Tax News and Developments
North America Tax Practice Group
May 2019 | Volume XIV, Issue 5
In This Issue:
IRS Proposes Modificationsto the "May Company" Re g u l a ti on s
IRS Withdraws the Proposed Basis Rules but Leavesthe Un ce rta i n ty
IRS Issues Memorandum Applying Substance Over Form, Step Transaction Doctrine to Include Amountsin Taxpayer's Income Under Section 956
Repeal of Section 958(b)(4) and Potential Impact on Portfolio Interest Exemption Structures
2018 IRS APA Annual Report: Insufficient Resourcesto Accomplish its Objectives?
OMB Issues New Guidance to Improve Agency Compliance with the Congressional Review Act
California Legislature Proposes a State Gift and Estate Tax Beginning 2021
New QOZ Proposed Regulations Provie Much Needed Clarity to Fundsand Investors
IRS to Obtain US Bank Information on Finnish Residents with US Bank Accounts
IRS Proposes Modifications to the "May Company" Regulations
On March 25, 2019, Treasury and the IRS issued proposed regulations (the "Proposed Regulations") under Code Section 337 that would amend final regulations issued on June 11, 2018 (T.D. 9833, the "Final Regulations"). The Proposed Regulations, if adopted in their current form, would make substantive changes to the definition of "Stock of the Corporate Partner" (defined below) that, among other things, would incorporate downward attribution when analyzing whether a higher-tier corporation "controls" a Corporate Partner (also defined below) under section 304(c) and would remove the affiliated partner exception from the regulatory framework.
The 2018 "Final Regulations"
In general, the Final Regulations prevent a Corporate Partner from using a partnership to avoid corporate-level gain recognition in a "Section 337(d) Transaction" (defined below). A "Corporate Partner" is defined as a person classified as a corporation for federal income tax purposes that either holds or acquires an interest in a partnership. The Final Regulations define "Stock of the Corporate Partner" to include (i) the Corporate Partner's stock or other equity interests (i.e. options, warrants, and similar interests), and (ii) stock or other equity interests in a corporation that controls the Corporate Partner within the meaning of section 304(c). Importantly, section 318(a)(1) (family attribution) and 318(a)(3) (downward owner-to-entity attribution) do not apply when determining control under the Final Regulations. Further, the Final Regulations contain an "affiliated partner exception," whereby Stock of the Corporate Partner does not include any stock or other equity interests acquired by the partner if all interests in the partnership's capital and profits are held by members of an affiliated group (as defined in section 1504(a)) that includes the Corporate Partner. Additionally, under the so-called "Value Rule," Stock of the Corporate Partner includes interests in any entity to the extent the value of the interest is attributable to Stock of the Corporate Partner (e.g., an interest in an entity, the value of which fluctuates based on fluctuations in the value of the stock of the corporate partner).
Under the Final Regulations, a Corporate Partner may recognize gain when it is treated as acquiring or increasing its interest in Stock of the Corporate Partner held by a partnership in exchange for appreciated property in a manner that
Global Tax Controversy Update Follow ing Tax Reform and BEPS: Cost and Benefit Profiles
New York, NY May 30, 2019
Cross Border Issues for Doing Business in Mexico
New York, NY June 6, 2019
Breakfast Briefing: Latin America Tax Update
San Francisco, CA June 10, 2019
Palo Alto, CA June 12, 2019
Tax Planning and Transactions / Transfer Pricing Seminar
Boston July 25, 2019
To review the complete Tax Events Calendar visit www.bakermckenzie.com/tax/event
avoids gain recognition under section 311(b) or section 336(a). Specifically, the Final Regulations require gain recognition on "Section 337(d) Transaction[s]," which are defined to include instances where (i) a Corporate Partner contributed appreciated property to a partnership that owns Stock of the Corporate Partner; (ii) a partnership acquires Stock of the Corporate Partner; (iii) a partnership that owns Stock of the Corporate Partner distributes appreciated property to a partner other than the Corporate Partner; (iv) a partnership distributes Stock of the Corporate Partner to the Corporate Partner; and (v) a partnership agreement is amended in a manner that increases a Corporate Partner's interest in Stock of the Corporate Partner (including in connection with a contribution to, or distribution from, a partnership).
The Final Regulations were largely an adoption of temporary regulations issued in 2015. See Baker McKenzie's August 2015 Tax Newsletter (Tax News and Developments, "IRS Issues Temporary Regulations Under Code Section 337(d)," Vol. XV, Issue 4, August 2015), where it was noted that the temporary regulations were amended earlier that year to clarify that, when applying the section 304(c) control test, downward attribution should not be used. There was a concern that downward attribution could sweep in stock of lower-tier corporations, which was not the intent as expressed in the preamble of the 2015 temporary regulations.
The preamble to the Proposed Regulations (the "2019 Preamble") echoes the concern raised in the preamble of the 2015 temporary regulations, but suggests that the Final Regulations do not precisely implement Treasury and the IRS's intent. The 2019 Preamble provides an example where Husband owns 90 percent of corporation A, which in turn owns 49 percent of Corporate Partner (CP). Wife owns 90 percent of corporation B, which in turn owns 49 percent of CP. CP owns an interest in partnership PRS. Here, if downward attribution is not applied, neither A nor B "control" CP for purposes of section 304(c), and other partners of PRS can contribute stock of A or B to PRS in exchange for an interest in PRS without triggering gain to A or B. The preamble highlights Treasury and the IRS's concern that if, instead of being held by Husband and Wife, the interests in A and B were held by a single corporation, then the same structure "take[s] advantage of the exclusion of section 318(a)(3) attribution from the determination of section 304(c) control." The Proposed Regulations are intended to curb these unintended results, and would thus amend the definition of "Stock of the Corporate Partner" to remove the exclusion of section 318(a)(1) and (3) attribution from the determination of section 304(c) control.
The 2019 "Proposed Regulations"
There are three significant changes, and one less significant change, to the Final Regulations in the recently Proposed Regulations. First, the Proposed Regulations, when defining Stock of the Corporate Partner, would insert the term "Equity Interest" to describe stock, warrants and other options to acquire stock, and similar interests in the Corporate Partner. Stock of the Corporate Partner also includes Equity Interests in corporations that control the Corporate Partner
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within the meaning of section 304(c) and which also have a direct or indirect interest in the Corporate Partner. As the 2019 Preamble explains, for the purpose of testing direct or indirect ownership of an interest in the Corporate Partner, the rules would attribute ownership of Stock of the Corporate Partner to an entity under section 318(a)(2) (except that section 318(a)(2)(C)'s 50-percent ownership threshold would not apply) and under section 318(a)(4) (relating to options), but otherwise without regard to section 318 (meaning that sections 318(a)(1), (3), and (5) would not apply for this purpose). However, once it is determined that an entity directly or indirectly owns an interest in Stock of the Corporate Partner, then the section 304(c) definition of control would apply in full to determine whether the entity is a "controlling corporation."
Second, the Proposed Regulations would make another notable modification to the definition of "Stock of the Corporate Partner" by eliminating the affiliated partner exception. The original 1992 "May Company" regulations did not include an exception for partners of an affiliated group, but the 2015 temporary regulations introduced the exception based on Treasury and the IRS's belief that "the purpose of these regulations is not implicated if a partnership is owned entirely by affiliated corporations." The 2019 Preamble notes Treasury and the IRS's concern that affiliated group members could enter into transactions that permanently eliminate built-in gain on an appreciated asset that a Corporate Partner contributes to the partnership. For example, using facts similar to Treas. Reg. 1.1502-13(h)(2), Example (4), assume P owns all the stock of each of M1 and M2. M1 owns P stock with a value of $100 and basis of $10. M1 contributes the P stock to a new partnership, PRS, in exchange for a 33% interest in PRS, and each of P and M2 contributes $100 cash to PRS in exchange for a 33% interest. After 7 years, PRS distributes the P stock to M2 in complete liquidation of M2's interest in PRS. Absent application of the "May Company" regulations or Treas. Reg. 1.1502-13(h)(1), M1 might avoid taxation on the $90 of gain built into the P stock because, under section 732(b), M2 takes a $100 basis in the distributed P stock. Treasury and the IRS have requested comments on the possibility of creating a tailored exception to accommodate ordinary business transactions between affiliated group members and group-owned partnerships.
Third, the Proposed Regulations would also narrow the scope of the Value Rule, which holds that "Stock of the Corporate Partner" includes interests in any entity to the extent that the value of the interest is attributable to the Stock of the Corporate Partner. Treasury and the IRS noted in the 2019 Preamble that the Value Rule in the Final Regulations could be overbroad and difficult (or impossible) to apply in some circumstances. However, Treasury and the IRS rejected a commentator's suggestion that interests in an entity are not subject to the Value Rule unless 20 percent or more of the entity's assets consist of Stock of the Corporate Partner. The Proposed Regulations instead adopt a five-percent threshold, whereby the Value Rule would treat interests in an entity as Stock of the Corporate Partner only if the entity owns, directly or indirectly, five percent or more of the stock, by vote or value, of the Corporate Partner. Again, ownership of Stock of the Corporate Partner would be attributed to an entity under section 318(a)(2) (except that the 50-percent ownership threshold in
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section 318(a)(2)(C) would not apply) and under section 318(a)(4) (relating to options), but otherwise without regard to section 318. This leaves open the question of whether other arrangements are covered by the Value Rule, such as ownership of an interest in an entity that has entered into a derivative contract (e.g., a total return swap with regard to publicly traded parent stock) that has nominal fair market value when entered into.
In addition, the Proposed Regulations would also clarify how taxpayers should determine the extent to which the value of an equity interest is attributable to Stock of the Corporate Partner. Taxpayers would multiply the value of the equity interest in an entity by a ratio, the numerator being the fair market value of the Stock of the Corporate Partner owned directly or indirectly by the entity and the denominator being the fair market value of all the equity interests in the entity. The same attribution rules as above would apply when determining direct and indirect ownership, and the ratio may not exceed one. The Proposed Regulations also clarify that if an equity interest is Stock of the Corporate Partner because it is an interest in the Corporate Partner or in an entity with a direct or indirect ownership interest that controls the Corporate Partner within the meaning of section 304(c), then the Value Rule will not apply to such interest. Treasury and the IRS have requested comments on changes to the scope of the Value Rule, including the appropriate measure of an entity's value.
Finally, the Proposed Regulations would modify the exception for some dispositions of stock found in Treas. Reg. 1.337(d)-3(f)(2) to harmonize the language of the regulations with the modified definition of "Stock of the Corporate Partner."
The Proposed Regulations would be effective on the date that final regulations are published in the Federal Register, but taxpayers may generally rely on the Proposed Regulations for transactions occurring on or after June 12, 2015, but before final regulations are published.
By Kai Kramer and Richard Fink, Houston
IRS Withdraws the Proposed Basis Rules but Leaves the Uncertainty
On March 28, 2019, Treasury withdrew the 2009 proposed basis recovery regulations (NPRM 84-60, 84 Fed. Reg. 11686). The avowed reason for the withdrawal was Treasury's agreement with comments that the proposed rules "represented an unwarranted departure from current law as a result of which minor changes to an overall business transaction could cause meaningful changes to the tax consequences, thereby elevating the form of the transaction over its substance." The proposed basis recovery regulations, published on January 21, 2009, were issued to provide guidance regarding basis allocations under section 358, the recovery of stock basis in distributions under section 301, and transactions that are equivalent to section 301 distributions (REG-14368607, 74 Fed. Reg. 3509). The 2009 proposed basis allocation and recovery rules
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were a second attempt at bringing clarity to the area and changing results Treasury doesn't like (REG-150313-01, 67 Fed. Reg. 64331).
The principal 2009 proposed rule was Prop. Treas. Reg. 1.301-2(a), which, as seems true under existing law, would have treated each share of stock as a separate asset such that the non-dividend portion of a section 301 distribution reduces the adjusted basis of each share of stock held by the shareholder within the class of stock upon which the distribution is made. For example, if A acquired 25 of the 100 shares of outstanding common stock of X (its only class of stock) for $25 and the remaining 75 shares on a later date for $200, and if X makes a distribution to A of $300 at a time when X has only $100 of earnings and profits, then (i) $100 of the $300 distribution is a dividend taxable as ordinary income to A under sections 301(c)(1) and 316; (ii) $200 of the $300 distribution is treated as a $2 "return of capital" distribution on each of the 100 X shares; (iii) because the 25-share block has a basis of only $25, the $50 "return of capital" distribution on the shares in that block reduces the basis of each share to $0 under section 301(c)(2) and results in $25 of capital gain to X under section 301(c)(3); and (iv) because the 75-share block has a basis of $200, the $150 "return of capital" distribution on the shares in that block results in no section 301(c)(3) gain and reduces the basis of each share in the block to $0.6667 ($50 in the aggregate) under section 301(c)(2).
In the case of a dividend equivalent redemption of less than all a shareholder's stock, Prop. Treas. Reg. 1.302-5(a)(1) provided that the "portion of the distribution that is not a dividend shall be applied to reduce the adjusted basis of each share held by the redeemed shareholder ... in the redeemed class ...." Prop. Treas. Reg. 1.302-5(a)(2) went on to state, "[Except in the case in which all the shares actually owned by the shareholder in a redeemed class are redeemed], immediately following the reduction of basis as provided in section 301(c)(2) and paragraph (a)(1) of this section, all shares of the redeemed class, including the redeemed shares, held by the redeemed shareholder will be treated as surrendered in a reorganization described in section 368(a)(1)(E) in exchange for the number of shares of the redeemed class directly held by the redeemed shareholder after the redemption. The basis of the shares deemed received in the reorganization ... will be determined under the rules of section 358 and [Treas. Reg.] 1.358-2."
The most significant 2009 change would have been to repeal the "popping basis" rule of Treas. Reg. 1.302-2(c), under which the unrecovered basis of shares redeemed in a transaction characterized as a section 301 distribution under section 302(d) is added to the basis of shares that are directly or constructively owned by the redeemed shareholder. For example, if each of W, an individual married to H, and H owns 50% of the stock of X, and X redeems all of H's shares in a transaction not qualifying for sale or exchange treatment under section 302(b), then the unrecovered basis of H's redeemed shares is added to the basis of W's X shares. The "popping basis" rule would have been replaced by Prop. Treas. Reg. 1.302-5(a)(1) and (2), discussed above, and Prop. Treas. Reg. 1.302-5(a)(3), which stated that if there is a redemption of all the shares of the redeemed class that are directly owned by the shareholder, any unabsorbed basis in the redeemed shares must be treated as a loss from the
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disposition of the redeemed stock on the redemption date. This loss would have been deferred until there is an "inclusion date" (e.g., the date on which an event occurs that would have entitled the redeemed shareholder to sale or exchange treatment had it occurred on the redemption date).
Other significant changes would have been made to the regulations under section 304 (stock transfers involving mutually controlled corporations or controlled subsidiaries) and section 358 (basis of stock issued or deemed issued in reorganizations and section 351 exchanges). The principal change would have been the extension of the basis tracing and other rules of Treas. Reg. 1.358-2(a) to section 351 exchanges and capital contributions. Notably, Prop. Treas. Reg. 1.358-2(g)(3) would apply a deemed issuance/recapitalization rule under which, if a shareholder transfers property to a corporation in an exchange to which section 351 applies but receives nothing in the exchange (or receives transferee stock and/or boot with an aggregate fair market value less than the fair market value of the transferred property), then (i) the transferor is treated as receiving, in addition to any transferee stock and/or boot actually received, additional shares of transferee stock equal in value to the excess value of the property transferred over the value of the property received; and (ii) the transferor is then treated as surrendering all of its transferee corporation shares (including shares actually owned before the exchange and those deemed received in the exchange) in a section 368(a)(1)(E) recapitalization in exchange for the number of transferee shares actually owned by the transferor after the deemed exchange. Prop. Treas. Reg. 1.1016-2(e) would extend the issuance/recapitalization principles to capital contributions to which section 118 applies.
We are now back to current law, with its many unanswered questions, as Treasury and the IRS go back to the drawing board with "particular focus on issues surrounding sections 301(c)(2) and 304, and 1.302-2(c) of the Income Tax Regulations" (NPRM 84-60, 84 Fed. Reg. 11686). The following summarizes some of the ambiguities:
Dividend Equivalent Redemption of Less Than All the Shareholder's Stock. X owns all 100 shares of the single class of stock of Y, a domestic corporation, via 2 certificates representing 2 blocks: block #1 (50 shares) has a basis of $50 ($1 per share) and value of $500, and block #2 (50 shares) has a basis of $400 ($8 per share) and value of $500. Y distributes $500 cash to X in exchange for the 50 shares of Y stock composing block #1 (basis of $50). $100 of the distribution is a dividend under sections 301(c)(1) and 316, and the remaining $400 is a return of capital. The 2009 proposed regulations would have treated the $500 distribution as pro rata with respect to all 100 shares (X has $150 of gain [$200 return of capital minus $50 of basis] vis--vis block #1, reducing the basis of each block #1 share to $0, and no gain [$200 return of capital minus $400 of basis] vis--vis block #2, reducing the basis of each block #2 share to $4). Thus, under the 2009 proposed rules, X recognizes $150 of gain and is left with 50 shares having a basis of $200 ($4 per share).
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There is no clear answer as to how basis is recovered under current law and there appear to be several approaches in addition to the approach of the 2009 proposed rules:
1) Unredeemed Share Approach. Add the $50 basis of the redeemed block #1 shares to the $400 basis of the unredeemed block #2 and then treat the $500 distribution as made pro rata on block #2. Thus, because there is $450 of total basis ($9 per share) in the unredeemed block #2 after the addition of the $50 basis of the block #1 shares, all of the $400 return of capital distribution is tax-free under section 301(c)(2), leaving $50 of basis in the unredeemed 50 shares of Y stock ($1 per share).
2) Pre-Redemption Recapitalization. Treat Y as recapitalizing 100 into 50 shares prior to the distribution, after which the distribution is made pro rata on 50 "new" shares. Now 25 "new" shares have a $50 ($2 per share), allocated under Reg. 1.358-2(a) from block #1, and 25 "new" shares have a basis of $400 ($16 per share) allocated from block #2. Under these facts, the result is the same as the 2009 proposed rule ($150 of gain, 25 shares with a $0 basis, and 25 shares with a $200 basis).
3) Redeemed Share Approach. Allow X to recover only the $50 basis of the block #1 shares canceled in the redemption. This results in $350 of gain and the retention of $400 of basis ($8 per share) in the retained block #2 shares. If X intends to take this approach, it should return to Y the certificate representing block #2 in exchange for the $500 Y distribution so that it can use the $400 basis in block #2 under section 301(c)(2).
Basis Blending. P, a domestic corporation, owns all 100 shares of the single class of stock of CFC in 2 blocks: block #1 (50 shares) has a basis $100 ($2 per share) and value of $500, and block #2 (50 shares) has a basis of $400 ($8 per share) and value of $500. In order to blend the basis of the 2 blocks, P transfers all the CFC stock to a newly formed foreign corporation, CFC Newco, in exchange for 10 shares of CFC Newco nonvoting common stock and 90 shares of CFC Newco voting common stock. P will argue that, under Treas. Reg. 1.358-2(b) (applicable to section 351 exchanges), it takes a blended $5 basis in each of the 100 shares of CFC Newco stock. While this argument should prevail under current law, it is not loved by Treasury which seems to continue to favor tracing and may address this case in future guidance.
By Jerred Blanchard, Houston and Derek Gumm, Palo Alto
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IRS Uses Memorandum Applying Substance Over Form, Step Transaction Doctrine to Include Amounts in Taxpayer's Income Under Section 956
The IRS has published a Chief Counsel Advice memorandum, CCA 201910021 (the "CCA"), that applies the step transaction and economic substance doctrines to inclusions in income for investments in US property under section 956 for taxable years prior to the enactment of the Tax Cuts and Jobs Act (the "Act").
In general, the substance over form doctrine applies to recast a transaction where the form does not comport with the reality of the transaction. Using the substance over form doctrine, a court may deny legal effect to transactions that comply with the literal terms of a statute, but contravene the purpose of a statute.
Separately, under the step transaction doctrine, individual steps in a transaction may be ignored if it appears those steps are superfluous and are intended to give rise to tax consequences inconsistent with a transaction in which that step is excluded.
While courts themselves apply the substance over form and step transaction doctrines, it is the longstanding ruling position of the IRS, and as illustrated in the CCA, to apply these doctrines to transactions and subsequently argue the applicability of those doctrines in court.
In the CCA, which is heavily redacted, the taxpayer was the parent company of a controlled group of corporations filing a consolidated return. The issue under audit was the proper inclusion in the taxpayer's income under section 956. Section 956 includes, via a deemed repatriation mechanic, in a taxpayer's US taxable income certain investments made in US property by controlled foreign corporations ("CFCs") of which the taxpayer is a US shareholder (as defined in section 951(b)). Generally, before the enactment of the Act, earnings of a CFC were deferred from US income tax until repatriated. However, Section 956 taxed certain amounts as if they were repatriated, including purported repatriations resulting from investments in US property by CFCs.
For this purpose, US property includes obligations of a domestic corporation that is a US shareholder of the CFC making the loan. A CFC is tested on a quarterly basis to determine whether it has loaned money to a US shareholder, thereby investing in US property, in a manner that gives rise to a section 956 inclusion.
US shareholders could avoid triggering section 956 by causing their CFCs to structure their loans in a manner to avoid having an investment in US Property on the quarterly measuring date. The regulations under section 956 attempted to counteract this incentive through use of an anti-abuse rule. This rule, contained in Treas. Reg. 1.956-1T(b)(4), states that a CFC will be considered to hold indirectly US property acquired by a foreign corporation that is controlled by the CFC if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) that foreign corporation is to avoid the application of section 956 with respect to the CFC. A foreign corporation is considered to be
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controlled by a CFC, under the anti-abuse rule, if a common parent owns at least 50 percent of the vote or value of both corporations.
Although the CCA is heavily redacted, it appears the taxpayer successfully avoided application of the anti-abuse rule. As a result, the IRS attacked the transaction through application of the substance over form doctrine and the step transaction doctrine.
First, the CCA addressed application of the substance over form doctrine. The CCA argued that Congress had evinced an intent to combat the repatriation of earnings to the US through CFCs by changing to quarterly measuring dates from the annual measuring dates under section 956 in 1993. At that time, Congress stated, in a Senate Report accompanying the change in law, that short-term loans should be disregarded when one of the principal purposes of the arrangement was to avoid taking assets into account for purposes of testing US property holdings under section 956. Applying that Congressional intent to this case, the IRS found that the taxpayer's (and its CFC's) form of the transaction was contrary to the substance that Congress intended. The CCA cited several court cases in which both courts and the IRS had applied the substance over form doctrine to include amounts in income under Section 956, including Jacobs Engineering Group v. US, 79 A.F.T.R. 2d 97-1673 (C.D. Cal. 1997), aff'd by unpublished decision, 168 F.3d 499 (9th Cir. 1999); cf. Humana Inc. v. Comm'r, 881 F.2d 247 (6th Cir. 1989) (lack of Congressional intent to nullify a type of transaction precluded application of substance over form doctrine). In the CCA, the IRS identified the 1993 change in law as indicative of Congressional intent to stop taxpayers from using short-term obligations to avoid section 956 income inclusions.
The IRS next analyzed the step transaction doctrine. The IRS discussed two possible tests under which the step transaction doctrine could apply. First, under the "end result test," a series of steps that are prearranged parts of a single transaction that, from the outset, are designed to achieve a specific end-result can be collapsed into a single step. For instance, in Jacobs Engineering, the taxpayer attempted to fund its working capital through a series of short-term loans that did not, in form, result in a section 956 income inclusion. Despite the form of the transaction, the court found that the end result was intended from the start: to fund the working capital of the taxpayer. In the CCA, the IRS concluded that application of the end result test was appropriate and could be used to ignore the form of the transaction.
Separately, the IRS applied the "interdependence test," where it analyzes the relationship between the intermediate steps in a complex transaction, rather than the end result, and determines whether intervening steps in a series of steps would have been fruitless or meaningless had the other steps taken place. While much of the reasoning is redacted, the IRS held that the interdependence test would also justify application of the step transaction doctrine to ignore the taxpayer's form with respect to the transaction at issue.
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The conclusion reached by the IRS in the CCA shows that the IRS still intends to apply the substance over form and step transaction doctrines to recharacterize transactions if the taxpayer's selected form is incompatible with Congress' intended substance. The IRS's citation to Humana, though, suggests the IRS recognizes that it may be required to respect a taxpayer's form if such form does not clearly violate a clearly articulated Congressional intent.
By Daniel Wharton, Chicago
Repeal of Section 958(b)(4) and Potential Impact on Portfolio Interest Exemption Structures
The United States generally imposes a 30% withholding tax on US sourced payments of interest to foreign persons if such interest income is not effectively connected with a US trade or business of the payee/borrower. However, under an exception commonly known as the "portfolio interest exemption," interest paid to foreign persons with respect to certain "portfolio debt instruments" may not be subject to such US withholding tax. Portfolio debt planning is a frequently used arrow in the inbound tax-planning quiver as the tax benefits can be substantial where the interest payments are subject to no or low taxation in the jurisdiction of tax residence of the lender, but are still deductible by a borrower for US tax purposes.
While common exceptions to the portfolio interest exemption include interest received by a bank, or interest received by a person who is considered to be a 10-percent shareholder, a lesser known exception applies to interest received by a controlled foreign corporation ("CFC") from a related person.
Subsequent to the changes under the Tax Cuts and Jobs Act of 2017 (the "Act"), a CFC is defined as a foreign corporation in which more than 50% of its total voting power or value is owned by US persons (i.e., US individuals, US trusts, US corporations, or US partnerships) who each own at least 10% of the combined voting power of all classes of the stock, or at least 10% of the total value of shares of all classes of stock. The applicable related party rules for purposes of the CFC exception are under section 267(b).
Certain changes made as part of the Act significantly expands the scope of this third exception. Specifically, subsequent to the repeal of section 958(b)(4) under the Tax Cuts and Jobs Act of 2017, certain "down-ward" attribution to US persons can apply to make entities CFCs, where they would not have otherwise been so treated prior to the change in law.
For example, if a foreign parent company ("F Parent Co") had a 100% owned foreign subsidiary company ("F Sub Co"), and F Parent Co were to directly or indirectly own a US corporation (or US partnership) that was not a subsidiary of F Sub Co, it is possible that F Sub Co could be considered a CFC because F Sub Co's stock would be attributed from F Parent Co. down to the US corporation (or US partnership) directly or indirectly owned by F Parent Co. Section 958(b)(4)
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previously precluded this nonsensical result by turning off attribution of stock under section 318(a)(3) from a non-US person to a US person for these purposes. The legislative history notes that the change to eliminate section 958(b)(4) was made so that taxpayers would be unable to avoid CFC status by "de-controlling" a foreign subsidiary by causing the foreign subsidiary to issue stock to the new foreign parent after an inversion transaction. Notwithstanding that this change was targeted at a specific type of transaction deemed abusive, the repeal of section 958(b)(4) has significantly broader and unintended effects. In essence, even if a foreign corporation has ultimate beneficial owners who are all non-US individuals, it is possible for such a foreign corporation to be a CFC if either: (i) the ultimate beneficial owners (or any non-US spouse, ascendant or descendant of the ultimate beneficial owners) own interests in a US corporation or US partnership, or (ii) any entity in the ownership chain between the foreign corporation and the ultimate beneficial owners owns interests in a US corporation or partnership.
Since such wide sweeping consequences appear to have been unintended and result in illogical outcomes (e.g., frequently classifying many foreign corporations as CFCs even when there is no US ownership), there is a common industry expectation for eventual technical corrections legislation to address this specific issue. However, under the current statutory regime, an entity that is technically considered to be a CFC generally cannot be the lender of a loan to a related party and still qualify for the portfolio interest exemption. As such, in structures where there is a foreign corporation as a lender, to determine whether the portfolio interest exemption will still be applicable subsequent to the changes made under the Act, it will be necessary to revisit the analysis of these structures to determine: (1) if the borrower is considered a related party to the foreign corporation lender, and (2) if the foreign corporation lender is considered a CFC.
By Michael Melrose, Miami
2018 IRS APA Annual Report: Insufficient Resources to Accomplish its Objectives?
On March 22, 2019, the IRS issued its Announcement and Report Concerning Advance Pricing Agreements (Announcement 2019-03, I.R.B. 2019-15 (Mar. 19, 2019)) ("2018 APA Report"), which presents the key results of the IRS's Advance Pricing and Mutual Agreement Office ("APMA"). The 2018 APA Report provides general information regarding the operation of the office, including staffing, and statistical information regarding the numbers of APA applications received and resolved during the year, including countries involved, demographics of companies involved, industries covered and transfer pricing methods ("TPMs") employed. The following article summarizes the highlights of the report and provides observations based on our experience with APMA and APAs, both within the program and as tax counsel to companies in the program.
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The 2018 APA Report suggests that, although APMA has been able to respond to certain challenges and attract an unprecedented level of new filings (double the number in 2017), it faced a wide variety of challenges and will continue to do so. In particular, the number of new applications and cases in inventory surged to historic levels. In almost all categories indicated in the 2018 APA Report, APMA's performance dropped compared to last year. At the same time, APMA's overall workload scope increased. APMA's bilateral APA filings and inventory reflect a somewhat more robust diversity of treaty partner jurisdictions, requiring resources in terms of, for example, more substantive negotiations with a larger number of treaty jurisdictions. In addition, according to an LB&I directive, IRS Examination is now required to consult with APMA regarding transfer pricing issues involving treaty partners. APMA also recently announced a "functional cost diagnostic model" ("FCDM") which indicates that APMA believes it may be necessary to deploy more complex profit split methods to evaluate transfer prices. See Client Alert: "APMA's New Model Signals Move Toward Profit Splits," (Mar. 6, 2019). Finally, APMA has offered to serve as a coordination point for various issues arising from the Tax Cuts & Jobs Act (e.g., BEAT issues) and customs duty matters, over which it may have relatively limited jurisdiction. It is difficult to envision how APMA can provide service levels to taxpayers that meet or exceed prior years' service levels with its current level of resources.
Some of APMA's notable achievements include a relatively high number of completed APAs and handling APAs involving a more diverse set of treaty partners. In addition, building on the revised APA procedures in IRS Rev. Proc. 2015-41, APMA issued a revised draft model APA agreement in May 2018 with further revisions circulated in September 2018, and requested comments thereon.
APMA implemented a staff restructuring in September 2018 which was reportedly aimed at aligning APMA's management structures with LB&I's structure. In terms of overall staffing levels, APMA had fewer personnel than last year, consisting of 56 team leaders, 12 economists, 6 managers and 3 assistant directors. This staffing level is lower than in many prior years and lower than the IRS's prior stated intention to increase APMA's staffing to approximately 65 team leaders (up from 63 for CY 2016) and 30 economists (up from 20 for CY 2016) to improve its case processing times. IRS budget issues and turnover have made this growth difficult to achieve, but APMA recently received approval to hir internally. Leadership at the APMA Director position and IRS Large Business & International Division with transfer pricing responsibilities, including Treaty & Transfer Pricing Operations (Director) and Transfer Pricing Practice (Director of Field Operations), was stable during 2018. Resource demands from the OECDG20's Base Erosion and Profit Shifting ("BEPS") project and the OECD's Forum on Tax Administration likely had an impact on internal operations, APA negotiations with companies and bilateral APA negotiations involving other
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countries' tax authorities, thereby requiring additional time to process certain types of APAs, as discussed below.
APA Demand and Output
Historic high in new applications: Possibly due, in part, to a 90% increase in APA filing fees for filings made after December 31, 2018 (compared with filings before two fee increases effective July 1, 2018 and January 1, 2019), the number of new APA filings (including user fee filings) doubled from 138 in 2017 to 274 in 2018. Even complete filings doubled from 101 to 203 in 2018. The number of filings indicates that company demand for APAs continued to grow, even during the period of tax reform uncertainty. It is likely that some of the increase reflects a pull forward of demand, suggesting that filings in 2019 may decline. The number of bilateral filings involving India and Japan represented more than half of the new bilateral filings and increased approximately 90% and 66%, respectively. Filings involving Canada, Germany, Korea, Mexico and Italy also increased but represented a much smaller percentage of the total filings. No separate information regarding bilateral filings involving the United Kingdom or Switzerland was provided (unlike in certain prior years), implying a relatively low number of filings for these jurisdictions given APMA's approach of not providing data for categories involving fewer than 3 APAs.
Processing insights: APMA continued to confront issues with controlling APA inventory as evidenced by the escalation in pending APAs to 458 (from 386 in 2017), and bilateral APA inventory increasing 21% from 2017 (387 of the 458 total in inventory). The pending unilateral APA inventory remained flat at 58. Of the 458 pending APAs, bilateral APAs outnumbered unilateral APAs by more than 6 to 1. APMA still encountered difficulties resolving bilateral APA renewals in a timely manner as they represent more than 80% of all pending bilateral APAs. Japan (31%), India (20%), Canada (9%) and Germany (8%) constituted the majority of the pending bilateral APAs, reflecting the high levels of pending APAs involving Japan and Canada and the increasing levels for India. Numbers of pending APAs involving Korea, Mexico, the UK and Italy were also indicated. Unlike in prior years, pending APAs involving China were not reflected, suggesting that there were fewer than 3 such pending APAs as of the end of 2018.
For APAs executed in 2018, new APA processing times showed some improvement, but renewal APAs required more time. Bilateral APAs executed in 2018 required more time to complete compared with 2017 (42.1 months (median) compared with 35.9 months (median)). Not surprisingly, APAs requiring the shortest processing times were unilateral APA renewals (27.2 months (median)). As indicated in the 2017 APA Report, of the 18 different measures of processing time (e.g., average vs. median months, unilateral vs. bilateral APA, new vs. renewal APA), only 4 measures showed improvement in 2018 compared with 2017.
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Executed APAs: The IRS executed fewer APAs than in 2017 (107 compared with 116), and the mix of bilaterals and renewals was approximately the same as 2017, with 76% bilateral and 58% renewals.
As in prior years, the 2018 APA Report indicates that US-Japan bilateral APAs continued to constitute the largest percentage of overall APAs that the program processed (39%), followed by Canada (20%). The heavy caseload involving APAs with Japan, Canada and India is reflected in the number of APA teams that have responsibility for those APAs. Regarding India, a comparison of (1) the number of APA filings, (2) the number of pending APAs and (3) the number of executed APAs shows there is a backlog for Indian APAs (fewer than 3 APAs executed involving India) as of the end of 2018.
Withdrawn APA requests: Companies withdrew more APAs in 2018 (21) than in 2017 (8), but still fewer than in 2016 (24). Higher levels of 2018 withdrawals could be due to several factors, including a desire by APMA to "clean up" pending APA inventory, companies achieving certainty through other means, company dissatisfaction with processing times, higher numbers of APA filing, etc. Similar to 2017, the IRS neither canceled nor revoked any APAs in 2018. Only 11 have been canceled or revoked since the program began.
APA Characteristics and Terms
US vs. Non-US parent companies: Similar to 2017, the majority of APAs involved non-US parent companies: 52% of the executed APAs for 2018 were for non-US parent companies and their US subsidiaries, while 22% involved US parent companies and their non-US subsidiaries. The ongoing appeal of the APMA program to non-US parent companies, particularly Japan parent companies, could be due to, among other things, the IRS's continued focus on transfer pricing involving non-US parent companies, non-US parent companies' desire for transfer pricing certainty, or an increase in audit activity in other countries which a bilateral APA with the United States could help resolve.
Industries represented: As in 2017, most of the APAs executed in 2018 involved mainly manufacturing, with the next most common being wholesale/retail trade and then management. APAs were also executed in the services industry as well as the finance, insurance and real estate industry category. Within the manufacturing segment, the miscellaneous manufacturing and transportation equipment industries were relatively equally represented, followed by computer and electronic products, machinery, and chemical industries. To some extent, the year-over-year industry breakdown is random, in that it provides a snapshot of a particular twelve-month period, and many factors can impact the resolution timing for specific cases. The other industry classification that is prominent in the APA program is wholesale/retail trade, and merchant wholesalers of durable goods dominate that class year after year.
TPMs applied: For 2018, the comparable profits method/transactional net margin method ("CPM/TNMM") continued to be the most commonly applied TPM
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for tangible and intangible property transactions (applied to 86% of such transactions). Regarding the profit level indicator ("PLI") used when the CPM/TNMM is employed, the operating margin (defined as operating profit divided by net sales) was applied 68% of the time a large decline from 85% in 2017. The Berry ratio, ROA or return on capital employed PLIs were applied in the remaining cases, and the 2018 APA Report, unlike pre-2016 reports, does not separately state the number of times that PLIs other than the operating margin were used. Similarly, it does not include other data that had been provided in pre-2016 year reports, such as tested party functions and risks.
For services transactions, PLIs under the CPM/TNMM favored the operating margin in 2018, with it being used for 86% of the services transactions. In comparison, in 2015, 55% of the cases applied the mark up on costs, followed by 32% for the operating margin and 13% for the Berry ratio.
Asset intensity adjustments: It is the policy of the APA office to make the asset-intensity adjustments identified in the US regulations, i.e., receivables, inventory and payables, in all cases where such adjustments can be made. Where appropriate, property, plant and equipment ("PP&E") adjustments are made, but the percentage of cases in which such an adjustment is made in any given year is a function of the specific facts of the cases that were resolved in that year.
APA terms: APA term lengths, including rollback years, averaged 7 years in 2018 (same as in 2017). The largest number of APAs were executed with fiveyear terms (33% of the total), and 84% had terms of 5 to 10 years. In 2018, 17 APAs had terms of 10 years or longer, which is similar to 2017. In addition to the impact of aging inventory, long term lengths can be a product of complex issues, difficult competent authority negotiations and the desire for prospective coverage. For example, when a difficult or contentious case reaches conclusion, often at the end or beyond the end of the requested term, both companies and governments may seek to extend the term of an APA and provide some prospectivity.
FX adjustments: The APA program has no set policy regarding adjustments to company financials to account for currency fluctuations. The 2018 APA Report notes in that regard that "[i]n appropriate cases, APAs may provide specific approaches for dealing with risks, including currency risk, such as adjustment mechanisms and/or critical assumptions." Over the years of the APA program, FX-adjustment mechanisms have been proposed by companies and by governments, and where the fluctuations are extreme, or where a currency has weakened significantly, this can be taken into account when shaping a bilateral agreement.
Observations and Conclusions
Keeping in mind that certain data in the 2018 APA Report reflects a snapshot in time, there are several trend lines we can identify. Although APMA had a few
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bright spots in 2018, APMA encountered more "head winds" compared with 2017 - a surge in new filings, historic levels of pending APA inventory, longer processing times in the majority of cases, broader scope of workload, etc. The streamlined intake processes and the increase in information required in the APA application as a result of IRS Rev. Proc. 2015-41 was intended to reduce processing time, by ensuring APMA started with the information it needed. The effects of these changes should become evident over time, and we should evaluate if improvements arise during 2019 and later years.
Looking forward, APMA's release of its FCDM may lead to more cases in which profit split methods are applied instead of the CPM/TNMM. As profit split methods are more complex and require additional time and resources to apply (and may be contrary to positions held by companies and other tax authorities), it is likely that those cases targeted by APMA will face higher processing times. It is not clear, however, whether any higher processing times will materialize in 2019 because of the FCDM (due to the early stage of its deployment).
With the continued need to provide companies with feasible alternatives to resolve complex transfer pricing and ancillary issues as efficiently and effectively as possible, particularly with more intensive transfer pricing enforcement globally, changes under the Tax Cuts and Jobs Act, heightened transparency, digitalization of the economy, customs duty matters and BEPS pressures, it is evident that APMA's resource constraints should be carefully evaluated. The increased user fees effective in stages (i.e., after June 30 and December 31, 2018), augmented IRS's collected fees, but APMA indicated that it does not directly receive such fees as part of its budget. Such increased fees will hopefully result in more well-placed and stable resources for APMA to increase its productivity, particularly in light of the need for APMA to review and analyze the larger amounts of information and data that companies are required to submit at the front end of the APA process.
By Richard Slowinski and Donna McComber, Washington, DC
OMB Issues New Guidance to Improve Agency Compliance with the Congressional Review Act
On April 11, 2019, the Office of Management and Budget ("OMB") released a memorandum to federal agencies titled "Guidance on Compliance with the Congressional Review Act." The memorandum is intended to improve compliance with the Congressional Review Act ("CRA") and also sets forth a process that the Office of Information and Regulatory Affairs ("OIRA") will use to properly categorize regulatory actions. This process took effect on May 11, 2019.
The CRA, enacted in 1996, provides a mechanism for Congress to exercise direct oversight of agency rulemaking. Under its terms, federal agencies must submit proposed rules to Congress for review. Congress may then pass a joint
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resolution of disapproval that, if signed by the president or enacted over the president's veto, invalidates the rule. In order to help prioritize congressional review, OIRA must determine whether a rule is "major." This standard definition is similar to the economic standard for "significant regulatory action" in Executive Order 12866, but also includes rules that are likely to result in "a major increase in costs or prices for consumers [or] individual industries" or likely to result in "significant adverse effects on competition, employment, investment, product ivity, innovation, or the ability of United States-based enterprises to compete with foreign-based enterprises in domestic or export markets."
The CRA applies to all federal agencies, including the Department of the Treasury, and uses the term "rule" expansively to include any "agency statement of general . . . applicability and future effect designed to implement, interpret, or prescribe law or policy . . . ." Thus, in addition to formal regulations, any form of IRS pronouncement, whether in the form of a Notice, a Revenue Ruling, or a Revenue Procedure, is subject to the CRA.
Notably, the CRA provides that if a federal agency does not follow the CRA's procedures, the proposed rule does not take effect.
The OMB memorandum comes in the wake of increasing congressional scrutiny of the federal regulatory process, including the House Oversight and Government Reform Committee's March 2018 report, "Shining Light on Regulatory Dark Matter." On December 8, 2017, and January 11, 2018, the Committee requested information from 46 federal agencies, including Treasury, on each agency's issuance of guidance over the last ten years and its compliance with the CRA.
The report concludes that federal agencies are largely not compliant with the CRA. Of the more than 13,000 guidance documents identified for the Committee, only 189 were submitted to Congress and the Government Accountability Office in accordance with the CRA.
In its response to the Committee, Treasury acknowledged that "the number of IRS documents that could be responsive to the request is extremely large" and that the IRS annually publishes about 2,000 pages of regulations and other guidance documents in the Internal Revenue Bulletin plus thousands of other documents that provide information to taxpayers, including IRS Publications, IRS Forms, Tax Topics, Tax Trails, Tax FAQs, Chief Counsel Notices, Internal Revenue Manual provisions, Chief Counsel Advice (CCA), Priority Guidance Plans, Action on Decisions, Appeals Settlement Guidelines, General Counsel Memoranda, Technical Advice Memoranda, Legal Advice issued by Associate Chief Counsel, and Program Manager Technical Advice.
Treasury asserted that "[t]he IRS meets its Congressional Review Act notice requirement . . . for regulations," but did not address other forms of agency guidance. A recent Government Accountability Office report confirms that the IRS issued the majority of its rules without complying with the CRA.
The OMB memorandum reaffirms that "federal agencies must coordinate with OIRA . . . for all final, interim final, and direct final rules, irrespective of whether a
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rule would otherwise be submitted for regulatory review." In addition, the memorandum emphasizes that agencies should not publish any rule "in the Federal Register, on their websites, or in any other public manner" until OIRA has reviewed the rule and the agency has complied with the CRA. The memorandum further provides that agencies should implement the following procedure:
1. Each agency should notify OIRA regularly of upcoming rules and submit a recommended designation of whether the rule is major.
2. For rules that an agency considers not major, OIRA may inform the agency that OIRA agrees with the agency's designation. Otherwise, the rule will be subject to the major rule determination process.
3. For rules the agency considers major and rules not previously designated by OIRA as not major, agencies should submit the rule to OIRA for a CRA determination, along with an analysis of whether the rule is major under the criteria established by the CRA.
4. OIRA will review each rule and accompanying analysis and designate the rule as major or not major.
5. After the designation, agencies may send the CRA report to Congress and the Comptroller General in accordance with the CRA and may then publish the rule in the Federal Register.
It remains to be seen whether Treasury and the IRS will begin complying with the CRA or whether there will be any repercussions for not doing so. Although the CRA provides that rules may not take effect unless the agency complies with the CRA, no federal court has ruled on whether the CRA permits judicial review of IRS actions. The CRA was used for the first time to challenge an IRS rule in CIC Services, LLC v. IRS, case No. 3:17-cv-00110 (E.D. Tenn. Nov. 2, 2017). The district court did not reach the CRA cause of action, but the taxpayer has appealed the case to the Court of Appeals for the Sixth Circuit and both parties have re-argued the CRA issues. The Court of Appeals has not yet issued a decision. A holding that the CRA permits judicial review of IRS actions would change the landscape for challenges to IRS rulemaking and represent a new tool for taxpayers in those suits.
By Mireille Oldak, Washington, DC
California Legislature Proposes a State Gift and Estate Tax Beginning 2021
The California senate recently introduced a bill that would impose a California gift, estate, and generation skipping transfer tax beginning January 1, 2021 on all gratuitous transfers during the life and upon the death of a California resident. Under the proposed California law, all California transfer taxes would be imposed at a rate of 40 percent, though there is a provision for a basic $3,500,000
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exclusion for each individual. The proposed law also provides for a credit to offset any federal transfer tax liability, meaning that California residents are essentially taxed on the difference between the California exclusion amount of $3,500,000 and the federal exclusion amount, currently $11,400,000. While the California State Assembly and the Governor have signaled support for the bill, the bill cannot become law unless it is also approved by a voter referendum in the statewide 2020 election. For a more thorough discussion, please see the Baker McKenzie Client Alert "California Legislature Proposes a State Gift and Estate Tax Beginning 2021," distributed in April 2019.
By Spencer Guillory, Chicago
New QOZ Proposed Regulations Provide Much Needed Clarity to Funds and Investors
A second set of proposed regulations relating to the qualified opportunity zone ("QOZ") program was released on April 17, 2019 and published in the Federal Register on May 1, 2019. The proposed regulations provide much-needed clarity to taxpayers seeking to obtain the tax benefits of the QOZ program. A wide range of QOZ topics, including the following, are covered by the proposed regulations: the original use and substantial improvement tests; qualifying investments in qualified opportunity funds; transactions triggering recognition of initially deferred gain; treatment of leased property as QOZ business property; 50% gross income test for QOZ businesses; debt-financed distributions by qualified opportunity funds; and reinvestment of proceeds by qualified opportunity funds.
For a detailed discussion, please see the Baker McKenzie Client Alert, "The New 2019 QOZ Proposed Regulations and Their Impact on the Life Cycle of a Qualified Opportunity Fund," distributed on May 16, 2019, which provides an indepth analysis of how the proposed regulations will impact funds and investors. The analysis is presented in accordance with a qualified opportunity fund's life cycle (formation, operation, and exit), and a summary chart at the end of the Client Alert especially highlights Baker McKenzie's observations and takeaways on some of the key aspects of the QOZ program.
By Mary Yoo, Chicago
IRS to Obtain US Bank Information on Finnish Residents with US Bank Accounts
In May 2019, the US Department of Justice announced that the IRS had obtained a court order authorizing the service of "John Doe" summonses on three US banks in connection with Finnish residents who were regularly and frequently using US bank payment cards in Finland. The recent use of "John Doe" summonses in this case, as well as public pronouncements by governmental representatives, confirm that the United States does cooperate with non-US jurisdictions despite very limited automatic exchange of information by the United
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States. Consequently, US financial institutions and non-US individuals with US financial accounts should consider the implications of these efforts.
For a more detailed discussion, please see the Baker McKenzie Client Alert, "IRS to Obtain US Bank Information on Finnish Residents with US Bank Accounts," distributed on May 20, 2019.
By Elliott Murray, Geneva
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