Corporate Matters: Angel Investing, An Introduction

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Bette Davis once said that growing old is not for sissies. If she were she alive today, she would no doubt be an accredited investor and may well add angel investing to the potentially long list of activities not for sissies.

Typically, angel investors provide seed capital to start-up companies or entrepreneurs. When an individual or newly formed closely-held entity seeks financing for a new venture, the most common sources of financing are individuals who have a preexisting relationship with the founders of the venture. With every IPO of a former start-up and the corresponding stories of amazing returns on investment for the few initial investors, angel investing activity, as a whole, and the number of people seeking out such investments has steadily increased over the last decade. The Center for Venture Research at the University of New Hampshire found that the number of active angel investors in 2012 was 268,160. A decade earlier, that number had been approximately 200,000. The dollar amount invested over the same period grew to $22.9 billion from $15.7 billion. There is potential for the numbers to grow further: The Angel Capital Association estimates that there are approximately 4 million potential accredited investors (persons with an individual or joint net worth with a spouse that exceeds $1 million - not counting the primary residence) in the United States who might be interested in start-up and early stage companies.

This increase is despite the fact that approximately 80% of start-ups fail. Many investments made by angel investors end up worthless or sit for long periods in inert companies that buyers have little interest in.

Cross-Border Estate Planning: Canadian Parents of U.S. Children

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U.S. transfer taxes (U.S. gift, estate and generation skipping taxes) should be a concern to any practitioner creating an estate plan with U.S. links. The following article addresses U.S. estate tax consequences of a family comprised of Canadian citizen/resident parents with American children.

IN GENERAL

Transfer tax is imposed on the fair market value of the property transferred, reduced by any consideration received.

U.S. citizens, and non-U.S. citizen individuals that are domiciled in the U.S., are subject to the U.S. transfer tax system on global assets.

A person acquires a domicile in a place by living there, for even a brief period of time, without the presence of a definite intention to leave.

A facts and circumstances test is used to determine domicile. Factors include, e.g.:

1. Statements of intent (as reflected, e.g., on tax returns filed, visa application, and similar evidence);
2. Time spent in U.S. versus time spent abroad;
3. Visa status (e.g., green card holder);
4. Ties to the U.S. versus abroad;
5. Country of citizenship;
6. Location of employment, business, and assets;
7. Other indicators such as voting, affiliations, membership, driver license, and similar items.

Residence without the intention to remain indefinitely will not constitute a domicile, and the intention to change domicile will not effect such a change unless accompanied by actual relocation.

Proposed Partnership Regulations Will Affect Partnership Deal Economics

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INTRODUCTION

In 2014-8 I.R.B., the I.R.S. proposed amendments to regulations issued under Code §707 relating to disguised sales of property to or by a partnership and under Code §752 regarding the treatment of partnership liabilities. The proposed regulations address certain deficiencies and technical ambiguities in the existing regulations and certain issues in determining partners’ shares of liabilities under Code §752. The proposals are designed to limit taxpayers’ ability to structure a sale of a partnership interest as a contribution of property by one partner and the receipt of a distribution by a second partner in a way that is not taxable in the year of the transaction. For a foreign investor, the proposed regulation regarding the interplay of partnership liabilities and investor basis in the partnership add another unwelcome level of complexity that must be accounted for in tax planning for an investment. The reason is that a partner’s ability to deduct losses of a partnership or L.L.C. is capped at the basis maintained in the partnership interest held. Partners have basis for liabilities of the partnership. The issue is the allocation of losses among the partners or members. The proposed regulations limit ways to increase basis through planning mechanisms that have been accepted for a long period of time.

PARTNERSHIP BASICS AND RELATED ISSUES

Background

A partnership is said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses.

Tax 101: Transactions in FX - A Primer for Individuals

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In our last issue, we discussed the recent I.R.S. guidance on bitcoins which, in general, stated that transactions in bitcoins should be treated as transactions in property under the general rules of the Internal Revenue Code (the “Code”) rather than the special rules applicable to foreign currency. We therefore thought it would be useful to provide a primer on common transactions involving foreign currency (sometimes hereinafter referred to as “FX”) with respect to U.S. individuals.

IN GENERAL

The first thing to note about engaging in transactions involving foreign currency is that foreign currency is treated as any other asset. Think stocks, bonds, or real estate. When an individual buys foreign currency, that individual has a basis in the FX (e.g., Euro) similar to any other investment. When the individual sells that foreign currency, that individual will have a realization event, in which case gain or loss may have to be recognized. Whether the character of that gain or loss is ordinary will depend on the specific transaction and the applicability of Code §988, as will be discussed in more detail below.

Example 1

Mr. FX Guy, a U.S. citizen individual, buys real property located in the U.K. for 100,000 British pounds (£) on January 1, 2014. In order to effectuate the purchase, Mr. FX Guy uses £100,000 that he purchased for $150,000 on January 1, 2012 when the exchange rate was $1.5 to £1. Assume on January 1, 2014, the exchange rate was $2: £1 as the British pound appreciated against the U.S. dollar. The £100,000 has a basis of $150,000. It was acquired on January 1, 2012 and disposed of on January 1, 2014. The disposition is a sale of an asset (in this case, the FX). The amount realized is the fair market value of the consideration received, or $200,000. Accordingly, the taxpayer has a gain of $50,000 attributable to the foreign currency that must be recognized. The character of the gain, and the applicability of §988, will depend on whether the transaction was a “personal transaction.”

Swiss Trustees and Board Members of Foundations Have to Prepare for F.A.T.C.A.

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BACKGROUND

Trusts are unknown under Swiss law and family foundations are not commonly used because their purpose is very limited by law. Consequently, many Swiss trust companies, family offices or lawyers act as trustees of non-Swiss trusts or as members of family foundations. It is not uncommon for trustees, trusts or foundations, and underlying companies to be established under the laws of different jurisdictions, and typically Liechtenstein is used.

Foreign trusts and foundations, foreign trustees and underlying holding companies that invest in the U.S. must determine their classification under the Foreign Account Tax Compliance Act (“F.A.T.C.A.”) and possibly a relevant intergovernmental agreement (“I.G.A.”). In the case of Switzerland, a Model 2 I.G.A. exists.

The determination must be made prior to the end of June 2014, even if no U.S. owners or beneficiaries are involved. The reason is that, by 1 July 2014, a foreign entity that is a Foreign Financial Institution (“F.F.I.”) must register on the I.R.S. F.A.T.C.A. portal and receive a G.I.I.N. The I.R.S. has announced that the last date to register and receive a G.I.I.N. prior to 1 July 2014 is 5 May. Registration is required unless the F.F.I. is a certified deemed-compliant F.F.I. or a Non-Financial Foreign Entity (“N.F.F.E.”). An exempt F.F.I. could be a sponsored investment entity, a sponsored closely held investment vehicle, or an owner-documented F.F.I. In each of those fact patterns, another entity is engaged to carry out the F.A.T.C.A. reporting. An N.F.F.E. is an entity that is formed outside the U.S. that is not an F.F.I.

Insights Vol. 1 No. 3: Update & Other Tidbits

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CORRECTION TO THE PROPOSED 2013 DIVIDEND EQUIVALENT REGULATIONS

On December 5, 2013, proposed and final Treasury Regulations were published, relating to U.S. source dividend equivalent payments made to nonresident individuals and foreign corporations. On February 24, 2014, a correction to the proposed regulations was published, which tackles errors contained in the 2013 proposed regulations. The corrections mainly clarify the 2013 proposed regulations and prevent any potential misleading caused by their formulation. In addition, on March 4, 2014, the I.R.S. released Notice 2014-14, which states that it will amend forthcoming regulations to provide that specified equity-linked instruments (“E.L.I.’s”) will be limited to those issued on or after 90 days following publication of the final regulations. This will allow additional time for financial markets to implement necessary changes.

UNITED STATES AND HONG KONG SIGN T.I.E.A.

On March 25, 2014, H.K. and U.S. governments signed a Tax Information Exchange Agreement (“T.I.E.A.”) confirming their commitment to enter into an I.G.A., subject to ongoing discussions. The T.I.E.A. will apply to profits tax, salaries tax, and property tax in H.K. and will cover federal taxes on income, estate and gift taxes, and excise taxes in the U.S.

New York State Makes Major Changes to Estate and Gift Tax Law

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New Exclusion Amount: Prior to April 1, 2014, an estate was required to file a New York State estate tax return if the total of the federal gross estate plus the federal adjusted taxable gifts and specific exemption exceeded $1 million (the “basic exclusion amount”) and the individual was either: (i) a resident of the state at the time of death or (ii) a resident or citizen of the U.S. at the time of death but not a resident of the state, whose estate includes real or tangible personal property located in the state. (Other rules apply to individuals who were not residents or citizens of the U.S., but who died owning real or tangible personal property located in the state.)

Recent N.Y.S. legislation has increased the basic exclusion amount as follows:

• For individuals dying on or after April 1, 2014 and before April 1, 2015 - $2,062,500
• For individuals dying on or after April 1, 2015 and before April 1, 2016 - $3,125,000
• For individuals dying on or after April 1, 2016 and before April 1, 2017 - $4,187,500
• For individuals dying on or after April 1, 2017 and before January 1, 2019 - $5,250,000

After January 1, 2019, the basic exclusion amount will be indexed for inflation from 2010, which should link the state exclusion amount to the federal amount.

U.S. Tax Treaty Update→

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At a business meeting on April 1, 2014, the Senate Foreign Relations committee approved two proposed treaties with Hungary and Chile, tax treaty amendments (“protocols”) with Switzerland and Luxembourg, and a protocol amending the Multilateral Convention on Mutual Administrative Assistance in Tax Matters.

As in recent years, improved information sharing and limitations on “treaty shopping” (the inappropriate use of a tax treaty by residents of a third country) continue to be important U.S. objectives.

Highlights of the approved measures include the following:

• The proposed treaty between Hungary and the U.S. encompasses a comprehensive “Limitation on Benefits” provision, unlike the current treaty with Hungary, of 1979, which contains no such limitation, and also provides for a full exchange of information. The new Limitation on Benefits provision includes a measure granting so-called “derivative benefits” similar to the provision included in all recent U.S. tax treaties with European Union members.

Corporate Matters: Shareholder Agreements

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In the first issue of our publication, we discussed the need and relative ease of preparing and entering into an agreement between partners and the consequences of not doing so. We used the recent case of Gelman v. Buehler 2013 NY Slip OP 01991 (March 26, 2013) to illustrate the sometimes expensive consequences of not documenting the initial agreements between partners. Following up on that, we thought it might be helpful to outline in broad terms what one should look for in a shareholders agreement.

While we have stated that it is relatively simple to prepare a shareholders agreement. Careful consideration still must be given to the contents of such an agreement, and it should be tailored to meet the needs of the parties involved. No two shareholders agreements are alike, and one size definitely does not fit all.

When one thinks of a shareholders agreement it is typically in the context of a corporation. Many of the same issues arise between partners when drafting a partnership agreement and members in a limited liability company operating agreement.

SHAREHOLDERS

All of the shareholders should be correctly named and their percentage ownership in the entity set forth. All shareholders that are entities should be in good standing, and individuals should have their complete address inserted.

Tax 101: Financing A U.S. Subsidiary - Debt vs. Equity

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INTRODUCTION

When a foreign business contemplates operating in the U.S. through a U.S. subsidiary corporation, it must take into account the options available for funding the subsidiary. As a practical matter, a foreign-owned subsidiary may encounter difficulty in obtaining external financing on its own, and thus, internal financing is often considered. It is a common practice for a foreign parent corporation to fund its subsidiary through a combination of equity and debt.

Using loans in the mixture of the capital structure is often advisable from a tax point of view. Subject to the general limitations under the Internal Revenue Code (the “Code”), financing the operations with debt will result in a U.S. interest expense deduction, often with a meaningful reduction of the overall tax rate applicable to the operation. (It should be noted that the U.S. has one of the highest corporate tax rates in the world.) Additionally, repayment of invested capital (in the form of debt principal) will be free of U.S. withholding tax if the investment qualifies as a debt instrument for U.S. tax purposes. If the lender is a resident of a treaty jurisdiction and eligible for treaty benefits, the interest payments will be subject to a reduced rate of taxation – or a complete elimination of taxation – under the treaty. Another reason multinational entities use debt to finance their subsidiaries is the possibility for tax arbitrage resulting from the differing treatment in various countries of debt and equity.

Transfer Pricing - Bankruptcy Court Prevents I.R.S. from Pursuing Unsupported Transfer Pricing Claims; In Re: DeCoro USA, Limited, Debtor (2014 U.S.T.C. PAR 50,227)

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INTRODUCTION

A recent decision by the U.S. Bankruptcy Court, Middle District North Carolina (the “Court”) provides interesting guidance on the practical application of U.S. transfer pricing rules. While one would not normally expect significant transfer pricing insight from a bankruptcy court, an I.R.S. claim for tax due caused the Court to apply U.S. tax transfer pricing rules in a surprisingly clear, concise and practical manner in order to determine the validity of the claim. In holding the claim invalid, the Court provided valuable guidance to taxpayers and the I.R.S. alike, finding that assertions of underpayment of tax in connection with the pricing of a controlled transaction must be based on the facts presented, rather than those imagined by the I.R.S.

BACKGROUND FACTS

The DeCoro Group was founded in 1997 by an Italian businessman whose goal was to produce high quality Italian leather furniture at affordable prices on a worldwide basis. In order to accomplish this, a Chinese manufacturing plant was purchased then expanded. Business management of the DeCoro Group was carried out by DeCoro Limited (“DCL”), a Hong Kong company. Strategic customer relationships with furniture retailers around the world were developed and maintained by DCL. Through a Chinese manufacturing facility, DCL was engaged in the manufacture and sale of high end leather furniture.

What Must Foreign Trusts and Family Corporations Do About F.A.T.C.A.?

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After years of preparation and trepidation, the Foreign Account Tax Compliance Act (“F.A.T.C.A.”) will soon become effective. While F.A.T.C.A. was initially targeted to major commercial and investment banks aiding U.S. persons in avoiding paying tax on their income, F.A.T.C.A.’s effective scope is far broader, covering any foreign trust or family corporation. Starting on July 1, 2014, F.A.T.C.A. can impose a new 30% U.S. withholding tax on payments of interest, dividends and other amounts from the U.S. to any foreign person unless that person complies with F.A.T.C.A. regulations. If the foreign person is a foreign financial institution (“F.F.I.”), compliance is onerous. However, with the recent revisions to the regulations and careful planning, the foreign trust or family corporation may be considered a nonfinancial foreign entity (“N.F.F.E.”) and thus subject to far less burdensome requirements.

F.A.T.C.A. divides the world of non-U.S. investors into two categories: F.F.I.’s and N.F.F.E.’s. The crucial factor for any foreign person is to first determine its classification. As F.F.I. status results in a much greater burden for an entity and the deadlines for actions are fast approaching, obtaining N.F.F.E. status holds numerous advantages. For a typical foreign trust or family corporation that holds investments for its beneficiaries or shareholders, this determination had been clouded in uncertainty, until the I.R.S.’s recent issuance of temporary F.A.T.C.A. regulations.

The O.E.C.D.'s Approach to B.E.P.S. Concerns Raised by the Digital Economy

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On March 24, 2014, ten days after the O.E.C.D. released its public discussion draft on prevention of treaty abuse, a second public discussion draft was released, addressing the tax challenges of the digital economy (the “Discussion Draft”).

The Discussion Draft emphasizes the concept that the digital economy should not be ring-fenced and separated from the rest of the economy, given its relationship to the latter. It provides a detailed introduction to the digital economy, including its history, components, operations, and different actors. Surprisingly, it does not propose any groundbreaking approaches to addressing the base erosion and profit shifting (“B.E.P.S.”) challenges encountered in the digital economy. It simply reflects an approach that is consistent with the fight against B.E.P.S. – seeking to determine where economic activity takes place in the digital economy in order to best achieve taxation in a non-abusive fashion.

The Discussion Draft singles out six factors that characterize the digital economy in light of B.E.P.S. concerns:

1. Mobility of all facets of the digital economy, including the intangibles used, the users themselves, and the business functions carried on by various players in the business model;
2. Reliance on data;
3. Network effects;
4. Use of multi-sided business models;
5. Tendency towards monopoly or oligopoly; and
6. Volatility

O.E.C.D. Discussion Drafts Issued Regarding B.E.P.S. Action 2 - Neutralizing the Effects of Hybrid Mismatch Arrangements

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INTRODUCTION

On March 19, 2014, the O.E.C.D. issued two discussion drafts proposing steps to neutralize abusive tax planning through hybrid mismatch arrangements. One report proposed changes in domestic law; the second proposed changes to the O.E.C.D. Model Tax Convention.

The discussion drafts reflect the O.E.C.D.’s attempt to bring “zero-sum game” concepts to global tax planning. In a zero-sum game, transactions between two or more parties must always equal zero (i.e., if one party to a transaction recognizes positive income of “X” and pays tax on that amount, the other party or parties generally must recognize negative income of the same amount, thereby reducing tax to the extent permitted under law). Seen from the viewpoint of the government, tax revenue is neither increased nor decreased on a macro basis if timing differences are disregarded.

If all transactions are conducted within one jurisdiction, the government is the ultimate decision maker as to the exceptions to the zero-sum analysis. For policy reasons, a government may decide to make an exception to a zero-sum game result by allowing the party reporting positive income to be taxed at preferential rates or not at all, while allowing the party reporting negative income to fully deduct its payment. But, when transactions cross borders and involve related parties, taxpayers have a say in what is taxed and what is not taxed.

Corporate Matters: Incorporation Basics

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A foreign entity or individual planning on making an acquisition or conducting some other form of commercial activity in the United States must consider what type of U.S. entity to use in that endeavor. We thought it might be helpful to set out the options and answer an even more basic question for those considering activity in the United States: Why should you incorporate?

There are many advantages to conducting business through a properly formed business entity:

• Asset Protection. C corporations and limited liability companies generally allow owners to separate and protect their personal assets in the event of a lawsuit or claims against the business entity.
• Name Protection. Most states will not allow another business to form an entity with the same name as an already existing entity. Once you have filed an organizational document with a State’s Secretary of State another entity cannot be formed with the same name.
• Credibility. In many instances, consumers, vendors and partners may prefer to do business with an incorporated entity.
• Tax Flexibility. Assuming you have no plans to go public, you generally will be able to choose whether your entity will be subject to a corporation income tax or whether profits and losses will be “passed through” to the shareholder, partner, or member.

Tax 101: Form 5471 - How to Complete the Form in Light of Recent Changes

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INTRODUCTION

As part of the obligation to file income tax returns, U.S. persons owning 10% or more of the stock of a foreign corporation – measured by voting power or value of the stock that is owned – are obligated to provide information on the foreign corporation. Ownership is determined by reference to stock directly held, indirectly held through foreign entities, and deemed held through attribution from others. The scope and detail of the information to be reported is dependent on the percentage of ownership maintained by the U.S. taxpayer. As the degree of ownership increases, the amount of information increases. The reporting vehicle is Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations). For returns that report on tax year 2013, this form also reports on the net investment income tax (“N.I.I.T.”) arising through a controlled foreign corporation (“C.F.C.”).

Great emphasis is put on international tax compliance, and from 2009, the I.R.S. systematically assesses penalties for late filing of Form 5471. In addition, the 2010 Foreign Account Tax Compliance Act (“F.A.T.C.A.”) extended the statute of limitations for the I.R.S. to examine a tax return if certain information returns, including Forms 5471, were not timely or properly filed. The statute of limitations will remain open on the entire tax return and not only on Form 5471 if Form 5471 is not timely filed. Once the form is filed the statute of limitation will begin to run. To assist the I.R.S. to spot inconsistencies, beginning in tax year 2012, the I.R.S. assigned a unique reference identification number to each foreign entity, which allows the I.R.S. to compare forms filed with respect to a certain company over several years.

In the Matter of John Gaied - New York State's Highest Court Pushes Back New York Taxing Authorities

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New York State will tax as a “resident” of New York: a domiciliary of the State and a person treated as a “statutory resident.” A domiciliary is generally a person whose permanent and primary home is located in New York. A statutory resident is a person who is not a domiciliary, but maintains a permanent place of abode in this state and spends in the aggregate more than 183 days of the taxable year in New York. In other words, to be a statutory resident for New York tax purposes, the person must be present in New York for more than 183 days (in the aggregate) AND maintain a permanent place of abode in New York.

New York’s highest court was asked to determine what it means to “maintain” a permanent place of abode in New York. The New York State taxing authority’s position is that a person can have a permanent place of abode, which he or she does not necessarily have to own or lease, if the person can stay there whenever he or she wants, even if he or she stays there occasionally or not at all. Special rules apply to corporate apartments, college students, and the military.

Insights Vol. 1 No. 2: Updates & Other Tidbits

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UPDATE TO STREAMLINED PROCEDURES: DIFFERENT STROKES FOR THE SAME FOLKS

In our prior issue, Insights Vol. 1, No. 1, we noted that, for a U.S. taxpayer entering into the Streamlined Procedures (i.e., fast-track program) in 2013, an I.R.S. agent informally advised filing tax returns for the years 2009, 2010, and 2011. Upon further discussions with the I.R.S., the agent revisited the issue, advising that a taxpayer entering into the program today would need to file the last three years of tax returns (i.e., 2010, 2011, and 2012). In the event the taxpayer does not file a timely 2013 return prior to the submission, the applicable look-back period is 2011, 2012, and 2013.

This advice is consistent with the 2012 O.V.D.P. F.A.Q. # 9, which answers the question “What years are included in the OVDP disclosure period?” as follows:

For calendar year taxpayers the voluntary disclosure period is the most recent eight tax years for which the due date has already passed. The eight-year period does not include current years for which there has not yet been non-compliance. Thus, for taxpayers who submit a voluntary disclosure prior to April 15, 2012 (or other 2011 due date under extension), the disclosure must include each of the years 2003 through 2010 in which they have undisclosed foreign accounts and/or undisclosed foreign entities. Fiscal year taxpayers must include fiscal years ending in calendar years 2003 through 2010. For taxpayers who disclose after the due date (or extended due date) for 2011, the disclosure must include 2004 through 2011. For disclosures made in successive years, any additional years for which the due date has passed must be included, but a corresponding number of years at the beginning of the period will be excluded, so that each disclosure includes an eight year period.

The I.R.S. Extends the Time for Estate Tax Portability Election for Small Estates

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On January 27, 2014, the I.R.S. released Rev. Proc. 2014-18. This revenue procedure provides an automatic extension of time to file a late portability election for estates of the first to die of a married couple provided that certain requirements are met. “Portability” refers to the option of the surviving spouse to make use of any gift and estate tax exemption that was not used by the deceased spouse. Thus, if the executor missed the opportunity to elect portability, now is the time to take advantage of this election, as this opportunity will end on December 31, 2014.

BACKGROUND

In 2010, Congress amended §2010(c) of the Code to allow the estate of a decedent who is survived by a spouse to make a portability election, which allows the surviving spouse to apply the decedent’s unused exclusion (“D.S.U.E.”) amount toward the surviving spouse’s own transfers during life and at death.

Notice 2011-82, issued on October 17, 2011, provided preliminary guidance regarding the requirements to elect portability of the decedent’s D.S.U.E. amount. Notice 2012-12, issued on March 3, 2012, provided temporary (and limited) relief by, in general, extending the deadline to file an estate tax return (Form 706, Unified States Estate (and Generation-Skipping Transfer) Tax Return) for portability election purposes by six months if certain requirements were met. In June 2012, temporary regulations were issued that provided more detailed guidance on portability.

F.A.T.C.A. and Trusts: A Primer

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The Foreign Account Tax Compliant Act (“F.A.T.C.A”) requires that “foreign financial institutions” (“F.F.I.’s”) and “non-financial foreign entities” (“N.F.F.E.’s”) identify and disclose their U.S. accounts and substantial U.S. holders or be subject to a 30% withholding on certain U.S. source payments (including gross proceeds) made to a foreign entity.

F.A.T.C.A. affects both:

• U.S. tax residents owning assets outside the U.S.; and
• Non-U.S. tax residents holding assets inside the U.S. provided they are tax residents of a country subject to a Model Intergovernmental Agreement (“I.G.A.”) that provides for reciprocity (i.e., U.S. financial institutions reporting information on non-U.S. tax residents to their non-U.S. home country).

More notably, F.A.T.C.A. withholding may apply to all foreign entities including foreign trusts. However, F.A.T.C.A. withholding will not apply if the entity qualifies for an exemption or complies with specified reporting requirements.