The Joint International Tax Shelter Information Centre—an organization of tax administrators from Australia, Canada, the United Kingdom and the United States—recently focused on transactions by U.S. taxpayers with foreign counterparts to generate foreign tax credits. The IRS in response proposed amendments to regulations section 1.901-2, which targets transactions involving U.S. borrowers and lenders and asset-holding transactions intentionally structured to create a foreign tax liability. The IRS also has identified foreign tax credit generators as a top-tier compliance issue within its Large and Mid-Size Business Division.

Section 901 of the Internal Revenue Code permits taxpayers to claim a credit for income taxes paid or accrued, or deemed paid, to any foreign country or U.S. possession. The proposed amendments say an amount paid to a foreign country is not a compulsory payment—and thus is not considered tax paid—if it is attributable to a structured passive investment arrangement. Such arrangements are defined by several criteria, including that a claimed credit is substantially greater than the taxpayer would reasonably expect to be eligible to claim had it directly owned its share of the arrangement’s assets.

Comments on proposed regulation 156779-06 are requested by June 28 via www.regulations.gov (search term: IRS_FRDOC_0001-0010), with a public hearing scheduled for July 30 at IRS headquarters in Washington.

Prepared by Bob Thomas , Ph.D., assistant professor of accounting, and Darlene Pulliam , CPA, Ph.D., professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

Congress should repeal the individual alternative minimum tax (AMT) or at least reform it, said Joseph W. Walloch, incoming chair of the AICPA’s technical resource panel on individual income tax. Walloch, along with other CPAs and taxpayers, testified in March before a House Ways and Means subcommittee to the AMT’s complexity and widening reach, with an estimated one-fourth of individual taxpayers subject to it this year unless Congress acts. David A. Lifson, president-elect of the New York State Society of CPAs, also called for repeal or overhaul, and Jon A. Nixon, CPA, a partner in Katzman Weinstein and Co. LLP of Bethpage, N.Y., described how the AMT fetters small businesses.

Short of abolishing the AMT, Walloch told Congress, it should adopt AICPA recommendations, including:

Increase and index for inflation the AMT brackets and exemption amounts, eliminate phase-outs and exempt regular-tax adjusted gross incomes under $100,000.

Set a single AMT tax rate below the regular-tax 25% bracket.

Allow certain regular-tax deductions, exemptions and credits barred or limited by the AMT, including the standard deduction, personal and dependent exemptions, and itemized deductions for medical expenses and state and local taxes.

Exclude the AMT from the estimated-tax penalty.

In the widely reported case Klamath Strategic Investment Fund (see “Tax Matters,” JofA, March 07, page 72), the district court disallowed claimed losses on a finding that the transactions were shams and lacked economic substance. An important but less widely known aspect of the case was the court’s refusal to apply any of the assessed penalties. The decision points out what penalties can be assessed and how a taxpayer can defend against them.

The transaction in question is the tax shelter known as Bond Linked Issue Premium Structure (BLIPS), which used foreign bank loans to create basis and loss on disposition. After disallowing a loss deduction, the court considered and declined to apply four penalties: 40% for gross valuation misstatement, 20% for substantial valuation misstatement, 20% for substantial understatement of tax and the 20% penalty for negligence or disregard of rules and regulations.

The 40% gross valuation penalty applies if one or more valuation misstatements exceed the actual valuation by 400% or more. Based on the decision in Heasley v. Commissioner (66 AFTR2d 90-5068), the court ruled the penalty applies only to valuation errors and not to inappropriate deductions or credits. Since Treasury was arguing that the loan should be ignored as a sham and not that assets were overvalued, the penalty could not apply. It is important to note that while the Fifth Circuit Court of Appeals applied this rule, others uphold the penalty if the denied deduction is the result of overvaluation. Given this split, it is likely a future case will go to the Supreme Court to determine the interaction of the valuation penalty with the denial of a deduction.

The 20% substantial-valuation penalty was not applied for the same reason. The taxpayer argued the 20% penalty for substantial understatement of income tax did not apply because there was substantial authority for the claimed position, supported by an opinion letter of the law firms Klamath consulted. The court agreed that there was substantial authority, based on the numerous authorities cited in the opinion letters.

The penalty for negligence or disregard of rules does not apply if there is a reasonable basis for the position claimed, a lower standard than substantial authority. The court noted that Klamath entered the transaction before it was announced as abusive, obtained advice from qualified professionals and responded to all IRS inquiries in a timely fashion. It also said Klamath hired an outside law firm to investigate the foreign-currency transaction, and also hired two well-known and highly respected tax lawyers who were unrelated to the transaction. Therefore, the taxpayer was not negligent and the penalty did not apply.

The taxpayer’s approach could be regarded as a road map for avoiding penalties. Still unanswered, however, is the interaction of valuation penalties and denied deductions.

Klamath Strategic Investment Fund LLC v. U.S., 99 AFTR2d 2007-850.

Prepared by Edward J. Schnee , CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

The statute of limitations does not protect a taxpayer from a deficiency assessment for fraudulent returns when the fraud was committed by a preparer, the Tax Court ruled.

In 2005, Vincent Allen was assessed a deficiency of $12,212 for income taxes in 1999 and 2000, based on false itemized deductions shown on copies of the returns the preparer provided to Allen. The preparer later pleaded guilty to 30 counts of fraud involving returns of other taxpayers.

Normally, the IRS has three years after a return is filed to assess a deficiency under section 6501(a), unless the return is false or fraudulent, in which case the time is unlimited. Allen unsuccessfully argued the exception applies only if the taxpayer had fraudulent intent. The preparer’s fraud was sufficient to permit the unlimited assessment period.

Allen v. Commissioner , 128 TC no. 4.

Prepared by Edward J. Schnee .

In U.S. v. MPM Financial Group Inc., the Sixth Circuit scolded the defendant for exercising poor internal controls as it upheld a penalty for failure to comply with a notice of levy against one of its employees, who was also the corporation’s co-owner and president. Because the employer did not have “reasonable cause” for its failure to comply with the IRS notice, it was found liable for the amount in back taxes it failed to turn over, plus a 50% penalty under IRC section 6332(a)(2).

MPM appealed the ruling out of the Eastern District of Kentucky that found it liable for $29,233, plus the 50% penalty of $14,616, along with post-judgment interest. After the government’s motion to reconsider the calculation, the judgment against MPM was increased to $77,058.

The notice of levy issued pursuant to IRC section 6332(a) was received by MPM’s co-owner and president, Michael Morton, who was the delinquent taxpayer. Morton owed the IRS $104,009 in unpaid income taxes and penalties. In August 2000, MPM received the levy notice at its office via regular mail. The IRS agent assigned to the case later hand-delivered a “final demand” to Morton at MPM’s office. No funds were paid to the IRS before the levy was released in June 2001.

MPM’s other co-owners argued that the IRS agent knew Morton was uncooperative and untrustworthy, and that the agent should have tried to contact the company’s other directors or mail a notice to the company’s registered agent for service of process.

The appeals court disagreed, pointing out the notice was mailed to MPM at its business address and it was received in the ordinary course of business. MPM failed to honor the levy only because Morton, who was duly authorized as president to manage the office and open mail, ignored it. “MPM’s lack of internal controls cannot amount to reasonable cause for failing to honor the levy” and avoid the penalty, the Sixth Circuit said.

The Sixth Circuit also quoted the district court, which said that “MPM must keep in mind that if there had been a system of checks and balances in place at its office at the time this levy was served …, it is unlikely that Morton, the truly culpable party in this situation, would have been able to keep this notice of levy from coming to the attention of … MPM’s two other principal owners.” The court said that allowing this conduct to pass muster as reasonable cause would “undermine the underlying principle” of the levy to aid the government in promptly securing its revenues.

U.S. v. MPM Financial Group Inc., 99 AFTR2d 2007-940.

Prepared by JofA staff member Jeffrey Gilman , J.D.

The agency tasked with processing more than 220 million tax returns annually is not doing an adequate job of protecting the sensitive personal financial information of the taxpayers submitting those forms, according to a report from the Treasury Inspector General for Tax Administration (TIGTA).

TIGTA said IRS employees reported the loss or theft of 490 laptop computers between Jan. 2, 2003, and June 13, 2006. Many of the thefts were attributed to employees failing to properly secure laptops in their homes and cars or not storing the machines in locked cabinets when not in use. TIGTA said it is likely many of the lost computers contained unencrypted taxpayer data and employee personnel data. The report also notes TIGTA warned the IRS as early as July 2003 that other devices such as flash drives, CDs and DVDs contained sensitive data that was not encrypted, but the IRS had not taken adequate corrective actions.

The report recommends the IRS take measures such as refining incident response, buying computer cable locks for employees’ laptops and including instructions on using approved encryption software on all electronic media devices.

The report is available at www.treas.gov/tigta/auditreports/2007reports/200720048fr.pdf .

Proposed regulations amending IRC section 987 may frustrate the intent of the Tax Reform Act of 1986 and place an undue burden on taxpayers, the AICPA said. The new regulations establish a “foreign exchange exposure pool” method of reporting gain and loss transacted in a foreign currency. Comments developed by the AICPA’s Section 987 Task Force and approved by its International Tax Technical Resource Panel and Tax Executive Committee were conveyed to the IRS in a March 29 letter by Jeffrey R. Hoops, chair of the Tax Executive Committee. The AICPA urged the IRS to reconsider the approach of the 2006 proposed regulations; barring that, it recommended 19 modifications of the proposed regulations, published Sept. 7, 2006, as REG-208270. The IRS substituted the rules for proposed changes in 1991 that it said had led to claims of large non-economic currency losses.

Electronic income-tax return filing rose in 2007 over the year before, the IRS said, surging as the April filing deadline approached. Late filers often owe the government money and tend to favor slower paper forms, the IRS said. But by early April, e-filed returns were up 6.2% over the same point in 2006. The biggest growth was in self-prepared returns, up 8.4% over the prior year. Earlier, the IRS Oversight Board analyzed what it called weak e-filing during 2006, when self-prepared e-filing of individual returns declined. In its report, the board said it planned to reassess the 2006 “setback” after comparing this year’s results.