In this article, some of the recent important foreign decisions are covered.
1. Finland: Supreme Administrative Court: Disposal of shares in a Finnish company holding shares in a real estate company not income from Finnish sources for a non-resident individual
The Supreme Administrative Court of Finland (Korkein hallinto-oikeus, KHO) gave its decision on 31st May 2013 in the case of KHO:2013:101. Details of the decision are summarised below.
(a) Facts: A, who was an individual subject to limited tax liability in Finland, fully owned a company resident in Finland (F Oy) whose assets mainly consisted of shares in a mutual real estate company. A was planning to dispose his shares in F Oy in 2012 or in 2013 and applied for an advance ruling on the tax treatment of the income from the sale of his shares.
(b) Legal background: Non-residents are taxed on their income derived from Finland. Section 10 of the Income Tax Law (Tuloverolaki, TVL) includes a list of items of income which are held to be derived from Finland and explicitly mentions income from shares in a company deriving more than 50% of its total assets from immovable property situated in Finland.
(c) Issue: The issue was whether the capital gain arising from the sale of shares in F Oy is regarded as income derived from Finland considering that the assets of F Oy mainly consisted of shares in a mutual real estate company (i.e. indirect holding).
(d) Decision: The Court upheld the ruling by the Central Tax Board and ruled that the income from the sale of shares in F Oy was not income from Finnish sources.
The Court pointed out that although the list of items regarded as income derived from Finnish sources provided in the relevant provision is nonexhaustive; there is no reason to interpret this provision which sets the limits to Finland’s taxing rights wider than what the wording of the provision is. Consequently, the provision cannot be interpreted so that a company holding shares in a real estate company would be itself regarded as a real estate company. Although F Oy’s assets mainly consist of shares in a real estate company, capital gain arising from the disposal of those shares is not regarded as income from Finnish sources.
Two of the five judges and the referendary, however, disagreed with the final decision of the Court. They stated that the wording of the law should be interpreted to also cover indirect ownership as the purpose of the legislator has been to guarantee that Finland retains its taxing right over immovable property located in Finland. Considering that the assets of F Oy consist mainly of shares in a real estate company, the nature of its business activity is in reality controlling real estates in Finland and as such the income arising from the disposal of the shares in F Oy should be regarded as income from Finnish sources and taxed accordingly.
2. United States: US Tax Court holds foreign insurance company subject to US tax upon termination of election to be treated as US domestic corporation
The US Tax Court has held that a foreign corporation’s filing of a US tax return did not commence the US period of limitations on a tax assessment because the return was not signed by a corporate officer. The US Tax Court also held that termination of the foreign company’s election to be treated as a US domestic corporation resulted in a deemed transfer of its assets that was taxable in the United States (Chapman Glen Limited vs. Commissioner of Internal Revenue, 140 T.C. No. 15, Docket Nos. 29527-07L, 27479-09, 28th May 2013).
The taxpayer was a British Virgin Islands company that elected u/s. 953(d) of the US Internal Revenue Code (IRC) to be treated as a US domestic corporation for US tax purposes for 1998 and subsequent tax years. In addition, the taxpayer was granted tax-exempt status under IRC section 501(c)(15) as a tax-exempt insurance company effective 1st January 1998.
In 2005, the US Internal Revenue Service (IRS) determined that the taxpayer was not operating as an insurance company during 2002 and thus did not qualify as a tax-exempt insurance company as of 1st January 2002.
In 2009, the IRS issued the taxpayer a notice of deficiencies on the ground, inter alia, that the termination of the taxpayer’s IRC section 953(d) election, which resulted from the loss of its status as an insurance company, gave rise to gain from a deemed transfer of its assets during a one-day taxable year beginning and ending on 1st January 2003 under IRC sections 354, 367, and 953(d)(5). The US Tax Court first rejected the taxpayer’s argument that the IRS was time-barred from assessing tax for 2003 under IRS section 6501(a), which requires any tax assessment be made within three years after a valid US tax return is filed.
The US Tax Court acknowledged that the taxpayer filed IRS Form 990 (Return of Organisation Exempt From Income Tax) for 2003, and that Form 990 might be regarded as a valid tax return for the three-year period of limitations purposes, even if the taxpayer was subsequently held to be a taxable organisation for that year. The US Tax Court, however, concluded that the taxpayer did not file a valid tax return for 2003 that commenced the period of limitations because the taxpayer’s IRS Form 990 for 2003 was not signed by an officer as required by IRC section 6062. Accordingly, the 2003 tax year remained open for examination and assessment by the IRS.
Next, the US Tax Court held that the taxpayer made a valid election of IRC section 953(d), which allows a foreign insurance company to elect to be treated as a US domestic corporation for US tax purposes if it meets certain requirements, including that a responsible corporate officer must sign the corporation’s election statement. The US Tax Court further held that the taxpayer’s election was terminated in 2002 when the taxpayer ceased to be an insurance company and therefore failed to satisfy the requirement for maintaining the IRC section 953(d) election.
The US Tax Court then upheld the IRS’s determination that, under IRC section 953(d)(5), in combination of IRC sections 354 and 367, the termination of the election caused the taxpayer to be treated as a domestic corporation that made a deemed transfer of all of its assets to a foreign corporation in a taxable exchange during a one-day taxable year commencing and ending on 1st January 2013.
The US Tax Court proceeded to evaluate the fair market price of the taxpayer’s assets, which consisted of real property owned by its disregarded entity, to determine the amount of US federal income tax imposed on the gain recognised from the deemed transfer.
3. France: Administrative Court of Appeal of Paris denies use of secret comparables
In a decision of 5th February 2013, the Administrative Court of Appeal of Paris gave its decision in Nestlé Entreprises vs. Minister of Economy and Finances (No. 12PA00469) regarding the use of secret comparables under the transfer pricing regulation, article 57 of the French Tax Code (FTC). Key elements of the decision are summarised below.
(a) Facts: The plaintiff, a French company which was a member of the Nestlé group, transferred the management function of an internal cash pool service to a Swiss affiliate company in October 2002. In 2004, based on a tax audit, the tax authorities considered this operation as an indirect transfer of profits under article 57 of the FTC, and thus required an arm’s length compensation.
The Court of Appeal noted that the cash pooling activity had a market value because the plaintiff received payment for this activity and consequently, the transfer should be compensated by the Swiss company. In order to calculate the compensation, the tax authorities used, as comparable, the cash pooling operations of three major groups listed on the French Stock Exchange (CAC 40) and concluded that the arm’s length compensation should have been 0.5% on the amount lent in the cash pool at the end of the previous 3 financial years.
Consequently, the tax authorities reassessed the tax base for corporate income tax and welfare tax for the fiscal year 2002 and imposed the corresponding adjustment for these taxes, plus related penalties and interest. The plaintiff’s appeal against the tax authorities’ assessment was dismissed by the Lower Court (Tribunal Administrative de Cergy-Ponoise) which, however, reduced the arm’s length compensation from 0.5% to 0.3325%. The plaintiff appealed against the Lower Court’s decision.
(b) Legal background: Under article 57 of the FTC, the tax authorities may add back to the taxable income of French companies, or branches of foreign companies, profits indirectly transferred to related companies or head offices abroad.
(c) Issue: The issue was whether or not the secret comparable used by the tax authorities could be used to qualify the transaction as abnormally low under article 57 of the CGI.
(d) Decision: The Court of Appeal accepted the plaintiff’s claim because the tax authorities failed in their obligation to use a valid comparable. While identifying the arm’s length compensation, the tax authorities used as comparable the cash pooling operations of three major groups listed on the French Stock Exchange (CAC 40), but without any indication of:
– the name of these groups;
– the condition of these cash pool agreements; and especially
– whether the comparable agreements included a guarantee similar to the guarantee granted to the plaintiff.
Consequently, the Court of Appeal considered that such secret comparables cannot be used in order to qualify the transaction as abnormally low under article 57 of the FTC. Thus, the tax authorities failed to demonstrate that this transaction was an indirect transfer of profit under article 57 of the FTC.
4. Belgium: Belgian Constitutional Court decides that taxpayers also need to be notified in case bank data are requested by a foreign tax administration
On 16th May 2013, the Belgian Constitutional Court (Court Constitutionelle/Grondwettelijk Hof) gave its decision in vzw Liga van Belastingplich-tigen, Alexis Chevalier, Olivier Laurent, Frédéric Ledain and Pierre-Yves Nolet on the compatibility of the provisions to collect bank data due to the abolition of the bank secrecy with articles 10 and 11 (non-discrimination), 22 (right to respect family and private life) and 29 (confidentiality of mail) of the Belgian Constitution and article 8 (right to respect family and private life) of the European Convention on Human Rights (ECHR). Details of the case are summarised below.
(a) Facts: The Taxpayers concerned had unreported bank accounts and the tax authorities had collected their bank data because indications (aanwijzingen) existed that relevant bank data were not reported in the tax return and were missing for the determination of the taxable income. A foundation interfered to represent the interests of the taxpayers. Both the tax-payers and the foundation argued that the tax administration was not allowed to collect those data, in particular because an unjustified right to respect family and private life existed.
(b) Legal Background: Article 333(1) of the Income Tax Code (ITC) provides that the obligation to notify the taxpayer about a request of bank data only applies if indications exist that relevant bank data is missing for the determination of the taxable income. No restrictions apply with respect to the request of such data (article 319bis ITC).
In addition, article 333(1) of the ITC provides that no notification obligations exist with respect to information requests from foreign administrations. This amendment is based on the fact that in such case, the foreign tax administration first has to try to obtain the information from the taxpayer directly.
(c) Decision: First, the Court observed that no incompatibility with article 29 of the Constitution exists because the tax administration cannot intercept and open letters sent by banks to their clients.
With respect to article 22 of the Constitution and article 8 of the ECHR, the Court held that an infringement of that provision is only allowed in cases and under conditions specified by law. The right to collect bank data was introduced by the Law of 7th November 2011 and intends to guarantee an efficient collection of taxes, the equal treatment of Belgian citizens and the treasury interests of the Belgian government.
Thereafter, the Court decided that the legality principle is met because the infringement possibility is based on law and it is clearly described that infringement is only possible in case clear indications of tax evasion exist.
In addition, the Court pointed out that the tax authorities have more far- reaching collection rights for the collection of taxes than for the vesting of a tax assessment. Despite those situations being comparable, the Court held that a different treatment is justified because the research to be made for the correct collection of taxes is less extensive than the research needed for the vesting of a tax assessment. Furthermore, the Court considered that the provisions concerned contain sufficient guarantees that the collected data may only be used for the collection of taxes and that the secrecy principle is respected.
Finally, the Court dealt with the fact that in case bank data is requested by the Belgian administration, the taxpayer has to be notified while this is not the case of the bank data being requested by a foreign administration. The Court held that this different treatment cannot be justified, also not with the argument that the notification obligation in the case of a request from a foreign tax administration could result in undue delay and the information first was requested from the taxpayer.
The Court held that the notification obligation constitutes an important guarantee against unjustified infringements of the right to respect family and private life.
Consequently, the Court nullified the provision that the taxpayer does not have to be notified if bank data is requested by a foreign administration. To avoid administrative complications, the Court held that the nullification only takes effect from the date of the decision.
5. China : Letter on Wal-Mart indirect share trans-fer case published
On 12th March 2013, Jiangsu provincial tax authority published a letter of the State Administration of Taxation (SAT), in response to requests of local tax authorities, and a plan of tax assessment (a kind of instruction) on its website. The letter, enumerated as Shui Zong Han [2013] No. 82, and the plan of tax assessment addressed the case of indirect share transfer conducted by Wal-Mart US. The content of both documents is summarised below.
Facts – Through a BIV subsidiary (MMVI China Investment Co. Ltd), Wal-Mart acquired a BIV holding company (Bounteous Holding Company Limited (BHCL) – controlled by Taiwanese retailer Trust-Mart) that owned 65 enterprises in China. The acquisition was carried out in two stages; 35% of the target holding company was transferred to Wal-Mart in 2007, and the remaining 65% on 15 June 2012. The transfer in 2012 was paid in $ 100.5 million cash and by offsetting a debt-claim of $ 376 million.
Tax liability – By reference to article 47 of the Enterprise Income Tax Law (general anti-avoidance rule) and article 6 of Guo Shui Han [2009] No. 698 (anti-abuse provision), the SAT ruled that BHCL is considered to dispose the shares in Chinese enterprises directly and therefore liable to income tax on the share transfer in 2012 at the rate of 10% in China. In contrast, the first transfer of 2007 was not taxable apparently, because Guo Shui Han [2009] No. 698, mentioned above, only applies to cases from 1st January 2008 onwards and does not have retroactive effect.
Calculation of proceeds – According to the plan of tax assessment, the proceeds of the share transfer consist of $ 100.5 million cash payment and offsetting $ 376 million debts which in total amount up to $ 476.5 million. This total amount must be attributed to 65 enterprises in reasonable ratios by taking into account the following three factors:
– actual invested capital on 31st May 2012 (if the capital was contributed in dollars, the published average exchange rate of 15th June 2012 (1:6.3089) applies to CNY conversion);
– net assets at the end of 2011 (a negative asset counts as zero); and
– annual operating revenue.
Each factor is equally important and counts as 1/3 in the calculation.
Calculation of cost price
The cost price for each enterprise transferred equals the actual invested capital on 31st May 2012 x 65% (the proportion of the second transfer).
Tax collection matter
By reference to article 6 of SAT Gong Gao [2011] No. 24, the SAT requires BHCL to file a tax return with and pay tax to each local tax authority of the 65 enterprises. Given the fact that BHCL does not have an establishment, the local tax authorities may notify each of the 65 enterprises for tax payment. Shenzhen tax bureau (one of the local tax authorities involved) has also requested Wal-Mart’s MMVI China Investment Co. Ltd (the buyer) to withhold a part of the payment for this latent tax liability.
Comment
The SAT letter and SAT’s plan of assessment at-tract attention as it is the first time that SAT publishes a letter and plan of assessment on a concrete indirect share transfer case. It also strikes that the plan of tax assessment was issued by the Department of Large Enterprises instead of the Non-Resident Division of the International Department which is normally in charge of indirect share transfer issues.
6. United Kingdom : UK Supreme Court allows cross-border group relief in Marks & Spencer case
On 22nd May 2013, the UK Supreme Court upheld a decision of the UK Court of Appeal of 14th October 2011, itself upholding a previous decision of a lower court, in the Marks & Spencer case, to the effect that the taxpayer could claim group loss relief in respect of its subsidiaries in Belgium and Germany.
The UK decision follows the recent decision of the Court of Justice of the European Union (ECJ) in Oy A (Case C-123/11) and, ultimately, from the ECJ judgment in Marks & Spencer (Case C-446/03).
Following the ECJ judgment in Marks & Spencer (C-446/03), the United Kingdom introduced new rules in respect of group relief losses to restrict such losses in the same way as the tax authorities had originally argued. These rules are themselves subject to a challenge by the European Commission.
7. United Kingdom: High Court – HMRC’s decisions in Goldman Sachs settlement not unlawful, but settlement “not a glorious episode”
On 16th May 2013, the High Court delivered its judgment in UK Uncut Legal Action Ltd vs. Commissioners of Her Majesty’s Revenue and Customs and Goldman Sachs International [2013] EWHC 1283 (Admin).
In 2010, HMRC and Goldman Sachs reached a settlement pursuant to which Goldman Sachs agreed to pay national insurance contributions if HMRC waived the outstanding interest on the NIC. UK Uncut, an advocacy/pressure group, challenged this decision.
The Court considered that the settlement “was not a glorious episode in the history of the [HMRC]”.
Nevertheless, the Court ruled that the decisions taken by HMRC in regard to the settlement were not unlawful. The settlement did not infringe HMRC’s policy pursuant to its Litigation and Settlement Strategy. In its decision-making process, HMRC was entitled to consider Gold-man Sachs’ threats to withdraw from the Code of Practice on Taxation for Banks. The then Permanent Secretary for Tax took into account the potential embarrassment to the Chancellor
of the Exchequer if Goldman Sachs were to withdraw from the Code: HMRC has accepted that this was an irrelevant consideration that should not have been a part of HMRC’s decision-making process.
8. Netherlands: Supreme Court decides that amount of released dividend withholding tax liability must be added to the taxable profits for corporate income tax purposes
On 8th March 2013, the Netherlands Supreme Court (Hoge Raad der Nederlanden) gave its decision in X BV vs. the tax administration (No. 12/01597) (recently published) on the inclusion of the amount of released dividend withholding tax liability in the taxable profits for corporate income tax purposes. Details of the case are summarized below.
(a) Facts: The Taxpayer (X BV) from 31 Decem-ber 2006 had reported on its balance sheet a dividend tax liability of EUR 45,378. This liability was based on the fact that the Taxpayer in a previous year had paid a dividend to its sole shareholder. From this distributed amount, the Taxpayer had withheld the dividend withholding tax due, in its capacity as paying agent.
However, the tax was not collected due to the fact that the statute of limitation period for the collection expired. Therefore, the tax authorities to took the view that the taxable profits of the Taxpayer for 2006 had to be increased with this dividend withholding tax claim.
The Taxpayer appealed that decision arguing that the release from a tax liability does not constitute a taxable event. Another argument of the Taxpayer was that a profit distribution paid to a shareholder and the related amount of dividend withholding tax due constitutes a non-deductible expense. Because no deduction could be claimed for the tax liability, the Taxpayer reasoned that a later release of that liability did not constitute a taxable profit.
(b) Legal background: Article 2(5) of the Corporate Income Tax Act (CITA) provides that companies are presumed to carry out their business activities with their entire property. Article 10(1) of the CITA, inter alia, provides that distributed profits are not deductible from the taxable profits.
(c) Decision: The Court decided in favour of the tax administration. First, the Court referred to article 10(1) of the CITA which provides that profit distributions are not deductible. This is because distribution of dividends by a company to its shareholders is a matter which comes within the capital sphere and not within the profit sphere.
This means that distribution concerns the use of a company’s profits and not the determination of the taxable profits.
In addition, the Court held that the above principles also apply if a shareholder does not retrieve a declared dividend. This does not increase a company’s profit.
Finally, the Court decided that a dividend tax liability, however, is not within the capital sphere. Instead, the Court held that it must be treated as an autonomous debt resulting from Dutch tax law based on the Taxpayer’s capacity as paying agent. This means that the release of the tax liability should be treated the same as the release of any other debt. Therefore, the Court confirmed the decision of the Court of Appeal, The Hague that based on article 2(5) of the CITA a capital increase resulting from the release of a tax liability must be added to the taxable profits.
Consequently, the Court decided that the released amount of dividend withholding tax had to be added to the Taxpayer’s ordinary income.
9. United States: Treaty between United States and India – US government’s motion denied regarding IRS summons issued to assist Indian tax authorities
The US District Court Northern District of Illinois Eastern Division has denied the US government’s motion to dismiss a petition that sought to quash a summons issued by the US Internal Revenue Service (IRS) to a US bank (Bikramjit Singh Kalra vs. United States of America, Case No. 12-CV-3154 (23 April 2013).
The plaintiff in this case was the subject of an investigation by the Indian tax authorities (ITA) for his tax liability in India. Pursuant to a treaty between the United States and India, the ITA requested the IRS’s assistance with regard to, inter alia, information on the plaintiff’s financial accounts held at a US bank.
After the IRS had served a summons on the US bank, the plaintiff filed a petition with the US District Court to quash the summons u/s. 7609 of the US Internal Revenue Code (IRC). IRC section 7609(b)(2) permits a petition to quash a summons provided the petition is filed not later than the 20th day after notice of the summons is given in the manner provided in IRC section 7609(a)(2). IRC section 7609(a)(2) provides that such notice is sufficient if it is mailed by certified or registered mail to the last known address of the taxpayer.
The US government filed a motion to dismiss the plaintiff’s petition on the ground that the petition was not filed timely. The plaintiff claimed that he never received a notice of the summons from the IRS, and that he filed the petition as soon as possible after he received a copy of the summons from the US bank.
After analysing the evidence submitted by the US government to support its motion, the US District Court held that the US government failed to demonstrate that the IRS served a notice of the summons on the plaintiff in compliance with the requirements of IRC section 7609(a)(2), and that the plaintiff was prejudiced by the IRS’s failure to provide him the notice as required by IRC section 7609. Therefore, the US District Court determined that the 20-day period did not begin to run until he received the notice from the US bank.
The US District Court then stated that, to enforce a challenged tax summons, the IRS must satisfy the requirements set out in United States vs. Powell, 379 U.S. 48 (1964), under which the IRS is required to show that:
– the investigation has a legitimate purpose;
– the information sought may be relevant to that purpose;
– the information sought is not in the IRS’s possession; and
– the IRS has followed the statutory steps for issuing a summons.
The US District Court held that the IRS failed to meet its minimal burden to show a prima facie compliance of the Powell test on the ground, inter alia, that the affidavit by an IRS officer that the government submitted was stricken as inadmissible for the lack of both a specific date and a notary public’s certification.
Accordingly, the US District Court denied the US government’s motion to dismiss the plain-tiff’s petition.
The exchange of information provision is contained in article 28 of the 1989 US-India income tax treaty. Under article 28(4) of the treaty, the IRS has the authority to subpoena documents that are central to the Indian government’s requests as if the IRS were requesting the documents for its own investigation.
10. United States: US Tax Court reclassifies loan structure as dividend payments
The US Tax Court has held that a complex finance structure was in substance dividend payments taxable under the US tax law (Barnes Group, Inc. and Subsidiaries vs. Commissioner of Internal Revenue, T.C. Memo. 2013-109, Docket No. 27211-09, 16th April 2013).
The case involved a US corporation that had a second-tier subsidiary in Singapore. The US corporation entered into a domestic and foreign finance structure, referred to as the reinvestment plan, for the purpose of using the Singaporean subsidiary’s excess cash and borrowing capacity to finance acquisitions. The reinvestment plan included the following steps:
– forming a subsidiary in Bermuda with the funds of the US corporation and its Singaporean subsidiary;
– forming a subsidiary in Delaware with the funds of the US corporation and its newly-formed Bermudan subsidiary;
– having the newly-formed Delaware subsidiary lend the funds received in the corporate organisation transaction to the US corporation; and
– having the Singaporean subsidiary borrow funds from a bank in Singapore and completing the above-mentioned transactions.
The US Internal Revenue Service (IRS) issued the US corporation a notice of deficiency increasing the US corporation’s income by the amount representing the transfers from the Singaporean subsidiary to the US corporations.
The US Tax Court held that the newly-formed subsidiaries in Bermuda and Delaware did not have a valid business purpose and that the various intermediate steps of the reinvestment plan are properly collapsed into a single transaction under the interdependence test of the step transaction doctrine. The interdependence test analyses whether the intervening steps are so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps. This test is one of three alternative tests that, if satisfied, invoke the step transaction doctrine, under which, a particular step in a transaction is disregarded for tax purposes if the taxpayer would have achieved its objective more directly, but instead included the step for the purpose of tax avoidance.
The US Tax Court further held that the Singaporean subsidiary transferred a substantial amount of cash to the US corporation through the reinvestment plan, and that the US corporation failed to show that it had returned any of the funds.
The US Tax Court concluded that the reinvestment plan resulted in substance in taxable dividend payments from the Singaporean subsidiary to the US corporation.
In addition, the US Tax Court held that the US corporation was liable for the accuracy-related penalties u/s. 6662(a) of the US Internal Revenue Code (IRC). The US Tax Court determined that the requirements for the reasonable cause and good faith exception to the penalty had not been met.
11. United States: US Federal Court of Appeals affirms denial of loss deduction for lack of economic substance
The US Federal Court of Appeals for the Sixth Circuit has disallowed a deduction for a loss from a transaction that was lacking in economic substance (Mark L. Kerman and Lucy M. Kerman vs. Commissioner of Internal Revenue, No. 11-1822, 8th April 2013).
The case involved a US taxpayer who entered into a complex series of transactions, referred to as the Custom Adjustable Rate Debt Structure (CARDS) transaction. The CARDS transaction centred on a “high basis, low value” foreign currency loan designed to generate a tax benefit by creating an artificial tax loss to offset real taxable income.
The CARDS transaction generally included the following steps:
– two British citizens created a limited liability company (LLC);
– the LLC borrowed $ 5 million worth of euros from a bank in Germany;
– the proceeds of the loan were left, as collateral, in the German bank, which paid less interest than due on the loan;
– the taxpayer purchased $ 784,750 worth of the euros from the LLC, and agreed to be jointly and severally liable for the entire loan of $ 5 million;
– the taxpayer exchanged his share of the loan for US dollars; and
– 1 year after the transaction was entered into, the collateral held by the German bank was used to pay off the loan.
The taxpayer took the position that $ 784,750 in foreign currency that he purchased had a basis of $ 5 million. The taxpayer claimed that an ordinary loss deduction of $ 4,251,389 resulted from the exchange of his share of the loan for the US dollars. The loss was claimed on his 2000 tax return, with a resulting tax saving of $ 1,248,876. US tax law treats a loss realized on the disposition of foreign currency as an ordinary loss.
The US Internal Revenue (IRS) issued a notice of deficiency to the taxpayer, disallowing the loss deduction and imposing an accuracy-related penalty. After the US Tax Court affirmed the IRS’s decision, the taxpayer appealed.
Denial of loss deduction
The US Court of Appeals stated that, for an asserted deduction to be valid under IRC section 165, the deduction must satisfy both components of a two-part test, that is, whether the transaction had economic substance and whether the taxpayer was motivated by profit to participate in the transaction.
The US Court of Appeals held that the CARDS transaction had both hallmarks of a sham transaction (i.e. a transaction that lacks economic substance) on grounds that:
– firstly, the transaction had negative pre-deduction cash flows, absent the tax benefits, because the transaction cost more than $ 600,000 including the interest and the borrowing fees, and returned approximately $ 60,000; and
– secondly, the transaction had no practical economic effects other than the creation of artificial income tax losses.
Accordingly, the US Court of Appeals affirmed the US Tax Court’s decision that disallowed the taxpayer’s deduction based on the transaction’s lack of economic substance.
The transaction predated the codification of the economic substance doctrine in 2010 as IRC section 7701(o) (see United States-1, News 15 September 2010). As a result, IRC section 7701(o) was not applied in the present case.
Accuracy-related penalty
IRC section 6662(a) and (b) imposes a 20% accuracy-related penalty for the underpayment of tax, including for any “substantial valuation misstatement”. Under IRC section 6662(e), a “substantial valuation misstatement” occurs when a taxpayer overstates the basis in property by 200% or more. IRC section 6662(h)(a)(i) doubles the penalty to 40% for “gross valuation misstatements” when a taxpayer overstates the basis in property by 400% or more.
IRC section 6664(c)(1) offers an exception to the imposition of accuracy-related penalties if there was a reasonable cause and the taxpayer acted in good faith with respect to the underpayment.
The Court of Appeals stated that, although the US federal courts of appeals are divided, the Sixth Circuit follows an approach of the majority of the circuits. Under the majority approach, the deficiency that occurs when a transaction is disallowed for lack of economic substance is deemed to be attributable to an overstatement of value, and is subject to the penalty pursuant to IRC section 6662.
The US Court of Appeals held that because the taxpayer’s actual basis in the currency is what he purchased (i.e. $ 784,750), he overstated the basis (i.e. $ 5 million) by 530%, which exceeds the 400% threshold of IRC section 6662(h).
The US Court of Appeals further held that the taxpayer did not act with reasonable cause because:
– the promotional materials for the CARDS transaction warned that the IRS might challenge the transaction; and
– the taxpayer did not reasonably investigate the CARDS strategy’s legitimacy before, during, or after the CARDS transaction.
The US Court of Appeals held that the valuation misstatement penalty of IRC section 6662(e), which may be enhanced by s/s. (h), is specifically targeted at tax shelters, and affirmed the US Tax Court’s imposition of the gross valuation misstatement penalty pursuant to IRC section 6662(h).
[Acknowledgement/ Source: We have compiled the above summary of decisions from the Tax News Service of IBFD for the period 18-03-2013 to 16-07-2013.]
