tax update

Explanation of the Obama Administration's General Business, International and Oil and Gas Tax Proposals

On May 11, 2009, the Treasury Department released a detailed explanation (the “Explanation”) of the Obama administration’s tax proposals for its fiscal year 2010 budget. The Explanation describes a number of amendments to the Internal Revenue Code that may be applicable to your business, including general business tax proposals, international tax proposals, and oil and gas tax proposals.

1. General Business Tax Proposals

   a. Expand the Net Operating Loss Carryback
   

   Net operating losses (“NOLs”) generally may be carried back two years. The American Recovery and Reinvestment Tax Act of 2009 extended the maximum carryback period from 2 years to 5 years for any net operating loss generated by a qualifying small business (generally, small businesses whose average annual gross receipts do not exceed $15,000,000). The Explanation indicates that a temporary extension of the NOL carryback period would provide taxpayers in all sectors of the economy that experience NOLs with the ability to obtain tax refunds which could be used to fund capital investment or other expenses. The Explanation further indicates that the “Administration looks forward to working with the Congress to make a lengthened NOL carryback period available to more taxpayers,” but does not provide any specific information as to which businesses would qualify for, or the length of, the extended carryback period.

   b. Tax Carried Interests as Ordinary Income
   

   The Explanation proposes to treat a partner’s share of partnership income attributable to a “services partnership interest” as ordinary income that is subject to self-employment taxes, regardless of the character of that income at the partnership level. For example, if a partnership recognizes long-term capital gain, the income allocated with respect to a services partnership interest would be ordinary to the partner holding that interest, and the partner would then be subject to self-employment taxes on that income. In addition, the Explanation proposes that the portion of any gain recognized on the sale of a services partnership interest would be taxed as ordinary income, not as capital gain.

   A services partnership interest is an interest in a partnership received in exchange for providing services to that partnership. If a partner provides services and “invested capital” to a partnership and the partnership reasonably allocates its income and loss between such invested capital and the remaining partnership interest, the income and gain allocable to, or resulting from the sale of, the portion of the partnership interest exchanged for invested capital would not be recharacterized as ordinary income. Invested capital is generally money or other property contributed to the partnership, but it does not include any proceeds of any loan or other advance made or guaranteed by any partner or the partnership.

   To prevent the avoidance of these rules through the use of compensatory arrangements other than partnership interests, the Explanation provides that any person who performs services for an entity and holds a “disqualified interest” in the entity (generally, convertible or contingent debt, an option, or any derivative instrument with respect to the entity) is subject to ordinary income tax on any income or gain with respect to the disqualified interest.

   These rules would be effective for taxable years beginning after December 31, 2010.

   c. Codify the “Economic Substance” Doctrine
   

   The “economic substance” doctrine generally denies tax benefits from a transaction that lacks “economic substance,” even if the transaction literally satisfies the requirements of the Internal Revenue Code. Under current law, the interpretation of the standards for determining “economic substance” has been left to the courts.

   The Explanation proposes the codification of the “economic substance” doctrine and the creation of a new understatement penalty for transactions that lack economic substance. These measures would apply to transactions entered into after the date of enactment.

   Under the proposal, a transaction would have economic substance only if both: (i) the transaction meaningfully changes the taxpayer’s economic position (without regard to federal tax effects) and (ii) the taxpayer has a substantial purpose for entering into the transaction (other than a federal tax purpose). The Explanation clarifies that the mere potential for profit is insufficient to show that a transaction has economic substance unless the present value of the reasonably expected pre-tax profit is substantial compared to the present value of the net federal tax benefits arising from the transaction.

   If a transaction lacks economic substance, a 30% penalty (or a 20% penalty when there was adequate disclosure of the transaction on the taxpayer’s tax return) would be imposed on any understatement of tax attributable to the transaction. The IRS could assert this penalty even if there has not been a court determination that the economic substance doctrine was relevant. This penalty would apply in lieu of other accuracy-related penalties on the understatement, but any understatement attributable to a lack of economic substance would be considered in determining if there was a substantial understatement of income tax under current law (e.g., for purposes of applying penalties other than the accuracy related penalty). The taxpayer would also be barred from deducting interest attributable to an understatement of tax resulting from a transaction lacking economic substance.

   d. Repeal the LIFO Method of Accounting for Inventories
   

   The Explanation proposes to eliminate the use of the last-in, first-out (“LIFO”) method of inventory accounting for federal income tax purposes. Taxpayers currently using the LIFO method would be required to write up their beginning LIFO inventory to its value utilizing the first-in, first-out method in the first taxable year beginning after December 31, 2011. The increase in gross income resulting from this write up would be taken into account ratably over eight years beginning in that first taxable year.

2. International Tax Proposals

   a. Limit Use of “Check-the-Box” Rules for Foreign Entities

   The Explanation proposes to amend the check-the-box rules such that a foreign entity with a single owner may be treated as a disregarded entity only if the owner is organized in the foreign country in which the foreign entity is organized. Under this proposal, a foreign entity with a single owner that is organized in a country other than the country in which the owner is organized would be treated as a corporation for U.S. federal tax purposes. The proposal presumably would not apply to foreign entities that are treated as partnerships. Except in cases of U.S. tax avoidance, the proposal generally would not apply to a first-tier foreign entity owned by a U.S. person. However, the proposal presumably would apply to lower-tier entities, even in a “flow-through” tax structure.

   The Explanation expresses the concern that the use of a foreign disregarded entity may avoid the current inclusion of earnings by a U.S. taxpayer that would otherwise apply under the subpart F provisions of the Code. However, the Explanation does not specifically indicate that the provision would apply only to foreign disregarded entities which are directly or indirectly owned by a U.S. person.

   The Explanation provides that, in the case of a foreign entity which is required to convert from a disregarded entity to a corporation under this proposal, the tax treatment of such conversion would be consistent with current Treasury regulations and tax principles.

   This proposal would be effective for taxable years beginning after December 31, 2010.

   b. Defer Deductions of Expenses Related to Deferred Income

   The Explanation proposes to defer deductions of a U.S. taxpayer for expenses (other than research and experimentation expenditures) that are allocated and apportioned to foreign-source income to the extent that such foreign-source income is not currently subject to U.S. tax. The amount of expenses properly allocated and apportioned to foreign-source income generally would be determined under current Treasury regulations. The amount of deferred expenses of a U.S. person for a taxable year would be carried forward to subsequent taxable years and, in each such year, combined with foreign-source expenses for such year before determining the deferred deduction, if any, with respect to such year.

   This proposal would be effective for taxable years beginning after December 31, 2010.

   c. Determine Indirect Foreign Tax Credit on an Aggregate Basis

   The Explanation proposes to require a U.S. corporation to determine its deemed-paid foreign tax credit on dividends from foreign corporations on an aggregate basis. To compute the deemed-paid credit for a year, a U.S. corporation would first determine the aggregate foreign taxes and earnings and profits of all foreign corporations with respect to which the U.S. corporation can claim a deemed-paid foreign tax credit. The taxpayer’s deemed-paid foreign tax credit would then be determined based on the amount of aggregate earnings and profits of the foreign corporations that is repatriated to the taxpayer in such year.

   This proposal would be effective for taxable years beginning after December 31, 2010.

   d. Prevent the Splitting of Foreign Income and Foreign Taxes for Foreign Tax Credit Purposes

   The Explanation proposes to permit a U.S. taxpayer to claim a foreign tax credit for foreign taxes paid to a foreign jurisdiction only if the taxpayer recognized the associated income for U.S. tax purposes.

   This proposal would be effective for taxable years beginning after December 31, 2010.

   e. Increase Taxation of Intangible Property Transfers

   The Explanation proposes to clarify that the definition of intangible property for purposes of sections 367(d) and 482 of the Code includes workforce in place, goodwill and going concern value. The Explanation also proposes to clarify that, for transfers of multiple intangible properties, the Commissioner may value the intangible properties on an aggregate basis where such valuation achieves a more reliable result. The Explanation further proposes to clarify that intangible property must be valued at its highest and best use, as it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. While, as indicated, the Explanation uses the term “clarify,” it is not clear that all of the proposed changes are in fact clarifications.

   This proposal would be effective for taxable years beginning after December 31, 2010.

   f. Tighten Earnings Stripping Rules for Expatriated Entities

   The Explanation proposes to amend section 163(j) of the Code as applied to certain expatriated entities. For this purpose, an “expatriated entity” would be defined by applying the rules of section 7874 of the Code and the regulations promulgated thereunder as if section 7874 were applicable for tax years beginning after July 10, 1989. However, an expatriated entity would not be so treated if the surrogate foreign corporation is treated as a domestic corporation under section 7874.

   In such cases, the Explanation proposes to limit further the deductibility of interest paid by an expatriated entity to related persons. The debt-to-equity safe harbor, which currently excludes certain corporations from the application of section 163(j), would be eliminated for expatriated entities. Additionally, the 50 percent adjusted taxable income threshold for applying section 163(j) would be reduced to 25 percent of adjusted taxable income for expatriated entities with respect to disqualified interest other than interest paid to unrelated parties on debt that is subject to a related-party guarantee. Further, the carryforward of disallowed interest, which is currently unlimited, would be limited for expatriated entities to 10 years, and the carryforward of the excess limitation amount (i.e., the amount by which the adjusted taxable income threshold exceeds net interest expense for a taxable year) would be eliminated for expatriated entities.

   This proposal would be effective for taxable years beginning after December 10, 2010.

   g. Expand the Taxation of Shareholders in Certain Cross-Border Reorganizations

   The Explanation proposes, in the case of any cross-border reorganization in which the acquiring corporation is foreign and the target shareholder’s exchange has the effect of a distribution of a dividend, to treat the entire amount of “boot” received by the shareholder as a corporate distribution. The income of such shareholder would no longer be limited to the shareholder’s gain on the exchange.

   This proposal would be effective for taxable years beginning after December 31, 2010.

   h. Repeal 80/20 Company Rules

   The Explanation proposes to repeal the 80/20 company provisions, which under current law treat as foreign-source income exempt from withholding taxes certain dividends and interest paid by a domestic corporation if at least 80 percent of such corporation’s gross income during a three-year testing period is foreign-source and attributable to the active conduct of a foreign trade or business.

   This proposal would be effective for taxable years beginning after December 31, 2010.

   i. Expand Taxation of Income from Certain Equity Swaps

   The Explanation proposes to treat income earned by foreign persons with respect to equity swaps that reference U.S. equities as U.S.-source income subject to withholding tax to the extent that the income is attributable to (or calculated by reference to) dividends paid by a domestic corporation. There would be an exception to the source rule for equity swaps with all of the following characteristics: (i) the terms of the swap do not require the foreign person to post more than 20 percent of the value of the underlying stock as collateral; (ii) the terms of the swap do not include any provision addressing the hedge position of the counterparty; (iii) the underlying stock is publicly traded and the notional amount of the swap represents less than 5 percent of the total public float of that class of stock and less than 20 percent of the 30-day average daily trading volume; (iv) the foreign person does not sell the stock to the counterparty at the inception of the contract, or buy the stock from the counterparty at the termination of the contract; (v) the prices of the equity that are used to measure the parties’ entitlements or obligations are based on an objectively observable price; and (vi) the swap has a term of at least 90 days.

   This proposal would be effective for payments made after December 31, 2010.

   j. Modify the Foreign Tax Credit Rules for Dual-Capacity Taxpayers and Limitations with Respect to Foreign Oil and Gas Income

   The Explanation proposes to redefine which foreign taxes paid by a “dual-capacity” taxpayer (viz., a taxpayer that is subject to a foreign levy and that also receives an economic benefit from the levying country) are creditable for U.S. federal tax purposes. Under the proposal, a foreign levy imposed on a dual-capacity taxpayer would qualify as a creditable tax only if the foreign country generally imposes an income tax. An income tax would be considered to be generally imposed only if it applies to trade or business income from sources in that country and has substantial application to non-dual-capacity taxpayers and to persons who are nationals or residents of that country.

   Additionally, the Explanation proposes to convert the foreign tax credit limitation rules of section 907 of the Code, regarding foreign oil and gas income, into a separate category within section 904.

   These proposals would not override provisions of U.S. tax treaties.

   This proposal would be effective for taxable years beginning on or after December 31, 2010.

3. Oil and Gas Tax Proposals

   a. Repeal Expensing of Intangible Drilling Costs
   

   Generally, a taxpayer who pays or incurs intangible drilling costs (“IDCs”) in the development of an oil or gas property located in the United States may elect under current law either to expense or to capitalize and amortize those costs, if the taxpayer holds a working or other operating interest in such property. The rule is an exception to the general rules requiring taxpayers to capitalize costs that provide a benefit to the taxpayer in future periods.

   If a taxpayer elects to expense IDCs, the amount of the IDCs is deductible as an expense in the taxable year the cost is paid or incurred. In the case of an integrated oil company that has elected to expense IDCs, 30% of the IDCs on productive wells must be capitalized and amortized over a 60-month period. Further, a taxpayer may elect to capitalize and amortize certain IDCs over a 60-month period beginning with the month the expenditure was paid or incurred.
   

   The Administration proposes to repeal the election to expense IDCs, as well as the election to amortize IDCs over a 60-month period. Under the proposal, all IDCs would be capitalized and amortized as depreciable or depletable property, depending on the nature of the cost incurred, in accordance with generally applicable rules. The proposal would be effective for costs paid or incurred after December 31, 2010.
   

   b. Increase Amortization Period for Geological and Geophysical Costs to Seven Years
   

   Geological and geophysical expenditures are costs incurred for the purpose of obtaining and accumulating data that will serve as the basis for the acquisition and retention of mineral properties. The amortization period for geological and geophysical expenditures incurred in connection with oil and gas exploration in the United States is two years for independent producers and seven years for integrated oil and gas producers.
   

   The Administration proposes to increase the amortization period from two years to seven years for geological and geophysical expenditures incurred by independent producers in connection with all oil and gas exploration in the United States. Seven-year amortization would apply even if the property is abandoned, and any remaining basis of the abandoned property would be recovered over the remainder of the seven-year period. The proposal would be effective for amounts paid or incurred after December 31, 2010.
   

   c. Repeal Percentage Depletion
   

   The capital costs of oil and gas wells are recovered through the depletion deduction. Under the cost depletion method, the basis recovery for a taxable year is computed on the unit of production method proportional to the exhaustion of the property during the year. Certain taxpayers qualify for percentage depletion with respect to domestic oil and gas properties. The amount of the percentage depletion deduction is a specified percentage (from 15% to 25%) of the gross income from the property, subject to several limitations, including that the percentage depletion deduction for a year may not exceed 100 percent of the taxable income from the property.
   

   A qualifying taxpayer determines the depletion deduction for each oil and gas property under both the percentage depletion method and the cost depletion method and deducts the larger of the two amounts. Because percentage depletion is computed without regard to the taxpayer’s tax basis in the depletable property, a taxpayer may continue to claim percentage depletion after all the expenditures incurred to acquire and develop the property have been recovered.
   

   The Administration’s proposal would repeal the percentage depletion deduction with respect to oil and gas wells for taxable years beginning after December 31, 2010. Thereafter, all taxpayers would only be permitted to report a deduction for cost depletion to recover their adjusted basis, if any, in oil and gas wells.
   

   d. Repeal Domestic Manufacturing Deduction for Oil and Gas Production
   

   A deduction is allowed with respect to income attributable to domestic production activities. The deduction is equal to 6 percent of the lesser of qualified production activities income for the year or total taxable income for the year, limited to 50 percent of the wages incurred by the taxpayer for the year.
   

   Qualified production activities income includes a taxpayer’s gross receipts derived from the disposition of oil, natural gas or primary products thereof extracted or produced by the taxpayer within the U.S. minus the cost of goods sold and other expenses, losses, or deductions attributable to such receipts.
   

   Under the Administration’s proposal, gross receipts derived from the disposition of oil, natural gas or a primary product thereof would be excluded from the definition of domestic production gross receipts for taxable years beginning after December 31, 2010.
   

   e. Repeal Passive Loss Exception for Working Interests in Oil and Gas Properties
   

   The passive loss rules generally limit the deductions and credits of individuals, trusts and certain closely held C corporations arising from passive activities. A “passive activity” is generally defined as any trade or business activity in which the taxpayer does not materially participate.
   

   Current law contains an exception, however, for certain oil and gas working interests. Under this exception, a working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest is not considered a “passive activity,” even though the taxpayer does not materially participate.
   

   The Administration proposes to repeal the oil and gas working interest exception for taxable years beginning after December 31, 2010. As a result, deductions and credits attributable to oil and gas working interests held by an individual, trust or closely held C corporation would become subject to the passive loss limitations described above, unless the taxpayer materially participates in the oil and gas activity.
   

   f. Repeal of Credits for Enhanced Oil Recovery Projects and Production from Marginal Wells
   

   The Administration proposes to repeal for taxable years beginning after December 31, 2010 (i) the 15% investment tax credit for domestic enhanced oil recovery projects and (ii) the production tax credit for oil and gas produced from marginal wells.
   

   g. Repeal Deduction for Tertiary Injectants
   

   Under current law, taxpayers are allowed to deduct the cost of qualified tertiary injectant expenses for the taxable year. Qualified tertiary injectant expenses are amounts incurred for any tertiary injectant (other than recoverable hydrocarbon injectants) that is used to augment the recoverable amount of hydrocarbons in their reservoir as a part of a tertiary recovery method (as such term is defined by regulation).
   

   The Administration proposes to repeal the deduction for qualified tertiary injectant expenses for amounts paid or incurred after December 31, 2010. As a result, such costs would be capitalizable and recovered over time.
   

   h. Levy Tax on Certain Offshore Oil and Gas Production
   

   The Explanation states that the Administration is developing a proposal to impose an excise tax on certain oil and gas produced offshore in the future.
   

This Tax Update is intended only to provide a general summary of certain tax provisions. If you would like to discuss how any of these or other tax provisions may impact your operations, please contact any Baker Botts tax lawyer, including the authors of this update listed above.

IRS Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any US federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.