a publication of bryan cave llp tax advice and …... a broader perspective america | asia | europe...

$: A Publication of Bryan Cave LLP Tax Advice and …... A Broader Perspective America | Asia | Europe 2 CH01DOCS\233487.3 Single Individuals Not over $8,925 10% of the taxable income$
www.bryancave.com A Broader Perspective

America | Asia | Europe 1

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Spring 2013 Tax News and Developments

A Publication of Bryan Cave LLP Tax Advice and Controversy Practice Group

Contents Current Events American Taxpayer Relief Act Highlights By Gregory J. Galvin ......................... 1 Update on FICA Taxation of Severance Payments By Gregory J. Galvin ......................... 6 Real Estate Capital Markets On-site Communications Antenna Power Generation Constitutes Qualifying REIT Income By Daniel F. Cullen & Peter R. Matejcak............................................ 7 Tax Controversy Avoiding an Accuracy-Related Penalty for Reasonable Cause Based on Reliance on a Tax Professional By Cathryn B. Chetek & Lauren K. Shores Pelikan................................ 13 Tax Credits Consolidated Edison and Historic Tax Credit and New Markets Tax Credit Transactions By Corenia Riley Burlingame .......... 17 Tax Exempt Organizations Churches in Politics By Nathan Boyce ............................ 22 Transactions Reporting Target’s Deductions in an Acquisition By Erika S. Labelle.......................... 24 Europe Does the U.S.-German Double Tax Treaty Also Apply to a U.S. Limited Liability Company? By Stefan Skulesch ......................... 27 Asia “Beneficial Owner” under China’s Tax Treaties By Ye Zhou ..................................... 32

CURRENT EVENTS

AMERICAN TAXPAYER RELIEF ACT HIGHLIGHTS In January, 2013, Congress passed the American Taxpayer Relief Act of 2012 (the “Act”),1 containing numerous individual and business tax changes and extensions. The following discusses a few of these changes and extensions.

Individual Tax Rates

The Act permanently extended (with some modifications) the tax rates contained in the 2001 and 2003 tax relief acts. As a result, the ordinary income rates and the dividend and capital gain rates for single individuals and married individuals filing jointly (for taxable years beginning after December 31, 2012) are as follows:2



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Single Individuals Not over $8,925 10% of the taxable income

Over $8,925 but not over $36,250 $892.50 plus 15% of the excess over $8,925 Over $36,250 but not over $87,850 $4,991.25 plus 25% of the excess over

$36,250 Over $87,850 but not over $183,250 $17,891.25 plus 28% of the excess over



$398,350 Over $400,000 $116,163.75 plus 39.6% of the excess over

$400,000

Married Individuals Filing Joint Returns and Surviving Spouses Not over $17,850 10% of the taxable income

Over $17,850 but not over $72,500 $1,785 plus 15% of the excess over $17,850 Over $72,500 but not over $146,400 $9,982.50 plus 25% of the excess over




$398,350 Over $450,000 $125,846 plus 39.6% of the excess over

$450,000

Dividend & Capital Gain Rates3

Married Individuals filing jointly with Taxable Income

Single Individuals with Taxable Income

15% Up to $450,000 Up to $400,000 20% Over $450,000 Over $400,000

Alternative Minimum Tax

The Act raised the Alternative Minimum Tax exemption amount from $45,000 to $78,750 for married individuals filing jointly; for single individuals the exemption amount was raised from $33,750 to $50,600. The exemption amounts are indexed for inflation.4 This increase is retroactively effective for tax years beginning after December 31, 2011.



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Extension of the Research Tax Credit

The Act retroactively reinstated the research and development tax credit for the period from January 1, 2012 through December 31, 2013.5 In addition, the Act made two technical changes. The first simplifies the rules governing the allocation of research expenses among commonly controlled groups. The second change provides that when a taxpayer incurs research expenses in a trade or business and disposes of that trade or business in the same year, the selling taxpayer is allocated the research expenses, not the purchasing taxpayer.

Extension of the Active Financing Exception to Subpart F Income

U.S. persons who own 10 percent or more of a controlled foreign corporation are subject to current taxation on certain types of income earned by the controlled foreign corporation, whether or not distributed (“Subpart F income”). Among other things, Subpart F income includes interest, rents and certain types of insurance income. Congress had passed a temporary exception that provided that income derived from the active conduct of banking, financing, securities dealing, the insurance business or similar businesses was not Subpart F income if other requirements were also satisfied. The Act retroactively reinstates this active financing exception from Subpart F for taxable years beginning after December 31, 2011 but before January 1, 2014.6

Extension of the Exclusion on Gain from Certain Small Business Stock

Section 1202 of the Internal Revenue Code permits noncorporate taxpayers to exclude from income 100 percent of the gain (up to a maximum amount of gain) realized from the sale of “qualified small business stock.” The noncorporate taxpayer must have acquired the stock after September 27, 2010 but before January 1, 2012, and held such stock for more than five years.7 The maximum gain a taxpayer can exclude from gross income is limited to the greater of $10,000,000 or ten times the taxpayer’s aggregate adjusted basis in the stock.8

Qualified small business stock is stock in a domestic C corporation that had aggregate gross asset basis of $50,000,000 or less at all times after 1993 (and including any amounts received by the corporation in exchange for its stock).9 In addition, the taxpayer must acquire the stock directly from the issuing corporation (i) in exchange for money or other property (but not stock) or (ii) as compensation for services.10

The Act retroactively extends this provision so that it applies to any qualified small business stock acquired by a noncorporate taxpayer during 2012 in addition to any such stock acquired before January 1, 2014.11



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Extension of the S Corporation “Built-in Gain” Tax Relief

In general, when an S corporation sells its assets, the gain on sale flows through to, and is reportable by, the shareholders and is not subject to a corporate level tax. In the case of an S corporation that previously was a C corporation, however, such S corporation is subject to a corporate level tax on its “built-in gain” if the asset sale occurs during the “recognition period.”

Generally, an asset’s built-in gain is the amount of gain that would have been recognized if the corporation’s assets were sold immediately before it converted to an S corporation. The recognition period is the first ten years following the conversion to an S corporation. The recognition period was shortened to seven years for sales occurring during a taxpayer’s 2009 and 2010 tax years, and to five years for sales occurring during a taxpayer’s 2011 tax year. The Act extended this shortened five-year recognition period for any built-in gains recognized during either the 2012 or 2013 tax years. For 2014 and later tax years, the recognition period will again be ten years, unless legislation to the contrary is passed before then.

Thus, an S corporation that converted from a C corporation at least five years ago should consider the tax benefits of an asset sale occurring in 2013 to avoid the corporate level tax on built-in gain.

Extension of Bonus Depreciation

The Act extended bonus deprecation for an additional year. As a result, there is an additional 50 percent bonus depreciation permitted for “qualified property” placed in service during 2013.12 The Act did not modify the definition of “qualified property.” Qualified property generally means property which (i) has a recovery period of 20 years or less, (ii) is computer software, (iii) is a water utility property, or (iv) is a qualified leasehold improvement.13 The property must be acquired pursuant to a binding contract entered into after December 31, 2007 and before January 1, 2014.14

1 H.R. 8 (Public Law 112-240). 2 Id. at §§ 101 – 103; Staff of the J. Comm. on Tax’n, General Explanation of Tax Legislation Enacted in

the 112th Congress, (JCS-2-13, Feb. 25, 2013) at p. 88. 3 H.R. 8 at § 103. This table does not include the 3.8% tax imposed on the lesser of (i) net investment

income or (ii) the excess of modified adjusted gross income over the threshold amount. The threshold amount is $250,000 for married individuals filing joint returns, $125,000 for married individuals filing separate returns or $200,000 in all other cases. This table also does not take into account special rates applicable to unrecaptured section 1250 gain or collectibles.

4 H.R. 8 at § 104; I.R.C. §§ 26 and 55. 5 H.R. 8 at § 301. 6 H.R. 8 at § 322.



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7 I.R.C. § 1202(a)(4). 8 I.R.C. § 1202(b). 9 Staff of the J. Comm. on Tax’n, General Explanation of Tax Legislation Enacted in the 112th

Congress, (JCS-2-13, Feb. 25, 2013) at p. 183. 10 I.R.C. § 1202(c)(1). 11 H.R. 8 at § 324. 12 For long-production period property and certain aircraft, the property must be placed in service during

2013 or 2014. 13 I.R.C. § 168(k)(2)(A)(i). 14 I.R.C. § 168(k)(2)(A)(iii).

By Gregory J. Galvin, Associate, New York, NY, (212) 541-1071, [email protected]



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UPDATE ON FICA TAXATION OF SEVERANCE PAYMENTS The Supreme Court recently granted the government an extension of time to file a petition for the Supreme Court to review the Sixth Circuit’s decision in United States v. Quality Stores. In this case, the Sixth Circuit held that severance payments that meet the statutory definition of supplemental unemployment compensation benefit payments (“SUB Payments”) are not wages for purposes of FICA taxation. SUB Payments are amounts paid to an employee pursuant to the employer’s plan because of the employee’s involuntary separation resulting from a reduction in force or discontinuance of a plant or operation and included in the employee’s wages. The Sixth Circuit’s holding is contrary to a prior decision of the Federal Circuit Court of Appeals and published IRS guidance. The government now has until May 3, 2013 to file its petition. Should the government file a petition, the Supreme Court is unlikely to decide whether to review the Quality Stores decision before Fall 2013.

By Gregory J. Galvin, Associate, New York, NY, (212) 541-1071, [email protected]



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REAL ESTATE CAPITAL MARKETS

ON-SITE COMMUNICATIONS ANTENNA POWER GENERATION CONSTITUTES QUALIFYING REIT INCOME Communications antenna and cellular tower leasing companies have recently been converting to real estate investment trusts (“REITs”) in the wake of a series of favorable rulings from the IRS. The increased confidence in the REIT structure as a viable alternative legal structure is the result of the IRS having blessed various types of communications, broadcast and cellular antennas, towers and other superstructure as constituting real property for REIT tax purposes.1 While such rulings certainly provide taxpayers operating in the wireless and broadcast infrastructure industry with new opportunities in the REIT arena, qualification of an asset as real property alone does not necessarily ensure qualification as a REIT and it is important to consider how the streams of income therefrom will fit within the “qualifying income” tests in the Code.2 In Private Letter Ruling 201301007 (the “PLR”), the IRS provided such guidance with respect to on-site power generation at communications antenna facilities, ruling that income received from such power generation qualifies as “rents from real property.”3

Background

The Taxpayer in the PLR is a wireless and broadcast infrastructure company that conducts business in the United States and various other countries around the world. The Taxpayer, together with its subsidiaries,4 owns a portfolio of communications sites, substantially all of which are freestanding and rooftop antenna towers, and engages primarily in the business of acquiring, developing and leasing antenna space. Its multi-tenant communications sites are leased to various types of tenants, including wireless telecom providers, radio and television broadcast companies and paging companies. The Taxpayer’s real estate portfolios consist of fee interests in land, as well as temporary or permanent easements in land. In addition, the Taxpayer also acts as a ground landlord for certain real estate portfolios consisting of secondary ground leases or rooftop lease positions where the space has already been leased to the Taxpayer for purposes of antenna tower use.

On-site Power Generation

Certain of the Taxpayer’s communications sites are equipped with on-site power generators that are intended to supply power to the site when the local power grid is offline or where local power may not be available.5 The generators are operated and maintained by either the Taxpayer, a



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taxable REIT subsidiary of the Taxpayer, an independent contractor, or some combination thereof. The power generated on-site is provided solely for the use of the tenants and the Taxpayer’s assets (e.g., HVAC, lighting systems) at the communications site, including the antenna tower itself. Because the communications sites are frequently in rural areas or in developing countries, licenses and leases of such facilities may require that the Taxpayer keep on-site generators fueled and ready for operations at all times, and may additionally require backup batteries. In addition, such licenses and leases may require that the taxpayer provide power to an antenna for a specified amount of time each day or month. In certain cases, the Taxpayer charges separately for the electricity generated by such on-site power generators.6

In seeking to receive the ruling from the IRS, the Taxpayer made the following representations with respect to the provision of on-site power generation:

• The Taxpayer does not and will not generate power to sell back to the local electricity grid, and any electricity generated on-site is contemporaneously consumed or stored in on-site backup batteries for later consumption.

• The on-site generation is intended to ensure that each communications site has a secure source of electric power, and such power is provided solely for the use of the communications site’s tenants and the Taxpayer’s assets.

• The use of on-site generators to provide power to tenants of communications sites is usual and customary in the geographic markets in which the Taxpayer has on-site generators.

• Any charges for electricity are not based on the income or profits of any person, and Taxpayer’s collection for such power generation may exceed or fall short of its actual costs for providing such power.

• The Taxpayer will compensate its taxable REIT subsidiaries on an arm’s-length basis for any services they provide in connection with on-site power generation.

While the IRS has issued a series of rulings indicating that the type of communications, broadcast and cellular antennas, towers and other superstructure at issue in the PLR constitute real estate assets for REIT tax purposes, the PLR takes the analysis a step further and addresses whether certain ancillary income generated in connection therewith (in this case, on-site power generation) nevertheless constitutes qualifying income for purposes of the REIT qualification tests under the Code.

Applicable Law

In order to qualify as a REIT, an entity’s gross income is evaluated under a series of tests in order to ensure that entities taking advantage of the beneficial REIT tax rules are generating



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income of the various types Congress intended when formulating the REIT rules.7 At least 95 percent of a REIT’s gross income must be derived from certain qualifying income, including, among other sources, rents from real property.8 Similarly, in general at least 75 percent of its gross income must be derived from, among other sources, rents from real property.9 Subject to certain exclusions and limitations, in general rents from real property includes rents from interests in real property, charges for services customarily furnished or rendered in connection with the rental of real property (whether or not such charges are separately stated), and rent attributable to personal property leased under, or in connection with, a lease of real property (but only if the rent attributable to such personal property for the taxable year does not exceed 15 percent of the total rent for the taxable year attributable to both the real and personal property).10

As the rules show, it is not enough that a service simply be provided in connection with real property. Services must additionally be “customarily furnished.” Services rendered to tenants will be considered to be customary if, in the geographic market in which the property is located, tenants in property of a similar class are customarily provided with the service.11 For example, in particular geographic areas where it is customary to furnish electricity or other utilities to tenants in property of a particular class, the sub-metering of those utilities to tenants will be considered a customary service.

Further, certain “impermissible tenant service income” is excluded from the definition of rents from real property and, if present in sufficient amounts, may taint all income received or accrued with respect to a particular property. Impermissible tenant service income is defined as any amount received or accrued directly or indirectly by a REIT for services furnished or rendered by the REIT to tenants at the property, or for managing or operating the property.12 If the amount of impermissible tenant service income exceeds one percent of all amounts received or accrued by the REIT with respect to the property during the tax year, then all amounts received or accrued with respect to the property will be considered impermissible tenant service income.13

Despite the limitations in respect of impermissible tenant service income, the Code does provide for certain exceptions to the general rule. For example, services furnished or rendered, or management or operation provided through an independent contractor from whom a REIT does not derive or receive income, shall not be treated as having been furnished, rendered or provided by the REIT.14 In addition, any amounts that would be excluded from “unrelated business taxable income” shall not be taken into account.15 For example, under the unrelated business taxable income regulations, payments for the use of occupancy of rooms or other space where services are also rendered to the occupant do not constitute rent from real property.16 Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only.17 Thus, for example, the furnishing of heat and light is not considered as services rendered to the occupant.18



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Application of Law to On-site Power Generation

In the PLR, the IRS concluded that the on-site power generation will not cause income from the communications sites to be treated as other than rents from real property, and amounts derived from providing on-site power generation will qualify as rents from real property. Describing the Taxpayer as a “responsible landlord” providing on-site power generation only in connection with the lease of real property, the IRS reasoned that the Taxpayer was merely bridging the gap between its tenant’s requirements for predictable power versus unpredictable or nonexistent power available from the local power grid. Citing the reference to the provision of heat and light in the unrelated business taxable income regulations, the PLR concludes that the provision of the on-site power should not be treated as impermissible tenant service income because it is not considered to be rendered to the occupant.

Conclusion

The PLR represents another ruling in the recent series of IRS guidance further opening the door for participants in the wireless and broadcast infrastructure industry to enter the REIT arena. While the PLR provides support for the classification of income generated in connection with on-site power generation at communications antenna sites as rents from real property, taxpayers should continue to proceed with caution. For example, the IRS’ conclusion in the PLR is limited to the Taxpayer’s particular facts and circumstances, most notably the location of the communications sites in rural areas and developing countries with inconsistent or nonexistent electricity grids. This raises the question of the wider applicability of the ruling to on-site power generation at communications antenna located in more developed areas. Regardless, this PLR is another significant ruling in connection with the burgeoning communications antenna REIT industry.

1 See, e.g., Priv. Ltr. Rul. 201129007 (Apr. 6, 2011) (wireless communications towers, broadcast communications towers and permanently installed backup generators will be treated as real estate assets and interests in real property); Priv. Ltr. Rul. 201149003 (Aug. 31, 2011) (easement to cell phone tower constitutes real property); Priv. Ltr. Rul. 201206001 (Feb. 10, 2012) (communications antenna structures may be classified as real property).

2 I.R.C. §§ 856(c)(2) and (3). 3 Priv. Ltr. Rul. 201301007 (Oct. 2, 2012). 4 The PLR indicates that the subsidiaries are “taxable REIT subsidiaries.” Taxable REIT subsidiaries

are statutorily allowed wholly-owned subsidiaries that can provide certain non-passive services without automatically disqualifying the parent REIT under the REIT qualification rules. For the purposes of this article, references to the Taxpayer are understood to include the subsidiaries as well.



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5 The PLR notes that, because the Taxpayer operates in certain rural areas of the United States or in developing countries, the local power generation is not necessarily always available on reasonable or predictable terms.

6 Per the PLR, the separate charge for on-site power generation can take several forms, including: actual usage; apportionment; prearranged periodic fees; or some formula negotiated at arm’s length.

7 Note that certain other qualification rules exist (e.g., the threshold REIT requirements of Section 856(a) and the qualifying asset test of Section 856(c)(4)); however, such additional tests are outside the scope of this article.

8 I.R.C. § 856(c)(2)(C). Other sources of qualifying income include: dividends; interest; gain from the sale or other disposition of stock, securities, and real property (including interests in real property and interests in mortgages on real property) that are not stock in trade of the taxpayer, inventory or property held primarily for sale to customers in the ordinary course of trade or business; abatements and refunds of taxes on real property; income and gain derived from foreclosure property; amounts (other than those depending upon the income or profits of any person) received or accrued as consideration for entering into certain agreements in respect of real property; gain from the sale or disposition of a real estate asset which is not a “prohibited transaction;” and certain mineral royalty income. The “prohibited transaction” rules can be found in Section 857(b)(6).

9 I.R.C. § 856(c)(3). Similar to the Section 856(c)(2) test, here other sources of qualifying income include: interest obligations secured by mortgages on real property or on interests in real property; gain from the sale or disposition of real property (including interests in real property and interests in mortgages on real property) that are not stock in trade of the taxpayer, inventory or property held primarily for sale to customers in the ordinary course of trade or business; dividends or other distributions on, and gain from the sale or disposition of, transferable shares in other REITs; abatements and refunds of taxes on real property; income and gain derived from foreclosure property; amounts (other than those depending upon the income or profits of any person) received or accrued as consideration for entering into certain agreements in respect of real property; gain from the sale or disposition of a real estate asset which is not a “prohibited transaction;” and qualified temporary investment income.

10 I.R.C. § 856(d)(1). 11 Treas. Reg. § 1.856-4(b)(1). 12 I.R.C. § 856(d)(7)(A). 13 I.R.C. § 856(d)(7)(B). Impermissible tenant service income in excess of the 1 percent de minimis

threshold can taint all income received or accrued from a property, thereby preventing such income from qualifying as rents from real property (and, thus, qualifying income under the 95 percent and 75 percent tests).

14 I.R.C. § 856(d)(7)(C)(i). 15 I.R.C. § 856(d)(7)(C)(ii). See Section 512(b)(3) regarding unrelated business taxable income and

Section 511(a)(2) regarding the types of organizations relevant to the impermissible tenant services income exclusion.

16 Treas. Reg. § 1.512(b)-1(c)(5). 17 Id. 18 Id.

By Daniel F. Cullen, Partner, Chicago, IL, (312) 602-5071, [email protected] and



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Peter R. Matejcak, Associate, Chicago, IL, (312) 602-5037, [email protected]



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TAX CONTROVERSY

AVOIDING AN ACCURACY-RELATED PENALTY FOR REASONABLE CAUSE BASED ON RELIANCE ON A TAX PROFESSIONAL Taxpayers seeking abatement from the accuracy-related penalty imposed under section 6662(a) of the Code often argue reasonable cause based upon reliance on the advice of a professional tax adviser.1 As explained by the Supreme Court, reliance upon the advice of a tax professional may, but does not necessarily, establish reasonable cause and good faith for the purpose of avoiding a section 6662(a) penalty.2 In Neonatology Associates, P.A., the Tax Court explained that for a taxpayer to rely reasonably upon advice to potentially negate a section 6662(a) accuracy-related penalty the taxpayer must prove “(1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.”3

Several recent Tax Court cases have examined the reasonable cause defense for penalty abatement based on reliance on a tax professional, focusing on the Neonatology factors and, in a more general sense, whether the tax consequences of the transaction were “too good to be true.”4

Giovacchini, et al. v. Comm’r

Most recently, the Tax Court considered whether penalty abatement was appropriate where an estate substantially understated the value of real property for estate and gift tax purposes.5 The estate argued that it was not liable for penalties because the estate relied on professional advisers in valuing the real property. The IRS argued that the estate could not establish the reasonable reliance defense because the estate failed to provide the professional advisers the information that was needed to accurately report the value of the real property.

With respect to the first prong of the Neonatology test, the Tax Court concluded that the estate had established that its tax advisers “were competent professionals who had sufficient expertise to justify reliance.” With respect to the second prong, the Tax Court was “satisfied that the evidence of record reflects that [the tax professionals] were provided the information that they needed to accurately and appropriately advise the family as to the [real property’s] value. Further, one of the tax professionals testified that the Giovacchinis were “always forthcoming, never misstated anything, and provided him with sufficient information to prepare the returns.”



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With respect to the third prong, the Tax Court explained that the Giovacchinis had no tax expertise and relied on their advisers in good faith.

The IRS argued that the estate’s reliance was unreasonable because an initial appraisal received by the estate put the taxpayers on notice that the relevant real property was worth at least $26 million. In response, the Tax Court noted that the estate had no reason to believe that such a high figure reflected reality, especially in light of the conflicting advice given by their tax adviser. Quoting Boyle, the Tax Court explained “[t]o require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify every purpose of seeking the advice of a presumed expert in the first [place].” Thus, the Tax Court held that the estate demonstrated reasonable cause and good faith for the underpayment and was not liable for the accuracy-related penalties under section 6662(a).

Gaggero v. Comm’r

In Gaggero, the Tax Court analyzed whether the taxpayer properly reported the tax consequences of transactions involving the acquisition, improvement and resale of the taxpayer’s principal residence, and whether the taxpayer was liable for accuracy-related penalties under section 6662(a).6

In 1990, the taxpayer purchased land with a rundown house in a relatively depressed market for approximately $3 million. The taxpayer planned to make improvements to the home and sought the advice of his longtime accountant in structuring the purchase and development of the property. In accordance with the accountant’s advice, the taxpayer executed a Land Contract Purchase and Sale Agreement and Development Contract with the taxpayer’s development corporation (“BCC”). Under this contract, BCC agreed to develop the property in exchange for an interest equal to half the increase in its value, less the costs of sale. The taxpayer then moved into the house and used the house as his primary residence as BCC performed the development work. When the house later sold for $9.6 million, the taxpayer reported $6.6 million on Form 2119, Sale of Your Home, while BCC reported over $3 million in ordinary income. The taxpayer then bought a replacement principal residence for $6.7 million within two years and deferred his gain on the sale of the original residence under section 1034 of the Code. The Tax Court held that the taxpayer’s adjusted sales price in his “old residence” was in fact $9.6 million, rather than the $6.6 million reported by the taxpayer. Accordingly, the taxpayer recognized an additional gain of $2.9 million in the year of the sale because the amount by which the adjusted sales price of his “old residence” exceeded the cost of his “new residence” could not be deferred under section 1034 of the Code.

In evaluating whether the taxpayer had a defense based on his reasonable reliance on the advice of his accountant, the Tax Court noted that the taxpayer’s accountant was “a thoroughly qualified professional adviser . . . . [with] extensive experience with these type [sic] of owner-



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developer real-estate transactions.” The Tax Court also acknowledged that the taxpayer had provided his accountant “with all the information they needed or asked for and that he actually followed their advice.”

The IRS claimed that even if the taxpayer proved reliance the taxpayer failed to act in good faith, arguing that the taxpayer had a “worldly understanding . . . [which] made him consciously aware that the tax consequences of the transaction were ‘too good to be true.’”7 The Tax Court flatly disagreed, explaining its impression of the taxpayer as “an honest craftsman who followed professional advice of his long-term consultants, a man who had to fight the IRS and then learn the case well enough to be familiar with the terms of the somewhat obscure issues that it raised.” The Tax Court agreed with the IRS as to the amount of gain to be recognized but overturned the accuracy-related penalty under section 6662(a).

Concluding Thoughts

The IRS frequently asserts that a taxpayer’s reliance was unreasonable because the taxpayer failed to disclose sufficient facts to allow the professional adviser to form a reasoned opinion. Further, the IRS often argues that a taxpayer’s reliance lacked good faith because, based on the education, experience, and sophistication of the taxpayer, or due to the taxpayer’s knowledge of a conflict of interest with the professional adviser, the taxpayer was aware that the tax consequences of a transaction were “too good to be true.”8 Taxpayers are generally “expected to ascertain the independence and qualification of their advisers, and are expected to provide the tax advisor with all relevant facts.”9 But, as we have seen in Gaggero, the fact that the IRS believes a taxpayer’s experience and sophistication puts the taxpayer on notice that the tax consequences are “too good to be true,” it is not necessarily fatal to the taxpayer’s reasonable and good faith reliance on the advice of a tax professional.

1 See Treas. Reg. § 1.6664-4(b)(1). 2 United States v. Boyle, 469 U.S. 241, 251 (1985). 3 115 T.C. 43 (2000). 4 See, e.g., Giovacchini, et al. v. Comm’r, T.C. Memo. 2013-27 (Jan. 24, 2013); Gaggero v. Comm’r,

T.C. Memo. 2012-331 (Nov. 29, 2012); Rawls Trading LP et. al. v. Comm’r, 138 T.C. 12 (Mar. 26, 2012).

5 Giovacchini, et al. v. Comm’r, T.C. Memo. 2013-27 (Jan. 24, 2013). 6 T.C. Memo. 2012-331 (Nov. 29, 2012). 7 Citing Treas. Reg. §§ 1.6662-3(b)(1), 1.6664-4(b)(1). 8 See Larry A. Campagna et al., But I Relied On My Accountant! The Scope of the Reasonable Cause

Defense to Penalties, J. Tax Prac. & Proc. 51, 56 (Aug.-Sept. 2012). 9 Id. at 56.



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By Cathryn B. Chetek, Associate, St. Louis, MO, (314) 259-2394, [email protected] and

Lauren K. Shores Pelikan, Associate, St. Louis, MO, (314) 259-2915, [email protected]



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TAX CREDITS

CONSOLIDATED EDISON AND HISTORIC TAX CREDIT AND NEW MARKETS TAX CREDIT TRANSACTIONS In January 2013, the Federal Circuit Court of Appeals handed down a decision in Consolidated Edison Co., Inc. of New York v. United States (“ConEd”) which could potentially affect the use of put options in tax credit transactions.1 The court in ConEd applied the standard set forth in its earlier decision in Wells Fargo & Co. v. United States2 that there was a reasonable likelihood that the purchase option in the Lease-in/Lease-out (“LILO”) transaction would be exercised and, thus, would be treated as having been exercised at closing.3 The reasonable likelihood standard set forth in Wells Fargo and ConEd is a departure from the standard applied by the Tax Court in Penn-Dixie Steel Corp. v. Commissioner, which considered whether the parties to the transaction were economically compelled to exercise the put option.4 If a put contained in a typical new markets tax credit or historic tax credit transaction were deemed exercised, the investor in such a transaction would not be treated as the owner of its interest, and the tax credits would be lost.

Consolidated Edison Company of New York (“ConEd”) leased a cogeneration plant located in the Netherlands from N.V. Electriceitsbedrijf Zuid-Holland (“EZH”) for a term of 43.2 years and subleased the plant back to EZH for 20.1 years.5 The rent under the head lease was fully funded at closing, and consisted of approximately $40 million in equity and an approximately $80 million nonrecourse loan (the “HBU Loan”).6 EZH deposited the loan proceeds into a debt defeasance account, retained $6.7 million as an “accommodation fee,” purchased a $1.4 million letter of credit, and deposited the remaining equity in an equity defeasance account to secure its obligations under the sublease.7 The rent payments under the sublease and corresponding debt service on the HBU Loan were funded by releases from the debt defeasance account, reflected solely by book entries, with no funds changing hands after closing.8 EZH was responsible for all costs of maintenance and operations of the plant.9 At the end of the term of the sublease, EZH had the option to acquire ConEd’s leasehold interest in the plant, at a price equal to the amount remaining in the debt defeasance account and the equity defeasance account.10 If EZH did not exercise its option, ConEd could choose to require EZH to renew the sublease or ConEd could take over operations of the plant, neither of which were attractive alternatives.11 The IRS disallowed ConEd’s deductions attributable to rent paid to EZH and the interest on the HBU Loan.12 ConEd paid the deficiency and filed a refund claim with the IRS and, when denied, appealed to the Court of Federal Claims.13 The Claims Court ruled in favor of ConEd and the IRS appealed. On appeal, the Federal Circuit Court of Appeals reversed, holding that the Claims Court erred in refusing to apply the substance over form doctrine.14 The court agreed with the IRS’ argument that, “if the Sublease Purchase Option were reasonably



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expected to be exercised, the transaction would be recharacterized as one without any meaningful substance.”15 Thus, ConEd had no ownership interest in the plant and the HBU Loan was not genuine indebtedness.

The Federal Circuit Court of Appeals could have attacked the LILO transaction in ConEd as a sham without applying the new, lower standard in determining whether an option should be treated as exercised as set forth in Wells Fargo. The court’s analysis in the ConEd decision supports the proposition that EZH was economically compelled to exercise the option at the end of the term of the sublease, and the Federal Circuit arguably had sufficient basis to reverse the Claims Court’s decision applying the standard set forth in Penn-Dixie. The court notes that statements made by ConEd executives prior to the closing date reveal their expectation that EZH would exercise the option, which was supported by the fact that the plant was a newly constructed, key asset for EZH, and EZH had analyzed the transaction on the assumption that the plant would be purchased.16 ConEd’s internal analysis of the transaction assumed no economic benefit from the period following the initial term of the sublease.17 Although the purchase price under the option was likely to be greater than the fair market value of the plant at the time of exercise, the proceeds used to fund the option price were set aside at closing, and required no expenditure of funds beyond those already set aside for the payment of the purchase price by EZH.18 The supporting documentation prepared by Deloitte prior to closing was intended to show that there was no “economic compulsion” to exercise the option, but the court dismissed this argument, perhaps in part because, under examination, Deloitte admitted that it had produced approximately 100 appraisal reports for LILO transactions, and never found that there was “economic compulsion” to exercise a purchase option.19

Investors in historic and new markets tax credit transactions often have the option to put their interest while developers or project owners hold an option to purchase the assets at fair market value. While the tax credit put option is the reverse of the option in ConEd, most investors have routinely exercised the put at the end of the compliance period (although there is no legal obligation to do so). The court’s decision in ConEd could arguably be applied to tax credit transactions that use a put option to unwind the transaction. As in the ConEd transaction, the purchase price with respect to the put option in tax credit transactions is frequently fixed prior to the initial closing. On these facts, the IRS could argue, as it argued in Wells Fargo and ConEd, that a prudent investor would reasonably expect that the put option would be exercised. If such an argument were successful, the investor would not be treated as the owner of its interest and would not be eligible to claim the historic or new markets tax credits arising from its investment.

Although there are similarities between LILO options and the put option used in tax credit transactions, there are also important differences. In tax credit transactions, taxpayers are availing themselves of tax benefits intended by Congress for certain types of activities or investments.20 Tax credit transactions are structured in such a way to provide real economic risk and potential return to the investor during the life of the transaction. For example, historic



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tax credit transactions require cash-on-cash returns to the investor during the term of the investment. Unlike the ConEd transaction, where sublease rent payments and debt service payments were made solely through book entries, in tax credit transactions cash changes hands throughout the life of the deal through rent and debt service payments which causes a meaningful change in the economic positions of the parties.

An argument could also be made that the policy behind the enactment of tax credits should result in more favorable treatment under tax principles of general applicability compared to LILO transactions. In the description prepared by the staff of the Joint Committee on Taxation of the codification of the economic substance doctrine, Footnote 344 clarifies that the Economic Substance Doctrine should not apply to disallow tax benefits in transactions, such as federal tax credit investments, “if the realization of the tax benefits…is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate.”21 Further, the Ninth Circuit in Sacks v. Commissioner, a case involving an alternative energy investment, indicated that a taxpayer is entitled to tax benefits produced by its investment, even though the investment was unlikely to generate a profit without regard to tax benefits, citing the legislative intent to subsidize alternative energy investments.22 The recent decisions by the Fourth Circuit in Virginia Historic Tax Credit v. Commissioner and the Third Circuit in Historic Boardwalk Hall, LLC v. Commissioner, however, indicate that tax credit transactions should be structured in such a way that respects the applicability of general tax principles.23 The Fourth Circuit specifically acknowledged the legislative intent of the Virginia historic tax credit program, but drew a distinction between attacking the program as a whole and applying tax law of general applicability.24 The Third Circuit echoed that sentiment in the final paragraphs of the Historic Boardwalk Hall decision, noting that “we reach our conclusion mindful of Congress’s goal of encouraging rehabilitation of historic buildings,” but concluding that it was appropriate to examine the substance over the form of the transaction and concluding that Pitney Bowes was not a bona fide partner because it did not have a meaningful stake in the success or failure of the transaction.25

Although the applicability of the principles of the ConEd decision to tax credit transactions is uncertain, particularly because Wells Fargo, on which the court relied, involved a similar LILO transaction, prudent taxpayers should take action to protect against an IRS challenge applying the ConEd standard. Where put options are used, care should be taken by practitioners and parties to the transaction in the description of the put option in transaction documentation, correspondence, and internal memoranda. The exercise of the put should always be described as a potential method of unwinding the transaction, but not the expected or only way that the transaction will be unwound, with full consideration of the alternative methods available. Any economic analyses prepared in connection with the transaction should consider both the consequences of the exercise of the put, as well as the result if the put is not exercised. Additionally, the sponsor’s obligation to pay the put price should not be secured (by funded reserves, guarantees or otherwise). Because the investor’s exercise of the put is not a legally



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enforceable obligation, the sponsor arguably gains no benefit by its existence in any given transaction, and would have the same rights as if an unwind structure using only a call option at fair market value with respect to the investor’s interest was used. The analysis in Revenue Procedure 2007-65 setting forth a safe harbor for the structuring of partnerships claiming wind energy production tax credits may be instructive. Among other factors, the IRS indicated that no party could have a right to purchase the wind farm, or an interest in the company owning the wind farm, at a price less than the fair market value of such property as determined at the time of exercise.26 Some major investors in the new markets tax credit space close transactions without puts. These transactions often use a mechanism where the debt is accelerated at the end of the compliance period at a discounted price to unwind the investment. While some historic rehabilitation investors are eliminating puts from their investment structure, there is not a consensus in the industry as to the use of puts.

The application of the reasonable likelihood standard of ConEd to tax credit transactions is not a certainty, but the Historic Boardwalk Hall and Virginia Historic decisions caution against treating tax credit transactions as exempt from the application of general tax principles. Accordingly, taxpayers and their advisors should consider whether the application of the “reasonable likelihood” standard to new markets and historic tax credit transactions with put options could cause such transactions to lose their intended tax benefits.

1 Consolidated Edison Co. of New York v. U.S., No. 2012-5040 (Fed. Cir. Jan. 9, 2013). 2 Wells Fargo & Co. v. U.S., 641 F.3d 1319 (Fed. Cir. 2011). “The appropriate inquiry is whether a

prudent investor in the taxpayer’s position would have reasonably expected that outcome.” Wells Fargo at 1325-26.

3 Consolidated Edison at 2. See also Treas. Reg. § 1.761-3 (providing that if, as of the date the noncompensatory option is issued, transferred, or modified, there is a strong likelihood that the failure to treat the holder of the noncompensatory option as a partner would result in a substantial reduction in the present value of the partners’ and the holder’s aggregate federal tax liabilities, the noncompensatory option will be treated as a partnership interest for all federal tax purposes).

4 Penn-Dixie Steel Corp. v. Comm’r, 69 T.C. 837 (1978). 5 Consolidated Edison at 5. 6 Id. 7 Id. 8 Id. at 6, 26. 9 Id. at 7. 10 Id. 11 Id. 12 Id. at 2. 13 Id. 14 Id. at 12-13.



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15 Id. 16 Consolidated Edison at 19. 17 Id. at 20. 18 Id. at 21-22. 19 Id. at 21-24. 20 Sacks v. Comm’r, 69 F.3d 982 (9th Cir. 1995). 21 Staff of the J. Comm. on Tax’n, Technical Explanation of the Revenue Provisions of the

“Reconciliation Act of 2010,” as Amended, in Combination with the “Patient Protection and Affordable Care Act” (JCX-18-10, Mar. 21, 2010).

22 “If the Commissioner were permitted to deny tax benefits when the investments would not have been made but for the tax advantages, then only those investments would be made which would have been made without the Congressional decision to favor them. The tax credits were intended to generate investments in alternative energy technologies that would not otherwise be made because of their low profitability.” Sacks at 992.

23 See generally, Virginia Historic Tax Credit v. Comm’r, 639 F.3d 129 (4th Cir. 2011) and Historic Boardwalk Hall, LLC v. Comm’r, 694 F.3d 425 (3d Cir. 2012).

24 See Virginia Historic at 146 n.20. 25 See Historic Boardwalk Hall at 462. 26 Rev. Proc 2007-65, 2007-45 I.R.B. 967.

By Corenia Riley Burlingame, Associate, Washington, DC, (202) 508-6057, [email protected]



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TAX EXEMPT ORGANIZATIONS

CHURCHES IN POLITICS Background

Organizations that are exempt under section 501(c)(3) of the Code may not participate or intervene in “any political campaign on behalf of (or in opposition to) any candidate for public office.”1 This rule applies to all 501(c)(3) organizations—including 501(c)(3) churches. Yet, just about every election season brings accusations that some church has violated the rule by its minister preaching support for a candidate from the pulpit.

Pulpit Freedom Sunday

The elections in 2012 were no exception. But some churches, rather than covertly violating this rule, openly do so. Since 2008, a religious freedom organization has organized “Pulpit Freedom Sunday” at which religious leaders deliberately break the rules. According to one report of this event, the position of the churches is that the IRS rule violates their First Amendment right to free speech. Their plan is to record and send their rule-breaking sermons to the IRS and, when the IRS revokes their exempt status, seek court relief on the grounds that the law against political participation is unconstitutional.2 Some 1,500 pastors participated in the October 2012 Pulpit Freedom Sunday.

According to information presently available, there has been no IRS response to Pulpit Freedom Sunday. This is surprising considering that the churches’ position has already been litigated several times in the past.3 In short, the response of the courts and the IRS is that tax exemption is a privilege–a conditional privilege. And it is not a violation of the First Amendment for Congress to refuse to subsidize First Amendment activities. In other words, if you really want to promote a candidate, you may do so–just not as a 501(c)(3).

Freedom From Religion Foundation

On November 14, 2012, the Freedom From Religion Foundation filed a lawsuit in the U.S. District Court for the Western District of Wisconsin to enjoin the IRS’ non-enforcement of campaign restrictions against churches and religious organizations. The basis for the Freedom From Religion Foundation’s standing to bring the claim—that it is discriminated against because, as a non-church, it actually needs to follow the law—may be tenuous. But it has managed to get the issue into court.



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Conclusion

The IRS rules prohibiting campaign activities by 501(c)(3) organizations are clear. It is interesting that the IRS has not taken action to enforce such rules in the face of blatant violations of them. In addition, the Freedom From Religious Foundation lawsuit may or may not resolve the issue. But given the public policy of only having rules if you are willing to enforce them, sooner or later the prohibition on campaign activity will either need to be revised or enforced against churches.

1 I.R.C. § 501(c)(3). Note that the rule pertains to candidates—not legislation. A 501(c)(3) organization may support or oppose legislation as long as it is insubstantial activity of the organization.

2 See, http://www.foxnews.com/us/2012/09/23/pastors-pledge-to-defy-irs-preach-politics-from-pulpit-ahead-election/.

3 See, e.g., Branch Ministries v. Rossotti (D.C. Ct. App. 2000).

By Nathan Boyce, Associate, St. Louis, MO (314) 259-2257, [email protected]



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TRANSACTIONS

REPORTING TARGET’S DEDUCTIONS IN AN ACQUISITION Corporate clients often want a transaction to close at the beginning or end of the day. Generally, the reason for choosing the beginning or end of the day is based on whether that days’ business activities should be attributed to the seller or the buyer. Unfortunately, tax rules do not always follow business desires and, in certain situations, an effective time that does not coincide with the Code can cause a major headache for a corporation’s tax department.

When a target corporation joins a consolidated group, its tax year ends at the end of the day on the closing date.1 Thus, closing day operations are generally reported by target on its tax return for the period ending on the closing date. When a purchase agreement contains an effective time of the closing at the beginning of the day on the closing date (i.e., 12:01 a.m.), the items are still reported on target’s tax return ending on the closing date. However, since the purchase agreement contains a 12:01 a.m. effective time, the target will have to collect any taxes attributable to business activities on the closing date from the buyer. Had the parties agreed to an effective time at the end of the day on the closing date (i.e., 11:59 p.m.), these accounting/tax issues would have been avoided. Additionally, to the extent permitted under the Code, the purchase agreement should provide specific allocations of various items (i.e., change of control bonuses) to pre-closing (target’s tax period ending on the closing date) and post-closing periods (target’s tax period beginning the day after the closing date) to ensure consistent tax reporting by both parties.

A recent 2012 Internal Revenue Service Legal Memorandum (the “2012 GLAM”)2 describes how a target corporation should report various items arising from an acquisition in the consolidated context in which the parties did not address the tax reporting of these items in the purchase agreement. In the 2012 GLAM, a calendar year acquiring corporation (“Buyer”) acquired a target corporation (“Target”) on November 30, 2012, by a merger of an acquiring subsidiary into Target, where Target shareholders exchanged their Target stock for cash (the “Acquisition”). The 2012 GLAM analyzes three items, all of which become deductible by Target on November 30 (the “Closing Date”).

Item 1 consists of amounts Target is required to pay its employees relating to the cancellation of non-qualified stock options and stock appreciation rights. These amounts became fixed on the Closing Date, but Target did not make payment until several days after the Closing Date. Item 2 consists of amounts Target was obligated to pay to service providers upon a successful closing.



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These amounts also became fixed on the Closing Date. Finally, with respect to item 3, Buyer had requested that some of Target’s outstanding debt be retired. Before the Acquisition, Target and Buyer had agreed that Target would give its bondholders the opportunity to tender their bonds, two days prior to the Closing Date, at a price that reflects a premium over the adjusted price, but Target would not be required to purchase any of the bonds. After the Acquisition had closed but on the Closing Date, Target accepted the tendered bonds, and later that day, using its own funds or funds from Buyer, Target retired the bonds at a premium.

Under the consolidated return Regulations, Target has two taxable years: one that ends on the Closing Date (the “Pre-Closing Period”) and one (as a member of the acquiring group) that begins on the day after the Closing Date (the “Post-Closing Period”). The Regulations provide various rules relating to transactions that occur on the closing date, including the “end of day” rule and the “next day” rule.

Under the end of day rule, a corporation becomes or ceases to be a member of a consolidated group at the end of day on which its status as a member changes, and its tax year ends on that date.3 Accordingly, the deductions attributable to the events that occur on the Closing Date generally would be reported on Target’s Pre-Closing Period tax return, unless an exception applies.

The next day rule provides an exception to the end of day rule. The next day rule was added to the Regulations in 1994 in response to comments that a seller should not bear tax liability for post-closing events that are under the buyer’s control and of which the seller may be unaware. Under this rule, if a transaction occurs that is properly allocable to the Post-Closing Period, then Target must treat the transaction for all federal tax purposes as occurring on the first day of the Post-Closing Period.4 A determination that a transaction should be allocated to the Post-Closing Period will be respected if it is reasonably and consistently applied by all affected persons.5

With respect to items 1 and 2, the IRS determined that the obligation to pay and the amount of Target’s liability became fixed and determinable upon the closing of the Acquisition. These items were from transactions that preceded the Acquisition and that involved the performance of services for Target by its employees. Even though the consummation of the Acquisition fixed the liability to make the payments, the deductions were not attributable to a transaction on the Closing Date other than the Acquisition itself. Accordingly, the next day rule was inapplicable, and it was not proper or reasonable to allocate those deductions to the post-closing period. Instead, the deductions were properly governed by the end of the day rule and were required to be reported in the Pre-Closing Period. Such treatment is consistent with the purpose underlying the next day rule, since the items result from events not within the control of Buyer.

However, with respect to item 3, the IRS found that the next day rule may be appropriate. Target retired the bonds at a premium for cash after the closing with cash provided by Buyer.



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Since the deduction arises as a result of a payment in the Post-Closing Period based on a decision made by Target after the Closing Date, it was reasonable for Target to report the deduction on the Post-Closing Return as a member of the consolidated group with Buyer.

Although the Regulations provide rules for allocating various items between the pre- and post-closing periods, the parties’ allocation of certain items will be respected if it is reasonably and consistently applied by all affected persons.6 Accordingly, a buyer and seller/target should discuss and negotiate the tax reporting of various items and include provisions in the purchase agreement to ensure each party reports the transactions consistently.

1 Treas. Reg. § 1.1502-76(b). 2 A.M. 2012-010 (Nov. 15, 2012). 3 Treas. Reg. § 1.1502-76(b)(1)(ii)(A). 4 Treas. Reg. § 1.1502-76(b)(1)(ii)(B). 5 In making this determination, certain factors are considered, including (i) whether income, gain,

deduction, loss, and credit are allocated inconsistently (e.g., to maximize a seller's stock basis adjustments under Treas. Reg. § 1.1502-32); (ii) if the item is from a transaction with respect to S stock, whether it reflects ownership of the stock before or after the event; (iii) whether the allocation is inconsistent with other requirements under the Code and regulations promulgated thereunder; and (iv) whether other facts exist, such as a prearranged transaction or multiples changes in target’s status, indicating that the transaction is not properly allocable to the portion of target’s day after the event resulting in target’s change. Treas. Reg. § 1.1502-76(b)(1)(ii)(B).

6 Most practitioners generally agree with this principle; however, some practitioners believe that the 2012 GLAM “staked out a position” on certain items and therefore, the Regulations may not provide the flexibility that the practitioners believed they had (even if that wasn’t the intent of the 2012 GLAM). See IRS Intended For Next-Day Rule Memo To Provide More Flexibility, 2013 TNT 66-3 (Apr. 5, 2013).

By Erika S. Labelle, Associate, St. Louis, MO, (314) 259-2454, [email protected]



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EUROPE

DOES THE U.S.-GERMAN DOUBLE TAX TREATY ALSO APPLY TO A U.S. LIMITED LIABILITY COMPANY? Introduction

Whenever a U.S. Limited Liability Company (“US-LLC”) is involved in cross-border shareholding structures concerning the United States and Germany, the implications under German tax law can be complex. For German tax purposes, a US-LLC may qualify as an opaque entity (corporation) or as a transparent entity (partnership) or even as a dependent branch office (permanent establishment) of a sole shareholder of the US-LLC. The qualification is particularly relevant (i) for the taxation of profits, distributions and advance remunerations which a German tax resident shareholder of the US-LLC receives, and (ii) for the application of the double tax treaty between the United States and Germany (the “DTT”) to a US-LLC receiving German source income, e.g., capital gains or distributions. The latter question is subject to the following explanations.

Basic principles

The view of the German tax administration is that the qualification of a US-LLC for German tax purposes and the application of the DTT to a US-LLC is exclusively subject to domestic German tax law. The DTT does not stipulate that the law of the country of residence is relevant for the qualification of an entity. In fact, each contracting state qualifies a respective entity in accordance with its own domestic law when applying the DTT. Therefore, for German tax purposes it is not decisive how the tax law of the United States and the states qualify a US-LLC or how the shareholders of a US-LLC exercise their option rights under the check-the-box rules.

During recent decades the German Supreme Fiscal Court (the “BFH”) has developed a number of principles for determining the qualification of a foreign entity. According to these principles, a foreign entity qualifies as a corporation if it can be compared legally and economically to a German corporation on the basis of an overall view against the background of the applicable foreign law provisions and of the decided organization and structure of the entity (the so-called “comparison of types”-test).



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Tax consequences arising from the qualification

In order to benefit from the DTT, the US-LLC must qualify as a “person” within the meaning of Article 3 sec. 1 lit. d of the DTT. For that purpose the US-LLC must qualify as a corporation under German tax law. In addition, such US-LLC must also have substance from a German tax perspective, otherwise the German tax administration may consider the interposition of a mere letter-box company as abusive, leading to the consequence that such corporation without substance is disregarded. Consequently, once it is confirmed that a US-LLC would qualify as a corporation, in a next step it would be necessary to examine whether the US-LLC meets the substance requirements.

In case the US-LLC qualifies as a partnership for German tax purposes, the German tax authorities would regard the US-LLC as transparent and examine whether the DTT (or a different double tax treaty) could be applied to the shareholders of the US-LLC.

LLC-Decree

On the basis of the judicature of the BFH, the German Federal Ministry of Finance has provided guidelines in an official statement dated March 19, 2004, regarding the application of the “comparison of types”-test to a US-LLC (the “LLC-Decree”). According to the LLC-Decree, the following criteria are relevant for the classification of the US-LLC as a corporation from a German tax perspective:

• centralized management;

• limited liability of the shareholders;

• possibility of unrestricted transfer of shares;

• distribution of profits;

• raising of capital;

• unlimited term of the entity;

• profit and loss allocation in accordance with nominal shares; and

• certain formal requirements for the establishment of the entity.

Centralized management

According to the LLC-Decree, a centralized management and administration of the entity is characteristic of a corporation.



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Such centralized management means the entitlement of one or more persons—in contrast to all shareholders or partners—to pass management decisions without the approval of the shareholders/partners in their entirety (e.g., management decisions made by an independent board, which can consist of third parties and shareholders/partners). By contrast, if the shareholders/partners in their entirety represent the entity internally and externally without the involvement of any third party, a centralized management would not exist, which implies characteristics of a partnership.

If some of the shareholders/partners are excluded from the management, and provided the entity is exclusively represented by managers in their capacity as partners (in contrast to an appointment of directors), a centralized management would still not exist. On the other hand, a centralized management could still exist if the articles of association rule that individually appointed managers must come from the board of shareholders.

If a corporation represents the entity, and the management of the corporation also includes non-shareholders, a centralized management can be assumed.

Limited liability

A typical indication of a corporation is the limited liability of the shareholder. The limited liability provides that a shareholder is not liable with his own private property for liabilities of the entity.

Unrestricted transfer of shares

Whereas shares in corporations can be transferred without further restrictions, the transfer of interests in partnerships is usually excluded, restricted or subject to the consent of some or all partners.

Distribution of profits

While the distribution of profits of a corporation requires a shareholders’ resolution, each partner of a partnership is entitled to dispose of his profit share without further resolution.

Raising of capital

With regard to a corporation the shareholders are obliged to contribute the share capital into the corporation. In contrast, German law does not explicitly demand the provision of share capital for partnerships. In case the articles of association waive the obligation to contribute capital or stipulate that contributions may also be made by ways of providing services, such clauses indicate a qualification as a partnership.



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Unlimited term of the entity

The lifetime of a corporation is usually unlimited and does not depend upon the consistency of shareholders. In case the articles explicitly provide for a limited term, this would be an indication of a partnership. A limited term can be assumed if the articles provide that the entity is terminated without additional actions from the shareholders once certain events occur. On the other hand, if the articles set forth that the entity is terminated on certain conditions precedent but allow the continuation of the entity without further conditions, the term of the entity is deemed as unlimited.

Profit and loss allocation

In general, the profit share of a shareholder of a corporation amounts to the relation of the shareholder’s share capital and the entire capital. In comparison, partnerships distribute profits in correspondence with the relation of contributions and per head. Any distribution of a partnership irrespective of the contributions considers the personal commitment of each partner, whereas the position of the shareholder as capital provider prevails.

Formal requirements for the establishment

A corporation under German law becomes effective once it is registered in the commercial register. A partnership becomes effective upon conclusion of a partnership agreement.

Decision with regard to the individual case

The overall picture is relevant with regard to the decision whether an entity would qualify either as a corporation or as a partnership. None of the above individual criteria is finally decisive for the final qualification. If the examination does not allow a clear qualification, an entity is to be qualified as corporation if the majority of the criteria “centralized management”, “limited liability”, “unrestricted transfer of shares”, “distribution of profits” and “raising of capital” imply the qualification as a corporation.

Different qualification of the US-LLC for German and for U.S. tax purposes

The qualification of a US-LLC for German tax purposes on the one hand and for U.S. tax purposes on the other can be different, in particular due to the check-the-box rules, for which there is no German equivalent.

No particularities exist if both tax administrations qualify the US-LLC as a partnership or as a corporation. When both sides agree on the qualification of the US-LLC, this concurring qualification is decisive.



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According to the LLC-Decree, the German tax perspective is decisive. If the U.S. tax law qualifies the US-LLC as a corporation, while the German tax administration considers the US-LLC as a partnership, the German tax administration would examine whether or not the DTT would apply to the shareholders of the US-LLC. In principle, the LLC-Decree is still in force, therefore, its principles must be observed by the German tax administration.

However, the LLC-Decree was issued prior to the modifications of the DTT coming into force. Since 2008, Art. 1 sec. 7 of the DTT rules that “in the case of an item of income, profit or gain derived by or through a person that is fiscally transparent under the laws of either Contracting State, such item shall be considered to be derived by a resident of a State to the extent that the item is treated for the purposes of the taxation law of such State as the income, profit or gain of a resident.” This clause is now interpreted by the German tax literature such that also a US-LLC which qualifies as a partnership from the German tax perspective benefits from the DTT, provided that the U.S. tax law qualifies the US-LLC as corporation. Something different could apply if the US-LLC qualifies as a “disregarded entity” in the United States. In such a case, German tax law would consider the shareholder of the US-LLC as recipient of the income and would apply the treaty benefits, if available, to the shareholder.

Currently, the interpretation of Art. 1 sec. 7 of the DTT is subject to a case which is pending on the level of the BFH (file no. I R 48/12). The court of first instance, the Local Tax Court of Cologne, held that entities, which are considered as transparent by the German tax administration, are per se not resident in the other contractual state. Therefore, such entity is disregarded for DTT purposes so that the shareholders of the transparent entity are automatically subject to the examination as to whether treaty benefits apply. This appears to be a misinterpretation of Art. 1 sec. 7 of the DTT, whose scope of application would be reduced to zero. Nevertheless, it has to be awaited what the outcome of the case will be.

In case the German tax authorities qualify the US-LLC as corporation, whereas for U.S. tax purposes the US-LLC is considered as partnership, the German tax literature argues that the US-LLC should not be regarded as a U.S. tax resident person. However, the rules of the DTT would then be applied to the shareholders of the US-LLC, provided that they are U.S. tax residents themselves.

By Stefan Skulesch, Counsel, Frankfurt, Germany, 49 69 509 514 1105, [email protected]



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ASIA

“BENEFICIAL OWNER” UNDER CHINA’S TAX TREATIES The Articles of the Organization for Economic Co-operation and Development Model Tax Convention (“OECD Articles”) address the taxation of prescribed passive income (i.e., dividends, interest and royalties). Under the OECD Articles, the recipient of an item of such passive income must be the Beneficial Owner (“BO”) of that income in order to enjoy the benefits available under the relevant treaty. However, neither the OECD Articles nor their commentary have provided a clear definition of the term. Consequently, the lack of a universal and precise meaning of the term BO in a treaty context has given rise to inconsistent interpretation and application of the term.

According to Guoshuifa [2009] No.124 (“Circular 124”), for the purpose of claiming treaty benefits, an approval-based application procedure is used for passive income (namely dividends, interest and royalties). In addition, the China State Administration of Taxation (the “SAT”) issued Guoshuihan [2009] No. 601 (“Circular 601”) and SAT Announcement [2012] No. 30 (“Announcement 30”), which establish the SAT’s interpretation of the term BO for the purpose of granting treaty benefits under Sino-foreign tax treaties.

Circular 601

The term BO refers to a person who has the right of ownership and control over an item of income, or the right or property from which that item of income is derived. A BO generally must be engaged in substantive business activities and may be an individual, a corporation or any other group.

Agent or conduit companies

An agent or conduit company is not regarded as a BO if the entity is considered a “conduit company”(and therefore does not qualify for treaty benefits). A conduit company normally refers to a company that is set up for the purpose of avoiding or reducing tax or transferring or accumulating profits. Additionally, conduit companies are generally those that are registered in their country of residence merely to satisfy the legal requirements of tax residence and are not companies that engage in substantive activities such as manufacturing, sales and management.



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Specific factors to assist in determining BO status

The presence of the following factors could negatively affect an applicant’s status as a BO:

1. The applicant is obliged to distribute most of its income (e.g., more than 60%) to a resident of a third country within a prescribed time period (e.g., within 12 months from the date of receipt);

2. The applicant has no or minimal business activities;

3. Where the applicant is an entity such as a corporation, its assets, scale of operations and deployment of personnel are not commensurate with its income;

4. The applicant has no or minimal control and decision-making rights, and does not bear any risks;

5. The income of the applicant is nontaxable or, if subject to tax, is subject to a low effective tax rate;

6. In the case of interest income, there is a loan or deposit contract between the applicant and a third party, the terms of which (i.e., the amount, interest rate, signing dates) are similar or close to those of the loan contract under which the interest income is received; and

7. In the case of royalty income, there is a license or transfer agreement between the applicant and a third party, the terms of which are similar to the terms under which the royalty income is received.

When a taxpayer applies for treaty benefits, it will need to provide documentation to the local tax authority to support its claim as being the BO of the relevant income.

Announcement 30

With regards to assessing the BO status of treaty resident applicants that have passive income derived from China, Announcement 30 emphasizes that each of the seven factors listed above should be comprehensively considered when assessing BO status. BO status should not be denied simply because one of the seven unfavorable factors exists. However, BO status also should not be granted simply because an applicant has not demonstrated any motivation to avoid or reduce their tax burden.



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Documents and evidence

Tax authorities consider a wide range of key documents and evidence in analyzing the factors under Circular 601. Such evidence includes articles of association, financial statements, board minutes and resolutions, functional analyses, legal contracts, asset ownership certificates and invoice registers.

Safe-harbor rule

In the case of dividend income, Announcement 30 provides a safe-harbor rule allowing those qualified listed companies with Chinese subsidiaries to be directly or indirectly accepted as a BO without the need to go through the vetting process. The safe-harbor rule requires that the immediate recipient of the China-sourced dividend, the listed company and the intermediate holding companies, if any, must be 100% related and tax resident enterprises of the same treaty jurisdiction.

Tentative denial

In situations where the Chinese tax authority receiving the application for the treaty benefit is not able to accurately determine the BO status of the applicant within the prescribed timeframe, it may tentatively deny the treaty benefit application and collect the China tax in full. However, if the applicant is eventually assessed and granted BO status and, thus, becomes entitled to the treaty benefit, the Chinese tax authority should refund the overpaid tax.

Authority to deny BO status

Only provincial-level tax bureaus have the authority to deny BO status.

By Ye Zhou, Director PRC Tax Consultant, Shanghai, PRC, (86)021-2308-3000, [email protected]



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Disclosure: Please note that the tax information in this article is not intended as and should not be construed as legal, tax, or investment advice. You should always consult your tax advisor to help answer specific questions regarding how tax laws apply to you and/or your business. The article we have provided is based on the U.S. Internal Revenue Code, its legislative history, treasury regulations thereunder, administrative and judicial interpretations, and relevant state laws as of the date of this article, all of which are subject to change, possibly with retroactive effect. Therefore, we do not guarantee and are not liable for the accuracy or completeness of any tax information provided, or any results or outcome as a result of the use of this information.

Tax News and Developments is a periodic publication of Bryan Cave LLP’s Tax Advice and Controversy Practice Group. The articles and comments contained herein do not constitute legal advice or formal opinion, and should not be regarded as a substitute for detailed advice in individual cases.

Tax News and Developments is edited by Senior Editors Bartley F. Fisher (New York), Timothy E. Glasgow (Denver), Robert J. Skinner (Colorado Springs) and Daniel F. Cullen (Chicago), and Administrative Editor Peter R. Matejcak (Chicago).



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