Corporate Matters: Breaking Up Shouldn't Be So Hard to Do

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We have found that clients typically have to be persuaded to think about what will happen if a commercial relationship does not work out. In this issue we will discuss break up provisions and what you should look for when entering a business relationship or other form of contractual obligation.

The problem of what happens if a relationship does not work out as planned can arise in many different legal contexts: (i) Landlord/Tenant – in some instances matters concerning lease renewal are not determined when the lease is signed, but rather, they are negotiated at the expiration of the term; (ii) Joint Venture/Partnerships – many joint ventures or partnership are set up in ways that make deadlock a distinct possibility; (iii) General Contracts – either party to a contract can breach the terms and conditions; (iv) Marriage Contracts – apparently 50% of these are breached by one of the parties (the cleanest resolution of these breaches one governed by a pre-nuptial agreement). When everyone is in a good mood the assets are divided, even when the last thing on anyone’s mind is the division of assets.

Tax 101: Taxation of Foreign Trusts

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INTRODUCTION: WHAT IS A FOREIGN TRUST?

In General

A trust is a relationship (generally a written agreement) created at the direction of an individual (the settlor), in which one or more persons (the trustees) hold the individual's property, subject to certain duties, to use and protect it for the benefit of others (the beneficiaries). In general, the term “trust” as used in the Internal Revenue Code (the “Code”) refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.

Trusts can be characterized as grantor trusts or ordinary trusts. Ordinary trusts can be characterized as simple trusts or complex trusts; U.S. tax laws have special definitions for these concepts. A simple trust is a trust that is required to distribute all of its annual income to the beneficiaries. Beneficiaries cannot be charitable. A complex trust is an ordinary trust which is not a simple trust, i.e., a trust that may accumulate income, distribute corpus, or have charitable beneficiaries. Ordinary trusts are “hybrid” entities, serving as a conduit for distributions of distributable net income (“D.N.I.”), a concept defined in the Code,52 to beneficiaries and receiving a deduction for D.N.I. distributions, while being taxed on other income (e.g., accumulated income, income allocated to corpus).

A trust can be domestic or foreign. This article will focus on the U.S. tax consequences with respect to “foreign grantor trusts” (“F.G.T.”) and “foreign nongrantor trusts” (“F.N.G.T.”).

O.V.D.P. Update

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I.R.S. ANNOUNCES MAJOR CHANGES TO O.V.D.P. AND STREAMLINED PROCEDURES

After more than two weeks of speculation, 49 on June 18, 2014, the I.R.S. announced major changes to its current offshore voluntary disclosure programs earlier today. The programs affected are the 2012 Streamlined Filing Compliance Procedures for Non-Resident, Non-Filer U.S. Taxpayers (the “Streamlined Procedures”) and the 2012 O.V.D.P.

In general, as will be discussed in more detail below, the changes to the programs relax the rules for non-willful filers and at the same time potentially increase penalties for willful non-compliance.

The changes to the O.V.D.P., as announced today, include the following:

• Additional information will be required from taxpayers applying to the program;
• The existing reduced penalty percentage for non-willful taxpayers will be eliminated;
• All account statements, as well as payment of the offshore penalty, must be submitted at the time of the O.V.D.P. application;
• Taxpayers will be able to submit important amounts of records electronically; and
• The offshore penalty will be increased from 27.5% to 50% if, prior to the taxpayer’s pre-clearance submission, it becomes public that a financial institution where the taxpayer holds an account or another party facilitating the taxpayer’s offshore arrangement is under investigation by the I.R.S. or the Department of Justice.

F.B.A.R. Update: What You Need to Know

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NOTWITHSTANDING OFFICIAL COMMENTS, BITCOIN EXCHANGE ACCOUNTS SHOULD BE REPORTED ON F.B.A.R.’S

As noted in our previous issue, the I.R.S. clarified the tax treatment of Bitcoin, ruling that Bitcoin will not be treated as foreign currency but will be treated as property for U.S. Federal income tax purposes. As a result, the I.R.S. ruling may allow for capital gains treatment on the sale of Bitcoin. However, the ruling did not address whether Bitcoin is subject to Form 114 reporting.

This month, pursuant to a recent I.R.S. webinar, an I.R.S. official stated that Bitcoins are not required to be reported on this year’s Form 114. However, the official noted that the issue is under scrutiny, and caveated that the view could be changed in the future.

Notwithstanding the official’s comments, whether Bitcoin is a reportable asset will depend on the nature and manner it is held.

F.B.A.R. Assessment and Collections Processes: A Primer

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With the June 30^th deadline fast approaching and the recent cases addressing F.B.A.R. penalties, we thought it would be useful to provide a primer on F.B.A.R. assessment and collections processes.

BACKGROUND

In general, a U.S. person having a financial interest in, or signature authority over, foreign financial accounts must file an F.B.A.R. if the value of the foreign financial accounts, taken in the aggregate and at any time during the calendar year, exceeds $10,000.

The F.B.A.R. must be filed electronically by June 30 of the calendar year following the year to be reported. No extension of time to file is available for F.B.A.R. purposes.

Failure to file this form, or filing a delinquent form, may result in significant civil and/or criminal penalties:

• A non-willful violation of the F.B.A.R. filing obligation can lead to a maximum penalty of $10,000. If reasonable cause can be shown and the balance in the account is properly reported, the penalty can be waived.
• In the case of a willful violation of the filing obligation, the maximum penalty imposed is the greater of $100,000 or 50% of the balance in the account in the year of the violation.

F.B.A.R. Penalty: Recent Cases

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U.S. v. ZWERNER: WILLFUL NON-FILINGS RESULT IN MONSTROUS CIVIL PENALTIES

United States v. Zwerner illustrates the potential for monstrous civil penalties resulting from willful failure to file F.B.A.R.’s. It further confirms the point that, if evidence of willfulness exists even in a sympathetic case, the I.R.S. may assert willful penalties in the case of “silent” or “quiet” disclosures, which the I.R.S. and its officials have consistently warned in official and non-official statements.

The facts of the case in brief are as follows:

From 2004 through 2007, Carl Zwerner, currently an 87-year-old Florida resident, was the beneficial owner of an unreported financial interest in a Swiss bank account that he owned indirectly through two successive entities. He did not report the income on the accounts for the period of 2004 through 2007, according to the complaint filed by the United States, but in his answer to the complaint, Zwerner, while admitting that he filed a delinquent F.B.A.R. for 2007, denied filing an amended return for that year, stating that his financial interest in the foreign account was reported on his timely-filed 1040 for that year. The complaint also alleged that, for 2006 and 2007, he represented to his accountant that he had no interest or signature authority over a financial account in a foreign country. Zwerner denied those allegations.

Insights Vol. 1 No. 4: Updates & Other Tidbits

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PASSIVE FOREIGN INVESTMENT COMPANY: RELAXATION OF RULES APPLICABLE TO TAX-EXEMPT SHAREHOLDERS

The passive foreign investment company (“P.F.I.C.”) rules can have an adverse impact on any U.S. person that may invest in a foreign company classified as a P.F.I.C. A P.F.I.C. can include an investment in an offshore investment company that owns investment assets such as stocks and securities. While ownership by a taxable U.S. investor can produce adverse tax results, ownership by a U.S. taxexempt entity, such as a retirement plan or an individual retirement account (“I.R.A.”), usually will not result in adverse tax results. This situation is helpful since many tax-exempt entities invest in offshore investment companies. The one exception is if the U.S. tax-exempt investor borrows money to make its investment in the P.F.I.C. then the U.S. tax exempt may recognize unrelated business taxable income (“U.B.T.I.”) from this investment. Despite its tax-exempt status, U.B.T.I. is taxable to a U.S. tax-exempt investor under Code §511.

The P.F.I.C. rules, as do many tax rules, include extensive constructive ownership rules whose purpose is to make sure that the statutory purpose behind the rules are not undercut by use of intermediate holding companies or other means. One lurking issue was whether these constructive ownership rules could possibly apply where a beneficiary of a retirement plan or I.R.A. or a shareholder of a tax-exempt entity gets a distribution from the entity that is attributed to its investment in a P.F.I.C. The I.R.S. recently issued Notice 2014-28 that alleviated this concern. As a result, a shareholder of a tax-exempt organization or a beneficiary of a tax exempt retirement plan or I.R.A. is not subject to the P.F.I.C. rules. This notice alleviates not only possible adverse tax results, but also the need to file any relevant P.F.I.C. tax forms such as Form 8621, Information Return for a shareholder of a P.F.I.C.

New York Enacts Major Corporate Taxation Reforms

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New York enacted major corporate tax reforms on March 31, 2014 when Governor Andrew Cuomo signed the final New York State budget legislation for Fiscal Year 2014-2015. Generally, the provisions are effective for tax years beginning on or after January 1, 2015. The new law changes do not automatically affect New York City taxes; conformity by New York City will require additional legislation. Significant changes are outlined below:

NEW NEXUS STANDARD

Historically, New York State taxed out-of-state corporations that had a physical nexus with the state, although physical nexus could be indirect or attenuated. The reform abandons the concept of physical nexus and adopts a new economic standard based on an annual dollar threshold of receipts derived from the state. By doing so New York significantly expands the number of corporations that will be subject to tax in the state. Corporations will now be taxable in New York for purposes of the corporation franchise tax and the metropolitan transportation business tax (“M.T.A.”) surcharge if they have $1 million or more of receipts from activity in New York. Furthermore, a corporation that is part of a combined reporting group and has receipts derived from New York of less than $1 million but more than $10,000 satisfies the threshold requirement if the New York receipts of all group members who individually exceed $10,000 equal $1 million or more in the aggregate.

FOREIGN (NON-U.S.) CORPORATIONS

Foreign (non-U.S.) corporations, referred to as alien corporations, will only be subject to New York tax if they are considered as U.S. domestic corporations under Internal Revenue Code (I.R.C.) §7701 or have effectively connected income under I.R.C. §882 for the tax year. This may have the effect of reducing the tax base of those foreign corporations that are subject to New York tax.

Insights Vol. 1 No. 4: F.A.T.C.A. 24/7

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I.R.S. RELEASES “GOOD FAITH” NOTICE

I.R.S. Notice 2014-33, issued on May 2, 2014, established a major relaxation of the F.A.T.C.A. withholding regime that will begin on July 1, 2014. While not providing for a delayed implementation, the Notice says that all affected persons may treat 2014 and 2015 as a transition period in which such parties must show a good faith effort to comply with F.A.T.C.A. As long as they act in good faith, there will be no liability for any withholding agent who did not properly withhold for F.A.T.C.A. or for any Foreign Financial Institution (“F.F.I.”) that failed to properly register or fill out the appropriate forms. While the scope of actions that comprise good faith is somewhat unclear, this notice eliminates the need for withholding agents to seek perfection in F.A.T.C.A. compliance, which may have driven them to over-withhold.

The I.R.S. also said that the definition of a pre-existing account will be delayed from July 1, 2014, to January 1, 2015. As a result, new on-boarding procedures can be delayed until January 1, 2015, and U.S. withholding agents do not have to get the new forms such as the Form W-8BEN-E until the end of the year. Likewise, F.F.I.’s do not have to get those forms from their own account holders until the end of the year.

I.R.S. RELEASES VARIOUS FORMS, INSTRUCTIONS

The I.R.S. released the much anticipated Form W-8IMY on April 30. The Form W-8IMY will need to be used by qualified or non-qualified intermediaries, foreign partnerships and foreign simple or grantor trusts. The I.R.S. has still not released instructions that will supplement the newly published F.A.T.C.A. compliant forms. I.R.S. officials said that the agency is working diligently to complete instructions for the series of W-8 forms covering W-8BEN-E, W-8IMY and W-8EXP.

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.