The year 2012 was very eventful from a tax perspective, with significant developments on the legislative front. This article takes a look back at tax developments in Canada and the United States in 2012 and offers a look forward to possible Canadian and U.S. tax developments in 2013.
I. CANADIAN TAX REVIEW AND OUTLOOK
Since 2008 corporate taxpayers in Canada have operated in an environment of declining tax rates, with the federal corporate income tax rate falling to 15% in 2012. In connection with changes to federal tax provisions, the Canadian Minister of Finance had encouraged all Canadian provinces to decrease their provincial corporate tax rates to 10% by 2013 so that Canada could have a national corporate tax rate of 25%. Only two provinces (British Columbia and New Brunswick) have responded by dropping their corporate tax rates to 10%. Alberta's provincial corporate tax rate has been at 10% since 2006.
The Province of Ontario had originally intended to gradually decease its provincial tax rate to 10% by July 1, 2013, but in its 2012 budget it was announced that Ontario's corporate tax rate would be frozen at 11.5% (for a combined federal and provincial rate of 26.5%), with any further rate decreases deferred until Ontario's deficit has been eliminated. In addition, the Province of British Columbia proposed in its 2012 budget to increase its general corporate income tax rate to 11% (from 10%) effective April 1, 2014 should the province's fiscal situation worsen.
Although the goal of a 25% Canadian national corporate tax rate by 2013 has not been achieved, the corporate tax rates across the Canadian provinces generally compare very favourably with those of the U.S. and the other members of the G7 (other than the U.K.).
With respect to personal taxes, both Ontario and Quebec have increased the tax rates for their top earners. In Ontario, the top marginal tax rate for earnings in excess of $500,000 went up from 46.41% to 47.97 per cent in 2012 and went up again on January 1, 2013 to 49.53%. In Quebec, the top marginal tax rate for earnings in excess of $100,000 went up from 48.22 per cent to 49.97 percent on January 1, 2013.
Key Canadian tax developments in 2012
Literally thousands of pages of proposed tax legislation and explanatory notes were released in 2012. In addition, a number of important tax cases were decided in 2012. The following provides a brief overview of some of the significant developments.
Budget and Bill C-45
The Minister of Finance delivered the 2012 Canadian federal budget on March 29, 2012. A number of the income tax initiatives announced in the budget were included in Bill C-45, tabled on October 18, 2012 . Bill C-45 received Royal Assent on December 14, 2012. The significant tax measures in Bill C-45 include:
- The Foreign Affiliate Dumping Rules. The foreign
affiliate dumping rules represent a significant shift in Canadian
tax policy and are among the most important international tax
developments in Canada in recent years. While the Canadian
government has been attempting to encourage investment in Canada by
reducing corporate tax rates, these rules may deter many legitimate
foreign investments in Canadian companies.
These provisions are intended to prevent foreign-based corporate groups from artificially loading up their Canadian subsidiaries with debt to generate tax shelter in Canada, or from indirectly extracting earnings from Canada without actually paying a dividend and incurring withholding tax by making investments in related foreign corporations. However, the foreign affiliate dumping rules are much broader than their stated objectives and contain numerous traps that may affect any number of transactions involving a foreign-controlled Canadian corporation that has investments in foreign affiliates, including in circumstances where the investment is directly related to the Canadian corporation's business.
- Amendments Targeting Transactions Involving
Partnerships. Two separate amendments target transactions
involving partnerships that were perceived by the Department of
Finance to abuse the flow-through nature of partnerships.
Under the so-called "bump rules", a qualifying Canadian corporate buyer of a Canadian corporate target can "push-down" its tax cost in the target shares to increase, or "bump", the tax cost of the target's non-depreciable capital property upon an amalgamation with or wind-up of the target. The first amendment imposes significant limits on the ability to bump the tax cost of a partnership interest held by a target, and is aimed at transactions that used the bump of a partnership interest to extract assets from a corporation that could not be "bumped' themselves.
The second amendment expands the scope of an existing anti-avoidance rule that applies where a partnership interest is sold to a tax exempt. The amended rule can cause a capital gain realized by a Canadian taxpayer on a sale or redemption of an interest in a partnership to be effectively taxed as ordinary income if a tax exempt or non-resident person (or certain trusts or partnerships of which a tax exempt or non-resident person is a beneficiary or partner) acquires an interest in the partnership from the Canadian taxpayer or from the partnership as part of the same series of transactions.
- Thin Capitalization Amendments. Canada's thin capitalization rules have been amended to limit the deductibility of interest paid or payable by a Canadian corporation to certain non-resident shareholders where the relevant debt-to-equity ratio exceeds 1.5 to 1, a reduction from the previous 2 to 1 debt-to-equity limit. The amendments also extend the application of the rule to loans made by these non-resident shareholders to certain partnerships and deem interest that is subject to these rules to be treated as a dividend for withholding tax purposes.
For a more detailed discussion of the amendments contained in Bill C-45, please see our fall tax update (which can be found http://www.dwpv.com/en/Resources/Publications/2012/Fall-Tax-Update).
On February 24, 2012, the Tax Court of Canada released its decision in Velcro Canada Inc. v. The Queen. The Velcro decision is the second Canadian tax case to meaningfully consider the term "beneficial owner" in the context of a tax treaty – the first being Prévost Car Inc. v. The Queen. Issues of beneficial ownership have been in the international spotlight worldwide in recent years. In Prévost Car Inc. v. The Queen, the CRA argued that a shareholder was not entitled to benefits under the Canada-Netherlands Income Tax Convention in respect of dividends paid by the taxpayer to the shareholder because the shareholder was not the beneficial owner of the dividends, taking into account all surrounding circumstances. The Canada Revenue Agency was unsuccessful at both the Tax Court and the Federal Court of Appeal. Although the Prévost decision was considered very helpful for non-residents investing in Canada through a third jurisdiction that has a beneficial tax treaty with Canada, it did not deal with "back-to-back" arrangements, and its significance in such circumstances was less clear.
In Velcro, a company resident in the Netherlands Antilles ("AntillesCo") held certain intellectual property and trademarks which it had licensed to an indirect Canadian subsidiary ("Canco") in consideration for Canco agreeing to pay a royalty. AntillesCo subsequently granted a subsidiary resident in the Netherlands ("BVco") a sublicense and assigned to it the rights to the royalty from Canco in consideration for BVco agreeing to pay AntillesCo a royalty equal to substantially all the royalty payments received from Canco. The Canada Revenue Agency challenged the parties' position that BVco was entitled to the benefits of the Canada-Netherlands Income Tax Convention, on the basis that BVco was not the beneficial owner of the royalty payments received from Canco for the purposes of the treaty.
The Court in Velcro applied the analysis in the Prévost decision and concluded that BVco was the beneficial owner of the royalty payments. In making this determination, the Court in Velcro noted that the royalty payments received by BVco were not segregated, but in fact were intermingled with BVco's other funds, funds from the intermingled accounts were used to pay general expenses, make investments, pay professional fees, repay loans, etc and the agreement between BVco and AntillesCo didn't restrict BVco from using the payments received from Canco, among other factors. The decision in Velcro continues the recent trend in Canadian court decisions involving tax treaties of rejecting expansive interpretations of limitations on the right to claim treaty benefits.
There were a number of tax treaty developments in Canada in 2012:
- Canada signed comprehensive tax treaties with the Republic of Serbia on April 30, 2012 and with Hong Kong on November 11, 2012. Canada also signed new tax treaties with New Zealand on May 3, 2012 and with Poland on May 14, 2012 to replace Canada's existing tax treaties with these two countries. Interestingly, the tax treaties with New Zealand, Poland and Hong Kong have a form of anti-treaty shopping provision in each of the dividend, interest and royalty articles. Previously, only a limited number of Canada's tax treaties have included similar provisions. The insertion of the anti-avoidance provisions may be Canada's response to the Canada Revenue Agency's unsuccessful attempts at challenging treaty shopping cases under existing law and may reflect a new standard tax treaty negotiating position.
- Canada's tax treaty with Columbia and its new protocol with Singapore entered into force.
- Canada signed new protocols amending its tax treaties with Austria and Luxembourg to include tax information exchange provisions and announced in November 2012 that it was in negotiations with the U.S. on an agreement to improve cross-border tax compliance through enhanced information exchange under the Canada-United States Income Tax Convention, including information exchange in support of the U.S. Foreign Account Tax Compliance Act (the "FATCA" rules are described under the U.S. tax law discussion).
- Prime Minister Stephen Harper announced in February 2012 that an agreement in principle had been reached to update the Canada-China Income Tax Convention signed in 1986, which the Prime Minister stated would help promote trade and investment between the two countries.
- The Department of Finance announced at the May 2012 seminar of the Canadian branch of the International Fiscal Association that it will not offer the relatively common treaty exemption from Canadian capital gains tax for indirect dispositions of Canadian real property through which a business is carried on in new tax treaties.
- The Department of Finance announced in June 2012 that it was in negotiations to update its tax treaty with Australia and requested that interested parties inform the Canadian government of any particular issues that should be taken into account during the ongoing negotiations. It was stated that the government was particularly interested in learning of any difficulties encountered by Canadians under the Australian tax system.
Tax Information Exchange Agreements (TIEAs)
Canada continued to expand its TIEA network in 2012 as TIEAs with four more countries (Costa Rica, Saint Lucia, Aruba and Dominica) came into force. Canada now has a total of 16 TIEAs in force and is in TIEA negotiations with 14 countries. The Department of Finance has been actively seeking TIEAs with tax haven countries in order to improve domestic tax enforcement. To encourage tax havens to enter into TIEAs with Canada, dividends received by a Canadian corporation out of active business income of a foreign affiliate resident in a jurisdiction with which Canada has a TIEA have been made exempt from Canadian tax. As a stick to go along with this carrot, active business income of a controlled foreign affiliate is taxed in Canada on an accrual basis (in the same manner as foreign passive income) where the controlled foreign affiliate is resident in a jurisdiction that does not enter into a TIEA with Canada within 60 months of Canada seeking to enter into negotiations for a TIEA with that country.
With 16 TIEAs now in force (including with the Cayman Islands and Bermuda), the range of attractive jurisdictions within which to establish foreign affiliates of Canadian corporations has grown significantly, and traditional notions about inappropriate offshore structuring can be questioned.
St. Michael Trust case
On April 12, 2012, the Supreme Court of Canada rendered its decision in St. Michael Trust Corp. v. The Queen. The taxpayer in the case claimed an exemption under the Canada- Barbados Income Tax Convention from Canadian capital gains tax on the sales of shares of a Canadian corporation by a family trust established under Barbados law on the basis that the trust was resident in Barbados for the purposes of the tax treaty. The Supreme Court agreed with the lower court's approach of effectively applying the corporate residence test of central management and control in determining the residence of the trust, rather than determining the residence of the trust based on the residence of the trustee. On this basis, the trust was found to be resident in Canada and not Barbados given the role played by the Canadian principals in the transactions.
On July 12, 2012, the Federal Court of Appeal issued its decision in Sommerer v. The Queen. Mr. Sommerer was a Canadian resident who sold shares at fair market value to a private Austrian foundation that was established in 1996 by Mr. Sommerer's father for the benefit of Mr. Sommerer and his family. A private Austrian foundation may engage in investment activities and is not subject to Austrian tax provided it files an information return disclosing the names of its beneficiaries. The foundation realized significant capital gains when it disposed of the shares acquired from Mr. Sommerer. The Canada Revenue Agency sought to include these gains in Mr. Sommerer's income on the basis that the foundation was a trust or held the property in trust, and that an anti-avoidance rule in subsection 75(2) of the Income Tax Act (Canada) applied to the capital gains realized by the foundation from the shares. Subsection 75(2) includes income or gains from property contributed to a trust in the contributor's income where the property can revert to the contributor. The Tax Court of Canada held that the foundation was a trust, but that subsection 75(2) did not apply to a sale of property to the trust at fair market value. The Federal Court of Appeal questioned whether the foundation had the character of a trust, but agreed with the Tax Court that subsection did not apply to a genuine sale.
Although it was not necessary to dispose of the appeal, the Federal Court of Appeal also considered the interaction of the Canada-Austria Income Tax Convention and the subsection 75(2) anti-avoidance rule, holding that absent specific language in the treaty to the contrary, the provisions of a specific anti-avoidance rule, such as subsection 75(2), do not allow Canada to override the general provisions of the treaty and impose tax on the gain. It is possible that the Department of Finance will seek to provide that subsection 75(2) overrides the capital gains articles in Canada's treaties in the Income Tax Conventions Interpretations Act to overrule this aspect of the Federal Court of Appeal's decision.
On October 18, 2012 the Supreme Court of Canada rendered its decision in GlaxoSmithKline Inc. v. The Queen, which is the first transfer pricing decision by the Supreme Court.
The taxpayer in Glaxo packaged and sold Zantac, a patented and trademarked drug, in Canada. The Canada Revenue Agency argued that the taxpayer paid an unreasonable amount to a related Swiss sister company for the active pharmaceutical ingredient in Zantac. The taxpayer licensed the Zantac trademark and patents from its parent for use in Canada under a licensing agreement that obligated the taxpayer to purchase the ingredient from the related Swiss company. The Tax Court held that the taxpayer had overpaid for the ingredient on the basis of evidence that, in the years in question, Canadian generic companies were able to purchase the ingredient for a price less than that paid by the taxpayer. In 2010, the Federal Court of Appeal reversed this decision and returned the case to the Tax Court for reconsideration on the basis that the Tax Court had not considered "all relevant circumstances which an arm's length purchaser would have had to consider", particularly the license agreement with the parent. The Federal Court's decision was appealed to the Supreme Court.
The Supreme Court agreed with the Federal Court's decision in referring the case back to the Tax Court for reconsideration and stating that other factors, such as licensing agreements, should be considered when determining a reasonable arm's length price for the active ingredient. The decision contains at least the implication that a portion of the purchase price for the drugs might be properly seen as a licensing cost.
Comprehensive Technical Amendments
On October 24, 2012, the Minister of Finance tabled a Notice of Ways and Means Motion ("NWMM"), which is an extensive package of legislation implementing a variety of proposed technical amendments that have been outstanding for a number of years. On November 21, 2012, the NWMM was tabled in the House of Commons as Bill C-48. The legislation includes amendments affecting reorganizations of and distributions from foreign affiliates, the taxation of non-resident trusts and their beneficiaries and the taxation of investors in offshore fund investment property. The amendments also include rules affecting "foreign tax credit generator" transactions, real estate investment trusts, mergers of mutual funds, tax bumps in respect of shares of foreign affiliates, securities lending arrangements, and include a new reporting regime for tax avoidance transactions.
For the most part the previously announced amendments have been included in Bill C-48 without changes, but in some cases technical corrections have been made including to, among other things, the foreign tax generator rules, the non-resident trust rules, the restrictive covenant rules and the foreign affiliate upstream loan rules.
Of particular relevance to Canadian multi-nationals are the foreign affiliate upstream loan and hybrid surplus rules, which radically alter two significant aspects of Canada's foreign affiliate system. For a discussion of the upstream loan and hybrid surplus amendments please see our fall tax update (which can be found http://www.dwpv.com/en/Resources/Publications/2012/Fall-Tax-Update).
Facilitating Butterflies and Tax Bumps
On December 21, 2012, the Department of Finance released for comment a new package of draft legislative proposals. Included in the proposals are a number of amendments to the exceptions to the Canadian capital gains stripping anti-avoidance rule (often referred to as the "butterfly rules") and to the tax bump rules.
These amendments to the butterfly and tax bump rules generally implement technical corrections that the Department of Finance has promised to make in comfort letters issued to taxpayers that date as far back as 2002. In addition to addressing the comfort letters, the proposed rules include amendments not previously addressed in comfort letters which are intended to allow a tax bump in a wider range of circumstances.
Canada Revenue Agency Folio Project
The Canada Revenue Agency has over the years included many of its technical interpretations of various areas of Canadian tax law in "Income Tax Interpretation Bulletins". Many of these bulletins are out of date and do not reflect changes in law. In addition, these bulletins are not organized in any meaningful way. In September of 2012, the Canada Revenue Agency announced that it was replacing bulletins in favour of new electronic "folios" that would be organized by subjects. The Canada Revenue Agency will be obtaining assistance from certain accounting and law firms to help draft the content.
Outlook for Canadian tax developments in 2013
Expected Legislative Developments
It is expected that Bill C-48 (containing the comprehensive technical amendments) will receive Royal Assent in early 2013. This will be welcome news as some of the legislation in Bill C-48 dates back a decade. The passage of this bill will clear a decade long log jam of technical amendments.
As discussed above, additional long-standing technical amendments are included in the draft legislative proposals released on December 21, 2012, which includes a number of amendments to the butterfly and tax bump rules. The Minister of Finance has asked for comments on these draft proposals by February 19, 2013. As a result, the Minister of Finance may release another version of these amendments in 2013 after it receives comments from interested parties.
The Minister of Finance is expected to deliver its 2013 budget at the end of March. It has been rumoured that the budget will include revenue raising tax measures. One possible such measure could be further amendments to Canada's thin capitalization rules. A 2008 government sponsored advisory panel recommended extending the application of the thin capitalization rules to partnerships, trusts and Canadian branches of non-resident corporations. The 2012 amendments only extended the thin capitalization rules to partnerships with a Canadian resident partner. It has been suggested that the thin capitalization rules may be amended further to implement the balance of the advisory panel's recommendation. Other revenue raising measures focussing on "unintended tax preferences" can be expected as well.
In the 2010 federal budget the Canadian Government announced that it would explore the possibility of adopting a formal loss transfer system or consolidated tax reporting for corporate groups, regimes that have been available in the United States and United Kingdom for many years. A discussion paper on the topic prepared by the Finance Department was released at the end of 2010 seeking comments from taxpayers. It is possible that we may see proposals in this regard in 2013.
Expected Judicial Developments
The Supreme Court of Canada will likely render its decision in Daishowa v. The Queen. The taxpayer in this case agreed to sell timber rights that gave rise to certain reforestation obligations for $180 million less the preliminary estimate of $11 million for the assumption of the reforestation obligations by the purchaser, which amount would be adjusted based on a final estimate of the reforestation obligations. The Federal Court of Appeal held that the seller's assumption of the reforestation liabilities constituted consideration (and additional proceeds of disposition) to the taxpayer and because the parties specifically "agreed to a price of $11,000,000 for the reforestation liability ... they should be held to that price for income tax purposes". The Federal Court's decision results in double taxation because the taxpayer was treated as having received taxable proceeds of disposition in respect of an economic obligation for which it had no deduction or cost for tax purposes. The Supreme Court is scheduled to hear this case in February of 2013. The treatment of contingent obligations in the context of sale transactions is surprisingly uncertain, and it is hoped that this decision will provide much needed clarity.
II. U.S. TAX REVIEW AND OUTLOOK
Key U.S. tax developments in 2012
Avoiding the fiscal cliff
The biggest U.S. tax news for 2012 did not occur until the early hours of 2013 when Congress and the White House finally brokered a deal to keep the nation from falling over the "fiscal cliff" when the Budget Control Act of 2011 was to go into effect. In a compromise to prevent draconian spending cuts in many areas of the budget, including defense, Congress was able to pass a bill extending the Bush-era tax cuts for those American trusts and individuals making $400,000 ($450,000 for joint-filers) or less. The highest marginal tax rate on these high-earners will increase from 35% to 39.6% and long-term capital gain rates will increase from 15% to 20%. Qualified dividend income will be subject to the 20% capital gains rate plus the 3.8% net investment income tax, although non-resident aliens are not subjected to the additional 3.8%. Ordinary income rates as well as rates on capital gains and qualified dividend income will not be increased from the 2012 levels for those making less than $400,000. Corporate tax rates are also unaffected.
Another important aspect of the compromise involves the U.S. estate tax. The 2012 exemption amount of $5 million was kept, but adjusted for inflation, while the maximum estate tax rate rose to 40%.
The fiscal cliff deal also extended the facility for U.S. multinationals to finance foreign operating subsidiaries through third country finance subsidiaries. Section 954(c)(6), which was extended through 2014, provides an exception from the general rule that requires a U.S. shareholder of a controlled foreign corporation ("CFC") to immediately take into account certain income, termed "subpart F income", of the CFC. Specifically, section 954(c)(6) provides that certain payments received by a CFC from related persons do not constitute subpart F income if the payment is not allocable to subpart F income of the related person or income effectively connected with the conduct of a trade or business within the United States.
Supreme Court upholds "Obamacare"
With all the campaigning President Obama and many members of Congress were doing in 2012, one is amazed they had time to reach this deal and certainly did not seem to have time for much else. And, indeed, 2012 marked another year of little legislative development. The Supreme Court, however, not having to solicit for its own votes, did manage to give a considerable boost to the Obama campaign in June when it upheld the Affordable Care Act, informally known as "Obamacare." The Court determined that the most controversial aspect of the Patient Protection and Affordable Care Act, a tax on individuals who do not acquire health insurance, is a constitutional exercise of the government's taxing authority.
Obamacare also contains a series of taxes that will begin in January, including a Medicare surtax of 0.9% on wages over $200,000 ($250,000 for joint-filers) and a 3.8% tax on investment income to the extent a taxpayer's adjusted gross income exceeds $200,000 ($250,000 for joint-filers).
Hurricane Sandy extends filing deadlines
Rivaling the hot air coming out of Washington, Hurricane Sandy made landfall in New Jersey causing significant damage in New Jersey and several surrounding States, but earning President Obama high marks for his swift and reassuring reaction. The government quickly granted emergency relief to affected people. The Internal Revenue Service also automatically extended various tax filing and payment deadlines that occurred starting in late October. As a result, affected individuals and businesses will have until Feb. 1, 2013 to file returns and pay any taxes due, including fourth quarter individual estimated tax payment, payroll and excise tax returns. The relief also applies to tax-exempt organizations required to file Form 990 series returns with an original or extended deadline falling during this period. Employment tax deposits required to be made after the commencement of the storm but prior to November 26 could be made by November 26 without penalty.
Presidential election impact
The federal elections in early November brought little change with Obama easily winning re-election and no change in the majority party in either the Senate or the House of Representatives.
Obama was not the only presidential candidate to influence future tax policy. With Mitt Romney, who was very successful as a private equity fund manager, in the race, attention was drawn to the favored treatment of certain earnings, such as the carried interest. The spotlight on his low tax rate may increase the likelihood of legislation to treat carried interests as ordinary income.
Prior to the election, President Obama spent time with a number of U.S. corporate executives and had expressed some support for reducing U.S. corporate income tax rates. With the election over, there is uncertainty regarding whether lowering the corporate rate will be a priority in the President's final 4-year term.
Secretary of the Treasury (the "Treasury") Timothy Geithner previously stated that he did not want to retain his position beyond Obama's first term and is expected to announce his departure soon. His replacement has not been identified and even after announced will need to be ratified by the U.S. Senate. With the new Secretary will come further changes in personnel at both the Treasury and the Internal Revenue Service (the "IRS").
2012 also brought a variety of important technical tax developments:
The IRS announced a delayed phase-in of the Foreign Account Tax Compliance Act ("FATCA") information reporting and withholding tax requirements. FATCA requires foreign financial institutions ("FFIs"), a broadly defined category that includes many investment vehicles not ordinarily thought of as financial institutions, including many Canadian investment vehicles, to enter into an agreement with the IRS to: (1) identify U.S. account holders (including foreign entities with substantial U.S. owners); (2) annually report information on such account holders to the IRS; and (3) withhold a 30% tax from any U.S. source fixed annual and periodical payments ("FDAP") or the proceeds from the sale of U.S. securities (as well as certain pass-thru payments) belonging to any account holders that fail to cooperate with FATCA's disclosure requirements. An FFI that fails to enter into the required agreement will itself become subject to this 30 percent withholding tax on all of its withholdable payments. FATCA also requires a withholding agent that makes a payment to a foreign entity that is not an FFI to obtain information on any U.S. substantial owners of the payee or a certification that the payee has no U.S. substantial owners. The 30% withholding tax applicable to both FFIs and non-FFIs will be effective for U.S. source FDAP payments made beginning on January 1, 2014. The withholding tax on proceeds from sales of U.S. securities and on pass-thru payments will be effective for payments made beginning on January 1, 2015. The IRS began accepting applications to enter into FFI agreements January 1, 2013. An FFI must enter into an FFI agreement by June 30, 2013, in order to be identified as a participating FFI and allow withholding agents to refrain from withholding beginning January 1, 2014. FFI's that enter into agreements after June 30, 2013, but before January 1, 2014, will be participating FFIs with respect to 2014, but might not be identified as such in time to prevent withholding beginning on January 1, 2014. An FFI will be required to put in place due diligence procedures for new account holders to identify U.S. accounts opened on or after the effective date of its FFI agreement. For existing accounts, the due diligence requirements will be phased in between one year and two years after the effective date of its FFI agreement, depending on whether the account is a private banking account and on the size of the account. The reporting requirements with respect to accounts open in 2013 will begin to take effect on September 30, 2014 (for new accounts or other accounts for which the FFI has obtained an IRS Form W-9 by June 30, 2014). For 2013, the IRS will require a reduced amount of information to be reported, including the identifying information of the U.S. account holder (or substantial U.S. owner of the account holder), the account balance as of December 31, 2013, and the account number. For 2014 and later calendar years, the full information reporting requirements described in IRS Notice 2011-34 will be required.
FATCA developments also included the release of two versions of a model agreement for foreign governments - a reciprocal version and a nonreciprocal version. The model agreement establishes a framework for reporting by financial institutions to their respective tax authorities, followed by automatic exchange of such information under tax treaties or tax information exchange agreements. The reciprocal version also provides for the U.S. to exchange information currently collected on accounts held in U.S. financial institutions by residents of the other country and is available only to countries with whom the U.S. has in effect an income tax treaty or tax information exchange agreement.
The IRS attempted to ease compliance by releasing a draft of a new IRS Form W-8BEN which would allow persons to certify compliance with FATCA and for purposes of withholding on one form and by allowing for electronic submission of registration by foreign financial institutions to be treated as "participating FFIs."
Foreign tax credit splitter regulations
Under the prior "technical taxpayer rules", a taxpayer was entitled to a foreign tax credit if it were liable for the tax under foreign law regardless of whether it earned the associated income. In response to an unfavorable court decision, the IRS proposed eliminating the technical taxpayer rule. Instead, Congress acted by enacting § 909, which provides that in the case of a "foreign tax credit splitting event" the foreign tax credit is suspended until the related income is taken into account by the taxpayer. A foreign tax credit splitting event includes any case in which the income related to a foreign tax is taken into account by a related person for US tax purposes. In February, the IRS issued final and temporary regulations under § 909.
Period of limitations for overstatement of deductions
In April, the Supreme Court handed taxpayers a significant victory in United States v. Home Concrete & Supply. The Court held that an overstatement of basis does not constitute an omission from gross income that triggers the six-year statute of limitations period under § 6501(e)(1)(A) of the Internal Revenue Code. Generally, if a taxpayer omits an item from gross income on its return that is in excess of 25% of the gross income stated on the return, the period for assessment is extended from three years to six years. Treasury issued regulations in 2010 retroactively extending the six-year limitations period to overstatements of basis. The Court invalidated these regulations and held that the three-year statute of limitations applies.
In 2012, decisions were rendered on several international debt-equity cases. In NA General Partnership v. Comm'r, T.C. Memo. 2012-172, the Court sided with the taxpayer finding that an investment in a subsidiary was debt. In Hewlett Packard Co. v. Comm'r, T.C. Memo. 2012-135, the Internal Revenue Service was in the surprising position of arguing that an investment was debt instead of equity as characterized by the taxpayer. In this case, the IRS prevailed. In a seemingly identical case, however, Pepsico v. Commissioner, T.C. Memo. 2012-269, the IRS lost and the investment was treated as equity. In distinguishing between HP and Pepsico, commentators have noted that HP involved a tax shelter and intent of repayment.
Substantial business exception to anti-inversion rules limited
On June 7, 2012, Treasury and the IRS issued new temporary regulations (the "2012 Temporary Regulations") under the § 7874 anti-inversion rules that would substantially limit the exception to these rules for taxpayers with an expanded affiliate group ("EAG") with substantial business activities in the relevant foreign country. These rules could have a significant impact on cross-border income trust and REIT deals. Section 7874 subjects a foreign corporation to adverse tax consequences, including the inability to offset gain from the inversion transaction with net operating losses, and potentially treating the foreign corporation as a U.S. corporation for U.S. federal income tax purposes if: (i) the foreign corporation completes a direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership; (ii) after the acquisition, at least 60% of the stock of the foreign corporation (measured by vote or value) is held by former shareholders or partners of the domestic corporation or partnership by reason of holding stock or a capital or profits interest in the target entity; and (iii) after the acquisition, the EAG does not have substantial business activities in the foreign country in which it is organized when compared to the total activities of the EAG. Thus, if a foreign corporation can prove that the EAG is engaged in substantial business activities in the relevant foreign country, it will not be subject to the burdens of § 7874 when acquiring a U.S. business. The 2012 Temporary Regulations removed the facts-and-circumstances test promulgated in the earlier regulations, and replaced this approach entirely with a four-part mechanical test requiring the foreign corporation to have 25% of its employees, assets, and income located in the foreign country (the "25% Test"). Under the 25% Test, an EAG will be considered to have substantial business activities in the "relevant foreign country" (i.e., the jurisdiction where the acquiring corporation is created or organized) only if all four of the following conditions are satisfied. If a foreign corporation's EAG fails to meet any of the components of the 25% Test, it will not be considered engaged in substantial business activities in the relevant foreign country, and accordingly, could be subject to § 7874 on an acquisition of a U.S. business.
Transfer of intangibles
In July, the IRS issued Notice 2012-39 announcing that regulations would be issued to address what it perceives as abusive situations relating to the transfer of intangibles. These regulations will require any boot received in a reorganization that involves the transfer of intangibles to be treated as a prepayment of a deemed royalty and currently includable in the income of the target corporation.
The IRS issued new regulations §§1.6049-4(b)(5)(i) and 1.6049-8 requiring reporting of bank deposit interest paid to persons who are not residents of the U.S. but are residents of any country identified as a country with which the U.S. has a treaty or other exchange of information agreement. Previously, such reporting had only been made with respect to Canadian residents.
Outlook for U.S. tax developments in 2013
Despite the fact that the Republican House of Representatives and the Democratic White House were able to come to a compromise to avoid the fiscal cliff, the American citizenry should still hold out little hope for passing more tax legislation. Their first challenge will be presented in two months when spending cuts are to take place in order to effectuate a rise in the debt ceiling.
One possible solution to avoiding the fiscal cliff, and the increasing debt, could have been the implementation of a value added tax ("VAT"). Many economists have noted that a VAT would help reduce the long-term imbalance between revenue and spending, but passing a VAT has been politically difficult. With a president in office who would not be seeking re-election, a VAT becomes more likely but would still have a difficult time getting through Congress.
In taking a more optimistic view, there are a few areas that Congress might be able to address in the coming year.
First, as mentioned above, the interest in limiting the tax advantage to carried interests may find renewed life as a result of the publicity brought by Romney's candidacy. Additionally, passage of the rule codifying Revenue Rule 91-32, on a prospective basis can be expected. Revenue Rule 91-32 held that gain or loss of a non-resident alien individual or foreign corporation from the sale or exchange of a partnership interest is effectively connected with the conduct of a trade or business in the U.S. to the extent of the partner's distributive share of unrealized gain or loss of the partnership that is attributable to property used or held for use in the partnership's trade or business within the U.S..
We are also likely to see passage of proposed further limits on earnings stripping by inverted companies. We can also expect pressure to reverse the proposed rule under the net investment income tax which requires an election to avoid timing mismatches for U.S. individual and trusts holding shares in CFCs and PFICs. As noted above the net investment income tax does not apply to non-resident aliens in any event.
Internal Revenue Service guidance
The IRS is expected to be busy dealing with a host of international tax items in its revised business plan. For one, it is expected to issue regulations to codify Revenue Ruling 91-32, discussed above, retroactively. Guidance will probably also be issued on the treatment of loans from a controlled foreign corporation to a related foreign partnership as well as on various accounting issues and foreign branches.
The proposed regulations under § 892, which provides a tax exemption for foreign governmental investors, are expected to be adopted largely as proposed. The exemption under § 892 does not apply to any "controlled commercial entity" of a foreign government. These regulations clarify what income may be earned by a controlled entity without causing the controlled entity to become a controlled commercial entity.
The regulations under the § 7874 anti-inversion rules, discussed above, are likely to be modified before adopted as final to alleviate some of the harsh results in the exceptions for companies with "substantial business" activities in their place of incorporation.
Treasury will also need to continue to focus on FATCA implementation. Among the FATCA issues that will need addressing are finalization of the form for applying online for status as a registered foreign financial entity and completion of additional intergovernmental agreements to coordinate relief from or implementation of FATCA.
With economic pressure from the growing debt, we can expect continued discussion about fundamental tax reform, including reduction of the corporate tax rate, territorial taxation, and further U.S. tax on the outbound transfer of highly appreciated intangibles, although perhaps not much actual reform. Legislative proposals to provide limited relief to U.S. multinational companies are likely to surface again in the form of a repatriation window, where foreign earnings can be brought back onshore at a reduced rate for a limited period of time, similar to rules applied in 2004. One can also expect concerns with spurring local employment through further or extended tax incentives, separately and as part of this repatriation relief.
The best news is that avoidance of the fiscal cliff is likely to increase interest in mergers and acquisitions in the coming year.
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