Introduction

Judicial, regulatory, and enforcement developments continued apace in September. At the start of the month, the First Circuit Court of Appeals ruled against the taxpayer in a case involving the outbound transfer of IP (TBL Licensing). On the guidance front, the Internal Revenue Service (IRS) released voluminous notices detailing future rulemaking for the Corporate Alternative Minimum Tax (CAMT) and for mandatory capitalization and amortization of research expense. Finally, in a cascade of announcements, the IRS detailed major enforcement initiatives, including a pledge to open audits of 75 large partnerships before the end of September. 

Tax fact: The Strategic Operating Plan for the IRS reports that, due to constrained resources, the audit rate for large corporations declined precipitously from 10.5 percent in 2011 to 1.7 percent in 2019.

"Like mothers, taxes are often misunderstood, but seldom forgotten." —Lord George Bramwell, 19th Century English jurist.

Tax Litigation Developments

Layla Asali and Lisandra Ortiz

Last month, the First Circuit Court of Appeals affirmed the Tax Court's decision in TBL Licensing LLC v. Commissioner holding that a reorganization resulting in the outbound transfer of intangible property (IP) led to immediate recognition of the gain in the transferred IP under section 367(d). See No. 22-1783 (1st Cir. Sept. 8, 2023), aff'g 158 T.C. No. 1 (2022). The dispute in TBL Licensing arose in connection with a restructuring that took place after the 2011 merger of VF Corporation (VF) and The Timberland Company (Timberland). Roughly $1.5 billion of Timberland's value was attributable to its IP. After the merger, TBL Licensing LLC (TBL), a domestic corporation for federal income tax purposes and an indirect wholly owned subsidiary of VF, owned the Timberland IP. The transaction at issue here was an F reorganization, which the parties agreed involved a transfer of the Timberland IP to a related foreign corporation and thus that section 367(d) applied. But the parties disagreed over the timing of the recognition of the gain attributable to the Timberland IP. The taxpayer reported annual income inclusions pursuant to the generally applicable rule in section 367(d), whereas the IRS took the position that the F reorganization included a "disposition" of the Timberland IP that triggered full gain recognition. The Tax Court and the First Circuit agreed with the IRS. The F reorganization involved two steps: (1) a transfer by TBL of the Timberland IP to a related foreign corporation in exchange for stock and (2) a distribution by TBL of the foreign transferee stock to TBL's shareholder. Based largely on its construction of the statutory text, the First Circuit affirmed the Tax Court's conclusion that the second step constituted a "disposition" of the Timberland IP, which followed the transfer of the IP (i.e., step one). As such, section 367(d)(2)(A)(ii)(II) applied and required the taxpayer to recognize the entire unrecognized gain in the Timberland IP at the time of the "disposition." 

We also saw developments in transfer pricing last month. The IRS filed a notice of appeal to the Eighth Circuit of the Tax Court's decision in the long-running dispute between the IRS and Medtronic. In August 2022, the Tax Court issued its second opinion in Medtronic, Inc. v. Commissioner, holding that the IRS's comparable profits method was not the best method to determine the arm's length royalty owed under intercompany licenses between the U.S. parent of the Medtronic group and its Puerto Rican affiliate (see prior coverage here). Instead, the Tax Court endorsed a novel multi-step unspecified method to allocate profits between the U.S. and Puerto Rican affiliates. In June 2023, the Tax Court entered its decision in the case determining the deficiencies due from Medtronic as a result of the court's opinion, which started the 90-day period to file a notice of appeal. 

Finally, on September 8, 2023, the taxpayer filed a brief in the DC Circuit Court of Appeals appealing the Tax Court's decision in Rawat v. Commissioner, T.C. Memo 2023-14. As we previously reported, the Tax Court held in Rawat that when a partner sells an interest in a partnership with "hot assets" – unrealized receivables or inventory items – and recognizes gain that is treated as ordinary income under section 751(a), the source of that gain is determined as if the partner sold the hot assets directly. The taxpayer in Rawat, a nonresident alien, argues in her brief that the Tax Court erred in interpreting section 751(a) to "adopt a 'disaggregation' theory of partnerships" pursuant to which she was "deemed" to sell inventory rather than a partnership interest. As a result, she argues, she should not be subject to U.S. tax on the portion of gain from the sale of her partnership interest attributable to inventory of the underlying partnership. 

Treasury Releases Long-Awaited Guidance on Capitalization and Amortization of Specified Research and Experimental Expenditures

Jim Gadwood, Jeffrey Tebbs, and Caroline Reaves

After much anticipation, the U.S. Department of the Treasury (Treasury) and the IRS have finally provided insight into what taxpayers should expect to see in proposed regulations addressing the capitalization and amortization regime that applies to specified research or experimental (SRE) expenditures under section 174. Notice 2023-63 announces that Treasury and the IRS intend to issue proposed regulations addressing (1) the capitalization and amortization of SRE expenditures (including how to identify and allocate SRE expenditures and the rules that apply to software development costs (SDCs) and contract research arrangements), (2) the treatment of SRE expenditures under section 460, and (3) the way in which section 482 applies to cost sharing arrangements involving SRE expenditures. The Notice does not address—but does request comments on—a variety of related issues, including how section 280C applies when a taxpayer claims a section 41 research credit and the way in which section 174's disposition rules apply to partnership transactions. Taxpayers may rely on the Notice before Treasury and the IRS issue proposed regulations but are not required to do so. Comments on the Notice are due by November 24, 2023.

Scope and Basic Rules

Before 2022, taxpayers could generally currently deduct research or experimental expenditures and SDCs. However, the Tax Cuts and Jobs Act of 2017 (TCJA) amended section 174, for tax years beginning after December 31, 2021, to require taxpayers to capitalize SREs and amortize them over five years for domestic research and 15 years for foreign research.

The Notice answers basic mechanical questions on how section 174's capitalization and amortization regime operates. For example, the Notice clarifies that the five-year amortization period for domestic research means 60 months and the 15-year amortization period for foreign research means 180 months. The place where the research activity is performed determines whether the related SRE expenditures are domestic or foreign. For this purpose, "domestic" means the U.S., Puerto Rico, and any U.S. territory or possession, while "foreign" means everywhere else.

Taxpayers must allocate costs to SRE activities, which consist of (1) activities in the experimental or laboratory sense intended to discover information that would eliminate uncertainty concerning the development, improvement, or appropriate design of a product (or component or subcomponent thereof) (i.e., Treas. Reg. § 1.174-2 activities) and (2) software development activities as defined in the Notice (which include planning the development of computer software, designing computer software, building a model of computer software, writing source code, and certain testing). This allocation must occur on the basis of a "cause-and-effect" relationship, such as allocating labor costs based on time spent on SRE activities as a percentage of total time. While the allocation method may differ from one type of cost to another, a taxpayer must use an allocation method consistently for each type of cost.

Once a taxpayer allocates costs to SRE activities, they must determine which of these costs are SRE expenditures subject to section 174. The Notice provides that SRE expenditures include (but are not limited to): labor costs (including stock-based compensation), materials and supplies costs, cost recovery allowances (including property placed in service before 2022), patent costs, travel costs, and certain overhead costs (e.g., rent, utilities, insurances, and taxes with respect to facilities used to perform or support SRE activities). The Notice also identifies certain costs that are per se excluded from being SRE expenditures, including costs incurred by general and administrative service departments that only indirectly support or benefit SRE activities (e.g., payroll or HR personnel), costs listed in Treas. Reg. § 1.174-2(a)(6) (e.g., consumer surveys and advertising), amortization of SRE expenditures, and interest on debt to finance SRE activities. 

Contract Research

The Notice addresses contract-research arrangements and proposes a broad rule providing that a research provider incurs SRE expenditures if the research provider either (1) bears financial risk under the contract or (2) has a right to use any resulting "SRE product" or otherwise exploit any such SRE product in the research provider's business without having to obtain prior approval from an unrelated counterparty. The term "SRE product" means any pilot model, process, formula, invention, technique, patent, computer software, or similar property subject to protection under domestic or foreign law but excludes "mere know-how" obtained in the course of performance. Taxpayers are encouraged to submit comments, with the Notice specifically requesting feedback on whether special methods are needed for government research contracts and whether the section 174 contract research rules should parallel the funded research rules for the section 41 research credit.

Long-Term Contracts Subject to the Section 460 Percentage of Completion Method

The Notice announces that Treasury and the IRS intend to revise existing regulations under section 460 to address how the percentage of completion (PCM) method applies to long-term contracts when allocable contract costs include SRE expenditures. Current regulations provide that the portion of the contract price a taxpayer must report in a tax year corresponds to the ratio of incurred allocable contract costs to total estimated allocable contract costs. Treasury and the IRS intend to issue proposed regulations providing that costs allocable to a long-term contract accounted for using the PCM include amortization of SRE expenditures rather that the capitalized amount of such SRE expenditures. Thus, SRE expenditures would enter the numerator of the PCM completion factor as such SRE expenditures are amortized under section 174. Regarding the denominator of the completion factor, the Notice requests comments on whether estimated total allocable contract costs should include all SRE expenditures that directly benefit or are incurred by reason of the performance of the long-term contract or only the portion of the SRE expenditures expected to be amortized during the contract's term.

Cost Sharing Arrangements

The Notice also announces that Treasury and the IRS intend to revise existing regulations under section 482 to address cost sharing arrangements (CSAs) involving SRE expenditures. Existing regulations under section 482 provide that a cost sharing transaction (CST) payment reduces the recipient's deductible intangible development costs (IDCs) and constitutes income to the extent the CST payment exceeds the recipient's deductible IDCs. Capitalizing SRE expenditures under section 174 would reduce a CSA participant's deductible IDCs, thereby increasing the likelihood that the CSA participant would recognize income upon receiving a CST payment. The Notice announces an intention to issue proposed regulations that revise the existing section 482 regulations to provide that a CST payment reduces the recipient's deductible and capitalizable IDCs proportionately and constitutes income to the extent the CST payment exceeds the sum of the foregoing.

Applicability Date 

The Notice is not currently binding, though a taxpayer can rely on the Notice before Treasury and the IRS issue proposed regulations provided the taxpayer applies the Notice consistently and in its entirety. We expect a robust comment process on the Notice and eventually, a notice of proposed rulemaking containing proposed regulations reflecting or addressing comments that Treasury and the IRS received on the Notice. After a second comment process, Treasury and the IRS would proceed to issue a Treasury Decision containing final regulations. The Notice announces an intention that any such final regulations apply to tax years ending after September 8, 2023 (the date Treasury and the IRS issued the advance release of the Notice). Of course, the Notice and any future proposed regulations or final regulations could be mooted by legislation that retroactively restores current deductibility of SRE expenditures.

Treasury Offers Additional Interim Guidance on the Corporate Alternative Minimum Tax 

Layla Asali, Jeffrey Tebbs, and Caroline Reaves 

On September 12, Treasury and the IRS released additional preliminary guidance on the CAMT. Among other items, Notice 2023-64 addresses rules for determining applicable financial statements (AFS) and financial statement income (FSI), the treatment of controlled foreign corporations (CFC) and foreign tax credits, adjustments for certain taxes, and additional guidance on section 168 property. In contrast to earlier notices, Treasury and the IRS no longer anticipate issuing regulations that will be binding for tax years that begin in 2023. The Notice announces that forthcoming proposed regulations would apply for tax years starting in 2024. Taxpayers may rely on the Notice, as well as the prior interim guidance described in the Notice, for any tax year that begins before 2024. Comments are due October 12, 2023. 

Of particular significance, the Notice offers guidance on:

• Determining a Taxpayer's AFS
  • The Notice imposes a requirement on members of foreign-parented multinational groups (FPMG) and U.S. tax consolidated groups to use the group's consolidated AFS and then determine the portion of FSI attributable to the taxpayer, even if the taxpayer has a separate AFS of equal or higher priority. For example, a U.S. subsidiary of a FPMG with audited U.S. generally accepted accounting principles (GAAP) financial statements must use the consolidated financials of its foreign parent as its AFS, even if those financials would otherwise be of a lower priority because they were prepared using International Financial Reporting Standards (IFRS).
• General Rules for FSI
  • FSI generally includes all items of income and expense, including nonrecurring items and net income or loss from discontinued operations. 
  • FSI excludes Other Comprehensive Income (OCI) and equity accounts, such as retained earnings. 
    • However, any cumulative adjustment to retained earnings from a change in financial accounting principle must be accounted for in Adjusted Financial Statement Income (AFSI).
    • Treasury "continues to study" the treatment of unrealized marked-to-market gains and losses. 
• The AFSI of CFCs 
  • The Notice confirms that the adjustment is to take into account items of CFC income in a U.S. shareholder's AFSI is determined on an aggregate basis, rather than CFC-by-CFC. Under this approach, a financial statement loss at one CFC may offset financial statement income at a different CFC. The Notice confirms that a CFC's net income includes its pro rata share income from partnerships and disregarded entities and is not limited to its U.S. effectively connected income. 
  • While the Notice states that a taxpayer includes both its pro rata share of CFC net income and any dividends from its foreign subsidiaries, it does not provide rules to prevent the duplication of CFC income, notwithstanding the statutory directive in section 56A(c)(15)(A) to issue guidance "to prevent the omission or duplication of any item." 
    • In the Notice's request for comment, Treasury and the IRS acknowledged this "potential duplication of income with respect to a CFC by reason of the application of § 56A(c)(2)(C) and (c)(3)" and requested comments as to approaches that should be considered to address this issue. 
• Rules for Financial Statement Net Operating Losses (FSNOL)
  • Under the Notice, the amount of an FSNOL carried forward to the first taxable year a corporation is an "Applicable Corporation" is determined without regard to whether the taxpayer was an Applicable Corporation for any prior taxable year.
  • As such, for taxpayers that are Applicable Corporations in 2023, the amount of an available FSNOL incurred in 2020 is reduced by any positive AFSI in 2021 and 2022. 
• Determining Applicable Corporation Status
  • The Notice confirms that for purposes of the determining whether the FPMG meets the average $1 billion AFSI test that causes the U.S. subsidiary to be subject to the CAMT, the taxpayer must include the AFSI of each member of the FPMG and the AFSI of persons treated as a single employer under the section 52 aggregation rules. 
• General Rules for Foreign Tax Credits (FTC)
  • Foreign income tax can be claimed as a CAMT FTC in the taxable year in which it is paid or accrued for federal income tax purposes by either an Applicable Corporation or a CFC with respect to which an Applicable Corporation is a U.S. shareholder, provided the foreign income tax has been taken into account on the AFS of such Applicable Corporation or CFC.
    • As such, foreign income taxes may be claimed as a CAMT FTC in a different year from the year in which the foreign income tax was taken into account on an AFS. 
  • The Notice also applies the "relation back" doctrine and requires CAMT FTCs resulting from foreign tax redeterminations to be claimed in the taxable year to which the foreign tax redetermination relates (and only if the taxpayer was an Applicable Corporation in the "relation back" year). 
  • The Notice confirms that an Application Corporation or CFC that is a partner in a partnership may credit its share of foreign income taxes paid or accrued by the partnership but refrains from providing guidance on the allocation of such partnership creditable foreign tax expenditures. 
• Additional Guidance on Substitution of Tax Depreciation for Book Depreciation for Certain Property
  • The substitution of tax depreciation for book depreciation for section 168 property was addressed in earlier interim guidance in Notice 2023-07. Among other items, this Notice offers additional guidance on section 481(a) adjustments and tax disposition events. 
  • The Notice does not address taxpayer requests for a transition rule and affirms through an example the proposed rule in Notice 2023-7 that the substitution of tax depreciation for book deprecation would apply to property in which tax depreciation deductions were claimed in any taxable year, including the years prior to January 1, 2023.

IRS Ramping Up its Enforcement Efforts, Particularly of Large Partnerships

George Hani, Rob Kovacev, and Jim Gadwood

As we previously reported, the IRS issued its long-awaited Strategic Operating Plan this past April for implementing the billions of dollars in additional funding provided by the Inflation Reduction Act (IRA). The Strategic Operating Plan's centerpiece was a new enforcement strategy, the intended target of which was explicit: large corporations, large partnerships, and high-net-worth individuals. To increase audit rates for these groups, the Strategic Operating Plan provides that the IRS "will develop a centralized, integrated approach to assess risk to inform the selection of cases and appropriate treatments," which "will use risk analytics to prioritize and assign cases." If all goes to plan, taxpayers will be selected for audit by a "centralized compliance planning function using new analytics systems and refined risk-based case selection and routing" by the IRS's fiscal year 2026 (October 1, 2025, through September 30, 2026).

This past month, the IRS issued several announcements taking steps in the direction outlined in the Strategic Operating Plan, particularly with respect to IRS efforts to audit large partnerships. First, on September 8, 2023, the IRS detailed some of its plans to increase scrutiny of large partnerships and high wealth individuals using artificial intelligence "that will help the IRS compliance teams better detect tax cheating, identify emerging compliance threats and improve case selection tools." The announcement also said the IRS was expanding its Large Partnership Compliance program and promised to open audits by the end of September of 75 of the largest partnerships in the U.S., which "represent a cross section of industries including hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms and other industries."

Second, on September 15, 2023, the IRS announced that it was adding more than 3,700 positions nationwide to help with the expanded enforcement of complex partnerships and large corporations. These positions are for "higher-graded Revenue Agents" who will focus on taxpayer audits.

Third, on September 20, 2023, the IRS announced plans to create a new unit within the Large Business & International (LB&I) operating division with a special focus on large or complex pass-through entities. The goal of the new unit, according to Commissioner Werfel, is to "disrupt efforts by certain large partnerships to use pass-throughs to intentionally shield income to avoid paying taxes they owe."

With greater emphasis on enforcement comes greater need for effective dispute resolution programs within the IRS. In that vein, on September 15, 2023, the IRS requested comments on how to improve and expand tax certainty and issue resolution options. Specifically included in the request for comments was whether partnerships should be eligible to participate in the Compliance Assurance Process (CAP) in which taxpayers and the IRS work together to resolve any issues prior to filing the tax return. In addition, the IRS requested comments on how to "improve tax certainty and issue resolution at the entity level through to the ultimate taxpayer of pass-through entities." The IRS also requested comments on existing programs, such as the Pre-Filing Agreement (PFA) program and the Industry Issue Resolution (IIR) program.

The IRS's request for comments on issue resolution programs follows similar announcements earlier this year. On May 11, 2023, the IRS Independent Office of Appeals requested public input on how best to improve access to Appeals, whether by telephone, video, or in-person conferences. More broadly, on July 27, 2023, the IRS requested comments on how to improve certain post-filing alternative dispute resolution programs currently offered to taxpayers, such as Fast Track Settlement and the Rapid Appeals Process.

These announcements show that the IRS is undergoing considerable self-evaluation of its enforcement programs as it starts to implement the goals reflected in the Strategic Operating Plan. Taxpayers and practitioners should expect more activity in this area in the near future. 

Proposed Revisions to Form 6765 Would Impose Burdensome New R&E Credit Reporting Requirements

George Hani and Rob Kovacev

On September 15, the IRS unveiled a proposed revision to Form 6765, which is used to report research credit claims on both original and amended tax returns. The revised form is published on the IRS website. According to the IRS press release accompanying the revised form, the revisions "will provide taxpayers with a consistent and predefined format for tax reporting and improve the information received for tax administration. They will also build on ongoing efforts to manage Research Credit issues and resources in the most effective and efficient manner possible."

There are several changes proposed to Form 6765. The most significant of these is a new Section F, which mandates considerable additional detail never before required on Form 6765 and requires taxpayers to list every business component as to which they claim a research credit. As to each business component, taxpayers would have to include detailed information, including a narrative "information sought to be discovered" and the identification of "one or more alternatives evaluated in the process of experimentation." These requirements largely track the requirements for research and experimentation (R&E) refund claims that the IRS sought to impose in audits of such refund claims through the October 15, 2021 Chief Counsel memorandum. The IRS the imposed these requirements by amending the instructions to Form 6765 to mandate inclusion of this information, but for refund claims only. Our prior coverage of the R&E Chief Counsel memorandum and revisions to the Form 6765 instructions can be found here. The proposed revised form will impose these new requirements on refund claims on original and amended returns.

If adopted, these new requirements will impose a considerable burden on taxpayers, particularly large enterprises with considerable investments in R&E. The burden on those taxpayers, with potentially thousands of business components, is potentially immense. This burden may disincentivize taxpayers from engaging in critical research activities, thereby defeating the very purpose of the section 41 credit. The IRS requested comments on the proposed form by October 31, 2023. 

IRS Halts New Employee Retention Credit Claims Processing, Previews Settlement Programs

Andy Howlett

In a surprising development, the IRS announced on September 14 that it would stop processing new claims for the employee retention credit (ERC). The ERC is a completely refundable employment tax credit that Congress first enacted as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March of 2020 and later extended and expanded. For applicable quarters (which include all of 2020 and the first three quarters of 2021 for most taxpayers), the ERC provides a benefit for each employee that a business keeps on its payroll where the business either was subject to a COVID-19 shutdown order or had a significant reduction in gross receipts. These rules are complicated and we gave a more comprehensive summary in a recent client alert. Significantly, taxpayers may generally file an ERC claim for quarters ending in 2020 any time before April 15, 2024, and for quarters ending in 2021, any time before April 15, 2025. The IRS to date has received approximately 3.6 million ERC claims.

The "moratorium," as the IRS described the pause, will last at least through December 31, 2023. The IRS's decision follows the IRS's July 26 announcement that it was instituting additional procedures to deal with the "growing fraud risk" relating to the ERC, and promising an increase in both audit and criminal investigation work on ERC claims, on both taxpayers filing claims and "promoters."  

Commissioner Werfel said that the IRS now has more than 600,000 open ERC claims, almost all of which have been filed in the third quarter of the year (the July 26 announcement mentioned above had indicated that the IRS had cleared the backlog of claims). Commissioner Werfel indicated that the IRS would release guidance allowing taxpayers with pending claims the chance to withdraw them. In theory, this would prevent the application of underpayment penalties, which apply to ERC refund claims under regulations finalized in July. A settlement program is also planned, which would apply to taxpayers that already received ERC payments that they now believe are improper (again, potentially avoiding penalties, though details are not yet clear). In the case of both programs, the IRS notes that "[t]hose who have willfully filed fraudulent claims or conspired to do so should be aware, however, that withdrawing a fraudulent claim will not exempt them from potential criminal investigation and prosecution."

The moratorium does not substantively change the law applicable to the ERC. The IRS says that it will continue to process already-filed claims "but at a greatly reduced speed due to the complex nature of these filings and the need to protect businesses from being improperly paid." Thus, technically, the moratorium only truly applies to claims that are filed after September 14. With respect to those claims, the IRS urges taxpayers "to carefully review the ERC guidelines during the processing moratorium period. The IRS urges businesses to talk to a trusted tax professional – not a tax promoter or marketing firm looking to make money generating applications that takes a big chunk out of the ERC claim."

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