BrassTax - August 23, 2023
Cadwalader, Wickersham & Taft LLP
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The Internal Revenue Service (“IRS”) recently issued guidance in Revenue Ruling 2023-14 , holding that taxpayers who stake their cryptocurrency and receive additional units of cryptocurrency as rewards when validation occurs must include the fair market value of the validation rewards received as gross income.
This long-anticipated ruling addresses an issue that was recently before a federal appeals court in Jarrett v. U.S. ?In Jarrett, the taxpayers sought a refund on crypto staking rewards that they had previously included as income on their 2019 tax return under the theory that staking rewards are newly-created property and are only taxable when disposed of, not when received.
Jarrett has not been argued on the merits because the IRS granted the taxpayers a refund and the case was dismissed by a U.S. district court as moot since there was no longer any controversy for the court to resolve regarding the taxpayers’ liability for 2019.? The taxpayers appealed to the Sixth Circuit, arguing that the IRS cannot unilaterally end their case by sending them a refund check. On Friday, the Sixth Circuit agreed with the district court that the lawsuit became moot after the IRS issued the refund. Many were hoping that the case would offer legal clarity to the millions of crypto users who generate cryptocurrency rewards through “proof-of-stake” blockchains.
Crypto staking is the process of pledging cryptocurrency holdings to assist in the validation of transactions on a crypto blockchain. ?This “proof-of-stake” consensus mechanism of validation requires validators to hold and stake cryptocurrency in exchange for transaction fees or “rewards” in the form of additional cryptocurrency. ?The cryptocurrency staked may be locked up and cannot be transferred or otherwise used by the validator for a period of time, and is subject to “slashing” if a validation is unsuccessful.
In the revenue ruling, the IRS cites case law providing that an accession to wealth over which a taxpayer has complete dominion and control constitutes income. ?Therefore, the IRS rules that staking rewards are taxed once a taxpayer gains dominion and control over a crypto token, which is when the taxpayer is able to sell, exchange or dispose of the cryptocurrency reward it receives.
The IRS’s ruling echoes the eagerness of Congress and the White House to resolve many unanswered crypto tax issues .
Last August, the Inflation Reduction Act of 2022 (the “IRA”) introduced transferability provisions that will allow developers to sell clean energy tax credits.? On June 14, 2023, the IRS released proposed regulations (which we discussed here ) and requested comments from the public.?
This request quickly prompted an outpouring of comments from tax organizations and practitioners, many of which suggest clarifications and modifications that may speed along the development of an efficient market for sales of clean energy tax credits.
Here is what some are saying:
All of the comments received to date are posted here .? We will continue to monitor further developments in this area and report notable updates.
The identification of where a company is resident is a critical element in accessing the benefits of a double tax treaty.
GE Financial Investments Limited (“GEFI Limited”) was a UK incorporated and tax resident company and a member of the General Electric group.? GEFI had a sister group company, GE Financial Investments Inc. (“GEFI US”), which was incorporated in the United States.? GEFI Limited and GEFI US were members of a Delaware-established limited partnership.? The shares in GEFI Limited were stapled to the common stock of GEFI US, the result of which was broadly that GEFI Limited was treated as being a domestic corporation for United States federal income tax purposes, and subject to United States tax on its worldwide income.
GEFI Limited received interest income from the Delaware limited partnership.? As GEFI Limited was incorporated in the UK, GEFI Limited was subject to UK corporation tax on its partnership income.? GEFI Limited claimed credit for the United States tax paid on the partnership income in its UK tax returns in accordance with the provisions of the US-UK double tax treaty (the “Treaty”).? The UK revenue authority, HMRC, denied GEFI Limited’s claim for relief under the Treaty for the double taxation it had suffered.
The dispute was heard originally by the UK’s First-tier Tribunal (“FTT”) in June 2021.? The decision of the FTT had been that GEFI Limited was not resident in the United States and, furthermore, that GEFI Limited did not carry on a business in the United States through a permanent establishment situated there.? GEFI Limited had appealed the FTT’s decision to the Upper Tribunal.
Where was GEFI Limited resident under the Treaty?
HMRC argued that GEFI Limited was not resident in the United States for the purposes of the Treaty.? Residence, for the purposes of the Treaty, was argued by HMRC as connoting more than mere taxation on worldwide income by reason of GEFI Limited’s shares being stapled to GEFI US’s stock.
HMRC argued that the concept of “residence,” under Article 4(1) of the OECD Model Tax Convention on Income and Capital, required a “personal” and “territorial” connection between the taxpayer and the taxing state.? Moreover, in the context of the Treaty itself, HMRC claimed that references to “citizenship” and “place of incorporation” in Article 4(1) of the Treaty connoted such a “personal” and “direct” connection.? By contrast, the mere taxation of GEFI Limited’s worldwide income displayed no such territorial or direct connection, as such taxation originated only from the legal stapling of GEFI Limited’s shares to the common stock of GEFI US.
The Upper Tribunal rejected HMRC’s appeal.? The conditions identified in Article 4(1) of the Treaty were, the Upper Tribunal decided, the criteria commonly adopted for the imposition of “full” taxation on income under the domestic law of the relevant contracting states. ?The Upper Tribunal saw “no credible basis for an additional requirement for the criteria to be of a direct nature in the form of a legal connection between the corporation and the US.”
The full taxation on GEFI Limited’s income for United States tax purposes was held to be sufficient by itself for GEFI Limited to be treated as resident in the United States under Article 4(1) of the Treaty. ?No additional “territorial,” “personal” or “direct” connection between GEFI Limited and the United States was needed.? As a result, the Upper Tribunal determined that double taxation relief was available under the Treaty in GEFI Limited’s UK tax returns for the United States tax which had been paid on the same income.
If GEFI Limited was not resident in the United States under the Treaty, was it carrying on a business through a permanent establishment there?
A second question had been raised on appeal, in the event that the Upper Tribunal had determined that GEFI Limited was not resident in the United States.? That question was whether GEFI Limited was carrying on a business through a permanent establishment in the United States.?
The intention of GEFI Limited was to argue (if it needed to) that United States tax on the income of a United States permanent establishment would be creditable against UK corporation tax in GEFI Limited’s UK tax returns.? Unusually, the parties accepted that some activities were being undertaken by GEFI Limited in the United States – but were such activities sufficient to constitute a “business” for the purposes of the Treaty?
The decision of the Upper Tribunal on this point was obiter dicta.? Nevertheless, the process followed by the Upper Tribunal in considering the meaning of the word “business” (described in earlier case law as an “etymological chameleon”), serves as a highly useful guide to the legislative use of that term.?
The FTT had determined that no business was being carried by GEFI Limited.? All that GEFI Limited did was to hold an interest in the Delaware limited partnership, an activity that the FTT had termed as being “more of a passive, sporadic or isolated activity than a regular and continuous series of activities.”? There had been nothing to suggest that personnel or agents acting on behalf of the Delaware limited partnership had conducted regular and continuous commercial activities in the United States.
The Upper Tribunal did not overturn the FTT’s earlier decision, implicitly concluding that the lower FTT had made no error of law in coming to its earlier decision.? While the tax planning utilised by GEFI Limited was carefully articulated, there are reminders from the case regarding the degree to which partners in limited partnerships can be expected to be treated, for tax purposes, as carrying on a business given their limited liability status.? Whether comparable activities by a member of a general partnership would be treated in the same manner remains a question that was not addressed by the Upper Tribunal.
An investment management firm founded and owned by legendary investor (and New York Mets owner) Steve Cohen on August 11 filed a petition in Tax Court contesting an IRS audit adjustment in the amount of $344,063,484 for tax years 2015 and 2016.? The adjustment relates to the IRS’s assertion that the taxpayer, Point72 Asset Management, LP (“Point72”), incorrectly reported $0 as its net earnings from self-employment.? At stake is over $13 million dollars in taxes, not counting interest and any potential penalties.
For the years in dispute, Point72 was owned .01% by Point72 Capital Advisors, Inc. (“Advisors”), an S corporation wholly owned by Mr. Cohen, and 99.99% by Point72 Capital Holdings, LP (“Holdings”), a limited partnership owned .01% by Advisors and 99.99% by Mr. Cohen.? The interest in Point72? owned by Advisors was a general partner interest and the interest owned by Holdings was a limited partnership interest.? Under Section 1402(a)(13) of the Internal Revenue Code, limited partners are excluded from paying self-employment tax.
Point72 is the latest of several asset managers to challenge the IRS’s view of what constitutes a limited partner for purposes of the self-employment tax exception for limited partners.? This is part of a long-running IRS battle to deny this exception to limited partners who also exercise management rights in separate capacities as general partners.? It is a classic dispute of substance versus form.
Point72, like most other asset managers, relies on the formal distinction between acting in one’s capacity as a general partner and acting in one’s capacity as a limited partner.? However, many asset managers who take advantage of the limited partner exception have multiple ultimate beneficial owners, as opposed to a single owner in this case, and have general partner interests at least equal to 1%, rather than Mr. Cohen’s .01%.? Many also pay their limited partners a “guaranteed payment,” which is subject to self-employment tax—there is no mention in the petition of whether Mr. Cohen received such a payment.
The IRS will presumably argue that Holdings was not a true limited partner of Point72 due to its majority ownership by Mr. Cohen, who, through his sole ownership of Advisors, exercised complete control over Point72.? They could also assert the partnership anti-abuse regulations.? In addition, given the low percentage interest of Advisors in Point72, they may argue that Advisors was not actually a partner of Holdings or Point72 for tax purposes, which would make the limited partner exception inapplicable.? Point72 will likely argue that Holdings’ status as a state law limited partner is all that the statute requires for the exception to apply.? The petition also mentions several other issues that would be a basis for a defense, among them that the statue of limitations has expired and that the amount of self-employment taxes allocated to a partner is not a partnership-level item that may be adjusted under a TEFRA audit.?
Given the high profile of the taxpayer and the somewhat unique structure, this will certainly be a case to watch as it makes its way through the Tax Court.
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In many respects, the Upper Tribunal’s decision in Hargreaves Property[1] will not have surprised tax practitioners as the decision reaffirms best practice considerations around a number of fundamental concepts in relation to UK withholding tax. However, the decision also raises questions concerning the interpretation of the UK’s statutory withholding tax exemptions.
Facts
The case concerned a UK tax resident company, which was the ultimate parent company of a UK property group (Hargreaves Property Holdings Ltd (“Hargreaves”)). Hargreaves had received financing from connected overseas lenders. Following tax planning advice, the terms of the loans were amended so that: (i) the loans were repayable on 30 days’ notice by the lender or any time by the appellant; (ii) all payments were made in Gibraltar from a source outside the UK; (iii) no assets in the UK were secured; and (iv) Gibraltar or Jersey was the governing law and the courts of Gibraltar or Jersey had exclusive jurisdiction.?
Shortly before the interest was paid by the borrower, the lender also assigned for consideration its right to interest to a third party. Initially, the third party was a Guernsey company (“Storrier”) or Guernsey trusts. In later years, the loans were assigned to a UK resident company (“Houmet”). The consideration for the assignment was an amount equal to almost all of the interest which Houmet received.
Together, these changes were made with the intention of ensuring that the interest was:
The? Upper Tribunal’s decisions on each of these issues are considered below.
Beneficially Entitled
Under section 933 ITA 2007, interest paid to a UK resident company that is “beneficially entitled” to such interest may be exempt from the obligation to withhold on account of UK income tax.
Hargreaves contended that Houmet was “beneficially entitled” to the interest for the purposes of section 933 ITA 2007 notwithstanding that Houmet had an obligation to pay an almost similar amount to Storrier as consideration for the assignment of the loans.
Hargreaves argued that “beneficial entitlement” should be interpreted in accordance with its ordinary English law meaning as given by Evans Lombe J in Indofood[2] , and specifically that a contractual obligation to pay income on to a third party should not preclude beneficial ownership (this being the case even though both parties and the First-tier Tribunal (“FTT”) recognised that the definition adopted by Evans Lombe J was not upheld on appeal[3] ).
The Upper Tribunal considered that the words should be construed “in their statutory context and with regard to their purpose” and went on to consider that Houmet should not be regarded as beneficially entitled to the interest given its lack of business purpose in the transaction. The Upper Tribunal went on to hold that the exception at section 933 ITA 2007 is “for the benefit of companies who are substantively entitled to receive and enjoy the income, not those who are beneficially entitled only in the narrower technical sense used to distinguish between legal and equitable interests in English common law.” This interpretation raises questions as to whether this has narrowed the scope of the UK’s domestic statutory exemptions and imported an interpretation that is more consistent with the “international fiscal meaning” that was found in Indofood.
Double Tax Treaty
Hargreaves argued that notwithstanding that the UK-Guernsey double tax treaty did not contain an interest article, the business profits article exempted the interest paid by Hargreaves to Storrier from the obligation to withhold on account of UK income tax. In any event, HMRC contended that two procedural requirements needed to be satisfied in order for the UK-Guernsey double tax treaty to be relied upon were not met. Firstly, that Storrier, as the recipient of the interest, did not make any claim for relief, and secondly that Hargreaves, as the payer of the interest, was not issued with a statutory notice for payments to be made gross. The Upper Tribunal upheld the decision of the FTT that both a claim for relief and corresponding direction from HMRC must be issued in order for the benefits of the business profits article of the UK-Guernsey double tax treaty to be relied upon.
Whilst the completion of procedural formalities in order to enable reliance on the interest articles of the UK’s double tax treaties (such as under HMRC’s double tax treaty passport scheme) is a familiar process, Hargreaves Property serves as a salient reminder that the obligation to comply with certain procedural formalities can extend to other articles of the UK’s double tax treaties.
Yearly Interest
The obligation to withhold on account of UK income tax applies where, amongst other things, the interest is regarded as “yearly interest”. A number of loans received by Hargreaves were advanced and repaid within a year. The FTT gave consideration to the fact that the loans were unsecured, and repaid on a regular basis within, or very shortly after, a year from the initial advance. The Upper Tribunal agreed with the FTT’s decision that the loans were intended to form part of Hargreaves’ longer-term financing arrangements when considered from “a business-like rather than a dry legal assessment of its likely duration.”[4] ?Accordingly, the Upper Tribunal held that the interest was “yearly interest” in respect of which an obligation to withhold on account of UK income tax could arise.
This aspect of Hargreaves Property reiterates that structuring longer-term financing arrangements as a series of shorter-term loans is ineffective in avoiding the obligation to withhold on account of UK income tax.
UK Source
Another fundamental requirement which must be satisfied in order for an obligation to withhold on account of UK income tax is that the interest “arises in the UK” – that is, whether the interest has a UK source. Here it was held that the interest had a UK source given that Hargreaves was a UK resident company and carried on its business exclusively in the UK, notwithstanding the changes that had been made to the terms of the loan relating to where the payments were made from, the governing law and jurisdiction for enforcement proceedings each being outside the United Kingdom.
Given the Court of Appeal’s decision in Ardmore[5] , the decision of the Upper Tribunal in Hargreaves Property was also unsurprising on this ground.
Whilst the Upper Tribunal’s decision has reaffirmed best practice considerations when dealing with a number of questions relating to UK withholding tax, the reasoning for the decision relating to the issue of “beneficial entitlement” will require more careful consideration, particularly in the context of intragroup financing arrangements and given that permission to appeal has been refused.
[1] Hargreaves Property Holdings Limited v HMRC [2023] UKUT 120 (TCC).
[2] Indofood International Finance v JP Morgan [2005] EWHC 2103 (Ch).
[3] [2006] EWCA Civ 158.
[4] Lindley LJ in Goslings and Sharpe v Blake (Surveyor of Taxes) (1889) 23 QBD 324, 23.
[5] Ardmore Construction v HMRC [2018] EWCA Civ 1438.
With loan modifications on the rise, this?chart? outlines the circumstances under which modifications may be made to CMBS loans included in REMICs or grantor trusts.
Key Contacts:
Linda Swartz ?- Tax Chair
Adam Blakemore ?- Partner
Jon Brose ?- Partner
Andrew Carlon ?- Partner
Mark Howe ?- Partner
Catherine Richardson ?- Partner
Gary Silverstein ?- Partner