Posted tagged ‘strict liability penalty’

Apple’s Double Irish With A Dutch Sandwich Goes Down Easy with SEC

October 9, 2013

By Phil Karter

Senator Carl Levin (D-Mich.) may have tried to take a bite out of Apple (AAPL) in congressional hearings last May examining the company’s overseas tax structure, calling it “the holy grail of tax avoidance.” However, it appears that more than just Irish eyes are smiling on the company these days, for in the eyes of the SEC, Apple’s efforts to minimize its tax burden are just fine thank you.  See e.g., O’Brian, Chris, “SEC reveals review of Apple’s Irish tax disclosures.” Los Angeles Times, 3 Oct. 2013, LATimes.com, 9 Oct. 2013.

But is that the happy end of the story for Apple and the many other companies such as Google (GOOG), Facebook (FB), Microsoft (MSFT) and Oracle (ORCL) that have replicated the Double Irish structure in one form or another?  Not necessarily given the continuing threat posed by a sweeping application of the economic substance doctrine.  For example, does the creation of foreign subsidiaries for the primary purpose and intent of minimizing tax liabilities meet either or both prongs of the infamous two-prong test examining objective non-tax profitability and subjective non-tax intent?

It very well should if cases like IES v. Comm’r. 253 F. 3d 350 (8th Cir. 2001) and Compaq Computer Corp. v. U.S., 277 F.3d 778 (5th Cir. 2001) continue to represent the state of the economic substance law.  IES’s and Compaq’s transactions were pure tax arbitrage plays whose profitability was derived solely from the monetization of foreign tax credits.  Is anything conceptually different really happening here? Yes, all the fuss over the Double Irish centers around keeping profits abroad beyond the reach of U.S. tax collectors but at bottom, each situation involves ways to reduce ETR and increase after-tax net profits (presumably along with shareholder value) through effective tax structuring.  At this point, the Supreme Court’s pronouncement in Gregory, v. Helvering, 293 U.S. 465 (1935), comes to mind: “The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”

The problem is that there remains considerable uncertainty about the potential reach of the economic substance doctrine based on the plethora of less taxpayer-friendly decisions, particularly recent ones.  Moreover, uncertainty about how and when the ESD could apply – along with the new strict liability penalty under § 6662(b)(6) – has only been heightened by the enactment of a statute, § 7701(o), containing far too many undefined terms.  For example, left open under the codified doctrine are such critical questions as when the doctrine is relevant and what the threshold is for non-tax profits to be substantial relative to tax benefits.

Finally, as reflected by taxpayers’ unsuccessful litigation of leveraged lease (LILO and SILO) transactions, the imprimatur by a government agency blessing the transaction is no assurance that it will thereafter be respected by the IRS.

During his illustrious career, the legendary Steve Jobs was renowned for his prescience.  Such talents would have come in handy in foreseeing the end to this story.  For the legion of companies employing these tax strategies, the hope is for a happy ending rather than a  Tofflerian “Future Shock.”

Could The New Economic Substance Statute Apply To End-Of-Year Stock Sales And Repurchases?

December 28, 2012

By Phil Karter

With the looming increase in tax rates on investment income and capital gains in particular, a large number of stock market investors have been selling long-term positions to lock in the 2012 rate, which currently tops out at 15%.  Come January 1,2013, gain on the same sale could be taxed at a rate as high as 23.8%, consisting of a long-term capital gains tax rate of 20% plus a Medicare surtax of 3.8% imposed on joint filers with AGI greater than $250,000 and single filers with AGI greater than $200,000.  (See Internal Revenue Code § 1411).

A question attracting attention as the year draws to a close and the pace of this activity has accelerated has been whether a stock sale undertaken solely to take advantage of the lower 2012 capital gains tax rates might fall within the scope of Code § 7701(o), the relatively new economic substance statute codified as part of the landmark Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 124 Stat. 1029).  Concerns about coming within the scope of this statute are that it might subject the investor to a 20% penalty enacted as part of the new law.  See Code § 6662(b)(6).  The penalty, if applicable, is a “strict liability” one, which means that taxpayers cannot avoid it on grounds of reasonable cause, such as reliance on a tax advisor. (The penalty for a transaction determined to lack economic substance is also increased to a whopping 40% if the transaction is undisclosed.  See Code § 6662(i).  However, as long as a taxpayer reports the transaction on his or her tax return, the 40% penalty should not apply.)

Thankfully, the eleventh hour concerns expressed about this issue should be put to rest for stock investment gain-recognition transactions in 2012.  Even assuming the economic substance statute is conceptually broad enough to ensnare stock sale transactions undertaken to lock in lower capital gains tax rates, the penalty is only applicable to “underpayments.”  Because a long-term capital gain recognized in 2012 does not reduce a taxpayer’s taxable income but rather increases it (unless the gain is offset by otherwise unused capital losses), there is no underpayment against which to apply a penalty.

Now let’s vary the circumstances by introducing a simultaneous buyback of the stock at the time of sale to reestablish the same position.  Does that change anything vis a vis a potential penalty risk?  We still have a gain recognition transaction in 2012, so there is no tax underpayment against which a penalty could apply for this year.  As for the repurchased stock, its cost basis is at the repurchase price, which means that a subsequent sale in a future year will either produce a smaller taxable gain or larger taxable loss than would have occurred had the original share lots with their lower cost basis simply been maintained.  Some have speculated that this could produce a tax underpayment against which the strict liability economic substance penalty might apply in the year of sale.  After all, in defining a transaction that has economic substance, § 7701(o) requires (1) that the transaction change in a “meaningful way” the taxpayer’s economic position apart from federal tax benefits, and (2) that the taxpayer have a non-tax purpose for entering into the transaction.

In theory, a sale and instantaneous repurchase might fail to satisfy both of these tests.  On the other hand, a repurchase transaction that occurs sometime after the sale introduces an element of market risk from stock price fluctuation that should mitigate any penalty risk.  Similarly, a repurchase in a different type of account (e.g., in a tax-deferred account where the original sale was in a taxable account or vice versa) should also put the taxpayer on firmer ground.

So what are the real risks that the IRS might choose some unfortunate taxpayers to assert a strict liability penalty?  It has, after all, been less than forthcoming in providing guidance on what types of plain vanilla transactions, if any, may be viewed as falling within the scope of the new economic substance statute.  Perhaps the best indicator one can draw upon is the title of § 7701(o), “Clarification of Economic Substance Doctrine.”  The codified doctrine has been portrayed as merely a clarification of the economic substance law in effect for transactions entered into before March 30, 2010. Under the pre-codification doctrine, which is derived solely from the common law, there do not appear to be any reported economic substance cases involving a taxpayer’s sale and repurchase transaction that results in accelerated gain recognition. Couple this with the fact that no court has been asked to interpret the breadth of the new economic substance statute since it was passed in 2010, and it is reasonable to believe that the IRS would prefer to choose a different, and presumably more compelling battleground to make its first stand defending the application of Section 7701(o) and the strict liability penalty.

Finally, in the case of a 2012 gain-recognition stock sale and simultaneous repurchase, it cannot be entirely certain that the transaction will even produce a tax savings when all is said and done.  This is because of the difference between the tax rates for long and short term capital gains (which are taxed at ordinary income rates).  Because a new holding period is established for the repurchased stock, it remains possible that the stock, when sold, will produce a short-term capital gain subject to a larger tax burden than might have occurred if if the original long-term position was held into 2013 or beyond.  In the end, the lack of certainty about the ultimate tax effect until the second sale occurs may be taxpayers’ best argument that the sale and repurchase transaction had economic substance after all.


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