Income tax treatment of foreign currency option gains

Here's an article I wrote (with minor edits to add endnotes) for the November 2009 edition of the AICPA Tax Section's The Tax Adviser (specifically, the Tax Clinic).  I hope you find it useful.

As many practitioners already know, Sec. 988 treats most (but not all) gains and losses from foreign currency transactions as ordinary in character. 

Depending on the taxpayer’s circumstances, this treatment can be favorable or otherwise.

While the full range of exceptions to this rule are beyond the scope of this article, there is one in particular that may be of particular interest to investors.

For this example, let’s say that individual U.S. “Investor” holds substantial foreign stocks (e.g., on the London Stock Exchange) denominated in foreign currency (e.g., UK pounds or “GBP”).  Further, let’s say that Investor is concerned about possible fluctuations in the USD/GBP exchange rate, and so decides to manage that risk by purchasing a foreign currency option as follows directly from a U.S. investment bank:

• European[i]-style GBP put/USD call, with “non-deliverable” settlement[ii]
• Not exchange-traded (or subject to the rules of an exchange)[iii]
• Call currency amount:   USD 650,000
• Put currency amount:    GBP 345,000
• Strike price:           1.8841 USD/GBP
• Reference currency:     GBP
• Settlement currency:    USD
• Trade date:             January 2, 200X
• Valuation date:         December 1, 200X
• Premium:                USD 15,000

In this example, this means that Investor pays USD 15,000 for the right to receive (in cash) the net value of the excess of the USD amount over the GBP amount on the valuation date.  If there is no net positive excess, no additional money changes hands.

More specifically, if on the valuation date the spot exchange rate is 1.6 USD/GBP (i.e., the value of the USD has increased compared to the GBP), then Investor would be entitled to receive USD 650,000 - (GBP 345,000 x 1.6 USD/GBP) = USD 98,000.  After consideration of the option premium, Investor’s net profit would be USD 83,000.  Query:  Should this profit be characterized as ordinary income, or capital gain?  And if the latter, what is the holding period?  While the answer might seem clear at the outset, getting there is somewhat circuitous and may also require specific action on Investor’s part in the form of an election by the end of the trade date.

1)      Section 988

a)      In general

In general, Sec. 988 treats foreign currency gains/losses attributable to a “section 988 transaction” as ordinary income/loss.  Moreover, by its express terms, Sec. 988 overrides any other contrary provisions under Chapter 1 of the Internal Revenue Code (sections 1 through 1400U-3, dealing with Normal Taxes and Surtaxes).  However, exceptions do apply.

In determining whether a particular arrangement is covered by this rule, Sec. 988(c)(1) treats as a “section 988 transaction” any specified transaction (e.g., any forward contract, futures contract, option, or similar financial instrument) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of such transaction is determined by reference to the value of 1 or more nonfunctional currencies.  Since the option in this example meets those criteria, it would appear (so far) to constitute a “section 988 transaction” and presumably give rise to ordinary income.

b)     Interplay with Sec. 1256

Next, we need to consider Sec. 988(c)(1)(D), which provides that the acquisition of any forward contract, futures contract, option, or similar financial instrument is not a “section 988 transaction” if it represents a regulated futures contract or nonequity option which would be marked to market under Sec. 1256  if held on the last day of the taxable year.

Under Sec. 1256(g)(1), a “regulated futures contract” is a contract with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and which is traded on or subject to the rules of a qualified board or exchange.  In our example, the option is clearly not a “regulated futures contract” since there were no amounts required to be deposited or able to be withdrawn.

Under Sec. 1256(g)(3), a “nonequity option” includes any listed option which is not an equity option.  Sec. 1256(g)(5), in turn, provides that a “listed option” is one which is traded on (or subject to the rules of) a qualified board or exchange.  Sec. 1256(g)(7) further provides that the term “qualified board or exchange” means (1) an SEC-registered national securities exchange, (2) a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or (3) any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of Sec. 1256. 

While this statutory language is less definitive than some might like, the IRS has provided guidance in identifying certain entities as qualified boards of exchange for purposes of Sec. 1256.[iv]  Nevertheless, in our example, the foreign currency option was not traded on (or subject to the rules of) an exchange of any sort.  Consequently, the option should not constitute a nonequity option.

As a result, the option should not be excluded from consideration as a “section 988 transaction” by Sec. 988(c)(1)(D).  Therefore, it would continue to appear (so far) to constitute a “section 988 transaction” and presumably give rise to ordinary income/loss.

c)      Election to treat as capital gain/loss

Having established the option as a “section 988 transaction,” one of the exceptions to ordinary income/loss treatment is found in Sec. 988(a)(1)(B), which permits taxpayers to elect to treat gains/losses on certain foreign currency arrangements as capital in nature.

This exception provides that (unless prohibited in the regulations), inter alia, a taxpayer may elect to treat any foreign currency gain or loss attributable to an option which is a capital asset in the hands of the taxpayer and which is not a part of a straddle as capital gain or loss if the taxpayer makes an election and identifies the transaction before the close of the day on which such transaction is entered into (or earlier as the Secretary may prescribe).

i)        Capital asset characterization

In relevant part, Sec. 1221(a) provides the definition of a “capital asset” as property held by a taxpayer, but excludes:

• Any commodities derivative financial instrument held by a commodities derivatives dealer,
• Any hedging transaction which is clearly identified as such before the close of the day on which it was entered into (or such other time as the Secretary may by regulations prescribe).

With respect to the first item, Investor is not a “commodities derivatives dealer” because he is not a person that regularly offers to enter into, assume, offset, assign, or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business.  Sec. 1221(b)(1)(A).

As for the second item, the option is not a “hedging transaction” because it was not a transaction entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily (i) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer, (ii) to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer, or (iii) to manage such other risks as the Secretary may prescribe in regulations.  Sec. 1221(b)(2).

Accordingly, since the option does not meet any of the exceptions in Sec. 1221(a), it is a capital asset and eligible for the aforementioned election.

ii)      Mechanics of election

Regs. Sec. 1.988-3(b) addresses the requirements of making the Sec. 988(a)(1)(B) capital gain/loss election.  The requirements for that election are as follows:

• The taxpayer makes the election by clearly identifying such transaction on his books and records on the date the transaction is entered into. While no specific language or account is necessary for identifying a transaction referred to in the preceding sentence, the method of identification must be consistently applied and must clearly identify the particular transaction subject to the election.
• The taxpayer must provide verification of the election by attaching a statement to his income tax return that set forth: (i) a description and the date of each election made by the taxpayer during the taxable year; (ii) a statement that each election made during the taxable year was made before the close of the date the transaction was entered into; (iii) a description of any contract for which an election was in effect and the date such contract expired or was otherwise sold or exchanged during the taxable year; (iv) a statement that the contract was never part of a straddle as defined in Sec. 1092; and (v) a statement that all transactions subject to the election are included on the statement attached to the taxpayer's income tax return.

Note:  Taxpayers that do not comply with these requirements run the risk of the IRS invalidating the election.  However, if the failure was due to reasonable cause or bona fide mistake, taxpayers may be able to obtain relief regarding that failure, but the burden of proving it would be on them.  Fortunately, Regs. Sec. 1.988-3(b)(5) provides a way for most taxpayers to obtain a presumption of having met the statement and verification requirements by getting “independent verification.”  Taxpayers may get this independent verification by (1) establishing a separate account (or accounts) with an unrelated broker or dealer through which all transactions to be independently verified pursuant to this paragraph are conducted and reported, (2) having only those transactions entered into on or after the date the taxpayer establishes such account be recorded in the account, (3) having transactions subject to the election entered into such account on the date such transactions are entered into, and (4) obtaining from the broker or dealer a statement detailing the transactions conducted through such account and that includes on such statement the following: “Each transaction identified in this account is subject to the election set forth in section 988(a)(1)(B).”

In this example, it is assumed that Investor fulfilled their obligations with respect to the election under Sec. 988(a)(1)(B), thereby resulting in the treatment of the gain as capital in character.

2)      Section 1256

Pursuant to Sec. 1256(a), certain contracts are generally required to be “marked to market” if held by the taxpayer at the close of the taxable year, and are further characterized as generating gain or loss that is 40% short-term capital gain or loss and 60% long-term capital gain or loss.  Moreover, Sec. 1256(c) generally provides that Sec. 1256(a) applies even if the contract is not held at year end (e.g., a transfer, lapse, or other disposal during the year).

Sec. 1256(b), by its terms, covers the following types of contracts (and are defined under Sec.  1256(g): (1)  any regulated futures contract, (2)  any foreign currency contract, (3)  any nonequity option, (4)  any dealer equity option, and (5)  any dealer securities futures contract.  Having already addressed regulated futures contracts and nonequity options above, and noting that the option is not a dealer equity option or a dealer securities futures contract (since Investor is not a “dealer”), that leaves the question of whether the option is a “foreign currency contract.”

Pursuant to Sec. 1256(g)(2)(A), a “foreign currency contract” is defined as a contract which (i)  requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts, (ii) is traded in the interbank market, and (iii) is entered into at arm's length at a price determined by reference to the price in the interbank market.

In a nutshell, the option is not a “foreign currency contract” even though a casual reading might suggest otherwise.  The rationale for this conclusion is as follows:

• In Notice 2007-71, the IRS and Treasury state that foreign currency options, whether or not the underlying currency is one in which positions are traded through regulated futures contracts, are not “foreign currency contracts” as defined in Sec. 1256(g)(2).  Apart from their resistance to what they view as an abuse (not relevant to our example), the Notice explains that a “foreign currency contract […is] a contract that requires delivery of, or the settlement of which depends on the value of, certain foreign currencies. The original statutory definition, however, did not allow for cash settlement and required actual delivery of the underlying foreign currency in all circumstances. Options, by their nature, only require delivery if the option is exercised. Section 102 of [TRA 1984] added the clause “or the settlement of which depends on the value of.” There is no indication, however, that Congress intended by this addition to extend the definition of “foreign currency contract” to foreign currency options. That conclusion is confirmed by the legislative history to  §988(c)(1)(E), enacted by [TAMRA 1988], which indicates that a foreign currency option is not a foreign currency contract as defined in §1256(g)(2).”
• Moreover, FSA 200025020 (which was issued prior to Notice 2003-81, which was modified and supplemented by Notice 2007-71) provided the following reasoning (internal citations omitted):

“Although the definition of a foreign currency contract provided in section 1256(g)(2) may be read to include a foreign currency option contract, the legislative history of [TCA 1982], which amended section 1256 to include foreign currency contracts, indicates that the Congress intended to extend section 1256 treatment only to foreign currency forward contracts that are traded on the interbank market. There is no indication that foreign currency option contracts were contemplated for inclusion in the statutory definition of a forward currency contract in section 1256(g)(2)(A).

Sections 1256(g)(3) and (4) deal comprehensively with options listed on a qualified board or exchange. These provisions were added to the Code by section 102(a)(3) of [TRA 1984].  They provide that only dealer equity options (i.e., listed stock options) and listed options (other options listed on exchanges) are section 1256 contracts. The legislative history to these provisions is silent regarding whether the failure to separately include a provision address in the treatment of foreign currency options was due to their having been included within section 1256(g)(2)(A).”

Further, commentators have seemed to accept (or at least not dispute) that foreign currency options are not “foreign currency contracts.” [v]  Consequently, the option should not be treated as a “foreign currency contract” and thus does not fall under Sec. 1256.

3)      Holding Period

Having established that the option is a capital asset, and not subject to Sec. 1256, the final step in our analysis is determining whether the gain on its disposition is long-term or short-term.

Sec. 1222 generally controls the holding period of property in determining the long-term vs. short-term character of the gain (or loss) on the disposition of a capital asset.  In short, that section provides that capital gains are long-term if held for not more than 1 year, and short-term otherwise.

Without going into great detail on this issue (since it should be fairly apparent from the trade and termination dates being less than 12 months), it is clear that the gain is short-term in nature.

Conclusion

As the reader can see from the above, reaching the ultimate answer to the initial query was not exactly a straightforward proposition, and highlights the need for additional clarity in situations like these.  After all, even in this relatively simple example, the conclusion was dependent on a close and critical reading of the legislative history given several easily-misinterpreted terms in the statute itself.

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[i] A “European” option may be exercised only at the expiry date of the option, i.e., at a single pre-defined point in time.  An “American” option may be exercised at any time on or before the expiry date.

[ii] “Non-deliverable” settlement means that settlement is made on a net value basis and that currencies do not change hands.

[iii] I.e., not traded on (or subject to the rules of) an SEC-registered national securities exchange, a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256.

[iv] See, e.g., Rev. Rul. 85-72 (the International Futures Exchange (Bermuda) Ltd.); Rev. Rul. 86-7 (the Mercantile Division of the Montreal Exchange , effective April 18, 1985); Rev. Rul. 2007-26 (ICE Futures, a U.K. Recognised Investment Exchange, effective for ICE Futures Contracts (commodity futures contracts and futures contract options) entered into on or after April 1, 2007); Rev. Rul. 2009-4 (the Dubai Mercantile Exchange, effective for Dubai Mercantile Exchange Contracts (commodity futures contracts and futures contract options) entered into on or after February 1, 2009); PLR 200726006 (an unnamed United Kingdom Recognized Investment Exchange that was a wholly-owned subsidiary of a U.S. corporation and overseen by the United Kingdom's Financial Services Authority, provided that the exchange continued to comply with certain specified conditions).

[v] Mulroney, 921-2nd T.M., Tax Aspects of Foreign Currency, section VII.B.4.:  “Comment: Nonlisted foreign currency options should not fall within the definition of a ‘foreign currency contract,’ even if the denomination currency is a currency in which positions are traded on a qualified board or exchange. This is because §1256(g)(3), which sets forth the definition of a nonequity option, should be viewed as preemptive in terms of the types of options covered under §1256.”

House passes "Taxpayer Assistance Act of 2010" (HR 4994)

This Bill passed the House by a large margin (399-9), and now goes to the Senate. I haven't yet seen any public comments on its chances for eventual enactment, but (1) its strong bipartisan support, (2) fairly limited scope, and (3) lack of highly controversial provisions suggests smooth sailing.

It isn't as massive as the recent Health Care legislation, which you can see from the following outline. If you want to see the full text, see http://bit.ly/awAhpf

TITLE I--CELL PHONES AND ELECTRONIC FILING

• Sec. 101. Removal of cellular telephones and similar telecommunications equipment from listed property.
• Sec. 102. Electronic filing exemption for religious reasons.
• Sec. 103. Accelerate interest on refunds for returns filed electronically.

TITLE II--COLLECTION

• Sec. 201. Study on the effectiveness of collection alternatives.
• Sec. 202. Repeal of partial payment requirement on submissions of offers-in-compromise.

TITLE III--TAXPAYER ASSISTANCE AND PROTECTION IMPROVEMENTS

• Sec. 301. Referrals to Low-Income Taxpayer Clinics permitted.
• Sec. 302. Programs for the benefit of low-income taxpayers.
• Sec. 303. EITC outreach.
• Sec. 304. Taxpayer notification of suspected identity theft.
• Sec. 305. Clarification of IRS unclaimed refund authority.
• Sec. 306. Study on delivery of tax refunds.
• Sec. 307. Study on timely processing and use of information returns.
• Sec. 308. Study on easing the burden of in-person tax payments.

TITLE IV--REVENUE PROVISIONS

• Sec. 401. Expansion of bad check penalty to electronic payments.
• Sec. 402. Increase in information return penalties.
• Sec. 403. Budget compliance.

More to come...

State Research Tax Credits - You May Be Entitled To More Than You Thought

Despite the sad fact that the federal research credit under section 41 has expired for amounts paid or incurred after December 31, 2009 (and which will hopefully be extended again), certain states still provide credits for qualified expenditures. However, many states impose additional requirements on the computation of the state credits (e.g., activities having been conducted in the state, computations of base amounts, etc.) that are easily overlooked, but can have substantial impact. Accordingly, it makes sense to revisit how these state rules might affect your clients.

Note: At the time of this writing more than half of the states provide some sort of tax credit for expenses paid or incurred with respect to a taxpayer’s qualified research activities. Since a review of each state’s provisions is beyond the scope of this article, we’ll focus on some of the more interesting California provisions under Cal. Revenue & Taxation Code section 23609. In addition, the federal and California research credit provisions also provide benefits for amounts paid for “basic research,” but those are also outside the scope of this article.

Background

The federal research credit was originally enacted in 1981 and was intended in large part to spur domestic innovation. It took the form of a nonrefundable credit against income tax available to taxpayers for certain qualified expenditures that exceeded a defined “base amount.” Even though it expired as of the end of 2009, many commentators believe that it will return (although possibly with additional changes), as it has many times before.

In computing the credit for both federal and California purposes, it is important to remember that there are various methods to consider, depending on whether the company had sufficient activity in the 1984 – 1988 time period, whether the taxpayer wants to elect an alternative computation method, whether the taxpayer is a member of a group of businesses that must aggregate their activities, and so on. However, for the sake of this discussion, the standard method of computing the credit is as follows (for both federal and California) for businesses that are not “start-ups.”

• Take the total of the taxpayer’s qualified research expenditures for tax years beginning after December 31, 1983, and before January 1, 1989.
• Divide that total by total gross receipts for those same years.
• The resulting percentage is the “fixed base percentage,” which, per section 41(c)(3)(C), cannot be greater than 16%.
• Take the average gross receipts for the 4 years preceding the current year and multiply that amount by the fixed base percentage. The result is the “tentative base amount.”
• Compare the tentative base amount against the current year qualified expenditures.
• If the current year qualified expenditures are less than the tentative base amount, no research credit is available.
• If the current year qualified expenditures are greater than the tentative base amount, then the “increment” is the lesser of (1) the difference between the total current year qualified expenditures and the tentative base amount, or (2) one-half of the current year qualified expenditures.
• The credit is then determined by multiplying the credit rate (20% for federal, 15% for California) by the above increment.
• Finally, the taxpayer needs to decide if they prefer to follow section 280C(c) and reduce their otherwise deductible/capitalizable research expenditures or instead elect a reduced credit that reflects an impact similar to that of section 280C(c).

Note: In this context, a start-up company is one that had both qualified research expenses and gross receipts either (1) for the first time in a taxable year beginning after December 31, 1983; or (2) for fewer than three taxable years beginning after December 31, 1983, and before January 1, 1989.

California R&TC section 23609

The California research credit (effective as of 1987), while based on the federal credit, does contain some notable differences. In the right circumstances, those differences sometimes provide substantial (and unexpected) benefits to those who read the California rules carefully.

The first key difference in the California rules restricts the credit by the location of the qualifying activity. Specifically, Cal. Revenue & Taxation Code (“R&TC”) section 23609(c)(2) provides that qualified research includes only research conducted in California. While this makes sense in that California doesn’t want to provide incentives outside of the state, it places the responsibility on the taxpayer to not only ensure its in-house expenses (e.g., wages, supplies) are for California activities, but contract research expenses are as well. This means that the taxpayer would have to be able to establish that its subcontractors performed their work in California as well to qualify those expenses for the California research credit.

The second key difference is one with which many California practitioners seem unfamiliar. In fact, I have encountered at least two relatively recent cases in which this difference in California law has provided the taxpayers with additional California research credits in excess of six figures that they otherwise might have missed! That provision is the one under R&TC section 23609(h)(3) which reads as follows:

“Section 41(c)(6) of the Internal Revenue Code, relating to gross receipts, is modified to take into account only those gross receipts from the sale of property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business that is delivered or shipped to a purchaser within this state, regardless of f.o.b. point or any other condition of the sale.”

In addition, California Publication 1082 (“Research & Development Credit: Frequently Asked Questions”), section 8 provides the following (in relevant part):

“Excluded receipts are items such as California “throwback” sales for apportionment purposes, as well as, receipts from services, rents, operating leases and interest. In addition, royalties and license payments are generally excluded from the definition of gross receipts for research credit purposes…This California definition of gross receipts applies to both the average annual gross receipts for the prior four years and the base years (1984-1988).”

Note: While the Publication does not have the weight of statutory authority, it is seemingly consistent with the statutory language noted above, and does represent the Franchise Tax Board’s official stance, so ignore it at your peril.

As innocuous as this second item may appear, it represents a fundamental conceptual difference in the computation of the California credit. In short, it redefines “gross receipts” for California purposes as basically only including inventory sales to California purchasers. So what does this really mean? It means that not only should practitioners expect the fixed base percentage to usually differ between federal and California, it also means that average gross receipts for the preceding 4 years will usually differ as well. Moreover, this can (in the right circumstances) provide a large (often beneficial) difference to the taxpayer.

For the sake of illustration, please consider the following simple example:

Abbreviations

• QREs = Qualified research expenditures
• GR = Gross receipts

Assumptions

• Taxpayer develops new/improved products for sale to customers
• All qualified activities are conducted in California
• Current tax year is 2009

What this example demonstrates is the fact that a taxpayer blindly using the federal rules in this case would have erroneously forgone $840,000 of California research credits to which it was entitled. Fortunately, the taxpayer in this case should be able to file an amended return and claim those credits, but having to go through that process isn’t the ideal way to claim that benefit.

Conclusion

In discussions with other practitioners, relatively few seem to be well-versed in the intricacies of the California research credit. Fortunately however, it’s not that complicated to take the time to read carefully through what amounts to the roughly two and a half pages of Cal. R&TC 23609.

Similarly, for those with clients conducting qualified research in other states, there could be some hidden gems there as well.

IRS Posts Employer Q&A re Tax Benefits for Certain Employers

Following the recent enactment of the HIRE Act, the IRS has posted on its website [http://bit.ly/aM1xzo] a set of questions and answers for employers that stand to benefit from some of the Act's new provisions by hiring certain qualified employees. The introductory text reads as follows, and is accompanied by links to IRS Q&As, News releases related to the HIRE Act, and References/Related Topics.

"Under the Hiring Incentives to Restore Employment (HIRE) Act, enacted March 18, 2010, two new tax benefits are available to employers who hire certain previously unemployed workers (“qualified employees”).

The first, referred to as the payroll tax exemption, provides employers with an exemption from the employer’s 6.2 percent share of social security tax on wages paid to qualifying employees, effective for wages paid from March 19, 2010 through December 31, 2010.

In addition, for each qualified employee retained for at least 52 consecutive weeks, businesses will also be eligible for a general business tax credit, referred to as the new hire retention credit, of 6.2 percent of wages paid to the qualified employee over the 52 week period, up to a maximum credit of $1,000."

Well worth a visit.

The New Health Care Law - How Does it Affect You?

As if the entire process and components of the Health Care legislation weren’t confusing enough, the first part (H.R.3590) not only modified itself in certain areas, but the second part (H.R.4872) partially modified the first just one week later!

If you do feel compelled to read through the actual legislation yourself, it’s probably a good idea to first review the Joint Committee’s explanation, which you can find at http://www.jct.gov/publications.html?func=startdown&id=3673 (released on 3/21/10 as document JCX-18-10 and entitled Technical Explanation Of The Revenue Provisions Of The “Reconciliation Act Of 2010,” As Amended, In Combination With The “Patient Protection And Affordable Care Act”).

In an attempt to clarify the overall impact, this overview incorporates the following two Acts that recently became law and addresses the law as it stands after their combined passage. They are as follows:

• H.R.3590 - Patient Protection and Affordable Care Act - signed into law on 3/23/10. (Available at http://hdl.loc.gov/loc.uscongress/legislation.111hr3590)
• H.R.4872 - Health Care and Education Affordability Reconciliation Act of 2010 - signed into law on 3/30/10. (Available at http://hdl.loc.gov/loc.uscongress/legislation.111hr4872)

While the thousands of pages of text in the new law address a host of issues relating to health care related items, including taxes (as well as seemingly unrelated items such as student loans), the key tax issues fall into a handful of categories that affect individuals and businesses:

• New and/or Increased Taxes and Fees
• New and/or Expanded Credits and Incentives
• Deduction/Exclusion Limitations and/or Restrictions
• Information Reporting and Disclosure
• New and/or Expanded Administrative Requirements

Without further ado, here is a brief discussion of the more widely-applicable tax related provisions.

NEW AND/OR INCREASED TAXES AND FEES

   BUSINESSES

• EXCISE TAX ON HIGH COST EMPLOYER-SPONSORED HEALTH COVERAGE
• Imposes a new nondeductible 40% excise tax on “coverage providers” of employer-sponsored health insurance if the aggregate value of such coverage for an employee exceeds a specified threshold. Depending on the type of coverage, “coverage providers” are generally employers, and/or plan administrators.
• The threshold for 2018 for individuals is $10,200 and for families it is $27,500, but will be subject to adjustment for differences in increases in health care costs between 2010 and 2018 compared to projections. In addition, adjustments will be made based on differences in age, gender, and high-risk profession rates.
• Effective for taxable years beginning after 12/31/17.
• IMPOSITION OF ANNUAL FEE ON BRANDED PRESCRIPTION PHARMACEUTICAL MANUFACTURERS AND IMPORTERS
• Imposes an annual nondeductible fee on entities that manufacture and/or import branded prescription drugs for sale to (or attributable to) certain government programs. The multi-billion dollar fees are to be apportioned amongst the covered businesses based on their relative shares of branded prescription drug sales for the prior year (more heavily weighted for businesses with higher sales).
• Effective for calendar years beginning after 12/31/10.
• IMPOSITION OF ANNUAL FEE ON HEALTH INSURANCE PROVIDERS
• Imposes an annual nondeductible fee on certain entities that provide health insurance coverage of United States health risks as part of their business.
• The multi-billion dollar fees are to be apportioned amongst the covered businesses based on their relative shares of their health insurance net written premiums for the prior year (more heavily weighted for businesses with higher sales).
• Effective for calendar years beginning after 12/31/13.
• EMPLOYER RESPONSIBILITY FOR EMPLOYEE COVERAGE
• Requires certain “large” employers (generally those with an average of at least 50 full time employees during the prior calendar year) to offer minimum essential health care coverage. Those failing to do so are generally subject to a nondeductible excise tax of $166.67 per employee per month (in excess of a 30-employee threshold).
• Also imposes a nondeductible excise tax on large employers that do offer employees the opportunity to sign up for minimal essential coverage, but one or more instead purchase coverage through an exchange that allows or pays a premium tax credit or cost-sharing reduction. The penalty for this situation is $250 per employee per month, and is limited to the amount of the first penalty noted above (which also serves as an overall limitation).
• Each of the dollar amounts above will be adjusted for inflation after 2014.
• Effective starting after 12/31/13.
• EXCISE TAX ON MEDICAL DEVICES
• Imposes a 2.3% excise tax on the sale of certain medical devices, to be borne by manufacturers, producers, or importers of covered devices. Taxable medical devices are those defined in section 201(h) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 321) that are intended for humans. This generally means the following:
• An instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article, including any component, part, or accessory, which is (1) recognized in the official National Formulary, or the United States Pharmacopeia, or any supplement to them, (2) intended for use in the diagnosis of disease or other conditions, or in the cure, mitigation, treatment, or prevention of disease, in man or other animals, or (3) intended to affect the structure or any function of the body of man or other animals, and which does not achieve its primary intended purposes through chemical action within or on the body of man or other animals and which is not dependent upon being metabolized for the achievement of its primary intended purposes. (One example might be an Ultrasonic air embolism monitor used as a monitoring device in the area of Anesthesiology.)
• However, the following items are generally excluded:
• Eyeglasses, contact lenses, hearing aids, and any other items determined to be typically purchased at retail by the general public for their own personal use.
• Effective for sales after 12/31/12.

   INDIVIDUALS

• ADDITIONAL HOSPITAL INSURANCE TAX ON HIGH-INCOME TAXPAYERS
• Imposes an additional 0.9% tax on wages (and self-employment income) of those earning more than a threshold amount. That threshold is $250,000 for joint (or surviving spouse) returns, $125,000 of married-filing-separate returns, and $200,000 for other returns.
• Effective for compensation received in tax years beginning after 12/31/12.
• EXCISE TAX ON INDOOR TANNING SERVICES
• Imposes (on the individual using the services) a 10% tax on the amount paid for the indoor tanning services.
• Effective for services performed on or after 7/1/10.
• INCREASE IN ADDITIONAL TAX ON DISTRIBUTIONS FROM HSAS AND ARCHER MSAS NOT USED FOR QUALIFIED MEDICAL EXPENSES
• Increases from 10% to 20% the additional tax imposed on disqualifying distributions from an HSA or Archer MSA.
• Effective for disqualifying distributions made during tax years starting after 12/31/10.
• EXCISE TAX ON INDIVIDUALS WITHOUT ESSENTIAL HEALTH BENEFITS COVERAGE
• Requires most U.S. citizens and legal residents, as well as their dependents, to maintain a minimum level of health care coverage. Those who do not will generally be subject to a penalty. This penalty is based on household income, with a maximum penalty (per month, per person) of $95 for 2014, $325 for 2015, $695 for 2016, and indexed for inflation thereafter. Penalty amounts for minors (under 18) are 50% of the adult amounts, and the maximum family penalty is 300% of the individual adult penalty (but further limited to certain national averages).
• Effective for tax years starting after 12/31/13.
• UNEARNED INCOME MEDICARE CONTRIBUTION
• Imposes 3.8% Medicare tax on individuals, trusts, and estates with unearned income and that have modified adjusted gross income in excess of certain thresholds.
• For individuals, that tax is based on the lesser of (1) net investment income or (2) modified AGI over $250,000 (for joint or surviving spouse returns; $125,000 for married filing separate; all other individuals have a threshold of $200,000).
• For trusts and estates, the tax is based on the lesser of (1) undistributed net investment income or (2) the excess of AGI over the dollar amount where the highest income tax bracket starts. Caveat: For trusts and estates, the threshold (for 2010) starts at only $11,200, far below the those applicable to individuals.
• Note that tax-free investments (e.g., certain bonds) are exempt from this tax.
• Effective for tax years beginning after 12/31/12.

NEW AND/OR EXPANDED CREDITS AND INCENTIVES

   BUSINESSES

• ESTABLISHMENT OF SIMPLE CAFETERIA PLANS FOR SMALL BUSINESSES
• Provides eligible small employers with a safe harbor exemption from some of the nondiscrimination rules that otherwise apply to cafeteria plans. Eligible employers are generally those that (1) allow all employees to participate and elect any available benefit under the plan, (2) provide a minimum contribution for all non-highly-compensated employees, and (3) have no more than 100 employees (as an average for the 2 prior years).
• Effective for tax years beginning after 12/31/10.
• QUALIFYING THERAPEUTIC DISCOVERY PROJECT CREDIT
• This provision is a real sleeper and has had surprisingly little press despite its generous provisions. It provides a 50% nonrefundable investment tax credit to certain small businesses (with no more than 250 employees) that invest in qualifying “therapeutic discovery” projects in years beginning in 2009 or 2010. Covered projects are those designed to:
• Treat or prevent diseases or conditions via pre-clinical activities, clinical trials, and clinical studies, or carrying out research protocols, for the purpose of obtaining approval of a product under specific sections of the Federal Food, Drug, and Cosmetic Act or the Public Health Service Act;
• Diagnose diseases or conditions or to determine molecular factors related to diseases or conditions by developing molecular diagnostics to guide therapeutic decisions; or
• Develop a product, process or technology to further the delivery or administration of therapeutics.
• Qualified investments are the aggregate amount of costs paid or incurred for the tax year for expenses necessary for and directly related to the conduct of a qualifying therapeutic discovery project, but exclude (1) compensation paid to the CEO and the four highest paid officers other than the CEO, (2) interest expense, (3) facility maintenance expenses, (4) service costs as determined under the uniform capitalization rules, and (5) any other expense determined by the Secretary to be appropriate under the circumstances.
• Alternatively, qualifying taxpayers may generally elect to receive a grant instead of a credit with respect to their qualifying investment.
• Note: This provision is not automatic for potentially qualifying small businesses. It requires potential recipients to apply to the program which is to be established by the Secretary (in consultation with the Department of Health and Human Services) within 60 days after 3/23/10. Following the submission of an application, the Secretary will have 30 days to approve or reject the application. Selection criteria will take into consideration only those projects
• That show reasonable potential to result in new therapies to treat areas of unmet medical need, or to prevent, detect, or treat chronic or acute diseases and conditions, to reduce long-term health care costs in the United States, or to significantly advance the goal of curing cancer within 30 years, and
• That have the greatest potential to create and sustain high quality, high-paying jobs in the United States, and to advance U.S. competitiveness in the fields of life, biological, and medical sciences.
• Effective for amounts paid or incurred in tax years beginning after 12/31/08.

   INDIVIDUALS

• EXCLUSION FOR ASSISTANCE PROVIDED TO PARTICIPANTS IN STATE STUDENT LOAN REPAYMENT PROGRAMS FOR CERTAIN HEALTH PROFESSIONALS
• Excludes from income amounts received by individuals under the National Health Service Corps loan repayment program (as well as certain state programs) intended to provide for increased health care availability in underserved areas.
• Effective for amounts received in tax years starting after 12/31/08.
• EXPANSION OF ADOPTION CREDIT AND ADOPTION ASSISTANCE PROGRAMS
• Raises the maximum adoption credit (as well as the income exclusion for employer-provided adoption assistance) to $13,170 for 2010, with additional changes to the inflation adjustment and income limitation threshold for post-2010 years. Also makes the credit refundable starting in 2010.
• The sunset of these provisions (which reduces the amounts to prior, lower amounts) is also delayed by 1 year (i.e., for tax years beginning after 12/31/11).
• PREMIUM ASSISTANCE TAX CREDIT
• Provides a refundable tax credit for individuals and families to help subsidize the purchase of health insurance through an exchange. The amount of the credit is based on the insured person’s income and is generally available for those with household incomes between 100% and 400% of the federal poverty level and who do not receive (or are not offered) health insurance through an employer.
• Effective for tax years ending after 12/31/13.
• REDUCED COST-SHARING FOR INDIVIDUALS ENROLLING IN QUALIFIED HEALTH PLANS
• Establishes a subsidy to help lower-income individuals and families (household incomes between 1 and 4 times the poverty level) afford health care coverage.
• Effective from 3/31/10.

CREDIT/DEDUCTION/EXCLUSION LIMITATIONS AND/OR RESTRICTIONS

   BUSINESSES

• MODIFICATION OF ITEMIZED DEDUCTION FOR MEDICAL EXPENSES
• Increases the lower limit for taking an itemized deduction for unreimbursed medical expenses from 7.5% to 10% of Adjusted Gross Income (for regular tax purposes, but leaves the threshold for AMT purposes unchanged). If taxpayer (or their spouse) reaches age 65 during any of the tax years 2013 through 2016, this increase does not apply to such years.
• Effective for taxable years beginning after 12/31/12.
• LIMITATION ON EXCESSIVE REMUNERATION PAID BY CERTAIN HEALTH INSURANCE PROVIDERS
• Denies a deduction for executive compensation in excess of $500,000 to certain health insurance providers. This generally excludes employers with self-insured plans. In addition, performance-based compensation does not escape this limitation.
• Effective for compensation for tax years beginning after 12/31/12 that are attributable to services performed during years beginning after 12/31/09.
• ELIMINATION OF DEDUCTION FOR EXPENSES ALLOCABLE TO MEDICARE PART D SUBSIDY
• Reduces the deduction for expenses attributable to retiree prescription drug expenses by the amount of the subsidy (to the extent the subsidy is excluded from income).
• Effective for tax years beginning after 12/31/12.
• MODIFICATION OF SECTION 833 TREATMENT OF CERTAIN HEALTH ORGANIZATIONS
• Restricts certain special insurance company tax benefits to those entities satisfying a minimum medical loss ratio of 85% for the year (i.e., the percentage of its total premium revenue expended on reimbursement for clinical services provided to enrollees during the year).
• These rules generally allow Blue Cross, Blue Shield, and similar organizations a deduction of 25% of the year’s claims and liabilities under cost-plus contracts as well as administrative expenses related to such claims and contracts (minus the prior year’s surplus for regular tax), as well as other tax benefits.
• Effective for tax years beginning after 12/31/09.
• ELIMINATION OF UNINTENDED APPLICATION OF CELLULOSIC BIOFUEL PRODUCER CREDIT
• Changes the cellulosic biofuel producer credit so that it no longer applies to unprocessed fuels with specified percentages of water, sediment, or ash content, such as “black liquor.”
• Effective for fuels sold or used after 1/1/10.

   INDIVIDUALS

• DISTRIBUTIONS FOR MEDICINE QUALIFIED ONLY IF FOR PRESCRIBED DRUG OR INSULIN
• Restricts allowable distributions from Health FSAs, HSAs, HRAs, and Archer MSAs to (1) prescribed drugs, including over-the-counter medicines if prescribed by a doctor and (2) insulin.
• Effective for expenses incurred after 12/31/10.
• LIMITATION ON HEALTH FLEXIBLE SPENDING ARRANGEMENTS UNDER CAFETERIA PLANS
• Imposes an upper limit on Health FSAs under cafeteria plans of $2,500 per year (indexed for future inflation).
• Effective for taxable year beginning after 12/31/12.

INFORMATION REPORTING AND DISCLOSURE

   BUSINESSES

• INCLUSION OF COST OF EMPLOYER-SPONSORED HEALTH COVERAGE ON W-2
• Requires employers to disclose the value of health insurance coverage on each employee’s W-2.
• Effective for tax years beginning after 12/31/10.
• EXPANSION OF INFORMATION REPORTING REQUIREMENTS
• Requires businesses to file information returns for all payments totaling $600 or more, even if the recipient is a corporation (but not including tax-exempt corporations).
• Also expands the scope of the type of payments for which reporting is required to include all payments in consideration for property, and other gross proceeds for both property and services.
• Effective for payments made after 12/31/11.

   BUSINESSES AND INDIVIDUALS

• CODIFICATION OF ECONOMIC SUBSTANCE DOCTRINE AND PENALTIES
• Having been discussed for quite some time, places the Economic Substance doctrine into the Code. The Economic Substance doctrine generally stands for the proposition that there should be no tax benefits to the extent that there was no real financial motive aside from saving federal taxes.
• Also establishes an increase in the penalty where the transaction(s) at issue did not have economic substance (i.e., 40% instead of 20%).
• Effective from 3/31/10.

NEW AND/OR EXPANDED ADMINISTRATIVE REQUIREMENTS

   BUSINESSES

• ADDITIONAL REQUIREMENTS FOR CHARITABLE HOSPITALS
• Sets new requirements for charitable hospitals, in addition to those previously established. These include (1) performance of a community health needs assessment once every 3 years, (2) creation/implementation of a written financial assistance policy, (3) limitation on charges billed for emergency or other medically necessary care for those qualifying for financial assistance, and (4) limitation on extraordinary collection efforts without first trying to determine if the responsible persons are eligible for financial assistance.
• Also imposes a penalty of up to $50,000 for failures to conduct the community health needs assessment.
• Generally effective for tax years beginning after 3/23/10, except for the community health needs assessment (effective for tax years beginning after 3/23/12) and the penalty for failure to perform the assessment (effective for failures after 3/23/10).
• TIME FOR PAYMENT OF CORPORATE ESTIMATED TAXES
• Increases the amount of the required federal estimated tax due in the 3rd quarter 2014 by 15.75 percentage points.
• Effective from 3/31/10.

As always, I look forward to your questions and comments.

The Reconciliation Act was signed into law today

As you may already know by now, the second part of the Health Care legislation (H.R. 4872 - Health Care and Education Affordability Reconciliation Act of 2010) was signed into law today, March 30, 2010.

While I'm still working on a combined write-up for the Reconciliation Act and the preceding Patient Protection and Affordable Care Act (H.R. 3590), you can access the actual laws here:

• H.R. 3590
• H.R. 4872

Caveat:  H.R. 3590 at times changes its own provisions (e.g., section 9001 is modified by section 10901), and H.R. 4872 goes on to further change H.R. 3590 (e.g., section 1401 of H.R. 4872 further changes section 10901 of H.R. 3590 which modified section 9001 of that Act), so read carefully!  Not exactly easy to follow.

Happy reading...

The Jobs Bill (aka the Health Care bill's quiet sibling)

With all the focus on Health Care legislation, not everyone got the message that on March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act ("HIRE"). While intended to spur job growth via tax breaks to businesses that add employees and invest in equipment, it also (among other things) imposes new disclosure requirements related to foreign investments. An overview of the more widely-applicable provisions follows. For more detailed information (and we do mean detailed), readers can refer to these official sources:

• The text of H.R. 2847 [http://hdl.loc.gov/loc.uscongress/legislation.111hr4872]
• The Joint Committee on Taxation's technical explanation [http://www.jct.gov/publications.html?func=startdown&id=3648]

Hiring and Retention Incentives

• Payroll Tax Forgiveness for Hiring Unemployed Workers - Eliminates the employer's share of OASDI paid by a qualified employer attributable to wages paid to a qualified individual (starting with the date immediately after enactment, i.e., 3/19/10) through 12/31/10, subject to minor adjustment for wages paid through 3/31/10.
• "OASDI" is the old age, survivors, and disability insurance tax equal to 6.2% of covered wages up to the taxable wage base ($106,800 in 2010), providing a maximum potential benefit to the employer of approximately $6,600.
• A qualified employer is any non-governmental employer (but does include public higher education institutions).
•  A qualified individual is anyone who (1) begins work for a qualified employer after 2/3/10 and before 1/1/11; (2) certifies by signed affidavit that he or she was employed for a total of 40 hours or less during the 60-day period ending on the date such employment began; (3) is not employed to replace another employee of the employer unless such employee separated from employment voluntarily or for cause; and (4) is not a related party with respect to the employer.
  
• Coordination with the Work Opportunity Tax Credit ("WOTC") - Qualified employers may not receive the WOTC with respect to wages paid to a qualified individual during the 1-year period starting with the employee's hire date if such wages qualify under this provision unless the employer expressly elects to forgo the benefits of this provision for that person.

• Business Credit for Retention of Certain Newly Hired Individuals in 2010 - Provides a general business tax credit for each retained "qualified invididual" (as defined above) who (1) is employed on any date during the taxable year; (2) remains employed for a period of not less than 52 consecutive weeks; and (3) receives wages during the last 26 weeks of such period that are least 80% of the wages received during the first 26 weeks of that period. The amount of this credit is the lesser of
• $1,000 or
• 6.2% of the wages paid by the taxpayer to the retained worker during the 52 consecutive week period referred to above.
• The retention credit may not be carried back to a taxable year that begins prior to the date of enactment of this provision.
• This provision is effective from the date of enactment (i.e., 3/18/10).

Section 179 Expensing

• Extends for one year the $250,000 maximum section 179 deduction (and the $800,000 phaseout limit) that would otherwise have dropped to $125,000 (and $500,000) in the absence of this legislation.
• This provision is effective for taxable years beginning after 12/31/09.

Qualified Tax Credit Bonds

• Permits tax credit bond issuers (of Clean Renewable Energy Bonds, Qualified Energy Conservation Bonds, Qualified Zone Academy Bonds, and Qualified School Construction Bonds) to elect to treat such bonds issued after 3/18/10 as Build America Bonds and qualifying for tax credits to be paid to the issuer instead of the holders of such bonds. While primarily applicable to state and local governments, potential purchasers of such bonds should be aware of this provision if they are considering these investments and were counting on possible credits coming to them.

Revenue Raisers

• Foreign Account Tax Compliance

• Reporting and withholding on certain foreign accounts - Adds a new chapter 4 to the Internal Revenue Code (comprising 4 new sections) that impose withholding and reporting requirements on persons making specified types of payments to certain foreign financial institutions and other foreign entities. The general rules are as follows: 

• The statutory withholding rate for withholdable payments to an applicable foreign financial institution or other covered foreign entity is 30%. 

• Withholdable payments generally include "(i) any payment of interest (including any original issue discount), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income, if such payment is from sources within the United States, and (ii) any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States." However, this term excludes any item of income that represents income connected with the conduct of a U.S. trade or business.

• Withholding agents are those "persons, in whatever capacity acting, having the control, receipt, custody, disposal, or payment of any withholdable payment."

• Covered foreign financial institutions are those that do not have an agreement with the U.S. Treasury for the collection, verification, maintenance, and reporting of information about direct or indirect U.S. owners of financial accounts held by that institution. Covered other foreign entities are those that are not covered "foreign financial institutions" as noted above and (1) the beneficial owner of the payment is either that entity or another non-financial foreign entity and (2) the recipient does not qualify for a waiver of withholding. A withholding waiver is generally available if the payee provides the withholding agent with either (a) certification that the beneficial owner does not have substantial U.S. owners or (b) the name, address, and taxpayer ID number of the beneficial owner. In addition, the withholding agent must not know or have reason to know that the information provided is incorrect and must also report the above information to the IRS.

• This provision is generally effective for payments made after 12/31/12.

• Repeal of certain foreign exceptions to registered bond requirements - This provision actually consists of several changes related to foreign-targeted bonds and the corresponding (1) exclusion from withholding on, and (2) deduction of, the interest payments on those bonds if certain tests are met.

• Repeal of exception to denial of deduction for interest on non-registered bonds - Repeals the exception to the denial of a deduction for interest on bonds not issued in registered form. As a result, interest deductions are disallowed attributable to obligations not issued in registered form, unless (1) issued by a natural person, (2) it has a maturity of one year or less, or (3) is not of a type offered to the public.
• An obligation is considered issued in registered form if (1) it is registered with its issuer (or agent) and may only be transferred by surrendering the old instrument and either (a) the reissuance to the new holder or (b) the issuance of a new instrument to the new holder, (2) the right to principal and interest may only be transferred through a book entry system maintained by the issuer (or agent), or (3) it is registered with the issuer (or agent) and may be transferred through both of the foregoing methods.

• Repeal of treatment as portfolio interest - Repeals the portfolio interest exception to withholding on interest from bonds that are not issued in registered form.
• Portfolio interest means any interest (including OID) that is (1) paid on a registered-form obligation and for which the beneficial owner has provided the U.S. withholding agent a statement certifying that the beneficial owner is not a U.S. person, or (2) paid on a non-registered form obligation that meets the foreign targeting requirements of the code. However, it does not include interest received by a 10% shareholder, certain contingent interest, interest received by a controlled foreign corporation from a related person, or certain interest received by a bank on an extension of credit.

• Dematerialized book-entry systems treated as registered form - Permits a debt obligation held through a dematerialized book entry system, or other specified book entry system, to be treated as being held through a book entry system for the purpose of treating the obligation as being in registered form.
• A dematerialized book entry system is one that tracks instruments (usually electronically) without the use of physical certificates.
• Effective for debt obligations issued after the date which is two years after the date of enactment (i.e., starting 3/19/12).

• Disclosure of information with respect to foreign financial assets - Imposes a disclosure requirement on individuals with an interest in a “specified foreign financial asset.” This requirement is met through a statement attached to their tax return for any year in which the aggregate value of all such assets is greater than $50,000.
• “Specified foreign financial assets” are specified accounts at foreign financial institutions. However, the following constitute such assets even if not held in an account at a financial institution: (1) stocks or securities issued by foreign persons, (2) financial instruments or contracts held for investment issued by (or having) a non-U.S. counterparty, and (3) any interest in a foreign entity.
• However, individuals are not required to disclose interests that are held in a custodial account with a U.S. financial institution.
• While the penalty is substantial ($10,000 plus additional amounts for continued failures, up to a maximum of $50,000 for each applicable taxable period), the penalty may be waived if the individual can establish the failure was due to reasonable cause and not willful neglect.
• Effective for taxable years beginning after 3/18/10.

• Penalties for underpayments attributable to undisclosed foreign financial assets - Adds a new 40% penalty on tax understatements related to undisclosed foreign financial assets. Applicable assets are those subject to mandatory information reporting where the disclosure requirements were not met. Applicable understatements are those attributable to any transaction involving such assets.
• Effective for taxable years beginning after 3/18/10.

• Modification of statute of limitations for significant omission of income in connection with foreign assets - Provides for an extended, 6-year, statute of limitations period within which the IRS can assess additional tax on understated income attributable to foreign financial assets. This provision applies if gross income in excess of $5,000 is omitted from an income tax return and that gross income is from assets for which foreign financial asset disclosure is required.
• Effective for returns filed after 3/18/10 as well as for any other return for which the assessment period has not yet expired as of 3/18/10.

• Reporting of activities with respect to passive foreign investment companies ("PFICs") - Imposes an information disclosure requirement on U.S. persons who are PFIC shareholders.
• A PFIC is any foreign corporation if (1) 75% or more of the gross income of the corporation for the taxable year is passive income, or (2) the average percentage of assets held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50%. Passive income generally includes dividends, interest, royalties, rents, annuities, and net gains on assets that give rise to those types of income.
• Effective from 3/18/10.

• Clarifications with respect to foreign trusts which are treated as having a United States beneficiary - Clarifies, for purposes of determining whether a foreign trust is treated as having a U.S. beneficiary, that amounts should be treated as accumulated for a U.S. person's benefit even if that person's trust interest is contingent on a future event. Also clarifies that discretion to identify beneficiaries may also cause the trust to be treated as having a U.S. beneficiary. This is important in light of disclosure requirements (as noted below).
• Effective from 3/18/10.

• Presumption that foreign trust has United States beneficiary - Generally creates a presumption that a foreign trust has a U.S. beneficiary if a U.S. person directly or indirectly transfers property to a foreign trust, unless the transferor provides satisfactory information to the contrary to the IRS.
• Effective for property transfers after 3/18/10.

• Uncompensated use of trust property - Provides that the use of trust property, including cash, by (1) the U.S. grantor, (2) U.S. beneficiary or (3) any U.S. person related to either of those two must be treated as a distribution to the extent of the fair market value of the property's use to the U.S. grantor or U.S. beneficiary, unless the fair market value of that use is paid to the trust within a reasonable amount of time.
• The provision applies to loans made and uses of property after 3/18/10.

• Reporting requirement of United States owners of foreign trusts - Requires any U.S. person treated as the owner of any portion of a foreign trust to submit IRS-required information and ensure that the trust file a return of its activities and provide such information to its owners and distributees.
• Effective for taxable years beginning after 3/18/10.

• Minimum penalty with respect to failure to report on certain foreign trusts - Increases the minimum penalty for failure to provide timely and complete disclosure on foreign trusts to the greater of $10,000 or 35% of the amount that should have been reported. In the case of failure to properly disclose by the U.S. owner of a foreign trust of the year-end value, the minimum penalty would be the greater of $10,000 or 5% of the amount that should have been reported. 
• Effective for notices and returns required to be filed after December 31, 2009.

• Substitute dividends and dividend equivalent payments received by foreign persons treated as dividends - Treats substitute dividends and dividend equivalents as if they were U.S.-source dividends for purposes of withholding on payments to foreign persons.
• Substitute dividends and dividend equivalent payments are those payments that are economically the same as dividends made with respect to the underlying stock in the context of a securities lending or sale-repurchase transaction.
• Effective for payments made on or after the date that is 180 days after 3/18/10 (i.e., starting 9/14/10).

• Delay in Application of Worldwide Allocation of Interest - Delays the availability date of the one-time election for an affiliated group's domestic members to allocate and apportion interest expense and a worldwide group basis for purposes of determining foreign source income in the context of the foreign tax credit.
• Election may not be made before tax years beginning after 12/31/20.

• Time for Payment of Corporate Estimated Tax - Accelerates the timing of required corporate estimated tax payments due in July, August, or September of 2014, 2015, and 2019. This provision applies to corporations with assets of at least $1 billion as of the end of the preceding year.

Contact me
Let me know if you have any questions or comments!

"Qualified research activities" in plain English

From talking with other CPAs and business owners, it seems pretty clear that even after all the years that the research credit has been around, the types of activities that qualify for the credit are still not widely recognized.

For the record, it does not necessarily require teams of scientists in lab coats, rows of Bunsen burners, and electron microscopes. In fact, it can involve something as seemingly simple as trying to create a nontoxic coating for the inside of a pizza box that minimizes leakage during delivery! Hardly what many people would consider high tech research, but often research nonetheless for purposes of IRC section 41.

Given that common misunderstanding, and in the interest of providing a relatively simple explanation to clients (and prospects) when discussing the research credit, I wrote a memorandum for that very purpose, which I'd like to share here as well.

So, without further ado, I've reproduced it below. (Caveat: I ask that you read it as a general guide and not as a definitive treatise on the subject. It is meant strictly as a starting point for discussion, and by design does not address every possible issue...not even close.)  If you're interested in seeing whether your business might qualify, drop me a note at my email address under "About Me."

(p.s. - While the federal credit did expire for expenditures after 12/31/09, it appears likely to be reinstated.  In addition, California's research credit is permanent, as may be other states.)

=================================================

For purposes of the credit, qualified research activities means those which satisfy the following criteria:

• The activity is experimental or laboratory in nature,
• For the purpose of discovering information,
• Which is technological in nature,
• The application of which is intended to be useful in the development of a new or improved business component, 
• Substantially all of the activities of which constitute elements of a process of experimentation, relating to
• A new or improved function;
• Performance; or
• Reliability or quality of a business component.

-------------------------------------------------------------------------

• An activity that qualifies as research and development (R&D) is one that is experimental or laboratory in nature. This term generally includes all activities incident to the development or improvement of a product.
• Activities represent R&D in the experimental or laboratory sense if they are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.
• Uncertainty exists if the information available to the company at the outset does not establish either the capability or the particular method for developing or improving the product or the appropriate design of the product.
• note: It is unnecessary that there be uncertainty as to whether the component or improvement can be designed at all; rather, there need only be uncertainty with respect to the best method of design necessary to achieve the desired result.
• Whether activities qualify as R&D depends on the nature of the activity to which the efforts relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.
• An activity which is for the purpose of discovering information,
• Which is technological in nature,
• This test depends on whether the process of experimentation (see below for definition) utilized in the research fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.
• Research does not rely on the principles of computer science merely because a computer is involved. However, research is considered to be undertaken to discover information which is technological in nature if such information expands or refines existing principles of computer science. The development or improvement of computer software can, in some cases, be considered an activity which is technological in nature.
• The application of which is intended to be useful in the development of a new or improved business component. A business component is any product, process, computer software, technique, formula, or invention which is:
• To be held for sale, lease or license, or
• Used by the taxpayer in the trade or business of the company.
• Also included in the definition of a business component are certain production processes such as any plant process, machinery, or technique for commercial production of a business component.
• Each business component must be evaluated separately to see if its R&D qualifies under the applicable rules. Thus, any plant process, machinery, or technique for commercial production of a business component is treated as a separate business component (and not as part of the business component being produced).
• If all aspects of the requirement of new or improved function, performance, or reliability or quality (mentioned below) are not met with respect to a business component, but are met with respect to one or more elements thereof, the term “business component” means the most significant set of elements of such product, etc. with respect to which all aspects of the requirement are met.
• The requirement of “new or improved function,” etc. is applied first at the level of the entire business component to be offered for sale, etc. by the taxpayer. If all aspects of that requirement are not met at that level, the test applies at the most significant subset of elements of the business component. This "shrinking back" of the product is to continue until either a subset of elements of the product that satisfies the requirement is reached, or the most basic element of the product is reached and such element fails to satisfy the test.
• Substantially all of the activities constitute elements of a process of experimentation, relating to:
• A new or improved function;
• Performance; or
• Reliability or quality of a business component.
• “Process of experimentation” means a process involving the evaluation of more than one alternative designed to achieve a result where the means of achieving that result is uncertain at the outset. This may involve developing one or more hypotheses, testing and analyzing those hypotheses (through, for example, modeling or simulation), and refining or discarding the hypotheses as part of a sequential design process to develop the overall component.
• Qualified research does not include the following:
• Any research conducted after the beginning of commercial production of the business component.
• Any research related to the adaptation of an existing business component to a particular customer's requirement or need.
• Work which is related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
• Surveys and studies of the following nature: efficiency surveys, management studies, market research, testing, or development (including advertising or promotions), routine data collection, or routine or ordinary testing or inspection for quality control.
• Testing or inspection to determine whether particular units of materials or products conform to specified parameters is quality control testing. However, quality control testing does not include testing to determine if the design of the product is appropriate.
• Any research conducted outside the United States.
• Research in the social sciences, arts, or humanities.
• Funded research.
• Activities relating to style, taste, cosmetic, or seasonal design factors.
• If an employee has performed both qualified services and nonqualified services, only the amount of time allocated to the performance of qualified services is treated as research.
• If substantially all of the services performed by an individual consist of R&D services, then all of that individual's time can be considered as R&D. The term “substantially all” is defined as 80% or more of the time spent by an individual on R&D activities.
• Direct supervision and direct support of qualified activities may also constitute qualified R&D under the following circumstances:
• Direct supervision means the immediate supervision (first-line management) of qualified research (as in the case of a scientist who directly supervises research, but who may not actually perform research). Direct supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist.
• Direct support includes the services which directly assist either those engaging in actual qualified R&D or those who are directly supervising those engaged in qualified R&D. Examples include the services of a secretary typing reports describing research results and a clerk for compiling research data. Direct support of research activities does not include general administrative services or other services only indirectly of benefit to research activities. For example, services of payroll personnel in preparing salary checks of scientists, of an accountant for accounting for research expenses, of a janitor for general cleaning of a research laboratory, or of officers engaged in supervising financial or personnel matters do not qualify as direct support of research. This is true whether general administrative personnel are part of the research department or in a separate department.
• Activities related to the development of computer software for the taxpayer's own internal use (e.g., for payroll, bookkeeping, or personnel management functions) are generally not considered qualified R&D. However, under forthcoming regulations, the development of internal-use computer software may be treated as qualified R&D only if it can established that, in addition to satisfying the general requirements for R&D treatment:
• That the software is innovative (as where the software results in a reduction in cost, or improvement in speed, that is substantial and economically significant);
• Note that the proposed regulations provide a slightly modified standard than the legislative history in that the software “is innovative in that the software is intended to be unique or novel and is intended to differ in a significant and inventive way from prior software implementations or methods”.
• That the software development involves significant economic risk (as where the taxpayer commits substantial resources to the development and also there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period); and
• That the software is not commercially available for use by the taxpayer (as where the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements just stated).

Uncertain Tax Positions - Policy of Restraint?

On January 26, 2010, the IRS released an advance copy of Announcement 2010-9 stating its intention to require certain business taxpayers to disclose their "uncertain tax positions" ("UTPs") on their income tax returns. This Announcement (and the IRS's reasoning behind it) was first revealed to the public on that same day as part of IRS Commissioner Doug Shulman's remarks to the New York State Bar Association Taxation Section's Annual Meeting.

While it may not be immediately obvious, the implications are huge.

BACKGROUND
In 2006, the Financial Accounting Standards Board ("FASB") issued its Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes, effective for fiscal years beginning after December 15, 2006. FIN 48 was intended to address the matter of uncertainty in a company's income tax positions in the context of the tax provision reflected in its financial statements (under FASB Statement No. 109, Accounting for Income Taxes).

More specifically, FIN 48 required companies to meet a set of two "more likely than not" (i.e., more than 50%) standards in determining whether they could recognize (for financial statement purposes) the tax benefit from any particular non-routine income tax position. In addition, it imposed new disclosure requirements on affected companies who would then have to report information about their UTPs in their financial statement footnotes.

Not surprisingly, many commentators expressed concern that this new requirement (particularly the footnote disclosures) would inappropriately provide tax authorities with a roadmap in auditing a company's tax returns. The Board responded, in part, by stating that (1) requiring disclosures at the specified aggregate level would not reveal information about a taxpayer's individual tax positions while at the same time providing information that financial statement users would find useful and (2) the FASB was aware that the IRS had recently instituted a detailed reconciliation requirement that provides information about differences between amounts reported in an enterprise s income tax return and its financial statements (i.e., federal form M-3). It went on to state that the FASB believed that this reconciliation requirement and those like it are the sources of information that taxing authorities use to focus their examination. In other words, the FASB didn't believe that such FIN 48 disclosures would end up serving as a roadmap to the taxing authorities. (Note: FIN 48 was subsequently made a part of FASB Accounting Standards Codification (ASC) 740-10, Income Taxes.)

THE ANNOUNCEMENT
Contrary to the FASB's expressed belief, the IRS is now seriously considering not only using that roadmap, but asking affected taxpayers to add signposts and neon signs to that roadmap to light the way!

In its Announcement, the IRS starts off with the following statement:

"The Internal Revenue Service is considering changes to reporting requirements regarding certain business taxpayers uncertain tax positions in order to improve tax compliance and administration. The Service is developing a schedule requiring certain business taxpayers to report uncertain tax positions on their tax returns. This Announcement discusses the potential content of such a schedule and invites public comment on the Service s proposed approach. The schedule will require the annual disclosure of uncertain tax positions in the form of a concise description of those positions and information about their magnitude. The proposal does not require the taxpayer to disclose the taxpayer's risk assessment or tax reserve amounts, even though the Service can compel the production of this information through a summons."

WHAT INFORMATION IS THE IRS CONTEMPLATING?
The Announcement provides that the IRS is currently contemplating that affected taxpayers will be required to provide the following information regarding each of their UTPs:

• The Internal Revenue Code sections potentially implicated by the position;
• A description of the taxable year or years to which the position relates;
• A statement that the position involves an item of income, gain, loss, deduction, or credit against tax;
• A statement that the position involves a permanent inclusion or exclusion of any item, the timing of that item, or both;
• A statement whether the position involves a determination of the value of any property or right;
• A statement whether the position involves a computation of basis; and
• Specification for each UTP, the entire amount of U.S. federal income tax that would be due if the position were disallowed in its entirety on audit. This amount is the maximum tax adjustment for the position reflecting all changes to items of income, gain, loss, deduction, or credit if the position is not sustained. 

Interestingly, while many practitioners and taxpayers would arguably view the above as troublesome (to say the least), Commissioner Shulman went on to say that "We could have asked for more a lot more but chose not to. We believe we have crafted a proposal that gives us the information we need to do our job without trying to get in the heads of taxpayers as to the strengths or weaknesses of their positions." Whether we agree or disagree with his comments (or the IRS's intentions in general on this matter), there is little question that the IRS will rely heavily on this disclosure in both selecting companies for examination and in carrying out those audits.

WHO WOULD THE IRS BE TARGETING?
As currently proposed, the new requirement would apply to business taxpayers with over $10 million in total assets if they have one or more UTPs of the type required to be reported on the contemplated schedule. According to the IRS, this "includes a taxpayer who prepares financial statements, or is included in the financial statements of a related entity that prepares financial statements, if that taxpayer or related entity determines its United States federal income tax reserves under FIN 48, or other accounting standards relating to uncertain tax positions involving United States federal income tax."

As written, the scope of this planned disclosure requirement would be fairly broad and will undoubtedly increase the compliance burden on many affected taxpayers.

HOW COMMITTED IS THE IRS TO THIS INTIATIVE?
Based on my reading of the Announcement, Commissioner Shulman's comments, and the state of the federal budget, it's probably fair to say that they are very committed to it. In addition, the Announcement itself states that the IRS intends to publish the new schedule as quickly as possible and will mandate its use for returns filed after its release. Nevertheless, they have requested comments by March 29, 2010.


Clearly, the new requirements could have very significant reporting implications. As this issue is very new and could have substantial changes be sure to keep an ear open for additional information on this important topic.


If you would like to read the entire Announcement, it is available on the IRS website at http://www.irs.gov/pub/irs-drop/a-10-09.pdf