LEXIS® FEDERAL TAX JOURNAL QUARTERLY September 2013

LEXIS® FEDERAL TAX JOURNAL QUARTERLY
September 2013

IN THIS ISSUE:
Featured Articles
Allison Christians on Reversal of Fortune: Did
PPL Corporation Get a Foreign Tax Credit
from the Wrong Government?

Dmitriy Kustov on Portfolio Interest:  Free
Money

Joel S. Newman on Deductions on a Higher
Plane:  Medical Marijuana Business Expenses

Special International Update
Tim Sanders and Eric Sensenbrenner on U.S.
Inversions Through European Mergers

Practitioner’s Corner
Robert S. Chase II, et al. on The End of an
Era: IRS Expands “No Rule” Policy for Spin‐
Offs and Other Common Corporate
Transactions

Adam B. Cohen, Vanessa A. Scott, Carol A.
Weiser, et al. on Fall of the DOMA‐n
Empire: Practical Employee Benefits
Implications

Lexis Commentary
Deanne B. Morton on The Medical Excise Tax:  Is
Repeal the Right Therapy?

Current Developments
CORPORATIONS
Final Treasury Regulations, TD 9619
EMPLOYMENT
Notice 2013‐17, 2013‐20 IRB 1082
HEALTH CARE
Revenue Procedure 2013‐25, 2013‐21 IRB 1
Notice 2013‐41, 2013‐29 IRB 60
Notice 2013‐42, 2013‐29 IRB 61
MEDICAL RELATED TAXES
Proposed Regulations, 78 FR 27873‐27877
PARTNERSHIPS
Announcement 2013‐30, 2013‐21 IRB 1134
PRACTICE & PROCEDURE
REAL ESTATE
SECURITIES TRANSACTIONS
Notice 2013‐38, 2013‐25 IRB 1251
Notice 2013‐48, 2013 IRB LEXIS 355

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Table of Contents

Featured Articles
Allison Christians on Reversal of Fortune: Did PPL Corporation Get a Foreign Tax Credit from
the Wrong Government?
§ 1.01 Introduction
§ 1.02 The Controversy
§ 1.03 The “Windfall Tax”
§ 1.04 The Claim of Right Doctrine
§ 1.05 Conclusion

Dmitriy Kustov on Portfolio Interest: Free Money
§ 2.01 Introduction: Tax-Free Interest in a Financially Troubled World
§ 2.02 The Enactment of the Portfolio Interest Tax Exemption
[1]
Capital Formation and Balance of Payments
[2]
Tax Equity Arguments
[3]
Tax Avoidance and Evasion
[4]
Subsequent Developments
§ 2.03 Requirements of the Portfolio Interest Income Exemption
[1]
U.S. Person
[2]
Foreign Person
[a]
Required Statement Proving Foreign Residency
[b]
Foreign Bank
[c]
Controlled Foreign Corporation (CFC)
[d]
“10-Percent Shareholder”
[3]
Registered Form
[a]
Regulations C(1): Physical Form
[b]
Regulations C(2): Book Entry
[4]
Contingent Interest
[5]
Jurisdiction Not “Blacklisted” by the Secretary
[6]
Effectively Connected Income (ECI)
[a]
Asset Test
[b]
Activities Test
[7]
Side Kick: Estate Tax
§ 2.04 Conclusion
Joel S. Newman on Deductions on a Higher Plane: Medical Marijuana Business Expenses
§ 3.02 Two Tax Court Cases
[1]
CHAMP v. Commissioner
[2]
Olive v. Commissioner
[3]
CHAMP and Olive Compared
§ 3.03 IRS Enforcement in Context

§ 3.04 Current Efforts
[1]
Harborside
[2]
Legislative Lobbying
[3]
Lobbying the Attorney General and the DEA
[4]
Litigation Strategy
§ 3.05 The Future

Special International Update from Lexis Tax Journal Magazine
Tim Sanders and Eric Sensenbrenner on U.S. Inversions Through European Mergers
§ 4.01 U.S. Inversions Through European Mergers

Practitioner’s Corner
Robert S. Chase II, et al. on The End of an Era: IRS Expands “No Rule” Policy for SpinOffs and Other Common Corporate Transactions
§ 5.01 The End of an Era: IRS Expands “No Rule” Policy for Spin-Offs and Other
Common Corporate Transactions
Adam B. Cohen, Vanessa A. Scott, Carol A. Weiser, et al. on Fall of the DOMA-n Empire:
Practical Employee Benefits Implications
§ 6.01 Fall of the DOMA-n Empire: Practical Employee Benefits Implications

Lexis Commentary
Deanne B. Morton on The Medical Excise Tax: Is Repeal the Right Therapy?
§ 7.02 Defining the Tax
[1]
Generally
[2]
Definitions
[a]
Manufacturer, Producer, or Importer
[b]
Taxable Medical Device; Dual Use Device
[c]
Taxable Sales Price for Calculating the Tax
§ 7.03 Exemptions
[1]
Retail Exemption
[a]
Facts and Circumstances Test
[b]
Retail Exemption Safe Harbor
[2]
Other Exemptions
§ 7.04 Applicable Form and Payment Procedures
§ 7.05 Deposit Safe Harbor and Penalties
§ 7.06 Prospects for Repeal
§ 7.07 Conclusion

Current Developments
§ 8.01 CORPORATIONS
Final Treasury Regulations TD 9619
§ 8.02 EMPLOYMENT
Notice 2013-17
§ 8.03 HEALTH CARE
Revenue Procedure 2013-25
Notice 2013-41
§ 8.04 MEDICAL RELATED TAXES
Proposed Regulations 78 FR 27873-27877
§ 8.05 PARTNERSHIPS
Announcement 2013-30
§ 8.06 PRACTICE & PROCEDURE
§ 8.07 REAL ESTATE
§ 8.08 SECURITIES TRANSACTIONS
Notice 2013-38
Notice 2013-48

Featured Articles
Allison Christians on Reversal of Fortune: Did PPL Corporation Get a Foreign Tax Credit from
the Wrong Government?
By Allison Christians
In PPL Corp. v. Commissioner,1 the Supreme Court reminded us that a foreign government’s
characterization of its own tax is not dispositive in deciding whether the tax ought to be creditable in the
United States. This dismissal accords with the established doctrine around the creditability of a tax, which
determines whether something is a tax at all, and, if so, whether it is an income tax, according to U.S.
principles.2 But something important seems to have been lost in this approach; namely, that the tax in this
case seems, in the words of Third Circuit Court Judge Ambros, “a bridge too far”3 from the kind of
income tax that the foreign tax credit was designed to alleviate. The tax in question appears instead to
force a disgorgement of profits in order to, in effect, re-price a preexisting sale of a company using the
benefit of hindsight to determine the then-fair market value.
The doctrine surrounding the creditability of a tax—which now, due to the PPL Corp. decision, expressly
allows a re-configuration of a foreign tax to accord with U.S. income tax principles—does not seem to
have a means of dealing with the distinction between an income tax qua income tax and an income tax
qua disgorgement of profits. That is troubling because the end result in PPL Corp. is that the U.S. fisc
bore the brunt of not one, but two foreign taxes imposed on the same income stream by the same foreign
government. Instead, the U.S. could have borne no cost at all to the extent the second tax in effect wiped
out profits that had been subject to the foreign income tax in the first place. To understand why this might
have been so requires both an examination of the controversy that led to the Supreme Court decision in
the first place, as well as another look at the U.K.’s intentions in enacting the tax in question.
§ 1.02 The Controversy
The controversy between PPL Corp. and the IRS arose as a result of a law passed by the British
Parliament in 1997, enacting what it called a “windfall tax” on 32 energy companies.4 PPL Corp. owned
shares in one such company at the time the tax was levied, and it accordingly sought a credit against its
U.S. tax liability for its share of the U.K. liability paid.5 The IRS had previously denied the creditability
of the windfall tax in a private letter ruling issued in 2007 on the grounds that “[b]y its express terms, the



Allison Christians is the H. Heward Stikeman Chair in Taxation Law at McGill University Faculty of Law.
Special thanks to Montano Cabezas for excellence in research assistance with this article.
1
133 US 1897 (2013). The ruling reversed the judgment of the Third Circuit (665 F3d 60 (3d Cir 2011)), and settled
a split with the Fifth Circuit in Entergy Corp v Commr, 683 F3d 233 (5th Cir 2012).
2
Treas Reg § 1.901-2(a)(2) (“A foreign levy is a tax if it requires a compulsory payment pursuant to the authority of
a foreign country to levy taxes. …. [which] is determined by principles of U.S. law and not by principles of law of
the foreign country.”), Biddle v Commr, 302 US 573 (1938).
3
PPL Corp v Commr, 665 F3d 60, 65 (3d Cir 2011).
4
Finance (No 2) Act 1997, c. 58, Pt I, clause 1 (Eng.).
5
PPL Corp v Commr, 135 TC 304 (2010).

U.K. Windfall Tax … is a tax on the appreciation of the company above its flotation value.”6
Accordingly, the IRS denied PPL’s credit. But PPL viewed the tax as one on income because the terms of
the foreign statute assessed “value” by reference to profits. PPL argued that the lawmakers used the term
“value” in the statute for political reasons, and by reconfiguring the formula used to calculate value, it
could be shown that, in effect, the statute imposed a 51.75 percent tax on “excess profits” earned by the
taxpayer over a specified period of time.
The case went to the Tax Court, along with an identical case brought by Entergy Corporation.7 The Tax
Court decided in favor of the taxpayers in both cases, finding that the tax was creditable under IRC
section 901 since it “did, in fact, ‘reach net gain’ as required by the applicable Treasury Regulation.”8 But
on appeal, a circuit split ensued. The Third Circuit reversed the Tax Court, holding that the windfall tax
failed the regulatory standards for creditability in the U.S., and rejecting the taxpayer’s algebraic
reformulation of the statute on the grounds that accepting such a reformulation would virtually eliminate
any limitation on creditability.9 Conversely, the Fifth Circuit affirmed the Tax Court, holding that the tax
was, in substance, based on excess profits.10 The Supreme Court accepted the petition for writ of certiorari
and resolved the split in the taxpayer’s favor, deciding that the windfall tax was in effect, if not
necessarily in form, imposed on the basis of profits.11
The Supreme Court declined to spend much time on the U.K. government’s intentions in enacting the
windfall tax, given the decision to treat such intentions as non-dispositive.12 Yet a reflection on the U.K.
government’s intentions in adopting the tax reveals that any entitlement PPL Corp. had to a tax credit
should have been against the government that imposed the forced disgorgement, and not against the
United States. That is because an extraction that is a forced disgorgement of profits—which clearly seems
to have been the purpose of the U.K. windfall tax—represents an undoing of an “error”, which in this case
was carried out by the former U.K. government in its sale of the energy companies at a below-market
price.

6

Ltr Rul 200719011 (stating that “[t]he statutory language of the U.K. Windfall Tax … is clear and does not satisfy
the net gain requirement of Treas Reg §1.901-2(b)”).
7
Entergy Corp v Commr, TC Memo 2010-166.
8
PPL Corp v Commr, 135 TC 304 (2010).
9
PPL Corp v Commr, 665 F3d 60, 67 (3d Cir 2011), “[a]ny tax on a multiple of receipts or profits could satisfy the
gross receipts requirement, because we could reduce the starting point of its tax base to 100% of gross receipts by
imagining a higher tax rate.”).
10
Entergy Corp v Commr, 683 F3d 233 (5th Cir 2012).
11
Petition for Writ of Certiorari, July 9, 2012, available at http://sblog.s3.amazonaws.com/wpcontent/uploads/2012/08/12-43-PPL-Cert-Petition.pdf.
12
It is perhaps of note that one of the original reasons to view foreign government intentions as non-dispositive was
revenue-protective in nature: those who viewed the foreign tax credit mechanism as a gift of revenue to other
countries feared that foreign governments would characterize their pre-existing taxes as income taxes in order to
make them available for credit in the U.S. Focusing on their substantive nature would serve to thwart such
formalistic efforts. For a discussion of this history, see Graetz & O'Hear, “The ‘Original Intent’ of U.S. International
Taxation,” 51 Duke L J 1021 (1997). The PPL Corp decision thus presents an irony in that the foreign government
did not intend the windfall tax to be considered an income tax for domestic purposes and even rejected their
creditability for foreign income tax purposes, but the taxpayer’s substance-over-form argument ultimately led the
U.S. government to sacrifice revenue anyway.

§ 1.03 The “Windfall Tax”
That the U.K. tax was intended to be a disgorgement of profits is apparent from both the record of the
PPL Corp. decisions and the public discussion surrounding the enactment of the law in 1997, even if not
discussed in the Supreme Court decision. In the Tax Court decision, Judge Halpern states the details
surrounding the enactment of the windfall tax. The main theme, repeated throughout the briefs of the
parties and in the decisions of the various courts, is that the windfall tax was enacted as a political
response to widespread public discontent over high consumer energy prices, which were juxtaposed
against what were viewed as excessive profits being earned by energy companies and excessive salaries
for their managers. These companies had been privatized under the Thatcher government, and it seems
clear from Judge Halpern’s and others’ discussions of the context of the tax that “the public retained a
strong feeling that the privatized utilities had unduly profited from privatization and that customers had
not shared equally in the gains therefrom.”13
In some ways it makes sense to disregard the U.K. government’s characterization of the tax, given that
the politics of tax policy are always shaped by emotional appeal rather than technical design. In this case,
lawmakers repeatedly confused the base of the tax in explanations of their legislation to the public.
Gordon Brown, then Chancellor of the Exchequer, called the legislation a tax on excess profits, but then
characterized its substance as a clawback of value lost by the taxpayer when the prior government underpriced and under-regulated the energy companies.14 The U.K. tax authority similarly deemed the
legislation a tax on excess profits, but then explained that the tax fell on the difference between two
estimated values of the targeted companies: that initially determined by the former government and that
recalculated by the current government.15 The U.K. Treasury, for its part, explained that the tax was
required “because the companies were sold too cheaply and regulation … was too lax.”16
At the same time, the social and political context of a given tax seems particularly relevant when, as in
this case, an argument could be made that the economic impact of the tax is not—or not only—imposed
on the basis of profits, as the Supreme Court notes, but is in fact imposed for the purpose of clawing back
the profits all together. There must be a difference between such a clawback and the act of imposing an
income tax. That difference probably lies somewhere in the underlying policy goals of income taxation,
which include, at their core, the requirement that income taxation be based on ability to pay.17

13

PPL Corp v Commr, 135 TC 304, 310 (2010).
Chancellor Brown explained that “I believe I have struck a fair balance between recognising the position of the
utilities today and their under-valuation and under-regulation at the time of privatisation. The windfall tax will be
related to the excessively high profits made under the initial regime. A company's tax bill will be based on the
difference between the value that was placed on it at privatisation, and a more realistic market valuation based on its
after-tax profits for up to the first 4 full accounting years following privatisation.” Id at 315 (2010).
15
According to Inland Revenue, the windfall tax was to be charged “on the difference between company value,
calculated by reference to profits over a period of up to four years following privatisation, and the value placed on
the company at the time of flotation.” Id.
16
Id at 340.
17
See, e.g., R Goode, The Individual Income Tax (1976); Dodge, “Theories of Tax Justice: Ruminations on the
Benefit, Partnership, and Ability-to-Pay Principles,” 58 Tax L Rev 399 (2005); Fleming, Peroni & Shay, “Fairness in
International Taxation: The Ability-to-Pay Case for Taxing Worldwide Income,” 5 Fl Tax Rev 299 (2001); Nancy
Kaufman, “Fairness and the Taxation of International Income,” 29 Law & Pol’y in Int’l Bus 145 (1998).
14

Various aspects of the U.K. tax legislation suggest that this tax was not designed to consider ability to pay
as a fundamental matter. For example, the tax was a one-time levy; it applied only to the specified
taxpayers, and could not and would not ever apply to any taxpayer other than those named specifically as
a class; it was retroactive; it was specifically designed and formulated to raise a pre-determined amount of
revenue, and it did raise that amount of revenue; and finally, its form was specifically chosen to ensure it
would not be viewed as a tax on profits.18 The various U.S. courts dismissed each of these factors as nondispositive to the question of whether the “predominate character” of the tax was of an income tax in the
U.S. sense, per U.S. regulations. Yet together, the factors paint a picture of a tax that is not, in qualitative
terms, an income tax.
Justice Thomas’s ultimate admonition was that we ought to assess the foreign tax in question from the
perspective of common sense. That is a perilous proposition because the common sense of the Court had
it crediting a tax that arguably does not look like an income tax in any sense other than under the
formulaically reconfigured version presented by the taxpayer. Moreover, an alternative common sense
interpretation of the tax could have employed the claim of right doctrine to explain that the tax credit
sought by the taxpayer should have been applied not against its income for U.S. purposes at all, but rather
against the income tax initially imposed by the U.K. on the income that later became subject to the
windfall tax.
§ 1.04 The Claim of Right Doctrine
In U.S. tax law, when a taxpayer has received income and later is determined not to have been legally
entitled to it, she can take a credit against future income to, in effect, undo the inclusion of income in the
prior year.19 Under this “claim of right” doctrine, the taxpayer is saved from permanently bearing an
incorrect amount of tax solely because an administrative convention—namely, the tax year—had the
taxpayer including income and paying tax on that income before the error was discovered. Obviously, [if
the error and its discovery thereof] had happened in the same year, no error correction would be needed,
since the taxpayer would simply refrain from including the income subsequently discovered to legally
belong to another. But if the error and discovery happen in two different years, some mechanism is
needed to right the administratively-produced wrong. That mechanism is a tax credit. Under IRC section
1341, “if an item was included in gross income for a prior taxable year (or years) because it appeared that
the taxpayer had an unrestricted right to such item,” then the tax in the current year is reduced by the
amount of the tax imposed in the prior year.20
In the present case, the taxpayer had a colorable claim of right case against the U.K. revenue authority. If
the windfall tax was truly meant to disgorge profits and was not, as its designers scrupulously sought to
avoid, a second tax on profits,21 then we might expect the taxpayer to have sought a credit against its U.K.
income tax in the prior year for the amount of income disgorged via the 1997 windfall tax. If PPL Corp.
had succeeded in making a claim of right argument in the U.K., this would have eliminated the original
income to which the regular income tax had been applied. That, in turn, could have prompted a claim of

18

PPL Corp v Commr, 135 TC 304, 312-314 (2010).
See, e.g., North American Oil Consolidated v Burnet, 286 US 417 (1932); IRC § 1341 (computation of tax where
taxpayer restores substantial amount held under claim of right).
20
IRC § 1341(a).
21
See PPL Corp v Commr, 135 TC 304, 312 (2010) (designers sought to avoid “a risk of criticism that it constituted
a second tax on the same profits.”).
19

right adjustment in the opposite direction in the United States, so as to undo any foreign tax credits that
had been taken in the prior year with respect to taxes on income that were subsequently disgorged.22
Of course, the claim of right doctrine is a U.S. principle, so the question would be whether the U.K. has
an equivalent regime and whether the taxpayer availed itself of it. But therein lies another issue in the
PPL Corp. decision, which was neither discussed by the parties nor the Court; namely, the regulatory
requirement that a U.S. taxpayer minimize its foreign tax liability in order to claim the foreign tax credit
in the U.S.23
This foreign tax minimization rule suggests that if the windfall tax indeed gave rise to the disgorgement
of profits its designers intended, then PPL Corp., Entergy Corp., and any other U.S. taxpayer that had
been indirectly charged with the windfall tax should have made an effort (even if unsuccessful) to have
the tax treated as a disgorgement under domestic U.K. law as well as under the U.S.-U.K. tax
convention,24 in order to ensure the U.S. creditability of the original income tax on the profits when they
were originally earned.
Indeed, a convincing case has already been made that PPL Corp. improperly failed to avail itself of tax
relief under the existing tax convention.25 The regulations under IRC section 901 suggest that the
taxpayer’s failure to turn to the treaty to seek relief, including via its dispute resolution mechanism, could
render the windfall tax not creditable even today, notwithstanding its now-undisputed character as an
income tax under U.S. law. As such, even after the PPL Corp. decision—and maybe even because of the
PPL Corp. decision, since that case cemented the windfall tax’ character as an income tax—the IRS has
an avenue to renew its rejection of the tax credit relief sought by the taxpayer.
Accordingly, if the U.K. windfall tax was a disgorgement of profits, then a series of events unfolds that
would reverse the U.S. foreign tax credit not once but potentially twice, after the PPL Corp. decision.
First, the income that had been earned by the energy companies in the period covered by the windfall
taxes (between 1984 and 1996) would have been reduced by the amount calculated under the windfall tax
statute. To the extent that a U.S. company owned shares in those companies during the years in question,
such companies may have credited their U.S. tax liabilities by an amount of normal income taxes (not
windfall taxes) paid to the U.K. tax authority in those years. As the underlying income would have been
reduced by the windfall tax, so too would the foreign tax on such income and in turn the U.S. tax credit.

22

See IRC § 1341(a)(2).
Treas Reg § 1.901-2 (e)(5) (“An amount paid is not a compulsory payment, and thus is not an amount of tax paid,
to the extent that the amount paid exceeds the amount of liability under foreign law for tax. An amount paid does not
exceed the amount of such liability if the amount paid is 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, and if the taxpayer exhausts all effective and practical remedies, including invocation of
competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer's liability
for foreign tax (including liability pursuant to a foreign tax audit adjustment.”).
24
Convention Between The Government Of The United States Of America And The Government Of The United
Kingdom Of Great Britain And Northern Ireland For The Avoidance Of Double Taxation And The Prevention Of
Fiscal Evasion With Respect To Taxes On Income And On Capital Gains, art. 10, TIAS 13161 (2001).
25
Cameron, “PPL Corp.: Where's the Treaty Argument?,” 138 Tax Notes 1117, reprinted in 69
Tax Notes Int’l 951 (2013).
23

Thus the company would need to adjust its income tax for U.S. purposes under the claim of right rule, to
reflect the amount of income, and the corresponding tax, based on the post-disgorgement amounts.
Of course, this is all a rather complicated undoing of income, taxes, and income tax credits. Perhaps the
common sense approach of the Court is compelling in its simplicity: viewing the windfall tax as an
income tax allows a circumvention of the implications of a foreign government forcing a disgorgement of
profits and the domino effect created by the subsequent unwinding. But the cost of this simplicity is that it
is the U.S. fisc, and not the U.K. treasury, that ultimately bore the cost of the U.K. windfall tax at issue in
the PPL Corp. decision.
§ 1.05 Conclusion
It doesn’t seem obvious that the U.S. fisc ought to bear the kind of cost imposed by the U.K. windfall tax
as if it involved a standard exercise of the foreign tax credit.26 Even if, as the petitioner successfully
argued in PPL Corp., the tax can be reconfigured algebraically to resemble one on profits and therefore
an income tax in the U.S. sense, it is not clear that the tax should be so reconfigured as a matter of
coherent tax policy. The foreign tax credit was designed to eliminate duplicative taxes on the same
income.27 In this case the foreign tax was, according to its own designers, not meant to be an iteration of a
domestic income tax but rather was intended to perform a distinct and independent function; namely, the
disgorgement of profits. If it nevertheless catches the same base as an income tax would in the United
States, should the foreign tax credit really apply?
The Supreme Court suggests that the answer is yes, under current law. But the result invites us to
reconsider what the foreign tax credit is meant to accomplish as a policy matter, and whether these goals
are in fact served when we dismiss evidence that the foreign government expressly intended the tax in
question to accomplish a very different result than that normally sought through income taxation.

26

The U.S. fisc bears the foreign tax credit as a cost in the sense that it represents revenue forgone. Thus, changes to
the mechanism for claiming the foreign tax credit can have significant budgetary impacts. See Office of
Management and Budget, Fiscal Year 2014, Analytical Perspectives, Budget of the U.S. Government, 187-190
(2013) available at http://www.whitehouse.gov/sites/default/files/omb/budget/fy2014/assets/spec.pdf. The tax credit
is not characterized as a tax expenditure because it is viewed as a structural component of the income tax rather than
a deviation therefrom. See discussion of tax expenditures, id at 143, 241-258 (“tax expenditures refer to the
reduction in tax receipts resulting from the special tax treatment accorded certain private activities.”). However, a
too-generous tax credit, which credits things that are not duplicative of the income tax in nature, should be
considered a tax expenditure. See, e.g., Fleming & Peroni, “Can Tax Expenditure Analysis Be Divorced from a
Normative Tax Base?: A Critique of the ‘New Paradigm’ and Its Denouement,” 30 Va Tax Rev 135 (2010).
27
For a discussion and critique, see Shaviro, “The Case Against Foreign Tax Credits,” 3 J of Legal Analysis 65
(2011).

Dmitriy Kustov on Portfolio Interest: Free Money
By Dmitriy Kustov
§ 2.01 Introduction: Tax-Free Interest in a Financially Troubled World
Following the world’s recent financial troubles, governments worldwide are seeking new sources
of revenue, raising tax rates, promising (only, it seems) to close gaping tax loop holes,
attempting to increase tax compliance generally, and actively fighting against bank secrecy
jurisdictions and tax havens. In this financially troubled world, many U.S. taxpayers may well
be surprised to learn that our government allows certain investors to pay absolutely no tax on
interest they receive from some common forms of debt. In fact, most U.S.-based taxpayers are
taxed at the highest applicable rates on the interest from these debt instruments while other
persons receive the interest from the exact same debt instruments tax free. This tax free interest
is the “Portfolio Interest” (PI) tax exemption.
PI, broadly defined, is the interest on specified debt obligations paid to certain foreign persons.
Since 1984, PI has been tax exempt, although interest in general had already been tax exempt for
many foreign investors under various U.S. tax treaties.
This article briefly discusses the enactment of the PI tax exemption, summarizes the policy and
economic considerations behind the exemption, and then details the requirements under IRC
Sections 871(h) and 881(c) for exempting non-resident aliens and corporations from taxation of
PI.
§ 2.02 The Enactment of the Portfolio Interest Tax Exemption
In 1984, the U.S. changed its game on certain interest income payments to non-residents.
President Ronald Reagan signed into law the Deficit Reduction Act of 1984,1 repealing the tax
on PI. Essentially, a pawn was sacrificed for bigger gains. On a closer look, it turned out to be an
inexpensive move as Congress gave up only about $50 million in revenues due to the repeal.2
According to the 1977 statistics, roughly only about five percent of the total interest paid to nonresidents went to the coffers as most of the PI payments were already tax exempt under the
provisions of various U.S. tax treaties. 3



Dmitriy Kustov, CPA, EA, MS Tax (Golden Gate University) has more than fifteen years of experience in tax
return preparation and tax consulting. He runs a boutique San Francisco accounting firm specializing in various tax
issues concerning small and medium size businesses.
1
PL 98-369, 98 Stat 494 (July 18, 1984).
2
1977 projected statistics from HR 7553, Subcommittee on Selected Revenue Measures of the Committee on Ways
and Means on June 19, 1980).
3
Compare this to the Deficit Reduction Act’s overall tax revenues increase of $18 billion per year coming on the
heels of the Tax Equity and Fiscal Responsibility Act of 1982, PL 97-248, 96 Stat 324 (Sept 3, 1982), which raised
taxes by $37.5 billion a year. See “Reagan was not a tax cutter, he was a tax raiser?” at
http://thelibertytree.me/tag/deficit-reduction-act-of-1984/.

Despite the minimal effect on tax revenues, the new law had its skeptics. A congressional
committee had weighed in on the pros and cons of the measure four years before its enactment.4
The policy and economic factors the committee had considered included: 1) capital formation
and balance of payments, 2) tax equity, and 3) tax avoidance and evasion.
[1]

Capital Formation and Balance of Payments

Proponents of the repeal bet on a considerable infusion of foreign capital into the United States
that would help the balance of payments, strengthen the dollar, assist in capital formation, and
help create new jobs. Since this capital infusion would be in the form of debt and not equity, the
inflow would also reduce the foreign ownership of U.S. businesses. As a result, U.S. owners
would realize greater profits by leveraging debt from abroad.
On the other hand, the opponents argued that the repeal of taxation on PI would merely substitute
the PI-related obligations for other existing investment forms, rather than increase the total
investment. Besides, the debt would need to be ultimately repaid, together with interest. These
repayments would thus create a greater outflow of capital than the original infusion. Also, the
increased debt would be directly contrary to the steps taken at that time to restrain the availability
of credit in an attempt to reduce inflation.5
[2]

Tax Equity Arguments

Opponents of the PI tax exemption argued that it would be unfair to tax U.S. taxpayers and not to
tax non-residents on the same type of income. Proponents countered that the proper comparison
is not with the U.S. tax treatment of U.S. lenders but rather with the way in which other foreign
countries tax similarly situated lenders from outside their borders. The second comparison is
more appropriate because other countries’ tax regimes determine the environment in which U.S.
borrowers must compete for foreign funds. For example, Australia, Denmark, France, Finland,
Japan, the Netherlands, Norway, and Sweden do not impose withholding taxes, at least in the
case of bonds issued in foreign currencies. Foreign lenders could always choose not to lend to
U.S. companies and merely lend elsewhere.6

4

“Every argument is like unto a dagger: two sharp and cutting sides” (Proverb).
Inflation in January of 1980 was 14.38%, nearly at its highest level in recent history after it reached its peak in
March of that year at 14.76%. 1980, however, saw a gradual reduction in inflation, which went uninterrupted
through 1983 when it was rained in to the levels at around 3-4%. See Tim McMahon, “Historical Inflation Rate,”
Apr 3, 2013, available at http://inflationdata.com/Inflation/Inflation_Rate/HistoricalInflation.aspx. Perhaps, this
victory over inflation paved the way for the portfolio interest tax repeal in 1984. If we ever see those inflation rates
go up again, might the portfolio interest rules be tightened with an aim of combating inflation? This situation could
probably depend on the amount of the capital borrowed versus GDP. The situation is very different now from when
the tax was repealed. In 1981 the percent of U.S. debt of GDP was 32.5%, in 2012 it was 100.8% and growing. See
United States Debt as a Percentage of GDP (1940-2012), available at http://visual.ly/united-states-debt-percentagegdp-1940-2012. The HIRE Act of 2010 (PL 111–147, 124 Stat 71 (Mar 18, 2010)) already excluded foreign
targeted obligation from portfolio interest exemption.
6
Currently, the following countries assess zero tax on interest paid to non-residents: Austria, Cyprus, Finland,
France, Germany, Gibraltar, Hong Kong, Hungary, Luxemburg, Malta, Netherlands, Norway, South Africa, and
5

[3]

Tax Avoidance and Evasion

Opponents argued that the only effective way to prevent tax avoidance and evasion, especially in
a world with tax havens and bank secrecy jurisdictions, is to withhold at the source. Those
favoring the PI tax exemption responded by pointing out that taxpayers have virtually unlimited
opportunities to avoid or evade taxes, if they intend to do so. As a result, the repeal of the U.S.
tax on PI income was unlikely to increase tax avoidance or evasion.7
[4]

Subsequent Developments

Four years after the congressional committee’s analysis, the proponents’ arguments prevailed as
the Deficit Reduction Act of 1984 was signed into law. The original law included the rule that a
10-percent or greater direct or indirect ownership of the creditor by the non-resident lender
disqualified the PI income as tax exempt.8 The denial of exemption on contingent interest
income came in 1993.9
The original provisions allowed bearer form obligations sold under procedures reasonably
designed to prevent sale or resale to U.S. persons. With these bearer obligations, the interest had
to be payable only outside the U.S., and the U.S. holders were subject to tax penalties.10 These so
called “targeted foreign obligations” were disqualified in 2010 with the repeal of certain foreign
exceptions to registered bond requirements, although allowing some transitional relief.11
§ 2.03 Requirements of the Portfolio Interest Income Exemption
A 30 percent tax is generally imposed on U.S. source Fixed or Determinable Annual or Periodic
(FDAP) income not effectively connected with a U.S. trade or business (e.g., interest, dividends,
and royalties) paid to non-resident aliens and corporations.12 The tax is reduced under most tax
treaties. Under the right circumstances, and only if certain complicated rules are observed, the
right non-residents can be exempt from the U.S. tax on FDAP interest income from U.S. sources
without regard to the respective tax treaty.13 This unique vehicle is called “Portfolio Interest”
(PI) and is described in IRC Sections 871(h) and 881(c) for the cases of non-resident aliens and
corporations, respectively. The favorable treatment of this special kind of interest under the
Internal Revenue Code also extends to the estate tax regime as the underlying loan instruments
are exempt from the estate tax.14 PI is also exempt from the reporting requirements of IRC

Sweden; to a limited extent, the tax rates on interest are zero in Canada, Colombia, Denmark, Estonia, Ireland,
Israel, Lithuania, Switzerland, and Turkey. See Deloitte Compare Rates Results
https://www.dits.deloitte.com/DomesticRates/resultCompareDomesticRates.aspx.
7
Remember, however, that in 1980, the U.S. still had zero tax on interest under the treaty with the Netherland
Antilles that comprised 18.8% of the total debt outstanding to foreign creditors. See H.R. 7553, Subcommittee on
Selected Revenue Measures of the Committee on Ways and Means on June 19, 1980, available at
https://www.jct.gov/publications.html?func=startdown&id=3978.
8
See Section 2.02[2][e].
9
Revenue Reconciliation Act of 1993, PL 103-66, 107 Stat 312 (Aug 10, 1993); see Section 2.03[4] discussing
Contingent Interest.
10
Conference Report, '84 DRA, PL 98-369, 7/18/84
11
See Notice 2012-20, 2012-1 CB 574 (Mar 7, 2012); Hiring Incentives to Restore Employment Act, PL 111-147,
124 Stat 100 (Mar 18, 2010). See Section 2.03[3] discussing Registered Form.
12
IRC §§ 871(a), 881(a).
13
IRC §§ 871(h), 881(c).
14
The gift tax will still apply though, according to IRC § 2511(b).

Section 6049, and the corresponding Treasury Regulation Section 1.6049-5(b)(8). No Form
1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, or
Form/1042(S) (Foreign Person’s U.S. Source Income Subject to Withholding) is necessary for
PI.
The rules for PI can, perhaps, be compressed into the following few statements, which will be
discussed further below:
1. The issuer must be a U.S. person.15
2. The holder must be a foreign person that:
a. provided proof of its foreign status,16 and that is:
b. not a bank extending credit in the course of its ordinary trade or business (except
if buying U.S. obligations);17
c. not related to the issuer, if the foreign person is a Controlled Foreign Corporation
(CFC);18 and
d. not a “10-percent shareholder” in the issuer at the time the interest is received.19
3. The underlying obligation must be in “registered form.”20
4. The interest must not be contingent interest (with some exceptions).21
5. Before the obligation is issued, the Secretary must not have determined in writing (and
published a statement) that the foreign country of the creditor has inadequate information
exchange with the U.S.22
6. The interest must be FDAP, and cannot be income “effectively connected” to the U.S.
trade or business (ECI).23
The main goals of these provisions are to ensure that (1) U.S. persons do not benefit from the tax
free interest, and (2) the underlying debt is not like equity in the hands of the holder.24

15

IRC § 871(h)(2)(B)(ii)(I).
IRC §§ 871(h)(2)(B)(ii)(I) & (II), 881(c)(2)(B)(ii)(I),(II), 871(h)(5).
17
IRC § 881(c)(3)(A).
18
IRC § 881(c)(3)(C).
19
IRC §§ 871(h)(3), 881(c)(3)(B).
20
IRC §§ 871(h)(2)(B)(i), 881(c)(2)(B)(i)) as defined by IRC §§ 163(f) (871(h)(7), 881(c)(7).
21
IRC §§ 871(h)(4), 881(c)(4)
22
IRC §§ 871(h)(6), 881(c)(6).
23
IRC §§ 871(a), 881(a), 871(h), 881(c).
24
The PI rule is to be distinguished from the general rule on deposits under IRC Section 871(i). The subsection
exempts non-residents from tax on any interest not effectively connected with U.S. trade or business and paid on:
16

(A) deposits with persons carrying on the banking business,
(B) deposits or withdrawable accounts with savings institutions chartered and supervised as savings
and loan or similar associations under Federal or State law, but only to the extent that amounts paid or
credited on such deposits or accounts are deductible under section 591 (determined without regard to
sections 265 and 291) in computing the taxable income of such institutions, and
(C) amounts held by an insurance company under an agreement to pay interest thereon.

[1]

U.S. Person

Who can be an issuer of a PI obligation? The definition is quite broad. The main rules under
IRC Section 871(h)(2)(B)(ii)(I) refer to a U.S. person as the one who “would otherwise be
required to deduct and withhold tax from such interest under Sec. 1441(a).” The regulations
under IRC Section 1441(a) clarify that “[a] U.S. person is a person described in section
7701(a)(30), the U.S. government (including an agency or instrumentality thereof), a State
(including an agency or instrumentality thereof), or the District of Columbia (including an
agency or instrumentality thereof).”25 IRC Section 7701(a)(30) lists the following as a “United
States person”: “(A) a citizen or resident of the United States, (B) a domestic partnership, (C) a
domestic corporation, (D) any estate (other than a foreign estate, within the meaning of
paragraph (31)), and (E) any trust if – (i) a court within the United States is able to exercise
primary supervision over the administration of the trust, and (ii) one or more United States
persons have the authority to control all substantial decisions of the trust.”
The original guidance from the IRS for IRC Section 871 provided that interest is PI within the
meaning of IRC Sections 871(h)(2)(B) or 881(c)(2)(B) if the underlying “obligation is a
registration-required obligation within the meaning of section 163(f)(2)(A).”26 Since registration
is not required for the obligations issued by individuals, such obligations were deemed ineligible
for portfolio interest treatment. Many early private letter rulings implied that this guidance was
to be followed.27 Final Treasury Regulation Section 1.871-14 does not have this particular
restriction.
[2]

Foreign Person

Generally, the term, Foreign Person, is also quite broad but has a few notable exceptions
discussed below. According to Treasury Regulation Section 1.1441-1(c)(2) “[t]he term foreign
person means a nonresident alien individual, a foreign corporation, a foreign partnership, a
foreign trust, a foreign estate . . . . Solely for purposes of the regulations under chapter 3 of the
Internal Revenue Code, the term foreign person also means, with respect to a payment by a
withholding agent, a foreign branch of a U.S. person that furnishes an intermediary withholding
certificate described in paragraph (e)(3)(ii) of this section. Such a branch continues to be a U.S.
payor for purposes of chapter 61 of the Internal Revenue Code. See [Treasury Regulation]
§ 1.6049-5(c)(4).”
[a]

Required Statement Proving Foreign Residency

No portfolio interest exemption is available unless either a timely statement is provided to the
withholding agent proving the foreign status of the payee, or the Secretary has determined that

25

Treas Reg § 1.1441-1(c)(2).
See Temp Treas Regs § 35a.9999-5, Q&A (8) (The full text of these old regulations can be found in PLR
8611066.)
27
See e.g., PLR 8611066, 8703052, 8703068.
26

no such statement is required.28 The statement can be made either by the beneficial owner or by a
financial institution that holds customers’ securities in the ordinary course of its trade or
business.29 The Secretary has the authority to determine that such statement from “any person (or
any class including such person)” does not meet these requirements.30
The statement must be furnished before expiration of the beneficial owner's limitations period for
claiming a refund of tax paid on the interest.31 Thus, as long as the statement is provided within
the statute of limitations (normally three years after the original tax return was due), the U.S. tax
return may be filed to claim a refund for the amounts withheld. The withholding certificate
(Form W-8Ben) along with the “Foreign Person's U.S. Source Income subject to Withholding”
(Form 1042-S) must be attached to the tax return.32 The ITIN (Individual Taxpayer Identification
Number) or EFIN (Employer Federal Identification Number) is required to file the tax return to
claim a refund (otherwise, the return will not be processed by the IRS) but neither ITIN nor
EFIN is necessary on the statement to the withholding agent under IRC Section 871(h)(2)(ii).33
The beneficial owner can use the official Form W-8Ben and intermediary can use the official
Form W-8IMY or a substitute form. The substitute form will be acceptable if it contains
provisions that are substantially similar to those of the official form, if it contains the same
certifications relevant to the transactions as are contained on the official form and these
certifications are clearly set forth, and if the substitute form includes a signature-under-penaltiesof-perjury statement identical to the one stated on the official form. The substitute form is
acceptable even if it does not contain all of the provisions contained on the official form, so long
as it contains those provisions that are relevant to the transaction for which it is furnished.34
Thus, a taxpayer may be asked to fill out an alternative to the official IRS forms but the content
of the statement would be the same.
[b]

Foreign Bank

The PI exemption is not available to a foreign bank extending credit in its ordinary course of
trade or business, except in the case of interest paid on an obligation of the United States.35 The
discussion of a “bank” for these purposes is found in Technical Advice Memorandum 9822007.36
In the situation described in the memorandum, a foreign entity provided financing to a U.S.
company under a complex “square trip financing” arrangement. In essence, this arrangement
was a lease-buy back with a third party advancing the cash for the buy-back part. The District
Director argued that the nature of the loan instrument, being, in effect, a loan that would

28

IRC § 871(h)(2)(ii)(I), (II).
IRC § 871(h)(5).
30
IRC § 871(h)(5).
31
Treas Reg § 1.871-14(c)(3)(i).
32
Treas Reg § 301.6402-3(e).
33
Preamble to TD 8734 (Oct 6, 1997).
34
Treas Reg § 1.1441-1(e)(4)(vi).
35
IRC § 881(c)(3)(A).
36
PLR 9822007 (Feb 10, 1998).
29

ordinarily be generated by a bank while it is engaged in the business of banking, should be the
decisive factor for determining what is a “bank.” The IRS counsel disagreed, however, siding
with the taxpayer and narrowly construing the definition of a bank for the purposes of IRC
Section 881(c)(3)(A). The IRS counsel acknowledged in the memo that neither the Code nor the
Treasury Regulations specifically defined the term “bank” for the purposes of IRC Section 881.
(These regulations still have not been issued as of July 2013). Because Congress frequently
cross-references IRC Section 581 when it uses the term, “bank,” by itself (as opposed to the
term, “banking, financing, or other similar business”) the same analysis should apply here. IRC
Section 581 requires that a substantial part of the entity’s business consists of receiving deposits
and making loans and discounts for it to be considered a “bank.” The foreign corporation in this
instance did not accept deposits and therefore was not considered a “bank.”
[c]

Controlled Foreign Corporation (CFC)

The foreign person can be a Controlled Foreign Corporation (CFC). The interest received by a
CFC, however, must not be from a related person as defined by IRC Section 267(b): members of
the immediate family, fiduciaries and beneficiaries of the trust, and by attribution of more than
50 percent ownership in entities. (See the detailed discussion of the related person rules under
the Contingent Interest rules below). Additionally, any 10-percent shareholder of the corporation
cannot be the issuer.37
CFC is defined in IRC Section 957(a) as a corporation more than 50 percent of which is owned
by the U.S. persons. The 50 percent ownership can be by vote or value, directly or indirectly –
the attributions rules of IRC Section 318(a) are applied with some modifications by IRC Section
958.
[d]

“10-Percent Shareholder”

The non-resident lender must not be a “10-percent shareholder” in the debtor at the time the
interest is received.38 A 10-percent shareholder is a person who owns either 10 percent or more
of the total combined voting power of all classes of voting stock of a corporation or 10 percent or
more of the capital or profits interest in a partnership.39 The direct and indirect ownership is
taken into consideration under the Section 318(a) attribution rules with some modifications.
Here is a brief description of the modified attribution rules:


Ownership by children (including those legally adopted), grandchildren, and parents is
attributed to the individual.40 Reattribution among the family members is not allowed.41

37

IRC §§ 881(c)(3)(A), 864(d)(4).
IRC §§ 871(h)(3), 881(c)(3)(B).
39
IRC § 871(h)(3)(B)(i),(ii).
40
IRC § 318(a)(1).
41
IRC § 318(a)(5)(B).
38








[3]

Ownership by partnerships is proportionately attributed to the partners,42 and ownership
by a partner is attributed to a partnership.43
From trusts, the ownership is attributed to grantors and beneficiaries. In the case of the
latter, the actuarial interest is used.44 Attribution from grantors and substantial
beneficiaries (more than 5 percent of contingent actuarially computed interest) back to a
trust is also proportionate.45
Ownership by a corporation is attributed proportionately to the shareholders based on the
value of the stock owned in the corporation.46 Ownership by the 50 percent shareholders
is attributed to a corporation,47 while for less than 50 percent shareholders the attribution
is measured by the proportionate value owned by shareholders in the corporation.48
There is no attribution by the reason of option ownership to or from partnership, trust, or
corporation.49
Registered Form

The PI rules borrow its registered form definitions from Section 163(f) of the Tax Equity and
Fiscal Responsibility Act (TEFRA) of 1982. 50 Under TEFRA, there are two ways for an
obligation to be considered registered: a) by requiring the obligation to be surrendered and
reissued to effect its transfer to another holder;51 or b) through a “book entry.”52 Unless an
obligation is in “registered” form, it is considered to be in “bearer” form,53 including an
obligation that can be transferred at any time until its maturity by any means other than those
consistent with the registered form.54 A term “bearer” is used throughout this article in a purely
technical sense as physical securities are seldom issued.55 Nonetheless, the interest received on
the obligation while it is in bearer form is disqualified from the PI tax exemption.

42

IRC § 318(a)(2)(A).
IRC § 318(a)(3)(A).
44
IRC § 318(a)(2)(B).
45
IRC § 318(a)(3)(B).
46
IRC §§ 318(a)(2)(C), 871(h)(3)(C)(i).
47
IRC § 318(a)(3)(C).
48
IRC § 871(h)(3)(C)(ii)(II).
49
IRC § 871(h)(3)(C)(iii).
50
PL 97-248, 96 Stat 324 (Sept 3, 1982). IRC § 871 itself only clarifies that the rules related to the book entry
system under IRC § 149 (a)(3) can be used. According to these rules, “a book entry bond shall be treated as in
registered form if the right to the principal of, and stated interest on, such bond may be transferred only through a
book entry consistent with regulations prescribed by the Secretary.” IRC § 149 (a)(3)(A). The chain of nominees is
allowed subject to the Secretary’s regulations. IRC § 149 (a)(3)(A). The actual portfolio interest regulations under
Treas Reg § 1.871-14(c) refer taxpayers specifically to the conditions described in Treas Reg § 5f.103-1. (These
regulations are now issued under IRC § 149).
51
Regulation C(1), TEFRA.
52
Regulation C(2), TEFRA.
53
Treas Reg § 5f.103-1(e)(1).
54
Treas Reg § 5f.103-1(e)(2).
55
See Stephen B. Land, “Bearer or Registered? Lingering Issues Under TEFRA,” 58 Tax Lawyer 3 (Spring 2005)
for a very in depth discussion of the subject.
43

[a]

Regulations C(1): Physical Form

This section concerns instruments issued in an old fashioned, physical form. A transfer of this
type of obligation may be effected only by surrender of the old instrument and either the
reissuance by the issuer of the old instrument to the new holder or the issuance of a new
instrument by the issuer to the new holder.56 In addition, under a special rule, an obligation that,
as of a particular time, is not in registered form under the above rules can be converted into
registered form at a later time when the requirements of the registered form are satisfied.57
Example: Corporation C issues obligations in bearer form. A foreign person purchases a
bearer obligation and then sells it to a U.S. person. At the time of the sale, the U.S.
person delivers the bearer obligation to Corporation C and receives an obligation that is
identical to the original, except that the obligation is now registered with the issuer or its
agent as to both principal and any stated interest, and may be transferred at all times until
its maturity only through a means described in Treasury Regulation Section 5f.103-1(c).
Under Treasury Regulation Section 5f.103-1(e), the obligation is considered to be in
registered form from the time it is delivered to Corporation C until its maturity.58
Example (4) of the Treasury Regulations59 describes a conversion to a bearer form.
Corporation A issues an obligation that is registered with the corporation as to both principal and
any stated interest. Transfer may be effected by the surrender of the old instrument and either
the reissuance by the issuer of the old instrument to the new holder or the issuance by the issuer
of a new instrument to the new holder. The obligation can be converted into a form in which the
transfer of the right to the principal of, or stated interest on, the obligation may be effected by
physical transfer of the obligation. Under Treasury Regulation Section 5f.103-1(c) and (e), the
obligation is not considered to be in registered form and is considered to be in bearer form.
The IRS has expressed its opinion on a sort of two-step arrangement where an obligation first is
issued in bearer form and is later “immobilized” in a clearing system.60 The obligation is
registered if: (1) the obligation is represented by one or more global securities in physical form
that are issued to and held by a clearing organization (as defined in Treasury Regulation Section
1.163-5(c)(2)(i)(B)(4)) (or by a custodian or depository acting as an agent of the clearing
organization) for the benefit of purchasers of interests in the obligation under arrangements that
prohibit the transfer of the global securities except to a successor clearing organization subject to
the same terms; and (2) the beneficial interests in the underlying obligation are transferable only
through a book entry system maintained by the clearing organization (or an agent of the clearing
organization).
[b]

Regulations C(2): Book Entry

An obligation shall be considered transferable through a book entry system if the ownership of
an interest in the obligation is required to be reflected in a book entry, whether or not physical
securities are issued. A book entry is a record of ownership that identifies the owner of an

56

Treas Reg § 5f.103-1(c)(1).
Treas Reg § 5f.103-1(e)(3).
58
Treas Reg § 5f.103-1(f), Example 6.
59
Treas Reg § 5f.103-1(f).
60
Notice 2012-20, 2012-1 CB 574 (Mar 7, 2012).
57

interest in the obligation.61 Thus, no physical form of the obligation is required. The rule is
especially welcome in this day and age of efficient securities markets. Such dematerialized
book-entry systems for holding and transferring bonds, as developed and now mandatory in
some foreign countries, were highlighted by Notice 2006-99.62 The Notice confirmed that the
registered form will be recognized if bondholders do not have the ability to withdraw bonds from
the book-entry system and obtain physical certificates representing the bonds.63 The mere
possibility of termination of the clearing organization’s business without a successor is not a
disqualifying factor.64 Other situations that are not disqualifying factors are the default by the
issuer (exception 2) and the issuance of definitive securities at the issuer’s request upon a change
in tax law that would be adverse to the issuer, but for the issuance of physical securities in bearer
form (exception 3).65 However, after the actual occurrence of one of the above events, any
obligation with respect to which a holder has a right to obtain a physical certificate in bearer
form will no longer be in registered form, regardless of whether any option to obtain a physical
certificate in bearer form has actually been exercised. Treasury and the IRS requested comments
regarding whether any exceptions should be provided to this general rule.66 Perhaps a “rollover
period” could be introduced giving the holders time to move the securities. Note that in
accordance with the Regulations C(1) above, as soon as an obligation is no longer in registered
form, a holder can transfer it to another clearing organization and regain the registered form.
Formerly, an exception to the registration requirement existed for certain “foreign targeted
obligations.”67 The regulations featured a host of rules designed to ensure that the obligations
were issued only to foreign persons, including the requirement that the instruments were issued
only outside the U.S. and restrictions on the offer and sale, delivery, and certification of the
instruments. The Hiring Incentives to Restore Employment (HIRE) Act of 201068 eliminated
this exception for instruments issued after March 18, 2012, by repealing IRC Section
163(f)(2)(B).
As international securities markets develop and the U.S. government becomes ever more
persistent about the information exchange programs, the rules discussed here are most likely to
evolve and be clarified further. We are especially looking forward to the regulations promised in
Notice 2012-20.69
In conclusion, it is important to remember that both issuers and holders have other non-PI
reasons to steer away from the bearer form. Under IRC Section 163(f), registration is required in
all situations other than if the obligation (1) is issued by a natural person, (2) is not of a type
offered to public, or (3) has a maturity of not more than one year.70 For the violators on the
issuer side, the consequences are no interest deduction71 and an excise tax of one percent for

61

Treas Reg § 5f.103-1(c)(2).
2006-2 CB 907 (Oct. 27, 2006).
63
Section 3 of Notice 2006-99, 2006-2 CB 907 (Oct. 27, 2006).
64
Section 3 (Exception 1) of Notice 2006-99, 2006-2 CB 907 (Oct. 27, 2006).
65
Section 3 of Notice 2012-20, 2012-1 CB 574 (Mar 7, 2012).
66
Id.
67
Referred to as Regulations “D.” See Treas Reg § 1.163-5(c)(2)(i)(D).
68
PL 111–147, 124 Stat 71 (Mar 18, 2010).
69
2012-1 CB 574 (Mar 7, 2012).
70
IRC § 163(f)(2).
71
IRC § 163(f)(1).
62

each year till maturity.72 Holders lose the right to deduct any losses on the sale73 and must pay
tax on any gain under ordinary rates.74
[4]

Contingent Interest

The portfolio interest exemption does not apply to certain contingent interest income received by
foreign persons. The amount of interest paid on obligation may not be determined by:
(i) reference to any receipts, sales, or other cash flow of the debtor or a related person;
(ii) any income or profits of the debtor or a related person;
(iii)any change in value of any property of the debtor or a related person;
(iv) any dividend, partnership distribution, or similar payments made by the debtor or a
related person.75
The Secretary may identify any other type of contingent interest to prevent avoidance of Federal
income tax.76 No special regulations have been issued yet.
The phrase “related person” under the above rules is rather inclusive.77 In addition to the
relationships described in IRC Sections 267(b) and 707(b)(1), the Code provides that a party to
any arrangement undertaken for a purpose of avoiding the application of the contingent interest
rules can be deemed “related” for these purposes.78 However, some types of contingent interest
are allowed, pursuant to a list of exceptions in IRC Section 871(h)(4)(C).
In the case of an instrument on which a foreign holder earns both contingent and non-contingent
interest, denial of the portfolio interest exemption applies only to the portion of the interest that
is contingent.79 Assume that the interest rate on a debt instrument is stated as the greater of either
of two amounts: 6 percent of the principal amount or 10 percent of gross profits. In such a case,
only the gross-profits-based interest is contingent interest. The conference report clarified that,
with respect to such an instrument, only the excess of the contingent amount, if any, over the
minimum fixed interest amount is disqualified from PI treatment.80

72

IRC § 4701(a).
IRC § 165(j).
74
IRC § 1287(a).
75
IRC § 871(h)(4)(A)(i).
76
IRC § 871(h)(4)(A)(ii).
77
See IRC § 871(h)(4)(B) (with reference to IRC §§ 267(b) or 707(b)(1)).
78
IRC § 871(h)(4)(B).
79
Revenue Reconciliation Act of 1993, PL 103-66, 107 Stat 312 (Aug 10, 1993) (House Explanation).
80
Revenue Reconciliation Act of 1993, PL 103-66, 107 Stat 312 (Aug 10, 1993) (Conference Report).
73

[5]

Jurisdiction Not “Blacklisted” by the Secretary

The IRS has the authority to name any jurisdiction as having inadequate information exchange
with the U.S. and suspend the PI income tax exemption treatment for creditors from that
country.81
More specifically, to disqualify a jurisdiction, the Secretary must provide in writing and publish
a statement that the provisions of IRC Sections 871(h) and 881(c) shall not apply to payments of
interest to any person within that foreign country during the period beginning and ending on the
dates specified by the Secretary.82 Retroactive disallowance of deduction is not valid.83
This authority has not been exercised as of July 2013.
[6]

Effectively Connected Income (ECI)

It is important to remember that PI exemption from tax merely works for FDAP interest income.
If the tax is due under any other section of the Code (e.g., under IRC Sections 872 or 882 – tax
on income connected with a U.S. trade or business), then the exemption is not available.
The ECI rules refer to two ways in which FDAP can become ECI. In both of those tests, the
primary weight is given to the accounting on the books of a given trade or business.84
[a]

Asset Test

The Asset Test determines whether the income, gain, or loss is derived from assets used in, or
held for use in, the conduct of a trade or business.85 Assets will tend to be considered so used if
they were held for the principal purpose of promoting the present conduct of the business,86 were
acquired and held in the ordinary course of the U.S. trade or business (e.g., an account or note
receivable arising from the business),87 or held in a “direct relationship” to the U.S. business.88
The “direct relationship” is measured by whether or not an asset is in the business to meet
present (rather than future) need. For example, an asset is needed for this purpose if held to meet
operating expenses, but it is not needed in this sense if it is held to provide for future
diversification into a new business, to expand the business activities outside the U.S., to provide
for future plant replacement, or to use for future business contingencies.89 The “direct
relationship” presumption is raised if the asset was acquired with funds generated by the
business, income from the asset is retained or reinvested in the business, and personnel who are

81

IRC § 871(h)(6).
IRC § 871(h)(6)(A).
83
IRC § 871(h)(6)(A).
84
IRC § 864(c)(2), Treas Reg § 1.864-4(c)(4).
85
IRC § 864(c)(2).
86
Treas Reg § 1.864-4(c)(2)(ii)(a).
87
Treas Reg § 1.864-4(c)(2)(ii)(b).
88
Treas Reg § 1.864-4(c)(2)(ii)(c).
89
Treas Reg § 1.864-4(c)(2)(iv)(a).
82

present in the U.S. and actively involved in the conduct of the business exercise significant
management and control over the investment of the asset.90 Such presumption can be rebutted if
it can be shown that such assets are held for future, not present, business needs.91
Example: M, a foreign corporation that uses the calendar year as the taxable year, is
engaged in industrial manufacturing in a foreign country. M maintains a branch in the
United States that acts as the importer and distributor of the merchandise it manufactures
abroad. By reason of these branch activities, M is engaged in business in the United
States during 1968. The branch in the United States is required to hold a large current
cash balance for business purposes, but the amount of the cash balance so required varies
because of the fluctuating seasonal nature of the branch's business. During 1968 at a time
when large cash balances were not required, the branch invests the surplus amount in
U.S. Treasury bills. Since these Treasury bills are held to meet the present needs of the
business conducted in the United States, they are held in a direct relationship to that
business, and the interest for 1968 on these bills is effectively connected for that year
with the conduct of the business in the United States by M.92
[b]

Activities Test

The Activities Test determines whether the activities of a trade or business were a material factor
in the realization of the income, gain, or loss.93 The test usually applies to passive type income,
gain, or loss that arises directly from the active conduct of the foreign corporation’s U.S. trade or
business.94 Activities relating to the management of investment portfolios are not treated as
activities of a trade or business conducted in the U.S. unless the maintenance of these
investments is the principal activity of the trade or business.95
Example: Foreign corporation S is organized for the purpose of investing in stocks and
securities. S is not a personal holding company or a corporation that would be a personal
holding company if all of its outstanding stock were not owned by foreign persons during
the last half of its taxable year. Its investment holdings consist of common stocks issued
by both foreign and domestic corporations and a substantial amount of high grade bonds.
The business activity of S consists of the management of its portfolio for the purpose of
investing, reinvesting, or trading in stocks and securities. During the taxable year, S has
its principal office in the U.S. and, by reason of its trading in the U.S. in stocks and
securities, is engaged in business in the U.S. The dividends and interest derived by S
during the year from U.S. sources, and the gains and losses from U.S. sources from the
sale of stocks and securities from its investment portfolios, are effectively connected for
the year with S’s conduct of business in the U.S.96

90

Treas Reg § 1.864-4(c)(2)(iv)(b).
Treas Reg § 1.864-4(c)(2)(v).
92
Treas Reg § 1.864-4(c)(2)(v), Example 1.
93
IRC § 864(c)(2)(B).
94
Treas Reg § 1.864-4(c)(3)(i).
95
Treas Reg § 1.864-4(c)(3)(i).
96
Treas Reg § 1.864-4(c)(3)(ii), Example 1.
91

For the purposes of ECI, the business of “banking, financing, or other similar business” is a
dangerous place. In the controversial Office of Chief Counsel Memorandum TAM 2009-010,97
the IRS put forward a somewhat convincing argument that, where a foreign entity is engaged in
“banking, financing, or other similar business” and makes loans to the U.S. public through an
agent (dependent or independent), this activity will render the taxpayer engaged in U.S. trade and
business. The interest income thus will be partially taxable in U.S. (under certain rules described
in the regulations) and PI treatment will not apply. The key is that Treasury Regulation Section
1.864-4(c)(5)(ii),(iii) does not require that the loan origination agent or its U.S. office be related
to the taxpayer.
Treasury Regulation Section 1.864-5 defines “banking, financing, or other similar business” for
these purposes in the following manner:
A nonresident alien individual or a foreign corporation shall be considered for
purposes of this section and paragraph (b)(2) of [Treasury Regulation] § 1.864-5
to be engaged in the active conduct of a banking, financing, or similar business in
the United States if at some time during the taxable year the taxpayer is engaged
in business in the United States and the activities of such business consist of any
one or more of the following activities carried on, in whole or in part, in the
United States in transactions with persons situated within or without the United
States (1.864- 4(c)(5)(i)):
(a) Receiving deposits of funds from the public,
(b) Making personal, mortgage, industrial, or other loans to the public,
(c) Purchasing, selling, discounting, or negotiating for the public on a
regular basis, notes, drafts, checks, bills of exchange, acceptances, or
other evidences of indebtedness,
(d) Issuing letter of credit to the public and negotiating drafts drawn
thereunder,
(e) Providing trust services for the public, or
(f) Financing foreign exchange transactions for the public.98
Thus, if any foreign entity that is regularly involved in making loans hires a loan originator in the
U.S. for obtaining the loan, this activity would subject the interest to a partial taxation in the U.S.
The results would probably be different if the issuer paid the fee directly to the loan originator,
instead of to the foreign entity lender.

97

GLAM 2009-010; 2009 GLAM LEXIS 15 (Sept 22, 2009). This memorandum was published internally and
obtained via FOIA.
98
Treas Reg § 1.864-4(c)(5).

[7]

Side Kick: Estate Tax

As a general rule, for purposes of the estate tax, stock in U.S. corporations and debt obligations
of United States’ persons, as well as debt obligations of the U.S. Government, the States or any
provincial subdivision thereof, and the District of Columbia, are included in the taxable estate of
the individual.99 IRC Section 2105 excludes from this rule PI-related obligations, if the interest
from these obligations is considered PI.100 Even if the statement of foreign ownership described
in IRC Section 871(h)(5) (or Form W-8Ben) is not provided and tax is being withheld on the
payments of the interest, the estate tax still does not apply.
If a portion of the interest on the underlying obligation is considered contingent under IRC
Section 871(h)(4), then only that portion of the obligation (based on the reasonable calculations
of the taxpayer) is subject to the estate tax.101
If the interest on the obligation, in addition to qualifying as PI, is exempt from tax under another
Code section, then the underlying obligation is not excludable from the estate.102 Classic
example used to be the United States Treasury Bills that matured in less than 183 days. These
instruments are excluded from the “original issue discount obligations” making interest
automatically not taxable to non-resident aliens.103 In 1997, Congress added provision excluding
from estate tax short term (under 183 days) taxable original issue discount obligations (including
U.S. Treasury Bills).104 These rules apparently leave state and municipal bonds includible in the
estate.105
No exemption for PI obligations applies to the gift tax.106
Note that no estate tax applies to bank deposits, savings and loan associations deposits, and
amounts held by an insurance company under an agreement to pay interest thereon.107
§ 2.04 Conclusion
Dogs bark, but the caravan goes on. (Proverb)
For most of us, the news that non-resident aliens do not pay income tax on U.S. source interest
income comes as a surprise, especially now, in the time of rising tax rates and precipitating
sequestration. Hopefully, this article sheds some light on the origins of the PI income tax
exemption and the various covenants for its availability under the Code.

99

IRC § 2104.
IRC § 2105(b)(3).
101
IRC § 2105(b).
102
PLR 9422001.
103
IRC §§ 871(g)(1)(B)(i), 871(a).
104
IRC § 2105(b)(4).
105
IRC §§ 103, 871(g)(1)(B)(ii), 2105(b)(4).
106
IRC § 2511(b).
107
IRC §§ 2105(b)(1); 871(i)(1),(3).
100

The big picture summary of the PI rules above should be viewed as a snapshot in the dynamic
process of tax policy and rulemaking. Barring some drastically evolving macroeconomic
considerations, the policy most likely will stay in place for the foreseeable future. There is,
however, an observable trend to tighten it, mainly in the direction of increasing U.S. (and
worldwide, for that matter) tax compliance. The 2010 repeal of the foreign targeted obligations
exception limited the PI universe and came in a package with a host of other “offset provisions”
(i.e., revenue raisers) primarily addressing tax evasion.108 If the perception of compliance
irregularities remains, the IRS might start taking more aggressive rulemaking steps to tighten the
exemption further by using its broad authorities under the two PI Code sections.
We shall see. One always hopes for the wise shepherds as the caravan enters new terrains.

108

Taxes to enforce reporting on certain foreign accounts, Disclosure of information with respect to foreign financial
assets, Modification of statute of limitations for significant omission of income in connection with foreign assets,
Clarifications with respect to foreign trusts which are treated as having a U.S. beneficiary, etc. See HIRE Act of
2010, PL 111–147, 124 Stat 71 (Mar 18, 2010).

Joel S. Newman on Deductions on a Higher Plane: Medical Marijuana Business Expenses
By Joel S. Newman
Imagine three sole proprietorships. The first, “Legal,” sells widgets, and is in complete
conformity with all federal, state and local laws. The second, “Illegal,” is a gambling
establishment, in violation of the laws of its state. The third, “MMJ,” dispenses marijuana, but
only to those who can certify that it is necessary to alleviate their medical conditions. It has no
other business. This dispensation of “medical marijuana”1 is legal under the laws of MMJ’s state,
but illegal under federal law.2 Legal, Illegal, and MMJ all have identical income and expenses:
Gross sales

$100,000

--Cost of goods sold

--$80,000

Gross profit

$20,000

--Other operating expenses

--$8,000

Operating income

$12,000

Legal will have taxable income of $12,000. The cost of goods sold will be subtracted from gross
sales, and the other operating expenses will be deductible. Illegal will be taxed exactly the same
way. However, MMJ will have taxable income of $20,000. Cost of goods sold will be
subtracted, but other operating expenses will not be deductible. Why is Illegal treated the same
as Legal? Why is MMJ treated differently from the other two?
Legal and Illegal are treated the same way because of Commissioner v. Sullivan.3 In Sullivan,
the Commissioner denied salary and rent deductions to an illegal gambling enterprise. Justice
Douglas wrote:



Joel S. Newman is a Professor of Law at Wake Forest School of Law in North Carolina. Before teaching at Wake
Forest, he taught as a visiting professor at the University of Hawaii, University of Florida, Notre Dame and Xiamen
University, in the People's Republic of China. Professor Newman has also served as a consultant for CEELI, the
ABA's rule of law initiative, for projects in Lithuania, Macedonia, Slovakia, Uzbekistan, Ukraine, and St.
Petersburg, Russia. He has also been an Associate with Shearman & Sterling in New York, and with Frederickson,
Byron, Colborn, Bisbee & Hansen, in Minneapolis.
1
For the remainder of this article, the term “medical marijuana” will be used to describe such marijuana usage. The
specific requirements for medical marijuana vary according to the formulations of the state statutes that legalize it.
See note 12, infra, for a list of the states in which medical marijuana has been legalized and citations to the relevant
statutes. See also, Historical Timeline-Medical Marijuana, available at
http://medicalmarijuana.procon.org/view.resource.php?resourceID=000143.
2
21 USCS § 801.
3
356 US 27 (1958).

If we enforce as federal policy the rule espoused by the Commissioner in this
case, we would come close to making this type of business taxable on the basis of
its gross receipts, while all other businesses would be taxable on the basis of net
income. If that choice is to be made, Congress should do it.4
Thus, generally, the cost of goods sold, and other operating expenses (a.k.a. ordinary and
necessary business expenses), are deductible, regardless of the underlying legality or illegality of
the business. Legal and Illegal might be treated differently with respect to criminal law, but, for
tax law, they are treated the same.5
Why, then, is MMJ treated differently? Recall that, in Sullivan, Justice Douglas conceded that
Congress had the power to deny deductions to certain kinds of businesses, if it so chose.6
Congress made that choice in 1982. Congress was apparently reacting to the Tax Court decision
in Edmondson v. Commissioner.7 In Edmondson, a drug dealer was busted, and then audited.
The IRS wanted to tax him on the unreported income from his drug-related activities. He
countered that, if he was to be taxed on the income, then he should be allowed to deduct his
expenses, including travel expenses, and the purchase of an accurate scale. The Tax Court
allowed the deductions.
Congress was horrified. It enacted IRC Section 280E, which provides:

4

Id at 29.
Cases allowing deductions to illegal enterprises include: Cavaretta v Comm’r, TC Memo 2010-4; Blanning v
Comm’r, TC Memo 2004-201 (2004); Nelson v Comm’r, TC Memo 2000-212 (2000); Steffen v US, 41 Fed Cl
134 (1998); Brizell v Comm’r, 93 TC 151 (1989); Raymond Bertolini Trucking Co v Comm’r, 736 F2d 1120 (6th
Cir 1984); , Carter v Comm’r, TC Memo 1984-443 (1984); Edmondson v Comm’r, TC Memo 1981-623;
Dukehart-Hughes Tractor & Equip Co v US, 341 F2d 613 (Ct Cl 1965); Stacy v US, 231 FSupp. 304 (SD Miss
1963); RCA Communications v US, 277 F2d 164 (Ct Cl 1960); Edwards v Bromberg, 232 F2d 107 (5th Cir 1956).
On the same day that Sullivan was decided, the Supreme Court handed down Tank Truck Rentals v Comm’r, 356
US 30 (1958). That decision created the “public policy exception”: that deductions would be disallowed “…if
allowance of the deduction would frustrate sharply defined national or state policies proscribing particular types of
conduct, evidenced by some governmental declaration thereof.” 356 US at 33-34. The public policy exception has
been codified in part in Sections 162(c) and (f), and the Foreign Corrupt Practices Act, 15 USCS § 78dd-1.
However, there is also a case law component. For example, in part due to the public policy doctrine, the expenses
incurred when assets of a criminal enterprise are forfeited or condemned are not deductible. McHan v Comm’r, TC
Memo 2006-84; Ruddel v Comm’r, TC Memo 1996-125; Holt v Comm’r, 69 TC 75 (1977); Wood v US, 863 F2d
417 (5th Cir 1989); Pring v Comm’r, TC Memo 1989-340; Fuller v Comm’r, 213 F2d 102 (10th Cir 1954).
However, legal fees in defending against criminal prosecution are usually deductible. Nelson v Comm’r, TC Memo
2000-212; Comm’r v Shapiro, 278 F2d 556 (7th Cir 1960); Comm’r v Tellier, 383 US 687 (1966); C Coat, Apron
& Linen Serv, Inc, v US, 298 F Supp 1201 (SDNY 1969); O’Malley v Comm’r, 91 TC 352 (1988); Sundel v
Comm’r, TC Memo 1998-78 (1998); Kent v Comm’r, TC Memo 1986-324. See Borek, “The Public Policy
Doctrine and Tax Logic: The Need for Consistency in Denying Deductions Arising from Illegal Activities,” 22 U
Balt L Rev 45 (1992).
6
Sullivan, 356 US at 27. See also, Commissioner v Tellier, 383 US 687 (1966): “Deduction of expenses falling
within the general definition of s 162(a) may, to be sure, be disallowed by specific legislation, since deductions ‘are
a matter of grade and Congress can, of course, disallow them as it chooses.’” 383 US at 693, quoting US v Sullivan.
7
Edmondson v Comm’r, TC Memo 1981-623 (1981). See generally, Joel S. Newman, “CHAMP: How the Tax
Court Finessed a Bad Statute,” Tax Notes Today, 2007 TNT 172-39 (Sept. 3, 2007).
5

No deduction or credit shall be allowed for any amount paid or incurred during
the taxable year in carrying on any trade or business if such trade or business (or
the activities which comprise such trade or business) consists of trafficking in
controlled substances (within the meaning of schedule I and II of the Controlled
Substances Act) which is prohibited by Federal law or the law of any State in
which such trade or business is conducted.8
The Senate Finance Committee Report commented:
To allow drug dealers the benefit of business expense deductions at the same time
that the U.S. and its citizens are losing billions of dollars per year to such persons
is not compelled by the fact that such deductions are allowed to other, legal,
enterprises. Such deductions must be disallowed on public policy grounds.
*

*

*

To preclude possible challenges on constitutional grounds, the adjustment to gross
receipts with respect to effective costs of goods sold is not affected by this
provision of the bill. 9
Thus, even though Legal and Illegal may deduct Cost of Goods Sold and other operating
expenses, MMJ can subtract its costs of goods sold, but not other operating expenses, because
Congress said so in IRC Section 280E.
For many years, Section 280E was applied routinely.10 Other cases mentioned the section,
without applying it.11 However, all of the cases involved the criminal drug trade. Then, things

8

IRC § 280E; see Carrie F. Keller, “The Implications of I.R.C. § 280E in Denying Ordinary and Necessary Business
Deductions to Drug Traffickers,” 47 St Louis U L J 157 (2003); Rutherford, “Taxation of Drug Traffickers’ Income:
What the Drug Trafficker Profiteth, the IRS Taketh Away,” 33 Ariz L Rev 701 (1991); Peace and Messere, “Tax
Deductions and Criminal Activities: The Effects of Recent Tax Legislation,” 20 Rutgers LJ 415 (1989).
9
S Rep 97-494, at 309 (1982). The Tax Court is convinced that the Senate was thinking of Edmondson.
Californians Helping to Alleviate Medical Problems, Inc v Comm’r, 128 TC 14 (2007). Curiously, the same thing
happened in Australia. In Commissioner of Taxation v La Rosa [2003] FCAFC 125 (5 June 2003), Mr. La Rosa was
busted for drug dealing, and required to pay tax on his unreported income. He argued that, if he was to pay tax on
his drug-related income, he should be allowed drug-related deductions, including the expense of a robbery which
occurred during a drug deal. The Federal Court of Australia allowed the deductions. The Australian Parliament was
horrified, and enacted Section 26-54 of the Income Tax Assessment Act of 1997, which disallows deductions for
expenditures relating to illegal activities. See Gupta, “Taxation of Illegal Activities in New Zealand and Australia,”
J Australasian Tax Teachers Assoc. 2008, V. 3, no. 2 ; Lund, “Deductions Arising from Illegal Activities,” v. 13
[2003] Revenue Law J, Iss. 1, Art. 7. See generally Edward J. Roche Jr., “Federal Income Taxation of Medical
Marijuana Businesses,” Tax Lawyer (Spring 2013).
10
Peyton v Comm’r, TC Memo 2003-146; Sundel v Comm’r, TC Memo 1998-78; Franklin v Comm’r, TC Memo
1993-184; Browning v Comm’r, TC Memo 1991-93; Bratulich v Comm’r, TC Memo 1990-600; Caffery v
Comm’r, TC Memo 1990-498; US v Petri, 917 F. 2d 1307 (9th Cir 1990) [unpublished] (prosecution for criminal
tax evasion for violating §7201 by willfully violating IRC § 280E).
11
Bilzerian v US, 41 Fed Cl 134 (1998) (finding that the perceived need to enact IRC § 280E proves that Congress
did not consider all of the expenses of illegal activity to be nondeductible); McHan, TC Memo 2006-84 (holding
that IRC § 280E was not raised in a timely manner); Ruddel, TC Memo 1996-125 (forfeiture nondeductible; “see

changed. A number of states enacted laws legalizing the dispensation of marijuana for medical
purposes. Now at least eighteen states, plus the District of Columbia, have legalized medical
marijuana.12 In addition, in the past year, two states have legalized the possession and sale of
small amounts of recreational marijuana, even if no medical need can be shown.13 How have
these state developments impacted IRC Section 280E?
First, can the federal government continue to criminalize marijuana, even in states which have
declared it to be legal for certain purposes? The Supreme Court says that it can. In Gonzalez v.
Raich,14 the Court held that, under the Commerce Clause, the federal government can do just
that.15 Second, should the deductibility of the expenses of the marijuana business be any
different in those states in which such business is, to some extent, legal? Apparently, the answer
is no, but it gets a bit complicated. The Tax Court has ruled on this question twice.
§ 3.02 Two Tax Court Cases
[1]

CHAMP v. Commissioner

In Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner,16 the taxpayer
(CHAMP), a nonprofit under state law but not tax-exempt under federal law,17 dispensed
marijuana to its members pursuant to the California Compassionate Use Act of 1996.18 It also
“provided caregiving services to its members.” In fact, the Tax Court found that this caregiving
function was the taxpayer’s “primary purpose.”19 The caregiving services included massages,
and weekly or biweekly support group sessions—for the HIV/AIDS group, the “wellness” group,
the Phoenix group (for elderly members), the Force group (focusing on spiritual and emotional

also IRC § 280E”; Wood v US, 863 F 2d 417 (5th Cir 1989) (IRC § 280E cited to show a sharply defined public
policy against deductibility of drug forfeitures); Ryan, TC Memo 1989-297 (IRC § 280E inapplicable to tax year in
question); Vasta, TC Memo 1989-531 (court notes that IRS did not argue for the applicability of IRC § 280E);
Styron, TC Memo 1987-25 (IRC § 280E inapplicable to tax year in question); Kent, TC Memo 1986-324 (legal
expenses deductible; court cites IRC § 280E without commenting on its applicability); Bender, TC Memo 1985375 (IRC § 280E does not change the applicability of IRC § 1348).
12
17 Legal Medical Marijuana States and DC: Laws, Fees and Possession Limits. I. Summary Chart.
http://medicalmarijuana.procon.org/view.resource.php?resourceID=000881&print=true; Six States with Pending
Legislation to Legalize Medical Marijuana,
http://medicalmarijuana.procon.org/view.resource.php?resourceID=002481.
13
Colorado: to be become Colo. Constitution, Art 18, §16; See Denver Post Marijuana News Page,
http://www.denverpost.com/news/marijuana. Washington: RCWA § 69.50, Brookes, “Pot Legalization is
Coming,” Rolling Stone, http://www.rollingstone.com/politics/blogs/national-affairs/pot-legalization-is-coming20120726; Dickinson, “The Next Seven States to Legalize Pot,” Rolling Stone,
http://www.rollingston.com/politics/news/the-next-seven-states-to-legalize-pot-20121218? In case you’re
interested, they are Oregon, California, Nevada, Rhode Island, Maine, Alaska, and Vermont.
14
545 US 1 (2005).
15
Id. See Mikos, “State Taxation of Marijuana Distribution and Other Federal Crimes,” 2010 Chi Legal F 223;
Mikos, “On the Limits of Supremacy: Medical Marijuana and the States’ Overlooked Power to Legalize Federal
Crime,” 62 Vand L Rev 1421 (2009).
16
128 TC 173 (2007).
17
See PLR 201013062, similarly denying tax exempt status to a provider of medical marijuana.
18
Cal Health & Safety Code § 11362.5; CHAMP, 128 TC at 174-175.
19
CHAMP, 128 TC at 174.

development), and the women’s group. Low-income members also received daily lunches and
hygiene supplies. One-on-one counseling was offered, as well as social events, including field
trips, movies, guest speakers, and live music.20
The taxpayer argued that IRC Section 280E should not apply at all, because its activities with
respect to medical marijuana were not “trafficking” within the meaning of the statute. However,
the Tax Court disagreed. Quoting the dictionary, the Tax Court defined “trafficking” as “…to
engage in commercial activity; buy and sell regularly.”21
The Tax Court held that CHAMP was engaged in two activities—the dispensation of medical
marijuana, and caregiving. Only those expenses allocable to the medical marijuana activity were
disallowed pursuant to IRC Section 280E. The Court allocated 18/25 of CHAMP’s salaries,
payroll taxes, employee benefits, employee development training, meals and entertainment, and
parking and tolls, to caregiving. Therefore, this 18/25 portion was fully deductible. Ninety
percent of most of the taxpayer’s other expenses were similarly allocated to caregiving, and were
also deductible.22
[2]

Olive v. Commissioner

In Olive v. Commissioner,23 taxpayer Martin Olive established the Vapor Room, a for-profit
dispensary of medical marijuana. In addition to providing the marijuana, there were yoga
classes, chess and other board games, movies with complimentary popcorn, and massages.24
However, the Tax Court characterized these as “… minimal activities and services as part of its
principal business of selling medical marijuana.”25 Further, it noted that “[t]he Vapor Room’s
sole source of revenue was its sale of medical marijuana and patrons did not specifically pay for
anything else connected with or offered by the Vapor Room.”26
The Tax Court found that taxpayer had under-reported his income. It also rejected his
calculations of cost of goods sold, and arrived at its own figure.27 Finally, as to expenses other

20

Id. at 175.
Id. at 182, quoting Webster’s Third New International Dictionary (2002).
The court also cited US v Oakland Cannabis Buyers’ Cooperative, 532 US 483 (2001) for the proposition that the
sale of medical marijuana is “trafficking.” Yet, the word “trafficking” cannot be found in Oakland Cannabis. That
case stands only for the proposition that marijuana—even medical marijuana—is a Schedule I substance under the
Controlled Substance Act.
22
Id. at 185.
23
Olive v Comm’r, 139 TC No 2 (2012).
24
Id. at 3. The Vapor Room provided an important service. Residents of Section 8 Housing in the San Francisco
area could not use medical marijuana in their homes, for fear of being evicted. The Vapor Room not only provided
them with the marijuana; it provided them with a safe place to use it. In fact, the shuttle busses from the local UC
medical facility routinely took patients directly from their chemotherapy sessions to the Vapor Room, for marijuana
therapy. Telephone conversation with Henry Wykowski, attorney for the petitioner in CHAMP and Olive, Feb. 1,
2013.
25
Id. at 1.
26
Id. at 3.
27
Despite rejecting the taxpayer’s COGS figures, the Tax Court still allowed a generous calculation of COGS, at
21

than cost of goods sold, the Court refused to accept the taxpayer’s figures, instead accepting only
those amounts which the Commissioner conceded. However, even these conceded amounts were
disallowed under IRC Section 280E.28
Part of Mr. Olive’s problem was the lack of substantiation, of income, of cost of goods sold, and
of other expenses. As to cost of goods sold:
Petitioner, in fact, concedes in his posttrial brief that he “freely admitted” to the
revenue agent that he had no receipts for COGS.
Petitioner argues nonetheless that the ledgers alone are sufficient substantiation
for taxpayers operating in the medical marijuana industry because, he states, that
industry “shun[s] formal ‘substantiation’ in the form of receipts.”29
* * * *
Petitioner consciously chose to transact the Vapor Room’s business primarily in
cash. He also chose not to keep supporting documentation for the Vapor Room’s
expenditures. He did so at his own peril.30
The lack of substantiation was exacerbated by the Court’s finding that the petitioner and his
witnesses lacked credibility.31 The major finding of the Tax Court in Olive, however, was that
the taxpayer was engaged in one business, not two. That one business was medical marijuana.
Therefore, IRC Section 280E disallowed essentially all of the deductions. Finally, the court in
Olive agreed with CHAMP that IRC Section 280E applied, because the taxpayer was
“trafficking.”32
[3]

CHAMP and Olive Compared

CHAMP and Olive differ in three respects. First, CHAMP, though not federally tax-exempt, was
a nonprofit under California law. The Vapor Room was for profit.33 It does not appear that this
distinction made any difference.
Second, CHAMP’s substantiation was accepted by the court; the Vapor Room’s was not.
Curiously, despite Mr. Olive’s statements to the contrary,34 those in the new, medical marijuana

75.16% of gross receipts, minus an allowance for the marijuana that the taxpayer either gave away or consumed
himself. Id. at 11.
28
Id. at 15.
29
Id. at 8-9.
30
Id. at 9.
31
Id. at 7.
32
Id. at 12.
33
Generally, medical marijuana dispensaries in California tend to be not for profit, while such dispensaries in
Colorado tend to be for profit. The dispensaries in northern California tend to provide substantial caregiving
services in addition to the marijuana; the dispensaries in southern California do not. Wykowski, supra note 24.
34
Olive, 139 TC at 8-9.

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