By Alan S. Lederman, Esq.
Gunster Yoakley & Stewart, P.A., Ft. Lauderdale, FL
The U.S. State Department has announced that the United States and Cuba have begun talks on settling property claims,1 including the claims from Cuban expropriations which have been certified by the Foreign Claims Settlement Commission (FCSC).2 The State Department's approach to settling the FCSC-certified Cuban claims will depend upon many political, social, and economic considerations, as well as legal considerations under U.S., Cuban, and international law.
The U.S. income tax consequences of any eventual recoveries by U.S. holders of FCSC-certified Cuban claims may be of considerable interest to those claimants, their tax advisors, and the Internal Revenue Service. Indeed, for the reasons discussed below, the IRS will be a major beneficiary of the FCSC-certified Cuban claims settlement process.
As noted by one author, "between 1959 and 1961, the Cuban government nationalized almost all U.S.-owned assets on the island. Such properties included 90% of all electricity generated in Cuba, the entire telephone system, most of the mining industry, oil refineries, bottling plants, warehouses, and over two million acres of land, including up to 80% of the rich traditional sugar lands. Expropriated assets also comprised hotels, commercial properties, private residences, artworks, insurance policies, bank accounts, and ships. As American corporate and private entities controlled two-thirds of the Cuban economy, this was the largest uncompensated taking of American property by a foreign government in history."3
In response, in 1964, Congress enacted 22 U.S. Code §1643–§1643m.4 As stated in 22 U.S.C. §1643, the "[Congressional declaration of purpose is] to provide for the determination of the amount and validity of claims against the Government of Cuba … which have arisen since January 1, 1959 … out of nationalization, expropriation, intervention, or other takings of, or special measures directed against, property of nationals of the United States … in order to obtain information concerning the total amount of such claims against the Government of Cuba, on behalf of nationals of the United States. This subchapter shall not be construed as authorizing an appropriation or as any intention to authorize an appropriation for the purpose of paying such claims."
Congress authorized the FCSC to certify the claims, upon the commission's finding that the claimant, at the time of expropriation through the time of filing the claim, was a U.S. citizen or a U.S. corporation directly or indirectly majority-owned by U.S. citizens,5 the claimant had suffered a covered Cuban expropriation loss, and the claimant established the amount of the loss resulting from this expropriation.6
The original FCSC-certified claimants were thus generally U.S. citizens and U.S. corporations. It seems likely that the current owners of these FCSC-certified Cuban claims are mainly the heirs of such U.S. citizens, and the U.S. corporate claimants themselves or their U.S. corporate successors by acquisition. The FCSC certification process provides a guide to the U.S. State Department to negotiating a settlement of the claims.
The largest FCSC-certified claims relate to directly owned assets of U.S. corporations and U.S. citizens of tangible property located in Cuba, and goodwill and other intangible assets associated with operations in Cuba. Indeed, the largest FCSC-certified claims generally relate to the expropriation of assets from Cuban operating branches of U.S. corporate claimants that were U.S. subsidiaries of well-known U.S. publicly traded corporations. Based upon the FCSC list of claimants and press reports, among the largest claimants currently are U.S. subsidiaries of Office Depot (the largest claimant (14% of the total claims by value) through a series of acquisitions of Cuban Electric Company, a U.S. corporation), Exxon, Starwood Hotels, Texaco, Coca-Cola, and IBM, based on the expropriation of their directly owned Cuban assets.7
However, besides losses incurred on assets located in Cuba owned directly by a majority-U.S.-owned U.S. corporation or directly by a U.S. citizen, many other types of claims were eligible for FCSC certification. For example, also eligible to be certified were claims relating to Cuban-expropriation-related losses on stock directly owned by the U.S. claimant in Cuban corporations.8
Also eligible to be FCSC-certified were Cuban-expropriation-related claims relating to debts directly owed to the U.S. claimant by Cuban corporate debtors, non-Cuban corporate debtors, and U.S. corporate debtors (but in case of a U.S. corporate debtor, only for mortgage debt formerly secured by expropriated Cuban property). Also eligible to be FCSC-certified were claims relating to accounts receivable directly owed to a U.S. claimant exporter for sales to a Cuban customer where payment was prohibited by the Cuban government.
Certain expropriations of property not directly owned by the U.S. claimant gave rise to certified claims. For example, a claim could be certified if the U.S. claimant owned stock in a Cuban corporation or non-Cuban foreign corporation, and that foreign corporation suffered a Cuban expropriation loss. Thus, in Louis Niewig,9 the FCSC certified a claim by a U.S. citizen who wholly owned a Panamanian corporation. The award was based upon the FCSC's finding that payment on an account receivable, due to the Panamanian corporation from a Cuban buyer for products exported by the Panamanian corporation to that Cuban buyer, was denied by the Cuban government in 1960.
The first FCSC Cuban claims certification program took place between 1967 and 1972. In that program, the FCSC certified 5,911 claims against Cuba, totaling in principal amount $1.85 billion.10 A second FCSC Cuban claims certification program took place in 2006, which resulted in the certification of two claims against Cuba, one arising from a Cuban government seizure of land owned directly by Starwood Hotels & Resorts Worldwide, Inc., a U.S. corporation, in the principal amount of approximately $51 million, and the second, a far smaller claim.11 No claims have been accepted since 2006, and the FCSC Cuban certification program is now closed.
Most of the claims from the first FCSC Cuban claims certification program date back to around 1960, and the FCSC added to all the claims' principal 6% interest from the date of seizure to arrive at the allowable claims. Commentators note that the U.S. government apparently interprets the FCSC-certified claims as carrying only simple interest, but argue that to achieve full compensation, interest should be compounded.12 Accrued simple interest on the $1.9 billion in principal claims in 2016 constitutes about 56 years × 6%/year × $1.9 billion = $6.4 billion.13 Thus, the overwhelming portion of the FCSC-certified claims now consists of accrued interest.
The claims' value is concentrated in a relatively few U.S. corporate claimants. By value, about 57% of the claims are held by 30 large U.S. corporations.14 By contrast, about 55% of U.S. corporation principal claims are less than $25,000.15
By value, U.S. citizens, who hold about 5,000 of the 5,912 claims, only hold about 12% of the value of total claims.16 About 59% of U.S. citizen principal claims are less than $5,000, and about 94% of the U.S. citizen principal claims are less than $100,000.17
Precedents on the settling of FCSC-certified claims with other countries, completed before the current Cuba talks, have produced uneven results. Some settlements have produced less than the principal value of the FCSC-certified claims, some have produced the full principal value of the FCSC-certified claims, and the Vietnam claims program produced the full principal value of the FCSC-certified claims plus some recovery of interest.18 Specifically, the 1995 settlement with Vietnam, relating to Vietnam's expropriation of U.S. properties around 1975, produced for the FCSC-certified claimants a lump-sum recovery of approximately $200 million, equal to 100% of the principal plus 80% of the accrued interest of the approximately $100 million in FCSC-certified principal claims.19 In connection with the Vietnam settlement, as is often done in the case of lump-sum payments, the foreign government settlement payments were distributed to the claimants in proportion with the amount of their FCSC-certified claims.20
Some commentators have questioned the financial feasibility of Cuba making sufficiently large lump-sum U.S. dollar payments to settle even the principal of the FCSC-certified Cuban claims.21 To raise sufficient dollars could require Cuba to privatize state-owned assets, which might not be feasible.22 As an alternative, Cuba could pay the smaller FCSC-certified Cuban claims in dollars, but seek to settle larger claims for non-dollar assets, such as Cuban land or Cuban franchise rights, vouchers that can be applied against future purchases of privatized Cuba assets, future Cuban income tax credits, or long-term, low-coupon-interest Cuban government bonds.23 Still another possibility raised by commentators is that lenders provide loans to Cuba to pay the FCSC-certified U.S. claimants in dollars.24
Further complicating the situation is a default judgment against the U.S. government entered in a Cuban court in the amount of $181 billion for damages allegedly created by the U.S. trade embargo on Cuba.25 This is expected to be used as a negotiating point by Cuba seeking to offset the FCSC-certified claims.
CHARACTERIZATION OF CASH RECOVERIES
For income tax purposes, it may be useful to divide the potential cash distributions on FCSC-certified Cuban claims into three portions: recoveries not in excess of the tax basis of the asset seized at its date of seizure; recoveries of the FCSC-certified principal of the claims in excess of the basis of the asset seized at date of seizure; and accrued interest. Payments received on FCSC-certified claims are taxed first as a recovery of the certified principal amount of the claim, and only then as interest income.26
Principal Recovery Not in Excess of Basis: The Tax Benefit Rules
The IRS position, supported by the courts, has been that U.S. citizens and U.S. corporations recognized their expropriation-related losses for business and investment property (equal to tax basis under §165(b))27 at the time (generally about 1960 for the claims arising under the first FCSC Cuban claims program) of the Cuban government confiscation, notwithstanding the possibility that they could achieve some recovery years later.28 In Nadler v. Commissioner,29 the Tax Court held that, under the tax benefit inclusion rule of Reg. §1.165-1(d)(2)(iii), if a loss resulting from a foreign government expropriation was deducted in an earlier year, later recovery for the loss from the expropriating foreign government is fully includible in income. Therefore, for claimants who suffered direct expropriation tax losses around 1960, the IRS will likely view recovery on FCSC-certified claims, to the extent of the earlier deduction (generally the adjusted basis of expropriated business or investment property), as generally fully taxable under the tax benefit inclusion rule.30 Commentators conclude that, under the Arrowsmith doctrine, recoveries of losses governed by the tax benefit inclusion rule retain the character of the original loss.31
In a 2007 report to the U.S. government concerning structuring settlements of FCSC-certified Cuban claims, consultants suggested a requirement that "the holder of medium and large claims, who likely took advantage of [a §165 deduction] present its tax records along with its claim and have the court reduce the award amount by the amount of gain achieved via prior tax break. In some cases, this may completely equal the entire amount of the claim."32 Given that this recommendation fails to take into account the application of the Reg. §1.165-1(d)(2)(iii) tax benefit inclusion rule to treat the recovery itself as taxable, as in Nadler, this recommendation seems misplaced.
An exception to inclusion of FCSC recoveries under the tax benefit inclusion rule arises under §111(a). Under that rule, to the extent that an expropriation loss was not utilized, currently or by carryback or by carryover, recovery of such amount is excludible from income. The §111(a) tax benefit exclusion rule may be largely unavailable in the case of recovery of the FCSC-certified claims. As noted above, many of the large U.S. FCSC-certified corporate claims involve direct asset expropriations from consolidated U.S. subsidiaries of major publicly traded U.S. corporations, such as Exxon and IBM. These corporations had substantial operations outside Cuba during the late 1950s through the early 1970s which could have generated sufficient U.S. taxable income to absorb the Cuban losses currently or through carrybacks or carryovers. U.S. corporations, as well as U.S. citizens, could elect an especially generous 15-year carryforward period for 1960s-era Cuban ordinary expropriation losses, and U.S. corporations could elect a 10-year carryforward period for 1960s-era Cuban capital expropriation losses.33
Some U.S. citizens benefited from special retroactive legislation expanding the scope of allowable §165 losses for expropriated personal use Cuban property, such as principal residences and vacation homes. The FCSC certified some claims for what apparently were personal residences located in Cuba.34 Rev. Rul. 62-19735 held that no loss deduction was available for Cuban expropriations of assets not held for business or investment, because "seizure[s] of property under the authority of laws of a foreign country are not casualty or theft losses within the meaning of §165(c)(3)." To the extent a casualty loss to a personal residence has been nondeductible under §165, a recovery of that loss by the homeowner is excludible under the §111(a) tax benefit exclusion rule.36 Therefore, if Rev. Rul. 62-197 hypothetically applied, recovery on an FCSC-certified Cuban claim of the cost basis in a U.S. citizen's former Cuban personal residence could be excludible under the §111(a) tax benefit exclusion rule. However, under special legislation enacted in 1971, personal use Cuban property owned by a U.S. citizen during early 1959, and seized by Cuba between early 1959 and the end of 1963, was, notwithstanding Rev. Rul. 62-197, favorably retroactively accorded §165(c)(3) treatment, including the ability to become part of a net operating loss carryover, and could be the subject of a refund claim filed in 1971.37 Where U.S. citizens took advantage of the 1971 special legislation to claim deductions for the seizures of their Cuban personal residences for which they held FCSC-certified claims, such 1971 legislation correspondingly expands the IRS's opportunity to apply the tax benefit inclusion rule in the year of recovery.
In view of the unlimited capital loss carryforward available to U.S. citizens, a §111(a) exclusion amount is unavailable for capital losses, although it can reduce capital gain income resulting from the recovery.38
In some situations, an FCSC-certified claimant may have expropriation losses that expired unused, and such claimant may have a §111(a) exclusion amount. Nevertheless, in claiming a §111(a) exclusion amount there is an issue of proof. It may be difficult for a claimant that receives a payment on its claim to demonstrate the amount of, and the absence of tax benefit from, a loss that arose around 1960, given that the tax return information from that period may be difficult to locate.39
Another circumstance in which a §111(a) exclusion amount may arise is with respect to FCSC-certified claims made on account of indirect losses. For example, in a situation, such as Niewig, where a U.S. citizen or U.S. corporate claimant holds an FCSC-certified claim based upon a Cuban expropriation from a non-Cuban corporation partially or wholly owned by that U.S. claimant, with no indication that the foreign corporation's post-expropriation non-Cuban assets were less than its liabilities, Rev. Rul. 62-197 indicates there would be no basis for the U.S. claimant to itself have received a §165 worthless securities deduction around 1960 that could, upon a later recovery, trigger the tax benefit inclusion rule.
Even where a U.S.-citizen FCSC-certified claimant had a §111(a) exclusion amount, however, it seems likely that most U.S.-citizen FCSC-certified claimants are deceased. There is doubt as to whether heirs inherit a decedent's §111(a) exclusion amount.40
Section 1033 provides for non-recognition of gain with respect to receipt of cash or property that has been the subject of a theft, seizure, requisition, or condemnation, and is timely replaced with qualifying property. It appears that the Cuban government's takings that were the subject of the FCSC's claims procedures would likely be viewed as "seizures" for purposes of qualifying under §1033.41
However, the IRS position is that recovery of previously deducted §165 losses that produced a tax benefit are ineligible for §1033 non-recognition.42 This position has been accepted by a district court.43 The possible general unavailability of the §111(a) tax benefit exclusion due to previous utilization of the §165 loss deduction may correspondingly create general unavailability of the §1033 non-recognition, for the collection of principal claims up to the amount of the tax basis of the seized property.
The financial accounting book value of the U.S. investments in Cuba in 1959 was reportedly about $0.96 billion, slightly more than half the ultimately FCSC-determined fair market value of certified expropriation claims.44 If, hypothetically, the tax basis of expropriated assets approximated their book value, and if, hypothetically, loss deductions producing a U.S. tax benefit were claimed for almost all the U.S. investments in Cuba, that could mean that about half of the eventual collections of FCSC-certified principal could be disqualified from §1033 non-recognition by reason of the tax benefit inclusion rule.
Many of the FCSC-certified claims involve debt obligations owned by majority-U.S.-owned U.S. corporations and by U.S. citizens. For example, the FCSC certified claims for the face amount of accounts receivable owned by majority-U.S.-owned U.S. corporate exporters whose Cuban customers were prevented by the Cuban government from paying their invoices.45 As another example, the FCSC certified claims for U.S. corporate bonds where the bonds were secured by a mortgage note secured by expropriated Cuban property of the U.S. corporate mortgagee.46 The IRS characterized such account receivable losses or bond losses as bad debt losses or worthless securities, and allowed a deduction for the adjusted basis of the debt, which was typically the principal of the debt.47 Accordingly, recovery of the principal of the debt would typically implicate either inclusion under the tax benefit recovery rule, if the original deduction was claimed, or exclusion under the tax benefit exclusion rule if no original deduction was claimed; in neither case would §1033 be applicable.
Principal Recovery in Excess of Basis
Recoveries of the principal of FCSC-certified claims in excess of tax basis of the seized asset will be taxable. Under the Arrowsmith doctrine, recoveries in excess of basis generally take the character of the original transaction.48 Such amounts may be eligible for §1033 non-recognition if the entire amount of the principal of the claim received, i.e., not merely the recovery in excess of tax basis, is timely reinvested in qualifying property.49
In Tiefenbrunn v. Commissioner,50 the Tax Court agreed with the IRS position that interest received as part of a condemnation award was not eligible for non-recognition under §1033. The Tax Court reasoned that the interest was not from the value of the property itself, but rather was due to the delay in the acquiring government entity paying such value. Because the accrued interest now constitutes the vast majority of the potential recovery of the FCSC-certified Cuban claims, Tiefenbrunn eliminates the eligibility of the vast majority of those potential claims proceeds from §1033 non-recognition.
Collection of authorized interest on inherited claims certified by, and collected through, an international claims commission has been characterized as income in respect of a decedent and thus to not have received a step-up in tax basis at death.51 The same result seems to be true of the principal of the claims themselves.52
POTENTIAL APPLICATION OF §1033
The largest element of the potential recovery on each FCSC-certified claim, namely, interest — as well as perhaps the second largest aggregate component, namely, tax benefit recovery — are ineligible for non-recognition under §1033. However, in some cases, including those involving the expropriation of property whose value exceeded pre-expropriation tax basis, a portion of such gain in excess of tax benefit recovery can be eligible for §1033.
There is a large amount of jurisprudence concerning §1033, involving such substantive topics such as when the replacement period begins and ends, and what is qualifying replacement property, and such procedural aspects such as making non-recognition elections.53 These aspects are common to all §1033 tax planning, including planning routinely done by practitioners in the context of U.S. eminent domain proceedings. These must likewise be considered by advisors to potential payees on FCSC-certified claims.
There are, however, certain frequently occurring factual aspects of the FCSC-certified Cuban claims program that present §1033 issues rarely encountered by practitioners in the context of U.S. eminent domain practice. These special Cuban FCSC program issues involve such matters as: (1) FCSC-certified claims often generated by governmental takings from an entity other than the FCSC-certified claimant; (2) FCSC-certified claims for governmental taking of shares rather than a directly owned operating business; (3) FCSC-certified individual claims often being owned not by that claimant, but rather the direct and remote heirs of that long-deceased individual; (4) FCSC-certified claims for governmental taking of entire operating businesses rather than land and buildings; (5) frequent absence of §1245 and §1250 recapture issues; and (6) frequently considered cross-border reinvestment. Each of these aspects is briefly discussed below.
Claimant's Property Not Seized
The Office Depot claim and most other large FCSC-certified Cuba claims involved U.S. corporation and U.S. citizen losses from the seizure of directly owned tangible and intangible operating assets located in Cuba. Such claims are consistent with a U.S. corporation's or a U.S. citizen's claim that it itself suffered the property seizure for purposes of §1033. The IRS, in Maloof v. Commissioner,54 apparently conceded the availability of §1033 to U.S. citizens and U.S. corporations for payments on FCSC-certified claims relating to formerly directly owned seized operating assets located in a foreign country.
However, in situations where the U.S. citizen or U.S. corporate claimant did not directly own the seized assets, the IRS's identification, for purposes of applying §1033(a), of the entity or individual whose property was the subject of the Cuban government's "seizure" may well differ from the FCSC's identification, for purposes of 22 U.S.C. §1643b(a), of the U.S. citizen or U.S. corporate claimant that suffered the taking for purposes of that claimant obtaining FCSC certification of its Cuban claim. That is, the eventual recipient of the proceeds of the settlement with Cuba may not necessarily be the same person who suffered the IRS-cognizable "seizure" for purpose of qualifying under §1033(a), leading to the recipient's possible ineligibility for §1033(a) non-recognition.
For example, under 22 U.S.C. §1643d(b), the FCSC was authorized to, and did, certify claims based on the Cuban government's expropriation of the assets of non-U.S. corporations in which the U.S. citizen or U.S.-majority-owned U.S. corporation owned stock, such as Cuban corporations and non-Cuban foreign corporations. The FCSC's decision in Louis Angel Pagliuca55 apparently involved the FCSC certifying a claim by a U.S. citizen for the Cuban government seizure of some of the assets of a Cuban corporation wholly owned by the U.S. citizen claimant, and not a seizure of the stock in that Cuban corporation.
Rev. Rul. 56-63656 sets forth the IRS view that a sole stockholder cannot make a §1033-qualifying reinvestment of insurance proceeds it received to compensate for depreciation in value of its wholly owned corporation stock caused by a casualty loss occurring to its subsidiary's assets. Rev. Rul. 56-636 is premised on its conclusion "that the property converted is not `property' of the parent corporation within the purview of §1033 of the Internal Revenue Code of 1954." Therefore, a recovery on an FCSC-certified claim like that in Angel Pagliuca — involving a Cuban government seizure of some of the assets of a Cuban corporation wholly owned by the U.S. citizen claimant (as distinguished from a seizure of the Cuban corporate stock) — may, under Rev. Rul. 56-636, be ineligible for non-recognition under §1033.
Original Claimant Deceased
It seems likely that the majority of U.S. citizens whose circa-1960 claims were certified by the FCSC are now deceased. The current state of the tax law as to when, if at all, the trustees, executors, heirs, or beneficiaries of a decedent can qualify for non-recognition under §1033 on account of a claim inherited from the decedent is unclear. Some authorities hold that where the reinvestment is made by executors or trustees pursuant to plans made by the decedent, §1033 may be available to the estate or trust.57 Nevertheless, the Cuban claims, which may well involve a decedent who died a long time ago — i.e., before the current rapprochement with Cuba and possible payment of the FCSC-certified claims were even envisaged, and whose estate was also closed a long time ago with a relatively small FCSC principal claim bequeathed among multiple individual heirs with differing reinvestment ideas — may generally present a poor case for availability of §1033 non-recognition if proof of continuation of the decedent's specific plan to reinvest is required.58
However, recoveries for Cuban confiscation of a decedent's property are likely to be viewed as income in respect of a decedent under §691.59 Given that §691(a)(3) generally characterizes an heir's income by reference to the character the income would have had in the hands of the decedent, some commentators argue that where recovery of a claim for a governmental seizure is characterized as income in respect of a decedent, the heir should likewise be eligible for §1033.60
In some cases, the IRS has accepted that, for U.S. income tax purposes, the shares of a Cuban corporation directly owned by a U.S. stockholder, rather than the assets of the Cuban corporation, were the subject of a Cuban government expropriation.61 In situations where the payments on FCSC-certified claims could properly be characterized as payment for the seizure of directly owned shares in Cuban corporations, achieving §1033 non-recognition on the gain in shares by reinvestment of the corresponding recovery in shares of other corporations may be possible. For example, in PLR 200118010, the IRS ruled that where the minority common stock interest in a non-publicly traded corporation was involuntarily converted, common or preferred stock in a publicly traded corporation in a similar business was eligible replacement property. Therefore, in cases where a minority interest in a Cuban corporation was expropriated, investment in stock in even a U.S. publicly traded corporation in a similar business could be suitable for investment under §1033.
The largest FCSC-certified claims involve the seizure of all the assets used in businesses located in Cuba. This implicates the somewhat unclear issue as to whether the assets have to be replaced on an asset-by-asset basis or rather on an overall business basis, and how similarity of an overall business will be evaluated. In Maloof, the Tax Court in dicta stated that in evaluating, for purposes of §1033 non-recognition, the reinvestment of a distribution of a recovery of an FCSC-certified claim, "some rearrangement of his investment among depreciable real and personal property may be tolerated where the overall effect is to reproduce the [seized] facility as closely as changed conditions permit."62 In Maloof, however, the Tax Court rejected the reinvestment in a manufacturing business of an award on an FCSC-certified claim relating to an expropriated distribution business.
Given the large amount of time that has elapsed and the intervening corporate changes, current management may not have an interest in reinvesting in a similar business. For example, the Office Depot claim originated in the seizure of assets of the Cuban electric utility.63 One doubts whether Office Depot wishes to invest its FCSC principal recovery in assets similar to those of an electricity generator rather than in assets similar to those of an office products distributor.
Although the first FCSC certification period was open for claims that arose between 1959 and the early 1970s,64 as noted above, most expropriations occurred during the 1959–1962 period. Section 1245(a)(1) does not apply to dispositions of property that occurred before 1963.65 Therefore, it would appear that §1245(b)(4)(B), which limits the gain taken into account under §1245(a)(1) in certain §1033 transactions involving replacement of §1245 property with non-§1245 property, would not adversely affect a §1033 replacement transaction relating to a Cuban expropriation that occurred before 1963.
Similarly, §1250(a) does not apply to dispositions of property that occurred before 1964. Therefore, it would appear that §1250(d)(4), which limits the gain taken into account under §1250(a)(1) in certain §1033 transactions involving replacement of §1250 property with non-§1250 property, would not adversely affect a §1033 replacement transaction relating to a Cuban expropriation that occurred before 1964.
Section 1031(h) states that "for purposes of this section" (i.e., §1031), property located in a foreign country (such as Cuba) is not like kind to property located in the United States. Commentators have concluded that this rule does not apply for purposes of §1033(g) (permitting business or investment real estate to be replaced by like-kind business or investment real estate, even if not similar or related in service or use) or otherwise for purposes of §1033.66 Therefore, assets seized directly from the FCSC-certified claimant located in Cuba should be eligible for replacement by assets located in the United States or elsewhere outside.
In their 2007 proposal to the State Department, consultants suggested that "for medium and large claims [Cuba] can propose a remedy other than cash compensation which will be awarded if deemed the fair equivalent of what the claimant would be entitled to under principles of international law."67 Where an FCSC-certified, medium- or large-claimant's recovery paid in Cuban property corresponds to taxable interest income, tax benefit inclusion amounts,68 or property outside the §1033 replacement standard, or some other barrier to non-recognition exists, such payment in property could trigger a U.S. income tax liability in excess of cash received.
Section 1031(a) non-recognition seems unavailable. Under §1031, for property relinquished before 1984, property received after 1986 is treated as not like-kind property.69
To alleviate the potential problems of a C corporation's tax liability in excess of cash received, §6167(a) provides generally that if less than 25% of a C corporation's principal recovery on an expropriation claim is cash, and such cash recovery is not greater than the corporate tax attributable to such recovery, the corporate tax attributable to such recovery may be paid ratably over 10 years, with interest accruing on the unpaid installments. Section 6167(b) provides that where the Treasury finds that payment of corporate tax on an expropriation recovery would result in undue hardship, the Treasury has discretion to permit payment of that corporate tax to be extended for up to nine years.
The percentage of the FCSC-certified principal and interest claims the State Department will recover for the FCSC-certified claimants against Cuba is unknown at this point. At the low end — i.e., a recovery less than the tax basis when the property was seized by the Cuban government — to the extent the tax benefit inclusion rule and resulting ineligibility for §1033 non-recognition are triggered, this will make these collections largely taxable. At the high end — i.e., a recovery of accrued interest as well as all principal — the accrued interest, like the tax benefit inclusion amount, will also trigger income which likewise is not eligible for §1033 non-recognition. But in the middle — i.e., a recovery of principal of the claims beyond that triggered into income by the tax benefit inclusion rule — there may be opportunities for §1033 non-recognition. However, even here, there are numerous pitfalls created by the uncertainty as to the application of §1033 in many circumstances.
This Insight also appears in the January 2016 issue of the Tax Management International Journal.
Copyright©2016 by The Bureau of National Affairs, Inc.
Ashby, U.S. Certified Claims Against Cuba: Legal Reality and Likely
Settlement Mechanisms, 40 U. Miami Inter-Am. L. Rev. 413 (2009), available
at: http://repository.law.miami.edu/umialr/vol40/iss3/2; Creighton University
School of Law & Department of Political Science, Resolution of
Outstanding Property Claims Between Cuba and the United States, Creighton
University Press (2007, available at http://works.bepress.com/cgi/viewcontent.cgi?article=1001&context=
michael_kelly, hereinafter "Creighton Report"); Bradley T. Gilmore, U.S.-Cuba Compensation Policy, 8 Tex. Hisp. J. L. & Pol'y 79 (2002); Mattias F. Travieso-Diaz, Some Legal and Practical Issues in the Resolution of Cuban Nationals' Expropriation Claims Against Cuba, 17 U. Pa. J. Int'l Econ. L. 659 (1996).
4 The International Claims Settlement Act, amendment, Pub. L. No. 88-666. Recoveries under private lawsuits against any traffickers of a Cuban property that was the subject of FCSC-certified claims, authorized by 22 U.S.C. §6082 (1996), or any recoveries by U.S. persons who were not U.S. citizens or U.S. corporations at the time of the Cuba expropriation, or recoveries of purchased FCSC-certified claims, are beyond the scope of this article.
5 Also allowed as claimants were Puerto Rico corporations, and non-corporate entities organized under the laws of the United States and Puerto Rico, if they were majority-owned by U.S. citizens. 22 U.S.C. §1643a(1), §1643c(a).
7 The list of FCSC-certified Cuban claims is at: http://www.justice.gov/sites/default/files/fcsc/docs/ccp-listofclaims.pdf. A summary is at Exhibit 15 of the final report of the FCSC's first Cuba claims program, Completion of the Cuban Claims Program Under Title V of the International Claims Settlement Act of 1949, (hereinafter "FCSC Cuban Claims Program Report"), available at the FCSC Cuba Program website, above n. 6. See also Taryn Luna, US-Cuba Thaw Could Bring Staples a Windfall, Boston Globe, electronic edition (July 21, 2015); Andres Oppenheimer, A Nobel Prize for Raul Castro, Miami Herald online edition (Sept. 30, 2015); Lenore Adkins, U.S. Not Updating Asset Claims Against Cuba Even as Trade Beckons, BNA Daily Rep. for Executives (Oct. 5, 2015). Cf. Ira T. Wender, Use of `Tax Haven' Corporations and Western Hemisphere Trade Corporations, 11 USC School of Law Major Tax Planning for 1959, 253 at 256–257 (1959).
8 22 U.S.C. §1643d(b) allowed a claim based on a direct ownership interest in a foreign corporation to be considered. 22 U.S.C. §1643d(c) allowed a claim based on an indirect interest in a foreign corporation, but only if at least 25% of the entire ownership interest was vested in U.S. citizens or U.S. corporations. See Richard B. Lillich, The Cuban Claims Act of 1964, 51 A.B.A.J. 445 (1965).
17 Id. See also Travieso-Diaz, Alternative Remedies in a Negotiated Settlement of the U.S. Nationals' Expropriation Claims in Cuba, 17 U. Pa. J. Int'l Econ. L. 659 (1996) at 663 ("Of the $1.8 billion in certified claims, over 85% [in value] were asserted by 898 corporate claimants, with the rest belonging to 5,013 individual claimants. There were only 131 claimants — 92 corporations and 39 individuals — with certified claims of more than $1 million. Only 48 of the claimants, 43 of them corporations, had certified claims in excess of $5 million. These figures demonstrate that U.S. claimants fall into two general categories: a limited number, mostly corporations, with large claims, and a larger group, mainly individuals, with small claims").
20 FCSC 2011 Annual Report (2012), available at http://www.justice.gov/sites/default/files/fcsc/docs/annrep11.pdf, at 6 ("In most programs, the amount of funds available to pay the Commission's awards is limited, often resulting in pro rata payments of awards by the Department of the Treasury").
24 Creighton Report, above n. 2 at 255. See also Lenore T. Adkins, above n. 7 (U.S. State Department spokesman states that "U.S. negotiators [and] their Cuban counterparts … are considering a `variety of options' to resolve the claims"). Any changes to U.S. and Cuban and other laws needed to implement such solutions are beyond the scope of this article.
27 Unless otherwise noted, all "§" references are to the Internal Revenue Code of 1986, as amended (the "Code"), and all "Reg. §" references are to the regulations issued thereunder and set forth in 26 C.F.R.
28 Rev. Rul. 62-197, 1962-2 C.B. 66 (Cuban expropriation loss fully recognized in 1959, when government took control of taxpayer's business, even if Cuba "expressed [an] intent to pay at some time in the future."); Rev. Rul. 80-17, 1980-1 C.B. 45 (non-U.S., Cuban, citizen who suffered an expropriation loss in 1959, and became a U.S. resident after 1959, incurred loss in 1959, and so could not claim any post-1959 expropriation loss in computing post-1959 U.S. taxable income); Sabas v. Commissioner, T.C. Memo 1973-133. See alsoElghanian v. Commissioner, T.C. Memo 2005-37.
30 Section 1351(d) generally allows a U.S. C corporation to compute a tax-benefit-type recovery for Cuban expropriation losses previously claimed, based upon a computation of the hypothetical increase in prior years' corporate tax from correspondingly reducing the deduction claimed in the earlier year, rather than by applying the general tax benefit rule outside §1351(d) that recaptures the deduction in the year of recovery. For purposes of determining the hypothetical increase in prior years' corporate tax, the corporation uses the maximum corporate income tax rate in the year of recovery (currently 35%) rather than the corporate tax rate that actually applied in the year in which the loss was claimed. See Bittker & Loken, Federal Taxation of Income, Estates, and Gifts (Electronic Ed. 2015), ¶5.7.6. As noted in Gertzman, Federal Tax Accounting (Electronic Ed. 2015), ¶12.05[b][iv], a C corporation with a recovery of an FCSC claim "should compute the result under all alternatives before deciding which course of action to follow."
31 See Matthew B. Krasner, Tax Benefit Rule and Related Doctrines as Applied to the Recapture of Research and Other Intangible Development Costs, 60 St. John's L. Rev. 26, 29–30 (1985); Deely v. Commissioner, 73 T.C. 1081, 1096–97 (1980). See also §80, generally codifying the tax benefit inclusion rule, tax benefit exclusion rule, and Arrowsmith character doctrines in the case of a C corporation that does not make a §1351 election and recovers a loss claimed for an expropriated security. For example, seizure of property from a U.S. citizen or U.S. corporation that was real or depreciable personal property used in a trade or business located in Cuba generally triggered a §1231 loss. See Thomas L. Wolfe and John B. White, Income Tax Consequences of Cuban Expropriations to Cuban Resident Aliens, 19 U. Miami L. Rev. 591 (1965).
32 Creighton Report, above n. 2, at 41. Compare S. Rep. No. 89-701, 89th Cong., 1st Sess., 1965 WL 4587 (1965), discussing the extent to which reductions in income tax should be viewed as within the scope of 22 U.S.C. §1643e, which instructs the FCSC that "in determining the amount of any claim, the Commission shall deduct all amounts the claimant has received from any source on account of the same loss or losses." That Senate report states: "The Internal Revenue Code presents [sic; author's note: should be `prevents'] double recovery by imposing a tax on any compensation received by a claimant to the extent he has previously derived a tax benefit from the loss … there is nothing in international law, the Internal Revenue Code, or previous practice under the International Claims Settlement Act that would increase or reduce the total U.S. claim against Cuba by the amount of the writeoffs allowed under U.S. tax legislation. Similarly, the amount of the private claim against Cuba by the persons suffering the loss is not diminished by reason of the fact that the deduction of the loss resulted in a savings in income tax." See also the letter from the General Counsel of the Treasury to the Chairman of the Committee on Foreign Affairs of the House of Representatives, in the Hearings Before the Subcommittee on Inter-American Affairs, House of Representatives, 89th Cong. 1st. Sess. at pp. 20 and 21 (Comm. Print 1965) (arguing that there should be no reduction in a claimant's recovery on FCSC-certified Cuban claims by reason of prior income tax benefits, reasoning that "when and if the taxpayer-claimant receives an award in settlement of his adjudicated claim, he is subject to tax on the amount of the award previously deducted as a loss, equal to and thus canceling out, the prior tax benefit").
39 Cf. Nadler v. Commissioner, above, n. 29; Khosrow v. Commissioner, T.C. Memo 1989-553 (where tax return filed for the year of the expropriation loss could not be located, no capital loss carryforward allowed); Powe Trust v. Commissioner, T.C. Memo 1982-488 (Tax Court uses approximation based on available evidence to arrive at $1.5 million adjusted basis of capital assets seized by Cuban government in 1960 that was the subject of a $9.5 million FCSC-certified Cuban claim, in order to establish capital loss carryforward to 1974); §7491.
40 Since the claim will likely be viewed as income in respect of a decedent, this creates an appealing case as a policy matter for the heir to be entitled to the decedent's §111(a) recovery amount. See PLR 8740042 (recovery of decedent-initiated personal injury claim is subject to income in respect of a decedent rules, but is entitled to same §111(a) exclusion to which decedent would have been entitled).
41 See Maloof v. Commissioner, 65 T.C. 263 (1975) (recovery of FCSC claim for foreign government's confiscation of taxpayer's "seized" business eligible for §1033 non-recognition if reinvested in qualifying property); §1351(b), §1351(e) (§1033 available to corporations under that section with respect to a portion or all of the recovery of "losses sustained by reason of the expropriation, intervention, seizure or similar taking of property"); Rev. Rul. 54-594, 1954-2 C.B. 10 (proceeds of property "seized" by U.S. Alien Property Custodian eligible for §1033 non-recognition); PLR 200946006 ("A seizure occurs when a government authority enters into physical possession of property without authority of a court order with compensation to be determined later."); Rev. Rul. 62-197, above n. 28 (in the context of §165, Cuban government takings were described as confiscation by "seizure, intervention in, or similar taking of property by Cuban officials," triggering a §165 loss, even though they were not a casualty or theft described in §165(c)(3); last sentence of ruling states "See also §1033"); §1351(e) (amounts received on recovery of expropriation loss in excess of amount of previously allowed deductions eligible for §1033).
43 Mager v. United States, 499 F. Supp. 37 (M.D. Pa. 1980), aff'd without opinion, 636 F.2d 1209 (3d Cir. 1980). See also §1351(d)(1) (requiring, in lieu of current year recapture of previously deducted losses under tax benefit principles, a recomputation to increase earlier year taxes based on denial of deductions claimed, at the recovery year corporate tax rate).
46 See Ebasco Industries Inc., FCSC Decision No. CU-3866 (1967) (FCSC certifies claims for total loss on mortgage bonds issued by Cuban Electric Company, a Florida corporation whose Cuban properties were nationalized in 1960).
50 74 T.C. 1566 (1980). See also S. Rep. No. 89-1091, 89th Cong., 2d Sess. 5 (1966) ("a foreign expropriation loss (as defined in sec. 1351(b)) does not include any interest element that may have been added or accrued with respect to the loss after the expropriation occurred. Thus, any such interest element is not subject to the treatment provided in new section 1351"); CCA 201203013.
56 1956-2 C.B. 522. See also TAM 9051001. Compare Reg. §1.381(c)(13)-1(c)(3) Exs. (4) and (5), allowing a U.S. corporate successor, in a §381(c) transaction, to a predecessor corporation that has suffered an involuntary conversion to obtain by reinvestment §1033 non-recognition with respect to a subsequent insurance recovery; and §1351(g), allowing a recovery by a C corporate stockholder of a Cuban corporation whose stock became worthless due to expropriation to qualify for §1033 non-recognition subject to the §1351(d)(1) tax benefit inclusion rule.
58 See Jayne v. Commissioner, 61 T.C. 744 (1974). But see GCM 37673, above n. 57 (non-recognition should be accorded to the executors or trustees of a decedent when it would have been unreasonable to expect decedent to have begun the replacement process before his death). See also 568 T.M., Involuntary Conversions, §VII.A.3 ("the estate must replace and not its beneficiaries").
60 See 862 T.M., Income in Respect of a Decedent, §IV.D.3. Conversely, the IRS could argue that, to the extent that the decedent received a tax benefit from the loss, the heir's recovery should be governed by the tax benefit income rule, with the tax benefit element being ineligible for §1033 non-recognition,
68 Although Mager, above n. 43, applied the tax benefit inclusion rule to a cash award described in §1033(a)(2) and did not involve receipt of similar property described in §1033(a)(1), the court's opinion can be viewed as equally applicable in the latter case.
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