Brief commentary on recent cases, rulings, notices, and related federal tax guidance as of December 14, 2021.
U.S. Agreements Expand Potential Tax Credits for Digital Service Taxes
The global tax landscape is rapidly changing as countries around the world adapt to taxing the digital economy. The digital components of many businesses could fall subject to taxation under new, and quickly changing, rules adopted throughout the world. Companies of all sizes, from startups to behemoths, with operations or customers in Austria, France, India, Italy, Spain, Turkey, or the United Kingdom should ensure they capture the proper information to comply with the digital service taxes imposed by those countries, update their tax models to account for new digital service taxes and foreign tax credits, and maintain documentation to substantiate any future foreign tax credits.
The taxation of the digital economy has been a major talking point over the last several years. While countries have debated a set of uniform rules for taxing the digital economy, several countries have unilaterally enacted digital services taxes. As a reaction to these unilateral measures, the United States proposed trade actions against countries who enacted such digital service taxes.
In October 2021, 136 of the 140 member countries of the OECD reached an agreement on a two-pillar framework for international taxation. Pillar 1 provides a unified framework for taxing the digital economy and requires countries to retract their unilateral measures—including digital service taxes. Soon after the OECD agreement, the U.S. reached an agreement with several countries, including Austria, France, Italy, Spain, and the United Kingdom, to transition from their unilateral digital service taxes to the Pillar 1 framework.
Recently, Turkey and India also reached an agreement with the U.S. regarding how to transition away from unilateral digital services taxes while implementing the OECD’s Pillar 1 framework. Under these agreements, any digital service tax liability that U.S. companies accrue before Pillar 1 is implemented will be creditable against future income taxes accrued under Pillar 1.
As a practical matter, taxpayers of all sizes and in all industries need to be paying attention to what is happening throughout the world. It is not enough to consider local, state, or federal changes as countries are expanding what types of activities are taxable within their jurisdictions. Taxpayers do not want to be caught off guard by a tax bill or fail to gather the proper information required for a tax credit under one of these recent agreements. Moreover, taxpayers should be taking a proactive approach and model out not only how they would fare under the current unilateral digital service taxes but also how Pillar 1 will affect their tax liability once it is implemented.
Partial Spin-Off of Subsidiary and Subsequent Sale of Remaining Subsidiary Stock can Satisfy Threshold Requirement for Tax-Free Treatment
Tax free spin-off transactions have been an important tool for corporate taxpayers due to their ability to reduce corporate and shareholder tax liability in certain scenarios. The importance of this tool is increasing in recent years, as many companies are eschewing the global conglomerate structure and focus instead on success in a single line of business. The resulting divisions and divestiture of unprofitable or undesirable lines of business could lead to high tax bills without the aid of tax-free spin-off structures.
On December 10, 2021, the Internal Revenue Service issued PLR 202149006, ruling that a parent corporation’s retention, and subsequent sale, of less than twenty percent of a subsidiary corporation’s equity following the spin-off of the subsidiary corporation is not in furtherance of a plan having a principal purpose of avoiding income tax. In this ruling, the parent corporation intended to distribute at least eighty percent of the equity interests in the subsidiary corporation, but would keep less than twenty percent of the subsidiary corporation equity and sells that equity in unrelated transactions as soon as possible (but no later than five years after the spin-off).
The laws governing spin-off transactions require, among other things, that the parent corporation divest enough stock in the subsidiary company to relinquish control of the subsidiary corporation. In most contexts involving corporate reorganizations, eighty percent or more will be treated as enough of an ownership interest to control a subsidiary corporation. Because the corporate taxpayer in this ruling only retained less than twenty percent of the subsidiary equity, it follows that the parent corporation spun-off a controlling interest (i.e. more than eighty percent of the subsidiary stock). Even if the corporate parent does distribute a controlling interest in the subsidiary, if the parent’s retention of subsidiary stock is part of a plan to avoid federal income taxes, the proposed spin-off will not qualify for tax-free treatment. The import of this ruling comes not from the formulaic application of the eighty percent control test, but rather from the IRS’ statement that the retention and subsequent sale of subsidiary stock over five years is not part of a plan to avoid federal income tax.
A separate requirement—unaddressed by this ruling—is that a spin-off transaction cannot be a device to distribute the earnings and profits of the subsidiary or parent corporation. In some instances, the subsequent sale of parent or subsidiary stock can be viewed as such a prohibited device. Although the facts stated in this ruling don’t give enough detail to give a meaningful analysis of this factor, it is sufficient to say that a subsequent sale of retained subsidiary stock could violate the device prohibition even if a controlling interest in the subsidiary corporation is spun-off.
Taxpayers Find Relief for Tax Elections Relating to Equity Granted for Services, Structuring Stock Acquisitions, and Self-Certifying a Qualified Opportunity Fund
The Internal Revenue Service periodically issues rulings granting or denying requests for relief from taxpayers that have failed to comply with various requirements applicable to their activities. These rulings serve as a reminder that many tax regimes are elective and require filings or notification to the IRS, undertaking tax-motivated planning should be done with the advice of a competent tax professional, and that relief may be available to those who take reasonable steps to comply with their legal responsibilities.
In PLR 202149009, the IRS granted a taxpayer’s request to revoke an election under Code Section 83(b) (electing to recognize taxable income in the current year, rather than later years) with respect to certain restricted units granted to the taxpayer in exchange for services. With this revocation, the restricted units would only be taxable when the restricted units become vested.
In PLR 202149008 and PLR 202147010, the IRS granted a request for an extension of time for an S corporation, its shareholders, and a purchaser of the S corporation to file an election under Code Section 336(e) to treat a sale of the S corporation’s stock as a sale of the S corporation’s assets. In each case, the taxpayers were deemed to have acted reasonably, including by virtue of reliance on a tax professional that failed to file the election on time.
In PLR 202149003, the IRS granted an extension of time to file Form 8996 self-certifying that a limited liability company was a “qualified opportunity fund” for purposes of the opportunity zone tax deferral regime. In that instance, the fund owners formed the fund with the counsel of an attorney, but did not fully inform the fund’s accounting firm of the facts relating to the fund, nor did the accountant make further inquiry. This is a good reminder for taxpayers to engage competent counsel, fully apprise them of the taxpayer’s plans, and ensure coordination and information sharing between legal and accounting functions.