The November 26, 2018, release by the Internal Revenue Service of proposed regulations (REG-106089-18) related to IRC § 163(j) has provided some clarity for federal income taxpayers. But the regulations’ treatment of federal consolidated groups gives rise to complexities and questions as to how the limitation will operate at the state level.
This Bottom Line videocast includes:

  • an overview of IRC § 163(j)
  • key elements of the proposed regulations
  • important SALT considerations

 

In their article for State Tax Notes, Sutherland attorneys Jonathan Feldman, Stephen Burroughs and Timothy Gustafson analyze the Multistate Tax Commission’s Arm’s-Length Adjustment Service (ALAS) program. While most taxpayers instinctively cringe at any new MTC initiative, the ALAS program is a potential positive for corporate taxpayers due to some disturbing trends arising in state corporate income tax audits:

  • States have increasingly used statutory variations of IRC section 482 to either disregard entities and intercompany transactions as shams or deny intercompany expense deductions without performing any substantive transfer pricing analysis.
  • State tax authorities often justify those adjustments by arguing that either:
    all intercompany transactions, no matter the underlying terms, are per se non-arm’s-length; or
    they lack the resources to determine whether an intercompany transaction satisfies the arm’s-length standard.
  • These justifications misapply state’s transfer pricing authority and the ALAS may provide a superior alternative.

View the full article reprinted from the April 25, 2016, issue of State Tax Notes.

By Zachary Atkins and Marc Simonetti

The U.S. Court of Appeals for the Second Circuit held that the attorney-client privilege and work-product doctrine protected legal memoranda prepared by an accounting firm that were disclosed to third parties. The Schaeffler Group sought to refinance its acquisition debt held by a consortium of banks and restructure its operations during the earliest stages of the economic downturn that subsequently threatened its solvency. Expecting the transactions to draw Internal Revenue Service (IRS) scrutiny, the Schaeffler Group and its eponymous owner (Taxpayers) sought advice from Ernst & Young (EY) on the federal tax consequences of the transactions. In connection with its eventual audit of the Taxpayers, the IRS sought all documents prepared by EY and disclosed to third parties. The Taxpayers withheld certain EY memoranda describing, among other things, the potential tax consequences of the transactions that they had shared with the banks and the banks’ counsel.

Rejecting the IRS’s waiver argument, the Second Circuit concluded that the attorney-client privilege (and necessarily the federal tax-practitioner privilege) applied to the EY memoranda because the bank consortium shared a “common legal interest” with the Taxpayers. The “common legal interest” rule, also known as the joint defense privilege exception, protects the confidentiality of communications from one party to the attorney for another party where the parties and their counsel have agreed on and undertaken a joint defense effort or strategy with respect to a legal matter. Although the refinancing and restructuring had both commercial and legal components, the court concluded that the rule applied because the transactions were tax-law driven, and both parties shared a common interest in ensuring exactly how the tax law applied. 

The court also held that the work-product doctrine applied to the EY memoranda. The work-product doctrine protects documents prepared in anticipation of litigation from disclosure, but it does not extend to documents prepared in the ordinary course of business when the form of the documents would not change even if litigation were expected. The court concluded that the EY memoranda directly addressed the legal issues arising from the refinancing and restructuring transactions and were prepared with an eye toward an anticipated IRS audit and litigation, both of which were highly probable. Schaeffler v. United States, No. 14-1965-cv (2d Cir. Nov. 10, 2015).

By Open Weaver Banks and Pilar Mata

The Indiana Department of Revenue ruled that a limited liability corporation (LLC) that elected to be taxed as a corporation was entitled to use net operating loss (NOL) deductions generated by its former members. The NOLs in question were generated in tax years 2003, 2005, and 2007 by two C corporations that were members of the LLC. During these years, the LLC had elected to be treated as a pass- through entity for tax purposes. In 2009, the members and the LLC reorganized so that the LLC was the surviving entity, and the LLC made an Internal Revenue Service election to be taxed as a C corporation. The Department ruled that the LLC was entitled to claim the NOL deductions resulting from its members’ losses on the LLC’s 2010 and 2011 returns. The Department reasoned that, under federal law, a deemed liquidation occurred when the LLC elected to be taxed as a corporation. As a result, for federal purposes, the LLC was allowed to carry over the pre-acquisition NOLs of its former members under I.R.C. § 381(c)(1)(A). Since the Department follows Internal Revenue Code guidelines on the treatment of NOLs, the Department concluded that the LLC was allowed to carry forward and utilize its pre-acquisition NOLs on its Indiana gross income tax returns for the 2010 and 2011 tax years, subject to the Department’s verification of the amount of the NOLs. Indiana Letter of Finding 02-20130190 (Oct. 1, 2014)

On March 2, 2011, the IRS released Appeals Settlement Guidelines (ASG) addressing the federal income tax treatment of state and local economic development tax credits and incentives, other than refundable or transferrable credits or incentives.

Many taxpayers have long taken the position that state and local tax credits and incentives (e.g., tax rate reductions, tax credits for job creation or investment, and tax abatements or exemptions) should be treated as a payment to the taxpayer by the state or local government equal to the amount of the credit or incentive, followed by a payment of the tax by the taxpayer in the same amount. Under this approach, the payment to the taxpayer is included in gross income under Section 61 and deductible as a payment of tax under Section 164, but then excluded from income as a non-shareholder contribution to capital under Section 118. As a result, taxpayers claim an expense for the amount of the credit or incentive in exchange for a reduction in the basis of property under Section 362(c). The net effect is a deduction in the current tax year which is not recaptured until the taxpayer disposes of the reduced-basis property or depreciates the property. Often the property subject to basis reduction is non-depreciable real property, which effectively allows a near-permanent deferral of income.

The IRS identified this position as a Tier 1 issue and previously addressed it in Coordinated Issue Paper (CIP) LMSB-04-0408-023 (May 23, 2008). The ASG continues the guidance provided in the CIP and details the IRS position that non-refundable state and local credits and incentives are most appropriately characterized as reductions in liability that do not constitute income under Section 61 and do not give rise to additional deductions under Section 164. The IRS also takes the position that even if the incentives were income, they are not excludable non-shareholder contributions to capital under Section 118.

The U.S. Court of Appeals for the District of Columbia, sitting en banc on September 29, raised serious questions in a suit seeking refund of telephone excise taxes paid to the Internal Revenue Service (IRS). A decision on the arguments raised could have far-reaching consequences for the IRS, potentially requiring it to conform to the Administrative Procedure Act (APA) when issuing guidance.

The case involves 26 U.S.C. § 4251, a three percent excise tax on long-distance phone calls for which the charges varied based only on transmission time, which five circuit courts declared invalid in 2005 and 2006. In May 2006, the IRS declared that it would no longer impose the tax and would allow taxpayers to claim refunds for excise taxes. The guidelines for claiming the refund, which were outlined in Notice 2006-50, required taxpayers to affirmatively request the refund on their 2006 federal tax return and precluded other administrative remedies.

A number of taxpayers filed suit to overturn the Notice, claiming that it represented final agency action that “arbitrarily, unreasonably, and unlawfully limits restitution of the funds unlawfully exacted.” In re Long-Distance Tel. Serv. Fed. Excise Tax Refund Litig., 501 F.Supp.2d 34, 38-39 (D.D.C. 2007). Taxpayers protested the fact that they were not allowed to seek refunds in any other manner than that set forth in the Notice. This, they argued, constituted “final agency action” subject to judicial review under the APA, and that the Notice was laden with mandatory language and created new obligations for taxpayers in violation of the rules of administrative procedure.

The IRS argued in Cohen v. United States, No. 08-5088 (D.C. Cir. Aug. 7, 2009), that the decision of whether or not to process refund requests was entirely up to the IRS’s discretion and that its methods were unreviewable under the APA. The IRS also insisted that the guidelines set forth in the Notice did not preclude other administrative action. The Court disagreed, noting that the taxpayers had no other remedy at law than to challenge the Notice on the grounds that it violated the APA. In response to the government’s contention that the Anti-Injunction Act (AIA) precluded the suit, taxpayers said the statute was inapplicable because the IRS had already collected the tax. The AIA only affects lawsuits while the agency is in the process of assessing or collecting a tax.

Gilbert Rothenberg, acting deputy assistant attorney general to the Justice Department Tax Division, pointed out during the en banc hearing that Congress had established procedures taxpayers must follow to obtain a refund—procedures the taxpayers had ignored in this case—and that the statute of limitations was in fact still open. It would be unprecedented, he said, for a court to find that it had jurisdiction to hear a case challenging compliance with the APA when a taxpayer had not first used the appropriate refund process. But the judges questioned how the IRS could be immune from the APA and criticized the terms of the Notice.

If the court finds that the IRS failed to adequately adhere to the APA in constructing the procedures in the Notice, the consequences could be significant. A ruling for the taxpayers could require the IRS to follow formal notice-and-comment procedures when formulating guidance—such as Revenue Rulings, Revenue Procedures, and Notices—that have the effect or force of law.