Category: Tax

Top Five Traps for the Unwary in Spin-Offs

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A wave of corporate breakups has swept through the United States over the last few years as investors have taken notice of the fact that smaller companies focused on a single business tend to outperform their more diversified peers.  A primary vehicle for these breakups has been the spin-off transaction, in which a publicly traded parent company distributes the shares of the spin-off company (spinco) to its own shareholders, creating a new, independent publicly traded entity.  The New York Times, citing Dealogic, reported that there were 93 spin-off transactions worth $128 billion in 2011, and that 2012 kept pace with 85 spin-off transactions worth $109 billion.  The rationale for a spin-off often is to unlock the value in a business or division that is trapped in a larger corporate bureaucracy.  Conglomerates tend to spread capital across all of their divisions rather than focusing on the individual opportunities within each business that are the most promising.  Holding company structures also can make decision-making more cumbersome and equity incentives less incentivizing for division management who feel as though their hard work is being diluted by the underperformance of other divisions or businesses.

Spin-offs, however, are complicated transactions that require a great deal of advance planning.  In many cases, an announcement that a parent company is considering the spin-off of one of its businesses is actually the start of a “dual-track” process wherein the parent company considers and plans for a spin-off while also remaining open to potential bids from third parties to acquire the business.  In even more complicated cases, a parent company agrees to sell a business to an acquirer in connection with a spin-off transaction.

The vast majority of spin-off transactions are designed to qualify under the rules of the Internal Revenue Code as “tax free” to the parent company and the shareholders who receive the spinco stock.

With this in mind, any company considering spinning off a division or business should keep in mind the following five potential traps.

1.  Tax-Free Qualification – Legitimate Business Purpose 

The spin-off must satisfy a legitimate business purpose in order to qualify under both the tax-free rules of the Internal Revenue Code and the Securities Act of 1933.  The tax authorities require that the spin-off be motivated in whole or in substantial part by one or more legitimate corporate business purposes in order to ensure that the purpose of the transaction is not simply “tax avoidance.”  The business purpose requirement is one of many requirements under the tax laws to qualify for a tax-free spin-off.  Because the costs of triggering tax in a spin-off transaction often are very high, most parent companies obtain a legal opinion from outside counsel and obtain a ruling from the Internal Revenue Service as a condition to completing a spin-off transaction.  As discussed in relation to trap number five below, a legitimate business purpose for the spin-off also is required under the securities laws in order for the distribution of the spinco stock to not be treated as a “sale” of securities by the parent company or the spinco requiring Securities Act of 1933 registration and the strict liability standard of care that comes with such a registration.  See the article entitled, “Five Key Tax Considerations for Spin-Off Transactions” for a more in depth discussion of tax issues raised in spin-offs.

2.  Separation of Assets and Liabilities

Before a business or a division can be spun off, both its assets and its liabilities must be separated.  Large companies with long operating histories often find that the process of separating out the spinco business is not straightforward, because the legal entities that house the business might also house other businesses and divisions that share assets, services, products, employees, vendors and customers with the spinco business.  The pre-spin separation transactions should avoid triggering contractual defaults and remedies under commercial agreements, financing agreements, intellectual property licensing agreements, collective bargaining agreements, employment contracts, benefit plans, etc.  Often the spinco and the parent company or another legacy business must enter into complex sharing or licensing agreements or joint ventures relating to valuable intellectual property, such as trade names, trademarks or patents, as well as employee matters.  See the article entitled “Trademark, Domain Name and Other IP Considerations for Spin-Offs” for a more in depth discussion of IP issues raised in spin-offs and see the article entitled, “Employee Benefit Issues in a Spin-Off” for a more in depth discussion of employee benefit issues raised in spin-offs.

The sharing of liabilities is often the most complicated endeavour because of the slew of legal obligations that are triggered.  In allocating liabilities to the spinco, the parent company must evaluate the impact such allocation will have on the solvency of the parent and the spinco.  Parent company directors can face personal liability under state corporate law for making an unlawful dividend because the company lacked sufficient capital to make such a dividend or for rendering the parent company insolvent by distributing out the spinco business, and the parent company itself can face claims of constructive fraudulent conveyance—i.e., the parent company received less than equivalent value, and either the parent or spinco was rendered insolvent (assets do not exceed liabilities), the parent and/or spinco was left with unreasonably small capital to run its respective business, or the parent or spinco was left with debts that exceed its respective ability to pay those debts as they become due.  Parent company directors can rely on legal experts and financial advisors to assist them in satisfying their duty of care.  A solvency opinion from a nationally recognized provider of such opinions is often a condition to the consummation of a spin-off transaction.  Such an opinion may be helpful to the directors of the parent company and spinco for a variety of reasons: (i) it can help to show that the directors properly exercised their duty of care in determining to enter into the spin-off transaction; (ii) it can assist in rebutting a fraudulent conveyance claim; and (iii) it can assist in rebutting a claim that the company had insufficient capital to make such a dividend.

3.  Transition Services

While one of the key rationales for spinning off a business or division is to allow the enterprise to operate independently, the reality in most cases is that, at least during the first year or so post-spin, a spinco must rely on its former parent company to provide many key administrative and operational services during the spinco’s transition period to a self-sufficient, independent public company.  During the pre-spin planning period, companies should consider, among other things, which transition services will be required, how they will be provided, for how long and under what pricing terms.  Typical transition services include legal, internal auditing, logistics, procurement, quality assurance, distribution and marketing.  These arrangements often have durations that last between six and 24 months.  Many parent companies agree to provide such transition services purely on a cost basis, while others will use a “cost plus” or “market” rate.

4.  Spinco Management and Board of Directors

Again, while independence from the former parent company is a key benefit for most spincos, having corporate managers with institutional knowledge and history with the enterprise is an important factor in assisting the spinco to successfully transition to independence.  Many spinco management teams include members who have served as executives at the former parent company.  In many cases, these are managers who served as division leaders who reported to the parent company CEO or CFO and are now ready to step into executive roles on their own.  It is also common for between one and three members of the parent company board to agree to take seats on the spinco board to provide the new public company board with a source of the company’s history and culture to ensure a smooth transition.  However, because of the competing fiduciary duties that these directors will face if they hold seats on both the parent and spinco boards, it is important for the spinco board to also have a majority of truly independent directors.  Spinco directors who are former executive officers of the parent also must be aware that the stock exchanges and influential shareholder services firms such as Institutional Shareholder Services will not view them as being truly independent from a corporate governance standpoint for some time after the completion of the spin-off.  This will inhibit their ability to serve on key board committees of the spinco.

5.  Preparation of the Disclosure 

Under the U.S. Securities and Exchange Commission’s rules, a spin-off of the shares of a subsidiary to a parent company’s shareholders does not involve the sale of securities by either the parent company or the subsidiary as long as the following conditions are met: (i) the parent company does not provide consideration for the spun-off shares; (ii) the spin-off is pro rata to the parent company shareholders; (iii) the parent company provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets; and (iv) the parent has a valid business purpose for the spin-off.

To meet the adequate public information requirement, parent companies are required to prepare and disseminate detailed “information statements” that effectively look like initial public offering registration statements for the spinco.  These information statements are filed with the spinco’s Form 10 registration statement, which is required in order to register the spinco’s shares under the Securities Exchange Act of 1934 and to permit listing of such shares on a national securities exchange.  The preparation of the spinco information statement can take up to three or four months and requires a great deal of effort and cooperation among the lawyers, the business leaders, the finance department, the human resources/employee benefits department and the auditors.  In addition, under New York law, a spin-off of all or substantially all of a company’s assets may require a vote of such company’s shareholders, while under Delaware law, such a requirement is much less likely.

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Obama Administration Aims to Restrict Physician Self-Referrals for Certain In-Office Services in Proposed Budget

Barnes & Thornburg

In its recently unveiled budget proposal for fiscal year 2014, the Obama administration has proposed saving billions in federal expenditures by tightening restrictions on certain services for which physicians can self-refer patients and receive government payment.

Under current federal law, a physician cannot make a referral to an entity for the furnishing of “designated health services” payable by government-funded health programs, such as Medicare, if the physician has a financial relationship with the entity. Correspondingly, this law—the “Stark Law”—also prohibits the entity receiving the referral from submitting a claim for payment for such services. Several exceptions, however, punctuate these prohibitions, including the “in-office ancillary services” exception, which shields referrals within physician practice groups for designated health services that meet specified criteria regarding the individual who furnishes the services, the location where the individual furnishes the services, and the party that bills for the services.

In an overview of the President’s 2014 budget plan for health care spending, the U.S. Department of Health and Human Services (HHS) notes that there are “many appropriate uses” for the in-office ancillary services exception, which the agency describes as designed to allow physicians to “self-refer quick turnaround services.” But, the agency cautions, some physicians have relied on the exception for certain services, such as advanced imaging and outpatient therapy that “are rarely performed on the same day as the related office visit.” Additionally, HHS claims, evidence suggests that the exception may have spurred “overutilization and rapid growth” of these services.

In light of these findings, the Obama administration has recommended excluding radiation therapy, therapy services (such as physical therapy and occupational therapy), and advanced imaging (such as CT scans and MRIs) from the in-office ancillary exception to encourage “more appropriate use of select services,” as HHS explains in the health spending overview. Notably, however, the administration would not extend this exclusion to “cases where a practice meets certain accountability standards,” which the HHS Secretary would have the authority to define, presumably before the exclusion would take effect in calendar year 2015 as the administration intends. Amending the Stark Law exception in this fashion would yield $6.1 billion in federal savings over 10 years, according to the administration.

Providers of the in-office services identified by the Obama administration should follow closely to see if the administration’s suggested change to the Stark Law makes it into the final budget and, if so, how the HHS Secretary ultimately defines the “accountability standards” that could make the difference between staying within the boundaries of the law and falling outside of them.

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Far From Perfection: Individual Alternative Minimum Tax Is Still Alive

Southern Methodist University, SMU Dedman School of Law

Spring 2013 Law Student Legal Writing Contest Winner

 

Introduction

On January 2, 2013, President Barack Obama signed the American Taxpayer Relief Act of 2012 (“ATRA”).[1] ATRA § 104 provides for annual inflation adjustments for purposes of the alternative minimum tax (“AMT”).[2] The law also makes Bush tax cuts permanent.[3] This paper focuses on the influences of the AMT on the individual tax liability with the proposals on a more rational AMT or a progressive replacement for the AMT. After a historical and academic overview of the AMT in Part I, the paper introduces the reasons of changing the AMT in Part II as failure of its intended purposes and the general tax policies. By elaborating in Part III the evaluation of ATRA and addressing the possible future reforms including a more rational AMT or a repeal of the AMT, the paper concludes that ATRA solution for the AMT is not the end but another start for the future tax reform.

I. Overview Of The AMT

The individual income tax has consisted of two parallel tax systems: a regular tax and an alternative tax.[4] The current version of the alternative tax is the AMT that operates parallel to the regular tax and sets a floor on total tax liability.[5] Taxpayers whose income exceeds the AMT exemption must calculate both regular tax and AMT liabilities and pay the larger amount of the two.[6]

1.          The History Of The AMT

The original minimum tax in 1969 was to guarantee that high-income individuals paid at least a minimal amount of tax.[7] Prior to ATRA, the AMT required annual congressional actions to prevent it from expansion on more taxpayers because of its design flaws.[8] 20 historical legislations on individual minimum taxes preceded ATRA.[9] Those changes before ATRA included the rates, the exemption amounts, and the credits allowed against the tax, but the basic structure had remained unchanged.[10] Over time, the AMT has become more influential on middle-class taxpayers.[11] Before 2000, the AMT was less than 2 percent of individual income tax revenue and 1 percent of total revenue, and affected less than 1 percent of taxpayers, so it played a minor role in the tax system.[12] Since 2000, the AMT is exploding.[13] The number of taxpayers owing the AMT grew from about 20,000 in 1970 to roughly 4 million in 2011.[14]

2.          The Definition And Operation Of The AMT

The Black Law Dictionary defines the AMT as “A tax, often a flat rate, potentially imposed on corporations and higher-income individuals to ensure that those taxpayers do not avoid too much (or all) income-tax liability by legitimately using exclusions, deductions, and credits.”[15] The AMT is the addition to regular income taxes,[16] and its amount equals to the excess of the AMT liability over the regular tax liability after appropriate credits.[17] Taxpayers calculate their taxes under the tentative AMT and the regular tax, and pay the higher of the two.[18] The following table shows the general formula of calculating the tentative AMT.

Taxable Income For Regular Tax Purposes[19]
− Certain Exclusions, Deductions, And Credits Allowed In The Regular Tax[20]
− The AMT Exemption Amount[21]
× The AMT Rate[22]
− The AMT Foreign Tax Credit[23]
= The Tentative AMT

The Tentative AMT Calculation

3.          The Intended Purposes And Policies Of The AMT

Underlying goals of the AMT are requiring high-income taxpayer to pay some tax, deterring the aggressive use of tax shelters, and ensuring progressivity.[24] Being originally motivated by a simplified version of vertical equity,[25] the AMT’s simple mission was making all Americans pay tax regardless of their tax shelters and avoidance efforts.[26] Additionally, the AMT is a second-best backstop for a porous regular income tax system by reducing distortions and avoiding tax sheltering because Legislature cannot address directly some unwarranted tax shelters in the regular income tax system.[27] Moreover, the AMT should increase the tax system progressivity, which means average tax burdens increase with income-size classes in all years and ensure the vertical equity of the tax system.[28]

II. Why To Change

The AMT failed its purposes and had explosive expand to the middle-class taxpayers because it was not indexed for inflation and Bush tax cuts reduced regular income tax without a permanent AMT fix. Moreover, the AMT thwarted generally accepted tax polices such as equity and efficiency bymodifying regular income tax incentives, altering marginal tax rates, increasing complexity, and reducing transparency.

1.          Failure of Intended Purposes Of The AMT

The AMT fails its intended purposes because of its expansion. Before ATRA, two main factors were responsible for the explosive growth in the AMT since 2000: it was not indexed for inflation and Bush tax cuts reduced regular income tax without a permanent AMT fix.[29] Inflation is an important factor of the long-term AMT receipts, but the exemption amounts and the tax rate brackets in AMT were not indexed to automatically adjust and keep pace with inflation as the regular tax before ATRA.[30] Because taxpayers pay the higher of the tentative AMT and the regular tax, the different treatments between the two tax systems would push more taxpayers to the AMT. Additionally, Bush tax cuts reduced regular tax rates without changing the AMT, which would have resulted a dramatic increase in the projected future number of AMT taxpayers.[31] If Legislature had not made the temporary adjustments (“patches”) to the AMT, more returns would be subject to the AMT after Bush tax cuts.[32] However, the patches have only served to mask the underlying problems rather than a permanent solution.[33] ATRA makes Bush tax cuts permanent.[34]

Because of its expansion, the AMT failed its purposes of requiring high-income taxpayer to pay some tax, deterring the aggressive use of tax shelters, and ensuring progressivity for the following ways.[35]

Although Congress originally enacted the AMT to prevent high-income individuals from sheltering all of their income and paying no tax, its expansion gradually moves the types of the AMT taxpayers from higher-income to lower-income by encroaching on the middle class.[36] Because taxpayers would pay higher of the tentative AMT and the regular tax, the top statutory rate for regular income tax higher than the top statutory rate for the AMT would move high-income individuals without substantial sheltering to the regular tax system.[37]

Additionally, the AMT fails to impede some tax shelters. For example, the current AMT cannot stop the tax shelters by reporting capital gains, which could be deferred for years and faced a low statutory rate after recognition.[38] Under the different tax rate treatments between ordinary income and capital gain in the regular tax, an investment that would be a loss before tax when the income including capital gains was less than the expense, but the same investment could be profitable after tax because expenses were overstated for tax purposes and capital gains had lower tax rates.[39] The post-1987 AMT does not have different rate treatment between long-term capital gains and ordinary income as the regular tax, which leads high-income taxpayers report large amounts of capital gains and generally receive the same tax break under the AMT as under the regular income tax.[40]

Furthermore, progressivity of the tax system means average tax burdens increase with income-size classes in all years.[41] The contribution to the AMT from middle-class families was increasing significantly while the contribution to the AMT from high-income families was decreasing, so the AMT becomes less progressive over time,[42] which causes less vertical equity in the tax system.

2.          The AMT Thwarting Generally Accepted Tax Policies

The AMT thwarted generally accepted tax polices such as equity and efficiency bymodifying regular income tax incentives, altering marginal tax rates, increasing complexity, and reducing transparency

A.         Modifying Or Limiting Regular Income Tax Incentives[43]

For the horizontal equity, the AMT should reduce the variance of average effective tax rates among taxpayers with similar incomes.[44] However, the AMT differently affects taxpayers with similar incomes but different family circumstances or different state of residence.[45] The AMT disallows the deduction for state and local taxes, so it affects more taxpayers who live in the places with high state and local taxes.[46] Moreover, the AMT replaces the personal exemptions based on filing status and number of dependents in the regular tax with one single exemption solely based on filing status, so the AMT will not benefit larger families and marriage.[47] Additionally, the AMT has the exemption for married couples less than twice of that for singles[48] and has the same brackets regardless of filing status, so the AMT has more impact on married than unmarried.[49] Furthermore, the AMT requires higher percent of AGI as the threshold (10 percent) to deduct medical expenses than the regular tax (7.5 percent), and disallows the deduction for mortgage interest paid on secondary residences and interest paid on certain other mortgage debt,[50] which discourage the incentives to get medical treatments and purchase real property.

B.         Altering Marginal Tax Rates

Because Legislature cannot address directly some unwarranted tax shelters in the regular income tax system, the most plausible economic rationale for the AMT is that it is a second-best backstop for a porous regular income tax system by reducing distortions and avoiding tax sheltering.[51] However, because the AMT exempts a large share of income for many middle-class taxpayers and has the phase-out of the AMT exemption,[52] the AMT fails on the efficiency policy by taxing narrower base of income and imposing higher marginal rates than the regular income tax for the most AMT taxpayers.[53] Narrower base and higher marginal tax rates in AMT can decrease after-tax income, discourage work, and reduce economic efficiency.[54]

C.         Increasing Complexity And Reducing Transparency

The AMT can increase the complexity of the tax calculations and reduce the transparency of the tax system because it can affect people’s behavior, alter the distribution of taxes, and complicate the tax planning decisions.[55] Taxpayers need to complete AMT forms in addition to their regular income tax returns,[56] and keep two separate sets of books because of the different deferral preferences between the AMT and the regular income tax.[57] Most people filling out the AMT forms end up owing no additional taxes.[58] Using computer software[59] may lower the complexity of filings, but it will increase the out-of-pocket costs and decrease taxpayer’s intended incentives in the tax code.[60]

III. ATRA Solution: Not The End But Another Start

The increasing number of taxpayers in the AMT placed pressure to permanently restructure of the AMT.[61] In 2013, President Obama signed ATRA, § 104 of which provides for annual inflation adjustments for purposes of the AMT and makes Bush tax cuts permanent.[62] This part lays out the evaluation of ATRA and addresses the possible future reforms including a more rational AMT or the AMT abolishment.

1.          Evaluation Of ATRA Solution

This section assesses ATRA solution in the context of possible legislative options before its enactment, the insufficiency of the current solution, and the potential barriers for the future AMT reform.

A.         Legislative Options Before ATRA

The problems in the AMT placed pressure to permanently restructure of the AMT. Before the enactment of ATRA, the alternative options to repeal the AMT included repealing regular tax, indexing the AMT’s parameters for inflation, and allowing additional exemptions and deductions under the AMT.

(1)  The AMT Or The Regular Income Tax[63]

A debate exists on the elimination of the AMT or the regular income tax. Because ATRA indexes the AMT for inflation and makes Bush tax cuts permanent,[64] the AMT will affect 8 million households by 2020.[65] After the permanent extension of Bush tax cuts by the ATRA, repealing the AMT would reduce revenues by over $2.7 trillion between 2011 and 2022.[66] On the contrary, the advocates of regular tax state that the single AMT system would lead undesirable policy changes from current law.[67] By eliminating the regular tax, the differences between the AMT and the regular tax would alter the current distribution of the income tax, which would be especially detrimental against middle class.[68]

This paper would respectfully join the pro-regular-tax alignment. The statistical indicators of immense scope of the AMT are mostly based on the legislations before ATRA, so it must be subject to change after ATRA. Even assuring that the statistical changes after ATRA are small, it would be against the legislative logic to remove the regular tax and preserve the AMT because the regular tax is the foundation of the AMT calculation.[69] The approach of eliminating the regular tax is analogous to remove the tree trunk (the AMT) from the root (the regular tax) and expect the tree trunk to grow bigger and stronger. Additionally, simply eliminating the regular tax would sacrifice substantial revenues, impose marriage penalties, produce higher marginal tax rates, etc.[70] Admittedly, neither the AMT nor the regular tax is a perfect tax system. However, the regular tax has fewer defects than the AMT.[71] As the discussion in Part II, Section 2A, the AMT rejects the deduction of the state and local taxes; disallows exemptions for dependents; requires higher percent of AGI as the threshold to deduct medical expenses than the regular tax; and disallows the deduction for mortgage interest paid on secondary residences and interest paid on certain other mortgage debt. These defects do not exist in the regular tax. Moreover, Legislature would consider the cost-benefit to eliminate the regular tax. The cost of eliminating the regular tax would be the lost revenue from the regular tax and the cost of correcting the defects of the AMT. Assuming that the lost revenue from eliminating either the regular tax or the AMT would be close in number, the cost of improving the AMT will probably be higher than improving the regular tax because the regular tax has fewer defects than the AMT.[72]

(2) Rationale Of Congress On Choosing Inflation Index

Before the enactment of ATRA, Legislature could permanently limit the expansion of the AMT’s impact in a number of ways, such as indexing the AMT’s parameters for inflation; allowing additional exemptions and deductions under the AMT; and eliminating the AMT.[73] This part will not discuss the elimination of the regular tax as a legislative option for the reasons in the preceding section (1).

Permanently indexing the AMT’s parameters for inflation was a compelling candidate for AMT reform before ATRA. Even though the patches to the AMT exemptions can have similar effects as the inflation indexing, they create uncertainty for taxpayers and their financial decisions.[74] Additionally, allowing additional exemptions and deductions under the AMT would offset the erosion of the un-indexed AMT exemptions caused by inflation and would provide similar relief as indexing the AMT for inflation.[75] To provide some reliefs for AMT taxpayers, Legislature could allow state and local taxes deductions and dependent exemptions, lower the threshold of medical expense deduction, and loose the rules on interest deductions.Moreover, because the AMT did not fulfill its purposes or policies but became a de facto ATM machine for generating additional tax revenue from middle-class taxpayers,[76] the most comprehensive approach would simply eliminate the individual AMT, which will relief all taxpayers from the complexity and opacity of two parallel tax systems.[77] The following table gives the brief comparisons and contrasts for the three options.

                Consequences

 

 

Legislative Options

 Decreased Number Of AMT Taxpayer In 2010 After Adopting The Optional Reform 2010-2019 Lost Tax Revenue By Adopting The Optional Reform
Option 1: Indexing The AMT’s Parameters For Inflation 22 million[78] $450 billion[79]
Option 2: Allowing Additional Preferences Under The AMT 25 million[80] $530 billion[81]
Option 3: Eliminating The AMT 27 million[82] $620 billion[83]

Legislative Options And Their Consequences Before ATRA

The table above can show that indexing the AMT’s parameters for inflation was the cheapest option before ATRA among the three options. Moreover, either allowing additional preferences under the AMT or eliminating the AMT is more difficult and complex legislation procedures than indexing the AMT for inflation. Allowing additional preferences will have a lot of detailed changes for the current regular tax system. Additionally, the following Section 3 of the paper can show that eliminating the AMT will be a progressive procedure with the AMT indexing as the initial step. Furthermore, indexing the AMT for inflation will be the prerequisite of allowing additional preferences under the AMT because the preferences should be indexed for inflation.[84] So Congress made a right choice to have the AMT indexing for inflation in ATRA.

B.         Insufficiency Of ATRA Solution

The AMT actually affects taxpayers with similar incomes but different family circumstances or different state of residence differently, raising the variance of after-tax income.[85] After ATRA, the AMT still rejects the deduction of the state and local taxes; disallows exemptions for dependents; requires higher percent of AGI as the threshold to deduct medical expenses than the regular tax; and disallows the deduction for mortgage interest paid on secondary residences and interest paid on certain other mortgage debt. Moreover, ATRA does not eliminate the phase-out of the AMT exemption that leads additional marginal tax rates,[86] so most taxpayers still have higher marginal tax rates under the AMT than under the regular income tax.[87] Additionally, ATRA does not reduce complexity and increase transparency of the AMT. Taxpayers still need to complete AMT forms in addition to their regular income tax returns,[88] and keep two separate sets of books.[89] Furthermore, the AMT after ATRA still fails to impede some shelters, such as the ones involved with capital gains.[90] The future legislations after ATRA should change these defects or abolish the whole AMT.

C.         Barrier To AMT Reform After ATRA

A significant barrier to AMT reform has been the challenge of what to do about the lost revenues.[91] If the AMT reform would have no offsets, federal budget deficits would rise and the cost would be shifted to the future taxpayers.[92] Methods of offsetting the revenue loss from the AMT reform include broadening the base for the regular income tax or raising its rates, increasing revenues from other tax sources, and reducing spending.[93] Regular tax system would have to rise by a similar magnitude to offset the revenue loss, may eliminate various tax preferences, and could raise all or some of rates on capital gains, dividend income, etc.[94] However, if other tax increases or spending reductions would offset the resulting revenue losses, the AMT reform would benefit some taxpayers and disadvantage others.[95]

2.          Possibility Of Creating A More Rational AMT

The more rational AMT should “keep the baby but throw out the bathwater.”[96] If the AMT will remain, a more rational system should allow additional exemptions and deductions as the regular tax[97], and neutralize the potential federal deficit by increasing the AMT tax bracket[98] and eliminating the preferential rates for capital gains in regular tax.[99]

3.          Feasibility Of Repealing The AMT

If Legislature will repeal the AMT, it can be a progressive elimination.[100] The following flowchart illustrates the progressive procedure of the AMT elimination.

à

Indexing The AMT For Inflation

Step 1

(Completed)

à

Allowing Dependent Personal Exemptions

Step 2

à

Repealing The Phase-out And Allowing Same Deductions As Regular Tax

Step 3

à

Deleting Deferral Preferences

Step 4

à

 NO AMT

AMT

The Flowchart On The AMT Progressive Elimination

ATRA has already finished Step 1.[101]  Step 2 can remove almost the entire middle class from the AMT.[102] Step 3 will eliminate the major different tax preferences between the AMT and the regular tax and end the AMT except for high-income taxpayers.[103] Step 4 will significantly increase the number of high-income taxpayers who pay no income tax because deferral preferences have a greater tendency to affect high-income taxpayers.[104]

Two reasonable methods can offset the revenue loss after the AMT progressive elimination. First, after the AMT deletion, Legislature can impose an add-on tax.[105] However, this option is actually back to the origin of the AMT,[106] and will have the possibility to repeat some AMT mistakes in future. Second, changing the regular income tax can reduce some federal deficits.[107] Some AMT provisions, which are preventing investment activities to avoid the regular income tax,[108] should be incorporated into the regular income tax after repealing the AMT.[109] But the legislation of such incorporations may not be easy because the AMT was created to backstop the unwarranted tax shelters that Legislature could not address directly for some reasons in the first place.[110] Additionally, Legislature can raise some or all of the regular income tax rates, including tax rates on capital gains and dividend income,to compensate the lost revenue after the termination of the AMT.[111] Moreover, the AMT elimination can pair with the abolishment of various regular tax preference, such as state and local tax deduction to reduce the federal deficits.[112]

Conclusion

The individual AMT operates parallel to the regular income tax by defining income differently, imposing different tax rates, and allowing different tax preferences. Ideally, the most comprehensive approach should be reforming the income tax to eliminate the AMT. But considering the reality under the huge pressure of potential federal revenue loss, Legislature chose the AMT indexing for inflation in ATRA. As Republican Senator Orrin Hatch of Utah told ABC News, “Far from perfect, this legislation does include a permanent fix to the ever-growing the AMT, giving millions of hard-working, middle-class families certainty that the nightmare of this tax has finally come to an end.”[113] As long as the individual AMT exists, the future tax reform is still foreseeable.

[1]126 Stat 2313 (2013).

[2]Id.

[3]Luke Landes, Fiscal Cliff Bill Passes: American Taxpayer Relief Act of 2012 (H.R. 8), http://www.consumerismcommentary.com/fiscal-cliff-bill-american-taxpayer… (last visited April 1, 2013).

[4]Congressional Budget Office, Economic and Budget Issue Brief: The Individual Alternative Minimum Tax, 1 (2010); Katherine Lim & Jeff Rohaly, The Individual Alternative Minimum Tax: Historical Data and Projections, Urban-Brookings Tax Policy Center, 1, 3 (2009).

[5]Id.

[6]Congressional Budget Office, supra note 4, at 2; I.R.S., supra note 7 (“Thus, the AMT is owed only if the tentative minimum tax is greater than the regular tax.”);Burman et al., supra note 7, at 1.

[7]I.R.S. Topic 556 – Alternative Minimum Tax, http://www.irs.gov/taxtopics/tc556.html (last visited April 1, 2013); Lim & Rohaly, supra note 4, at3; Leonard E. Burman et al., The Individual Alternative Minimum Tax (AMT): 12 Facts and Projections, Urban-Brookings Tax Policy Center, 1 (2008).

[8]Lim & Rohaly, supra note 4, at3.

[9]Leonard E. Burman et al., Historical Features of Individual Minimum Taxes, Urban-Brookings Tax Policy Center, 1, 2 (2011).

[10]Greg Leiserson & Jeff Rohaly, What Is Responsible for the Growth of the AMT?, Urban-Brookings Tax Policy Center, 1 (2007).

[11]Burman et al., supra note 9, at 1.

[12]The Joint Committee on Taxation, Present Law and Background Relating to the Individual Alternative Minimum Tax, JCX-10-07 (2007); Lim & Rohaly, supra note 4, at5-7.

[13]Burman et al., supra note 7, at 1.

[14]Aggregate AMT Projections 2011-2022, Urban-Brookings Tax Policy Center (2011).

[15]Black’s Law Dictionary, 1, 1594 (9th ed. 2009) (under the definition of “Tax”).

[16]1 MertensLaw of Fed.Income Tax’n§ 4:39 (“The alternative minimum tax is a tax upon income.”).

[17]Congressional Budget Office, supra note 4, at 2.

[18]Id. at 2; I.R.S., supra note 7;Burman et al., supra note 7, at 1.

[19]Lim & Rohaly, supra note 4, at3.

[20]I.R.S., supra note 7.

[21]I.R.S., supra note 7 (stating that the AMT exemption amount is set by law).

[22]Id. (stating that AMT rate is set by law and the rates in effect for the regular tax are used for capital gains and certain dividends).

[23]I.R.C. § 59; Leonard E. Burman & David Weiner, Suppose They Took the AM Out of the AMT?,Urban-Brookings Tax Policy Center, 1, 6 (2007) (“After determining pre-credit tentative AMT liability above, taxpayers subtract foreign tax credits (FTC) to calculate tentative AMT liability.”).

[24]Lim & Rohaly, supra note 4, at6.

[25]Leonard E. Burman et al., The Expanding Reach of the Individual Alternative Minimum Tax, Urban-Brookings Tax Policy Center, 1, 7 (2005).

[26]2005 Report of the President’s Advisory Panel on Federal Tax Reform, Chapter Five-Seven, supra note 26, at 86.

[27]Burman et al., supra note 25, at 8 (“For example, by taxing interest income from bonds that state and local governments issue to support private activities like shopping centers or stadiums, income that is exempt from the regular income tax, the AMT reduces the subsidy afforded such investments.”).

[28]Tom Petska & Mike Strudler, Income, Taxes, And Tax Progressivity: An Examination Of Recent Trends In The Distribution Of Individual Income And Taxes, Statistics of Income Division, I.R.S., http://www.irs.gov/pub/irs-soi/indincdi.pdf (last visited April 1, 2013).

[29]Lim & Rohaly, supra note 4, at3; Burman et al., supra note 7, at 2; Leiserson & Rohaly, supra note 10, at 1.

[30]Congressional Budget Office, supra note 4, at 1.

[31]Leiserson & Rohaly, supra note 10, at 3; Gabriel Aitsebaomo, The Individual Alternative Minimum Tax and the Intersection of the Bush Tax Cuts: A Proposal for Permanent Reform, 23 Akron Tax J. 109, 134 (2008).

[32]Congressional Budget Office, supra note 4, at 1.

[33]Leiserson & Rohaly, supra note 10, at 3.

[34]Landes, supranote 3.

[35]Burman et al., supra note 25, at 11.

[36]Congressional Budget Office, supra note 4, at 5-7; Lim & Rohaly, supra note 4, at6; Burman et al., supra note 7, at 2.

[37]Lim & Rohaly, supra note 4, at6.

[38]Burman et al., supra note 25, at 9.

[39]Burman et al., supra note 25, at 9 (2005).

[40]Lim & Rohaly, supra note 4, at6, n.10.

[41]Petska & Strudler, supra note 28.

[42]Burman et al., supra note 25, at 7.

[43]Congressional Budget Office, supra note 4, at 7.

[44]Burman et al., supra note 25, at 7.

[45]Id. at 7-8.

[46]Burman et al., supra note 7, at 2.

[47]I.R.C. §§ 55, 56, 151; Burman et al., supra note 7, at 2.

[48]I.R.C. §§ 55(d)(1), 56; Rev. Proc. 2013-15, 2013-5 I.R.B. 444.

[49]Lim & Rohaly, supra note 4, at7.

[50]I.R.C. §§ 55, 56, 163, 213; Congressional Budget Office, supra note 4, at 8.

[51]Burman et al., supra note 25, at 8.

[52]Lim & Rohaly, supra note 4, at8-9.

[53]Lim & Rohaly, supra note 4, at10.

[54]Burman et al., supra note 7, at 2 (“Marginal tax rates affect the incentive to work, save, and comply with the tax system.”); Congressional Budget Office, supra note 4, at 7-8 (“The AMT can subject taxpayers to higher marginal tax rates—which, in turn, influence decisions about how much to work and save, potentially reducing economic efficiency.”).

[55]Congressional Budget Office, supra note 4, at 7.

[56]Id. at 8.

[57]Burman et al., supra note 25, at 11.

[58]Burman et al., supra note 7, at 2; Burman et al., supra note 25, at 11.

[59]See, e.g.,I.R.S., supra note 7 (“If you are filing the Form 1040, you may use the AMT Assistant for Individuals, which is an electronic version of the AMT worksheet available on the IRS website.”).

[60]Congressional Budget Office, supra note 4, at 9.

[61]Congressional Budget Office, supra note 4, at 3.

[62]126 Stat 2313 (2013); Landes, supranote 3.

[63]Burman & Weiner, supra note 23, at Table 2 (listing the regular tax and the AMT provisions for comparison and contrast).

[64]126 Stat 2313 (2013); Landes, supranote 3.

[65]Lim & Rohaly, supra note 4, at6.

[66]Urban-Brookings Tax Policy Center, supra note 14.

[67]2005 Report of the President’s Advisory Panel on Federal Tax Reform, Chapter Five-Seven, supra note 26, at 87.

[68]Burman et al., supra note 7, at 2 (“The AMT is encroaching on the middle class.”);2005 Report of the President’s Advisory Panel on Federal Tax Reform, Chapter Five-Seven, supra note 26, at 87 (“Relative to the current system, many middle-income taxpayers would face higher marginal tax rates, while lower- and very high-income taxpayers would face lower marginal tax rates.”).

[69]I.R.S., supra note 7 (“The AMT is the excess of the tentative minimum tax over the regular tax.”); Congressional Budget Office, supra note 4, at 2 (stating that the AMT is the addition to regular income taxes, and its amount equals to the excess of the AMT liability over the regular tax liability after appropriate credits).

[70]Burman & Weiner, supra note 23, at 17.

[71]2005 Report of the President’s Advisory Panel on Federal Tax Reform, Chapter Five-Seven, supra note 26, at 87.

[72]Id.

[73]Congressional Budget Office, supra note 4, at 9.

[74]Id. at 10.

[75]Congressional Budget Office, supra note 4, at 10.

[76]Aitsebaomo, supra note 31, at 141.

[77]2005 Report of the President’s Advisory Panel on Federal Tax Reform, Chapter Five-Seven, supra note 26, at 85-87.

[78]Congressional Budget Office, supra note 4, at 10 (“If the exemption amounts in effect for 2009 were made permanent and indexed for inflation after 2009, along with the AMT’s brackets and the threshold at which the exemption phased out, 5 million taxpayers would pay the AMT in 2010—rather than the 27 million projected to pay under current law—and revenues would be about $450 billion lower from 2010 to 2019 than they would be otherwise.”).

[79]Id.

[80]Id. (In January of 2010, The CBO estimates that this option would decrease the number of people affected by the AMT from 27 million to 2 million in 2010).

[81]Id.

[82]Lim & Rohaly, supra note 4, at3 (“Absent another temporary fix or other change in law, the tax cuts and lack of indexation will combine to push more than 27 million taxpayers onto the AMT in 2010.”).

[83]Congressional Budget Office, supra note 4, at 10 (The CBO estimating a revenue cost of more than $620 billion from 2010 to 2019 for the AMT elimination). See also Urban-Brookings Tax Policy Center, supra note 14(showing that the cost of repealing the AMT would be over $2.7 trillion between 2011 and 2022 after the permanent extension of Bush tax cuts by the ATRA).

[84]Id. (“To provide some relief to taxpayers, lawmakers could allow them to use the standard deduction, personal exemptions, and deductions for state and local taxes (as they are used under the regular tax) when computing their tax liability under the AMT. The standard deduction and personal exemptions are both indexed for inflation, and state and local taxes also generally rise with prices.”).

[85]Burman et al., supra note 25, at 7-8.

[86]I.R.C. §§ 55(d)(1), 56; Rev. Proc. 2013-15, 2013-5 I.R.B. 444; 2005 Report of the President’s Advisory Panel on Federal Tax Reform, Chapter Five-Seven, supra note 26, at 87 (“The phase-out of the AMT exemption at higher income levels actually creates two additional marginal tax rates – and a resulting tax rate schedule of 26, 32.5, 35, and 28 percent.”).

[87]Congressional Budget Office, supra note 4, at 8.

[88]Id.

[89]Burman et al., supra note 25, at 11.

[90]Lim & Rohaly, supra note 4, at6, n.10.

[91]Burman et al., supra note 7, at 3 (“Paying for reform or repeal is a key issue”).

[92]Congressional Budget Office, supra note 4, at 1.

[93]Id. at 9.

[94]Id.

[95]Id. at 1.

[96]Burman et al., supra note 25, at 11.

[97]Aitsebaomo, supra note 31, at 139 (“Given that the major pitfall of the AMT is its increasing proliferation into the unintended returns of middle and upper middle class taxpayers, a permanent remedy to this unintended spread should be to exempt taxpayers with AGI of $250,000 or less from the AMT altogether. The implementation of such exemption would help align the AMT closer to its original purpose and policy objective of ensuring that wealthy individuals (not middle and upper middle class taxpayers) would be subject to the AMT.”); Burman et al., supra note 25, at 13.

[98]Burman et al., supra note 25, at 13 (proposing increasing the 28 percent AMT bracket to 33.5 percent to offset the revenue loss because it would only increase taxes for those with incomes above the AMT exemption phase-out).

[99]Burman et al., supra note 25, at 13; Burman & Weiner, supra note 23, at 15 (“If capital gains are taxed at the same 37 percent rate as other income, the option could raise $67 billion that could be applied to deficit reduction.”).

[100]Burman et al., supra note 25, at 11-13.

[101]Id.at 11.

[102]Id. at 12.

[103]Id.

[104]Id. at 12-13.

[105]Leonard E. Burman & Greg Leiserson, A Simple, Progressive Replacement for the AMT, Tax Analysts Viewpoints, 945 (2007) (proposing the 4 percent add-on tax of AGI above certain amount that will be indexed for inflation.).

[106]Burman et al., supra note 9, at 1(illustrating 4 add-on tax related legislations in the early stage of the AMT as 1969 TRA, 1976 TRA, 1978 Revenue Act, and 1982 TEFRA).

[107]Burman et al., supra note 25, at 14.

[108]Id. at 8 (“For example, by taxing interest income from bonds that state and local governments issue to support private activities like shopping centers or stadiums, income that is exempt from the regular income tax, the AMT reduces the subsidy afforded such investments.”).

[109]Congressional Budget Office, supra note 4, at 10.

[110]Burman et al., supra note 25, at 8.

[111]Congressional Budget Office, supra note 4, at 10.

[112]Id.; Burman et al., supra note 25, at 14, n.13 (stating that eliminating the regular income tax deduction for state and local taxes would more than pay for repealing the AMT).

[113]Dan Kadlec, At Long Last, a Permanent Patch for a Dreaded Tax Read, Time Business & Money (Jan. 03, 2013), http://www.consumerismcommentary.com/fiscal-cliff-bill-american-taxpayer-relief/.

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Considerations For International Clients Who Intend to Buy A Home In the U.S.

Sheppard Mullin 2012

International buyers invested $82.5 billion in U.S. residential real estate (4.8% of total U.S. sales) according to the most recent survey conducted by the National Association of Realtors for the 12 month period ending with March 2012. According to that survey, the top states in the U.S. for international buyers were Florida, California, Arizona and Texas. That survey also finds that the top-five international buyers were from Canada, China, Mexico, India, and the United Kingdom and that Brazil also remains a major source of purchasers. Homes are bought in the U.S. for investment, vacation-use, temporary use for professional, educational (which could include providing a home to a child who is pursuing his or her education in the U.S.), and a myriad of other reasons.

U.S. home buying and ownership, without proper planning, can have unexpected and unintended consequences. Many international clients are not aware that ownership of a U.S. home triggers U.S. estate tax on death and a gift of the property during lifetime triggers U.S. gift tax. U.S. estate and gift tax is imposed at a rate of 40%. An individual who is neither a U.S. citizen nor domiciled in the U.S. can shelter only $60,000 of U.S. situs assets on death (i.e. assets located or deemed to be located within the U.S.). In terms of gifting, an individual who is neither a U.S. citizen nor domiciled in the U.S. can make annual exclusion gifts of $14,000 per year to anyone and can currently pass $143,000 per year to a spouse who is not a U.S. citizen free of gift tax. That is in contrast to the $5,250,000 that a U.S. citizen or domiciliary can pass free of estate tax on death or by gift during lifetime as well as unlimited transfers to a U.S. citizen spouse.

To avoid triggering U.S. estate tax on death, many international clients are counseled to take title to the home in a foreign “blocker” corporation which, if respected, is not subject to U.S. estate tax on death. This form of title has the added advantage of providing anonymity and liability protector to the shareholder . Owning a home in a foreign corporation triggers other more immediate tax concerns such as application of the corporate tax rate (up to 35%) in lieu of the preferential long-term capital gains rates on sale (up to 20%), possible imputed rental income for use of corporate property by the shareholder, loss of step-up in the income basis of the home on the death of the owner (the basis of the stock in the corporation would be adjusted but the inside basis—the home itself would not be entitled to a basis adjustment), and loss of the ability to avoid the home being reassessed for California real property tax purposes on transfer from parent to a child. In addition, a U.S. person who will inherit shares in a corporation that will either become a Controlled Foreign Corporation (CFC) or a passive foreign investment company (PFIC) faces numerous special compliance obligations and substantive tax issues as a result of the ownership of those shares. There are many other ways to take title, such as through a LLC or a trust and each option should be explored in depth to achieve the client’s objectives to the maximum extent possible. Consideration should also be given to planning aimed at avoiding a public court proceeding that would be necessary to convey title to the beneficiaries of an international client who dies holding title directly to a U.S. home.

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Investment Regulation Update – April 2013

GT Law

The Investment Regulation Update is a periodic publication providing key regulatory and compliance information relevant to broker-dealers, investment advisers, private funds, registered investment companies and their independent boards, commodity trading advisers, commodity pool operators, futures commission merchants, major swap participants, structured product sponsors and financial institutions.

This Update includes the following topics:

  • SEC Adopts Rules to Help Protect Investors from Identity Theft
  • Increased Attention to Broker-Dealer Registration in the Private Fund World
  • SEC Issues Guidance Update on Social Media Filings By Investment Companies
  • AIFMD — Effect on U.S. Fund Managers
  • SEC Announces 2013 Examination Priorities
  • Reminder — Upcoming Form PF Filing Deadline
  • Reminder — Upcoming Dodd-Frank Protocol Adherence Deadline
  • Are you a Lobbyist?
  • Recent Events

SEC Adopts Rules to Help Protect Investors from Identity Theft

On April 10, 2013, SEC Chairman Mary Jo White’s official first day on the job, the SEC, jointly with the CFTC, adopted rules and guidelines requiring broker-dealers, mutual funds, investment advisers and certain other regulated entities that meet the definition of “financial institution” or “creditor” under the Fair Credit Reporting Act (FCRA) to adopt and implement written identity theft prevention programs designed to detect, prevent and mitigate identify theft in connection with certain accounts. Rather than prescribing specific policies and procedures, the rules require entities to determine which red flags are relevant to their business and the covered accounts that they manage to allow the entities to respond and adapt to new forms of identity theft and the attendant risks as they arise. The rules also include guidelines to assist entities subject to the rules in the formulation and maintenance of the required programs, including guidelines on identifying and detecting red flags and methods for administering the program. The rules also establish special requirements for any credit and debit card issuers subject to the SEC or CFTC’s enforcement authority to assess the validity of notifications of changes of address under certain circumstances. Chairman White stated, “These rules are a common-sense response to the growing threat of identity theft to all Americans who invest, save or borrow money.” The final rules will become effective 30 days after date of publication in the Federal Register and the compliance date will be six months thereafter.

Increased Attention to Broker-Dealer Registration in the Private Fund World

The role of unregistered persons in the sale of interests in privately placed investment funds is an area of great interest for the SEC and the subject of recent enforcement actions. On March 8, 2013, the SEC filed and settled charges against a private fund manager, Ranieri Partners, LLC, one of the manager’s senior executives and an external marketing consultant regarding the consultant’s failure to register as a broker-dealer. The Ranieri Partners enforcement actions are especially interesting for two reasons: (i) there were no allegations of fraud and (ii) the private fund manager and former senior executive, in addition to the consultant, were charged.

On April 5, 2013, David Blass, the Chief Counsel to the SEC’s Division of Trading and Markets, addressed a subcommittee of the American Bar Association. His remarks have been posted on the SEC website. Mr. Blass referenced a speech by the former Director of the Division of Investment Management, who expressed concern that some participants in the private fund industry may be inappropriately claiming to rely on exemptions or interpretive guidance to avoid broker-dealer registration.

In addition, Mr. Blass noted Securities Exchange Act Rule 3a4-1’s safe harbor for certain associated persons of an issuer generally is not or cannot be used by private fund advisers. He suggested that private fund managers should consider how they raise capital and whether they are soliciting securities transactions, but he did acknowledge that a key factor in determining whether someone must register as a broker-dealer is the presence of transaction-based compensation. The Chief Counsel also raised the question of whether receiving transaction-based fees in connection with the sale of portfolio companies’ required broker-dealer registration. He suggested that private fund managers may receive fees additional to advisory fees that could require broker-dealer registration, e.g., fees for investment banking activity.

On a related note, in two recent “no-action” letters, the SEC has established fairly clear rules regarding how Internet funding network sponsors may operate without being required to register as broker-dealers. On March 26 and 28, 2013, the SEC’s Division of Trading and Markets addressed this narrow, fact-specific issue in response to requests from FundersClub Inc. and AngelList LLC seeking assurances that their online investment matchmaking activities would not result in enforcement action by the SEC. The April 10, 2013 GT Alert—SEC Clarifies Position on Unregistered Broker-Dealer Sponsors of Internet Funding Networks is availablehere.

SEC Issues Guidance Update on Social Media Filings by Investment Companies

On March 15, 2013, the SEC published guidance from the Division of Investment Management (IM Guidance) to clarify the obligations of mutual funds and other investment companies to seek review of materials posted on their social media sites. This report stems from the SEC’s awareness of many mutual funds and other investment companies unnecessarily including real-time electronic materials posted on their social media sites (interactive content) with their Financial Industry Regulatory Authority filings (FINRA). In determining whether a communication needs to be filed, the content, context, and presentation of the communication and the underlying substantive information transmitted to the social media user and consideration of any other facts and circumstances are all taken into account, such as whether the communication is merely a response to a request or inquiry from the social media user or is forwarding previously-filed content. The IM Guidance offers examples of interactive content that should or should not be filed with FINRA. The IM Guidance is the first in a series of updates to offer the SEC’s views on emerging legal issues and to provide transparency and enhance compliance with federal securities laws and regulations. You may find a link to the SEC Press Release and IM Guidance here.

On a related note, on April 2, 2013, the SEC released a report of an investigation regarding whether the use of social media to disclose nonpublic material information violates Regulation FD. The SEC has indicated that, in light of evolving communication technologies and habits, the use of social media to announce corporate developments may be acceptable; however, public companies must exercise caution and undertake careful preparation if they wish to disseminate information through non-traditional means. The April 5, 2013 GT Alert—Social Media May Satisfy Regulation FD But Not Without Risk and Preparation by Ira Rosner is available here.

AIFMD – Effect on U.S. Fund Managers

New European Union legislation that regulates alternative asset managers who manage or market funds within the EU comes into force on July 22, 2013. The Alternative Investment Fund Managers Directive (AIFMD) will have a significant impact on U.S. fund managers if they actively fundraise in Europe after July 21, 2013 (or if they manage EU-domiciled fund vehicles). Historically, U.S. private equity firms raising capital in Europe have relied on private placement regimes that essentially allowed marketing to institutions and high net worth investors. Beginning July 22, 2013, U.S. fund managers may continue to rely on private placement regimes in those EU jurisdictions that continue to operate them; however, they will now be under an obligation to meet certain reporting requirements and rules set out in the AIFMD relating to:

  • transparency and disclosure, and
  • rules in relation to the acquisition of EU portfolio companies.

The transparency and disclosure rules require, for the most part, the disclosure of information typically found in a PPM; however, additional items are likely to be required such as the disclosure of preferential terms to particular investors and level of professional indemnity cover. The rules also require reports to be made to the regulator in each jurisdiction in which the fund has been marketed. The reports will need to include audited financials, a description of the fund’s activities, details of remuneration and carried interest paid, and details of changes to material disclosures. Acquisitions of EU portfolio companies also lead to reporting obligations on purchase – an annual report – and a rule against “asset stripping” for 24 months after the acquisition of control. Firms with less than €500 million in assets under management are exempt from the reporting requirements and reverse solicitation is potentially an option, as the directive does not prevent an EU institution from contacting the U.S. fund manager, but in practice it may be difficult to apply systematically.  Fund managers may choose to register in the EU on a voluntary basis from late 2015. This will allow marketing across all EU member states on the basis of a single registration. However, registration will come with a significant compliance burden. If you plan to market in the EU after July 23, 2013, ensure that you review your marketing materials, evaluate your likely reporting obligations and consider how the portfolio company acquisition rules are likely to impact your transactions.

SEC Announces 2013 Examination Priorities

On February 21, 2013 the SEC’s National Examination Program (NEP) published its examination priorities for 2013. The examination priorities address issues market-wide, as well as issues relating to particular business models and organizations. Market-wide priorities include fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and technology controls.  Priorities in specific program areas include: (i) for investment advisers and investment companies, presence exams for newly registered private fund advisers, and payments by advisers and funds to entities that distribute mutual funds; (ii) for broker-dealers, sales practices and fraud, and compliance with the new market access rule; (iii)for market oversight, risk-based examinations of securities exchanges and FINRA, and order-type assessment; and (iv) for clearing and settlement, transfer agent exams, timely turnaround of items and transfers, accurate recordkeeping, and safeguarding of assets, and; (iv) for clearing agencies, designated as systemically important, conduct annual examinations as required by the Dodd-Frank Act. The priority list is not exhaustive. Importantly, priorities may be adjusted throughout the year and the NEP will conduct additional examinations focused on risks, issues, and policy matters that are not addressed by the release.

Reminder—Upcoming Form PF Filing Deadline

SEC registered investment advisers who manage at least $150 million in private fund assets with a December 31st fiscal year end should be well underway in preparing their submissions for the approaching April 30, 2013 deadline. Filings must be made through the Private Fund Reporting Depository (PFRD) filing system managed by the Financial Industry Regulatory Authority (FINRA). As a reminder, advisers to three types of funds must file on Form PF: hedge funds, liquidity funds and private equity funds. Hedge funds are generally defined as a private fund that has the ability to pay a performance fee to its adviser, borrow in excess of a certain amount or sell assets short. Liquidity funds are defined as a private fund seeking to generate income by investing in short-term securities while maintaining a stable net asset value for investors. Private equity funds are defined in the negative as not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not generally provide investors with redemption rights. When classifying its funds, advisers should carefully read the fund’s offering documents and definitions on Form PF and should seek assistance of counsel. Particularly, we have seen the broad definition of hedge fund cause a fund considered a private equity fund by industry-standards to be a hedge fund for purposes of Form PF, thus subjecting the fund to more expansive reporting requirements. As is the case with filing Form ADV through IARD, the $150 Form PF filing fee is paid through the same IARD Daily Account and must be funded in advance of the filing. FINRA recently updated their PFRD System FAQs. The SEC has also posted new Form PF FAQs, which should be referred to for upcoming filings.

Reminder — Upcoming Dodd-Frank Protocol Adherence Deadline

All entities, including private funds, engaged in swap transactions must adhere to the ISDA Dodd-Frank Protocol no later than May 1, 2013 in order to engage in new swap transactions on or after May 1. Adherence to the Dodd-Frank Protocol will result in an entity’s ISDA swap documentation being amended to incorporate the business conduct rules that are applicable to swap dealers under Dodd-Frank.  Adherence to the Protocol involves filling out a questionnaire to ascertain an entity’s status under Dodd-Frank (e.g., pension plan, hedge fund and corporate end-user).  Further information on adherence to the Protocol can be obtained at ISDA’s website by clicking here.

Are you a lobbyist?

Over the last decade, many state and municipal governments have enacted new laws regarding how businesses may interact with government officials. These laws often establish new rules expanding the activities that are deemed to be “lobbying,” who is required to be registered as a lobbyist and what information must be publicly disclosed. Approximately half of the states, and countless municipalities, now define lobbying to include attempts to influence government decisions regarding procurement contracts – including contracts for investment advisors and placement agents – and impose steep penalties for companies that fail to register and disclose their “lobbying” activities and expenditures. Although some lobbying laws include exceptions for communications that occur as part of a competitive bidding process, the rules are inconsistent and not always clear. For example, although New York City’s lobbying law long included procurement lobbying, in 2010 the City’s Corporation Counsel and the City Clerk issued letters warning businesses that “activities by placement agents and other persons who attempt to influence determinations of the boards of trustees by the City’s . . . pension funds” are likely to be considered lobbying activity that requires registration and disclosure. Similarly, California’s lobbying law was expanded in 2011 to expressly include persons acting as “placement agents” in connection with investments made by California retirement systems, or otherwise seek to influence investment by local public retirement plans. Greenberg Traurig’s Investment Regulation Group, in conjunction with our Political Law Compliance team, is available to assist clients with questions regarding how to navigate increasingly complex lobby compliance laws and rules across the country and beyond. GT has a broad range of experience in advising to some of the world’s leading corporations, lobbying firms, public officials and others who seek to navigate lobbying and campaign finance laws.

Recent Events

On April 18, 2013, GT hosted the seminar, “The Far Reaching Impact of FATCA Across Borders and Across Industries” as both a webinar and live program in NY and Miami. The seminar explored the latest FATCA regulations and key intergovernmental agreements as well as their applications to a variety of industries. Click here to view the presentation.

On April 10, 2013, GT sponsored Artisan Business Group’s EB-5 Finance seminar at our NYC office. The program exposed participants to a unique alternative financing opportunity for projects that lend themselves to the EB-5 immigrant investor program and featured several GT speakers, including Steve Anapoell and Genna Garver, Co-Chair of the Investment Regulation Group, who provided a securities law update and considerations in the EB-5 area. Guest speakers included Jeff Carr from EPR, Phil Cohen from the EB-5 Resource Center, and Reid Thomas from NES Financial.

On April 2, 2013, GT co-hosted a Global Compliance seminar with Dun & Bradstreet on Foreign Corrupt Practices Act (FCPA) issues. The program included an overview of the FCPA, with a specific emphasis on the Department of Justice’s recently released Resource Guide to the FCPAand recent enforcement activities. A link to the Resource Guide can be found here.

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Internal Revenue Service (IRS) Capitalized Legal Fees Incurred by Pharmaceutical Company

 

McDermottLogo_2c_rgbIn a recently released Field Attorney Advice, the Internal Revenue Service (IRS) Office of Chief Counsel concluded that a pharmaceutical company must capitalize legal fees incurred to obtain Food and Drug Administration approval for marketing and selling generic drugs and to prevent the marketing and sale of a competing generic drug.  The IRS Office of Chief Counsel also concluded that it could impose an adjustment on audit to capitalize legal fees that the taxpayer expensed in prior years, including years closed by statute of limitations.

In a recently published Internal Revenue Service (IRS) Field Attorney Advice (FAA 20131001F, March 8, 2013), the IRS Office of Chief Counsel concluded that a pharmaceutical company must capitalize legal fees incurred to obtain U.S. Food and Drug Administration (FDA) approval for marketing and selling new generic drugs and to prevent the marketing and sale of a competing generic drug.  The IRS also concluded that the Commissioner could change the taxpayer’s method of accounting for the legal fees and impose an adjustment on audit to capitalize legal fees that the taxpayer expensed in prior years, including years closed by the statute of limitations.

NDA and ANDA

In order to market or sell a new drug in the United States, a New Drug Application (NDA) must be submitted to and approved by the FDA.  An NDA consists of clinical and nonclinical data on the drug’s safety and effectiveness, as well as a full description of the methods, facilities and quality controls employed during manufacturing and packaging.  An NDA also must disclose all the patents that cover the drug.

To market or sell a generic version of an existing FDA-approved drug, the maker of the generic drug must submit an Abbreviated New Drug Application (ANDA) for FDA approval.  An ANDA generally is not required to include preclinical and clinical trial data to establish safety and effectiveness.  Instead, an ANDA applicant must show that its generic drug is bioequivalent to an existing drug.  In addition, an ANDA applicant is required to provide certification that the ANDA will not infringe on the patent rights of a third party.  Specifically, if an applicant seeks approval prior to the expiration of patents listed by the NDA holder, then a “paragraph IV certification” must be submitted by the applicant to certify that it believes its product or the use of its product does not infringe on the third party’s patents, or that such patents are not valid or enforceable.  The first generic drug applicant that files an ANDA containing a paragraph IV certification is granted, upon approval, 180 days of marketing exclusivity.

For an ANDA with a paragraph IV certification, the applicant must send notices to the NDA holder for the referenced drug and to all patentees of record for the listed patents within 20 days of FDA notification that the ANDA is accepted for filing.  If neither the NDA holder nor the patent holders bring an infringement lawsuit against the ANDA applicant within 45 days, the FDA may approve the ANDA.  If the NDA holder or the patent holders file a patent infringement lawsuit against the ANDA applicant within 45 days, a stay prevents the FDA from approving the ANDA for up to 30 months.  If, however, the patent infringement litigation is still ongoing after the 30 months, the FDA may approve the ANDA.

The Facts

The taxpayer is a pharmaceutical company engaged in developing, manufacturing, marketing, selling and distributing generic and brand name drugs.  In the process of filing ANDAs with a paragraph IV certification, the taxpayer incurred legal fees in lawsuits filed by patent and NDA holders for patent infringement.  In addition, the taxpayer as an NDA holder incurred legal fees in a lawsuit it filed against an ANDA applicant with a paragraph IV certification to protect its right to sell its branded drug until all patents expired.  The taxpayer sought to deduct its legal fees as ordinary and necessary business expenses.

The IRS Analysis

Legal Fees Incurred in the Process of Obtaining FDA Approval of ANDAs

The IRS concluded that the legal fees incurred by the taxpayer as an ANDA applicant to defend actions for patent infringement in the process of filing the ANDA with paragraph IV certification must be capitalized under Treas. Reg. § 1.263(a)-4.  The IRS characterized the fees as incurred to facilitate the taxpayer obtaining the FDA-approved ANDAs with paragraph IV certification, which granted the applicant the right to market and sell a generic drug before the expiration of the patents covering the branded drugs, and by filing early, potentially with a 180-day exclusivity period.  As such, the IRS concluded, the fees are required to be capitalized as amounts paid to create or facilitate the creation of an intangible under Treas. Reg. § 1.263(a)-4(d)(5).  In so concluding, the IRS rejected the taxpayer’s argument that its fees did not facilitate obtaining FDA-approved ANDAs because it could have commercialized its generic drugs after the 30-month stay expired regardless of the outcome of the lawsuits.  The IRS reasoned that the filing of the ANDAs with paragraph IV certification and the defense of the patent infringement lawsuit were a part of a series of steps undertaken in pursuit of a single plan to create an intangible.

The IRS further concluded that the cost recovery of the capitalized legal fees incurred to obtain the FDA-approved ANDAs must be suspended until the FDA approves the ANDAs, and the capitalized fees must be amortized on a straight-line basis over 15 years as section 197 intangibles.

Legal Fees Incurred to Protect Its Right Against Other ANDA Applicants with Paragraph IV Certification

With respect to the legal fees incurred by the taxpayer as an NDA holder in the litigation against another ANDA applicant, the IRS characterized the fees incurred to defend the validity of the patents owned by the taxpayer as amounts paid to defend or perfect title to intangible property that are required to be capitalized under Treas. Reg. § 1.263(a)-4(d)(9).  In contrast, the fees incurred by the taxpayer in the litigation relating to determining whether valid patents have been infringed are not required to be capitalized under Treas. Reg. § 1.263(a)-4(d)(9).

The IRS further concluded that the capitalized fees incurred to protect the patents and the FDA-approved NDA must be added to the basis of the patents to be depreciated under section 167.  The cost recovery begins in the months in which the legal fees were incurred and is allocated over the remaining useful lives of the patents.

In characterizing the legal fees incurred by the taxpayer in defending the validity of its patents as costs of defending or perfecting title to intangible property, the IRS distinguished the legal fees at issue from the litigation expenses incurred by the taxpayers in defending a claim that their patents were invalid in Urquhart v. Comm’r, 215 F.2d 17 (3rd Cir. 1954).  In Urquhart, the taxpayers were participants in a joint venture that was engaged in the business of inventing and licensing patents.  The taxpayers obtained two patents involving fire-fighting equipment and, after threatening litigation against Pyrene Manufacturing Company, brought an infringement suit against a customer of Pyrene, seeking an injunction and recovery of profits and damages.  The case was dismissed, and Pyrene subsequently commenced an action against the taxpayers seeking a judgment that the taxpayers’ patents were invalid and that its own apparatus and methods did not infringe the patents.  A counterclaim was filed for an injunction against infringement, and an accounting for profits and damages.  Pyrene did not raise any questions as to title to, or ownership of, the patents and was successful in the lawsuit.  The patents held by the taxpayers were found to be invalid.  In holding that the legal fees incurred by the taxpayer were deductible as ordinary and necessary business expenses, the U.S. Court of Appeals for the Third Circuit rejected the IRS’s contention that the litigation was for the defense or protection of title.

Distinguishing the FAA from Urquhart, the IRS focused on the fact that the taxpayers in Urquhart were professional inventors engaged in the business of exploiting and licensing patents, and that Urquhart involved the taxpayers’ claims for recovering lost profits.  By emphasizing that Pyrene did not raise any issue as to title to the patents in Urquhart, the IRS seemed to ignore the fact that, like the taxpayer in the FAA, Pyrene sought a judgment on the validity of the taxpayers’ patents and that the outcome of the litigation in Urquhart also focused on the validity of the patents.

Change of Accounting Method for Legal Fees Incurred by the Taxpayer 

The IRS also concluded that the taxpayer’s treatment of its legal fess associated with each ANDA or patent as either deductible or capitalizable is a method of accounting that the Commissioner can change on an ANDA-by-ANDA or patent-by-patent basis.  The consequence of this conclusion, if valid, is that the IRS can impose on audit an adjustment to capitalize legal fees that the taxpayer deducted in prior years, including years closed by the statute of limitations.  For example, the IRS can include in the taxpayer’s gross income for the earliest year under examination an adjustment equal to the amount of the legal fees the taxpayer previously deducted, less the amount of amortization that the taxpayer properly could have taken had the taxpayer capitalized the legal fees.

A taxpayer that voluntarily changes its method of accounting, however, receives more favorable terms and conditions than a taxpayer that has its method of accounting changed by the IRS on examination.  For example, a taxpayer that changes its method of accounting voluntarily can spread the adjustment resulting from the change over four taxable years, and the first year of the adjustment is the current taxable year as opposed to the earliest open taxable year.

The publication of this FAA likely will bring the attention of examining agents to this issue.  Therefore, if a taxpayer believes it is using an improper method of accounting for legal fees (or any other item), it should carefully consider whether to voluntarily change its method of accounting before the IRS proposes to change the taxpayer’s method of accounting on examination.

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SEC Staff Meets with IRS to Discuss Tax Implications of a Floating Net Asset Value (NAV)

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SEC staff recently met with staff members of the IRS to discuss the tax implications of adopting a floating net asset value (NAV) for money market funds. The discussion centered on the tax treatment of small gains and losses for investors in money market funds, and the IRS reportedly told the SEC there is limited flexibility in interpreting current tax law. A floating NAV could require individual and institutional investors to regard every money market fund transaction as a potentially taxable event.

Investors would have to determine how to match purchases and redemptions for purposes of calculating gains, losses and share cost basis. The SEC reached out to the IRS as it continues to consider measures, including a floating NAV, to enable money market funds to better withstand severe market disruptions.

For additional discussion of money market reform, please see “SEC Debates on Money Market Reforms Continue” in our January 2013 and October 2012 updates.

Sources: John D. Hawke, Jr., Economic Consequences of Proposals to Require Money Market Funds to ‘Float’ Their NAV, SEC Comment Letter File No. 4-619, November 2, 2012; Christopher Condon and Dave Michaels, SEC Said to Discuss Floating NAV for Money Funds with IRS, Bloomberg, March 7, 2013; Joe Morris, SEC Sounding Out IRS on Floating NAV, Ignites, March 7, 2013.

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340B Drug Pricing Program Notices on Group Purchasing Organizations and Medicaid Exclusion File

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Following the recent release of new Program Notices regarding the Group Purchase Organization (GPO) prohibition and Medicaid Exclusion File, 340B participating entities should review their 340B program policies and procedures to ensure compliance with new and clarified guidance regarding GPO purchasing and dispensing of 340B drugs to Medicaid patients.

On February 7, 2013, the Health Resources and Services Administration Office of Pharmacy Affairs (OPA) issued new Program Notices related to the Group Purchasing Organization (GPO) prohibition and the Medicaid Exclusion File (the Program Notice).

GPO Prohibition 

Disproportionate Share Hospitals, children’s hospitals and freestanding cancer hospitals that participate in the 340B program are prohibited from purchasing “covered outpatient drugs” through a GPO or other group purchasing arrangement.  Covered outpatient drugs include most outpatient drugs obtained by written prescription, with the exception of vaccines and certain drugs classified as devices by the U.S. Food and Drug Administration.

Prior to the release of the new Program Notice, OPA had provided little guidance regarding the scope and enforcement of the GPO prohibition.  The Program Notice appears to have resulted from OPA concern that certain hospitals may have been routinely using outpatient GPO accounts when unable to purchase drugs at 340B prices.  With the Program Notice, OPA has now formally established policies regarding the application of the GPO prohibition to drug shortages, outpatient clinics and virtual inventory/replenishment purchasing models.

With the new Program Notice, and accompanying FAQs released subsequent to the publication of the Program Notice, OPA advises that the GPO prohibition applies even when a covered outpatient drug is not available at the 340B price due to a manufacturer shortage.  In such cases, hospitals are instructed to notify OPA of the issue, but may not obtain the drug through a GPO.

The Program Notice also provides that the GPO prohibition does not extend to certain off‑site outpatient clinics.  A hospital may use a GPO to purchase covered outpatient drugs for an off-site outpatient clinic if all of the following requirements are met:

Further, OPA establishes that a hospital may not use a GPO to purchase covered outpatient drugs for dispensing to patients through a contract pharmacy.  This guidance does not prohibit a contract pharmacy that is not owned by a hospital (which is the entity that would be subject to the GPO prohibition) from accessing GPO pricing through its own account, so long as the hospital is not involved in the pharmacy-GPO arrangement and does not benefit from the pharmacy’s GPO pricing.

  • The off-site outpatient clinic is located at a different physical address than the hospital
  • The off-site outpatient clinic is not registered in the OPA 340B database as participating in the 340B program
  • Covered outpatient drugs for the off-site outpatient clinic are purchased through a separate pharmacy wholesaler account than the hospital
  • The hospital maintains records demonstrating that drugs purchased through a GPO for the off-site outpatient clinic are not utilized by or transferred to the hospital or any off-site outpatient location registered in the OPA 340B database

Hospitals, including their outpatient sites, subject to the GPO prohibition must discontinue GPO purchasing of covered outpatient drugs before the first day of their respective 340B program eligibility, although each may continue to dispense previously purchased GPO inventory.  Those hospitals that maintain pharmacy inventory through a virtual inventory/replenishment model, in which 340B drugs are purchased based on prior dispensing to 340B-eligible patients, are also prohibited from using a GPO to purchase covered outpatient drugs.  OPA has advised that hospitals utilizing a replenishment model in “mixed use” (inpatient and outpatient) pharmacies must now account for (“accumulate”) dispensed drugs for inventory replenishment as either inpatient, 340B-eligible or outpatient non-340B.  Drugs accumulated for outpatient non-340B replenishment may only be purchased through a non-340B, non-GPO account.  In addition, a hospital may not purchase drugs on a 340B account until the 340B-eligible accumulator reaches a full package size and/or minimum order quantity.  The result is that such drugs typically must be purchased at wholesale acquisition cost (WAC) or prices individually negotiated between the hospital and manufacturer.

The new Program Notice advises that hospitals subject to the GPO prohibition that are found in violation of the prohibition may be immediately removed from the 340B program and subject to repayment to manufacturers for the period of non-compliance.  However, in a separate FAQ on the OPA website, OPA advises that it will not enforce the GPO prohibition until after April 7, 2013.  Those hospitals that are unable to meet the compliance deadline are advised to either notify OPA of non-compliance and submit a corrective action plan (such submissions will be handled on a case-by-case basis) or disenroll either the entire hospital or, if applicable, non-compliant off-campus locations, from the 340B program.

Medicaid Exclusion File

Drug manufacturers are not required to provide a 340B discount and Medicaid rebate on the same drug.  In order to prevent these “duplicate discounts,” OPA maintains the Medicaid Exclusion File.  This database lists all 340B participating entities (covered entities) and indicates whether the covered entity has elected to dispense 340B drugs to Medicaid patients (carve-in) or obtain drugs for Medicaid patients at non-340B pricing (carve-out).  Covered entities that have elected to carve-in are listed in the Medicaid Exclusion File by Medicaid billing number.

State Medicaid programs are instructed to access the Medicaid Exclusion File to ensure they do not seek manufacturer rebates from those covered entities that are listed in the database.  In the Program Notice, OPA reminds states to use the Medicaid Exclusion File to prevent duplicate discounts and to report any discrepancies between provider billing practices and the information in the database to OPA.

The Program Notice advises covered entities of a change in OPA policy regarding the timing of changes to a covered entity’s decision to carve-in or carve-out.  While changes previously could be made at any time, OPA will now only permit changes on a quarterly basis.  OPA also clarifies that a covered entity may choose to carve-in or carve-out for a subset of 340B enrolled locations, but if it does so, must obtain a separate Medicaid provider number for any eligible locations that carve-in.  Covered entities are also reminded that they must ensure their information is accurately reflected in the Medicaid Exclusion File and that they may be subject to manufacturer repayment if the database reflects that the covered entity opted to carve-out, but the covered entity has been dispensing 340B drugs to Medicaid patients.

Next Steps

340B participating hospitals subject to the GPO exclusion should review their current operations and policies and procedures to evaluate compliance with the guidance released in the new Program Notice and FAQs, with particular attention to use of GPO purchasing to obtain covered outpatient drugs that are not available at 340B pricing and for replenishment inventory.  As necessary, hospitals should cease purchasing covered outpatient drugs through a GPO and begin revising purchasing procedures to ensure compliance by April 8, 2013.

Hospitals should also evaluate current policies regarding use of GPOs at off-site outpatient clinics not registered in the OPA 340B database to determine whether such locations may be eligible to purchase covered outpatient drugs through a GPO.  Previously, many such off-site outpatient clinics were restricted to only purchasing at WAC pricing due to the GPO exclusion.  The new Program Notice makes clear that, so long as purchasing is conducted through a separate pharmacy wholesaler account (not the hospital’s), hospitals subject to the GPO exclusion can use a GPO to purchase drugs for off-campus outpatient clinics that are not registered in the OPA 340B database.  Therefore, outpatient sites now have the flexibility to purchase drugs through a GPO for those clinics that are not yet eligible for 340B enrollment (e.g., they have not yet appeared on a filed Medicare cost report) and to opt-out of enrolling off-site outpatient clinic sites if certain locations would see greater benefit from GPO purchasing than from 340B participation.  Further, hospitals may wish to explore opportunities for selective enrollment of off-site outpatient locations to ensure patient access to certain drugs, such as intravenous immunoglobulin, that have historically been difficult to obtain at 340B pricing and cost-prohibitive to obtain at WAC.

All covered entities should review their information in the Medicaid Exclusion File to ensure the database reflects current Medicaid billing practices and be aware that any changes will only be effective as of the next quarter beginning January 1, April 1, July 1 or October 1.  Covered entities should also use this opportunity to review state Medicaid program requirements regarding carve-in or carve-out restrictions and billing rules related to 340B drugs.

© 2013 McDermott Will & Emery

DOL, IRS, and HHS Put the Brakes on Stand-Alone Health Reimbursement Arrangements Used to Access Health Insurance Coverage in the Individual Market

The National Law Review recently featured an article regarding Health Reimbursement Arrangements written by Alden J. Bianchi and Gary E. Bacher of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.:

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In a set of Frequently Asked Questions1 (FAQs) posted to the Department of Labor’s website on January 24, the Departments of Health and Human Services, Labor, and Treasury (the “Departments”) put a stop to an approach to health plan design under which employers furnish employees with a pre-determined dollar amount (a “defined contribution”) that employees can apply toward the purchase of health insurance coverage in the individual health insurance market.

An arrangement under which an employer provides an amount of money to employees to pay for unreimbursed medical expenses or for individual market premiums is itself a “group health plan.” Such an arrangement is referred to and regulated under the Internal Revenue Code as a “health reimbursement arrangement” or “HRA.”2 The HRA approach described above is referred to as a “stand-alone HRA” to distinguish it from arrangements in which the HRA is paired with an employer’s group health plan. This latter HRA design is referred to as an “integrated HRA.”

The rules governing HRAs stand in contrast to cafeteria plans and medical flexible spending arrangements, which pave the way for employee contributions to be paid with pre-tax dollars. Where employee contributions are limited to premiums, the cafeteria plan is referred to colloquially as a “premium-only” plan. Where employees can set aside their own money to pay for certain medical expenses including co-pays and co-insurance with pre-tax dollars, the arrangement is referred to as a “medical flexible spending arrangement” or “medical FSA.” Medical FSAs can include employer money (typically in the form of “flex credits”), but they cannot be used to pay health insurance premiums.

While some vendors have begun to market stand-alone HRAs, it was never clear that HRAs used to access individual market coverage could pass muster under the Patient Protection and Affordable Care Act (the “Act”) or other applicable laws. The regulatory hurdles, both before and after 2014, include the following:

  1. Before 2014, carriers issuing coverage in the individual market are free to impose all manner of underwriting conditions, which raise the specter of discrimination based on health status in violation of Title I of the Health Insurance Portability and Accountability Act (HIPAA). These concerns disappear commencing in 2014 as a consequence of the Act’s comprehensive overhaul of health insurance underwriting practices.
  2. The Act generally prohibits group health plans and health insurance carriers from imposing lifetime or annual limits on the dollar value of essential health benefits. In prior guidance, the regulators gave a “pass” to integrated HRAs, but not to stand-alone HRAs.
  3. Because individual market products are age rated, the same coverage will cost more in the hands of an older employee than in the hands of a similarly-situated younger employee. Before 2014, the variations in premium costs are a matter of state law; from and after 2014, the Act establishes a federal floor under “modified community rating” rules that permit a disparity of no more than 3:1. Under either regulatory regime, a flat dollar amount is thought to raise questions under the Age Discrimination in Employment Act (ADEA). Under the ADEA, variations in premiums are permitted only where the added cost charged to an older employee is justified by the actuarially-adjusted cost of providing the benefits to the older employee.

The FAQs cite the Act’s ban on lifetime and annual limits as the basis for their objection to stand-alone HRAs used to access individual market coverage. Specifically, the FAQs note that—

“[A]n HRA is not considered integrated with primary health coverage offered by the employer unless, under the terms of the HRA, the HRA is available only to employees who are covered by primary group health plan coverage provided by the employer. …”

The Departments state their objections unequivocally: an HRA used to purchase coverage in the individual market cannot be considered integrated with that individual market coverage. Therefore, such an arrangement does not satisfy the requirements Act prohibiting group health plans and health insurance carriers from imposing lifetime or annual limits on essential health benefits. The Departments also made clear that an employer-sponsored HRA may be treated as integrated with other coverage only if the employee receiving the HRA is actually enrolled in that coverage. Thus, if an HRA credits additional amounts to an individual only when he or she does not enroll in the employer’s group health plan, the HRA will not comply with the Act.

Recognizing the potential hardship to existing stand-alone HRAs, the FAQs include a special rule for amounts credited or made available under HRAs in effect prior to January 1, 2014. Whether or not an HRA is integrated with other group health plan coverage, unused amounts credited before January 1, 2014 may be used after December 31, 2013 to reimburse medical expenses without running afoul of the Act. If the HRA did not prescribe a set amount or amounts to be credited during 2013, then the amounts credited cannot exceed the amount credited for 2012.

©1994-2013 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

District Court Holds IRS Lacks Authority to Issue and Enforce Tax Return Preparer Regulations

The National Law Review recently featured an article, District Court Holds IRS Lacks Authority to Issue and Enforce Tax Return Preparer Regulations, written by Gale E. Chan and Robin L. Greenhouse with McDermott Will & Emery:

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On January 18, 2013, the District Court for the District of Columbia (District Court) issued a surprising decision in Loving v. Internal Revenue Service, No. 12-385 (JEB), holding that the Internal Revenue Service (IRS) lacked the authority to issue and enforce the final Circular 230 tax return preparer regulations that were issued in 2011 (Regulations).  The District Court also permanently enjoined the IRS from enforcing the Regulations.

Background

As part of the IRS’s initiative to increase oversight of the tax return preparer industry by creating uniform and high ethical standards of conduct, the IRS created a new category of preparers, “registered tax return preparer,” to be subject to the rules of Circular 230.  Attorneys, certified public accountants, enrolled agents and enrolled actuaries were already subject to IRS regulation under Circular 230, and thus, were not affected by the issuance of the Regulations.

In June 2011, the IRS and the U.S. Department of the Treasury (Treasury) issued the Regulations relating to registered tax return preparers and practice before the IRS.  T.D. 9527 (June 3, 2011).  Under these rules, registered tax return preparers have a limited right to practice before the IRS.  A registered tax return preparer can prepare and sign tax returns, claims for refunds and other documents for submission to the IRS.  A registered tax return preparer who signs the return may represent taxpayers before revenue agents and IRS customer service representatives (or similar officers or employees of the IRS) during an examination, but the registered tax return preparer cannot represent the taxpayer before IRS appeals officers, revenue officers, counsel or similar officers or employees of the IRS.  In addition, a registered tax return preparer can only advise a taxpayer as necessary to prepare a tax return, claim for refund or other document intended to be submitted to the IRS.

The Regulations also impose additional examination and continuing education requirements on registered tax return preparers in addition to obtaining a preparer tax identification number (PTIN).  Under the rules, to become a “registered tax return preparer,” an individual must be 18 years old, possess a current and valid PTIN, pass a one-time competency examination, and pass a federal tax compliance check and a background check.  The Regulations require a registered tax return preparer to renew his or her PTIN annually and to pay the requisite user fee.  To renew a PTIN, a registered tax return preparer must also complete a minimum of 15 hours of continuing education credit each year that includes two hours of ethics or professional conduct, three hours of federal tax law updates and 10 hours of federal tax law topics.

Loving v. Internal Revenue Service

In Loving, three individual paid tax return preparers (Plaintiffs) filed suit against the IRS, the Commissioner of Internal Revenue and the United States (collectively, Government) seeking declaratory relief, arguing that tax return preparers whose only “appearance” before the IRS is the preparation of tax returns cannot be regulated by the IRS, and injunctive relief, requesting the court to permanently enjoin the IRS from enforcing the Regulations.  In filed declarations, two of the Plaintiffs indicated that they would likely close their tax businesses if they were forced to comply with the Regulations, and the third Plaintiff, who serves low-income clients, indicated that she would have to increase her prices if forced to comply with the Regulations, likely resulting in a loss of customers.  The Plaintiffs and the Government each filed separate motions for summary judgment.

At issue in the case was the IRS’s claim that it can regulate individuals who practice before it, including tax return preparers.  The IRS relied on an 1884 statute, 31 U.S.C. § 330, which provides the Treasury with the authority to regulate the people who practice before it.  The statute currently provides that the Treasury may “regulate the practice of representatives of persons before the Department of the Treasury.”  31 U.S.C. § 330(a)(1) (emphasis added).  The statute further requires that a representative demonstrate certain characteristics prior to being admitted as a representative to practice, including “competency to advise and assist persons in presenting their cases.”  31 U.S.C. § 330(a)(2)(D) (emphasis added).  The statute also gives the Treasury authority to suspend or disbar a representative from practice before the Treasury in certain circumstances, as well as to impose a monetary penalty.  31 U.S.C. § 330(b).

The District Court’s Application of Chevron

The District Court applied the framework of Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), and concluded that the text and context of 31 U.S.C. § 330 unambiguously foreclosed the IRS’s interpretation of the statute.  Chevron applies a two-step inquiry to determine whether a statute is ambiguous.  The first step asks whether the intent of Congress is clear in the statute—i.e., has Congress “directly spoken to the precise question at issue.”  Chevron, 467 U.S. at 842.  If a court determines that the intent of Congress is clear, under the Chevron framework, that is the end and the court “must give effect to the unambiguously expressed intent of Congress.”  Id. at 842–43.  However, if the court determines that the statute is silent or ambiguous, the court must proceed to step two of Chevron and ask whether the agency’s interpretation “is based on a permissible construction of the statute.”  Id. at 843.  An agency’s construction under step two is permissible “unless it is arbitrary or capricious in substance, or manifestly contrary to the statute.”  Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 711 (2011) (citation omitted).

In Loving, the District Court concluded that 31 U.S.C. § 330 was unambiguous as to whether tax return preparers are “representatives” who “practice” before the IRS for three reasons.  First, the District Court stated that 31 U.S.C. § 330(a)(2)(D) defines the phrase “practice of representatives” in a way that does not cover tax return preparers.  As noted above, 31 U.S.C. § 330(a)(2)(D) requires a representative to demonstrate that he or she is competent to advise and assist taxpayers in presenting their “cases.”  The District Court stated that the statute thus equates “practice” with advising and assisting with the presentation of a case, which the filing of a tax return is not.  Thus, the District Court concluded that the definition in 31 U.S.C. § 330(a)(2)(D) “makes sense only in connection with those who assist taxpayers in the examination and appeals stages of the process.”

Second, the District Court stated that the IRS’s interpretation of 31 U.S.C. § 330 would undercut various statutory penalties in the Internal Revenue Code (Code) specifically applicable to tax return preparers.  The District Court noted that if 31 U.S.C. § 330(b) is interpreted as authorizing the IRS to penalize tax return preparers under the statute, the statutory penalty provisions in the Code specific to tax return preparers would be displaced, thereby allowing the IRS to penalize tax return preparers more broadly than is permissible under the Code.  Thus, the District Court stated that the specific penalty provisions applicable to tax return preparers in the Code should not be “relegated to oblivion” and trumped by the general penalty provision of 31 U.S.C. § 330(b).

The District Court also stated that 31 U.S.C. § 330(b) does not authorize penalties on tax return preparers because Section 6103(k)(5) of the Code, which provides that the IRS may disclose certain penalties to state and local agencies that license, register or regulate tax return preparers, does not identify 31 U.S.C. § 330(b) as one of the reportable statutory penalty provisions.

Finally, the District Court stated that if the IRS’s interpretation of 31 U.S.C. § 330 is accepted, Section 7407 of the Code would be duplicative.  Section 7407 of the Code provides the IRS with the right to seek an injunction against a tax return preparer to enjoin the preparer from further preparing returns if the preparer engages in specified unlawful conduct.  This right is similar to the authority under 31 U.S.C. § 330(b) to penalize if the IRS’s interpretation of 31 U.S.C. § 330 is accepted.  Under the IRS’s interpretation of 31 U.S.C. § 330, the IRS could disbar a representative from practice before the IRS if a tax return preparer engages in the conduct described in 31 U.S.C. § 330(b) (incompetence, being disreputable, violating regulations and fraud).  Thus, the District Court noted that disbarment under 31 U.S.C. § 330(b) is wholly within the IRS’s control and would be an easier path to penalize a tax return preparer than offered by Section 7407 of the Code.  The District Court stated that under the IRS’s interpretation, the IRS likely would never utilize the remedies available under Section 7407 of the Code, thereby rendering the statute pointless.

Conclusion

The District Court granted the Plaintiffs’ motion for summary judgment, holding that the IRS lacked statutory authority to issue and enforce the Regulations against “registered tax return preparers,” and permanently enjoined the IRS from enforcing the Regulations.  The Government will likely appeal the District Court’s decision.  Nevertheless, the District Court’s decision will have a great impact on the hundreds of thousands of tax return preparers ensnared by the Regulations and the clients they serve.

© 2013 McDermott Will & Emery