the states, and statistical areas within the states released by the Department of Housing and Urban Development on either December 1, 2011, or December 11, 2012. If an issuer uses the median gross income released on December 1, 2011, to compute the housing-cost-to-income ratio, the issuer must use the December 1, 2011, median gross income for all purposes under IRC Section 143(f). If an issuer uses the median gross income released on December 11, 2012, to compute the housingcost-to-income ratio, the issuer must use the December 11, 2012, median gross income for all purposes under IRC Section 143(f).
  • 76. § 8.08 SECURITIES TRANSACTIONS Revenue Procedure 2013-26, 2013-22 IRB 1160 IRS allows Utilization of the Proportional Method to Account for OID on Pooled Credit Card Receivables Synopsis: The IRS has issued guidance that allows a taxpayer to use a simplified method of accounting, the proportional method, to allocate original issue discount on a pool of credit card receivables to an accrual period for purposes of IRC Section 1272(a)(6). Revenue Procedure 2013-26 provides a safe harbor method of accounting for OID on a pool of credit card receivables for purposes of IRC Section 1272(a)(6) called the "proportional method." The proportional method generally allocates to an accrual period an amount of unaccrued OID that is proportional to the amount of the stated redemption price at maturity ("principal") of the pool that is paid by cardholders during the period. The proportional method generally produces the same results as the method described in IRC Section 1272 (a) (6). The follow are the rules for utilizing the proportional method of accounting: 1. The required computations must be made monthly. Thus, the computation period referred to is a calendar month (or that portion of a month that falls within a short taxable year). A taxpayer that changes its method of accounting to the proportional method must make the required computations for each month in the year of change by the due date for the taxpayer's timely filed (including extensions) original federal income tax return implementing the change in method of accounting for the year of change. 2. At the beginning of each computation period, the taxpayer must determine the following information for each pool of credit card receivables: a. The SRPM as of the beginning of the period ("Beginning SRPM"), which is equal to the aggregate balance owed on all credit card receivables included in the pool at the beginning of such period, other than amounts representing charges or fees that are not properly treated as OID (such as finance charges that are qualified stated interest). b. The unaccrued OID as of the beginning of the period ("Beginning OID"), which is equal to the OID with respect to the pool at the beginning of such period that has not previously been taken into income. 3. During each computation period, the taxpayer must determine for each pool of credit card receivables the sum of the payments during the period of amounts that reduce the Beginning SRPM for the period ("SRPM Payments") (equivalently, total payments less amounts that are not included in SRPM, such as charges or fees that are not properly treated as OID).
  • 77. 4. For each computation period, the taxpayer must compute the OID allocated to the period ("Monthly OID") and include this amount in income for the period. Monthly OID is the product of (1) the Beginning OID multiplied by (2) the quotient of the SRPM Payments divided by the Beginning SRPM. 5. The formula in section 5.04 of this revenue procedure can be restated as follows: M_OID = BEG_OID * (SRPM_P / BEG_SRPM), where M_OID = Monthly OID; BEG_OID [*10] = Beginning OID; SRPM_P = SRPM Payments; and BEG_SRPM = Beginning SRPM. 6. For purposes of determining the Beginning SRPM and Beginning OID for a period, the taxpayer should take into account the following items: a. The charges and fees relating to the pool for the preceding period that are properly treated as OID; b. Credit card accounts transferred into the pool during the preceding period, including any unaccrued OID attributable to the accounts; c. Credit card accounts transferred out of the pool during the preceding period, including any unaccrued OID attributable to the accounts; and d. Credit card accounts written off during the preceding period, including any unaccrued OID attributable to the accounts. 7. The taxpayer may determine the unaccrued OID attributable to an account in a pool as the portion of the unaccrued OID attributable to the pool as of the beginning of the preceding period that is proportional to the SRPM of the account as of the beginning of the preceding period. 8. If the taxpayer transfers credit card accounts from one of its pools into another one of its pools, the unaccrued OID transferred out of the first pool must be equal to the unaccrued OID transferred into the second pool. 9. In the case of a pool wholly owned by two or more members of an affiliated group of corporations that file a consolidated return for federal income tax purposes, the members of the group may apply the proportional method to the entire pool and then allocate the OID among the owners, provided that the OID is allocated using a reasonable method. For example, an allocation in proportion to the SRPM attributable to the members' interests in the pool is reasonable.
  • 78. 10. Section 1.6001-1 (a) of the Procedure and Administration Regulations provides that any person subject to tax under subtitle A of the Code shall keep such permanent books of account or records to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax. To satisfy the recordkeeping requirements of IRC Section 6001 and the regulations thereunder, a taxpayer that uses the proportional method of accounting should maintain records supporting all aspects of its method, including, but not limited to, the computations described in section 5 of this revenue procedure. A taxpayer that wants to change its method of accounting to the proportional method must use the automatic change in method procedures of Revenue Procedure 2011-14, 2011-1 CB 330, or its successor, to make the change. If a taxpayer changes to the proportional method, the unaccrued OID for the pool as of the beginning of the first period in the year of change is equal to the unaccrued OID for the pool as of the end of the preceding year under the taxpayer's previous method of accounting for the pool. If a taxpayer does not already have a method of accounting for OID on any pool of credit card receivables, the taxpayer may adopt the proportional method by using it on a timely filed (including extensions) original federal income tax return for the first taxable year the taxpayer must account for OID on a pool of credit card receivables. A taxpayer may adopt or change its method of accounting to the proportional method for a taxable year that ends on or after December 31, 2012. Notice 2013-38, 2013-25 IRB 1251 IRS Provides Guidance on Empowerment Zone Designation Extensions Synopsis: The IRS provides guidance on how a state or local government amends the nomination of an empowerment zone to provide for a new termination date. Notice 2013-38 provides that a state or local government entity may nominate areas in its jurisdiction for designation as an empowerment zone under IRC Section 1391. The nomination for all empowerment zones originally had a termination date of December 31, 2009. Amendments to IRC Section 1391 allow an empowerment zone designation to remain in effect through December 31, 2013, if the nominating entity amends the nomination to provide for a new termination date of December 31, 2013. The Notice provides that any nomination for an empowerment zone that was in effect on December 31, 2009, is deemed to be amended to provide for the new termination date, unless the nominating entity sends written notification to the IRS by July 29, 2013. The written notification must affirmatively decline extension of the empowerment zone nomination through December 31, 2013. Notice 2013-48, 2013 IRB LEXIS 355
  • 79. IRS Issues Proposed Revenue Procedure on Wash Sale Rules for Money Market Funds Synopsis: The IRS has issued a proposed revenue procedure describing circumstances in which the IRS will not treat a redemption of shares in a money market fund as part of a wash sale under IRC Section 1091. The proposed revenue procedure provides that if a taxpayer realizes a loss upon a redemption of certain money market fund shares and the amount of the loss is not more than a specified percentage of the taxpayer's basis in such shares, the IRS will treat such loss as not realized in a wash sale. This proposed guidance is intended to mitigate tax compliance burdens that may result from proposed changes in the rules that govern the prices at which certain money market fund shares are issued and redeemed. The Securities and Exchange Commission (SEC) has issued proposed regulations to effect these changes. The proposed revenue procedure is drafted as if the SEC had already adopted final rules addressing floating net asset value in substantially the same form as the proposed rules. If those rules are not adopted in substantially the same form as they have been proposed, the revenue procedure proposed by this notice may not be adopted or may be adopted in materially modified form.