Daily Tax Update - July 6, 2007

D.C. CIRCUIT AFFIRMS DISTRICT COURT DECISION IN MURPHY AFTER VACATING PRIOR JUDGMENT:  On July 3, 2007, the D.C. Circuit Court of Appeals affirmed the district court's decision in Murphy v. United States, 362 F. Supp. 2d 206 (D. D.C. 2005), after vacating its prior reversal of the district court's decision.

  • At issue in Murphy was whether the taxpayer's compensatory damages could be taxable as gross income.  The district court concluded that taxpayer's damage award was not excludable from gross income under section 104(a)(2).  Section 104(a)(2) excludes damage awards received "on account of personal physical injuries or physical sickness" from gross income, but not damage awards received on account of other types of injuries, such as emotional distress or damage to reputation.
  • The D.C. Circuit initially reversed the district court decision.  The court held that, although section 104(a)(2) did not permit the taxpayer to exclude the award from gross income, the IRS could not constitutionally tax the damage award because the award was not "income" within the meaning of the 16th Amendment.
  • In December 2006, the D.C. Circuit vacated its decision and agreed to rehear the case.  The D.C. Circuit affirmed the district court decision upon rehearing.  The D.C. Circuit held that section 104(a)(2) was not unconstitutional because Article 1, Section 8 of the Constitution permits Congress to impose an excise tax uniformly throughout the United States.  The court therefore avoided the issue of whether the award was properly treated as income.

IRS ISSUES REGULATIONS RELATED TO CHARITIES INVOLVED IN PROHIBITED TAX SHELTER TRANSACTIONS: On July 5, 2007, the IRS issued a series of final, temporary, and proposed regulations concerning disclosure requirements and excise taxes with respect to prohibited tax shelter transactions in which a tax-exempt entity is a party.

  • The Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA"), enacted on May 17, 2006, defined certain transactions as prohibited tax shelter transactions and imposed excise taxes and disclosure requirements with respect to such transactions to which a tax-exempt entity is a party.  The provisions enacted by TIPRA apply to tax years ending after its date of enactment, except that no tax applies with respect to income or proceeds that are properly allocable to any period ending on or before August 16, 2006.
  • The IRS had issued Notice 2006-65 to alert taxpayers to these new provisions and to solicit comments regarding their implementation.  The IRS subsequently issued Notice 2007-18 to provide for interim guidance regarding the circumstances under which a tax-exempt entity would be treated as a party to a prohibited tax shelter transaction and regarding the allocation to various periods of net income and proceeds attributable to a prohibited tax shelter transaction.  The final, temporary, and proposed regulations issued by the IRS incorporate the guidance provided in Notice 2007-18 and provide for additional guidance.
  • The regulation package issued by the IRS includes proposed regulations under section 4965 relating to entity-level and manager-level excise taxes with respect to prohibited tax shelter transactions to which tax-exempt entities are parties.  The proposed regulations incorporate the definition of "party" set forth in Notice 2007-18 that included entities that either facilitate the prohibited tax shelter transaction by reason of its tax-exempt, tax indifferent, or tax-favored status, or that treat the prohibited tax shelter transaction on its tax return as reducing or eliminating its own federal tax liability.  The proposed regulations clarify that a tax-exempt entity does not become a party to a prohibited tax shelter transaction merely because it invests in an entity that in turn becomes involved in such a transaction.  The proposed regulations also clarify the definition of entity managers who may be subject to excise taxes under section 4965.  The proposed regulations provide for "reason-to-know" rules that describe the circumstances under which an entity or an entity manager knows or has reason to know that the entity has become a party to a prohibited tax shelter transaction.
  • The regulation package also includes temporary and proposed regulations relating to the requirement that a return accompany the payment of excise taxes under section 4965 with respect to prohibited tax shelter transactions in which a tax-exempt entity is a party.
  • Finally, the regulation package includes temporary and proposed regulations under section 6033(a)(2) and proposed regulations under section 6011(g) that provide rules regarding the form, manner, and timing of disclosure obligations with respect to prohibited tax shelter transactions to which tax-exempt entities are a party.  Section 6033(a)(2) requires every tax-exempt entity to which section 4965 applies that is a party to a prohibited tax shelter transaction to disclose to the IRS the identity of any other party to the transaction which is known to the tax-exempt entity.  Section 6011(g) requires that taxable party to a prohibited tax shelter transaction notify any tax-exempt entity which is a party to such transaction that the transaction is a prohibited tax shelter transaction.

SENATE FINANCE COMMITTEE SCHEDULES HEARING ON CARRIED INTEREST: On July 11, the Senate Finance Committee will hold a hearing on the tax treatment for the carried interest income given to private equity fund managers.  Finance Committee Chairman Max Baucus (D-MT) is likely to schedule a follow up hearing at a later date.  Baucus and ranking member Charles Grassley (R-IA) introduced legislation that would tax all publicly traded partnerships as corporations if they derive all of their income from their investment adviser or asset management services.

  • The House Ways and Means Committee is also likely to hold hearings in July, although nothing has been scheduled. 

TRANSFER PRICING DOCUMENTATION DEADLINE ON SEPTEMBER 15, 2007 FOR CALENDAR YEAR TAXPAYERS:  To avoid penalties, taxpayers should have appropriate documentation of their transfer pricing methodologies and results by the time they file their tax returns.  For calendar year taxpayers, this means that the documentation must be completed by September 15.  IRS agents have been instructed to look critically at this documentation, so companies may want to reconsider the standards they have used in the past for determining whether their documentation is rigorous and specific enough.  Steptoe's transfer pricing group is available and particularly well-situated to assist with that work.  Click here for more information

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