Use of Third-Party Contract Manufacturer Precludes Sec. 199 Deduction; Taxpayer Lacked Benefits and Burdens of Ownership

In a case of first impression, the Tax Court was asked to decide how Code Sec. 199 applies to U.S. corporations that manufacture products through agreements with contract manufacturers. The court had to determine whether a taxpayer's gross receipts attributable to printed direct mail advertising qualified as domestic production gross receipts (DPGR) such that the taxpayer was eligible for the Code Sec. 199 domestic production activities deduction (DPAD). In this case, the taxpayer supplied advertising material to clients, but contracted with third-party commercial printers to print it. The IRS argued that because the taxpayer contracted out the actual printing to third-party printers, it did not manufacture any qualifying production property and could not take the deduction. ADVO, Inc. & Sub v. Comm'r, 141 T.C. No. 9 (10/24/13).

In ADVO, the Tax Court sided with the IRS and concluded that because the taxpayer did not have the benefits and burdens of ownership of the direct advertising materials, it was not considered to have manufactured, produced, grown, or extracted qualifying production property under Code Sec. 199 and was thus was not entitled to the deduction.

Observation: This case has broad implications for a number of companies that use U.S.-based contract manufacturers. The issue of whether or not a company can claim that it is the manufacturer of a product it sells when it contracts with third parties to assist in producing the product is one of the biggest areas of dispute between the IRS and taxpayers taking the Code Sec. 199 deduction. Another case currently before the Tax Court involves L. Brands, Inc., the owner of Victoria's Secret and Bath & Body Works stores. The issue in that dispute is whether or not L. Brands can claim the Code Sec. 199 deduction for lotions sold by Victoria's Secret but made by an outside contractor.

Practice Tip: In July 2013, in recognition of the fact that the IRS and taxpayers could expend significant resources to determine which party may claim the Code Sec. 199 deduction in situations where third-party contract manufacturers are used, the IRS issued a Large Business & International Directive, LB&I-04-0713-006 (7/24/13), which provides that the IRS will not challenge a taxpayer's claim that it has the benefits and burdens of ownership for purposes of a Code Sec. 199 deduction if that taxpayer provides a certification executed by both parties designating the party who is to receive the Code Sec. 199 deduction. An acceptable form of certification is included as an exhibit to the guidance.

Background

ADVO, Inc. (ADVO) was the common parent of the consolidated group ADVO, Inc., & Subsidiaries for the tax years ending September 24, 2005, and September 30, 2006, and for the short tax year ending March 2, 2007. On March 3, 2007, ADVO was acquired by Valassis Communications, Inc. and continues to exist as its wholly owned subsidiary. Read more...

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IRS Expands Guidance on Energy Credits for Nonbusiness Property

Taxpayers that place certain nonbusiness energy property in service before 2014 or before 2017 may be eligible for tax credits under Code Sec. 25C and Code Sec. 25D, respectively. Each credit has different requirements and covers different types of property. The credits, which are aimed at homeowners installing energy efficient improvements such as insulation, new windows (including skylights), certain roofs, furnaces, and hot water boilers, range from $50 to $1,500, depending on the type of property placed in service. In Notice 2013-70, the IRS provides additional guidance on the types of property that qualify for the credits.

For example, while improvements made to a second home are not eligible for the credit under Code Sec. 25C nor under Code Sec. 25D with respect to fuel cell property, Notice 2013-70 provides that a taxpayer may claim a Code Sec. 25D credit for other qualifying property described in Code Sec. 25D, such as solar electric property, solar water heating property, small wind energy property, and geothermal heat pump property, installed in a dwelling unit used as a second home or a vacation home by the taxpayer. Notice 2013-70 also provides that, because the sales tax on a qualifying property is part of the amount paid or incurred, a taxpayer may include the amount of sales tax when calculating both the Code Sec. 25C credit and the Code Sec. 25D credit. In addition, Notice 2013-70 provides that window sash replacement kits may be eligible for the Code Sec. 25C credit even though they are not whole windows.

Practice Tip: To the extent the notice provides new insight into the types of property that qualify, practitioners may be able to use this guidance to take credits on a client's 2013 tax return or file amended returns for prior years in which their clients placed such property in service.

Observation: While the credit under Code Sec. 25C is scheduled to expire for property placed in service after 2013, there are ongoing efforts in Congress to extend tax provisions scheduled to expire at the end of 2013. The Obama administration, however, is not backing the annual tax extenders package and instead wants to make a few of the provisions permanent while pushing forward with tax reform.

Background

Code Sec. 25C allows a credit in an amount equal to the sum of (1) 10 percent of the amount paid or incurred by the taxpayer for qualified energy efficiency improvements installed during the year, and (2) the amount of the residential energy property expenditures paid or incurred by the taxpayer during the year. The credit is allowed for qualifying property placed in service through December 31, 2013. For property placed in service in tax years beginning in 2009 and 2010, Code Sec. 25C allowed taxpayers to claim a maximum aggregate credit of $1,500. However, for years other than tax years beginning in 2009 and 2010, Code Sec. 25C limits the credit allowable to any taxpayer to the excess of $500 over the aggregate credits allowed to that taxpayer under Code Sec. 25C for all prior tax years ending after December 31, 2005 (including credits claimed in 2009 and 2010). Read more...

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2014 Tax Season to Start Later Following Government Shut Down

The IRS announced a delay of approximately one to two weeks to the start of the 2014 filing season to allow adequate time to program and test tax processing systems following the 16-day federal government closure. IR-2013-82 (10/22/13).

The IRS is exploring options to shorten the expected delay in starting the 2014 filing season and will announce a final decision on the start of the 2014 filing season in December. The original start date of the 2014 filing season was January 21. However, the IRS now expects a one- to two-week delay, meaning the IRS would start accepting and processing 2013 individual tax returns no earlier than January 28 and no later than February 4.

According to the IRS, the government closure came during the peak period for preparing IRS systems for the 2014 filing season. Programming, testing, and deployment of more than 50 IRS systems is needed to handle processing of nearly 150 million tax returns. Updating these core systems is a complex, year-round process with the majority of the work beginning in the fall of each year.

About 90 percent of IRS operations were closed during the shutdown, with some major workstreams closed entirely during this period, putting the IRS nearly three weeks behind its tight timetable for being ready to start the 2014 filing season. There are additional training, programming, and testing demands on IRS systems this year in order to provide additional refund fraud and identity theft detection and prevention.

Readying our systems to handle the tax season is an intricate, detailed process, and we must take the time to get it right, Acting IRS Commissioner Danny Werfel said. The adjustment to the start of the filing season provides us the necessary time to program, test, and validate our systems so that we can provide a smooth filing and refund process for the nation's taxpayers. We want the public and tax professionals to know about the delay well in advance so they can prepare for a later start of the filing season.

The IRS will not process paper tax returns before the start date, which will be announced in December. There is no advantage to filing on paper before the opening date, and taxpayers will receive their tax refunds much faster by using e-file with direct deposit.

The IRS noted that its processes, applications, and databases must be updated annually to reflect tax law updates, business process changes, and programming updates in time for the start of the filing season.

During the closure, the IRS received 400,000 pieces of correspondence, on top of the 1 million items already being processed before the shutdown.

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IRS Modifies FSA Rules to Allow Up to $500 to Be Used in Following Year

To make health flexible spending arrangements (FSAs) more consumer-friendly and provide added flexibility, new guidance permits employers to allow plan participants to carry over up to $500 of their unused health FSA balances remaining at the end of a plan year. Notice 2013-71.

A Code Sec. 125 cafeteria plan generally does not include any plan that provides for deferred compensation. Proposed regulations under Code Sec. 125 that predate the enactment of the Affordable Care Act generally have prohibited participants from using contributions made for one plan year to purchase a benefit that will be provided in a subsequent plan year. Commonly referred to as the use-or-lose rule, this rule requires that unused benefits or contributions remaining as of the end of the plan year (that is, amounts credited to a health FSA participant's account that remain unused) be forfeited.

Notice 2013-71 modifies the rules for cafeteria plans and permits employers to allow employees to carry over up to $500 of the unused amounts left in their health FSAs for expenses in the next year. Some plan sponsors may be eligible to take advantage of the option to adopt a carryover provision as early as plan year 2013. In addition, the existing option for plan sponsors to allow employees a grace period after the end of the plan year remains in place. However, a health FSA cannot have both a carryover and a grace period; it can have one or the other or neither.

Observation: Many taxpayers requested that the use-or-lose rule for health FSAs be modified. Comments pointed to the difficulty for employees of predicting future needs for medical expenditures, the need to make FSAs accessible to employees of all income levels, and the desire to minimize incentives for unnecessary spending at the end of the year.

For a discussion of FSAs, see Parker Tax ¶122,555.

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University Professor's Record Label Activity Had No Bona Fide Profit Objective

The music record label activity conducted by a university professor and his wife, which supported their daughter's career in the music industry, did not have a bona fide profit objective and thus losses attributable to the activity were disallowed. Schlievert v. Comm'r, T.C. Memo. 2013-239 (10/22/13).

Patrick Schlievert, a university professor, and his wife, Shirley, a homemaker, had a net worth of $1.8 million. Patrick created two biotechnology companies, a limited liability company, and a corporation to develop drugs for the prevention and treatment of infectious diseases. The companies had a business plan and timetable toward profitability but were not yet profitable in the year at issue. In 2010, Patrick and Shirley entered into an oral agreement to produce a record for a rock music band managed by the couple's daughter, Sara. The agreement provided that the couple would fund the band's expenses and would be repaid for all expenses from any money the band received from a future record label advance or 50 percent of record sales. The couple would also receive 10 percent of the amount over $200,000 that the band earned. The agreement required that Sara would continue to serve as the band's manager for a 15 percent fee. Prior to 2010, the couple had no experience with the music industry or music record labels.

Patrick and Shirley named the music record label activity Schlievert's Ultimate Record Facility (SURF). The activity was not organized as an LLC or a corporation and had no bank account or employees. The activity name was not registered as a trademark or advertised. In addition, the couple did not seek to invest in other music bands. The agreement provided that Sara would pay for the band's expenses from her personal checking account or with her personal credit card and subsequently be reimbursed by the couple. The band released an album in 2010 and a compact disc (CD), which was produced by another individual. The couple's record label activity sustained losses in 2010, 2011, and 2012. In 2013, the couple stopped investing in the music band and their record label activity. Patrick and Shirley filed a joint federal income tax return in 2010 and reported a net loss of $44,445 on Schedule C, Profit or Loss From Business. They claimed deductions for advertising, commissions and fees, legal and professional services, supplies and travel expenses but reported no gross income on the Schedule C. The IRS disallowed the Schedule C losses for 2010, determined a deficiency, and imposed an accuracy-related penalty.

Deductions are allowed for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business or for the production of income under Code Sec. 162. Code Sec. 183 provides that in the case of an activity engaged in by an individual or S corporation, if the activity is not engaged in for profit, then no deduction attributable to the activity will be allowed.

Reg. Sec. 1.183-2(b) provides nine nonexclusive factors to determine whether an activity is engaged in for profit: (1) the manner in which the taxpayer carried on the activity, (2) the expertise of the taxpayer or his advisers, (3) the time and effort the taxpayer expended in carrying on the activity, (4) the expectation that the assets used in the activity may appreciate in value, (5) the taxpayer's success in carrying on other activities, (6) the taxpayer's history of income or loss with respect to the activity, (7) the amount of profits, if any, which are earned, (8) the taxpayer's financial status and (9) whether elements of personal pleasure or recreation are involved.

Observation: The following facts are evidence that the taxpayer has a profit motive for carrying on an activity: (1) the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records; (2) the taxpayer carries on the activity in a manner substantially similar to the manner in which he carries on other profitable activities of the same nature; or (3) the taxpayer changes operating methods, adopts new techniques, or abandons unprofitable methods in a manner consistent with an intent to improve the profitability of the activity.

Patrick and Shirley argued that the record label activity was conducted with a bona fide profit objective. The IRS contended that the couple used their record label activity solely as a way to support and help their daughter, Sara, get into the music industry.

The Tax Court held that Patrick and Shirley did not engage in the music record label activity for profit and were not entitled to deduct expenses in excess of gross income from the activity. The court found that the couple did not conduct the record label activity in a businesslike manner since they did not form an entity, prepare a business plan, or keep records to make informed business decisions. They failed to provide any receipts or invoices of the band's expenses. In addition, the commingling of their funds with Sara's indicated the activity was more of a hobby than a business. The couple also did not represent any other band, have any employees, or advertise the record label.

The court rejected the couple's contention that they took steps to educate themselves and consulted experts in the music industry. The investment of large sums of money without a written agreement was a poor business practice, the court said, even if done pursuant to advice. The court noted that, as a full-time professor and creator of two other companies, it was unlikely that Patrick devoted substantial time and effort to the record label activity. There was no evidence presented that Shirley devoted any time to the activity.

The court also found that Patrick's two biotechnology companies were operated in a vastly more professional manner than the record label activity. Although the band released a CD in 2010, the couple did not collect any portion of the band's sales income. Further, the couple's substantial wealth enabled them to fund the band and assist their daughter in her music industry career. Finally, the accuracy-related penalty for substantial understatement of tax was upheld, as Patrick and Shirley presented no evidence that they had reasonable cause for any portion of the underpayment.

For a discussion of determining whether or not an activity is engaged in for profit, see Parker Tax ¶97,505.

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Failure to Follow State Law Prevents Taxpayer from Excluding Full Settlement Proceeds from Income

A $250,000 lawsuit settlement was not excludable under Code Sec. 104(a)(1) because the taxpayer did not obtain the requisite approval for the settlement required by state law; however, the amount was partially excludable under Code Sec. 104(a)(2). Simpson v. Comm'r, 141 T.C. No. 10 (10/28/13).

Kathleen Simpson sued her employer, Sears, Roebuck & Co. (Sears), for employment discrimination under California's Fair employment and Housing Act (FEHA), claiming, among other things, that she was entitled to compensatory damages for, among other things, physical injuries. After the state court dismissed all but one claim alleged in the suit, Kathleen's attorney concluded that she would not be able to extract a settlement from Sears on the basis of the one remaining FEHA claim. The attorney learned, however, that Kathleen was eligible for workers' compensation benefits under California's workers' compensation laws. On that basis alone, Kathleen and Sears engaged in settlement discussions and eventually entered into a settlement agreement by which Kathleen released Sears from each and every claim she might have against Sears, including, but not limited to, claims asserted in the FEHA lawsuit.

In exchange for the release, Sears agreed to pay Kathleen $12,500 for her claim for lost wages and employment benefits; $98,000 for her claims for emotional distress, physical and mental disability; and $152,000 to her attorney for attorney's fees and court costs. The attorney understood that the $98,000 was intended to compromise Kathleen's claim for workers' compensation benefits for emotional distress and physical and mental disabilities that she suffered from work-related injuries (i.e., clinical depression, irritable bowel syndrome, and fibromyalgia), while working for Sears, and he attributed 10 percent to 20 percent of the $98,000 to the work-related physical illness and disabilities Kathleen suffered. The settlement agreement provided that California laws governed the contract.

The settlement agreement did not specifically mention Kathleen's possible workers' compensation claims. Neither Kathleen nor Sears submitted the settlement agreement to the California Workers' Compensation Appeals Board (WCAB) for the approval required under California's workers' compensation laws. Ten percent of the settlement award was attributable to Kathleen's personal physical injuries and physical sickness.

Kathleen's 2009 return reported the $12,500 as income for lost wages and employment benefits. However, she did not report anything else from the settlement. She attached to the 2009 return a letter from her attorney explaining the nature of the $250,000 proceeds reported on the Form 1099-MISC, Miscellaneous Income, received from Sears and why none of that amount was being reported on the tax return. The letter stated that the settlement was entirely based on the claim that Kathleen became ill due to work, became disabled due to the severity of that illness, and she should have been accommodated by being provided Workers' Compensation or Short Term Disability Leave, but was not.

The IRS issued a notice of deficiency in which it determined that Kathleen failed to report the $250,000 settlement proceeds as income.

The Tax Court was asked to decide whether any portion of $250,000 was excludible from gross income under Code Sec. 104(a)(1) or (2). The Court held that the $250,000 was not excludable under Code Sec. 104(a)(1) because Kathleen did not obtain the requisite approval from the WCAB required by the state's workers' compensation laws. However, the amount but was partially excludable under Code Sec. 104(a)(2).

According to the court, 10 percent of Kathleen's settlement award was excludable from gross income under Code Sec. 104(a)(2) and the newly amended regulations under that section, which exclude damages from income as long as recovery is for personal physical injuries or physical sickness even if recovery is under a statute that does not provide for a broad range of remedies and even if the injury is not defined as a tort under state or common law.

For a discussion of the tax treatment of damages received on account of physical injuries or sickness, see Parker Tax ¶75,910.

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Spouses with Separate Businesses Must Separately Compute Self-Employment Tax

A married couple who separately owned a realty and an accounting business were required to separately compute their self-employment tax and could not combine the net income from the realty business, which was allocable to the wife, with the net losses from the accounting business, which was allocable to the husband. Fitch v. Comm'r, T.C. Memo. 2013-244 (10/28/13), supplementing T.C. Memo. 2012-358.

Brenda Fitch was a licensed real estate agent in California and worked full time for a realty business, Remax. Donald Fitch was a CPA and operated an accounting practice. For the years in issue, Brenda and Donald reported income and expenses regarding their respective realty and accounting businesses on Schedule C, Profit or Loss From Business. Apart from their businesses, Brenda and Donald owned and managed eight rental properties. Income and expenses from the rental properties was reported on Schedule E, Supplemental Income or Loss.

Upon examination of their returns for 2005, 2006 and 2007, the IRS computed the self-employment tax separately for Brenda and Donald. The IRS determined that Brenda had net self-employment tax from her realty business of $1,766 for 2005, $334 for 2006, and $2,919 for 2007. It determined that Donald had net losses from his accounting business and his self-employment tax was zero for each year in issue. Brenda and Donald's self-employment tax was added together to arrive at the couple's self-employment tax. In objecting to the IRS's computations, Brenda and Donald filed computations in which they combined the net income from Brenda's realty business with the net losses from Donald's accounting business. They determined that they had net losses from self-employment and computed their self-employment tax to be zero for each year in issue.

Code Sec. 1402(b) defines the term net earnings from self-employment as the gross income derived by an individual from any trade or business carried on by the individual less any deductions allowed that are attributable to the trade or business. If the trade or business is jointly operated, then the gross income and deductions are treated as the gross income and deductions of each spouse on the basis of the respective distributive shares of the gross income and deductions under Code Sec. 1402(a)(5)(a).

If a married couple files a joint return, the self-employment tax is computed separately for the husband and for the wife under Code Sec. 6017. Each spouse's self-employment tax liability is added to arrive at the couple's total self-employment tax liability.

Observation: On a joint return, the taxpayers should show the name of the spouse with self-employment income on Schedule SE, Self-Employment Tax. If both spouses have self-employment income, each must file a separate Schedule SE.

Brenda and Donald argued that the net income from the realty business should be attributable solely to Donald because Brenda did not substantially manage and control the realty business. In the alternative, the couple argued that the net income from the realty business should be attributed to each of them on the basis of their respective contributions to the realty business.

The IRS contended that the realty business was operated solely by Brenda and the net income should therefore be attributed to her alone.

The Tax Court held that Brenda owned and operated the realty business and Donald owned and operated the accounting business and neither business was jointly held. There was substantial evidence that Brenda operated the realty business and that she was a licensed real estate agent and member of professional real estate organizations. Although Donald was a CPA, Brenda kept and maintained the accounting records for the realty business. In addition, the couple failed to establish any involvement by Donald in the realty business. Thus, the court found that the realty business was operated by Brenda and the net income derived from the business must be attributed solely to her for self-employment tax purposes. The court concluded that the couple must separately compute the self-employment tax for Brenda and Donald and may not combine the net income from the realty business, which was allocable to Brenda with the losses from the accounting business, which was allocable to Donald.

For a discussion of the reporting of self-employment tax, see Parker Tax ¶13,135.

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Siblings Who Agreed to Special-Use Valuation of Inherited Ranch Could Not Later Assign a Different Basis to Their Interests in the Ranch

A brother and sister who benefited from an estate's special-use valuation election for inherited ranch property could not later claim a different valuation for purposes of determining their capital gains on the subsequent sale of a conservation easement on that property. Van Alen v. Comm'r, T.C. Memo. 2013-235 (10/21/13).

Bret Van Alen and his sister, Shana Tomlinson, inherited an interest in a family ranch from their father, Joseph Van Alen. Joseph died in 1994, and his will directed that his interest in his ranch be placed in trust for his children's benefit in equal shares. Their stepmother, Bonnie Van Alen, was the estate's executor and filed Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, for Joseph's estate. Instead of using the ranch's fair market value of $1.9 million, the estate elected to use the special-use valuation under Code Sec. 2032A. Brett, Shana and Bonnie executed an agreement to use the special valuation, which was attached to the Form 706, and consented to personal liability for additional estate tax if the ranch ceased to be used for agricultural purposes or if they sold their interests in the ranch.

In 2007, a California conservation trust bought a conservation easement on the ranch and Bret and Shana's trust received $910,000 from the sale. On its 2007 income tax return, the trust reported the conservation easement sale proceeds and calculated gain using a basis of $100,000. After other trust-level deductions, the trust reported income of almost $720,000 and an income distribution in the same amount for distributions made to Brett and Shana. Brett and Shana's Schedules K-1, Beneficiary's Share of Income, Deductions, Credits, etc., each reported a net long-term capital gain of nearly $360,000. However, Brett and Shana did not report any of the gain on their individual federal income tax returns. The IRS sent Brett and Shana each a notice that the amount of income reported on their respective returns did not match amounts reported to the IRS from third-party payors. The trust filed an amended return for 2007 and reported an increased basis in the ranch of $900,000 based on the fair market value of the ranch at the time of Joseph's death, which resulted in a capital gain of less than $25,000. Brett and Shana's amended Schedules K-1 reported no long-term capital gain. The IRS subsequently issued notices of deficiency.

The basis of inherited property is generally equal to its fair market value at the date of the decedent's death under Code Sec. 1014(a). Code Sec. 2032A provides that an executor may elect to value qualified farm and other real property for estate tax purposes at its actual use at the date of death rather than in its hypothetical highest and best use.

Brett and Shana argued that the estate greatly understated the value of their interest in the ranch and also understated their basis, which resulted in increased taxable capital gains.

The IRS contended that the tax benefit that Brett and Shana received from using a low valuation on their father's estate tax return should be balanced by an increased capital gains tax burden.

The Tax Court held that the special-use valuation election by Joseph's estate determined the basis in the ranch property that carried over to the trust of which Brett and Shana were beneficiaries, and they could not claim a different valuation for determining their subsequent capital gain on the sale of the conservation easement. The court stated that the special-use valuation was properly elected by Joseph's estate. The court rejected the siblings reliance on Rev. Rul. 54-97, which provides that an heir's carryover basis might be changed if clear and convincing evidence shows that the estate was incorrectly valued for estate tax purposes, because that ruling does not apply to special-use valuations.

The court found that a valuation different from the initial valuation was also barred by the duty of consistency doctrine because (1) the estate elected the special-use valuation, (2) the IRS relied on the election, and (3) the statute of limitations had expired on changing the election for estate tax purposes. The court noted that, although Brett and Shana were not fiduciaries of the estate, they had sufficiently identical economic interests with the estate because they all benefited from the election. While Brett and Shana did not directly make the special-use valuation election, they consented to it by executing the required agreements making them liable for additional income tax if they altered the use of the ranch.

Finally, the court determined that Brett and Shana were liable for the accuracy-related penalty for failing to report the capital gain. Although their accountant had advised them to change the basis in the inherited property, they did not reasonably rely on that advice in good faith because they had filed their individual returns omitting the gains from the sale of the conservation easement before they consulted him.

For a discussion of estate tax special use valuation of farms and other real property, see Parker Tax ¶224,900.

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District Court Rejects IRS Arguments; Allows Foreign Tax Credit in STARS Transaction

A taxpayer who engaged in a STARS transaction, a transaction that other courts have held lacked economic substance, was entitled to a foreign tax credit. Santander Holdings USA, Inc. & Subs. v. U.S., 2013 PTC 333 (D. Mass. 10/17/13).

From 2003 through 2005, Santander Holdings USA, Inc. was known as Sovereign Bancorp, Inc. Sovereign sued to recover approximately $234 million in federal income taxes, penalties, and interest that it claimed were improperly assessed and collected by the IRS for tax years 2003 - 2005 as a result of the IRS's disallowance of foreign tax credits claimed for those years. The IRS defended the disallowance on the ground that the transaction in which Sovereign incurred and paid the foreign taxes against which the credit was taken was a sham and lacked economic substance. The case centered on a Structured Trust Advantaged Repackaged Securities transaction, otherwise known as a STARS transaction, and also involved Barclays Bank PLC, a U.K. bank, and its advisor, KPMG.

The STARS transaction was designed to give Barclays substantial benefits under U.K. tax laws, in light of which Barclays could and would offer to lend funds to U.S. banks at a lower cost than otherwise might be available to them. The banks could relend the money in their normal banking operations, using the lower cost either to obtain a competitive advantage or to increase their marginal return on lending or both. In the transaction, Sovereign created a trust to which it contributed $6.7 billion of income-generating assets. The trustee of the trust was purposely made a U.K. resident, causing the trust's income to be subject to U.K. income tax at a rate of 22 percent. The trust income was also subject to U.S. income tax and was attributed to Sovereign, but with a credit available for the amount paid in U.K. income taxes. Sovereign paid U.K. taxes and then claimed credits for the amounts paid in calculating its U.S. income tax liability for the tax years in question. The transaction included a number of contrived structures and steps that, each viewed in isolation, would make little or no sense. In the context of the entire transaction, however, it was crucial to Barclays' obtaining favorable tax treatment under U.K. law, which gave it the ability to lower its effective lending rate to a U.S. bank. The result of the STARS transaction for Barclays was a net tax gain, which it was able to use to reduce other U.K. tax liabilities that it owed.

One feature of the loan arrangements was what that Barclays would make a payment to Sovereign calculated at approximately one-half of the amount Sovereign paid in taxes to the U.K. on the income earned by the trust. While in the intricacies of the transaction it was actually a monthly credit to Sovereign figured into its interest costs, the IRS characterized it as a rebate. According to the IRS, the transaction lacked economic substance because the Barclays payment was effectively a rebate of taxes originating from the U.K. tax authorities. The IRS's theory was that Barclays was only able to make the payment because of the tax credits it had received from the U.K.

Under Reg. Sec. 1.901-2(e)(2), an amount is not a tax paid to a foreign country, and thus is not eligible for the foreign tax credit, to the extent it is reasonably certain that the amount will be refunded, credited, rebated, abated, or forgiven. Further, under Code Sec. 901(i) and Reg. Sec. 1.901-2(e)(3), an amount of foreign income tax is not an amount of income tax paid or accrued by a taxpayer to a foreign country to the extent (1) the amount is used, directly or indirectly, by the foreign country imposing the tax to provide a subsidy by any means to the taxpayer, to a related person, to any party to the transaction, or to any party to a related transaction; and (2) the subsidy is determined, directly or indirectly, by reference to the amount of the tax or by reference to the base used to compute the amount of the tax.

A district court rejected the IRS argument as wholly unconvincing. The court noted that Code Sec. 901(i) and Reg. Sec. 1.901-2(e)(2) explicitly provide when a foreign tax may be considered rebated by the taxing authority and when a taxpayer may be considered to have received a subsidy (i.e., a rebate being a type of subsidy) from a foreign source to pay its foreign taxes. Since the IRS could point to no governing or precedential legal authority that supported treating the private payment between two banks as a payment from the U.K. treasury, the court allowed the foreign tax credit.

Observation: In Santander Holdings, the court distinguished its holding from the holdings reached by the Court of Federal Claims and the Tax Court in Salem Financial, Inc. v. U.S., 2013 PTC 282 (Fed. Cl. 2013) and Bank of N.Y. Mellon Corp. v. Comm'r, 140 T.C. No. 2 (2013). In both of those decisions, the courts held that the STARS transactions in which the taxpayers engaged lacked economic substance and, thus, denied the foreign tax credit to the taxpayers. The district court said that those decisions dealt with the question of whether the payment by the other bank to the trust in which the taxpayers had an ownership interest was in substance a tax effect as a matter of fact, rather than as a matter of law. By looking at the question as a matter of law, the district court in Santander Holdings came to a different conclusion than the Court of Federal Claims and the Tax Court.

For a discussion of the foreign tax credit and situations where it is not allowed, see Parkers Tax ¶101,915.

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Conviction of Tax Return Preparer Sentenced to 42 Months in Prison Upheld

The conviction of a tax return preparer, who was sentenced to 42 months in prison and ordered to pay over $360,000 in restitution, was upheld. U.S. v. Stargell, 2013 PTC 319 (9th Cir. 10/17/13).

After completing a course on tax preparation and receiving state certification, Willena Stargell began preparing taxes for Liberty Tax Service (LTS) in Moreno Valley, California. She left LTS in 2003, and began her own tax preparation business called Liberty Bell Tax Service (LBTS).

While operating LBTS, Stargell prepared federal income tax returns containing false statements and engaged in schemes to obtain refund anticipation loans (RALs) based on these fraudulent returns. In some instances, the IRS detected the fraud and declined to issue a tax refund, resulting in a loss to the banks that made the loans. The government proved that Stargell engaged in identity theft by using the names and social security numbers of former clients or other individuals, without their knowledge or consent, to file tax returns and to request RALs. The vast majority of the returns filed by Willena contained both false wage and false withholding figures. The total amount of refunds sought in the returns was $598,657. The IRS issued $276,331 of refunds in connection with these returns before it stopped the remaining refund claims.

Willena was convicted of wire fraud affecting a financial institution, aiding and assisting in the preparation of a false return, fraud by wire, and aggravated identity theft, arising out of her work as a tax preparer. A district court imposed a $1,200 special assessment, restitution in the amount of $362,796, and a 42-month prison sentence. Willena appealed.

On appeal, Willena argued that the district court committed the following three errors in computing the amounts of loss and restitution: (1) It never actually made a finding regarding the amount of loss; (2) if a loss finding was made, the finding was unsupported by the evidence because the amount should not have included qualified refunds; and (3) the restitution amount should not have included refunds the taxpayers were legally entitled to claim.

The Ninth Circuit upheld the conviction, the sentence, and the restitution amount. According to the court, new or increased risk of loss was sufficient to establish that wire fraud affects a financial institution, and that the fraudulent tax returns prepared by Willena in schemes to obtain refund anticipation loans affected banks, regardless of whether the banks ultimately paid out on such a loan or suffered any loss, because the banks' risk of loss on the loans was increased by the fraudulent nature of the returns.

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IRS Releases Inflation-Adjusted Amounts and Pension Colas for 2014

Last week, the IRS released Rev. Proc. 2013-35 and IR-2013-86 (10/31/13), which provide the annual inflation-adjusted amounts and pension cost-of-living adjustments, respectively, for 2014.

Inflation-Adjusted Amounts

The following are some of the more important provisions included in Rev. Proc. 2013-35, relating to the annual inflation-adjusted amounts.

Taxable Income Subject to the Maximum Rates

The tax rate of 39.6 percent affects single individuals whose income exceeds $406,750; taxpayers filing joint returns whose income exceeds $457,600; head of household individuals whose income exceeds $432,200; and married filing separately individuals whose income exceeds $228,800. The other marginal rates 10, 15, 25, 28, 33 and 35 percent and the related income tax thresholds are described in the revenue procedure. Read more...