Procter & Gamble - Baker & McKenzie

Tax News and Developments 

North American Tax Practice Group 

Newsletter 

April 2011 | Volume XI-2 

In This Issue: 

Procter & Gamble Washes Away 

Some Questions Regarding the 

Extent of the Foreign Tax Credit 

“Exhaustion” Requirement 

California Court Treats Copyright 

Royalties as Income from Tangible 

Property in Microsoft Case 

The Ralphs Grocery Decision 

Restricts the Ability of Creditors to 

be Considered Equity Owners for 

Purposes of the Continuity of 

Interest Doctrine 

Chief Counsel Advice Adds More 

Confusion to Questions Regarding 

Place of Use of Intangibles 

Federal Circuit Upholds Regulation 

Extending Six Year Statute of 

Limitations to Overstated Basis 

Cost-Sharing “Divisional Interests” 

Rule as Applied to e-Commerce 

Business Models 

Proposed Regs Would Require US 

Financial Institutions to Report 

Bank Deposit Interest Income for all 

Non-Resident Alien Individuals 

First Annual BNA/Baker & 

McKenzie Transfer Pricing 

Conference to be held June 8-9 in 

Washington, DC 

Procter & Gamble Washes Away Some Questions 

Regarding the Extent of the Foreign Tax Credit 

“Exhaustion” Requirement 

The foreign tax credit, set forth in Code Sections 901 through 908, was designed 

to alleviate the double-taxation of foreign-source income. The foreign tax credit, 

however, is subject to a number of requirements and restrictions. One such 

requirement is that the taxpayer exhaust available remedies in determining the 

actual amount of foreign tax owed, such as pursuing administrative appeals in 

the foreign country. The IRS scored a recent victory with respect to this 

requirement in Procter & Gamble Co. v. United States, 106 A.F.T.R.2d 2010- 

5311 (S.D. Ohio 2010), in which the District Court denied the taxpayer a full 

foreign tax credit on the basis that the taxpayer had failed to exhaust all effective 

and practical remedies, such as seeking competent authority assistance, when 

two foreign countries imposed tax on the same item of income. Perhaps 

emboldened by this triumph, the IRS subsequently announced that it would be 

more closely examining foreign tax credits claimed by multinational taxpayers to 

determine whether the “exhaustion” requirement has been satisfied. 

Treasury Regulations promulgated under section 901 set forth the exhaustion 

requirement. A foreign levy is a “tax” if it “requires a compulsory payment 

pursuant to the authority of a foreign country to levy taxes,” as determined by 

principles of US law. Treas. Reg. § 1.901-2(a)(2)(i). A payment is not a 

“compulsory payment” to the extent that the amount paid exceeds the amount of 

tax liability under foreign law. Treas. Reg. § 1.901-2(e)(5)(i). Such liability must 

be determined by the taxpayer “in a manner that is consistent with a reasonable 

interpretation and application of the substantive and procedural provisions of 

foreign law (including applicable tax treaties) in such a way as to reduce, over 

time, the taxpayer’s reasonably expected liability under foreign law for tax.” This 

rule requires that the taxpayer exhaust “all effective and practical remedies,” 

including competent authority procedures available under applicable tax treaties, 

to effect such a reduction. The limiting term “effective and practical” spares 

taxpayers from engaging in herculean efforts in order to obtain the benefits of the 

foreign tax credit and requires only that the cost of pursuing such remedies be 

reasonable in light of the amount at issue and the likelihood of success. In 

interpreting foreign tax law, a taxpayer may generally rely on advice obtained in 

good faith from a competent foreign tax advisor to whom the taxpayer has 

disclosed the relevant facts. 

The Procter & Gamble decision has clarified just how far taxpayers must go in 

order to meet the exhaustion requirement. In that case, the taxpayer, a US 

corporation, was the common parent of an affiliated group of corporations, 

including P&G Northeast Asia (“P&G NEA”), a Singapore corporation that 

managed the taxpayer’s Japanese and Korean operations from a principal office

Upcoming Tax Events: 

A Basic Introduction to China 

Tax, M&A and Structure 

Considerations 

Webinar 

April 26, 2011 

State and Local Tax Roundtables 

State Limitations on Transfer 

Pricing: Other Current 

Developments 

Dallas 

April 26, 2011 

Houston 

April 27, 2011 

Focus on Japan: Coping with the 

Business and Legal Aftershocks 

Webinar Series 

April - May 2011 

2011 European Tax Seminar 

London, England 

May 18, 2011 

BNA/Baker & McKenzie Transfer 

Pricing Conference 


June 8-9, 2011 

Tax Planning & Transactions 

Workshop 

New York, NY 

June 24, 2011 

Global Transfer Pricing 

Workshop 

Bellevue (Seattle), WA 

July 22, 2011 

2 Tax News and Developments �April 2011 

Baker & McKenzie 

located in Japan. During the years at issue, P&G NEA paid royalties to the 

taxpayer and withheld a 10 percent Japanese tax, but paid no taxes to Korea. 

The taxpayer claimed a foreign tax credit with respect to the Japanese taxes. In 

2006, the Korean tax authorities audited the taxpayer and determined that a 

portion of the royalties paid by P&G NEA was attributable to Korean sales and 

thus subject to a Korean withholding tax of 15 percent (as well as a 1.5 percent 

local surcharge), even though P&G NEA had no physical location or employees 

in Korea. 

The taxpayer engaged a prominent Korean law firm and received a legal opinion, 

which concluded that the Korean tax was properly assessed under both Korean 

tax law and the US-Korea Income Tax Treaty. The opinion further advised that 

any challenge would be unlikely to succeed. Based on this advice, the taxpayer 

determined that there was no reasonable basis for disputing the Korean 

assessment or invoking the competent authority procedures under the US-Korea 

Income Tax Treaty and instead paid the tax. The taxpayer then filed a refund 

claim with the IRS requesting an additional foreign tax credit for the Korean taxes 

paid. The IRS disallowed the credit on the grounds that the taxpayer had failed 

to exhaust all effective and practical remedies. In response, the taxpayer filed 

suit in District Court. 

The court began by explaining that the exhaustion requirement is a “core 

component” of the foreign tax credit system. Its absence would create a “moral 

hazard,” the court continued, as “[t]axpayers would have no incentive to 

challenge any foreign tax whether or not properly imposed, thereby leaving the 

United States to foot the bill through the credit system.” In the case at bar, the 

court held that the taxpayer should have sought a redetermination of its 

Japanese tax or invoked competent authority proceedings regarding its 

Japanese tax liability. Thus, while Korea and Japan may ultimately uphold their 

claims on the same item of income, the court noted that the “onus” was on the 

taxpayer to exhaust all effective and practical remedies in both countries before 

claiming a foreign tax credit. The court required that the taxpayer “at least 

investigate the possibility of challenging these claims.” Although the taxpayer 

had consulted with Korean counsel, the court pointed out that the taxpayer had 

not obtained any advice from Japanese counsel, implying that, had the taxpayer 

obtained a similarly adverse opinion with respect to the possibility of challenging 

its Japanese tax liability, the exhaustion requirement would have been fulfilled. 

Thus, the court held, on a summary judgment motion, that the taxpayer was 

entitled to a foreign tax credit only in the amount of the withholding tax payments 

it made to Korea, and the taxpayer could not also claim additional credit in the 

amount of the withholding tax payments it made to Japan. Given the fact that the 

taxpayer had already received a tax credit for its Japanese taxes, the court 

mandated that the taxpayer’s credit for Korean taxes be reduced by the amount 

already allowed as a credit for Japanese taxes. 

In addition to its success in Procter & Gamble, the IRS has recently warned 

taxpayers and practitioners more broadly that it would be closely scrutinizing 

foreign tax credit claims to ensure that the exhaustion requirement is met. On 

February 16, 2011, Michael Danilack, Deputy Commissioner (International) of the 

IRS Large Business and International Division, spoke at a Tax Policy Institute 

Conference regarding foreign tax credits. Danilack emphasized the IRS’ concern 

that claimed foreign tax credits be “legitimate” and indicated that the IRS would 

be asking multinational taxpayers “more serious questions” about its credits than 

it had in the past. Danilack specifically mentioned that the IRS would be 

examining whether “administrative remedies have been exhausted before those 

credits are taken.” See Tamu N. Wright, Cross-Border Taxation: Danilack Invites



Competent Authority Calls, Warns IRS Scrutinizing Foreign Tax Credits, Daily 

Tax Report, 33 DTR G-4 (Feb. 17, 2011). 

Unfortunately, with foreign tax authorities throughout the world facing depleted 

coffers, the situation faced by the taxpayer in Procter & Gamble is not unique, 

and multinationals often find themselves subject to competing tax claims on the 

same items of income. Procter & Gamble illustrates the critical role that 

competent authority can play in resolving such multi-jurisdictional disputes. 

Moreover, the exhaustion requirement mandates that taxpayers at least 

investigate the involvement of competent authority as well as other potential 

remedies in each affected jurisdiction prior to claiming a foreign tax credit. 

Perhaps one comfort that taxpayers can draw from Procter & Gamble is that a 

legal opinion from a foreign advisor concluding that a challenge to the 

assessment is unlikely to be successful will ordinarily satisfy the exhaustion 

requirement for that jurisdiction, and a court will generally not require the 

taxpayer to pursue costly overseas litigation with little chance of success. With 

the convergence of increased audit and assessment activity by foreign tax 

authorities and the IRS’ invigorated focus on the foreign tax credit exhaustion 

requirement, the tax departments of multinational taxpayers have yet another tax 

issue to monitor on top of their already lengthy list. 

By Daniel V. Stern, Washington, DC 

California Court Treats Copyright Royalties as 

Income from Tangible Property in Microsoft Case 

The San Francisco Superior Court recently denied Microsoft Corporation’s 

(“Microsoft”), claim for refund of over $30 mil in franchise (income) taxes plus 

applicable interest and penalties imposed by the California Franchise Tax Board 

(“FTB”). Microsoft Corp. v. FTB, Case No. CGC 08-471260 (Feb. 17, 2011). 

The case involved four issues: 

1. Whether Microsoft’s receipts from licensing its proprietary computer 

software to original equipment manufacturers (OEMs) was income from 

tangible property or intangible property? 

2. Whether receipts from Microsoft’s Treasury operations should be 

excluded from the denominator of Microsoft’s sales factor? 

3. Whether the standard apportionment formula should be modified to 

include the value of Microsoft’s intangible property? 

4. Whether the FTB was statutorily and constitutionally authorized to 

assess the amnesty penalties against Microsoft? 

Two of these were issues of first impression in California: whether software 

licensing income gives rise to income from tangible or intangible property and 

whether intangible property should be included in the property factor for a 

company like Microsoft where the value of intangible property exceeds that of 

tangible property. 

During tax years ending 1995 and 1996 (“Periods at Issue”), Microsoft’s business 

activities included manufacturing, distributing, and licensing its proprietary 

computer software to OEMs. Microsoft’s licensed software products were carried 

on “Golden Master” disks, which licensees used to copy Microsoft’s software



onto hard drives on computers they built and sold and back-up disks included 

with the assembled computer units. The Microsoft license gave OEMs the right 

to install Microsoft software into OEM computer systems and sell those 

computers with the pre-installed software. 

Income from Copyright Rights 

In this case, Microsoft argued that its royalty income constituted receipts from the 

licensing of something “other than tangible personal property,” i.e., intangible 

property (“IP”). As such, the income should be sourced under California’s “costsof-performance” 

method. Cal. Rev. & Tax Code Section 25136. Under this 

method, Microsoft’s IP royalties would be sourced entirely to Washington, where 

the majority of the IP’s income-producing activity took place, thus significantly 

reducing Microsoft’s California franchise tax liability. The court rejected 

Microsoft’s argument, holding that the royalties constituted receipts from the 

licensing of tangible as opposed to intangible personal property, and thus should 

be sourced to California if the licensed property is located in the state. Cal. Code 

Regs. 25136(d)(2)(B). Pointing to the “Golden Master” disk format, the court 

stated that “the computer software licensed by Microsoft was inextricably 

intertwined with the disks on which they were embedded” and therefore “the 

royalties from the licensing of such programs should be classified as deriving 

from the sale of tangible personal property.” 

In reaching this conclusion, the Trial Court relied primarily on sales tax cases 

treating the sale of canned software as tangible property along with other 

authorities classifying the transfer of software to an end user as a transaction 

involving tangible personal property. The Trial Court failed to cite any authorities 

dealing with the license of copyright rights, such as the right to reproduce 

involved in Microsoft’s case. The federal tax regulations in Treas. Reg. § 1.861- 

18, distinguishing between a copyrighted article and a copyright right, were 

summarily dismissed by the Trial Court as “unpersuasive.” The Court failed to 

grasp the fundamental distinction between tangible objects and intangible rights. 

Treasury Receipts 

Microsoft also protested the FTB’s exclusion of total gross receipts from the sale 

or disposition of marketable securities from its sales factor denominator. In 

making its adjustment, the FTB sought to modify the standard three-factor 

apportionment formula, pursuant to Cal. Rev. & Tax Code Section 25137. 

Microsoft’s marketable securities were handled by its Treasury Department in 

Washington, and any sales or dispositions occurred entirely out-of-state. Under 

the standard apportionment formula, such total gross receipts would have 

increased the size of Microsoft’s sales factor denominator without affecting its 

numerator, thus significantly reducing its California franchise tax liability. The 

court upheld the FTB’s use of a modified three-factor-formula, holding that only 

net receipts from the marketable securities should be included in Microsoft’s 

sales factor. In so doing, the court largely followed the reasoning of prior 

decisions in Microsoft Corp. v. Franchise Tax Board, 39 Cal. 4th 750 (Cal. 2006) 

and Limited Stores, Inc. v. Franchise Tax Board, 152 Cal. App. 4th 1491 (Cal. 

2007).


Property Factor Modification 


The court also rejected Microsoft’s argument that the three-factor apportionment 

formula should be modified to include the value of Microsoft’s IP. Microsoft 

sought modification under section 25137, arguing that the failure to include IP in 

its property factor unfairly reflected the extent of Microsoft’s California business 

activity. Clearly, Microsoft’s IP represents a major business income producing 

asset that is core to its business. The court rejected this argument, holding that 

Microsoft failed to establish by clear and convincing evidence that modification 

was warranted. 

Penalties 

Finally, the court also upheld the imposition of amnesty penalties, imposed 

pursuant to Cal. Rev. & Tax Code Section 19777.5. Microsoft argued that the 

penalty statute was void because it operated retroactively, was unconstitutionally 

vague, and did not provide an opportunity for administrative or judicial prepayment 

or post-payment review. Instead, the court held that the statute did not 

operate retroactively, as it did not increase the amount of a taxpayer’s underlying 

tax liability, but rather increased “the consequences of not paying the proper 

amount for the years at issue within the dictates of the amnesty program.” The 

court also held that the amnesty penalty statute was not vague as applied to 

Microsoft, and there was adequate opportunity for pre-payment and postpayment 

review. 

Significance of Case 

In practice, the FTB has long treated end-user software, even when delivered 

electronically, as tangible personal property, and a few taxpayers have received 

informal written statements from the FTB confirming this position. However, we 

are not aware of previous instances where the FTB publicly staked out the 

position that the license of copyright rights produced income from tangible 

property for apportionment purposes. The impact of the court’s decision 

depends on the location of the taxpayer. Classification as income from tangible 

property is helpful to California-based software companies licensing to out-ofstate 

unrelated parties who reproduce and distribute the software. Conversely 

this classification results in higher California apportionment for out-of-state 

software licensors licensing to California based OEMs, like Microsoft. If 

California switches from elective to mandatory single sales factor, the effects of 

this decision will be doubly important (and disadvantageous) for out-of-state 

software licensors. At the time this article was written, Microsoft had not 

announced whether it will appeal the decision. 

By Scott L. Brandman, New York, J. Pat Powers, Palo Alto 

and Sahang-Hee Hahn, New York



The Ralphs Grocery Decision Restricts the Ability 

of Creditors to be Considered Equity Owners for 

Purposes of the Continuity of Interest Doctrine 

Judge Chiechi of the Tax Court recently issued a surprising decision in Ralphs 

Grocery Co. v. Commissioner, T.C. Memo 2011-25, significantly limiting the 

ability of creditors of a bankrupt company to qualify as equity owners of the 

company for purposes of the continuity of interest (“COI”) doctrine. The Tax 

Court, strictly interpreting the facts in Helvering v. Alabama Asphaltic Limestone 

Co., 315 U.S. 179 (1942), held that creditors of a bankrupt company must have 

“effective command” over the property of the company for the creditors to qualify 

as equity owners in the company. The strict requirements of Ralphs Grocery 

could thus limit the number of pre-1998 (and possibly post-1997) bankruptcy 

reorganizations that can be structured as nontaxable reorganizations. 

In Ralphs Grocery, Federated Stores, Inc. (“FSI”) was the domestic parent of a 

consolidated group of corporations. FSI held all of the outstanding stock of 

Holdings III, Inc. (“Holdings III”). Holdings III, in turn, indirectly held all of the 

outstanding stock of Allied Stores Corp. (“Allied”) and directly held 83.75% of the 

outstanding stock of Ralphs Grocery Co. (“Ralphs”). Allied held the remaining 

16.25% of the outstanding stock of Ralphs. 

In 1990, FSI and Allied filed petitions under Chapter 11 of the Bankruptcy Code. 

At no time did Ralphs file a petition. In 1992, the bankruptcy court confirmed a 

Chapter 11 bankruptcy plan (the “Plan”) proposed by FSI and Allied. Pursuant to 

the Plan, a newly formed domestic company, Ralphs Holding Co., Inc. (“RHC”), 

acquired all of the outstanding common stock of Ralphs from Holdings III and 

Allied (83.75% and 16.25% of the Ralphs common stock, respectively). In 

exchange for the Ralphs stock, RHC issued to Holdings III and Allied 83.75% 

and 16.25%, respectively, of its outstanding common stock. Thereafter, Holdings 

III transferred all of its RHC stock to FSI’s creditors, and Allied transferred 9.65% 

of its RHC stock to its creditors (the “Ralphs Transaction”). RHC and FSI filed a 

joint election under Code Section 338(h)(10) with respect to RHC’s acquisition of 

the common stock of Ralphs from Holdings III and Allied, thereby stepping up the 

basis of Ralph’s assets. 

The IRS asserted that the Ralphs Transaction qualified as a nontaxable 

reorganization under Code Section 368(a)(1)(B), (C) or (G), and that 

consequently RHC had a carryover basis under Code Section 362 in the Ralphs 

common stock it received. For the Ralphs Transaction to qualify as a nontaxable 

reorganization, the non-statutory COI doctrine must also be satisfied in addition 

to the statutory requirements under section 368. The COI doctrine generally 

requires that a target corporation’s shareholders must have a continuing interest 

in the acquiring corporation. Under pre-1998 law, relevant for the Ralphs 

Transaction that occurred in 1992, transitory ownership in the acquiring 

corporation by the target’s shareholders was disregarded in determining whether 

the COI requirement was satisfied. See, e.g. Penrod v. Commissioner, 88 T.C. 

1415, 1427 (1987); Heintz v. Commissioner, 25 T.C. 132, 142-143 (1955). As 

part of the Plan, assuming the Ralphs Transaction satisfied the statutory 

requirements of section 368(a)(1)(C) or (G), the historic shareholder (FSI) of the 

target (Holdings III) disposed of its interest in the acquiring corporation (RHC) to 

the creditors of FSI. The disposition of the RHC stock thus caused the Ralphs 

Transaction to fail the COI requirement under pre-1998 law.



The COI doctrine would be satisfied, however, if the creditors were considered 

equity owners under Alabama Asphaltic. The parties stipulated (the critical 

litigating mistake of the IRS) that it was material to the Supreme Court’s holding 

in Alabama Asphaltic that the COI requirement would be satisfied if the creditors 

“had effective command over the disposition of the property.” The Tax Court 

reasoned that the creditors in Alabama Asphaltic had “effective command” 

because they took the necessary steps to enforce their rights to “exclude 

stockholders [of the bankrupt corporation] entirely from the reorganization plan” 

by instituting involuntary bankruptcy proceedings. In Ralphs Grocery, 

conversely, FSI filed a voluntary (and not involuntary) petition for bankruptcy. 

Moreover, FSI operated as a debtor in possession at all times during the FSI 

bankruptcy proceedings. The creditors did not ask the bankruptcy court to 

appoint a trustee, nor did it object to FSI operating as a debtor in possession. 

Lastly, FSI filed with the bankruptcy court the proposed Plan, and the FSI 

creditors never objected to or rejected that proposed Plan. 

The Tax Court also considered the Alabama Asphaltic progeny, see e.g., Palm 

Springs Holding Corp. v. Commissioner, 315 U.S. 185, 188-189 (1942); Wells 

Fargo Bank & Union Trust Co. v. United States, 225 F.2d 298, 300-301 (9th Cir. 

1955), noting that the creditors in those cases took proactive steps to enforce or 

protect their rights in the bankrupt corporations’ properties, such as filing a 

foreclosure action under mortgages securing the bankrupt corporations’ debt, 

selling the bankrupt corporations’ assets under an indenture, filing a receivership 

action against the bankrupt corporation, or entering into possession and 

operating the property of the bankrupt corporation. The creditors of FSI in 

Ralphs Grocery did not take any of these proactive steps. The Tax Court thus 

concluded that the Ralphs Transaction did not squarely fit under the facts in 

Alabama Asphaltic and its progeny, and thus the creditors could not be 

considered equity owners. 

The effect of Ralphs Grocery on post-1997 bankruptcy reorganizations remains 

unclear. First, for reorganizations occurring after January 28, 1998, Treas. Reg. 

§ 1.368-1(e)(1) permits historic target shareholders to dispose of their interest in 

the acquiring corporation without violating the COI requirement. Subject to 

substance-over-form or other anti-abuse judicial doctrines, historical 

shareholders of the bankrupt corporation could thus transfer the stock of the 

reorganized bankrupt corporation to its creditor(s) and still meet the COI 

requirement. However, for a creditor that receives stock of a reorganized 

bankrupt corporation in exchange for its debt claims directly from the reorganized 

bankrupt corporation (and not the historic shareholders), Ralphs Grocery 

arguably applies. Second, the IRS promulgated regulations, effective for 

bankruptcy reorganizations occurring on or after December 12, 2008, addressing 

whether creditors count positively towards the COI requirement. Under Treas. 

Reg. § 1.368-1(e)(6), if any creditor receives a proprietary interest in the 

reorganized bankrupt corporation in exchange for its claim, every claim of that 

class of creditors, and every claim of all equal and junior classes of creditors is a 

property interest. What remains unclear is whether the “effective command” 

requirement under Ralphs Grocery is an additional requirement to the 2008 

regulations. 

To the extent Ralphs Grocery applies to any post-1997 bankruptcy 

reorganization, creditors will be required to take the necessary formalistic steps 

to assert their control over the bankrupt corporation’s assets, including placing 

the debtor in involuntary bankruptcy and requesting the bankruptcy court to 

appoint a trustee. These requirements could severely restrict the number of 

bankruptcy reorganizations that could qualify as nontaxable reorganizations. 

By Elizabeth A. Lieb, Palo Alto



Chief Counsel Advice Adds More Confusion to 

Questions Regarding Place of Use of Intangibles 

On October 13, 2010, the IRS Office of Chief Counsel issued Chief Counsel 

Advice 201106007 (the “CCA”), addressing whether the sale of software 

products by a controlled foreign corporation (“CFC”) into the US market gave rise 

to an investment in US property for purposes of Code Section 956(c)(1)(D). In 

general, a CFC is treated as holding an investment in US property for purposes 

of section 956 if it has any right to use in the United States a copyright which is 

acquired or developed by the CFC for use in the United States. Thus, in the 

case of a CFC that has rights with respect to software, it is necessary to 

determine where the underlying copyright rights are “used” to determine whether 

the CFC has made a section 956 investment in US property. The subject matter 

of the CCA is of particular interest given the muddled state of existing US tax law 

regarding the place of use of intangible property, which has relevance under 

sections 956, 861 and 954 (among others). Unfortunately, however, the CCA is 

not particularly helpful in resolving or shedding light on the inconsistencies in the 

existing case law and IRS guidance on the place of use of intangibles. 

The taxpayer involved in the CCA was a US entity that distributed information 

technology products and services. The taxpayer developed software in the 

United States under a cost-sharing agreement (“CSA”) with its wholly-owned 

foreign subsidiary, a CFC. The CSA was somewhat unusual in that the foreign 

subsidiary obtained the rights to exploit copyrights in the United States. When a 

newly-developed software product was ready for sale to end-user customers, the 

taxpayer first transferred the final version of the software code to a “gold master” 

disk which was sent to the subsidiary. The subsidiary then reproduced and sold 

copies of the software to end-user customers in the United States. 

The CCA reached three conclusions, with virtually no discussion of the 

underlying reasoning: (1) the foreign subsidiary made an investment in US 

property for purposes of section 956 when it acquired or developed the rights to 

use the copyrights in the United States under the CSA; (2) the actual sales of 

software copies to US customers were not in themselves an investment in US 

property; and (3) the transfer of software copies to US customers did not affect 

the calculation of the amount includible under section 956 on account of the 

subsidiary’s initial investment in US property because the CFC did not acquire or 

develop any additional, or relinquish any, rights to use the software rights in the 

United States as a result of selling the software copies to US end-users. 

Although the CCA neither provides the reasoning nor refers to any case law or 

prior administrative guidance to support its conclusions, its first (and most 

interesting) conclusion could only follow from the determination that the CFC had 

acquired the right to use the copyright in the United States with the intent to use 

such right in the United States. Thus, the CCA implicitly provides that acquisition 

of a copyright right that permits the CFC to reproduce offshore and sell software 

copies to US customers is the use of a copyright in the United States. 

In reaching its conclusion in the CCA, the IRS appears to have followed the 

reasoning it took in the so-called “textbook ruling” or Rev. Rul. 72-232, 1972-1 

C.B. 276 for determining the place of use of intangible property for sourcing 

purposes. In that ruling, a US publisher paid royalties to a nonresident for the 

right to print books and sell them outside the United States. The IRS ruled that 

although the books were printed in the United States, the royalties were entirely 

foreign source because “there [was] no commercial publication of the textbooks



within the United States in that the textbooks [were] not sold within the United 

States.” Although, from a legal perspective, the printing of the books in the 

United States could not have been undertaken without a license of the US 

copyright rights, the IRS focused only on where the books were sold in 

determining where the copyrights were used for purposes of sourcing the 

royalties. Thus, the ruling suggests that intangible property is “used” for US tax 

purposes where the customers for the product are located. 

Notably, however, the IRS’s approach in the CCA is at odds with its own prior 

guidance in the software sale context which looked to the location of the 

licensee’s actual commercial activities with respect to the licensed intangibles to 

determine where such intangibles are used. In FSA 200222011, the IRS 

National Office advised that a royalty should be treated as wholly from US 

sources because the licensee performed its commercial activities related to the 

software in the United States. In that advice, a US company licensed the 

exclusive worldwide (except Country X) rights to sell, use, copy, manufacture or 

sublicense computer software from its Country X parent. The licensee’s software 

ultimately was sold to users both within and without the United States. The 

National Office did not look to where the ultimate customers were located in 

determining where the copyrights were used, but focused instead on the location 

of the licensee’s business activities. Unfortunately, the field service advice did 

not reference or distinguish the textbook ruling or any other authority, nor did it 

explain why it reached a contrary result. 

The CCA is also inconsistent with relevant case law. In Sanchez v. 

Commissioner, 6 T.C. 1141 (1946), aff’d, 162 F.2d 58 (2d Cir. 1947), the Tax 

Court held that the patent royalties were sourced by reference to the location of 

the payor’s business activities, and not by reference to where the products were 

ultimately consumed or which country’s laws protected the sale and use of the 

patented processes. Similarly, in Sabatini v. Commisioner, 32 B.T.A. 705 (1935), 

aff’d on this point, 98 F.2d 753 (2d Cir. 1938), the Board of Tax Appeals 

determined that a US licensee’s copyright royalty payments to a foreign person 

were from US sources where the publication and printing occurred in the United 

States, even though some of the rights related to the non-US markets. 

In sum, the CCA neither provides any useful rationale to support its conclusion 

nor attempts to address the inconsistencies in the IRS’ approach to determine 

the place of use of copyrights where a CFC sells software to US end-users but 

performs all of its actual operations outside the United States. Taxpayers are 

thus left to sort through existing legal authorities and erratic IRS approaches in 

determining where intangible property is used for US tax purposes. 

For further discussion regarding Chief Counsel Advice 201106007, see Gary D. 

Sprague’s upcoming article Section 956 Aspects of the Right to Duplicate and 

Sell Software in the US – a Wisp of Guidance from the Service, to be published 

in the May 2011 edition of Tax Management International Journal. 

By Diana B. Lathi and Paula R. Levy, Palo Alto



Federal Circuit Upholds Regulation Extending Six 

Year Statute of Limitations to Overstated Basis 

In Grapevine Imports, Ltd. v. United States, No. 2008-5090 (Fed. Cir. Mar. 11, 

2011), the Federal Circuit considered whether the normal three-year statute of 

limitations applied to time-bar 2004 administrative adjustments made to a 1999 

partnership return on the grounds that the taxpayers had overstated their basis in 

certain assets via a tax shelter. The Code extends the period of limitations to 

adjust a return when the return “omits” certain items that should have been 

included in gross income. The IRS argued that the overstatement of basis in 

certain capital assets via a tax shelter constituted an omission of income 

sufficient to trigger the extended, six-year limitations period. See Code Sections 

6501(e)(1)(A), 6229(c)(2) (2004). The taxpayers countered that the normal 

three-year statute of limitations governed the IRS’ Final Partnership 

Administrative Adjustment (“FPAA”) and that the adjustments were therefore 

time-barred under sections 6501(a) and 6229(a). See section 6501(a) (2004) 

(stating the general rule that the IRS may not assess tax more than three years 

after the taxpayer’s return); id. section 6229(a) (2004) (reflecting the three-year 

limitations rule for tax attributable to partnership items). The Grapevine Court of 

Federal Claims relied upon the Supreme Court’s opinion in Colony, Inc. v. 

Commissioner, 357 U.S. 28 (1958), which held that under the precursor statute, 

overstatement of basis was not an omission from gross income and did not 

therefore trigger the extended limitations period. Grapevine Imports, Ltd. v. 

United States, 77 Fed. Cl. 505 (2007). 

At issue in Grapevine before the Federal Circuit was whether the government 

could invoke recently issued Treasury regulations to extend the limitations 

period, when judicial precedent limited the IRS’ ability to extend the limitations 

period. In Salman Ranch Ltd. v. United States, 573 F.3d 1362 (Fed. Cir. 2009), 

another panel of the Federal Circuit determined that the Colony holding was not 

limited to the context of income from the sale of goods or services by a trade or 

business. Accordingly, Salman Ranch concluded that overstatement of basis did 

not constitute an omission from gross income to trigger the extended six-year 

limitations period. Shortly after Salman Ranch was issued, the US Department 

of Treasury issued new regulations that disputed the Federal Circuit’s reasoning, 

stating that Treasury and the IRS disagreed that the Supreme Court’s reading of 

the predecessor to section 6501(e) in Colony applied to sections 6501(e) and 

6229(c)(2). 75 Fed. Reg. 78,897 (Sept. 28, 2009). 

In T.D. 9511, the IRS finalized these temporary regulations, which define an 

omission from gross income for purposes of the six-year statute of limitations for 

tax assessment set forth under sections 6229(c)(2) and 6501(e)(1)(A). The final 

regulations provide that the six-year limitations period for tax assessment applies 

to an overstatement of basis in a sold asset that results in an omission from 

gross income exceeding twenty-five percent of the income stated in the 

taxpayer’s tax return. Under Treas. Reg. § 301.6501(e)-1(a)(iii), “gross income,” 

as it relates to any income other than from the sale of goods or services in a 

trade or business, has the same meaning as provided under Code Section 61(a). 

In the case of amounts received from the disposition of property, gross income 

equates to the excess of the amount realized from the disposition of property 

over the unrecovered cost of basis of the property. Consequently, under the final 

regulations, an overstatement of basis that results in an understatement of 

income constitutes an omission from gross income for the purposes of section 

6501(e)(1)(A)(i) to which the extended six-year limitations period applies.



The final regulations were made retroactively effective for all tax years for which 

the six-year limitations period for assessing tax was open on or after September 

24, 2009. Treas. Reg. § 301.6501(e)-1 (2010). Consequently, the new six-year 

limitations period provided in the final regulations effectively reopens tax years 

ordinarily closed under the ordinary three-year statute of limitations. 

On December 17, 2004, the IRS issued an FPAA that reduced the partners’ 

basis in Grapevine by $10 million for 1999, necessitating a recomputation of the 

partners’ tax liability. Grapevine challenged the adjustment as untimely, arguing 

that the appropriate statute of limitations for such adjustments was three years 

under section 6501(a) (2004). Conversely, the government argued that 

Grapevine’s overstatement of basis – which led to understatement of gain and 

consequent underpayment of tax – triggered an extended six-year statute of 

limitations under section 6501(e)(1)(A) such that the adjustment was not timebarred. 

To determine whether it was bound by the prior precedential decision in Salman 

Ranch, the Federal Circuit considered what amount of deference it owed the 

intervening controlling authority reflected in the Treasury Department’s newly 

issued regulations. The court dismissed Grapevine’s argument that it was an 

abuse of discretion to retroactively apply the 2010 final regulations to a 1999 tax 

assessment. Relying on Mayo Found. for Med. Educ. & Research v. United 

States, 131 S. Ct. 704 (2011), the court interpreted the regulations under the 

standards set forth under Chevron, which require a court to defer to an agency’s 

reasonable interpretation of Congress’s intent in an ambiguous statute. Chevron, 

U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 843-44 (1984). The 

court first found that, while instructive, Colony and Salman Ranch did not resolve 

the interpretation of ambiguous provisions of what constituted a “substantial 

omission” of income under sections 6501(e) and 6229. Further, because 

legislative intent did not elucidate the meaning of the provisions, the court found 

that there was room for agency interpretation. Determining that the Treasury 

regulations were reasonable, the court concluded that the regulations provided 

new intervening authority that required a departure from its own prior opinion in 

Salman Ranch. 

The panel disagreed with Grapevine’s complaint that the government was “trying 

to change the rules in the middle of the game” by issuing the final regulations and 

concluded that Treasury’s issuance of regulations during litigation “does not 

diminish the Department’s authority, nor its right to have its interpretations, when 

promulgated, respected by the judiciary – so long as they are reasonable.” The 

Federal Circuit reversed the Court of Federal Claims’ judgment, concluding that 

because the statutory language in the new regulations was entitled to deference, 

Grapevine’s overstatement of basis constituted an “omission from gross income” 

for the purposes of the limitations statute, triggering the extended six-year 

limitations period under section 6501(e)(1)(A). 

In its conclusion, the Federal Circuit joined the Seventh Circuit in upholding the 

final regulations as a reasonable interpretation of section 6501(e)(1)(A). The 

Fourth, Fifth, and Ninth Circuits have reached the opposite conclusion. Thus, 

Grapevine Imports has exacerbated the intercircuit split between those courts 

that have upheld the final regulations’ six-year statute of limitations period and 

those courts who have rebuffed the IRS’ attempt to retroactively reopen closed 

statutes. Compare Beard v. Commissioner, 2011 U.S. App. LEXIS 1575 (7th Cir. 

Jan. 26, 2011), rev’g T.C. Memo 2009-184 (concluding that the six-year 

limitations period under section 6501(e)(1)(A) applies to a 25% or greater 

omission of gross income attributable to overstating the basis of property, aside 

from situations involving a trade or business), with Bakersfield Energy Partners



LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009); Salman Ranch Ltd. v. United 

States, 573 F.3d 1362 (Fed. Cir. 2009); see also, Intermountain Insur. Serv. of 

Vail v. Commissioner, 134 T.C. No. 11 (May 6, 2010), appeal docketed, No. 10- 

1204 (D.C. Cir.) (concluding that overstatement of basis does not constitute an 

omission from gross income for purposes of application of the six-year limitations 

period for tax assessment); and Home Concrete & Supply, LLC v. United States, 

2011 U.S. App. LEXIS 2334 (4th Cir. Feb. 7, 2011), rev’g 599 F. Supp. 2d 678 

(E.D.N.C. 2008); Burks v. United States, No. 09-11061 (5th Cir. Feb. 9, 2011) 

(concluding that because the Treasury cannot overturn a court’s holding 

concerning plain meaning of statutory language, the 2010 final regulations are 

not entitled to Chevron deference under Mayo Foundation, and therefore 

overstatement of basis does not constitute an omission from gross income). 

The Home Concrete and the Burks cases were discussed in a previous article. 

See Tax News and Developments,“Decolonized?” Treasury Promulages Final 

Regulations Extending Six-Year Assessment Period to Certain Overstatements 

of Basis, Vol. 11, Issue 1, February 2011, available under publications at 

www.bakermckenzie.com. 

By concluding that regulatory interpretation supersedes precedential judicial 

interpretation of ambiguous statutory provisions, the Grapevine Imports case 

illustrates that, at least some courts may rely upon Mayo Foundation and 

Chevron, as a basis for granting the government great latitude to interpret 

ambiguous code provisions and to issue regulations that constitute “new 

controlling authority” and contradict judicial precedent. 

The panel’s analysis in Grapevine Imports is unsatisfying on a number of levels. 

When made, the IRS’ 2004 adjustment to Grapevine’s 1999 return was invalid, 

barred by the three-year limitations period that had already run. The application 

of the new six-year limitations period provided in the final regulations effectively 

grants the IRS a third bite at the apple and reopens tax years ordinarily closed 

under the ordinary three-year statute of limitations. Absent recodification of the 

statutory language given plain meaning in Colony, the Federal Circuit improperly 

concluded that the 2010 final regulations governed the interpretation of statutory 

language made unambiguous by a prior Supreme Court interpretation. See 

NCTA v. Brand X, 545 U.S. 967 (2005). 

By Robert S. Walton and Sonja Schiller, Chicago 

Cost-Sharing “Divisional Interests” Rule as Applied 

to e-Commerce Business Models 

In a recent article, Gary D. Sprague proposes a practical approach to interpreting 

the “divisional interests” rule under the 2009 cost-sharing regulations that would 

give e-commerce businesses more flexibility in complying with the requirements. 

See Gary D. Sprague, Cost-Sharing “Divisional Interests” Rule as Applied to e- 

Commerce Business Models, 40 Tax Mgm’t Int’l J. 190 (Mar. 11, 2011) available 

under publications at www.bakermckenzie.com. 

Under the divisional interests requirement of Treas. Reg. § 1.482-7T(b)(1)(iii) and 

(b)(4), each controlled participant in a cost-sharing agreement “must receive a 

non-overlapping interest in the cost shared intangibles without further obligation 

to compensate another controlled participant for such interest.” The regulations 

sanction two ways of dividing interests: by territory and by field of use. In 

addition, interests may be divided on some other basis if certain requirements 

are met: (1) all interests in cost shared intangibles must be clearly and



unambiguously divided among the controlled participants, (2) the controlled 

participants must be able to verify the consistent use of the basis for the division, 

(3) the rights of the controlled participants must be non-overlapping, exclusive, 

and perpetual, and (4) the resulting benefits associated with each controlled 

participant’s interest in cost shared intangibles must be “predictable with 

reasonable reliability.” 

The examples in the regulations suggest that this last requirement will be strictly 

interpreted, essentially requiring the resulting benefits to be “locked in stone.” 

The article argues that Treasury should permit a more flexible approach. 

The article considers the example of a business that uses a single cost-shared 

software platform to operate a series of websites, each of which focuses on a 

distinct subject but attracts subscribers from around the world. The article 

proposes that a division of rights that allocates to each participant the right to 

exploit the market through specified sites should be respected as satisfying the 

“predictable with reasonable reliability” requirement. Such a division 

accomplishes the primary purpose of the divisional interests rule, which is to 

prevent taxpayers from gaming the system by cost sharing based on one set of 

assumptions about the expected benefits and then intentionally shifting 

exploitation from one party to another to change their relative benefits. For 

instance, a taxpayer that operates separate sites for ballet lovers and hip-hop 

fans will not easily be able to shift customers from one site to the other. 

This approach acknowledges the differences between e-commerce and more 

traditional businesses involving the manufacture and sale of tangible property. In 

the e-commerce context, there will be many cases where neither a territorial nor 

a field-of-use division will make sense; the proposal offers a workable alternative. 

Furthermore, a more flexible reading of the divisional interests rule should not 

harm the interests of the Treasury because the cost sharing regulations already 

include sufficient safeguards to ensure that parties are compensated on an arm’s 

length basis for any change in expected benefits. 

By Paula R. Levy, Palo Alto 

Proposed Regs Would Require US Financial 

Institutions to Report Bank Deposit Interest 

Income for all Non-Resident Alien Individuals 

Under Code Section 871(i)(2), non-resident alien individuals are exempted from 

US taxation on the receipt of non-effectively connected interest income from 

amounts deposited with certain domestic financial institutions, including banks, 

savings institutions, and amounts held by insurance companies (“Bank Deposit 

Interest Income”). Additionally, under Treas. Reg. § 1.6049-8(a), these domestic 

financial institutions are not required to report the amount of Bank Deposit 

Interest Income earned by non-resident alien individuals, with the exception of 

amounts paid to Canadian residents (and amounts paid to US tax residents). The 

exemption from tax and reporting has been a part of the Internal Revenue Code 

for over 50 years. See former Code Section 861(a)(1)(A) [12/31/1954]. At the 

time it was understood that Congress’ intent was to provide an incentive for nonresident 

alien individuals to bank in the United States. 

On January 7, 2011, the Treasury issued proposed regulations (Prop. Reg. § 

1.6049-8) that would require US financial institutions to annually report Bank 

Deposit Interest Income of all non-resident individuals to the IRS (“2011


North America Tax 

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Proposed Regulations”). It should be noted that these new rules affect only 

reporting requirements and do not affect the taxation of Bank Deposit Interest 

Income. The 2011 Proposed Regulations are similar to proposed regulation that 

were issued 2001, which never became effective but would have required 

domestic financial institutions to report bank deposit interest income earned by all 

non-resident alien individuals to the IRS. In response to strong opposition, the 

Treasury withdrew the 2001 Proposed Regulations and issued revised proposed 

regulations, which would have limited the scope of the reporting by domestic 

financial institutions to residents of only 15 countries (the (“2002 Proposed 

Regulations”). The 2002 Proposed Regulations never became effective and have 

been replaced by the 2011 Proposed Regulations, which essentially reinstated 

the 2001 Proposed Regulations. 

The 2011 Proposed Regulations were released in close time proximity to the 

Foreign Account Tax Compliance Act of 2010 (“FATCA”), which generally 

provided for increased information exchange by foreign financial institutions that 

hold financial accounts of US taxpayers. The preamble to the 2011 Proposed 

Regulations provides two reasons for the extended scope of reporting: 

First, since the 2002 proposed regulations were released, 

there is a growing global consensus regarding the importance 

of cooperative information exchange for tax purposes that has 

developed. Significant agreements have been reached on 

international standards for the exchange of information, 

including, for example, the understanding that information 

exchange will not be limited by bank secrecy or the absence of 

a domestic tax interest. Second, requiring routine reporting to 

the IRS of all U.S. bank deposit interest paid to any 

nonresident alien individual will further strengthen the United 

States exchange of information program, consistent with 

adequate provisions for reciprocity, usability, and 

confidentiality in respect of this information. Finally, this 

extension will help to improve voluntary compliance by U.S. 

taxpayers by making it more difficult to avoid the U.S. 

information reporting system (such as through false claims of 

foreign status). 

Under Prop. Reg. § 1.6049-8(a), the domestic financial institution may rely on a 

valid Form W-8BEN to determine whether the payment is made to a non-resident 

alien individual. Prop. Reg. § 1.6049-6(e)(4) clarifies that Bank Deposit Interest 

Income should be reported on a Form 1042-S, “Foreign Person’s U.S. Source 

Income Subject to Withholding.” Furthermore, Prop. Reg. § 1.6049-6(e)(4) states 

that Form 1042-S should be furnished to the recipient by either providing it 

directly to the recipient or mailing it to the last known address of the recipient. 

The 2011 Proposed Regulations are to become effective on Bank Deposit 

Interest Income payments made after December 31 of the year in which they are 

published as final regulations in the Federal Register. The Preamble provides 

that the Treasury believes that the 2011 Proposed Regulations will not have a 

significant impact on a substantial number of small entities because depository 

accounts tend to be deposited with larger financial institutions and banks are 

already required to gather the underlying information on Forms W-8 when 

individuals initially open bank accounts. However, the IRS has requested 

information regarding the economic impact of the 2011 Proposed Regulations on 

small commercial banks, savings institutions, credit unions, and small securities 

brokerages. 

By Steven Hadjilogiou and Daniel W. Hudson, Miami

www.bakermckenzie.com 


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First Annual BNA/Baker & McKenzie Transfer 

Pricing Conference to be held June 8-9 in 



This summer, Baker & McKenzie teams with BNA to offer their first annual 

Transfer Pricing Conference where senior government, corporate and private 

transfer pricing practitioners will gather to discuss cutting edge transfer pricing 

issues facing multinational companies today. The one and a half day conference 

will take place on Wednesday, June 8 and Thursday, June 9, and will feature a 

range of topics from the reorganized LB&I and solutions for resolving crossborder 

transfer pricing disputes to the new OECD project on the transfer pricing 

of intangibles and how recent transfer pricing legislation may impact multinational 

companies. 

Over 15 US and foreign Baker & McKenzie transfer pricing practitioners will 

present at the upcoming conference, along side corporate and government 

speakers. Key government speakers include: 

� Christopher Bello (Chief, Branch 6, Office of Associate Chief Counsel 

(International), IRS); 

� Mary Bennett (Head of Tax Treaty & Transfer Pricing Division, OECD); 

� Michael Danilack (LB&I Deputy Commissioner (International), IRS); 

� David Ernick (Associate International Tax Counsel, US Department of 

the Treasury); 

� John Hinding (Director, APA Program, IRS); 

� Cyndi Lafuente (LB&I, Senior Advisor to the Deputy Commissioner 

(International), IRS); and 

� Caroline Silberztein (Head of Transfer Pricing Unit, OECD) 

The brochure containing full conference details, agenda and registration 

information is accessible by clicking on this link or visiting BNA online at 

www.bnatax.com/transfer-pricing-conference. We hope to see you in 

Washington, DC at what promises to be an interesting and informative 

conference! 

Tax News and Developments is a periodic publication of Baker & McKenzie’s North American 

Tax Practice Group. The articles and comments contained herein do not constitute legal advice or 

formal opinion, and should not be regarded as a substitute for detailed advice in individual cases. 

Past performance is not an indication of future results. 

Tax News and Developments is edited by Senior Editors, David G. Glickman (Dallas) and 

David R. Tillinghast (New York), and an editorial committee consisting of James H. Barrett 

(Miami), Theodore R. Bots (Chicago), Salim R. Rahim (Washington, DC), Michael Snider 

(Houston), Angela J. Walitt (Washington, DC), and Beth L. Williams (Palo Alto) 

For further information regarding the North American Tax Practice Group or any of the items or 

Upcoming Events appearing in this Newsletter, please contact Carol Alexander at +1 312 861 8323 

or carol.alexander@bakermckenzie.com. 

Your Trusted Tax Counsel ® 

www.bakermckenzie.com/tax 

©2011 Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service 

organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm. 

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