Canada: U.S. Tax Law: What To Watch For In 2012

This Perspective takes a look back at tax developments in the United States in 2011 and offers a look forward to possible U.S. tax developments in 2012.


Although 2011 saw some significant changes in U.S. tax law, the year was marked by partisan politics limiting the ability of Congress to accomplish much. The U.S. government's credit rating was downgraded by Standard & Poor's because of the Congressional gridlock and the year ended with Democrats and Republicans almost failing to extend cuts in employment taxes – cuts both parties wanted – until a compromise was reached in the last hours. As the United States approaches the 2012 Presidential and Congressional elections, the political bickering can be expected to continue.

Short review of U.S. tax developments in 2011

Once again, the United States led by doing less than expected in 2011. With relatively little new revenue on the horizon, and large budget deficits, Congress largely failed to deliver on many of its promises.

Among the most widely anticipated developments that did not occur was the promise of international tax reform. The Obama Administration had proposed ideas for changes to the international tax system, including deferring a deduction for interest expense related to foreign deferred income, determining the foreign tax credit on a pooling basis, and taxing currently excess returns associated with the transfer of intangibles offshore, but none of those proposals has been adopted. Instead, the focus of the international community this year has been largely on the upcoming effective dates for a new system of reporting U.S. investments in foreign accounts under the Foreign Account Tax Compliance Act ("FATCA"). These broad-reaching rules have subjected the United States to tremendous criticism and threats from foreign financial institutions, some of whom may no longer do business with U.S. clients as of 2013.

So what was Congress doing in 2011? At the end of 2010, Congress barely squeaked through extension of the George W. Bush tax cuts, which are now set to expire at the end of 2012. For the first half of 2011, Congress was able to accomplish little else in the tax area. In February, the Senate Finance Committee announced that it would hold numerous hearings and spend 2011 examining changes in the Internal Revenue Code since 1986 and overhauling the U.S. tax system. In September, it held one such hearing on corporate tax reform and issued a report comparing the U.S. international tax system to tax systems of other developed countries. The report found that the United States lagged behind other developed countries both in reducing corporate tax rates and how it taxes foreign income. Although many ideas were developed in the hearings, few have come to fruition.

Another major pressure facing Congress was that spending was quickly approaching the national debt limit. Again, just in time, Congress avoided a general downgrade in the nation's credit rating, and potential default by the United States on its debt, by entering into a compromise that would raise the debt limit, but tasked a "Supercommittee" with making recommendations to reduce U.S. debt in the long-term or face across-the-board reductions in expenditures to the general account and military spending in 2013. Unfortunately, this last minute compromise failed to save the U.S. debt from a downgrade by Standard & Poor's. Additionally, the Supercommittee did not deliver and was dissolved in November without taking any action.

For their part, the Treasury Department and the Internal Revenue Service (the "Service") continued to develop their business plans, and they formalized an approach that provides for periodic updates to their priorities list throughout the year. In 2011, the Service also delivered limited relief to foreign financial institutions and U.S. citizens and residents delinquent in filing their foreign bank account reports ("FBARs"). For the first group, the Service declared a short unilateral delay in the rollout of FATCA until 2014 (Notice 2011-53). For U.S. citizens and residents delinquent in filing FBARs, the Service offered a second voluntary disclosure program and, for failure to file U.S. income tax returns, some relief was offered by FS 2011-13. Guidance was also provided in some areas, including guidelines under the recently codified economic substance doctrine issued to auditing agents, a reminder to report foreign investment accounts and interests in passive foreign investment companies under revised forms being developed, and proposed regulations on the scope of the foreign governmental exemption.

The courts issued a few major tax decisions in 2011. In January, the Supreme Court, in Mayo Foundation for Medical Education and Research v. United States, ruled that the standard for reviewing Treasury Regulations was to be the same standard that applied to non-tax regulations and not a stricter multiple-factor test long thought to apply. As a result of this decision, taxpayers face far greater difficulty successfully challenging a Treasury Regulation in court. In particular, the decision eliminated the relevance of the history and context of the promulgation of the regulation and instead focuses solely on its reasonableness. The Fifth Circuit Court of Appeals, in Container Corp v. Commissioner, held that a guarantee fee received by a Mexican parent from a U.S. subsidiary constituted foreign-source income and was not subject to U.S. tax. Congress had changed this rule to provide that guarantee fees were to be treated as U.S.- source income in the future. The Tax Court also issued an interesting ruling in Goosen v. Commissioner. That case involved income received by professional golfer Retief Goosen from various sponsorships. The Tax Court divided the income between income received for personal services and royalty income and determined the source of royalty income based on where the sponsors sold products.

Outlook for U.S. tax developments in 2012

Few expect major tax legislation in 2012. Yet, there is much housekeeping for Congress to do with corporations and individuals continuing to seek relief under extenders legislation for everything from Subpart F (extension of Code § 954(c)(6)) to the § 41 research credit. In addition, absent major legislation, very substantial increases in U.S. income tax rates will go into effect automatically for individuals, trusts and estates beginning on January 1, 2013, and that will likely result in a large number of transactions being structured to accelerate gain into 2012. Increased rates will also make planning more important going forward.

The Service's business plan includes providing extensive guidance required under FATCA, revising procedures for obtaining qualified intermediary status, guidance on application of the rules for averaging foreign tax credits triggered by an inclusion under Code § 956, implementing limits on foreign tax credit "splitter" transactions, limiting foreign tax credits upon an applicable foreign asset acquisition, and describing substitute dividend arrangements that will attract U.S. withholding tax.

As the United States moves into its Presidential election in November 2012, expect greater rhetoric and discussion about the progressivity of individual income tax rates, the closing of "loopholes" and carried interest legislation, which proposes to tax private equity fund managers on their income at higher, ordinary income rates, rather than as capital gain, as the "99%" look to the "1%" to bail them out. Ironically, as noted above, if no new law passes, the maximum individual income tax rate on net investment income will rise in the United States to 43.4%, and that rate will apply to all sources of ordinary income including (taxable) interest and dividends, as a result of the expiration of tax cuts from the administration of George W. Bush and enactment of a new 3.8% Medicare tax on investment income.

Quixotically, this debate may occur alongside discussion of reducing U.S. corporate income tax rates (to keep the United States "competitive" with the rates in other countries, including Canada, where rates are headed to 25% in 2014), renewal of a temporary allowance to repatriate offshore cash at reduced corporate tax rates and other, more unusual proposals to provide for more radical "international tax reform" which could reduce taxes permanently on offshore income or raise revenue from new sources, including adoption of a value-added tax (like the vast majority of other developed countries) as an add-on tax to permit funding of larger reductions in the corporate or individual income tax rate.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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