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.
Revenue Scoring Rules Approved by the House
On January 6, the House approved H. Res. 5—a change to its rules that directs the Congressional Budget Office and the Joint Committee on Taxation to incorporate macroeconomic effects (e.g., changes in gross national product, employment, and capital stock) into revenue estimates of "major" tax legislation provided under the Congressional Budget Act of 1974.
In the past, Joint Committee on Taxation ("JCT") official estimates have taken into account behavioral changes associated with tax legislation, but have held GNP fixed.
House Rule XIII (adopted in 2003) also directs the JCT to prepare an analysis of the macroeconomic effects of tax legislation reported by the Ways and Means Committee, but that analysis is not part of the official revenue estimate.
When Rep. Dave Camp, then chair of the House Ways and Means Committee, released his tax reform proposal last year, he requested an alternate, non-official, estimate that considered the proposal's macroeconomic effects on revenues. The JCT analyzed the Camp proposal using different models that employed different assumptions about the deficit, monetary and fiscal policies, sensitivities of individual labor and savings choices and business decisions to changes in tax law, and other matters. Depending on the model and assumptions used, the JCT projected that the reform proposal would increase revenues relative to the conventional revenue estimate by as little as $50 billion to as much as $700 billion, over the 10-year budget period.
The new House resolution—H. Res. 5—goes one step further and requires the JCT to produce a "point" estimate of the revenue effect of major tax legislation that takes into account macroeconomic changes, as opposed to a range of possible results, and that estimate would be the official estimate of revenue.
It is thought that, to the extent the macroeconomic model employed by JCT shows increased growth and, consequently, more revenue raised than under conventional scoring rules, the use of such an estimate could change the dynamic and substance of tax reform by permitting greater revenue-neutral reductions in tax rates or allowing preservation of tax preferences.
The Senate has not yet considered a complementary rule.
Senate Finance Chair Addresses Tax Reform, Inversions
On January 23, Senate Finance Committee Chairman Orrin Hatch (R-UT) delivered a wide-ranging speech on the topics of international taxation, inversions, and tax reform.
In his speech presented at a Brookings Institution conference, Corporate Inversions and Tax Policy, Chairman Hatch reiterated his view that the best way to address the issue of inversions is business tax reform. He said:
The best solution to [inversions] is, in my view, tax reform. Tax reform, if it's done right, will help grow our economy, create jobs in the U.S. and discourage businesses from leaving our shores and invite businesses to set up and locate here. . . . I believe there is real momentum to get something done on tax reform this year, if we remain committed. And, believe me, I'm committed.
Hatch also discussed how tax reform, in his view, is to address the taxation of multinationals, expressing his preference for a territorial system:
For my part, I don't believe in a worldwide tax system. I believe we need to go a different direction when it comes to taxing international income and move from our worldwide-leaning international tax system more toward territoriality.
For the record, I'm no fan of inversions. . . . I see these inversions as symptomatic of a dysfunctional tax code that is taxing at too high a rate and is attempting to tax worldwide income.
We cannot be competitive with our current treatment of taxation of foreign-source business income and our current tax rates.
Finally, Hatch addressed his plans for pursuing tax reform this year. He committed to introduce his own tax reform bill, and to mark it up in the Senate Finance Committee this year.
Hatch previously stated, in a Finance Committee release, that he expects the various Senate Finance tax reform working groups to report their findings to the full committee by the end of May.
Proposed Regulations on Research Credit for Internal Use Computer Software Development
On January 16, the Treasury Department and IRS released a notice of proposed rulemaking (REG-153656-03) concerning the application of the research credit for computer software development for internal use purposes.
These regulations have been long-awaited. The IRS issued final regulations (T.D. 9104) on many aspects of the research credit at the end of 2003, but deferred addressing the rules dealing with internal use software.
Under section 41(d)(4)(E), no research credit is allowed for internal use software development except as provided by regulations. The IRS earlier issued several regulatory proposals on the subject, and assured taxpayers that a credit is allowed if the software development meets some additional requirements referred to as the "high threshold of innovation test."
There has been continuing controversy over the definition of internal use software and the precise application of this test. The IRS announced at the beginning of 2004 that work would continue on proposed regulations on this subject.
A hearing at the IRS on the proposed regulations has been scheduled for April 17, 2015. The proposed regulations, once finalized, will be prospective only, applicable in tax years ending on or after the date final regulations are published in the Federal Register. However, the IRS will not challenge return positions consistent with the proposed regulations for tax years ending on or after January 20, 2015.
Senate Bill to Repeal Medical Device Excise Tax
On January 13, the Senate Finance Committee announced that a bipartisan group of 10 Senators, led by Chairman Orrin Hatch (R-UT), introduced a bill that would repeal the medical device excise tax.
A provision of the Patient Protection and Affordable Care Act imposes an excise tax, at a rate of 2.3%, on sales by manufacturers and importers of certain medical devices. The medical device excise tax was effective in January 2013.
"Tax Extenders" Enacted
On December 19, Tax Increase Prevention Act of 2014 (the "Act") was signed into law by President Obama. The Act was passed by the House and the Senate on December 3 and December 17, respectively.
The Act retroactively extends most of the provisions that expired at the end of 2013 (or that expire during 2014)—the "tax extenders"—for one year, until the end of 2014. Therefore, Congress will have to address tax extenders in the next session.
In addition to addressing expired provisions, the bill would increase the threshold amount for refunds requiring Joint Committee on Taxation review and approval for C corporations from $2 million to $5 million.
The Act also includes measures allowing certain disabled individuals to set up section 529 savings accounts, as passed by the House as H.R. 647, the Achieving a Better Life Experience (ABLE) Act of 2014.
Congress Extends Internet Tax Freedom Act as Part of Omnibus Spending Bill
On December 15, Congress has passed the 1,603-page omnibus spending bill that includes a provision to extend the Internet Tax Freedom Act until October 1, 2015.
The Internet Tax Freedom Act—which prohibits state and local governments from levying taxes on internet access or discriminatory taxes on electronic commerce—was scheduled to sunset on November 1, 2014. Last month, as part of a joint resolution to continue funding the government, the provision was temporarily extended until December 11, 2014.
The provision was again extended by Congress. Then, the House and the Senate passed the omnibus spending bill that includes the most recent extension.
IRS Chief Counsel - Taxpayer Derives No DPGR from Computer Software "App" that Customers Download Free of Charge
On December 5, the IRS posted a memorandum that concludes that for purposes of section 199, a taxpayer does not derive any domestic production gross receipts ("DPGR") from the disposition of computer software that allows customers to download an application (App) free of charge when the App only allows customers to access the taxpayer's online fee-based services. AM2014-008 (release date December 5, 2014, and dated November 21, 2014)
The taxpayer (a bank) offers banking services to customers by a variety of means, including online banking which may be accessed when customers use the bank's App. The bank does not charge customers a fee to download or use its App, but customers may incur fees for receiving some banking services that are provided by the App (with the fees being equal to those that customers would incur for banking services received via the website).
The IRS memo concludes that: (1) the bank does not dispose of computer software when customers download the App; (2) the bank does not derive any gross income receipts from its App; and (3) this situation does not satisfy the self-comparable or third-party comparable exceptions under regulations.
The IRS found that even if the download of the taxpayer's App were a disposition, the gross receipts derived from it are entirely from the provision of online fee-based services—and not from a disposition of computer software.
Senate Finance Republican Staff's Report on Comprehensive Tax Reform
On December 11, the Senate Finance Committee released an over-300-page report—Comprehensive Tax Reform for 2015 and Beyond—prepared by the Finance Committee's Republican staff.
In a press release (transmitting text of the report), Senator Hatch (R-Utah) said that the:
…report is intended to provide background on where we are and where we have been with regard to our tax system as well as some possible direction on where our reform efforts should go in the near future.
The report addresses individual, business, and international issues and sets forth seven guiding principles for tax reform: (1) efficiency and economic growth, (2) fairness, (3) simplicity, (4) revenue neutrality, (5) permanence, (6) competitiveness, and (7) incentives for savings and investment.
The report observes, among many other things, that, because of pass-through entities, it is important that tax reform be approached "in a comprehensive manner, addressing both individual and corporate tax systems."
Tax Court - Motion to Quash IRS Trial Subpoena on Taxpayer's CEO is Granted
On December 10, the U.S. Tax Court granted Amazon.com, Inc.'s motion to quash a trial subpoena served by the IRS on its founder and CEO, Jeff Bezos. The case concerns deficiencies in the taxpayer's income for 2005 and 2006, under section 482, stemming from a cost sharing arrangement executed between the taxpayer and a Luxembourg affiliate (Amazon.com, Inc. v. Commissioner, T.C. Memo. 2014-245 (December 10, 2014)).
Initially, the CEO was not identified by the IRS as one of the fact witnesses that it would seek to depose. The IRS first identified the CEO as a potential witness in September 2014, and served a trial subpoena for testimony of the CEO.
The taxpayer filed a motion to quash the trial subpoena, asserting that causing the CEO to appear at trial would require a "significant commitment" of his time and would cause a "significant disruption of his management responsibilities" during the taxpayer's peak holiday season.
Following 17 days of trial testimony—including testimony of six members of the taxpayer's senior leadership team—the Tax Court granted the taxpayer's motion to quash the subpoena.
IRS to Open Tax Filing Season as Scheduled, in January 2015
On December 29, the IRS announced that it anticipates opening the 2015 filing season as scheduled, in January 2015.
According to the IRS release (IR-2014-119), with enactment of the extenders legislation earlier in December, the IRS stated that it will begin accepting tax returns electronically on January 20, 2015, with paper tax returns to begin processing at the same time.
Post-Election Leadership Changes in Tax Writing Committees
Republican control of the Senate in the next Congress will mean a leadership change in the Senate Finance Committee. Senator Orrin Hatch (R-UT) will become the Finance Committee chairman, replacing Senator Ron Wyden (D-OR). In the House, the chairman of the Ways and Means Committee, Dave Camp (R-MI), announced his retirement earlier this year. Reps. Paul Ryan (R-WI) and Kevin Brady (R-TX) both have stated their interest in becoming the new chairman and are seeking support of House Republicans for leadership of the committee.
California - Out-of-State Limited Partner's 0.2% Interest in Fund did not Trigger Nexus
A Fresno County superior court granted a taxpayer's motion for summary judgment, effectively determining that an Iowa corporation that owned a 0.2% non-managing interest in a fund was not "doing business" in California and was not subject to the $800 minimum tax on corporations. Swart Enterprises Inc. v. FTB, No. 13CECG02171 (Superior Court, Fresno County, November 14, 2014)
The taxpayer (an Iowa corporation) had no business activities or physical presence or other connection with California other than holding its interest in the fund. The Franchise Tax Board (FTB) asserted that an entity owning an interest in an limited liability company (LLC) operating in California is "actively engaging" in transactions "for financial or pecuniary gain or profit."
Although not binding, the superior court in Fresno County found the decision in Appeals of Amman & Schmid Finaz AG, (1996) 96-SBE-008, to be "very persuasive." In that decision, the State Board of Equalization (SBE) noted that limited partners were inactive participants in partnerships and, therefore, were not "actively engaging" in profit-seeking transactions. Further, as limited partners, the partners had no interest in specific limited partnership property; had no right to participate in partnership management; had no authority to bind the partnership; and were not liable for the obligations of the partnerships.
Similarly, in the present case, the court found that the taxpayer had no interest in specific property of the fund; was not personally liable for the fund's obligations; had no right to play a role in the fund's management; and could not act as an agent for the fund or bind it in any way. The Fresno superior court also noted that the taxpayer, as investor in the fund, had no power to exercise control the LLC. Because the taxpayer was not a founding member of the fund, the court determined that it could not be said that the taxpayer once had such control but relinquished it. And even if it had, the taxpayer had such a small ownership interest that it could not have influenced management decisions.
New Jersey: Tax Court Interprets Related Party Expense Disallowance Rule
The New Jersey Tax Court addressed the application of certain exceptions to New Jersey's related-party expense disallowance rules (Morgan Stanley & Co., Inc. v. Director, New Jersey Division of Taxation). Recall, under New Jersey law interest paid to a related party is generally required to be added back in determining New Jersey Corporation Business Tax. There are, however, certain exceptions to the general add back requirement. The taxpayer at issue originally filed returns adding back interest payments made to certain related parties. Later, the taxpayer filed an amended return claiming that it was not required to add back the interest payments at issue and requesting a refund of tax previously paid. The Division of Taxation recalculated the taxpayer's interest expense addback and assessed additional tax. The matter eventually came before the tax court.
In addressing whether the taxpayer was required to add back its interest expense, the tax court addressed two of the statutory exceptions. First, the subject to tax exception permits related-party interest expenses to be deducted to the extent the taxpayer establishes by clear and convincing evidence it meets certain requirements listed in the statute, including that the related member receiving the interest income is taxed by a state on net income at a rate that is "equal to or greater than a rate three percentage points less than the rate of tax applied to taxable interest" by New Jersey. The other exception at issue in this case was the "unreasonable" exception. This exception simply requires that the taxpayer establish by clear and convincing evidence that the disallowance of the deduction is unreasonable.
The tax court first addressed the taxpayer's argument that certain of the interest payments qualified for the subject to tax exception. Certain recipients of the interest were subject to tax in New York and were included on a New York combined report for the tax year at issue. However, the combined group ultimately paid minimum franchise tax, rather than tax on entire net income. The tax court held that it was clear that the measure of tax imposed on the combined group—a minimum tax— did not include the interest paid by the taxpayer. As such, the court concluded that the taxpayer did not qualify for the subject to tax exception.
The court next addressed whether the taxpayer qualified for the unreasonable exception for the interest paid to affiliates included in the New York return, as well as other affiliates not included in the New York return. Looking to the legislative history behind the enactment of the expense disallowance statute, as well as the statutory language, the court concluded that, contrary to the taxpayer's position, something more than a valid non-tax business purpose and economic substance must be demonstrated in proving the "unreasonableness" of the interest addback. According to the court, indicators that the unreasonable exception might apply would include, but is not limited to, unfair duplicative taxation, a technical failure to qualify the transactions under the statutory exceptions, an inability or impediment to meet the requirements due to legal or financial constraints, an unconstitutional result, or a demonstration that the transaction for all intents and purposes is an unrelated loan transaction.
Texas: Licensed Electronically Downloaded Software and Digital Images Created Physical Presence Nexus for Sales Tax Purposes
A Texas Administrative Law Judge (ALJ) concluded that a taxpayer had sales tax nexus with Texas by virtue of licensing software and digital images to Texas customers. The Utah-based taxpayer licensed digital content and computer software to customers throughout the U.S. All of the licensing agreements provided that the taxpayer retained all property rights to its products. After an audit, the Texas Business Activity Research Team concluded that the taxpayer should have been collecting sales tax on its licenses of software and content to Texas customers. The taxpayer contested the subsequent assessments, and the matter eventually went to the ALJ.
The ALJ noted the licensing agreements between the taxpayer and its customers specifically stated that the taxpayer retained all property rights in its products. In Texas, software (regardless of delivery method) is considered tangible personal property. In the ALJ's view, retaining property rights in the tangible personal property licensed to Texas customers created physical presence in the state.
Reach out to KPMG's U.S. Japanese Practice
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.