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 or Makoto Nomoto, Partner, Tax, at email@example.com or 212 872 2190 with questions.
On October 2, a California appeals court issued its second opinion for the taxpayer, concerning an election to apportion income to California using the Multistate Tax Compact's evenly weighted three-factor (Gillette Co. v. Franchise Tax Board, A130803 (Cal Ct. App. October 2, 2012)).
Previously, the state appeals court held in favor of the taxpayer on July 24, 2012, but on its own motion, vacated that decision on August 8, 2012.
In the new opinion, the court concluded that a taxpayer could apportion its income to California using the Multistate Tax Compact's evenly weighted three-factor formula, despite statutory language mandating the use of a three-factor double-weighted sales formula for general corporations because California is bound by the Compact and its apportionment election provision throughout the years at issue as California had not repealed the implementing statutory provisions or withdrawn from the Compact during the timeframe.
The reissued opinion was nearly identical to the original decision issued in July, differing primarily in that the second opinion noted that California legislation (Senate Bill 1015, signed June 27, 2012) repealing the Multistate Tax Compact had been passed subsequent to oral argument in this case.
Following the decision, the Franchise Tax Board (FTB) issued guidance on October 5, 2012.
As the election to use the evenly weighted three-factor formula is valid only when made on timely filed original returns but not on amended returns according to the FTB's view, calendar year taxpayers had to decide whether they should make the election on the 2011 returns due October 15, 2012 based on the decision issued on October 2. They were concerned that California's 20% "substantial understatement" penalty may apply to taxpayers with an understatement of tax greater than $1 million or 20% of the tax if the decision is subsequently modified or reversed by the California Supreme Court. Note that the substantial understatement penalty is not subject to waiver or abatement for "reasonable cause."
Under California's court rules, the reissued opinion will not be final for a 30-day period. As such, taxpayers making the compact election on returns filed on or before October 15, 2012, would be relying on a judicial decision that is not yet finalized. In guidance issued on October 5, the FTB announced that because the court opinion is not yet final, taxpayers that make the compact election on an October 15 return "run the risk of incurring" the substantial understatement penalty if the decision is later modified by the California Supreme Court.
Also, according to the October 5 notice, if the decision is not reversed by the California Supreme Court, the FTB plans to raise additional defenses to refund claim including that the election was invalid because it was not made on an originally filed return. Regardless, the FTB issued Notice 2012-01 which addresses how taxpayers are to file protective refund claims. The FTB indicated that it will take no action on the protective claims until all the legal issues in Gillette are resolved.
The IRS released Announcement 2012-42 which provides timelines for withholding agents and foreign financial institutions (FFIs) to complete due diligence and other requirements under the Foreign Account Tax Compliance Act ("FATCA"). The announcement reflects comments about "practical issues" that FFIs could encounter in implementing the FATCA rules within the time frames prescribed in the proposed regulations issued in February 2012.
The announcement, in part:
- Provides a timeline that withholding agents including participating FFIs and registered- deemed compliant FFIs generally will be required to implement new account opening procedures by January 1, 2014;
- Modifies the definition of the term "preexisting obligation";
- Provides transition rules for completing due diligence on preexisting obligations;
- Provides that a participating FFI will be required to file the information reports with respect to the 2013 and 2014 calendar years not later than March 31, 2015;
- Clarifies definitions of the terms "withholdable payment" and "grandfathered obligations"; and
- Expands applicability of the grandfathered obligations rules.
The announcement states that the IRS and Treasury Department intend to incorporate these rules in final regulations.
The California Franchise Tax Board (FTB) issued a Chief Counsel Ruling addressing when throwback is required with respect to foreign sales for tax years beginning on or after January 1, 2011. Under California's throwback rule, sales of tangible personal property are required to be "thrown back" to California for apportionment purposes if shipped from California and the taxpayer is not "subject to tax" in the destination jurisdiction. In analyzing whether a taxpayer is "subject to tax" in a foreign (non-US) country, California's regulations provide that it is necessary to look at whether the taxpayer's activity in the foreign jurisdiction would be sufficient to give rise to jurisdiction under the US domestic rules without regard to tax treaties.
For tax years beginning on or after January 1, 2011, California applies new "economic nexus" standards. In general, the FTB will consider a corporation to have California corporate income/franchise tax nexus if it has more than $500,000 in California sales, $50,000 in California property, or $50,000 in California payroll. The taxpayer at issue made sales of tangible personal property into several foreign countries. Applying California's economic nexus standards to the taxpayer's activities in the foreign countries, the FTB determined that the taxpayer would be considered taxable for throwback rule purposes in the foreign jurisdictions where it had over $500,000 of sales.
On October 29, the IRS posted an IRS Chief Counsel Advice memorandum that addresses when a Form W-8 (Certificate of Foreign Status) signed with a handwritten signature and electronically transmitted to a withholding agent (for example, as a PDF or facsimile) may be relied upon by the withholding agent (AM2012-008). The memorandum states that an electronically submitted Form W-8 would meet the electronic submission requirements of the regulations if the withholding agent performs certain due diligence and satisfied certain conditions described in the memorandum.
On September 7, the U.S. Court of Appeals for the Sixth Circuit affirmed a federal district court decision that severance payments are not wages for purposes of the Federal Insurance Contributions Act (FICA) tax (In re Quality Stores, Inc., No. 10-1563 (6th Cir. September 7, 2012)).
The company laid off approximately 75 employees prior to the bankruptcy and terminated all remaining employees after filing a Chapter 11 petition. Severance payments made pursuant to the company's severance plan were reported as wages on Forms W-2. The company withheld federal income tax and FICA taxes from the severance payments but sought a refund of approximately $1 million for the FICA taxes paid with regard to the severance payments during the bankruptcy proceedings. The bankruptcy court ordered a full refund, holding that the severance payments constituted supplemental unemployment compensation benefits (SUB payments) that are not taxable as wages under FICA. The federal district court affirmed the decision of the bankruptcy court.
The Sixth Circuit affirmed, and concluded that the payments made to the employees qualified as SUB payments and, therefore, are not subject to FICA tax (although the payments are still a treated as income to the employee) by noting that:
…Congress has provided that a SUB payment is: (1) an amount paid to an employee; (2) pursuant to an employer's plan; (3) because of an employee's involuntary separation from employment, whether temporary or permanent; (4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and (5) included in the employee's gross income.
The decision is contrary to the Federal Circuit's decision in CSX Corp. v. United States which characterized severance payments as "dismissal pay" subject to FICA tax.
On September 14, the Treasury Department released proposed regulations [REG-138367-06] to modify the standards that govern written tax advice provided by individuals who are admitted to practice before the IRS.
To accommodate practitioner concerns regarding the written advice standards, Treasury and the IRS propose to significantly revise Circular 230 by deleting the written advice standards that are currently incorporated in §10.35. If finalized, the regulations would eliminate the current requirements for practitioners to fully describe the relevant facts (including the factual and legal assumptions relied upon) and the application of the law to the facts in the written advice itself. The regulations would also end the need to incorporate what are referred to as "Circular 230 covered opinion disclaimers" in documents and transmissions, including e-mails.
On September 7, the U.S. Court of Appeals for the Second Circuit affirmed a decision of the Tax Court denying the taxpayer a research credit for supplies used in improvements to production process (Union Carbide Corp. v. Commissioner, No. 11- 2552 (2d Cir. September 7, 2012)).
During the 1994 and 1995 tax-credit years, the taxpayer conducted numerous research projects at its production plants, dealing with ways to improve the production process, rather than the products produced. The taxpayer claimed the costs of these projects as qualified costs for research credit purposes.
The research credit statute, and regulations, provide that the costs eligible for the research credit include "any amount paid or incurred for supplies used in the conduct of qualified research." The regulations include an additional statement that expenditures for supplies that are "indirect research expenditures" do not qualify, but do not further explain the difference between a direct and an indirect expenditure.
The taxpayer requested a research credit not just for the additional costs of supplies associated with the research, but also for the costs of all supplies used in the production runs during which research was conducted. The IRS argued that no research credit is to be allowed for supplies that would have been used regardless of any research performed.
The Tax Court in March 2009 held that the taxpayer was not entitled to research credits for the entire amount spent for the supplies, but was entitled to a credit for only those additional supplies that were used to perform the research.
The Second Circuit agreed with the Tax Court that the costs at issue were, at best, "indirect research costs." The appeals court acknowledged that the regulations do not clearly resolve how to distinguish between expenses that are indirect costs and expenses that are direct costs. However, the court concluded that it would defer to the IRS's position that such supplies are indirect costs if they would have been used in the course of the taxpayer's manufacturing process regardless of any research performed. The Second Circuit found the IRS position was reasonable, prudent, and consistent with the legislative history and congressional purpose of the research credit.
On September 20, the Senate permanent investigations subcommittee released documents related to a hearing examining U.S.-based multinationals' shifting of profits offshore through provisions of the Internal Revenue Code and accounting rules.
The subcommittee called witnesses from the IRS, Financial Accounting Standards Board, multinational corporations, and an accounting firm and released an 81-page document of the subcommittee's investigation, which states:
Current weaknesses in the tax code's transfer pricing regulations and Subpart F, and in accounting standard APB 23 relating to deferred tax liabilities on permanently or indefinitely invested foreign earnings, encourage and facilitate the shifting of intellectual property and profits offshore by multinational corporations headquartered in the United States.
The subcommittee posted other documents and testimony on its website.
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