Two Irish companies were involved in an "aggressive" tax-avoidance scheme that resulted in a settlement by two US companies with the US Internal Revenue Service (IRS).
The IRS announced that its "eight-figure" settlement with two financial firms should warn others that the agency is getting tough on tax-avoidance strategies.
The Diversified Financial Corporation, an affiliate of The Diversified Group Incorporated in New York, and AVM L.P, a broker-dealer, agreed to pay the settlement after the IRS claimed they were engaged in an illegal tax-avoidance scheme.
Both companies purchased non-economic residual interests (NERIs) from various Wall Street investment banks and resold them to a Wyoming limited liability company owned by the two Irish companies not subject to US tax. The system saved the companies tens of millions in taxes, but under US tax law, foreigners are not allowed to buy such securities.
NERIs are mortgage-type securities that entitle the holder to little or no cashflow but typically generate "phantom" taxable income for the holder in the early years of the holding and corresponding amounts of phantom tax losses in the later years.
Although the phantom losses can be used to offset income from other sources, the holder is prohibited under applicable law from offsetting the phantom income with any type of loss or deduction.
As a result, at the time of issuance, NERIs generally have a negative value attributable to the time value of money detriment associated with having to pay tax on the phantom income in the early years of the related REMIC (real estate mortgage investment conduits) and receiving a corresponding tax benefit from the phantom losses in later years.
Due to this negative value, issuers or sponsors of REMICs generally "sell" NERIs by paying the "buyer" an inducement fee.
For some time, the IRS has been concerned that buyers of NERIs have attempted to avoid the tax due during the early years of the related REMIC by taking an overly aggressive interpretation of the applicable tax rules.
The announcement noted that the agency's efforts "are directed not just at listed tax shelter transactions, but at all tax planning strategies determined to be overly aggressive by the IRS."
The companies have agreed to cease NERI trading activities and to a limited waiver of the taxpayer privacy and anti-disclosure rules.