Corporate Tax Shelter Provisions
Pass-through Entity Provisions
Insurance Law Changes
On Monday, February 1, in conjunction with President Clinton's budget announcement, the U.S. Treasury released a proposal for income tax law changes to be taken into account in the budget deliberations ("Budget Proposal"). While recent years' strained budget deliberations have at times produced no revenue bill, we believe a tax bill is likely to emerge this year. The policy discussions about broad-based tax cuts versus shoring up social security will attract most of the press attention. Of greater interest to businesses, however, are the many proposed changes to fundamental and well established principles of tax law.
The proposed corporate tax law changes include a broadside aimed at the growing corporate tax shelter industry as well as significant changes to main-stream corporate, partnership, financial instrument and accounting provisions, certain leasing provisions and tracking stock. Significant changes are also proposed for international tax provisions and life and property insurance taxation. The effective dates are generally the date of enactment or, for tax abuse items, not earlier than the date of first committee action (the date the Means Committee first announces its preliminary determinations - presumably not earlier than late April or May). The discussion below will only mention effective dates that are different from these general effective dates.
We urge all interested readers to contact the Tax, Benefits, Trusts & Estates Department lawyers of Thelen Reid & Priest LLP for specific information on the described provisions and others in the Treasury proposals of interest to you. Many of these provisions may be regarded as uncontroversial and could be enacted merely because of lack of opposition. It may make sense to discuss changes of vital interest with our legislative affairs law-yers in Washington, D.C., monitor progress of the Budget Proposal, join a lobbying consortium, or put forward your position on the consequences of particular provisions of the proposals in your industry. Set forth below is a description of many of these changes which we regard as important.
Corporate Tax Shelter Provisions
A major focus of the Budget Proposal has been the introduction of a series of provisions aimed at closing down the growth of "corporate tax shelters." The corporate shelter provisions begin with a broad definition of tax shelter, similar to IRS Notice 98-5 and the ACM case commentary: an entity, plan or arrangement in which a direct or indirect corporate participant attempts to obtain a tax benefit in a "tax avoidance transaction." A tax avoidance transaction is generally described as any transaction in which the reasonably expected pre-tax profit of the transaction is insignificant relative to the reasonably expected net tax benefit. A tax avoidance transaction would also include certain transactions involving the "improper elimination or significant reduction of tax on economic income."
The Proposal contains new provisions that increase the current penalty from 20% to 40%, subject to reduction for adequate disclosure. The reasonable cause exception would be eliminated.
B. Expand Section 269
This proposal would add a subsection to Code section 269 specifically to address tax shelters.
C. Disallow Tax Shelter Advice Fees
The Proposal also contains a provision that denies a tax deduction to corporations for fees paid or incurred in connection with the purchase and implementation of corporate tax shelters, and for the rendering of tax advice related to corporate tax shelters.
D. Excise Tax on Tax Benefit Protection
Any insurance, rescission right, guarantee or other arrangement protecting an investor's tax benefits would be subject to a 25% excise tax. The Budget Proposal would also impose an excise tax:
- (i) On investment bankers, accountants and lawyers equal to 25% of the investment banker fees and fees for tax advice received in connection with a tax shelter.
- (ii) On corporations equal to 25% of the amounts payable under a tax benefit protection arrangement if the tax benefits of a transaction are denied.
E. Tax Indifferent Parties
Another provision would tax otherwise tax-indifferent entities (e.g., foreigners, tax-exempt charities, Native American Indian tribes and NOL companies) on any income allocated to them from a corporate tax shelter. All other participants in such tax shelter would also be jointly and severally liable for such tax. Taxpayers would also be precluded from characterizing a transaction with a tax indifferent party differently from its form.
F. Lessors of Tax-Exempt Use Property
The provisions of the Budget Proposal also include specific changes to lessors utilizing foreigners or other effectively tax-exempt persons as recipients of income from U.S. transactions. The proposal would limit the U.S. lessor's loss in respect of the leasing transaction to future income recognized from the very same transaction in a manner similar to the method for restricting passive activity losses utilized in Code section 469. These provisions would curtail, if not eliminate, the cross-border lease industry.
G. Further Restrictions on Company-Owned Life Insurance
Prior legislation has substantially restricted the ability of corporations to claim interest deductions from debt-financed company-owned life insurance ("COLI"). The rules would further restrict COLI by repealing the ex-ception for COLI pro-ration for contracts covering em-ployees, officers and directors other than 20% owners.
The Budget Proposal contains several changes applicable to nonrecognition transaction deductions and other provisions involving corporations, as well as changes in connection with certain types of stock.
A. Tracking Stock
The issuer of tracking stock (i.e., stock that relates to, or tracks the economic performance of, less than all of the issuer’s assets) would recognize gain upon the issuance on the difference between the fair market value and the basis of the "tracked" assets. In addition, the Service would have regulatory authority to treat tracking stock as other than equity of the issuer.
B. Spinoff Trade or Business
The Budget Proposal expands the ability of parties to a spin-off, split-off or split-up to meet the active trade or business requirement. This requirement must be met by both the distributing and the controlled companies (or a direct subsidiary of either). The proposal would permit the determination of whether the distributing or controlled companies have active trades or business based on the activities of all members of each entity's consolidated group.
C. Harmonize Control Requirements
The Budget Proposal would modify the definition of control in a tax-free reorganization. Currently, control for such purposes is 80% of each class of voting stock and 80% of every other class of stock. If the proposal is adopted, this definition would be changed to 80% of vote and value of the target company, which is the same definition of control used to determine affiliated groups.
D. Downstream Mergers
The merger of a parent company into its subsidiary (so-called "downstream mergers") would only qualify for nonrecognition if the parent owns stock of the subsid-iary representing 80% of the voting power and value of such subsidiary. To the extent that this control requirement is not met, the parent corporation would be re-quired to recognize gain, but not loss, on the distribution of the stock of the subsidiary to the former parent shareholders.
E. Intangible Property
With respect to intangible property, there is currently some question as to whether the transfer of less than all rights associated with intangibles (e.g., a nonexclusive license on a patent) constitutes a transfer of property. The Budget Proposal would statutorily resolve this question in the affirmative.
F. DRD for Redeemable Preferred Stock
Corporations would no longer be permitted to claim the dividends received deduction to the extent that such dividend is attributable to nonqualified preferred stock, as defined in Code section 351(g).
The Budget Proposal includes numerous provisions affecting the taxation of financial products. Included among these provisions are Changes targeted to new financial products.
A. Rules on Hedging
The Budget Proposal codifies the hedging rules previously promulgated by the Treasury Department to clarify that certain assets are ordinary assets for federal income tax purposes, and to provide more equitable timing of losses under the straddle rules.
B. Forward Contracts on Issuer's Stock
A forward purchase contract of an issuer's stock economically resembles a present sale for a deferred payment (or a future sale secured by an interest bearing deposit). Accordingly, the Budget Proposal would require that such contracts include a time value of money component. This rule will affect a number of tax products currently being marketed
C. Defer Cost of Funds Deduction for Convertible Debt
The Budget Proposal would defer the deduction for accrued stated interest and OID on convertible debt until actual payment. For this purpose, "convertible debt" includes:
- (i) Debt exchangeable for the stock of the issuer or a related party.
- (ii) Debt that provides for cash settlement conversion features.
- (iii) Debt issued with warrants (or similar instruments) as part of an investment unit in which the debt component may be used to satisfy the exercise price for the warrant, but does not include debt that is convertible solely because a fixed payment of principal or interest is payable, at the election of the holder, in an amount of the issuer's or related party's equity that has a value equal to the amount of the fixed payment.
D. End Special Rules for Cash Basis Banks
Banks otherwise qualifying for cash method of accounting would be required to accrue all interest, original issue discount, and acquisition discount on short-term obligations, including loans originated in the ordinary course of business.
E. Current Accrual of Market Discount
Holders of market discount bonds that use an accrual method of accounting would be required to include market discount in income as it accrues
F. Tighten Rules for Debt-Financed Portfolio Stock
The Budget Proposal contains a modification to the standard for determining whether portfolio stock is debt-financed for purposes of denying the dividends received deduction. Indirectly financed stock would be captured under an apportionment method.
G. Defer Deductions for Debt Repurchase Premium
A modification and clarification would be made to certain rules relating to debt-for-debt exchanges, including:
- (i) Spreading the issuer's net deduction for bond repurchase premium over term of the new debt instrument using constant yield principles.
- (ii) A clarification of the measurement of net income or deduction in cases where the new debt instrument is contingent and neither the new debt instrument nor the old debt instrument is publicly traded.
- (iii) The treatment as taxable boot in a reorganization of the excess of the issue price of the new security over the adjusted issue price of the old security.
H. Defer Expense in Straddles
A modification of the straddle rules would be made to:
- (i) Clarify that a taxpayer holding an appreciated position in personal property cannot currently recognize loss or deduct expenses (including interest expenses) that are attributable to structured financial transactions that include a leg of the straddle.
- (ii) Repeal the exception for stock in the definition of personal property.
Pass-Through Entity Provisions
The Budget Proposal contains provisions aimed at various pass-through entities, including partnerships, subchapter S corporations, and real estate investment trusts.
A. Basis Adjustments for Ownership Distributions
While not directly tied to the corporate tax shelter provisions, several provisions of the Budget Proposal are aimed at uses of partnership rules to effect unintended results. The rules for allocating basis adjustments with respect to property distributions by partnerships would be modified to prevent the possibility of the duplication of claimed tax losses by making the Code section 754/734 election mandatory. A related provision would prevent an inappropriate shift of tax basis among assets in liquidating distributions. The proposal would also prevent the deferral of gain on a partial liquidation of the partnership.
B. Repeal Tax Free Conversions of Large C Corporations to S Status
The S corporation rules would be modified to provide for a large C corporation (i.e., having at least a $5 million value) that converts into an S corporation, to be treated upon its conversion as having made a taxable liquidating distribution followed by a reincorporation triggering both corporate and shareholder level taxable gain.
C. REIT Provisions
Two proposals would regulate attempts to broaden the use of REITs. First, the test for calculating a REIT's satisfaction of its widely-held requirement would be changed to limit the growth of closely-held REITs. Second, changes would be made to activities conducted by taxable REIT subsidiaries to prevent improper use of the REIT's exempt status.
A. 10/50 Companies
10% or greater interests in uncontrolled foreign corporations (10/50 companies) are subject to a very restrictive basket for foreign tax credit purposes, which under current law will be liberalized for earnings accruing after 2002. The Budget Proposal would allow the look-through approach now scheduled for 2003 to apply to 10/50 company dividends for taxable years beginning after December 1, 1998.
B. Mutual Fund Dividends
Foreign taxpayers are currently subject to U.S. dividend withholding tax on distributions from U.S. based bond funds (regulated investment companies) paying out interest income. Such foreign companies would presumably be exempt from U.S. withholding by virtue of the portfolio interest exemption if they had owned a direct interest in the underlying bond assets. Effective for mutual fund and taxable years beginning after the date of enactment, dividends from funds substantially all of whose assets are U.S. debt securities would be exempt from withholding tax.
C. Mandatory Code Section 338 Election
In an effort to stop the trafficking in built-in losses, credits and other tax attributes of entities not previously relevant for U.S. tax purposes (e.g., previously non-CFC foreign companies or previously tax-exempt entities), such entities would be required for transactions on or after the date of enactment to make a "fresh start" when they first become relevant for U.S. tax purposes. Their asset basis would be marked to fair market value; foreign taxes and presumably, the entities' prior earnings and profits history, would be eliminated.
D. Interest Equivalents
Under current law, interest income is sourced by the residence of the borrower, whereas income paid in respect of a guarantee is sourced by reference to where the risk was located. This could result in income equivalent to interest being treated as foreign source and not subject to U.S. tax. The rules would conform the treatment of sourcing guarantee income to that of interest.
Overall foreign losses ("OFL's") created in respect of a particular controlled foreign corporation ("CFC") would be recaptured as ordinary income in the year a CFC is disposed of to avoid indefinite deferral of OFL consequences.
F. 80/20 Companies
Treasury expressed concern that current rules allow for the manipulation of withholding payments by the insertion of a newly formed 80/20 company. An 80/20 company is a U.S. company 80% of whose gross income for the testing period is from sources outside the United States. Income of an 80/20 company may be foreign source income. The proposed rules would prevent the creation of new 80/20 companies to artificially manipulate the rules by applying the 80/20 test on a group-wide basis. The proposal would apply to interest and dividends accrued 30 days after the date of enactment.
G. Material Participation By Foreign Companies
Under existing rules, inventory sales income may be sourced to a foreign office which materially participates in the sale. The Budget Proposal would limit the rule to foreign offices that pay a minimum income tax of 10%.
H. Inventory Sales Rules
Under current law, inventory sales with title passing outside the United States produce 50% foreign source income under a mechanical simplifying rule. The proposed rules would require taxpayer to allocate income based upon the relative economic production of the sales activities.
I. Basis Shift Transactions Involving Foreign Shareholders
Redemptions of stock are treated as dividends if the shareholder's interest in the corporation is not meaningfully reduced. In this situation, the shareholder's basis in its remaining stock is generally increased by the basis of the redeemed stock. To prevent taxpayers from attempting to offset capital gains by generating artificial capital losses through basis shift transactions involving foreign shareholders, the Budget Proposal would expand existing rules and require a shareholder to reduce the basis of stock to the extent that such a dividend to a shareholder is not subject to current U.S. tax, as, for example, by reduced tax rates under a treaty.
J. Limit Tax-Free Liquidations of U.S. Subsidiaries of Foreign Corporations in Order to Preserve the Imposition of U.S. Tax on Distributed Earnings
The Budget Proposal would prevent the use of a transitory U.S. holding company (one used to receive tax-free dividends from U.S. operating subsidiaries and then distribute those dividends to its foreign parent in a tax-free liquidating distribution) to defeat the imposition of U.S. withholding tax. Withholding tax would be imposed on any distribution made to a foreign corporation in complete liquidation of a U.S. holding company if the holding company was in existence for less than five years. A similar result would be achieved under the branch profits tax with respect to termination of a U.S. branch of a foreign corporation.
A. Restrict Change in Method of Accounting
Code section 381 requires an acquired target to use its historical accounting method. This restriction may be avoided by contributing assets to a new corporation or partnership prior to reorganization. The Budget Proposal applies the restrictions under Code section 381 to contributions made under Code sections 351 and 721.
B. Repeal Installment Method
For accrual method taxpayers, the installment method under Code section 453 provides an exception to accrual. The Administration's view is that the installment method causes the normal accrual of income to be distorted and should be repealed for accrual method taxpayers, with exceptions for certain types of dealers.
C. No Deduction for Punitive Damages
Under current law, no deduction is allowed for fines, criminal penalties or certain payments for antitrust violations. The Budget Proposal extends this rule to all types of punitive damages and requires information reporting by insurers that pay punitive damages.
D. Tollers Must Apply Uniform Capitalization
”Tollers” perform manufacturing or processing operations on property which is owned by their customers in exchange for a fee. Under this arrangement, the toller may currently deduct, instead of capitalize, certain direct and indirect costs because it does not own the manufactured property. The Budget Proposal requires tollers to capitalize certain direct and indirect costs of their manufacturing activity.
E. Repeal Lower-of-Cost-or-Market Inventory Method
Certain taxpayers determine the carrying value of inventory by writing down their nonsalable goods using market prices. The Budget Proposal states that this practice is a one-way mark-to-market that distorts income and should be repealed.
F. Eliminate "Non-Accrual Experience" Method for Service Providers
Under current law, an accrual method service provider may avoid accrual of a receivable if it appears uncollectible on the basis of experience. The Budget Proposal would repeal the non-accrual experience method exception to accrual method accounting. Any resulting Code section 481 adjustment would be included in income ratable over a four-year period.
G. Expand Interest Disallowance Under Code Section 265
The Budget Proposal would expand the disallowance of interest deductions for carrying tax-exempt obligations to securities dealers and financial intermediaries.
H. Amortization of Start-Up Expenses
The Budget Proposal extend the minimum amortization of start-up expenses from 60 months to 15 years, similar to other intangible assets.
I. Increase Cost Recovery Period for Utility Grading Costs
The Budget Proposal would increase the cost recovery period for utility grading and clearing from seven years to 15 years for gas utilities, and up to 20 years for electric utilities.
A. Tax Credit for Energy-Efficient Building Equipment
The Budget Proposal provides a new tax credit for the purchase of certain highly efficient building equipment technologies. The credit would equal 10 or 20 percent of the amount of qualified investment, depending upon the energy efficiency of the qualified item.
B. Level Playing Field/Electric Industry Restructuring
The Administration continues to propose that existing indebtedness of governmental utilities be exempted from private activity bond restrictions. However, a governmental utility would not be allowed to issue new tax-exempt bonds to finance electric output facilities, other than distribution facilities.
C. Nuclear Decommissioning
With regard to contributions to qualified nuclear decommissioning trust funds, the Budget Proposal would repeal the present law provision limiting the amount of the deduction to amounts included in the taxpayer's cost of service for rate-making purposes.
D. Credit Extenders
The research and experimentation tax credit would be extended through June 30, 2000. The wind and biomass tax credit would be extended for 5 years to facilities placed in service before July 1, 2004, and would be expanded to include certain biomass from forest-related resources, and agricultural and other sources. The work opportunity tax credit and welfare-to-work tax credit would be effective for individuals who begin work before July 1, 2000. The deduction for brownfields remediation costs would be made permanent.
Insurance Law Changes
The Budget Proposal contains several provisions relating to life insurance, including two potentially costly changes to the taxation of life insurance companies.
A. PSA Recapture
The Budget Proposal would require that policy holders' surplus accounts ("PSA") accrued in respect of life policies through 1983 be recaptured over ten years commencing with the first taxable year starting after enactment. This PSA recapture terminates the tax deferral life companies had enjoyed in respect of untaxed profits which might have been distributed in respect of policies written before 1984.
B. Capitalization of Policy Commissions
Potentially of greater significance is the requirement for increased capitalization percentages of policy acquisition costs. This provision expands the Indopco case rationale to agent commissions and other costs associated with the acquisition of various life insurance products. The provision calls for a capitalization of a higher percentage of policy premiums in five categories of insurance products which amounts will then be amortized over a ten-year period.
C. Structured Settlements
The Budget Proposal would change the rules for structured settlement payments which have been discounted to third persons. Treasury states that their intention to permit defendants to currently deduct amounts transferred to fund structured settlements while permitting beneficiaries to defer taxation of their income has been abused by the new industry, under which companies loan money for the purchase of the structured settlement stream. An excise tax of 40% would be imposed on the difference between the payments made to the insured person and the undiscounted value of the structured settlement payment stream.
D. Property and Casualty Pro-ration Percentage
Property and casualty insurance companies' pro-ration percentage would be increased from 15% to 25%. The pro-ration percentages represent the reduction of allowable property and casualty reserves for the amount of tax exempt interest earned on the investments of reserves.
The Budget proposal would permit direct rollovers between IRAs, 403(b) plans and 401(a) or 403(a) plans, as well as rollovers of after-tax money from qualified plans to IRAs and rollovers of 457(b) plans of state and local governments to IRAs or 403(b) plans. Tax-free transfers from 403(b) or state and local government 457 plans to purchase service credit under a state or local government defined benefit plan would also be permitted. Plans would still retain the right to decide whether to accept these rollovers or transfers. This should add little, if any, burden to plan administration.
The Budget Proposal provides for faster vesting of employer contributions to 401(k) plans.
Vesting would either be:
- (i) 100% after three years of employment, or
- (ii) 20% per year after two years of employment, with full vesting after six years of employment.
C. Nondiscrimination Testing
The Budget Proposal would require a mandatory contribution of 1% of salary for all non-highly compensated employees in addition to current match if the 401(k) plan uses the safe harbor matching formula. Employers would be required to offer employees the opportunity to join a 401(k) plan during a 60-day period at the beginning of each plan year and provide reasonable notice of this election period, if the employer uses any of the ACP or ADP safe harbors. Finally, the definition of highly compensated employee would be simplified to eliminate the top paid group election. This may make it more difficult for some plans to pass nondiscrimination testing.
The Budget proposal provides that a Qualified Joint and Survivor Annuity must pay at least 75% to the survivor, and notices must be given to spouses. Leave time under the Family Medical Leave Act would count towards eligibility and vesting in a retirement plan. Elective withholding rates on non-periodic retirement distributions (that applies unless waived) would be increased from 10% to 15%
The unrelated business income tax on income flowing through S corporations to ESOPs would be restored.
F. Welfare and Other Fringe Benefit Plans
The Budget Proposal facilitates the creation of Qualified Health Purchasing Coalitions, and tax credits for small businesses are provided to join them. The exclusion for employer-paid college tuition would be extended to January 1, 2002 and the exclusion for tuition for graduate programs would be reinstated beginning June 30, 1999 and would end January 1, 2002. Tax credits would be available for employers offering certain workplace literacy programs. Deductions for severance pay and death benefits (other than group term life insurance) for 10 or more employer plans would be curtailed by limiting the deductions for pre-funded benefits.
G. Small Employers
The Budget Proposal would create the SMART plan, which is a simple defined benefit plan for small businesses. In addition, small businesses would be eligible to receive a tax credit for starting new retirement plans by December 31, 2001. n