Therapeutic Discovery Project Tax Credit / Grant - IRS Releases Form 8942, Instructions, and Additional Guidance

More information to follow as soon as I've had a chance to review, but in the interim:

• Form 8942: http://bit.ly/cNFF2Y
• Form 8942 instructions: http://bit.ly/9hdjI9
• IRS Q&A: http://bit.ly/depaMx

Let me know if you have any questions, I'd love to help!

 

How's this for Random and Fishing (Library of Congress)

Did you know that the Library of Congress has a YouTube channel where it stores old (and I mean really old) videos and cartoons?  Here's a link to a 1903 video of a guy bass fishing: http://www.youtube.com/user/LibraryOfCongress#p/u/114/93RpuHxFY2g.

The main channel has hundreds of old (and apparently recent) videos and is at http://www.youtube.com/user/LibraryOfCongress.  Very cool!

IRS News Release IR-2010-69 reminds taxpayers of several recent tax incentives for small business

Pretty self-explanatory, but worth reviewing in case your business might be able to take advantage of one or more of these incentives.  Original release at http://bit.ly/bAEW2J

Recent Legislation Offers Special Tax Incentives for Small Businesses to Provide Health Care, Hire New Workers


Videos
HIRE Act: English
Small Business Health Care Tax Credit: English


IR-2010-69, May 28, 2010


WASHINGTON — In recognition of National Small Business Week, the Internal Revenue Service encourages small businesses to take advantage of tax-saving opportunities included in recently enacted federal legislation.


A variety of business tax deductions and credits were created, extended and expanded by the American Recovery and Reinvestment Act of 2009 (ARRA), this year’s Hiring Incentives to Restore Employment (HIRE) Act and the Affordable Care Act. Because some of these changes are only available this year, eligible businesses only have a few months to take action and save on their taxes. Here is a rundown of some of the key provisions.


New Health Care Tax Credit Helps Small Employers


The small business health care tax credit, created under the Affordable Care Act, is designed to encourage small employers to offer health insurance coverage for the first time or maintain coverage they already have.


The credit takes effect this year and is generally available to small employers that pay at least half the cost of single coverage for their employees in 2010. The credit is specifically targeted to help small employers that primarily employ low- and moderate-income workers.


For tax years 2010 to 2013, the maximum credit is 35 percent of premiums paid by eligible small business employers. The maximum credit goes to smaller employers ­­–– those with 10 or fewer full-time equivalent (FTE) employees ––­­ paying annual average wages of $25,000 or less. The credit is completely phased out for employers with more than 25 FTEs or with average wages of more than $50,000.


Because the eligibility rules are based in part on the number of FTEs, not the number of employees, businesses that use part-time help may qualify even if they employ more than 25 individuals. More information about the credit, including a step-by-step guide and answers to frequently asked questions, is available on the IRS website.


Two New Benefits for Employers that Hire and Retain Recently Unemployed


Employers who hire unemployed workers this year (after Feb. 3, 2010, and before Jan. 1, 2011) may qualify for a 6.2-percent payroll tax incentive, in effect exempting them from the employer’s share of Social Security tax on wages paid to these workers after March 18. In addition, for each qualified employee retained for at least a year whose wages did not significantly decrease in the second half of the year, businesses may claim a new hire retention credit of up to $1,000 per worker on their income tax return.


These tax benefits are especially helpful to employers who are adding positions to their payrolls. New hires filling existing positions also qualify but only if the workers they are replacing left voluntarily or for cause. Family members and other relatives generally do not qualify.


Employers must get a signed statement from each eligible new hire, certifying under penalties of perjury, that he or she was not employed for more than 40 hours during the 60 days before beginning employment with that employer. IRS Form W-11 can be used to meet this requirement. Further details, including answers to frequently asked questions, are posted on IRS.gov.


Work Opportunity Tax Credit Aids Employers That Hire Certain Workers


The work opportunity tax credit (WOTC) offers tax savings to businesses that hire employees belonging to various targeted groups. These groups include people ages 18 to 39 living in designated communities in 43 states and the District of Columbia, recipients of various types of public assistance, certain veterans, ex-felons and certain youth workers. The instructions for Form 8850 detail the requirements for each of these groups.


Certification by the state workforce agency is generally required. Normally, a business must file Form 8850 with the state workforce agency within 28 days after the eligible worker begins work.


An eligible employer can claim both the WOTC and the new hire retention credit for the same employee. However, an employer may not claim both the payroll tax exemption and the WOTC for the same employee. Therefore, any employer that chooses to apply the exemption to wages paid to a qualified employee may not receive the WOTC on any wages paid to that employee during the one-year period beginning on the employee’s hiring date.


Exclusion of Gain on the Sale of Certain Small Business Stock


An extra incentive is now available to individuals who invest in small businesses. Investors in qualified small business stock can exclude 75 percent of the gain upon sale of the stock. This increased exclusion applies only if the qualified small business stock is acquired after Feb. 17, 2009, and before Jan. 1, 2011, and held for more than five years. For previously-acquired stock, the exclusion rate remains at 50 percent in most cases.


COBRA Credit


Employers that provide the 65 percent COBRA premium subsidy to eligible former employees can claim credit for this subsidy on their quarterly or annual payroll tax returns. To help avoid imposing an unnecessary cash-flow burden, affected employers can reduce their payroll tax deposits by the amount of the credit. For details, see the instructions for Form 941.


Small business owners can find a variety of helpful on-line resources in the Small Business and Self-Employed Tax Center on IRS.gov.

IRS releases guidance on Therapeutic Discovery Project Credit / Grant

This morning, the IRS released advance guidance on the Therapeutic Discovery Project Credit / Grant.

A few items stand out:

• Applications must be filed on Form 8942 (and in conformity with the form's instructions) and each project must be applied for separately.
• That form is expected to be released no later than June 21, and applications must be filed (i.e., postmarked) no later than July 21.
• The Department of Health & Human Services seems to be the primary determiner of which projects should be funded.
• There will be a $5 million per-taxpayer limitation on allocations of credits/grants (for 2009 and 2010 together), regardless of the number of projects sponsored.
• In the first round of allocations, the IRS will approve or deny applications no later than October 29, 2010 and will notify taxpayers by letter.
• Taxpayers will not have a right to Conference or Appeal related to any matters under the Notice.  i.e., all decisions are final.
• The 250-employee limit includes both full-time and part-time employees (but not leased employees).
• Taxpayers are required to inform the IRS of any significant changes in plans that arise prior to the date of IRS certification of the projects.  A significant change is any change (including any change that would affect the continuing accuracy of a statement made in the application) that a reasonable person would conclude might have influenced HHS’ evaluation.
• Grant applicants must provide a DUNS number with their application.  If the applicant does not already have a DUNS number, it may request one at no cost by calling the dedicated toll-free DUNS Number request line at 1-866-705-5711.
• Grant applicants must also register with the Central Contractor Registration ("CCR"). To register, go to
  http://www.ccr.gov/startregistration.aspx. The registration must be completed before a payment can be made.
• Approved credit and grant applicants are advised that the IRS will publicly disclose their identities, and the amount of their credit or grant.
• The statute authorizes public disclosure of more information for taxpayers awarded grants than for those awarded credits (e.g., types of projects).  As a result, the IRS requests authorization to publish such information for approved projects awarded credits.  While such consent is not required to receive a credit allocation, it's not clear whether withholding it could have any impact on a borderline project being approved.
• Unnecessarily elaborate applications are discouraged and brochures or other presentations are not permitted as part of the applications and will not be considered.

The release read as follows:

Notice 2010-45 establishes the qualifying therapeutic discovery project program under § 48D of the Internal Revenue Code.   Section 9023(a) of the Patient Protection and Affordable Care Act (Act) added § 48D to the Code as part of the investment credit under § 46.  Section 48D provides a nonrefundable tax credit equal to 50 percent of an eligible taxpayer’s qualified investment in a qualifying therapeutic discovery project.  Under section 9023(e) of the Act, an eligible taxpayer may elect to receive a grant in lieu of credits.  Section 48D(d)(1)(B) limits the total amount of credits or grants to be allocated under the program to $1 billion during the two-year period from 2009 through 2010.  The Service, in consultation with Department of Health and Human Services, will award certifications for qualified investments.  The credits or grants will only be available to taxpayers having 250 or fewer full-time and part-time employees.

Notice 2010-45 will appear [in] IRB 2010-23, dated June 7, 2010. 

link to Notice:   http://bit.ly/aDH2li

Draft application for Therapeutic Discovery Project Tax Credit (or Grant)

Many of you have heard about the very lucrative Therapeutic Discovery Project Tax Credit, which can alternatively be taken as a nontaxable (for federal income tax purposes) grant.

Unfortunately, there has been no official guidance (except for the text of new IRC section 48D itself) about how taxpayers will be able to apply for an allocation from the $1 billion available for the program.  Treasury has until May 21, 2010 to provide that guidance.  However, since (a) there is a limited pool of funds available, (b) the promised turnaround time for application review is 30 days from receipt by Treasury, and (c) there is likely to be a mad rush to apply, it makes sense for all qualified taxpayers to submit their applications as soon as possible.

For that reason, I've prepared a draft  and unofficial application for use in gathering the information until further information becomes available.  The standard caveats apply (i.e., my version is not official, use at your own risk, talk to your professional tax advisor before taking any action on this, etc.).  Nevertheless, I hope you find it useful in starting the application process.  If you do use it, I'd love to hear from you.  If you want to use it for others, please go ahead and do so but (1) please keep my attribution on it, and (2) please provide caveats to your users as well.

Quick recap of my post from April 5 on this subject:

• QUALIFYING THERAPEUTIC DISCOVERY PROJECT CREDIT
• 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.

http://www.docstoc.com/docs/document-preview.aspx?doc_id=37142261

IRS releases new Form 3115 for tax accounting method changes

The IRS issued today an advance copy of Announcement 2010-32 (which will be published in Internal Revenue Bulletin 2010-19 on May 10, 2010) discussing the new December 2009 revision of Form 3115, which is required for both automatic tax accounting method changes as well as non-automatic tax accounting method change requests.

In short, the IRS will generally accept either the new or the old (December 2003) version through May 30, 2010, after which it will only accept the December 2009 version.  Nevertheless, taxpayers are urged to use the new version before the deadline.

All links are to Adobe Acrobat (PDF) files.

• Copy of Announcement 2010-32 is available at http://bit.ly/btMBtS

• Copy of December 2009 version of Form 3115 is available at http://bit.ly/bTLbbz

• Copy of December 2009 version of Form 3115 instructions is available at http://bit.ly/dvBdnT

I hope to get a chance soon to review the specific changes between the old and new versions and will update when I'm done.

IRS Announcement 2010-30 re disclosure of Uncertain Tax Positions (UTPs)

Just received the following advance release of Announcement 2010-30:

Announcement 2010-30 releases the draft schedule, Schedule UTP, accompanied by draft instructions that provide a further explanation of the Service’s proposal requiring reporting of uncertain tax positions, and invites public comment on the draft schedule and instructions.

Announcement 2010-30 will be in IRB 2010-19, dated May 10, 2010.

The advance is available at http://bit.ly/dn4Ubm but does not include a copy of proposed "Schedule UTP."

EDIT 4/20/10:

The IRS has now uploaded Schedule UTP  http://bit.ly/dugHbf and the instructions http://bit.ly/aHZ7Kn

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.

---

[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.