INTEREST RATES FOR TAX OVERPAYMENTS AND UNDERPAYMENTS (JULY 2009 QUARTER)

The IRS has announced the interest rates for tax overpayments and underpayments for the calendar quarter beginning July 1, 2009.

For noncorporate taxpayers, the rate for both underpayments and overpayments will be 4% (unchanged).

For corporations, the overpayment rate will be 3% (unchanged). Corporations will receive 1.5% (unchanged) for overpayments exceeding $10,000. The underpayment rate for corporations will be 4% (unchanged), but will be 6% (unchanged) for large corporate underpayments.

Rev. Rul. 2009-17

IRS PREVAILS IN COST SHARING CONTROVERSY

The 9th Circuit Court of Appeals reversed the Tax Court in an interesting case involving issues of Section 482 cost sharing, precepts of regulatory interpretation, and penalties.

The Section 482 cost sharing issue related to the question whether compensation expenses of a U.S. participant in a cost sharing arrangement relating to stock options can be allocated exclusively to the U.S. participant (thus fully reducing taxable income of the U.S. participant), or whether the Section 482 cost sharing regulations required that such compensation expenses are “costs” that had to be allocated in part to the (non-U.S.) cost sharing participant. This became an issue because two Treasury Regulations under Section 482 conflicted with each other.

The conflict was between the general Section 482 regulation that only costs that are normally shared between unrelated parties are subject to Section 482 adjustment, and a specific regulation relating to cost sharing that said that all costs had to be shared to be respected under Section 482. The Tax Court had found that stock option costs are not typically costs that are shared between unrelated parties in a cost sharing arrangement, and thus the general rule in the regulations precluded the stock option costs from being reallocated in part away from the U.S. participant under Section 482 .

The appellate court gave more weight to the specific cost sharing regulation, and less to the general statement of Section 482 principles. It based this weighting on the statutory and regulatory interpretative rule that a provision that is specific takes precedence over a more general provision. The appellate court also rejected as not applicable the principle that ambiguities in the tax law should be interpreted against the government.

The appellate decision is not as relevant to Section 482 cost sharing law as it might appear, since the IRS had already revised its Regulations to require the same result that the appellate court eventually reached. It made this change after it had lost in the Tax Court. Since Section 482 is a very short Code provision, with the meat on its bones being provided by extensive Regulations, the IRS has a fairly free hand to write the Regulations in any reasonable manner (unlike other areas of the Code where it may be more constrained by Code language) and thus set clear law for future tax years and taxpayers regardless of how the appellate court resolved the current case.

One area where the new Regulations might still be challenged is if a different interpretation of cost sharing arises in a treaty context. However, the appellate court opinion will likely constrain such challenges, since a treaty was involved in the case and the court did not feel it constrained them in its decision. Further, it noted that even if the treaty language did mandate a different result, the typical provision of a treaty that provides that it will not impact the taxation of taxpayer by its own taxing jurisdiction will act to negate the application of the treaty provision when it relates to U.S. taxpayers.

The one ray of sunshine for the taxpayer in the case related to the government seeking to impose accuracy related penalties on the taxpayer for not having allocated the stock option costs in part to the other participant. The appellate court noted that the Tax Court found for the taxpayer, and that the Treasury Department felt compelled to rewrite the Regulations to avoid the above conflict. As such, the court questioned whether the taxpayer should be subject to penalty when both the Tax Court and the IRS noted the uncertainty of the Regulations, and remanded the case for further action in regard to the imposition of penalties.

Xilinx, Inc. v Commissioner of Internal Revenue, 9th Circuit Court of Appeals, Case No. 06-74246 & –74269, May 27, 2009

EXTREME CARE NEEDED WHEN USING QUALIFIED INTERMEDIARIES IN SECTION 1031 EXCHANGES

Section 1031 of the Internal Revenue Code allows taxpayers to exchange real property and other types of property for property of “like-kind.” Since it is rare to find a buyer and seller with two properties that each is willing to exchange directly to the other, the Code allows for a deferred exchange where the seller sells his property, with the proceeds being used to buy a replacement property from a third party within certain time limits. As part of this exchange process, the seller cannot take into his or her own possession the sale proceeds from the sale of his property. One method of conducting such exchanges while keeping the sale proceeds out of the hands of the seller is to use a facilitator, or “qualified intermediary” (QI).  The QI usually takes title to the property from the seller, sells the property, holds the sale proceeds, and then acquires the replacement property which it exchanges back to the original seller.

The QI business is big business, with many millions of dollars of cash and properties passing through the hands of the QI’s each year. Like any business, a QI can fail and go under. What happens to the funds the QI is holding that are in the middle of an exchange if the QI goes into bankruptcy?

For customers of Landamerica, they are learning the hard way that their funds may be lost. Landamerica’s Section 1031 customers had $420 million with Landamerica that were in the middle of their swaps when the company went into bankrutpcy. The 450 customers claimed that their cash was held either in escrow or in trust, so they should be able to get all of their money back. The bankruptcy trustee argued that since no true escrow or trust was established to hold the funds, the customers are merely general, unsecured creditors of Landamerica. This means that they will be paid only after the secured creditors of the company are paid, and then only pro rata with all other unsecured creditors of the company.

In a ruling last year as to “segregated accounts,” and a ruling earlier this month as to other Section 1031 accounts, the Bankruptcy Court held that the funds of the customers were not held in trust or escrow, and that the customers are mere unsecured creditors. Therefore, it is unlikely that the customers will be made whole on their swap funds.

To make matters worse for these unfortunate customers, their swap funds were invested in auction-rate securities, which are difficult to value and may be substantially impaired in today’s poor credit market. Further, as time goes on, the attorney fees relating to the bankruptcy continue to further deplete the funds available for repayment to creditors.

The real tragedy here is that with proper structuring, as noted by the Bankruptcy Court itself, it should have been possible to both avoid these bankruptcy problems and still obtain Section 1031 deferred gain treatment. Further, contractual limitations could have been used to assure that the funds were invested in more conservative cash investments.

In re Landamerica Financial Group, Inc., 2009 WL 1269578
Bkrtcy.E.D.Va., May 07, 2009