Massachussetts Appeals Court Affirms Operational Approach to Cost of Performance without a Published Opinion

The appeal of AT&T Corporation v. Commissioner from the Massachusetts Appellate Tax Board (“ATB”) was among the 10 most requested dockets on the Supreme Judicial Court of Massachusetts website. It’s unlikely that observers got exactly what they expected because the decision came with a considerable caveat.

On July 13, 2012, the Massachusetts Appeals Court affirmed the decision of the ATB under Rule 1:28. A decision under Massachusetts Appeals Court Rule 1:28 exists somewhere between an unpublished decision and a per curium opinion. The rule is reserved for the summary disposition of cases where the panel of judges “determine that no substantial question of law is presented by the appeal.” It normally is not accompanied by an opinion (as was the case here) and is regarded as an unpublished decision by the Appeals Court. However, it is not regarded in exactly the same fashion as an unpublished decision in the federal context. Prior to 2008, and the Massachusetts Appellate Court’s decision in Chace v. Curran, 71 Mass. App. Ct. 258, appeal denied, 451 Mass. 1103 (2008), unpublished decisions were not to be relied upon or cited as authority. The Chace opinion, which was accompanied by an official amendment to the court rules, changed the status of Rule 1:28 decisions by holding that unpublished decisions “may be cited for persuasive value but…not as binding precedent.”

The affirmation of the ATB’s decision certainly was a good thing for AT&T even if the application of those facts to others might be approached with some caution. AT&T was subject to the Massachusetts public service corporation franchise tax. They sought a refund of taxes when they changed their approach to apportioning service income earned in Massachusetts. The Department of Revenue rejected the refund claim and they ended up in front of the ATB.

The central issue is what receipts should be included in the sales factor of Massachusetts apportionment purposes. Service income earned in Massachusetts is sourced to the commonwealth using a two-part analysis, often referred to as “cost of performance.” The first step is to determine the income producing activity. The second step is to then to determine if the greater portion of the cost of performing that activity occurs in Massachusetts or elsewhere.

The nature of the income producing activity was crucial to the ATB’s analysis of AT&T’s refund position. The Commissioner of the Department of Revenue argued that AT&T’s income should be measured based on each individual call or data transmission – the transactional approach. Under that analysis, the costs of performing each transaction was greater in Massachusetts than anywhere else, do the income from all the calls would be sourced to Massachusetts and subject to tax by Massachusetts.

AT&T countered that its income producing activity was “providing a national, integrated telecommunications network” – the operational approach. Of course, under AT&T’s method most of the costs related to performing the income producing activity happened at their corporate headquarters in New Jersey, outside of Massachusetts, thus depriving Massachusetts of the privilege of taxing the income.

AT&T had lost this argument in the Oregon Tax Court, but prevailed in the ATB. The ATB found that AT&T’s system of re-routing calls, sometimes across the nation, to make a connection in response to heavy network demands, and the unpredictability of that routing, illustrated that the income producing activity was part of an entire integrated network. It was this decision that the Appeals Court affirmed with its ruling.

The Appeals Court did not issue an opinion with its ruling, but you can read the ATB’s decision here.
AT&T Corp. v. Massachusetts, ATB 2011-524 (June 8, 2011)

1st Circuit Vacates Tax Court on Historical Facade Conservation Easement

In a case that has been followed closely by many interested parties, the First Circuit Court of Appeals ruled in favor of the taxpayers and the validity of their charitable contribution of an historical façade conservation easement in Kaufman v. Shulman. The 1st Circuit vacated the Tax Court’s legal ruling on partial summary judgment and remanded the matter for further findings on the questions of penalties and valuation.

The taxpayers in Kaufman owned an approximately 150 year-old row house in the historic district of South End in Boston. The home reflected mid-nineteenth century architecture and included a unique Venetian-Gothic style façade. In 2003, the taxpayers executed a “Preservation Restriction Agreement” donating an easement over the property to a qualified charitable organization for the purpose of protecting and preserving the historical features of the home. On the advice of the donee, the taxpayers obtained an appraisal of the contribution from an experienced appraiser who valued the easement at $220,800. The taxpayers took deductions on their 2003 and 2004 tax returns for the value of the donated easement, subject to the limits of IRC Sec. 170(b)(1)(E).

The property was subject to a mortgage when the taxpayers made the donation. The taxpayers obtained an agreement from the lender subordinating certain of the mortgage-holder’s rights in the property to the donee in accordance with the regulations governing the charitable donation of conservation easements. The agreement included several restrictive clauses, one of which became the focus of the Tax Court’s determination and the 1st Circuit’s ruling. That clause read as follows:

The Mortgagee/Lender and its assignees shall have a prior claim to all insurance proceeds as a result of any casualty, hazard or accident occurring to or about the Property and all proceeds of condemnation, and shall be entitled to same in preference to Grantee until the Mortgage is paid off and discharged, notwithstanding that the Mortgage is subordinate in priority to the [Preservation Restriction] Agreement.

Following an examination of their 2003 and 2004 returns, the IRS issued a notice of deficiency to the Kaufmans disallowing the deductions for the charitable contribution of the easement. The IRS maintained that the donation did not meet the regulatory requirements of Section 170(h). The taxpayers petitioned the U.S. Tax Court.

The Tax Court, in a division opinion by Judge Halpern, ruled for the IRS on a motion for partial summary judgment. Kaufman v. Commissioner, 134 T.C. 182 (2010). The Tax Court held that the conservation easement as executed failed to satisfy the requirement of Treas. Reg. Sec. 1.170A-14(g)(6). The Tax Court’s position on summary judgment, as summarized by the First Circuit, was that

although the Kaufmans in the Preservation Restriction Agreement governing 19 Rutland Square granted the Trust an entitlement to a proportionate share of post-extinguishment proceeds, thus seemingly complying with the regulation, the lender agreement executed by Washington Mutual undercut this commitment–and so defeated the deduction–by stipulating that “[t]he Mortgagee/Lender and its assignees shall have a prior claim to all insurance proceeds . . . and all proceeds of condemnation, and shall be entitled to same in preference to Grantee until the Mortgage is paid off and discharged.”

Even though the Tax Court decided for the government “entirely” on the basis of Treas. Reg. Sec. 1.170A-14(g)(6), the Court of Appeals also addressed paragraphs (g)(1) (perpetuity), (g)(2) (remote events), and g(3) (subordination) of the regulation in its opinion. The First Circuit observed that the IRS’s arguments in support of the Tax Court’s decision under g(6) would “appear to doom practically all donations of easements, which is surely contrary to the purpose of Congress.” The appellate court continued that it “cannot find reasonable an impromptu reading [of a regulation] that is not compelled and would defeat the purpose of the statute, as we think is the case here.” So on the big issue in the case, whether the mortgage subordination clause that granted the lender a prior claim to insurance and condemnation proceeds defeated the deduction, the First Circuit vacated the Tax Court’s legal conclusion.

The First Circuit made clear that it did not rest its decision on either the application of paragraphs (g)(3), addressing the defeasance of the deduction by remote future events, or (g)(2) which the taxpayers argued would have upheld the subordination agreement regardless of the extinguishment provision. This caveat seems to preserve the Tax Court’s recent opinion in Mitchell v. Commissioner from the scope of this ruling.

The appellate panel also addressed the “in perpetuity” requirement of Treas. Reg. Sec. 1.170A-14(g)(1) and the language in the agreement stating that “nothing herein contained shall be construed to limit the [Trust’s] right to give its consent (e.g., to changes in the façade) or to abandon some or all of its rights hereunder.” The First Circuit noted its agreement with the D.C. Circuit who decided the same issue in Commissioner v. Simmons, 646 F.3d 6 (D.C. Cir. 2011) and added that the question was not whether the paragraph was a reasonable interpretation of the underlying statute, Sec. 170(h)(5), but whether the IRS’s interpretation of the regulation was reasonable. The court concluded that the regulation did not support the IRS’s stringent view.

Read the entire opinion here:
Kaufman v. Shulman, Docket No. 11-2017P-01A (1st Cir., July 19, 2012)

This Train is Coming: IRS Notice Challenges Outbound Intangible Reorganizations

Often the best way to defend a tax position is to see the train before it gets to the station.

On Friday, the Internal Revenue Service issued Notice 2012–39, which addresses certain transactions that allow a U.S. taxpayer to repatriate foreign income in a tax efficient manner by using low basis domestic intangibles and the corporate reorganization rules. The Notice announced that the IRS will be issuing new regulations, with an effective date of July 13, 2012, to prevent these transactions. In the meantime, taxpayers are expected to follow the guidance in the Notice to report income from transactions that might be described in the Notice.

Notice 2012–39 describes the primary transaction of concern as follows:

USP, a domestic corporation, owns 100 percent of the stock of UST, a domestic corporation. USP’s basis in its UST stock equals its value of $100x. UST’s sole asset is a patent with a tax basis of zero. UST has no liabilities. USP also owns 100 percent of the stock of TFC, a foreign corporation. UST transfers the patent to TFC in exchange for $100x of cash and, in connection with the transfer, UST distributes the $100x of cash to USP and liquidates.

The taxpayer takes the position that neither USP nor UST recognizes gain or dividend income on the receipt of the $100x of cash. USP then applies the section 367(d) regulations to include amounts in gross income under §1.367(d)-1T(c)(1) in subsequent years. USP also applies the 367(d) regulations to establish a receivable from TFC in the amount of USP’s aggregate income inclusion. USP takes the position that TFC’s repayment of the receivable does not give rise to income (notwithstanding the prior receipt of $100x in connection with the reorganization). Accordingly, under these positions, the transactions have resulted in a repatriation in excess of $100x ($100x at the time of the reorganization and then through repayment of the receivable in the amount of USP’s income inclusions over time) while only recognizing income in the amount of the inclusions over time.

The Notice also notes that the transaction can be accomplished through the foreign subsidiary’s assumption of liabilities belonging to the domestic corporation. Another variation on the theme occurs when a controlled foreign corporation (CFC) uses deferred earnings to acquire the stock of a domestic corporation from an unrelated party for cash, followed by an outbound asset reorganization of the domestic corporation, avoiding income inclusion under section 956.

Given the IRS’s “significant policy concerns” about these transactions, this Notice should be taken as a warning for taxpayers who may have engaged in these transactions in recent years – expect the issue to be challenged under examination. Those companies may want to revisit their financial accounting reserve for these items and prepare for the controversy coming up around the bend.

Read the notice here:
IRS Notice 2012-39

Tax Court: Deed Is Substantiation of Conservation Easement Donation

The Tax Court continues to define the limits on the charitable donation of conservation easements while the IRS maintains its frontal assault on these transactions. In Averyt v. Commissioner, the Tax Court considered respondent’s motion for summary judgment and petitioner’s cross-motion for partial summary judgment on the question of whether or not the timely recorded deed of conservation easement satisfied the substantiation requirements of IRC Sec. 170(f)(8).

IRC Sec. 170(f)(8) generally requires that a charitable contribution of $250 or more must be substantiated with a contemporaneous written acknowledgment from the donee organization. A written acknowledgement must include

(i) the amount of cash and a description (but not value) of any property other than cash contributed; (ii) whether the donee organization provided any goods or services in consideration, in whole or in part, for any property; and (iii) a description and good faith estimate of the value of any goods or services.

The IRS argued that, as a matter of law, the taxpayers had not met the substantiation requirements of Section 170(f)(8). The taxpayers argued that the conservation deed was a contemporaneous written acknowledgment of the charitable contribution that satisfied Section 170(f)(8).

The Commissioner relied on Schrimsher v. Commissioner, T.C. Memo. 2011-71, where the court held that the contribution of a conservation easement was not deductible because the taxpayers did not receive a contemporaneous written acknowledgment from the donee organization. The taxpayers in Schrimsher relied on the conservation deed as evidence that the donee acknowledged the donation. The deed recited consideration of “the sum of TEN DOLLARS, plus other good and valuable consideration.” The Court held that the deed did not meet two of the three requirements of Section 170(f)(8) because it did not describe the property donated or provide a good faith estimate of its value.

The deed recorded in this case, however, recited consideration more particularly. The conservation easement in Averyt was granted “in consideration of the foregoing recitations and of the mutual covenants, terms, conditions, and restrictions hereinunder set forth.” The Court found that the deed language in this case compared favorably with the deed in Simmons v. Commissioner, T.C. Memo. 2009-208, aff’d, 646 F.3d 6 (D.C. Cir. 2011) where the Court held that the deed satisfied the Sec. 170(f)(8) substantiation requirements. Accordingly, the Court found that the deed in this case met all of the requirements of Section 170(f)(8) including the provision that no goods or services were received in exchange for the donation.

The Court granted petitioner’s motion for partial summary judgment. The Court also determined that material questions of fact remained with regard to the other issues in dispute, so a trial may be forthcoming to determine those facts.

Read the opinion here:
Averyt v. Commissioner, TC Memo. 2012-198

Tax Court: Apartment Building Cost Segregation Largely Denied

This case arises from an unusual set of circumstances that include an aggressive cost segregation report and a “missing” taxpayer. The potentially avoidable determinations made in this case may concern many who specialize in property depreciation and cost segregation.

AmeriSouth XXXII was one of several apartment complexes owned by general partner AmeriSouth Texas and controlled by real estate investor Ruel Hamilton. AmeriSouth XXXII acquired a then 33-year old “garden-style” apartment complex in 2003. It promptly started a $2 million renovation and commissioned a cost segregation report. The report broke down the apartment complex (generally 27.5 year property) into over 1000 parts and moved several items into 5 year and 15 year property classifications for depreciation purposes. The changes substantially accelerated AmeriSouth’s depreciation expense on the property. AmeriSouth XXXII reported depreciation expense of $632,674 in 2003, $1,578,212 in 2004, and $818,143 in 2005. Under examination the IRS adjusted the depreciation expense in each year by $314,996, $508,977, and $255,778, respectively. That is the aggressive cost segregation study.

The missing client is more unusual. Either very near or during the time the case went to trial, AmeriSouth Texas and Mr. Hamilton sold the apartment complex held by AmeriSouth XXXII and decided to abandon its defense of the claimed depreciation. It did this by refusing to respond to communications from the Tax Court, IRS Counsel and its own lawyers, even as they were litigating the case at a Buffalo trial session. After an extension of time and several attempts to reestablish communication, the litigation team requested permission to withdraw from the matter prior to post-trial briefings. The court allowed the attorneys to withdraw but there is little question that the lack of post-trial briefing did not benefit the taxpayer and resulted in several of the conclusions reached by the court. That is the missing taxpayer.

Before we get to the court’s determinations, there is one more thing to cover. This case, AmeriSouth XXXII v. Commissioner, is a Memorandum Opinion of the Tax Court heard and authored by Judge Mark V. Holmes. As experienced observers know, depreciation cases are always fact intensive and rarely result in new legal conclusions. Thus, they are often not published as official reports of the Tax Court, i.e., division or conference opinions. Rather, depreciation cases are often disposed of, as this case was, in memorandum opinions where the emphasis is on the application of well established law to the particular facts of the case.

Memorandum opinions are not published in the official Tax Court Reports and have limited, if any, legal precedent. However, all memorandum opinions since 1995 are published on the U.S. Tax Court website and have been published in print by various legal publishing houses for decades. These opinions establish the application of settled law in certain factual circumstances. While many will insist, correctly, that memorandum opinions are not legal precedents they nonetheless are important guideposts for the court on factual matters. When on point, these cases are often followed by the Tax Court when similar facts reappear before the court (presumably in order to create a pattern of consistency and predictability for taxpayers). As further evidence of the relative importance of memorandum opinions, please consider that the court recently announced a uniform method for spot-citing memorandum opinions and will adopt that method in its own opinions beginning on August 1, 2012. In short, observers should not be surprised if the same determinations made on specific items of property in this case are cited in future decisions of the court. You can also almost certainly expect to see revenue agents relying on these determinations to make adjustments under examination.

Given all of that, where did Judge Holmes come down on the reclassified items claimed by the taxpayers? The list of reclassed items in this case is long, and as the judge quipped in the opinion, “[t]he details of depreciation spur many to more interesting pastures.” Accordingly, the entire 61-page opinion is included below for those who wish to sift through the details.

Highlights include wins for the taxpayer on the water-distribution system, the underground portion of “site electric”, and the gas lines (once it reached the apartments). However, the taxpayer won these issues because the Commissioner did not raise them until trial and thus bore the burden of proof, which he did not carry. Judge Holmes also allowed the taxpayers to depreciate electrical outlets located in the apartments to service refrigerators, stoves and laundry machines over 5 years under the rationale that they were not structural components, i.e. depreciable over the same 27.5 year period as the apartment building, but instead were personal property which served a specific piece of equipment. See generally, Hosp. Corp. of Am. v. Commissioner, 109 T.C. 21, 54-55 (1997). The Commissioner won nearly every other item claimed by AmeriSouth including some that may surprise practitioners who specialize in this area such as site preparation, HVAC and sanitary sewer.

Read the entire opinion here:
AmeriSouth XXXII v. Commissioner, TC Memo. 2012-67

Tax Court: No Deduction for Burning Down the House

The Tax Court held that taxpayers who allowed local firefighters to conduct training exercises in a house they owned, which included burning the house to the ground, could not deduct the value of the destroyed structure as a charitable contribution under Section 170.

Taxpayers purchased a property in Vienna, Virginia with the intent of tearing down the existing structure and building a new home on it. Rather than simply tearing the existing house down the taxpayers allowed the Fairfax County Fire and Rescue Department to burn the house down as part of a training exercise. Before allowing the fire department to destroy the house, the taxpayers hired an outside appraisal firm to value the property with the then-existing structure. The taxpayers deducted approximately one half of the appraised value of the property as a non-cash charitable deduction. The IRS disallowed the deduction under examination and imposed accuracy-related penalties.

The court held that the taxpayers only gave the fire department a license to use the house and did not convey a property interest in the property. Since the taxpayers donated only the use of the property, it only constituted a partial property interest and therefore did not meet the requirements of Section 170(f)(3). Despite disallowing the deduction in full, the court refused to impose penalties.

Read the entire opinion here:
Patel v. Commissioner, 138 T.C. No. 23 (2012)

Please note that the opinion made no mention of the Talking Heads or their music. Compare U.S. v. Abner, 825 F.2d 835 (5th Cir. 1987).