IRS presumption of correctness -

Tax deficiency assessments determined by the Commissioner of Internal Revenue carry a presumption of correctness, and this presumption imposes upon the taxpayer the burden of proving that the assessment is erroneous. See, e.g., United States v. Janis, 428 U.S. 433, 440 (1976) (stating that the policy behind the presumption of correctness applies the same way in civil collection suits that it does in taxpayer-initiated refund suits and pre-assessment Tax Court proceedings); Kikalos v. Commissioner, 434 F.3d 977, 982 (7th Cir. 2006), citing Tax Court Rule 142(a). "Justification for the presumption of correctness lies in the government's strong need to accomplish swift collection of revenues and in the need to encourage taxpayer recordkeeping." Portillo v. Commissioner, 932 F.2d 1128, 1133 (5th Cir. 1991). The presumption attaches virtually regardless of the information, procedures, or policies used because the presumption "recognizes the structural inequality of information in the possession of the Commissioner relative to the taxpayer." Zuhone v. Commissioner, 883 F.2d 1317, 1325-26 (7th Cir. 1989).


United States of America, Plaintiff v. Dennis L. Cochran, Sandra G. Cochran, and GMAC Mortgage Group, Defendants.

U.S. District Court, So. Dist. Ind., New Albany Div.; 4:06-cv-0041-DFH-WGH, July 11, 2008.

[ Code Sec. 6203]

Tax assessments: Presumption of correctness. --

The IRS's tax assessments with respect to a couple's unpaid taxes, interest and penalties were presumptively correct because they were based on records from another year and were not, therefore, arbitrary. The couple had not filed their returns for three of the four tax years they owned and operated a restaurant, and did not provide any financial records for those years. Accordingly, the IRS was entitled to make its assessments for those years based on the income reported on the one return that the couple did file.




[ Code Sec. 7403]


Although the IRS's tax assessments with respect to a couple's unpaid taxes, interest and penalties for three of the four tax years when they had owned and operated a restaurant were presumptively correct, summary judgment was not granted. A genuine issue of material fact existed regarding the amount of deficiency because the government's assessments assumed a total tax liability more than ten times the amount reported by the couple on the one return they did file. Furthermore, it was necessary to determine at trial whether the IRS mailed a notice and demand to the couple.







ENTRY ON CROSS-MOTIONS FOR SUMMARY JUDGMENT


HAMILTON, Chief Judge: The United States of America has sued defendants Sandra and Dennis Cochran to collect federal income tax for the years 1994, 1995, and 1996. During those years, the Cochrans operated a restaurant but did not file federal income tax returns. The Commissioner of Internal Revenue assessed taxes in 1998 for unreported income stemming from the restaurant's operation. The government now seeks taxes, penalties, and interest from the Cochrans. The GMAC Mortgage Corporation may claim an interest in the real property involved in this action and was made a party pursuant to 26 U.S.C. §7403(b). The court has jurisdiction under 26 U.S.C. §7402.

Both sides have moved for summary judgment under Rule 56 of the Federal Rules of Civil Procedure. The small record in this case is largely undisputed, but there are two material factual disagreements about whether proper notice was given to the Cochrans and about the size of the tax deficiency. Accordingly, both motions for summary judgment are denied.




Summary Judgment Standard


The purpose of summary judgment is to "pierce the pleadings and to assess the proof in order to see whether there is a genuine need for trial." Matsushita Electric Industrial Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 587 (1986). Summary judgment is appropriate when there are no genuine issues of material fact, leaving the moving party entitled to judgment as a matter of law. See Fed. R. Civ. P. 56(c). The moving party must show that there is no genuine issue of material fact. See Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986). The moving party need not positively disprove the opponent's case; rather, it may prevail by establishing the lack of evidentiary support for that case. See id. at 325. Where the non-moving party bears the burden of proof on an issue at trial and the motion challenges that issue, the non-moving party must set forth specific facts showing that there is a genuine issue for trial. See Fed. R. Civ. P. 56(e)(2); see also Silk v. City of Chicago, 194 F.3d 788, 798 (7th Cir. 1999). Bare allegations not supported by specific facts are not sufficient in opposing a motion for summary judgment. Hottenroth v. Village of Slinger, 388 F.3d 1015, 1027 (7th Cir. 2004), quoting Hildebrandt v. Illinois Dep't. of Natural Resources, 347 F.3d 1014, 1036 (7th Cir. 2003).

When deciding a motion for summary judgment, the court considers those facts that are undisputed and views additional evidence, and all reasonable inferences drawn therefrom, in the light reasonably most favorable to the nonmoving party. See Fed. R. Civ. P. 56(c); Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255 (1986). However, a party must present more than mere speculation or conjecture to defeat a summary judgment motion. The issue is whether a reasonable trier of fact might rule in favor of the non-moving party based on the evidence in the record. Anderson, 477 U.S. at 251-52.

The fact that both sides have filed motions for summary judgment does not alter the applicable standard; the court must consider each motion independently and will deny both motions if there is a genuine issue of material fact. See, e.g., Heublein, Inc. v. United States, 996 F.2d 1455, 1461 (2d Cir. 1993); Harms v. Laboratory Corp. of America, 155 F. Supp. 2d 891, 905-06 (N.D. Ill. 2001). In considering cross-motions for summary judgment, the court must consider the evidence through two lenses. When considering the Cochrans' motion for summary judgment, the court must give the government the benefit of all conflicts in the evidence and the benefit of all reasonable inferences that might be drawn from the evidence in its favor, even if the evidence or the inferences seem improbable. When considering the government's motion for summary judgment, the roles are reversed.




Undisputed Facts


Sandra and Dennis Cochran owned and operated the Dillsboro Family Restaurant during the period of 1993 through 1996. Def. Resp. to Pl. Interrog. No. 11. For 1993, the Cochrans filed a federal income tax return. Their total tax liability for that year was approximately $1,800. Def. Ex. E 3. The Cochrans did not file tax returns for 1994, 1995, and 1996, and they have produced no financial records for those years.

In 1998, the Internal Revenue Service made assessments against the Cochrans for unpaid income tax for 1994, 1995, and 1996. The IRS based its assessments for those years on income reported for 1993. Def. Ex. A 12; Def. Ex. B 11. With penalties and interest, the IRS claims that the Cochrans now owe approximately $185,000. Pl. Ex. A 3, 5. The Cochrans claim that they made no profit at their restaurant in 1994-96 and therefore owe nothing. Def. Resp. to Pl. Interrog. Nos. 7, 8. Additional facts are noted below as needed.




Discussion


The Cochrans argue (1) that the collection suit cannot proceed because the IRS did not send them a notice and demand letter, (2) that the suit should be dismissed because they have no financial resources to pay a judgment, and (3) that the assessment against them is arbitrary and excessive. The IRS asserts: (1) that it sent the Cochrans the notice and demand, (2) that the defense of poverty is meritless, and (3) that its tax assessment is presumed valid.



I. Notice and Demand

Within sixty days of making an assessment of a tax, the IRS must "give notice to each person liable for the unpaid tax, stating the amount and demanding payment thereof." 26 U.S.C. §6303. In general, the taxpayer has ninety days to file a petition with the Tax Court to challenge the deficiency assessment. 26 U.S.C. §6213. No court proceeding for collection shall be made, begun, or prosecuted until notice has been mailed and the ninety day period has expired. 26 U.S.C. §6213.

Yvette Stiger of the IRS testified in her affidavit: "Notice of each of the assessments...and demand for its payment, was sent to [the Cochrans] on or about the date of the assessment." Pl. Ex. A, ¶ ¶4, 7. There is no separate documentary support for this claim. The Cochrans testified that they reviewed the IRS records about them and found no indication that the IRS mailed a Notice and Demand to him or his wife. D. Cochran Aff. ¶14; S. Cochran Aff. ¶14. The Cochrans both declare that they "did not receive any Notice and Demand for Payment as required by law from the IRS for the years 1994, 1995, 1996." D. Cochran Aff. ¶14; S. Cochran Aff. ¶14. No other evidence bears on this question, and the government did not respond to this evidence and argument by the Cochrans.

The statute does not require the Cochrans to admit that they received a Notice and Demand letter. See 26 U.S.C. §6213. In the absence of a response from the government, however, the court finds that the government's motion for summary judgment must be denied. This issue will be available for further briefing and evidence at trial.



II. Ability to Collect a Judgment

The Cochrans contend that they are entitled to summary judgment because they have no assets with which to pay a tax judgment against them. The Cochrans have submitted evidence to show their current inability to pay a judgment. Def. Ex. H, I, J, K. They underscore that their real property was recently valued at $39,200, Def. Ex. I, and that they have a mortgage on the property with a principal balance of more than $50,000, Def. Ex. J. 1 The Cochrans state that the mortgagee's interest in their property has priority over a tax lien via 26 U.S.C. §6323(a). The Cochrans have not come forward with any authority, however, and the court is aware of none, holding that the IRS must prove that it can collect a judgment before it wins a judgment. The Cochrans are not entitled to judgment as a matter of law on this theory.



III. The Amount of the Tax Deficiency

The Cochrans argue that the tax assessments for 1994, 1995, and 1996 should not be given the normal presumption of correctness accorded to IRS tax assessments. They claim that the assessment is arbitrary and excessive, and that the IRS has not supplied the evidence needed to support a judgment in its favor. The evidence also indicates a fundamental disagreement between the parties about the existence and size of the Cochrans' tax liability for the years 1994 to 1996.

Tax deficiency assessments determined by the Commissioner of Internal Revenue carry a presumption of correctness, and this presumption imposes upon the taxpayer the burden of proving that the assessment is erroneous. See, e.g., United States v. Janis, 428 U.S. 433, 440 (1976) (stating that the policy behind the presumption of correctness applies the same way in civil collection suits that it does in taxpayer-initiated refund suits and pre-assessment Tax Court proceedings); Kikalos v. Commissioner, 434 F.3d 977, 982 (7th Cir. 2006), citing Tax Court Rule 142(a). "Justification for the presumption of correctness lies in the government's strong need to accomplish swift collection of revenues and in the need to encourage taxpayer recordkeeping." Portillo v. Commissioner, 932 F.2d 1128, 1133 (5th Cir. 1991). The presumption attaches virtually regardless of the information, procedures, or policies used because the presumption "recognizes the structural inequality of information in the possession of the Commissioner relative to the taxpayer." Zuhone v. Commissioner, 883 F.2d 1317, 1325-26 (7th Cir. 1989).

In some situations, however, the taxpayer may rebut the presumption and shift the burden back to the IRS by showing that the Commissioner's deficiency assessment is both "without rational foundation and excessive" (and thus a "naked assessment"). Janis, 428 U.S. at 441; see also Kikalos, 434 F.3d at 985 ("the taxpayers must demonstrate that the Commissioner's deficiency assessment lacks a rational foundation or is arbitrary and excessive"). The necessary showing is arbitrary and excessive, not just excessive. Pittman v. Commissioner, 100 F.3d 1308, 1317 (7th Cir. 1996).

The government's burden is not high; all that is required is that the Commissioner's determination have some minimal factual predicate. Kikalos, 434 F.3d at 985, quoting Pittman, 100 F.3d at 1317; United States v. Smith, 950 F. Supp. 1394, 1399 (N.D. Ind. 1996). The presumption of correctness is appropriate where the IRS produces evidence to link the taxpayer with the taxgenerating activity. Gold Emporium, Inc. v. Commissioner, 910 F.2d 1374, 1378 (7th Cir. 1990), quoting Anastasato v. Commissioner, 794 F.2d 884, 887 (3d Cir. 1986).

At its core, the arbitrary and excessive exception recognizes that when the IRS has based its assessment on presumed receipt of unreported income, the taxpayer is in the difficult position of proving that she did not receive the attributed income. Smith, 950 F. Supp. at 1399, quoting Anastasato, 794 F.2d at 887; cf. Zuhone, 883 F.2d at 1326 (noting that, once an assessment has been found arbitrary, some courts have imposed a lesser burden of proof on a taxpayer who must prove a negative proposition, such as the non-existence of alleged unreported income). The exception serves a valuable protective purpose where the taxpayer could not reasonably be expected to produce financial records. "Even the most innocent of persons would have difficulty in disproving such a serious charge as selling heroin, when the party making the charge was not required to present any evidence." Weimerskirch v. Commissioner, 596 F.2d 358, 361 (9th Cir. 1979) (finding a naked assessment in view of the total absence of any substantive evidence).

The situation is very different where the tax is assessed on the basis of known income-generating activity for which the taxpayer has simply failed to keep adequate records. In Gold Emporium, the taxpayer claimed that he made business notations on scrap paper and discarded them when payments from customers were received. Gold Emporium, 910 F.2d at 1376. The Seventh Circuit affirmed the judgment of the Tax Court, finding that the presumption of correctness applied, "especially here where the taxpayer failed to produce or maintain adequate records from which actual income could be ascertained." Id. at 1379.

Similarly in Zuhone, the IRS based its deficiency estimate for 1975-1976 mineral interests on reports from 1978. The Seventh Circuit affirmed the Tax Court's approval of the IRS estimate:


The accuracy of the Commissioner's method, of course, is irrelevant if the value ascertained by using the 1978 reserve reports is higher than would have resulted using solely that information available in the two taxable years in question. But [the] taxpayer has not presented a single piece of concurrent evidence, such as reserve reports from the taxable years in question, offers to purchase taxpayer's mineral interests, purchase prices of comparable mineral interests during the taxable years, or electric log analyses, to indicate that the value would be lower if the 1978 reserve reports were not used.


Zuhone, 883 F.2d at 1327. When the taxpayer fails to produce or maintain adequate records from which actual income may be ascertained, the Commissioner may use any reasonable method of calculation. Id. at 1326, quoting Goodmon v. Commissioner, 761 F.2d 1522, 1524 (11th Cir. 1985).

In the Cochrans' case, the IRS based its 1994-96 deficiency assessment on the Cochrans' 1993 tax return. The Cochrans contend that the gross receipts assigned for the years 1994, 1995, and 1996 have no logical connection to the gross receipts of 1993 and that the assessment is therefore arbitrary. Def. Reply Br. 7. The Cochrans both assert that their restaurant became unprofitable after 1993, forcing them eventually to sell it. Def. Resp. to Pl. Interrog. Nos. 7, 8. They provide no financial records or even detailed recollections, noting that "it would be difficult, if not impossible, for the Defendants to have an accurate memory of events that occurred more than ten years ago." Id., No. 5.

Ultimately the Cochrans misconstrue the amount of evidence needed to support the presumption of correctness. The presumption is appropriate here because the IRS has linked the Cochrans to the alleged income-generating activity. Gold Emporium, 910 F.2d at 1378. The 1993 tax return suffices to create a minimal factual predicate for the deficiency assessment. See Kikalos, 434 F.3d at 985. The 1993 return indicates that the Cochrans were liable for tax in that year arising from sales in the restaurant they owned. The Cochrans' responses to interrogatories admit that they continued to operate the same restaurant in 1994, 1995, and 1996. The argument that the tax is excessive in relation to the 1993 income, even if true, does not make this assessment a naked assessment. The assessment loses its presumption of correctness only if it is both excessive and arbitrary. Pittman, 100 F.3d at 1317; see also United States v. Schroeder, 900 F.2d 1144, 1149 (7th Cir. 1990) (reversing district court's use of naked assessment doctrine where assessment was admitted by the IRS to have been approximately five percent too high).

The IRS is entitled to use indirect methods of assessment where the taxpayer has failed to keep adequate records. Zuhone, 883 F.2d at 1326. It was the Cochrans, not the IRS, who ran the Dillsboro Family Restaurant. The presumption of correctness exists in part because our tax system is based on selfreporting, so that the IRS has relatively little information about a taxpayer's finances. Id. at 1325-26. The Cochrans cannot fault the government's use of old tax records when they failed to submit any substantive evidence themselves. Accordingly the presumption's policy goal of encouraging taxpayer recordkeeping is in full force here. See Portillo, 932 F.2d at 1133.

The Cochrans cannot show that the IRS assessment was arbitrary or without a rational foundation. Because the parties have stipulated to the facts relevant to this issue, the use of the naked assessment doctrine is therefore barred here as a matter of law.

Nevertheless, that does not mean that the government is entitled to every penny it seeks here. The court has attempted to decipher the more precise grounds for the government's calculations and concludes that the precise amount of the Cochrans' liability is a disputed material fact that should be resolved in a trial. For each of the three years in question, the government's assessment assumes a total tax liability (before interest and penalties) more than ten times the amount reported by the Cochrans as their tax liability for 1993. Accordingly, both sides' motions for summary judgment are hereby denied. The court trial remains set for November 3, 2008 in New Albany, with a final pretrial conference on October 23, 2008 in Indianapolis.

So ordered.

1 The IRS conducted its own appraisal of the Cochrans' property in May or June 2007 but did not submit that evidence with its motion. Def. Br. 11.

Sections 6321 and 6322 of Title 26 of the United States Code work together in addressing the subject of tax liens. Under §6321 , a tax lien arises by operation of law if "any person liable to pay any tax neglects or refuses to pay the same after demand," and the lien amount equals the amount of unpaid taxes plus "any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto...." 26 U.S.C. §6321 . The lien encumbers "all property and rights to property, whether real or personal, belonging to" the taxpayer. Under §6322 , a tax lien "shall arise at the time the assessment is made and shall continue until the liability for the amount so assessed (or a judgment against the taxpayer arising out of such liability) is satisfied or becomes unenforceable by reason of lapse of time."3 26 U.S.C. §6322 . A tax lien is valid only if two things are true: (1) the lien has arisen because an "assessment" has been made; and (2) the collection period has not expired. The lien has may "become[] unenforceable by reason of time." 26 U.S.C. §6322 . Because the collection period's expiration date follows from the assessment date, pinpointing the assessment date is essential.





J..G. Hoklin

July 22, 2008

UNITED STATES OF AMERICA, Plaintiff v. JOHN G. HOKLIN, BARBARA U. HOKLIN, STATE OF MINNESOTA, and COUNTRYWIDE FUNDING CORPORATION, Defendants.

UNITED STATES DISTRICT COURT DISTRICT OF MINNESOTA. Case No. 0:06-CV-2382 (PJS/RLE). Dated: July 2 , 2008.




MEMORANDUM OPINION AND ORDER


LaQuita Taylor-Phillips, UNITED STATES DEPARTMENT OF JUSTICE, TAX DIVISION, for plaintiff.

John G. Hoklin and Barbara U. Hoklin, plaintiffs pro se.

Eric D. Cook, WILFORD & GESKE, PA, for defendant Countrywide Funding Corporation.

SCHILTZ, United States District Judge: Defendants John and Barbara Hoklin did not pay their federal income taxes in full for tax years 1992 through 1997. In October 2001, they filed for bankruptcy protection, and their debts --including their back taxes --were discharged in January 2002. But the bankruptcy discharge released the Hoklins only from personal liability; it did not affect federal tax liens on their home. The government now sues to foreclose on those liens.1

The government moved for summary judgment, and the Court referred the motion to Chief Magistrate Judge Raymond L. Erickson pursuant to 28 U.S.C. §636(b)(1)(B) . Judge Erickson issued a Report and Recommendation ("R&R") in which he recommends denying the government's motion in its entirety. The government objects.

The Court has reviewed de novo those portions of the R&R to which the government has objected, as required by 28 U.S.C. §636(b) and Fed. R. Civ. P. 72(b). The Court sustains in part the government's objection and grants partial summary judgment.




I. TAX LAWS AND REGULATIONS


Before turning to the facts of this case, the Court first sets out the relevant laws and regulations.2 In this action to foreclose on tax liens, the key event on which the government's case turns is the "assessment" by the IRS of taxes against the Hoklins. Such an "assessment" is a precondition for a valid tax lien.

Sections 6321 and 6322 of Title 26 of the United States Code work together in addressing the subject of tax liens. Under §6321 , a tax lien arises by operation of law if "any person liable to pay any tax neglects or refuses to pay the same after demand," and the lien amount equals the amount of unpaid taxes plus "any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto...." 26 U.S.C. §6321 . The lien encumbers "all property and rights to property, whether real or personal, belonging to" the taxpayer. Id. Under §6322 , a tax lien "shall arise at the time the assessment is made and shall continue until the liability for the amount so assessed (or a judgment against the taxpayer arising out of such liability) is satisfied or becomes unenforceable by reason of lapse of time."3 26 U.S.C. §6322 .

Under §§6321 and 6322 , then, if the government has demanded and assessed taxes, the tax lien arises automatically upon assessment. Significantly, the government need not record the lien to enforce it against the taxpayer. See Internal Revenue Manual ("IRM") §5.17 .2.2.1 (Dec. 14, 2007) ("The lien is effective from the date the Government assesses the tax....The Service is not required to file a NFTL [i.e., notice of federal tax lien] in order for the tax lien to attach."), available at http://www.irs.gov/irm/part5/ch17s02.html. But if the government wants its lien to have priority against the claims of third parties, the government must record a notice of the lien with the appropriate state agency. IRM §5.17 .2.3.1 ("The filing of a NFTL is not a step required to give rise to or to perfect the lien against the taxpayer. The act of filing protects the Government's right of priority as against certain third parties, typically a purchaser, holder of a security interest, mechanic's lienor, or judgment lien creditor."); 26 U.S.C. §6323(a) , (f). The notice of lien expires in roughly ten years unless it is refiled. IRM §5.17 .2.3.3; 26 U.S.C. §6323(g) ; 26 C.F.R. §301.6323(g)-1 .

Because the government's notice of lien operates only with respect to third parties, and not with respect to the taxpayer, whether that notice expires or is renewed is irrelevant to the validity of the lien against the taxpayer. But the lien does not endure in perpetuity; rather, under §6322 , the lien can "become[] unenforceable by reason of lapse of time." 26 U.S.C. §6322 .

Section 6322 does not specify when a tax lien becomes unenforceable "by reason of lapse of time." Instead, the applicable time limits are found in §§6502 and 6503 .4 Section §6502 provides that, as a general rule, proceedings for collecting unpaid taxes must be brought "within 10 years after the assessment of the tax...." 26 U.S.C. §6502(a)(1) ; see also United States v. Dawes , 161 Fed. Appx. 742, 746-47 (10th Cir. 2005) (applying §6502 in action to foreclose tax liens). Section 6503 further provides that this ten-year period is suspended under various circumstances, such as when court proceedings prevent the government from collecting the unpaid taxes. 26 U.S.C. §6503(a)(1) . If a taxpayer files for bankruptcy, §6503(h) suspends the collection period while the bankruptcy case prevents collection activities and for the following six months. 26 U.S.C. §6503(h)(2) .

To sum up, a tax lien is valid only if two things are true: (1) the lien has arisen because an "assessment" has been made; and (2) the collection period has not expired --that is, the lien has not "become[] unenforceable by reason of time." 26 U.S.C. §6322 . Because the collection period's expiration date follows from the assessment date, pinpointing the assessment date is essential.

Roughly speaking, there are two types of assessments: "deficiencies" and what might be called "self-assessments." When a taxpayer files a return that shows how much he owes in taxes, the amount shown on the return will be assessed by the government automatically under §6201(a)(1) . This can be called a "self-assessment" because it reflects the taxpayer's own assessment of how much he owes.

Deficiencies are different. A "deficiency," as defined in §6211 , is the amount of taxes that the government contends a taxpayer owes beyond the amount that he reported as owing on his return.5 26 U.S.C. §6211(a) . Deficiencies are not assessed automatically. Rather, §6213 forbids the government from assessing a deficiency until the taxpayer has been mailed a formal notice of the deficiency. 26 U.S.C. §6213(a) . Once the government mails the notice, the taxpayer has ninety days to file a petition in the United States Tax Court challenging the deficiency. Id. If the taxpayer does not file a timely petition, then once the ninety-day postnotice period has expired, the government can assess the deficiency. 26 U.S.C. §6213(c) . If the taxpayer does file a petition, then the deficiency cannot be assessed until the Tax Court proceedings conclude. 26 U.S.C. §6213(a) .

A taxpayer can, however, waive the notice requirements associated with deficiencies. 26 U.S.C.§6213(d) . Those requirements can be waived only by "a signed notice in writing filed with the Secretary...." Id. One event that can lead to a taxpayer's waiver of notice requirements, and thus to the immediate assessment of a deficiency, is a "field examination" by the IRS (i.e., an audit). If the government conducts an in-person audit of a taxpayer's records and determines that taxes are owing, the government will ask the taxpayer to agree to the determination. 26 C.F.R. §601.105(b)(4) . If the taxpayer does agree, "the agreement is evidenced by a waiver by the taxpayer of restrictions on assessment and collection of the deficiency, or an acceptance of a proposed overassessment." Id.

Basically, then, there are three times that an assessment arises: (1) when a taxpayer files a return showing taxes owing (the self-assessment); (2) after the government first determines that a deficiency exists, then sends a notice of deficiency to the taxpayer, and the taxpayer then either fails to challenge the deficiency or loses such a challenge; or (3) after the government determines that a deficiency exists and the taxpayer then executes a signed waiver of the otherwiseapplicable notice requirements.

As noted above, when taxes are assessed, a tax lien arises automatically in favor of the government. If the collection period has not expired, the government may, under §7403 , enforce the lien through a civil suit in federal district court. 26 U.S.C. §7403 . This action brought against the Hoklins is such a suit.




II. DISCUSSION





A. Standard of Review


Summary judgment is appropriate "if the pleadings, the discovery and disclosure materials on file, and any affidavits show that there is no genuine issue as to any material fact and that the movant is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(c). A dispute over a fact is "material" only if its resolution might affect the outcome of the suit under the governing substantive law. Anderson v. Liberty Lobby, Inc. , 477 U.S. 242, 248 (1986). A dispute over a fact is "genuine" only if the evidence is such that a reasonable jury could return a verdict for either party. Ohio Cas. Ins. Co. v. Union Pac. R.R. , 469 F.3d 1158, 1162 (8th Cir. 2006). In considering a motion for summary judgment, a court "must view the evidence and the inferences that may be reasonably drawn from the evidence in the light most favorable to the non-moving party." Winthrop Res. Corp. v. Eaton Hydraulics, Inc. , 361 F.3d 465, 468 (8th Cir. 2004).




B. The Asserted Tax Liens


The government seeks to foreclose tax liens that it contends arose when the Hoklins failed to pay in full their taxes for tax years 1992 through 1997. The government has provided only two types of evidence to support its summary-judgment motion: printouts of information in the IRS's computer system and admissions from the Hoklins.6 Gov't Exs. 1-14 [Docket No. 36]. Unfortunately, though, the government has not offered any affidavits or testimony explaining the IRS printouts.

For each tax year, the government has provided two different IRS printouts. The first is titled "Certificate of Assessments, Payments, and Other Specified Matters" (or "Certificate of Assessments" for short) and is IRS Form 4340. Gov't Exs. 1-6. The second is a "transcript of account for Form 1040" and seems to be a computerized record of what appeared on a given year's Form 1040, as well as a record of payments and charges related to that tax year. Gov't Exs. 7-12.

Judge Erickson recommended denying summary judgment because he found that the government failed to establish that it had lawfully made the tax assessments underlying the liens it seeks to foreclose. He considered two possibilities: (1) that the Hoklins' unpaid taxes were deficiencies; and (2) that the Hoklins' unpaid taxes had been self-reported. Judge Erickson found that if the unpaid taxes were deficiencies, the government was not entitled to summary judgment because it did not establish that it sent the required notices of deficiencies. R&R at 12-18. The government does not contest this point. Obj. at 4-5.

Judge Erickson also considered whether the Certificates of Assessment demonstrated that the Hoklins had made a self-assessment by reporting the amount of their unpaid taxes on their returns. R&R at 18-19. He concluded that the Certificates of Assessment were not sufficient to establish that the Hoklins had self-reported their unpaid taxes. Id. It is not clear why Judge Erickson discussed only the Certificates of Assessment and not the Form 1040 transcripts of account. It should be noted, though, that the government's briefing before Judge Erickson, like its briefing before this Court, was murky at best.7

In objecting to the R&R, the government first argues that this Court should reject the R&R and grant summary judgment because the Hoklins failed to oppose its motion. Id. at 2-4. The government would be correct if the Hoklins had the burden of proof. Summary judgment may be granted against the nonmoving party when --for whatever reason --that party "has failed to make a sufficient showing on an essential element of her case with respect to which she has the burden of proof ." Celotex Corp. v. Catrett , 477 U.S. 317, 323 (1986) (emphasis added). But the Hoklins do not have the burden of proof in this proceeding; they could sit mute at trial, submitting no evidence and making no argument, and still prevail. If the Hoklins can win at trial without saying anything, obviously they can defeat a summary judgment motion without saying anything. To receive summary judgment, the government must establish that it is "entitled to judgment as a matter of law," Fed. R. Civ. P. 56(b), and, as the party with the burden of proof, the government cannot establish that it is entitled to judgment by simply pointing out that the party without the burden of proof has submitted no evidence or argument.

The government also argues that it was not required to send notices of deficiency and that Judge Erickson erred in finding otherwise. Obj. at 4-6. Specifically, the government contends that because the Hoklins self-reported certain amounts on their tax returns and agreed to certain other amounts, notices of deficiency were not required as a prerequisite to assessment. Id. at 5. The Court agrees in part with the government. Because different tax years raise different issues --including some important issues that the government did not address in its moving papers or its objection --the Court discusses tax years 1992, 1993, and 1994 separately, and tax years 1995 through 1997 as a group.




1. Tax Year 1992


The IRS Certificate of Assessments for tax year 1992 shows an amount of $6,493 labeled with the words "Return Filed & Tax Assessed."8 Gov't Ex. 1 at 2. Two dates are associated with this entry. In the left margin, in the column labeled "Date," the date August 18, 1993 appears. In the right margin, in the column labeled "Assessment Date," the date September 20, 1993 appears. The Court agrees with Judge Erickson that this entry, by itself, does not clearly show that the Hoklins self-reported on their Form 1040 that they owed $6,493. R&R at 18-19.

The transcript of account for tax year 1992, however, clarifies matters. (Again, Judge Erickson did not discuss this, or any other, transcript of account.) That transcript, like the Certificate of Assessments, shows an amount of $6,493, but the amount is labeled "Tax Per Return ." Gov't Ex. 7 at 2 (emphasis added). The transcript identifies August 18, 1993 as the "Return Due Date or Return Received Date (Whichever is Later)" and September 20, 1993 as the "Processing Date." Id. (emphasis added). The Court finds that a reasonable jury would have to conclude, based on the Certificate of Assessments and the transcript of account taken together, that the Hoklins self-reported $6,493 in taxes owing on their 1992 return. The government was therefore not required to send a notice of deficiency before assessing this amount, and a lien arose on September 20, 1993, when the return was processed and the taxes were assessed.

This is not the end of the matter, however, because the government's evidence --specifically, the transcript of account --establishes that the Hoklins paid this amount in full, plus associated interest and penalties, by May 22, 1995.9 Id. at 2-3. The $6,493 on the Hoklins' return therefore cannot be the basis for the tax lien that the government now seeks to foreclose.

Instead, the basis of the government's lien for tax year 1992 is an amount of additional taxes ostensibly assessed by the government in May 1995 after the IRS audited the Hoklins. The government glossed over this important detail in its complaint and in the summary-judgment brief it submitted to Judge Erickson. In both, the government asserted that it assessed $6,493 in taxes for tax year 1992 and that the Hoklins still owed taxes for that year, but the government failed to indicate that the balance owing from 1992 relates not to the original $6,493 but to a later ostensible assessment. See Compl. ¶8 ; Br. Supp. U.S. Mot. for S.J. ("Gov't SJ Mem.") ¶¶1 -2 [Docket No. 36]. This is a crucial distinction, and the government should have brought it to Judge Erickson's attention.

Only in its objection to the R&R did the government clarify that it is trying to foreclose a lien based on its purported assessment in 1995 of additional taxes for 1992. Obj. at 5-6. The government, without citing any law, says that the IRS was not required to issue a notice of deficiency with respect to the additional amount because it was "an agreed audit deficiency...." Obj. at 6.

It is somewhat unclear from the Certificate of Assessments for 1992 exactly what the IRS did in 1995. There is a transaction on the form labeled a "Quick Assessment," in the amount of $6,281. Gov't Ex. 1 at 4. There is no date in the "Date" column to the immediate left of the entry for this "Quick Assessment" transaction, but in the "Assessment Date" column associated with the transaction, the date April 18, 1995 appears. Id. On the same page, there is a transaction labeled "Additional tax assessed by examination[;] agreed audit deficiency prior to 30 or 60 day letter," but the corresponding transaction amount is $0, the date in the "Assessment Date" column is May 22, 1995, and there is no date in the "Date" column to the left of the entry. Id.

The related entries in the transcript of account for 1992 are consistent and equally unhelpful. An entry that reads "Additional tax assessed by examination" bears the date May 22, 1995 and an amount of $0. Gov't Ex. 7 at 3. Another entry that reads "Quick assessment" bears the date April 18, 1995 and an amount of $6,281. Id.

The government, in its objection to the R&R, says that these additional taxes were assessed on May 22, 1995. Obj. at 6. If so, why is the "Quick Assessment" of the amount dated April 18, 1995 on both the Certificate of Assessments and the transcript of account? The government has offered no competent evidence about how to interpret these documents.

More importantly, the government has offered no evidence that it complied with §6213(d) and secured a written waiver from the Hoklins of the otherwise-applicable requirement that the government send them a notice of deficiency with respect to the additional $6,281 in taxes ostensibly assessed on May 22, 1995. The only evidence related to this requirement is the phrase on the Certificate of Assessments, "Additional tax assessed by examination[;] agreed audit deficiency prior to 30 or 60 day letter." Gov't Ex. 1 at 4. This phrase does not establish beyond dispute that the Hoklins waived, in writing, their right to receive a notice of deficiency.

Under IRS regulations, if a taxpayer agrees with the results of an audit, "the examiner will invite the taxpayer to execute either Form 870 or another appropriate agreement form....If the agreed case involves income...taxes, the agreement is evidenced by a waiver by the taxpayer of restrictions on assessment and collection of the deficiency, or an acceptance of a proposed overassessment." 26 C.F.R. §601.105(b)(4) . Despite the regulatory and statutory requirement that the IRS secure a written waiver, no such waiver has been provided by the government to support its motion.

Finally, even if the Hoklins did execute a written waiver with respect to the $6,281 in taxes imposed in 1995, resulting in the assessment of those taxes at that time, the government has failed to establish that the lien for those taxes has not "become[] unenforceable by reason of time." 26 U.S.C. §6322 .

The government filed this suit on June 14, 2006. If the government assessed the additional taxes for tax year 1992 on May 22, 1995, then under §6502 , the ten-year period for collecting those taxes expired on May 22, 2005, unless that period was suspended under §6503 . 26 U.S.C. §§6502 -03. The period was necessarily suspended during the Hoklins' bankruptcy and for the following six months under §6503(h) , but the bankruptcy case itself lasted only five months. See In re Hoklin , No. 01-44519, Docket Report (Bankr. D. Minn.) (petition filed Oct. 17, 2001; case closed February 21, 2002). By the Court's calculations, the bankruptcy resulted in a suspension of 308 days, and the government's collection period therefore expired on March 26, 2006, roughly two and a half months before this suit was filed. The government has not even attempted to establish that the collection period has not expired under §6502 .10




2. Tax Year 1993


For tax year 1993, the Certificate of Assessments together with the transcript of account establish that the Hoklins self-reported that they owed $9,078 in taxes on their Form 1040. Gov't Exs. 2, 8. The records also establish, however, that --unlike with respect to their 1992 taxes --the Hoklins did not pay these taxes in full. Instead, based on the transcript of account, it appears that they still owed $7,685.40 toward this original amount (plus associated penalties and interest). Gov't Ex. 8. Because the government was not required to send a notice of deficiency with respect to these taxes, they were assessed on September 26, 1994, when the IRS processed the Hoklins' return, and a tax lien for this amount arose then.

The government is also trying to collect additional taxes for tax year 1993. When the IRS audited the Hoklins' returns in 1995, it imposed additional taxes for both tax year 1992 (as discussed above) and tax year 1993. For tax year 1993, the government determined that the Hoklins owed an additional $5,655 in taxes. Gov't Ex. 2 at 3; Gov't Ex. 8 at 3.

The facts and legal issues related to this ostensible assessment of additional taxes are identical to the facts and legal issues discussed above in connection with the assessment for tax year 1992 made after the audit in 1995. For one thing, the government failed to expressly identify that its claim was based on this assessment until it objected to the R&R. More importantly, the government has not established that the Hoklins executed a written waiver of their right to receive a notice of deficiency with respect to these additional taxes.

Further, the government has not established that the collection period with respect to tax year 1993 has not expired under §6502 . It is quite probable that, with respect to the $7,685.40 balance remaining from the Hoklins' self-reported taxes, the collection period has expired, rendering the associated lien unenforceable. The original tax amount was assessed on September 26, 1994, and the collection period would thus have expired on September 26, 2004. To collect these taxes in this suit by foreclosing on its tax lien, the government would have to establish that the ten-year collection period was suspended for roughly eighteen months. No evidence of such a lengthy suspension appears in the record.

With respect to the additional $5,655 in taxes imposed in May 1995, it is also possible that the collection period for the government's lien --if a lien arose --has expired. As explained above in connection with tax year 1992, to foreclose on a lien for the additional taxes assessed in May 1995, the government would need to establish both that the taxes were properly assessed and that the ten-year collection period was suspended for a little over a year. It has established neither of those things.




3. Tax Year 1994.


For tax year 1994, the Certificate of Assessments together with the transcript of account establish that the Hoklins self-reported that they owed $14,952 in taxes on their Form 1040. Gov't Exs. 3, 9. The government assessed this amount when it processed the Hoklins' return on August 28, 1995. Gov't Ex. 9 at 2.

The government was not required to file a notice of deficiency with respect to this amount. Further, the undisputed facts establish that the ten-year collection period did not expire before this suit was filed. Under §6503(h) , the collection period was suspended at least from October 17, 2001 (when the Hoklins filed their bankruptcy petition) through August 21, 2002 (six months after the case was closed), for a total of 308 days. The ten-year collection period would have ended on August 28, 2005, but because it was suspended, the period ended 308 days later, on July 2, 2006. The government filed its complaint in this case roughly two weeks earlier, on June 14, 2006.

The government is therefore entitled to foreclose on its lien with respect to unpaid taxes, plus interest and penalties, for tax year 1994.




4. Tax Years 1995 Through 1997


Tax year 1995 is similar to tax year 1994. The government's evidence establishes that the Hoklins self-reported that they owed $13,319 in taxes for tax year 1995 and that the government assessed this amount on April 15, 1996. Gov't Exs. 4, 10. Accordingly, no notice of deficiency was required for this year. Further, although the ten-year collection period would have expired on April 15, 1996, the period was suspended because of the Hoklins' bankruptcy case and thus had not expired when this suit was filed. The government is therefore entitled to foreclose on its lien with respect to unpaid taxes, plus interest and penalties, for tax year 1995.

For tax year 1996, the government's evidence establishes that the Hoklins self-reported that they owed $19,014 in taxes for the year and that the government assessed this amount on November 24, 1997. Gov't Exs. 5, 11. No notice of deficiency was required for this year, and this suit was filed before the ten-year collection period expired. The government is therefore entitled to foreclose on its lien with respect to unpaid taxes, plus interest and penalties, for tax year 1996.

For tax year 1997, the government's evidence establishes that the Hoklins self-reported that they owed $18,672 in taxes for the year and that the government assessed this amount on June 1, 1998. Gov't Exs. 6, 12. No notice of deficiency was required for this year, and this suit was filed before the ten-year collection period expired. The government is therefore entitled to foreclose on its lien with respect to unpaid taxes, plus interest and penalties, for tax year 1997.




ORDER


Based on the foregoing and on all of the files, records, and proceedings herein, the Court SUSTAINS IN PART the government's objection [Docket No. 48] and DECLINES TO ADOPT Judge Erickson's Report and Recommendation [Docket No. 47]. Accordingly, IT IS HEREBY ORDERED THAT:

1. The motion of the United States for summary judgment [Docket No. 34] is GRANTED IN PART as follows:


a. The government has valid tax liens against the property of defendants John G. Hoklin and Barbara U. Hoklin with respect to unpaid taxes, plus interest and penalties, for tax years 1994, 1995, 1996, and 1997.



b. The government is entitled to foreclose on those liens against the Hoklins' real property at 5014 Vine Hill Road, Excelsior, Minnesota 55331, which is legally described as follows: Lot 7, Block 1, Forest Hill Farm, according to the recorded plat thereof, and situated in Hennepin County, Minnesota.


2. The motion of the United States for summary judgment [Docket No. 34] is DENIED in all other respects.

1 Defendant Countrywide Funding Corporation has its own lien --a mortgage --on the Hoklins' home, and Countrywide and the government have stipulated that Countrywide's lien is superior to the government's. Stipulation [Docket No. 24]. Accordingly, if the Court orders the house to be sold, Countrywide will be paid first and the government will be paid second. Defendant the State of Minnesota has not appeared and has been found to be in default. Clerk's Entry of Default [Docket No. 29].

2 The Court's summary of the tax laws in this section is not intended to be comprehensive, and the Court deliberately skips over exceptions and fine points that are not germane to this case.

3 All statutory sections referred to in the text are found in Title 26 of the United States Code.

4 Section 6501 also imposes time limits on tax collection, but only indirectly, by limiting the period for making the underlying assessments. Generally, taxes must "be assessed within 3 years" after a tax return is filed. 26 U.S.C. §6501(a) (emphasis added). But §6501 does not limit the duration of a lien , because a lien only arises after an assessment is made. If the government fails to assess a tax liability within three years as required by §6501 , a tax lien cannot arise in the first place.

5 Simplified and translated into mathematical terms, §6211(a) provides: Deficiency = Tax imposed by IRS - [(Amount shown on return) + (Other amounts previously assessed) - Rebates]

6 The government has also provided documents related to the its filing of notices of tax lien with state agencies. Gov't Exs. 15-24. As noted above, however, these notices operate only with respect to third parties; they are irrelevant to the government's ability to enforce its tax liens against the Hoklins.

7 The government has been neither clear nor thorough in describing the law and facts in this case, forcing this Court to have to devote a great deal of time to trying to educate itself about the tax laws and figure out the meaning of various exhibits. The government must bear in mind that the tax laws are extremely complex, particularly to the uninitiated, which includes most federal judges. The government must take care to explain the tax laws clearly and to provide a full and adequately explained factual record, especially when, as here, the taxpayers are representing themselves.

8 The phrase "Return Filed & Tax Assessed" is in all capital letters in the Certificate of Assessments. Throughout this order, to improve legibility, the Court uses upper- and lower-case letters for phrases that are in all capital letters in original documents.

9 The Hoklins wrote "this is correct" in response to the government's request for an admission that they "failed to pay in full the $6,493 in federal income taxes assessed against [them] for the 1992 year." Gov't Ex. 14 at 2. But the government's documentary evidence establishes conclusively that the Hoklins did pay this amount in full. Gov't Ex. 7 at 2-3.

10 Judge Erickson understood the government to be contending that the collection period was extended when the government refiled its notices of federal tax liens with the state. R&R at 4. As explained above, however, those notices affect only the validity of a tax lien with respect to third parties. See IRM §5.17 .2.3.1. Refiling a notice of tax lien thus does not extend the ten-year collection period, which can be extended only in accordance with §6503 .

IRS Referrals of Criminal Tax Investigations at Eight-Year High


Referrals of criminal tax investigations by the IRS to the U.S. Department of Justice continue to climb dramatically, the Treasury Inspector General for Tax Administration (TIGTA) has reported. At the same time, however, the IRS's Criminal Investigation Division continues to lose experienced investigators faster than it can recruit new ones. TIGTA unveiled its findings in a special report, Statistical Portrayal of the Criminal Investigation Division's Enforcement Activities for Fiscal Years 2000 through 2007, 2008-10-133.


Investigations and Convictions


Investigations referred to the Justice Department has increased continually for five years and are now at an eight-year high, TIGTA discovered. Fiscal year (FY) 2007 ended with 4,600 subject investigations, a three-percent increase over FY 2006 and a nearly 50 percent increase since FY 2002. "For the first time since we began reporting on its enforcement activities, the Criminal Investigation Division had more investigations awaiting prosecution by the Justice Department than open criminal investigations," TIGTA reported.



Criminal convictions are also up, TIGTA found. "The number of taxpayers convicted of a crime was 2,155, which exceeded the FY 2007 performance plan goal of 2,069 and was an increase of 6.7 percent from FY 2006"


Enhanced Publicity


TIGTA also found that greater publicity of tax crimes fosters compliance. The publicity rate for prosecutions in FY 2007 was nearly 80 percent, an all-time high. Enhanced publicity, according to TIGTA, "sends a message to taxpayers that violations of the Internal Revenue Code and related financial crimes are investigated and prosecuted."




Despite the uptick in criminal referrals and convictions, the Criminal Investigation Division appears troubled by high employee turnover. The total number of special agents fell three percent from FY 2006 to FY 2007 and the trend appears to be continuing. "According to most recent estimates, the Criminal Investigation Division's planned hiring of approximately 96 special agents would not offset the FY 2007 attrition of 150 agents or the FY 2008 attrition of approximately 150 agents." TIGTA predicted that the loss of experienced employees will negatively affect productivity in the near future.

Amendments of Reg. §§1.901-1 and 1.901-2 and Temporary Reg. §§1.901-1T and 1.901-2T, relating to the determination of the amount of taxes paid for purposes of the foreign tax credit, are adopted.


T.D. 9416 , filed with the Federal Register on July 16, 2008.

[ Code Sec. 901]



AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations

SUMMARY: This document contains final and temporary regulations under section 901 of the Internal Revenue Code providing guidance relating to the determination of the amount of taxes paid for purposes of the foreign tax credit. The regulations affect taxpayers that claim direct and indirect foreign tax credits. The text of these temporary regulations also serves as the text of the proposed regulations (REG-156779-06) published in the Proposed Rules section in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective on July 15, 2008.

Applicability Dates: For dates of applicability, see §1.901-1T(j) and §1.901-2T(h)(2).

FOR FURTHER INFORMATION CONTACT: Michael Gilman, (202) 622-3850 (not a toll-free number).

SUPPLEMENTARY INFORMATION:



Background

On March 30, 2007, the Federal Register published proposed amendments (72 FR 15081) to the Income Tax Regulations (26 CFR part I) under section 901 of the Internal Revenue Code (Code) relating to the amount of taxes paid for purposes of the foreign tax credit (the "2007 proposed regulations"). The 2007 proposed regulations would revise §1.901-2(e)(5) in two ways. First, for purposes of §1.901-2(e)(5), the 2007 proposed regulations would treat as a single taxpayer all foreign entities in which the same U.S. person has a direct or indirect interest of 80 percent or more (a "U.S.-owned foreign group"). Second, the 2007 proposed regulations would treat amounts paid to a foreign taxing authority as noncompulsory payments if those amounts are attributable to certain structured passive investment arrangements. The 2007 proposed regulations provide that the regulations will be effective for foreign taxes paid or accrued during taxable years of the taxpayer ending on or after the date on which the regulations are finalized.

The IRS and Treasury Department received written comments on the 2007 proposed regulations, which are discussed in this preamble. A public hearing was held on July 30, 2007. In response to written comments, the IRS and Treasury Department determined that the proposed change to §1.901-2(e)(5) relating to U.S.-owned foreign groups may lead to inappropriate results in certain cases. Accordingly , on November 19, 2007, the IRS and Treasury Department issued Notice 2007-95, 2007-49 IRB 1 (see §601.601(d)(2)(ii)( b)). Notice 2007-95 provided that the proposed rule for U.S.-owned foreign groups would be severed from the portion of the 2007 proposed regulations addressing the treatment of foreign payments attributable to certain structured passive investment arrangements. Notice 2007-95 further provided that the proposed rules for U.S.-owned groups would be effective for taxable years beginning after final regulations are published in the Federal Register.

In light of comments, the IRS and the Treasury Department believe that it is appropriate to issue new proposed and temporary regulations addressing the treatment of foreign payments attributable to structured passive investment arrangements. These new regulations make several changes to the 2007 proposed regulations to take into account comments received, while adopting without amendment substantial portions of the 2007 proposed regulations. The new temporary and proposed regulations will permit the IRS to enforce the rules relating to structured passive investment arrangements, while also allowing taxpayers a further opportunity for comment. The significant comments and revisions are described in this preamble.



Explanation of Provisions

The temporary regulations address the application of §1.901-2(e)(5) in cases in which a person claiming foreign tax credits is a party to a structured passive investment arrangement. These complex arrangements are intentionally structured to create a foreign tax liability when, removed from the elaborately engineered structure, the basic underlying business transaction generally would result in significantly less, or even no, foreign taxes. The parties use these arrangements to exploit differences between U.S. and foreign law in order to permit a person to claim a foreign tax credit for the purported foreign tax payments while also allowing the foreign counterparty to claim a duplicative foreign tax benefit. The person claiming foreign tax credits and the foreign counterparty share the cost of the purported foreign tax payments through the pricing of the arrangement.

The temporary regulations treat foreign payments attributable to such arrangements as noncompulsory payments under §1.901-2(e)(5) and, thus, disallow foreign tax credits for such amounts. For periods prior to the effective date of the temporary regulations, the IRS will continue to utilize all available tools under current law to challenge the U.S. tax results claimed in connection with these and other similar abusive arrangements, including the substance over form doctrine, the economic substance doctrine, debt-equity principles, tax ownership principles, other provisions of §1.901-2, section 269, and the partnership anti-abuse rules of §1.701-2.

The temporary regulations retain the general rule in the existing regulations that a taxpayer need not alter its form of doing business or the form of any transaction in order to reduce its foreign tax liability. However, §1.901-2T(e)(5)(iv)(A) provides that, notwithstanding the general rule, an amount paid to a foreign country (a "foreign payment") is not a compulsory payment, and thus is not an amount of tax paid, if the foreign payment is attributable to a structured passive investment arrangement. For this purpose, §1.901-2T(e)(5)(iv)(B) defines a structured passive investment arrangement as an arrangement that satisfies six conditions. The six conditions consist of features that are common to arrangements that are intentionally structured to generate the foreign payment.



A. Section 1.901-2T(e)(5)(iv)(B)(1): Special Purpose Vehicle

The first condition provided in the 2007 proposed regulations is that the arrangement utilizes an entity that meets two requirements (an "SPV"). The first requirement is that substantially all of the gross income (for United States tax purposes) of the entity, if any, is attributable to passive investment income and substantially all of the assets of the entity are assets held to produce such passive investment income. The second requirement is that there is a purported foreign tax payment attributable to income of the entity. The purported foreign tax may be paid by the entity itself, by the owner(s) of the entity (if the entity is treated as a pass-through entity under foreign law) or by a lower-tier entity (if the lower-tier entity is treated as a pass-through entity under U.S. law).

For purposes of the first requirement, §1.901-2(e)(5)(iv)(C)( 4) of the 2007 proposed regulations defines passive investment income as income described in section 954(c), with two modifications. The first modification excludes income of a holding company attributable to qualifying equity interests in lower-tier entities that are predominantly engaged in the active conduct of a trade or business (or that are themselves holding companies). The second modification is that passive investment income is determined by disregarding sections 954(c)(3) and 954(c)(6) and by treating income attributable to transactions with a counterparty as ineligible for the exclusions under sections 954(h) and 954(i).

One commentator recommended, in lieu of the holding company rules in the 2007 proposed regulations, applying look-through rules to income and assets of lower-tier entities similar to the rules of section 1297(c), under which a foreign corporation, if it owns at least 25 percent of the stock of another corporation, is treated as owning its proportionate share of the assets of the other corporation and receiving its proportionate share of the income of the other corporation. Alternatively, the commentator recommended that the holding company rules in the 2007 proposed regulations be modified to eliminate the requirement that substantially all of the assets of the tested entity must consist of qualified equity interests; to permit income other than dividends (for example, interest and royalties) received from a lower-tier entity that is predominantly engaged in an active business to qualify as active income; and to treat a lower-tier entity as an operating company if more than 50 percent of either its assets or its income meet the active business test. In addition, commentators suggested eliminating the requirement that the U.S. party and the counterparty must share the opportunity of gain or loss with respect to the lower-tier entity, or replacing it with a rule disqualifying the equity interest if contractual restrictions limit the counterparty's recourse against the lower-tier entity's income or assets. Finally, commentators suggested that preferred stock should be treated as a qualifying equity interest.

These comments were not adopted. The holding company exception is intended only to clarify that a joint venture arrangement is not treated as a structured passive investment arrangement solely because it is conducted through a holding company structure, not to liberalize the definition of structured passive investment arrangements. The requirement that the parties share the opportunity for gain and risk of loss with respect to the holding company's assets is intended to ensure that the arrangement between the parties is a bona fide joint venture. In this regard, a commentator recommended that the regulations be clarified to provide that the holding company exception is not satisfied if either the U.S. party or the counterparty is solely a creditor with respect to the entity because it either owns a hybrid instrument that is debt for U.S. tax purposes or purchases stock subject to an obligation to sell the stock back. This modification is reflected in §1.901-2T(e)(5)(iv)(C)( 5)( ii) of the temporary regulations. In addition, Example 2 of §1.901-2T(e)(5)(iv)(D) is modified to clarify that the holding company exception is not met if the counterparty's interest is acquired in a sale-repurchase transaction.

The IRS and Treasury Department recognize that under the regulations an entity conducting business through an active foreign subsidiary may fail to meet the holding company exception, even though the entity would not be treated as an SPV under the "substantially all" test if it operated the subsidiary's business directly through a branch operation. The IRS and Treasury Department believe this result is appropriate because the segregation of active business income and assets in a lower-tier entity may facilitate the use of an upper-tier entity to conduct a structured passive investment arrangement.

The IRS and Treasury Department remain concerned that taxpayers may continue to enter into structured passive investment arrangements designed to generate foreign tax credits through entities that meet the technical requirements of the holding company exception. The IRS and Treasury Department intend to monitor the use of holding companies to facilitate abusive foreign tax credit arrangements, utilize all available tools under current law to challenge the U.S. tax results claimed in connection with such arrangements (including the substance over form doctrine, the economic substance doctrine, debt-equity principles, tax ownership principles, other provisions of §1.901-2, section 269, and the partnership anti-abuse rules of §1.701-2) in appropriate cases, and to issue additional regulations modifying or eliminating the holding company exception if necessary to prevent abuse.

The second modification in the 2007 proposed regulations is that passive investment income is determined by disregarding sections 954(c)(3) and 954(c)(6) and by treating income attributable to transactions with a counterparty as ineligible for the exclusions under sections 954(h) and 954(i). The IRS and Treasury Department received a number of comments suggesting that the definition of passive investment income should be narrowed by excluding income that would be treated as non-subpart F income under section 954(c)(3) or 954(c)(6), excluding income from unrelated persons other than the counterparty, or eliminating the requirement in section 954(h) that the tested entity's activity be conducted in the entity's "home country." Other commentators suggested substituting other tests for the active financing exception in section 954(h), such as exempting financial services income as defined in section 904(d), with or without modification. For example, commentators suggested various modifications, such as excluding income derived from unrelated persons or from direct activities of employees of the tested entity; exempting any income derived from or related to transactions with customers; exempting income that would be considered attributable to an active foreign trade or business under the principles of section 864 and §1.367(a)-2T(b); or exempting income other than income from "tainted" assets such as cash or cash equivalents, stock or notes of persons related to the U.S. party or counterparty, or assets giving rise to U.S. source income. One commentator suggested that payments described in section 954(c)(3) should not be treated as passive investment income to the extent the payment was deductible under foreign law and the corresponding income inclusion by the tested entity did not result in a net increase in foreign taxes paid. This commentator suggested that the result in the U.S. borrower transaction described in Example 2 of the 2007 proposed regulations was inappropriate since the foreign tax paid by the SPV was offset by a reduction in tax paid by the CFC borrower.

The IRS and Treasury Department carefully considered these suggestions but ultimately determined that none of the suggested approaches has significant advantages over relying on section 954(h) to determine whether income from financing activities is sufficiently active that it should be excluded from passive investment income for purposes of these regulations. Section 954(h) includes detailed requirements that ensure that the entity is predominantly engaged in the active conduct of a banking, financing or similar business and conducts substantial activity with respect to such business. In addition, the IRS and Treasury Department continue to believe it is not appropriate to exclude income described in sections 954(c)(3) and 954(c)(6) from passive investment income, because financing arrangements between related parties that are engaged in the active conduct of a trade or business are commonly used in the structured transactions that are the target of these regulations. The IRS and Treasury Department also do not believe that U.S. borrower transactions should not be considered to result in a net increase in foreign tax, since in the absence of the structured passive investment arrangement the CFC borrower would still reduce its foreign tax by reason of the interest expense deduction but the U.S. party would not claim foreign tax credits for foreign payments attributable to income in the SPV that is in substance the foreign lender's interest income. Accordingly, §1.901-2T(e)(5)(iv)(C)( 5)( i) generally retains the definition of passive investment income in the 2007 proposed regulations.

However, the temporary regulations include two modifications in response to comments. First, the IRS and Treasury Department agree it is appropriate to require the entity's activities to be conducted directly by its own employees rather than by employees of affiliates, because the purpose of the SPV condition is to distinguish between active entities and those with largely passive income, and it is reasonable to require an entity engaged in an active business to conduct that business through its own employees. Accordingly, §1.901-2T(e)(5)(iv)(C)( 5)( i) provides that section 954(h)(3)(E) shall not apply, and that the entity must conduct substantial activity through its own employees.

Second, the IRS and Treasury Department agree that the requirement that activities be conducted in the entity's "home country" reflects a subpart F policy that is more restrictive than necessary for purposes of these regulations. Accordingly, §1.901-2T(e)(5)(iv)(C)( 5)( i) provides that for purposes of these regulations the term home country means any foreign country.

Concerning the requirement in §1.901-2(e)(5)(iv)(B)( 1)( i) of the 2007 proposed regulations that substantially all of the gross income of the entity be passive investment income and substantially all of the entity's assets are assets held to produce such passive investment income, one commentator recommended that the regulations provide examples illustrating situations in which such requirement is met. The IRS and Treasury Department did not adopt this comment because the "substantially all" test requires evaluation of all the facts and circumstances and cannot be satisfied by reference to a specific percentage benchmark.

Several commentators requested that the regulations clarify the time at which the six conditions must be met to result in a structured passive investment arrangement. Section 1.901-2T(e)(5)(iv)(B)( 1)( ii) of the temporary regulations is revised to clarify that the foreign payment must be made with respect to a U.S. tax year in which substantially all of the gross income (for U.S. tax purposes) of the entity, if any, is attributable to passive investment income and substantially all of the assets of the entity are assets held to produce such passive investment income. This clarification is intended to ensure that foreign tax credits are disallowed for foreign payments that relate primarily to passive investment income, but not for taxes that relate to active business income earned in an earlier or later year when the entity is not treated as an SPV. The regulations do not, however, require all six conditions to be met in the same tax year. For example, the regulations disallow credits for foreign payments with respect to income of an SPV even if the U.S. party acquires its interest, or a hybrid instrument is issued to the counterparty, after the foreign payments are made.

Other commentators recommended that the regulations eliminate the SPV condition and treat as noncompulsory payments only those foreign payments that directly relate to passive investment income, or with respect to which duplicative tax benefits are claimed. The IRS and Treasury Department did not adopt such an approach in the temporary regulations because of the administrative difficulty of tracing specific foreign payments to specific income or to the duplicative tax benefits. Accordingly, the temporary regulations retain the SPV condition and the approach of treating all foreign payments attributable to a structured passive investment arrangement as noncompulsory. However, the IRS and Treasury Department recognize that an element of the arrangements intended to be covered by the regulations is that they are designed to generate duplicative tax benefits, and that some connection between the counterparty's foreign tax benefit and the U.S. party's share of the foreign payments should be a precondition to the finding of a structured passive investment arrangement. Accordingly, as described in section D of this preamble, the foreign tax benefit condition is revised to provide that the counterparty's foreign tax benefit must correspond to 10 percent or more of the U.S. party's share of the foreign payments or the U.S. party's share (under U.S. tax principles) of the foreign tax base used to compute such payments.



B. Section 1.901-2T(e)(5)(iv)(B)(2): U.S. Party

Section 1.901-2T(e)(5)(iv)(B)( 2) of the temporary regulations adopts without change the second overall condition of the 2007 proposed regulations that a person (a "U.S. party") would be eligible to claim a credit under section 901(a) (including a credit for foreign taxes deemed paid under section 902 or 960) for all or a portion of the foreign payment if such payment were an amount of tax paid.

One commentator requested that the regulations be amended to clarify that the "U.S. party" condition must be met at the same time as the other five conditions. The temporary regulations do not include this condition because the IRS and Treasury Department believe it is inappropriate to exempt arrangements that are structured so that the U.S. party claims a credit in a taxable year or period that is not the same taxable year or period in which the counterparty is entitled to a foreign tax benefit. In addition, the IRS and Treasury Department are concerned that this modification would allow a person to acquire an interest in an SPV and claim credits with respect to purported foreign taxes paid in an earlier period by the SPV in connection with an arrangement that met the other five conditions of the regulations.



C. Section 1.901-2T(e)(5)(iv)(B)(3): Direct Investment

The third overall condition provided in the 2007 proposed regulations is that the foreign payment or payments are (or are expected to be) substantially greater than the amount of credits, if any, that the U.S. party would reasonably expect to be eligible to claim under section 901(a) if such U.S. party directly owned its proportionate share of the assets owned by the SPV, other than through a branch, a permanent establishment or any other arrangement (such as an agency arrangement) that would subject the income generated by its share of the assets to a net basis foreign tax. Commentators recommended several changes to the direct investment condition, several of which are adopted in the temporary regulations. First, in order to reach appropriate results in cases where more than one person owns an equity interest in the SPV for U.S. tax purposes, the temporary regulations amend the direct investment test to compare the U.S. party's proportionate share of the foreign payment made by the SPV to the amount of foreign tax the U.S. party would be eligible to credit if the U.S. party directly owned its proportionate share of the assets. Second, the temporary regulations clarify that a dual resident corporation that is an SPV meets the direct investment condition since its ownership of the passive assets is treated the same as ownership through a branch operation. Third, a commentator suggested that the direct investment test of the 2007 proposed regulations could be avoided by entering into a sale-repurchase transaction using an SPV that acquires passive assets subject to foreign withholding tax. This commentator recommended that the direct investment condition be revised to reduce the value of the U.S. party's interest by any amount advanced by the foreign counterparty that is treated as debt for U.S. tax purposes but as equity for foreign tax purposes. The IRS and Treasury Department agree that situations where the SPV's income is subject to gross basis foreign taxes raise the same foreign tax credit policy concerns as situations where the SPV's income is subject to net basis foreign taxes. The IRS and Treasury Department, however, believe the commentator's recommended solution is incomplete, since the other conditions of the regulations can be met by structures employing techniques other than sale-repurchase agreements. Accordingly, the temporary regulations provide that the U.S. party's proportionate share of the SPV's assets does not include any assets that produce income subject to gross basis withholding tax.

Several commentators recommended that the regulations include an exception for certain transactions in which the amount of the foreign payments attributable to income of an SPV does not substantially exceed the amount of foreign taxes that would have been paid by a controlled foreign corporation that owns the SPV in the absence of the arrangement. The commentators suggested that such foreign payments should not be treated as noncompulsory payments because they effectively substitute for taxes that would have been imposed on the controlled foreign corporation in the absence of the arrangement.

These comments raise the fundamental question as to the appropriate baseline to which such transactions should be compared to determine if there has been a significant increase in the total amount of foreign taxes paid. Although the IRS and Treasury Department carefully considered an exception from the definition of structured passive investment arrangements for such transactions, the IRS and Treasury Department have been unable to develop an exception that can be administered by the IRS and that does not exclude abusive cases. Accordingly, the temporary regulations do not include this exception.



D. Section 1.901-2T(e)(5)(iv)(B)(4): Foreign Tax Benefit

The fourth condition provided in the 2007 proposed regulations is that the arrangement is structured in such a manner that it results in a foreign tax benefit (such as a credit, deduction, loss, exemption or a similar tax benefit) for a counterparty or for a person that is related to the counterparty, but not related to the U.S. party. In response to comments, to relieve administrative burdens these regulations clarify that while the benefit must be reasonably expected, there is no requirement to show that the benefit be intended or actually realized. The temporary regulations also provide that the ability to surrender the use of a tax loss to another person is a foreign tax benefit because a foreign tax benefit need only be made available to a counterparty. See Example 9 of §1.901-2T(e)(5)(iv)(D).

Several commentators recommended that the regulations be revised to require a causal relationship between one or more of the six conditions. For example, one commentator recommended adding a requirement that the foreign tax benefit either relate to the foreign tax paid by the SPV or result from the counterparty being treated for foreign but not U.S. tax purposes as owning an equity interest in the SPV or a portion of the SPV's assets. Another commentator suggested requiring that the inconsistent aspect of the arrangement be created or used to achieve the foreign tax benefit. Another commentator recommended requiring that the foreign tax benefit would not have been allowed or allowable "but for" the existence of one or more of the other conditions.

In response to the comments, the temporary regulations revise the "foreign tax benefit" condition to provide that the credit, deduction, loss, exemption, exclusion or other tax benefit must correspond to 10 percent or more of the U.S. party's share (for U.S. tax purposes) of the foreign payment or 10 percent or more of the foreign tax base with respect to which the U.S. party's share of the foreign payment is imposed. The revisions are intended to clarify that a joint venture that does not involve any duplication of tax benefits is not covered by the temporary regulations. At the same time, the temporary regulations provide that the duplication need not be direct. For example, while the U.S. party generally seeks to claim foreign tax credits in the United States for foreign payments attributable to income of the SPV, the counterparty's foreign tax benefit may consist of tax-exempt income paid out of the SPV's income with respect to which foreign payments claimed as credits by the U.S. party were made and deductions or losses attributable to payments of corresponding amounts to the SPV or U.S. party. See Example 3 of §1.901-2T(e)(5)(iv)(D).



E. Section 1.901-2T(e)(5)(iv)(B)(5): Counterparty

The 2007 proposed regulations define a counterparty as a person (other than the SPV) that is unrelated to the U.S. party and that (i) directly or indirectly owns 10 percent or more of the equity of the SPV under the tax laws of a foreign country in which such person is subject to tax on the basis of place of management, place of incorporation or similar criterion or otherwise subject to a net basis foreign tax or (ii) acquires 20 percent or more of the assets of the SPV under the tax laws of a foreign country in which such person is subject to tax on the basis of place of management, place of incorporation or similar criterion or otherwise subject to a net basis foreign tax.

Commentators proposed that the counterparty factor be amended to include certain related parties. Commentators noted that structured transactions engaged in by related persons under common foreign ownership present the same tax policy concerns as transactions between unrelated persons. However, these same commentators noted that structured transactions engaged in by related parties that are under common U.S. ownership do not pose the same tax policy concerns because the reduction in foreign tax liability obtained by the U.S.-controlled foreign counterparty will result in a corresponding increase in U.S. taxes when the foreign counterparty repatriates its earnings to the United States. The IRS and Treasury Department agree with these comments. Consequently, the temporary regulations amend the definition of a counterparty to include related persons, but excluding cases where the U.S. party is a U.S. corporation or individual that owns (directly or indirectly) at least 80 percent of the value of the potential counterparty and cases where at least 80 percent of the value of the U.S. party and the potential counterparty are owned (directly or indirectly) by the same U.S. corporation or individual.

Several commentators also suggested that the requirement that the counterparty own at least 10 percent (directly or indirectly) of the equity of the SPV or acquire at least 20 percent of the assets of the SPV should be revised. Some commentators proposed these thresholds be increased to 50 percent. Other commentators proposed that the ownership of all foreign parties deriving a foreign tax benefit should be aggregated to determine whether the thresholds are met. The IRS and Treasury Department agree that the regulatory conditions should be revised to better reflect that the counterparty is entitled to more than a nominal foreign tax benefit. Accordingly, the temporary regulations eliminate the percentage ownership thresholds from the counterparty definition, and modify the definition of a foreign tax benefit in §1.901-2T(e)(5)(iv)(B)( 4), as described in section D of this preamble.



F. Section 1.901-2T(e)(5)(iv)(B)(6): Inconsistent Treatment

The sixth condition in the 2007 proposed regulations is that the U.S. and an applicable foreign country treat the arrangement differently under their respective tax systems. For this purpose, an applicable foreign country is any foreign country in which either the counterparty, a person related to the counterparty or the SPV is subject to net basis tax. To provide clarity and limit the scope of this factor, the 2007 proposed regulations provide that the arrangement must be subject to one of four specified types of inconsistent treatment. Specifically, the U.S. and the foreign country (or countries) must treat one or more of the following aspects of the arrangement differently, and the U.S. treatment of the inconsistent aspect must materially affect the amount of foreign tax credits claimed, or the amount of income recognized, by the U.S. party to the arrangement: (i) the classification of an entity as a corporation or other entity subject to an entity-level tax, a partnership or other flow-through entity or an entity that is disregarded for tax purposes; (ii) the characterization as debt, equity or an instrument that is disregarded for tax purposes of an instrument issued in the transaction; (iii) the proportion of the equity of the SPV (or an entity that directly or indirectly owns the SPV) that is considered to be owned directly or indirectly by the U.S. party and the counterparty; or (iv) the amount of taxable income of the SPV for one or more tax years during which the arrangement is in effect.

Commentators recommended that this condition be clarified so that the U.S. treatment of the inconsistent aspect must materially increase the amount of the U.S. party's foreign tax credits or materially decrease the U.S. party's income for U.S. tax purposes. The temporary regulations reflect this clarification. In addition, commentators requested that this factor be limited to instances when the inconsistent treatment is reasonably expected to result in a permanent difference in the U.S. party's income or foreign tax credits. The IRS and Treasury Department believe that the revisions to the foreign tax benefit condition described in Section D of this preamble are sufficient to establish the appropriate linkage between the inconsistent U.S. and foreign law treatment and the duplicative tax benefits. Accordingly, the temporary regulations retain the inconsistent treatment factor without further changes.

One commentator also recommended that the inconsistent treatment condition be narrowed to instances where the inconsistent treatment under U.S. and foreign law related to definitions of ownership and the amount of the SPV's taxable income. The IRS and Treasury Department have not adopted this recommendation because it would cause certain types of abusive arrangements to fall outside the scope of the regulations and because differences in entity classification are features common to structured passive investment arrangements.



G. Other Comments

Commentators also made suggestions that did not relate to any single factor. For example, commentators also requested clarification that the foreign payments treated as noncompulsory amounts under the regulation may be deductible payments under sections 162 and 212 and reduce a foreign corporation's earnings and profits for purposes of subpart F. The IRS and Treasury Department believe that providing guidance regarding sections 162, 212, and 964 is beyond the scope of this regulation project. The usual rules for determining the deductibility of a payment and determining the earnings and profits of a foreign corporation for subpart F purposes apply.

In addition, commentators requested that foreign payments attributable to a structured passive investment arrangement be excluded from the scope of the regulations if the arrangement has a valid business purpose. Other commentators suggested that the regulations adopt a broad anti-abuse rule that would deny a foreign tax credit in any case where allowance of the credit would be inconsistent with the purpose of the foreign tax credit regime. The IRS and Treasury Department are concerned that these approaches would create uncertainty for both taxpayers and the IRS. The IRS and Treasury Department have concluded that, at this time, a targeted rule denying foreign tax credits in arrangements described in the temporary regulations is more appropriate.



H. Other Examples

In response to comments, the temporary regulations include more examples illustrating additional variations of the structured passive investment arrangements that are covered by the regulations. For example, new Example 3 illustrates a U.S. borrower transaction in which a foreign lender acquires assets instead of an equity interest in the SPV and new Example 10 illustrates a joint venture in which the counterparty's foreign tax benefits do not correspond to the U.S. party's share of the base with respect to which the foreign payment is imposed. Modifications to examples in the 2007 proposed regulations were also necessary to reflect comments received and other changes to the regulations.



I. Effective/Applicability Dates

The 2007 proposed regulations were proposed to be effective for foreign taxes paid or accrued during taxable years of the taxpayer ending on or after the date on which the final regulations are published in the Federal Register. A commentator observed that the final regulations would potentially be retroactively effective because the regulations would apply, for example, to calendar year taxpayers as of January 1 of the year in which the final regulations are published in the Federal Register and to taxpayers that participated in structured passive investment arrangements involving entities with taxable years that differ from the U.S. taxpayers' taxable years. Commentators also requested clarification of whether the relevant taxable year for purposes of the effective date is the taxable year of the SPV in which it pays or accrues the purported foreign taxes, or the taxable year of the U.S. taxpayer in which it claims a credit. For example, commentators observed that if the taxable year of the U.S. taxpayer in which it claims a credit is the relevant taxable year, the final regulations would apply to U.S. shareholders of controlled foreign corporations where the shareholder claims a deemed paid credit under section 902 with respect to foreign taxes paid by the foreign corporation in years prior to the effective date of the regulations. These commentators recommended that the regulations provide that the relevant taxable year is the SPV's taxable year. Commentators also recommended that the final regulations apply only to foreign taxes paid or accrued in taxable years beginning after the date the final regulations are published, or only to foreign taxes paid or accrued with respect to income accrued after the date the final regulations are published.

The IRS and Treasury Department have not adopted the recommendation to delay the effective date of these regulations to apply only in tax years beginning after the regulations are published. The IRS and Treasury Department generally believe the regulations should apply to disallow credits for foreign payments that would otherwise be eligible to be claimed as credits in taxable years ending after the regulations are published. The IRS and Treasury Department agree, however, that the regulations should not apply to foreign taxes paid or accrued by a foreign corporation in a U.S. taxable year of the foreign corporation ending prior to the effective date of the regulations, provided that such year ends prior to the first taxable year of the domestic corporate shareholder for which these regulations are first applicable.

Accordingly, the effective date for these regulations is July 15, 2008. The regulations generally apply to foreign payments that, if they were an amount of tax paid, would be considered paid or accrued by a U.S. or foreign entity in taxable years ending on or after July 15, 2008. In the case of foreign payments by a foreign corporation that has a domestic corporate shareholder, the regulations also apply to such payments that would be considered paid or accrued in the foreign corporation's U.S. taxable years ending with or within taxable years of its domestic corporate shareholder ending on or after July 15, 2008. Finally, in the case of foreign payments by a partnership, trust or estate for which any partner or beneficiary would otherwise be eligible to claim a foreign tax credit, the regulations also apply to payments that would be considered paid or accrued in taxable years ending with or within taxable years of such partners or beneficiaries ending on or after July 15, 2008.

No inference is intended regarding the U.S. tax consequences of structured passive investment arrangements prior to the effective date of the regulations.

For periods after the effective date of the temporary regulations, the IRS and Treasury Department will continue to scrutinize other arrangements that are not covered by the regulations but are inconsistent with the purpose of the foreign tax credit. Such arrangements may include arrangements that are similar to arrangements described in the temporary regulations, but that do not meet all of the conditions included in the temporary regulations. The IRS will continue to challenge the claimed U.S. tax results in appropriate cases. In addition, the IRS and Treasury Department may issue additional regulations in the future in order to address such other arrangements.



J. Miscellaneous Amendments

The temporary regulations also amend §1.901-1(a) and (b) to reflect statutory changes made by the Foreign Investors Tax Act of 1966 (Public Law 89-809 (80 Stat. 1539), section 106(b)), the Tax Reform Act of 1976 (Public Law 94-455 (90 Stat. 1520), section 1901(a)(114)), and the American Jobs Creation Act of 2004 (Public Law 108-357 (118 Stat. 1418-20), section 405(b)).



Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. For applicability of the Regulatory Flexibility Act, please refer to the cross-referenced notice of proposed rulemaking published elsewhere in this issue of the Federal Register. Pursuant to section 7805(f) of the Internal Revenue Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.



Drafting Information

The principal author of these regulations is Michael I. Gilman, Office of Associate Chief Counsel (International). However, other personnel from the IRS and the Treasury Department participated in their development.




List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.



Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:



PART 1 --INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.901-1 is amended by revising paragraphs (a) and (b) to read as follows:



§1.901-1 Allowance of credit for taxes.

(a) and (b). [Reserved]. For further guidance, see §1.901-1T(a) and (b). * * * * *

Par. 3. Section 1.901-1T is added to read as follows:



§1.901-1T Allowance of credit for taxes (temporary).

(a) In general. Citizens of the United States, domestic corporations, and certain aliens resident in the United States or Puerto Rico may choose to claim a credit, as provided in section 901, against the tax imposed by chapter 1 of the Code for taxes paid or accrued to foreign countries and possessions of the United States, subject to the conditions prescribed in paragraphs (a)(1) through (a)(3) and paragraph (b) of this section.

(1) Citizen of the United States. A citizen of the United States, whether resident or nonresident, may claim a credit for --

(i) The amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States; and

(ii) His share of any such taxes of a partnership of which he is a member, or of an estate or trust of which he is a beneficiary.

(2) Domestic corporation. A domestic corporation may claim a credit for --

(i) The amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States;

(ii) Its share of any such taxes of a partnership of which it is a member, or of an estate or trust of which it is a beneficiary; and

(iii) The taxes deemed to have been paid under section 902 or 960.

(3) Alien resident of the United States or Puerto Rico. Except as provided in a Presidential proclamation described in section 901(c), an alien resident of the United States, or an alien individual who is a bona fide resident of Puerto Rico during the entire taxable year, may claim a credit for --

(i) The amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States; and

(ii) His share of any such taxes of a partnership of which he is a member, or of an estate or trust of which he is a beneficiary.

(b) Limitations. Certain Code sections, including sections 814, 901(e) through (l), 906, 907, 908, 911, 999, and 6038, limit the credit against the tax imposed by chapter 1 of the Code for certain foreign taxes.

(c) through (i) [Reserved]. For further guidance, see §1.901-1(c) through (i).

(j) Effective/applicability date. This section applies to taxable years beginning after July 15, 2008.

(k) Expiration date. The applicability of this section expires on July 15, 2011.

Par. 4. Section 1.901-2 is amended by adding paragraphs (e)(5)(iii) and (e)(5)(iv) and revising paragraph (h) to read as follows:



§1.901-2 Income, war profits, or excess profits tax paid or accrued.

* * * * *

(e) * * *

(5) * * *

(iii) and (iv) [Reserved]. For further guidance, see §1.901-2T(e)(5)(iii) and (iv).

* * * * *

(h) Effective/applicability date --(1) In general. This section and §§1.901-2A and 1.903-1 apply to taxable years beginning after November 14, 1983.

(2) [Reserved]. For further guidance, see §1.901-2T(h)(2).

Par. 5. Section 1.901-2T is added to read as follows:



§1.901-2T Income, war profits, or excess profits tax paid or accrued (temporary).

(a) through (e)(5)(ii) [Reserved]. For further guidance, see §1.901-2(a) through (e)(5)(ii).

(e)(5)(iii) [Reserved].

(iv) Structured passive investment arrangements --(A) In general.

Notwithstanding §1.901-2(e)(5)(i), an amount paid to a foreign country (a "foreign payment") is not a compulsory payment, and thus is not an amount of tax paid, if the foreign payment is attributable (within the meaning of paragraph (e)(5)(iv)(B)( 1)( ii) of this section) to a structured passive investment arrangement (as described in paragraph (e)(5)(iv)(B) of this section).

(B) Conditions. An arrangement is a structured passive investment arrangement if all of the following conditions are satisfied:

( 1) Special purpose vehicle (SPV). An entity that is part of the arrangement meets the following requirements:

( i) Substantially all of the gross income (for U.S. tax purposes) of the entity, if any, is passive investment income, and substantially all of the assets of the entity are assets held to produce such passive investment income. As provided in paragraph (e)(5)(iv)(C)( 5)( ii) of this section, passive investment income generally does not include income of a holding company from qualified equity interests in lower-tier entities that are predominantly engaged in the active conduct of a trade or business. Thus, except as provided in paragraph (e)(5)(iv)(C)( 5)( ii) of this section, qualified equity interests of a holding company in such lower-tier entities are not held to produce passive investment income and the ownership of such interests will not cause the holding company to meet the requirements of this paragraph (e)(5)(iv)(B)( 1)( i).

( ii) There is a foreign payment attributable to income of the entity (as determined under the laws of the foreign country to which such foreign payment is made), including the entity's share of income of a lower-tier entity that is a branch or pass-through entity under the laws of such foreign country, that, if the foreign payment were an amount of tax paid, would be paid or accrued in a U.S. taxable year in which the entity meets the requirements of paragraph (e)(5)(iv)(B)( 1)( i) of this section. A foreign payment attributable to income of an entity includes a foreign payment attributable to income that is required to be taken into account by an owner of the entity, if the entity is a branch or pass-through entity under the laws of such foreign country. A foreign payment attributable to income of an entity also includes a foreign payment attributable to income of a lower-tier entity that is a branch or pass-through entity for U.S. tax purposes. A foreign payment attributable to income of the entity does not include a withholding tax (within the meaning of section 901(k)(1)(B)) imposed on a distribution or payment from the entity to a U.S. party.

( 2) U.S. party. A person would be eligible to claim a credit under section 901(a) (including a credit for foreign taxes deemed paid under section 902 or 960) for all or a portion of the foreign payment described in paragraph (e)(5)(iv)(B)( 1)( ii) of this section if the foreign payment were an amount of tax paid.

( 3) Direct investment. The U.S. party's proportionate share of the foreign payment or payments described in paragraph (e)(5)(iv)(B)( 1)( ii) of this section is (or is expected to be) substantially greater than the amount of credits, if any, that the U.S. party reasonably would expect to be eligible to claim under section 901(a) for foreign taxes attributable to income generated by the U.S. party's proportionate share of the assets owned by the SPV if the U.S. party directly owned such assets. For this purpose, direct ownership shall not include ownership through a branch, a permanent establishment or any other arrangement (such as an agency arrangement or dual resident status) that would result in the income generated by the U.S. party's proportionate share of the assets being subject to tax on a net basis in the foreign country to which the payment is made. A U.S. party's proportionate share of the assets of the SPV shall be determined by reference to such U.S. party's proportionate share of the total value of all of the outstanding interests in the SPV that are held by its equity owners and creditors. A U.S. party's proportionate share of the assets of the SPV, however, shall not include any assets that produce income subject to gross basis withholding tax.

( 4) Foreign tax benefit. The arrangement is reasonably expected to result in a credit, deduction, loss, exemption, exclusion or other tax benefit under the laws of a foreign country that is available to a counterparty or to a person that is related to the counterparty (determined under the principles of paragraph (e)(5)(iv)(C)( 7) of this section by applying the tax laws of a foreign country in which the counterparty is subject to tax on a net basis). However, a foreign tax benefit is described in this paragraph (e)(5)(iv)(B)( 4) only if any such credit corresponds to 10 percent or more of the U.S. party's share (for U.S. tax purposes) of the foreign payment referred to in paragraph (e)(5)(iv)(B)( 1)( ii) of this section or if any such deduction, loss, exemption, exclusion or other tax benefit corresponds to 10 percent or more of the foreign base with respect to which the U.S. party's share (for U.S. tax purposes) of the foreign payment is imposed.

( 5) Counterparty. The arrangement involves a counterparty. A counterparty is a person that, under the tax laws of a foreign country in which the person is subject to tax on the basis of place of management, place of incorporation or similar criterion or otherwise subject to a net basis tax, directly or indirectly owns or acquires equity interests in, or assets of, the SPV. However, a counterparty does not include the SPV or a person with respect to which for U.S. tax purposes the same domestic corporation, U.S. citizen or resident alien individual directly or indirectly owns more than 80 percent of the total value of the stock (or equity interests) of each of the U.S. party and such person. In addition, a counterparty does not include a person with respect to which for U.S. tax purposes the U.S. party directly or indirectly owns more than 80 percent of the total value of the stock (or equity interests), but only if the U.S. party is a domestic corporation, a U.S. citizen or a resident alien individual.

( 6) Inconsistent treatment. The United States and an applicable foreign country treat one or more of the following aspects of the arrangement differently under their respective tax systems, and for one or more tax years when the arrangement is in effect either the amount of income recognized by the SPV, the U.S. party, and persons related to the U.S. party for U.S. tax purposes is materially less than the amount of income that would be recognized if the foreign tax treatment controlled for U.S. tax purposes, or the amount of credits claimed by the U.S. party (if the foreign payment described in paragraph (e)(5)(iv)(B)( 1)( ii) of this section were an amount of tax paid) is materially greater than it would be if the foreign tax treatment controlled for U.S. tax purposes:

( i) The classification of the SPV (or an entity that has a direct or indirect ownership interest in the SPV) as a corporation or other entity subject to an entity-level tax, a partnership or other flow-through entity or an entity that is disregarded for tax purposes.

( ii) The characterization as debt, equity or an instrument that is disregarded for tax purposes of an instrument issued by the SPV (or an entity that has a direct or indirect ownership interest in the SPV) to the U.S. party, the counterparty or a person related to the U.S. party or the counterparty.

( iii) The proportion of the equity of the SPV (or an entity that directly or indirectly owns the SPV) that is considered to be owned directly or indirectly by the U.S. party and the counterparty.

( iv) The amount of taxable income of the SPV for one or more tax years during which the arrangement is in effect.

(C) Definitions. The following definitions apply for purposes of paragraph (e)(5)(iv) of this section.

( 1) Applicable foreign country. An applicable foreign country means each foreign country to which a foreign payment described in paragraph (e)(5)(iv)(B)( 1)( ii) of this section is made or which confers a foreign tax benefit described in paragraph (e)(5)(iv)(B)( 4) of this section.

( 2) Counterparty. The term counterparty means a person described in paragraph (e)(5)(iv)(B)( 5) of this section.

( 3) Entity. The term entity includes a corporation, trust, partnership or disregarded entity described in §301.7701-2(c)(2)(i) of this chapter.

( 4) Indirect ownership. Indirect ownership of stock or another equity interest (such as an interest in a partnership) shall be determined in accordance with the principles of section 958(a)(2), regardless of whether the interest is owned by a U.S. or foreign entity.

( 5) Passive investment income --( i) In general. For purposes of paragraph (e)(5)(iv) of this section, the term passive investment income means income described in section 954(c), as modified by this paragraph (e)(5)(iv)(C)( 5)( i) and paragraph (e)(5)(iv)(C)( 5)( ii) of this section. In determining whether income is described in section 954(c), paragraphs (c)(3) and (c)(6) of that section shall be disregarded, and sections 954(h) and 954(i) shall be taken into account by applying those provisions at the entity level as if the entity were a controlled foreign corporation (as defined in section 957(a)). For purposes of the preced