t c memo united_states tax_court american metallurgical coal co and subsidiaries petitioner v commissioner of internal revenue respondent heimdal investment_company inc petitioner v commissioner of internal revenue respondent docket nos filed date derek b matta for petitioners nina e chowdhry carol bingham mcclure and russell scott shieldes for respondent memorandum findings_of_fact and opinion cohen judge in these consolidated cases respondent determined deficiencies penalties and additions to tax as follows american metallurgical coal co and subsidiaries docket no year deficiency dollar_figure penalty sec_6662 dollar_figure heimdal investment_company inc docket no year deficiency dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number sec_6651 dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure additions to tax sec_6651 dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure sec_6656 dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure unless otherwise indicated all section references are to the internal_revenue_code code in effect for the years in issue and all rule references are to the tax_court rules_of_practice and procedure the remaining five issues for decision are docket no whether american metallurgical coal co and subsidiaries norse group is entitled to deduct a purported interest_expense of dollar_figure for the tax_year and if so whether it is entitled to a net_operating_loss nol deduction for that year and whether the norse group is liable for an accuracy- related penalty under sec_6662 for the tax_year docket no whether heimdal investment_company inc heimdal is liable for withholding_tax on the gross amounts of distributions it made to a foreign_entity from through whether heimdal is liable for the failure_to_file addition_to_tax under sec_6651 for tax years and whether heimdal is liable for the failure to deposit addition_to_tax under sec_6656 for tax years findings_of_fact the stipulation of facts and the accompanying exhibits are incorporated herein by this reference at the time their petitions were filed the norse group’s and heimdal’s principal places of business were in texas although the norse group formally began filing returns on a consolidated basis in we use the term the norse group to mean amc and its subsidiaries past and present the norse group comprises the american metallurgical coal co amc and its subsidiaries which include heimdal amc is a domestic_corporation that is indirectly wholly owned by jan petter roed a norwegian shipowner who has a background in shipping and ore transportation the focal point of these cases is a transaction between heimdal and lausanne energy inc lausanne a liberian corporation that took place over the course of tax years through the years in issue brief history of lausanne and the norse group’s business relationship lausanne and the norse group have a business relationship that dates back to since a current norse group subsidiary norse services has provided management services to lausanne and acted as lausanne’s agent in the united_states in lausanne purchased a company heimdal investment co n v heimdal nv that was formerly a member of the norse group at that time heimdal nv was an original investor in caithness geothermal ltd cg a domestic privately held partnership and independent power producer based in southern california cg developed owned managed and operated geothermal projects in that region under power purchase agreements with southern california edison co in lausanne made a direct investment in cg by contributing dollar_figure to the partnership in exchange for three limited_partnership units in amc was a general_partner in a domestic_partnership called allied minerals that year it granted two banks a security_interest in the distributions it received from allied minerals in amc’s parent company underwent a reorganization in response to the termination of the united states-netherlands antilles tax_treaty at the time amc’s president torgeir mantor consulted with robert pfaff a partner at kpmg about the tax aspects of the reorganization the purpose of the reorganization was to ensure the preservation of net_operating_loss nols carry forwards for possible future use as a result of the reorganization amc lowered its tax burden and generated substantial nols but it was still subject_to the security interests held by the banks in particular den norske bank dnb amc incorporated heimdal in as a domestic holding_company of lausanne’s interests heimdal’s first director was hans rinderknecht h rinderknecht a swiss lawyer who had previously represented lausanne in negotiations concerning its services agreement with norse services in h rinderknecht was also the director of lausanne his son dr thomas rinderknecht t rinderknecht was lausanne’s managing director for the years in issue leading up to the transaction between heimdal and lausanne in distributions from cg caused lausanne to turn a profit and it became liable for u s income_tax specifically the branch_profits_tax which it paid via withholding in that year later that year t rinderknecht initiated discussions with mantor over how to make changes to lausanne’s investment in cg because income from the cg partnership had grown to be substantial and lausanne might face branch profits taxation problems t rinderknecht asked mantor to reach out to tax experts about restructuring lausanne’s investments to reduce the potential tax exposure mantor contacted pfaff and apprised him of lausanne’s situation he also told pfaff that the norse group had an interest in participating in some way on date pfaff mailed a preliminary letter to mantor proposing that lausanne contribute its cg partnership_interest to the norse group in exchange for shares and possibly debentures pfaff believed the proposal would appeal to lausanne because the norse group’s nols would shelter the income in all likelihood but expressed concern that the security_agreement with the bank would make his proposal unlikely to be implemented in the fall of the parties further discussed restructuring lausanne’s investment in cg for tax purposes on date mantor faxed a proposed diagram of the norse group to t rinderknecht the fax cover sheet advised t rinderknecht that dnb was a creditor of the norse group and had agreed only to hold a security_interest in a newly formed subsidiary company newco which would hold amc’s coal properties therefore mantor believed that dnb would not be in a position to attack any assets other than what is held in this company mantor’s diagram identified that amc would be the parent company of heimdal newco and amc’s other subsidiaries the diagram also identified lausanne as the holder of a security_interest with respect to heimdal and newco as the norse group subsidiary that o wns coal properties and has bank debt on date pfaff mailed a letter to mantor and t rinderknecht outlining the tax impacts of a proposed sale of lausanne’s cg partnership units to norse services in the letter pfaff indicated that lausanne would transfer its cg partnership_interest in exchange for a note with principal due upon maturity he suggested that the terms of the note call for the payment of fixed interest at an assumed rate of over a term not to exceed seven years and additional interest whereby lausanne would share in excess cash_flow he assumed a maximum purchase_price of dollar_figure million for the cg partnership_interest and suggested that lausanne perfect a security_interest in the cg partnership units such that in the event of a default by the norse group subsidiary lausanne would have first deed on the partnership_interest pfaff determined that the transaction would be characterized as an installment_sale for tax purposes and that lausanne would defer recognition of gain on the sale of its cg partnership_interest until lausanne recovered the note’s principal he stated that this was the case regardless of the fact that sec_897 would classify the cg partnership_interest as a u s real_property interest and possibly subject lausanne to withholding_tax under the foreign_investment_in_real_property_tax_act firpta pfaff also concluded that the interest_paid to lausanne would be considered portfolio_interest free from withholding taxes under sec_871 he concluded his letter by stating that in order for the sale to proceed several tasks would have to be completed including applying for an exemption so that the firpta_withholding tax rules would not apply and that the parties should evaluate very carefully the economic value of the partnership_interest to negotiate an arm’s length sales_price on date mantor sent roed a cashflow analysis which he believed showed the tax benefits of the transaction mantor stated that the analysis was a quick draft that was based on some information which needs to be discussed with lausanne in the analysis he compared the after-tax profit to the norse group with reorganization and the after-tax profit to lausanne without reorganization for the period the analysis assumed that total distributions from cg would be dollar_figure from for both scenarios he believed that he had a pretty good idea of what the cashflow and income would be from cg because he had access to all of cg’s documentation pursuant to the services agreement between lausanne and norse services the analysis assumed that the norse group would give a note payable to lausanne worth dollar_figure million interest only for seven years and an e quity kicker of of the remaining cash_flow the analysis projected how the norse group’s nols and expected interest_expenses to lausanne would offset anticipated distributions from cg in the end the analysis projected a total after-tax profit for the norse group of dollar_figure with reorganization and a total after-tax profit for lausanne of dollar_figure without reorganization in projecting the after-tax profit to the norse group with reorganization the analysis assumed that the norse group would pay to lausanne of the total distributions from cg the analysis did not provide for the norse group’s repayment of the principal of the note to lausanne at some point during this time lausanne and the norse group agreed that the transaction regarding the cg partnership units would be between lausanne and heimdal on date t rinderknecht faxed a letter to mantor and pfaff regarding the sale of lausanne’s cg partnership_interest to heimdal in the letter t rinderknecht stated that he had spoken with jim bishop of caithness corp cc the general_partner of cg bishop was the president and ceo of cc and he assured t rinderknecht that cc would cooperate with lausanne and the norse group on the transaction bishop believed that in the foreseeable future the limited partners of cg like lausanne would be taxed for distributions only up to their net capital_investment and that thereafter all distributions to the partners would be tax free he advised t rinderknecht to contact cc’s tax adviser regarding this assessment and before selling lausanne’s partnership_interest t rinderknecht requested that pfaff contact cc’s tax adviser to verify whether it was true that lausanne would not face adverse tax consequences if it retained the cg units for a while t rinderknecht also insisted that in the event lausanne were to sell its cg partnership units to heimdal lausanne retain an option to repurchase the units from heimdal t rinderknecht insisted on an option period of not less than years and that lausanne should be able to repurchase the units for a price consisting of the purchase_price paid_by heimdal increased by a certain margin for heimdal on date mantor faxed a memorandum to roed regarding norse restructuring the memorandum outlined the background structure tax considerations and risk factors of two transactions the first transaction was a continuation of amc’s reorganization and involved a new amc subsidiary’s owning of assets that had been previously owned by two amc affiliates this new subsidiary would assume and be responsible for all of the bank debt associated with the assets and would join in amc’s consolidated_return as a result of the restructuring mantor believed that amc would be able to use a combined nol of approximately dollar_figure million the second transaction involved heimdal’s purchase of lausanne’s cg partnership units mantor summarized the structure of the second transaction as follows heimdal would purchase lausanne’s interest in cg for a note to be negotiated of no more than dollar_figure million with interest only for seven years lausanne would be given an equity kicker of no more than of the remaining annual distribution from cg and lausanne would also be given an option to purchase the interest back from heimdal if certain further development of the geothermal properties were to occur as a result of this transaction mantor believed that heimdal would have high deductible_interest expenses which would partially reduce its taxable_income in the united_states he also believed that heimdal’s remaining income would be reduced by the use of the nols in amc attached to mantor’s fax was a copy of pfaff’s date letter the letter agreement and the promissory note on date the parties signed a written letter agreement whereby heimdal agreed to purchase lausanne’s three partnership units referred to as units in the agreement in cg referred to as partnership for a purchase_price of dollar_figure million payable with a promissory note referred to as note the letter agreement included the following relevant terms f without lausanne’s prior written consent which lausanne may withhold in its sole and absolute discretion heimdal will not i liquidate ii merge or consolidate with any other entity iii sell all or substantially_all of its assets iv enter into or engage in any business other than ownership of the units v enter into any guarantees or pledge any of its assets other than liabilities in the ordinary course of business not exceeding an aggregate of dollar_figure in any year and liabilities in lausanne’s favor heimdal undertake s to cause the partnership to deliver to lausanne copies for so long as the note remains outstanding of all notices and correspondence which are sent to heimdal are generally distributed by the partnership to its limited partners at the same time such materials are sent or distributed in the event the partnership fails to timely deliver such materials to lausanne heimdal will immediately send lausanne copies thereof in addition for so long as the note remains outstanding heimdal shall provide lausanne with access to all books_and_records pertaining to the units in the event it is proposed that the limited partners make any capital_contribution to the partnership in respect of their units lausanne and heimdal agree to consider in good_faith whether the cash_flow interest provisions of the note should be modified to reflect the economic_effect of such capital_contribution that same day heimdal furnished lausanne with a dollar_figure million promissory note that was payable on date as consideration for the transaction the promissory note included the following terms the principal balance of this note shall bear interest at the rate of twelve percent per annum based on a day year such interest shall be payable annually in arrears on december of each year and upon the maturity of the principal hereof upon the stated maturity hereof prepayment acceleration or otherwise provided however that upon payor receiving any distribution from the partnership with respect to the three units of limited_partnership_interest in the partnership purchased as of the date hereof by payor from payee payor shall apply such distribution to pay or prepay any interest accrued or which shall thereafter accrue during the then current calendar_year hereunder in addition to the interest described above additional interest cash_flow interest equal to fifty percent of the excess if any of i distributions paid_by the partnership in any calendar_year over ii the sum of a six hundred thousand dollars dollar_figure and b the reasonable costs of collection of such distributions if any shall be due and payable by payor to payee immediately upon receipt of any such distribution which represents in whole or in part any such excess any principal or interest including cash_flow interest not paid when due hereunder shall bear at a rate of per annum payor shall not prepay the principal_amount of this note without the prior written consent of payee which may be withheld in payee’s sole and absolute discretion this note is entitled to the benefits of the security_agreement of even date herewith between payor as debtor and payee as secured party the security_agreement the transfer of this note which as provided in the payee’s note may only occur with the prior written consent of payor is registerable on the note registry maintained by payor upon surrender of this note for registration of transfer at the address of payor duly endorsed by or accompanied by a written instrument of transfer and duly executed by the holder or its attorney duly authorized in writing and thereupon a new note in the same principal_amount will be issued by payor to the designated transferee each of the following events shall constitute an event of default hereunder a if any portion of the principal interest or other_amounts payable by payor under this note is not paid within five days after the same is due b if payor violates or does not comply with any of the provisions of this note or the letter agreement d if payor shall make an assignment for the benefit of creditors f if the partnership shall sell all or substantially_all of its properties or liquidate or g if any event of default as defined in the security_agreement shall occur upon the occurrence at any time of any of the foregoing events of default i payee may by written notice to the payor declare the outstanding balance of the principal and interest payable hereunder to be immediately due and payable upon which declaration such principal and interest shall be immediately due and payable notwithstanding anything to the contrary contained in this note or in any other instruments or documents executed and delivered in connection herewith in no event shall the total of all charges payable under this note which are or could be held to be in the nature of interest exceed the maximum rate permitted to be charged by applicable law of the state of new york should payee receive any payment which is or would be in excess of that permitted to be charged under any such applicable law such payment shall have been and shall conclusively be deemed to have been made in error and shall automatically thereupon be applied to reduce the unpaid principal_amount then outstanding on this note this provision shall control interpretation of any other conflicting provisions in this note and any other instruments or documents executed and delivered in connection herewith or therewith with respect to the payment of interest this note may not be waived changed modified terminated or discharged orally but only by agreement in writing signed by the holder hereof pfaff’s memorandum of advice to t rinderknecht on date pfaff mailed a letter to t rinderknecht copying mantor that included a memorandum of advice concerning the tax consequences of the transaction between heimdal and lausanne the memorandum explained that the transaction was effected as had been outlined in pfaff’s date letter with the modification that the sale was made to heimdal instead of norse services and that the promissory note was for a term of years rather than no more than seven years pfaff’s memorandum concluded that the transfer of the cg units from lausanne to heimdal could be treated as an installment_sale and that withholding on the disposition of a u s real_property interest would therefore be required when heimdal made a principal payment to lausanne pfaff also observed that the note included a provision whereby cashflow interest on the note was limited to the maximum allowable interest under new york state law and concluded that this provision would be sufficient to classify these payments as interest payments rather than additional principal payments the memorandum also informed t rinderknecht and mantor that u s interest_paid by a u s entity to a foreign_corporation is generally subject_to tax under sec_881 and withholding under sec_1442 but portfolio_interest is exempt from u s tax under sec_881 pfaff explained that in order to meet the portfolio_interest exception heimdal had to receive a form_w-8 certificate of foreign status from lausanne before making payment attach the completed form_w-8 with form 1042-s foreign person’s u s source income subject_to_withholding to form_1042 annual withholding_tax return for u s source income of foreign persons and file form_1042 with the internal_revenue_service by march following the calendar_year of the payment the memorandum stated that form_w-8 would be valid for three years but could be requested annually or before each payment the memorandum concluded that the note appears to be registered and will meet the portfolio_interest exception of sec_881 if the payor receives a statement that the beneficial_owner of the obligation is not a united_states_person the memorandum was not a full tax opinion letter subject_to prior review with the kpmg washington national_office modifications to the promissory note on date heimdal and lausanne extended the term of the note to date extension all other terms and conditions of the note including those with respect to fixed interest and cashflow interest were incorporated in the extension and remained in full force and effect during the term of the extension on date heimdal and lausanne amended the promissory note agreement to state that heimdal would accrue rather than pay up front the fixed interest of dollar_figure for each of the amendment occurred after heimdal had received distributions from cg in that were less than the dollar_figure fixed interest payment due to lausanne for that year on date heimdal and lausanne extended the term of the note to date extension the extension provided that certain other terms and conditions of the note including the fixed rate of interest and the rate of cashflow interest would be renegotiated in good_faith but provided that should the parties not agree on revised terms the existing terms of the extension would remain in full force and effect finally on date heimdal and lausanne extended the term of the note to date extension as part of the extension heimdal and lausanne agreed to reduce the fixed interest rate portion of the agreement from to and prohibit prepayment of the principal during the period covered by the extension heimdal continued to pay fixed interest to lausanne at the rate of rather than the reduced_rate of on date heimdal prepaid the dollar_figure million principal_amount of the note to lausanne cg’s investor relations report and heimdal’s profit and loss statements cg’s investor relations report states that from date through date heimdal received distributions of approximately dollar_figure million from cg heimdal reported on its profit and loss statements that it had remitted approximately dollar_figure million to lausanne as interest payments during this period in alone heimdal received distributions from cg totaling dollar_figure for that year heimdal reported that it had remitted approximately dollar_figure to lausanne as interest payments heimdal’s profit and loss statements for showed that it had received consulting income totaling dollar_figure in presumably heimdal had received the consulting income in violation of the letter agreement between heimdal and lausanne which prohibited heimdal from engaging in any business other than ownership of the cg units without lausanne’s prior written consent tax reporting for heimdal did not file form sec_1042 or forms 1042-s in these same years heimdal did not deposit or pay any withholding_tax on distributions it made to lausanne the record shows that lausanne sent heimdal one completed form_w-8 dated date certifying that lausanne was not a u s citizen or resident i burden_of_proof opinion generally the taxpayer has the burden of proving that the determinations in the notice_of_deficiency are incorrect rule a 290_us_111 we resolve these issues on the preponderance_of_the_evidence in the record see 124_tc_95 ii the tax implications of the transaction between heimdal and lausanne sec_881 generally imposes a tax of on fixed or determinable annual or periodical fdap_income received from sources within the united_states by a foreign_corporation if the income is not effectively connected with the conduct of a united_states trade_or_business this tax may be reduced under a bilateral income_tax treaty between the united_states and the foreign corporation’s country of residence see sec_894 because the transaction in these cases involves heimdal a domestic entity and lausanne an entity incorporated in a country that does not have a tax_treaty with the united_states we look to the code for the rules governing the transaction the code defines fdap_income broadly and includes in it income from interest payments see 337_us_369 the u s payors of such income are generally required under sec_1441 and sec_1442 to deduct and withhold therefrom an amount equal to the tax imposed by sec_871 and sec_881 and in the event that they fail to do so they are liable for those withholding taxes under sec_1461 in congress repealed the withholding_tax imposed by sec_871 and sec_881 with respect to certain interest_paid on portfolio debt referred to as portfolio_interest for the most part and as relevant here portfolio_interest refers to interest payments made to a foreign_corporation owning less than of the payor entity pursuant to debt obligations that are either in_registered_form with the appropriate certification or sold exclusively to non-u s persons with proper precautions taken that such debt obligations will not be held by u s persons see sec_881 sec_163 the remaining issues in these two cases turn on whether the transaction between heimdal and lausanne generated bona_fide portfolio_interest payments for tax purposes from the former to the latter if the disbursements were bona_fide for tax purposes the norse group would be able to deduct the payments on its consolidated tax_return as a result no penalty would be imposed on the norse group for including this large deduction on its return furthermore heimdal would not have to withhold tax on behalf of lausanne for the years in issue--provided certain formalities were met--and no additions to tax would be imposed for its failure to do so before we decide whether heimdal’s payments to lausanne meet the reporting requirements for it to claim the portfolio_interest exemption from withholding we must first decide whether heimdal’s payments were genuine interest payments a bona_fide debt the question of whether heimdal’s payments to lausanne were bona_fide interest payments is a factual question to be decided on the basis of all of the relevant facts and circumstances see 52_tc_255 aff’d 422_f2d_198 5th cir 29_tc_1193 aff’d 271_f2d_267 5th cir for a promissory note to constitute bona_fide indebtedness there must be an unconditional legally enforceable obligation to pay the money 90_tc_908 the simple expedient of drawing up papers is not controlling for tax purposes when the objective economic realties are to the contrary 435_us_561 the u s court_of_appeals for the fifth circuit has identified nonexclusive factors to be considered in distinguishing bona_fide indebtedness from an equity_investment or other return on capital see 464_f2d_394 5th cir some of these factors are as follows the names given to the certificate evidencing the indebtedness the presence or absence of a fixed maturity_date the source of the funds used to pay interest and repay the creditor the right to enforce the payment of principal and interest the extent of a creditor’s participation in management the status of the advance in relation to other corporate creditors the intent of the parties thinness of capital structure in relation to the debt identity of interest between creditor and stockholder the debtor’s ability to obtain loans from outside lending institutions the extent to which the advance was used to acquire capital assets and the failure of the debtor to pay on the due_date or to seek a postponement see id in re indian lake estates inc 448_f2d_574 5th cir pk ventures inc v commissioner tcmemo_2006_36 aff’d in part rev’d in part on other grounds and remanded sub nom 311_fedappx_196 11th cir the identified factors are not equally significant and no single factor is determinative in each case or relevant in every case see 659_f2d_618 5th cir 95_tc_257 the real issue for tax purposes has long been held to be the extent to which the transaction complies with arm’s length standards and normal business practice estate of mixon f 2d pincite the various factors are only aids in answering the ultimate question of whether there was a genuine intention to create a debt with a reasonable expectation of repayment and did that intention comport with the economic reality of creating a debtor-creditor relationship ’ 61_tc_367 see also calumet indus inc v commissioner t c pincite 74_tc_476 the form of the transaction and the labels the parties place on the transaction may not have as much significance when the parties can mold the transaction at their will calumet indus inc v commissioner t c pincite the internal_revenue_service recently released proposed_regulations in an attempt to bring clarity and consistency to the analysis of distinguishing between indebtedness and equity investments see notice of proposed rulemaking fed reg date because the transaction at issue in these cases took place more than years ago we mention these regulations for posterity’s sake only applying the above factors we find that the advance of the purchase_price of the three cg partnership units from lausanne to heimdal was not a bona_fide loan but an equity_investment the norse group and lausanne worked together to create a transaction that reduced their respective tax_liabilities rather than create a strict debtor-creditor relationship and this was their sole objective the norse group may have established the existence of a formal debt_instrument with a fixed maturity_date at the outset but it did not establish that any of the note’s terms were properly negotiated the terms of the promissory note were largely based on pfaff’s date letter which proposed a dollar_figure million dollar note that provided for fixed interest and additional cashflow interest pfaff recommended that heimdal and lausanne obtain a valuation of the cg partnership units before their sale so that they could show that they were dealing at arm’s length but they did not obtain one furthermore pfaff stated at trial that he did not know how the fixed interest rate was devised an asset’s sale price may be considered to be at arm’s length where each party in the transaction can distinguish his economic_interest from that of the other party and where they conflict always choose that to his individual benefit see 492_f2d_515 5th cir here that simply did not occur nothing in the record suggests that these terms were negotiated although the note had a 10-year fixed maturity_date at the outset of the transaction that maturity had to be postponed for years because heimdal did not have sufficient cashflow stemming from the cg distributions to repay the note on time the repayment of the debt was strictly contingent upon the success of the cg partnership units to generate income suggesting equity classification see 561_f2d_572 5th cir as a condition to the transfer of the three cg partnership units to heimdal lausanne obtained the right to approve of heimdal’s business activities and debts and precluded heimdal from engaging in any other business activities and incurring any other debt when an entity advances funds for the right to participate in the management of the debtor’s business the advance may not be intended as bona_fide debt and instead may be intended as an equity_investment see am offshore inc v commissioner 97_tc_579 under the restrictive terms of the letter agreement lausanne effectively managed heimdal the norse group places great weight on its professed intent to enter into a debtor-creditor relationship with lausanne and its reflection of the debt as such in its and lausanne’s books records and tax returns the intent of the parties weighs heavily in determining the debt versus equity question but subjective intent does not suffice to alter the relationship or duties created by an otherwise objectively indicated intent in re 742_f2d_1311 11th cir conclusory and self-serving statements by taxpayers that they intended to create debts have been accorded little weight by the courts the court_of_appeals for the fifth circuit has stated primary reliance upon subjective indications of intent is simply not an effective way of resolving the debt versus equity problem in a land of hard economic facts we cannot root important decisions in parties’ pious declarations of intent tex farm bureau v united_states 725_f2d_307 5th cir thus we must look not simply at the pronouncements of the parties but also at the circumstances surrounding the transaction to reveal their intent 414_f2d_844 5th cir the circumstances surrounding lausanne’s transfer of its three cg partnership units to heimdal reveal that they did not intend to enter into a debtor-creditor relationship in late it became apparent that lausanne might be liable for the branch_profits_tax as its ownership of the cg units was becoming profitable around that time rather than try to address this issue using its own business exigencies it worked in conjunction with the norse group to find a mutually compatible way to lower both companies’ tax burdens in late and throughout mantor and t rinderknecht regularly corresponded with one another regarding the transaction meanwhile the norse group reached out to its own tax adviser pfaff regarding the transaction mantor would ask for pfaff’s advice regarding certain aspects of the deal and he would pass along pfaff’s advice to t rinderknecht mantor’s correspondence with pfaff was not necessarily as concerned with the norse group’s sole business or tax consequences regarding the deal as it was with the norse group’s and lausanne’s tax consequences together at some point pfaff started to communicate directly with t rinderknecht regarding the salient terms of the deal these discussions suggest that the norse group’s and lausanne’s dealings were not at arm’s length see creme mfg co f 2d pincite noting that a transaction is not at arm’s length if each party is not in a position to distinguish its own economic interests from the other’s the parties continued to act in concert with one another to devise a seller- financed purchase of the cg partnership units that was mutually beneficial to the norse group and lausanne in the months leading up to the transaction mantor created a cashflow analysis for the norse group that analyzed the contemplated transaction in this analysis mantor considered the tax ramifications to both the norse group and lausanne he was able to consider lausanne’s tax implications because he had its financial data from a previous agreement his concern over the tax aspects for lausanne implies that the norse group was not primarily concerned with its own business interests but instead with creating a mutually beneficial arrangement with lausanne thus the norse group and lausanne’s ability to mold the transaction to their collective will diminishes any significance that the transaction’s form and labels may have held as determinants of bona_fide debt see calumet indus inc v commissioner t c pincite the norse group admits that the source of the repayment of its debt to lausanne was the cg partnership_distributions it purchased from lausanne heimdal had no assets at the time it entered into the transaction to purchase the cg partnership units and it required an advance of the entire purchase_price from lausanne this fact strongly suggests that lausanne’s advance to heimdal was equity rather than debt see 375_f2d_36 5th cir moreover heimdal’s and lausanne’s conduct while the note was enforceable indicates that they did not consider the note to be genuine indebtedness heimdal violated the terms of the letter agreement by failing to pay interest timely in and rather than treat the note as defaulted on however lausanne allowed heimdal to accrue interest and continue holding the cg units for several years after the original maturity_date furthermore the extension reduced the fixed interest rate from to yet in heimdal paid lausanne fixed interest at the higher rate where a debtor does not make required_payments or a creditor does not enforce its right to receive payments an advance appears more like equity than debt 50_tc_236 aff’d 406_f2d_288 2d cir in the end the norse group and lausanne devised a transaction whereby lausanne would sell the cg partnership units in exchange for a promissory note from heimdal that generated interest payments to lausanne the terms of the agreement prevented heimdal from engaging in any business other than holding the cg units and provided lausanne with access to heimdal’s books_and_records pertaining to the cg units because some portion of the interest payments was contingent on the performance of cg lausanne would still generate income from cg without having to pay the branch_profits_tax they anticipated that a portion of the interest could be classified as portfolio_interest provided the legal formalities were met therefore heimdal could claim interest deductions on the interest payments and offset the income generated by its new ownership of the cg units with the nols of the norse group in substance the economics of the transaction remained the same--lausanne generated income from the cg units and had substantial control_over the units themselves the expected extra benefit was that both lausanne and the norse group received large tax advantages for having the transaction structured in this way in frank lyon co u s pincite the supreme court stated that a genuine multiple-party transaction with economic_substance compelled or encouraged by business or regulatory realities imbued with tax-independent considerations and not shaped solely by tax-avoidance features should be respected for tax purposes many cases demonstrate the difference between arranging a contemplated business transaction in a tax-advantaged manner which is legitimate and entering into a prearranged transaction designed solely to use preserved nols and create a tax_benefit which is not see eg 608_f3d_1366 fed cir 454_f3d_1340 fed cir 446_f2d_690 5th cir we believe mantor and t rinderknecht with the approval of roed created this transaction solely to generate a tax_benefit the norse group and lausanne designed and implemented this elaborate system to create the appearance that heimdal was paying interest while in substance it was not therefore the payments were not deductible by the norse group and they were fdap_income which required heimdal to withhold income_tax b reporting requirements to meet the portfolio_interest exemption although we find that the norse group did not really pay interest to lausanne for purposes of sec_881 an alternative ground for decision is that heimdal did not meet the reporting requirements to satisfy the portfolio_interest exemption in order for a debtor paying interest on registered debt to a foreign_corporation to claim the portfolio_interest exemption and thus not be subject_to_withholding procedures it generally must receive a statement that the beneficial_owner of the registered obligation is not a u_s_person see sec_871 sec_881 sec_1_881-2 income_tax regs referring to sec_1_871-14 income_tax regs for rules applicable to a foreign corporation’s receipt of interest on certain portfolio debt instruments sec_1_871-14 income_tax regs applicable to interest payments made after date a debtor that does not have a beneficial_ownership statement before the interest payment must rely on presumption rules in the regulations to determine whether to withhold under sec_1442 see sec_1_871-14 income_tax regs applicable to interest payments made after date sec_1_1442-1 income_tax regs referring to sec_1_1441-1 through income_tax regs for rules concerning the withholding of tax at the source in the case of foreign_corporations sec_1_1441-1 income_tax regs applicable to interest payments made after date for interest payments made in tax years this statement must be signed by the beneficial_owner under penalty of perjury and provide the name and address of the beneficial_owner sec_35a b q a-9 temporary income_tax regs fed reg date for interest payments made after date this statement has the added requirement that it must be provided every three years during the period in which the beneficial_owner owns the obligation see sec_871 sec_881 sec_1_871-14 income_tax regs a properly completed form_w-8 will satisfy the requirements under sec_871 see sec_35a b q a-9 temporary income_tax regs supra sec_1_871-14 sec_1_1441-1 ii income_tax regs for interest payments made in tax years the form_w-8 must be received by the payor in the calendar_year in which the payment is made or collected or in either of the preceding two calendar years sec_35a b q a-9 temporary income_tax regs supra sec_1_6049-5 income_tax regs for interest payments made after date the form_w-8 must be provided before the expiration of the beneficial owner’s period of limitation for claiming a refund of tax on such interest see sec_1_871-14 and ii income_tax regs in these cases a form_w-8 had to be provided before the expiration of lausanne’s period of limitation for claiming a refund in order for the interest to qualify as portfolio_interest the parties agree that the promissory note purported to be a debt obligation and was in_registered_form the parties do not argue that the presumption rules in the regulations permit heimdal to avoid withholding obligations under sec_1442 therefore for interest payments on the note to be classified as portfolio_interest heimdal must have received a statement from lausanne stating that lausanne is not a u_s_person heimdal received only one proper form_w-8 from lausanne that was issued in this statement of beneficial_ownership would have been effective only during taxable years see 35a b q a- temporary income_tax regs supra sec_1_6049-5 income_tax regs heimdal also provided an unsigned form w-8eci certificate of foreign person’s claim that income is effectively connected with the conduct_of_a_trade_or_business in the united_states irrespective of whether the form w-8eci has any impact on these cases the regulations state that a beneficial_ownership form is valid only if it is signed under penalty of perjury by the beneficial_owner in these cases lausanne therefore we cannot rely on this document as a statement of beneficial_ownership finally lausanne’s period of limitation for claiming a refund for any of the years in issue has expired see sec_6511 providing that the period of limitation for claiming a refund is generally within three years from the time the return was filed or two years from the time the tax was paid whichever period expires later therefore the time for heimdal to receive a proper beneficial_ownership statement has run out thus for the years in issue heimdal did not satisfy the reporting requirement for claiming the portfolio_interest exemption c conclusion in conclusion we hold that heimdal’s payments to lausanne were not bona_fide interest payments therefore the norse group is not entitled to deduct a purported interest_expense of dollar_figure for the tax_year and heimdal is liable for a withholding_tax on the gross amount of distributions it made to lausanne for the years in issue iii penalty and additions to tax respondent determined that the norse group is liable for the sec_6662 accuracy-related_penalty on its underpayment for the tax_year respondent also determined that heimdal is liable for additions to tax under sec_6651 and and for tax years respondent now concedes that heimdal is not liable for the sec_6651 additions to tax a the norse group sec_6662 and b imposes a accuracy-related_penalty on any underpayment of federal_income_tax which is attributable to a substantial_understatement_of_income_tax in the case of a corporation other than an s_corporation or a personal_holding_company an understatement of income_tax is substantial if it exceeds the lesser_of of the tax required to be shown on the return or if greater dollar_figure or dollar_figure million sec_6662 the norse group as a corporate taxpayer bears the burden of proving that it is not liable for an accuracy-related_penalty pursuant to sec_6662 see 126_tc_191 the taxpayer must come forward with persuasive evidence that the penalty is inappropriate because for example the taxpayer acted with reasonable_cause and in good_faith sec_6664 higbee v commissioner t c pincite the decision as to whether a taxpayer acted with reasonable_cause and in good_faith is made on a case-by-case basis taking into account all of the pertinent facts and circumstances see sec_1_6664-4 income_tax regs reliance on the advice of a tax professional may but does not necessarily establish reasonable_cause and good_faith for the purpose of avoiding a sec_6662 penalty 469_us_241 reliance by a lay person on a lawyer or an accountant is of course common but that reliance cannot function as a substitute for compliance with an unambiguous statute that petitioners had an accountant prepare their returns does not in and of itself prove that they acted with reasonable_cause and in good_faith see 115_tc_43 aff’d 299_f3d_221 3d cir caselaw sets forth the following three requirements in order for a taxpayer to use reliance on a tax professional to avoid liability for a sec_6662 penalty the adviser was a competent professional who had sufficient expertise to justify reliance the taxpayer provided necessary and accurate information to the adviser and the taxpayer actually relied in good_faith on the adviser’s judgment see id pincite see also 425_f3d_1203 n 9th cir quoting with approval the above three-prong test aff’g 121_tc_89 in addition the advice must not be based on unreasonable factual or legal assumptions including assumptions as to future events and must not unreasonably rely on the representations statements findings or agreements of the taxpayer or any other person sec_1_6664-4 income_tax regs the norse group reported tax of dollar_figure on its return while it was required to show tax of dollar_figure notwithstanding certain deductions this understatement exceeds dollar_figure of the required tax to be shown on norse group’s return an amount which is the lesser_of dollar_figure million and the greater of dollar_figure therefore the understatement of income_tax was substantial the norse group argues that it had substantial_authority for its position to treat its disbursements to lausanne as interest payments it also argues that it acted with reasonable_cause and in good_faith with respect to this position because it relied on pfaff’s advice as explained above the arguments the norse group offered to show support for its position are not adequately supported by the caselaw and do not show substantial_authority see sec_1_6662-4 and income_tax regs the position the norse group took on its tax_return was a gamble at best as the weight of the authorities supporting its treatment of the disbursements to lausanne as interest payments was slim to none while the weight of the authorities supporting contrary treatment was abundant see id furthermore the norse group’s argument that it relied on the advice of a competent tax professional is not persuasive while pfaff assisted in the development of the transaction between heimdal and lausanne the norse group failed to follow his recommendations of obtaining a valuation of the cg units or filing the requisite forms to claim the portfolio_interest exemption additionally pfaff’s suggestions were informal and not up to the strict standards of his firm’s opinion_letters on which clients could reasonably rely heimdal and lausanne simply took pfaff’s recommendations for the design of the transaction at face value without negotiating the terms when it came time for pfaff to write a memorandum of advice regarding the transaction it was unclear whether pfaff’s memorandum was directed towards the norse group lausanne or both pfaff’s multiple correspondence with both the norse group and lausanne shows that the norse group did not use his advice so much for properly assessing their tax_liability as they did for entering into a transaction for pure tax-avoidance purposes we conclude that the norse group did not act with reasonable_cause and in good_faith in deducting its disbursements to lausanne as interest payments for b heimdal sec_6651 provides for an addition_to_tax of of the tax required to be shown on the return for each month or fraction thereof for which there is a failure_to_file not to exceed however the addition_to_tax for failure_to_file is not imposed if it is shown that the failure_to_file did not result from willful neglect and was due to reasonable_cause see boyle u s pincite to prove reasonable_cause the taxpayer must show that he exercised ordinary business care and prudence but nevertheless could not file the return when it was due see 92_tc_899 sec_301_6651-1 proced admin regs sec_6656 imposes an addition_to_tax equal to of the portion of an underpayment in withholding_tax that is required to be deposited if the failure to deposit extends more than days a taxpayer may also avoid the addition_to_tax under sec_6656 if its failure to deposit was due to reasonable_cause and not willful neglect charlotte’s office boutique inc v commissioner t c pincite it is undisputed that heimdal filed no withholding_tax returns form sec_1042 and deposited no withholding taxes with the treasury heimdal argues that its failure_to_file form sec_1042 was due to reasonable_cause because its very obligation to file the returns is the issue being litigated in these cases and it reasonably relied on the advice of a competent tax professional who informed heimdal that it had no withholding obligation this argument fails there is no evidence that heimdal was told that it need not file form sec_1042 in fact there is evidence to the contrary pfaff specifically told heimdal that its disbursements to lausanne would be subject_to_withholding taxes if heimdal failed to receive a form_w-8 from lausanne every three years and failed to attach each form_w-8 with form 1042-s to form_1042 heimdal did not follow this important advice therefore heimdal cannot show that it acted with reasonable_cause and in good_faith accordingly we sustain respondent’s determination that heimdal is liable for additions to tax and penalties for tax years we have considered all the other arguments made by the parties and to the extent not discussed above find those arguments to be irrelevant moot or without merit to reflect the foregoing decisions will be entered under rule


t c memo united_states tax_court rolland and clara rose rue petitioners v commissioner of internal revenue respondent docket no filed date larry d harvey for petitioners randall l preheim for respondent memorandum opinion vasquez judge this case is before the court on respondent’s motion for summary_judgment pursuant to rule unless otherwise indicated all rule references are to the tax_court rules_of_practice and procedure and all section references are to the internal_revenue_code in effect for the year in issue after a concession the sole issue for decision is whether petitioners can exclude from income wages earned during from working in antarctica background at the time they filed the petition petitioners resided in denver colorado during petitioners performed services at mcmurdo station in ross island antarctica on their federal_income_tax return petitioners excluded wage income earned and received during for services performed in antarctica i summary_judgment discussion rule a provides that either party may move for summary_judgment upon all or any part of the legal issues in controversy full or partial summary_judgment may be granted only if it is demonstrated that no genuine issue exists as to any material fact and that the legal issues presented by the motion may be decided as a matter of law see rule b 98_tc_518 affd 17_f3d_965 7th cir we conclude that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law respondent concedes that no penalty pursuant to sec_6662 is due from petitioners for ii in general sec_61 provides that gross_income means all income from whatever source derived accordingly citizens of the united_states generally are taxed on income earned outside the geographical boundaries of the united_states unless the income is specifically excluded from gross_income 117_tc_95 affd sub nom 68_fedappx_44 9th cir affd sub nom 357_f3d_1108 10th cir exclusions from income are construed narrowly and taxpayers must bring themselves within the clear scope of the exclusion id iii sec_911 in 126_tc_89 473_f3d_790 7th cir arnett ii we addressed the arguments made by the parties herein regarding sec_911 the u s court_of_appeals for the seventh circuit agreed with our analysis of sec_911 and affirmed our conclusion that antarctica is not a foreign_country pursuant to sec_911 and the regulations thereunder arnett v commissioner f 3d pincite we shall not repeat our analysis from arnett i herein we follow our analysis and holding in arnett i and the analysis and holding of the court_of_appeals in arnett ii in 126_tc_89 affd 473_f3d_790 7th cir we concluded our opinion with a continued iv conclusion accordingly for the reasons stated in arnett i arnett ii and herein we conclude that petitioners cannot exclude from gross_income wages earned during from working in antarctica to reflect the foregoing an appropriate order and decision will be entered continued citation of sec_863 suggesting that sec_863 provided an additional reason to rule against the taxpayer id pincite see also sec_863 providing that income earned in antarctica by a u_s_person is sourced in the united_states in arnett v commissioner f 3d pincite the u s court_of_appeals for the seventh circuit addressed sec_863 in greater detail stating at the outset we think that it is important to note that considering antarctica not to be a foreign_country is compatible with the general statutory scheme notably sec_911 is found under subtitle a chapter subchapter_n of the irc which is designated tax based on income from sources within or without the united_states part i of this subchapter entitled source_rules and other general rules relating to foreign_income deems any activity in antarctica to be space_or_ocean_activity in turn the united_states is designated the source country of income from such activity when earned by a citizen_of_the_united_states sec_863 although this provision does not provide a definitive answer as to whether antarctica is a foreign_country it supports the conclusion that sec_911 is not intended to apply to income earned for services provided in antarctica we take this opportunity to state our agreement with the court of appeals’ conclusion set forth above see also 450_us_1


department of the treasury internal_revenue_service washington d c of f i c e of c h i e f c ou n s e l date number release date cc ita postf-144166-01 uilc internal_revenue_service national_office field_service_advice memorandum for associate area_counsel phoenix lmsb nr area from associate chief_counsel income_tax and accounting cc ita subject accounting for maintenance reserves this chief_counsel_advice responds to your memorandum dated date in accordance with sec_6110 this chief_counsel_advice should not be cited as precedent legend a b c equipment equipment x date a b c d e issue whether the transferred accumulated maintenance reserves described in the below purchase transaction constitute income to a under a’s established method_of_accounting for maintenance reserves conclusion a’s treatment of the transferred accumulated maintenance reserves described in the below purchase transaction1 constitutes an unauthorized change in a’s method_of_accounting for maintenance reserves the purchase transaction increased a’s maintenance reserve liability by dollar_figuree under a’s existing method_of_accounting this increase should have been recognized as taxable_income by a facts a is in the business of leasing equipment in a typical transaction a receives monthly rental payments under the lease a also receives an additional_amount from the lessee described in the leases as supplemental rent or maintenance reserves which is based on usage of equipment and certain specific maintenance categories the maintenance reserves increase monthly and are held by a for the lessee generally as the lessee makes expenditures_for required or scheduled maintenance of equipment a will reimburse lessee with funds from the maintenance reserve for the amount of the expenditure for book purposes a has historically debited cash and credited equipment maintenance reserves upon receiving supplemental rent or maintenance reserve sec_1 although a may have entered into numerous leases and or purchases of equipment with terms similar to those in the specific transaction addressed here our conclusion reflects only the specific purchase agreement with b and should be limited to that transaction it should not be used for or treated as a determination with respect to any of a’s other transactions your office has also asked whether a basis_adjustment in equipment x is warranted if the transferred accumulated maintenance reserves do not constitute income to a because this office concludes that under a’s existing method_of_accounting the dollar_figuree increase in a’s maintenance reserve liability should have been recognized as taxable_income by a we do not reach this basis question from a lessee upon payment or reimbursement to the lessee for required maintenance a has debited equipment maintenance reserves and credited cash for income_tax purposes a has historically recorded a schedule m adjustment which included all maintenance reserves received from lessees during the tax_year in its income a has generally treated disbursements of such reserves as current period deductions or capital expenditures a generally acquires its equipment by purchasing used equipment from sellers the equipment is usually under lease from the seller to a third party lessee at the time it is purchased by a consequently a purchases the equipment subject_to the lease to the third party these leases generally include maintenance reserve provisions similar to those described above consequently a’s purchase transactions include either a transfer from the seller to a of the amount of the accumulated maintenance reserve for the equipment that is the amount by which the maintenance reserves received by the seller from the lessee up to the date of sale exceed the cost of repairs and maintenance covered by such reserves or a credit against the purchase_price equal to the amount of the accumulated maintenance reserve your submission requests field_service_advice concerning the accumulated maintenance reserves in the following specific transaction in date a purchased equipment x from b at the time equipment x was subject_to a lease from b to c which required c as lessee at its own cost and expense to service repair maintain overhaul test or cause the same to be done to the equipment x in addition c was responsible under the lease for all routine and non-routine services checks and inspections to ensure that adequate funds would be available to cover the lessee’s maintenance and repair responsibilities the lease established a maintenance reserve to which c paid to b an additional_amount each month based upon the actual usage of equipment x when c performs or causes a third party to perform for example if at the time of sale to a the seller lessor had received a total of dollar_figure in maintenance reserves from the lessee under a lease for equipment and had disbursed dollar_figure of these reserves for covered repairs the difference of dollar_figure would be considered the accumulated maintenance reserves this dollar_figure amount would be transferred with the equipment to a as buyer either as a credit against the purchase_price of equipment or in the form of a separate check this dollar_figure plus subsequent monthly payments of maintenance reserves by the lessee to a as the successor lessor would then be held by a and ultimately disbursed by a as the purchased equipment received covered repairs and maintenance covered maintenance as defined in the lease c would submit documentation to b regarding such maintenance b as lessor would then pay c the cost of the covered maintenance from its accumulated maintenance reserve under the lease any amounts paid to the lessor as maintenance reserves which were not used to reimburse the lessee for covered maintenance would be returned to c at the end of the lease with all accrued interest a’s purchase agreement with b for equipment x provided for a purchase_price of dollar_figurea plus transaction costs of dollar_figureb a received certain credits against the purchase_price including a credit of dollar_figurec which is the sum of a dollar_figured security deposit and dollar_figuree of accumulated maintenance reserves plus accumulated interest as indicated above a acquired equipment x subject_to the terms of the lease to c contrary to its practice regarding maintenance reserves payments received monthly from other lessees under leases for other equipment a did not include in its income the dollar_figuree in accumulated maintenance reserves plus accumulated interest acquired by virtue of the credit against the purchase_price of equipment x instead a decreased its cost_basis in equipment x by dollar_figuree the amount of the accumulated maintenance reserves plus accumulated interest consistent with expenditures_for which it has received payments from the lessee or through a transfer from the seller a currently deducts all expenditures from the transferred maintenance reserves for which it took a basis_adjustment when due you have requested our analysis of whether under the facts provided in the submission a must use the same method_of_accounting for the accumulated maintenance reserves transferred in the purchase agreement with b as a has previously used for amounts received from its equipment lessees as supplemental rent or maintenance reserves law and analysis sec_446 of the internal_revenue_code provides that taxable_income shall be computed under the method_of_accounting on the basis of which the taxpayer regularly computes its income in keeping its books sec_446 provides that a taxpayer that changes the method_of_accounting on the basis of which it regularly computes its income in keeping its books shall before computing its taxable_income under the new method secure the consent of the commissioner sec_1_446-1 of the income_tax regulations provides in part that a change in method_of_accounting includes a change in the treatment of any material_item used in an overall plan of accounting for gross_income or deductions a material_item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction in determining whether a taxpayer’s accounting practice for an item involves timing generally the relevant question is whether the practice permanently changes the amount of the taxpayer’s lifetime income if the practice does not permanently affect the taxpayer’s lifetime income but does or could change the taxable_year in which the income is reported it involves timing and is therefore a method_of_accounting see revproc_91_31 1991_1_cb_566 revproc_97_27 1997_1_cb_680 the facts presented in the submission demonstrate that a has established a method_of_accounting for the item variously known as maintenance reserves or supplemental rent this item represents money held by a as lessor of equipment to secure the performance of required maintenance by the lessee in accounting terms the item is a liability of a to the lessee when the lessee pays maintenance reserves to the a the liability is increased credited and a recognizes taxable_income when a reimburses the lessee for required maintenance the liability is decreased debited and a treats the amount as a deduction or a capital_expenditure as appropriate a’s treatment of the accumulated maintenance reserves transferred in the purchase agreement with b constitutes an unauthorized change in its method_of_accounting for maintenance reserves the purchase increased a’s maintenance reserve liability by dollar_figuree under its existing method_of_accounting such increase should have been recognized as taxable_income by a a however failed to recognize taxable_income instead it reduced the basis of the acquired equipment x by the amount of the increase this novel accounting practice constitutes a change in method_of_accounting because it affects postpones only the time when income will be recognized and does not affect the amount of a’s lifetime income the absence of any cash inflow directly corresponding to the accumulated maintenance reserves transferred in the purchase agreement with b does not distinguish such reserves as a different item from the maintenance reserves resulting from supplemental rentals received by a from its other lessees in both cases a’s liability to pay for specified maintenance increased by a known amount as a result of valuable consideration received in one case the consideration was a purchase_price concession that reduced cash outflow in the other the consideration consisted of cash inflows both forms of consideration had the same net effect an increase in the a’s assets and a corresponding increase in its liability to lessees to pay for specified maintenance of leased equipment because a changed its method_of_accounting for maintenance reserves without obtaining the consent of the commissioner the examining agent may change a back to its former method_of_accounting for such item such change should be made in the taxable_year that a changed its method without consent or if that year is closed by the running of the period of limitations in the earliest open taxable_year the examining agent may impose such change even if a’s former method_of_accounting is impermissible and a’s new method_of_accounting is permissible see revproc_2002_18 sec_2 2002_13_irb_678 and citations therein case development hazards and other considerations in our view a will find it difficult to show that the transferred accumulated maintenance reserves are a different item for tax_accounting purposes such that it can adopt an accounting_method different from the method used for the other similar reserves the primary hazard is that a court could conclude that the maintenance reserves are not income to a and thus its accounting treatment for the maintenance reserves was an error rather than an accounting_method therefore a would not be bound to report the transferred accumulated maintenance reserves as income a may not want to make this argument because if the argument succeeds no deductions would be allowed for the amounts paid out of the reserve moreover if there is no change in accounting_method there will be no sec_481 adjustment to prevent the omission of the deductions this writing may contain privileged information any unauthorized disclosure of this writing may have an adverse effect on privileges such as the attorney client privilege if disclosure becomes necessary please contact this office for our views please call if you have any further questions heather maloy associate chief_counsel income_tax and accounting by william a jackson branch chief branch associate chief_counsel income_tax and accounting we express no opinion regarding the propriety of either method


department of the treasury int ernal revenue service washington d c o f f i c e o f c h i e f c o u n s e l date number release date cc intl br4 postn-159641-01 uilc internal_revenue_service national_office field_service_advice memorandum for chief_counsel lmsb heavy manufacturing transportation from michael frankel senior technician reviewer cc intl br4 subject in accordance with sec_6110 this chief_counsel_advice should not be cited as precedent field_service_advice is not binding on examination or appeals and is not a final case determination field_service_advice is chief_counsel_advice and is open to public inspection pursuant to the provisions of sec_6110 the provisions of sec_6110 require the service to remove taxpayer identifying information and provide the taxpayer with notice of intention to disclose before it is made available for public inspection sec_6110 and i sec_6110 also authorizes the service to delete information from field_service_advice that is protected from disclosure under u s c sec_552 and c before the document is provided to the taxpayer with notice of intention to disclose only the national_office function issuing the field_service_advice is authorized to make such deletions and to make the redacted document available for public inspection accordingly the examination appeals or counsel recipient of this document may not provide a copy of this unredacted document to the taxpayer or its representative the recipient of this document may share this unredacted document only with those persons whose official tax_administration duties with respect to the case and the issues discussed in the document require inspection or disclosure of the field_service_advice legend taxpayer x1 x2 x3 x4 y1 y2 postn-159641-01 y3 y4 pr sec_1 pr sec_2 y5 y6 y7 y8 y9 y10 y11 pr sec_3 pr sec_4 pr sec_5 z1 z2 z3 z4 z5 z6 z7 fc1 fc2 property a property b property c type i type ii year year year year article z act1 cite1 cite2 cite3 cite4 cite5 cite6 cite7 cite8 cite9 cite10 cite11 opinion a postn-159641-01 opinion b claim1 claim2 claim3 sharing company receiving company group1 issues there are two issues addressed in this memorandum first whether y8 qualifies as a dual_resident_corporation second whether the taxpayer has provided sufficient information to prove that the losses of its other entities meet the exception to the definition of a dual_consolidated_loss under sec_1_1503-2 conclusions we believe that y8 may not be a dual_resident_corporation however you may wish to consider whether its activities in fc1 are sufficient to meet the definition of a foreign_branch if it is a foreign_branch then it is treated like a dual_resident_corporation we also believe that the taxpayer has apparently failed to meet its heavy burden to show that the losses of its other entities meet the exception to the definition of a dual_consolidated_loss in order to meet this burden the taxpayer must provide a well reasoned and well supported analysis that supports its claim that both parts of the exception in sec_1_1503-2 are met for each entity the opinions the taxpayer submitted to support its claim do not appear to meet this test background the taxpayer is presently under examination for its year and year tax years it is the common parent of an affiliated_group of companies that files a consolidated_return one of the issues in the audit concerns the application of sec_1503 to losses from foreign activities incurred by various subsidiaries of the taxpayer and used to offset the taxpayer’s consolidated income after the examiner raised that issue the taxpayer submitted a request to the national_office for an extension to file agreements as described under sec_1_1503-2 that would allow use of these losses while this request was under review the taxpayer also took the position that one of the entities involved was not a dual_resident_corporation and that the others did not have dual consolidated losses the taxpayer was advised that it must represent that the entities were dual resident corporations and that those entities had dual consolidated losses in order to receive the extension to file the agreements at that point the taxpayer withdrew its request for the extension for all but three of the entities as to the extension request for those remaining three entities that was dealt with separately and therefore is not the subject of this memorandum this memorandum reviews the taxpayer’s arguments with regard to the withdrawn entities and suggests additional information that the taxpayer may need to provide to support those arguments postn-159641-01 facts the taxpayer owns all of the interests in x1 x1 owns all of the interests in x2 all three are domestic corporations x2 owns all of the interests in x3 and x4 both x3 and x4 are domestic corporations fc1 entities x2 owns all of the interests in y1 y2 y3 and y4 these are all domestic corporations y1 and y2 each own a percent interest in pr sec_1 y3 and y4 each own a percent interest in pr sec_2 both pr sec_1 and pr sec_2 are fc1 corporations that are treated as partnerships for u s federal_income_tax purposes x3 owns all of the interests in y5 y6 y7 and y8 all of these are domestic corporations x4 owns all the interests in y9 y10 and y11 y5 and y9 each own a percent interest in pr sec_3 y6 and y10 each own a percent interest in pr sec_4 and y7 and y11 each own a percent interest in pr sec_5 pr sec_3 pr sec_5 and pr sec_4 are all fc1 corporations that are treated as partnerships for u s federal_income_tax purposes pr sec_1 pr sec_2 pr sec_3 pr sec_4 and pr sec_5 each owns land in fc1 that it net leases to unrelated third parties y8 provided a loan to an unrelated fc1 corporation fc2 entities x4 owns all of the interests in z1 z2 z3 and z4 all domestic corporations x3 owns all the interests in z5 z6 and z7 all domestic corporations z1 owns all of the interests in a_trust settled in the united_states that owns property a in fc2 that it net leases to an unrelated third party z5 is structured like z1 z7 z2 and z3 each owns a partial interest six percent four percent and two percent respectively of a_trust settled in the united_states that was created to own and net_lease_property b located in fc2 to a party unrelated to either z7 z2 or z3 z6 owns all the interest of a_trust settled in the united_states that owns property c in fc2 that it net leases to an unrelated_person z4 is structured like z6 dual_resident_corporation issue law and analysis the taxpayer contends that y8 is not a dual_resident_corporation and therefore is not subject_to the dual_consolidated_loss limitations y8 is a domestic_corporation that is not managed or controlled in fc1 its only activity is a loan to an unrelated fc1 corporation a dual_resident_corporation is a domestic_corporation that is subject_to the income_tax of a foreign_country on its worldwide income or on a residence basis treas reg postn-159641-01 c a corporation is taxed on a residence basis if it is taxed as a resident under the laws of a foreign_country id a corporation is resident in fc1 if it is either incorporated there see cite1 or it is centrally managed and controlled from fc1 see cite2 management and control is determined by where the board habitually meets and decides matters of fundamental policy id the taxpayer has represented that y8 was not incorporated in fc1 and that all board meetings and decisions for the company were conducted in the united_states if this is correct then we understand that the taxpayer is not a resident of fc1 for purposes of fc1 corporate_income_tax the taxpayer has also represented that y8 is not taxed by fc1 on its worldwide income in that case since y8 is apparently not a resident of fc1 nor is it taxed on its worldwide income in fc1 it is not a dual_resident_corporation under the test of sec_1_1503-2 however if the company is a separate_unit then it is treated like a dual_resident_corporation sec_1_1503-2 a separate_unit is a foreign_branch an interest in a_trust or partnership or a hybrid_entity_separate_unit id only the foreign_branch separate_unit might apply in this case a foreign_branch is an integral business operation carried on by a u_s_person outside the united_states sec_1_367_a_-6t this is a facts_and_circumstances_test id factors indicating a branch include the existence of a separate set of books_and_records and the existence of an office or other fixed place of business used by officers or other employees of the u_s_person in carrying out its activities outside the united_states the taxpayer has represented that y8 has no offices or employees in fc1 and that the only connection with fc1 is that it has provided financing to an unrelated fc1 corporation through preference shares and a loan fc1 does not treat y8 as a resident nor tax it on its worldwide income thus there are no factors that make it immediately apparent that there is a branch however we have not reviewed all the details of y8’s activities and therefore we cannot determine if there was enough activity related to the loan to create a branch you may wish to explore the facts surrounding the activities of y8 with regard to this financing_arrangement to determine whether the activities are enough to meet the definition of a branch if these activities constitute a branch then the branch is a separate_unit and thus treated like a dual_resident_corporation an activity is also considered a branch if it constitutes a permanent_establishment under the tax_treaty the united_states has with that foreign_country id we note though that it appears y8 is not a permanent_establishment in fc1 article z of the tax_treaty between the united_states and fc1 defines a permanent_establishment as a fixed place of business through which the business of an enterprise is wholly or partly carried on since the company apparently has no offices no employees and no other connection to fc1 except for the financing it provided it does not appear to meet the definition of a permanent_establishment postn-159641-01 exception to the definition of dual_consolidated_loss a background the taxpayer concedes that its other entities are dual resident corporations or are treated as dual resident corporations under sec_1_1503-2 the general_rule is that a dual_consolidated_loss of a dual_resident_corporation may not be used to offset the income of any member of the affiliated_group sec_1503 sec_1_1503-2 a dual_consolidated_loss is the net_operating_loss of a domestic_corporation incurred in a year in which the corporation is a dual_resident_corporation sec_1_1503-2 thus without an exception the taxpayer could not claim the losses of these entities on its consolidated federal_income_tax return there are two exceptions to the rule denying use of a consolidated loss the first allows the use of the dual_consolidated_loss where there is an agreement in place between the united_states and the foreign_country that puts into place an elective procedure in which the losses may only offset income in only one country sec_1_1503-2 to date the united_states has not entered into any such agreement with any foreign_country the other exception permits use of the losses if an election is made by the consolidated_group agreeing not to use the loss to offset the income of any other person the taxpayer did not make this election for any of these entities and has withdrawn its request for an extension to make the election thus neither exception to the general_rule applies there is however also an exception to the definition of a dual_consolidated_loss if this exception is met then there is no dual_consolidated_loss and the thus the general_rule preventing use of a dual_consolidated_loss will not apply this is the exception upon which the taxpayer is relying to justify its use of the losses in order to qualify for this exception two tests must be met a stand alone test and a carry over test the stand alone test is met if the income_tax laws of the foreign_country do not permit the dual_resident_corporation to use its losses expenses or deductions to offset the income of any other person that is recognized in the same taxable_year in which the losses expenses or deductions are incurred sec_1_1503-2 the carry over test is met if the tax laws of the foreign_country do not permit the losses expenses or deductions of the dual_resident_corporation to be carried over or back to be used by any means to offset the income of any other person in other taxable years sec_1_1503-2 because most countries provide for loss_carryovers in at least some circumstances the carry-over test is rarely met see t d 1992_2_cb_240 the taxpayer must satisfy both tests in order to meet the exception to the definition of a dual_consolidated_loss the burden is on the taxpayer to prove that these tests are met it is a difficult burden to overcome that difficulty arises because the taxpayer must prove a negative that is the taxpayer must show that it cannot use the losses expenses or deductions by any means to offset the income of another person under the tax laws of a foreign_country thus the taxpayer must be able to address every conceivable means by which the losses might be used for example under the carry over test if the taxpayer is able postn-159641-01 to share its losses deductions or expenses through a reorganization liquidation sale_or_other_disposition the taxpayer fails the test and the loss is a dual_consolidated_loss furthermore if the taxpayer is able to share the losses in a partnership arrangement by using allocations of income and expenses that differ between federal_income_tax law and the foreign tax law the carry over test is not satisfied these examples are not exhaustive they merely illustrate some of the transactions in which losses might be shared the taxpayer cannot show that it meets these tests merely by stating conclusions rather we believe that the taxpayer must present a well reasoned analysis that cites the specific foreign tax laws upon which it relies together with other substantial_authority that may exist and applies those laws to the particular facts of the dual_resident_corporation a well reasoned opinion from tax counsel in the foreign_country may be useful if it meets this standard while the credentials of the expert preparing the opinion may make some difference in the weight given to the opinion an impressive curriculm vitae will not suffice to make conclusory statements persuasive enough to meet the taxpayer’s burden it is the substance of the opinion that is really important b fc1 entities pr sec_1 pr sec_2 pr sec_3 pr sec_5 and pr sec_4 are all fc1 corporations that are treated as partnerships for federal_income_tax purposes they are therefore hybrid_entity separate units sec_1_1503-2 as a result they are treated like a dual_resident_corporation sec_1_1503-2 the taxpayer concedes that these entities are treated as dual resident corporations it contends however that these entities do not have dual consolidated losses because they meet the exception to the definition under sec_1_1503-2 fc1 tax law1allows corporations to share losses through claim1 cite3 there are two types of claim1 a claim2 and a claim3 the company giving up the loss is the sharing company and the company receiving the loss is the receiving company during the years at issue both the sharing company and the receiving company were required to be fc1 companies cite4 for claim2 two companies are members of the same group and thus eligible to share losses if one is the percent subsidiary of the other or both are percent subsidiaries of a third company cite5 for claim3 either the sharing company or the receiving company must be a member of group1 and the other company must be a trading company which is owned by group1 and which is not the percent subsidiary of any company or this discussion of fc1 law is cursory and for general information purposes only it does not represent a definite conclusion by our office of the effect of fc1 tax provisions there may be other interpretations of the law by court cases or by the fc1 tax agency for example which may be pertinent postn-159641-01 a trading company which is a percent subsidiary of a holding_company a holding_company that is owned by group1 and that is not a percent owned by group1 or subsidiary of any company cite6 the taxpayer represents that during and pr sec_1 pr sec_2 pr sec_3 pr sec_4 nor pr sec_5 owned any interests in a subsidiary it also represents that each of these corporations only had u s_corporations as shareholders assuming these facts are correct then pr sec_1 pr sec_2 pr sec_3 pr sec_4 and pr sec_5 could not qualify for claim1 because they did not meet the requirements for either claim2 or claim3 as a result these entities appear to meet the stand alone test since they were not eligible for claim1 in year and year2 see sec_1_1503-2 however the taxpayer must also satisfy the carry-over test in order to meet the exception to the definition of a dual_consolidated_loss here the taxpayer has at this point failed to meet its difficult burden to prove it satisfies this test the taxpayer’s arguments for the carry over test are contained in an opinion a from tax counsel in fc1 the opinion notes that if a fc1 corporation has trading losses it is possible for those losses to be transferred to another company see for example cite7 which allows trading losses to be used in certain reorganizations thus if the losses are trading losses the carry over test is not met the opinion states that net leasing of real_estate is a type i activity this may be correct see cite8 it then makes the conclusion that a type i activity is not a trading activity as those are covered by type ii opinion a page notably type ii states it applies in six cases case i states that it applies in respect of any trade carried on in fc1 or elsewhere but not contained in type i cite9 emphasis added that seems to imply that a type i activity may include a trade thus because it lacks analysis we believe that opinion a does not support its conclusion that a type i activity cannot include a trade this problem could be solved if a definition of a trade was provided but opinion a does not do that either it simply points to cite10 which states that a trade includes a vocation or an office or employment it then states without support that a passive_activity like net leasing is too passive to constitute a vocation even if the opinion was able to support the statement that net leasing cannot constitute a vocation the definition simply says a trade includes a vocation but does not seem to exclude the possibility that other activities may also constitute a trade therefore you may wish to ask the taxpayer to provide further support for its claim that none of the losses used from pr sec_1 pr sec_2 pr sec_3 pr sec_4 and pr sec_5 included a trading loss note that if any part of the loss may be used to offset the income of another person then the entire loss is a dual_consolidated_loss even if the losses are not trading losses the taxpayer must establish that those losses cannot be used by any other person by any means under fc1 tax law the fc1 changed it tax laws in year it is now possible for claim1 to apply even if the corporations are owned by a foreign company postn-159641-01 opinion starts with the proposition that carried forward losses that may not be shared by way of claim1 with another company the opinion provides some support for that conclusion though only by general reference to an entire chapter of act1 therefore you may wish to ask the taxpayer for a more detailed analysis to support this contention there are other ways that losses might be shared other than directly via claim1 provisions opinion a attempts to address this problem by analyzing seven different circumstances in each of them it concludes that the losses cannot be shared with any other person under fc1 law however the analysis focuses only on those events as though they occur in some of the relevant provisions of act1 were amended in year it is important for the application of the exception to the dual_consolidated_loss definition to know whether it was possible for the losses to be shared under the law as it existed at the time the losses occurred therefore we believe the taxpayer must also analyze whether the losses could have been shared under the law as it was in year and year furthermore opinion a discusses only the direct use of the carried over losses it does not discuss indirect use of losses credits or deductions such as by basis carry over finally we note there may be other transactions not covered by the seven mentioned in the opinion by which losses might be shared you may wish to ask the taxpayer for additional information and analysis to address these shortcomings we note that fc1 has a provision that prevents some companies from sharing losses through claim1 if those losses may be used to offset the income of another person in another country cite11 this is known as mirror legislation because the concept is similar to sec_1503 if a company is subject_to mirror legislation it cannot use that as the basis for meeting the exception to the definition of a dual_consolidated_loss furthermore a company subject_to mirror legislation cannot make the election for the agreement under sec_1 g see sec_1 c iv thus it would be precluded from using the losses to offset the income of any other member of the consolidated_group since the taxpayer in this case has withdrawn its request for extension to make that agreement we do not need to consider whether the mirror legislation would apply to any of the taxpayer’s fc1 entities c fc2 entities z1 z5 z7 z2 z3 z6 and z4 are all domestic corporations that have interests in trusts with activity in fc2 these trust interests are separate units sec_1_1503-2 because the trust interests are separate units they are treated like dual resident corporations sec_1_1503-2 the taxpayer agrees with this result however the taxpayer contends that these interests meet the exception to the definition of a dual_consolidated_loss described in sec_1_1503-2 as a result the taxpayer states that it is not prohibited from claiming the losses from these interests against its consolidated income the opinion lists eight circumstances but two of them are actually duplicates postn-159641-01 the argument that the taxpayer makes to support that claim is that fc2 tax law4 treats the net leases as a loan arrangement as a result the taxpayer states that fc2 tax law does not tax these transactions and the trusts are therefore not recognized at all under fc2 tax provisions the taxpayer has submitted opinion b in support of it claims opinion b starts out with a general explanation of the fc2 tax system it states that there are two direct taxes imposed in fc2 an income_tax and a corporate_income_tax the former applies to individuals while the latter applies to corporations and other entities general partnerships are not taxed instead the partners account for their share of partnership items on their returns limited_partnerships are subject_to corporate tax resident corporate taxpayers are taxed on their worldwide income whereas non-residents are taxed only on specified items of fc2 source income whether a company is a resident for corporate tax purposes depends on all the facts and circumstances including the location of effective management the location of the head office and the location of the shareholder’s general meeting all of this is well supported by citation to the relevant provisions of fc2 law opinion b also states that a lease in which the property subject_to lease is considered for fc2 tax purposes as owned by the lessee is treated as though the lessor simply provided financing to the lessee known as a financial_lease leases in which the lessor is considered the owner for tax purposed are known as operating leases it implies that a financial_lease is not subject_to income_tax in fc2 though it does not provide any citations or analysis to support it assuming the taxpayer can provide you with support for this position the question then becomes whether under fc2 law the leases at issue are financial leases opinion b provides an agreement between the fc2 tax agency and an association of leasing companies that sets forth guidelines for establishing when a lease is an operational lease it also provides two letters that are apparently signed by fc2 tax officials that describe the leases in which z7 z2 z3 and z6 participate as financial leases the taxpayer claims that z4 is covered by the same letter as z6 because its lease is identical to z6 thus if the taxpayer can show that financial leases are not subject_to fc2 income_tax the trusts in which these entities participate would appear not to be taxable in fc2 they would as a result meet the stand alone test because these entities have no ability to use losses at all in fc2 in the years in which they were incurred opinion b does not however provide any analysis to show that the z1 and z5 leases are financial leases therefore we believe more analysis is needed in order to this discussion of fc2 law is cursory and for general information purposes only it does not represent a definite conclusion by our office of the effect of fc2 tax provisions there may be other interpretations of the law by court cases or by the fc2 tax agency for example which may be pertinent postn-159641-01 establish that these are financial leases if the taxpayer can provide that these two entities may also meet the stand alone test however z7 z2 z3 z6 z4 z1 and z5 must also meet the carryover test in order to meet the exception to the definition of dual consolidated losses opinion b attempts to meet this test by describing ten transactions and concluding that none of them would permit these entities to share their losses with another person under fc2 law it states that fc2 law requires a step up or step down in basis when effective management of a company is transferred to fc2 and provides case law as support unfortunately apart from that it provides no analysis or citation to law to back up the conclusions that these transactions would not permit another person to use the losses thus we believe opinion b appears not to meet the carry over test even if the taxpayer demonstrates that these ten transactions would not result in the ability of another person to use the loss we note that these transactions may not cover all the possible transactions in which losses might be shared thus the taxpayer must satisfy you that it meets this test this writing may contain privileged information any unauthorized disclosure of this writing may have an adverse effect on privileges such as the attorney client privilege if disclosure becomes necessary please contact this office for our views please contact our office at if you have any questions or need further assistance michael frankel senior technician reviewer by michael frankel senior technician reviewer office of associate chief_counsel international