February 3, 2010
On February 1, 2010, the Obama Administration released the fiscal year 2011 Budget of the United States. This update summarizes the principal tax provisions identified in the Budget. The prospects for passage of these proposals is uncertain and depends in large part on the priorities of Congress and the Administration and the need for specific revenue offsets. Moreover, the inclusion of a proposal in the Budget does not necessarily provide a clear path to enactment. We invite your questions about specific details of these and any other tax-related provisions of the Budget.
The update will cover the following topics:
The Budget proposes to impose a Financial Crisis Recovery Fee (the "Fee," also referred to as the "Bank Tax") of 0.15% on the "Covered Liabilities" of certain financial institutions. The Fee is intended to recover a portion of the government funds provided to the banking sector as a part of the Troubled Asset Relief Program (TARP), and to serve as a deterrent against excessive leverage.
The institutions covered by the Fee would include banks, thrifts, bank and thrift holding companies, brokers, dealers, and U.S. and foreign companies owning such entities. The Fee would apply only to firms with at least $50 billion in assets worldwide (for foreign institutions, only U.S. assets would count toward the $50 billion threshold). The Fee is expected to target about 35 U.S. firms and 10 to 15 U.S. subsidiaries of foreign institutions. It will apply regardless of whether the firms received financial assistance through TARP.
The assessable base of the Fee would be a firm’s Covered Liabilities, defined as the firm’s assets, less Tier 1 Regulatory Capital, less FDIC-insured deposits and/or insurance policy reserves, as appropriate (for foreign institutions, only U.S. liabilities would be used to determine the base). Adjustments would be provided to prevent avoidance and appropriately account for risk. Covered Liabilities would be determined with reference to balance sheets filed with the appropriate federal or state regulators.
The effective date of the Fee would be July 1, 2010. The Fee would be collected by the IRS and reported on federal income tax returns. Estimated payments of the Fee would be made on the same schedule as estimated income tax payments.
Taxing Carried Interests as Ordinary Income
The Budget proposes to tax income and gains associated with certain "carried interests" as ordinary income.
Managers of investment services partnerships typically receive a "carried interest" in the partnership entitling them to share in the gains and profits of the partnership. Currently, a holder of this kind of interest is taxed on its allocable share of the partnership’s taxable income. The character of that income to the manager is generally the same as it is to the partnership. This means that in the many cases where the underlying income is long term capital gain, the manager is taxed at the long term capital gains preference rate, which is currently 15 percent. Under the proposal, all such income allocated to the managers generally would be taxed as ordinary income, regardless of the character of the income to the partnership, and subject to self-employment tax. Similarly, gains on the disposition of such interests would be taxed as ordinary income and subject to self-employment tax. But, to the extent any allocable income or gain is properly attributable to an interest received in respect of contributed money or property, it will continue to be taxed under the existing rules. These rules are expected to apply to partnership interests held by persons providing investment advisory or management services with respect to a variety of investment assets, such as securities, partnership interests, investment real estate, commodities, and options and derivatives with respect to such assets.
The Budget proposes to make this provision effective for taxable years beginning after 2010, although pending legislation would make these provisions effective for tax years ending after 2009.
Legislation (H.R. 1935 [111th] and H.R. 4213 [111th]) is currently pending that would implement this proposal. Please refer to our April 7, 2009, update, "Legislation Reintroduced to Tax Carried Interests as Ordinary Income," and our December 8, 2009, update, "House Moving Quickly on Tax Extenders Bill That Would Tax Carried Interests as Ordinary Income and Crack Down on Foreign Tax Evasion," for further detail on the pending legislation.
Deferral of Interest Expense Deductions Related to Deferred Income
The Budget proposes to defer deduction of interest expenses attributable to deferred foreign income.
U.S. taxpayers can defer recognition of some foreign income earned by foreign subsidiaries until that income is repatriated to the United States. In the meantime, the taxpayer does not pay U.S. taxes on the accrued foreign earnings. However, U.S. taxpayers may generally deduct all interest expenses currently, even the interest expense paid in the U.S. but allocable to debt incurred to finance the foreign income that has been deferred. Furthermore, the interest paid in the U.S. is deductible regardless of whether the expense exceeds the foreign earnings, or even whether there are foreign earnings at all.
Under the proposal, deductions from interest expenses related to deferred foreign income can only be taken as the deferred income is recognized. A taxpayer can deduct such interest expenses in proportion to the amount of previously-deferred foreign-source income that becomes subject to U.S. tax. Treasury regulations may provide exceptions for the deduction of previously deferred interest expenses.
When this proposal was introduced previously, the Joint Committee noted that this proposal might lead to distortions if Congress delayed the effective date of certain legislation that adjusted the method for allocating interest expense to domestic and foreign source income. We caution clients that the recent Affordable Health Care for America Act (H.R. 3962 111th) passed by the House would delay the effective date of that interest allocation legislation to taxable years beginning in 2019.
This provision would be effective for taxable years beginning after 2010.
Foreign Tax Compliance Measures
The scope of withholding obligations would be expanded under the Budget to include certain "withholdable payments" made to accounts in foreign financial institutions, unless those institutions agree to comply with certain information gathering and reporting procedures with respect to those accounts. The universe of payments subject to withholding is expanded in these cases (through the definition of withholdable payments) to include payments of gross proceeds from the disposition of any property that can produce U.S.-source interest or dividends.
In addition, the Budget would expand reporting obligations with respect to foreign assets. Individuals would be required to file information returns disclosing certain interests in foreign accounts and assets. It would also impose a penalty of up to 40 percent of the amount of any understatement that is attributable to an undisclosed foreign financial asset. The statute of limitations would be extended to six years in certain cases relating to financial assets required to be disclosed. These reporting obligations and penalty provisions would generally apply upon the enactment of the provisions.
Beginning in 2013, the Budget would require individuals to report certain transfers of money or property to or from foreign financial accounts. U.S. financial institutions would similarly be required to report certain such transfers made on behalf of U.S. individuals.
The Budget would also eliminate the exception from the registration requirements for debt obligations for foreign-targeted debt. This change would generally eliminate deductions for interest paid with respect to such unregistered debt and subject interest payments on such debt to U.S. withholding tax. These provisions generally would not be effective for obligations issued on or before the second anniversary of the enactment of the legislation.
Certain "dividend equivalent" payments would be treated as dividends for tax purposes under the Budget. This provision would generally subject to U.S. tax certain notional principal contract (swap) payments and other substitute payments that are economically similar to dividends but currently avoid U.S. tax. This change is proposed to be effective for payments made after 2010.
Legislation (H.R. 3933 [111th], S. 1934 [111th]. and H.R. 4213 [111th]) is currently pending that would implement some of these proposals. Please refer our December 8, 2009, update, "House Moving Quickly on Tax Extenders Bill That Would Tax Carried Interests as Ordinary Income and Crack Down on Foreign Tax Evasion," for further detail on the pending legislation.
Transfer Pricing of Intangibles
In an effort to enhance the enforcement and effective application of the transfer pricing rules, the Budget proposes two new rules targeting transfers of intangibles.
First, transfers of intangible assets by U.S. persons to related controlled foreign corporations (CFCs) would be scrutinized. The IRS will no longer need to rely on IRC Section 482 to reapportion income in cases of transfer pricing abuse. If the CFC is subject to a lower effective tax rate and circumstances indicate that there is excessive income shifting, the excessive return will be treated as subpart F income in a separate foreign tax credit limitation basket.
Second, the proposed budget attempts to clarify the definition of intangible property to include goodwill, going concern value, and workforce in place. Furthermore, the Commissioner may consider prices or profits of a taxpayer’s alternative transactions and also may value multiple intangible properties on an aggregate basis if doing so would achieve a more reliable result.
Both provisions would be effective for tax years beginning after 2010.
Miscellaneous International Tax Reforms
Other foreign tax related proposals include the following:
These provisions would generally be effective beginning after 2010.
Elimination of Fossil Fuel Tax Preferences
The Budget proposes to eliminate the following oil and gas tax preferences:
The Budget proposes to eliminate the following coal tax preferences:
The elimination of these preferences would generally apply beginning after 2010.
Codification of "Economic Substance" Doctrine
Economic Substance
The Budget proposes codifying the existing common-law "economic substance" doctrine that generally denies a taxpayer tax benefits from a transaction that does not meaningfully change the taxpayer’s economic position, other than tax consequences. A transaction would satisfy the economic substance requirement only if (1) the transaction changes in a meaningful way (apart from federal tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction. Furthermore, under the new provision, a transaction would not be treated as having economic substance solely by reason of a profit potential unless the reasonably expected pre-tax profit is substantial in relation to the net federal tax benefits arising from the transaction.
New Understatement Penalty
In addition, the Budget would impose a penalty on an understatement of tax attributable to a transaction that lacks economic substance. The penalty would be equal to thirty percent of the tax underpayment, but would be reduced to twenty percent if the taxpayer provides adequate disclosure of the relevant facts in its tax return. This economic substance understatement penalty would be in addition to the existing twenty percent penalty for a substantial understatement of tax.
The Budget proposal states that the I.R.S. could assert and abate the new economic substance penalty. The I.R.S. could assert the penalty even if a court had not determined that the economic substance doctrine was applicable to the transaction. Any abatement of the penalty must be proportionate to the abatement of the underlying tax liability.
New Denial of Interest Deduction
The new law would also deny any interest deduction attributable to an understatement of tax arising from the application of the economic substance doctrine.
Effective Date
The proposal states that the new economic substance law and the related penalty would apply to transactions entered into after the date of enactment of the new law. The new law regarding the denial of interest deductions would be effective for taxable years ending after the date of enactment with respect to transactions entered into after the enactment date.
Upper-Income Taxpayer Rate Changes and Limitations
The Budget proposes the following changes to the tax rules that would govern taxpayers with income over $200,000 ($250,000 for married taxpayers filing jointly):
The thresholds for these provisions will be indexed for inflation in subsequent years and will be effective for taxable years beginning after 2010.
While the Budget does not identify it as a "proposal," it assumes a baseline that includes an annual "patch" of the alternative minimum tax based on the 2009 alternative minimum tax exemption and indexed for inflation.
Extension of Expiring Tax Provisions
A number of temporary tax provisions scheduled to expire before the end of 2011 would be extended by the Budget through 2011. Among the provisions targeted for extension are
Legislation (H.R. 3933 [111th], S. 1934 [111th]. and H.R. 4213 [111th]) is currently pending that would implement some of these proposals. Please refer our December 8, 2009, update, "House Moving Quickly on Tax Extenders Bill That Would Tax Carried Interests as Ordinary Income and Crack Down on Foreign Tax Evasion," for further detail on the pending legislation.
Miscellaneous Business Tax Provisions
The Budget proposes a variety of additional business tax measures, including the following:
Among the other tax proposals included in the Budget are the following:
In addition, the Budget would provide for a variety of reforms designed to reduce the tax gap. These measures include revisions to information reporting obligations, increased or expanded penalties, extending certain statutes of limitations where state adjustments affect federal tax liability, and increasing certain IRS administrative powers.
Finally, the Budget assumes gift, estate, and generation-skipping-tax rates and lifetime exemptions in place in 2009 (45% top rate and $3.5 million exemption) will be extended. It would also modify certain rules dealing with valuations for these transfer tax purposes and the grantor retained annuity trusts (GRATS).
Source Documents
Fiscal Year 2011 Budget of the U.S. Government:
http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf
Department of Treasury’s General Explanations of the Administration’s Fiscal Year 2011 Revenue Proposals:
http://www.treas.gov/offices/tax-policy/library/greenbk10.pdf
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To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these developments. If you have any questions, please contact the Gibson Dunn attorney with whom you work or one of the following members of the firm’s Tax Practice Group:
New York
Charles F. Feldman (212-351-3908, cfeldman@gibsondunn.com)
David B. Rosenauer (212-351-3853, drosenauer@gibsondunn.com)
Jeffrey M. Trinklein (212-351-2344, jtrinklein@gibsondunn.com)
Romina Weiss (212-351-3929, rweiss@gibsondunn.com)
Washington D.C.
Art Pasternak (202-955-8582, apasternak@gibsondunn.com)
Benjamin Rippeon (202-955-8265, brippeon@gibsondunn.com)
Los Angeles
Hatef Behnia (213-229-7534, hbehnia@gibsondunn.com)
Stephen L. Tolles (213-229-7502, stolles@gibsondunn.com)
Paul S. Issler (213-229-7763, pissler@gibsondunn.com)
Dora Arash (213-229-7134, darash@gibsondunn.com)
J. Nicholson Thomas (213-229-7628, jnthomas@gibsondunn.com)
Orange County
Gerard J. Kenny (949-451-3856, gkenny@gibsondunn.com)
Scott Knutson (949-451-3961, sknutson@gibsondunn.com)
Dallas
David Sinak (214-698-3107, dsinak@gibsondunn.com)
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