In this section of Jnet, we provide brief updates on regulatory developments in tax that may impact Japanese companies operating in the United States. Please contact your local KPMG representative with questions.
The U.S. Supreme Court denied certiorari in a taxpayer’s appeal from the First Circuit which held en banc that the taxpayer could not, in response to an IRS summons, withhold from production to the IRS its tax accrual workpapers under the work product doctrine. Textron Inc. v. United States, 09-750 cert. denied, (May 24, 2010).
The tussle over tax accrual workpapers between the taxpayer and the IRS began when the government issued a summons to the company for documents related to deemed tax shelter transactions. Textron refused to turn over its tax accrual workpapers, citing work product privilege. The IRS sued in court to obtain the documents.
A federal district judge held that the workpapers were protected from disclosure because the documents had been prepared in anticipation of litigation. The IRS appealed to the First Circuit, which originally agreed with the lower court. But a later en banc ruling by the circuit court overturned the prior decisions in the case, holding that work product privilege only extends to documents prepared for use in litigation, rather than documents created to comply with financial reporting rules.
Many legal observers considered the appeal by the taxpayer an ideal opportunity for the Supreme Court to resolve conflicting standards in the circuit courts for the application of work product protection to a company's legal analysis. Several notable advocacy groups filed amicus briefs with the Court urging the justices to grant the appeal, including the U.S. Chamber of Commerce, the Association of Corporate Counsel, and the American Bar Association.
The IRS released Notice 2010-46 which addresses the U.S. withholding tax imposed on substitute dividend payments received by foreign taxpayers that lend U.S. dividend paying securities in securities lending transactions. The notice:
- States that Treasury and the IRS intend to issue regulations to address potential over-withholding that may occur as a result of recently enacted section 871(l);
- Withdraws the formulary approach under Notice 97-66 and replaces it with a documentation-based system as enacted by the HIRE Act; and
- Provides transition relief with respect to substitute dividend payments made between the effective date of the HIRE Act and the issuance of the future regulations.
The U.S. Government Accountability Office (GAO) today released a report on compliance with U.S. tax laws by nonresident aliens (GAO-10-429, April 2010). The GAO report includes a suggestion that Congress consider raising the exemption threshold for income paid by a foreign employer (which has not been adjusted since the exemption was introduced in 1936) and eliminating the certificate of compliance (sailing permit) requirement which is difficult to enforce. The GAO also recommended that the IRS determine if creating an automated program to identify improper filing of Form 1040 by nonresident aliens would be a cost-effective means of improving compliance.
On May 6, IRS held a hearing on the proposed regulations requiring tax return preparers to obtain preparer tax identification numbers (PTINs). Under proposed regulations released in March 2010, all return preparers will be required to provide a PTIN on all tax returns and refund claims filed after December 31, 2010. The IRS expects that preparers subject to the new rules -- possibly 1.2 million of them -- will be able to begin registering for PTINs in September. Registration will include a user fee and possible tax compliance check. Subsequent renewals will occur every three years. Failure to provide the PTIN on returns filed beginning January 1, 2011, will result in a section 6695(c) penalty.
The hearing focused on who is subject to the new regulations. Almost all of the witnesses appearing at the hearing agreed that individuals who prepare returns for free should not be exempt from the new requirements. A representative from the American Institute of Certified Public Accountants pressed the government panelists to consider exempting nonsigning employees of CPA firms pointing out that CPA firms are monitored by their state boards and that the IRS can go to the signing preparer with questions about a return.
Several witnesses pressed the government to remove the Social Security number prerequisite for a PTIN because that would exclude many foreigners from tax preparation.
On May 27, the Treasury Department announced that representatives of the United States and 16 other countries (not including Japan) signed a Protocol to the Convention on Mutual Administrative Assistance on Tax Matters, as it was jointly opened for signature by the Organization for Economic Cooperation and Development (OECD) and the Council of Europe. The Protocol will bring the existing treaty into conformity with current international standards for the exchange of information for tax purposes between national revenue authorities by providing:
- For the full exchange of information on request in tax matters without regard to a domestic tax interest requirement or bank secrecy laws;
- Updated rules regarding the confidentiality and permitted uses of exchanged information as well as the level of detail that countries must provide when making a request for information; and
- That countries not members of the OECD or of the Council of Europe to become parties to the treaty, subject to unanimous consent by the existing parties.
As June 1 was the deadline for submitting public comments on the draft Schedule UTP on which the IRS plans to require large corporations to report uncertain tax positions, numerous comments letters were submitted to the IRS asking the IRS to abandon the plan and/or reconsider the approach. The letters were submitted by the AICPA, ABA, state CPA societies and state bar associations, major accounting firms including all Big 4 firms, prominent law firms, and various industry groups.
However, IRS Chief Counsel William J. Wilkins said during his speech that the IRS does not anticipate releasing a second draft of the proposal for additional comment. In fact, the IRS is close to becoming publicly silent on the UTP proposal so that it can focus on determining the final form, he said.
Mr. Wilkins also acknowledged that the IRS may eliminate the requirement to list positions not reserved due to administrative practice or expectation to litigate as many practitioner comments pointed out that such requirements are unnecessary and violate privilege standards.
In United States v. Quality Stores, Inc. (In re Quality Stores, Inc., 2010 U.S. Dist. LEXIS 15825, 2010-1 U.S.T.C. ¶50,250, (W.D. Mich. 2010), a federal district court found that severance payments are not wages for purposes of FICA taxation, and upheld a Bankruptcy Court’s decision on a refund of the overpayment of FICA tax for the debtors of a company in bankruptcy. In light of the Quality Stores holding, many taxpayers filed protective refund claims for FICA taxes paid with regard to involuntary severance payments.
Despite the IRS’s general policy of allowing protective claims to remain in suspense pending an Appeals court decision, the IRS began issuing notices of disallowance in response to these protective claims. The IRS’s notice of disallowance provides taxpayers 30 days to file a protest with the Office of Appeals.
Michael Danilack, deputy commissioner (international) in the IRS Large and Midsize Business Division, and Rosemary Sereti, acting director of IRS Large and Midsize Business Division field operations for Manhattan, said during their speech that multinational withholding is one area where the IRS is getting tougher on enforcement. They said the IRS became aware of multinational corporations outside of the financial services industry that were improperly handling payments of interest, royalties, personal service fees, and rent to foreign persons as the IRS conducted the Voluntary Compliance Program to encourage taxpayers to come forward with failure to comply with the withholding tax requirements to mitigate penalties. They indicated that the IRS would continue to push for better compliance from such companies.
At another conference, Stuart Mann, operations manager (foreign payments) in the IRS Large and Midsize Business Division, also said that the IRS will be more aggressive in asserting penalties for routine administrative noncompliance with foreign withholding rules.
The Treasury Department and IRS issued final regulations (T.D. 9487) concerning limitation on use of losses due to an ownership change under section 382 by adopting the proposed regulations issued in 2007 (which cross-referenced to the temporary regulations) with no substantive change. The regulations provide that
prepaid income received in the period before the change date but included in gross income in the recognition period cannot be treated as recognized built-in gain that can increase the section 382 limitation to use pre-ownership change losses.
The IRS also issued two notices concerning section 382.
Notice 2010-49 reports that the IRS and Treasury Department are considering modifying the regulations under section 382 regarding the operation of the rules relating to “small shareholders” (those that are not 5% shareholders). IRS seeks comments until September 9, 2010.
Notice 2010-50 provides guidance as to how fluctuations in value among multiple classes of stock are to be reflected in calculating section 382 owner shifts. The Notice approves several "reasonable" methods that taxpayers have been using in practice.
The U.S. Court of Appeals for the D.C. Circuit vacated and remanded a case concerning documents prepared by a company’s independent auditor in connection with ongoing tax litigation between the taxpayer and the government (United States v. Deloitte LLP, No. 09-5171 (D.C. Cir. June 29, 2010)).
The federal district court issued an order denying the government’s motion to compel the taxpayer’s independent auditor to produce three documents in connection with ongoing tax litigation. The documents included one draft memorandum prepared by the auditor and two documents prepared by attorneys and disclosed to the auditor.
On appeal, the government contended that (1) the draft memorandum prepared by the auditor was not work product because it was prepared during the audit process and was not attorney work product; and (2) while the other two documents were attorney work product, the taxpayer had waived work-product protection when it disclosed them to the auditor.
The D.C. Circuit rejected the government’s arguments that the draft memorandum prepared by the auditor cannot be work product because a document can contain protected work-product material even though it serves multiple purposes so long as the protected material was prepared because of the prospect of litigation. However, in remanding, the appeals court concluded that the district court lacked sufficient information to determine that the entire draft memorandum was work product. With respect to the other two documents, the D.C. Circuit affirmed the district court’s decision that the taxpayer had not waived work-product protection when it disclosed them to the auditor.
On July 20, the Joint Committee on Taxation (JCT) released a report—Present Law and Background Related to Possible Income Shifting and Transfer Pricing (JCX-37-10, July 20, 2010)—which includes a background discussion of business restructuring, a description of past and present law relevant to the studies, and six case studies of US-based multinational corporations and how their business structure interacts with US tax law to determine the corporations’ US tax liability. Some of the studies indicate that multinational enterprises (both U.S. and foreign based) may be able to shift income to low-tax jurisdictions, which may suggest deficiencies in the application of transfer pricing rules.
On July 22, the House Ways and Means Committee held a hearing on the issue. Some of the hearing witnesses advocated moving to a formulary apportionment method as an alternative to the arm's-length standard. However, Stephen Shay, Treasury deputy assistant secretary for international tax affairs, said that adopting formulary apportionment without significant international consensus "poses important problems and difficulties," because the arm's-length standard is "virtually universal in its application."
The IRS issued Notice 2010-51 which requests comments concerning guidance to be provided under new rules requiring the reporting of payments made to corporations by every person engaged in a trade or business. A provision in the health care reform legislation enacted earlier this year expanded information reporting requirements for certain payments including payments made to corporations which have been previously exempt. The new reporting requirements apply to payments made beginning in 2012.
Shortly after the Notice was issued, various interested parties started sending comments to the IRS expressing concerns about the expected heavy burden to comply with the new requirement especially on small businesses. Comments are due by September 29, 2010.
The U.S. District Court for the Southern District of Ohio (Western Division) ruled on the creditability of withholding taxes paid by Procter and Gamble (P&G) to Japan and Korea (Procter & Gamble Co. v. U.S., S.D. Ohio, No. 1:08-cv-00608).
During the years at issue, P&G’s wholly-owned subsidiary, P&G Northeast Asia (P&G NEA), paid royalties to P&G with respect to the sales made in Japan and Korea. P&G NEA withheld and paid a 10% Japanese withholding tax under the old U.S.-Japan Income Tax Treaty on the full amount of royalties paid. P&G claimed a foreign tax credit for the Japanese withholding tax.
The Korean National Tax Service later determined that the royalties attributable to Korean sales were subject to Korean withholding tax. P&G then received an opinion from a Korean law firm that any challenge against the assessment would unlikely be successful. As P&G claimed a foreign tax credit for the additional Korean tax, the IRS disallowed the claim because P&G did not exhaust all effective and practical remedies available in Korea.
The court concluded that the additional Korean tax was creditable because obtaining an opinion from a local law firm was sufficient to satisfy the exhaustion of administrative remedies requirement. However, the court denied the credit for the Japanese withholding tax paid on the portion of the royalties taxed by Korea because P&G did not pursue remedies to attempt to reduce the Japanese tax liability.
The IRS issued an action on decision acquiescing in the result, but not the reasoning, of the Ninth Circuit’s decision in the Xilinx case (Xilinx, Inc. v. Commissioner, Nos. 06-74246, 06-74269 (9th Cir. March 22, 2010)) concerning qualified cost-sharing arrangement (CSA) transactions governed by the regulations in effect prior to their amendment in 2003 (IRB No. 2010-33). The Ninth Circuit in March 2010 held that costs associated with stock-based compensation are not required to be shared by taxpayers in cost sharing arrangements under the pre-2004 regulations. According to the action on decision, although the IRS believes the Ninth Circuit’s opinion is erroneous, the IRS acquiesces in the result only for these CSA transactions because the significance of the Ninth Circuit’s opinion is mooted by the 2003 amendments made to Reg. sections 1.482-1(b)(1) and 1.482-7(d).
The IRS has issued proposed regulations (REG-139343-08) implementing a new user fee for individuals who apply for or renew a preparer tax identification number (PTIN), which will be required for all returns and refund claims filed after December 31, 2010. The regulations implement a nonrefundable $50 user fee for all PTIN registrants to cover the government's costs in administering the PTIN application process. The third-party vendor administering the PTIN registration system will also be able to charge a reasonable fee in addition to the government's user fee.
National Taxpayer Advocate Nina Olson released her midyear report to Congress on July 22 expressing concerns about the IRS’s declining budget for taxpayer services. The report cites recurring taxpayer service issues, including decline in telephone inquiry response rate and slow processing of stimulus payments and new tax credits, and points out that inflation-adjusted spending for taxpayer services in the fiscal year 2011 is expected to decline by approximately 6.8 percent as compared to the fiscal year 2004 although enforcement spending is expected to increase by 17.9 percent during the same period. The report also predicts that those spending disparities will continue into the fiscal year 2013 as the administration's budget proposals project service funding would decrease by 7.2 percent from the fiscal year 2011 to the fiscal year 2013 although enforcement spending would increase by 13.7 percent over that same period.
A state aid bill, which includes a $10 billion (over 10 years) package of international provisions as revenue offsets, was approved by the Congress and signed into law by President Obama on August 10. The foreign tax credit changes account for most of the revenue. The provisions will generally be effective either for tax years beginning after the date of enactment or tax years beginning after December 31, 2010
The provisions include:
- Rules to suspend foreign tax credits while the income to which they relate remains offshore and untaxed in the U.S. The new rules target the situation where, for example: 1) a US corporation wholly owns a foreign subsidiary (FS1) which in turn wholly owns another foreign subsidiary (FS2) in the same country; 2) FS1 is disregarded but FS2 is treated as a corporation for US tax purposes; 3) FS1 is treated as a corporation but FS2 is treated as a disregarded entity for local tax purposes; and 4) the US corporation only picks up FS1’s income (but not FS2’s income) and claims foreign tax credits for the taxes paid by FS1 on income of both FS1 and FS2.
- Denial of foreign tax credits where foreign source income for US tax purposes is reduced as a result of a basis step up which is not available under the local tax laws. The rule applies to 1) a stock acquisition treated as an asset acquisition for US tax purposes by a section 338 election; 2) an acquisition of a foreign entity that is treated as a corporation for local tax purposes but is disregarded for US tax purposes; or 3) an acquisition of interests in a partnership with a section 754 election in effect.
- Requirement to maintain separate foreign tax credit limitation baskets for items of income that would be US source under the domestic law but would be treated as foreign source under an income tax treaty.
- Limitation on the amount of foreign taxes deemed paid with respect to deemed distributions to US shareholders of a controlled foreign corporation (CFC) due to the CFC's investment of earnings in US property.
- Limitation on application of section 304 to cause foreign-to-foreign deemed distribution bypassing a US intermediary corporation.
- Modification of affiliation rules for purposes of rules allocating interest expense.
- Termination of the “80/20 company rules” exempting withholding tax on interest and dividends paid by US corporations that generate at least 80% of their gross income from active foreign businesses.
- Technical correction to clarify that, with respect to returns filed before March 19, 2010, the extension of statute of limitations for failure to disclose certain foreign transactions only applies to the item or items related to the failure, rather than the entire return, if the failure was due to reasonable cause and not willful neglect.
The IRS released Notice 2010-60 which provides preliminary guidance on the foreign account tax compliance provisions of the Hiring Incentives to Restore Employment Act of 2010 (also known as Foreign Account Tax Compliance Act or “FATCA”) enacted in March 2010. After December 31, 2012, these provisions expand the information reporting requirements imposed on foreign financial institutions with respect to certain U.S. accounts and impose withholding, documentation, and reporting requirements with respect to certain payments made to the foreign financial institutions and certain other foreign entities.
The preliminary guidance provided by Notice 2010-60 regarding priority issues include:
- The scope of exemption from the withholding requirement;
- The definition of a foreign financial institution;
- The scope of collection of information and identification of persons by financial institutions;
- The information that foreign financial institutions must report to the IRS pursuant to an agreement with the IRS with respect to their US accounts;
Notice 2010-60 states that Treasury and the IRS intend to issue proposed regulations incorporating the guidance provided in the release and to address other matters. In future guidance, Treasury and the IRS intend to publish a draft Foreign Financial Institution (FFI) Agreement and draft information reporting and certification forms. Treasury and the IRS are requesting comments on the issues addressed in Notice 2010-60 and the priority of other issues to be addressed in future guidance. Comments are due November 1, 2010.
The IRS released IR-2010-88 announcing the realignment of the Large and Mid-Size Business (LMSB) division to allow for an enhanced focus on international tax compliance. Beginning October 1, 2010, the IRS’s new division will be known as the Large Business and International (LB&I) division.
According to the IRS release, the new LB&I division will create a more centralized organization dedicated to improving international tax compliance including transfer pricing. The IRS says that the new LB&I division will add about 875 employees to the existing staff of nearly 600. Most of the additional examiners, economists, and technical staff are current employees who specialize on international issues within other parts of the IRS. The new LB&I division will continue to serve the same taxpayers currently served by the LMSB division—corporations, S corporations and partnerships with assets greater than $10 million as well as certain high wealth individuals.
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