Tax Talks

The Proskauer Tax Blog

Extended tax liabilities for directors in insolvencies linked to tax avoidance

Draft legislation included in the Finance Bill 2019-2020 will potentially make directors and certain other individuals closely connected to a company jointly and severally liable for a company’s tax liabilities that arise from avoidance, evasion or repeated insolvency and non-payment of tax debts or tax-related penalties of the company.

The legislation is targeted at individuals closely connected to companies that:

  1. exploit the insolvency regime to avoid or evade tax payments or conceal the gains arising from tax avoidance or evasion;
  2. repeatedly accumulate tax debts without payment by passing these through a succession of corporate entities which are then made insolvent (so-called phoenixism); and/or
  3. seek to get avoid penalties under certain tax avoidance or evasion provisions by going into insolvency.

The new rules will be effective in respect of accounting periods that have not closed before the Finance Bill receives Royal Assent or tax-related penalties incurred after that date. Continue Reading

IRS provides very modest relief from downward attribution resulting from the repeal of section 958(b)(4)

On October 2, 2019, the Internal Revenue Service (“IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued Revenue Produce 2019-40 (the “Revenue Procedure”) and proposed regulations (the “Proposed Regulations”) that provide guidance on issues that have arisen as a result of the repeal of section 958(b)(4) by the tax reform act of 2017.[1] The repeal of section 958(b)(4) was intended to prevent certain taxpayers from “de-controlling” their controlled foreign corporations (“CFCs”) and avoid paying current tax on earnings of those CFCs. However, the repeal has inadvertently caused a number of foreign corporations to be treated as CFCs for U.S. federal income tax purposes. As a result, U.S. persons who directly or indirectly own between 10% and 50% of the voting stock or value of foreign corporations that are now treated as CFCs are subject to tax on income (“subpart F income”) and 951A (globally intangible low-taxed income, or “GILTI”). The repeal has had other unintended consequences. For example, if a foreign corporation receives U.S.-source interest from a related person, the repeal of section 958(b)(4) may cause the interest to be subject to U.S. withholding tax (i.e., the interest would fail to qualify for the “portfolio interest exemption”).[2]

The Proposed Regulations “turn off” certain special rules that arise solely as a result of the repeal of section 958(b)(4). However, the Proposed Regulations do not prevent foreign corporations from being treated as CFCs as a result of the repeal of section 958(b)(4), do not limit the subpart F or GILTI income required to be reported as a result of the repeal of section 958(b)(4), and do not reinstate the portfolio interest exemption for foreign corporations affected by the repeal of section 958(b)(4).

The Revenue Procedure provides safe harbors for certain U.S. persons to determine whether they own stock in a CFC and to use alternative information to determine their taxable income with respect to foreign corporations that are CFCs solely as a result of the repeal of section 958(b)(4) if they are unable to obtain information to report these amounts with more accuracy.

The Proposed Regulations are generally proposed to apply on or after October 1, 2019. However, a taxpayer may rely on the Proposed Regulations for taxable years prior to the date they are finalized. The Revenue Procedure is effective for the last taxable year of a foreign corporation beginning before January 1, 2019. Continue Reading

Change to IR35 tax obligations from April 2020 for medium- and large-sized companies

New rules to be introduced from April 2020 will make certain companies who engage workers through intermediaries (the “client”) subject to:

  1. assessing whether the workers should be treated as employees of the company; and
  2. operating employment tax (PAYE and NICs) in respect of payments made to the workers or their intermediary.

Currently these obligations rest with the worker’s intermediary and not with the client organisation.

The off-payroll worker tax rules (known as IR35) were introduced in 2000 to ensure that an individual working for an organisation through an intermediary (often that individual’s personal services company (“PSC”)) who would be an employee if engaged directly by the client is taxed like an employee. Under the rules, the employment tax liability is the responsibility of the PSC (or other intermediary) and not of the client. The difficulties of determining whether or not the individual providing their services should be taxed as an employee under the rules has been highlighted recently with a number of cases involving well-known British television and radio personalities which have come to different conclusions.

The rules were changed for individuals providing their services to public sector bodies in April 2017, so that the responsibility for determining the individual service provider’s employment status and operating PAYE and NICs, if applicable, falls on the public sector body and not the PSC.

Draft legislation has been published in the Finance Bill 2020 which sets out changes to the rules to apply from April 2020 for individuals providing their services to medium- and large-sized organisations in the private sector. These changes are designed to increase compliance with the existing IR35 rules under which HMRC estimate that only one in ten workers currently operates the rules correctly. HMRC’s assessment is that the new rules will generate an additional £3 billion of tax over the next four years.

While the new rules are not retrospective, they will apply to payments made from April next year under existing arrangements. Continue Reading

IRS answers some, but not all, questions in long-awaited cryptocurrency guidance

The first official guidance on the taxation of cryptocurrency transactions in more than five years has been issued.

The guidance includes both a Revenue Ruling (Rev. Rul. 2019-24, 2019-44 I.R.B. 1) and answers to Frequently Asked Questions on Virtual Currency Transactions (the “FAQs,” together with Revenue Ruling 2019-24, the “Guidance”) was issued on October 9, 2019 by the U.S. Internal Revenue Service (the “IRS”).  The Guidance provides much sought information concerning the tax consequences of cryptocurrency “hard forks” as well as acceptable methods of determining tax basis for cryptocurrency transactions.  The Guidance also reasserts the IRS’s position, announced in Notice 2014-21, 2014-16 I.R.B. 938, that cryptocurrency is “property” for U.S. federal income tax purposes and provides information on how the rules generally applicable to transactions in property apply in the cryptocurrency context.  However, important questions remain unanswered.  It remains to be seen whether more definitive regulatory or administrative guidance is forthcoming.

The Guidance comes amidst an ongoing campaign by the IRS to increase taxpayer compliance with tax and information reporting obligations in connection with cryptocurrency transactions.  In 2017, a U.S. district court ordered a prominent cryptocurrency exchange platform to turn over information pertaining to thousands of account holders and millions of transactions to the IRS as part of its investigation into suspected widespread underreporting of income related to cryptocurrency transactions.  Earlier this year, the IRS sent more than 10,000 “educational letters” to taxpayers identified as having virtual currency accounts, alerting them to their tax and information reporting obligations and, in certain cases, instructing them to respond with appropriate information or face possible examination.  Schedule 1 of the draft Form 1040 for 2019, released by the IRS shortly after publishing the Guidance, would require taxpayers to indicate whether they received, sold, sent, exchanged, or otherwise acquired virtual currency at any time during 2019.[1]

Taxpayers who own or transact in cryptocurrency or other virtual currency should consider carefully any tax and information reporting obligations they might have.  Please contact the authors of this post or your usual Proskauer tax contact to discuss any aspect of the Guidance.  Read the following post for background and a detailed discussion of the Guidance. Continue Reading

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.

Continue Reading

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.

 *     *     *

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.

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