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Excluding High-Taxed Foreign Income Under Final GILTI HTE Regulations and Proposed Section 954(b)(4) Regulations

Posted on August 24, 2020 at 4:05 PM


On July 20, 2020, Treasury and the IRS issued proposed regulations (“Proposed Regulations”) under section (“Section”) 954(b)(4) of the Internal Revenue Code of 1986, as amended (“Code”) conforming the rules for electing into a high-tax exception (“HTE”) for “subpart F” income and a high-tax exclusion from global intangible low-taxed income (“GILTI”) (“GILTI HTE”). As part of the same regulations package, Treasury and the IRS issued final regulations under Sections 951A and 954 for the high-tax election to limit federal tax on GILTI subject to a high rate of foreign tax (“Final Regulations”). Under Proposed Regulations, when finalized, the high-tax election for GILTI HTE in Final Regulations would be removed and substituted with HTE rules in Proposed Regulations for both subpart F income and GILTI.

Section 951A was enacted under section 14201 of Pub. L. No. 115-97 (2017), commonly known as the Tax Cuts and Jobs Act, or “TCJA”. Section 951A generally requires inclusion in gross income of a United States shareholder of a controlled foreign corporation (“CFC”), as defined in Section 957, “tested income” of a CFC. The GILTI regime works in tandem with Section 250 and with other TCJA provisions, which were enacted to replace the extraterritorial system of taxing income of a United States citizen or resident with a territorial-like approach. Generally, tested income consists of intangible income of a CFC, less 10 percent of adjusted basis in depreciable tangible property of the CFC, the latter reduced by interest expense allocable to interest income, which is excluded from tested income.

A purpose of the GILTI regime was to ensure that a U.S. shareholder of a CFC does not avoid income tax by relocating operations to a low-tax jurisdiction. However, a foreign income tax rate may be sufficiently high so that tax liability would be greater under the new participation exemption system than under the extraterritorial framework preceding TCJA. Under Section 951A(c)(2)(A)(i)(III), foreign base company income and insurance income excluded under the high-tax exception in Section 954(b)(4) from subpart F, the Code provisions governing federal tax treatment with respect to foreign income of a CFC, is not gross income included in tested income to calculate GILTI. By definition, reflecting Congressional intent, GILTI is low-taxed income.

To ensure tax parity and avoid an incentive for taxpayers in high-tax foreign jurisdictions to convert tested income into subpart F income, Treasury regulations proposed in 2019 created a “high tax exclusion” (“HTE”) from GILTI, excluding income subject to a foreign tax rate of at least 18.9 percent. The statutory authority for the GILTI HTE remains subject to debate. In general, the regulations allow a U.S. shareholder to make a Section 954(b)(4) election to exclude high-taxed CFC income from GILTI.

Treasury and the IRS finalized the GILTI HTE regulations on July 20, 2020 (“Final Regulations”), and simultaneously, issued proposed regulations (“Proposed Regulations”), to conform the HTE with the high-tax exception. The IRS substituted calculation of income of each qualified business unit (“QBU”) under Subpart F with a new, “tested unit” method under proposed amendment to Section 954(b)(4). This article discusses the method of computing CFC tested income in Proposed Regulations and compares the tested unit basis to a QBU level determination.

Grouping Rules in Final Regulations and Proposed Regulations

The Final Regulations permit a shareholder to elect annually into the GILTI HTE. Section 954(b)(4) generally excepts certain items of foreign base company income or insurance income from U.S. tax if the taxpayer demonstrates that such income was taxed by a foreign country at an effective income tax rate exceeding 90 percent of the highest corporate income tax rate under the Code, or 18.9 percent. The effective tax rate on income excluded under the HTE contrasts with the 13.125 percent effective tax rate on GILTI after taking into account the Section 250 deduction. CFC income with an effective tax rate above 13.125 and 18.9 percent or below is included in tested income of a CFC and is not subject to a GILTI HTE.

As a result of a Section 950 deduction and available foreign tax credits, a U.S. corporate shareholder may not owe any GILTI tax on CFC income with an effective foreign tax rate of at least 13.125 percent. On the other hand, an individual U.S. shareholder, such as a partner in a domestic partnership that owns the CFC, would have to make a Section 962 election under final Treasury regulations issued in July 2020 to claim a Section 250 deduction. The Section 962 election would result in a federal corporate income tax rate, currently 21 percent, applying to a distributive share of both GILTI and any subpart F income of the shareholder partner. Individuals should consult with counsel to determine whether a Section 962 election with respect to GILTI subject to an effective foreign income tax rate below 18.9 percent would result in favorable tax treatment to the partner of other Section 951(a) inclusions.

Final Regulations require tentative gross tested income to the extent attributable to a tested unit of a CFC to be aggregated within a separate category of income for HTE purposes. This rule contrasts with the net foreign base company income determination in current Section 954 regulations. Furthermore, tentative items of tested income and foreign taxes of tested units of a CFC, including the CFC, which have substantially equal effective tax rates, are aggregated. This structure limits “blending” of different tax rates that may apply to a certain item of income in a foreign jurisdiction. The uniform taxing rule was to ensure only high-taxed income was excepted.

Moreover, in Proposed Regulations, general category items of income that would have been GILTI or subpart F income, which are attributable to a tested unit, are aggregated under the unified HTE rule. The unified rule, applied to calculate the effective tax rate, results in a taxpayer avoiding determining whether an item of income is subject to GILTI or Subpart F. However, under Proposed Regulations, passive foreign personal holding company income, a category of subpart F income, and certain income and deductions attributable to equity transactions, the timing of which may be manipulated by a taxpayer is separately grouped for purposes of the HTE.

Overview of Tested Unit Concept in Applying the HTE

Treasury and the IRS, consistently with legislative history of Section 951A, intended to apply the anti-base erosion principle to the GILTI HTE. In 2019 proposed regulations, the IRS considered determining the gross tested income on a QBU by QBU basis, a QBU being defined under Section 989(a). In the preamble to Final Regulations, the IRS rejected a CFC by CFC effective foreign tax rate computation that applies generally in computing foreign tax credits under Section 904 regulations. In addition, in Final Regulations, the IRS substituted a QBU level determination of high-taxed income with a novel approach based on “tested units”.

The tested unit approach permits some blending of income subject to different tax rates under the mandatory tested unit combination rule in Final Regulations. The rule applies generally to tested units of a CFC that are tax residents of, or located in, the same country. Generally, there are three categories of tested units in Final Regulations, as reflected in Proposed Regulations.

A tested unit may be a CFC itself, or an interest held directly or indirectly by a CFC in a pass-through entity that is a tax resident of a foreign country or regarded for income tax purposes under applicable foreign law. A tested unit also may be a branch, the activities of which are carried on, directly or indirectly, by a CFC, which gives rise to a taxable presence in the foreign country. In some cases, a branch may not be subject to income tax under the laws of the foreign country, in which it is located. In that instance, the branch still may be a tested unit. However, an exclusion, exemption, preferential tax rate or other similar relief must apply with respect to income attributable to the branch under the tax laws of the foreign country, in which the CFC or other entity carrying on the activities of the branch is a tax resident. A tested unit also may be a portion of the activities of a branch, if they are carried on indirectly through an interest in a partnership.

In addition, Proposed Regulations contain a de minimis combination rule, which applies after the tested unit combination rule. The non-elective de minimis rule combines tested units with attributed gross income of less than the lesser of one percent of the gross income of the CFC or $250,000 for a tax year, without regard to the foreign country of tax residence. The de minimis rule is subject to an anti-avoidance provision in Proposed Regulations.

The High-Tax Election Under Proposed Regulations

In Proposed Regulations, the IRS conforms the rules implementing the Subpart F HTE with the GILTI HTE by applying the tested unit effective tax rate calculation under Section 954(b)(4). The preamble to the Final Regulations states the purpose of Proposed Regulations is to eliminate the disparity between the two elections or the incentive for taxpayers to structure into the Subpart F high-tax exception. Under Proposed Regulations, the Section 954(b)(4) election must be made with respect to all of the CFCs that are members of a CFC group pursuant to the GILTI HTE consistency requirement.

In addition, a unified rule applies to cover both subpart F income and tested income under a Section 954(b)(4) election (“HTE”). Furthermore, taxpayers are afforded additional flexibility in being permitted to make the GILTI HTE election on an annual basis. United States shareholders making the election are subject to specific contemporaneous documentation requirements.

An HTE election on an amended return must be filed within six months during the 24 months following the due date of the original income tax return without extensions. The original return would have been filed within the inclusion year of the controlling domestic shareholder, with or within which the relevant CFC inclusion year ends. Generally, all U.S. shareholders of the CFC must file amended returns within the prescribed period in order to make or revoke an HTE election on an amended return, unless the original returns of the shareholders had not been filed yet for the tax year.

If a U.S. shareholder is a partnership, the HTE election may be made or revoked by filing an amended Form 1065 or an administrative adjustment request (“AAA”). In the case of an AAA, a partner that is a U.S. shareholder in the CFC and the partnership comply with the requirement if both timely comply with the AAA requirements under Section 6227. Additional Form 5471 reporting requirements apply with respect to an HTE.

Another special rule applies in determining subpart F income for purposes of the HTE which carries over to a subsequent tax year of a CFC due to the application of the earnings and profits (“E&P”) limitation under Section 952(c)(1). Generally, under Section 952(c)(2), any E&P in excess of the subpart F income of the CFC for such subsequent tax year is recharacterized as subpart F income to the extent of the carryover of subpart F income due to the limitation from a prior tax year. To determine the carryover amount, rules similar to the rules under Section 904(f)(5) apply. In the event of a Section 381(a) transaction, Proposed Regulations clarify that there is a carryover of an overall foreign loss account of the distributing or transferor corporation to the acquiring or transferee corporation as of the close of the date of the distribution or transfer.

Calculating Gross Income for HTE Under Proposed Regulations

Final Regulations currently provide rules for calculating gross income attributable to a tested unit, subject to adjustments for certain disregarded payments, for the GILTI HTE. An item of income attributable to more than one tested unit would be deemed attributable to only one tested unit, and in a tiered structure, the item would be deemed attributable to the lowest-tier tested unit. Proposed Regulations generally mirror the rules in Final Regulations for calculating gross income attributable to a tested unit and the effective foreign tax rate for the HTE for both subpart F income and GILTI.

However, Proposed Regulations introduce new nomenclature with respect to gross income or net income items of a tested unit for calculating the effective foreign tax rate in determining applicability of the HTE. Also, Proposed Regulations provide that tentative gross income of a tested unit is determined based on items of gross income attributable to an applicable financial statement of the tested unit, replacing a “books and records” rule in Final Regulations. Treasury and the IRS, as stated in the preamble to Final Regulations, generally expect a tested unit to maintain a set of separate books and records. However, an entity, including a disregarded entity, a branch or a portion of the activities of a branch may qualify as a tested unit even if it does not maintain separate books and records.

In particular, an applicable financial statement of a portion of the activities of a branch that is a tested unit would be the applicable financial statement of the branch. Under the “booking rule” in Proposed Regulations, deductions, other than deductions for current year taxes, are attributable to a tested unit to the extent they are properly reflected on the applicable financial statement of the tested unit. Such deductions are allocated and apportioned on the basis of the income and activities to which the expense relates, provided that they reduce certain items of gross income attributable to the same tested unit.

Certain items of gross income may not be booked separately with respect to a portion of the activities of a CFC branch. Such activities may give rise to high-taxed income compared with other items of income of the same branch. Moreover, the branch may be subject to cost sharing arrangements or other circumstances, which may result in proper allocation and apportionment of expenses to a tested unit other than the portion of the activities of the branch which gave rise to high-taxed income. In this manner, applying the definition of an applicable financial statement may result in a high-taxed income qualifying for the HTE due to failure to book items separately. Domestic shareholders should obtain counsel to avoid adverse tax consequences in such circumstances.

In addition, subpart F coordination rules apply to ensure appropriate qualification for the HTE. These rules include determining subpart F income subject to the HTE without applying the earnings and profits limitation under Section 952(c)(1), determining foreign base company income for the HTE before applying the full inclusion rule and conforming amendments to Section 951A regulations.

Allocation and Apportionment of Deductions Under Proposed Regulations

The effective foreign tax rate is calculated first by taking into account gross tested income attributable to a tested unit, and then determining tentative net items of tested income by allocating and apportioning deductions to the extent they are properly reflected on an applicable financial statement of the tested unit. By contrast, allocation and apportionment rules under Section 861 would have applied for purposes of the HTE under Final Regulations. Those latter rules still apply for purposes of calculating foreign tax credits under Section 960, GILTI and Subpart F income. However, the IRS requested comments on conforming the two separate calculations for administrability and to avoid “double counting” of deductions for HTE, and GILTI or Subpart F.

Therefore, the taxpayer must allocate and apportion deductions to tentative gross tested income items to determine the amount subject to an effective foreign tax rate for GILTI HTE. Items of income of a tested unit approximate foreign taxable income. In contrast, timing and other tax accounting principles under the Code apply to tested income, gain, deduction and loss items for purposes of the HTE. The effective foreign tax rate, at which taxes are imposed on a tentative net item is the U.S. dollar amount of foreign taxes paid or accrued with respect to the tentative net item, divided by the U.S. dollar amount of the tentative net item, adding in the above foreign tax.

In addition, a taxpayer allocates and apportions the deductions to tentative gross tested income items for the CFC inclusion year, as if each tentative gross tested income item was in a separate tested income group. The current treatment is described in Treas. Reg. section 1.951A-2(c)(7)(iii). Likewise, the scope of a separate tested income group is defined in Treas. Reg. section 1.960-1(d)(2)(ii)(C). The superimposition of these rules may result in part or all of certain deductions on the books and records of a tested unit, which are generally taken into account for foreign tax purposes in computing foreign taxable income, not being taken into account for purposes of the GILTI HTE.

In some instances, the allocable and apportioned deductions, including a deduction for foreign taxes paid on the income, may exceed the amount of gross income. Therefore, booking the tentative net income item may result in an undefined or negative effective foreign tax rate. In that case, the tentative net item of tested income is treated as high-taxed under Proposed Regulations. Therefore, the items of gross income and deductions allocated and apportioned to such gross income under Section 861 regulations are assigned to a residual grouping and credit is not allowed for the foreign taxes allocated and apportioned to such gross income.

Applicability of Proposed Regulations and Final Regulations

Proposed Regulations generally would apply to tax years of CFCs beginning after the date of publication of final regulations and to tax years of U.S. shareholders in which or with which such CFC tax years end. However, the subpart F income recapture provision under Prop. Treas. Reg. section 1.954-1(f)(4) would apply to tax years of a foreign corporation ending on or after July 20, 2020 and would affect recapture accounts of an acquiring corporation for such tax year, even if the distribution or transfer subject to Section 381(a) occurred in a tax year ending before July 20, 2020.

The Final Regulations are effective on September 21, 2020. Consistent with the applicability date in proposed Section 951A and Section 954 GILTI HTE regulations, the Final Regulations provide that the GILTI HTE applies to tax years of CFCs beginning on or after July 23, 2020 and to tax years of U.S. shareholders in which or with which such CFC tax years end.


Overview of Proposed Carried Interest Regulations Under Code Section 1061

Posted on August 4, 2020 at 8:20 PM


On July 31, 2020, Treasury and the IRS issued proposed regulations, REG-107213-18 ("Proposed Regulations") under section (“Section”) 1061 of the Internal Revenue Code of 1986, as amended (“Code”) regarding taxing gain from certain carried interests held less than three years as short term capital gain (“STCG”). Section 1061 was enacted under section 13309 of Pub. L. No. 115-97, 131 Stat. 2054 (2017) (the "Tax Cuts and Jobs Act"). Section 1061(a) in general treats gain attributable to an applicable partnership interest (“API”) received or held by a taxpayer during a tax year as STCG taxable at an ordinary income tax rate under the Code, which ranges from 10 to 37 percent, rather than the rate for long term capital gain (“LTCG”) of zero to 20 percent for 2020, depending on the income level of the taxpayer.

Under Section 1061(c)(1), the interest has to be transferred or held in connection with substantial performance of services by the taxpayer, or any other related person, in any applicable trade or business (“ATB”). Furthermore, the partnership interest may be either transferred to or held by a taxpayer. In addition, a taxpayer may have received or held the partnership interest directly or indirectly. This article reviews key concepts in the Proposed Regulations affecting fund investors, sponsors and executives in the private equity space. Treasury and the IRS responded in the Proposed Regulations to certain concerns in the private equity community, addressed to an extent in public comments submitted pursuant to IRS Notice 2018-18, 2018-18 I.R.B. 443 ("Notice 2018-18").

Recharacterization Amount, Owner Taxpayer, API Holder and Other Key Terms

Under Proposed Regulations, the amount subject to Section 1061(a) is the difference between net LTCG with respect to one or more APIs and the net LTCG with respect to such APIs calculated by substituting a three-year holding period for a one-year holding period under Section 1222(3) and 1222(4). The amount subject to Section 1061(a) is the “Recharacterization Amount” under the Proposed Regulations. Notably, Section 1061(a) does recharacterize a long-term capital loss as a short-term capital loss with respect to an API.

A taxpayer may be subject to income tax consequences under Section 1061(a) with respect to an API whether the taxpayer receives or holds the API directly or indirectly, in some cases, through one or more Passthrough Entities, another defined term in the Proposed Regulations. Taking this rule into account, the person who is required to recognize a gain or loss on the Recharacterization Amount for federal income tax purposes is the “Owner Taxpayer”, and such recognized gains or losses are “API Gains and Losses” under the Proposed Regulations. API Gains and Losses exclude amounts calculated outside the holding period rules in Section 1222. API gains and losses not realized yet by a taxpayer, including partnership allocations through a tiered structure, on the other hand, are termed “Unrealized API Gains and Losses” in the Proposed Regulations.

In a tiered structure, the Owner Taxpayer may be the ultimate owner of the API. Intermediate passthrough entities also are deemed each to hold the API. Each of the intermediaries are termed “API Holder” under the Proposed Regulations. In addition, partnerships or other pass-through intermediaries, which are treated as a taxpayer for purposes of determining whether a partnership interest is an API but are not taxpayers with respect to the API are “Passthrough Taxpayers” under the Proposed Regulations. Moreover, in summary, to determine whether a partnership interest is held or transferred in connection with performance of substantial services in an ATB, an “ATB Activity Test” applies under the Proposed Regulations.

Section 1061(c)(2) defines an ATB generally as any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part, of raising or returning capital, and either investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or developing specified assets. Section 1061(c)(3) defines a specified asset generally as securities in Section 475(c)(2), commodities in Section 475(e)(2), real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any such assets, and an interest in a partnership to the extent of the partnership’s proportionate interest in any such asset.

The preamble provides the Proposed Regulations generally track the statutory definition of “Specified Assets”. Thus, the Proposed Regulations do not carve out an exception for cash or cash equivalents, which may result in broader applicability by including interests in partnerships that actively identify, invest in or dispose of only cash or cash equivalents.

Exceptions to Section 1061

Section 1061(c)(4) sets forth exceptions to converting LTCG to STCG with respect to an API under Section 1061(a). First, Section 1061(a) does not apply to any partnership interest held directly or indirectly by a C corporation. Second, the definition of an API in Section 1061(c)(2) does not include certain capital interests. The exempt capital interest has to be commensurate with the amount of capital contributed at the time of issuance or has to be taxed as property transferred in connection with performance of services under Section 83 upon receipt or vesting of such capital interest. In sum, under the capital interest exception in the Proposed Regulations, realized LTCG or long-term capital loss (“LTCL”) on a return on capital invested in a Passthrough Entity is not subject to Section 1061(a). Consistently, Capital Interest Allocations, Passthrough Interest Capital Allocations and Capital Interest Disposition Amounts are treated as Capital Interest Gains and Losses, all defined terms in the Proposed Regulations. Proposed Regulations permit bifurcation of an interest upon disposition into a capital interest subject to the capital interest exception and an API subject to Section 1061(a).

Proposed Regulations “track” the statutory language in the Section 1061(c)(1) exemption for partnership interests held by a person employed by another entity that conducts a trade or business other than an ATB, and who provides services only to such other entity. Proposed Regulations add an exception for a partnership interest, generally acquired by an unrelated purchaser, who does not provide services, in an arm’s-length transaction. But Proposed Regulations reserve on Section 1061(b) statutory authority for an exception to Section 1061(a) for income or gain attributable to any asset not held for portfolio investment on behalf of third party investors.

Accelerated Recognition of Gain on a Related Party API Transfer in Section 1061(d)

Section 1061(d) provides that, upon a direct or indirect transfer of an API to a person related to the taxpayer, the taxpayer includes in gross income as STCG the LTCG with respect to the API for the tax year, which would be attributable to the sale or exchange of a capital asset held for less than three years, and which would be allocable to the API, less any LTCG with respect to the API already converted to STCG under Section 1061(a). Section 318 attribution rules apply for identifying a related person with respect to the taxpayer under Section 1061(d). Proposed Regulations clarify that only family members of a taxpayer, colleagues of a taxpayer who were service providers in the ATB during certain time periods and a Passthrough Entity to the extent of ownership by a family member or colleague of the taxpayer may be a related person. Proposed Regulations also clarify that gain recognition is required under Section 1061(d)(1), even if the transfer of the API otherwise would not be a taxable event. Under Proposed Regulations, a transfer includes transactions, such as contributions, distributions, sales and exchanges, and gifts.

Section 1061(e) Information Reporting by Owner Taxpayer and Passthrough Entities

Section 1061(e) authorizes the IRS to prescribe reporting requirements under Section 1061. Proposed Regulations provide that an Owner Taxpayer must report any information the IRS may require in forms, instructions, or other guidance to evidence compliance with Section 1061. Also, under Proposed Regulations, a Passthrough Entity in which an Owner Taxpayer holds its interest must provide information needed by Owner Taxpayer to comply with Section 1061 and to determine the Recharacterization Amount. Thus, the Passthrough Entity must provide to the Owner Taxpayer the API One Year Distributive Share Amount under Proposed Regulations.

Moreover, the Passthrough Entity must provide to the Owner Taxpayer the adjustments that must be made to the distributive share of Owner Taxpayer’s LTCG or LTCL, so as to enable Owner Taxpayer to calculate independently its API One Year Distributive Share Amount and its API Three Year Distributive Share Amount, as defined in Proposed Regulations. Absent substantiation of the amounts in a manner satisfactory to the IRS, Owner Taxpayer would not be allowed to take into account any Section 1061 exclusions.

Furthermore, a Passthrough Entity that has an API Holder must furnish sufficient information to the API Holder to assist in compliance with Section 1061 Treasury regulations. The preamble states that this requirement means the Passthrough Entity generally would furnish the information to the API Holder as an attachment to Schedule K-1 for the tax year. Under Proposed Regulations, the information furnished to the partner in this manner would include the API One Year Distributive Share Amount, the API Three Year Distributive Share Amount, LTCG and LTCL allocations to the API Holder that are excluded from Section 1061 under Proposed Regulation section 1.1061-4(b)(6), Capital Interest Gains and Losses allocable to the API Holder and API Holder Transition Amounts, as defined in Proposed Regulations.

In addition, if there is a disposition by the API Holder of an interest in a Passthrough Entity during the tax year, the Passthrough Entity must provide any information required by the API Holder for purposes of Section 1061 as may be applicable to the disposition. Required information with respect to the disposition would include information on the application of the Lookthrough Rule in Proposed Regulation section 1.1061-4(b)(9) and for determining the Capital Interest Disposition Amount. A Passthrough Entity would be subject to reporting penalties under the Code for failure to furnish the required information.

Finally, a lower-tier partnership or other entity, in which a Passthrough Entity holds an interest, may be required to provide information to the Passthrough Entity for compliance with reporting rules under Proposed Regulations. Thus, the Passthrough Entity must request this information from any lower-tier entities in which it holds an interest not later than 30 days following the close of the tax year, or if later, within 14 days of receipt of the request for information from an API Holder. The lower-tier entity must respond to the request not later than the filing date for Schedule K-1 for the tax year, including extensions.

In some instances, a lower-tier Passthrough Entity might fail to report the requested information. In that case, Proposed Regulation section 1.1061-6(b)(2)(vi) provides that the upper-tier Passthrough Entity must take actions to otherwise determine and substantiate the missing data. Absent requisite substantiation and determination of the amounts, the upper-tier Passthrough Entity generally would not take into account Section 1061 exclusions, unless the Owner Taxpayer independently is able to substantiate the amounts to satisfaction of the IRS. Furthermore, the upper-tier Passthrough Entity must notify both the API Holder and the IRS that paragraph (b)(2), the tiered-structure information requirement, applies to the disclosures as required by the IRS.

Effective Date for Applicability, Certain Corporations, Partner’s Distributive Share

Under Proposed Regulations, the final Section 1061 regulations apply to taxable years of Owner Taxpayers and Passthrough Entities beginning on or after the date the final regulations are published in the Federal Register. Generally, Owner Taxpayers and Passthrough Entities may rely on the Proposed Regulations for tax years beginning before the date of publication of the final regulations, provided they follow the Proposed Regulations in their entirety and in a consistent manner. As an exception, in some instances, a partnership may treat capital gains and losses from certain assets as Partnership Transition Amounts and API Holder Transition Amounts, as defined in Proposed Regulations, for the year in which the election is made and all subsequent years beginning before the publication date for the final regulations. In that event, Owner Taxpayers and Passthrough Entities do not have to follow all the rules in the Proposed Regulations consistently regarding the Partnership Transition Amounts and API Holder Transition Amounts.

Proposed Regulations, consistently with Notice 2018-18, provide that the term corporation with respect to the corporate exception under Section 1061(c)(4)(A) does not include an S corporation, effective for taxable years beginning after December 31, 2017. In addition, under Proposed Regulations, a corporation does not include a passive foreign investment company (“PFIC”) with respect to which the shareholder has in effect a qualified electing fund (“QEF”) election under Section 1295, effective for tax years beginning after the publication date of the Proposed Regulations.

Section 706 requires generally taking into account in computing the taxable income of a partner for a tax year the distributive share of separately stated partnership items for any tax year of the partnership ending within or with the tax year of the partner. Under Proposed Regulations, Section 706 applies to an API in a partnership with a fiscal year ending after December 31, 2017. Thus, a partnership with a fiscal year that ends after December 31, 2017 may have sold an API prior to December 31, 2017. Section 1061 would apply in determining the distributive share of LTCG or LTCL of an individual Owner Taxpayer with respect to the API in calendar year 2018.  For any questions or assistance regarding the applicability of Proposed Regulations, please contact the Firm.  


Covid-19 Leave-Based Donation Program Necessitates Strict Compliance With Safe Harbor

Posted on July 27, 2020 at 11:45 AM

On June 11, 2020, the IRS issued Notice 2020-46 (the “Notice”) permitting employers to claim a charitable contribution deduction under Section 170(c) of the Internal Revenue Code of 1986, as amended, for cash payments to charities amounting to paid leave donated by employees. Alternatively, even if the requirements for a Section 170(c) deduction are met, an employer may deduct the payment as an ordinary and necessary business expense under Section 162(a). Also, under the Notice, payment of donated leave to a Section 501(c)(3) tax-exempt organization will not be treated as wages subject to employment excise taxes, tax withholding or wage reporting.  Moreover, a leave-based donation program may be exempt from most employee benefit plan requirements under the Employee Retirement Income Security Act of 1974, as amended ("ERISA") as a payroll practice if it meets certain conditions.  

The Notice sets forth several conditions for exclusion of foregone paid leave from gross income or wages of donor employee and deductibility of the payments by employer.  First, the payment by the employer must be made in cash.  Second, the cash payment has to be in exchange for vacation, sick or personal leave foregone by employees.  Third, an employee must elect to forego the paid leave.  Fourth, the cash payment of foregone leave must be made to a Section 170(c) organization for the relief of victims of Covid-19 in the affected georgraphic areas.  Fifth, an employer must make the cash payment of foregone leave to a Section 170(c) relief charity before January 1, 2021.  

The Notice, or the predecessor IRS guidance does not set forth any specific operational requirements for an employer-sponsored leave-based donation program, other than the five factors generally outlined above. The leave-based donation program established under the Notice is not statutory, and does not clarify tax authorities for excluding the payments from gross income of donor employees.  The safe harbor in the Notice is an exception to two general tax principles for inclusion of amounts in gross income of a taxpayer under Section 61(a), the common law assignment of income doctrine devised by federal courts in interpreting Section 61 and the constructive receipt doctrine codified in Section 451.

Thus, the IRS has assumed effectively a noneforcement position with respect to general tax treatment of foregone paid leave of a donor employee in the safe harbor. Therefore, employers may find advisable to draft and implement a leave-based donation program in strict compliance with the safe harbor and applicable ERISA exemption requirements to avoid adverse tax or ERISA consequences of participation in the charitable relief program.  

Extension of PPP, Discontinued EIDL Advances Offer Limited Tax Planning Opportunities for Employers in Financing Payroll

Posted on July 12, 2020 at 2:45 PM

On July 4, 2020, legislation introduced in the Senate on June 30, 2020, initially the last date for submitting an application under the Paycheck Protection Program (PPP), was signed into law.  The bill, S. 4116, titled, "A bill to extend the authority for commitments for the paycheck protection program and separate amounts authorized for other loans under section 7(a) of the Small Business Act, and for other purposes" extended the covered period for the federal relief program authorized under section 1102 of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Pub. L. No. 116-136 (2020) to August 8, 2020.  Subject to the extended deadline, employers, including nonprofit organizations, with workforce not exceeding 500 employees have additional planning opportunities for financing payroll and other operating expenses with loans backed by the Small Business Administration (SBA) subject to forgiveness, SBA grants, and refundable employment tax credits.  

As of July 11, 2020, SBA grants up to $10,000 in the aggregate per applicant under section 1110 of the CARES Act (emergency EIDL grants or EIDL Advances) were discontinued due to depletion of $20 billion in funding allocated for the program. See SBA Rel. No. 20-56 (July 11, 2020).  An eligible recipient of a PPP loan, which is subject to forgiveness under CARES Act section 1106, may not receive an emergency EIDL grant.  However, eligible recipients of PPP funds would be able to structure business operations to maximize the economic and tax benefits of PPP loan proceeds or payroll credits under sections 7001 or 7003 of the Families First Coronavirus Response Act, Pub. L. No. 116-127 (2020) (FFCRA) as financial assistance.  

For example, a business entity may have suspended operations, utilized an employee retention credit under CARES Act section 2301 to subsidize certain payroll liabilities during the first two calendar quarters in 2020 and applied for an emergency EIDL grant.  Employers that have reopened may be required to provide paid sick leave or family leave under FFCRA to employees due to Covid-19 medical or family circumstances.  Such employers may claim certain refundable FICA tax credits for qualified sick leave or family leave wages and certain other payroll expenses under FFCRA. However, receipt of a PPP loan would preclude an employer from claiming any employee retention credit under CARES Act section 2301.  

In addition, any amount of an emergency EIDL grant is deducted from a PPP loan forgiveness amount applied to payroll costs.  Furthermore, a covered employer may not apply PPP loan proceeds to fund qualified sick leave or family leave wages, for which a credit is allowed under FFCRA. Employers impacted by Covid-19 may require economic relief for financing business operations in the current environment.  Businesses, which have claimed an employee retention credit or received an emergency EIDL grant may engage tax counsel to determine, among other tax considerations, whether to apply for PPP funds by the extended August 8, 2020 deadline or claim FFCRA refundable tax credits to offset certain payroll liabilities.

PPP Flexibility Act Approaches Tax Parity Between Loan Forgiveness and Employee Retention Credits

Posted on June 28, 2020 at 2:50 PM

Section 1102 of the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. No. 116-136 (2020) (CARES Act) sets forth requirements for loans issued to small business employers, including nonprofit organizations under the Paycheck Protection Program (PPP) administered by the United States Small Business Administration (SBA).  Under CARES Act section 1106, a PPP loan amount for costs and payments incurred during the covered period beginning on the origination date, may be forgiven, subject to certain limitations.  Separately, an eligible employer, including a tax-exempt organization may qualify for an employee retention credit of 50% of qualified wages up to $10,000 paid to an employee under section 2301 of the CARES Act.  The employee retention credit first is applied against employer portion of FICA social security tax on any wages paid to employees of the employer for a calendar quarter, for whcih the employer claims the credit.  Any remaining portion of the credit is refundable to the employer.

On June 5, 2020, the President signed into law the Paycheck Protection Program Flexibility Act of 2020 (Flexibility Act).  Initially, pursuant to SBA guidance published on April 15, 2020, non-payroll costs could not exceed 25% of the forgiven loan amount. Section 3 of the Flexibility Act increased the maximum percentage of PPP loan that may be used for non-payroll costs from 25% to 40% of the covered loan amount in order to qualify for forgiveness.  Among other provisions of the Flexibility Act, section 4 allows delay of payment of payroll taxes by an employer that received forgiveness of PPP loan amounts under CARES Act section 1106 or of coronavirus loans issued by additional authorized lenders under CARES Act section 1109. Section 4 of Flexibility Act, which eliminated the deferral exception for eligible recipients in CARES Act section 2302(a), is effective retroactively for any PPP loan.

Thus, eligible recipients may defer payment of the employer portion of FICA social security tax or equivalent RRTA taxes due for the payroll tax deferral period, beginning March 27, 2020, and ending December 31, 2020. Employers may defer deposit of 50% of the amount of the excise tax due for the deferral period until December 31, 2021. Likewise, employers may pay over to the IRS the remaining 50 percent by December 31, 2022.

Generally, employers may retain certain amounts of withheld employment taxes in anticipation of receiving an employee retention credit or refundable paid leave credits under the Families First Coronavirus Response Act, Pub. L. No. 116 – 127 (2020) (FFCRA). Eligible recipients may not seek PPP financing for wages subject to FFCRA credits, and would not be eligible for a CARES Act employee retention credit. Thus, allowing deferral of payroll tax payments by employers, which received PPP loan forgiveness, was a legislative step toward achieving parity of tax benefits of financing payroll through PPP or employment tax credits.  

Employers seeking financial assistance for operating expenses in the current COVID-19 environment have until June 30, 2020 to apply for and be approved for a PPP loan, but generally may claim an employee retention credit for wages paid through 2020. Employers should consult with tax counsel to determine the economic benefits of each program based on individual facts and circumstances and the business, economic and tax objectives of each employer.


SBA Clarifies Inclusion of Foreign Affiliates in Employee Limit for PPP Loan Eligibility

Posted on May 19, 2020 at 1:45 AM

Employees of foreign affiliate of a small business based in the United States count toward the 500-employee limit under SBA guidance issued on May 18, 2020 (SBA-2020-0030) for loan eligibility under the Paycheck Protection Program (“PPP”), economic assistance for employers affected by COVID-19, authorized in section 1102 of the CARES Act, Pub. L. No. 116-136. SBA published on its website an overview on April 3, 2020, which provided criteria for determining affiliates of an employer seeking PPP financing.

SBA regulations, 13 C.F.R. 121.301, set forth four tests for affiliation based on control, which apply to loan applications in the PPP. In summary, the four respective tests are affiliation based on ownership, affiliation arising under stock options, convertible securities, and agreements to merge, affiliation based on management and affiliation based on identity of interest.

Under SBA guidance issued initially on April 2, 2020 (85 Fed. Reg. 20,811, 20,812 (Apr. 15, 2020)), generally, an applicant would be eligible for a PPP loan if, among other things, it has “500 or fewer employees whose principal place of residence is in the United States” and is a small business concern defined in section 3 of the Small Business Act, 15 U.S.C. 632. There was uncertainty in the practitioner community regarding whether employees with a principal place of residence in a foreign jurisdiction would be excluded from the 500-employee limit.

In question and answer guidance, Q&A 44 added on May 5, 2020, the SBA clarified that for purposes of the employer size PPP eligibility standard, an employer must count all of its employees and the employees of its U.S. and foreign affiliates, absent an applicable waiver or exception. Employers seeking to qualify as a small business concern, a prerequisite for PPP eligibility, on the basis of the 500-or-fewer-employee-based size standard, must do the same.

Among other qualifications, to be a small business concern, under an SBA regulation, 13 C.F.R. 121.105, an employer must have a principal place of residence in the United States and operate primarily within the United States or make a significant contribution to the U.S. economy through payment of taxes or use of American products, materials or labor.

In turn, SBA regulation section 121.106 sets forth the rules for determining a number of employees. For calculating the number of employees, an employer takes into account all individuals employed on a full-time, part-time, or other basis. An employer calculates an average number of employees for each of the pay periods for the preceding completed 12 calendar months. In the average number, the employer includes employees of domestic and foreign affiliates. Thereafter, the average number of employees of a business concern with affiliates is calculated by adding the average number of employees of the business concern with the average number of employees of each affiliate.

Thus, employers with a principal place of residence in the U.S. first must apply the interim final rule (85 Fed. Reg. 20,817 (Apr. 15, 2020)) originally posted on April 3, 2020 and the four factors in the SBA regulations to identify the affiliates, if any, for purposes of the PPP. An employer must determine whether any affiliate under the affiliation rule is a foreign affiliate under the principles in April 3 and April 15, 2020 SBA guidance and SBA regulations.

An employer includes the affiliates in the number of employees reported on SBA Form 2483, the Borrower Application Form, the loan forgiveness application with respect to which was released on May 15, 2020. SBA regulations provide exceptions for some employers from the affiliation rules for PPP eligibility, such as franchise operations. International small businesses needing economic assistance to support their ongoing operations affected by COVID-19 may consult with a tax advisor on meeting the 500-employee limit under the SBA guidance for purposes of determining eligibility for PPP financing.


Tax Credits and PPP Loans for Eligible Employer Payroll Costs

Posted on May 6, 2020 at 7:20 PM

On May 5, 2020, three senators who are leaders of their respective congressional tax-writing committees asked Treasury in a letter to reverse Notice 2020-32 issued last week denying deductions for certain small business expenses that are subject to loan forgiveness. Section 1102(a) of the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. No. 116-127 (2020) (“CARES Act”) sets forth rules for forgiveness of certain covered loans to small business employers under the Paycheck Protection Program (“PPP”) administered by the United States Small Business Administration (“SBA”). CARES Act section 1102 added paragraph (36) to section 7(a) of the Small Business Act, as amended (the “Act”).

Generally, a covered loan (“PPP loan”) amount for costs and payments incurred during the covered period, or the 8-week period beginning on the origination date, may be forgiven, subject to certain limitations. Pursuant to SBA guidance published on April 15, 2020, non-payroll costs may not exceed 25 percent of the forgiven loan amount. Payroll costs subject to a PPP loan exclude qualified sick or family leave paid by a small business employer subject to a refundable credit under the Families First Coronavirus Response Act, Pub. L. No. 116 – 127 (2020) (“FFCRA”). In addition, if a taxpayer receives a PPP loan, the taxpayer would not be eligible for an employee retention credit of up to 50 percent of $10,000 per employee of certain qualified wages for all calendar quarters, allowed under CARES Act section 2301.  Similarly to a taxpayer that receives an employee retention credit under the CARES Act but by contrast to a taxpayer allowed an FFCRA payroll credit, a recipient excludes the amount of PPP loan forgiveness from gross income under section 1106(i) of the CARES Act.  Generally, factors to consider in analyzing the tax benefits of each program may vary for taxpayers and tax-exempt organizations that, unless subject to unrelated business income tax, may be indifferent to income inclusion.

On April 30, 2020, the IRS issued Notice 2020-32, which provides generally that an employer may not deduct business expenses paid using PPP loan proceeds, to the extent that any forgiven portion of the PPP loan is excluded from gross income of the employer under section 1106(i) of the CARES Act. The purpose of the guidance is to prevent a double tax benefit to the employer.  Pending Treasury or legislative action on Notice 2020-32, eligible employers, which include tax-exempt organizations should consult with counsel regarding tax benefits with respect to applicable qualified paid leave requirements and related credits under the FFCRA, employee retention credits under the CARES Act or PPP loan forgiveness with respect to payroll costs of the eligible employer.


Bill Passed by Senate Provides Further Allocations for PPP Loans

Posted on April 21, 2020 at 11:55 PM

Today, the Senate passed the bill, Paycheck Protection Program and Health Care Enhancement Act (“PPP and HCE Act”), which provides generally $484 billion in new coronavirus aid to small businesses and hospitals. The PPP and HCE Act includes a further allocation for the PPP administered by the Small Business Association (“SBA”), following initial $349 billion funding under the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”). The PPP funds, earmarked generally to provide covered business loans up to $10,000,000 to eligible recipients adversely impacted by COVID-19 were depleted last week. Senate acted to replenish the PPP. The bill is expected to pass the House of Representatives on April 23, 2020.

Section 1102(a) of the CARES Act initially authorized the SBA to administer the PPP by amending section 7(a) of the Small Business Act, 15 U.S.C. 636(a). Section 101(a)(1) of the PPP and HCE Act raises the appropriations limit for the PPP from $349 billion to $659 billion by amending CARES Act section 1102(b)(1). Payroll costs taken into account for determining the maximum loan amount exclude qualified sick leave or qualified family leave paid by an employer with fewer than 500 employees, for which a credit is allowed under the Families First Coronavirus Response Act. Thus, among other considerations, employers affected by COVID-19 restrictions should consult with a tax advisor on the distinct benefits of applying for a PPP loan and claiming a payroll credit for qualified sick or family leave provided by the employer.


Federal Paid Leave Tax Credits for Religious Employees Affected by Coronavirus

Posted on April 5, 2020 at 1:35 PM

Paid Leave requirements and tax credits under the Families First Coronavirus Response Act (the "Act"), as amended by the CARES Act, apply generally to private sector and not-for-profit employers, including religious organizations, that are under 500 employees, and to self-employed individuals. MInisterial workers employed by religious organizations generally are subject to self-employment tax on their earnings under section ("Section") 1402(a)(8) of the Internal Revenue Code of 1986, as amended ("Code").  Under sections 7002 and 7004 of the Act, equivalent self-employment sick or family leave tax credits apply to individuals deemed to carry on a trade or business within the meaning of Section 1402(a).  

At first impression, religious employees subject to SECA would not appear to carry on a trade or business in a colloquial sense.  In fact, ministerial workers subject to SECA are deemed employees of the employer for purposes of the requirements under the Act, including the threshold employee count or an exemption from the Act requirements for employers with fewer 50 employees.  And, under Section 1402(c)(4), a trade or business as a general rule does not include services performed by a duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry or by a member of a religious order in the exercise of duties required by such order.  However, the exclusion applies only to ministerial employees who has an effective exemption from the Social Security Act, 42 U.S.C. §§ 301 et seq., with respect to the earnings under Section 1402(e)(1).  

Thus, a religious employee who pays SECA tax would be deemed to be carrying on a trade or business within the meaning of Section 1402(a). Therefore, the ministerial employee may claim a refundable credit against self-employment tax with respect to a qualified sick leave and qualified family leave equivalent amounts, as applicable, under Act sections 7002 and 7004.  Accordingly, tax-exempt religious organizations may consult with tax and employment counsel to assist ministerial employees affected by the coronavirus in determining eligibility for self-employment tax credits.

The comprehensive article on paid leave requirements and tax credits, including DOL and IRS guidance, "Paid Leave Credit for Private Sector and Nonprofit Employers Within The Families First Coronavirus Response Act" in the April 2020 issue of the Tax Management Compensation Planning Journal may be viewed in the News section.  

IRS Notice 2020-22 Offers Guidance on Retaining Withheld Taxes in Anticipation of Payroll or Employee Retention Tax Credits

Posted on April 1, 2020 at 5:35 PM

IRS Notice 2020-22, issued on March 31, 2020, offers guidance with respect to the payroll credits under the Families First Coronavirus Response Act sections 7001 or 7003, or the employee retention credit under the Coronavirus Aid, Relief, and Economic Security ("CARES") Act section 2301 for avoiding a failure to deposit penalty under section 6656 ("Section 6656") of the Internal Revenue Code of 1986, as amended ("Code").  The refundable tax credits, respectively, were intended to refund certain employers for required paid leave provided to employees due to coronavirus, or for wages to businesses suspending operations or incurring significant reductions in gross receipts due to COVID-19-related restrictions.  Both tax credits are capped at $10,000 per employee and expire on December 31, 2020.  

An employer would not incur a Section 6656 penalty generally if the amount of withheld taxes not deposited is less than or equal to the amount of the payroll credit, to which the employer is entitled. The second requirement for waiver is that the employer has not filed IRS Form 7200 for an advance of the credit. Thus, the amount of credit for which an employer ultimately is eligible may be lower than anticipated. In that case, an employer that retains withheld taxes in the maximum amount of expected payroll credit may be liable under Section 6656. In addition, the employer would be subject to recapture of credit. In this instance, considering the respective benefits of retaining withheld taxes or seeking an advance of the payroll credit may be advisable.  Employers, the operations, workforce and revenues of which were affected by COVID-19 may consult with a tax advisor to determine eligibility for each of the tax credits and optimal method for claiming the credits or refunds of the excess credit where there is insufficient payroll tax liability.