Tag: Tax

Eleventh Hour Fiscal Cliff Deal – What Does it Mean for Canadians?

Altro Levy LogoJust hours before midnight on New Years Eve, the US Senate hammered out a tentative deal to avoid sending the country over the Fiscal Cliff. Yesterday, a reluctant, Republican-controlled House of Representatives has also blessed the plan, which deals with many of the major tax issues at stake, while pushing back the spending issues to later into the new year.

The “Fiscal Cliff”, a term coined by Ben Bernanke, the Chairman of the Federal Reserve, refers to the cumulative effect of spending cuts and tax increases, which were scheduled to occur January 1, 2013 as a result of the expiry of several pieces of legislation. The issue has received a great amount of press in recent months, as commentators continued to hope that Congress would agree on compromise legislation to soften the economic blow. In this post, we will outline the primary cross border tax impacts on Canadians.

Federal Estate Tax

For Canadians with interests in the US, the primary consequence of going over the Fiscal Cliff would relate to the federal estate tax. The Canada – US Tax Treaty allows Canadian residents to piggy-back onto some estate tax exemptions that are available to US citizens and residents. In particular, in 2012, there was a $5.12 million exemption from estate tax, such that only estates worth greater than that amount would end up paying taxes, and the maximum rate was capped at 35%. The looming Fiscal Cliff threatened to bring us back to the $1 million exemption amount at maximum rate of 55%, which was in effect when President Bush took office in 2001. Note that this is not a capital gains tax on death, as we have in Canada. This tax applies to the fair market value of assets at the time of death.

The good news for Canadians is that the deal will extend the $5.12 million exemption amount, which will increase with inflation. The maximum rate will increase to 40% on a permanent basis. As a consequence, if a Canadian owns US assets (such as real estate or US securities) worth more than $60,000, and passes away with a worldwide estate valued in excess of $5.25 million, some US estate tax is likely going to be payable. It is important to note that the worldwide estate value includes everything: real estate, investment accounts, RRSPs, business interest, even the proceeds of life insurance. However, the tax is only applied against the value of the US situated assets, and some tax credits ought to be available under the Tax Treaty thanks to the extension of the high exemption amount.

Nonetheless, it remains worthwhile for high-net worth Canadians to evaluate their estate tax exposure and hold US assets in Cross Border structures that minimize or eliminate the potential for US estate tax liability.

Income and Capital Gains Tax

Most of the press on the Fiscal Cliff has centered on the increases in income tax rates. This issue is very unlikely to cause Canadian residents much concern, even though US income tax may be payable. Since Canadian residents pay Canadian tax on their world wide income, any US source income earned by a Canadian will be added on the top of their Canadian income, such that it will be taxed at a relatively high marginal rate. In contrast, that same US sourced income will be taxed in the US at the lower marginal rates, and Canada will give a credit for US tax paid. As such, as long as the marginal rate in the US is lower than the marginal rate in Canada on the same income (which it clearly will), increases in US income tax rates will not be noticed by Canadians when the dust settles at the end of a tax year.

One expiring tax cut that was not renewed under the Eleventh Hour Deal relates to the long-term capital gains tax rate on the disposition of capital assets. This is one tax increase that will be felt by some Canadians. In Canada, we pay regular income tax on half of the capital gain. As such, if the gain pushes a taxpayer into the top marginal rate in Canada, the effective capital gains tax rate ranges from approximately 19.5% in Alberta to almost 25% in Quebec. In 2012, the US federal capital gains tax for individuals who had held an asset for longer than one year was capped at 15% on the gain. That rate has increased to 20% with the Fiscal Cliff Deal (high income earners will pay 23.8% including an “Obamacare” surcharge). Where state-level tax also applies, the US capital gains tax may well exceed that owed in Canada, resulting in a higher overall tax burden. For example, California has a state capital gains tax rate of 9.3%. Therefore, any Canadian selling a California property will owe more tax to the US (combined rate of 29.3%) than to Canadian jurisdictions. Other states have a lower rate of tax, such that the effective US rate may not exceed the Canadian rates. For example, Florida does not impose a capital gains tax on individuals, trusts, or limited partnerships.

Market Volatility

The other aspect of the Fiscal Cliff that may affect Canadians is the most difficult to anticipate. Many economics were predicting that the overall effect of the Fiscal Cliff would send the US back into recession. This was the concern that prompted Bernanke and others to characterize the issue as a ‘cliff’ connoting catastrophic economic consequences. While the economy should respond favorably to the agreement that Congress passed, there are many pressing issues that were simply deferred in this week’s deal. Many of the spending cuts, which are thought to jeopardize the economic recovery, were pushed back two months for Congress to resolve later on. If worst fears are realized, the value of many US assets may decline as economic conditions generally erode.

As cross border tax and estate planners, we often advise Canadian clients to consider repositioning their investment portfolios to exclude directly held US securities because of the US estate tax exposure they represent. If you believe that the fiscal transition will negatively impact the value of US securities, it may be a good time to discuss repositioning with your investment advisor.

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Employers Have Until October 1st to Comply with Affordable Care Act’s Notice Requirements

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The Patient Protection and Affordable Care Act (the “Affordable Care Act”) represents the most substantial overhaul of the nation’s healthcare system in decades.  Much of the Affordable Care Act is meant to expand access to affordable health insurance coverage, including provisions for coverage to be offered through a Health Insurance Marketplace (the “Marketplace”) beginning in 2014.  As part of the overhaul, the Affordable Care Act requires most employers to provide written notice to their employees of coverage options available through the Marketplace and to give employees information regarding the coverage, if any, offered by the employer.

The United States Department of Labor (“DOL”) recently issued a Technical Release, which provides temporary guidance regarding the notice requirement and announces the availability of the Model Notice to Employees of Coverage Options.  The Technical Release can be obtained from the following link to the DOL’s website:  www.dol.gov/ebsa/newsroom/tr13-02.html.

Notice to Employees Under the Affordable Care Act

Beginning October 1, 2013, most employers must give a written notice to each employee,[1] regardless of plan enrollment status or the employee’s status as a part-time or full-time employee, with the following information:

  • The notice must include information regarding the existence of the new Marketplace as well as contact information and a description of the services provided by the Marketplace
  • The notice must inform the employee that the employee may be eligible for a premium tax credit under section 36B of the Internal Revenue Code if the employee purchases a qualified health plan through the Marketplace
  • The notice must include a statement informing the employee that if the employee purchases a qualified health plan through the Marketplace, the employee may lose the employer contribution (if any) to any health benefits plan offered by the employer and that all or a portion of such contribution may be excludable from income for federal income tax purposes

Employers must provide the notice to current employees no later than October 1, 2013 when “open enrollment” begins for coverage through the Marketplace.  For new employees, employers must provide the notice at the time of hiring beginning October 1, 2013.  For 2014, if the notice is provided within 14 days of an employee’s start date, the DOL will consider the notice to be provided at the time of hiring.

The notice must be provided to employees in writing.  The notice may be sent via first class mail or it may be provided electronically as long as the requirements of the DOL’s electronic disclosure safe harbor are met.  Employers may not charge their current employees or new hires a fee for providing the notice.

To assist employers with complying with the notice requirement, the DOL has drafted two model notices that meet the notice content requirements discussed above.  The model notice for employers who do not offer a health plan is available at the following link:  www.dol.gov/ebsa/pdf/FLSAwithoutplans.pdf.  The model for employers who do offer a health plan to some or all of their employees is available at the following link:  www.dol.gov/ebsa/pdf/FLSAwithplans.pdf.

Updated Model Election Notice Under COBRA

Under COBRA, a group health plan administrator must provide qualified beneficiaries with an election notice describing their rights to continuation of health insurance coverage and how to make an election.  A “qualified beneficiary” is an individual who was covered by a group health plan on the day before the occurrence of a qualifying event, such as termination of employment or reduction in hours that causes loss of health insurance coverage under the group health plan.

The DOL’s Technical Release includes a revised COBRA model election notice to help make qualified beneficiaries aware of other coverage options available in the Marketplace.  Upon the group health plan administrator filling in the blanks in the model election notice with the appropriate plan information and using the notice, the DOL will consider the use of the model notice to be good faith compliance with the election notice content requirements of COBRA.  Employers should begin using the model election notice immediately.

The COBRA model election notice can be obtained from the following link to the DOL’s website:  www.dol.gov/ebsa/cobra.html.

[1] Employers are not required to provide a separate notice to employees’ dependents or other individuals who are or may become eligible for coverage under the plan but who are not employees of the employer.

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IRS, Treasury Department Issue Proposed Rules Governing Minimum Value, Affordability, and Wellness Programs

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A key policy goal of the Patient Protection and Affordable Care Act (the “Act”) is the expansion of health insurance coverage to all Americans. The concepts of “minimum value” and its correlate “actuarial value” speak to the generosity of that coverage. What constitutes minimum value is important both for employers that sponsor group health plans and for low-income individuals seeking government subsidies to help pay for coverage through newly established public insurance exchanges. Recently issued proposed regulations provide important clarifications on how employers determine minimum value, and how those determinations impact their compliance with the Act. The proposed rule also clarifies the relationships among minimum value and affordability, on the one hand, and wellness programs, Health Reimbursement Accounts and Health Savings Accounts, on the other. This advisory explains these and other features of the proposed regulations.

Overview

Beginning in 2014, the Act requires most U.S. citizens and green card holders to maintain health insurance coverage, which the Act refers to as “minimum essential coverage.” The phrase minimum essential coverage refers not to the content but to the source of coverage, which can include Medicare, Medicaid, or an “eligible employer-sponsored plan,” among others. Low income individuals may qualify for premium tax credits and cost sharing reductions (collectively, “premium assistance”) to assist with the purchase of coverage through public insurance exchanges. Where an individual is eligible for coverage under an eligible employer-sponsored group health plan that is both affordable and provides minimum value, however, that individual is ineligible for premium assistance.

Beginning in 2014, the Act also imposes certain obligations on “applicable large employers” — i.e., employers with 50 or more full-time and full-time equivalent employees — under which these employers must either offer group health plan coverage or face the prospect of a penalty. These “employer shared responsibility” (or “pay-or-play”) rules include two options:

  • The “no-coverage” prong:
    The employer fails to offer to at least 95% of its full-time employees (and their dependents) the opportunity to enroll in a group health plan of the employer, and any full-time employee qualifies for premium assistance, or

  • The “coverage” prong
    The employer offers to at least 95% of its full-time employees (and their dependents) the opportunity to enroll in a group health plan of the employer that is either unaffordable or fails to provideminimum value, and one or more full-time employees qualifies for premium assistance.

These rules are set out in new Internal Revenue Code section 4980H. The no-coverage prong is referred to more formally in proposed regulations as the “4980H(a) penalty,” and the coverage prong, the “4908H(b) penalty.” Both penalties are determined monthly, but they are easiest to understand when expressed as an annual amount. The no-coverage penalty is determined by multiplying the number of the employer’s full-time employees (excluding the first 30) by $2,000. In contrast, the coverage penalty (i.e., the penalty for offering coverage that is either unaffordable or fails to provide minimum value) is determined by multiplying the number of the employer’s full-time employees who qualify for premium assistance by $3,000. This latter penalty can never exceed the 4980H(a) penalty. Where an employer makes an offer of coverage that is both affordable and provides minimum value, there is no penalty.

Coverage is affordable if the employee premium for self-only coverage does not exceed 9.5% of an employee’s household income. Recognizing the difficulty with obtaining household income data, proposed regulations under Code section 4980H provide three proxies or safe harbors for determining affordability: W-2 income, rate-of-pay, and (lowest) Federal Poverty Limit.

Minimum value

A plan fails to provide minimum value if the plan’s “share of the total allowed costs of benefits provided under the plan is less than 60 percent of the costs.” A plan with a minimum value of 100% would cover all benefit costs with no cost-sharing. Anything below 100% simply means that the covered employee or family member will pay a portion of the costs for covered services. The lower the value, the more the employee will need to pay by way of co-pays, deductibles, co-insurance and other cost sharing requirements.

The terms “minimum value” and “actuarial value” both describe the percentage of expected health care costs a health plan will cover for a “standard population.” In the case of minimum value, it’s a population that reflects typical self-insured group health plans. In the case of actuarial value, the standard population is a population that reflects the average health risk of the individual and/or small group health markets.

When determining actuarial value for individual and small group coverage, the services that must be covered include “essential health benefits.”1 For minimum value determinations involving large and self-funded groups, the standards are less clear. Should minimum value be based on the plan’s share of the cost of coverage for all essential health benefits? Or should it be based on the plan’s share of the costs of only those benefits that the plan actually covers? Both prior guidance (i.e., IRS Notice 2012-31) and the proposed regulations concede that there is no support under the Act for the former approach, and both reject the latter. In Notice 2012-31, the Treasury Department and the IRS charted a middle path, noting that the Act directs that the statutory phrase “percentage of the total allowed costs of benefits provided under a group health plan” is determined under rules contained in the regulations to be promulgated by HHS relating to actuarial value, and that the determination of whether an employer-sponsored plan provides minimum value “will be based on the actuarial value rules with appropriate modifications.” Notice 2012-31 proposed that, for an employer-sponsored plan to provide minimum value, it would be required to cover four core categories of benefits: physician and mid-level practitioner care, hospital and emergency room services, pharmacy benefits, and laboratory and imaging services.

HHS has since published a final rule defining the “percentage of the total allowed costs of benefits provided under a group health plan” as

  1. The anticipated covered medical spending for essential health benefits (EHB) coverage … paid by a health plan for a standard population,

  2. Computed in accordance with the plan’s cost-sharing, and

  3. Divided by the total anticipated allowed charges for EHB coverage provided to a standard population.

HHS provided employers with three ways to determine actuarial and minimum value:

  • AV and MV calculators. Employer-sponsored plans may determine their actuarial or minimum value by entering information about the cost-sharing features of the plan for different categories of benefits into an online calculator made available by HHS.

  • Design-based safe harbor checklists. Employers will be able to use safe harbor checklists. If the employer-sponsored plan’s terms are consistent with or more generous than any one of the safe harbor checklists, the plan would be treated as providing minimum value.

  • Actuarial certification. For plans with nonstandard features that preclude the use of the AV calculator, or the MV calculator, actuarial value or minimum value is determined based on the AV or MV calculator with adjustments as certified to an actuary.

The proposed regulations include a fourth option: For small groups, plans that satisfy any of the metal tiers (platinum, gold, silver, and bronze) specified for coverage under a public insurance exchange are deemed to provide minimum value.

The minimum value proposed regulation coordinates with and builds on the HHS final regulation. The proposed regulations refer to the proportion of the total allowed costs of benefits provided to an employee that are paid by the plan as the plan’s “MV percentage.” According to the proposed regulation,

“The MV percentage is determined by dividing the cost of certain benefits the plan would pay for a standard population by the total cost of certain benefits for the standard population, including amounts the plan pays and amounts the employee pays through cost-sharing, and then converting the result to a percentage.” (Emphasis added).

A plan with an MV percentage of 60% or more is deemed to provide minimum value. Anything less, and a plan fails to provide minimum value.

The proposed regulations do not require an employer to provide coverage for all EHB categories. Instead, minimum value is measured with reference to “benefits covered by the employer that also are covered in any one of the EHB benchmark plans.” Or, put another way, a plan’s anticipated spending for benefits provided under any particular EHB-benchmark plan for any state “counts towards” that plan’s MV. Thus, while large groups are not required to offer EHBs, their minimum value percentage is tested against an EHB benchmark plan. The categories of EHB provided in the IRS/HHS calculator include:

  • Emergency Room Services

  • All Inpatient Hospital Services (including mental health and substance use disorder services)

  • Primary Care Visit to Treat an Injury or Illness (except Preventive Well Baby, Preventive, and X-rays) Specialist Visit

  • Mental/Behavioral Health and Substance Abuse Disorder Outpatient Services

  • Imaging (CT/PET Scans, MRIs)

  • Rehabilitative Speech Therapy

  • Rehabilitative Occupational and Rehabilitative Physical Therapy

  • Preventive Care/Screening/Immunization

  • Laboratory Outpatient and Professional Services

  • X-rays and Diagnostic Imaging

  • Skilled Nursing Facility

  • Outpatient Facility Fee (e.g., Ambulatory Surgery Center)

  • Outpatient Surgery Physician/Surgical Services

  • Drug Categories

    • Generics

    • Preferred Brand Drugs

    • Non-Preferred Brand Drugs

    • Specialty Drugs

Safe harbor minimum value plans

The proposed regulations establish the following safe harbor plan designs for plans that cover all of the benefits included in the minimum value calculator:

  • A plan with a $3,500 integrated medical and drug deductible, 80% plan cost sharing, and a $6,000 maximum out-of-pocket limit for employee cost-sharing;

  • A plan with a $4,500 integrated medical and drug deductible, 70% plan cost sharing, a $6,400 maximum out-of-pocket limit, and a $500 employer contribution to an HSA; and

  • A plan with a $3,500 medical deductible, $0 drug deductible, 60% plan medical expense cost-sharing, 75% plan drug cost-sharing, a $6,400 maximum out-of-pocket limit, and drug co-pays of $10/$20/$50 for the first, second and third prescription drug tiers, with 75% coinsurance for specialty drugs.

HSAs, HRAs, and wellness programs — Impact on minimum value

The proposed regulations provide that current year employer contributions to a health savings account (HSA) and amounts newly made available under a health reimbursement arrangement (HRA) that is integrated with an eligible employer-sponsored plan and that are limited to the payment or reimbursement of medical expenses count toward the plan’s share of costs included in calculating minimum value. But if the HRA can be applied toward both the reimbursement of medical expenses and the payment of premiums, employer HRA credits may not be used in the minimum value determination. An integrated HRA is an HRA that coordinates with an employer’s group health plan.

The proposed regulations also provide that a plan’s share of costs for minimum value purposes is generally determined without regard to reduced cost-sharing available under a nondiscriminatory wellness program. But in the case of nondiscriminatory wellness programs designed to prevent or reduce tobacco use, minimum value may be calculated assuming that every eligible individual satisfies the terms of the program. These rules apply to wellness program incentives that affect deductibles, co-payments, or other cost-sharing.

HSAs, HRAs, and wellness programs — Impact on affordability

Because HSAs cannot be used to pay premiums, they don’t affect affordability.

Amounts newly made available under an integrated HRA for the current plan year are taken into account in determining affordability if the employee may use the amounts only for premiums or if he or she may choose to use the amounts for either premiums or cost-sharing. According to the preamble to the proposed regulation, treating amounts that may be used either for premiums or cost-sharing towards affordability prevents double counting the HRA amounts when assessing minimum value.

Tracking the rules for determining minimum value, after 2014, wellness incentives may not be included as either additions to, or deletions from, an individual’s plan premium for purposes of calculating affordability unless the incentive is related to a tobacco cessation program. Thus, the affordability of a plan that charges a higher initial premium for tobacco users will be determined based on the premium that is charged to non-tobacco users, or tobacco users who complete the related wellness program, such as attending smoking cessation classes.

2014 Transition Rule

For purposes of applying the employer shared responsibility rules, for plan years beginning before January 1, 2015, an employer will not incur a penalty under the coverage prong where an employee qualifies for premium assistance if the offer of coverage would have been affordable or would have satisfied minimum value based on the required employee premium and cost-sharing determined as if the employee satisfied the requirements of any such wellness program (including a wellness program relating to tobacco use). This rule applies only to wellness plan terms and incentives in effect as of May 3, 2013, and only to employees who are in a category of employees eligible for the program as of that date.

The following table summarizes the rules governing wellness programs, HSAs and HRAs:

Health Savings Accounts, Health Reimbursement Accounts, and Non-discriminatory Wellness Programs: Summary of Impact on Affordability and Minimum Value

 

Affordability

Minimum Value

Current-year contributions to Heath Savings Accounts

Does not apply, since HSAs can’t be used to pay premiums

Amounts contributed by an employer for the current plan year to an HSA are taken into account in determining the plan’s share of costs for MV purposes.

Current-year contributions to integrated Heath Reimbursement Accounts—premiums and payment/reimbursement of medical expenses

Applies for purposes of the affordability determinations

Amounts newly made available under an integrated HRA for the current plan year are not taken into account for MV purposes.

Current-year contributions to integrated Heath Reimbursement Accounts—Limited to payment/reimbursement of medical expenses

Applies for purposes of the affordability determinations

Amounts newly made available under an integrated HRA for the current plan year are taken into account for MV purposes.

Non-discriminatory wellness programs for 2014

For purposes of applying the employer shared responsibility rules (i.e., Code § 4980H), affordability is determined by assuming that each employee satisfies the requirements of a wellness program (including a wellness program relating to tobacco use).

For purposes of applying the employer shared responsibility rules (i.e., Code § 4980H), MV is determined by assuming that each employee satisfies the requirements of a wellness program (including a wellness program relating to tobacco use).

Non-discriminatory wellness programs—other than tobacco cessation for 2015 and later years

Affordability is determined by assuming that each employee fails to satisfy the requirements of a wellness program.

A plan’s share of costs is determined without regard to reduced cost-sharing available under a nondiscriminatory wellness program.

Non-discriminatory wellness programs—tobacco cessation for 2015 and later

Affordability is based on the premium charged to non-tobacco users (or tobacco users who complete the alternative standard).

A plan’s share of costs is determined assuming every eligible individual satisfies the terms of a nondiscriminatory wellness program.

Modified Rule for Retirees

The proposed regulations provide that a pre-Medicare retiree who declines to enroll in available retiree coverage may qualify for premium assistance. This is similar to the rule adopted in final regulations under Code section 36B, under which an individual who may enroll in continuation coverage required under federal law or a state law is eligible for minimum essential coverage only for months that the individual is enrolled in the coverage. Under this proposed rule, a low-income retiree who declines to enroll in an employer’s retiree health plan may still qualify for premium assistance despite that employer’s coverage is both affordable and provides minimum value.

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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The Fiscal Cliff Legislation: An Executive Summary of What You Need to Know

The National Law Review recently published an article, The Fiscal Cliff Legislation: An Executive Summary of What You Need to Know, written by Michael L. Pate and Elizabeth L. McGinley of Bracewell & Giuliani LLP:

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As everyone knows, the American Taxpayer Relief Act of 2012 (aka, the “Fiscal Cliff Deal”) was passed by the U.S. House of Representatives late in the evening on January 1, 2013. The legislation includes provisions related to tax relief, business tax extenders, energy tax extenders, and the federal budget, among other issues.

To help you navigate this legislation, we have prepared documents featuring concise information on these provisions:

  1. A Summary of the Provisions in the American Taxpayer Relief Act of 2012
  2. The Fiscal Cliff Deal: What’s Included, What Isn’t, and What’s Next
  3. Estimated Revenue Effects of the American Taxpayer Relief Act of 2012

© 2012 Bracewell & Giuliani LLP

2013 Expiring and Changing Employee Tax Provisions

The National Law Review recently published an article by Jacob Mattinson, Diane M. Morgenthaler, and Ruth Wimer, Esq., CPA of McDermott Will & Emery titled, 2013 Expiring and Changing Employee Tax Provisions:

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With the fiscal cliff approaching in 2013, several favorable tax provisions affecting individuals and businesses are set to expire.  These changes include an expiration of the lower federal income tax rates implemented under President Bush, a return of the “marriage penalty” and an expiration of an extensive list of previously extended temporary tax provisions.  Given this tax uncertainty, employers must prepare for possible changes to payroll taxes, flexible spending account contribution limits, adoption assistance benefits and educational assistance benefits.

Payroll Taxes

The 2 percent payroll tax cut enjoyed in 2011 and 2012, which reduced the employee’s share of Social Security payroll taxes, will expire as of January 1, 2013.  Specifically, this tax cut reduced the employee’s share of Social Security taxes from 6.2 percent to 4.2 percent on the first $110,100 of wages in 2012.  A similar reduction from 12.4 percent to 10.4 percent applied to the income of self-employed individuals. Although the increase is on employee contributions, the increase also affects an employer’s withholding obligations.  Furthermore, if an employer provides a gross-up of any type to an employee, such gross-up will be commensurately more expensive beginning in 2013.

At the same time that the temporary 2 percent decrease in employee payroll taxes expires, a new 0.9 percent Medicare payroll tax increase applies (from 1.45 percent to 2.35 percent) under the Patient Protection and Affordable Care Acton wages over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers.  Self-employed individuals will have a similar increase in self-employment tax liability.  Although this increased rate of tax is not an employer liability, employers must be prepared to withhold the additional 0.9 percent from wages for any employee with wages over $200,000.  Because this withholding is required on an employee’s wages over $200,000, which does not particularly correlate with an employee’s ultimate tax liability, many employees, particularly those who are married, may find that they are over- or under-withheld, depending upon the earnings of their spouse.  For example, if a husband and wife each earn $200,000, with joint wages totaling $400,000, this couple will be under-withheld because their respective employers will withhold nothing.  However, the additional 0.9 percent tax for them is owed on combined wages over $250,000, resulting in an under-withholding of $1,350 ($150,000 times 0.9 percent).

Qualified Adoption Assistance

The income tax exclusion for amounts paid by an employer under a qualified adoption assistance program is also set to expire on December 31, 2012.  A qualified adoption assistance program allows an employer to reimburse an employee on a tax-free basis for as much as $12,650 in 2012 for expenses related to the adoption or attempted adoption of a child.  Qualified adoption expenses include reasonable and necessary adoption fees, including court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging while away from home) and other expenses directly related to the legal adoption of an eligible child.

Flexible Spending Account Contributions

Employee contributions to health care flexible spending accounts will be reduced to $2,500 per year for plan years beginning in 2013.  Prior to 2013, the tax code did not limit health care flexible spending account contributions.  This new limit must be documented in a flexible benefits plan by December 31, 2014, regardless of the fiscal year of the flexible benefits plan, and this change must be retroactive to the beginning of the 2013 plan year.

Educational Assistance

Certain reimbursements for employer-provided educational assistance will expire at the end of 2012.  Section 127 of the Internal Revenue Code allows an employer to reimburse an employee on a tax-free basis up to $5,250 for certain educational expenses provided through a non-discriminatory educational assistance program, including reimbursements for graduate school and programs that allow the employee to qualify for a new position.  Even if employer-provided educational assistance programs no longer have tax subsidies in 2013, employers can still provide some type of educational reimbursements in a more limited manner if the educational reimbursements qualify as a business expense and meet certain requirements, such as enhancing the employee’s performance but not qualifying the employee for a new position or career.

Next Steps

With the uncertainty of the approaching fiscal cliff, employers should consider advising employees of the ambiguity surrounding educational assistance and adoption assistance benefits for 2013 and the possibility of a 2 percent payroll tax increase.  However, even if tax extensions for education assistance, adoption assistance and the 2 percent payroll tax increase are adopted in a new tax bill, employers should note that it is highly unlikely that either the new limits on health care flexible spending accounts or the new 0.9 percent payroll tax increase for high-income employees will be altered or eliminated.

© 2012 McDermott Will & Emery

IRS Extends Transition Relief for Puerto Rico Qualified Plans to Participate in U.S. Group Trusts and Deadline to Transfer Assets

Posted in the National Law Review an article by attorney Nancy S. Gerrie and Jeffrey M. Holdvogt of McDermott Will & Emery regarding  U.S. employers with qualified employee retirement plans that cover Puerto Rico:

On December 21, 2011, the U.S. Internal Revenue Service (IRS) issued Notice 2012-6, which provides welcome relief for U.S. employers with qualified employee retirement plans that cover Puerto Rico employees.  Notice 2012-6 provides that the IRS will extend the deadline for employers sponsoring plans that are tax-qualified only in Puerto Rico (ERISA Section 1022(i)(1) Plans) to continue to pool assets with U.S.-qualified plans in group and master trusts described in Revenue Ruling 81-100 (81-100 group trusts) until further notice, provided the plan was participating in the trust as of January 10, 2011, or holds assets that had been held by a qualified plan immediately prior to the transfer of those assets to an ERISA Section 1022(i)(1) Plan pursuant to a spin-off from a U.S.-qualified plan under Revenue Ruling 2008-40.

Notice 2012-6 also extends the deadline for sponsors of retirement plans qualified in both the United States and Puerto Rico (dual-qualified plans) to spin off and transfer assets attributable to Puerto Rico employees to ERISA Section 1022(i)(1) Plans, with the resulting plan assets considered Puerto Rico-source income and not subject to U.S. tax.

There are now two separate deadlines:

    • First, in recognition of the fact that Puerto Rico adopted a new tax code in 2011 with significant changes to the requirements for qualified retirement plans, the IRS has extended the general deadline to December 31, 2012, for dual-qualified plans to make transfers to Puerto Rico-only plans, in order to give plan sponsors time to consider the effect of the changes made by the new tax code.
    • Second, in recognition of the fact that the IRS has not yet issued definitive guidance on the ability of an ERISA Section 1022(i)(1) Plan to participate in 81-100 group trusts, the IRS has extended the deadline for dual-qualified plans that participate in an 81-100 group trust to some future deadline, presumably after the IRS reaches a conclusion on the ability of a dual-qualified plan to participate in an 81-100 group trust, as described in Revenue Ruling 2011-1.

For more information on the issues related to participation of ERISA Section 1022(i)(1) Plans in 80-100 group trusts, see “IRS Permits Puerto Rico-Qualified Plans to Participate in U.S. Group and Master Trusts for Transition Period, Extends Deadline for Puerto Rico Spin-Offs.”

For more information on the issues plan sponsors should consider with respect to a dual-qualified plan spin-off and transfer of assets attributable to Puerto Rico employees to ERISA section 1022(i)(1) plans, see “IRS Sets Deadline for Transfers from Dual-Qualified to Puerto Rico-Only Qualified Plans.”

© 2011 McDermott Will & Emery

Congress Reconsiders Independent Contractor Classification

Posted in the National Law Review an article by Robert B. Meyer and David L. Woodard of  Poyner Spruill LLP regarding Employee MisClassification Prevention Act (EMPA):

 

 

It appears that Congress has again turned its attention to the issue of employee/independent contractor classification.  On October 13, 2011, Rep. Lynn Woolsey (D-CA) reintroduced legislation titled the “Employee Misclassification Prevention Act” (EMPA).  This bill, if enacted, would amend the Fair Labor Standards Act to impose new obligations on employers which utilize independent contractors, and also penalties for employers which misclassify employees as contractors.  Similar legislation was also introduced in the Senate last April, further suggesting that this issue of contractor classification is gaining traction in Congress.  The EMPA, as it is presently drafted, proposes the following:

  • Require employers to keep records of wages and hours worked by independent contractors.  The failure to do so would result in a presumption that the worker is an employee.
  • Require employers to provide written notice to every worker of his/her classification as either an employee or contractor.  The notice must also direct the worker to a Department of Labor website for information regarding worker rights under the EMPA, and encourage workers to contact the DOL if they have questions about classification.
  • Prohibit employers from discriminating or retaliating against workers who exercise their rights under the EMPA.
  • Amend the FLSA to make misclassification a prohibited act, and impose double liquidated damages for violations of the minimum wage and overtime pay provisions of the FLSA resulting from the misclassification.
  • Impose civil penalties upon employers for violating the EMPA (up to $1,100 for first violation, and up to $5,000 for repeat or willful violations).
  • Authorize the DOL to conduct targeted audits of employers in “certain industries with frequent incidence of misclassifying employees as non-employees….”
  • Permit the DOL to share information with the Internal Revenue Service regarding employers found to have misclassified workers.
  • Amend the Social Security Act to establish “administrative penalties for misclassifying employees, or paying unreported wages to employees without proper recordkeeping, for unemployment compensation purposes.”
  • Require state unemployment benefits agencies to conduct worker classification audits of employers.

The potential impact of this proposed legislation is far-reaching.  It is apparent that the EMPA would create a new federal offense for both intentional and unintentional contractor misclassifications.  In addition, the law would create a federal source of new employee rights, and would empower the DOL to seek expanded monetary damages on behalf of workers.  Therefore, employers should not only remain watchful of this legislation as it works its way through Congress, but also cautious about their use and classification of independent contractors.

© 2011 Poyner Spruill LLP. All rights reserved.

Ford Motor Credit Company v. Chesterfield County: Reading Constitutional Fairness And Supply Side Economics Into The Virginia Tax Code

Recently posted in the National Law Review, Winner of the Winter 2011 Student Legal Writing Contest, Adam Blander of Brooklyn Law School wrote an article regarding the recent decision of Ford Motor Credit Company v. Chesterfield County:

In the recent decision of Ford Motor Credit Company v. Chesterfield County,[1] the Virginia Supreme Court held that the gross receipts of a taxpayer’s local business branch reflected activity generated outside of the branch itself, and was therefore not taxable to Chesterfield County as a licensing privilege. This Note argues that despite the rather case-specific and constrictive holding of the decision (which was decided on state-statutory grounds), the facts of the case actually confronted the Court with a much broader, yet more delicate constitutional and public policy determination — what constitutes “fair” tax apportionment of large multi-state businesses?

I. Background: Constitutional Boundaries of State Tax Apportionments

Tax apportionment is the attempt by a governing body to levy taxes based on a corporation’s earned income in that jurisdiction.[2] Almost by definition, “[a]ny state tax apportionment formula will be inaccurate – either overstating or understating the portion of a corporation’s income that should be subject to tax.”[3] Consequently, any formula, at some level, is unfair. In Complete Auto Transit, Inc. v. Brady, the Supreme Court held that the U.S. Constitution required all state taxes affecting multi-state businesses to be, among other things, “fairly apportioned.”[4] In Container Corp. of America v. Franchise Tax Board, the Court explained that a “fairly apportioned” tax must be both “internally” and “externally consistent.”[5] Container directed courts to test for “internal inconsistency” through engaging in a hypothetical exercise: if more than 100 percent of the business’s income would be taxed if every jurisdiction applied the challenged apportionment formula, then formula was internally inconsistent.[6]Internal inconsistency is a facial challenge – the taxpayer need only prove that he faces a “theoretical risk of multiple taxation.”[7] The more elusive element of externalinconsistency, on the other hand, requires the challenged formula to “actually reflect a reasonable sense of how income is generated.”[8]  As such, the taxpayer must show by “clear and cogent evidence that the income attributed to the State is in fact out of all appropriate proportions to the business transacted in that State” or that it “has led to a grossly distorted result.”[9] In Goldberg v. Sweet, the Court clarified that that “[t]he external consistency test asks whether the State has taxed only that portion of the revenues from the interstate activity which reasonably reflects the in-state component of the activity being taxed.”[10]

The practical effect of these Supreme Court decisions is that state courts have been entrusted with the daunting task of determining what constitutes “fair apportionment.” State courts have analyzed challenges to tax schemes utilizing these Supreme Court directives, but have also taken cues from their state’s common law tradition, the state’s own statutory code, and, when possible, the legislative intent of the state’s taxing body. Patrolling for constitutional defects presents an interpretative and political challenge to any court adjudicating tax disputes- how should it reconcile a taxpayer’s right to be free from unfairly apportioned taxes (even if the “unfairness” is entirely theoretical), while at the same time, faithfully interpret the tax systems passed by the legislative body, whose purpose is to collect vital revenue from all taxpayers in its jurisdiction?  This dilemma becomes all the more problematic when the taxpayer is a complex interstate business, which may organize its corporate make-up or accounting scheme in an attempt to avoid payingthese taxes. The Virginia Supreme Court faced such a dilemma in Ford Motor Credit Company.

II. Ford Motor Credit Company v. Chesterfield County: The Facts

In February 2007, Ford Motor Credit Company (FMCC), filed in Virginia circuit court an “Application for Correction of Erroneous Assessment of Business, Profession and Occupation License [“BPOL”] Tax,”[11] claiming it had mistakenly overpaid Chesterfield County, Virginia for the tax years of 2001, 2002, 2003, and 2004. FMCC asserted that its BPOL payments to Chesterfield County, which was based on “the entire gross receipts of loans related to its Richmond branch,”[12] did not actually “reflect the limited contribution of the Richmond Branch to [its] nationwide business.”[13] As such, FMCC sought a refund of $1,515,935.05.[14]

FMCC, a subsidiary of Ford Motor Company, is a “financial services provider, primarily to the automobile purchase or loan lessee environment,” headquartered in Dearborn, Michigan, with hundreds of sales branches throughout the Country, the Richmond branch being one of them.[15] The FMCC headquarters provided the Richmond branch with the capital needed to provide loans, and dictated to the branch “the policies and criteria governing loan approval, contract terms, and other management issues.”[16]

Roughly 75 percent of the branch’s revenue came from “retail and lease contracts,” in which the branch would provide financing to customers wishing to purchase or lease a vehicle from a Ford Motor Company dealership. While the Richmond branch provided the administrative duties necessary to effectuate a loan, such as reviewing the loan application, collecting paperwork and forwarding account information, [17] it generally “did not process funds, receive payments, engage in collection or other customer service activities, or handle delinquent debts.”[18] Upon approval of the loan, the paperwork was forwarded to a service center, in charge of taking title to the vehicle,[19] and the “branch had no further involvement in the loans.”[20] FMCC would then record these loans as receivables in its internal “management, analysis and performance system” (“MAPS”).[21] FMCC would also “book” as revenue any payments due to FMCC. In the event of default on a loan, FMCC would record revenue once the “principle was satisfied on the note.”[22] FMCC paid BPOL taxes based on the gross receipts that MAPS attributed to the Richmond Branch.

FMCC argued that MAPS, in fact, was not an “an activity based system,” but merely a “contract revenue-based system.”[23] In other words, MAPS tracked revenue via the branch in which the loan was originally processed, but was unable to verify which office was actually responsiblefor the specific revenue-generating activities.[24] An FMCC accounting expert testified that it would be “very difficult” to design a system which actually “attribute[d] revenue based on where services are performed.”[25]Accordingly, the BPOL tax assessment, which was based on the gross receipts of “all loans originating in the Richmond Branch” failed to consider the role of other offices in the administering of these loans, including, in particular, the Dearborn headquarters. Because reliance on the gross receipts did not actually reflect revenue collected based on the Richmond branch’s activities, FMCC argued that the BPOL tax, as administered, violated the “fair apportionment prong” for local taxation set forth in Brady.[26] The expert proposed that a BPOL tax based on payroll apportionment would more accurately reflect “all the activities [of the Richmond branch] thatgeneratedrevenues” which, incidentally, would entitle FMCC to a sizable refund.[27]

Unmoved, the circuit court dismissed FMCC’s application with prejudice, finding that the “MAPS figures accurately reflect the gross receipts generated as [a] result of the distinct efforts of the Richmond Branch” and consequently, was not “‘out of all appropriate proportion’ to the business transacted in the locality,” thus satisfyingBrady’s fair apportionment requirement.[28]

III. Ford Motor Credit Company: The Decision

On appeal, the Supreme Court of Virginia reversed the circuit court’s decision, and found for FMCC. Writing for the majority, Chief Justice Cynthia D. Kinser declined to directly address the constitutional challenges under Brady, and instead held that the assessment contravened the Virginia Taxation Code. Nonethless, this Note contends that the decision was not an exercise in “constitutional avoidance”: while the Court did not state so explicitly, it read into the state Tax Code its own value-laden interpretation of what constitutes “fair apportionment,” regardless of whether such an interpretation was a faithful interpretation of the actual legislation.  In so doing, the Court hinted that any alternate interpretation of the Code faced the risk of being challenged on constitutional grounds as well.

The Virginia Tax Code allows the “governing body of any county” to collect “liscence taxes” (BPOL taxes) upon any person, firm, or corporation “engaged” in any business or trade “within the county.”[29] The question, therefore, was whether “gross receipts [] falls within a locality’s statutory power to tax.”[30] Citing a prior Virginia case, City of Winchester v. American Woodmark (Woodmark I), the Court noted that additional tax burdens “are not to be extended by implication beyond the clear import of the language used. Whenever there is just doubt, that doubt should absolve the taxpayer.”[31] The Code provides that local BPOL taxes may only tax “those gross receipts attributed to the exercise of a privilege subject to licensure at a definite place of business within this jurisdiction.”[32] With regards to service businesses in particular, gross receipts should be “attributed to the definite place of business at which the service is performed…directed, or controlled.”[33] Nonetheless, if the licensee  “has more than one definite place of business and it is impractical or impossible to determine to which definite place of business gross receipts should be attributed under the general rule,” then gross receipts are to be “apportioned based on payroll.”[34]

The Court, relying upon its prior holding in City of Winschester v. American Woodmark Corp. (Woodmark II), which itself relied upon the language of the Supreme Court decision, Goldberg v. Sweet, concluded that the gross receipts werenotattributable solely to FMCC services rendered in the County.[35]Woodmark II held that a BPOL tax may be levied “only to the portion of the revenues from the interstate activity which reasonably reflects the in-state component of the activity being taxed.”[36] In Woodmark II, American Woodmark, a furniture manufacturer with 24 facilities in different states, alleged that city’s imposition of BPOL taxes on 100% of its revenue constituted “unfair apportionment” because only its corporate headquarters were located in Winchester. Woodmark argued that an assessment of the gross receipts was not “attributable to [its] business activities within the city.”[37] The Court determined it a matter of “common sense” that the value by the headquarters alone could “not possibly produce 100% of the revenues.”[38] It thus held that American Woodmark had presented “clear and cogent evidence” that the “assessments attributed to operations conducted in Winchester [were] out of all appropriate proportions to…the business transacted in Winchester.”[39]

The FMCCcourt noted that “[a]lthough a statutory challenge was not presented inWoodmark II” the case nonetheless stood for the proposition that a locality, under the Code, may only tax the gross receipts “attributed to the exercise of a privilege subject to licensure at a definite place of business.”[40] Regarding the facts of this case, the court observed that service centers outside the County had refinanced loans (initially contracted into at the Richmond branch), assisted customers with administration changes, titled vehicle, and tracked the progress of loan payments. The court also recognized that FMCC headquarters directly provided the Richmond branch with capital. In light of these realities, the court held that FMCC had demonstrated “by clear and cogent evidence” that the gross receipts attributed to the Richmond Brach, were in fact, the product of “financial services provided in other jurisdictions.”[41] “In other words, the operation of the Richmond Branch did not produce 100 percent of the gross receipts that the County taxed.”[42] Therefore, a tax assessment based on these gross receipts was invalid. Finally, because MAPS only tracked revenues by contract, the Court determined it would be “impossible, or, at least, impractical” for FMCC to track the actual services performed over the lives of the approximately 20,000 loans which originated in the Richmond Branch. As such, the court concluded that the “BPOL tax assessment must be calculated using payroll apportionment.”[43]

IV. Possible Consequences

FMCC received a significant windfall from the ruling, which, as the dissent observed, was now entitled to recover approximately 93% of its past payments.[44] Still, the Court’s uncritical acceptance of FMCC’s contention that it would be “very difficult” to design an alternative accounting system may spawn unanticipated mischief in the near future. Without judicial incentives (punitive or otherwise), a complex interstate business, well aware of the financial stakes, will simply fail to create an accounting system which records revenue generated by each definite places of business. At that stage, the business will self-servingly insist to the taxing authority that redesigning the system would be “very difficult,” entitling itself to the more attractive BPOL based on payroll. In effect, a company may fleece itself from paying higher taxes simply through its own negligence, willful blindness, or lack of innovative impetus.

Perhaps more significantly, the court’s reliance on Woodmark II,  which was decided on non-statutory based grounds,  in interpreting the BPOL statutory provisions seems to be an effort by the court to inject constitutional principles of “fair apportionment” into the Tax Code itself. The FMCC court could have determined the extent of Chesterfield County’s authority to tax through utilizing the traditional maxims of statutory interpretation, in which the provisions dealing with the BPOL tax were analyzed within the context to the Code as a whole. Instead, the FMCC court relied onWoodmark II’s broad “reasonableness” standard of external inconsistency, set forth by the Supreme Court in Goldberg v. Sweet. Apparently, the court signaled that it would interpret the Code itselfto mandate that all assessments reasonably reflect the in-state component of the taxed activity in accordance with Goldberg. The Virginia Supreme Court, moreover, has set a considerably higher external inconsistency standard than Goldberg’s – Both Woodmark II and FMCC held that an assessment which taxed anythingmore than revenue attributed to that definite place of business constituted clear and cogent evidence that the assessments were out of all appropriate proportion. Proportionality was measured, not through any mathematical ratio or formula, but rather through an appeal to “common sense” (Woodmark II), or through realization that the revenue could not be quantified (FMCC). Both decisions’ reference to an opaque “100% of revenue” hypothetical exercise indicates that the Court has attempted to articulate a “reasonableness” standard which (rather coarsely) incorporates both internal and external consistency models.

V. Trending Towards a More Business-Friendly Virginia

To appreciate how far-reaching the FMCC decision is, it is crucial to highlight the actual holding in WoodmarkI, approvingly cited in FMCC. Woodmark Iheld that office equipment located at a manufacturer’s headquarters was sufficiently “used in manufacturing” under the Virginia Tax Code, thus exempting it from local property taxes.[45] The Virginia legislature thereafter amended the Code to codifyWoodmark’s broad interpretation of “manufacturing.”[46] The practical consequence of these actions was that anybusiness involved in manufacturing, however tangentially, could now claim exemptions for its personal property.[47] FollowingWoodmark I, the Virginia courts further broadened these exceptions to include, among other things, vending machines and advertising scoreboards used by a manufacturer, and even raises questions of whether the exemption may extend to property leased to a manufacturer which is owned by a non-manufacturer.[48] One scholar opined that Woodmark I’s interpretation of the Virginia Codeare  “convoluted” and “not easily categorized by [ ] theoretical rationales.”[49] She concluded that “on a more practical level, Virginia…seems willing to enlarge the tax breaks offered to manufacturing businesses.”[50]

FMCC’s reference to Woodmark I, regardless of its actual relevance to the facts of the case, evinces how broad Woodmark I’s holding has become. Instead of being constrained only to the manufacturing realm, Woodmark Iapparently has evolved into a judicial mandate to create additional tax breaks for interstate companies, even those engaged in distinctly non-manufacturing enterprises, such as financing loans. Seen in this light, Ford Motor Credit Company, inspired by Woodmark I (and to a degree, Woodmark II) is the latest incident of a growing trend in Virginia to resolve discrepancies in the tax code in favor of big business. The creation of these corporate “tax-loopholes,” either through judicial fiat or legislative codification, is likely an attempt to lure large businesses, particularly manufacturers, into locating or expanding their operations inside Virginia. As the Circuit Court in Woodmark I put it, “the term manufacturing is to be construed liberally because ‘the public policy of Virginia is to encourage manufacturing in the Commonwealth.’”[51]

Virginia, in essence, has endorsed a localized version of “supply side economics,” predicting that the lowering of taxes on the production of both goods (e.g., furniture, as in Woodmark I) and services (e.g., financing, as in FMCC)[52] will, in turn, spur economic growth in Virginia, particularly in the form of job creation. As a result, Virginia localities, faced with a subtle yet significant decrease in millions of dollars of property tax and BPOL tax revenue, may be compelled to shift this burden directly onto consumers, whom, incidentally, are less capable lobbyists than large corporations.[53] If the courts succeed in incentivizing large employers to make Virginia their home, it may come at the cost of overtaxing less lucky Virginians.

[1] Ford Motor Credit Company v. Chesterfield County, 2011 WL 744985 (Va. 2011).

[[2] David Shipley, The Limits of Fair Apportionment: How Fair is Fair Enough?, 93 St. & Loc. Tax Law 34, 34 (2007).

[3] Id.

[4] 430 U.S. 274 (1977).

[5] 463 U.S. 159, 169.

[6] Id.

[7] Shipley, at 34.

[8] Container,463 U.S. at 169 (emphasis added).

[9] Id.at 170.

[10]  488 U.S. 252, 262  (emphasis added).

[11] Ford Motor Credit Company, at *3.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id.

[17] Id. at *4.

[18] Id.

[19] Id.

[20] Id.

[21] Id.

[22] Id.

[23] Id.

[24] Id. at *5

[25] Id.

[26] Id. at *6

[27] Id. at *5 (emphasis added).

[28]  Id. at *6.

[29] Idat *7.

[30] Id.

[31] Id. The Court also ruled that a “tax assessment made by the proper authorities isprima facie correct and valid, and the burden is no the taxpayer to show that such assessment is erroneous.” Id.

[32] Id. (emphasis added).

[33] Id. at*8.

[34] Id.

[35] Id. at *9.

[36] Id (emphasis added).

[37] Id.

[38] Id. 

[39] Id.

[40] Id. (emphasis added).

[41] Id. at *10.

[42] Id. at *11.

[43] Id.

[44] Id. at *13.

[45]  American Woodmark Corp. v. City of Winchester, 464 S.E.2d 148 (Va. 1995).See generally, Stacey Wilson, Good Intentions, But Unintended Consequences: Expanding Virginia’s Manufacturing Tax Exemption Under City of Winchester v. American WoodmarkCorp, 41 WM & MARY L. REVIEW 67 (2000)

[46] Virginia Code § 58.1-1101(A)(2), cited in Wilson at 69.

[47] Wilsonat 73.

[48] Id.

[49] Id.

[50] Id.

[51] 34 Va. Cir. 421, 434 (1994) (citing County of Chesterfield v. BBC Brown Boveri, Inc., 380 S.E.2d 890, 893 (Va. 1989)), cited by Wilson at 84.

[52] Ford Motor Company, at *8. (“Neither party contests that FMCC was a service business for purposes of Code § 58.1–3703.1(A)(3)(a)(4).”)

[53] Wilson, at 73.

Adam Blander © Copyright 2011

Is the $5 Million Gift Tax Exempt Amount About to End?

Recently posted in the National Law Review an article by Elyse G. Kirschner and Carlyn S. McCaffrey  of McDermott Will & Emery regarding the The Tax Relief Act of 2010 made significant changes to the gift, estate and generation-skipping, however, not permanent:

 

 

 

The Tax Relief Act of 2010 made significant changes to the gift, estate and generation-skipping transfer tax regimes by increasing the amount each individual can give without incurring tax from $1 million to $5 million.  The increase was not permanent however, and rumor has it that it may be in jeopardy.  To avoid any risk, those who have decided to use their full exemptions should do so no later than December 31, 2011, and, if feasible, November 22.

The Rumors

The Tax Relief Act of 2010 made significant beneficial changes to the gift, estate and generation-skipping transfer tax regimes.  Most important, it increased the amount each individual can give without incurring gift tax and generation-skipping transfer tax to $5 million from $1 million.  For married individuals, the combined exemptions can be as high as $10 million.  The 2010 increase was not a permanent one.  Congress scheduled the exemption to return to $1 million after the end of 2012.

Rumors circulating recently within the financial and estate-planning communities have suggested the $5 million exemptions may be in immediate jeopardy.  Democratic staff on the U.S. House Committee on Ways and Means recently proposed decreasing the $5 million gift, generation-skipping transfer tax and estate tax exemptions to $3.5 million, effective January 1, 2012.  There also are rumors the Joint Select Committee on Deficit Reduction (the Super Committee) may recommend a drop down in the gift tax exemption to $1 million, effective at year end, or possibly as early as November 23, 2011, when its recommendations are scheduled to be released, though there is no confirmation this rumor is true.

What Should You Do?

Although it seems unlikely that Congress will focus on changes to the transfer tax system before year end, congressional action in the transfer tax area has been notoriously difficult to predict.  Congress’ decision in December 2010 to reinstate the estate tax retroactively, to permit the estates of 2010 decedents to opt out of paying estate tax and to reduce the generation-skipping transfer tax rate to zero, was a noteworthy example of congressional action that took the entire estate-planning community by surprise.  A congressional decision to reverse the 2010 transfer tax reductions would be more surprising because it would immediately strip from taxpayers a benefit that was clearly agreed to last December.  However, Congress is unpredictable.

In view of the uncertain availability of the $5 million exemption, those who have decided to use their full exemptions may want to do so quickly, rather than run the risk of losing them.  To avoid any risk, your deadline should be no later than December 31, 2011, and, if feasible, November 22.  The choices to be made include identifying the property to be transferred, selecting the individual recipients and determining the manner in which the recipients should receive their gifts.

Selection of Assets to Give

Assets to be transferred to the trust should be those that are likely to appreciate over time.  The transfer of appreciating assets will help leverage the initial gift.  Investments that are temporarily depressed as a result of recent market conditions, for example, could prove to be successful gifts. Remainder interests in residences in today’s depressed housing markets may also be attractive gifts.  Marketable securities, interests in hedge funds or other investment partnerships and real estate are all good possibilities.  High-basis assets typically are a good choice, but assets that are valued today at less than their basis are not usually the best choice.

If non-marketable assets are given, an appraisal of those assets is needed to properly value and report the gift, but the appraisal can be completed after the gift is made.  In most instances, a formal appraisal of non-marketable assets will take into account certain valuation discounts (for example, lack of marketability and minority interest discounts).  The effect of these valuation discounts will be to further leverage the gift tax credit.

Selecting Recipients

The logical recipients of gifts will be those family members who will receive the estate.  Because tax-free gifts can be made to a spouse and charity, gifts to them do not need to be accelerated to take advantage of the gift tax exemption.  In some cases, clients may plan to use their increased exemptions to forgive debts previously made to friends and family members with financial needs, or to meet the living expenses of adult children.

Making Gifts in Trust

Outright gifts are a simple way to use the gift and generation-skipping transfer tax exemptions, but gifts in trust offer many more advantages.  For example, transferring assets to a trust for the benefit of children can protect those assets from the claims of their creditors or spouses.  In addition, with a trust the trustees of the trust can control the timing and manner of distributions to children.

Furthermore, if portions of the remaining $5 million generation-skipping transfer tax exemption are allocated to the trust, future distributions to grandchildren and more remote issue can be made free of the generation-skipping transfer tax.  Finally, if the trust that is established is a so-called “grantor trust” for income tax purposes, you, and not the trust, will pay the income tax on the income generated inside the trust.  When the gift-giver pays the income tax on the income of the trust, the size of the estate is reduced without having to make additional taxable gifts to the trust.

An Existing Trust or a New Trust?

Once the decision is made to make a gift in trust, the next question is whether to make the gift to an existing trust or to a new one.  Whether an existing trust or a new trust is selected is a function of a number of considerations, such as whether the trusts that are already created have the appropriate beneficiaries, whether a spouse also plans to make a gift in trust and whether certain provisions should be in the trust to address uncertainties at this time.

© 2011 McDermott Will & Emery