On August 5, 1997, the President signed the Taxpayer Relief Act of 1997 (the "Act"). This memorandum summarizes the provisions of the Act which we believe have particular significance to high technology companies and their investors. The Act makes many substantial changes in the taxation of capital gains, partnerships, corporate reorganizations, financial products and a variety of other important areas. Although the Act creates many new pitfalls, we believe it offers substantial potential benefits for those companies and investors who become familiar with its provisions.
PROVISIONS AFFECTING VENTURE AND OTHER INVESTORS
The Act generally reduces the tax rates applicable to capital gains recognized by non-corporate taxpayers.
Corporations continue to be taxed at the same rate for ordinary income and for capital gains. The maximum rate of tax on long-term capital gains has been reduced to 20% (10% for individuals taxed at a 15% rate on ordinary income). Previously, the maximum rate of tax on long-term capital gains for individuals was 28%. However, the holding period for determining eligibility for the reduced rate is 18 months for sales after July 28, 1997.
The Act preserves the 28% rate for assets held more than 12 and up to 18 months, thus substantially complicating the treatment of capital gains. In addition, the maximum rate is scheduled to be reduced still further (to 18%) for assets acquired after December 31, 2000 and held for five years. For purposes of the purchase date requirement (but for no other provision), property acquired pursuant to the exercise of an option will be deemed to have been acquired on the date of receipt of the option rather than the date of exercise. In addition, readily tradable stock and capital assets used in a trade or business and owned prior to January 1, 2001 may be deemed to have been sold on that date and repurchased on the next business day at the election of the taxpayer; such assets will then be deemed to have been purchased after December 31, 2000 for purposes of the purchase date requirement. Such a deemed sale will naturally give rise to the full tax consequences of a sale and repurchase at fair market value, however.
The rate structure for capital gains after the Act is summarized below as follows:
For purposes of determining the holding period of an asset, special rules may apply. For example, straddle transactions may suspend or restart the holding period. The application of these rules is uncertain, however, for assets held more than one year but not more than 18 months, and there may be planning opportunities with respect to such assets.
Deferral of Gain from the Sale of Qualified Small Business Stock
The Act also enhances the attractiveness of Qualified Small Business Stock currently eligible for relief under Section 1202 by creating an important deferral opportunity for investors realizing gain on the sale of Qualified Small Business Stock. Under new Section 1045, individual taxpayers using the proceeds of the sale of Qualified Small Business Stock to invest in other Qualified Small Business Stock may defer any gain recognized (and tack their original holding period to the newly acquired stock), provided the taxpayer has: (i) held the original Qualified Small Business Stock for at least 6 months, (ii) sold the original Qualified Small Business Stock after August 5, 1997, (iii) purchased new Qualified Small Business Stock within the 60-day period beginning on the date of sale, and (iv) made the election contemplated by the Act.
It is important to note that Section 1045 literally applies only to individuals selling Qualified Small Business Stock that they hold directly, even though under Section 1202 individuals may realize the benefits of Section 1202 where they hold Qualified Small Business Stock indirectly through pass-through entities such as partnerships, limited liability companies treated as partnerships and S corporations. We believe this limitation is an oversight and have requested clarification of this point from the Treasury Department.
Treatment of Capital Gains Under the Alternative Minimum Tax
The Act modifies the alternative minimum tax (the "AMT") to create maximum capital gains rates under the AMT for non-corporate taxpayers that mirror the capital gains rates under the regular income tax. Previously, the rates used in computing the minimum tax under Section 55(b) did not distinguish between capital gains and other income. Under the Act, the normal maximum rates for long term capital gains will now be used in computing the tentative minimum tax under Section 55(b) for non-corporate taxpayers. With the addition of this provision, capital gains should no longer be a factor in determining whether or not a non-corporate taxpayer is subject to the AMT.
The Act also decreases the preference applied to the 50% exclusion under Section 1202. Previously, 50% of the amount of any Section 1202 exclusion (for the sale of Qualified Small Business Stock) was treated as an item of tax preference for purposes of the AMT. Under the Act, only 42% of the amount of any Section 1202 exclusion will now be treated as an item of tax preference.
Constructive Sales of Stock, Debt and Partnership Interests
Gain Recognition. The Act adds new Section 1259 which limits the ability of taxpayers to defer the recognition of gain with respect to assets for which the risk of loss has been substantially limited. Section 1259 requires the recognition of gain on certain constructive sales of a position in stock, certain debt instruments or partnership interests. Pursuant to Section 1259, such positions will be deemed sold, and gain will be recognized, where a holder enters into an offsetting short sale, offsetting notional principal contract, or futures or forward contract, or covers one of the foregoing positions. While the new provision generally applies only to publicly traded property, it may apply to non-publicly traded property where the constructive sale contract does not settle within one year of being entered into. For purposes of a subsequent actual sale, the adjusted tax basis of the underlying position is adjusted to account for any gain recognized, and a new holding period will be deemed to begin on the date of constructive sale. Other risk reduction transactions such as "collars" will be treated as constructive sales only to the extent provided in future Treasury regulations (and in the case of "abusive transactions" may be attacked retroactively by such regulations).
An important exception provides that a holder may disregard one or more constructive sales entered into during the taxable year, as long as the position giving rise to the constructive sale is closed within 30 days after the end of the taxable year, and the underlying position is held "naked" for the 60-day period following thereafter (e.g., the asset is neither disposed of nor subject to a put within such 60-day period).
Effective Date; Immediate Identification Suggested. The new provision generally applies to constructive sales after June 8, 1997. However there are two important provisions that apply to constructive sale transactions that occurred on or before June 8, 1997. First, the Act allows taxpayers to identify the positions in a pre-June 9, 1997 constructive sale, in which case the pre-June 9, 1997 positions will not be taken into account in determining whether another constructive sale has occurred after June 8, 1997. Taxpayers must identify the pre-June 9, 1997 positions in their books and records by September 3, 1997 (or later, if so provided by Treasury). While there is no guidance yet as to the proper method of identification, a similar rule under the straddle provisions provides that a taxpayer will have established a presumption of identification where there is independent verification of the identification, such as through the establishment of a special brokerage account. In the absence of independent verification, the straddle rules provide that the burden is on the taxpayer to establish that identification was properly made. Taxpayers who have not yet identified pre-June 9, 1997 positions should consider taking advantage of these identification procedures.
Repeal of Offshore Principal Office Requirement for Investment Partnerships
Under a "safe harbor" rule, foreign persons not otherwise subject to United States Federal income tax ("foreign investors") generally are not subject to United States Federal income tax on capital gains attributable to investments in stock and other securities issued by United States corporations. Prior to amendment by the Act, this rule applied for investments made through partnerships and limited liability companies (such as venture capital, hedge, and buyout funds, referred to herein as "securities investment funds") only if such entities maintained a "principal office" outside the United States. Accordingly, many securities investment funds that raised capital from foreign investors (i) were organized outside the United States and (ii) utilized the services of non-United States persons to perform those administrative tasks associated with the maintenance of a principal office.
Beginning with taxable years that commence after December 31, 1997, the Act repeals the "principal office" requirement of the safe harbor rule. In consequence, foreign investors participating in securities investment funds generally may qualify for the safe harbor (and, therefore, be exempt from United States Federal income taxes on capital gains attributable to the portfolio securities purchased, and disposed of, by such funds) even if the funds are organized and operated entirely within the United States.
It is expected that this change will substantially reduce the number of securities investment funds that are required to organize outside the United States. In addition, existing funds that have maintained an offshore principal office may wish to re-organize within the United States, or move the conduct of administrative tasks to a United States office, in order to reduce operating costs.
Anti-"Mixing Bowl"/Exchange Fund Provisions
General. The Act contains a number of provisions intended to narrow taxpayers' ability to effect a tax-free diversification of their investment portfolios through the use of "partnership mixing bowl" arrangements. One type of mixing bowl arrangement specifically targeted by the Act is commonly known as an "exchange," "swap," or "diversification" fund ("Exchange Fund"). Exchange Funds typically have been used by investors that hold non-diversified portfolios of substantially appreciated securities (e.g., technology company founders whose companies have gone public or been acquired by a public company). Prior to the Act, these investors could contribute a portion of their securities to an Exchange Fund on a tax-free basis and, after an appropriate holding period (generally five years), receive from the Exchange Fund as a tax-free distribution a mixed portfolio of securities contributed by other investors in the Fund. As described below, the Act targets such mixing bowl arrangements by (i) making it more difficult to contribute appreciated property to a partnership on a tax-free basis and (ii) lengthening the holding period that must elapse before a partnership that has received a contribution of appreciated property can distribute property on a tax-free basis.
Contributions of Appreciated Property. In general, a taxpayer may contribute appreciated property to a partnership without triggering taxable recognition of the built-in gain. However, tax-free treatment is denied in the case of a contribution that effectively diversifies the taxpayer's investment position if, immediately after the contribution, the partnership is classified as an "investment company."
Prior to the Act, regulations provided that a partnership would be treated as an investment company only if more than 80 percent (by value) of the partnership's assets consisted of certain "readily marketable" assets, including exchange traded and over-the-counter quoted stocks and securities, REIT and mutual fund interests, and rights to acquire the foregoing (the "80 Percent Test"). Thus, an Exchange Fund could avoid qualifying as an investment company by holding non-marketable securities, including high-grade custom-tailored securities made available for this purpose by a variety of financial institutions.
Under the Act, the class of assets that are deemed to be "readily marketable" for purposes of the 80 Percent Test has been substantially broadened to include, among other things, most types of securities whether or not actually tradable on a public market. In consequence, future Exchange Funds will need to hold different types of assets (e.g., direct interests in real estate) in order to avoid qualifying as investment companies. This may increase the administrative costs and/or change the risk profiles of many Exchange Funds. This change is generally applicable to contributions of property after June 8, 1997.
Holding Period. In general, partnerships may distribute property to their partners on a tax-free basis. Under one significant prior-law exception to this rule, a partner that contributed appreciated property to a partnership generally was required to recognize gain in respect of the contributed property if, within five years after the contribution, either (i) the contributing partner received from the partnership a distribution of different property or (ii) the contributed property was distributed by the partnership to another partner. Thus, Exchange Fund investors typically were required to hold their Exchange Fund interests (without receiving distributions of securities) for at least five years.
Under the Act, the holding period needed to avoid gain recognition has been extended from five years to seven years. This may make a variety of mixing bowl arrangements, including Exchange Funds, less attractive to many investors. This change is generally applicable to contributions of property after June 8, 1997.
Transfers of Appreciated Property to Certain Foreign Persons
Repeal of Excise Tax. Under prior law, Section 1491 generally imposed a 35 percent excise tax on transfers of appreciated property by U.S. persons to foreign partnerships, trusts and estates. The broad scope of this provision generated significant concern among investment fund managers and others that the excise tax might be applied to ordinary partnership distributions of appreciated property. After being made aware of these concerns, the Internal Revenue Service temporarily suspended the application of Section 1491 to partnership distributions pending further study and public comment. The Act repeals Section 1491 in its entirety as of August 5, 1997.
Enactment of Gain Recognition Requirement. The Act adds to the Code new Section 684, effective for distributions occurring on or after August 5, 1997. Except to the extent provided in regulations (which regulations are not expected to be available this year), new Section 684 generally requires immediate gain recognition on transfers of appreciated property by U.S. persons to foreign trusts and estates. For domestic partnerships whose partners include foreign trusts or estates, new Section 684 may burden distributions of appreciated property in a way similar to the now-repealed Section 1491. While this burden may ultimately be reduced or eliminated by regulations, domestic partnerships should consider requiring that foreign partners hold their partnership interests through partnerships or corporations to avoid the possibility of gain recognition under new Section 684.
Clarification of Information Return Filing Requirements for Non-U.S. Partnerships
The Act clarifies the information reporting requirements applicable to non-U.S. partnerships by adding to the Code new Section 6031(e). Under new Section 6031(e), except as otherwise provided in regulations, non-U.S. partnerships generally are required to file information returns for any taxable year in which they have either (i) gross income derived from U.S. sources or (ii) gross income which is effectively connected with the conduct of a U.S. trade or business. Because income that is not otherwise derived from U.S. sources may be treated as having been so derived if it is allocated to a partner that is a U.S. person, many non-U.S. partnerships that are not engaged in a U.S. trade or business will nevertheless be required to file information returns if they have one or more U.S. partners.
In general, such returns must set forth the same information as the information returns filed by U.S. partnerships, including each partner's name, address and allocated share of partnership income for the taxable year. New Section 6031(e) applies to taxable years beginning after August 5, 1997.
In the case of a non-U.S. investment partnership with one or more U.S. partners, new Section 6031(e) generally will require information returns. Accordingly, foreign investors that do not wish to be identified on such returns should consider holding their partnership interests through one or more intermediate entities.
Moratorium on Self-Employment Tax Regulations
Under Section 1402(a)(13), limited partners generally are exempt from self-employment taxes on their allocated shares of partnership income. Historically, for purposes of Section 1402(a)(13), the term "limited partner" generally has been interpreted to mean any person that qualifies as a limited partner under applicable state law. Proposed regulations issued in January 1997 would have (i) narrowed the term to exclude an individual who materially participates in his or her partnership's business and (ii) clarified that the term includes certain members of limited liability companies. Prior to issuing the proposed regulations, the Internal Revenue Service took the position that limited liability company members could not qualify as limited partners for purposes of Section 1402(a)(13).
The proposed regulations generated significant controversy. In consequence, the Act prohibits until June 1, 1998 the issuance or effectiveness of temporary or final regulations that relate to the definition of limited partner for purposes of Section 1402(a)(13). This moratorium on new regulations may be helpful to a state-law limited partner who materially participates in his or her partnership's business, but it leaves open the question of whether a limited company liability company member may be exempt from self-employment taxes as a "limited partner."
Effective for taxable years beginning after December 31, 1998, the Act expands the definition of a principal place of business to include a place which is used by the taxpayer to conduct administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts such activities. This change will expand the number of taxpayers eligible for home office deductions.
MERGERS, ACQUISITIONS AND FINANCINGS
Limitation on Tax-Free Spin Offs
The Act made several amendments to the rules governing spinoffs, i.e., transactions in which a corporation (often referred to as "Distributing") distributes a business (commonly known as "Controlled") to its shareholders in a transaction that meets the requirements of Section 355. The most significant change is a rule that generally denies corporate-level tax-free treatment to an otherwise qualifying spinoff if certain 50% or more shifts (measured by vote or value) in the ownership of Distributing or Controlled (by reason of an acquisition or an issuance of stock in connection with a financing) occur within the four year period beginning two years prior to the spinoff.
The Act, which is generally effective for spinoffs after April 16, 1997, requires Distributing to recognize gain on the spinoff as if it had sold Controlled for cash. Although nominally only applicable when a 50% owner shift has occurred or is contemplated at the time of the spinoff, every spinoff will be affected. For example, every spinoff should be structured so as to prevent a subsequent event from rendering the spinoff taxable. The new law may also have the effect of limiting post-spinoff financings that take the form of preferred stock since the issuance of highly valued preferred stock may exacerbate the post-spinoff changes in ownership.
Treatment of Certain Preferred Stock as "Boot"
The Act treats certain debt-like preferred stock received in otherwise tax-free exchanges as taxable "boot." Previously, such instruments could be received tax-free, for example upon the contribution of assets to a new entity or in connection with an otherwise tax-free reorganization.
The provision applies to stock which is "limited and preferred as to dividends and does not participate in corporate growth to any significant extent," and either (i) has a dividend right which varies with interest rates or other indices or (ii) is subject to a put, call or redemption right that may be exercised within twenty years of the date of issuance. There are a variety of exceptions to the new rules. For example, put and mandatory redemption rights generally may be disregarded if they are subject to a contingency that renders the likelihood of exercise or redemption remote, and a call right may be ignored if it is unlikely to be exercised. Depending on the circumstances, there may be ways to plan around the new legislation. For example, we believe that a meaningful conversion privilege can frequently preclude preferred stock from being taxed under the new law. Other techniques are available as well. The provision is generally effective for transactions after June 8, 1997.
Limitation of Interest Deductions
The Act denies an interest deduction in the case of certain debt instruments where a substantial amount of the principal or interest is required or permitted: (i) to be paid in equity of the issuer or a related party, or (ii) to be determined with reference to the value of the equity of the issuer or a related party. An exception applies if any such principal or interest is so payable or determinable only at the option of the holder (as opposed to the issuer or a related party) and such option is not "substantially certain" to be exercised. This exception generally will preclude the new provision from applying to typical convertible debt instruments where the conversion price is "significantly higher" than the stock price of the stock on the issue date. However, this provision may limit the deductibility of interest paid on typical venture bridge loans that convert into equity at the price of the next round of equity financing. The new law generally applies to issuances after June 8, 1997.
PROVISIONS AFFECTING HIGH TECHNOLOGY CORPORATIONS
The Act contains two significant changes in the AMT rules applicable to corporations. The first provides for a complete exemption from the AMT for certain Small Corporations. A corporation will qualify as a Small Corporation if it has (i) average annual gross receipts not exceeding $5 million for the three-year period ending with such corporation's first taxable year beginning after December 31, 1996 and (ii) average annual gross receipts not exceeding $7.5 million for all taxable years beginning thereafter. If a corporation qualifies as a Small Corporation in any taxable year and then ceases to so qualify in a subsequent taxable year, the AMT will generally apply on a prospective basis to transactions occurring after the start of the first taxable year of non-exempt status.
The second significant AMT-related change repeals the AMT adjustment for depreciation by conforming the system of depreciation lives to be used for purposes of computing the AMT to the system of depreciation lives used for calculating non-AMT related depreciation under the Code. The repeal of the AMT depreciation adjustment is applicable to property placed in service after December 31, 1998.
FSC Benefits for Software Exports
A Foreign Sales Corporation ("FSC") is a tax law mechanism designed to provide export incentives for U.S. manufactured products. The incentive is provided by means of an exemption from taxation of a portion of the profits realized from export sales. The Act has clarified the treatment of income generated from the export of computer software.
Income generated from the export of software in the form of disks, tapes, CDs, etc. (and likely, based on recent proposed regulations, software exported electronically) has been eligible for FSC benefits. In many cases, however, multiple copies of software are not physically exported. Rather, a master is often provided to a distributor who will duplicate the software and distribute the copies. In those instances, the U.S. exporter receives licensing income based on the number of copies produced. Similar licensing income received with respect to audio and video tapes in the entertainment industry is eligible for FSC benefits. Nonetheless, the Internal Revenue Service has taken the position that such benefits are not applicable to computer software licensing income.
The Act has amended the Code to specifically include income from the reproduction of computer software, in addition to films, tapes, records, etc. as eligible for FSC export benefits. This provision is effective with respect to software revenue attributable to periods after December 31, 1997.
It is important to note that the Committee Report for the new provision expresses an intent that "computer software" be liberally construed to account for the rapid rate of innovation in the industry, and, in particular, that software not be narrowly distinguished from hardware. However, this intent is not itself a part of the new law, and may or may not be reflected in any Treasury regulations interpreting future interpretation of the new provision.
Finally, the new provision neither admits nor denies the correctness of the Department of the Treasury's past interpretive regulations with respect to computer software license revenue attributable to periods before January 1, 1998. This is important because the matter is currently in litigation in the Tax Court and many companies have taken these benefits on their tax returns.
Other International Provisions
The Act makes a number of other significant changes in the area of international taxation, including:
The Act modifies the Passive Foreign Investment Company ("PFIC") rules to eliminate the overlap between the PFIC provisions and Subpart F. In general, controlled foreign corporations subject to Subpart F will not also be subject to the PFIC rules. The Act also makes a number of other PFIC modifications.
The foreign tax credit limitation applicable to non-controlled foreign corporations (the so-called "10-50 basket") has been liberalized for certain distributions and is scheduled to be eliminated after 2002.
Gain from the sale of the stock of lower tier subsidiaries will be eligible for dividend treatment under Section 1248.
The Act extends the indirect foreign tax credit of Section 902 and 960 to certain fourth, fifth and sixth-tier controlled foreign corporations.
The Act attempts to simplify the treatment of foreign joint ventures, by among other things, repealing Section 1491. (See discussion above.)
Net Operating Loss Carryover Period
The Act generally reduces the net operating loss carryback period from three to two years and extends the carryforward period from 15 to 20 years. This may offer some benefit to venture-financed technology startups which undergo ownership changes under Section 382 and thereby lose the ability to utilize net operating losses within the 15-year carryover period of prior law.
The Act extends the availability of the research and development tax credit for an additional 13 months, from June 1, 1997 through June 30, 1998.
PENALTY AND REPORTING PROVISIONS
Substantial Understatement Penalty - Exemption Denied for Tax Shelter Items
The tax law now imposes a 20% penalty on "substantial understatements" of tax liability. The term "substantial understatement" includes an understatement of at least 10% of the amount of tax due. For the purpose of making this calculation, underpayments that are attributable to certain positions are disregarded. Specifically, in non-tax shelter cases, the position must either be supported by substantial authority or be both (i) adequately disclosed on the return and (ii) have a reasonable basis. In the case of a tax shelter (as defined below), the position must be supported by substantial authority and the taxpayer must have reasonably believed the position was more likely than not to have prevailed. Moreover, in the case of a corporate tax-shelter, satisfying this higher "more likely than not" standard does not provide complete protection from the substantial understatement penalty, but rather merely gives the corporate taxpayer the ability to argue on "reasonable cause" grounds that the penalty should not be imposed.
The Act made several changes to the substantial understatement penalty, all of which are effective for transactions entered into after August 5, 1997. The most significant change is that the definition of tax shelter has been expanded to include any entity, plan or arrangement a significant purpose of which (rather than the principal purpose) is the avoidance or evasion of federal tax. As a result of this expansion, the number of circumstances in which obtaining a substantial authority opinion will be sufficient are dramatically reduced. This change will affect both corporate and noncorporate taxpayers.
The Act also tightened up the rules in the case of non-tax shelter items of corporations. Specifically, a corporate taxpayer will no longer be able to avoid the penalty by return disclosure of an item if the item is attributable to a "multiparty financing transaction" and such item does not "clearly reflect" the income of the corporation.
Registration Requirement for Tax Shelter Promoters and Investors
Section 6111 now requires certain investments be registered as tax shelters. In general, registration is required for any investment that exceeds $250,000, has five or more investors in any year and provides deductions that exceed the amount invested by a ratio of two to one. For these purposes, the amount invested does not include amounts attributable to non-recourse debt.
The Act also expands registration requirements to cover "confidential corporate tax shelters." In general, a confidential corporate tax shelter is an investment that is offered under conditions of confidentiality, for which the promotor receives fees in excess of $100,000, and a significant purpose of which is the avoidance or evasion of Federal income tax.
The burden of registering tax shelters is generally, but not always, placed on the promotor. In addition, investors bear the risk of increased IRS audit and scrutiny. Registration will be required only upon the issuance of applicable Treasury regulations. Once effective, care should be taken whenever there are discussions with the promoter of a confidential tax shelter.