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The Proskauer Tax Blog

LIBOR Transition: U.S. Tax Guidance From the IRS

The U.S. tax authorities have issued substantial guidance related to the phase-out of LIBOR – relevant to lenders, borrowers and parties to financial instruments of virtually every type.

In proposed regulations (“the Proposed Regulations”) released on October 9, 2019, the Internal Revenue Service (“IRS”) and the U.S. Department of the Treasury (the “Treasury”) addressed market concerns regarding the U.S. tax effect of the expected transition from LIBOR and other interbank offered rates (“IBORs”) on debt instruments (e.g., loans, notes and bonds) and non-debt contracts (e.g., swaps and other derivatives). The key tax concern to date has been whether the replacement of an IBOR-reference rate in a debt instrument or non-debt contract with a different reference rate would result in a taxable exchange of the debt instrument or contract, potentially triggering a current U.S. tax liability to one or more of the parties.

The core of the Proposed Regulations provide some comfort – they detail the requirements for the rate replacement to not result in a taxable event (either in respect of the instrument itself or to certain integrated hedging transactions). The Proposed Regulations also contain transition guidance on other matters potentially impacted by the rate change, such as maintenance of REMIC status and the calculation of interest expense of a foreign bank with a U.S. branch.

While the Proposed Regulations are broadly taxpayer favorable – and indeed draw heavily on input from the Alternative Reference Rates Committee (“ARRC”),[1] which was charged with facilitating voluntary acceptance of alternative reference rates, as well as comments from other industry groups – their scope is limited enough that affected taxpayers should take care to ensure that amendments to their loans and other financial instruments are tailored to conform to the Proposed Regulations. In particular, in order to avoid a taxable event, affected taxpayers substituting an IBOR-referencing rate for a new rate, such as SOFR, will need to satisfy several tests, including a test of whether the fair market value of the affected loan or financial instrument is substantially equivalent both before and after the rate is changed, taking into account any lump-sum payment made.

Taxpayers may generally rely on the Proposed Regulations until final regulations are published, provided that the rules are applied consistently by taxpayers and their related parties. Read the rest of this post for background on the LIBOR transition, and a more complete description of the Proposed Regulations. Please contact any of the authors listed above or your usual Proskauer contact to discuss any aspect of the Proposed Regulations applicable to your specific circumstances.

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Proposed Regulations on Built-in Gains and Losses under Section 382(h)

On September 10, 2019, the Internal Revenue Service (“IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued proposed regulations (the “Proposed Regulations”) on calculation of built-in gains and losses under Section 382(h) of the Internal Revenue Code of 1986, as amended.[1] In general, the Proposed Regulations replace the existing guidance on the calculation of net unrealized built-in gains (“NUBIG”), net unrealized built-in losses (“NUBIL”), realized built-in gains (“RBIG”) and realized built-in losses (“RBIL”) under Section 382(h). This guidance had largely taken the form of Notice 2003-65[2] (the “Notice”), which had been the key authority relied upon by taxpayers for purposes of the various calculations required under Section 382(h).

By eliminating the Notice’s 338 Approach and by making certain other changes, the Proposed Regulations, if finalized in their current form, could significantly cut back on a loss corporation’s ability to use pre-change losses and therefore could substantially diminish the valuation of this tax asset in M&A transactions and could hamper reorganizations of distressed companies. In fact, these proposed changes could put more pressure on companies in bankruptcy to attempt to qualify for the benefits of Section 382(l)(5) or to engage in a “Brunos-like” taxable restructuring transaction, and, when those options are not available, could lead to more liquidations rather than restructurings.

The Proposed Regulations are another factor in a series of changes and circumstances that affect the value of tax assets such as net operating losses for corporations. Both the current low applicable federal long-term tax-exempt rate (1.77% for October 2019)—which creates relatively small Section 382 limitations—and the new rule from the 2017 tax reform that limits the usability of net operating losses arising in tax years beginning after December 31, 2017 to 80% of taxable income are developments that, in conjunction with the Proposed Regulations, put downward pressure on the expected value of this tax asset.

The Proposed Regulations are not effective until they are adopted as final regulations and published in the Federal Register, and will apply only with respect to ownership changes occurring after their finalization. Until that happens, taxpayers may continue to rely on the Notice for calculations of NUBIG, NUBIL, RBIG and RBIL. Continue Reading

State Tax on Trust Income Based Solely on In-State Residence of Beneficiaries Found Unconstitutional

On June 21, 2019, the United States Supreme Court decided North Carolina Dept. of Revenue v. Kimberly Rice Kaestner 1992 Family Trust (hereinafter, “Kaestner”).[1] In a unanimous opinion delivered by Justice Sotomayor, the Court held that under the Fourteenth Amendment’s Due Process Clause,[2] a state may not tax trust income based solely on the in-state residency of the trust’s beneficiaries where the beneficiaries have not received a distribution from the trust and have an interest in the income and assets of the trust that is entirely contingent on the exercise of the trustee’s discretion. Because of the expansive nature of North Carolina’s tax provisions at issue, and the greatly limited set of rights that the beneficiaries had to the trust assets pursuant to the terms of the trust agreements analyzed by the Court, the scope of Kaestner seems narrow and should have a limited impact on the state taxation of trusts.

The Kimberly Rice Kaestner 1992 Family Trust

The Kimberly Rice Kaestner 1992 Family Trust (referred to herein as the “Kaestner Trust” or the “Trust”) was formed in New York nearly thirty years ago for the benefit of the grantor’s children, none of whom lived in North Carolina at that time. The grantor was a New York resident, the Trust was governed by New York law and the trustee kept the Trust documents and records in New York. All of the Trust asset custodians were in Massachusetts. The Trust agreement gave the trustee, who was a Connecticut resident during the relevant tax years, “absolute discretion” over when, in what amounts and to which beneficiaries distributions, if any, would be made.

After Kimberly Rice Kaestner and her minor children (all of whom were beneficiaries of the Trust) moved to North Carolina, the State imposed tax in excess of $1.3 million on the Trust’s income that had accumulated while they were North Carolina residents.[3]

The Due Process Clause

The Due Process Clause prohibits states from imposing taxes that do not “bea[r] fiscal relation to protection, opportunities and benefits given by the state.”[4] A two-step analysis from Quill Corp. v. North Dakota is used to determine whether a state tax is permissible under the Constitution:

  1. There must be a “minimum connection” or “definite link” between the state and the person, property or transaction it seeks to tax; and
  2. The income attributed to the state for tax purposes must be “rationally related to values connected with the taxing state.”[5]

Prior to Kaestner, the Court has upheld a state tax based on a trustee’s in-state residence, and has indicated that a state tax based on the site of the administration of a trust is permissible.[6]

Where a state tax is based on a connection to a beneficiary, the Court has focused on the extent of the in-state beneficiary’s right to control, possess, enjoy or receive trust assets. The Court has upheld state taxes based on in-state residency of a beneficiary where the beneficiary had close ties to the taxed trust assets and where the tax was imposed on income that has been distributed to the beneficiary.[7] However, the Court found a state tax based on the in-state residency of a beneficiary to be unconstitutional when the tax was imposed on the entirety of a trust’s property and was not limited to the in-state beneficiary’s share of the trust’s property.[8]

Pre-Kaestner case law left a gap between a permissible state tax on trust income actually distributed to an in-state beneficiary and an impermissible state tax on all of a trust’s assets, even those to which the in-state beneficiary was not entitled. The North Carolina law in Kaestner attempted to tax only the in-state beneficiaries’ share of trust income, but without regard to the beneficiaries’ control or possession of, or rights to, such income.[9]

The Lower Court Decisions

The trial court found the tax to be unconstitutional under the Due Process Clause because the beneficiaries’ residence in North Carolina alone did not sufficiently connect the State and the Kaestner Trust. The North Carolina Supreme Court ultimately affirmed, reasoning that because the beneficiaries and the Trust have separate taxable existences, the beneficiaries’ residence fails to establish a connection between the Trust and the State.

The Supreme Court: Taxation Based Solely on In-State Residency of a Beneficiary Does Not Satisfy Due Process

The Supreme Court found North Carolina’s tax to be unconstitutional under the Due Process Clause because the tax failed to satisfy the first prong of Quill’s two-step analysis. Whether a minimum connection exists under Quill requires an inquiry into whether the taxpayer has “certain minimum contacts” such that the tax does not offend traditional notions of fair play and substantial justice.[10]

The Court reasoned that when a state bases a tax on a trust beneficiary’s in-state residence, the Due Process Clause requires “a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax.”[11] Where the resident beneficiary does not have “some degree” of control, possession or enjoyment of the trust property, there is no minimum connection under Quill.

The Court went through a litany of rights and benefits that the beneficiaries did not have and did not receive in the tax years in question:

  • there was no actual distribution of income;
  • there was no right to demand Trust income, or otherwise control or possess the Trust assets;
  • the distribution of Trust assets was left to the trustee’s “absolute discretion” (and, in fact, the Trust agreement specifically allowed the trustee to distribute income and assets to one beneficiary to “the exclusion of other[s]”);[12]
  • there was no control over investment decisions regarding Trust assets;
  • there was no power to assign any right a beneficiary had in the Trust assets; and
  • there was no right to ever receive the Trust assets—the trustee had the power to roll Trust assets into a new trust rather than terminating it on the scheduled date (which was, in the original Trust agreement, set for 2009).

Because the beneficiaries possessed such greatly limited rights to the Trust assets, the Court determined there was no minimum connection between the Kaestner Trust and North Carolina, and thus North Carolina could not impose a tax on the Kaestner Trust.

Consequences

The Court in Kaestner in many ways bent over backwards to minimize the reach of its holding. Every particular limitation created by the Trust documents was emphasized by the Court, and the Court did not specify if any of the identified limits on the beneficiaries’ rights could be altered while retaining the same result under the Due Process Clause. Indeed, the Court in multiple parts of the opinion emphasized that it was not deciding what would happen if the facts were even slightly more expansive, such as (1) if the “relationship to trust assets differ[ed] from that of the beneficiaries” in Kaestner,[13] (2) if “the degree of possession, control, or enjoyment” of the trust assets were greater in any way than that possessed by the beneficiaries in Kaestner,[14] (3) if the beneficiaries had the “ability to assign a potential interest in income from a trust”[15] and (4) if “the beneficiaries were certain to receive funds in the future.”[16] The Court also emphasized how North Carolina’s taxing regime was more expansive than most other state regimes, specifically contrasting it to the tax provisions of (among others) Alabama, Connecticut, Georgia and California.

It is possible that the narrowness of the Court’s holding is what inspired Justice Alito (joined by Chief Justice Roberts and Justice Gorsuch) to write a concurring opinion. The concurring opinion suggests that these Justices find the questions presented by the facts of Kaestner to be an even more straightforward application of prior precedent than the rest of the Court. The concurring opinion, in fact, could be read to endorse the conclusion that a state could never tax a trust’s accumulated income based solely on the in-state residence of a beneficiary even if the beneficiary were non-contingent. If the Court were to end up adopting such a view, then certain jurisdictions (such as California) could no longer tax the accumulated income of out-of-state trusts based solely on the presence of non-contingent beneficiaries according to its current practice.

The only sure conclusion that can be drawn from Kaestner is that nothing much has changed in the taxation of trusts. It is unlikely that courts will expand Kaestner beyond its particular facts, that states will alter their approach to trust taxation or that advice to taxpayers will be different following Kaestner. That said, taxpayers should continue to be aware of the facts-and-circumstances approach that seems to be taken to determine whether a trust’s assets may be subject to certain state taxes, and as always, that the establishment and maintenance of a trust requires careful planning and good advice. Please contact any of the authors listed above, or your usual Proskauer attorney, to discuss this further.

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The authors would like to thank Michael LaMonte, law clerk at Proskauer Rose LLP, for his invaluable assistance with writing this blog post.

 

[1] North Carolina Dept. of Revenue v. Kimberly Rice Kaestner 1992 Family Trust, No. 18–457, slip op. (U.S. June 21, 2019).

[2] The Due Process Clause of the Fourteenth Amendment states: “No state shall . . . deprive any person of life, liberty, or property, without due process of law . . . .” U.S. Const. amend. XIV, § 1.

[3] Note that the original trust was divided into three subtrusts by the trustee. One of the subtrusts was formed for the benefit of Kaestner (one of the original beneficiaries) and her three children, and was governed by the same agreement that governed the original trust. For purposes of this blog post, all references to the “Kaestner Trust” or the “Trust” refer to both the original trust and the subtrust at issue.

[4] Wisconsin v. J.C. Penny Co., 311 U.S. 435, 444 (1940).

[5] 504 U.S. 298, 306 (1992).

[6] See Greenough v. Tax Assessors of Newport, 331 U.S. 486, 494 (1947) (tax based on trustee’s residence); Hanson v. Denckla, 357 I.S. 235, 251 (1958) (tax based on site of trust administration); Curry v. McCanless, 307 U.S. 357, 370 (1939) (tax based on site of trust administration).

[7] See Guaranty Trust Co. v. Virginia, 305 U.S. 19 (1938); Maguire v. Trefry, 253 U.S. 12 (1920).

[8] See Safe Deposit & Trust Co. of Baltimore v. Virginia (Safe Deposit), 280 U.S. 83 (1929); Brooke v. Norfolk, 277 U.S. 27 (1928).

[9] See N.C. Gen. Stat. Ann. § 105-160.2 (providing for a tax on any trust income that “is for the benefit of” a North Carolina resident).

[10] International Shoe Co. v. Washington, 326 U.S. 310, 316 (1945).

[11] Kaestner, at 9 (citing Safe Deposit, 280 U.S. at 91).

[12] Id. at 11.

[13] Id. at 7.

[14] Id. at 10 n.8.

[15] Id. at 11 n.9.

[16] Id. at 12 n.10.

Proposed Regulations Provide Clarity for Qualified Foreign Pension Fund Exception

On June 7, 2019, the U.S. Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) released proposed Treasury regulations under Sections 897, 1445 and 1446 (the “Proposed Regulations”) regarding the exception for qualified foreign pension funds (“QFPFs”) from taxation under the Foreign Investment in Real Property Tax Act (“FIRPTA”) provisions of the Internal Revenue Code of 1986, as amended (the “Code”).[1] This exception was added to the Code pursuant to the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”).

The Proposed Regulations are taxpayer favorable because they broadly construe which entities may constitute QFPFs and the requirements that must be met under Section 897(l) in an effort to include a wide range of plans that are in substance foreign pension funds but that might not qualify under a strict interpretation of the statute. The Proposed Regulations should encourage further investment in U.S. real property by foreign pension plans by providing greater clarity regarding whether a plan meets the requirements to be treated as a QFPF. Rules for certifying an exemption from FIRPTA withholding and plans to revise IRS Form W-8EXP are also provided in the Proposed Regulations.

Background

In general, in the case of a nonresident alien individual or a foreign corporation, Section 897(a)(1) provides that any gain or loss arising from the disposition of a U.S. real property interest (“USRPI”) is taxed as if such gain or loss is effectively connected with the conduct of a U.S. trade or business (commonly referred to as effectively connected income, or “ECI”) by the nonresident alien individual or foreign corporation. Furthermore, under Section 897(h), any distribution from a qualified investment entity (“QIE”), which includes any real estate investment trust (“REIT”) and certain regulated investment companies (“RICs”), to a nonresident alien individual, foreign corporation, or other QIE is treated as gain recognized from the sale or exchange of a USRPI to the extent such gain is attributable to sales or exchanges of USRPIs by the distributing QIE. However, the PATH Act added Section 897(l) to provide an exception for QFPFs by not treating them as nonresident alien individuals or foreign corporations for the purposes of Section 897 (referred to herein as the “Section 897 exception” or the “exception”). Please see our blog post and client alert relating to the enactment of the PATH Act for a more detailed background discussion.

Scope of the Exception

 Qualified Segregated Accounts

The Proposed Regulations limit the scope of the Section 897 exception to gain or loss attributable to one or more qualified segregated accounts maintained by the QFPF (together with qualified controlled entity, defined below, is referred to as a “qualified holder” in the Proposed Regulations). A qualified segregated account is defined to be an identifiable pool of assets maintained for the sole purpose of funding qualified benefits (generally, retirement, pension and certain ancillary benefits) to qualified recipients (generally, plan participants and beneficiaries). Whether each requirement under Section 897(l)(2) is satisfied is determined solely with respect to the income and assets held by an eligible fund in one or more qualified segregated accounts, including the qualified benefits funded by such accounts, the qualified recipients whose benefits are funded by such accounts, and the information reporting and regulation related to such accounts.

Qualified Controlled Entity

Under Section 897(l)(1), a QFPF is defined to include any entity all the interests of which are held by a QFPF (a “qualified controlled entity”).[2] It was unclear whether this meant that such an entity must be directly owned by the QFPF, rather than owned through a series of entities, or whether it could be owned by multiple QFPFs. The Proposed Regulations clarify that a qualified controlled entity may be owned directly or indirectly by one or more QFPFs through one or more qualified controlled entities. In addition, only corporations and trusts may be treated as qualified controlled entities. The Treasury and the IRS determined it is unnecessary to allow partnerships to be treated as qualified controlled entities because indirect ownership is permitted.

In order to determine the status of an entity as a qualified controlled entity, the Proposed Regulations exclude any interest solely as a creditor and ignore the more limited definition of controlled entity under Treasury regulation section 1.892-2T(a)(3) (relating to entities controlled by a foreign sovereign).[3] To prevent avoidance of tax by taxpayers other than QFPFs, de minimis ownership by a taxpayer other than a QFPF is explicitly prohibited, and an anti-abuse rule prohibits any entity or governmental unit that was not (or was not part of) a QFPF or a qualified controlled entity at any time during a specific testing period from qualifying for the exception under the Proposed Regulations.

Eligible Fund

The Treasury and the IRS, stating their intent to be consistent with congressional intent, provided for a broad range of structures (referred to as “eligible funds”) that may be treated as a QFPF under the Proposed Regulations. Section 897(l)(2) states that “any trust, corporation or other organization or arrangement” may be an eligible fund. One of the big questions about this language was how to interpret “organization or arrangement.” The Proposed Regulations specify that an “organization or arrangement” means one or more trusts, corporations, employers or governmental units. Furthermore, a “governmental unit” means any foreign government, or part thereof, and includes any person, body, group of persons, organization, agency, bureau, fund, instrumentality, however designated, of a foreign government.

 The Proposed Regulations, through the use of the terms “eligible fund,” “qualified controlled entity” and “qualified segregated accounts,” clarify that various types of pension plans can be QFPFs including: foreign private and government-sponsored public pension plans, multi-employer plans and pension plans of trade unions or professional associations. Furthermore, a plan may be structured as one or more segregated pools of assets.

Qualified Foreign Pension Fund Requirements

The additional five requirements under Section 897(l)(2) that must be met in order for an eligible fund to be treated as a QFPF are clarified and generally expanded by the Proposed Regulations as follows:

A. Created or organized under the law of a country other than the United States

Recognizing that it is common for pension plans to be organized or governed by local laws (e.g., provincial law in Canada), the Proposed Regulations provide that the reference to “country” may include states, provinces, or political subdivisions of a foreign country.

B. Established to provide retirement or pension benefits

Because foreign pension plans often provide some ancillary benefits, the Proposed Regulations permit a QFPF to provide some benefits other than retirement benefits and pension benefits. Certain “ancillary benefits” are treated as “qualified benefits” under the Proposed Regulations, including benefits payable upon the diagnosis of a terminal illness, death benefits, disability benefits, medical benefits, unemployment benefits, or similar benefits. However, no more than 15% of the present value of the qualified benefits that an eligible fund reasonably expects to provide in the future can be from ancillary benefits.

C. 5% limitation on right to assets or income

Section 897(l) contains no rule regarding constructive ownership. However, the Proposed Regulations apply the attribution rules under Section 267(b) or Section 707(b) to determine whether an individual has a right to more than 5% of a QFPF’s assets or income under Section 897(l)(2)(C). No specific computation rules are provided, and the Proposed Regulations instead require a facts and circumstance determination for calculating the 5% limitation.

D. Subject to governmental regulations and information reporting

A QFPF must be subject to government regulation and must provide or otherwise make available annual information about its beneficiaries to the relevant tax authorities in the country in which it is established or operates. The Proposed Regulations provide useful clarifications:

  • The Proposed Regulations require such information to include the amount of qualified benefits provided to each qualified recipient, but also provide that an eligible fund will not fail the information requirement if it is not required to provide information in a year in which no qualified benefits are provided to qualified recipients.
  • A government-sponsored pension plan that is administered by one or more governmental units, other than in its capacity as an employer, will automatically satisfy the regulation and information requirements under the Proposed Regulations.
  • Private foreign pension plans may be required to provide information to one or more governmental bodies responsible for regulating pensions in the relevant country. Those governmental bodies may be separate and distinct from the tax authorities. Accordingly, the Proposed Regulations provide that an eligible fund will satisfy the information requirement if, pursuant to the applicable foreign laws, it provides the required information, or makes it available, to one or more governmental bodies.

E. Preferential tax treatment in the foreign country in which it is established or operates

The laws of the foreign country in which an eligible fund is established or operates must provide either that (1) contributions to the eligible fund which would otherwise be subject to tax under such laws are deductible or excluded from gross income of such eligible fund or taxed at a reduced rate, or (2) any investment income of the eligible fund is deferred, excluded from gross income of the eligible entity or is taxed at a reduced rate. The Proposed Regulations relax this requirement and provide exceptions in cases where (i) the foreign country does not have an income tax, (ii) where at least 85% of the contributions or investment income is subject to the required tax treatment, and (iii) where the eligible fund is subject to a preferential tax regime that has a substantially similar effect as the required tax treatment under this provision. For purposes of this requirement, the Proposed Regulations specify that it is determined with respect to the national laws of a foreign country. It is important to note that although an eligible fund may be created or organized under the laws of states, provinces, or political subdivisions of a foreign country, it must receive preferential tax treatment on a national level (e.g., for a pension fund established under the laws of a Canadian province, the preferential tax treatment under Canadian federal tax rules is relevant, not a preference under provincial tax rules).

Withholding

The IRS intends to revise Form W-8EXP to be used by qualified holders to certify their status as non-foreign for withholding tax purposes. In the interim, a certificate of non-foreign status may be used. It is also intended that withholding agents and partnerships may rely on the revised Form W-8EXP.

Note that withholding taxes other than FIRPTA, such as those imposed on payments to non-U.S. persons generally under Sections 1441 and 1442, and on certain allocations of ECI to foreign partners under Section 1446 may still be imposed.

Observations

The rules regarding QFPFs apply specifically for purposes of the FIRPTA rules. These rules do not impact the definition of “pension plan” under any income tax treaties between the United States and another country or under the Foreign Account Tax Compliance Act (“FATCA”). Accordingly, a pension plan may be a QFPF under the FIRPTA rules but may not be a pension plan under an applicable income tax treaty or FATCA.

REIT Related Observations

Publicly-Traded Exemption.  The Section 897 exception allows a QFPF to own more than 10% of a publicly traded REIT and not be subject to FIRPTA. Foreign investors in publicly traded REITs generally are exempt from ECI treatment under Section 897 on capital gain dividends attributable to gain from the sale of a USRPI by the REIT (pursuant to Section 897(h)(1)), and on gain from the sale of REIT stock (pursuant to Section 897(c)(3)), if the foreign investor owns no more than 10% of the REIT.[4] However, a QFPF could rely on the Section 897 exception to be exempt from ECI treatment under Section 897 even if it owns more than 10% of a REIT. In practice, REITs typically limit ownership of their shares to 9.8% or less of any class or series of shares unless the investor receives a waiver of the limitation. Accordingly, a QFPF would need to obtain a waiver of the ownership limit in order to own more than 10% of a REIT. Any REIT considering waiving its ownership limit for a QFPF should be careful that a large ownership position by the QFPF does not raise any related party rent issues if the QFPF owns a large interest in any of the REIT’s tenants.

Domestically-Controlled Exemption.  A QFPF may be able to own 50% or more of a private REIT (through a joint venture or other fund structure) and exit the investment through the sale of the underlying real property and liquidation of the REIT, rather than by selling REIT stock. Foreign investors in U.S. real property typically desire to structure their investment in U.S. real property through a domestically-controlled REIT[5] so that they can exit the investment through a sale of the REIT stock. Section 897(h)(2) exempts gain from the sale of stock of a domestically-controlled REIT from being treated as ECI under the FIRPTA rules. The alternative generally would be for the REIT to sell its assets and redeem the foreign investor’s shares in liquidation of the REIT. Shareholders generally are treated as recognizing capital gain or loss with respect to their stock in the complete liquidation of a REIT;[6] however, the IRS takes the view that liquidating distributions made by REITs to foreign investors are taxed under Section 897(h)(1) as ECI to the extent attributable to gain from the sale of a USRPI by the REIT. The Section 897 exception exempts QFPFs from tax on liquidating distributions under Section 897(h)(1) regardless of whether the REIT is domestically-controlled.

It is unclear what the impact of the Section 897 exception is on determining whether a REIT is domestically controlled. Section 897(l)(1) states that for purposes of the FIRPTA rules, a QFPF “shall not be treated as a nonresident alien individual or a foreign corporation,” but it does not go so far as to say that a QFPF is treated as a domestic entity. This creates an inherent tension between QFPFs that may not need to rely on the domestically-controlled exemption to avoid ECI, and other foreign investors that need to rely on this exemption. Guidance from the IRS would be welcome on this point.

Pension-Held REIT.  It is understood that the intention behind the Section 897 exception was to put QFPFs on a similar footing as domestic pension funds with respect to the taxation of their investment in U.S. real property. Whether a REIT acts as an effective blocker of unrelated business taxable income (“UBTI”) for domestic tax exempt entities depends on the REIT not being treated as a pension-held REIT. A REIT is treated as pension-held if its ownership is concentrated in trusts “described in Section 401(a) and exempt from tax under Section 501(a).”[7] A QFPF is not defined by reference to these Code Sections. Accordingly, absent further guidance to the contrary, it may be reasonable to assume that a QFPF could own more than 25% of a REIT and not cause the REIT to be treated as a pension-held REIT.

Effective Dates

The Proposed Regulations generally will apply to dispositions and distributions occurring on or after the date of the adoption of the rules as final Treasury regulations. However, certain provisions of the Proposed Regulations containing the general rule for the exception and several definitions are proposed to apply to dispositions and distributions occurring on or after June 6, 2019.[8] Taxpayers may rely on the Proposed Regulations with respect to dispositions or distributions occurring on or after December 18, 2015 and prior to the applicability date of the final Treasury regulations.

___________________________________

[1] References to “Section” are to the Code.

[2] Section 897(l)(1) provides that “an entity all the interests of which are held by a qualified foreign pension fund shall be treated as such a fund.”

[3] In order for an entity to be treated as a controlled entity under Treas. Reg. section 1.892-2T(a)(3), the entity must be organized in the same jurisdiction as its foreign sovereign owner, and may not be owned by more than one foreign sovereign.

[4] The exception is specific to the class of stock of the REIT owned by the foreign investor. The particular class of stock must be regularly traded and the foreign investor cannot own more than 10% of such class of stock, determined by applying certain constructive ownership rules.

[5] A REIT is domestically-controlled if 50% or more of the value of its stock is owned, directly or indirectly, by U.S. persons at all times during a testing period.

[6] Section 331 treats liquidating distributions as payment in exchange for the stock held by a shareholder.

[7] See Section 856(h)(3)(E).

[8] See Prop. Treas. Reg. sections 1.897(l)-1(b)(1) (containing the general rule that gain or loss of a qualified holder from the disposition of USRPI, including gain from a distribution described in Section 897(h), is not subject to tax under Section 897(a)), 1.897(l)-1(d)(5) (definition of “governmental unit”), 1.897(l)-1(d)(7) (containing the definition of “qualification date”), 1.897(l)-1(d)(9) (containing the definition of “qualified controlled entity”), 1.897(l)-1(d)(11) (containing the definition of “qualified holder”), 1.897(l)-1(d)(14) (containing the definition of “testing period”).

Upper Tribunal Rules in Favour of Taxpayer in Tax Residence Case

Development Securities plc and others v HMRC [2019] UKUT 169 (TCC)

The Original Judgment

As we reported in our August 2017 UK Tax Round-Up [https://www.proskauer.com/newsletter/uk-tax-round-up-august-2017], the UK’s First Tier Tribunal (“FTT”) found against the taxpayer in the Development Securities case, and ruled that certain Jersey-incorporated companies were, in fact, UK tax resident through central management and control.

By way of reminder, Development Securities plc (“DS”) – a UK company – had incorporated a number of Jersey subsidiaries intended to be Jersey tax resident as part of its implementation of a scheme which was intended to increase available capital losses on UK real estate. The facts showed that all the board of directors had a Jersey-resident majority of directors (three were Jersey-resident and one was UK-resident), the board meetings all took place in Jersey and decisions were actually taken at those board meetings.

However, the FTT pointed to the uncommercial nature of the transactions from the perspective of the Jersey subsidiaries themselves (which could only be justified in the context of the tax benefit to the DS group as a whole) and that Jersey corporate law meant that the Jersey subsidiaries could only enter into the uncommercial transactions with the approval of their UK-resident parent company.

Consequently, the FTT had held that central management and control of the Jersey companies had been undertaken by the UK DS parent and, in taking on their director appointments, the Jersey directors were simply agreeing to implement what the UK DS parent company had already decided to do.

The Upper Tribunal Decision

The Upper Tribunal (“UT”) has overturned that decision in a judgment published this month. The UT ruled that central management and control was exercised in Jersey and not the UK.

The UT found that the relevant assets were indeed acquired at an overvalue, but the overpayment by the Jersey companies was not funded by them. So the FTT’s decision that the transactions were “uncommercial” for the Jersey companies was doubtful.

The UT analyzed Jersey company law in some depth, looking at how the directors were obliged to act in the best interests of the (Jersey) company. Jersey company law requires the company to consider the interests of shareholders, employees and creditors. In this case, given that the Jersey Companies had no employees and the transactions that the Jersey Companies were to enter into, pursuant to the scheme, did not prejudice creditors, the UT decided that the primary consideration can only have been the interest of the shareholder (DS). The UT reported that the directors gave detailed consideration to the appropriateness of the scheme – including the apparently uncommercial nature of the options and the acquisition by the Jersey companies of the relevant assets – and concluded that the transactions were in the best interests of the shareholder and therefore in the best interests of the Jersey companies.

It is very clear from the judgment that, just because the transactions were uncommercial, they were not automatically to be treated as contrary to the best interests of the Jersey companies

Although the UT agreed that the UK resident director had acted as a puppet or “rubber stamp”, the FTT had not made a similar finding regarding the Jersey directors. The evidence pointed strongly to the Jersey directors properly applying their minds to the transactions. The UT noted that one board meeting lasted five hours; and that the Jersey directors sough clarification on a number of points including the potential stamp duty liability arising; and also noticed and raised with advisers an inconsistency between the terms of the option and the drafting of the option notice.

HMRC tried to argue that the FTT had excluded from consideration material factor(s) going to the question of central management and control because they had occurred outside a board meeting. The UT rejected that argument and said that the FTT had, correctly, focused on the board meetings, but clearly also took account of matters occurring outside these meetings: for example, actions by the group more generally and events pre-dating the incorporation of the Jersey companies.

Analysis

This is a welcome decision in favour of the taxpayer. It demonstrates again the importance of running offshore companies properly. The evidence as to what happened in the Jersey board meetings proved critical here. The board minutes showed that the three Jersey-based directors had met in Jersey, and had spent some considerable time analyzing and discussing the terms of the deals over several board meetings. It was important to the UT’s decision that the board minutes demonstrated that the directors had asked meaningful questions about the transaction and had called for explanations where necessary. Well-prepared contemporaneous minutes of such meetings are vital.

UK Tax Round Up

UK General Tax Developments

HMRC updates guidance on what constitutes “ordinary share capital”

Following the decision by the First-tier Tribunal (FTT) in Warshaw V HMRC, reported in our UK tax blog earlier this month, HMRC has updated its guidance on what constitutes “ordinary share capital” for the purposes of most tax provisions using that term.

As well as providing further guidance in relation to certain non-UK entities, the guidance has updated HMRC’s view on certain categories of shares with particular rights. Following Warshaw, HMRC has included in its guidance reference to fixed rate preference shares where the dividend compounds over time or where a rate of interest is added if a dividend is unpaid. HMRC states that such shares would be “borderline” in respect of whether or not they are ordinary share capital. This update is in response to the Warshaw decision, in which the FTT held that cumulative, compounding fixed rate preference shares were ordinary share capital for the purposes of section 989 ITA 2007. This could be seen to contrast with HMRC’s previous guidance that stated that cumulative fixed rate shares (with no reference to whether there was compounding on any unpaid dividend) are not ordinary shares. HMRC describes the decision in Warshaw as of “persuasive rather than precedent authority” in its updated guidance.

Although this update to HMRC’s guidance is welcome in order to address the lack of detail in HMRC’s previous guidance on the point highlighted by the decision in Warshaw, it is unfortunate that there is no clarity for taxpayers on the potentially significant tax consequences for them which may arise depending on the specific terms of their shares, such as for entrepreneurs’ relief purposes. Taxpayers holding shares with fixed rate, cumulative, compounding dividends who expect the shares to be ordinary shares (or not) should seek advice on the possible consequences for them of this updated position from HMRC.

Anti-avoidance: two latest GAAR Advisory Panel opinions released

Two GAAR Advisory Panel opinions (Opinion 11 and Opinion 12) have been released, both agreeing with HMRC’s assertion that the schemes in question were not reasonable courses of action in the circumstances and so the general anti-abuse rule (GAAR) applied to them.

Under both schemes, the company and the shareholder(s) acquired a bond from the scheme promoter for consideration comprising, broadly, the company assuming debt guaranteed by the shareholder. Various swaps were entered into with third parties, immediately novated to the bond manager as additional contributions to the bond (i.e., the debt) and the bond manager then entered into mirror swaps. The whole process was reversed during the respective “cooling off” periods. The effect of such transactions was that the same amount payable by the company to the shareholder(s) was created in the company loan accounts of that shareholder.

In Opinion 11, the GAAR Advisory Panel determined that the credits were equivalent to remuneration as a cash bonus. In Opinion 12, it determined that the credits were equivalent to distributions to the shareholders. The Panel stated that the steps undertaken in both situations, although not unlawful, lacked any commercial purpose and were contrived and abnormal. The Panel further commented that any correspondence relating to, or disclosure under, the disclosure of tax avoidance schemes (DOTAS) rules did not preclude the scheme falling within the GAAR given the different requirements applicable for such rules compared with the GAAR.

The two opinions highlight both HMRC’s willingness to attack what they consider to be abusive schemes to avoid employment taxes and the GAAR Advisory Panel’s willingness to agree with HMRC in these cases.

Anti-avoidance: HMRC’s Spotlight 51 and Spotlight 52

HMRC has released new anti-avoidance spotlight guidance in relation to transactions using loans or fiduciary receipts (Spotlight 51) and using offshore trusts (Spotlight 52).

In Spotlight 51, HMRC confirms its awareness of tax avoidance schemes that, whilst marketed as wealth management strategies, attempt to disguise employment income and other profits as loans or fiduciary receipts. In Spotlight 52, HMRC highlights two recent FTT cases involving disclosure of schemes that utilised offshore trust structures to disguise income on which employment tax and NI contributions would otherwise be due. In both cases, the FTT agreed with HMRC that the schemes were notifiable under the DOTAS rules.

These Spotlights further highlight HMRC’s willingness to challenge artificial and contrived avoidance schemes aiming to avoid employment taxes and the support that HMRC expects to get, and is getting, in doing so at tribunal level (and from the GAAR Advisory Panel as discussed above).

UK Case Law Developments

Section 75A Finance Act 2003 – Stamp duty land tax and the general anti-avoidance rule

The case of Hannover Leasing Wachstumswerte Europa Beteiligungsgesellschaft mbH and another v HMRC concerned arrangements for the sale of a property which were found by the FTT to fall within the scope of the stamp duty land tax (SDLT) anti-avoidance rule in section 75A of Finance Act 2003 (section 75A) even though the arrangements were not tax avoidance arrangements.

The property in question was held by an English limited partnership which itself was owned by a Guernsey unit trust in a form of tax planning generally considered acceptable. The buyer requested that the seller move the property out of the English limited partnership, due to its concerns relating to historic liabilities within the partnership, and into the Guernsey unit trust and then move the partnership itself out of the unit trust prior to completion of the sale. £55,540 of SDLT was paid in respect of the various transfers and steps giving effect to the sale.

HMRC argued that SDLT was payable on the full value of the property (approximately £140 million) as section 75A applied in respect of any reduction in tax liability, regardless of whether one of the main purposes of the transactions was avoidance of tax. The taxpayers argued that there were no scheme transactions for the purpose of section 75A and that the right amount of SDLT had been paid in respect of the transaction. The taxpayers also drew the FTT’s attention to HMRC’s own guidance on section 75A which states that it is an anti-avoidance provision and that HMRC will not apply it where transactions have been taxed appropriately.

The FTT, agreeing with HMRC, held that section 75A did apply and that SDLT was chargeable on the full cost of the property despite the lack of a tax avoidance motive. The FTT considered HMRC’s guidance on section 75A either wrong or irrelevant. Interestingly, the FTT indicated that if the sale had proceeded with the partnership as the seller of the property, or if the steps had been undertaken in a different order, section 75A would not have applied. The taxpayer is expected to appeal.

Following this decision, there is more uncertainty on the application of section 75A to property transactions with corporate holding structures, especially where there is no tax avoidance motive. Those undertaking, and advising on, such property transactions should carefully consider the structures involved and whether they could be caught be the seemingly ever-widening scope of section 75A.

Redemption of QCBs crystallised a gain rolled over from earlier conversation of non-QCBs

In Hancock and another v HMRC, the Supreme Court dismissed the taxpayers’ appeal and held that the redemption of qualifying corporate bonds (QCBs) crystallised a gain previously rolled into the QCBs by the prior conversion of non-QCBs (and other QCBs).

The Supreme Court dismissed the taxpayers’ argument that because the previous conversion “included” QCBs as well as non-QCBs the crystallisation of a held over gain did not occur as the QCBs were outside of the scope of section 116 of the Taxation of Chargeable Gains Act 1992. The Supreme Court acknowledged that the taxpayers had a strong argument on a literal reading of the relevant provision but concluded that such interpretation would be contrary to the policy behind the legislation and create opportunities for abuse. The Supreme Court did not, however, follow the Court of Appeal and apply what might be considered to be a “strained” interpretation of the provisions. Instead, it placed weight on the fact that the relevant provisions had to be applied on their terms with “necessary adaptations” in respect of conversions of securities as part of a reorganisation. Accordingly, the Supreme Court felt able to rely on the wording of the legislation to determine that the prior conversion of the loan notes was two separate conversions, one of the QCBs and the other of the non-QCBs.

Given the focus on the wording of the legislation in the Supreme Court’s decision, it did not provide much further detail for taxpayers and their advisers on the approach the courts may take in situations where apparent clear statutory language could be set aside in favour of an approach requiring a strained interpretation of the relevant statutory language. The Court simply commented that the instances where such an approach can be applied must be limited.

Single composite supply for VAT purposes where two separate items acquired in one package

The case of HMRC v The Ice Rink Company concerned whether the supply of access to an ice rink and the hire of ice skates were together one composite supply or two separate supplies for VAT purposes.

The taxpayer offered various ice skating packages to customers, including access to an ice skating rink with or without skate hire as well as skate hire without access to the ice rink. If the supplies were separate supplies, the hiring of children’s ice skates was zero-rated whilst the access to the ice rink was standard-rated. If the ice skates were part of the access to the ice rink, the whole supply was standard-rated.

The Upper Tribunal (UT), overturning the decision of the FTT, held that there was one composite standard-rated supply as, considering only those customers purchasing the combined access to ice rink and skate hire package, the two aspects were acquired as a single supply.

The UT stated that the FTT had been wrong to consider not only the customers who purchased the combined package but also those customers who purchased other products and that the FTT should not have considered supplies made to persons other than the “typical customer” of the combined package as being relevant to the nature of the supply to a typical customer. Taking that approach, the UT held that it was not possible to extract the skate hire as a separate zero-rated supply and so the whole composite supply was standard-rated.

This case highlights that the nature of the supply for the actual customers involved is important in determining the nature of such supply for VAT purposes and that, where there is a supply comprising multiple elements, a particular element of the supply could not be extracted simply because it could be acquired on its own.

Overpayment of car parking charges was consideration for VAT purposes

In National Car Parks Ltd v HMRC, the Court of Appeal held that “overpayment” by customers in respect of car parking charges as result of not having the correct change to put in the machine was consideration for VAT purposes.

In reaching its decision, the Court stated that the meaning of “consideration” was autonomous across the EU and could differ from a domestic contract law interpretation. The VAT meaning was a subjective, not objective, value based on the amounts actually paid for the service. Therefore, it was the actual price paid for the services, including any overpayment, which was the relevant consideration for VAT purposes. Looked at another way, the customers had made their entire payment for the parking services notwithstanding that they could have paid less had they had the correct change.

The case illustrates that the key consideration in ascertaining consideration for VAT purposes is whether there is a direct link between the service provided and the payment made in respect of that service. In this instance, the fact that the payment made exceeded the market value and the original contractual offer price did not prevent this higher payment being the consideration.

International Developments

Guidance on new substance requirements in the Isle of Man, Guernsey and Jersey

Guidance has been released by the Crown Dependency (CD) governments of Guernsey, Jersey and the Isle of Man in relation to legislation outlining economic substance requirements.

Under pressure from the EU of being blacklisted as “uncooperative tax jurisdictions”, the governments have collaborated on the guidance following the introduction of new legislation at the end of 2018 by all three jurisdictions. The guidance confirms that companies that fall within the scope of the new legislation must perform their core income-generating activities in any relevant sector within the relevant jurisdiction. To fall within the scope of the legislation, companies must perform real commercial activities such as the sale or exchange of goods or provision of services for profit.

The guidance confirms that pure equity-holding companies that passively hold equity investments, broadly, will not be considered as carrying on an economic activity and so will not fall within the scope of the new substance requirements.

CD resident corporate managers (such as corporate general partners to fund partnerships) will fall within the scope of the new legislation and so whether the manager performs “core income generating-activity” within the relevant CD will be key in determining whether it meets the substance requirements. It will also be a requirement that the manager is directed and managed in the CD and the guidance provides a list of what is expected to satisfy this.

The guidance does not provide details as to the process that tax officials will use to determine if an entity has met the substance requirements and further guidance is expected in relation to particular sectors, as well as outlining the reduced requirements for pure equity-holding companies.

Funds and companies operating in any of the CD jurisdictions should consider their existing activities and substance status in response to the new legislative requirements.

Final IRS Regulations Sync Section 956 with TCJA Participation Exemption – Limits “Deemed Dividends” for U.S. Corporate Shareholders of CFCs

Implements 2018 Proposed Regulations, ending most limitations on investments in U.S. property, as well as pledges and guarantees by CFCs wholly-owned by U.S. corporations – also provides PTI guidance for CFC shareholders.

EXECUTIVE SUMMARY

In anticipated and important guidance, the U.S. tax authorities have issued final regulations under I.R.C. Section 956 (the “New 956 Regulations”).[1] The New 956 Regulations are intended to eliminate, in most situations, the “deemed-dividend” issue with respect to controlled foreign corporations (“CFCs”) that are subsidiaries of U.S. corporations, including where the U.S. domestic corporation is a partner in a partnership.

The New 956 Regulations achieve this result by generally giving a U.S. corporation’s income inclusions under Section 956 the same benefit of the U.S.’s limited participation exemption[2] that is otherwise available to actual dividends received from a CFC. The impact of Section 956 on noncorporate U.S. entities (which generally do not benefit from the participation exemption), including where the noncorporate entity is a partner in a partnership, is generally unchanged by the New 956 Regulations. The New 956 Regulations finalize, with limited but important changes, proposed regulations from November 2018.

An immediate impact of the New 956 Regulations will be on the use of non-U.S. subsidiaries to secure borrowings by U.S. corporations. A U.S. borrower generally should now be able to grant lenders complete pledges of stock of CFCs and provide full security interests in the assets of CFCs (and so-called CFC Holdcos — i.e. borrower subsidiaries that hold CFC stock) as long as the CFCs are directly or ultimately owned, in whole, by U.S. domestic corporations and partnerships where all of the direct and indirect partners are either U.S. domestic corporations or entities not subject to U.S. income tax (e.g., tax-exempts, foreign investors) without negative U.S. federal income tax consequences. Under existing Section 956 regulations, the effective limit to avoid phantom dividend income was a pledge of 65% of the voting stock in the CFC, with no guarantee by the CFC. The New 956 Regulations should end the position that new loan agreements must include the old, limited 65% voting stock pledge to protect U.S. corporate borrowers – which was an arguable residual concern while the regulations were still proposed.

The New 956 Regulations also provide a welcome change for multinationals with substantial previously taxed income (“PTI”) under the CFC rules relating to certain hypothetical distributions under the ordering rules for PTI.

These final regulations were issued and became effective on May 23, 2019 (with lookback effectiveness to taxable years beginning after December 31, 2017 in certain circumstances).

Please contact any Proskauer tax lawyer, or your usual Proskauer contact, for further information about the New 956 Regulations and their effect on shareholders of CFCs, as well as lenders and borrowers in structures with non-U.S. subsidiaries or operations. A detailed description of the New 956 Regulations, along with background, a description of the U.S. tax authorities’ explanation of the provisions and discussion of differences from the proposed regulations, continues below.

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