Tax Update

Tax Update

In this section of Jnet, we provide brief updates on legislative, judicial, and administrative developments in tax that may impact Japanese companies operating in the United States.

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January 2014

Guidance for Accounting Method Changes under the Final Repair Regulations

On January 24, the IRS issued Rev. Proc. 2014-16 that describes the procedural rules that taxpayers must follow to change a method of accounting to comply with the final "repair regulations." The final repair regulations are effective for tax years beginning on or after January 1, 2014.

The revenue procedure modifies the procedures for obtaining the automatic consent of the Commissioner for certain changes in methods of accounting for amounts paid to acquire, produce, or improve tangible property. It also provides procedures for obtaining automatic consent to change to (1) a reasonable method for self-constructed assets, and (2) a permissible method for certain costs related to real property acquired through a foreclosure or similar transaction.

It does not address method changes under the proposed disposition regulations. Those procedures are expected to be released in the near future.

LB&I Directive - No Challenge to Treatment of Certain "Milestone Payments" Paid to Investment Bank

On January 27, the IRS Large Business and International (LB&I) division issued a directive stating that if certain requirements are satisfied, the LB&I examiner is not to challenge a taxpayer's treatment of eligible "milestone payments" made as part of certain business acquisitions and for which the taxpayer incurs a success-based fee paid to an investment bank (LB&I-04-0114-001). The LB&I directive applies only with respect to investment banker fees incurred by either an acquiring corporation or a target corporation.

The LB&I directive explains that Rev. Proc. 2011-29 provides a safe harbor for allocating success-based fees paid or incurred for certain transactions generally allowing a taxpayer to treat 70% of such fee as a deductible amount with the remaining 30% of the fee to be capitalized. Rev. Proc. 2011-29, however, does not provide a safe harbor for "milestone payments."

Under the LB&I directive, examiners are instructed not to challenge a taxpayer's treatment of eligible milestone payments if the taxpayer 1) have not deducted more than 70% of any eligible milestone payment, 2) is not contesting its liability for the eligible milestone payment, and satisfies one of the following:

  • For tax years ended on or after April 8, 2011, the taxpayer timely elects the Rev. 
    Proc. 2011-29 safe harbor for the covered transaction;
  • If a taxpayer is unable to elect the Rev. Proc. 2011-29 safe harbor because the taxpayer makes eligible milestone payments prior to the year in which the success-based fee would be paid, taxpayer documents its intention to elect the safe harbor and in fact makes the safe harbor election upon  successful closing of the transaction; 
  • For tax years ended before April 8, 2011, the taxpayer's return position meets the requirements of LB&I Directive 04-0511-012 with regard to success-based fees paid or incurred.

Texas - Decision to Broaden Scope of Qualifying Expenses for COGS Deduction

A Texas state appeals court held that a subsidiary of an integrated oilfield services company was entitled to a cost of goods sold (COGS) deduction for costs associated with removing and disposing of drilling mud waste (Combs v. Newpark Resources, No. 03-12-00515-CV).

Under Texas franchise tax law, taxable "margin" is the lesser of:

  • 70% of total revenue, or
  • Total revenue minus either (1) cost of goods sold (COGS) or (2) compensation and benefits

The COGS statute allows a company to deduct "all direct costs of acquiring or producing goods," and up to 4% of other "indirect or administrative overhead costs." Generally, only entities that own and sell real or tangible personal property can elect to deduct COGS, and an election to deduct COGS applies to the combined group as a whole.

In this case, the parent company's primary business activity involved the manufacture, sale, injection, and removal of drilling mud which is injected into an oil well hole as it is being drilled, to cool and lubricate the drill, as well as to facilitate the removal of rock, soil, and other waste material from the hole. Several subsidiaries were involved in its drilling-mud operations—including one that claimed the disputed COGS expenses (that subsidiary removed nonhazardous waste materials from drilling sites, transported the waste to underground disposal sites, and injected the waste into the sites for permanent disposal).

On audit, the Comptroller disallowed the deduction on the basis that the disposal and removal of drilling waste was a service that did not qualify for as COGS for Texas franchise tax purposes. The trial court held in favor of the taxpayer. The Comptroller filed an appeal.

On appeal, the central issue was whether the subsidiary was entitled to a COGS deduction for its labor and materials associated with the waste removal services.

The Comptroller appeared to argue that the subsidiary must be viewed in isolation to determine the eligibility of its expenses as COGS. Thus, because the subsidiary did not own or sell goods, it was not entitled to deduct its labor and materials as COGS. In contrast, the taxpayer argued that the Comptroller must look at the overall combined group's business to determine whether the expenses of each group member were eligible to be deducted as COGS.

After analyzing a number of statutory provisions illustrating that a combined group must be viewed as a whole, the appeals court concluded that it would be inconsistent to: …consider a combined group as a single taxable entity, require each member to take the same general deduction, but nevertheless treat each member as an isolated entity for purposes of determining eligibility to take the cost-of-goods-sold deduction.

December 2013

Senate Bill to Extend Expired Tax Provisions

On December 19, Senate Majority Leader Harry Reid (D-Nev.) introduced a bill (S. 1859) to extend 57 tax relief provisions (the "extenders") expiring on December 31, 2013. However, Congress failed to act on it before adjourning in 2013. It is unclear when Congress will address the expired provisions in 2014.

Among the 57 provisions previously identified in a JCT report issued on January 11, 2013 that expired at the end of 2013 are the following items:

  • The research and experimentation tax credit
  • Exemptions under subpart F for active financing income
  • Look-through treatment of payments between related controlled foreign corporations (CFCs) under the foreign personal holding company rules
  • 15-year straight line depreciation for qualified leasehold, retail, and restaurant improvements
  • Additional first-year "50% bonus" depreciation
  • Increased expensing of property under section 179
  • A variety of energy-related provisions and biofuel incentives
  • The work opportunity tax credit
  • Parity of tax treatment of employer-provided parking and mass transit benefits
  • Deduction for state and local sales taxes

Finance Committee Staff Discussion Draft of Energy Tax Incentive Reforms

On December 18, the Senate Finance Committee released a "staff discussion draft" of proposals concerning reform of energy tax incentives.

Under current law, there are 42 different energy tax incentives—including a dozen preferences for fossil fuels, 10 different incentives for renewable fuels and alternative vehicles, and six different credits for clean electricity. Of the 42 different energy incentives, 25 are temporary and expire every year or two years. The credits for clean electricity alone have been adjusted 14 times since 1978. According to the Finance Committee release, if Congress continues to extend current incentives, they will cost nearly $150 billion over 10 years.

The Finance Committee staff discussion draft proposes a smaller number of targeted and simple energy incentives that would be intended to be flexible enough to accommodate advances among fuels and technologies of any type—whether renewable, fossil, or anything in between. The proposals are intended to promote domestic energy production and reduce pollution. Specifically, the discussion draft offers proposals to:

  • Establish a new, technology-neutral tax credit for the domestic production of clean electricity
  • Establish a new, technology-neutral tax credit for the domestic production of clean transportation fuel
  • Consolidate almost all of the existing energy tax incentives into these two new credits, with appropriate transition relief
  • Provide businesses and investors with greater certainty by making the new incentives long enough to be effective, but phasing them out once clearly defined goals have been met

The package of reforms draws heavily from proposals offered by both Republican and Democratic members of the Senate Finance Committee.

Proposed Regulations on Treatment of Research Credit Among Controlled Group Members

On December 12, the Treasury Department and IRS released proposed regulations (REG-159420-04) concerning the calculation of the research credit for a controlled group that includes one or more foreign corporations that derive foreign-source gross receipts.

The traditional method of computing the research credit allows a taxpayer a credit equal to 20% of its qualified research expenses (QREs) for the tax year in excess of a base amount. The base amount is determined in part by reference to average gross receipts in earlier tax years. The larger those average gross receipts are, generally a smaller amount of the QREs will be allowed the 20% credit.

All members of a controlled group of taxpayers—corporations, partnerships, trusts, estates, and sole proprietors—must compute the credit as if they are a single taxpayer, and allocate the group credit among them. Regulations provide that, because of the single-taxpayer group computation, transactions between members of the group are generally disregarded. A provision in the Code says that a foreign corporation, in computing its research credit, is to count only gross receipts that are effectively connected with the conduct of a trade or business in the United States, Puerto Rico, or a U.S. possession.

In 2006, IRS examiners took the position in published guidance that a U.S. taxpayer that is in a controlled group with a more-than-50% owned controlled foreign corporation (CFC) is not to exclude gross receipts from sales to the CFC. The 2006 guidance did not limit this position to situations in which the CFC had gross receipts from non-U.S. third party sales of the same property or services. In 2010, a federal district court held that the IRS could not enforce this position, and that the law allows a controlled group to exclude all intragroup gross receipts in computing its research credit (Procter & Gamble Company v. United States, 733 F.Supp.2d 857 (S.D. Ohio 2010)). Following that decision, the IRS stopped enforcing the 2006 position. However, the IRS and Treasury turned to work on developing regulations addressing the issue.

The proposed regulations would require a controlled group to count the gross receipts from an intragroup sale of tangible or intangible property, or of services, if there is a foreign corporation in the controlled group that sells that same property or services to a third party in a transaction that is not effectively connected with the conduct of a trade or business in the United States, Puerto Rico, or a U.S. possession.

For example, if a U.S. parent receives gross receipts from selling goods to its foreign corporate subsidiary, and the subsidiary sells those goods to a third party in a sale that is not effectively connected with the conduct of a trade or business within the United States, Puerto Rico, or a U.S. possession, the foreign subsidiary does not recognize any gross receipts from the sale, but the U.S. parent would not be able to exclude the gross receipts from its sale to the foreign subsidiary.

The preamble to the proposed regulations explains that the IRS and Treasury believe that a complete exclusion of gross receipts in that situation distorts the base amount, and thus distorts the amount of credit that Congress intended to be allowed.

Comments concerning the proposed regulations must be received by March 13, 2014. A public hearing on the proposed regulations is scheduled for April 23, 2014.

November 2013

Proposed Procedures for Competent Authority Assistance and APAs

On November 22, the IRS released two notices (Notice 2013-78 and Notice 2013-79) containing "draft" revenue procedures with respect to competent authority (CA) assistance and advance pricing agreements (APAs).

These draft revenue procedures represent substantial changes from the current revenue procedures that were issued in 2006. These changes reflect a desire by the IRS to enhance integration between Competent Authority matters and APAs and to increase transparency and efficiency in these processes. These draft revenue procedures are out for comments, which are due by March 10, 2014.

The proposed revision of procedures for Competent Authority (CA) assistance under tax treaties (contained in Notice 2013-78):

  • Clarifies that CA issues may arise as a result of taxpayer-initiated positions
  • Makes clear that the offices of the U.S. CA are available for informal consultations on CA-related issues
  • States that U.S. CA may seek to initiate a mutual agreement procedure (MAP) case in the absence of a MAP request or may require that the scope of a MAP case be expanded
  • Provides new pre-filing procedures applicable to MAP cases, including mandatory submission of a pre-filing memorandum depending on the nature of the issues or the adjustment amount involved
  • Provides a revised listing of the standard specifications for the content of a request for CA assistance in various types of cases
  • Elaborates on potential interactions of requests for CA assistance, accelerated competent authority process (ACAP) and APAs

 The proposed revision of procedures for APAs (contained in Notice 2013-79):

  • Provides expanded pre-filing procedures, including mandatory submission of a pre-filing memorandum in cases raising certain issues
  • Provides for a new filing deadline for bilateral and multilateral APA requests
  • Provides a revised listing of the specifications for the content of APA requests
  • Clarifies that a complete APA request (updated and supplemented as required) will be a factor in determining whether the taxpayer has met the documentation requirements of Reg. section 1.6662-6(d)(2)(iii) for the proposed APA years
  • Describes new general practices that will be followed after an APA request has been filed with respect to, among other things, issuing case plans, conducting due diligence, and conveying its views on APA requests to the taxpayer
  • Increased coordination between requests for APAs, requests for CA assistance and ACAP including procedures for filing an abbreviated APA request in certain circumstances
  • Provides that there may be coordination with applicable IRS offices to pursue an APA rollback to any or all of the taxpayer's open pre-APA years, regardless of whether the taxpayer requests an APA rollback
  • Provides that a taxpayer may seek permission to submit an abbreviated APA request in cases involving renewals of current APAs

Senate Finance Discussion Draft of International Tax Reform Proposals

On November 19, Senator Max Baucus (D-MT) released a discussion draft outlining possible reforms to the international tax provisions of the Internal Revenue Code. The draft envisions two possible approaches, Option Y and Option Z, each of which would represent a substantial change in how the United States taxes international operations of US- based corporate groups through controlled foreign corporations (CFCs).

  • Option Y: Under current law, income earned by CFCs is generally not subject to US tax until distributed to US shareholder unless it is characterized as a form of "subpart F income." Option Y keeps subpart F income subject to immediate US taxation but exempts other income of CFCs when earned or distributed. However, Option Y significantly modifies the definition of subpart F income to include income subject to a foreign tax rate of less than a specified rate (tentatively set at 80% of the US corporate tax rate) as well as income generated with respect to services rendered to US persons or property imported into the United States. Moreover, the exemption would only be available to 10 percent corporate US shareholders.
  • Option Z: Option Z requires the immediate inclusion of all income of a CFC by its US shareholders. Option Z allows exclusion of a portion (tentatively set at 40 percent) of "active foreign market income" in computing the amount included in the US shareholder's taxable income.
  • Foreign Tax Credits (FTCs): FTCs remain available under each option. Under Option Y, no FTC would be available with respect to distributions qualify for complete exemption. Under Option Z, FTCs attributable to "active foreign market income" would be reduced to reflect the partial exclusion.
  • Interest Expense: Both options would apportion a fraction of a US shareholder's interest expense to exempt income of its CFCs (i.e., the wholly exempt income under Option Y or the partially excluded "active foreign market income under Option Z) and would permanently disallow such amounts.
  • Transition Rules: Under both options, accumulated deferred earnings of a CFC as of the effective date would be includible by its corporate US shareholders and subject to a 20 percent tax, payable in installments over eight years.
  • Intangibles: Definition of intangible property in the international context would include going concern value and goodwill as well as any item whose value is not attributable to tangible property or the services of an individual.
  • Base Erosion Transactions: The draft includes a complex provision designed to prevent reduction of the US tax base.
  •  Check-the-Box Rule: All business entities wholly owned within a group of CFCs would be treated as corporations, effectively repealing the "check-the-box" rules for foreign entities belonging to a single group.
  • Others: The draft proposes changes with respect to portfolio debt exemption, PFICs, FIRPTA, sourcing of income from inventory sales, sales of interests in partnerships engaged in a US trade or business, reinsurance transactions with foreign affiliates.

LB&I Directive - IRS Enforcement Process When Taxpayers Do Not Comply with IDRs

On November 4, the IRS Large Business and International (LB&I) division posted an LB&I directive setting forth a new, more stringent enforcement process when taxpayers do not timely comply with information document requests (IDRs) or do not provide complete responses to an IDR by the response date (LB&I-04-1113-009). The LB&I directive is effective January 2, 2014, but a transition rule will apply.

The LB&I directive provides that the three-step IDR enforcement process of issuing a delinquency notice, a pre-summons letter, and a summons is mandatory. LB&I managers are encouraged to be actively involved early in the IDR process. All IRS exam teams are directed to discuss with taxpayers currently under examination the new requirements no later than December 15, 2013.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and do not necessarily represent the views or professional advice of KPMG.

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