Joint Committee on Taxation releases description of revenue provisions in President's FY2011 budget proposal

On August 16, Joint Committee on Taxation released its "Description Of Revenue Provisions Contained In The President’s Fiscal Year 2011 Budget Proposal" which is available at http://bit.ly/b6WD70.

The full document runs 521 pages, here's the outline.

Notes:

• Some of the proposed items have already been enacted (e.g., several of the items under "Reform U.S. International Tax System" were part of H.R. 1586 discussed at http://tax-fishing-and-other.blogspot.com/2010/08/hr-1586-signed-into-law-today.html).

• These are the President's revenue (i.e., tax) proposals, not current law (nor necessarily even pending legislation).  Nevertheless, they do provide some insight into the Administration's views and *may* ultimately find their way into future legislation.

I.             INDEX THE INDIVIDUAL ALTERNATIVE MINIMUM TAX AMOUNTS FOR INFLATION

II.            MAKE PERMANENT AND MODIFY CERTAIN TAX CUTS ENACTED IN 2001 AND 2003

A.            Dividends and Capital Gains Tax Rate Structure

B.            Extend Temporary Increase in Expensing for Small Business

C.            Marginal Individual Income Tax Rate Reductions

D.            Child Tax Credit

E.            Increase of Refundable Portion of the Child Credit

F.            Marriage Penalty Relief and Earned Income Tax Credit Simplification

G.           Education Incentives

H.            Modify and Make Permanent the Estate, Gift, and Generation Skipping Transfer Taxes After 2009

I.             Other Incentives for Families and Children (includes extension of the adoption tax credit, employer-provided child care tax credit, and dependent care tax credit)

J.             Reinstate the Overall Limitation on Itemized Deductions and the Personal Exemption Phase-out

III.           TEMPORARY RECOVERY MEASURES

A.            Extend the Making Work Pay Credit for One Year

B.            Provide $250 Economic Recovery Payment and Special Tax Credit

C.            Extend COBRA Health Insurance Premium Assistance

D.            Provide Additional Tax Credits for Investment in Qualified Property Used in a Qualifying Advanced Energy Manufacturing Project

E.            Extend Temporary Bonus Depreciation for Certain Property

F.            Extend Option for Cash Assistance to States in Lieu of Low-Income Housing Tax Credit for 2010

IV.          TAX CUTS FOR FAMILIES AND INDIVIDUALS

A.            Increase in the Earned Income Tax Credit

B.            Expand the Child and Dependent Care Tax Credit

C.            Automatic Enrollment in Individual Retirement Arrangements

D.            Saver’s Credit

E.            Extend American Opportunity Tax Credit

V.            TAX CUTS FOR BUSINESSES

A.            Increase Exclusion of Gain on Sale of Qualified Small Business Stock

B.            Make the Research Credit Permanent

C.            Remove Cell Phones from Listed Property

VI.          OTHER REVENUE CHANGES AND LOOPHOLE CLOSERS

A.            Reform Treatment of Financial Institutions and Products

1.            Impose a financial crisis responsibility fee

2.            Require accrual of the time-value element on forward sale of corporate stock

3.            Require ordinary treatment for dealer activities with respect to section 1256 contract

4.            Modify the definition of control for purposes of the section 249 deduction limitation

B.            Reinstate Superfund Excise Taxes and Corporate Environmental Income Tax

C.            Permanent Extension of Federal Unemployment Surtax

D.            Repeal Last-In, First-Out Inventory Accounting Method

E.            Repeal Gain Limitation on Dividends Received in Reorganization Exchanges

F.            Reform U.S.       International Tax System

1.            Defer deduction of interest expense related to deferred income

2.            Determine the foreign tax credit on a pooling basis

3.            Prevent splitting of foreign income and foreign taxes

4.            Tax currently excess returns associated with transfers of intangibles offshore

5.            Limit shifting of income through intangible property transfers

6.            Disallow the deduction for excess nontaxed reinsurance premiums paid to affiliates

7.            Limit earnings stripping by expatriated entities

8.            Repeal 80/20 company rules

9.            Prevent the avoidance of dividend withholding taxes

10.          Modify the tax rules for dual capacity taxpayers

G.           Combat Under-Reporting of Income on Accounts and Entities in Offshore Jurisdictions

1.            Require reporting of certain transfers of assets to or from foreign financial accounts

2.            Require third-party information reporting regarding the transfer of assets to or from foreign financial accounts and the establishment of foreign financial accounts

H.            Reform Treatment of Insurance Companies and Products

1.            Modify rules that apply to sales of life insurance contracts

2.            Modify dividends received deduction for life insurance company separate accounts

3.            Expand pro rata interest expense disallowance for company-owned life insurance (“COLI”)

4.            Permit partial annuitization of a nonqualified annuity contract

I.             Eliminate Fossil Fuel Tax Preferences

J.             Treat Income of Partners for Performing Services as Ordinary Income

K.            Modify the Cellulosic Biofuel Producer Credit

L.             Eliminate Advance Earned Income Tax Credit

M.          Deny Deduction for Punitive Damages

N.           Repeal the Lower-of-Cost-or-Market Inventory Accounting Method

O.           Reduce the Tax Gap and Make Reforms

1.            Require information reporting on payments to corporations

2.            Require information reporting for rental property expense payments

3.            Require information reporting for private separate accounts

4.            Require a certified taxpayer identification number from contractors and allow certain withholding

5.            Increased information reporting for certain government payments for property and services

6.            Increase information return penalties

7.            Require e-filing by certain large organizations

8.            Implement standards clarifying when employee leasing companies can be held liable for their clients’ Federal employment taxes

9.            Increase certainty with respect to worker classification

10.          Codify economic substance doctrine

11.          Allow assessment of criminal restitution as tax

12.          Revise offer-in-compromise application rules

13.          Allow Internal Revenue Service expanded access to information in the National Directory of New Hires

14.          Make repeated willful failure to file a tax return a felony

15.          Facilitate tax compliance with local jurisdictions

16.          Extension of statute of limitations where state tax adjustment affects Federal tax liability

17.          Improve investigative disclosure statute

18.          Clarify that the bad check penalty applies to electronic checks and other payment forms

19.          Impose a penalty on failure to comply with electronic filing of returns

20.          Require consistency in value for transfer and income tax purposes

21.          Modify rules on transfer tax valuation discounts

22.          Require minimum term for grantor retained annuity trusts (“GRATs”)

VII.         UPPER-INCOME TAX PROVISIONS

A.            Limit the Tax Rate at Which Itemized Deductions Reduce Tax Liability

VIII.        SUPPORT CAPITAL INVESTMENT IN THE INLAND WATERWAYS

IX.           OTHER INITIATIVES

A.            Extend and Modify the New Markets Tax Credit

B.            Reform and Extend Build America Bonds

C.            Restructure Transportation Infrastructure Assistance to New York City

D.            Implement Unemployment Insurance Integrity Legislation

E.            Authorize Post-Levy Due Process

F.            Increase Levy Authority to 100 Percent for Vendor Payments

G.           Allow Offset of Federal Income Tax Refunds to Collect Delinquent State Income Taxes for Out-of-State Residents

HR 1586 signed into law today - Say hello to some revenue raisers re international taxes

Don't let HR 1586's title(s) ("FAA Air Transportation Modernization and Safety Improvement Act," "Education Jobs and Medicaid Assistance Act," and several others) fool you.  It's chock-full of revenue raisers (i.e., tax increases) mostly in the area of international tax.

Further information (and explanations) will follow, but here are the key revenue offsets and corresponding effective dates:

• Rules to Prevent Splitting Foreign Tax Credits from the Income to Which They Relate - Effective with respect to foreign income taxes paid or accrued by U.S. taxpayers and section 902 corporations in taxable years beginning after December 31, 2010.
• Denial of Foreign Tax Credit with Respect to Foreign Income Not Subject to U.S. Taxation by Reason of Covered Asset Acquisitions - Effective for covered asset acquisitions after December 31, 2010.
• Separate Application of Foreign Tax Credit Limitation, etc., to Items Resourced Under Treaties - Effective for taxable years beginning after the date of enactment (i.e., August 10, 2010).
• Limitation on the Amount of Foreign Taxes Deemed Paid with Respect to Section 956 Inclusions - Effective for acquisitions of United States property after December 31, 2010.
• Special Rule with Respect to Certain Redemptions by Foreign Subsidiaries - Effective for acquisitions after the date of enactment.(i.e., August 10, 2010).
• Modification of Affiliation Rules for Purposes of Rules Allocating Interest Expense - Effective for taxable years beginning after the date of enactment (i.e., August 10, 2010).
• Termination of Special Rules for Interest and Dividends Received from Persons Meeting the 80-Percent Foreign Business Requirements - Effective for taxable years beginning after December 31, 2010.
• Limitation on Extension of Statute of Limitations for Failure to Notify Secretary of Certain Foreign Transfers - Effective for returns filed after March 18, 2010.
• Elimination of Advance Refundability of Earned Income Tax Credit - Effective for taxable years beginning after December 31, 2010.

Source data:

• HR 1586 on Thomas (part of the Library of Congress):  http://bit.ly/ciHQse
• Joint Committee on Taxation's writeup:  http://bit.ly/cEZ5MN

The Passive Foreign Investment Company (“PFIC”) Provisions – A Quick Q&A

(or “Just when you thought you were safe because your foreign corporation isn’t a CFC…”)

Background – There seems (understandably) to be a fair amount of confusion on how to treat PFICs, whether directly owned by US taxpayers or by entities (e.g., partnerships) in which they have an ownership interest.  The purpose of this Q&A is to clarify some of the questions and provide guidance for further research if needed.  This is not meant to be an exhaustive discussion of the PFIC rules, but simply a starting point.  If you have further questions, please ask someone with experience in this area (e.g., me!).

1.            What is a PFIC and why is that classification relevant?

A PFIC (short for Passive Foreign Investment Company) is a foreign corporation that meets either an asset test (at least 50% of the foreign corporation’s assets either actually produce, or are held to produce, passive income) or an income test (at least 75% of the foreign corporation’s gross income is passive income).  PFICs are subject to special rules meant to limit a US taxpayer’s benefit from deferring income earned by the PFIC (e.g., section 1291, which imposes an interest charge on “excess distributions”).

Passive income in this context is any income treated as “foreign personal holding company income” under section 954(c).  This generally (but with exceptions) includes dividends, interest, royalties, rents, annuities, net gains on property that give rise to the aforementioned items, certain net commodity transaction gains, certain net foreign currency gains, income equivalent to interest and dividends, certain net derivative gains, and certain personal service contracts that can be fulfilled by others.

While there are a number of exceptions to these general rules, they are beyond the scope of this Q&A.  For further information, please start with sections 1291 through 1298.

2.            What is a QEF and why is it relevant?

A QEF (short for Qualified Electing Fund) is a PFIC for which the US shareholders (whether direct or indirect) have elected under section 1295 to recognize their proportionate share of the PFIC’s current earnings and profits (as ordinary earnings and net long-term capital gain, as the case may be).  Please see below for further information.

In addition, a QEF election (if made for the year in which the electing US shareholder first held the PFIC’s stock) will generally prevent the application of the otherwise-required anti-deferral rules (e.g., section 1291).

3.            How is a PFIC’s US shareholder taxed if the PFIC does not have a QEF election in place?

If no QEF election was made, the US shareholder will generally be taxed as follows:

·         Income/gains earned by the PFIC – No impact.

·         Deductions/losses incurred by the PFIC – No impact.

·         Distributions by the PFIC:

o    Distributions by the PFIC will be treated as dividends to the extent of the US shareholder’s share of the PFIC’s E&P (short for “Earnings & Profits”), with any excess applied first against stock basis (until zero) and then to capital gain.

o    In addition, “excess distributions” are subjected to the interest charge rules of section 1291 (as well as a historical lookback/grossup re the taxes that would have been paid, using the highest applicable ordinary income rates for those years).  This requires the US shareholder to track taxable distributions for the preceding 3 years and if the current year distributions exceed 125% of that 3-year average, the excess is considered an “excess distribution.”

Note:  If the US shareholder held the stock for less than 3 years, they use the average for that shorter preceding period.  In addition, there can be no excess distributions in the 1^st year in which the US shareholder held the PFIC’s stock.

Note: All distributions “in respect of stock” of the PFIC are included for purposes of determining excess distributions, even if those amounts would otherwise have been nontaxable to the US shareholder (e.g., distributions in excess of the PFIC’s E&P which would otherwise have been treated as returns of capital).

·         Gain on disposition of the PFIC stock by the US shareholder – Treated as an excess distribution in its entirety, which includes taxation at ordinary income rates.

·         Loss on disposition of the PFIC stock by the US shareholder – Treated as a capital loss.

4.            How is a PFIC’s US shareholder taxed if the PFIC has a QEF election in place?

If a QEF election was made, the US shareholder will generally be taxed as follows (but see also the comment below regarding situations in which the US shareholder doesn’t make the QEF election with respect to a particular PFIC in the 1st year of stockholding):

·         Income/gains earned by the PFIC – Included in income and an increase to basis in PFIC stock.

o    Ordinary income – As ordinary income, the US shareholder's pro rata share of the ordinary earnings of the QEF for such year.

o    Capital gain – As long-term capital gain, the US shareholder's pro rata share of the net capital gain of the QEF for such year.

·         Deductions/losses incurred by the PFIC – No impact.

·         Distributions by the PFIC:

o    Distributions of previously recognized/taxed income – Excluded from income, but reduces basis in PFIC stock.

o    Distributions of current-year recognized/taxed income – Excluded from income, but reduces basis in PFIC stock.

o    Distributions in excess of cumulatively recognized/taxed income – Reduces basis in PFIC stock as a return of capital; amounts in excess of basis are capital gains.

·         Gain on disposition of the PFIC stock by the US shareholder – Treated as a capital gain (long or short as the facts dictate).

·         Loss on disposition of the PFIC stock by the US shareholder – Treated as a capital loss.

5.            What if the PFIC is also a CFC (a Controlled Foreign Corporation)?

A CFC is defined under section 957(a) and is a foreign corporation controlled (more than 50%) by US shareholders that each own at least 10% of the foreign corporation.

If a PFIC is also a CFC, section 1297(d)(1) generally treats the foreign corporation as not being a PFIC during the “qualified portion” of such shareholder’s holding period with respect to stock in that corporation.  The “qualified portion” means the portion of the shareholder’s holding period which is after 12/31/97, and during which the shareholder is a “United States shareholder” (i.e., owns at least 10% of the foreign corporation) and the foreign corporation is a CFC.

Caveat:  Just because a CFC isn’t generally subject to the PFIC rules doesn’t mean there aren’t issues to deal with.  There are, but they are beyond the scope of this Q&A.

6.            Who makes the QEF election, and when/how is it made?

The QEF election may only be made by the first US person (including a domestic partnership, S corporation, or estate) that is a direct or indirect shareholder of the PFIC.  For example, if a US individual (“USI”) is a partner in a US partnership (“USP”), which is a partner in a foreign partnership (“FP”), which is a shareholder in a PFIC, the QEF election could only be made by the US partnership (“USP”).

A US shareholder generally must make a QEF election by the due date (including extensions) for filing the US shareholder’s federal income tax return for the first year to which the election is desired to apply.  The election will then apply to that (and all subsequent) years of that foreign corporation.  The election is made by completing the applicable parts of Form 8621 (instructions here) and attaching it to the US shareholder’s timely-filed federal income tax return.

7.            Is the QEF election required to be made in the first year the US shareholder owns the PFIC stock?

No.  However, if the US shareholder does not make the election in the 1^st year of holding the stock, it will be subject to both the section 1291 rules and the QEF rules.

8.            If the US shareholder doesn’t make the QEF election with respect to a particular PFIC in the 1^st year of stockholding, how can they avoid the section 1291 rules?

There are several ways to do so, including (but not limited to) the following:

·         Deemed sale election – The US shareholder may prospectively treat the PFIC as if it had been a QEF from the 1^st year in which they held stock (i.e., a “pedigreed PFIC”) by electing under section 1291(d)(2)(A) to recognize gain on the sale of that PFIC’s stock on the first day of the year for its fair market value (with the gain, if any, treated as an excess distribution for section 1291 purposes).  Caveat:  The US shareholder must meet 3 tests to qualify for this election:

o    The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986,

o    The US shareholder holds stock in that PFIC on the first day of such taxable year, and

o    The US shareholder establishes to the IRS’s satisfaction the fair market value of such stock on such first day.

·         Deemed dividend election – The US shareholder may prospectively treat the PFIC as if it had been a QEF from the 1^st year in which they held stock (i.e., a “pedigreed PFIC”) by electing under section 1291(d)(2)(B) to include in gross income as a dividend an amount equal to the portion of the post-1986 earnings and profits of such company attributable to the stock in the PFIC. This amount will be treated as an excess distribution.  Note/Caveat:  The US shareholder must meet 3 tests to qualify for this election, but this election is generally relevant to less-than-10% US shareholders due to the elimination of the CFC/PFIC overlap (as noted above) in 1997.

o    The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986,

o    The US shareholder holds stock in that PFIC on the first day of such taxable year, and

o    The PFIC is a CFC.

·         Retroactive election – The US shareholder may retroactively treat the PFIC as if it had been a QEF from the 1^st year in which they held stock (i.e., a “pedigreed PFIC”) by electing under Treas. Reg. section 1.1295-3(b) if they:

o    Reasonably believed that as of the election due date the foreign corporation was not a PFIC for its taxable year that ended during the retroactive election year;

o    Filed a Protective Statement with respect to the PFIC, applicable to the retroactive election year, in which the shareholder described the basis for their reasonable belief and extended the periods of limitations on the assessment of PFIC-related taxes for all taxable years of the shareholder to which the Protective Statement applies; and

o    Complied with any other terms and conditions of the Protective Statement.

9.            Do dividends from a PFIC qualify for the federal 15% capital gains tax rate (whether or not a QEF election has been made)?

No.  Section 1(h)(11)(C)(iii) specifically excludes dividends from a PFIC from the special beneficial rate.

10.         Does California conform to these rules?

No.  As a result, you will often see differences in both income recognized (as well as differences in stock basis) between federal and California.  California taxes distributions from a PFIC when made to the US shareholder.