By Steven M. Etkind and Roger D. Lorence
The Treasury Department has released its lengthy explanation of the President’s wide-ranging tax proposals. The President aims to deliver on both tax “fairness,” especially the ending of perceived tax abuses and “loopholes,” and increasing federal tax revenues. Particularly hard hit would be U.S. businesses with operations outside the U.S. and the financial services sector. Because of the very large number and diversity of the President’s proposals, we outline below only those of most interest to the financial services industry. If the entire package were to be enacted, this would be one of the most sweeping revisions to the tax law since the enactment of the Internal Revenue Code of 1986.
Repeal of the Carried Interest
Under current law, the manager of a domestic partnership may receive an incentive allocation of partnership profits which is treated as a share of the various income components realized by the partnership that taxable year. This special allocation of profit is termed the “carried interest” and has been a major spur to development in the oil and gas, real estate and investment fund industries. The President proposes to repeal the carried interest rules for taxable years beginning after December 31, 2010. The carried interest would be taxed as “services partnership interest” income that would be ordinary income, whatever the character of income generated by the partnership, and would be subject to self-employment taxes. Only a manager’s profits on their own capital interest in the partnership would be exempt from these rules. Individuals performing services holding derivatives instruments in that entity would also be subject to ordinary income treatment with respect to the derivative interest. If enacted, this would likely reduce the “mini-master” structure of offshore hedge funds which are structured to claim the benefits of the carried interest.
Commodities Dealers: Partial Repeal of Section 1256
Current law treats U.S. persons who are dealers in commodities, equity options, and commodity derivatives as generally entitled to treatment under Section 1256 of the tax law whereby 60% of gain or loss is long-term capital gain and 40% is short-term capital gain (for so-called “60/40” contracts). The favorable 60/40 treatment (currently a blended maximum rate of 23% for gains) is, the President contends, unwarranted, particularly compared to tax treatment of other types of dealers, whose gains and losses are ordinary income. The President proposes that dealer income of commodities dealers, including dealers in equity options, be taxable as ordinary income, effective for taxable years beginning after the date of enactment.
Major Stiffening of Rules for Offshore Income
The President’s proposals would, if enacted, impose very stringent information reporting requirements on U.S. taxpayers with income offshore and financial institutions that hold the assets of such U.S. taxpayers. Among the new rules would be a duty to report on the appropriate income transactions involving foreign financial accounts, and a 40% penalty on U.S. taxpayers whose tax liabilities reflect amounts held in foreign accounts that were not reported on the Report of Foreign Bank and Financial Accounts (“FBAR”). These rules would be effective at varying dates after enactment of the proposals.
U.S. Withholding Tax Rules on Payments to Foreign Taxpayers
The President proposes to significantly tighten up procedural rules governing payments to foreign persons. Payments of certain types of income from U.S. sources (such as dividends and interest) to foreign payees are subject to a 30% withholding tax on the gross payment, as a general rule. Where the foreign payee is a foreign partnership or other intermediary, the President’s proposals report, in some cases the foreign intermediary provides inaccurate information, so as to defeat the application of the withholding tax. The President proposes, for payments made after December 31 of the year of enactment, that U.S. withholding agents withhold 30% of the gross amount of any payment subject to withholding in the case of a foreign intermediary. The President also proposes, with the same effective date, a type of backup withholding at a 20% rate for certain payments made to payees in jurisdictions with which the U.S. does not have an income tax treaty.
Oil and Gas Tax Advantages Attacked
Domestic investors in oil and gas partnerships benefit from a number of special tax advantages to incentivize them to invest in these often economically risky endeavors. These benefits include an exception from the passive activity rules for investors whose liability is not limited, depletion and certain geological and geophysical expenses. The President proposes to repeal these tax incentives, effective at varying dates after enactment, asserting that repeal would reduce carbon emissions and encourage the use of renewable energy sources. The President would also repeal many other tax benefits currently enjoyed by the oil and gas industry.
Attack on Dividend Swaps
Foreign taxpayers that receive dividends from U.S. corporations are subject to a 30% withholding tax on the gross amount of the dividend, unless the rate is reduced under an applicable income tax treaty. However, if a foreign taxpayer enters into a “dividend swap” whereby the foreign taxpayer receives swap payments based on the dividend yield of U.S. corporations, no U.S. withholding taxes are applied, based on longstanding Treasury regulations. The President proposes to reverse the current law for swap payments made after December 31, 2010. There is a proposed exception for certain kinds of equity swaps that are speculative in nature, as opposed to a dividend-capture type of strategy. If enacted, the proposal may lead to double taxation of the same dividend; once in the hands of the domestic recipient (such as the swaps dealer entering into the contract with the foreign counterparty) and then to the foreign counterparty as well, as a “deemed” dividend.
“Life Settlements” are purchases of life insurance contracts from the insured by investors who pay the remaining premiums due on the policy and receive the death benefit (or cash surrender value of the policy). The President proposes to tighten up current rules regarding transfers of life insurance contracts in three instances:
- the purchaser of the contract whose death benefit is at least $1 million must report the purchase price, the buyer’s and seller’s tax identification numbers (“TINS”), the name of the issuer and the policy number to the Internal Revenue Service (“IRS”), the insurance company issuing the policy and the seller. A new model of IRS Form 1099 is clearly contemplated as a spur to increased tax compliance.
- The insurance company making payments to a buyer of a life insurance contract must report to the IRS and the payee the gross benefit payment, the buyer’s TIN, and the insurance company’s estimate of the buyer’s basis. A new model of IRS Form 1099 is also clearly contemplated here. It is unclear how the insurance company can estimate the buyer’s basis, as this information is maintained on a confidential basis and is not provided to the life insurance company.
- The President would tighten up exemptions from rules that provide where a policy is transferred for “fair value”. The buyer must report gain on the policy to the extent amounts are received in excess of the tax basis. The main exemptions relate to transfers where the transferee’s basis is determined in whole or in part, by the transferor’s basis. The mechanics by which the transfer-for-value rules would be tightened are not provided. These proposals would apply to transfers of life insurance policies and payments of death benefits for taxable years beginning after December 31, 2010.
Investors may invest part of their life insurance premiums in a tax-deferred separate account at the life insurance company issuing the policy. Separate accounts are structured so that the policyholder may direct the investment of the premiums, but not so as to have such control that the policyholder would be treated as the taxable owner of the assets in the variable account. The Treasury’s explanation of the President’s tax proposals states that in some cases private accounts are being used for tax avoidance in ways that are not explained. The President’s proposals require life insurance companies to report to the IRS detailed information about these separate accounts, but only for those separate accounts that are part of a group in which related persons own at least 10% of that separate account’s value. The proposal would be effective for taxable years beginning after December 31, 2010.
Corporate Owned Life Insurance (“COLI”)
Many corporations hold life insurance policies on the lives of key personnel, which typically includes employees, officers, directors and 20% owners. Current law permits a corporation to deduct interest expense on loans taken out to fund premiums on such policies, subject to certain limitations. The President proposes to repeal the deduction for interest expense, except for policies on the lives of persons owning at least 20% of the business. This proposal would be effective for life insurance contracts entered into after the date of enactment of the provision.
Attack on Tax Shelters
The President would enact into law the so-called “economic substance” doctrine which has been applied by courts in inconsistent ways. A transaction would have economic substance only if it changes in a meaningful non-tax way, the taxpayer’s economic position and the taxpayer has a substantial non-federal tax purpose for entering into the transaction. A 30% penalty would be applied to any tax deficiency attributable to a transaction lacking economic substance (reduced to 20% if the taxpayer disclosed the relevant facts on the return). The rule would apply to transactions entered into after the date of enactment.
Higher Taxes from High Net-Worth Taxpayers
To fund deficit reduction, the President would enact several tax raising provisions aimed at the highest income taxpayers. We highlight the two most important. The President proposes to bring back the 39.6% rate for the highest income taxpayers, up from 35% currently. This would begin in 2011. In addition, the President proposes to impose a 20% rate on dividends and net long-term capital gains for married taxpayers filing jointly with incomes over $250,000 ($200,000 for single taxpayers). The current maximum rate on these classes of income is 15%. The 20% rate would be imposed for taxable years beginning after December 31, 2010.
International Tax Proposals
The President proposes to drastically overhaul the regimes governing taxation of U.S. business with overseas operations. Current law, which is extremely complex, permits a U.S. corporation to defer U.S. taxation on its qualifying foreign income. U.S. corporate income taxes are presently among the highest among all industrialized nations, and it is not clear what impact the proposals, if enacted, would have on U.S. multinational corporations.
There are many other proposals that we must omit for lack of space. Many of these proposals, if enacted, would significantly impact the tax position of many readers. If you have any questions concerning this Tax Alert or any related matters, please contact Steven M. Etkind, 212-573-8412 (firstname.lastname@example.org) or Roger D. Lorence, 212-573-8413 (email@example.com). We welcome your input.
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