Federal Headlines

Guidance on Tax Consequence of Distressed Homeowner Payments Provided (Notice 2011-14)

The IRS has provided guidance on the federal tax consequences of payments made to or on behalf of financially distressed homeowners under the Treasury Department's Housing Finance Agency (HFA) Innovative Fund for the Hardest-Hit Housing Markets and the Department of Housing and Urban Development's (HUD) Emergency Homeowners' Loan Program. Guidance on the information reporting requirements for these payments is also provided.

Similar to the payments described in Rev. Rul. 2009-19, I.R.B. 2009-29, 112, payments made with approved homeowners' aid program funds promote the general welfare by helping homeowners who are at risk of losing their homes either pay on their mortgage loans or transition to more affordable housing and do not involve the performance of services. Therefore, payments made under these programs to or on behalf of a homeowner are excluded from gross income under the general welfare exclusion.

Because the payments made under these programs are excluded from the homeowners' gross income they are not fixed or determinable income under Code Sec. 6041. Thus, payors are not required to file information returns or furnish copies to homeowners for payments made under these programs.

Further, for purposes of Code Sec. 6050H, interest received from a governmental unit or its agency or instrumentality is not interest received on a mortgage and, thus, is not required to be reported as interest received on a mortgage. Accordingly, if a person receives mortgage interest payments from a governmental unit or its agency or instrumentality, that person should not include those payments in the amount reported as interest received on a mortgage on Form 1098.

Finally, the IRS will not assert Code Sec. 6721 or Code Sec. 6722 penalties under against a mortgage servicer that reports payments received under an approved program on Forms 1098 during 2010. Additionally, the IRS will not assert penalties against mortgage servicers that report on Forms 1098 payments received under an approved program during calendar years 2011 or 2012 if the servicer notifies homeowners that the amounts reported on the Form 1098 are overstated because they include government subsidy payments.

The IRS will not assert Code Sec. 6721 or Code Sec. 6722 penalties against any state housing finance authority (HFA) for failing to file and furnish Forms 1098 for calendar year 2010. For calendar years 2011 and 2012, the IRS will not assert penalties if the state HFA provides each homeowner and the IRS a statement with the homeowner's name and TIN, and separately stating the amount the state HFA and the amount the homeowner paid to the mortgage servicer under the approved program during that year. The IRS intends to issue future published guidance specifying the IRS office where these statements should be filed.

Notice 2011-14, 2011FED ¶46,279

Other References:

Code Sec. 61

CCH Reference - 2011FED ¶5504.026

CCH Reference - 2011FED ¶5504.184

Code Sec. 6041

CCH Reference - 2011FED ¶35,836.075

CCH Reference - 2011FED ¶35,836.30

CCH Reference - 2011FED ¶35,836.61

Code Sec. 6050H

CCH Reference - 2011FED ¶36,186.075

CCH Reference - 2011FED ¶36,186.12

Code Sec. 6721

CCH Reference - 2011FED ¶40,220.75

Code Sec. 6722

CCH Reference - 2011FED ¶40,240.58

Tax Research Consultant

CCH Reference - TRC INDIV: 33,354

CCH Reference - TRC REAL: 6,106.25

CCH Reference - TRC FILEBUS: 9,312

State Headlines

California --Corporate Income Tax: Apportionment of Software Company's Intangible Property Upheld

In rejecting an out-of-state taxpayer's efforts to reduce the percentage of its total business income apportionable to California for corporation franchise tax purposes, the Superior Court of San Francisco County held that:

-- royalties from the licensing of computer software products were properly assigned to the California numerator of the taxpayer's sales factor;

-- gross receipts from the sale or disposition of the taxpayer's marketable securities were properly excluded from the sales factor denominator in order to fairly reflect the extent of the taxpayer's business activity in California; and

-- California's standard apportionment formula, which omits the value of intangible property from the property factor, should not be modified to include the value of the taxpayer's intellectual property.

In addition, the court noted that the California Franchise Tax Board (FTB) was authorized to assess amnesty penalties against the taxpayer as a result of the taxpayer's failure to pay its tax liabilities during a two-month tax amnesty period.

 Royalties From Licensing of Software

The taxpayer received royalties from the licensing of proprietary software products to Original Equipment Manufacturers (OEMs) and other licensees. The licensing agreements gave the OEMs the right to install the taxpayer's software into OEM computer systems and then sell those computer systems with the pre-installed software. The taxpayer made its licensed software available to the OEMs primarily through the shipment of master disks that allowed OEMs to copy the software onto the hard drives of the computer units that they were assembling and plastic back-up disks that the OEM derived from authorized replicators to be bundled with the assembled computer units.

The taxpayer claimed that the royalties it received from the licensing of its software to OEMs and other licensees with California billing addresses were not attributable to the licensing of "tangible personal property" but, rather, to the licensing of "other than tangible personal property" (i.e., intangible property). As such, the taxpayer claimed that, because the greater cumulative amount of the "costs of performance" relating to the licensed products was incurred in another state, the royalties should be completely excluded from the California numerator of the sales factor. On the other hand, the FTB maintained that the royalties were attributable to the licensing of software that qualified as tangible personal property and, therefore, were properly assigned to California in accordance with the California location to which those licensed products were delivered.

According to the court, the royalties received from licensees with California billing addresses were derived from the licensing of tangible personal property because (1) state courts from a number of jurisdictions have determined that computer software constitutes tangible personal property; (2) California appellate courts have determined that, for sales and use tax purposes, a transfer of tangible personal property (such as a master tape or master recording) that is physically useful in the manufacturing process results in a taxable sale even where the true object of the transfer is an intangible property right like a copyright; (3) finding that the software constitutes tangible personal property is consistent with the manner in which software that is prewritten (or "canned," as opposed to customized) is treated by California for sales and use tax purposes; and (4) although California courts have not addressed the licensing of computer software specifically for purposes of computing the sales factor numerator for income apportionment purposes, the Nebraska Supreme Court has held that computerized information goods licensed by the taxpayer to other businesses were tangible personal property for purposes of computing Nebraska's sales factor, which is nearly identical to California's sales factor. Finally, after finding that the royalties were derived from the licensing of tangible personal property, the court then determined that they were properly assigned to the California sales factor numerator since the taxpayer failed to produce any evidence that the OEMs with California billing addresses took delivery of the licensed software for installation outside of California.

 Gross Receipts From Marketable Securities

During the tax years at issue, the taxpayer maintained a treasury operation in its out-of-state headquarters. The treasury operation was responsible for all cash management of the taxpayer's worldwide operation and for the taxpayer's buying, managing, and disposing of financial instruments. A total of 21 employees were engaged in the purchase, maintenance, sales, or disposition of the taxpayer's marketable securities. By contrast, there were over 17,000 employees developing, licensing, manufacturing, and distributing computer software and providing software-related services. Because the operations and gross receipts of a corporate treasury department are attributed to the state where it operates, the taxpayer's treasury receipts from marketable securities would be credited to the state where the taxpayer's headquarters is located, thereby contributing to the taxpayer's overall sales (sales factor denominator) but not to its California sales (sales factor numerator). However, on audit, the FTB adjusted the denominator of the sales factor by removing this amount. This increased the California sales factor, which resulted in an increase to the amount of the taxpayer's business income that was subject to tax by California.

In applying the two-pronged test for determining whether the standard apportionment formula can be modified, the court determined that (1) the taxpayer's treasury functions were "qualitatively different from its principal business" as a software taxpayer, and (2) that the FTB met its burden of proving by clear and convincing evidence that the quantitative level of distortion from the taxpayer's inclusion of the full redemption price from the sale or disposition of its marketable securities was substantial. The court then concluded that the FTB's proposal to include in the sales factor denominator only the net receipts from the taxpayer's redemptions of its marketable securities was reasonable. As a result, the court upheld the FTB's adjustment.

California's standard three-factor apportionment formula includes the value of real and tangible personal property in the property factor, but not the value of intangible property. The taxpayer claimed that its intellectual property must be included in the property factor of the apportionment formula because such property represents a major business income-producing asset that is part of its core business. The FTB argued that (1) the taxpayer did not presented clear and convincing evidence that the absence of its intangible property from the standard formula (as statutorily mandated) actually resulted in an unfair reflection of the level of its business activity in the state, or (2) its proposed alternative was reasonable.

According to the court, the taxpayer did not meet its burden of proving that California's standard apportionment formula should be modified to include the value of its intellectual property. The court first noted that the taxpayer's expert witness provided evidence that the level of "distortion" to California's apportionment percentage resulting from the omission of the taxpayer's intellectual property was de minimis at best and did not establish the necessity for formula modification. In addition, the court concluded that even if the taxpayer could demonstrate quantitative distortion of a substantial nature, its contention that the omission of its intellectual property from the standard formula results in an unfair reflection of its California business activity was based on a flawed methodology. The court also noted that the standard formula already takes into account much of the value of the taxpayer's intellectual property and that the taxpayer's proposed modification was contrary to the UDITPA goal of uniformity. Finally, even assuming that the taxpayer could make a showing of substantial quantitative distortion, the court found that the taxpayer did not demonstrate by clear and convincing evidence that either of its proposed alternative methods of calculation were reasonable.

 Amnesty Penalties

The taxpayer did not take advantage of an available amnesty program by paying the full amount of its proposed tax deficiencies during the amnesty period. Instead, the taxpayer waited nearly three years after the amnesty period before making payments in an amount sufficient to cover the entire amount of the tax deficiencies, plus interest, asserted in the notices of proposed assessment. The taxpayer claimed that the FTB's assessment of amnesty penalties was contrary to due process under both the federal and state constitutions on the grounds that (1) the amnesty penalty statute applies retroactively; (2) the statute is unconstitutionally vague; (3) the statute provides no opportunity for pre-payment or post-payment review of the penalties; and (4) the penalties were imposed on tax deficiencies that were not "due and payable" within the meaning of the statute. The court rejected all of the taxpayer's arguments.

Subscribers can view the Statement of Decision (not a formal judgment).

Microsoft Corporation v. Franchise Tax Board, California Superior Court for San Francisco County, No. CGC08-471260, February 17, 2011