Saturday, February 28, 2015

The Timing of E&P to US Parent Corporations of CFCs

The earnings and profits (E&P) of a corporation dictate the income tax treatment of non-liquidating distributions it makes to its shareholders. Distributions from a corporation to the extent of its current or accumulated E&P are taxable as dividends, which generally results in ordinary income treatment. Other distributions are treated as return of capital, which can result in no taxation or capital gains to the recipient shareholder.

Controlled foreign corporations (CFCs) are non-US corporations owned and controlled by US persons, within specific statutory parameters. US shareholders of CFCs generally must include in income a pro rata share of the Subpart F income of the CFC as such income is earned, and must also include in income non-Subpart F income when it is invested in the US by the CFC.

So what happens to the E&P of a domestic parent corporation of a CFC when that domestic corporation must include income under the above rules? Does the income create E&P as earned, or only upon later distribution of those earnings from the CFC to the domestic parent corporation?

Arguments for delaying the E&P until distribution include (1) the US parent’s ability to make dividend distributions is not increased until it receives an actual distribution from the CFC, (2) a corporation does not generally have E&P on receipt of a corporate distribution until received, and (3) the E&P cannot be in two places at once (both in the parent corporation and the CFC). Despite these arguments, the Associate Chief Counsel (International), in a legal advice memorandum, concludes that E&P is increased at the time the domestic parent corporation incurs income through the Subpart F rules.

This conclusion was based on various aspects of the E&P rules (bearing in mind that E&P is not defined under the Internal Revenue Code). For example, Treasury Regulations Section 1.312-6 ties the initial computation of E&P to gross income when it provides that items “entering into the computation of corporate earnings and profits for a particular period are ... all items includible in gross income under section 61.” Further, such treatment dovetails with Code Section 312(f)(2). Distributions of a CFC are nontaxable to its domestic shareholder to the extent of income previously taxed under these Subpart F rules, and the tax basis of the domestic shareholder is similarly decreased (to offset the increase in basis that occurred when the income was taxable to the domestic shareholder). Code Section 312(f)(2) provides that a nontaxable distribution in which the tax basis of stock is decreased, does not increase the E&P of the distributee corporation. These general E&P rules work in the context of CFC ownership only if E&P increases as income is earned by the CFC.

Legal Advice Issued by Associate Chief Counsel 2015-001

Tuesday, February 24, 2015

Hollow Taxpayer Victory When IRS Unlawfully Discloses Taxpayer Information to Japan

By law, the U.S. is not permitted to disclose false return information, even if the release of false return information is authorized by law and treaty. Code Section 7431 imposes liability on the U.S. if it discloses return information, the information is false, and the U.S. knew the information was false.

A recent case addressed the application of this Code provision in regard to disclosure of return information by the U.S. to Japan. It makes for interesting reading – one doesn’t read too much about Code Section 7431.

In the case, the U.S. was found liable for violating Code Section 7431 when it made up figures for unreported income in preparing a Simultaneous Examination Proposal that sought to have a joint examination of taxpayers with Japan. The U.S. argued that the estimate was not “return information.”  It also argued that an estimate of unreported income cannot be false because it is only an estimate. The appeals court disagreed and found the U.S. violated the statute.

Code Section 7431(c) provides the damages for a violation. The taxpayers sought an award of $52 million in actual damages, consisting of $47 million in economic damages and $5 million in attorneys’ fees in a successful defense of Japanese tax assessments (although these damages included damages for other disclosures which were found not to violate Code Section 7431). Code Section 7431(c) does allow for actual and punitive damages. However, the appeals court was not convinced that the disclosure caused any damages to the taxpayer, since the taxpayers could not prove that “but for” the false information, Japan would not have otherwise audited the taxpayer. That is, the taxpayers did not meet their burden of proof that Japan would not have audited if they had not received this information – the court noted that there was other information that could have triggered the audit.

In the absence of actual or punitive damages, the statute provides for $1,000 per incident statutory damages. Finding three violations, the appellate court awarded $3,000 in damages. Thus, the taxpayers won their case for liability, but were unable to prove any material actual damages. The taxpayers surely did not pursue this matter solely for $3,000 in damages.

The taxpayers may still be able to get their attorneys fees paid – that issue has not yet been decided.

ALOE VERA INC v. U.S., 115 AFTR 2d 2015-XXXX, (DC AZ), 02/11/2015