3rd Circuit: Historic Rehab Tax Credits Denied for Lack of a Bona Fide Partnership

The Third Circuit Court of Appeals has reversed the Tax Court on the transfer of historic rehabilitation tax credits from the New Jersey Sports and Exposition Authority (“NJSEA”) to Pitney Bowes through the purchase of a partnership interest that held the credits.

NJSEA formed a partnership, Historic Boardwalk Hall (“HBH”), in order to sell federal historic rehabilitation tax credits (section 47) earned when it redeveloped an Atlantic City property known as East Hall. A number of investors purchased interests in the partnership. The partnership interest allowed the investors to claim ownership of the rehab tax credits for the purposes of offsetting other federal taxable income. Pitney Bowes purchased a partnership interest and used the credits to offset its taxable income.

The IRS challenged the validity of the partnerships and the two sides found themselves in the U.S. Tax Court. The Tax Court found in favor of the taxpayers in Historic Boardwalk Hall v. Commissioner, 136 T.C. No. 1 (2011). The IRS appealed.

The appellate court focused on the government’s argument that Pitney Bowes “should not be treated as a bona fide partner in HBH because [it] did not have a meaningful stake in the success or failure of the partnership.” The Third Circuit viewed the transactions through the lens of the Second Circuit’s opinion in TIFD III-E v. United States, 459 F.3d 220 (2d Cir. 2006) (better known as “Castle Harbour“) and the Fourth Circuit’s holding in Virginia Historic Tax Credit Fund LLC 2001 v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Applying that perspective, the Third Circuit determined that Pitney Bowes was not a bona fide partner in the HBH partnership. It follows that Pitney Bowes therefore was not entitled to use the historical rehabilitation tax credits held in the partnership.

The taxpayer argued in favor of the substance of the partnership, but was rebuked by the Court of Appeals with this strong language, “[r]ecruiting teams of lawyers, accountants, and tax consultants does not mean that a partnership, with all its tax credit gold, can be conjured from a zero-risk investment of the sort [Pitney Bowes] made here.” As suggested by the amici in this case, this opinion may have a chilling effect on future historic redevelopment projects by limiting the transfer of the valuable historic rehabilitation tax credits generated by those projects.

Read the opinion here.
Historic Boardwalk Hall v. Commissioner, No. 11-1832 (3d Cir. August 27, 2012)

Food Lion Loses Forced Combination Fight and Gains Penalties in North Carolina Court of Appeals

Delhaize v. Lay has been a closely followed case on the North Carolina “forced combination” question. Interest waned a bit when the North Carolina Court of Appeals decided against Wal-Mart on the same issue in Wal-Mart v. Hinton, 197 NC App, 30, 676 S.E.2d 634 (NC App. 2009). In Wal-Mart, the court found that the Department of Revenue could force combined reporting to reflect the “true earnings” of the enterprise regardless of whether or not it made a finding of “non-arm’s length pricing” between the company’s related entities. The big box retailer petitioned the North Carolina Supreme Court for review but was denied a hearing.Now comes Delhaize, the parent company of the grocery chain, Food Lion, who had the unfortunate luck to have to follow in Wal-Mart’s wake.

It all started in 1998, when Delhaize, with the assistance of Coopers & Lybrand (now PwC), entered into a state tax planning strategy designed to exploit states that employ the separate reporting method of calculating state income tax. The strategy involved isolating trademarks, trade names, and other assets in a new legal entity in a single state. The new entity would then charge the parent entity royalties and fees for the intellectual property and services housed in the new entity, usually at a pre-determined arm’s length rate. The parent entity would deduct these business expenses even though the fees collected by the new entity later would be returned to the parent company as inter-company dividends. On a consolidated tax return the fee expense and the inter-company dividend would be eliminated against one another having no real effect on reportable income. However, in a separate reporting state only the expense items hit the tax return. The result was a reduction in taxable income in the separate reporting state for the expense of payments that never left the corporate family.

Most separate reporting states had statutory provisions in place to prevent this kind of manipulation by forcing the two related entities to file a combined tax return thus bringing the dividend income back into the picture and triggering the tax neutral inter-company elimination. The arm’s length standard was often employed to justify a forced combination. If the inter-company transactions were not arm’s length, and supported by credible documentation to that effect, then the state could force the combination of the returns. This is exactly what happened under audit for Delhaize. Delhaize maintained that the transactions were arm’s length and therefore the state could not force the combination.

As we mentioned before, it was Wal-Mart who tripped up Delhaize. Wal-Mart made the arm’s length argument and lost at both the North Carolina Business Court and the Court of Appeals. When the North Carolina Supreme Court denied review of their case, the cards had been dealt. Delhaize also lost at the North Carolina Business Court on the substantive tax issues. However, they were vindicated on penalties. The Business Court found that the penalties were an unfair violation of 14th Amendment due process, a violation of the power of taxation under the North Carolina constitution, and that the state had abused its discretion in applying the penalty.

Feeling their oats after the Business Court’s strong language dismissing the penalties, Delhaize decided to try a similar approach to reverse the substantive tax issue at the Court of Appeals. Delhaize argued on appeal that North Carolina had violated their 5th Amendment Due Process rights when it changed the “guidelines” for applying its forced combination authority and adopted a “new approach” without properly notifying taxpayers. The Court of Appeals roundly rejected the argument. The other three arguments put forth by Delhaize were all rejected as governed by the binding authority of the Wal-Mart decision.

By putting the substantive tax arguments into play with the appeal, Delhaize also gave the state an opportunity to challenge the Business Court’s determination on the penalties. The state did exactly that and the Court of Appeals agreed with them. It rejected the lower court’s decision on the penalties and reversed the order to refund $1.8 million in penalties to Delhaize.

Read the entire opinion here:
Delhaize v. Lay, No. 11-868-1 (NC App. Aug. 21, 2012)

LB&I Announces End of Tiered Issue Process

On Friday, the Large Business and International (“LB&I”) division of the IRS abandoned the Tiered Issue Process according to an announcement to the field by Division Commissioner, Heather Maloy. The IRS will replace the Tiered Issue Process with two “knowledge management groups”: Issue Practice Groups (“IPGs”) for domestic issues and International Practice Networks (“IPNs”) for international issues. Agents and managers at all levels are encouraged to contact these resource groups for guidance on unfamiliar or complex technical issues.

The Tiered Issue Process was established primarily to ensure consistent treatment of certain high-profile issues. Foreign Tax Credit Generators, Research Tax Credit Claims, and Backdated Stock Options are all examples of Tiered Issues. The IRS has replaced the Tiered Issue Process in an effort to “[balance] the need for consistency with the recognition that there is no “one size fits all” approach to examining and resolving issues.”

The L&BI withdrawal from the Tiered Issue approach is comprehensive. All Tier I, II, and III issues are no longer tiered. All guidance for these issues should no longer be consulted or followed, including Industry Director Directives (“IDDs”). References to Tiered Issues in the Internal Revenue Manual, Coordinated Issue Papers, or Industry Guides, are no longer valid.

Taxpayers currently defending a Tiered Issue at any stage of controversy should reference this guidance.

Read the release here:

California Court of Appeal Decision on MTC Election Vacated for Rehearing

On August 9, 2012, the California Court of Appeal (1st Appellate District) “on its own motion and for good cause” vacated its decision and opinion issued on July 24, 2012 in Gillette v. Franchise Tax Board, and ordered a rehearing.

The vacated opinion held that, absent a complete or specific repeal, the Multistate Tax Compact (“MTC”) was binding on member states and a member state could not prevent taxpayers from electing into the MTC’s three-factor apportionment method. The appellants and other practitioners welcomed the decision but, alas, it is no more. Taxpayers and advisors anxious to take action based on the decision will have to wait.

Though the Court of Appeal’s order indicates that the decision to rehear the case was on its own motion, the Franchise Tax Board had filed a Motion for Rehearing the day before which was met by a request to modify the opinion by one of the appellants’ counsel (the case had been consolidated on appeal). It seems that the court did not recognize either motion in its order, but it did make it clear that “additional briefing from any party or any amicus curiae is not requested.”

A date for rehearing has not yet been scheduled.

Second Circuit: Exxon Mobil Entitled to Retrospective Interest Netting

The Second Circuit Court of Appeals has affirmed the decision of the Tax Court holding that Exxon Mobil is entitled to net interest for periods of overlapping underpayments and overpayments even where the statute of limitations for one “leg” of the overlapping periods has expired.

Congratulations to the taxpayer’s lead counsel and fellow blogger, Alan Horowitz, and our friend on the brief, Kevin Kenworthy.

Read the entire opinion here:
Exxon Mobil v. Commissioner, No. 11-2814 (2d Cir. August 8, 2012)

Second Circuit Vacates Tax Court in Façade Easement Case

Second Circuit Court of Appeals The Second Circuit Court of Appeals vacated and remanded the U.S. Tax Court’s finding that Ms. Huda Scheidelman failed to obtain a qualified appraisal for the 2004 façade easement donation over her New York City home.

In March of 2003, Ms. Scheidelman and her husband completed a façade conservation easement application and made a fully refundable $1,000 deposit to the National Architectural Trust (“NAT”). The taxpayers waited to pursue the donation until 2004, so that they could save enough money to pay for the appraisal.  In April of 2004, the taxpayers hired an appraiser from a list of appraisers provided by NAT.

The appraiser’s report used the sales comparison approach to determine that the estimated market value of the property was $1,015,000.  Looking at historical comparisons of attached row homes in New York City, the appraiser determined that the façade easement value is about 11% to 11.5% of the total value of the property.  Using these estimates the appraiser found that the value of the façade conservation easement would be estimated at $115,000 or 11.33% of the fee simple value of the property.

After receiving the appraisal, NAT notified Ms. Scheidelman that all of the trust’s easement owners must make a cash contribution toward operating costs equivalent to 10% of the cash value of their easement. Ms. Scheidelman wrote NAT a check for $9,275. NAT accepted the appraisal and the City of New York recorded the conservation deed of easement for the property. The taxpayers attached Form 8283 to their 2004 tax return reporting a $115,000 gift to charity. They carried over $63,083 of the reported contribution to their 2005 and 2006 tax returns.

The IRS conducted an examination of Ms. Scheidelman and disallowed her cash contribution to NAT and the deductions for her conservation easement in all three years. The IRS issued a notice of deficiency and Ms. Scheidelman filed a petition with the United States Tax Court. In Scheidelman v. Commissioner the Tax Court ruled that she did not obtain a “qualified appraisal” under Treas. Reg. § 1.170A-13(c)(3) because it did not use a sufficient method and basis of valuation. The Tax Court also disallowed a deduction for a cash contribution to NAT.

On appeal, the Second Circuit considered the Tax Court’s interpretation of Treas. Reg.  § 1.170A-13(c)(3), qualified appraisals. The appellate panel focused on the Tax Court’s interpretation of Treas. Reg. §§ 1.170A-13(c)(3)(ii)(J)&(K), requiring that a qualified appraisal specify both a method and a basis of valuation. 

The Court of Appeals disagreed with the Tax Court’s conclusion that the appraiser did not provide a proper method of valuation under Treas. Reg. § 1.170A-13(c)(3)(ii)(J). The court held that the appraiser’s use of the “before and after” method and his reliance on a published IRS article proposing an acceptable discount range for facade easements was appropriate.

Reviewing the basis of valuation requirement under Treas. Reg. § 1.170A-13(c)(3)(ii)(K), the Second Circuit found that the appraiser’s approach was “nearly identical” to the method used in Simmons v. Commissioner. The court noted the similarities between the two cases and held that the appraisal provided by Ms. Scheidelman gave the IRS “sufficient information to evaluate the claimed deduction,” thus satisfying Treas. Reg. § 1.170A-13(c)(3)(ii)(K).

The Second Circuit also held that Ms. Scheidelman’s $9,275 cash donation was a deductible charitable contribution because NAT did not give her any goods or services, any benefit, or anything of value in return for her donation. The Court noted that although Scheidelman hoped to obtain a charitable deduction for her gifts, it was not a quid pro quo because the facade easement deduction would not come directly from the receipt of the cash gift. 

The case was remanded to the Tax Court for further findings on the value of the easement consistent with the findings of the Court of Appeals.

Read the entire opinion here:
Scheidelman v. Commissioner, 682 F.3d 189 (2nd Cir., June 15, 2012).