Corporate Matters: Don't Be Late - Time is of the Essence

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When purchasing New York real estate, whether a commercial building or residential property, choosing the correct words with which to provide for the closing date in the contract of sale can make the difference between a smooth closing and a calamitous default. This article discusses the nuances of various terms of art so that a purchaser can protect its contract deposit and position as contract vendee.

New York is unusual in that a contract may recite a specific date for the closing of title but without the addition of certain talismanic words it is not the “Law Date” with regard to the property, meaning the date on which title must close. In order for a closing date specified in a contract of sale to become a Law Date, the specified date must be qualified by the phrase time is of the essence. “Time Is of the Essence” is a term of art that renders the specified closing date an ironclad date. Consequently, when Time Is of the Essence a purchaser’s failure to close on a specified date will result in default; by the purchaser and typically the loss of its contract deposit.

Thus, a closing scheduled for “on,” or “on or about,” or “on or before” or “in no event later than” a specified date does not lock-in the parties to close on that date. Such phrases assure that the parties will be afforded a reasonable time within which to perform the closing, beginning on the specified date. Generally, utilization of one of the foregoing phrases is regarded as permitting a 30-day adjournment of the closing date set forth in the contract.

Often, however, the seller will attempt to set an initial closing date or agree to adjourn a closing date only if Time Is of the Essence with regard to the new date. The purchaser must beware because the new date will be set on an iron-clad basis.

So what happens when a purchaser is confronted with a seller who demands a Time Is of the Essence closing date? There are various strategies which can be implemented by the purchaser to avoid a default if it is not ready to close on the specified date.

New I.R.S. Procedures for Canadian Retirement Plans

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On October 7, 2014, the I.R.S. released Revenue Procedure 2014-55, which provides guidance for U.S. citizens or residents who own a Canadian Registered Retirement Savings Plan (“R.R.S.P.”). In short, U.S. citizens/Canadian residents, Canadian citizens/U.S. residents, and dual citizens will no longer need to file Form 8891 to defer the accrued R.R.S.P./R.R.I.F income for U.S. tax purposes. The deferral will now occur automatically, assuming the individual is “eligible.” These new procedures will apply even if the contributions to the R.R.S.P./R.R.I.F. were made as a resident of Canada.

However, practitioners should note that this does not alleviate the need to file Form 8938 or FinCen Form 114 upon receiving a distribution from an R.R.R.P.

Original Treatment

An individual who is both a U.S. citizen/resident and a beneficiary of a R.R.S.P will be subject to current U.S. income taxation on income accrued in the plan even though the income is not currently distributed to the beneficiary. In Canada, the individual is not subject to Canadian income taxation until the accrued income is actually distributed from the plan. This leads to a mismatch in the timing of the U.S. tax and the Canadian tax, resulting in possible double taxation.

Article XVIII, Paragraph 7 of the U.S.-Canada Income Tax Convention (the “Treaty”) provides that an individual may defer U.S. taxation on income accumulated in an R.R.S.P., but only if the individual makes an annual election to defer the taxation of income.

Expansion of Non-Willful Standard for Relief From Non-Filing of Gain Recognition Agreement Reduces Compliance Burdens

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BACKGROUND

Outbound transfers (as defined) of stock or assets, as well as reorganization transactions that involve a foreign party to the reorganization, are subject to Code §367 and the regulations thereunder. Code §367(a) deals with outbound transfers of stock or assets and attempts to prevent the removal of appreciated property from U.S. taxing jurisdiction before its sale or other disposition. Code §367(b) applies to certain inbound and foreign-to-foreign reorganization transactions and is aimed at preserving the ability of the United States to tax, either currently or at a future date, the accumulated earnings and profits of a foreign corporation attributable to the stock of that corporation held by U.S. shareholders.

In the case of an outbound transfer of assets consisting of tangible property for use by the transferee, a foreign corporation in the active conduct of a trade or business outside of the United States, no gain under §367(a)(1) is triggered. Otherwise, gain under Code §367(a) equal to the fair market value in excess of tax basis is triggered. Code §367(a)(2) and Treas. Reg. §1.367(a)-3, in pertinent part, provide for exceptions to the general Code §367(a) gain recognition for outbound transfers of stock or securities. These sections provide for non-recognition of gain where appropriate, upon entering into a gain recognition agreement (a “G.R.A.”).

Under a G.R.A., gain recognition under §367(a) generally can be avoided on the condition that a G.R.A. is entered into by any U.S. transferor who owns at least 5% of the transferee foreign corporation immediately after transfer. The 5% threshold for requiring a G.R.A. is determined based on the greater of vote or value, taking into consideration attribution rules. A U.S. shareholder who does not own 5% or more of the stock does not have to sign a G.R.A. in order to claim non-recognition treatment for their exchange of stock for stock. The foreign parent corporation that issues stock or securities to these U.S. transferors is treated as the transferee foreign corporation for purposes of applying the G.R.A. provisions.

Canadian Immigration Trust Exemption Withdrawn

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INTRODUCTION

For over 40 years, Canada offered a unique tax benefit to individuals not previously Canadian resident or who had been resident in Canada for less than 60 months. Such persons were allowed to establish a nonresident trust, which would not be taxable by Canada and from which a Canadian resident beneficiary could receive tax-free capital distributions. In addition, and in comparison to U.S. tax rules, income accumulated in the trust at the end of the calendar year automatically became capital, following typical provisions in discretionary trusts. Once converted into capital, the rules for tax-free distributions of capital became applicable.

This made Canada an attractive jurisdiction for global elite. Wealthy immigrants to Canada could shelter foreign investment income and capital gains from Canadian tax for a period of up to 60 months after becoming resident. Needless to say, these structures became quite popular.

In a surprise move announced in February 2014, the tax benefit was withdrawn from 2015 onwards. However, if the trust received a contribution after February 22, 2014, it would become taxable from 2014 onwards. Importantly, no grandfathering was provided for existing trust arrangements, which is both unfortunate and unfair. The change impacts a large number of individuals, as many people have structured their tax planning on the basis of having this exemption for 60 months.

CANADIAN TAX SYSTEM

Canada has a common law definition of residence, which is basically a facts and circumstances test. When an individual establishes sufficient ties to Canada, that person will become resident. While Canada also has a substantial presence rule (183 days in the calendar year), this rule is only applicable to persons who spend time in Canada without becoming resident under common law principles. Citizenship and immigration status are not a basis for levying tax.

Insights Vol. 1 No. 10: Updates & Other Tidbits

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ISRAEL ANNOUNCES ADOPTION OF O.E.C.D.’S COMMON REPORTING STANDARD

Israel has announced that it will adopt the Standard for Automatic Exchange of Financial Account Information: Common Reporting Standard (“C.R.S.”) issued by the O.E.C.D. in February 2013.

The C.R.S. establishes a standardized form that banks and other financial institutions would be required to use in gathering account and transaction information for submission to domestic tax authorities. The information would be provided to domestic authorities on an annual basis for automatic exchange with other participating jurisdictions. The C.R.S. will focus on accounts and transactions of residents of a specific country, regardless of nationality. The C.R.S. also contains the due diligence and reporting procedures to be followed by financial institutions based on a Model 1 F.A.T.C.A. intergovernmental agreement (“I.G.A.”).

At the conclusion of the October 28-29 O.E.C.D. Forum on Transparency and Exchange of Information for Tax Purposes, about 50 jurisdictions had signed the document. The U.S. was notably absent as a signatory to the agreement. In addition to the C.R.S., the signed agreement contains a model competent authority agreement for jurisdictions that would like to participate at a later stage.

Insights Vol. 1 No. 10: F.A.T.C.A. 24/7

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CENTRAL AMERICAN COUNTRIES MOVE TO COMPLY WITH F.A.T.C.A.

While Mexico, the largest Central American nation, signed an I.G.A. in April of 2014, other Central American nations are also deciding to join the F.A.T.C.A. bandwagon. Panama, which has the greatest number of U.S. residents in Central America along with Costa Rica, are leading an effort to have Central America move towards compliance by the September 2015 deadline. In May 2014, Panama reached an agreement in substance to adopt an I.G.A., and has been treated as if an I.G.A. has been in effect since then. Costa Rica had already signed a Model 1 I.G.A. in December 2013.

Though Guatemala has not yet signed an I.G.A., many local financial institutions have registered for direct exchange with the I.R.S. under the Treasury Regulations. It was reported that nearly 100 foreign financial institutions (“F.F.I.’s”), including 18 banks, ten stock brokerages, and 28 insurance firms have registered with the I.R.S. to start sharing information by March 31, 2015, as required under the Regulations with respect to F.F.I.’s in non-I.G.A. jurisdictions. Edgar Morales, operation subdirector at banking trade group Asociación Bancaria de Guatemala, said that unlike Panama or Costa Rica, where aggregating these lists of U.S. resident account holders “will be much harder,” the process in Guatemala hasn’t been so complex because “there aren’t that many people who qualify under F.A.T.C.A. here.” Guatemala has a robust banking secrecy law that forbids banks from sharing customer data with other government institutions, and therefore banks that register with the I.R.S. have to obtain privacy waivers from customers to be able to reveal their information under F.A.T.C.A.

Corporate Matters: Series Limited Liability Companies

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Clients frequently tell us they have heard of series limited liability companies but are unsure what they are and when they should be used. In this issue we will briefly explain the series limited liability company (“Series L.L.C.”) and outline some of the pros and cons, with respect to its formation and use.

SERIES L.L.C. ESSENTIALS

Delaware and a handful of other states have allowed the formation of Series L.L.C.’s since the mid-1990’s. A Series L.L.C. is a limited liability company (“L.L.C.”) composed of an individual series of membership interests where the L.L.C. is essentially subdivided into many separate series, each series holds distinct assets, and obligations with respect to the assets designated as being in a series. The creation of the series must be included in the Certificate of Formation and the management and operation of each series must be set forth in the Series L.L.C. agreement. The Delaware statute provides that “a limited liability company agreement may establish or provide for the establishment of one or more designated series of members, managers, limited liability company interests orassets” and that each series may have a separate business purpose or investment objective. This allows, in theory, for each series to have its own management structure and distinct business purpose.

The feature that most piques the interest of our clients is the ability of the assets of each separate series to be protected from the creditors of another. An owner of an L.L.C. that holds real estate assets, for example, that comprises both ownership and management could hold each business in a separate series of the same L.L.C., and a suit against the ownership series could not attack the assets of the management series.

T.I.G.T.A. Advises the I.R.S. on Improving International Tax Compliance

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In 2006, the I.R.S. created the International Collection program (“International Collection”), whereby collections officers are primarily responsible for collection of all delinquent taxes and tax returns of taxpayers located outside the U.S., but subject to the United States tax and reporting requirements. Since its inception, International Collection has undergone certain changes with the intention of developing a well-structured, long-term strategy to curb international tax noncompliance.

INTERNATIONAL TAXPAYERS

Significant emphasis now is placed on international tax compliance. The I.R.S. is concentrating on collecting delinquent payments, and through the three voluntary programs alone, it collected $6.5 billion from 45,000 participating taxpayers.

There are four types of international taxpayers that are of interest to the I.R.S.

• U.S. individual taxpayers and resident aliens working, living, or doing business abroad;
• U.S. corporations doing business abroad;
• Nonresident aliens working or doing business in the United States; and
• Foreign corporations doing business in the United States

Tax 101: Understanding U.S. Taxation of Foreign Investment in Real Property - Part I

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INTRODUCTION

U.S. real estate has been a popular choice for foreign investors, whether the property is held for personal use, rental or sale, or long-term investment. Since the passage of the Foreign Investment in Real Property Tax Act of 1980 (“F.I.R.P.T.A.”), the governing tax rules have developed and evolved, but have not succeeded in discouraging foreign investment. F.I.R.P.T.A. can be a potential minefield for those unfamiliar with U.S. income, estate, and gift taxation – all of which come into play. This article is the first of a series on understanding U.S. taxation of foreign investment in real property.

TAXATION OF A FOREIGN PERSON

“A foreign person is subject to U.S. income tax only on income that is characterized as U.S. source income.”

As simple as the concept sounds, there are applicable nuances, caveats, exemptions, and exceptions. Therefore, several questions must first be answered to determine the U.S. income tax consequences for a foreign person engaged in U.S. economic activities, including ownership of real property:

1. Is the income derived from a U.S. source and therefore potentially taxable?
2. Is the income taxable or exempt from tax?
3. Is the income passive or active, subject to a flat withholding tax on gross income or, alternatively, to graduated rates on net income?
4. Is the income earned by an individual or corporation or other entity, each of which may have different rules and applicable tax rates?

Recapitalization of L.L.C. Interests and Issuance of Profit Interests Held to be Gifts in Estate Freeze

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Code §2701 is a provision which renders the transfer of a partnership or membership interest to a family member a gift. The tax typically applies in an “estate freeze” scenario, where one generation attempts to transfer assets which appreciate in value to another generation, thereby removing it from their estate for estate tax purposes. In its latest Chief Counsel Advice (“C.C.A.”), the I.R.S. held that a recapitalization of a limited liability company (“L.L.C.”) triggers a gift under Code §2701 in a case where a mother retained a right of distribution but transferred the gain or loss attributable to the L.L.C.’s assets to her sons. The I.R.S. held that the interest retained by the transferor (a distribution right on the existing capital account balance) was a senior interest, whereas the transferred interest held by the sons (the right to future gain of the L.L.C.’s assets) was found to be a subordinate interest. What is notable and most troubling here is that the interests transferred to the sons are so-called “profits interests,” issued for future services to be rendered to the L.L.C.

IN GENERAL

Code §2701 imposes special gift tax valuation rules when partnership or membership interests are transferred to family members. Family members covered under Code §2701 include the spouse of the transferor, any lineal descendant of the transferor or the transferor's spouse, and the spouse of any such descendant. In general, Code §2701 devalues interests of senior family members in order to increase the value of interests transferred to junior family members. Code §2701 generally applies to situations where the transferor retains a senior interest and transfers a subordinate interest to the transferee – such as when a parent keeps preferred shares and transfers common shares to family members.

Anti-Deferral Regimes: U.S. Taxation of Foreign Corporations

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When a U.S. business expands abroad, it is frequently believed that the income of foreign subsidiary corporations will not be taxed in the U.S. until dividends are distributed to the U.S. shareholder. This is known as tax deferral, which is the general expectation of clients. However, in the U.S., tax deferral may be overridden by provisions accelerating the imposition of U.S. tax on U.S. shareholders of foreign corporations. As a result, income may be taxed before a dividend is distributed. This article describes the anti-deferral provisions of U.S. tax law that may be applicable in certain situations.

ANTI-DEFERRAL REGIMES

The Internal Revenue Code contains two principal anti-deferral regimes that may impose tax on a U.S. taxpayer on a current basis when its foreign subsidiaries generate income. These provisions reflect a policy under which Congress believes the deferral rules are being abused to inappropriately defer U.S. tax, especially if foreign tax is not imposed for one reason or another. The two regimes are the:

• Controlled Foreign Corporation (“C.F.C.”) regime under Code §§951-964, also known as the “Subpart F” provisions; and
• Passive Foreign Investment Company (“P.F.I.C.”) regime under Code §§1291-1298.

Controlled Foreign Corporations

Under Code §957(a), a foreign corporation is a C.F.C. if stock representing more than 50% of either the total combined voting power or the total value of shares is owned, directly, indirectly, or by attribution, by “U.S. Shareholders” on any day during the foreign corporation’s taxable year. With respect to a foreign corporation, a U.S. Shareholder is defined as a “U.S. person” that owns, under the foregoing expanded ownership rules, stock representing 10% or more of the total voting power of all classes of the foreign corporation’s stock that is entitled to vote. A “U.S. person” includes a U.S. citizen or resident, a U.S. corporation, a U.S. partnership, a domestic trust, and a domestic estate. Stock ownership includes indirect and constructive ownership under the rules of Code §958. Consequently, ownership can be attributed, inter alia, from foreign corporations to shareholders, from one family member to another, and from trusts and estates to beneficiaries, legatees, and heirs.

Corporate Matters: Covering Your Partner's Tax Tab

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A district court, affirming a bankruptcy court decision, recently held that a partner can be secondarily liable for a partnership's unpaid employment taxes and that the I.R.S. could proceed with collection without having commenced specific individual action against the partner.

Case History

In Pitts v. U.S., Wendy K. Pitts, a California resident, was a general partner of DIR Waterproofing (“DIR”), a California general partnership. On March 1, 2012, Pitts filed a Chapter 7 bankruptcy petition in the U.S. Bankruptcy Court for the Central District of California. As of that date, DIR had unpaid Federal Insurance Contribution Act taxes and unpaid Federal Unemployment Tax Act taxes for various quarters in 2005, 2006, and 2007. It also had unpaid penalties.

Commencing in 2007, the I.R.S. recorded a number of tax liens naming DIR and Pitts as the taxpayers for the unpaid amounts. The I.R.S. identified Pitts as a DIR partner on the liens. At the time of the district court proceeding, the liens still encumbered the property of Pitts.

On June 21, 2007 and August 7, 2007, the I.R.S. issued Notices of Federal Taxes Due naming DIR as the taxpayer and Pitts as a partner.

As of the time of the summary judgment proceeding in June 2013, DIR still owed at least $114,859 in tax debt, plus unassessed interest. However, the I.R.S. never assessed DIR's taxes against Pitts or brought a judicial action against her.

Insights Vol. 1 No. 9: F.A.T.C.A. 24/7

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TREASURY ACCEPTS CANADIAN NARROWING OF INVESTMENT ENTITY DEFINITION

Canada’s recently published guidance with respect to F.A.T.C.A. provides that only “listed financial institutions” should be considered investment entities subject to F.A.T.C.A. under the intergovernmental agreement (“I.G.A.”) with Canada (“U.S.-Canada I.G.A.”). The U.S. Treasury has accepted this position.

The U.S.-Canada I.G.A. provides that the definition of “investment entity” is to be interpreted in a manner consistent with the definition of “financial institution” in the recommendations of the Financial Action Task Force (“F.A.T.F.”). The F.A.T.F. provides that any natural person or legal entity that conducts, as a business, one or more listed activities or operations for, or on behalf of, a customer, would be treated as a “financial institution.” The F.A.T.F. also provides a list of designated nonfinancial businesses and professions, including certain trust and company service providers that are not otherwise financial institutions and act as trustees for trust entities. Canada’s anti-money laundering rules interpret this standard to treat the unlisted financial institutions as designated nonfinancial businesses. The Canadian F.A.T.C.A. guidance treats only the expressly listed financial institutions as investment entities, and as mentioned above, the I.R.S. has approved this position.

Action Item 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties

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AN EXERCISE IN “POINT/COUNTERPOINT”

Implementation of many of the B.E.P.S. Action Items would require amending or otherwise modifying international tax treaties. According to the O.E.C.D., the sheer number of bilateral tax treaties makes updating the current treaty network highly burdensome. Therefore, B.E.P.S. Action Item 15 recommends the development of a multilateral instrument (“M.L.I.”) to enable countries to easily implement measures developed through the B.E.P.S. initiative and to amend existing treaties. Without a mechanism for swift implementation of the Action Items, changes to model tax conventions merely widen the gap between the content of the models and the content of actual tax treaties.

Discussion of Action Item 15 has centered on the following issues:

• Whether an M.L.I. is necessary,
• Whether an M.L.I. is feasible, and
• Whether an M.L.I. is legal.

In the spirit of these ongoing discussions concerning Action Item 15, we offer our commentary in a “point/counterpoint” format.

Action Item 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting

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INTRODUCTION

On July 19, 2013, the Organization for Economic Cooperation and Development (“O.E.C.D.”) released its full Action Plan on Base Erosion and Profit Shifting (the “B.E.P.S. Action Plan”), with expectations to roll out specific items over the subsequent two years. According to the O.E.C.D., the B.E.P.S. Action Plan will allow countries to draft coordinated, comprehensive, and transparent standards that governments need to prevent B.E.P.S., while at the same time updating the current rules to reflect modern business practices. Of the 15 action items listed in the B.E.P.S. Action Plan, four relate specifically to transfer pricing and several others indirectly address this area, as well. The four with direct impact on transfer pricing are Action Items 8, 9, 10, and 13:

• Action Items 8, 9, and 10 (Assure that Transfer Pricing Outcomes are in Line with Value Creation) develop rules to prevent B.E.P.S. by (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles, capital, or other high-risk transactions are appropriately allocated in accordance with value creation; (iii) developing transfer pricing rules for transfers of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements.
• Action Item 13 (Re-examine Transfer Pricing Documentation) develops rules regarding transfer pricing documentation to enhance transparency for tax administrations, taking into consideration the compliance costs for multinationals.

With these and the 11 other Action Items, the O.E.C.D. aims to foster (i) coherence of corporate income taxation at the national level; (ii) enhanced substance, through bilateral tax treaties an in transfer pricing; and (iii) transparency and consistency of requirements.

Action Item 8: Changes to the Transfer Pricing Rules in Relation to Intangibles - Phase I

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INTRODUCTION

Unlike some of the other B.E.P.S Action Items, Action Item 8 has a basis in existing O.E.C.D. rules. In this regard, the O.E.C.D. Transfer Pricing Guidelines41 have established the operating rules for transfer pricing. It is understandable that Action Item 8 merely presents a series of amendments to Chapters I, II, and VI of the O.E.C.D. Guidelines.

Action Item 8 states that it seeks to:

• Clarify the definition of I.P.,
• Provide guidance on identifying transactions involving I.P., and
• Provide supplemental guidance for determining arm’s length conditions for transactions involving I.P.

Action Item 8 also considers the treatment of local market features and corporate synergies.

Action Item 6: Attacking Treaty Shopping

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BACKGROUND

Action Item 6 addresses abuse of treaties, particularly focusing on treaty shopping as one of the most important sources of B.E.P.S. The approach adopted amends the O.E.C.D. Model Convention that borrows from the U.S.'s approach to treaties but expands upon it in a way that can be very helpful to the U.S. and other developed countries if adopted by the C.F.E. next year in their final report. Among other measures, the report recommends inclusion of a Limitation on Benefits (“L.O.B.”) provision and a general anti-avoidance rule called the Principal Purpose Test (“P.P.T.”) to be included in the O.E.C.D. Model Convention. While it is expected the report will be finalized next year, whether countries will adopt the recommendations is the crucial factor that is still unclear.

RECOMMENDATIONS

The key recommendations can be found in Paragraph 14. It contains two basic recommendations:

• Countries should agree to include in the tax treaties an express statement of the common intention to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance through use of treaties.
• Countries should demonstrate their commitment to this goal by adopting an L.O.B. provision and a P.P.T. provision in income tax treaties.

The report also notes that special rules may be needed to address application of these rules to collective investment funds (“C.I.F.’s”). The provision should be supplemented by a mechanism that would deal with conduit arrangements not currently dealt with in tax treaties.

Action Item 5: Countering Harmful Tax Practices More Effectively

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The Organization for Economic Co-operation and Development (“O.E.C.D.”) worked together with G20 countries to develop a 15-point action plan to deal with Base Erosion and Profit Shifting (“B.E.P.S.”). The goal of the B.E.P.S. Action Plan is to develop a single global standard for automatic exchange of information and stop corporations from shifting profits to jurisdictions with little or no tax in order to ensure taxation in the jurisdiction where profit-generating economic activities are performed and where value is created.

B.E.P.S. occurs in situations where different tax laws interact in a way that creates extremely low global tax rates or results in double non-taxation. This kind of planning gives a competitive advantage to multinational entities that have substantial budgets to engage high-powered tax advisers and to implement their plans.

The O.E.C.D. published deliverables that intend to eliminate double non-taxation resulting from B.E.P.S. The final measures will be completed in 2015 and will be implemented either through domestic law or the existing network of bilateral tax treaties.

ACTION ITEM 5: HARMFUL TAX PRACTICE

Harmful Tax Competition: An Emerging Global Issue

In 1998, the O.E.C.D. published the report Harmful Tax Competition: An Emerging Global Issue (“the 1998 Report”) with the intention of developing methods to prevent harmful tax practices with respect to geographically mobile activities. These methods have been adopted in the Forum on Harmful Tax Practice (“F.H.T.P.”) with some modifications. Significant attention is given to:

• Elaborating on a methodology to define a substantial activity requirement in the context of intangible regimes; and
• Improving transparency through compulsory spontaneous exchange on rulings related to preferential regimes.