2006 FEDERAL TAX ACT PROVISIONS AFFECTING BUSINESS AND THE CAPITAL MARKETS

Transcription

1 ALBANY AMSTERDAM ATLANTA BOCA RATON BOSTON CHICAGO DALLAS DELAWARE DENVER FORT LAUDERDALE HOUSTON LAS VEGAS LOS ANGELES MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PHILADELPHIA PHOENIX SACRAMENTO SILICON VALLEY TALLAHASSEE TOKYO TYSONS CORNER WASHINGTON, D.C. WEST PALM BEACH ZURICH Strategic Alliances with Independent Law Firms* BRUSSELS LONDON MILAN ROME TOKYO 2006 FEDERAL TAX ACT PROVISIONS AFFECTING BUSINESS AND THE CAPITAL MARKETS GREENBERG TRAURIG, LLP ATTORNEYS AT LAW

2 On May 17, 2006, President Bush signed H.R into law. This law, referred to as the Tax Increase Prevention and Reconciliation Act of 2005 ( TIPRA ), contains a substantial number of provisions that affect business and investment generally and the capital markets in particular. Set forth below is a summary of the significant provisions affecting business and investment transactions, many of which are favorable but several of which are not. In reviewing this summary, please note that many of the provisions contained in TIPRA, like so many tax statutes enacted in recent years, have sunsets, that is, the provisions are effective for only a limited period of time. Of course, it is much too early to say whether any of these provisions will have long lives and, given the partisan nature surrounding the enactment of TIPRA, whether they would survive a change in the balance of power between Republicans and Democrats. CONTROLLED FOREIGN CORPORATION ( CFC ) BANKING AND INSURANCE PROVISIONS EXTENDED Insurance. The general rules for insurance income earned by a CFC, which includes both premium income and income earned on reserves, requires the CFC s U.S. shareholders to include such income currently as ordinary subpart F income. A CFC provision, enacted in 1998, and effective beginning in 1999, created a category of exempt insurance income and was set to expire at the end of Exempt insurance income includes certain insurance of non-u.s. risks written by qualifying insurance companies. This provision, which has been extended twice before, has been extended again, this time through the end of Banking. Income earned in banking or financing businesses by CFCs is usually treated as passive income and included in the income of the U.S. shareholders. The 1999 insurance rule described above has a companion in the banking and finance area that exempts banking and financing income from subpart F treatment when earned by a CFC predominantly engaged in the active conduct of a financial business. This provision was set to expire at the end of 2006 and has been extended through the end of Moving Money Among CFCs. Prior to TIPRA, payments between CFCs generated subpart F income, that is, income subject to current inclusion by the U.S. shareholders of the CFC, unless the socalled same country exception applied. Under TIPRA, from 2006 through the end of 2008, payments of dividends, rents, royalties and interest by a CFC to a related CFC are not treated as subpart F income to the extent attributable to non-subpart F income of the payor. When this relief is added to the banking and insurance extenders described above, U.S.-based financial conglomerates now have substantial flexibility in structuring their off-shore arrangements in a way that makes the most sense without the financial drag of U.S. tax on such capital movements. NOTE: Foreign tax credit planning may need to be revisited. To the extent that U.S.-based multinational corporations were using payments among CFCs to generate foreign-source subpart F income to use foreign tax credits ( FTCs ), such payments will no longer generate the income necessary to use the FTCs. In addition, there is some uncertainty as to whether the new rules apply to certain off-shore restructurings. Specifically, although sales of one CFC to another CFC are characterized as dividends (see Section 964(e) of the Tax Code), it is not clear that the exception from subpart F income for dividends extends to such deemed dividends

3 MAXIMUM CAPITAL GAIN AND DIVIDEND TAX RATES The cornerstone of President Bush s tax policy has been the 15% maximum tax rate on capital gains and dividends paid by domestic and qualified foreign corporations. Before TIPRA, tax rates on capital gains were scheduled to increase in 2008 to a maximum rate of 20% and tax rates on dividends were scheduled to increase to a maximum rate of 35% (the rate otherwise applicable to ordinary income items). The lower 15% maximum tax rate on both capital gains and dividends has been extended to all tax years ending on or before December 31, In addition, TIPRA continued a number of favorable related rules, such as limiting the AMT to capital gains to a maximum rate of 15%. TREATMENT OF GAINS AND EXPENSES RELATING TO MUSICAL WORKS Capital Gains. Since the enactment of the original income tax laws, musical compositions or copyrights of musical works created by a taxpayer s own efforts have been excluded from the definition of a capital asset. Under TIPRA, from 2007 through 2010 (a 4-year window), these assets are treated as capital assets and gain from the sale of these assets will be taxable at a maximum rate of 15% (but note that the taxpayer may not claim a charitable contribution deduction for the fair market value of such musical work even though it is treated as a capital asset). Although many of the initial music securitizations did not perform up to investors expectations, this law change could reinvigorate this asset class. Expenses. TIPRA provides a special election to permit taxpayers to elect to amortize certain costs of acquiring or creating musical works (or copyrights related to musical works) over a five year period, for expenses incurred in taxable years beginning in 2006 and ending before Prior to TIPRA, such costs could only be deducted using the income forecast method or through a special election in Code Section 263A. Those methods will continue to be available if the new Code election is not made for expenses incurred between 2006 and The election does not, however, apply to the following category of costs and expense: (1) qualified creative expenses under Code Section 263A(h); (2) expenses to which a simplified procedure established under Code Section 263A(j)(2) applies; (3) amortizable section 197 intangibles; or (4) expenses that, without regard to this new provision, would not be allowable as a deduction. TREATMENT OF EXEMPT ORGANIZATIONS THAT PARTICIPATE IN TAX SHELTERS. The Reportable Transaction regime has been in effect for over five years now. These rules require special tax disclosures by persons who participate in a variety of transactions, including listed transactions (those designated by the Internal Revenue Service with a high potential for tax avoidance), confidential transactions and certain loss transactions. In addition, persons who act as material advisors in these transactions must make disclosure regarding the transaction to the IRS and keep a list with certain information about the transaction and its participants. Certain of the transactions with the highest potential for tax avoidance are those that attempt to shift income to so-called tax indifferent parties, such as, pension funds and foreign persons who are not subject to U.S. tax. See ASA Investerings P ship. v. Commissioner, 340 U.S. App. D.C. 55, 201 F.3d 505 (D. C. Cir. 2000), aff g T.C. Memo (abusive installment sale transaction in which artificial gain was allocated to Dutch banks)

4 TIPRA seeks to raise the stakes for U.S. pension funds that make affirmative use of their tax exemption in prohibited tax shelter transactions (a PTST ). PTSTs includes listed transactions, transactions with contractual protection against the loss of tax benefits and confidential transactions. The provision is generally effective for transactions undertaken after May 17, There are now three consequences for tax-exempt entities that participate in a PTST: An entity-level tax equal to the greater of 100% of the after-tax income from the transaction or 75% of the net proceeds received by the tax-exempt organization. (The tax can be waived if participation was not willful and is due to reasonable cause.); Each taxable party to the transaction is required to disclose to the tax-exempt organization that the transaction is a PTST and the tax-exempt organization is required to disclose each instance of its participation to the IRS. A penalty, not to exceed $50,000, is imposed on the tax-exempt organization (or its managers in the case of qualified pension funds) for failures to make this disclosure; and A tax of $20,000 is imposed on an entity manager that approves or otherwise causes a taxexempt entity to participate in a PTST. EXPANSION OF EARNINGS STRIPPING RULES The U.S. earnings stripping rules (equivalent to many European thin capitalization rules) limit the ability of U.S. corporations to deduct interest expense paid to, or guaranteed by, foreign related parties if certain conditions are satisfied. (Specifically, the rules apply if the payor s debt-toequity ratio exceeds 1.5 to one and net interest expense exceeds 50% of adjusted taxable income.) TIPRA codifies a proposed Treasury Regulation requiring that a U.S. corporation take into account interest expense and indebtedness incurred by partnerships in which the U.S. corporation is a partner, with certain modifications, effective for taxable years beginning after May 17, Indebtedness of the partnership is allocated to the U.S. corporation in the same proportion that the U.S. corporation includes the interest expense of the partnership. An anti-abuse rule prevents circumvention of the rule by allocating interest expense away from partners. REVISIONS TO FIRPTA (FOREIGN INVESTMENT IN REAL PROPERTY TAX ACT) RULES Since 1980, gains recognized by foreign persons from the disposition of U.S. real property interests have been subject to U.S. federal income tax, even if the U.S. real property interest is not held in connection with a U.S. trade or business or through a U.S. permanent establishment. U.S. real property interests include interests in U.S. real property holdings companies ( USRPHCs ) as well as direct interests in real property. (In general, a corporation is a USRPHC if 50% or more of its assets are U.S. real property interests.) In order to balance the policy of extracting federal income tax from U.S. real property gains realized by non-u.s. persons against the policy of encouraging foreign investment in U.S. capital markets, special exceptions have been created for mutual funds (regulated investment companies or RICs ) holding real property interests and for real estate investment trusts ( REITs ). TIPRA refines these rules further. Retroactive RIC Exemption. Prior to TIPRA, if a mutual fund recognized a gain from a disposition of a real property interest, it was required to withhold tax on the distribution of such gain to its non-u.s. shareholders. TIPRA changes this rule effective for taxable years beginning in 2005 and ending on or before December 31, Under the revised rules, a RIC is required to withhold - 4 -

5 FIRPTA tax on distributions of gain attributable to the disposition of U.S. real property interests only if the RIC is a USRPHC. In determining whether a mutual fund is a USRPHC, the mutual fund is required to look through stock in other RICs and REITs that it holds, if such portfolio holdings are themselves USRPHCs. The retroactive nature of this provision creates refund opportunities for affected non-u.s. persons. The recharacterization of such gains as non-firpta income, however, does not mean that such distributions are necessarily tax-free; regular dividend withholding rules could then apply if the shareholder holds 5% or less of the RIC s stock and the stock is publicly traded. Tiered RIC and REIT Structures. Prior to TIPRA, if a RIC or REIT distributed cash attributable to the disposition of a real property interest to a non-u.s. person, such gain was generally subject to FIRPTA withholding and tax. If, however, the RIC or REIT distributed such gains to an upper-tier RIC or REIT which, in turn, distributed such gains to a non-u.s. person, many persons believed that such gains were not subject to FIRPTA taxes. TIPRA amends the Tax Code, effective as of January 1, 2006, to provide that such gains retain their character as FIRPTA gains subject to withholding as cash attributable to such gains pass through upper-tier RICs and REITs. As a result, upper-tier REITs and RICs will now be required to collect FIRPTA taxes on distributions of such gains to non-u.s. persons. Withholding Exemption for Publicly-Traded REITs and RICs Is Expanded. Prior to TIPRA, a non- U.S. person who held 5% or less of the publicly-traded stock of a REIT or RIC was subject to U.S. tax on distributions attributable to gains recognized by the REIT or RIC from its own disposition of U.S. real property interests, but was not subject to U.S. tax on gains from the disposition of stock in the REIT or RIC. Effective as of January 1, 2006, TIPRA conforms the rules for distributions attributable to gains recognized from the dispositions of U.S. real property interests to stock gains. Specifically, distributions of gains attributable to dispositions are no longer treated as FIRPTA gains to foreign persons. Instead, solely with respect to non-u.s. persons, such distributions are treated as ordinary REIT or RIC dividends. Ordinary dividends can be subject to the default 30% withholding tax attributable to dividends paid to non-u.s. persons or can be eligible for a lower tax treaty rate if the recipient is eligible to claim the benefits of the treaty. This rule applies to distributions attributable to capital gain distributions received from other REITs or RICs as well. FIRPTA Swaps and Wash Sales. Special new rules have been enacted, effective as of June 16, 2006, to curtail certain financial transactions that previously had the benefit of allowing non-u.s. persons to avoid FIRPTA taxes on capital gain distributions from RICs and REITs. (It is worth noting that the TIPRA legislative history expressly reserves on the efficacy of these strategies under current law.) In order for the new rules to apply, the non-u.s. person engaging in the strategy must have been subject to FIRPTA if it had received the distribution directly from the REIT or RIC. The new rules are written broadly, and clearly encompass wash sale transactions. Wash Sale Example. For example, if (i) a non-u.s person sells RIC or REIT stock, (ii) the RIC or REIT then pays a capital gain distribution that would have been subject to FIRPTA withholding if received directly by the non-u.s. person and (iii) within the 61-day period beginning 30 days prior to the disposition, the non-u.s. person re-establishes his position in the RIC or REIT stock, the non-u.s. person is subject to FIRPTA taxes in the amount that it would have incurred if it had held the stock instead of engaging in the wash sale. Mercifully, the new rule is not enforced through withholding, so financial institutions will not be required to police the activities of the transactions on U.S. securities markets engaged in by their non-u.s. customers

6 Securities Loans Are Also Encompassed. Capital market participants engaged in crossborder securities lending transactions know that U.S. rules treat substitute dividend payments in the same manner as actual dividend payments, with the result that if withholding would have been required on an actual dividend payment, withholding is required on the substitute dividend payment. In a footnote in the legislative history (fn. 534), Congress has made clear that substitute capital gain distribution payments are now subject to withholding in the same manner that an actual capital gain distribution would have been subject to U.S. withholding. Accordingly, securities lending transactions will no longer provide any shelter from FIRPTA taxes. Forwards, Options and Swaps. The new rules apply not only to traditional wash sales, but also to transactions in which the long exposure is re-established pursuant to a contract or option to acquire such an interest. This expansive definition of a wash sale mirrors a recent amendment to the regular wash sales which pick-up a broad array of financial derivatives within the definition of re-established positions. In that context, many practitioners have advised their clients that stock dispositions coupled with synthetic long positions under swaps could be encompassed by the wash sales rules. It appears that similar caution is warranted here. ROTH IRA CONVERSIONS An unexpected, but extremely favorable, opportunity has been provided that will prove helpful to the private wealth management industry. Specifically, in 2010, individuals who hold traditional IRAs will be entitled to make a one-time election to convert their traditional IRAs to Roth IRAs. Roth IRAs are very favorable investment vehicles. The contributions are made with after-tax dollars, but no tax whatsoever is imposed on withdrawals. In addition, Roth IRAs may be willed to descendents, who may continue to defer taxes as there is no minimum distribution requirement for Roth IRAs. Traditional IRAs are less favorable because distributions are taxed as ordinary income and have the effect of converting favorable long-term capital gains into less favorable ordinary income. In addition traditional IRAs are subject to minimum distribution requirements, whereas Roth IRAs are not. The new law allows any tax due as a result of conversion to be paid ratably in 2011 and As a result, wealth planners should look carefully at traditional IRAs in 2006 through 2009 with a view towards maximizing the amount that may be converted in Although a conversion to a Roth IRA will not remove the IRA from a decedent s gross estate, it will prevent the IRA income from being treated as taxable income in respect of a decedent. INTEREST REPORTING ON TAX-EXEMPT BONDS Beginning with interest paid in 2006, issuers of tax-exempt obligations will now be required to report interest in the same manner as issuers of taxable debt instruments. It is worth noting that, in general, such reporting only applies with respect to interest paid to individuals and partnerships. It is reasonable to expect that the IRS will either amend the instructions to its existing interest reporting rules (Forms 1099-INT) or promulgate new reporting forms. One aspect that will require further clarification is whether issuers of tax-exempt bonds will now be required to comply with the back-up withholding rules. These rules, which require withholding when a person subject to information reporting has failed to provide his taxpayer identification number (or has failed to pay his taxes) are keyed to the information reporting rules

7 NEW FAVORABLE RULES FOR SPINOFF TRANSACTIONS Section 355 of the Code provides that, if certain requirements are met, a corporation may distribute the stock of a controlled subsidiary in a transaction that is tax free to both the distributing corporation and the shareholders receiving the stock. Generally, this is the only mechanism for a tax free distribution of corporate assets. One of the requirements for a tax free corporate division is that the distributing corporation and the controlled corporation whose stock is distributed must both be engaged in the active conduct of a trade or business after the distribution. This requires that each corporation either (i) be engaged directly in an active trade or business or (ii) immediately before the distribution have no assets other than stock or securities of controlled corporations each of which is engaged in an active conduct of a trade or business. The Internal Revenue Service has interpreted the second alternative to require that at least 90% of the corporation s gross assets consist of stock or securities of controlled corporations engaged in the active conduct of a trade or business. Frequently, prior to TIPRA, a corporate group had to undergo elaborate restructuring to satisfy the active trade or business requirement in the case of a holding company. Where the distributing corporation was a holding company, the test of active trade or business was actually more stringent than when the distributing corporation itself had an active trade or business. In that case only 5% of the distributing corporation s assets had to be used in the active trade or business. For distributions made after the date of enactment and before January 1, 2011, TIPRA permits all members of a corporation s separate affiliated group to be treated as one corporation for purposes of this requirement. Therefore, if at least one member of an affiliated group is engaged in the active trade or business, each member of the group headed by the distributing corporation or the controlled corporation will be treated as engaged in an active trade or business. thus, TIPRA provides a logical change in the law which avoids the need for corporate restructurings that may be inefficient simply to allow a spin off or split up to take place. The second change with respect to corporate divisions addresses the amount of investment assets that may be held by the distributing corporation or the controlled corporation. Under prior law, even if the distributing corporation and the controlled corporation had substantial passive assets, the IRS found that so long as at least 5% of the total fair market value of each corporation s assets were used in an active trade or business, the active trade or business test was met. The presence of substantial non-business assets was a factor with respect to the prohibition on using a spin off as a device to distribute earnings and profits, but this issue could be overcome by a sufficiently strong business purpose. Under TIPRA, there is a limitation on the amount of investment assets that may be held. A distribution will not qualify as a tax free corporate division if immediately after the distribution either corporation is a disqualified investment corporation. A disqualified investment corporation is a corporation, for distributions more than one year after the date of enactment, where twothirds or more of the fair market value of the corporation s assets are investment assets. For the first year following enactment of TIPRA, this rule applies where 75% or more of the fair market value of assets are investment assets. Investment assets include cash, stock or securities, interest in a partnership, debt instruments or other evidence of indebtedness, any options, forward or futures contract, foreign currency, and any similar asset. However, this restriction only is effective where any person holds a 50% or greater interest in a disqualified investment corporation after the spin off who did not hold a 50% or greater interest before the spin off. Thus, the restriction will - 7 -

8 generally not apply to pro rata spin offs in which shareholders receives shares of the controlled corporation also retain historic holdings in the distributing corporation. WITHHOLDING ON PAYMENTS FROM GOVERNMENT ENTITIES In a surprise move, the Conference Committee added a 3% withholding tax for payments from any governmental entity (federal or state) for property or services, effective for payments made after December 31, However, payments from political subdivisions of States (or any instrumentality thereof) with less than $100 million of annual expenditures for property or services are exempt from this withholding requirement The new statue also imposes reporting requirements on the payments that are subject to withholding. For this purpose, withholding is imposed on voucher and certificate programs, such as payments to a commodity producer under a government commodity support program. There are several significant exceptions to this withholding requirement, including the following: (i) payments of wages; (ii) payments with respect to which mandatory (e.g., U.S.-source income of foreign taxpayers) or voluntary (e.g., unemployment benefits) withholding applies under present law [Note: the provision does not exclude payments that are potentially subject to backup withholding under section If, however, payments are actually being withheld under backup withholding, withholding under the provision does not apply.]; (iii) payments of interest; (iv) payments for real property; (v) payments to tax-exempt entities or foreign governments; (vi) intra-governmental payments; (vii) payments made pursuant to a classified or confidential contract (as defined in section 6050M(e)(3)); and (viii) payments to government employees that are not otherwise excludable from the new withholding provision with respect to the employees' services as an employees. Also, as noted above, this withholding tax is not required currently, and will only be applied to payments made by governmental entities after December 31, We anticipate that many government contractors and other interested groups will spend the next three years lobbying against this provision. INCREASE IN ESTIMATED TAXES OWED BY LARGE C CORPORATIONS In another surprise move, the Conference Committee raised some additional revenue by fiddling with the estimated payments due from large corporations (i.e., corporations with assets of at least $1 billion). Under the new rules (i) estimated tax payments due in July, August, and September of 2006 shall be increased to 105 percent of the payment otherwise due and the next required payment shall be reduced accordingly; (ii) estimated tax payments due in July, August, and September of 2012 shall be increased to percent of the payment otherwise due and the next required payment shall be reduced accordingly; and (iii) estimated tax payments due in July, August, and September of 2013 shall be increased to percent of the payment otherwise due and the next required payment shall be reduced accordingly. Notwithstanding the above increases, all corporations (and not just large ones) are given some relief from estimated withholding taxes, as follows: 20.5 percent of the corporate estimated tax payments otherwise due on September 15, 2010 are deferred until October 1, 2010, and 27.5 percent of the corporate estimated tax payments otherwise due on September 15, 2011 are deferred until October 1, It is quite possible that TIPRA could be followed by an additional tax bill year, most likely in connection with pension reform. We will continue to monitor developments and provide our friends and clients with updates as developments warrant. Members of the Greenberg Traurig tax department are available to answer questions that you may have regarding this legislation

9 This Alert was written by Mark H. Leeds in the New York office, Richard J. Melnick in the Tysons Corner office, and Harry J. Friedman in the Phoenix office. Please contact Mr. Leeds at , Mr. Melnick at , Mr. Friedman at , or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this GT Alert. Albany Amsterdam Atlanta Boca Raton Boston Chicago Dallas Delaware Denver Fort Lauderdale Houston Las Vegas Los Angeles Miami New Jersey New York Orange County Orlando Philadelphia Phoenix Sacramento Silicon Valley Tallahassee Tokyo Tysons Corner Washington, D.C West Palm Beach Zurich This Greenberg Traurig ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A Greenberg Traurig, LLP. All rights reserved. *Greenberg Traurig has entered into Strategic Alliances with the following independent law firms, where Greenberg Traurig attorneys are available for consultation by appointment only: Olswang in London and Brussels, Studio Santa Maria in Milan and Rome, and the Hayabusa Kokusai Law Offices in Tokyo. Greenberg Traurig is not responsible for any legal or other services rendered by attorneys employed by the Strategic Alliance firms