ABA SECTION OF TAXATION 2013 LAW STUDENT TAX CHALLENGE OFFICIAL LL.M. DIVISION PROBLEM

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1 ABA SECTION OF TAXATION 2013 LAW STUDENT TAX CHALLENGE OFFICIAL LL.M. DIVISION PROBLEM The following is an received from the partner you work with at your firm, dated September 6: This morning, GMG management called us asking for advice on how to defer U.S. income tax on its foreign earnings. GMG owns all of the stock of two subsidiaries, MyFace and Longshot through a foreign holding company, GMG Holdings, which was formed in 2011 with an initial election to be treated as a disregarded entity. GMG Holdings earnings are thus currently taxed in the U.S. We have tentatively suggested that GMG Holdings could make an election to be treated as a corporation for U.S. federal income tax purposes, with the result that the earnings would not be taxed in the U.S. currently. The idea is that GMG would make the election retroactive to the last day of its 2013 fiscal year. We need to research the consequences of making such an election and advise the client accordingly. GMG management has also asked us to evaluate whether a similar election elsewhere in the structure would be possible. I suspect that the outcome of that analysis may be useful to us, so I think it is worth your spending some time on that question as well. I ve summarized my notes from my phone call with the client below and have attached the limited amount of information they sent over, which includes a chart of the current structure of GMG and a term sheet. My instructions are also stated below. Summary of Facts General Media Group ( GMG ) is a U.S. corporation engaged in the software development and social media businesses. GMG has a June 30 fiscal year end. In 2011, GMG s wholly-owned subsidiary, GMG European Holdings S.á.r.l ( GMG Holdings ), a Luxembourg corporation treated as a disregarded entity for U.S. federal income tax purposes, acquired MyFace for $35 million from an unrelated party. MyFace, a corporation based in Ireland, has operated a social networking website that was originally a market leader but, in recent years, has failed to keep pace with its newer competitors. GMG attempted to revamp the platform and relaunch as MyNewFace but ended up alienating a large percentage of the remaining customer base in the process by accidentally deleting all of the old data saved in their profiles. GMG Holdings borrowed $25 million of the $35 million MyFace purchase price from a third party lender and the remaining $10 million from GMG. GMG Holdings has not paid down any of the debt to date. In connection with the acquisition, GMG Holdings made a section 338 election, and immediately distributed the excess cash in MyFace, reducing its basis in the MyFace stock to $20 million. In January of 2013, MyFace sold some of its valuable intellectual property so that, despite losses for the past few years, MyFace had substantial earnings during its

2 2013 fiscal year. Still, GMG management states that GMG has a built-in loss in its MyFace stock, estimating the value of MyFace to be approximately $15 million. Late in 2011, GMG was approached by Gladblokes plc, an English bookmaker, with an idea to create a web-based research software for use by its customers. This software would survey information posted on social networking sites, assisting customers in making the most informed wagers. Based on the customers perceived interests, the software would make recommendations on the hedging of bets and suggest other bets that might interest the customer. The idea seemed far-fetched to GMG management, but Gladblokes was enthusiastic that such a service, available exclusively to its customers, would allow it to capture significant additional market-share. Seeing a potential revenue stream, GMG agreed to enter into an arrangement to develop the required web-based software. In January 2012, GMG formed Longshot Limited, a UK company treated as a disregarded entity for US federal income tax purposes. Longshot Limited immediately entered into an agreement with Gladblokes to collaborate on the development of the software. The agreement outlined the following conditions: (1) Any development costs will be charged against the operating profits of the collaboration; (2) Management and finances will be handled by committees whose members are appointed in equal numbers by GMG and Gladblokes; (3) Records shall be maintained of all costs, expenses, sales, and payments; (4) Gladblokes will determine annually if any true-ups are necessary; (5) GMG and Gladblokes will jointly share all accruals and reserves and jointly own assets, including the software and copyrights. During 2012, both parties contributed to developing the software, and according to the records that Gladblokes presented at the end of December, each party incurred approximately $5 million in expenses under the collaboration agreement during its first year. From GMG s standpoint, most of the expense it incurred on the project was the salaries of its software engineers. There was no profit from the project during Gladblokes insisted that the software be launched, ready or not, by the end of GMG management agreed, but insisted that the service not bear the GMG name so as not to risk ruining its reputation as a developer of software. Therefore, on January 1, 2013, the software was launched as a new service called Sure Thing, available as a link on Gladblokes website and marketed as as exclusively available to Gladblokes customers for an additional fee. Because of a huge surge in betting on any fact related to the impending arrival of the Royal Baby and a growing demand for information that would identify the biggest potential payoffs, the software was hugely successful. By June 30, 2013, Gladblokes was estimating that the collaboration would result in significant profits. However, GMG Management, which did not

3 make any mention of the collaboration on its U.S. federal tax return in 2012, is taking the position that it can wait for the December 31, 2013 true-up to take into account any income under the agreement and plans to treat any income as a fee for development services. Revenues from Sure Thing continue to grow even after the birth and announcement of the Royal Baby s name, with bets being placed on everything from the baby's first word to the details of his future siblings. In addition, it seems that customers are becoming hooked on the software, as an increasing percentage of wagers placed through Gladblokes also result in a fee for use of the Sure Thing service. GMG management currently estimates that its interest in the collaboration agreement is worth $15 million. Given the unexpected success of the collaboration, GMG management realized they needed to do some tax planning to keep their historically low U.S. federal tax liability from skyrocketing at a time when they are still pouring cash into MyFace. Keeping earnings from Sure Thing offshore seems the logical choice. Instructions I need you to do some research for me and write up your analysis by Monday. I ve never worked with this client before, but I m going to see them next week in Phoenix and will take you with me if you can keep me from having to do this analysis myself. GMG management certainly didn t leave us much time when they called earlier this week. I need a legal memorandum (no more than twelve pages in length) summarizing the issues and analysis related to the proposed transaction. It would also be useful for you to draft a client letter (no more than four pages in length) that summarizes the tax treatment and consequences. The client letter should use plain English to the extent possible. Please address only the issues I ask you to cover we don t have time to waste on other issues. Please research and provide analysis on the following questions: 1. Could GMG be required to recognize any income as a result of the proposed check-the-box election to treat GMG Holdings as a corporation, and if so, under what code sections? 2. Would it be possible to make a check-the-box election to treat the Sure Thing collaboration as a corporation? Don t get into the consequences of making such an election, but evaluate whether it can be done. Please make sure to support your analysis with the proper authorities. If there are any facts that need to be clarified or any ambiguity in the law, please note that in your memorandum. If you make any assumptions on which your conclusions are based, please note those as well. Also, disregard any issues arising under Section 367. We have the international transactions people looking at the application of Section 367 to these facts.

4 Social media the old-fashioned way $10 million debt to GMG GMG (US) 100% GMG Holdings (Lux) $25 million 3 rd party debt 100% 100% MyFace (Ireland) Longshot (UK) Gladblokes Sure Thing Collaboration

5 Profit Participation Agreement between Gladblokes plc and Longshot Limited - TERM SHEET - This term sheet summarizes the terms of the arrangement through which Gladblokes plc, a private limited company formed under the law of England & Wales ( Gladblokes ) and Longshot Limited, a limited company also formed under the law of England & Wales ( Longshot ), will collaborate in connection with a venture to produce, market and operate the software business to be called SureThing. Legal personality This agreement is purely contractual in nature. All legal relationships arising through the establishment of the collaboration agreement are governed by contract law. It is not the intent of the parties that a separate juridical entity will be created in connection with the collaboration agreement. Equity As the venture has no separate legal personality, it cannot hold legal title to the assets. Consequently, the assets can be jointly held by the parties (i.e. coownership); or one of the members can have the exclusive ownership of the assets (if so agreed). There is no legal requirement to make any contribution to the venture; however, each party shall agree to provide such contributions as may be necessary, including funds, services or other assets, to enable the venture to carry out its purpose. Each party s contribution shall be recorded in the accounts of the venture as set forth below. Accounts Separate books and records shall be kept in connection with the profit sharing arrangement, in which shall be recorded all costs, expenses, sales and payments. All costs associated with the development of SureThing shall be charged against the operating profits of the venture.

6 Gladblokes shall be tasked with the keeping of accounts, and shall determine at the end of each fiscal year whether any adjustments must be made to the members respective balances. Statutory seat Tax treatment Liability Management and representation Distribution of proceeds Termination Governing law The members shall jointly share all accruals, reserves and assets, including interest in any intangibles created as a result of the arrangement. The venture has no registered place of business nor a statutory seat. However, it is anticipated that most day-to-day oversight of the company shall take place at the offices of Gladblokes in the United Kingdom. As the venture has no legal personality for tax law purposes under the law of the United Kingdom, it will be fully transparent under U.K. law, and all income derived shall be taxable only as taxable in the hands of the members. The members will share liability arising from this arrangement equally. Under the law of the England & Wales, each member is jointly and severally liable for any liabilities arising to third parties in connection with the profit sharing agreement. All management and finances shall be the responsibility of committees whose members shall be appointed in equal numbers by Longshot and Gladblokes. The distribution of profits between the members can be freely decided upon (i.e., distributed to the members, put at the disposal of the venture, or allocated to the members capital account). Each member is entitled to its respective share in the venture s profit or loss. The arrangement shall be terminated only upon mutual written agreement of the parties. The contract shall be governed by the law of England & Wales. In the event of a dispute between the parties, such dispute shall be arbitrated in London in accordance with the rules of the London Court of International Arbitration before a panel of three judges, one selected by each party and a third selected by joint

7 agreement. The contract memorializing the terms of this arrangement shall be signed between the parties in London. END OF PROBLEM