TAX NEWS - DECEMber 2009

US Tax: House approves one-year extenders package offset by carried interest tax hike, offshore account restrictions

The House of Representatives voted 241-181 on December 9 to approve legislation that would extend through 2010 some 50 tax incentives that are scheduled to expire at the end of this year. The Joint Committee on Taxation (JCT) staff estimates that the extenders provisions in the Tax Extenders Act of 2009 would cost $31 billion over 10 years. As expected, that cost is fully offset primarily by provisions that would tax carried interest as ordinary income and curb offshore tax evasion.


Business, individual extenders

Notable business provisions that would be extended under the bill include, among others, the research and experimentation tax credit, the New Markets Tax Credit, 15-year straight-line cost recovery for qualified leasehold improvements, the exception for active financing income under subpart F, and lookthrough treatment of payments between related controlled foreign corporations.

Among the individual incentives extended under the bill are the itemized deduction for state and local general sales taxes, the additional standard deduction for state and local real property taxes, and the above-the-line deduction for qualified tuition and related expenses. The bill also would extend an array of charitable-giving provisions, economic development tax incentives, and energy incentives.


Tax treatment of carried interests

To offset nearly $25 billion of the cost of the extenders package, the bill would tax carried interests as ordinary income. These provisions, which generally mirror legislation (H.R. 1935) proposed in April by Rep. Sander Levin, D-Mich., would amend section 83 so that the transfer of a partnership interest in connection with the performance of services for the partnership would be included in the service provider-partner's gross income on the date of transfer in an amount equal to the amount of the distribution the partner would receive in a deemed liquidation of the partnership on the date of the transfer.


Investment services partnerships – The bill also would add new code section 710 that would create special rules for "investment services partnership interests" (ISPIs), which are broadly defined as interests held by a person or related party that at the time of the acquisition of the interest is "reasonably expected" to provide directly or indirectly a "substantial quantity" of the following:

- Advising on the investment, purchase, or sale of a specified asset;
- Managing, acquiring, or disposing of a specified asset;
- Arranging financing for specified assets; or
- Any activity in support of the first three categories.

The bill would treat the distributive share of all items of income, gain, deduction, and loss attributable to an ISPI as ordinary. Further, the disposition of an ISPI would receive ordinary income treatment. Exceptions to ordinary income treatment would apply to the extent that income was attributable to and proportional in amount to the recipient's "qualified capital interest," which is defined as the portion of a partnership interest attributable to the amount of money or the fair market value of property contributed or the amount that was subject to inclusion in gross income under section 83.

Avoidance of new section 710 would be subject to underpayment penalties in section 6662, and the penalty would be doubled to 40 percent. This provision does not include the no-fault application of penalties that was in Levin's legislation. The bill provides that amounts that are treated as ordinary income under new section 710 would also be taken into account in determining net earnings from self-employment under code section 1402 and section 211 of the Social Security Act.


Publicly traded partnerships – For publicly traded partnerships, the bill would amend section 7704 to exclude from qualifying income ordinary income under new section 710. It would apply a 10-year transition rule for partnerships that are publicly traded on the date of enactment, and it would provide exceptions for certain real estate investment trust partnerships and certain partnerships investing in other publicly traded partnerships.

The extenders bill does not include a provision in Levin's original proposal relating to the treatment of gains in transfers of partnership interests between related parties and tax-sharing agreements.

These provisions would be effective for income recognized in taxable years beginning after December 31, 2009.


Foreign accounts

The bill would raise an additional $7.7 billion by adopting substantial portions of the Foreign Account Tax Compliance Act (H.R. 3933, S. 1934), introduced in late October by House Ways and Means Committee Chairman Charles Rangel, D-N.Y., and Senate Finance Committee Chairman Max Baucus, D-Mont.


Reporting certain foreign accounts – The bill would add several new code sections devoted to the enforcement of information reporting. The new sections would impose 30 percent withholding on income from U.S. financial accounts or assets held by a foreign financial institution unless that institution enters into and complies with an agreement with Treasury to report U.S. account/asset holders and other related account information.

The agreement would require the financial institution to request waivers (from account holders) of any applicable foreign secrecy law and to close any account for which the holder refuses to provide such a waiver. Reporting would not be required for account holders that are public corporations, tax-exempt organizations, banks, real estate investment trusts, or regulated investment companies.

Similar withholding requirements would apply to nonfinancial foreign entities, such as corporations or trusts. Withholding would not be required for income connected with U.S. business and taken into account under sections 871(b)(1) or 882(a)(1).

These provisions would be effective for payments made after December 31, 2012.


Individual reporting requirement – Under a new section 6038D, an individual holding an interest in a foreign financial asset in any taxable year would be required to attach a disclosure statement to his or her tax return for that year if the aggregate value of all such assets exceeds $50,000. Applicable assets would include financial accounts, foreign stock and securities, and other financial instruments and contracts.

Failure to disclose for any taxable year would subject the individual to a $10,000 penalty. If the individual were to continue such failure after notification by the Secretary, an additional $10,000 penalty would apply for each 30-day period following the 90-day period after the Secretary mails the notice. The "continuation" penalty would not exceed $50,000. The bill would provide a penalty exception for reasonable cause.

Any entity "formed or availed of for purposes of holding" such assets would be treated as if the entity were an individual. These requirements would be effective for taxable years beginning after the date of enactment.


Penalties – The bill would amend section 6662 to make the underpayment penalty applicable to understatements attributable to undisclosed foreign financial assets. For such understatements, the penalty imposed by section 6662 would be 40 percent, rather than 20 percent. The bill also would extend the statute of limitations on assessments to six years for significant omissions of income.


No disclosure requirement for material advisors – In a change from the Rangel-Baucus proposal, the extenders bill would not require reporting of material assistance or advice with respect to the acquisition of an interest in a foreign entity.


PFICs and trusts – The bill would require any person who is a shareholder of a passive foreign investment company (PFIC) to file an annual return, regardless of whether the shareholder has gain from the sale of PFIC stock.

Section 679 would be amended to provide that a trust would be treated as having a U.S. beneficiary even if the U.S. person's interest is contingent. A trust would also be treated as having a U.S. beneficiary if any person has the discretion to determine beneficiaries, unless the trust identifies the class of persons to whom distributions may be made and none of those persons are U.S. persons. If a U.S. person transfers property to a foreign trust, there would be a presumption that a foreign trust has a U.S. beneficiary unless the person discloses all required information and satisfies other requirements of section 679.

The penalty under section 6677 for failure to report foreign trusts would also be amended to impose a minimum $10,000 penalty for failing to file the required information return.


Dividend equivalent payments – In addition, the legislation would define dividends to include substitute dividends, dividend equivalent payments made pursuant to specified notional principal contracts, and similar payments, and would require withholding. This provision would be effective 90 days after enactment.


On to the Senate

The bill now moves to the Senate, where reception to the carried interest offset in particular has been cool. Lawmakers in that chamber are reportedly considering removing that revenue raiser in favor of a provision that would make "black liquor" – the wood pulp byproduct that paper companies use to power their mills – ineligible for the cellulosic biofuel producer credit under section 40(b). The JCT staff has estimated that this provision would raise $23.9 billion over 10 years.

Timing for consideration of an extenders bill in the Senate is currently uncertain due to the ongoing health care debate, and the current-law incentives could expire if Congress fails to approve the measure prior to the end of the year. One option for moving extenders legislation would be to combine it with a must-pass estate tax fix for 2010. The House voted December 3 to approve legislation that would avoid a zero-estate tax year in 2010 by permanently extending the estate tax at its 2009 levels. They are currently awaiting Senate action on the bill.


White House on board

The White House expressed its support for the House extenders bill in a Statement of Administration Policy released December 8, saying it "will provide much-needed relief to families and businesses who are struggling in the current economic downturn." The statement further noted that the "legislation would fulfill the Administration's commitment to crack down on overseas tax havens and put a stop to billions of dollars worth of tax abuse and would end the special preferential tax treatment for carried interest income."