Recent developments on Section 199 and other IRS accounting method issues

Accounting Methods Spotlight / Issue 12 / December 2014
Did you know? p2 / IRS guidance assessing Section 199 issues p2 / Other IRS
guidance p8
Recent developments on
Section 199 and other IRS
guidance shed light on tax
accounting method issues
In this month’s issue, taxpayers are reminded that a 52-53 week taxable year is deemed to begin (or
end) on the first (or last) day of the month in certain circumstances. In addition, this month’s issue
includes IRS rulings on several Section 199 issues, including holdings that: damage awards from
litigation begun in pre-Section 199 years did not reduce a taxpayer's Section 199 deduction; a banking
app is online software that does not qualify for the Section 199 deduction; revenue from the license of
computer software distributed to end-users by the taxpayer’s customers is eligible for the Section 199
deduction; and, gross receipts derived from a taxpayer’s production and distribution of multichannel
video programming subscription packages do not qualify for the Section 199deduction. This month’s
issue also includes discussions on: the final regulations modifying the definition of an acquiring
corporation in certain asset acquisitions; a ruling that a successor to a Treasury Troubled Asset Relief
Program (TARP) recipient, was not eligible for an extended NOL carryback; IRS advice on the
absorption rules for certain alternative tax net operating losses (ATNOLs); a ruling that preacquisition qualified research expenses belong to the target not the acquiring corporation; and, finally,
a ruling that a taxpayer’s payment to a manufacturer as a contribution towards the costs to develop
and market certain products need not be capitalized.
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Did you know..?
52-53 week taxable year deemed to begin (or end) on the first (or last)
day of the month in certain circumstances
For various reasons, a taxpayer may elect to use a 52-53 week taxable year. This type
of fiscal year always ends on the same day of the week with respect to the end of a
specific calendar month, on either the last time that day occurs in the month or the
closest that day occurs to the end of the month. As a result, a 52-53 week taxable year
often does not coincide with the last day of a month. This fact can cause confusion
when the effective date of new law, or the applicability of a particular provision,
references the first or last day of a specific calendar month.
To avoid this confusion, as well as the potential inconsistency between taxpayers
using a 52-53 week taxable year and taxpayers that do not use a 52-53 week taxable
year, the regulations provide a special rule to address the application of effective dates
and provisions that reference a particular day of the month. Specifically, the rule
provides in any case in which the effective date or the applicability of any provision is
expressed in terms of taxable years beginning, including, or ending with reference to a
specified date that is the first or last day of a month, a 52-53 week taxable year is
deemed to begin on the first day of the month beginning nearest to the first day of the
52-53 week taxable year, and to end on the last day of the month ending nearest to the
last day of the 52-53 week taxable year.
This special rule was recently applied by the IRS in PLR 201447027 with respect to
the W-2 wage limitation for the domestic production activities deduction under
Section 199, which limits the amount of the Section 199 deduction to 50 percent of the
W-2 wages of the taxpayer for the taxable year. For this purposes, W-2 wages are
defined generally to mean wages paid during the calendar year ending during such
taxable year.
The taxpayer in the PLR computes its taxable income on the basis of a 52-53 week
taxable year ending on the last Saturday in December. The taxpayer sought IRS
guidance because there is potentially no calendar year (i.e., a period of 12 months that
ends on December 31) that ends within the taxpayer’s 52-53 week taxable year for
2017. That is, the taxpayer’s taxable year for 2017 will begin on January 1, 2017, and
end on December 30, 2017 (the last Saturday in December 2017), and literally does
not include a December 31. Therefore, absent the special rule discussed above, there
potentially is no calendar year that ends during the 2017 taxable year for purposes of
applying the W-2 wage limitation. To the extent a calendar year does not end during
the taxable year, the W-2 wage limitation is zero, resulting in no deduction under
Section 199.
In PLR 201447027, the IRS ruled that the special rule in the regulations applies such
that the taxpayer is required to use wages reported on Forms W-2, Wage and Tax
Statement, for the calendar year ending nearest to the last day of the corporation’s 5253 week taxable year for purposes of computing the W-2 wage limitation. Thus, the
52–53 week taxable year of the taxpayer that will begin on January 1, 2017, and will
end on December 30, 2017, is treated as ending on December 31, 2017. As such, the
IRS concluded, the calendar year 2017 is treated as ending during the taxpayer’s 5253 week taxable year that ends on December 30, 2017 for purposes of applying the W2 wage limitation.
IRS guidance assessing Section 199 issues
Damage awards from litigation begun in pre-Section 199 years held
not to reduce deduction
In CCA 201446018, the IRS concluded that litigation damages award payments
(litigation payments) were exclusively apportioned to gross income not attributable to
domestic production gross receipts (DPGR). As a result, the litigation payments did
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not reduce the taxpayer's qualified production activities income (QPAI) and its
corresponding domestic production activities deduction (the Section 199 deduction).
The IRS noted that even though the litigation payments were made in a year for which
Section 199 was effective, the allocation and apportionment of such payments had a
strong factual relationship to gross income attributable to pre-Section 199 sales that
did not generate DPGR. As a result, the IRS agreed with the taxpayer's affirmative
claim that such expenses do not reduce a taxpayer's QPAI, thereby increasing the
taxpayer's Section 199 deduction for the tax years under exam.
In CCA 201446018, a parent holding company (Parent), and its U.S. subsidiaries that
manufactured and sold various products, filed a consolidated return for all years and
used the Section 861 method to allocate and apportion deductions for purposes of
computing its QPAI. One of the Parent's subsidiaries (Subsidiary) manufactured and
sold Product W and Product X in years before and after enactment of Section 199.
During Years 1 and 2 (post-2004 tax years), substantially all of Subsidiary's gross
receipts were DPGR from sales of Products W and X. On a consolidated level, the
group's gross receipts were comprised of DPGR and non-DPGR. Thus, Parent was
required to determine which costs are allocable to DPGR for purposes of calculating
its QPAI for Years 1 and 2.
In years preceding the enactment of Section 199, Subsidiary was a defendant in two
separate lawsuits related to Product W. In Year 1 and Year 2, Subsidiary made
litigation payments to two different parties that were calculated by reference to
Product W sales in years prior to the enactment of Section 199. The taxpayer deducted
the litigation payments on its consolidated U.S. federal income tax return for Years 1
and 2, respectively. The taxpayer also reduced its QPAI in Years 1 and 2 for the
amount of litigation payments made in each year for purposes of determining its
Section 199 deduction for each year.
In a subsequent year, the taxpayer filed an affirmative claim for each year to treat
litigation payments as allocable to non-DPGR, thereby increasing its Section 199
deduction for each year. As part of the IRS examination process, the exam team
requested advice from the IRS Office of Chief Counsel regarding the proper method of
allocating and apportioning litigation payments relating to litigation that commenced
in years prior to the effective date of Section 199 under the section 861 regulations.
The IRS concluded that the litigation payments are indirect costs similar to warranty
or product liability costs that are not capitalizable under Section 263A, and that the
payments must be allocated and apportioned under the Section 861 method. Under
the Section 861 method, the IRS analyzed the factual relationship between the
litigation payments and gross income. In the instant case, the IRS ruled that the
litigation payments made in Year 1 and Year 2 arose from a class of gross income
attributable to the sale of Product W made prior to the enactment of section 199. As a
result, the IRS concluded that such payments were "incurred as a result of, or incident
to, and so are properly allocated to, the class of gross income from the specific sales of
Product W that gave rise to the litigation...."
Accordingly, the IRS determined that all sales of Product W that gave rise to the
litigation occurred in years prior to the effective date of Section 199, and therefore did
not generate DPGR. Under the Section 861 method, no portion of the deduction
relating to the litigation payments should be apportioned to the statutory group of
Section 199 gross income in Years 1 and 2. The IRS therefore concluded that the
litigation payments did not reduce Subsidiary's QPAI and the consolidated group's
Section 199 deduction.
IRS concludes that banking app does not qualify for Section 199
deduction
In a generic legal advice memorandum (GLAM), AM 2014-008, the IRS concluded
that revenue from a downloadable computer software application (App) provided to
customers free of charge, which allows customers to access online fee-based services
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(i.e., online banking services), is “online software,” the gross receipts of which do not
constitute domestic production gross receipts (DPGR) eligible for the domestic
production activities deduction under Section 199. In addition, the IRS concluded
that a third-party’s software was not comparable to such online software because the
users of the two software programs used them for different purposes.
The GLAM outlines a generic fact pattern whereby the taxpayer is a bank that offers
banking services to its customers in a number of ways including via bank branches,
text messaging, automated teller machines, and over the Internet through the
taxpayer’s mobile banking App (the App), traditional website, and mobile website.
The taxpayer’s online platforms (including its App) allow customers to perform
various banking activities, such as accessing bank accounts, making deposits, and
wiring funds. Regardless of whether customers use individual tellers, websites, or the
App to receive banking services, any banking transaction is executed in essentially the
same way. In all cases, A’s internal computer systems (computer hardware, software,
equipment, and data), which A does not license to its customers or allow them to
download, complete any banking transaction. The taxpayer’s customers must be
connected to the Internet for any of the taxpayer’s online platforms, including the
App, to function.
The taxpayer’s customers can download the App free of charge. The taxpayer grants
its customers a non-exclusive, non-sub-licensable, non-transferable, personal, limited
license to install and use the App on mobile devices that are owned and controlled by
the taxpayer’s customers, solely for personal use as the taxpayer permits. While the
taxpayer does not charge its customers a fee to use or download the App, customers
may incur fees for some banking services provided through the App that are equal to
the fees customers incur for receiving banking services via the taxpayer’s websites.
The example also provides that Z, an unrelated third party, produces a mobile
banking software application (App Z) that it offers to its customers, who are the
taxpayer’s competitor banks, by download over the Internet. Z licenses App Z to the
taxpayer’s competitor banks and derives gross receipts from those licenses on a
regular and ongoing basis. The taxpayer’s competitor banks use App Z to provide
banking services to its account holders, in the same manner that the taxpayer’s
account holders use the taxpayer’s App.
The Section 199 regulations provide that DPGR includes gross receipts of the taxpayer
that are derived from the disposition of certain computer software. For this purpose,
gross receipts derived from customer and technical support, telephone and other
telecommunication services, online services (such as Internet access services, online
banking services, providing access to online electronic books, newspapers, and
journals), and other similar services do not constitute gross receipts derived from a
disposition of computer software. As a result of this rule, computer software provided
to customers for their direct use while connected to the Internet or other public or
private communications network, also known as ‘online software’, is classified as a
service provided to customers. Accordingly, because providing access to online
software is classified as the provision of services, any gross receipts attributable to the
use of online software generally are not considered to be derived from a qualified
disposition of software, subject to two exceptions.
The GLAM addressed whether the download of the taxpayer's App by its customers
qualifies as a disposition under Section 199, whether the taxpayer derives gross
receipts from the App, and whether the taxpayer satisfied either of the two exceptions
for online software in the Section 199 regulations (i.e., the self-comparable and thirdparty comparable exceptions).
The IRS first analyzed whether the taxpayer makes a qualifying disposition of
computer software when customers download the App. The IRS determined that the
App fits within the definition of online software set forth in the Section 199
regulations because the App is computer software used by customers while connected
to the Internet or other public or private communications network. When not
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connected to the Internet, the App does not have any functionality. Although the IRS
recognized that the regulations under Section 199 contain references to computer
software downloads as dispositions, the IRS clarified that those references are to
downloaded software that has independent functionality after customers have
downloaded it and are no longer connected to the Internet. The IRS concluded that
the taxpayer’s App functions more akin to a website, and thus, the taxpayer is not
treated as disposing of computer software when customers download its App.
The IRS next concluded that even if the taxpayer disposes of computer software when
customers download the App, the taxpayer does not directly derive any gross receipts
from the lease, rental, license, sale, exchange, or other disposition of qualifying
production property which was manufactured, produced, grown, or extracted by the
taxpayer in whole or significant part within the United States as part of the
transaction because the App only allows customers to utilize online banking services.
The only fees that the taxpayer charges are for completed banking transactions, such
as check deposits or wire transfers. Consequently, the IRS concluded that the gross
receipts received through the App are attributable to online banking services and are
non-DPGR.
Finally, the IRS concluded that the taxpayer does not meet either of the exceptions set
forth in the Section 199 regulations; thus, no portion of its gross receipts should be
treated as derived from the disposition of computer software. According to the IRS,
the taxpayer does not meet the self-comparable exception with respect to any of its
online software because the taxpayer’s online software constitutes both its website
and the App, neither of which are disposed of in a qualified disposition to satisfy the
self-comparable exception. In addition, the IRS reasoned that even if the download of
the taxpayer’s App is considered a qualified disposition of computer software, the
taxpayer cannot use its App as a self-comparable to qualify any of its online software
because the taxpayer does not directly derive gross receipts from the download of the
App.
The IRS also concluded that the taxpayer does not meet the third-party comparable
exception because the third-party disposition of App Z to the taxpayer’s competitor
banks is not a disposition of substantially identical computer software. The IRS stated
that the computer software provided by Z provides a different functional result, and
does not have significant overlap of purpose with the taxpayer’s computer software.
According to the IRS, the fact that the competitor banks’ account holders utilize App Z
in the same manner as the taxpayer’s account holders use the App does not affect this
analysis because the competitor banks’ account holders are not relevant customers for
purposes of the third-party comparable exception. Accordingly, the IRS concluded
that even though Z derives gross receipts on a regular and ongoing basis in Z’s
business from the disposition of App Z to its customers, App Z is not substantially
identical to the taxpayer’s online software for purposes of the third-party comparable
exception.
Accordingly, the IRS concluded that the taxpayer derives no DPGR from the
disposition of computer software when it allows its customers to download its App
free of charge, and the App only enables the customers to access taxpayer’s online feebased services. Because the App is considered online software, the taxpayer does not
make a qualifying disposition of computer software. Moreover, even if the download
of the taxpayer’s App is a disposition, the gross receipts taxpayer derives are entirely
from the provision of online fee-based services and not from a disposition of
computer software
IRS rules Section 199 deduction available for revenue from licensing
software distributed to end-users by contracting parties
In TAM 201445010, the IRS determined that revenue from the license of computer
software to contracting parties, who in turn use the computer software and their own
proprietary data to provide services to end users, constitutes domestic production
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gross receipts (DPGR) eligible for the domestic production activities deduction under
Section 199.
According to the facts of the TAM, the taxpayer is engaged in developing and licensing
computer software that is distributed to end-users through contracting parties.
Specifically, the taxpayer designs and develops unique computer software for each
contracting party’s data, and subsequently licenses the computer software to the
contracting parties. The contracting parties use the taxpayer’s licensed computer
software in coordination with their own proprietary data to generate and distribute
products (i.e., ‘results’) to end-users through subscriber agreements. In some cases,
the taxpayer grants end-users a license to use the results. Under the subscriber
agreements, contracting parties collect fees from the end-users and subsequently pay
the taxpayer in accordance with the terms of master agreements.
Under Section 199, DPGR includes gross receipts of the taxpayer derived from any
lease, rental, license, sale, exchange, or other disposition of qualifying production
property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the
taxpayer in whole or in significant part within the United States. QPP includes
computer software, even if the customer provides the computer software to its
employees or others over the Internet. However, gross receipts derived from the
performance of services do not qualify as DPGR. As a general rule, gross receipts
derived from customer and technical support, telephone and other
telecommunication services, online services — such as Internet access services, online
banking services, and providing access to online electronic books, newspapers, and
journals — and other similar services do not constitute gross receipts derived from a
lease, rental, license, sale, exchange, or other disposition of computer software.
In evaluating the taxpayer’s Section 199 deduction, the IRS Large Business and
International Division (LB&I) asserted that the taxpayer derives its gross receipts
directly from the provision of services to end-users and receives no compensation
from contracting parties for the license of computer software. Conversely, the
taxpayer asserted that it derives its gross receipts directly from the license of
computer software to its contracting parties. Accordingly, the TAM specifically
addresses whether the taxpayer derived DPGR from the license of computer software
to contracting parties, or non-DPGR from providing services to end-users.
The TAM states that the transactions between the taxpayer and the contracting
parties effectively represent two separate steps: (1) taxpayer produces unique
computer software for contracting parties, followed by a license of the computer
software to the contracting party; and (2) contracting parties utilize the computer
software, in conjunction with their own data, when providing services (i.e., generation
and distribution of the ‘results’) to end-users.
After reviewing the relevant agreements with contracting parties, the IRS concluded
that (1) the taxpayer's fees from contracting parties were royalty payments, and thus
directly paid by the contracting parties for the license of computer software; and (2)
the taxpayer's license to end-users pursuant to the subscriber agreements did not
indicate that the taxpayer is providing services to end-users; rather, the license in the
subscriber agreement was intended to clarify limitations on the license provided by
the taxpayer to contracting parties.
Consequently, the IRS concluded that the taxpayer produced computer software that
qualifies as QPP. The taxpayer made a qualifying disposition by licensing computer
software to each of the contracting parties and, accordingly, derived gross receipts
directly from the license of computer software to contracting parties.
IRS addresses questions surrounding Section 199’s qualified film
provisions
In CCA 201446022, the IRS concluded that gross receipts derived from a taxpayer’s
production and distribution of multichannel video programming subscription
packages do not qualify as domestic production gross receipts (DPGR) from the
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disposition of a qualified film under Section 199 and the regulations thereunder. In
reaching this conclusion, the IRS took the position that license fees paid by the
taxpayer for the right to broadcast third-party programming are not required to be
capitalized under Section 263A, and therefore are not overhead costs for purposes of
the qualified film safe harbor under Section 199.
Under section 199, DPGR includes, in part, gross receipts derived from any lease,
rental, license, sale, exchange, or other disposition of any qualified film produced by
the taxpayer. The final regulations under Section 199 provide that a qualified film will
be treated as ‘produced by the taxpayer’ if the production activity performed by the
taxpayer is ‘substantial-in-nature.’ Alternatively, under the ‘qualified film safe
harbor,’ a taxpayer will be treated as producing a qualified film if the taxpayer meets
both of the following two tests: (1) the taxpayer's direct labor and overhead account
for 20 percent or more of the total cost (or unadjusted basis) of the qualified film (the
‘20-percent production rule’), and (2) 50 percent or more of the total compensation
paid by the taxpayer is compensation for services performed within the US (the ‘50percent compensation rule’).
The taxpayer in the CCA creates ‘Subscription Packages’ comprised of multiple
channels of video programming. Each Subscription Package is tailored to meet
specifications selected by its customers, including what and how many channels the
customer will receive. Each Subscription Package may include programming that the
taxpayer licenses from unrelated third parties, such as television and cable networks
(‘licensed programming’), as well as programming that is self-produced by the
taxpayer (‘self-produced programming’).
For licensed programming, the taxpayer licenses rights to broadcast certain television
and cable network’s channels in exchange for a license fee. Certain contracts require
the taxpayer to rebroadcast the channel feed it receives without altering the content in
the signal, while other contracts allow the taxpayer to add advertisements and
‘interstitials’ produced by the taxpayer into a channel's feed. Taxpayer distributes the
licensed channels using proprietary technologies, for example by making the digital
channel signals (if included in a customer’s Subscription Package) available to the
customer for viewing on the customer’s televisions or other devices. The taxpayer’s
self-produced programming consists of promotional advertising and certain shows
produced by a production company under the taxpayer’s control.
In creating the Subscription Packages, the taxpayer combines all licensed
programming and all self-produced programming into one continuous broadcast
‘feed’ that is then distributed to its customers. The CCA states that the taxpayer
performs the following activities in its broadcast centers with respect to the collective
programming to produce the Subscription Packages that are eventually broadcast to
its customers: receive programming via fiber optic cable, tape, etc. from the television
and cable networks; decode and review the incoming content; insert interstitials and
advertisements into the signal, embed metadata, and encode the content for outside
broadcast; balance the amount of the outgoing signal; and digitalize, encode, and
transmit the signal. This technical work at the broadcast centers is carried out mostly
by the taxpayer's engineers.
The first issue addressed in the CCA was whether the gross receipts the taxpayer
derives from the distribution of its Subscription Packages qualify as DPGR derived
from the disposition of qualified films produced by the taxpayer for purposes of
Section 199. In concluding that gross receipts derived from the distribution of
Subscription Packages do not qualify as DPGR, the IRS stated that the taxpayer must
apply the qualification rules under Section 199 to each component of the Subscription
Packages (i.e., licensed programming and self-produced programming) to determine
whether the separate components individually meet the requirements under Section
199. In its analysis, the IRS determined that the taxpayer’s activities related to its
Subscription Packages are not considered the production of qualified films because
they were not substantial in nature. Rather, considering the nature of the taxpayer’s
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business and products, the IRS concluded that the taxpayer’s activities consist of the
distribution of a group of films. Because a Subscription Package is a package made up
of various films, the IRS concluded that the nature of the taxpayer’s product is a
group of channels offered for disposition together rather than one cohesive ‘film.’
However, the IRS noted that the taxpayer may have film production activities with
respect to its self-produced channels, shows, advertisements, or interstitials
promoting the taxpayer.
The second issue addressed in CCA 201446022 was whether license fees paid by the
taxpayer to unrelated third-party programming producers for the right to broadcast
and distribute programming are overhead costs for purposes of the qualified film safe
harbor. Under Section 199, there are two alternative definitions of overhead. For a
taxpayer that is subject to Section 263A, overhead is all costs required to be
capitalized under Section 263A, except direct materials and direct labor. For a
taxpayer not subject to Section 263A, overhead may be computed using any
reasonable method.
Consistent with its conclusion in Issue 1, the IRS analyzed the safe harbor based on
the view that the Subscription Packages are comprised of individual components (i.e.,
licensed programming and self-produced programming) that must be analyzed
separately for purposes of Section 199. For self-produced programming, the IRS
concluded that the taxpayer was engaged in production activities and thus was subject
to Section 263A. Because the taxpayer was subject to Section 263A for these
activities, the taxpayer's overhead incurred in connection with its self-produced video
programming was all costs required to be capitalized under Section 263A, except
direct materials and direct labor.
For licensed programming, the IRS concluded those activities are not subject to
Section 263A because the licensed programming is not real property or tangible
personal property produced by the taxpayer, and is not real property or personal
property acquired by the taxpayer for resale. Rather, the licensed programming is
created by third parties and licensed to the taxpayer for transmission and distribution
over the taxpayer's network. In making this determination, the IRS considered the
relevant item to be the content, not the Subscription Package, and concluded without
further analysis that the licensed programming is created by a third party and
licensed to the taxpayer for distribution. After determining the licensed
programming is neither produced nor acquired for resale by the taxpayer, the IRS
concluded that “the costs of the licensed programming are not required to be
capitalized under section 263A. Accordingly, the license fees are not overhead costs
for purposes of [the 20-percent production rule].”
Other IRS guidance
IRS issues final regulations modifying the definition of an acquiring
corporation for certain asset acquisitions
The IRS issued final regulations under Section 381 that modify the definition of an
acquiring corporation with regards to certain asset acquisitions. The final
regulations, effective November 10, 2014, adopt the proposed Section 381 regulations
issued in May 2014 without substantive change. Also adopted were the proposed
regulations under Section 312 which cross reference the final Section 381 regulations
and provide that the acquiring corporation in a Section 381 transaction will succeed to
the earnings and profits of the transferor corporation.
Section 381 provides that the acquiring corporation in certain asset reorganizations
succeeds to the tax attributes of the transferor corporation, including methods of
accounting. Prior to the issuance of the final regulations, the acquiring corporation
was defined as the corporation that directly or indirectly acquired all of the assets
transferred by the transferor corporation. For example, if a transferor corporation (T)
merged into another corporation (A) and, subsequent to the merger, A transferred all
of the T's assets acquired in the merger to its wholly owned subsidiary (S), then for
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purposes of Section 381, S would be treated as the acquiring corporation that
succeeds to T's attributes. On the other hand, if only a portion of the T assets were
transferred to S, then A would be treated as the acquiring corporation that succeeds to
T's attributes.
Commenters suggested that the existing regulations under section 381 should be
revised to limit the degree of electivity regarding the identity of the acquiring
corporation, as well as the uncertainty regarding whether all of the assets transferred
in the section 381 transaction were further transferred to a single controlled
corporation. In response, the final regulations modify the definition of an acquiring
corporation to mean the corporation that directly acquires the assets transferred by
the transferor corporation, even if the direct transferee corporation ultimately
retained none of the assets so transferred. Therefore, in the examples above, A would
be considered the acquiring corporation in both circumstances (i.e., it is no longer
relevant whether all or a portion of the acquired assets are passed down to S). The
IRS and Treasury Department believe that the adoption of this modified definition is
appropriate with respect to determining the location of earnings and profits, as well
as other tax attributes (such as methods of accounting), of a transferor corporation
because it generally maintains such tax attributes at the corporation closest to the
transferor corporation’s former shareholders in a manner that minimizes electivity
and administrative burden.
IRS rules that corporation is not eligible for extended NOL carryback
In FAA 20144601F, the IRS determined that a corporation was not eligible for an
extended 5-year net operating loss (NOL) carryback because it was the successor to a
taxpayer that received assistance from the Treasury under the Troubled Asset Relief
Program (TARP).
The taxpayer in the FAA is the parent of an affiliated group of corporations that files a
consolidated U.S. federal tax return. Through a reverse subsidiary cash merger
treated as a stock purchase, the taxpayer acquired an entity that had previously
received money from the Treasury for its preferred stock and warrants under the
TARP program. At the time of the acquisition, the taxpayer made no Section 338
election to treat the stock acquisition as an asset purchase. Immediately following the
acquisition, the acquired company was merged into the parent through a tax free
statutory merger.
In the year of the acquisition, the taxpayer reported an NOL on its consolidated U.S.
federal income tax return. Although no statement was attached to the return claiming
an extended carryback period, the taxpayer nonetheless filed Form 1139 claiming a
carryback of the NOL extending to the fifth preceding tax year and requesting a
refund of prior year taxes. Later, the taxpayer filed a second Form 1139 with a
correction to the carryback calculations as well as an additional statement disclosing
that the taxpayer is not a TARP recipient. After the IRS issued a tentative refund, the
taxpayer filed an amended tax return which included additional dividend income and
filed a third Form 1139 to revise the carryback claim accordingly. The IRS then issued
another tentative refund pursuant to the revised Form 1139.
Under the general rules of Section 172(b), when an NOL is generated in a given year,
the taxpayer may carry the loss back to each of the 2 taxable years preceding the loss
year and carry forward any excess to each of the 20 taxable years following the loss
year. However, the Worker, Homeownership, and Business Assistance Act of 2009
(WHBAA) amended Section 172 to allow for an extended carryback period of up to 5
years for NOLs generated in years ending after December 31, 2007, and beginning
before January 1, 2010. To obtain the extended carryback, taxpayers were required to
make an election by the due date (including extensions) of the tax return for the last
taxable year beginning in 2009. While the WHBAA provided the extended carryback
to most taxpayers, there were certain exceptions. Among others, the carryback was
not available to any taxpayer who received money from the federal government under
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the TARP program, including any taxpayer that was a member of the same affiliated
group as a TARP recipient in 2008 or 2009.
In FAA 20144601F, the taxpayer acquired the TARP recipient company through a
reverse subsidiary cash merger. Because no Section 338 election was made, the
subsequent merger of the acquired corporation into the parent was considered a tax
free statutory merger. As such, the IRS looked to the rules under Section 381
regarding the carryover of tax attributes in this type of acquisition. Under these rules,
the successor corporation to an acquired company steps into the shoes of the acquired
company and inherits its tax attributes. The IRS asserted that the acquired
company’s status as a TARP recipient is one of the attributes the acquirer inherits in
the merger transaction. Therefore, the taxpayer is not eligible for the extended 5-year
NOL carryback period under the WHBAA.
IRS issues advice on alternative tax net operating loss (ATNOL)
absorption rules
In FAA 20144201F, the IRS addressed whether the absorption rules for alternative tax
net operating losses (ATNOLs) were modified under the provisions of the Worker,
Homeownership, and Business Assistance Act of 2009 (WHBAA). Specifically, the
IRS concluded that WHBAA did not create new ordering rules for the absorption of
ATNOLs, and taxpayers are not permitted to use “WHBAA year” ATNOLs after
ATNOLs that are generated in subsequent years.
Taxpayers are permitted to take a deduction for net operating losses (NOLs) in
computing their regular taxable income. Under the general rules of Section 172, when
a net operating loss is generated in a given year, the taxpayer may carry the loss back
to each of the 2 taxable years preceding the loss year, and carry forward any excess to
each of the 20 taxable years following the loss year. Under these absorption rules, the
loss must first be carried back to the earliest available tax year, unless the taxpayer
elects to waive such carryback. The portion of the NOL that is carried to each of the
other taxable years is the excess, if any, of the amount of the NOL over the sum of the
taxable income for each of the earlier taxable years to which the NOL may be carried.
However, the NOL deduction for a prior taxable year may not include the loss year
NOL or NOLs from any years after the loss year. Accordingly, NOLs generally are
absorbed chronologically i.e., NOLs from earlier years are absorbed before NOLs from
later years.
In computing the alternative minimum tax (AMT) liability, taxpayers are allowed a
similar deduction for ATNOLs. ATNOLs are computed similar to regular NOLs, but
with certain adjustments and preference items taken into account. The ATNOLs also
are subject to the same Section 172 carryback and carryforward rules as the regular
NOL. However, Section 56(d)(1) limits the deduction for ATNOLs to 90% of
alternative minimum taxable income (AMTI). Therefore, taxpayers generally are not
able to fully eliminate an AMT liability through the utilization of ATNOLs.
The WHBAA allowed taxpayers to elect an extended NOL carryback period of 3 to 5
years for NOLs generated in 2008 or 2009 (WHBAA years). Additionally, WHBAA
provided an exception to Section 56(d)(1) whereby a WHBAA year ATNOL could
offset 100% of AMTI in the years to which they are carried (i.e., not subject to the
90% AMTI limitation).
Following the enactment of WHBAA, articles by commentators suggested that the Act
created new ordering rules for the absorption of ATNOLs. This interpretation
appears to be based on a reading of Section 56(d)(1) that suggests that the ATNOL
deduction for a given year consists of two separate components: (1) a WHBAA year
portion, and (2) ATNOLs from non-WHBAA years. Under the modified ordering
rules suggested by commentators, WHBAA year ATNOLs may be absorbed only after
taking into account all other available ATNOLs, regardless of the year in which they
were generated (i.e., even if they arose after the WHBAA year ATNOL), to effectively
eliminate any remaining AMTI.
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In FAA 20144201F, the IRS rejected the assumption that WHBAA created new
ordering rules for ATNOLs. The IRS asserted that the provisions under Section
56(d)(1) merely limit the amount of the ATNOL deduction allowed for a given year
and do not set forth any ordering or absorption rules. As such, the absorption of the
ATNOLs is still governed by the normal ordering rules under Section 172, which
require that NOLs be absorbed chronologically.
However, the IRS does note one exception where the ordering rules may be altered.
The exception occurs when the only ATNOL that can be used to reduce AMTI for a
taxable year is a WHBAA year ATNOL that arises after an ATNOL that is subject to
the 90% limit and that is ineligible to offset a portion of the AMTI as a result of that
limit. This situation is illustrated in the FAA using the following example:
A taxpayer comes into existence in 2008. For 2008, the taxpayer has an ATNOL
of $200 and for 2009 the taxpayer has a WHBAA ATNOL of $100. In 2010, the
taxpayer has positive AMTI, before any ATNOL deduction, of $100. In this case
only $90 of the 2010 AMTI can be offset by the 2008 ATNOL. The only ATNOL
that can offset the remaining $10 of 2010 AMTI is the 2009 WHBAA ATNOL.
Under these circumstances, the normal ordering rules of section 172(b)(2) must
be altered so that $10 of the WHBAA ATNOL is absorbed.
The IRS concluded that this is the only situation in which the ATNOL absorption
rules should be altered as a result of the WHBAA provisions. In all other
circumstances, the IRS position would require taxpayers to follow the chronological
ordering rules under Section 172.
Pre-acquisition qualified research expenses belong to target
In a redacted field attorney advice, FAA 20144701F, the IRS concluded that a parent
/acquiring corporation cannot include on its consolidated return a target
corporation's qualifying research expenses (QREs) that were paid or incurred by
Target during the short period before Target was acquired in calculating the parent’s
Section 41 research credit for the year of the merger.
The parent of a consolidated group (Parent) files a consolidated federal tax return
with a December 31 taxable year. The target corporation (Target) was a publicly
traded corporation and the parent of its own consolidated group with a December 31
taxable year. Parent acquired 100% of the stock of Target during the taxable year.
Target filed a short year return for the period prior to the merger. Parent filed a
consolidated return for Year 1, including Target in the consolidated group for the
period after the merger, through December 31. Both Parent and Target claimed a
research credit under Section 41 in the acquisition year for QREs that Target incurred
in the pre-acquisition period.
Under Section 41, in calculating the research credit, the QREs of the taxpayer are
aggregated, and all members of the controlled group are treated as a single taxpayer.
Section 1563 defines a controlled group as any chain of corporations connected
through stock ownership of a parent company based on 80 percent of the vote or
value of the stock.
The taxpayer argued that an amendment to Section 41(f)(3) supported its position
that Target could treat expenses paid or incurred before an acquisition as QREs on its
final return, and Parent could also treat those expenses as current year QREs for a tax
year that includes the pre-acquisition period. Although the IRS acknowledged that an
amendment to Section 41(f)(3) by the American Taxpayer Relief Act of 2012 revised
the rules for determining which entity is allowed to include the QREs in the event of
an acquisition, the IRS clarified that the purpose of this legislative change was to
provide that only the disposing business entity receives the research credit for
expenses incurred before the date of the ownership change. According to the General
Explanation to that Act, “[QREs] paid or incurred by the disposing taxpayer in a
taxable year that includes or ends with a change in ownership are treated as current
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year qualified research expenses of the disposing taxpayer and such expenses are not
treated as current year qualified research expenses of the acquiring taxpayer.”
The IRS concluded that QREs paid by Target during the pre-acquisition period are
not includable in Parent’s consolidated return. Such QREs must be included only in
Target’s pre-acquisition short year return, because they were not paid or incurred
when Target was part of Parent's consolidated group. The pre-acquisition period
QREs must be included Target’s consolidated return for the short taxable year prior to
the acquisition.
Payments made to manufacturer need not be capitalized
In PLR 201447004, the IRS ruled that a taxpayer’s payments to a manufacturer under
an agreement to design and manufacture components for new products need not be
capitalized under Section 263(a).
The taxpayer designs, manufactures, and services certain items, and spare parts and
components of such items (collectively components). The taxpayer enters into
agreements with product manufacturers pursuant to which it agrees to design and
manufacture components for the manufacturer’s new Products. Under the
agreements, the product manufacturer agrees to develop and manufacture a new
product, to secure any required approval to market the product, and to market it to
customers. The taxpayer typically agrees to design and develop the components,
secure any required approval to market the components, and to support the product
manufacturer's marketing and certification efforts.
In the PLR, the product manufacturer agreed that the taxpayer would be the exclusive
(or semi-exclusive) supplier of certain components for a new product to be developed
by the product manufacturer. Under the agreement, the taxpayer must look to future
sales of product to recoup its investment. If a new product is successful, such sales
will occur in connection with both the initial sales of the component to customers and
any subsequent servicing and spare parts orders from those customers. If a product is
unsuccessful, however, the taxpayer may not receive any orders for its components.
Thus, the product manufacturer does not guarantee that the taxpayer will receive any
orders or compensation, but grants the taxpayer the exclusive (or semi-exclusive)
right to supply components for any orders that do materialize.
In exchange for the exclusivity rights, the taxpayer agreed to absorb all the nonrecurring costs and expenses that it incurs in the performance of the agreement, and
to contribute a fixed amount to product manufacturer's development and marketing
costs for certain products via certain milestone payments. The total amount of the
taxpayer's contribution must be fully refunded if the product manufacturer does not
comply with the exclusively agreement. In addition, if the product manufacturer
cancels development of the new product before it enters into production, the
taxpayer's total contribution will be reduced.
The regulations under Section 263(a) provide that, in general, a taxpayer must
capitalize: (i) an amount paid to acquire an intangible; (ii) an amount paid to create
certain specified intangibles; (iii) an amount paid to create or enhance a separate and
distinct intangible asset; (iv) an amount paid to create or enhance a future benefit
identified in published guidance as required to be capitalized under the regulations;
or (v) an amount paid to facilitate the acquisition or creation of an intangible, whether
the taxpayer is the acquirer or the target.
The IRS first ruled that the payments made under the agreement neither created nor
enhanced a separate and distinct intangible asset within the meaning of the Section
236(a) regulations because the benefit that the taxpayer receives is not capable being
sold, and would not have any value if it were separated from the taxpayer’s
manufacturing business. Additionally, the IRS found that the payments did not result
in a future benefit identified in published guidance or in the acquisition of an
intangible.
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Next, the IRS analyzed whether the payments constitute an amount paid to create
certain specified intangibles, in particular the requirement to capitalize an amount
paid to create certain financial interests. In this regard, a taxpayer must capitalize
amounts paid to another party to create, originate, enter into, renew, or renegotiate
with that party certain financial interests. Among the financial interests described in
the regulations are forward contracts, under which the taxpayer has the right and
obligation to provide or to acquire property (or to be compensated for such property)
regardless of whether the taxpayer provides or acquires the property, and options
under which the taxpayer has the right (but not the obligation) to provide or to
acquire property (or to be compensated for such property), regardless of whether the
taxpayer provides or acquires the property. However, an amount paid to another
party is not paid to create, originate, enter into, renew or renegotiate a financial
interest with that party if the payment: (1) is made with the mere hope or expectation
of developing or maintaining a business relationship with that party and (2) is not
contingent on the origination, renewal, or renegotiation of a financial interest with
that party.
Under the agreement, the product manufacturer was not required to purchase any
specific number of components from the taxpayer during the term of the agreements,
and the price of the any particular component was not fixed at the time the agreement
was executed. Further, the taxpayer did not have the right to provide any components
to the manufacturer as the manufacturer may place no orders. Under these
circumstances, the IRS concluded the agreement does not constitute a forward
contract or option because the price, quantity, and date of purchase of the
components to be ordered were not specified.
The IRS last considered whether the taxpayer’s payments made pursuant to the
agreement represent amounts paid to facilitate the acquisition or creation of an
intangible. Even though the payments made under the agreement are part of a
business strategy to create sales of the taxpayer’s items, the IRS concluded the
payments are not part of a plan to create or acquire any identifiable intangible
described in the Section 263(a) regulations. Because the payments that the taxpayer
made or will make in connection with the agreement do not fit into any of the
categories of items required to be capitalized, the IRS ruled that the payments need
not be capitalized under Section 263(a).
Let’s talk
For a deeper discussion of how these issues might affect your business, please
contact:
Annette Smith, Washington, DC
+1 (202) 414-1048
[email protected]
Christine Turgeon, New York
+1 (646) 471-1660
[email protected]
Adam Handler, Los Angeles
+1 (213) 356-6499
[email protected]
Jennifer Kennedy, Washington, DC
+1 (202) 414-1543
[email protected]
Dennis Tingey, Phoenix
+1 (602) 364-8107
[email protected]
George Manousos, Washington, DC
+1 (202) 414-4317
[email protected]
Jason Black , Washington, DC
+1 (202) 346-5043
[email protected]
© 2014 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a
Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each
member firm of which is a separate legal entity.
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