articles - morgan lewis

December 2009Volume 9, Number 12

Planning PerspectiveRecent Legislative Developments in Renewable Energy Tax IncentivesBy Robert G. McElroy, Michael J. Schewel and Jonathan G. Neal (McGuireWoods LLP) .............................. p. 2

Federal TaxTextron, Inc. Petitions Supreme Court to Review the First Circuit’s Evisceration of the Work Product PrivilegeBy Douglas S. Stransky (Sullivan & Worcester LLP) ............ p. 3

IRS Issues Proposed Regulations on Basis Reporting by Mutual Funds and BrokersBy Gregory J. Nowak and Bryan D. Keith (Pepper Hamilton LLP) ...................................................................................... p. 4

IRS Issues Document Corrections Program for Deferred Compensation Plans under Code Section 409ABy Leslie E. DuPuy, Daniel L. Hogans, Mims Maynard Zabriskie and Allison T. Wilkerson (Morgan, Lewis & Bockius LLP) ......................................................................... p. 7

Tax Court Upends IRS’s Billion Dollar Buy-in Valuation Adjustment in VeritasBy C. Cabell Chinnis Jr., Gregory L. Barton, Brian P. Trauman and John C. C. Hughes (Mayer Brown LLP) ......................... p. 15

HOW US BUSINESS MANAGES ITS TAX LIABILITY

Advisory Board page 6

www.wtexec.com/dts.htmlwww.wtexec.com/dts.htmlwww.wtexec.com/dts.html

Pending Legislation Offers Tax Breaks to Renewable Energy ProjectsNew renewable energy projects, including wind, biomass and solar, would benefit from tax incentives offered in several bills introduced in both the House and Senate in December. The incentives include Section 45 production tax credits and depreciation deductions. Page 2

Supreme Court Asked to Determine if Tax Work Papers are PrivilegedLast year’s controversial decision in U.S. v. Textron permitted the IRS to view tax accrual work papers, including those that had been prepared by counsel. Textron has petitioned the Supreme Court to review the decision. Page 3

December Deadline for Avoiding Punitive Tax Penalties for Errors in Deferred Compensation PlansA recently released IRS Notice provides employers with guidelines for correcting inadvertent errors in fashioning deferred compensation plans. Employers should review plans and make necessary changes before the December 2010 deadline to avoid signifi cant penalties. Page 7

Court Rejects IRS Re-valuation of Intangibles The U.S . Tax Court ruled in December that the IRS’s re-valuation of intangibles contributed by a parent company was arbitrary and capricious. The potential impact of the decision on audits and transfers of intangibles is far-reaching. 5

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2 Practical US/Domestic Tax Strategies® December 2009

FEDERAL TAX

Tax Incentives, continued on page 12

Planning Perspective

Four new bills recently introduced in Congress would amend or clarify tax incentives available for certain renew-able energy projects and, for a subset of such projects, would extend or expand current tax incentives.

Tax Technical Corrections Act of 2009 On December 2, 2009, House Ways and Means Commit-tee Chairman Charles Rangel (D-N.Y.) and Ranking Member Dave Camp (R-Mich.) introduced H.R. 4169, Tax Technical Corrections Act of 2009 (Corrections Bill). The Corrections Bill makes technical corrections to recently enacted tax legislation, including corrections to the energy provisions of the Internal Revenue Code (Code), as amended earlier this year by the American Recovery and Reinvestment Act (Stimulus Act). The Stimulus Act provided, in relevant part, that tax-payers who timely place in service certain renewable energy facilities—including wind, biomass, and municipal solid waste facilities—may elect to claim one of three tax incen-tives: a Section1 45 production tax credit (PTC), a Section 48 investment tax credit (ITC), or a new federal grant generally equal to the amount of the ITC that could be claimed with respect to such facility (grant). Previously, such facilities were eligible only for the PTC. In general, the PTC is calculated based on the amount of electricity produced by the taxpayer and sold to an unrelated party over a ten-year period. Conversely, the ITC (and grant) is equal to 30 percent of the basis of qualifi ed property that is an integral part of a qualifi ed energy facility timely placed in service during the taxable year. The ability to elect the ITC or grant in lieu of PTC allows taxpayers to select a tax incentive that best fi ts their particular needs. The Stimulus

Robert McElroy ([email protected]) and Michael Schewel ([email protected]) are Partners, and Jonathan Neal ([email protected]) is an Associate, with the Richmond, Virginia offi ce of McGuireWoods LLP. Mr. McElroy is Chair of the fi rm’s Business Tax Group. His practice is focused on tax issues related to public corporations and private business, including acquisitions, joint ventures and tax-advantaged capital restructurings. Mr. Schewel’s practice is concentrated primarily on corporate law, mergers and acquisitions, and the development and fi nancing of energy projects. Mr. Neal specializes in tax matters associated with domestic and cross-border mergers and acquisitions, debt and equity offerings, and tax controversies.

Recent Legislative Developments in Renewable Energy Tax IncentivesBy Robert G. McElroy, Michael J. Schewel and Jonathan G. Neal (McGuireWoods LLP)

Act prohibits taxpayers from claiming more than one such incentive.

The Corrections Bill clarifi es congressional intent for certain points that arguably were unclear in the Stimulus Act. Namely, the Corrections Bill makes the following clarifi cations:

1. The ITC or grant in lieu of PTC is available only for facilities that otherwise would be eligible for PTC un-der Section 45 (i.e., a qualifi ed investment credit facil-ity)—except there is no requirement to sell the electricity generated to an unrelated third party.

2. The ITC or grant in lieu of PTC is available only for tangible property that is an integral part of the quali-fi ed investment credit facility. As currently drafted, the statute could be interpreted to mean that all tangible personal property qualifi es, regardless of whether it is

The bills would extend or expand tax incentives for some types of renewable

energy projects.

an integral part of the facility. This proposed change would be consistent with the legislative history of the Stimulus Act and applicable Treasury Department guidance, both of which clearly indicate that all tan-gible property must be used as an integral part of the facility.

3. For ITC in lieu of PTC, the original use of the property must begin with the taxpayer. For the grant in lieu of ITC or PTC, the original use of the property must begin with the taxpayer and the property must be originally placed in service by the taxpayer. Although the appli-cable Treasury Guidance indicated the applicability of these requirements, a plain reading of the Code did not compel it.

4. The grant in lieu of ITC or PTC is not includible in al-ternative minimum taxable income (including adjusted current earnings of a corporation) and excessive grants are recaptured as if they were underpayments of tax owed by the persons to whom the grant was made.

5. Certain information relating to applications for the grant in lieu of ITC or PTC does not constitute return information for purposes of Section 6103 of the Stimulus

December 2009 Practical US/Domestic Tax Strategies® 3

FEDERAL TAX

Textron, continued on page 13

On December 24, 2009, Textron, Inc. (Textron) fi led a petition with the United States Supreme Court for a writ of certiorari to review a decision of the Court of Appeals for the First Circuit, which held, en banc, that Textron’s tax accrual workpapers are not protected by the work product privilege.1

Because the decision by the en banc court “has thrown the law of work product protection into disarray,”2 at-torneys and their clients can only hope that the Supreme Court will “intervene and set the circuits straight on this issue which is essential to the daily practice of litigators across the country.”3

Background In June 2005, the Internal Revenue Service (IRS) issued a summons to Textron seeking its tax accrual workpapers for 2001. When Textron refused to produce these workpapers on privilege grounds, the government sought to enforce its summons in the district court. The district court held that the work product privilege protected Textron’s workpapers because they were prepared in anticipation of possible litiga-tion in an unsettled area of the law.4 The court therefore de-nied the government’s petition to enforce the IRS summons seeking Textron’s workpapers.5 In January 2009, the Court of Appeals for the First Circuit, in a 2-1 panel, affi rmed the lower court on the question of work product privilege.6

In March 2009, the First Circuit agreed to rehear the Textron work-product privilege ruling en banc.7 As a result, the court withdrew the panel opinion and the dissent, and vacated the earlier judgment.

The En Banc Decision The en banc court overturned the district court’s deci-sion, concluding that “the work product privilege is aimed at protecting work done for litigation, not in preparing fi nancial statements. Textron’s workpapers were prepared to support fi nancial fi lings and gain auditor approval . . .”8

The majority of the First Circuit found no precedent for a case “in which a document is not in any way prepared “for” litigation but relates to a subject that might or might not oc-casion litigation.”9 The court then fashioned a new test for determining if documents are entitled to work product pro-tection by requiring an inquiry into whether the documents were “prepared for” use in possible litigation.10 According

Doug Stransky ([email protected]) is a Tax Partner in the Boston offi ce of Sullivan & Worcester LLP. His practice is concentrated in international tax planning for multinational companies across a wide range of industries with a particular emphasis on U.S.-based companies investing in foreign jurisdictions. He is a member of the Advisory Board of Practical Tax Strategies.

Textron, Inc. Petitions Supreme Court to Review the First Circuit’s Evisceration of the Work Product PrivilegeBy Douglas S. Stransky (Sullivan & Worcester LLP)

to the court, work product protection only applies to docu-ments “prepared for” litigation or trial, but does not apply to the subject matter of a document “that might conceivably be litigated.”11 In applying this new test, it is not “enough that the materials were prepared by lawyers or represent legal thinking . . . It is only work done in anticipation of or for trial that is protected.”12

Petition for Writ of Certiorari In its petition for a writ of certiorari, Textron sets forth three reasons why the Supreme Court should hear the case. First, Textron argues that the en banc decision widens the existing split in the circuits over the scope of the work product privilege. Second, Textron asserts that the en bancdecision is wrong as a matter of law. Finally, Textron’s petition emphasizes that the question presented is one of paramount importance to all attorneys and their clients and

Under the newly fashioned text of the First Circuit, the work product privilege

does not protect materials that were prepared by lawyers or that refl ect legal

thinking if the documents were not specifi cally prepared for trial.

thus deserves the Court’s attention. Each of these reasons is discussed below.

Widening the Split Among Circuits. According to Textron, eight courts of appeal have interpreted the “anticipation of litigation” requirement as a “because of” test, protecting documents “prepared or obtained because of the prospect of litigation.”13 However, “documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation” do not receive protection.14 In contrast, the Fifth Circuit has ad-opted the “primary purpose” test.15 The “primary purpose” test restricts work product protection to those documents that were prepared primarily to assist in litigation.16 This confl ict among the circuits existed before the First Circuit’s en banc decision. Textron’s petition emphasizes that the First Circuit’s new “prepared for” test confl icts with those of the other nine courts of appeals that have adopted either the “because of” test or the “primary purpose” test. In addition, many state courts have applied the “because of” standard. Further, whether work product protection is available in the First


Tax Basis, continued on page 5

FEDERAL TAX

On December 16, 2009, the Internal Revenue Service (IRS) issued proposed regulations (REG-101896-09) regarding the reporting of tax basis by stockbrokers and mutual fund companies to investors and the IRS. The proposed regulations refl ect new rules enacted in 2008 by the Energy Improvement and Extension Act (part of the Emergency Economic Stabilization Act, Public Law 110-343) (Act). IRS Commissioner Douglas Shulman stated that “this important reporting change will improve tax compliance while reducing the recordkeeping and paperwork burden for millions of investors. These taxpayers will now receive the information they need to more easily report their gains and losses correctly.”1

The proposed regulations describe, among other things, who is subject to the applicable reporting requirements, which transactions are reportable, and what information needs to be reported. Some of the key aspects of the proposed regulations follow.

Reporting Requirements Section 6045 generally provides that brokers must provide to customers and the IRS certain information, such as the gross proceeds from the disposition of securities.2

For these purposes, the term “broker” includes not only those persons one might associate with the term, such as a stockbroker or real estate broker, but includes any U.S. or foreign person that in the ordinary course of a trade or business stands ready to effect sales (including redemptions and terminations) to be made by others. Section 6045(g), as amended by the Act, expands the broker reporting requirements, and provides that brokers must report to customers and the IRS the customer’s adjusted tax basis in “covered securities” sold, and whether any gain with respect to such securities is long-term or short-term.

Comment: The new Section 6045(g) reporting requirements are effective for dispositions of most corporate shares that are covered securities starting January 1, 2011. The new rules are effective for regulated investment company (RIC) shares or dividend reinvestment plan (DRP) shares that are

Gregory Nowak ([email protected]) is a Partner, and Bryan Keith ([email protected]) is an Associate, with Pepper Hamilton LLP. Mr. Nowak’s practice is focused on securities law, particularly in representing investment management companies on matters arising under the Investment Companies Act of 1940 and the related Advisers Act of 1940. He is resident in Pepper Hamilton's Philadelphia offi ce. Mr. Keith’s practice is concentrated in federal and state corporate tax matters. He is in the Washington, D.C. offi ce.

IRS Issues Proposed Regulations on Basis Reporting by Mutual Funds and BrokersBy Gregory J. Nowak and Bryan D. Keith (Pepper Hamilton LLP)

covered securities starting January 1, 2012.The information required by Section 6045 must be

reported on Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, which will be modifi ed under the proposed regulations. Section 6045(b), as amended by the Act, extended the due date by which brokers must provide Form 1099-B to customers from January 1 to February 15. The proposed regulations generally maintain the rule that brokers must report the activities within an account in a single information return. However, the IRS pointed out in the preamble to the proposed regulations that brokers must report covered securities separately from non-covered securities, and must report gain on covered securities as

The proposed regulations would eliminate the “double-category method” for

determining average basis.

short-term or long-term gain. Thus, the IRS noted that a single sale in an account could necessitate as many as three returns if the sale included covered securities held more than a year, covered securities held one year or less, and non-covered securities.

Covered SecuritySection 6045(g)(3)(A), as enacted under the Act,

provides that a “covered security” is any “specified security” acquired on or after the applicable date, as discussed above, if the security (1) was acquired through a transaction in the account in which the security was held, or (2) was transferred to that account from an account in which the security was a covered security, but only if the broker receiving custody of the security receives an information statement for the statement. Section 6045(g)(3)(B) provides that a “specifi ed security” is any (1) share of stock in a corporation, (2) note, bond, debenture, or other evidence of indebtedness, (3) commodity, or a contract or a derivative for a commodity, and (4) other fi nancial instrument as determined by the IRS.

Determining Adjusted Tax Basis The proposed regulations provide rules regarding how a broker should calculate the adjusted tax basis of securities held in a customer’s account. The proposed regulations clarify that, generally, a taxpayer’s adjusted basis in securities held in his or her account is the amount paid, adjusted for commissions and certain other transactions. Brokers must adjust the basis reported on Form 1099-B to


FEDERAL TAX

Tax Basis, continued on page 6

Tax Basis (from page 4)

take into account certain information available to the broker, including information received on a transfer statement in connection with the transfer of a security or information received from the stock issuer about corporate actions affecting basis. However, brokers are generally not required to adjust the reported basis for transactions or events occurring outside of the customer’s account and without the broker’s direct actual knowledge.

Comment: The proposed regulations adhere to the general rule under Section 6045(g)(2)(B)(i)(I) that for corporate stock in a customer’s account, a broker must determine and report basis using the FIFO (fi rst-in, fi rst-out) method for determining what shares were sold. In situations in which a customer does not sell all shares of a particular corporate security held in an account, the customer may request that the broker use a permissible method other than FIFO, and the selling broker must follow the customer’s instructions to identify the specifi c shares sold. Thus, customers may specifi cally identify the shares to be sold or request that another method, such as average basis, be used.

In contrast to the rule for most corporate stock held in an account, the general rule under Section 6045(g)(2)(B)(i)(II) for RIC and DRP shares provides that basis must be calculated based on the broker’s default method. The default method is not prescribed by statute or regulation, and the broker may choose any permissible method as its default method. Once again, however, the customer is permitted to notify the broker that he or she has elected an alternative permitted method and, if so, the broker must adhere to such elected method.

Average Basis Method The proposed regulations would eliminate the “double-category method” for determining average basis. Under current rules, Treas. Reg. Section 1.1012-1(e)(3) and (4) provide that taxpayers may compute average basis by choosing one of the two available methods. The “double-category method” divides stock by the holding period and averages long-term shares separately from short-term shares. The “single-category method,” however, ignores the short-term versus long-term distinction and averages all shares together.

Comment: Only the single-category method would be permitted under the proposed regulations. Brokers must use a FIFO ordering rule when determining the holding period of stock to which the single-category basis method applies.

The proposed regulations extend to DRP stock the average basis method of Treas. Reg. Section 1.1012-1(e) that is already available for RIC stock. Thus, taxpayers would be permitted to elect the average basis method for DRP shares acquired after December 31, 2010. DRP shares are eligible for the average basis method only if they are identical. The

proposed regulations defi ne identical shares of stock as stock with the same Committee on Uniform Security Identifi cation Procedures (CUSIP) number. Shares acquired through a DRP are not considered identical to shares not acquired through a DRP even if the shares have the same CUSIP number. Certain corporate actions, such as mergers, consolidations, spin-offs, or split-offs, will not cause the underlying shares to be ineligible for averaging; the stock of a successor entity following such a corporate action is identical to the stock of the predecessor entity.

Comment: Commentators had suggested to the IRS that even if a customer requested a broker to do so, brokers should not be required to compute basis for a DRP using the average basis method. The IRS rejected this suggestion. The broker must use the average basis method if elected by the taxpayer; otherwise, the broker must use its default method. The proposed regulations do not mandate a broker default method for RIC or DRP shares, and the broker may determine its own default method.

Taxpayers should elect the average basis method on the income tax return for the fi rst year when the taxpayer desires the method under Treas. Reg. Section 1.1012-1(e)(6). The taxpayer must notify his or her broker of the election in writing in order to request the broker to follow the method. The proposed regulations provide that a taxpayer may change from the average basis method to another permissible method at any time, and that such a change is considered a change in method of accounting subject to Sections 446 and 481.

Wash Sales Under the proposed regulations, brokers must report the effect of wash sales under Section 1091 only if the purchase and sale transactions occur with respect to covered securities in the same account with the same CUSIP number. The broker must report the amount of the disallowed wash sale loss in addition to the adjusted basis and gross proceeds for the sold security. Then, upon the subsequent sale of the purchased security, the broker must adjust the basis of the purchased security by the previously disallowed loss.

Comment: The IRS did not incorporate into the proposed regulations certain wash sale reporting exceptions as requested by commentators for certain de minimis items and for high frequency traders. The IRS still appears to be considering the matter and has requested additional comments about the treatment of high frequency traders under this rule, including comments on the inter-relatedness of the Section 475 mark-to-market rules, which generally exempt traders from the Section 1091 wash sale rules.

Sales by S Corporations Recently enacted Section 6045(g)(4) requires brokers to report sales by S corporation customers of covered securities


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Tax Basis (from page 5)

Richard E. AndersenArnold & Porter LLP (New York)

Joan C. ArnoldPepper Hamilton LLP (Boston)

William C. BenjaminWilmer Cutler Pickering Hale and Dorr LLP

(Boston)

Eric J. Coffi llMorrison & Foerster

(Sacramento)

Joseph B. Darby IIIGreenberg Traurig LLP (Boston)

David FlanaganDJF Consulting (Boston)

Jeff FriedmanSutherland Asbill & Brennan LLP

(Washington, DC)

Jorge GrossPricewaterhouseCoopers LLP

(Miami)

Jamal Hejazi, Ph.D.Gowlings, Ottawa

Lawrence M. HillDewey & LeBoeuf LLP (New York)

Marc LewisSony USA (New York)

Advisory BoardLisa C. Lim

Ernst & Young (New York)

Keith MartinChadbourne & Parke LLP

(Washington, DC)

Yongjun (Peter) NiErnst & Young (New York)

Antoine PaszkiewiczKramer Levin Naftalis & Frankel LLP

(Paris)

Kevin RoweReed Smith (New York)

Eric D. RyanDLA Piper (Palo Alto)

John A. SalernoPricewaterhouseCoopers LLP

(New York)

Michael J. SemesBlank Rome LLP (Philadelphia)

Michael F. SwanickPricewaterhouseCoopers LLP

(Philadelphia)

Edward TanenbaumAlston & Bird LLP (New York)

David R. TillinghastBaker & McKenzie LLP (New York)

acquired on or after January 1, 2012. This rule is an exception to the general rule under Treas. Reg. Section 1.6045-1(c)(3)(i)(B)(1) that a broker is not required to report sales of securities by a corporation. The proposed regulations clarify the new rule, and provide that the broker is not permitted to rely solely on the customer’s name to determine whether it is a corporation exempt from reporting, since a corporate name does not generally distinguish a C corporation from a S corporation. If a broker does not have actual knowledge that a corporation is a C corporation exempt from reporting, the broker must either request a Form W-9 exemption certifi cate from the corporation or else make and deliver to the corporate customer and the IRS a return of information for such corporation for sales of covered securities acquired on or after January 1, 2012.

Transfers of Gifted or Inherited Securities Under the proposed regulations, gifted or inherited securities would retain “covered security” status when transferred from the account of the donor or decedent to the recipient’s account. In both instances, a transfer statement should accompany the gifted or inherited shares. For inherited shares, the transfer statement must indicate (i) that such securities are inherited, (ii) the acquisition date (date

of death), and (iii) the adjusted basis in accordance with instructions and valuations from the estate’s authorized representative. The selling broker must then take this information into account when the shares are disposed by the recipient on a subsequent sale. For gifted shares, the transfer statement must indicate (i) that such securities are gifted, (ii) the adjusted basis in the hands of the donor, (iii)the donor’s original acquisition date, (iv) the date of the gift (if known), and (v) the fair market value of the gift (if known) on the transfer date. Similarly, the selling broker must then take this information into account when the recipient disposes of the shares in a subsequent sale.

Comments on the Proposed Regulations The IRS has requested comments by February 8, 2010 on the proposed regulations and its preliminary draft of the new Form 1099-B. In addition, a public hearing on the proposed regulations is scheduled for February 17, 2010.________________1IRS News Release, IR-2009-118 (Dec. 16, 2009).2Unless otherwise stated, all references to “Section” are to the Internal Revenue Code of 1986, as amended, and all references to the “Regulations” or to “Treas. Reg.” are to the Treasury Regulations promulgated thereunder.

© 2010 Pepper Hamilton LLP q


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409A, continued on page 8

On January 5, 2010, the Internal Revenue Service (IRS) issued Notice 2010-6 (Notice), which establishes a document correction program for nonqualifi ed deferred compensation programs under section 409A of the Internal Revenue Code (Section 409A). Previously, the IRS had only permitted correction of operational failures, specifically excepting document errors from such correction. The Notice is a signifi cant piece of guidance that fi lls the hole left by prior guidance. Affected taxpayers now have the opportunity to voluntarily correct both operational failures under Section 409A and failures to comply with the document requirements under Section 409A, potentially saving immediate and punitive taxes that can be triggered by innocent errors in arrangements covered by Section 409A. Importantly, the Notice provides a relatively generous initial timeline to correct document errors, setting the transitional deadline for fixing document failures at December 31, 2010, which is extremely valuable in that it substantially limits the income inclusion and additional taxes that might otherwise apply. The Notice does, however, include some potential traps for the unwary. One of the most signifi cant pitfalls is that while the Notice does permit the correction of many

Leslie E. DuPuy ([email protected]) is an Associate, and Daniel L. Hogans ([email protected]) is a Partner, in Morgan Lewis’s Washington office. Mims Maynard Zabriskie ([email protected]) is a Partner in the Philadelphia offi ce, and Allison T. Wilkerson ([email protected]) is an Associate in the Dallas offi ce. Ms. DuPuy focuses her practice on a variety of employee benefi ts and compensation matters, including equity and incentive compensation plans, nonqualified deferred compensation plans, employment arrangements, tax-qualifi ed retirement plans, severance programs, and health and welfare arrangements. Mr. Hogans’s practice is concentrated in benefi ts and compensation matters, including equity and incentive compensation plans, employment arrangements, nonqualifi ed deferred compensation plans, ERISA, qualifi ed retirement plans, and pension and profi t-sharing plans. Ms. Zabriskie designs and assists in the implementation of executive compensation programs, equity compensation plans such as stock option plans and tax-qualifi ed retirement plans. Ms. Wilkerson focuses her practice on the design, implementation, and administration of tax qualifi ed and nonqualifi ed retirement plans, including 401(k) plans, employee stock option plans, and executive and deferred compensation plans; regulatory compliance with the Internal Revenue Code and ERISA; and plan correction through various benefi t plan correction programs.

IRS Issues Document Corrections Program for Deferred Compensation Plans under Code Section 409ABy Leslie E. DuPuy, Daniel L. Hogans, Mims Maynard Zabriskie and Allison T. Wilkerson (Morgan, Lewis & Bockius LLP)

document failures without current tax consequences or the imposition of additional taxes under Section 409A, the Notice also includes a number of instances in which an employee may face a negative tax result upon the occurrence of subsequent events. Under several of the correction procedures, various scenarios can result in an employee having to include up to 50 percent of the amount deferred under the plan in income, and to pay both federal income taxes as well as the additional 20 percent penalty tax under Section 409A on such amount. Another administrative

The costs of a failure to comply with Section 409A are potentially enormous and can be disproportionate to the magnitude

of the error.

concern with making corrections under the Notice is that, as with prior correction guidance issued to correct Section 409A failures, most of the correction procedures set forth in the Notice require that both the employer1 and all affected employees2 comply with notice and reporting requirements. In light of the favorable transition rules and the expectation that the IRS intends to increase audit activity under Section 409A, it is important for employers to review nonqualifi ed deferred compensation plan arrangements to determine if correction may be necessary and, if so, take quick action to meet the more advantageous correction principles applicable before December 31, 2010.

Background Section 409A generally provides that all amounts deferred under a nonqualified deferred compensation plan are currently includible in gross income to the extent they are not subject to a substantial risk of forfeiture unless the plan meets specifi ed restrictions, including, for example, restrictions as to the timing of deferral elections and permissible distributions. Section 409A applies to a wide variety of compensatory arrangements in addition to traditional deferred compensation plans, including a number of arrangements not intuitively viewed as deferred compensation arrangements (e.g., severance and change-in-control arrangements, equity compensation plans, discounted stock options, and stay or sign-on bonuses). Failure to comply with the requirements of Section 409A generally results in automatic taxation of all amounts deferred under the plan (whether or not actually paid or


FEDERAL TAX


409A (from page 7)

available), and such amounts are subject to an additional 20 percent federal penalty tax (and potentially a similar state tax) plus an interest charge, bringing the effective tax rate on the amounts involved to well over 50 percent. The costs of a failure to comply with Section 409A are potentially enormous and can be disproportionate to the magnitude of the error. Section 409A generally became effective as of January 1, 2005, but was subject to transition relief provisions that expired effective January 1, 2009.3

Transition Relief One of the most favorable provisions of the Notice is the ability to correct document failures during a transition period on or before December 31, 2010 or December 31, 2011 without subjecting the deferred amount to tax under Section 409A. If a plan document failure is corrected under the Notice on or before December 31, 2010, the plan may be treated as having been corrected on January 1, 2009 (the transition relief expiration date), and no income inclusion under Section 409A will be required as a condition of the relief. However, as part of the correction, any operational failures arising out of the retroactive amendment to the plan (e.g., payments made in 2009 or 2010 that should not have been made under the corrected plan) must be corrected on or before December 31, 2010 under Notice 2008-113. The transitional rules also permit correction of certain document failures on or before December 31, 2011, including correction of (i) impermissible provisions linking nonqualifi ed deferred compensation plans, (ii) payment schedules determined by the timing of payments received by the employer, and (iii) errors impacting employers under examination for returns covering periods beginning on or before December 31, 2011.

The opportunity to correct documentary mistakes under this more benefi cial regime, i.e., without facing negative tax consequences, will expire at the end of 2010 or, as noted, in some instances at the end of 2011. In order to take advantage of the transition period, all correction steps must be completed by December 31, 2010, or December 31, 2011, as applicable. Prompt attention is required to fi rst determine if correction is necessary, then if needed, to complete all necessary correction steps.Complete correction, even under the transition rules, requires compliance with the notice and reporting requirements set forth in the Notice.

Eligibility Requirements The rules for correction under the Notice are detailed, and in some cases complex. The Notice is clear that the relief is available only for document failures that are inadvertent and unintentional. The relief is not available for document failures that are directly or indirectly related to participation in an abusive tax-avoidance transaction. The Notice provides that correction is not available for a document failure unless the employer identifi es all other nonqualifi ed deferred compensation plans that have a similar document failure

and all such failures are corrected in a manner consistent with the Notice. Except as provided under the transition rules, the Notice does not generally provide relief for document failures due to plans linked to qualifi ed plans or other nonqualifi ed deferred compensation plans. In addition, the relief does not apply to a stock right.

Issues Addressed under the Notice The Notice generally addresses the following issues, each of which is discussed in greater detail below:

• application of Section 409A to certain ambiguous plan terms

• correction of faulty distribution provisions— correction of impermissible defi nitions of otherwise permissible payment events

— correction of impermissible payment periods following a permissible payment event

— correction of impermissible payment events and payment Schedules

— correction of failure to include six-month delay of payment for specifi ed employees

• correction of provisions providing for impermissible initial deferral elections

• amendment period following an employer’s initial adoption of a plan

• information and reporting requirements The Notice also (i) modifi es Notice 2008-113 to clarify the application of certain correction methods and the calculation of certain amounts if payment would have been made in shares of stock, and (ii) modifi es Notice 2008-115 to conform the reporting requirements under Notice 2008-115 with the tax consequences and reporting requirements under the Notice.

Application of Section 409A to Certain Ambiguous Plan Terms

The Notice provides clarifi cation that a plan provision that sets forth a permissible payment event under Section 409A, but that requires payment “as soon as reasonably practicable” following such permissible payment date (or includes substantially similar language), will generally not cause a document failure under Section 409A so long as the plan operationally complies with Section 409A. Therefore, if payment is made by the later of (i) the end of the employee’s tax year in which the payment event occurs, or (ii) two and a half months following the payment event, the failure to pay will not constitute an operational failure under Section 409A. Assuming the plan complies with the payment requirements of Section 409A in operation, the plan does not need to be amended to remove a provision that requires payment “as soon as reasonably practicable” following such permissible payment date (or that includes substantially similar language). The Notice provides that if a plan does not defi ne a payment event or has an ambiguous defi nition of the payment event, the plan generally can be amended at any


FEDERAL TAX

409A (from page 8)


time to either (i) add language requiring that the plan terms be interpreted as necessary to comply with Section 409A, or (ii) set forth explicit defi nitions that comply with Section 409A. If the deferred compensation is paid in a manner that is not compliant with Section 409A, the payment (or failure to make a payment) may be treated as an operational failure. If the facts and circumstances indicate that the employer has intentionally used ambiguous terms for a payment event, the plan is not eligible for relief under the Notice. The Notice provides instances where a term will be deemed to be no longer ambiguous, and notes that in such event, this provision of the Notice will no longer be applicable to such term.

Correction of Faulty Distribution Provisions The Notice provides a procedure for correcting faulty distribution provisions resulting from (i) an impermissible defi nition of otherwise permissible payment events, (ii)an impermissible payment period following a permissible payment event, (iii) an impermissible payment event and payment schedule, and (iv) a failure to include the six-month delay for specifi ed employees. While the Notice generally requires a plan amendment to correct the listed document failures, in many instances the Notice also imposes adverse tax consequences upon the occurrence of certain events. Most commonly, if the previous and incorrect distribution event occurs within one year after the plan correction to fi x the event under these provisions of the Notice, each affected employee must include a stated percentage (generally 50 percent) of the amount deferred under the plan that was corrected under this Notice in income for purposes of Section 409A. Including such amounts in income for purposes of Section 409A will require the employee to pay federal income taxes, as well as the additional 20 percent penalty tax under Section 409A, on such amount (but not the additional premium interest tax) for the year in which the event occurred. The tax consequences imposed by the Notice must be paid in order to complete correction.

Correction of Impermissible Definitions of Otherwise Permissible Payment Events The Notice provides relief for plans that contain impermissible definitions of the following otherwise permissible payment events: (i) separation from service; (ii)change in control; and (iii) disability. For a plan including an impermissible defi nition of separation from service and/or a change in control, the plan must be amended before the event meeting the impermissible defi nition occurs. To avoid confusion, if the plan includes an impermissible defi nition of change in control but requires a “double trigger” for payment (e.g., the plan pays upon a separation from service following a change in control event), no correction is needed, so long as separation from service is defi ned in accordance with Section 409A. If the defi nition of separation from service is corrected and within one year of the correction an event occurs that

is not a separation from service under Section 409A but would have required payment under the plan prior to its correction, or that is a separation from service under Section 409A but would not have required payment under the plan prior to its correction, the affected employee must pay taxes under Section 409A for the year in which the separation from service occurred on 50 percent of the amount deferred under the plan to which the pre-amendment plan provisions applied. The same rule applies if the defi nition of change in control is corrected, and within one year of the correction, an event occurs that is not a change in control under Section

The rules for correction under the Notice are detailed and, in some cases, complex.

409A but would have required payment under the plan prior to its correction, except that the amount included in income is reduced to 25 percent (instead of 50 percent). For a plan with an impermissible defi nition of disability, the plan may be amended to remove the payment event or defi ne the payment event as a Section 409A disability. The plan may be corrected in the same manner after an event occurs that is not a Section 409A disability but is a payment event under the plan if the amount can be, and is, corrected under Notice 2008-113.

Correction of Impermissible Payment Periods Following a Permissible Payment Event Under the Notice, a plan that correctly provides that payment will be made following a permissible payment event but then improperly provides that such payment (i) may be made or commenced during a period of time later than 90 days and earlier than 366 days following the payment event, or (ii) is conditioned on an employment-related action of the employee (e.g., the execution of a release of claims), may be amended to comply with Section 409A. A plan that includes an impermissible payment period may be amended to remove the payment period or, alternatively, provide for payment within a designated period, or upon a specifi ed date, following the payment event that complies with Section 409A. For example, a plan with an impermissible payment period may be amended to provide that payment will be made within 90 days following a permissible payment event, provided that the employee does not have the right to designate the taxable year of payment. The Notice provides fewer leniencies in amending a plan that conditions payment upon the employee completing an employment-related action (e.g., the execution of a release of claims). In this instance, the only permissible correction is to either (i) remove the condition or (ii) remove the employer’s ability to delay or accelerate the timing of payment based on the employee’s actions by setting a fi xed payment date, subject to certain conditions regarding the timing of the


409A (from page 9)

FEDERAL TAX


fi xed payment date as set forth in the Notice. For example, a plan provides for payment within 90 days of an employee’s separation from service, but not until the employee executes and submits a release of claims. The Notice states that the payment provisions do not comply with Section 409A but may be amended to either (i) remove the release requirement, or (ii) provide that payment shall be made on the 90th day following the employee’s separation from service, provided the employee has executed a release of claims and the revocation period has expired before the 90th day. The amendment may not otherwise change the time or form of payment. For a failure involving an improper payment period following a permissible payment event, if the plan is not amended before the occurrence of the permissible payment event, but complies with Section 409A in operation and is amended within a reasonable time after the occurrence of the payment event, the plan will not be treated as failing to comply with Section 409A so long as the affected employee pays taxes under Section 409A for the year in which the event occurred on 50 percent of the amount deferred under the plan to which the pre-amendment plan provisions applied. The Notice does not provide for amendments to be made after the fact with respect to correcting a plan which conditions payment upon the employee completing an employment-related action (e.g., the execution of a release of claims).

Correction of Impermissible Payment Events and Payment Schedules The Notice permits plans to be amended to correct failures resulting from provisions providing for (i)payment upon both permissible and impermissible payment events, (ii) payment upon impermissible payment events only, (iii) impermissible alternative payment schedules, (iv) impermissible discretion with respect to a payment schedule following a permissible payment event (including impermissible subsequent deferral elections), (v)impermissible employer discretion to accelerate payment events, and (vi) impermissible reimbursement or in-kind benefi t provisions. In each instance the Notice generally requires that the plan be amended to remove the provision that is not compliant with Section 409A and/or replace the provision with a provision that is both compliant with Section 409A and meets any additional requirements imposed by the Notice. Under certain correction events, the Notice limits the employer’s options for amending the payment provisions. For example, to correct a plan that provides for payments only upon impermissible payment events, the Notice requires the plan to be amended to provide for payment upon the later of the employee’s separation from service or the sixth anniversary of the date of correction. Even though Section 409A provides other acceptable payment events that could have been originally included in the plan (e.g., death, change in control), the Notice limits the permissible

payment event that may be included upon correction to the later of the employee’s separation from service or the sixth anniversary of the date of correction. Additionally, to correct a plan which includes impermissible alternative payment schedules, the Notice sets forth specific requirement for determining which impermissible alternative form of payment must be removed, and which are the appropriate remaining forms of payment. Any amendment made to the plan in accordance with this provision of the Notice must be effective prior to the event that would trigger an impermissible payment under Section 409A. An exception exists for plans permitting impermissible subsequent deferral elections. If a plan provides a default time or form of payment that would be in effect if the employee or employer did not exercise discretion to change the time or form of payment or alternatively, if the employee or employer revoked any exercised discretion more than one year before the payment event occurs, then no amounts will be included in income under Section 409A, regardless of whether an amendment was in place prior to the occurrence of the payment date.

Senior Editor: Scott P. Studebaker, Esq.

Assistant Editor: Edie Creter Contributing Editor: George Boerger, Esq.

Special Interviews: Scott P. Studebaker

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FEDERAL TAX


409A (from page 10)

As described above, the Notice imposes certain requirements on any correction undertaken for a plan that provides for payments only upon impermissible payment events. In addition to limiting the payment provisions that may be incorporated into the plan by an amendment, the Notice also imposes adverse tax consequences on all employees participating in the plan, regardless of whether a triggering payment event occurs for each employee. This means that all affected employees must pay taxes under Section 409A for the year in which the correction occurred. The taxable amount will equal 50 percent of the amount deferred under the plan to which the pre-amendment plan provisions applied.

For all other failures described in this provision of the Notice, if within one year of the correction an event occurs that would require payment under the pre-amendment provisions of the plan, and such payment would not comply with Section 409A, the affected employee must pay taxes

comply with Section 409A. The plan may be corrected by amending the plan to remove the ability to make the impermissible initial deferral election, provided that any amounts that were not paid during one or more of the employee’s taxable years due to an impermissible deferral election are treated as operational failures and corrected under Notice 2008-113. Correction must be made no later than the end of the employee’s second taxable year immediately following the taxable year during which the deadline for making an initial deferral election occurs. A plan that provides for an initial election to defer compensation that does not comply with Section 409A will not result in a failure so long as the provision has not been applied with respect to an employee. However, if either the employee or the employer does make an initial deferral election under a plan that provides for an initial election to defer compensation that does not comply with Section 409A, but all action is actually completed on or before the date required under Section 409A for an initial deferral (e.g., December 31 of the plan year preceding the plan year in which the election will be effective), the initial deferral election will be treated as having been made in accordance with Section 409A.

Amendment Period Following an Employer’s Initial Adoption of a Plan

The Notice provides a grace period for corrections made under a new plan, taking into consideration the Plan aggregation rules under Section 409A and disregarding those plans identifi ed in the Notice. A document failure can be corrected so long as it is corrected no later than the later of (i) the end of the calendar year in which the date on which the fi rst legally binding right to deferred compensation arose under the newly adopted plan, or (ii) the 15th day of the third calendar month following such date.

If the plan is properly corrected, including correction under Notice 2008-113 of operational failures that may have occurred under the non-corrected plan, the applicable section of the Notice may be applied without any requirement that an amount be includible in income if an event occurs within one year following the date of correction.

Information and Reporting Requirements The Notice requires compliance with the notice and reporting requirements for almost all of the corrections allowed under the Notice. However, there are no notice or reporting requirements for corrections made with respect to “certain ambiguous plan terms.”

The notice and reporting requirements require that the employer attach a statement to its original federal income tax return for both (i) the taxable year in which a correction is made, and (ii) if an employee is required to include an amount in income during the subsequent taxable year, the subsequent taxable year. The statement must contain certain information mandated by the Notice. This information includes the name and taxpayer identifi cation number of each

Under certain correction events, the Notice limits the employer’s options for amending

the payment provisions.

under Section 409A for the year in which the event occurred on 50 percent of the amount deferred under the plan to which the pre-amendment plan provisions applied.

Correction of Failure to Include Six-Month Delay of Payment for Specifi ed Employees

A plan that fails to include the requisite provision providing for a six-month delay of payment for a specifi ed employee may be corrected by amending the plan to incorporate the six-month delay, and to further provide that any amount payable under the plan that is subject to the six-month delay may not be paid before the later of (i) 18 months following the date of correction, or (ii) six months following the date of the payment event. Any amendment made to the plan in accordance with the Notice must be effective prior to the event that would trigger an impermissible payment under Section 409A. If, within one year of the correction, an event occurs that results in the corrected plan provisions being applied to avoid a payment that would have been due under the pre-amendment plan provision, the affected employee must pay taxes under Section 409A for the year in which the event occurred on 50 percent of the amount deferred under the plan to which the pre-amendment plan provisions applied.

Correction of Provisions Providing for Impermissible Initial Deferral Elections

The Notice allows correction of a plan that provides for an initial election to defer compensation that does not


FEDERAL TAX

Tax Incentives, continued on page 13

409A (from page 11)

employee affected by the failure, the identifi cation of the nonqualifi ed deferred compensation plan affected by the failure, and information regarding the amount involved in each failure and whether such amount is

The Notice allows correction of a plan that provides for an initial election to defer

compensation that does not comply with Section 409A.

taxable. The employer must also provide a statement to each affected employee that contains the information

outlined above but only to the extent such information relates to a deferred amount of that employee.

The employee must attach a copy of the statement to its original federal income tax return for both (i) the taxable year in which a correction is made, and (ii) the taxable year subsequent to the taxable year in which a correction is made, if the employee is required to include an amount in income during such subsequent year. As with prior guidance under Notice 2008-113, the onerous notice and reporting requirements may create signifi cant incentives for taxpayers to consider alternative solutions outside the parameters of the Notice wherever possible.____________________1While this article refers only to “employers,” the Notice applies to all “service recipients,” as defi ned under Section 409A. 2While this article refers only to “employees,” the Notice applies to all “service providers,” as defi ned under Section 409A.

© 2010 Morgan, Lewis & Bockius LLP q

Act, which means that the information is not confi den-tial and therefore is subject to disclosure (including the grant amount, the identity of the grant recipient, a description of the property, the fact and amount of any recapture, and the content of any report fi led in connection with the grant).

6. The prohibition on awarding grants to certain tax-ex-empt organizations does not apply if, and to the extent, the grant is with respect to an unrelated trade or busi-ness property, i.e., property with respect to which sub-stantially all the income is derived by an organization described in Section 511(a)(2)(relating to organizations subject to unrelated business income tax). This is con-sistent with the existing rules (under Section 50(b)(3)) for Section 48 ITC projects.

Clean Renewable Energy Advancement Tax Extension Jobs Act of 2009

In addition to the changes set forth in the Correction Bill, on December 3, 2009, Senator Chuck Grassley (R-Iowa) introduced S. 2826, the “Clean Renewable Energy Advance-ment Tax Extension Jobs Act of 2009” (Grassley Bill), which would extend the available PTC for wind and open-loop biomass projects through December 31, 2016 (which is an extension of three years under present law). Moreover, the Grassley Bill would extend for one year the 50 percent fi rst-year bonus depreciation deduction that is scheduled to expire at the end of this year. Under present law, taxpayers may take a bonus depreciation deduction for qualifi ed property acquired and placed in service in calendar year 2009 (or 2010 for certain property with longer production periods and transportation property). Generally,

Tax Incentives (from page 2)the deduction is equal to 50 percent of the adjusted basis of certain qualifi ed property timely placed in service. Subject to certain exceptions, qualifi ed property means property to which the modifi ed accelerated cost recovery system applies with a recovery period of 20 years or less, certain computer software, water utility property, and qualifi ed leasehold improvement property purchased and placed into service within the applicable time period.

American Clean Technology Manufacturing Leadership Act

On December 10, 2009, Senators Jeff Bingaman (D-N.M.), Orrin G. Hatch (R-Utah), Debbie Stabenow (D-Mich.), and Richard G. Lugar (R-Ind.), introduced S. 2857, the American Clean Technology Manufacturing Leadership Act, which would amend Section 45C of the Code to provide an additional $2.5 billion in tax credits for qualifying invest-ments in any qualifi ed advanced energy project (Qualifying Advanced Energy Project Credit). On December 16, 2009, the White House followed with its own proposal for expanding this program by up to $5 billion. The Qualifying Advanced Energy Project Credit pro-gram, established as part of the Stimulus Act, is capped at $2.3 billion and is set to run out of funding by mid-Janu-ary 2010 due to an unexpectedly high level of demand. A qualifying advanced energy project includes a project that re-equips, expands, or establishes a manufacturing facility for the production of:

1. property designed to be used to produce energy from the sun, wind, geothermal deposits, or other renewable resources;

2. fuel cells, microturbines, or an energy storage system for use with electric or hybridelectric motor vehicles;


Textron, continued on page 14

FEDERAL TAX

Tax Incentives (from page 12)

3. electric grids to support the transmission of intermittent renewable energy, including storage of such energy;

4. property designed to capture and sequester carbon dioxide emissions;

5. property designed to refi ne or blend renewable fuels, or to produce energy conservation technologies;

6. new plug-in electric drive motor vehicles, qualifi ed plug-in electric vehicles, or components that are de-signed specifi cally for use with such vehicles, including electric motors, generators, and power control units; and

7. other advanced energy property designed to reduce greenhouse gas emissions as may be determined by the Internal Revenue Service.The qualifi ed investment for any taxable year is the

basis of eligible property placed in service by the tax-payer during the taxable year that is part of the qualifying advanced energy project. Credits are available only for qualifying advanced energy projects certifi ed by the Sec-retary of the Treasury. The available credits are awarded through a competitive bidding process (applications for the original program were due to the Energy Department and IRS in mid-October, with 183 projects being awarded the full $2.3 billion in available tax credits on January 8, 2010). A taxpayer that claims the Qualifying Advanced

Energy Project Credit may not also claim the ITC, PTC, or grant for the same investment.

Renewable Energy Incentive Act On December 17, 2009, Senators Diane Feinstein (D-Calif.) and Jeff Merkley (D-Ore.) introduced S. 2899—the Renewable Energy Incentive Act—that would, among other things, extend the federal grant program established under the Stimulus Act for renewable energy projects until 2012 (under present law, the program is set to expire in 2010). In addition, the bill would permit public power utilities to receive grants for renewable energy projects. Currently, public power utilities are prohibited from receiving grants for renewable energy projects and, accordingly, must enter into complex fi nancial arrangements with private develop-ers in order to build renewable energy projects that qualify for the grants. Finally, the bill would allow a 30 percent ITC for equipment that makes solar panels, and would create a 30 percent ITC for the purchase, consolidation, and use of multiple 100 acre or less blocks of high solarity, disturbed private lands for solar development. ______________________1Unless otherwise noted, all “Section” references are to the Internal Revenue Code of 1986, as amended.

© Copyright 2010, McGuireWoods LLP. Reprinted with permission. All rights reserved. q

Textron (from page 3)

Circuit now depends on whether state or federal court is the venue for a case. Therefore, because the First Circuit’s decision widens the split, Textron argues that the Supreme Court should hear the case.

Wrong as a Matter of Law. Textron’s petition argues that the en banc court’s severe restriction on work product protec-tion is inconsistent with (1) prior First Circuit precedent, and (2) the long-recognized policies underlying work product protection.17

In Textron, the en banc court held that tax-accrual workpapers do not qualify for work product protection under its previous decision in Maine v. Dep’t of Interior18

because they are mandatory business documents, created annually by public companies to satisfy federal securities law requirements. According to the court, Textron had to create its tax accrual workpapers incident to its fi nancial reporting requirements, whether it actually anticipated litigation or not. Furthermore, because Textron (like all public companies) must generate tax accrual workpa-pers—whether or not it anticipates litigation over any spe-cifi c issue—such workpapers should not qualify for work product protection. Even where tax accrual workpapers analyze hypothetical litigation, the en banc court concluded that this does not mean they were generated to assist litiga-

tion or otherwise merit work product protection. Although the en banc majority purported to follow Maine

in its holding, Textron’s petition asserts that the court’s reason-ing is diffi cult to square with the facts and the law. As such, the decision has thrown prior precedent into disarray, includ-ing the Second Circuit’s decision in United States v. Adlman,19

which fi rst articulated the “because of” test. Indeed, as Judge Torruella in his Textron dissent noted, “Adlman’s articulation of the “because of” test is fatal to the majority’s position [because] Adlman makes it explicitly clear that the broader “because of” formulation is not limited to documents prepared for use in litigation.”20 Textron therefore argues that the Supreme Court must hear the case to correct this erroneous application of the law and establish the standard under which to apply the work product privilege.

Paramount Importance. Textron’s petition also stresses that lawyers and their clients in the First Circuit have con-cluded from the en banc decision that lawyers’ analyses of their clients’ exposures, in litigation with adversaries, must be turned over to adversaries whenever these analyses are for the clients’ use in preparing their fi nancial statements and related disclosures. As a result of the en banc court’s decision that Textron’s counsel prepared the analysis in the workpapers to assist Textron in making its fi nancial


Textron (from page 13)

FEDERAL TAX

statement disclosures, tax accrual workpapers prepared by corporate counsel to assess their clients’ potential tax li-abilities in challenges by the IRS or state tax authorities, as well as backup materials refl ecting counsels’ evaluations, are no longer protected under the work product privilege in the First Circuit..21 The court’s new “prepared for” test sets a troubling precedent that could hinder in-house counsel from preparing analyses that are of the great-

12Id. at 29-30.13See, e.g., Maine v. Dep’t of Interior, 298 F.3d 60, 67-68 (1st Cir. 2002). The Maine court recognized the need to protect documents that “although prepared because of expected litigation, are intended to inform a business decision infl uenced by the prospects of the litigation.” Id. at 68. Furthermore, Maine acknowledged that docu-ments can have dual purposes. Although dual-purpose documents can lose work product protection, they do so only if they would have been created in a substantially similar form irrespective of litigation. Therefore, dual-purpose documents—those prepared for both litigation and business purposes—should be protected under the “because of” test. 14Id. at 70.15See United States v. El Paso, 682 F.2d 530 (5th Cir. 1982). The Fifth Circuit is the only circuit that has adopted the “primary purpose” test.16Id.17The work product privilege was adopted, in part, to enable at-torneys to best serve their clients without fear that their mental processes would be subject to disclosure to their opponent. See Hickman v. Taylor, 329 U.S. 495, 511(1947). 18See n. 13, infra.19134 F.3d 1194 (2d Cir. 1998).20Textron, 577 F.3d at 33.21But cf. Comm’r of Revenue v. Comcast Corp., 901 N.E.2d 1185 (Mass. 2009) (affi rming a fi nding of work product protection for docu-ments prepared by accountants “because of” litigation, and also to enable the taxpayer to make business decisions about the outcome of that litigation). 22In addition, the majority’s opinion is troubling because of its at-tempt to “hide the ball” in its analysis. As the dissent notes, the en banc court had the power to overturn prior First Circuit precedent, “though it would be better if it admitted that it was doing so,” rather than purporting to follow Maine. Textron, 577 F.3d at 35. q

The court’s new “prepared for” test sets a troubling precedent that could hinder

in-house counsel from preparing analyses that are of the greatest importance to

corporations and their investors.

est importance to corporations and their investors.22

Under this “prepared for” test, every party (not only the IRS or state tax authorities) in commercial litigation whose opponent fi les GAAP fi nancial statements that report contingent liabilities for litigation exposure will be able to discover the hazards of litigation analysis of its opponent’s lawyers. The First Circuit’s decision has eviscerated the work product protection that exists to protect exactly the type of attorney analysis that was present in this case. Moreover, this decision goes beyond simply impacting tax workpapers, as every lawyer must now evaluate its legal advice in the context of the First Circuit’s decision. Because of the importance of this case, lawyers and their clients can only hope that the Supreme Court grants Textron’s petition.____________________1See United States v. Textron, 577 F.3d 21 (1st Cir. 2009). For further discussion of this decision, see Douglas S. Stransky, “United States v. Textron, Inc.: “The First Circuit En Banc Eviscerates the Work Product Doctrine and Creates a New ‘Prepared For’ Test,” Practical U.S./Domestic Tax Strategies (July 2009). 2Textron, 577 F.3d at 43 (Torruella, J., dissenting).3Id.4United States v. Textron, 507 F. Supp. 2d 138 (D. RI 2007).5Id. at 155.6Textron v. United States, 553 F.3d 87 (1st Cir. 2009) (vacated). For further discussion of the panel decision, see Douglas S. Stransky, “United States v. Textron, Inc.: A Hollow Taxpayer Victory for Privilege in the First Circuit,” Practical U.S./Domestic Tax Strategies(January 2009).72009 WL 775439 (1st Cir. 2009). For further discussion, see Douglas S. Stransky, “First Circuit Vacates Textron Work-Product Privilege Ruling and Grants Petition for Rehearing En Banc,” Practical U.S./Domestic Tax Strategies (January 2009).8Textron, 577 F.3d at 31.9Id. at 27.10Id.11Id. at 29.

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FEDERAL TAX

Valuation, continued on page 16

In a closely watched case concerning the valuation of preexisting intangibles in cost-sharing arrangements (CSAs), the United States Tax Court handed the taxpayer a victory in Veritas, Inc. v. Commissioner, 133 T.C. No. 14 (2009), Veritas, Inc. v. Commissioner, 133 T.C. No. 14 (2009), Veritas, Inc. v. Commissionerreleased December 10, 2009. At issue was the IRS’s claim that preexisting intangibles contributed by Veritas Inc., a U.S. corporation (Veritas US), to a CSA with its Irish subsid-iary (Veritas Ireland) had a value of more than $1.5 billion, nearly 10 times the value determined by the taxpayer. In a lengthy and sometimes strongly worded opinion, the court held that the IRS’s valuation of these preexisting intangibles was “arbitrary, capricious, and unreasonable.” The potential impact the decision will have on current audits, on the new temporary cost-sharing regulations, and, more generally, on purported transfers of intangibles, is signifi cant.

Technology License AgreementThe basic facts of the case are similar to those in many

CSAs. Through a technology license agreement (TLA), Veritas US granted rights to Veritas Ireland to conduct research and development under their CSA on various “covered intan-gibles” relating to data storage software and related devices. According to the TLA, such preexisting intangibles included various technology intangibles, such as computer programs, designs, and manufacturing process technologies.

Under the cost-sharing regulations in effect during 1999 through 2001, the years at issue in the case, Veritas Ireland was required to make a “buy-in payment” to Veritas US for this grant of rights. The taxpayer calculated the required buy-in

C. Cabell Chinnis Jr. ([email protected]) is a Partner in the Palo Alto offi ce, Gregory Barton ([email protected]) is a Partner in the Chicago offi ce, Brian Trauman ([email protected]) is a Partner in the New York offi ce, and John C. C. Hughes ([email protected]) is an Associate in the Washington offi ce, of Mayer Brown LLP. Mr. Chinnis’ practice is focused on IRS audits and appeals, as well as advance pricing agreements, tax treaties, and transfer pricing issues. Mr. Barton specializes in tax controversies and litigation, including administrative appeals, and litigation of federal tax disputes, with particular emphasis on cross-border transfer pricing of tangible and intangible goods and services. Brian Trauman’s practice is concentrated primarily on federal and international tax controversies, including transfer pricing strategies, audits, administrative appeals and litigation, and compliance and controversies through coordination of parent companies and their worldwide affi liates. Mr. Hughes’ practice is concentrated in transfer pricing planning, advance pricing agreements, competent authority proceedings, and tax controversies. The authors gratefully acknowledge the assistance of Jonathan Hunt and Lili Kazemi with this article.

Tax Court Upends IRS’s Billion Dollar Buy-in Valuation Adjustment in VeritasBy C. Cabell Chinnis Jr., Gregory L. Barton, Brian P. Trauman and John C. C. Hughes (Mayer Brown LLP)

payment to be approximately $160 million, which Veritas Ire-land paid as a lump sum in 2000. This valuation was based upon royalty rates that Veritas US had received from seven original equipment manufacturers (OEMs) for rights to incorporate Veritas US’s software and technologies into an operating sys-tem, adjusted along several dimensions. Veritas US contended that its application of the comparable uncontrolled transaction (CUT) method was the “best method” within the meaning of the Section 4821 regulations for valuing the buy-in payment.

$160 Million Adjusted to $2.5 Billion In its notice of defi ciency, the IRS adjusted the buy-in pay-ment due from Veritas Ireland by magnitudes, up to $2.5 billion. At trial, however, the IRS abandoned the method upon which this adjustment was based and the independent economic consultant who had pursued it. Instead, the IRS adopted a report using a different methodology, authored by a different consultant who then testifi ed on behalf of the IRS.

“Akin to a Sale” This consultant characterized the agreements that com-prised the taxpayer’s CSA and the conduct of the parties as being “akin to a sale” of Veritas US’s business (Opinion 39). On this view, the rights Veritas US granted Veritas Ireland to its preexisting intangibles should be aggregated and treated as a sale of Veritas US’s business rather than a sale of its discrete assets because the “assets collectively possess[ed] synergies that imbue[d] the whole with greater value than each asset standing alone” (Opinion 39). Using a discounted cash fl ow analysis, the consultant arrived at a lump-sum buy-in payment of $1.675 billion. In addition, the IRS later amended its position to allege that Veritas US had granted rights not just to its technology intangibles, but also rights of access to Veritas US’s mar-keting and R&D teams and rights to its trademarks, trade names, customer base, customer lists, distribution channels, and sales agreements. The court was critical of the substance of the IRS’s posi-tion and of the weaknesses of its presentation at trial. The court found the IRS’s testifying expert witness’s testimony to be “unsupported, unreliable, and thoroughly unconvinc-ing” (Opinion 38). The court also faulted the IRS for using terms and concepts, such as “platform contribution,” that appear only in the new temporary regulations released in January 2009, years after the audit period (Opinion 32).

The IRS’s substantive position came under attack from the court on two important fronts: the valuation method it used and the scope of intangibles that were required to be valued. First, on the valuation method, the court determined that the IRS failed to support key elements of its “akin to a sale” theory. When asked whether he believed his valuation methodology


FEDERAL TAX

Valuation (from page 15)

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accurately captured synergistic value, for example, the IRS expert testifi ed that he “really [did not] have an opinion” (Opinion 39-40). The court also found that the IRS’s valuation did not discriminate between the value of subsequently developed intangibles and the value of preexisting intangibles, thus going beyond what was required to be included in the buy-in payment (Opinion 44-45). The theory also assumed that the preexisting intangibles had a perpetual useful life, despite evidence offered by the taxpayer (and even acceded to by the IRS expert) that preexisting intan-gibles in the relevant industry would “wither on the vine” within only four years (Opinion 45). Moreover, the court took issue with the discount and growth rates used in the IRS expert’s analysis, highlighting the expert’s own concession at trial that the discount rate he used was unreasonable (Opinion 38, 46-49).

Marketing Information is Not Compensable Intangible Property

Second, the court criticized the IRS’s view on what intan-gibles were required to be valued. As indicated above, the IRS alleged during the trial proceedings that Veritas US granted rights to intangibles beyond those relating specifi cally to the development of technology, notably rights of access to Veri-tas US’s marketing and R&D teams. Citing the ambivalent testimony offered by the IRS’s expert, the court found that there was insuffi cient evidence to conclude that access to the marketing and R&D teams was either transferred to Veritas Ireland or that such items had value. In a lengthy footnote, the court added that even if such evidence had existed, these rights of access are not compensable “intangible property” within the meaning of the controlling statutory and regula-

tory framework of Section 936(h)(3)(B) and Treas. Reg. § 1.482-4(b) (Opinion 43-44, Footnote 31). The court observed that access to marketing and R&D teams is not among the specifi c intangibles recognized for purposes of Section 482. In addition, neither item is “similar to” any of the listed in-tangibles and neither has “substantial value independent of the services of any individual,” because any value inherent in these teams is based upon the work, knowledge, and skills of individual team members (Id.). In this regard, the court rejected the IRS’s arguments that existing case law, includ-ing the U.S. Supreme Court’s decision in Newark Morning Ledger v. United States and the U.S. Fourth Circuit Court of Appeals’ opinion in Ithaca Industries v. United States, supports the proposition that access to a R&D or marketing team quali-fi es under the criteria set forth above for recognition as an intangible under Section 482.

Clarifying or Materially Expanding Existing Law? Further, in the same footnote, the court referred to the current initiatives on the part of the IRS and U.S. Treasury Department and the Obama Administration regarding the defi nition of intangibles. Although it did not opine on how these efforts bore on the present case or on their broader signifi cance, one may infer from the court’s discussion that it views the Treasury Department’s effort to list workforce in place, goodwill, and going-concern value among the in-tangibles subject to Section 482 as no mere “clarifi cation” of existing law, but rather as a material expansion of it.

It is natural to read the court’s rejection of the IRS’s posi-tion against the backdrop of the temporary cost sharing regu-lations, effective January 5, 2009, and the IRS’s and Treasury Department’s stepped-up efforts to curb what they consider

abusive transfers of intangibles. From this perspective, the taxpayer’s victory in this case is undoubtedly signifi cant. The IRS stumbled in this case in its analysis of key facts and in its presentation of the under-lying rationale for the income method, which is most extensively discussed in the Coordinated Issue Paper (LMSB-04-0907-62, Sep. 27, 2007) (CIP). The question remains, though, whether the Veritas court did not so much invalidate the IRS’s income method—as that method is discussed in the CIP and incorporated into the temporary cost sharing regulations—as it did chastise the IRS for the predicates of its adjustment: questionable views on the scope of rights made available under the CSA; an unjusti-fi ed presumption of perpetual life in an industry characterized by rapid obsoles-cence; and unsubstantiated assumptions about discount rates, growth rates, and other factors critical to the calculation.__________________1Unless otherwise noted, all “Section” refer-ences are to the Internal Revenue Code of 1986, as amended.

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