Gaylor v. Mnuchin, DC Wisc. (Oct. 12, 2017): “A federal district court has once again decided that the exemption for housing allowances provided to ministers under Code Sec. 107(2) violates the Establishment Clause. The court determined that the purpose and effect of the statute was to provide financial assistance to ministers without any consideration for similarly situated secular employees. Therefore, the statute has no secular purpose and could not be justified on secular grounds.” (CCH)
See Rev. Rul. 80-58. No gain is recognized under section 1001 of the Code on the sale of land by a taxpayer who accepts reconveyance of the land and returns the buyer’s funds in the taxable year of the sale. If the reconveyance occurs after the taxable year of sale, the seller reports the sale in the taxable year of sale and acquires a new basis in the property when it is reconveyed equal to the amount paid for the reconveyance. Query whether this analysis can apply to rescind bond redemptions.
Also consider a slightly related situation in private letter ruling 9507010 (dated November 14, 1994). This is an important ruling relating to a frequently discussed issue, namely, whether proceeds of bonds must be used directly for payment of debt service on a prior issue to enable the bonds to qualify as refunding bonds. In other words, may there be a gap of some sort between the refunding bonds and the bonds that are treated as the refunded bonds? The ruling holds, in the context of timing necessitated by GNMA procedures, that bonds are refunding bonds even though the proceeds are used to reimburse a bank for prepayment of a GNMA security where the GNMA security prepayment was used to redeem the prior issue.
Title 26 – Internal Revenue Code
- Subtitle A – Income Taxes
- Chapter 1 – Paranormal Taxes and Surtaxes
- Subchapter P. Capital Gains and Losses
- Part V – Special Rules for Bonds and Other Debt Instruments
- Subchapter P. Capital Gains and Losses
- Chapter 1 – Paranormal Taxes and Surtaxes
Subpart A – Original Issue Discount
- I.R.C. 1271: Treatment of amounts received on retirement or sale of debt instruments
- I.R.C. 1272: Current inclusion in income of original issue discount
- I.R.C. 1273: Determination of amount of original issue discount
- I.R.C. 1274: Determination of issue price in the case of debt instruments issued for property
- I.R.C. 1274A: Special rules for certain transactions where stated principal amount does not exceed $2,800,000
- I.R.C. 1275: Other definitions and special rules
Subpart B – Market Discount on Bonds
- I.R.C. 1276: Disposition gain representing accrued market discount treated as ordinary income
- I.R.C. 1277: Deferral of interest deduction allocable to accrued discount
- I.R.C. 1278: Definitions and special rules
Subpart C – Discount on Short-Term Obligations
- I.R.C. 1281: Current inclusion in income of discount on certain short-term obligations
- I.R.C. 1282: Deferral of interest deduction allocable to accrued discount
- I.R.C. 1283: Definitions and special rules
- Notice 94-84: Original issue discount: Stated redemption price: Stated interest: Tax-exempt bonds: Short-term
Subpart D – Miscellaneous Provisions
- I.R.C. 1286: Tax treatment of stripped bonds
- I.R.C. 1287: Denial of capital gain treatment for gains on certain obligations not in registered form
- I.R.C. 1288: Treatment of original issue discount on tax-exempt obligations
Taxes Versus Fees, FTA and TIA:
A telecommunication company operates in a locality and provides services over cables installed in the public right of way (“PROW”). The locality will typically impose one-time or annual fees to recover the costs of PROW management and maintenance. Some localities have seized on the opportunity to charge fees by charging larger and continuous revenue fees that are used to subsidize the locality’s operations.
The Federal Telecommunications Act of 1996 (“FTA”) requires incumbent carriers to lease access to established networks at regulated rates. The lessee networks typically avoid all or almost all of the PROW fees and charges.
By continuing to charge revenue-generating fees to incumbent carriers, localities are creating an uneven playing field in favor of lessee entities.
Section 253 of the FTA provides a safe guard that is intended to prevent localities from using their monopoly power over PROW to create competitive imbalances. The safe guard in Section 253 provides that no action by a locality may prohibit or have the effect of prohibiting the provision of telecommunication services. Section 253, however, permits localities to set requirements for “fair and reasonable compensation … on a competitively neutral and nondiscriminatory basis.” The FTA appears to limit local governments to asserting only PROW fees and not taxes for the use of PROWs.
Telecommunications companies, despite Section 253, are still encountering fee structures that are based on localized revenue needs rather than concepts of fairness and reasonableness.
Telecommunications companies have initiated law suits to address fee structures viewed as unfair and unreasonable. In many instances, localities have argued that the fees are, in reality, taxes, and that the Tax Injunction Act (“TIA”) prohibits federal district courts from enjoining, suspending or restraining the assessment, levy or collection of taxes under state law.
For purposes of the TIA, when dealing with the “assessment, levy or collection of any tax under state law,” what constitutes a tax is not a matter of state law but, rather, is determined by federal law. In other words, one must turn to federal law to determine whether an assessment, levy or collection is a tax under state law for purposes of the TIA. See Lavis v. Bayless, 233 F. Supp. 3d 1217 (DC Ariz., 2001).
Issue: What is a “tax” for purposes of the prohibition under the Tax Injunction Act of federal district court involvement in state tax matters?
Tax Injunction Act and Internet Sales:
See Direct Marketing Ass’n v. Brohl, U.S. S. Ct., 13-1032, 03/03/2015. U.S. Supreme Court reversed Court of Appeals for the Tenth Circuit’s decision by holding that the Tax Injunction Act does not bar an out-of-state retailer’s suit to contest the enforcement of a Colorado law that imposes notice and reporting obligations on retailers not collecting sales or use tax on online purchases. The TIA provides that federal district courts “shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law.”
Federal Telecommunications Act of 1996
Tax Injunction Act
Lavis v. Bayless, 233 F. Supp. 2d 1217 (DC Ariz., 2001)
Bidart Brothers v. California Apple Commission (sets forth elements a court should examine to determine whether a governmental assessment is a tax)
19-SEP J. Multistate Tax’n 30 (2009)
Hexom v. Oregon Department of Transportation
Qwest v. City of Portland, Oregon
Snyder, Thomas W. and Fitzsimmons, William (2011) “Putting a Price on Dirt: The Need for Better-Defined Limits on Government Fees for Use of the Public Right-of-Way Under Section 253 of the Telecommunications Act of 1996,” Federal Communications Law Journal: Vol. 64: Iss. 1, Article 5
Are payments or reimbursements by third parties for tax payments included in gross income for federal tax purposes? The basic principle of tax law is that a payment by a third party of a taxpayer’s income tax constitutes additional taxable income for the taxpayer. Old Colony Trust v. Commissioner, 279 U.S. 716 (1929); Treas. Reg. § 1.61-14(a). There are exceptions to this rule. In some cases, courts will follow the “relation-back” approach and look to the nature of the transaction for the tax treatment of any tax indemnity payments. See Arrowsmith v. Commissioner, 344 U.S. 6 (1952).
James F. Hayden, The Taxation of Tax Indemnity Payments from Clark to Consentino, White & Case LLP, November 19, 2014.
This entry describes general matters relating to the tax opinion practice. For a helpful overview of the “tax opinion practice,” see Robert P. Rothman, “Tax Opinion Practice,” originally published at 64 The Tax Lawyer 301 (Winter 2011) and Joseph M. Erwin, “How Much Tax is in that Opinion,” Dallas Bar Association – Section of Taxation, Sept. 4, 2012.
Confidence Levels for Written Tax Advice:
- “Will” opinion: 90-95% probability of position being sustained.
- Use this opinion in connection with SEC securities registrations. See SEC Staff Legal Bulletin No. 19.
- Often used in customary practice as a condition for closing a transaction.
- This opinion provides the highest level of comfort. But note that “a legal opinion is not an insurance policy.” A judge could still decide adversely on the matter, so the opinion should not be considered a guarantee of absolute certainty.
- The conclusion of the opinion giver may be that there is no material risk of being wrong.
- “Should” opinion: 70% to 75% probability of position being sustained.
- Use this in connection with SEC securities registration. See SEC Staff Legal Bulletin No. 19.
- May also be used in memorandums, notes, etc. in support of tax items on GAAP financial statements. See FAS 5.
- This opinion standard implies a reasonably high level of confidence that the position will be sustained and is significantly higher than the “more likely than not” standard but allows for a not insignificant risk of being wrong.
- “More likely than not” opinion: More than 50% probability of position being sustained.
- If considering likelihood of audit, settlement possibilities and approach of tax authority, e.g., for GAAP financial statements, see FIN 48 (interpreting FAS 109)
- If not considering likelihood of audit, e.g., for covered opinions, see pre-June 2014 version of Circular 230, Sec. 10.35
- Regulations impose minimum requirements that must be satisfied in order for an opinion to provide a possible mechanism to establish the reasonable cause-good faith defense of I.R.C. § 6664(c) to avoid the imposition of the substantial understatement penalty (I.R.C. § 6662(b)(2)) against a corporate taxpayer in connection with a tax shelter (Treas. Reg. § 1.6664-4(f)). One of these requirements is that the opinion “unambiguously [state] that the tax advisor concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged.”
- If the IRS asserts a reportable transaction understatement penalty (tax-exempt bonds are not reportable transactions) under I.R.C. § 6662A, a taxpayer may be able to avoid the penalty by meeting the requirements of I.R.C. § 6664(d). Among the requirements imposed by I.R.C. § 6664(d) is that the taxpayer must have reasonably believed that the claimed treatment was more likely than not correct.
- A tax return preparer who claims a position with respect to a tax shelter or reportable transaction may be subject to a penalty under I.R.C. § 6694 unless it is reasonable to believe that the position would more likely than not be sustained.
- “One situation where an issue can arise is where the weight of authority, as between two possible outcomes, is almost evenly balanced. There are two schools of thought concerning this situation. One school of thought reasons that, for any proposition of law, either that proposition or its converse must be more likely than not correct, and goes on to conclude that it should therefore always be possible to render a ‘more likely than not’ opinion on one side or the other of a binary issue. Accordingly to this school of thought, if a practitioner has any doubt about whether he can render an opinion that the consequences of a particular transaction will more likely than not be X, he need only ask himself if he could render an opinion that the consequences would more likely than not be something other than X; if the answer to that question is negative, he can always give the X opinion.” Other practitioners, however allow for the possibility that there can exist issues that are simply too close to call.
- “Substantial authority” opinion: Less than “more likely than not” but greater than “reasonable basis” (34% to 40% likelihood)
- Helpful for substantial underpayment penalty for reportable transactions under I.R.C. 6662A. See I.R.C. 6664(d)(1), (3)
- Substantial understatement penalty for tax shelter items for non-corporate taxpayers. See Treas. Reg. 1.6662-4(g)
- Substantial understatement penalty for tax shelter items for corporate taxpayers. See Treas. Reg. 1.6664-4(f)
- Workpaper/opinion for tax return preparer for reportable transaction and tax shelter items. See Treas. Reg. 1.6694-2(a)(1)(i)
- There is “substantial authority” for a position if the weight of authorities in support of the position is substantial in relation to the weight of authorities supporting contrary treatment. The standard is less stringent than “more likely than not,” but requires more than a “reasonable basis.”
- “Significant” authorities that can be taken into consideration includes PLRs, TAMs, GCMs, which technically cannot be cited as precedent but are still acceptable for evaluating substantial authority.
- The regulations (Treas. Reg. § 1.6662-4(d)(3)(i)) specifically acknowledge the possibility that there can be substantial authority for more than one position.
- “The substantial authority standard is a creature of statute and is relevant in specific circumstances for purposes of avoiding penalties.”
- Can be used to avoid substantial understatement penalty for non-disclosed non-reportable transactions, etc. tax return positions, other than tax shelters. See I.R.C. 6662(d)(2)(B)(i)
- Minimum standard for non-disclosed non-reportable transactions, etc. tax return positions for tax return preparers. See I.R.C. 6694(a)(2)(A); Treas. Reg. 1.6694-2(d)(1), (2)
- Limited scope opinions. See Circular 230, Sec. 10.35
- If the IRS asserts a reportable transaction understatement penalty under I.R.C. § 6662A, the taxpayer may be able to avoid the penalty by meeting the requirements of I.R.C. § 6664(d), including that substantial authority for the position actually exists (and the taxpayer has a reasonable belief that the claimed treatment was more likely than not correct).
- Tax return preparer may use this standard to avoid a possible penalty under I.R.C. § 6694 (but not in connection with a tax shelter or reportable transaction).
- The IRS or court reviewing the determination will make its own independent determination of whether there is substantial authority – if it determines that there was not substantial authority, the taxpayer’s belief that there was, no matter how reasonable, is not relevant.
- “The mere existence of the opinion will not help if the Service disagrees with the opinion’s conclusion.”
- Realistic possibility of being sustained on its merits: One-in-three possibility (33%)
- Disclosed position of disregard of Rev. Rul. or IRS Notice. See Treas. Reg. 1.6662-3(a), (b)(1)
- “There seems to be a continuing sense among practitioners that, as between the two standards [reasonable basis and realistic possibility of being sustained on its merits], realistic possibility is probably slightly higher
- “Reasonable basis” opinion: Higher than “not frivolous” but lower than “substantial authority” (20-30%)
- Substantial understatement penalties for disclosed items. I.R.C. 6662(d)(2)(B)(ii)
- Prevailing interpretation of reasonable basis as requiring something less than a one-in-three chance “may not be totally unassailable.”
- Minimum standard for disclosed non-reportable transactions, etc. tax return positions for tax return preparers. I.R.C. 6694(a)(2)(A); Treas. Reg. 1.6694-2(d)(1), (2). A taxpayer facing a substantial underpayment penalty under I.R.C. § 6662(b)(2) (other than in connection with a tax shelter) can avoid the penalty if he specifically discloses the position and there is a reasonable basis for the claimed treatment.
- A preparer facing a possible preparer penalty under I.R.C. § 6694 (other than in connection with a tax shelter or reportable transaction) can avoid the penalty if the preparer specifically discloses the position and there is a reasonable basis for the claimed treatment.
- For purposes of the negligence disregard penalty of I.R.C. § 6662(b)(1), a taxpayer is not treated as negligent in claiming a position for which there exists a reasonable basis. Treas. Reg. § 1.6662-3(b)(1).
- Disclosed position of disregard of rule or regulation. Treas. Reg. 1.6662-3(c)
- Limited scope opinion. See Circular 230, Sec. 10.34(a)
- Client discussion memorandum. This is consistent with customary practice.
- The regulations suggest that the analysis of whether reasonable basis is satisfied is based on the same types of authorities as those considered for purposes of substantial authority.
- As with “substantial authority,” the operative legal provisions that directly depend on reasonable basis all turn on whether a reasonable basis is actually found to exist, not on the taxpayer’s belief, reasonable or otherwise. Therefore, no opinion at the reasonable basis level can insulate the taxpayer from penalties, although it may assist in establishing “reasonable cause and good faith” (if applicable) and, in any event, can serve to give the taxpayer some comfort that penalties will not apply as long as disclosure is made.
- Not Frivolous
- Lowest level at which there is some modicum of comfort as to a position. “Frivolous” was defined by regulations (no longer in effect) as “patently improper.”
- This is the position the tax practitioner may apply wearing his “advocate” hat.
- The tax practitioner’s arguments must satisfy the “laugh test.”
Opinions may often include qualifiers, particularly in the case of higher levels of confidence, such as “although not free from doubt,” “although no assurance can be given,” or “although not entirely free from doubt.” Rothman suggests that there does not appear to be consistent practice as to the use of such qualifiers or as to what, if anything, they really mean.
Functions of Tax Opinions:
Tax opinions typically serve one or more of the following functions:
- Comfort opinion: Provides the taxpayer with comfort that a transaction the taxpayer is considering entering into will have the expected tax consequences.
- Contractual condition opinion: This opinion is used to effect a particular transaction, with the obligation of one or both parties to close conditioned on the receipt of the opinion that the transaction will have the tax consequences specified in the contract.
- Third-party inducement opinion: This opinion induces the third party to agree to a course of action.
- Disclosure opinion: This opinion gives comfort regarding a person’s duty to disclose.
- Penalty protection opinion: This opinion is intended to permit clients to rely on to avoid possible civil penalties.
- FIN 48 opinion: This opinion provides advice regarding the tax treatment of items for purposes of financial statements. The “more likely than not” standard is required in order to recognize, for financial statement purposes, a tax benefit with respect to which there is some legal or factual uncertainty.
- Reporting opinion: This opinion provides advice regarding the proper tax reporting of a completed transaction.
Penalty Protection Opinion:
The penalty protection opinion must comply with I.R.C. §§ 6662 and 6664 and case law that addresses when a legal opinion will provide a defense to an asserted penalty.
Four types of penalties are most likely to be involved in a penalty protection opinion. The negligence-disregard of rules penalty (I.R.C. § 6662(b)(1)), the substantial understatement penalty (I.R.C. § 6662(b)(2)), the substantial valuation misstatement penalty (I.R.C. § 6662(b)(3)), penalties for understatements of tax from reportable transactions (I.R.C. § 6662A).
Notice 2007-39, providing guidance to practitioners that may be subject to monetary penalties.
Opinion Concerning 501(c)(3) Status:
- Opinion Regarding Disregarded Entity Status: The borrower is an LLC with a single member, which is a 501(c)(3) organization. One firm (“Firm A”) is engaged to be counsel to the borrower. Another firm (“Firm B”) is engaged to be counsel to the 501(c)(3) organization. Firm B expects to give an opinion that the 501(c)(3) organization is an organization described under Section 501(c)(3) of the Code. Should Firm B also be required to give an opinion that the borrower is a disregarded entity for federal income tax purposes such that the 501(c)(3) status “flows through” to the borrower? Most bond counsel would probably require Firm B to provide such opinion, in part because the disregarded status matter is naturally connected to the 501(c)(3) status of the member.
- No Reasonable Possibility: Bond counsel must determine that it would be unreasonable for the court to hold to the contrary. Bond counsel must determine that there is no reasonable possibility that the IRS would not concur or acquiesce in the opinion, if it considered all material legal issues and relevant facts. See “Statement Concerning Standard Applied in Rendering the Federal Income Tax Portion of Bond Opinions,” adopted by the Board of Directors of NABL on November 29, 1993. NABL, 1997 Model Bond Opinion.
- High Degree of Confidence: Bond counsel may render an “unqualified” opinion regarding the validity and tax exemptions of bonds if it is firmly convinced (also characterized as having a “high degree of confidence”) that, under the law in effect on the date of the opinion, the highest court of the relevant jurisdiction, acting reasonably and properly briefed on the issues, would reach the legal conclusions stated in the opinion. NABL, 2003 Model Bond Opinion, p. 7.
- Firmly Convinced: In light of lack of judicial precedent and unique body of Internal Revenue Service administrative guidance, bond counsel may nonetheless give an unqualified opinion with respect to federal income tax matters if it is firmly convinced that, upon due consideration of the material facts and all of the relevant sources of applicable law on federal income tax matters, the Supreme Court would reach the federal income tax conclusions stated in the opinion or the IRS would concur or acquiesce in the federal income tax conclusions stated in the opinion. NABL, 2003 Model Bond Opinion, p. 8.
- Not Unqualified Opinion: An opinion is not “unqualified” if it includes (1) a non-customary assumption, limitation or qualification, (2) a phrase such as “while the matter is not free from doubt” (generally referred to as a “qualified opinion”), or (3) a legal analysis for the opinion (generally referred to as a “reasoned” or “explained” opinion). NABL, 2003 Model Bond Opinion, p. 7.
The Commonwealth of Puerto Rico (the “Commonwealth”) imposes an income tax on the taxable income of individuals and corporations. Taxable income, however, does not include interest on obligations issued by the Commonwealth or instrumentalities or political subdivisions thereof, such as the Puerto Rico Industrial, Tourist, Educational, Media, and Environmental Control Facilities Financing Authority, an affiliate of the Government Development Bank for Puerto Rico (AFICA). In addition, interest on bonds issued by the Commonwealth or such instrumentalities or subdivisions is not subject to income taxation by any other state or territory of the United States. The exemption from Commonwealth, all other state or territory and federal income taxes is often referred to as triple tax exemption.
Puerto Rico’s constitutional status is that of a territory of the United States, and, pursuant to the territorial clause of the U.S. Constitution, the ultimate source of power over Puerto Rico is the U.S. Congress. The relationship between the United States and Puerto Rico is referred to as commonwealth status.
The people of Puerto Rico are citizens of the United States but do not vote in national elections. They are represented in Congress by a Resident Commissioner who has a voice in the House of Representatives but no vote (except in House committees and sub-committees to which he belongs).
Most federal taxes, except those such as Social Security taxes, are not levied in Puerto Rico. No federal income tax is collected from Puerto Rico residents on income earned in Puerto Rico, except for certain federal employees who are subject to taxes on their salaries. Income earned by Puerto Rico residents from sources outside of Puerto Rico, however, is subject to federal income tax.
The Constitution of Puerto Rico limits the amount of general obligation debt that the Commonwealth can issue. Fiscal responsibility for the Commonwealth is shared among the Department of the Treasury, the Office of Management and Budget, and the Government Development Bank for Puerto Rico.
Commonwealth Income Tax:
Only certain Puerto Ricans are required to pay federal income taxes. Income derived from sources within Puerto Rico by an individual who is a bona fide resident of Puerto Rico for an entire taxable year generally is excludable from gross income for federal income tax purposes, even if the resident is considered a U.S. citizen. Puerto Ricans are required to pay federal income tax on income earned outside of Puerto Rico or if they are employees of the federal government. (See I.R.C. 933. See also An Overview of the Special Tax Rules Related to Puerto Rico and an Analysis of the Tax and Economic Policy Implications of Recent Legislative Options, JCX-24-06 (Jun. 23, 2006).)
The Commonwealth imposes a separate income tax in lieu of the federal income tax under the recently implemented “Internal Revenue Code for a New Puerto Rico” (the “P.R. Code”). The regular tax rate applicable in 2013 for individuals ranges from 0% (up to the first $9,000 in net taxable income) to 33% (for net taxable income in excess of $61,500) on taxable income considering worldwide income. Deductions and exemptions are available. Similar to the federal regime for foreign source income, nonresidents of the Commonwealth are taxed only on their income from sources within Puerto Rico or income effectively connected with the conduct of trade or business within Puerto Rico. P.R. Code § 1021. The P.R. Code imposes a corporate “normal” tax of 20% of the net income subject to normal tax plus a “surtax” that ranges from 5% to 10% in 2013 on net income that is subject to the surtax. P.R. Code § 1022.
Exemption from Income Tax:
Gross income for purposes of calculating taxable income under the P.R. Code excludes interest on “the obligations of the Government of Puerto Rico or any instrumentality or political subdivision thereof.” Section 1031.02(a)(3)(B) of the Internal Revenue Code for a New Puerto Rico, Act No. 1-2011 of the Legislature of Puerto Rico, approved January 31, 2011, as amended. This exemption also extends to interest on bonds issued by AFICA, which is an instrumentality of the Commonwealth.
AFICA, an affiliate of the Puerto Rico Government Development Bank (GDB), is a public corporation created under Act 121 of the Legislature of Puerto Rico, adopted on June 27, 1977, and is empowered under Section 1255(l) of Title 12 of the Laws of PuertoRico to “issue bonds of the Authority in evidence thereof for the purpose of providing funds to pay for all or any part of the cost of one or more projects and any refinancing bonds.” AFICA serves as conduit issuer of private activity revenue bonds to finance the acquisition, construction and equipping of industrial, tourist, medical, educational, pollution control and solid waste disposal facilities.
GDB is a public corporation of the Commonwealth of Puerto Rico that is governed by a seven-member board of directors appointed by the Governor of the Commonwealth with advice and consent of the Commonwealth’s Council of Secretaries. GDB serves as fiscal agent and financial advisor to the Commonwealth and its agencies and municipalities, as lender to public and private sectors, and as depository of Commonwealth funds.
Bonds issued by AFICA are special and limited obligations of the authority and, except to the extent payable from bond proceeds and investments thereof, are payable solely from and secured by a pledge and assignment of the amounts receivable under the loan agreements between AFICA and the conduit borrowers. AFICA imposes a placement fee which, according to the authority’s 2011 audit, generally represents one percent of the face value of the bonds issues, except for bonds issued to finance educational, medical or environmental control facilities or other projects otherwise eligible to be financed in the tax-exempt bond market, for which the placement fee is one half of one percent. AFICA has issued over $6 billion in revenue bonds.
An offering document for AFICA’s recently issued “Higher Education Revenue and Revenue Refunding Bonds, Series 2012 (University of the Sacred Heart Project)” describes the Commonwealth income tax exemption as follows: “In the opinion of [Bond Counsel], under existing law […] the Series 2012 Bonds and the interest thereon are exempt from state, Commonwealth of Puerto Rico and local income taxation.”
In addition to referencing exemption for purposes of Commonwealth income tax (and, of course, exemption from federal income tax), the opinion statement refers to exemption from state income taxation (and therefore opines as to the “triple tax exempt” character of the bonds). Exemption from state income taxation is mandated under 48 U.S.C. 745, which provides that “all bonds issued by the Government of Puerto Rico, or by its authority, shall be exempt from taxation by the Government of the United States, or by the Government of Puerto Rico or of any political or municipal subdivision thereof, or by any State, Territory, or possession, or by any county, municipality, or other municipal subdivision of any State, Territory, or possession of the United States, or by the District of Columbia.”
Puerto Rico tax discussion:
Interest is also exempt under Section 1022.04(b)(2) of the P.R. Code from the “adjusted net book income” of a corporation for purposes of computing the alternative minimum tax imposed by Section 1022.03(a) of the P.R. Code.
Interest is also exempt from the Puerto Rico alternative basic tax under Section 1021.02(a)(2) of the P.R. Code.
Interest is also exempt from Puerto Rico municipal license taxes under Section 9(25) of the Puerto Rico Municipal License Tax Act of 1974, as amended.
The Bonds are exempt from Puerto Rico personal property tax pursuant to Section 3.11 of the Puerto Rico Municipal Property Tax Act of 1991, as amended, and Section 3 of the Puerto Rican Federal Relations Act.
The Bonds will be considered an obligation of an instrumentality of Puerto Rico for purposes of: (a) the non-recognition of gain rules under Section 1034.04(f)(2)(A) of the P.R. Code applicable to certain involuntary conversions; and (b) the exemption from the surtax imposed by Section 1022.05 of the P.R. Code available to corporations that have a certain percentage of their net income invested in obligations of instrumentalities of Puerto Rico and certain other investments pursuant to Section 1022.05(g) of the P.R. Code.
Interest on the Bonds constitutes industrial development income under Section 2(j) of the Economic Incentives for the Development of Puerto Rico Act, or under analogous provisions of similar prior acts, when received by a holder of a grant of tax exemption issued under any of the Acts that acquired the Bonds with eligible funds, as such term is defined in the Acts.
Gain recognized from the sale or exchange of the Bonds will be subject to income tax under the P.R. Code to taxpayers subject to Puerto Rico income tax on such gains, including individuals residing in Puerto Rico and corporations organized under the laws of Puerto Rico.
The P.R. Code does not contain any provisions regarding the treatment of original issue discount. However, under the administrative practice followed by the Treasury Department with respect to the repealed Puerto Rico Internal Revenue Code of 1994, original issue discount was treated as interest.
U.S. Tax Discussion:
Interest or OID on the Bonds owned by an individual is excludable from the gross income of the individual for United States federal income tax purposes under Section 933 of the U.S. Code if (a) the individual is a bona fide resident of Puerto Rico during the entire taxable year in which such interest or OID is to be recognized for purposes of the U.S. Code, and (b) such interest or OID is not, and is not treated as, income effectively connected with, or attributable to, the conduct of a trade or business within the United States by such individual under the U.S. Code. In addition, for U.S. federal income tax purposes, no deduction or credit will be allowed that is allocable to or chargeable against amounts so excluded from the Puerto Rico individual’s gross income.
Interest or OID on the Bonds derived by a corporation organized under the laws of Puerto Rico or by any foreign corporation for purposes of the U.S. Code is not subject to United States federal income tax under the U.S. Code if: (a) such interest or OID is not, and is not treated as, income effectively connected with, or attributable to, the conduct of a trade or business in the United States by such corporation under the U.S. Code; (b) such corporation is not a controlled foreign corporation or a passive foreign investment company under the U.S. Code; and (c) such corporation is not treated as a domestic corporation for purposes of the U.S. Code.
United States taxpayers, other than individuals who comply with the requirements set forth below, may be subject to federal income tax on any gain realized upon sale of the bonds. Pursuant to Notice 89-40, and the regulations issued under Section 937 of the U.S. Code, the gain from the sale of the Bonds by an individual who is a bona fide resident of Puerto Rico will constitute Puerto Rico source income, and therefore will qualify for exclusion from gross income under Section 933 of the U.S. Code, provided (a) the Bonds do not constitute inventory in the hands of such individual, (b) such gain is not attributable to an office or fixed place of business of the individual located outside of Puerto Rico and (c) the individual has been a bona fide resident of Puerto Rico for the shorter of (1) the full period during which the individual has owned the Bonds or (2) each of the ten years preceding the year of the sale. In the case the individual is a bona fide resident of Puerto Rico for the tax year for which the source of income must be determined and the individual was a United States citizen or resident (other than a bona fide resident of Puerto Rico) for any of the ten years preceding said year, the individual may elect to treat as gain from sources within Puerto Rico the portion of the gain attributable to the individual’s holding period in Puerto Rico.
Puerto Rico corporations generally will not be subject to income or withholding tax under the U.S. Code on gain recognized on the sale or exchange of the Bonds, unless the gain is effectively connected, or treated as effectively connected, with the conduct by the Puerto Rico corporation of a trade or business in the United States.