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NEWS & INSIGHTS
Publications
13 MAY 2009

Obama Administration's Fiscal Year 2010 Revenue Proposals Revenue Proposals
TAX ALERT

The US Department of the Treasury has released its General Explanation of the Administration's Fiscal Year 2010 Revenue Proposals (Greenbook). The Greenbook, issued on May 11, 2009, contains important new details relating to the tax law changes that President Barack Obama proposed on May 4, 2009. Set forth below is a brief summary of what we view as the most important of the proposals. Provisions Affecting Individual Taxpayers Ordinary Income. The top two rate brackets applicable to ordinary income (33 percent and 35 percent) would be increased to 36 percent and 39.6 percent, respectively, in taxable years beginning after December 31, 2010. For married individuals filing a joint return, the 35 percent bracket would begin at taxable incomes greater than $250,000 less the standard deduction and two personal exemptions (estimated to be approximately $235,000). The starting points for the 39.6 percent bracket would track the starting points for the 35 percent bracket under current law ($372,950 in 2009 for joint return filers). The current system of indexing the bracket breakpoints would continue. Capital Gains and Qualified Dividends. The maximum tax rate on long-term capital gains and qualified dividends would be increased to 20 percent for married individuals filing a joint return having taxable incomes greater than $250,000 less the standard deduction and two personal exemptions. The reduced rates applicable under current law to gains on assets held over 5 years would be repealed. These changes would take effect in taxable years beginning after December 31, 2010. Limitations on Deductions of Higher Income Taxpayers. For taxable years beginning after December 31, 2010, most itemized deductions would be reduced by 3 percent of the amount by which AGI exceeds statutory floors ($250,000 in the case of joint return filers) which are higher than those in effect under a current law provision being phased out, but not by more than 80 percent of the otherwise

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allowable deductions. The floors would be indexed annually for inflation. For taxable years beginning after December 31, 2010, the tax value of all itemized deductions would be limited to 28 percent of the amount by which they would otherwise reduce taxable income in the 36 percent or 39.6 percent brackets. A similar limitation also would apply under the AMT. This proposal would apply to itemized deductions after they have been reduced under the limitation discussed in the preceding paragraph. The proposal would phase out deductions for personal exemptions of taxpayers having AGI in excess of certain levels. The AGI levels at which the phase-out begins would be adjusted for inflation starting with a value of $250,000 in 2009 for joint return filers. Estate and Gift Tax Reforms. The proposal would impose several new rules that would limit the ability to minimize estate and gift taxes through valuation discounts and “freezes.” The proposal would require consistency between the decedent or donor of property and the recipient of property in determining the basis of the property. The proposal would apply special valuation rules for interests in family controlled entities that would make valuation discounts more difficult to sustain. The proposal would also prohibit the use of “grantor retained annuity trusts” as valuation “freeze” vehicles if the retained interest period is less than 10 years. These proposals would generally become effective upon enactment. Provisions Affecting Taxpayers Generally Codification of the "Economic Substance Doctrine." The proposal would essentially impose, by statute, a variation of the common law "economic substance" doctrine upon "transactions." Under the proposal, a transaction satisfies the economic substance doctrine only if (i) it changes in a "meaningful" way (apart from federal tax effects) the taxpayer’s economic position and (ii) the taxpayer has a "substantial" purpose (other than a federal tax purpose) for entering into the transaction. The proposal would also provide that a transaction will not be treated as having economic substance solely by reason of a profit potential unless the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the net federal tax benefits arising from the transaction. It is not clear how broadly this rule would apply. A new penalty is also proposed that would apply a 30 percent penalty to the amount of an understatement of tax that is found to result from a transaction lacking economic substance. No effective date was provided; the change might be deemed retroactive. Taxation of Partnership Profits Interests (including Carried Interest) as Ordinary Income. Under the proposal, partnership income allocated to a partner who has received a partnership interest in exchange for services would be taxed as ordinary income, regardless of the underlying character of the income, and would be subject to self-employment taxes. Also, gain on the sale of a partnership interest received in exchange for services would be taxed as ordinary income. Income or gain attributable to a service partner’s capital contributions of money or other property to the partnership would not be subject to the ordinary income rule, provided that the capital contribution was not funded by a loan made or guaranteed by the partnership or any partner. The proposal states that it is not intended to adversely affect the qualification of a real estate investment trust that owns a carried interest in a real estate investment partnership but it does not indicate whether publicly traded partnerships would be adversely affected. Although similar to the Levin bill recently introduced in Congress (H.R. 1935), the proposal would apply to all partnership profits interests received for services, not just interests received for investment services. Thus, although the Levin bill and similar legislative initiatives target the “carried interest” received by hedge fund and private equity fund managers, the proposal would apply to service

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partners in other contexts as well, including service providers who receive interests in startup companies organized as partnerships or LLCs. The proposal would apply to taxable years beginning after December 31, 2010. Miscellaneous Provisions Affecting Businesses Intention to Work with Congress to Lengthen the NOL Carryback Period for More Taxpayers. The Administration signaled its desire to include more taxpayers in the expanded five year NOL carryback period that was enacted for businesses whose gross receipts do not exceed $15M in the stimulus package of February 17 (the American Recovery and Reinvestment Act of 2009) but made no concrete proposal. Repeal of Last-In, First-Out Inventory Accounting Method (LIFO). The proposal would repeal the LIFO method of valuing inventories, which is beneficial in a time of cost inflation but which is not permitted under International Financial Reporting Standards. In their first taxable years beginning after December 31, 2011, taxpayers would need to adjust their beginning LIFO inventories to their FIFO values. The resulting, one-time increase in gross income would be taken into account ratably over that taxable year and the following seven taxable years. Repeal Lower-of-Cost-or-Market Inventory Accounting Method (LCM). The proposal would prohibit taxpayers from writing down the value of inventories under the LCM method and from writing down the cost of “subnormal” goods, as these are one-way mark-to-market elections which can only benefit taxpayers. Wash-sale-type rules would be enacted to preclude taxpayers from restating values by selling and repurchasing inventories. A book-tax conformity rule would be imposed on the retail method of valuing inventories. These changes would be effective for taxable years beginning after 12 months from the date of enactment, and any resulting, one-time increase in gross income would be including ratably over a four year period beginning with the year of change. Provisions Affecting Foreign Persons and Multinational Taxpayers Repeal of the "Check-the-Box" Rules. Under the proposal, a foreign eligible entity may be treated as a disregarded entity only if the single owner of the foreign eligible entity is created or organized in, or under the law of, the foreign country in, or under the law of, which the foreign eligible entity is created or organized. Therefore, a foreign eligible entity with a single owner that is organized or created in a country other than that of its single owner would be treated as a corporation for federal tax purposes. As phrased, the proposal indicates that corporate treatment will affirmatively be imposed and that taxpayers cannot simply rely upon the common law entity classification rules that prevailed prior to the 1997 introduction of the "Check-the-Box" Rules. Except in cases of US tax avoidance, the proposal would generally not apply to a first-tier foreign eligible entity wholly owned by a United States person. The proposal would be effective for taxable years beginning after December 31, 2010. Deferral of Deductions Expenses (Except for R&E Expenses) Related to Foreign Income. The proposal would defer a deduction for expenses (other than research and experimentation expenditures) of a US person that are properly allocated and apportioned to foreign-source income to the extent the foreign-source income associated with the expenses is not currently subject to US tax. The amount of expenses properly allocated and apportioned to foreign-source income generally would be determined under current Treasury regulations. The amount of deferred expenses for a particular year would be carried forward to subsequent years and combined with the foreign-source expenses of the US person

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for such year before determining the impact of the proposal in such year. The proposal would be effective for taxable years beginning after December 31, 2010. Requirement that Foreign Tax Credits be Determined on a Pooling Basis. Under the proposal, a US taxpayer would be forced to determine its deemed paid foreign tax credit (under section 902) on a consolidated basis by determining the aggregate foreign taxes and earnings and profits of all of the foreign subsidiaries with respect to which the US taxpayer can claim a deemed paid foreign tax credit (including lower tier subsidiaries described section 902(b)). The deemed paid foreign tax credit for a taxable year would be determined based on the amount of the consolidated earnings and profits of the foreign subsidiaries repatriated to the US taxpayer in that taxable year. Thus, taxpayers who currently might have separate pools of low-taxed and high-taxed income would be forced to commingle such pools, producing a blended effective foreign tax rate for crediting purposes. The proposal would be effective for taxable years beginning after December 31, 2010. Adoption of a Foreign Tax Credit "Matching" Rule. The proposal would adopt a "matching" rule to prevent the “separation” of creditable foreign taxes from the associated foreign income. Evidently, this proposal would statutorily repeal the so-called technical taxpayer rule, under which the person considered to have paid the foreign tax is the person on whom foreign law imposes legal liability for such tax. Thus, the Administration is proposing a statutory override of the result arising under Guardian Industries. The proposal would be effective for taxable years beginning after December 31, 2010. Modifications Relating to Intangible Property Transfers. The proposal would affirmatively provide that the definition of intangible property for purposes of sections 367(d) and 482 includes workforce in place, goodwill and going concern value. The reference to “goodwill and going concern value” requires further clarification, particularly in light of the fact that such property currently is expressly excluded from the application of section 367(d) by regulation. The proposal would also provide a rule requiring that in a transfer of multiple intangible properties, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. Finally, the proposal would also require that intangible property be valued at its “highest and best use,” as it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. All three of these issues have been characterized by substantial controversy between the IRS and taxpayers. The proposal would be effective for taxable years beginning after December 31, 2010. Modification of the Section 163(j) Interest Rules in the Case of an “Expatriated Entity.” The proposal would revise section 163(j) to tighten the limitation on the deductibility of interest paid by an “expatriated entity” to related persons. The current law debt-to-equity safe harbor would be eliminated. The 50 percent adjusted taxable income threshold for the limitation would be reduced to 25 percent of adjusted taxable income with respect to disqualified interest other than interest paid to unrelated parties on debt that is subject to a related-party guarantee (guaranteed debt). The 50 percent adjusted taxable income threshold would generally continue to apply to interest on guaranteed debt. The carry-forward for disallowed interest would be limited to ten years and the carry-forward of excess limitation would be eliminated. An “expatriated entity” would be defined by applying the rules of section 7874 and the regulations thereunder as if section 7874 were applicable for taxable years beginning after July 10, 1989. This special rule would not apply, however, if the surrogate foreign corporation is treated as a domestic corporation under section 7874. The proposal would be effective for taxable years beginning after December 31, 2010.

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Modification of Section 356(a) with Respect to Cross-Border Reorganizations. The proposal would repeal the boot-within-gain limitation of section 356(a)(1) in the case of any reorganization in which the acquiring corporation is foreign and the shareholder’s exchange has the effect of the distribution of a dividend, as determined under section 356(a)(2). The proposal would be effective for taxable years beginning after December 31, 2010. Repeal the 80/20 Company Provisions. The proposal, motivated by a concern that the provisions can be “manipulated,” would be effective for taxable years beginning after December 31, 2010. Compliance Provisions. The proposal contains numerous provisions designed to combat underreporting of income through use of accounts and entities in offshore jurisdictions. These proposals would generally be effective beginning after the date of enactment and will be the subject of a separate alert that will be posted to this site. Extensions of Subpart F Active Financing and Look-Through Exceptions. This proposal would extend, through December 31, 2010, the section 954(h) Subpart F active financing exception and the section 954(c)(6) Subpart F look-through exception. Provisions Affecting Financial Instruments Requirement that Corporations Accrue Interest Income on the Forward Sale of Their Stock. This proposal would require a corporation to treat as interest income a portion of the payment on a contract to issue its stock in the future in exchange for consideration to be paid in the future (a forward sale) of its stock equal to an imputed time-value element of the contract. It appears that the imputed interest would accrue at the time payment is made rather than during the life of the contract. The proposal is designed to treat a corporation’s forward sale of its stock identically to its current sale of stock for a note, in terms of taxing the time-value element—but from the corporation’s perspective only. In a current sale for a note, the buyer would be entitled to a deduction for interest expense, while no such deduction appears available under this proposal. The proposal would apply to forward contracts entered into after December 31, 2010. Ensure Payment of Dividend Withholding Tax on Equity Derivatives. This proposal would change the source rule for part of the income earned by a foreign person on a swap referencing US equities. To the extent that swap income is attributable to dividends paid by a US corporation, it would be US-source to a foreign person and the counterparty would need to withhold. As an exception, the entire income earned by a foreign person on a swap referencing US equities would be considered foreign source if: (i) the referenced shares are a limited proportion of a public float and have an objectively observable price; (ii) the foreign person does not sell the shares to the counterparty at the outset and the contract does not require the counterparty to hedge; (iii) the swap lasts for at least 90 days; and (iv) the collateral requirements are limited. This exception would clearly not embrace a total return equity swap for a brief period around a dividend record date. As for foreign-to-foreign US share loans, Notice 97-66 will be revoked and the “cascading dividend” problem will be dealt with by regulation. The proposal would apply to payments made after December 31, 2010. Requirement that Certain Dealers of Equity Options, Commodities and Securities Treat Income from Dealer Activities as Ordinary. This proposal would revoke the automatic capital gain treatment (60 percent long term, 40 percent short term) of dealer income for dealers in commodities and commodities derivatives, securities and equity options. It would be effective for taxable years beginning

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after the date of enactment. Restrict the Deductibility of Repurchase Premium for Convertible Debt. This proposal would broaden the definition of controlled and controlling corporations into whose stock debt is convertible, for purposes of the existing restrictions on the deductibility of premium on the repurchase of such debt. It would be effective on the date of enactment. Modification of the Rules that Apply to Sales of Life Insurance Contracts. The proposal would impose information reporting on (i) buyers of existing life insurance contracts with death benefits of at least $1 million and (ii) insurance companies upon payment of policy benefits to such buyers. The proposal would also ensure that exceptions to the “transfer-for-value” rule do not apply to buyers of existing life insurance contracts. This rule normally requires buyers of life insurance contracts to recognize income when death benefits are received; however, current law exceptions to the rule are considered too broad in light of a significant increase in the number of life settlement transactions. The proposal would apply to the sale of policies and the payment of death benefits for taxable years beginning after December 31, 2010. Provisions Affecting Energy Matters Elimination of Oil and Gas Company Preferences. All of the following proposals (other than the excise tax on offshore oil and gas production) would be effective for years beginning in 2011. Tax on Certain Offshore Oil and Gas Production. The proposal would impose an excise tax on certain offshore oil and gas production. This proposed excise tax, the details of which (including the proposed effective date) are yet to be determined, could end the tax free production of oil and gas from the Outer Continental Shelf. Repeal of the Current Expensing and Amortization rules for Intangible Drilling Costs (IDC). The proposal would repeal the present IDC expensing and amortization rules, in favor of the generally applicable uniform capitalization rules. Currently operators of oil and gas property may elect to deduct the cost of IDCs, including expenditures for wages, fuel, repairs, hauling and supplies, as an expense in the year paid or incurred. An operator that has elected to deduct IDCs may, nevertheless, elect to capitalize and amortize certain IDCs over a 60-month period, beginning with the month the expenditure was paid or incurred. This rule applies on an expenditure-by-expenditure basis, allowing an operator to deduct a portion of IDC and amortize the rest, thus permitting reduction or elimination of IDC adjustments or preferences under the alternative minimum tax. Repeal of the Deduction for Tertiary Injectants. The proposal would eliminate the deduction for amounts paid or incurred for qualified tertiary injectants. Under current law, the costs of qualified tertiary injectants, which are used as part of a tertiary recovery method, are deductible as an expense in the year paid or incurred. Under the proposal the costs of qualified tertiary injectants will be subject to the uniform capitalization rules. Repeal of the Passive Loss Rules Exception for Working Interests in Oil and Gas Properties. Under the proposal, the current exemption from the passive activity loss rules for working interests in oil or gas property would be repealed . The current exemption applies to a working interest in oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest. The proposal's repeal of this exemption would subject such interests to the passive activity loss rules, pursuant to which deductions and credits attributable to

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activities in which the taxpayer does not materially participate will be limited in a given year to income and taxes allocable to passive activities. Suspended deductions and credits are carried forward to offset future passive income, or taxes allocable thereto, and are fully allowed when the taxpayer completely disposes of the activity. Repeal of Percentage Depletion for Oil and Gas Wells. The proposal would eliminate use of the percentage depletion method for oil and gas wells, in favor of the cost depletion method, for taxable years beginning after December 31, 2010. Under present law, independent producers and royalty owners of oil and gas interests calculate depletion under both the cost and percentage depletion methods and then deduct the larger of the two amounts. Under the percentage depletion method, the deduction equals a statutory percentage of gross income, which ranges from 15 to 25 percent for oil and gas properties. This deduction is not limited to the basis in the property. Under the cost depletion method, the deduction is equal to the amount of basis in the property that is proportionate to the amount of the property exhausted during the year. Under the cost depletion method no deduction is permitted in excess of the basis of the property and no deduction is allowable on an accelerated basis. Repeal of the Domestic Manufacturing Deduction for Oil and Gas Production. Under the proposal, the definition of domestic production activity gross receipts, used to determine the amount of the deduction for domestic production activities, would exclude receipts derived from the sale, exchange or other disposition of oil, natural gas or a primary product thereof. Increase in the Amortization Period for Geological and Geophysical Costs to Seven Years. The proposal would increase the amortization period for geological and geophysical expenditures incurred by independent producers in connection with oil and gas exploration in the United States from two years to seven years. This seven-year amortization period, which currently applies to integrated oil and gas producers, would apply even if the property were abandoned. Modification of the Alternative Fuel Mixture Credit. Effective after the date of enactment, this proposal would limit the federal excise tax credit for alternative fuels and fuel mixtures derived from the processing of paper and pulp (so-called black liquor) to mixtures that are sold for use as fuel in a motor vehicle or motor boat. Therefore, the proposal would eliminate the credit for use of black liquor mixtures as a fuel in paper processing. Proposals to Continue Certain Expiring Provisions The proposal would make the research and experimentation credit permanent. This proposal would extend certain provisions through December 31, 2010 including: the optional deduction for state and local general sales taxes, Subpart F active financing and look-through exceptions (as referred to above), the exclusion from unrelated business income of certain payments to controlling exempt organizations, the new markets tax credit, the modified recovery period for qualified leasehold improvements and qualified restaurant property, incentives for empowerment and community renewal zones, credits for biodiesel and renewable diesel fuels and several trade agreements, including the Generalized System of Preferences and the Caribbean Basin Initiative. Clearly, it is at this point impossible to predict which of these proposals will be enacted into law and, if enacted, what their final terms will be.

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For more information about the proposals, please contact: Bruce Wein Thomas S. Dick Jeffrey Korenblatt

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