2011 Legal, Tax and Accounting Subcommittee Reports

NATIONAL COUNCIL OF FARMER COOPERATIVES

2011

Legal, Tax and Accounting Subcommittee Reports

INTRODUCTION

The LTA subcommittee reports are prepared annually through the efforts of individuals who serve on NCFC’s Legal, Tax and Accounting Committee. NCFC is deeply grateful for the dedication and generosity of these volunteers, many of whom are national experts in their respective areas of practice.

The purpose of the reports is to interpret and highlight the legal, tax and accounting events of the past year, and to discuss in detail many of the issues faced by cooperatives.

The legal, tax and accounting issues of farmer cooperatives are affected by a number of external forces and general practice issues, with the added focus of specific industry issues. The LTA subcommittee reports are the only resource summarizing all these issues in a single volume.

If you have questions or need materials referred to in the reports, please notify me by e-mail at [email protected] or by telephone at 202.879.0825.

Sincerely,

Marlis Carson Senior Vice President & General Counsel

The following reports do not constitute specific advice and may fail to address aspects of an issue or development relevant to the reader. Readers should be particularly aware of the importance of checking for subsequent developments, as these reports may not have been updated since originally composed.

Table of Contents

2011 Subcommittee Reports of the Legal, Tax and Accounting Committee Page

Introduction ...... 2

Financial Reporting and Audit Issues of Agricultural Cooperatives ...... 5 - Dick Cisne and Jay McWatters

Overview of New Tax, Other Legislation and Implementation Issues Affecting Farmer Cooperatives ...... 13 - Barry Jencik and Kevin Feeley

Operating on a Cooperative Basis for Subchapter T and Section 521 Cooperatives ...... 21 - Terrance Costello, Ronald Peterson and Lisa Maloy

Cooperative Structures: Mergers, Acquisitions, Joint Ventures and Subsidiaries ...... 28 - David Swanson, Brent Bostrom and Steve Rowe

Calculating Patronage Dividends ...... 39 - Teresa Castanias, Daniel Groscost and Daniel Schultz

Issues Specific to Marketing Orders and Bargaining Cooperatives ...... 46 - Stephen Zovickian and Julian Heron

Litigation between Cooperatives and Their Members, Including Member Insolvency ...... 53 - William Hutchison, Terry Bertholf and David Hayes

AMT, Tax Accounting and State and Local Tax Issues Affecting Agricultural Cooperatives ...... 64 - Brett Huston, Wayne Sine and David Simon

Antitrust ...... 66 - Michael Lindsay, Don Barnes and Chris Ondeck

Securities ...... 79 - Todd Eskelsen

Environmental Laws and Regulation ...... 83 - B. Andrew Brown and Daniel Hall

Digest of Cases...... 95 - George Benson and David Antoni

IRS Industry Specialist ...... 136 - Marla Aspinwall 4

Financial Reporting and Audit Issues of Agricultural Cooperatives

2011 Report

Chair Vice-Chair

Dick Cisne Jay McWatters Hudson, Cisne & Co. LLP Dopkins & Company, LLP 11412 Huron Lane 200 International Drive Little Rock, AR 72211 Williamsville, NY 14221 Ph: 501-221-1000 Ph: 716-634-8800 Fax: 501-221-9236 Fax: 716-634-8987

E-mail: [email protected]

Contributors: David Burlage, CoBank

The information available on financial reporting issues which could be applicable to agricultural cooperatives is vast. It is beyond the scope of this subcommittee’s resources to analyze and report on each one. This year’s report will cover the most talked about developments, some with effective dates prior to 2011 but whose application is still of interest to cooperatives and their advisors.

The Financial Accounting Standards Board Accounting Standards Codification can be obtained at ASC.fasb.org while the pre-codification standards, proposed accounting standards, and final Accounting Standards Updates can be obtained from www.FASB.org. Statements and pronouncements on auditing standards along with statements of position, interpretations and professional pronouncements by the American Institute of Certified Public Accountants can be obtained from its website at www.AICPA.org. Exposure drafts outstanding are listed each month in the Journal of Accountancy by issuer, which also lists the issuer’s web address and mailing address.

Definitions/Terms:

GAAP - Generally Accepted Accounting Principles AICPA - American Institute of Certified Public Accountants ASC - Accounting Standards Codification ASU - Accounting Standards Update SFAS - Statement of Financial Accounting Standards FASB - Financial Accounting Standards Board IASB - International Accounting Standards Board IFRS - International Financial Reporting Standards SAS - Statement of Auditing Standards SEC - Securities and Exchange Commission the “Boards” - FASB and IASB joint projects

ED - Exposure Draft

Revenue Recognition in Contracts with Customers (joint IASB and FASB project) On June 24, 2010, the Boards jointly issued an exposure draft, Revenue From Contracts With Customers. The ED, released by the FASB as a proposed ASU, gives entities a single comprehensive model to use in reporting information about the amount and timing of revenue resulting from contracts to provide goods or services to customers. The proposed ASU, which would apply to any entity that enters into contracts to provide goods or services, would supersede most of the current revenue recognition guidance. In the course of their re-deliberations since the release of the ED, the Boards have made numerous tentative changes to the proposal’s guidance. As a result of these changes, the Boards have decided to expose for public comment a revised ED. The Boards also discussed effective dates pertaining to the revenue project and noted that such dates would not be earlier than January 1, 2015. The ED has been re-exposed as of November 14, 2011 with comments due March 13, 2012. A copy of the new draft can be viewed at www.fasb.org.

FASB and IASB Issue Proposed Guidance on Lease Accounting On August 17, 2010, the FASB and IASB issued an ED on lease accounting, which creates a new accounting model for both lessees and lessors and eliminates the concept of operating leases. The proposed ASU, if finalized, would converge the FASB's and IASB's accounting for lease contracts in most significant areas.

On July 21, 2011, the FASB and IASB announced their intention to re-expose their proposal for a common leasing standard. Re-exposing the leasing standard will provide interested parties with an opportunity to comment on revisions undertaken since the initial August 2010 publication. A final leasing standard is expected to be issued in mid-2012 and the earliest expected adoption date is 2015. The ED has not been re-exposed as of the end of 2011.

Several characteristics of the proposed lease accounting model were included in last year’s report. Following are updates to the most significant provisions of the proposed lease accounting model:

Lessees • Lessees will recognize a right-of-use asset and a liability for their obligation to make lease payments for all leases. “Off-balance-sheet” leases and the concept of “lease classification” in the current accounting model will no longer exist for lessees. • For leases previously classified as operating leases, rent expense will be replaced with amortization expense and interest expense. Amortization of the right-of-use asset will generally be on a straight-line basis; however, interest expense will be front-end loaded, similar to interest on an amortizing mortgage. • The lessee will recognize contingent rentals and residual value guarantees as part of the lease liability. • The lease term for both lessees and lessors will be defined as: the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together 6

with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.. • Unlike the current lease accounting model, the new model will require a lessee and a lessor to reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease. • The identification of non-lease components (e.g., maintenance costs in certain arrangements) will become more important under the new model. • Lease payments will be treated as financing cash outflows in the statement of cash flows. Under current U.S. GAAP, operating lease rent payments are treated as an operating cash flow.

Lessors • The proposed ASU provides for a “receivable and residual” accounting model for the lessor, in which the lessor would recognize a right to receive lease payments and a residual asset at the commencement of the lease. • The lessor would initially measure the right to receive lease payments as the sum of the present value of the lease payments discounted using the rate the lessor charges the lessee. • The lessor would initially measure the residual asset as an allocation of the carrying amount of the underlying asset and would subsequently measure the residual asset by accreting it over the lease term using the rate the lessor charges the lessee. • If profit on the right-of-use asset transferred to the lessee is reasonably assured, the lessor would recognize that profit at the date of the commencement of the lease. The profit would be measured as the difference between (a) the carrying amount of the underlying asset and (b) the sum of the initial measurement of the right to receive lease payments and the residual asset. • If profit on the right-of-use asset transferred to the lessee is not reasonably assured, the lessor would recognize that profit over the lease term. In that case, the lessor would initially measure the residual asset as the difference between the carrying amount of the underlying asset and the right to receive lease payments. The lessor would subsequently accrete the residual asset, using a constant rate of return, to an amount equivalent to the underlying asset’s carrying amount at the end of the lease term as if the underlying asset had been subject to depreciation.

Business Consequences • An increase in assets and liabilities could result in lower asset turnover ratios, lower return on capital, and an increase in debt-to-equity ratios. This could affect borrowing capacity or compliance with loan covenants. • The elimination of “off-balance-sheet” financing eliminates one of the advantages of leasing for lessees. This could result in a push toward shorter term leases or buying an asset rather than leasing it. The other benefits of leasing — flexibility to change locations

or equipment, reduced property management responsibilities, potential for financing 100 percent of the asset cost, improved cash flows, etc. — remain unchanged. • Accounting systems will most likely need to be enhanced or updated to address the new standard — lease contract management systems will need to be more closely integrated with lease accounting systems. • The new model will result in additional temporary differences for income tax accounting purposes. In addition, state and local taxes will be affected when the computation (or impact) of taxes is based on U.S. GAAP amounts.

FASB Clarifies a Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring

In April 2011, the FASB issued an ASU which clarified when a loan modification qualifies as a troubled debt restructuring (TDR). To qualify as a TDR, two criteria must be met: (1) the borrower is experiencing financial difficulties and (2) the lender has granted a concession to the borrower. Other specific clarifications in the ASU address whether the lender has granted a concession to the borrower. In addition, the ASU amends ASC 310-40 to include the indicators from ASC 470-60 that a lender should consider in determining whether a borrower is experiencing financial difficulties.

Effective Date and Transition For public entities, the ASU was effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. For nonpublic entities, the ASU is effective for periods ending on or after December 15, 2012, including interim periods within those annual periods.

Multiemployer Retirement Plans, ASU 2011-09 (ASC 715-80)

In September 2011, the FASB issued an ASU to address concerns from various users of financial statements on the lack of transparency about an employer's participation in a multiemployer pension plan. A unique characteristic of a multiemployer plan is that assets contributed by one employer may be used to provide benefits to employees of other participating employers. This is because the assets contributed by an employer are not specifically earmarked only for its employees. If a participating employer fails to make its required contributions, the unfunded obligations of the plan may be borne by the remaining participating employers. Similarly, in some cases, if an employer chooses to stop participating in a multiemployer plan, the withdrawing company may be required to pay to the plan a final payment (the withdrawal liability).

For employers that participate in multiemployer pension plans, this ASU requires an employer to provide additional quantitative and qualitative disclosures. The amended disclosures provide users with more detailed information about an employer's involvement in multiemployer pension plans, including:

• The significant multiemployer plans in which an employer participates, including the plan names and identifying number

• The level of an employer's participation in the significant multiemployer plans, including the employer's contributions made to the plans and an indication of whether the employer's contributions represent more than 5 percent of the total contributions made to the plan by all contributing employers

• The financial health of the significant multiemployer plans, including an indication of the funded status, whether funding improvement plans are pending or implemented, and whether the plan has imposed surcharges on the contributions to the plan

• The nature of the employer commitments to the plan, including when the collective-bargaining agreements that require contributions to the significant plans are set to expire and whether those agreements require minimum contributions to be made to the plans.

For public entities, the amendments in this ASU are effective for annual periods for fiscal years ending after December 15, 2011, with early adoption permitted. For nonpublic entities, the amendments are effective for annual periods for fiscal years ending after December 15, 2012, with early adoption permitted. The amendments should be applied retrospectively for all prior periods presented.

Testing Goodwill for Impairment, ASU 2011-08 (ASC 350)

In September 2011, the FASB issued an ASU to address concerns about the cost and complexity of performing the first step of the two-step goodwill impairment test. The amendments in the Update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.

Previous guidance under Topic 350 required an entity to test goodwill for impairment, on at least an annual basis, by comparing the fair value of a reporting unit with its carrying amount, including goodwill (step one). If the fair value of a reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any. Under the amendments in this Update, an entity is not required to calculate the fair value

of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount.

The amendments in this Update are intended to reduce complexity and costs by allowing an entity the option to make a qualitative evaluation about the likelihood of goodwill impairment to determine whether it should calculate the fair value of a reporting unit. The amendments also improve previous guidance by expanding upon the examples of events and circumstances that an entity should consider between annual impairment tests in determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Also, the amendments improve the examples of events and circumstances that an entity having a reporting unit with a zero or negative carrying amount should consider in determining whether to measure an impairment loss, if any, under the second step of the goodwill impairment test.

The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity's financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance.

FASB Requires Changes to Comprehensive Income Presentation In June 2011, the FASB issued an ASU which amended ASC 220 (FAS 130) by revising the manner in which entities present comprehensive income in their financial statements. The new guidance removes the presentation options in ASC 220 and requires entities to report components of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. Under the two-statement approach, the first statement would include components of net income, which is consistent with the income statement format used today, and the second statement would include components of other comprehensive income (OCI). The ASU does not change the items that must be reported in OCI.

Effective Date and Transition For public entities, the ASU is effective for fiscal years and interim periods within those years, beginning after December 15, 2011. For nonpublic entities, the ASU is effective for fiscal years ending after December 15, 2012, including interim periods within those annual periods. The amendments in this ASU should be applied retrospectively.

IFRS – Moving Towards a Single International Accounting Standard

Presently, approximately 100 nations, including those of the European Union, have adopted IFRS as their accounting standards of choice. As mentioned in last year’s report, there are key differences between the IFRS and U.S. GAAP that are noteworthy. The differences will vary with respect to individual companies and industries. 10

On May 26, 2011, the SEC issued a staff paper that elaborates and requests comment on an additional potential method of incorporating IFRSs into the U.S. financial reporting system. Under this approach, IFRSs would be incorporated into U.S. GAAP “over some defined period of time (e.g., five to seven years).” Although acknowledging that the timeline for incorporation is a critical issue, the staff paper indicates that this issue is outside its scope. The staff paper also points out that “[t]he Commission has not yet made a decision as to whether and, if so, how, to incorporate IFRS into the financial reporting system for U.S. issuers.”

On August 17, 2011, the AICPA submitted a comment letter to the SEC in which the AICPA expressed its views on the SEC staff paper on incorporating IFRSs into the U.S. financial reporting system. The comment letter supports IFRSs and the continued efforts of the IASB and FASB to develop a single set of global financial reporting standards for public companies. In addition, the letter backs an "endorsement approach" similar to the one described in the staff paper and emphasizes that U.S. companies should be given the option of whether to adopt IFRSs as long as they also remain compliant with U.S. GAAP.

Additional information on convergence towards international accounting standards is available in last years’ “Financial Reporting and Audit Issues of Agricultural Cooperatives 2010 Report” or at http://www.fasb.org/intl/convergence_iasb.shtml.

Differential Accounting (i.e. Big GAAP, Little GAAP)

Currently, there are 15,000 SEC reporting companies and 28 million non-SEC reporting companies. Therefore, the FASB and the AICPA have established a joint committee to serve as an additional resource to the FASB to further ensure that the views of private company constituents are incorporated into the standard-setting process. The joint committee formed is known as the Private Company Financial Reporting Committee (PCFRC). PCFRC members represent users and preparers of private company financial statements as well as CPA practitioners.

On December 17, 2009, the AICPA and the Financial Accounting Foundation (FAF) announced the establishment of a “blue-ribbon panel” (BRP) to address how U.S. accounting standards can best meet the needs of users of private company financial statements. The work and recommendations of the PCFRC played a significant part in helping to form the Panel. For current information about the meetings and work of the Panel, go to http://www.accountingfoundation.org/jsp/Foundation/Page/FAFSectionPage&cid=11761577710 83&pid=1175804985611. On January 26, 2011, the BRP released a report that includes recommendations to the FAF, the FASB’s parent organization, on how “accounting standards can best meet the needs of users of U.S. private company financial statements.” The major recommendations include (1) the creation of a new private company standards board that would focus on “making exceptions and modifications to U.S. GAAP” for private companies and (2) the creation of a differential accounting framework that would allow the FASB to make appropriate and justifiable exceptions and modifications. The BRP report does not recommend the development from scratch of a separate set of GAAP for private companies. 11

Other matters

The following matters were presented in the 2010 report. However, due to focusing on other matters, the boards have not moved forward with these projects during 2011. The boards have indicated that they will resume these projects during 2012 when they have the requisite capacity.

x Financial Instruments with Characteristics of Equity, ASC 480-10 (formerly Liabilities vs. Equity Project- SFAS 150) – Joint Project of FASB and IASB x Changes to Financial Statement Presentation proposed by the FASB and IASB x Proposed Amendment to ASC 450 and 805 (FAS 5 and 141(R), respectively) - Disclosure of Certain Loss Contingencies This concludes the committee’s coverage of selected current issues and pronouncements for 2011. We welcome any comments or additional information and would appreciate any suggestions and information related to these issues which should be covered in future reports.

END.

LTA REPORTING SUBCOMMITTEE

OVERVIEW OF NEW TAX, OTHER LEGISLATION AND IMPLEMENTATION ISSUES AFFECTING FARMER COOPERATIVES

2011 REPORT

December 31, 2011

Barry Jencik, Chair Greendyke Jencik & Associates CPAS, PLLC

Kevin Feeley, Vice Chair McDermott Will & Emery LLP

Summary 2011 had been a relatively quiet year for tax legislation, with the potential for significant tax reform in 2012 or 2013 – Congress did enact some legislation including laws that create hiring incentives and repeal three percent government withholding. One common theme during 2011 and going into 2012 among practitioners and taxpayers is the lack of certainty in tax planning for future years. This uncertainty was magnified by the expiration of many tax incentives after December 31, 2011 (so-called “tax extenders”), and the looming end of the Bush-era tax cuts after 2012, due to extension by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Relief). It has become clear that significant tax legislation is likely to remain in a holding pattern until the after 2012 presidential elections. Certain tax provisions, such as the extension of the payroll tax cut and extension of "tax extenders," may be considered, but any significant tax legislation is more than likely on hold until late 2012 or early 2013. States continue to enact legislation that impact cooperatives and their members. Many states have enacted and continue to consider gross receipts-based taxes, movement to single-factor sales apportionment, expansion of “nexus” creating activities and other measures aimed at raising revenue from non-resident taxpayers. Following is a brief summary of some federal and state tax legislation enacted in 2011 and late 2010 that may impact cooperatives and their members. I. Enacted Legislation Directly Impacting Farmer Cooperatives

A. Illinois. General assembly adopted legislation that enables cooperatives to elect to net patronage losses against nonpatronage income and vice versa, or elect to follow the federal tax treatment of patronage and nonpatronage losses, effective for taxable years beginning after December 31, 2010. In response, the Illinois Department of Revenue issued a form for cooperatives to file in order to make this election.

B. Missouri. S.B. 366 authorizes the formation of a cooperative association as a new type of business organization. It may be formed for any lawful purpose to conduct business in the state of Missouri. The association shall be comprised of members and governed by a board of directors. Members may be patron or nonpatron members. Patron members are those that conduct business through or with the cooperative. The cooperative may elect to be taxed as a corporation or as a partnership.

II. Recent Federal Tax Legislation of General Interest

A. The Temporary Payroll Tax Cut Continuation Act of 2011 (H.R. 3765)

1. The Act continues the 2011 calendar year employee-side payroll tax cut for the first two months of 2012. The new law also includes a recapture provision.

2. Under the new law, the employee-share of OASDI taxes is 4.2 percent for the first two months of 2012 (10.4 percent for self-employment income).

B. 1099 Taxpayer Protection Act of 2011 (H.R. 4)

1. In March 2010, Congress approved the Patient Protection and Affordable Care Act (PPACA) (P.L. 111-148), which included among its revenue raisers an expansion of business information reporting. Section 9006 of the PPACA required businesses, charities and government entities to file a Form 1099 when they make annual purchases aggregating $600 or more to a single vendor, other than to a vendor that is a tax-exempt organization, for payments made after December 31, 2011 and reported in 2013 and thereafter. The PPACA also repealed the long-standing reporting exception for payments made to corporations.

2. Observation: Businesses immediately began voicing their concerns regarding the burden of reporting. Cooperative organizations that process and manufacture would have seen a dramatic increase in their information reporting burden.

3. H.R. 4 repeals the expanded information reporting requirements for business payments as if Section 9006 of the PPACA had not been enacted.

C. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (“The 2010 Tax Relief Act”). The 2010 Tax Relief Act extends the Bush-era individual and capital gains/dividend tax cuts for all taxpayers for two years. The bill also provides for an AMT “patch,” a one-year payroll tax cut, 100 percent bonus depreciation through 2011 and 50 percent bonus depreciation for 2012, a top federal estate tax rate of 35 percent with a $5 million exclusion, and more. Highlights include the following:

1. Individual Tax Rates. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) The individual income tax rates had been scheduled to revert from their current levels of 10, 15, 25, 28, 33, and 35 percent to 15, 28, 31, 36, and 39.6 percent after December 31, 2010 (the 10 percent rate was put in place by EGTRRA). The 2010 Tax Relief Act extends all individual rates at 10, 15, 25, 28, 33 and 35 percent for two years, through December 31, 2012.

2. Dividends/Capital Gains. Qualified capital gains and dividends are taxed at a maximum rate of 15 percent (zero percent for taxpayers in the 10 and 15 percent income tax brackets) for 2010. The 2010 Tax Relief Act continues this treatment for two years, through December 31, 2012.

3. Alternative Minimum Tax (“AMT”). The 2010 Tax Relief Act provides an AMT “patch” intended to prevent the AMT from impacting middle income taxpayers by providing higher exemption amounts and other targeted relief for 2010 and 2011. Without this patch, which had expired at the end of 2009, an estimated 21 million additional households would be subject to the AMT. The 2010 Tax Relief Act

increases the exemption amounts for 2010 to $47,450 for individual taxpayers, $72,450 for married taxpayers filing jointly and surviving spouses, and $36,225 for married couples filing separately.

4. Payroll Tax Cut. The 2010 Tax Relief Act reduces the employee-share of the OASDI portion of Social Security taxes from 6.2 percent to 4.2 percent for wages earned during the payroll tax holiday period (calendar year 2011) up to the taxable wage base of $106,800. Self-employed individuals will pay 10.4 percent on self-employment income up to the threshold.

5. 100 Percent Bonus Depreciation. The 2010 Tax Relief Act boosts 50-percent bonus depreciation to 100-percent for qualified investments made after September 8, 2010 and before January 1, 2012. The 2010 Tax Relief Act also makes 50- percent bonus depreciation available for qualified property placed in service after December 31, 2011 and before January 1, 2013. Certain long-lived property and transportation property is eligible for 100-percent expensing if placed in service before January 1, 2013.

6. Section 179 Expensing. The 2010 Small Business Jobs Act increased the Code Sec. 179 dollar and investment limits to $500,000 and $2 million, respectively, for tax years beginning in 2010 and 2011. The 2010 Tax Relief Act provides for a $125,000 dollar limit (indexed for inflation) and a $500,000 investment limit (indexed for inflation) for tax years beginning in 2012 (and sunsetting after December 31, 2012). The 2010 Tax Relief Act also extends the treatment of off- the-shelf computer software as qualifying property if placed in service before 2013. Observation: 100 percent bonus depreciation, unlike Code Sec. 179 expensing, is not limited to use by smaller businesses and is not capped at the above mentioned dollar levels. Bonus depreciation can also generate net operating losses. However, bonus depreciation applies only to new property.

7. Refundable credits in lieu of bonus depreciation. The new law also includes an election to accelerate the alternative minimum tax credit in lieu of claiming bonus depreciation provided for “round 2 extension property.”

8. Research Tax Credit. The Code Sec. 41 research tax credit expired at the end of 2009. The 2010 Tax Relief Act renews the credit for two years, through December 31, 2011 and is effective for amounts paid or incurred after December 31, 2009.

9. The 2010 Small Business Jobs Act enhanced the exclusion of gain from qualified small business stock to non-corporate taxpayers. For stock acquired after September 27, 2010 and before January 1, 2011, and held for at least five years, the 2010 Small Business Jobs Act provided an exclusion of 100 percent. The 2010 Tax Relief Act extends the 100 percent exclusion for one more year, for stock acquired before January 1, 2012.

10. Work Opportunity Tax Credit. The Work Opportunity Tax Credit (WOTC) is intended to encourage employers to hire individuals from targeted groups. The WOTC is equal to 40 percent of up to $6,000 of the targeted employee’s qualified first-year wages, subject to certain requirements and limitations. The WOTC was scheduled to expire after August 31, 2011. The 2010 Tax Relief Act extends the WOTC for individuals who begin employment after August 31, 2011 and before January 1, 2012, but with some modifications.

11. Business Tax Extenders. The 2010 Tax Relief Act extends a number of business tax benefits, which had expired at the end of 2009. These business tax extenders are generally extended for two years: 2010 and 2011 (in some cases calendar years, in other cases tax years beginning after December 31, 2009 and before January 1, 2012 and in other cases for property placed in service on or before December 31, 2011). Business tax incentives extended by the 2010 Tax Relief Act include:

(a) Indian employment credit and accelerated depreciation for business property on an Indian reservation;

(b) New Markets Tax Credit with modifications;

(c) 15-year recovery period for qualified leasehold improvements, restaurant building and improvements, and retail improvements; and

(d) Brownfields remediation expensing.

12. Energy Incentives. The 2010 Tax Relief Act temporarily extends for one or two years a number of energy tax incentives, primarily targeted to businesses. Business energy incentives extended by the 2010 Tax Relief Act include:

(a) Credits for biodiesel and renewable diesel fuel (two years);

(b) Credit for refined coal facilities (two years with modifications);

(d) Excise tax credits and outlay payments for alternative fuel and alternative fuel mixtures (two years);

(e) Sales of electric transmission property (sales before January 1, 2012);

(f) Percentage depletion for oil and gas from marginal wells (two years);

(g) Grants for certain energy property in lieu of tax credits (variable);

(h) Tax credits and outlay payments for ethanol and duties on imported ethanol (one year with modifications); and 17

(i) Energy efficient appliance credit (one year with modifications).

13. Charitable Incentives. In addition to extending tax-free distributions from IRAs for charitable purposes, the 2010 Tax Relief Act also extends through 2011 (not an exhaustive list): (a) Charitable deduction for contributions of food inventory; (b) Charitable deduction for contributions by C corporations of books to public school; and (c) Charitable deduction for corporate contributions of computer equipment for educational purposes.

D. Federal Estate Tax. EGTRRA gradually reduced over a period of years and then abolished the federal estate tax for decedents dying in 2010. The pre-EGTRRA estate tax (with a maximum tax rate of 55 percent and a $1 million applicable exclusion amount) was scheduled to be revived after 2010. Additional EGTRRA changes affected the gift and generation skipping transfer (GST) tax.

1. The 2010 Tax Relief Act revives the estate tax for decedents dying after December 31, 2009, but at a significantly higher applicable exclusion amount and lower tax rate than had been scheduled under EGTRRA. The maximum estate tax rate is 35 percent with an applicable exclusion amount of $5 million. This new estate tax regime, however, is itself temporary and is scheduled to sunset on December 31, 2012.

2. Together with the revival of the estate tax, the 2010 Tax Relief Act eliminates the modified carryover basis rules and replaces them with the stepped up basis rules that had applied until 2010. Property with a stepped-up basis receives a basis equal to the property’s fair market value on the date of the decedent’s death (or on an alternate valuation date). Under a modified carryover basis that EGTRRA had put into place for 2010, the executor may increase the basis of estate property only by a total of $1.3 million, with other estate property taking a carryover basis equal to the lesser of the decedent’s basis or the fair market value of the property on the decedent’s death. An executor may increase the basis of assets passing to a surviving spouse by an additional $3 million (for a total of $4.3 million).

3. Option for 2010. The 2010 Tax Relief Act gives estates of decedents dying after December 31, 2009 and before January 1, 2011, the option to elect not to come under the revived estate tax. The new law gives those estates the option to elect to apply (1) the estate tax based on the new 35 percent top rate and $5 million applicable exclusion amount, with stepped-up basis or (2) no estate tax and modified carryover basis rules under EGTRRA. Any election would be revocable only with the consent of the IRS.

4. Portability. The 2010 Tax Relief Act provides for “portability” between spouses of the estate tax applicable exclusion amount. Generally, portability would allow a surviving spouse to elect to take advantage of the unused portion of the estate tax applicable exclusion amount of his or her predeceased spouse, thereby providing the surviving spouse with a larger exclusion amount. A “deceased spousal unused exclusion amount” would be available to the surviving spouse 18

only if an election is made on a timely filed estate tax return. Portability would be available to the estates of decedents dying after December 31, 2010. Under the Tax Relief Act of 2010, the portability election will sunset on January 1, 2013.

5. Gift Taxes. For gifts made in 2010, the 2010 Tax Relief Act provides that gift tax is computed using a rate schedule having a top tax rate of 35 percent and an applicable exclusion amount of $1 million. For gifts made after 2010, the gift tax is reunified with the estate tax with a top gift tax rate of 35 percent and an applicable exclusion amount of $5 million.

6. GST Tax. The 2010 Tax Relief Act provides a $5 million exemption amount for 2010 (equal to the applicable exclusion amount for estate tax purposes) with a GST tax rate of zero percent for 2010. For transfers made after 2010, the GST tax rate would be equal to the highest estate and gift tax rate in effect for the year (35 percent for 2011 and 2012). The 2010 Tax Relief Act also extends certain technical provisions under EGTRRA affecting the GST tax.

III. Recent State Tax Legislation of Interest

A. Michigan Corporate Income Tax HB 4361 / 4362 (eff. January 1, 2012)

1. Eliminates the Michigan Business Tax (MBT). Replaces MBT with a 6% tax on apportioned business income of C corporations. Eliminates special exemptions and most tax credits (except small business credit).

2. Observation: The prior Michigan Business Tax and Single Business Tax provided that cooperatives were generally taxed only on their non-patronage activities; it does not appear that the new Michigan corporate income tax contains any special provisions for cooperatives.

B. Illinois Corporate Income Tax

1. SB 2505 (eff. January 1, 2011) Increases the corporate income tax rate from 4.8% to 7% for taxable years 2011-2014, then phases back down to 4.8%;

2. Suspends NOL deductions for 4 taxable years beginning in 2011;

3. Increases required estimated tax payments for installments due after January 31, 2011 and before February 1, 2012

C. Indiana Corporate Tax

1. HB1004 (eff. January 1, 2012) Phases in reduction in corporate income tax rate from 8.5% to 6.5%;

2. Eliminates carryback of NOLs generated under the adjusted gross income tax;

3. NOLs still available for carry forward. 19

D. Affiliate Nexus Legislation

1. Arkansas (SB 738, eff. July 26, 2011) Rebuttable presumption arises if “affiliated person” has nexus and performs certain activities in Arkansas

2. California (AB 28X, eff. June 28, 2011) “Controlled group” member performs in- state services to retail TPP or solicits sales

3. Illinois (HB 3659, eff. July 1, 2011) Commissions to similarly-named entity selling similar products

4. South Dakota (SB 147, eff. July 1, 2011) Substantial (common) ownership; “controlled group” retailer presumption; contracts for installation or maintenance

5. Texas (SB 1, Special Session, eff. Jan. 1, 2012) Expands “engaged in business” statute.

E. Apportionment Legislation

1. Alabama (HB 434, eff. December 31, 2010) Mandates double-weighted sales factor apportionment of business income and market-based sourcing for sales other than sales of TPP

2. Arizona (HB 2001, eff. June 30, 2011) Phases in optional single sales factor apportionment by 2017

3. New Jersey (SB 2753, eff. April 28, 2011) Phases in single sales factor apportionment

IV. Proposed Federal Legislation

A. S. 559, Securing America’s Future with Energy and Sustainable Technologies, was introduced in March 2011 and has been referred to the Senate Finance Committee. This legislation would allow a cooperative, at its option, to allocate a cellulosic biofuel producer credit to its patrons.

B. H.R. 317, Fresh Fruit and Vegetable Grower Tax Incentive Act of 2011, was introduced in January 2011 and has been referred to the House Ways and Means Committee. This legislation would allow a credit against tax for certain eligible small producers engaged in the business of fruit and vegetable farming.

2011 Report of the LTA Reporting Subcommittee on Operating on a Cooperative Basis for Subchapter T and Section 521 Cooperatives

Terrance A. Costello, Chair Ronald C. Peterson, Vice Chair Lakes and Plains Office Building Hanson Bridgett LLP 842 Raymond Avenue 425 Market Street, 26th Floor St. Paul, Minnesota 55114 San Francisco, California 94105 (651) 698-8102 (415) 995-5005 [email protected] [email protected]

Lisa Maloy, Vice Chair American Crystal Sugar Company 101 North 3rd Street Moorhead, Minnesota 56560 (218) 236-4404 [email protected]

This subcommittee will report on three (3) private letter rulings regarding the question of operating on a cooperative basis under Section 1381 of the Internal Revenue Code this year. The subcommittee is not aware of any other developments, including developments regarding Section 521 cooperatives.

Ltr. 201105008 (COOPERATIVE STATUS ON LIQUIDATION)

The Internal Revenue Service (IRS) on February 4, 2011 released Ltr. 201105008 which addressed the tax treatment of a cooperative's distribution of proceeds from a liquidation of its facilities. Specifically, the IRS ruled that the passage of time during which the cooperative had discontinued business with its member patrons prior to liquidation was a "reasonable liquidation period" and did not cause the cooperative to lose its status of operating on a cooperative basis under Section 1381 of the Internal Revenue Code. The IRS further ruled that the net gain from the sale of the cooperative's facilities that were used in providing the fundamental services to member patrons represented patronage sourced income and any amount remaining after the payment of prior obligations and member equity accounts could be distributed to members in proportion to an established look-back period as a deductible patronage dividend.

The cooperative was a marketing cooperative which sold its member patrons' crops at auction. The cooperative's facilities which were liquidated were located on land owned by the cooperative and included an auction floor, office and a warehouse with storage space where member patrons could bring their crops prior to auction and from which auction buyers' trucks could be loaded with the purchased crops to be transported to manufacturing plants.

The specialized purpose and need for the facilities to serve patrons limited their use by the cooperative to the annual fall crop harvest period. Commissions charged to cover the costs of providing the auction services were the cooperative's only revenues except for some rental income from leasing the facilities to local businesses for storage during the off season. Legislation had terminated the federal supply control (quota) and price support programs for the 21

crops marketed at auction by the cooperative for its members. At the same time, manufacturers of products made from the crops obtained the crops largely from growers under direct contracts or from imports. As described in the ruling, this caused an erosion in the number of crop growers in the cooperative's geographic market area which needed the cooperative's auction services making it uneconomic for the cooperative to continue to conduct auctions.

Prior to the decision to liquidate, the cooperative's board of directors had suspended further auctions pending possible changes in market conditions and decided not to sell the facilities because there was uncertainty as to whether the changes in the government's role in regulating the production and marketing of the crop would work as intended or whether government policy might change resulting in renewed needs for the cooperative's auction services. Although not altogether clear from the ruling, it appears that the cooperative had been providing an essential service to the crop growers in the community for many years and that the facilities could not be replaced if they might be needed again. The suspension of auction services prior to liquidation appears to have been about two (2) years.

Prior Rulings

Ltr. 201105008 is consistent with several prior rulings where cooperatives desired to retain cooperative status and distribute gains as patronage dividends during the course of liquidation. In Ltr. 8842018 (July 22, 1988), a cooperative was permitted to retain its Section 521 status while in the process of liquidating "provided the cooperative is dissolved within a reasonable period after the adoption of the resolution to dissolve." In addition, the cooperative was permitted to deduct patronage distributions of gain from the sale of assets in liquidation. In Ltr. 8952019 (September 28, 1989), a nonexempt Subchapter T cooperative was permitted to retain its cooperative status where the liquidation was estimated to take one to three years to complete, provided the cooperative "dissolves within a reasonable period after the adoption of the resolution to dissolve." Ltr. 9021013 (February 21, 1990) reached the same conclusion for a Section 521 cooperative in the process of dissolution. See also, Ltr. 9138014 (June 18, 1991), where the IRS permitted a cooperative in the process of liquidation to restore retroactively its Section 521 status so that it could distribute and deduct gains on asset sales.

There is one prior contrary ruling. As reported by this subcommittee in 2005, IRS released Ltr. 200526012 (March 22, 2005) which, in somewhat similar circumstances, ruled that the cooperative was not operating on a cooperative basis and could not avail itself of the patronage dividend deduction under subchapter T. Like the cooperative in Ltr. 201105008, the cooperative in Ltr. 200526012 marketed crops for its members by holding auctions at which members sold their crops to local produce brokers. Subsequently, the cooperative ceased operations and closed. However, the cooperative kept the property/auction facility in the hope that the auction would open again. At some point in time (which is not disclosed in the ruling), the members voted to liquidate the cooperative. Thereafter, the property was sold at a gain. In ruling against the cooperative, the IRS observed that "[m]ost of the appreciation in value of the property occurred after the taxpayer closed."

Ltr. 200526012 may just be a product of bad facts. First, the ruling does not state the exact amount of time that elapsed after the auction facility was closed and before the plan of liquidation was adopted and the sale occurred. Second, the ruling specifically notes that most of 22

the appreciation in the property occurred after the facility was closed suggesting that many years may have lapsed between the date the auction facility closed and the plan of liquidation was adopted. If this were true, then the ruling may simply reflect a situation where the cooperative did not liquidate within a reasonable period of time.

Allocation of Gain under Ltr. 201105008

Ltr. 201105008 also approved the cooperative's proposed method of allocation of gain for patronage dividend purposes. Because of a variety of factors, including a fire that had destroyed records relating to patronage, the cooperative did not have complete records as to prior patronage on which to base the allocation of gain. Among other things, the cooperative's experience in attempting to make equity redemption payments indicated that a large number of former members could not be located because they had quit farming and left the area or had died. As a result, the cooperative appears to have used patronage for an abbreviated number of years as a basis for allocation. In approving the basis for allocation, the IRS noted that a substantial portion of the asset sale proceeds would otherwise go unclaimed and be transferred to the state as abandoned property, defeating the objective of proportionally sharing the cooperative's distributions among members who used the facilities.

Ltr. 261141007 (CORPORATION WITH FOREIGN MEMBERS PROVIDING GLOBAL FINANCIAL SERVICES)

This letter ruling released by IRS on October 14, 2011, involves a corporation to be formed to provide global finance and treasury services to its owner-members including foreign owner-members. The services will include serving as a source of credit to members needing to borrow funds and as a place where members with temporarily unused capital can loan funds and earn a market rate of return.

In general, each of the members of the corporation will be a separate legal entity which operates in one country. Each member currently manages its treasury operations independently, dealing directly with local financial institutions on terms and conditions that have been negotiated based upon the size and financial strength of each member.

The formation of the corporation as a global finance and treasury services company operating on a cooperative basis will allow members to enhance their treasury functions. The purpose of the corporation will be to provide members with a variety of treasury services. Although each member will continue to remain responsible for its own treasury function, the corporation will coordinate and implement a global treasury strategy in order to achieve operational efficiencies which will allow each member to operate its treasury function more efficiently. The corporation also will serve as a source of credit on a structured and strategic basis for members needing to borrow funds and as a place where members with temporarily unused working capital can earn a market rate of return from a loan to the corporation (and at perhaps a lower risk than otherwise).

It is further anticipated that the corporation will reduce the borrowing costs for members by consolidating credit lines with fewer larger lenders. Members will transition from having individual credit lines with a large number of banks to having credit lines with the corporation

which, in turn, will borrow from a select group of key relationship banks. The corporation will be able to negotiate better terms and rates than most of its members thereby lowering the total cost of borrowing.

The corporation will be authorized to do business on a patronage basis with certain parties who are not members who will be entitled to share in patronage dividends, the distribution of non-patronage earnings, and the residual assets on dissolution, but will have no vote. The corporation also will be authorized to do business with non-members on other than a patronage basis.

Each member will purchase and own one share of common stock which will serve as its membership stock entitled to one vote. Dividends will not be paid on the common stock. Upon dissolution and liquidation, a member will receive the purchase price of the common stock and no more. On termination of membership, the cooperative may purchase the share at its issue price.

The corporation also will be authorized to issue shares of non-voting preferred stock in various series with rights established by the board of directors, but with dividends not to exceed eight percent (8%) of the issue price per annum. Holders of preferred shares will be entitled to be paid the issue price plus accumulative accrued and unpaid dividends upon dissolution and liquidation. At the time of formation, the cooperative will issue shares of Series A non-voting preferred stock to members and nonmembers participating on a patronage basis, with dividends not to exceed 8% per annum. The cooperative will have the right to redeem the Series A preferred stock at any time at the issue price, and no more. Preferred stock other than Series A may be sold to outside investors as well as members and nonmember patrons.

The corporation will be obligated to allocate and distribute its earnings done with or for members and nonmembers participating on a patronage basis as patronage dividends after setting aside amounts (i) required to pay for dividends chargeable to patronage earnings; (ii) for net operating losses; and (iii) for reasonable reserves. Dividends on preferred stock and to provide for taxes will be paid from non-patronage earnings. To the extent non-patronage earnings are insufficient to pay preferred stock dividends, such dividends will be paid from patronage earnings. The corporation also will be authorized to allocate and distribute on a patronage basis non-patronage earnings to members and nonmembers participating on a patronage basis.

Patronage will be determined based upon the amounts paid by each member and nonmember participating on a patronage basis for treasury services, loans and credit support. This will include interest paid, loan origination fees, loan participation or commitment fees, guarantee fees, letter of credit fees and comfort letter fees, but will exclude amounts in repayment of loan principal.

On dissolution, after the payment of all indebtedness, the remaining assets will be distributed as follows: (i) first, to the holders of preferred stock in the order of any preferences that may be established an amount equal to the issue price plus cumulative accrued and unpaid dividends; (ii) second, to the holders of common stock; (iii) to the holders of qualified and nonqualified written notices of allocation an amount equal to the stated dollar amount thereof; and (iv) any remaining assets to members and nonmembers participating on a patronage basis 24

based upon their patronage during the seven (7) fiscal years immediately preceding dissolution (or the period of existence of the cooperative, if shorter).

The ruling concludes, based upon applying the principles of the Puget Sound Plywood v. Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B.3., that the corporation will be formed and operated on a cooperative basis within the meaning of section 1381 of the Internal Revenue Code. In this regard, the ruling reaches a number of other conclusions as follows:

(i) There is nothing in Subchapter T limiting membership of a nonexempt cooperative to United States citizens, residents or businesses, citing Rev. Rul. 66-53, 1966-1 C.B. 206 and Rev. Rul. 70-481, 1970 - 2 C.B. 170. Accordingly, the inclusion of foreign members does not preclude compliance with operating on a cooperative basis under Section 1381.

(ii) The Puget Sound Plywood subordination of capital test with respect to the common stocks will be met because only members will own common stock with no right to dividends and limited rights on dissolution.

(iii) The preferred stock will not pay dividends in excess of eight percent (8%); the rights of preferred stock holders to share in earnings will be fixed and limited; and preferred stock will have no voting rights. Thus, the preferred stock meets the subordination of capital test.

(iv) The corporation will meet the democratic control test of Puget Sound Plywood which the ruling states is typically achieved by voting on a one-member one-vote basis because it will have voting on a one-member, one-vote basis.

(v) The corporation's articles of incorporation and bylaws provide for the sharing of earnings (not just patronage earnings) on a cooperative basis in proportion to the patronage of the members and nonmembers participating on a patronage basis both currently and on dissolution. These provisions meet the third element of the Puget Sound Plywood test.

(vi) The ruling, in reliance on Rev. Rul. 93-21, 1993-1 C.B. 188, states that a corporation will not be precluded from being considered as operating on a cooperative basis simply because it may do less than fifty percent (50%) in value of its business with members. In this instance, the corporation has represented that over fifty percent (50%) of its business will be conducted on a patronage basis with its members and nonmembers participating on a patronage basis.

(vii) The dissolution provision using a 7-year look-back period is considered long enough to assure sharing on a patronage basis without placing an undue recordkeeping burden on the cooperative.

PLR 201143021 (REDEMPTION OF EQUITY AT DISCOUNT)

This letter ruling released by IRS on October 28, 2011, involves an electric cooperative exempt from federal income tax under section 501(c)(12)(A) of the Internal Revenue Code. The cooperative is obligated to account on a patronage basis to all its patrons for all amounts received from the furnishing of electrical energy in excess of operating expenses. The cooperative's bylaws provide that the cooperative is further obligated to pay credits to a capital account for each patron of all such amounts in excess of operating expenses; and that the capital credited to 25

patrons' accounts may be retired in full or in part if the financial condition of the cooperative would not be impaired. The cooperative's board has discretion to determine the method, basis, priority and order of retirement, if any, for any amounts furnished as capital.

The cooperative historically has retired allocated patronage capital on a cycle of approximately 20 years on a first-in, first-out basis. Anticipating a need to strengthen its equity resources, the cooperative has proposed a plan to retire current patronage allocations to current, former and deceased patrons on an accelerated basis by the cash payment of the "present value" of the future capital credits retirement payments many years in the future. The difference between the face amount of the equity capital credit and the amount paid will be reserved as permanent equity, to be distributed only at dissolution or liquidation. The discount rate would be equal to the 20-year treasury bond rate plus a risk factor unique to the cooperative as determined by the board. Participation in the program would be voluntary at the members'/patrons' option.

Section 501(c)(12) of the Internal Revenue Code provides for the exemption from federal income tax of benevolent life insurance associations of a purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone companies, or like organizations, but only if 85 percent or more of the income of the organization consists of amounts collected from members for the sole purpose of meeting losses and expenses. As an initial determination, the ruling concludes (in reliance upon certain prior Revenue Rulings) that providing electric services on a cooperative basis qualifies as activities of a "like organization" under section 501(c)(12).

According to the letter ruling, to qualify for exemption under Section 501(c)(12), an organization must be organized and operated as a cooperative under the principles of Puget Sound Plywood v. Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B.3. These include (i) democratic control by members; (ii) operation at cost for the benefit of members; and (iii) subordination of capital. The letter ruling summarizes the application of these principles in this instance as follows: (1) democratic control requires each member to have one vote regardless of the amount of business the member does with the cooperative; the cooperative is operated on a one-member, one-vote basis which is not affected by the capital credit discount program and thus complies with this requirement. (2) since the cooperative returns its net earnings or savings to its members in proportion to the amount of business of each with the cooperative, it complies with the operation at cost principle and the premature capital credit redemption program does not violate this principle; and (3) the principle of subordination of capital is satisfied because the proposed redemption program does not adversely affect the members' control and ownership of the cooperatives' assets.

The ruling further determined that the redemption plan does not violate the requirements of Rev. Rul. 72-36, 1972-1 C.B. 151, because there is no forfeiture of former members rights to assets of the cooperative. In this regard, the ruling points out that the discount rate is the prevailing market rate and that the plan permits both current and former members to receive their capital credit accounts at a date earlier than the historical 20 year holding period or cycle.

Finally, the ruling further determines that the reservation as permanent equity of the difference between the face amount of the equity capital credits and the amount paid in early redemption to be distributed only upon dissolution or liquidation does not violate any cooperative requirements. 26

Accordingly, the ruling concludes that the implementation of the discount program will not jeopardize the cooperative's tax-exempt status under section 501(c)(12)(A) of the Internal Revenue Code.

Comments

Interestingly, the ruling does not address the issue of whether the gain from the redemption of capital credits is treated as nonmember income for purposes of the 85 percent member income test. Also, it is interesting to note that the ruling states rather unequivocally that democratic control requires voting on the basis of one-member, one-vote.

2011 REPORT

OF THE

LTA REPORTING SUBCOMMITTEE

ON COOPERATIVE STRUCTURES: MERGERS,

ACQUISITIONS, JOINT VENTURES,

AND SUBSIDIARIES

AS OF January 6, 2012

Prepared by:1

David P. Swanson, Chair Dorsey & Whitney LLP Telephone: (612) 343-8275 E-mail: [email protected] AND Brent Bostrom, Vice Chair GROWMARK, INC. Telephone: 309-557-6288 E-mail: [email protected] AND Steve Rowe, Vice Chair Darigold Telephone: 206-286-6745 E-mail: [email protected]

1 Special thanks to Thomas Ryan for his assistance with this report. 28

INTRODUCTION ...... 30

I. NEWS REGARDING THE SALE OR ACQUISITION OF ASSETS ...... 30

1. CHS acquires Eastern European grain company ...... 30 2. Heartland Co-op purchases four grain elevators ...... 30 3. DairiConcepts acquires Swiss Valley Farms' Hard Italian Cheese business ...... 30 4. Swiss Valley Farms acquires Faribault Dairy ...... 30 5. GROWMARK acquires four CF Industries fertilizer terminals ...... 31 6. Farmers Cooperative acquires Shear Elevator Inc ...... 31 7. Dairy Farmers of America acquires Castro Cheese Company ...... 31 8. GROWMARK acquires Seneca Terminal ...... 31 9. CHS will become sole owner of NCRA ...... 32 10. GROWMARK announces intent to purchase Indiana seed company ...... 32 11. GROWMARK acquires Ft. Dodge, Iowa refined fuels terminal ...... 32 12. GROWMARK acquires S.H. Bell terminals ...... 33

II. MERGER AND CONSOLIDATION NEWS ...... 33

1. Southwest Landmark and Advanced Agri Solutions finalize merger to create Trupointe Cooperative ...... 33 2. Cooperative Plus and Landmark Services merge to form Landmark Services Cooperative33 3. Grainland Cooperative merges with CHS, Inc...... 34 4. Florida farm credit associations merge ...... 34 5. Northwest Dairy Association and Country Classic Dairies merge ...... 34 6. U.S. AgBank and CoBank receive preliminary approval for merger ...... 34 7. Servco FS Cooperative becomes GROWMARK, Inc. Retail Division ...... 35 8. Frontier FS Cooperative becomes GROWMARK, Inc. Retail Division ...... 35

III. MISCELLANEOUS TRANSACTIONS AND NEWS ...... 35

1. CHS Inc. and West Central Ag Services launch Central Plains Grain joint venture ...... 35 2. Consolidated Sourcing Solutions joint venture formed ...... 36 3. Ocean Spray partners with Disney ...... 36 4. Swiss Valley Farms and Emmi-Roth Kase USA joint venture announced ...... 36 5. Winfield Solutions partners with GEOSYS Inc ...... 37 6. Landmark Service Coop partners with Feed County ...... 37 7. National Renewables Cooperative Organization members contract with Pennsylvania Wind Farm ...... 37 8. Three generation and transmission cooperatives purchase Miso Wind Energy ...... 37

Introduction

There are three sections in this year’s subcommittee report for the Reporting Subcommittee on Cooperative Structures. Each section reflects the different types of transactions or ventures involving cooperatives highlighted by the news media this year and are as follows: Sales or Acquisitions of Assets; Mergers; and Miscellaneous Transactions and News.

I. News Regarding the Sale or Acquisition of Assets

1. CHS acquires Eastern European grain company

CHS Inc. acquired Agri Point Limited from East Point Holdings Limited, Nicosia, Cyprus on January, 18, 2011. The Agri Point acquisition is part of CHS’ ongoing global grain origination expansion, adding approximately 1.5-to-2 million metric tons of corn, wheat and barley. "Acquiring Agri Point enables CHS to further develop its global competency and presence into the high growth areas of Romania, Bulgaria, Hungary and Serbia," said Claudio Scarrozza, general manager, CHS Europe, Geneva, Switzerland. "In addition, we're adding important infrastructure to our global supply chain capabilities with a deep-water port in Constanta, Romania, a barge loading facility on the Danube River at Giurgiu, Romania, and an inland grain terminal at Oroshaza, Hungary."

Source: CHS Acquires Eastern European Grain Company, CHS Inc. Press Release, Jan. 18, 2011.

2. Heartland Co-op purchases four grain elevators

Heartland Co-op announced that it purchased the assets of Newton Feed Center Elevator, Monroe Feed Center, Prairie City Feed Center Elevator and Runnells Grain Elevator in Iowa. The elevators had been owned by Keith Roorda. Terms of the deal were not disclosed. Heartland manages 48 cooperative elevators in its system, primarily in central Iowa and began operating the four grain elevators on July 1, 2010.

Source: Heartland Co-op to buy four Iowa elevators, Heartland Co-op Press Release, July 1, 2010.

3. DairiConcepts acquires Swiss Valley Farms' Hard Italian Cheese business

DairiConcepts and Swiss Valley Farms announced DairiConcepts' acquisition of Swiss Valley Farms' Hard Italian Cheese business on May 28, 2010. DairiConcepts also acquired the Dalbo, Minnesota plant, formerly operated by Rochester Cheese. As part of the agreement, DairiConcepts exited the Club Cheese business, which is a category Rochester Cheese is expected to expand. DairiConcepts is a joint venture between two of the world’s leading dairy co-operatives, Fonterra Co-operative Group and Dairy Farmers of America (DFA).

Source: DairiConcepts acquires Hard Cheese Business, DairiConcepts Press Release, May 28, 2010.

4. Swiss Valley Farms acquires Faribault Dairy

Swiss Valley Farms Cooperative, based in Davenport, Iowa, acquired Faribault Dairy Co., Inc., located in Faribault, Minnesota, on August 3, 2010. The sale includes the ownership of Faribault's Blue cheese manufacturing facility as well as Faribault's line of branded cheeses, including its popular blue cheese 30

Amablu, cave-aged blue cheese. Don Boelens, CEO of Swiss Valley Farms, said the Faribault facility will allow for an immediate increase in production and serve as an excellent companion operation to Swiss Valley's other Blue cheese plant in Mindoro, Wisconsin and will allow Swiss Valley to process and ship online orders through Faribault’s online store. Terms of the acquisition were not disclosed.

Sources: Swiss Valley Farms Buys Faribault Dairy; Partners With Emmi-Roth Kase USA, Gourmet Retailer, Aug. 30, 2010.

Swiss Valley Farms acquires Faribault Dairy Co., Inc., Swiss Valley Farms Press Release, August 3, 2010.

5. GROWMARK acquires four CF Industries fertilizer terminals

GROWMARK, Inc. acquired three fertilizer storage terminals from CF Industries, and a joint venture LLC owned by GROWMARK and another company acquired a fourth terminal as well on January 6, 2011. The facilities acquired by GROWMARK are located in Albany and Mapleton, Illinois. and St. Louis, Missouri and the fourth facility is located in Cincinnati, Ohio. Overall, the acquisition represents approximately 226,000 tons of dry and liquid plant food storage. GROWMARK is using the increased terminal storage base to provide additional truck outlets along with the ability to economically reach extended rail delivery points.

Source: GROWMARK Acquires CF Industries Fertilizer Terminals In Albany and Mapleton, IL and St. Louis, MO, Grainnet, January 6, 2011.

6. Farmers Cooperative acquires Shear Elevator Inc

Farmers Cooperative, the largest farmer owned cooperative in Iowa, acquired Shear Elevator Inc. effective August 31, 2010. Shear Elevator was located in Bristow, Iowa and Allison, Iowa, and offered one million bushels of grain storage as well as 4,700 tons of UAN storage.

Source: Farmers Cooperative Co. (FC) Announces the Acquisition of Shear Elevator Inc., Farmers Cooperative Press Release, September 3, 2010.

7. Dairy Farmers of America acquires Castro Cheese Company

On October 29, 2010, Dairy Farmers of America (DFA) acquired Houston-based Castro Cheese Company, Inc. Castro Cheese owned "La Vaquita," a brand product line that includes Queso Fresco, Panela, Queso Quesadilla and other artisan cheeses commonly used in Hispanic dishes. La Vaquita is the second largest Hispanic cheese brand in the nation, available at retailers such as H.E.B., Walmart, Fiesta Mart, Kroger and Costco. Castro Cheese is now a wholly owned subsidiary of DFA and is operating as a separate business unit within the Global Dairy Products Group Consumer Brands Division. DFA retained the company’s current 72 employees and operating executive.

Source: Dairy Farmers of America make Entrée to Ethnic Cheese Market, Dairy Farmers of America Press Release, November 1, 2010.

8. GROWMARK acquires Seneca Terminal

GROWMARK, Inc. acquired George Lamb’s Seneca Terminal in Seneca, Illinois on January 6, 2011. The acquisition included 45,000 tons of dry fertilizer storage, dock, and acreage. GROWMARK plans on adding liquid nitrogen storage at the site. Terms of the deal were not disclosed. 31

Source: GROWMARK Acquires CF Industries Fertilizer Terminals In Albany and Mapleton, IL and St. Louis, MO, Grainnet, January 7, 2011.

9. CHS will become sole owner of NCRA

CHS Inc. and the two minority owners of the National Cooperative Refinery Association have reached agreement to transfer full ownership of the petroleum refiner to CHS, currently its majority shareholder.

Under the agreements between CHS of Inver Grove Heights, Minnesota, GROWMARK, Inc. of Bloomington, Illinois, and MFA Oil Company of Columbia, Missouri, CHS will purchase additional interest in the McPherson, Kansas, refinery in annual increments beginning on September 1, 2012. The series of transactions will culminate on September 1, 2015. CHS currently owns 74.4 percent of NCRA, with GROWMARK and MFA Oil holding 18.6 percent and 6.9 percent respectively.

NCRA was created in 1943 with the purchase of the former Globe Refinery by five farmer-owned cooperatives. Today, NCRA consists of an 85,000 barrels-per-day refinery, along with offsite storage at Conway, Kansas, 1,500 miles of crude oil and refined products pipeline, and a terminal in Council Bluffs, Iowa. NCRA’s 650 employees will become CHS employees when the purchase is completed in 2015.

Source: CHS will become sole owner of NCRA, CHS Inc. Press Release, December 1, 2011.

10. GROWMARK announces intent to purchase Indiana seed company

Regional agricultural cooperative GROWMARK, Inc. announced it intends to purchase the assets of Select Seed, Camden, Indiana. Terms of the transaction were not disclosed.

Owned and operated by the Eggerling family, Select Seed is a third generation, family business. Select Seed’s proprietary brand is sold through more than 100 active farmer dealers in Indiana, southern Michigan, Ohio, and Kentucky.

Source: GROWMARK Announces Intent to Purchase Indiana Seed Company, GROWMARK, Inc. Press Release, April 19, 2011.

AUTHOR’S NOTE: This transaction closed on May 1, 2011.

11. GROWMARK acquires Ft. Dodge, Iowa refined fuels terminal

GROWMARK, Inc. announced its agreement to acquire a refined fuels terminal near Ft. Dodge, Iowa, from Magellan Pipeline Company. Terms of the acquisition were not disclosed. Magellan will continue to deliver refined fuels into the Ft. Dodge terminal via its Midwest pipeline system.

Acquisition of the facility will enable GROWMARK to ensure continued supply of refined fuels and solidify the cooperative’s commitment to the energy business and to North-Central Iowa, according to Kevin Carroll, GROWMARK Vice President, Energy Division.

“This acquisition provides the opportunity to invest in one of our core businesses and is a strategic location for our Iowa member cooperatives,” Carroll said. “With the Ft. Dodge addition, we can better serve our petroleum business and this important part of our geography.”

Source: GROWMARK acquires Ft. Dodge, Iowa refined fuels terminal, GROWMARK, Inc. Press Release, September 23, 2010. 32

AUTHOR’S NOTE: This transaction closed on November 1, 2010.

12. GROWMARK acquires S.H. Bell terminals

GROWMARK, Inc. acquired the Little England terminal in East Liverpool, Ohio, from S.H. Bell Company on January 31, 2011. The property is located northeast of GROWMARK’s current operation and has direct access to the Ohio River.

The transaction includes a river unloading cell, storage facilities, an office, scale, and crane. Terms of the transaction were not disclosed.

Rod Wells, GROWMARK’s Director, Agronomy Sales and Operations, said the acquisition will enhance current operations, provide additional storage capacity, and improve overall operational efficiency. “This will also give us another option to offload barges at East Liverpool, which is a high volume facility. Additionally, this will enhance our service to customers and those who are responsible for shipping product by truck from East Liverpool,” he said.

Source: GROWMARK acquires S.H. Bell terminals, GROWMARK, Inc. Press Release, January 31, 2011.

II. Merger and Consolidation News

1. Southwest Landmark and Advanced Agri Solutions finalize merger to create Trupointe Cooperative

Southwest Landmark and Advanced Agri Solutions merged to create Trupointe Cooperative, Inc. and officially began operations on September 1, 2010. The new cooperative has 4,300 members and 45 branches in 26 Ohio and 3 Indiana counties. The new cooperative will offer products, services and expertise in fertilizer, crop protection, seed treatments, propane and liquid fuel, lawn and garden, home and pet supply, commercial and club livestock and horses, grain marketing and risk management and turf landscaping and nursery.

Source: Southwest Landmark & Advanced Agri Solutions are now Trupointe, Ohio’s Central Journal, September 1, 2010.

2. Cooperative Plus and Landmark Services merge to form Landmark Services Cooperative

Cooperative Plus and Landmark Services, two of Wisconsin’s largest farm service cooperatives, merged to form Landmark Services Cooperative on September 30, 2011. Cooperative Plus, which was headquartered in Burlington, Wisconsin, earned $72 million is gross sales in 2010. Cooperative Plus had seven locations and over 5,000 active members in southeastern Wisconsin and northeastern Illinois. Landmark Services, which is headquartered in Cottage Grove, Wisconsin, had $288 million sales in 2010 and employs about 400 people at its 16 locations in Wisconsin and Illinois serving 15,000 patron- members.

Source: Cooperative Plus, Landmark Services Members Okay Merger, Wisconsin Ag Connection, July 20, 2011.

3. Grainland Cooperative merges with CHS, Inc.

Grainland Cooperative merged with regional coop CHS, Inc. on June 27, 2011. Grainland will continue to operate under the same name, providing agronomy, feed, grain and energy products and services from Colorado locations in Holyoke, Amherst, Fleming, Haxtun, Julesburg, New Haven and Stateline.

Source: Chris Lee, Grainland merger with CHS effective last week, Holyoke Enterprise, July 7, 2011.

4. Florida farm credit associations merge

Three major farm credit associations in Florida, Farm Credit of Southwest Florida, Farm Credit of North Florida and Farm Credit of South Florida, merged to form Farm Credit of Florida on December 31, 2010. Farm Credit of Florida will have $1 billion in assets, 150 employees and more than 2,300 members in 36 Florida counties.

Source: Brian Bandell, Farm credit merger creates $1B institution, South Florida Business Journal, November 11, 2010.

5. Northwest Dairy Association and Country Classic Dairies merge

Northwest Dairy Association (NDA), and its subsidiary Darigold, Inc., merged with Montana dairy cooperative Country Classic Dairies. Country Classic’s 33 members became part of the larger cooperative, NDA, while Country Classic’s sales and marketing, along with its plant operation, were incorporated into Darigold. Country Classic processed milk at its facility in Bozeman, Montana, which is now a Darigold processing plant producing the Darigold label.

NDA is a milk marketing cooperative that is headquartered in Seattle. It is owned by more than 500 dairy producers. NDA members ship 7.2 billion pounds of milk annually from farms in Washington, Oregon, Idaho, Northern California, Utah and now Montana.

Source: Northwest Dairy Association Merges with Montana Dairy Cooperative Country Classic Dairies, Businesswire, August 2, 2010.

6. U.S. AgBank and CoBank receive preliminary approval for merger

U.S. AgBank and CoBank, two of the five funding banks in the Farm Credit System, have announced their intention to merge effective January 1, 2012 and operate under the CoBank name. The new bank will be headquartered in Denver, Colorado but it will maintain U.S. AgBank's existing presence and operations in Wichita, Kansas, and Sacramento, California. The merger has been granted preliminary approval by the Farm Credit Administration and the stockholder vote on the merger will end on September 7, 2011.

U.S. AgBank provides loan funds and financial services to Agricultural Credit Associations, Federal Land Credit Associations, and other financing institutions across 11 states. Its headquarters is currently in Wichita, Kansas and the bank has approximately $25 billion in total assets. CoBank is a $69 billion cooperative bank which provides loans, leases, export financing and other financial services to agribusinesses and rural power, water and communications providers in all 50 states. In addition to serving its direct retail borrowers, the bank also provides wholesale loans and other financial services to affiliated Farm Credit associations and other partners across the country

Source: Farm Credit Administration Board Votes to Grant Preliminary Approval of CoBank-U.S. AgBank Merger, U.S. AgBank and CoBank Press Release, June 22, 2011.

7. Servco FS Cooperative becomes GROWMARK, Inc. Retail Division

Servco FS Cooperative of Antigo, Wisconsin, transitioned from a member of regional agricultural cooperative GROWMARK, Inc. to a GROWMARK Retail Division as of October 1, 2010, following approvals by the Servco FS Cooperative Board of Directors, its stockholders, and the GROWMARK Board of Directors.

According to Shelly Kruse, GROWMARK’s Vice President, Midwest Retail & Acquisitions, this arrangement is part of the GROWMARK System’s Member Partnering Program, under which member cooperatives and GROWMARK voluntarily join together to provide programs, products, and services to serve the needs of members and customers.

Ms. Kruse added that partnering efforts between GROWMARK and its member cooperatives help further the GROWMARK System’s goal of having the most efficient agricultural cooperative distribution processes available for the farmers it serves.

Source: GROWMARK Communication to Stockholders and Employees, October 1, 2010.

8. Frontier FS Cooperative becomes GROWMARK, Inc. Retail Division

Frontier FS Cooperative of Jefferson, Wisconsin, transitioned from a member of regional agricultural cooperative GROWMARK, Inc. to a GROWMARK Retail Division as of November 1, 2010, following approvals by the Frontier FS Cooperative Board of Directors, its stockholders, and the GROWMARK Board of Directors.

Source: GROWMARK Communication to Stockholders and Employees, November 1, 2010.

III. Miscellaneous Transactions and News

1. CHS Inc. and West Central Ag Services launch Central Plains Grain joint venture

CHS, Inc. and West Central Ag Services, a diversified grain and agricultural supply cooperative from Ulen, MN, announced an agreement to launch a grain-handling joint venture, Central Plains Grain LLC on November 29, 2010. The joint venture will include a new shuttle grain elevator on the BNSF rail line which should be completed by the end of 2011.

"This is an excellent opportunity to provide producers in the Hannaford area with a variety of services in grain marketing and handling, in addition to those already provided by Central Plains Agronomy, LLC," explained Jesse McCollum, general manager, West Central Ag Services. 35

Sources: CHS Inc. and West Central Ag Services Launch Central Plains Grain LLC Joint Venture, Grainnet, November 29, 2010.

CHS Inc and West Central Ag Services launch grain joint venture, CHS Press Release, November 29, 2010.

2. Consolidated Sourcing Solutions joint venture formed

Central Valley Ag Cooperative, headquartered in O'Neill, Nebraska, South Dakota Wheat Growers, headquartered in Aberdeen, South Dakota, and Farmers Cooperative Company, headquartered in Ames, Iowa, formed an entity named Consolidated Sourcing Solutions in June, 2010, to provide a partnership in fertilizer sourcing.

Central Valley Ag Cooperative is a member-owned farmers' cooperative located in north-central and northeastern Nebraska. It provides agronomy, energy, and feed and grain products and services to over 10,000 producers in the area. South Dakota Wheat Growers is a grain and agronomy cooperative in the heart of the James River Valley of South and North Dakota. Farmers Cooperative Co. has corporate headquarters in Ames, Iowa, and is the largest farmer-owned local agriculture cooperative in Iowa. Farmers Cooperative serves over 5,200 active members throughout its trade territory of over 3,000,000 acres. Members are served from over 50 locations by more than 450 employees.

Source: Staff, Iowa's Largest Farm Cooperative Joins Partnership to Buy Fertilizer, Wallaces Farmer, May 19, 2010.

3. Ocean Spray partners with Disney

On October 20, 2010, Ocean Spray announced a partnership with Disney Parks and Resorts to bring Ocean Spray cranberry to a number of retail points at Disney parks, including a new presence at Disneyland Resort in Anaheim, Calif., Disney World Resort in Orlando, Fla., and Disney Cruise Line. The partnership includes selling Craisins Dried Cranberries at Disney Parks and Resorts and the launch of a special, co-branded version of Craisins packaging featuring Chip ‘n Dale that will be used on Ocean Spray products sold on Disney properties. The partnership is the largest in Ocean Spray’s history.

Source: Ocean Spray and Walt Disney Parks and Resorts Announce a Multi-Year Alliance to Offer Craisins Dried Cranberries to Guests at the Walt Disney World Resort and the Disneyland Resort, Ocean Spray and Disney Press Release, October 20, 2010.

4. Swiss Valley Farms and Emmi-Roth Kase USA joint venture announced

Swiss Valley Farms and Emmi-Roth Kase USA announced White Hill Cheese Co., LLC, a joint venture to manufacture cheese in Shullsburg, Wisconsin on August 4, 2010. Emmi-Roth Kase USA is a subsidiary of Emmi Group. The Shullsburg site has been owned by Swiss Valley Farms since 2005 and includes a 24,000-square- foot cheese manufacturing plant, a 50,000 square-foot warehouse, and a wastewater treatment facility. Utilization of this site will also allow for additional storage capacity of these cheeses. The new plant is employs about 30 people. The joint venture will allow the two entities to increase production of Baby Swiss, No-Salt-Added Swiss, and other varieties.

Sources: Swiss Valley Farms Buys Faribault Dairy; Partners With Emmi-Roth Kase USA, Gourmet Retailer, Aug. 30, 2010.

Swiss Valley Farms and Emmi-Roth Kase USA partner together to create White Hill Cheese Co., LLC, Swiss Valley Farms Press Release, August 4, 2010.

5. Winfield Solutions partners with GEOSYS Inc

Winfield Solutions, a subsidiary of Land O’Lakes, began a partnership on December 17, 2010 with GEOSYS Inc. intended to enhance Winfield Solutions’ ability to provide its business partners tools and technologies that help growers make data-driven agronomic decisions on a field-by-field basis. GEOSYS Inc. is based in Minneapolis, Minnesota and is a wholly owned subsidiary of GEOSYS SA, a European- based company, with headquarters in Toulouse, France. The 10-year agreement provides Winfield Solutions the preferred rights to GEOSYS Inc.’s FarmSat™ Platform for major field crops in the United States. FarmSat™ is an innovative set of web-based tools that enables local agronomists to deliver a full set of precision farming services to growers.

Source: Winfield Solutions, LLC and GEOSYS Inc. Announce Strategic U.S. Partnership, Land O’Lakes Press Release, December 17, 2010.

6. Landmark Service Coop partners with Feed County

Landmark Services Cooperative, headquartered in Cottage Grove, Wisconsin, announced a new arrangement with Feed Country, LLC of Cassville, Wisconsin for Feed Country to become the newest Animal Nutrition location as of August 1, 2011. Feed Country is a full-service bag and bulk retail feed outlet that serves customers throughout Grant County, Crawford County, and Clayton County, Wisconsin. The facility has been owned and operated by Larry and Elaine Campbell for the past seven years.

Source: Landmark Service Coop Forges Another Partnership, Wisconsin Farm Report, June 23, 2011.

7. National Renewables Cooperative Organization members contract with Pennsylvania Wind Farm

Under separate purchased power agreements (PPAs) announced June 5, 2011, Southern Maryland Electric Cooperative Inc. (SMECO), a customer-owned electric utility based in Hughesville, Maryland, and Old Dominion Electric Cooperative (ODEC), a Glen Allen, Virginia based cooperative that supplies wholesale power to 11 member distribution cooperatives in Virginia, Maryland and Delaware, have agreed to purchase energy and associated environmental attributes for the next 20 years from the Mehoopany Wind Farm in Wyoming County, Pennsylvania. The project, to be constructed, owned, and operated by BP Wind Energy, is slated to have a nameplate capacity of 144 MWs. The facility is expected to achieve commercial operations in late 2012. SMECO has contracted to purchase 30 MWs or about 21% of the facility’s output, while ODEC will purchase 75 MWs or 52% of the energy.

Source: NRCO members contract with 2nd PA Wind Farm, National Renewables Cooperative Organization Press Release, June 5, 2011.

8. Three generation and transmission cooperatives purchase Miso Wind Energy

Three generation and transmission cooperatives announced the purchase of 40 megawatts of wind energy from the Pioneer Trail Wind Farm, which is under development east of Paxton, Illinois, on July 5, 2011. The three member-owned generation and transmission cooperatives, Prairie Power, Inc., Southern Illinois Power Cooperative and Wabash Valley Power Association, are entering into an 18-year power purchase agreement with E.On Climate & Renewable North America, Inc. The agreement was coordinated through the National Renewables Cooperative Organization. 37

The project is expected to create 200 construction jobs, ten full time jobs, and more than $1.6 million in tax revenue to support the local county and school system.

Source: NRCO members purchase Miso Wind Energy, National Renewables Cooperative Organization Press Release, July 5, 2011.

Subcommittee on Calculating Patronage Dividends

Chairman Teresa H. Castanias, CPA 7401 Pedrick Road Dixon, CA 95620 [email protected]

Vice Chairman Vice Chairman Daniel Groscost Daniel R. Schultz Alabama Farmers Cooperative, Inc. Cooperative Consulting LLC Box 2227 1710 Carriage Path Decatur, Alabama 35603-2227 Golden Valley, Minnesota 55422-4195 [email protected] [email protected]

The Subcommittee is reporting on a number of areas this year. Many of these issues have developed as cooperatives have implemented strategies to effectively utilize the Section 199 manufacturing deduction (aka “DPAD”). In our report, we will address the following developments during the year:

1) Additional rulings in the Section 199 area, and other issues including:

x IRS audit developments related to carryback claims for Section 199 benefits

x Related reviews of cooperative bylaws to ensure that payments to members/patrons are properly covered to meet the IRS definitions of patronage payments

x Form 1099-PATR reporting of “per-unit retain paid in money” (PURPIM) in Box 3

x Section 199 issue – Grain (or other products) delivered to a joint venture rather than to the cooperative and whether the PURPIM add-back would apply to the JV or coop’s Section 199 computation

x Form 8903 revised to require patronage/nonpatronage reporting by cooperatives 2) Tax or book method modifications to patronage computations x concern with state statutes

x business combination issues

x pension funding issues

x expensing vs capitalizing certain costs

3) Making changes to cost allocation methodologies for patronage dividend purposes

x Section 263A issues

x Section 861 approach

Section 199 Developments

Rulings Issued Since October 2010

The IRS National Office has issued the following rulings in the last 12 months:

x PLR 201105015 – October 13, 2010 – grain

x PLR 201115009 – January 10, 2011 – grain (also, no effect on use of NOL)

x PLR 201115010 – January 3, 2011 – grain

x PLR 201118009 – January 28, 2011 – grain

x PLR 201120008 – February 15, 2011 – grain

x PLR 201126012 – March 23, 2011 – grain

x PLR 201138002 – June 9, 2011 – grain

x PLR 201138029 – June 9, 2011 - grain All of the rulings are consistent with others that have been issued for grain and other types of cooperatives – i.e. the payment to the member for his grain is considered a “per-unit retain paid in money” (PURPIM) for purposes of the Section 199 computation.

In one of the rulings, PLR 201115009 issued on January 10, 2011, the IRS also discussed a Net Operating Loss (NOL) issue. The grain cooperative in the ruling had incurred an NOL in the year and also passed through its section 199 deduction to its patrons. The IRS held that there was no effect on the amount of the loss available to be carried back or forward under section 172. In determining the amount of an NOL carryover section 172(d)(7) states the section 199 deduction shall not be allowed. The effect of this provision is to exclude the carryover of non-economic losses. The cooperative’s section 199 deduction is always reported in full on the cooperative’s tax return. If the cooperative elects to pass-through the deduction under section 199(d)(3)(B), the cooperative must reduce its section 1382 deduction for PURPIMs and patronage dividend. The net result of the pass-through is that the cooperative’s NOL is not created or increased by the section 199 deduction. The ruling confirms that the cooperative should disregard both the section 199 deduction and the section 199(d)(3)(B) reduction of the section 1382 deductions in computing its NOL carryover.

IRS Audit Developments – Grain Cooperatives

In October 2009, the IRS National Office began issuing the first of the grain cooperative rulings that held that the payments to the member for his grain (aka “grain check”) is a PURPIM for section 199 purposes. Up until then, most grain cooperatives had not taken this position on their returns. With these rulings, the cooperatives and their advisors began considering the impact on their organizations. Section 199 was effective for tax years beginning after December 31, 2004. The 3 year statute of limitations began to expire on September 15, 2009 for cooperatives.

Section 199 requires that the cooperatives elect to pass-through the section 199 deduction within 8 ½ months of the cooperative’s year end. Since the 8 ½ period had passed for the grain cooperatives

(except for their latest tax year), the cooperative could only use the section 199 deduction in prior years against its own taxable income. There were a number of Midwest grain cooperatives that had taxable income and tax, and therefore filed refund claims for the 2005 tax year with the “grain check” PURPIM added back for section 199 purposes. Most cooperatives filed refund claims only for 2005 where the statute of limitations was due to run out. Since that time, cooperatives have filed claims for the 2006, 2007 and 2008 tax years.

A number of these cooperatives have received their refunds for those amended returns, but some received audit notices instead. The auditor came from the Des Moines office of the IRS and was new to cooperatives and section 199. The exams started in June 2010, and almost immediately the auditor indicated that the IRS did not believe the payments were PURPIMs. The draft denial of the refunds was issued in September 2010. It implied that there was a choice between the treatment of the “grain check” as either a PURPIM or a purchase. It also stated that the cooperative’s accounting method was treating the “grain check” as a purchase, not as PURPIM. A verbal denial of the refund claims was given to the cooperatives in November based on a Field Service Advice (FSA) which was not publicly released until December 2010. Proposed denials were issued in late December after the FSA was publicly released.

In Field Service Advice 20105101F, IRS Industry Counsel concluded in a lengthy discussion with the following: 1) Prior year crop payments were not PURPIMs. The FSA argued that the cooperative’s payment to the patron can be either a PURPIM or purchase. It held that the PURPIM treatment was not the intent of the parties and that there had been no timely mutual agreement to treat the crop payments as PURPIMs. It had been originally accounted for as a purchase, and no Form 1099- PATR had been issued showing the “grain check” as a PURPIM. The FSA also indicated its concern that double counting may have occurred.

2) “Reclassification” of the crop payments by the cooperative was determined to be detrimental to patrons and the government, and therefore the cooperative must stay with its original treatment of the crop payments for section 199 purposes.

The affected taxpayers have responded that the IRS’ arguments are flawed in the following ways: 1) The crop payments meet the definition of a PURPIM. Intent is not part of the definition.

2) In some cases, the cooperative being audited had received a Private Letter Ruling for a subsequent year, and there had been no change in their documents or facts between the two years. If the facts and the law did not change, how could the conclusion be different?

3) Allowing the amended returns is not detrimental to the government or patrons because: a) most farmers don qualify for or claim the section 199 deduction; b) the cooperative’s deduction is limited by remaining taxable income, and in most cases, this was significantly less than the computed deduction; and c) the total PURPIMs are typically substantially higher than needed to claim the maximum deduction due to the 50% W-2 wage limitation.

4) The reporting on Form 1099-PATR is not required in order to claim the deduction or to compute the section 199 deduction.

5) There is no alternative way to report the crop payments made to member/patrons on the Form 1120-C. The Form requires cooperatives to report PURPIMs in the Cost of Goods Sold section on the “Purchases” line.

6) The IRS’s argument that the cooperative and patron can choose which payments are PURPIMs would cause even more disruption in tax administration.

Currently, the cooperatives are continuing to file amended returns for years after 2005. For those who have received denials of their refund claims, protests have been filed and the IRS rebuttals have been received. The cases are being consolidated in Appeals, and there is hope for a resolution there. However, it may be that the cases (or a test case) will have to go on to court for resolution.

Review of Bylaws and Member Agreements

In light of the IRS audits of the grain cooperatives and the arguments made in the FSA, many cooperatives are reviewing their bylaws and member agreements to clarify the definition of crop payments therein. It is hoped that by making these documents clear, the IRS’s argument that the member is not aware of the treatment of the crop payment will be dispelled.

Form 1099-PATR Reporting of “per-unit retain paid in money” (PURPIM)

An issue that has arisen as a result of the section 199 deduction is whether Form 1099-PATR, Box 3 titled “Per-Unit Retain Allocations” should include the cash payments to members (aka PURPIMs). In PLR ____ dated ___, 2009, the IRS stated that the PURPIMs should be included in Box 3 of Form 1099-PATR. This was the first time this issue had been raised in the section 199 PLRs.

Section 1388(f) defines “per-unit retain allocation” (PUR) as an allocation to a patron of a cooperative with respect to products marketed for the patron. The allocated amount is fixed without reference to the net earnings of the cooperative pursuant to an agreement between the organization and the patron. The allocation may be paid in money, property or certificates.

Section 6044 deals with Form 1099 reporting for cooperatives and states in relevant part that “per-unit retain allocations as defined in IRC section 1388(f) which is paid in qualified per-unit retain certificates (as defined in IRC section 1388(h)” should be reported on Form 1099-PATR. Treasury Regulation 1.6044- 3 makes no reference to per-unit retain amounts to be reported. It only discusses patronage dividends and non-qualified redemptions. Section 6044 and 1385(a)(3) (discussing treatment of patronage dividends and per-unit retain certificates) were not amended in 1969 when the term PURPIM was added to section 1382. The IRS National Office believes this was an oversight and that the IRS has the power to interpret these sections. As a result, the instructions to the Form 1099-PATR have stated for over 10 years that the PURPIMs as well as the PUR certificates should be included in Box 3.

Most cooperatives have interpreted section 6044 to exclude PURPIMs from Form 1099-PATR reporting. But in light of the PLR, many are rethinking this position. There are a number of implementation issues related to the reporting of the PURPIM in Box 3. The biggest issue for most cooperatives is that the cash payments to members for their crop also include a number of other adjustments, additions and deductions. The Form 1099-PATR, Box 3 should include the gross commodity payment made during the calendar year regardless of the payer’s fiscal year end. It should not include sales of supplies and

services. The determination of this amount is complicated by the cooperative’s computer systems as well as the member relations aspects. In spite of these challenges, many cooperatives are now moving toward reporting the PURPIMs on their Form 1099-PATRs.

Products Delivered to Joint Venture

Another issue that has arisen in the section 199 implementation for cooperatives is whether the special cooperative computation provisions apply to a situation where the members of the cooperative deliver their product to a joint venture (taxed as a partnership) instead of to the cooperative. The cooperative formed a joint venture with another cooperative for cost savings. The joint venture receives the product, stores it, and markets it for the members of the two cooperatives. The joint venture tracks the member’s deliveries and reports it to the cooperative for patronage dividend reporting purposes. The profits of the joint venture are treated as patronage source by both cooperative owners.

The cooperatives would like to treat the product payments made by the joint venture to their members as a PURPIM deemed paid by the LLC on behalf of the cooperatives for section 199 computation purposes. This position needs to be carefully considered and reconciled with section 199’s very specific reporting rules for partnerships.

Revised Form 8903

Recently the IRS issued a revised Form 8903 which is the form used to compute the section 199 deduction on the tax return. The instructions to the Form state the following:

Allocation of patronage and nonpatronage income and deductions.

Cooperatives must calculate the “domestic production activities deduction “ (DPAD) separately to determine patronage and nonpatronage income or losses for purposes of determining unused patronage or nonpatronage losses on lines 12 and 13, respectively, of Schedule G, Form 1120-C.

If you have only patronage income and deductions, complete the Form 8903 as described in the instructions. However, if you have both patronage and nonpatronage income and deductions, see the instructions for line 25 before completing the Form 8903.

Line 25 instructions state, in part:

How to report. Cooperatives are not permitted to net patronage losses with nonpatronage income. Therefore, they must compute taxable income from patronage or nonpatronage activities separately on Schedule G, Form 1120-C.

Patronage and nonpatronage income and deductions. Cooperatives with both patronage and nonpatronage income or deductions must follow the below instructions for completing Form 8903.

Report the total amount of the DPAD to be claimed on Form 1120-C on line 25 of Form 8903, and leave lines 1 to 24 blank. Attach to Form 8903 separate calculations of the DPAD from patronage and nonpatronage activities, which conform to lines 1 to 24 of the Form 8903. 43

These instructions rely on the Farm Services case. Many cooperatives have already been doing these computations and allocating the amounts between patronage and nonpatronage on Schedule G. However some have not made these allocations. In addition, there are many ways to do these computations which can change the results markedly. We believe this is an area where the IRS is likely to become more active.

Tax or Book Method Modifications to Patronage Computations

A number of practitioners and cooperative managers have reported that their cooperatives are considering or have considered and made changes to the cooperative’s method of paying patronage. Originally cooperatives used the tax method for paying patronage to members. Over the years, many cooperatives have moved to the book method. The main reason given for making the change is that it is easier for the members to understand. In addition, the books are normally closed and profits are determined for financial statement purposes (aka “generally accepted accounting principles” (GAAP)) fairly quickly after the cooperative’s year end. The tax return generally follows several months after that. This delay has become more difficult for cooperative’s to deal with for member relations purposes. Both methods have pros and cons. In recent years, there have been more cooperatives looking at their patronage computation and making adjustments to their method to more fairly and equitably distribute profits to the members.

One of the reasons that more cooperatives are considering these changes is the change in the accounting rules for business combinations. Under the old rules, GAAP allowed the “pooling of interest” method for mergers. This allowed cooperatives to merge with no change in their asset values. The two entities’ assets and liabilities were added together. Under the new rules, GAAP requires the “purchase” method for mergers. Now one of the entities must be considered the “acquirer”. The acquired company must be valued at its “fair market value”, but the acquiring company’s value is not similarly stepped up or down. As a result of these rules, two cooperatives that merge can find some unexpected and unintended consequences in their new patronage computation. Many cooperatives, particularly those paying patronage on the book basis, are considering changes to their bylaws to attempt to deal with these rules.

Another reason that cooperatives have been considering changes to their bylaws in this area is the Section 199 deduction. Cooperatives that use the tax method generally assume they must reduce their patronage dividend for the amount of the Section 199 deduction, unless the patronage computation is modified to adjust for this.

Changes have been made in book basis patronage computations for issues such as the timing of recognition of hedging transactions and pension plan contributions. Other cooperatives have made changes to spread out certain costs that are required to be expensed for book purposes. The magnitude of the expenses and the role they play in the future activities of the cooperative generally drives the board and management to explore the change in the patronage computation for these items.

Changes to Cost Allocation Methodologies for Patronage Computations

Other practitioners have also reported that cooperatives are making changes to their cost allocation methodologies for patronage computation purposes. Various methods are being considered. Some are looking at detailed cost accounting studies. Others are using tax methodologies such as those in Section

861 or Section 263A. The cooperatives have been motivated to consider these changes in many cases because of the Section 199 deduction.

2011 LTA REPORTING SUBCOMMITTEE

COOPERATIVE ISSUES SPECIFIC TO MARKETING ORDERS AND BARGAINING ASSOCIATIONS

Stephen Zovickian, Chair BINGHAM MCCUTCHEN LLP Three Embarcadero Center San Francisco, California 94111 Telephone: 415.393.2382 [email protected]

Julian B. Heron, Jr., Vice-Chair TUTTLE, TAYLOR & HERON 1025 Thomas Jefferson St., NW Suite 407 West Washington, DC 20007 Telephone: 202.342.1300 [email protected]

2011 SUBCOMMITTEE ON COOPERATIVE ISSUES SPECIFIC TO MARKETING ORDERS AND BARGAINING ASSOCIATIONS

I. MARKETING ORDERS

FREE SPEECH AND MARKETING ORDERS

Last year’s report noted that plaintiffs in Delano Farms Co. v. California Table Grapes Comm’n, 586 F.3d 1219 (9th Cir. 2009) petitioned the US Supreme Court for certioriari on June 4, 2010. The Supreme Court denied certioriari, bringing an end to the plaintiff’s argument that mandatory assessments used for the generic marketing of table grapes were subject to a First Amendment challenge. See Delano Farms Co. v. California Table Grapes Comm’n, 131 S. Ct. 159 (Oct. 4, 2010). The Committee is not aware of any other reported decisions this year in which a court addressed this issue, which has been the subject of several reported decisions over the past decade.

FEDERAL MILK MARKETING ORDERS: FILED RATE DOCTRINE

Last year’s report included analysis of Carlin v. Dairy America, Inc., 690 F. Supp. 2d 1128 (E.D. Cal. 2010). In Carlin, the court held that the “filed rate doctrine” bars producers from bringing state law challenges to minimum milk prices set under Federal Milk Marketing Orders (“FMMO”). Id. Although there were no new developments to the Carlin case, two cases cited Carlin approvingly.

In In re Dairy Farmers of America, Inc. Cheese Antitrust Litig., 767 F. Supp. 2d 880 (N.D. Ill. 2011), the court cited Carlin, stating “because the logic of Carlin. . . is persuasive, the Court holds that the filed rate doctrine is generally applicable to government minimum milk rates, even in cases of fraud.” In re Dairy Farmers, involved a motion to dismiss antitrust and unfair competition claims including allegations that defendants conspired to artificially inflate milk and cheese prices. Applying the “filed rate doctrine,” the court dismissed all claims arising from purchase of milk and cheese priced based on the government minimum milk prices. In re Dairy Farmers, 767 F. Supp. 2d at 893. This decision closes the door on damages claims arising from government minimum milk prices and affirms the holding from Carlin that the “filed rate doctrine” bars damages for claims based on government minimum milk prices.

Similarly, in In re Hawaiian & Guamanian Cabotage Antitrust Litig., 754 F. Supp. 2d 1239, 1247 (W.D. Wash 2010) the court held that the “filed rate doctrine” applied to cabotage rates set by government agencies and barred any claim that the rates were unreasonable. Although outside of the marketing order context, In re Hawaiian is significant in that it affirmed the holding from Carlin. In fact, the court relied heavily on Carlin. The court found the Carlin court’s refusal to engage in determination of “what

the rate would have been” as a persuasive reason to dismiss all claims seeking review of the filed rates. Id.

FEDERAL MILK MARKETING ORDERS: GEOGRAPHIC REGION AS RELEVANT MARKET IN AN ANTITRUST SUIT

In Allen v. Dairy Farmers of America, Inc., 748 F. Supp. 2d 323 (D. Vt. 2010), defendant challenged application of Federal Milk Marketing Order (“FMMO”) geographic regions as the relevant geographic market in an antitrust case. The court held that FMMO geographic regions plausibly could be the relevant market for antitrust purposes, and therefore denied plaintiff’s motion to dismiss. Id. at 338. The court later approved settlement as to one defendant in Allen v. Dairy Farmers of America, Inc., 2011 WL 1706778, (D. Vt., May 4, 2011).

Although this case does not directly address typical issues regarding Federal Milk Marketing Orders, this novel approach to an antitrust geographic region could impact milk producers. Given the posture of the case, the court does not expressly find that the milk marketing region is in fact the relevant geographic region. Instead, the court merely found it sufficient for pleading standards. However, this suffices to put milk producers on notice that courts might sometimes look to the FMMO geographic regions to define the relevant market for antitrust purposes.

FEDERAL MILK MARKETING ORDERS: CONSTITUTIONAL CHALLENGE OF THE MILK REGULATORY EQUITY ACT

In Hettinga v. U.S., 770 F. Supp. 2d 51 (D.D.C. 2011) plaintiffs challenged the constitutionality of the Milk Regulatory Equity Act (MREA). The challenged provisions of the MREA were enacted in 2006 to subject producer-handlers of milk in the revised Arizona Milk Marketing Area to federal pricing and pooling requirements. Id. at 58. As the only entity affected by these provisions, plaintiffs challenged the constitutionality of the MREA on three grounds; 1) that the act was a bill of attainder, 2) that it violated equal protection and 3) that the act violated due process. Dismissing the claim on all three grounds, the Court held, 1) that the plaintiff’s failed to allege that the MREA targeted them specifically, 2) that the goals of the MREA were a legitimate, and the structure of the MREA was a rational means to achieve those goals, and finally 3) the plaintiffs did not plead fact sufficient to allege a due process violation. Id. at 60.

MILK MARKETING ORDER: LANDMARK SETTLEMENT

The District Court recently vacated a settlement reached on July 12, 2011 between Dean Foods Co. and the class action plaintiffs in In re Southeastern Milk Antitrust Litig., No 2:07-cv 208 (E.D. Tex. 2011). The settlement reportedly would have required Dean Foods to pay a total of

$140 million over four years to the class, which includes both DFA member dairy farmers and independent dairy farmers.

Certified as a class action in 2010, In re Southeastern Milk involved claims asserted on behalf of 7,200 current and former dairy farmers alleging a conspiracy to artificially lower the price paid to dairy farmers in the Southeast U.S. for fluid Grade A milk in violation of Sherman Act section 1. Additionally, the plaintiffs alleged a conspiracy to monopolize and monopsonize in violation of the Sherman Act section 2.

On August 31, 2011, District Judge Ronnie Greer, on the motion of Dean Foods, shelved, at least temporarily, proceedings to approve the settlement.

Judge Greer stated he "would like nothing better than to deny Dean's motion," but concluded he "ha[d] no choice but to grant" it. Relying on Amchen Products, Inc. v. Windsor, 521 U.S. 591 (1997), and Ortiz v. Fibreboard Corp., 527 U.S. 815 (1999), Judge Greer decided the court could not "make an 'undiluted' determination that the class including both DFA member dairy farmers and independent dairy farmers meets the requirement of Rule 23," as required to approve the class-wide settlement. This determination was not possible, since the court on July 28, 2011, had found "'a conflict of interest [between DFA dairy farmers and independent dairy farmers] requiring the Court to decertify' the DFA member subclass."

The Dean Foods settlement may yet be approved. The motion for preliminary approval of the settlement will be taken "under advisement pending appointment of separate counsel and class representatives for the DFA subclass," after which "it may be possible for the Court to certify the DFA subclass for settlement purposes, [and] grant the motion to preliminar[il]y approve the settlement agreement . . . ."

MIDEAST MILK MARKETING ORDER: PROPOSED AMENDMENTS

USDA received a proposal on June 17, 2011, to amend the pooling standards of a distributing plant as part of the definition of a pool plant in the Mideast Milk Marketing Order. The proposal was submitted on behalf of Foremost Farms USA Cooperative, Inc., National Farmers Organization, Inc., and Dairy Farmers of America, Inc. The proponents assert that the current pool distributing plant pooling standards enables distributing plants to change their regulatory status and this has led to a disruption of orderly marketing conditions and should, therefore, be revised.

Based on the information submitted by proponents, USDA is considering initiation of a rulemaking proceeding that will include a public hearing to collect evidence regarding proposed changes to the pooling standards of a pool distributing plant in the Mideast Milk Marketing Order. USDA is requesting additional proposals 49

by August 12, 2011. A pre-hearing workshop will likely not be held. Data must be received no later than ten days before start of hearing. The hearing date is tentatively planned for October 2011.

FEDERAL MILK MARKETING ORDERS: PROPOSED LEGISLATION

A bill was introduced into the U.S. Senate that would allow modified bloc voting by cooperative associations of milk producers in connection with a referendum on Federal milk marketing order reform. See 112th CONGRESS, 1st Session S 457, Introduced in Senate, March 2, 2011. The bill was read twice and referred to the Committee on Agriculture, Nutrition and Forestry.

USDA TO TERMINATE MARKETING ORDERS ON NECTARINES AND PEACHES

On March 25, 2011 the USDA announced that it will terminate the marketing order programs for California nectarines and peaches, which have been in place since 1958. The USDA will suspend all nectarine and peach handling regulations for the 2011 season. The order was terminated in response to three referenda conducted between January and February of 2011.

RAISIN PRODUCERS VOTE TO CONTINUE STATE MARKETING ORDER

In March 2011, California raisin growers approved the continuation of the state marketing order (different from the federal order). Over 71 percent of eligible growers voted, with 91 percent voting in favor. The California Raisin Marketing Board, created in 1998, is grower-funded. The board currently funds crop production and nutrition science research.

CRANBERRY PRODUCERS VOTE TO CONTINUE MARKETING ORDER

On June 30, 2011, the USDA announced that cranberry producers voted to continue their federal marketing order program. Over 76 percent of eligible voters supported the order’s continuance. Noting the importance of the order, the USDA stated that “continuance will provide opportunities to expand cranberry markets and help growers thrive.”

MARKETING ORDERS: OTHER RELATED LITIGATION UPDATES

The Ginseng Board of Wisconsin (“GBW”), a non-profit charged with administering a state ginseng marketing order, was sued for libel, slander, and breach of contract in Boehner v. Heise, 734 F. Supp. 2d 389 (S.D. N.Y. 2010). As a part of GBW’s duties in carrying out the Wisconsin Ginseng Marketing order, GBW became concerned with the safety of imported 50

ginseng. Id. at 394. Accordingly, GBW wrote a letter to US Senator Russell Feingold, soliciting his assistance in dealing with the suspect ginseng imports. Plaintiff’s ginseng business was adversely affected by this letter and the subsequent actions the letter catalyzed. Id. at 395. Plaintiffs brought suit claiming numerous torts, most predicated on the letter between GBW and Senator Feingold. Id. In dismissing all claims except the breach of contract claim (this claim was unrelated to the Senator Feingold letter), the court held that GBW enjoyed a qualified privilege, in the context of defamation, for communications with Senator Feingold. In recognizing the qualified privilege, the court acknowledged the common concern for Wisconsin consumers shared by the Senator and the GBW.

This case is significant in that it recognizes the litigation dangers faced by entities tasked with carrying out marketing orders. Also, the case illustrates that some courts recognize that the public safety purpose marketing orders serve places them in a position where otherwise libelous communications enjoy a qualified privilege.

ALMOND MARKETING ORDER: JURISDICTION

Last year’s report included a discussion of Koretoff v. Vilsack, 626 F. Supp. 2d 4 (D.D.C. 2009), in which the court granted the USDA’s motion to dismiss based on lack of subject matter jurisdiction. At issue in Koretoff, plaintiffs—almond growers, handlers, grower-handlers, and retailers—sued the Secretary of Agriculture for adopting rules under the Almond Marketing Order (7 C.F.R. §§ 981.1 et seq.) for mandatory treatment of almonds to reduce the potential for Salmonella bacteria prior to shipment. Although the D.C. District Court dismissed those claims, on appeal, in Koretoff v. Vilsack, 614 F.3d 532, 534 (D.C. Cir. 2010) reh'g denied, 09-5286, 2010 WL 5082029 (D.C. Cir. Dec. 13, 2010), the D.C. Circuit Court reversed the lower court dismissal as to the almond growers, but affirmed dismissal as to the almond retailers.

The court’s holding turned on whether or not judicial review was precluded by Congress in the Agricultural Marketing Agreement Act (“AMAA”). By reviewing precedent from the Supreme Court the court came to the conclusion that the AMAA does not preclude producer suits challenging rules and orders issued under the AMAA. Id. at 539. However, the court agreed with the lower court’s dismissal of suit brought by the differently situated almond “producer-retailers.” Id. The court found that the AMA does require “handlers” to exhaust administrative remedies before bringing suit. Because the lower court held that the “producer- retailers” meet the definition of “handler,” those plaintiffs claims were dismissed for a failure to exhaust administrative remedies. Id. at 541.

RAISIN MARKETING ORDER: HANDLERS

Reports for the last two years catalogued developments in the ongoing battle between the USDA and Marvin and Laura Horne and their partners. This year saw not one, but two installments in this continuing litigation.

Last year’s report noted that on December 9, 2009, the District Court for the Eastern District of California granted summary judgment in favor of the USDA. Horne v. USDA, 2009 U.S. Dist. LEXIS 115464 (E.D. Cal. Dec. 9, 2009). That ruling was affirmed on appeal on July 25, 2011. Horne v. USDA, No 10-15270, (July 25, 2011) aff'g, 2009 U.S. Dist. LEXIS 115464 (E.D. Cal. Dec. 11, 2009). Addressing each issues decided in the lower court, the court affirmed that Hornes were “handlers” subject to the Raisin Marketing Order; that the Raisin Marketing Order’s reserve requirement does not violate Due Process Clause of Fifth Amendment as a physical taking; that fines imposed on the Hornes did not violate the Excessive Fines Clause of the Eighth Amendment; and that the dismissal of the Hornes’ administrative appeal was not arbitrary, capricious, or an abuse of discretion.

Meanwhile, the Horne’s appealed a 2008 USDA ruling, and again lost in Horne v. U.S.D.A. 395 F. App'x. 486 (9th Cir. 2010). Plaintiffs challenged the constitutionality of the Raisin Marketing Order to the Judicial officer of the USDA. After loosing that petition, plaintiffs failed to file action in the trial court within the required 20 day period. On appeal here, the Hornes argued that the USDA’s failure to provide notice caused their failure to make a timely appeal. Despite these procedural flaws that prevented plaintiff form challenging the administrative decision, the court affirmed dismissal holding that it was the province of the Department to decide the process for appeal, and the province of Congress to prevent future procedural hurdles from preventing challenges.

II. BARGAINING ASSOCIATIONS

California Conciliation Proceedings

After the California Tomato Growers Association reached agreement with the eight processors who buy over 77 percent of California’s processing tomatoes, two processors refused to agree to the same terms of sale and demanded “conciliation,” a non-binding form of mediation authorized by California’s Food & Agricultural Code. After a two-day session with a professional mediator, the first processor -- ConAgra -- finally agreed to the same terms. After ConAgra reached agreement, the second processor -- Olam Tomato Processors (the successor to SK Foods) -- withdrew its conciliation demand and also agreed to the same terms.

NATIONAL COUNCIL OF FARMER COOPERATIVES

LEGAL TAX & ACCOUNTING COMMITTEE

2011 Report of Subcommittee on Litigation Between Cooperatives and Their Members, Including Member Insolvency

Chair: William P. Hutchison, Esq. Lane Powell PC 601 SW 2nd, Suite 2100 Portland, OR 97204 Phone: (503) 778-2150 Fax: (503) 778-2200 [email protected]

Vice-Chair: Terry D. Bertholf, Esq. Kansas Farmers Service Association 1515 East 30th Avenue P.O. Box 2560 Hutchinson, KS 67504-2560 Phone: (620) 663-5453 Fax: (620) 663-1653 [email protected]

Vice-Chair: David M. Hayes, Esq. Bond, Schoeneck & King, PLLC One Lincoln Center Syracuse, NY 13202 Phone: (315) 218-8188 Fax: (315) 218-8100 [email protected]

Subcommittee Members:

John Curran Adam Jussel 651-481-2855 206-622-8484 [email protected] [email protected]

Joel Dahlgren Bill McCullough 612-819-8677 919-828 0564 [email protected] [email protected]

David Geisler Andrew Romanow 816-801-6455 303-740-4195 [email protected] [email protected]

Brian Griffith Larry Steier 573-876-5226 402-498-5592 [email protected] [email protected]

David VanderHaagen 517-371-8102 [email protected]

TABLE OF CONTENTS

1. Andrews Farms, et al. v. Calcot, Ltd., et al.

2. Walnut Producers of California, et al v. Diamond Foods, Inc.

3. Hayton Farms, Inc. v. Pro-Fac Cooperative, Inc.

4. Setoffs in Bankruptcy Proceedings

5. In-House Counsel and the Attorney-Client Privilege

6. Antitrust Litigation

1. Andrews Farms, et al. v. Calcot, Ltd., et al.

A lawsuit was first filed January 2007 in the Superior Court of California, Kern County, by two members, Andrews Farms and Greg Palla, seeking class action status, against Calcot, Ltd., a cotton marketing cooperative in Bakersfield, CA. Also named as defendants were Eadie and Payne, LLP, the cooperative’s auditors, and Robert W. Norris, a former CEO and President of Calcot. The legal action was removed to U.S. District Court, Eastern District of California.

The complaint alleged fraud; breach of fiduciary duty; constructive fraud and deceit based on a fiduciary relationship; accounting; breach of contract; fraud and deceit – intentional misrepresentation of material fact; negligent misrepresentation against the auditors; and, violations of the federal RICO (Racketeer Influenced and Corrupt Organizations) statute, 18 U.S.C. § 1962.

According to the suit, Calcot improperly charged its members more than $23 million in interest expenses during the last two decades to pay for the development of real estate formerly used to warehouse cotton. The plaintiffs claim that interest costs were incurred for a commercial real estate venture unrelated to marketing Calcot members’ cotton, and the interest was deducted from the amounts due members for their cotton. The plaintiffs allege that the interest deductions were concealed from members and from the Board of Directors. The suit relates to the accounting treatment of interest and the disclosures related to interest. The plaintiffs seek treble damages under RICO as well as punitive damages.

The original complaint was dismissed with leave to amend the complaint. In July 2007, the plaintiffs filed an amended complaint in federal court containing similar allegations. In October 2007, the U.S. District Court denied Calcot’s motion to dismiss the amended complaint in its entirety. On motions to dismiss by Calcot’s auditors, Eadie and Payne, the Court denied both the auditors’ motion to dismiss and its motion to strike the plaintiffs’ request for punitive damages; but, the Court did grant the auditors’ motion to strike plaintiffs’ request for attorneys’ fees and granted, in part, the auditors’ motion for a more definite statement.

In August 2009, the District Court granted the plaintiffs’ request for class certification.

On July 18, 2011, the District Court granted its preliminary approval of a proposed settlement agreement. Under the proposed settlement, the gross sum of $3,250,000 will be paid ($2,000,000 by Calcot; $750,000 by Mr. Norris; and, $500,000 by Eadie and Payne).

Among the unresolved issues identified by the District Court Judge in his July 18 preliminary approval are:

x Whether the cooperative was authorized to charge members?

The plaintiffs contend that charges related to the development of real estate were unauthorized because they are unrelated to the handling of cotton. The cooperative argues that the costs to

maintain the property were related to the handling of cotton and are authorized by statute2, its bylaws and its marketing agreement.

x Whether the cooperative improperly failed to disclose the charges?

The plaintiffs assert that the non-capitalized interest expenses were not fairly disclosed, tracked or segregated on the cooperative’s books. They further contend that the financial performance of the real estate development project was never disclosed. The cooperative disputes that its accounting practices were improper. Furthermore, the cooperative submitted evidence that the accounting decisions were made on advice from its outside auditors.

The Cooperative submitted evidence that the actions of the Board of Directors were disclosed and approved by the members each year; the Judge described this as a hotly contested factual issue.

x Whether a fiduciary relationship existed between the parties?

The Judge observed that while the undisputed evidence demonstrates that there was a contractual relationship between the parties, questions of fact remain to establish a fiduciary relationship.

x Whether the cooperative breached the contract between the cooperative and its members?

A fairness hearing was held on October 4, 2011, and the District Court Judge gave his final approval to the settlement agreement.

2. Walnut Producers of California et al v. Diamond Foods, Inc.

In March 2008, a walnut grower and a cooperative bargaining association named Walnut Producers of California filed suit against Diamond Foods, Inc., the publicly traded successor entity to Diamond Walnut Growers, Inc., a California cooperative, in San Joaquin County Superior Court, California, for breach of contract relating to the alleged underpayment for walnuts delivered to Diamond Foods for the 2005 and 2006 crop years. The plaintiffs brought the suit individually, on their own behalfs, and as a class action of walnut growers who entered into contracts with Diamond Foods.

As background, in 2005, the members of Diamond Walnut Growers, Inc. voted to approve the conversion of the agricultural cooperative into a stockholder-owned corporation, Diamond Foods, Inc. The corporation is a branded food company specializing in processing, marketing and distributing culinary, snack, inshell and ingredient nuts under the Diamond of California and Emerald of California brands. Products include walnuts, pine nuts, pecans, peanuts, macadamia nuts, hazelnuts, cashews, Brazil nuts and almonds. Diamond Foods is a publicly owned company with its common stock trading on the NASDAQ Exchange.

2 Cal. Food & Agr. Code Section 54176. 57

In the lawsuit, the growers allege that they have not been paid a “competitive price” for their products since the conversion of the organization from an agricultural cooperative to a publicly owned company.

The underlying theory is breach of contract for failure of the defendant to pay the growers the competitive price (sometimes referred to as reasonable, market, or competitive price) for walnuts they have delivered. Since the conversion of the cooperative to a stockholder-owned corporation, the defendant has paid the growers a price that is reported to be significantly less than the market price. Historically, the cooperative paid growers above market prices for their walnuts. The contract between Diamond Foods and its former members does not include a price, which the plaintiffs alleged is contrary to California law. (California Food and Agriculture Code section 62801.)

Counsel for plaintiffs has observed the so-called “horizon problem” that is inherent in conversion from a member-owned cooperative to a stockholder-owned corporation. The older members desire an exit strategy to realize the value that has accumulated over the years while the younger generation is more interested in assuring a continuing market for their products.

Plaintiffs filed their original complaint in March of 2008 seeking class designation. There may be as many as 1,600 growers involved. The plaintiffs include an individual and the Walnut Producers of California, a bargaining association.

Upon motion by Diamond Foods, the trial court summarily struck the class action allegations from the plaintiffs’ amended complaint.

On August 16, 2010, the California Court of Appeal, Third Appellate District, issued an opinion upholding the trial court’s order striking the class allegations. 187 Cal. App. 4th 634 (2010) 2010 WL 3213613. According to the Court, the plaintiffs could not establish procedural unconscionability due to the fact that the association was comprised of sophisticated business people. The Court observed that an obvious alternative for plaintiffs was not to approve the cooperative’s merger into Diamond Foods. On the issue of substantive unconscionability, the Court ruled that the claims of each individual grower were sufficiently large (approximately, $43,750) so as to not render adjudication contingent on a class action. In other words, according to the Court, each grower could practically file an individual legal action.

Also, the Court of Appeal rejected the plaintiffs’ argument that the class action waiver was unenforceable because it prohibits them from vindicating their statutory right to have the purchase price for their walnuts stated in writing in a definite sum under Section 62801 of the California Food and Agriculture Code. The Diamond Foods’ marketing agreement provides that Diamond Foods will establish the price in good faith each year following the harvest, taking into account market conditions, quality, variety and other relevant factors. The Court ruled that the statute’s express language, “[U]nless the parties agree otherwise, every contract for the sale of edible nuts shall be in writing and shall state the full purchase price in a definite sum which is to be paid in accordance with the terms of the contract. ... ” (emphasis added), permits the parties to waive the protections under the statute. Therefore, the class action waiver in the marketing agreement did not affect an unwaivable statutory right.

As a result, the litigation reached impasse. With the court’s encouragement, both sides are reported to currently be engaged in settlement discussions.

3. Hayton Farms, Inc. v. Pro-Fac Cooperative, Inc.

In Hayton Farms, Inc. v. Pro-Fac Cooperative, Inc., 2:10-CV-00520-RSM, 2011 WL 289 865 (W.D. Wash July 18, 2011), a group of cucumber farmers and former members of Pro-Fac Cooperative, Inc., a New York cooperative corporation, (“Pro-Fac”), sued Pro-Fac and its directors alleging breach of contract, negligence, and breach of fiduciary duties.

Pro-Fac is in the process of liquidation and the net liquidation proceeds will be distributed to current and former members based on their “CMV credit” on the books of Pro-Fac. (CMV is the weighted average price paid by commercial processors for the same or similar crops, used for the same or similar purposes, in the same or similar marketing areas.) Plaintiffs allege that the proceeds from liquidation will be distributed inequitably for a variety of reasons including the preferential treatment of members of the Board of Directors.

Plaintiffs point to Pro-Fac’s sale of its subsidiary Birds Eye Foods, Inc. to Allens, Inc. (“Allens”), and Plaintiffs allege that Allens assumed the duty to buy vegetables from Pro-Fac, however, Allens wanted to buy vegetables directly from growers/Pro-Fac Board members, which would negate the grower/Board members’ ability to accumulate CMV credit (since the deliveries would be going to Allens and not Pro-Fac). Plaintiffs assert that to assure themselves more CMV credit, those Board members’ growers created a scheme to make it appear that they were delivering their vegetables through Pro-Fac by forming an entity called Farm Fresh First, LLC (“Farm Fresh”); however, Plaintiffs allege that they were not offered a similar opportunity to earn CMV credit, and by allowing some members to accumulate CMV credit while denying similar deals to Plaintiffs, they suffered diminution in the value of their distributions in the eventual dissolution of Pro-Fac.

Plaintiffs allege that after the sale of the Birds Eye Foods subsidiary, Pro-Fac purchased back most of the common stock and delivery rights of most members, but certain members, including Board members, were permitted to continue accumulating CMV credit.

While the Plaintiffs present an interesting set of facts involving a closed cooperative and liquidating such a cooperative, the Court based its decision granting summary judgment to defendants because Plaintiffs failed to bring their action as a shareholders derivative action, holding “the action is derivative (if) the gravamen of the complaint is injury to the corporation, or to the whole body of stock or property without any severance or distribution among individual shareholders. (If) damages to the stockholders result indirectly, as the result of an injury to the corporation, and not directly, he cannot sue as an individual.” id The Court decision is demonstrative of the fact that cooperatives are corporations and that general corporate legal principles apply to farmers’ cooperatives.

The Court held that Plaintiffs presented no exceptions to the rule that an individual may not sue for injuries suffered by a corporation – the injury to the individual did not result from the violation of some special duty owed to the stockholders.

The case was dismissed on October 18, 2011, with prejudice as to some defendants and without prejudice as to others.

4. Setoffs in Bankruptcy Proceedings

This Subcommittee’s 2010 Report included a discussion of Golden Gem Growers, Inc. v. Ferguson, In re Golden Gem Growers, Inc., 2010 WL 74546 (Bankr. N.D. Fla. Mar 2, 2010), which confirmed that capital equity credits in an agricultural cooperative do not constitute an indebtedness of the cooperative, and the member has no right to setoff debts owed to the cooperative against the member’s capital equity credits. (The cooperative, Golden Gem Growers, was the debtor in bankruptcy, and the cooperative sued a member to recover debts which the member owed to the cooperative.)

When considering a cooperative’s legal right or obligation to setoff a member’s equity credits against amounts due the cooperative from the member, it may be helpful to distinguish between an “offensive” setoff situation and a “defensive” setoff situation. See chart below.

SETOFFS

Offensive (sword) Context Defensive (shield) Context

The cooperative seeks to enforce the The cooperative asserts that it does not have the cooperative’s right to setoff equity credits duty or obligation to setoff a member’s debts on its books against debts owed to the owed to the cooperative against the member’s cooperative by a member. equity credits on the books of the cooperative. (The member seeks to require that the debts be setoff against the equity credits.)

Generally, cooperatives have been successful in defensive setoff cases based on the language in the cooperative’s bylaws, other governing documents or the state’s statute allowing the cooperative’s Board of Directors to exercise discretion in deciding whether and when to redeem or pay equity credits to members. Courts have held that the cooperative cannot be forced to setoff equity credits against debts due the cooperative from members. But, in cases where a cooperative has attempted to use offensive setoff, the cooperatives have not been as successful.

Occasionally, a cooperative desires to setoff equity credits on its books against a member’s debts to the cooperative. For example, it is not unusual that a Chapter 12 Farm Reorganization Plan will provide for no payment to general unsecured creditors. If the cooperative is such a creditor in a Chapter 12 Bankruptcy, the member’s debt will eventually be discharged, and the member will emerge from the bankruptcy with his cooperative equities unchanged unless the cooperative is allowed to setoff the equities against the debt.

If a member is a debtor in bankruptcy proceedings, the cooperative must obtain the prior approval of the Bankruptcy Court in order to setoff equity credits against the member’s prepetition debts to the cooperative. 11 U.S.C. § 362(a)(7).

The Bankruptcy Code does not create a federal right of setoff, but Code Section §553 preserves the right of setoff that otherwise exists under state or federal law. 11 U.S.C. § 553.

“(a) Except as otherwise provided in this section and in sections 362 and 363 of this title, this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor …”. Id. § 553. Section 553 preserves the right of setoff when four conditions are met: (1) the creditor holds a prepetition claim against the debtor; (2) the debtor owes a debt to the creditor that arose prepetition; (3) the claim and the debt are mutual; and, (4) the claim and the debt are enforceable. Collier on Bankruptcy §553.01(1). The key determination is the right to setoff. Id. §553.01(2).

Creditors and debtors may by contract determine the scope of their setoff right. Collier §553.04(1).

The cooperative should be able to preserve the claim against the debtor’s equity in the cooperative by establishing a security interest in that equity and then perfecting that security interest under state law. (An unperfected security interest will be subject to the Trustee’s lien in bankruptcy.)

The cooperative’s Bylaws will also need to establish the counter obligation as “mutual.” Nelson v. Cavalier Rural Electric Co-operative of Langdon, ND (In re Axvig), 68 B.R. 910 (Bankr. D.N.D. 1987).

Bankruptcy Courts have held that a cooperative is not entitled to offset a debtor’s obligation to it against the debtor’s patronage account, In re Axvig Id 918; Taylor v. Assumption Cooperative Grain Co. (In re Beck), 96 B.R. 161 (Bankr.C.D.Ill.1988); and Sherman v. Eugene Farmers Cooperative: (In re Cosner) 3 B.R. 445 (Bankr.D. Or. 1980).

In Kansas, an offensive setoff is usually denied, based on the Kansas Supreme Court’s decision in Atchison County Farmers Union Co-op Association v Turnbull, 241 Kan. 357, 736 P.2d 917 (1987), which adopted the general rule later applied in Golden Gem. The Turnbull decision characterized the member’s equity credit investment in the cooperative as capital, “an interest which is contingent and not immediately payable”. The Kansas rule is that in order for setoff to be available there must be two mature debts, Turnbull, 360-61 and 921.

In summary, in defensive setoff cases, cooperatives have generally been able to refuse to apply equity credits against a member’s debts. However, Bankruptcy Courts have usually denied requests by cooperatives seeking Bankruptcy Court approval of setoffs in offensive setoff cases.

5. In-House Counsel and the Attorney-Client Privilege

With permission from the author of the following article, Bryan K. Prosek of Steptoe & Johnson PLLC, the Committee thought to include in our report this analysis of this topic which is particularly pertinent for our in-house counsel committee members. It appeared in the March 2011 Associates Now Newsletter from The Center for Association Leadership.

Q: What communications with in-house counsel will be protected by attorney-client privilege?

A: Attorney-client privilege exists with respect to a communication when:

x The asserted holder of the privilege is or is sought to become a client. x The person to whom the communication was made is an attorney. x The communication relates to a fact of which the attorney was informed. x The communication was made in confidence. x The communication was made for the purpose of securing legal advice. x The privilege has not been waived.

These six elements must be established for attorney-client privilege to apply to a communication with outside counsel or between in-house counsel and a company employee. However, courts have traditionally been biased against applying the privilege to communications between in- house counsel and company employees. Courts assume that companies will take unfair advantage of the protection of the privilege by funneling all information through in-house counsel. In addition, courts assume that most internal communications relate to business advice rather than legal advice since in-house counsel regularly provide advice on business issues. This bias makes it difficult for a company to establish all of the elements necessary for a communication to be privileged.

Answering the following questions in a manner that meets the elements to establish attorney- client privilege is particularly difficult:

x Who is the client? x Does the communication provide legal advice or business advice? x Who within the company can waive the privilege?

Client. Three tests have evolved in different states for determining who constitutes the client: the control group test; the subject matter test; and the Upjohn test [from Upjohn v. United States, 449 U.S. 383 (1981)]. The control group test results in the most narrow application of privilege. It provides that the client is only someone from the group of people who can control or be significantly involved in the direction of the company. Under the subject matter test, an employee is a client for purposes of attorney-client privilege if the communication occurred at the direction of the employee’s superior and the subject matter of the communication falls within the scope of the employee’s duties. The Upjohn test is similar to the subject matter test, but slightly more flexible. Under this test, an employee is a client for purposes of attorney-client privilege if the employee made the communication to in-house counsel at the direction of the employee’s superior, the communication related to the employee’s duties, individuals within the control group did not possess the information, and the employee knew that the communication was being made so that the company could obtain legal advice.

Legal Advice. Attorney-client privilege only applies to legal advice, not business advice. Problems arise when a communication contains both legal and business advice, which is often the case in communications with in-house counsel. The most prevalent test used to determine whether a communication that contains both legal advice and business advice is protected, is the 62

predominate purpose test. This test provides that privilege applies to the communication if in- house counsel was acting in the role of a lawyer and the predominate purpose of the communication was the seeking or provision of legal services.

Waiver. If an otherwise privileged communication is disclosed to an employee who does not qualify as the corporate client, the communication may lose its privileged status because there can be no expectation of confidentiality. Therefore, the issue of waiver depends on the test that the particular jurisdiction uses in determining who constitutes the client: control group, subject matter, or Upjohn. For example, if a jurisdiction follows the control group test to determine who the client is for purposes of establishing attorney-client privilege, then a disclosure of the communication to anyone outside the company or to anyone in the company but outside of the control group will waive the privilege.

Establishing communications that are protected by attorney-client privilege requires the effort of both in-house counsel and company employees. Similarly, both in-house counsel and employees with access to privileged communications must know how to maintain the privilege once a communication is determined to be protected. Therefore, companies should educate in-house counsel, as well as those employees who regularly communicate with in-house counsel or regularly handle privileged communications, regarding what it takes to establish and maintain attorney-client privilege with respect to a communication.

* * * *

The Committee notes that examples of precautionary steps include a “Privileged/Confidential” legend on pertinent correspondence (including e-mail), noting that the communication is “legal advice,” taking care not to copy someone who is not entitled to the privilege, and maintaining copies of privileged correspondence in a separate file.

6. Antitrust Litigation.

The Antitrust Subcommittee’s report contains a summary of antitrust litigation.

Report of LTA Subcommittee

Alternative Minimum Tax, Tax Accounting and State and Local Tax Issues Affecting Agricultural Cooperatives

Chair: Brett V. Huston [email protected] KPMG LLP 400 Capitol Mall Suite 800 Sacramento, California

Vice Chairs: Wayne E. Sine [email protected] Southern States Cooperative, Inc. 6606 West Broad Street Richmond, VA 23230

David R. Simon [email protected]

The subcommittee wishes to report on the following issues of relevance to agricultural cooperatives. Those issues include:

Issue # 1: The State of Oregon and IRC Section 199 Issue # 2: The State of Oregon Minimum Tax Law for Agriculture Cooperatives

Issue # 1 The State of and Oregon IRC Section 199

The committee has been informed that the Oregon Department of Revenue is currently auditing cooperatives that have filed Oregon corporate tax returns and have claimed an IRC Section 199 Domestic Production Activity Deduction on their federal tax returns. The committee has learned that the Oregon Department is requiring the cooperative to include as an add back on its Oregon corporate tax return the IRC Section 199 deduction taken on the federal tax return even if the amount has been passed through to its members as allowed by IRC Section 199(d)(3)(A). Upon learning of the Oregon Department of Revenue’s position, a group of CPA’s, cooperatives and Oregon Agriculture Council of Cooperatives provided a memorandum to the department on why the Oregon law does not require the IRC Section 199 deduction to be added back on the Oregon corporate tax return if the IRC Section 199 amount has been passed through to its members. The group explained that a cooperative that passes through the deduction to its members, does not have a net deduction on its federal return due to the requirement under IRC Section 199(d)(3)(B)

to reduce the patronage dividend by the amount that has been passed through. Upon reviewing the memorandum, the Oregon Department of Revenue disagreed with the argument provided and indicated that, even though they understand that when the IRC Section 199 amount has been passed through to its members a net deduction has not been claimed on the federal tax return, Oregon law under Oregon Section 317.398 does not have a provision to exclude the pass-through amount from being added back on the Oregon tax return. Upon learning of the Oregon Department of Revenue’s decision, the group is now trying to work with the legislature to have a change made to the Oregon law retroactively. The Oregon Department of Revenue indicated they would not challenge this change.

The committee included this discussion in their report to make others aware that states may still be challenging the IRC Section 199 deduction and pass-through treatment on state tax returns. The committee notes that the IRC Section 199 deduction has been law since 2006; however, the Oregon Department of Revenue has just now raised the issue in 2011.

Issue # 2 New Oregon Minimum Tax Law for Agriculture Cooperatives

For years beginning after January 1, 2009 the state of Oregon increased the minimum tax for corporations and cooperatives based on the level of Oregon gross receipts corporations or cooperatives generated in the state. The new minimum tax is based on Oregon gross receipts with the minimum tax of $150 for Oregon gross receipts of less than $500,000 up to a maximum minimum tax of $100,000 if Oregon gross receipts are in excess of $100 million. This change increased minimum tax for agriculture cooperatives from the previous minimum tax of $10 to the potential new minimum tax of a $100,000. This increase would even apply if the agriculture cooperative had zero taxable income since the new minimum tax is now based on Oregon gross receipts. So a agriculture cooperative that had zero taxable income due to payment of patronage dividend to it members, but had sales of member product in the state of Oregon, would potentially have an increase of the minimum tax to $100,000. Upon learning of this increase in minimum tax to cooperatives, a group of CPA’s, attorney’s, cooperatives and the Oregon Council of Agriculture Cooperatives worked with Oregon legislature to get a bill passed that addressed specific cooperative provisions. The new law allows agriculture cooperatives to exclude from gross receipts the business done with or for its members. With the new law an agriculture cooperative that only generates gross receipts from business done for or with its members would only be subject to $150 minimum tax. This new law excluding business done with or for its members from gross receipts for agriculture cooperatives applies to years beginning after January 1, 2011.

2011 Report of the

NCFC Legal, Tax & Accounting Committee, Antitrust Subcommittee

The past year saw several important litigation developments for cooperatives. This report discusses developments in seven matters, but two are particularly noteworthy:

x In the Mushrooms litigation, the Third Circuit Court of Appeals held that the Capper-Volstead Act provides immunity from liability, but not immunity from suit.

x In the Potato Litigation, a district court held that Capper-Volstead does not protect pre-production supply management activities such as acreage reduction and production restrictions. The court also held that the availability of the Act’s protections for cooperatives with vertically integrated members will require a fact-intense inquiry that focuses on economics, the history of the commodity’s marketing, the actual functions of the cooperative, and the degree of integration of the participants.

1. In Re Mushroom Direct Purchaser Antitrust Litigation, No. 06-cv-00620 (E.D. Pa.) (Don Barnes)

The multidistrict Mushroom antitrust litigation is now in its fifth year. Originally filed in February 2006 on the heels of a government investigation and consent decree, the consolidated litigation includes seven class actions by direct purchasers and one individual customer action against the Eastern Mushroom Marketing Cooperative (“EMMC”) and thirty-seven (37) of its members and officers. The suit alleged violations of Sections 1 and 2 of the Sherman Act and Section 7 of the Clayton Act (15 U.S.C. §§ 1, 2, 18). The suit attacked the co-op’s minimum pricing program and its “supply control” program which involved the purchase and resale of out- of-production mushroom farms with deed restrictions prohibiting future mushroom production on the property.

The lawsuit raised a number of issues under the cooperative antitrust exemptions (§ 6 of the Clayton Act and the Capper-Volstead Act) including:

1. Inadvertent sign-up of a non-grower entity.

2. Membership of vertically-integrated grower entities.

3. The legality of supply control programs.

4. The applicability of the “50% Rule” to the non-member product handled by the cooperative and its members. 66

5. Individual grower immunity from suit as opposed to immunity from ultimate liability.

After ordering limited discovery on the co-op immunity issues, the parties filed cross- motions for summary judgment. NCFC filed an amicus brief in the district court supporting the cooperative’s position on the Capper-Volstead issues.

On March 26, 2009, the district court ruled against the cooperative on a very narrow issue and held that, because the wrong corporate entity (a non-grower) of an integrated family enterprise signed the membership agreement, the Capper-Volstead exemption was lost. A mother, father, and three adult sons owned equal shares in a distribution/processing company and a company that operated a mushroom farm. The father mistakenly signed the membership agreement in the name of the distribution company. The district court rejected the argument that this was a mere “technical, de minimis violation” and never specifically addressed the points raised in the NCFC amicus brief. In re Mushroom Direct Purchaser Antitrust Litigation, 621 F. Supp. 2d 274, 284 (E.D. Pa. 2009).

Because of the importance of the issue and the disregard for prior Supreme Court precedent, the growers filed an interlocutory appeal with the Third Circuit and moved to stay all further proceedings in the district court. The motion for a stay was granted and the appeal was initially allowed on April 17, 2010.

Once again, the NCFC filed an amicus curiae brief in the Third Circuit in defense of the Capper-Volstead exemption. The NCFC argued inter alia that:

1. The exemption is not lost due to a technical or inadvertent mistake in the membership rolls;

2. Integrated producers are protected by the Act;

3. Farmer-members of a co-op are entitled to a “good faith” defense, i.e., innocent members should not automatically lose the Act’s protections for the error or inadvertent mistake of their cooperative or another member.

On August 23, 2011, a panel of the Third Circuit issued its opinion dismissing the appeal for lack of jurisdiction because there was, as yet, no final judgment and the interlocutory appeal did not meet one of the requirements of Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541 (1949). The court held: “that an order [in a private civil antitrust case] denying a defendant the Capper-Volstead Act’s protections is not effectively unreviewable on appeal from final judgment and therefore does not satisfy the third requirement of the Cohen test.” Slip Op. at 16. But virtually in the same breath, in a footnote to that statement, the court stated: “There is no dispute that the question whether the arguably inadvertent inclusion of an ineligible member strips an agricultural cooperative of Capper-Volstead protection, is both serious and unsettled.” Slip Op. 16, fn. 4.

In reaching its conclusion that the appeal was too early, the Court did not rule on the merits of the underlying cooperative exemption issues. The Court gave a very narrow reading to certain legislative history and ignored other legislative pronouncements in drawing an artificial distinction between government “prosecutions” and private civil antitrust suits. Since, according to the Court, immunity from suit (as opposed to liability) applies only to antitrust actions brought by the government, an adverse interlocutory denial of the applicability of the Capper-Volstead exemption is immediately appealable only in a government “prosecution.” In contrast, growers must endure years of costly and potentially ruinous private antitrust litigation and await a “final judgment” before they can appeal an interlocutory, adverse Capper-Volstead ruling. But the ultimate immunity from liability (as opposed to suit) remains intact.

The cooperative and grower members filed a Petition for Panel Rehearing and in the Alternative for Rehearing by the Full Court on September 6, 2011. The petition was denied on September 22, 2011, without comment on the merits of the panel opinion.

2. In Re Processed Egg Products Antitrust Litigation, No. 2:08-md-02002 (E.D. Pa.) (Chris Ondeck and Michael Lindsay)

The eggs antitrust litigation began in September 2008. The case began when approximately 20 class action antitrust lawsuits, listing both direct and indirect purchasers as plaintiffs, were filed against companies engaged in producing eggs and processed egg products, as well as against an agricultural cooperative, United Egg Producers (“UEP”) and two related entities. These cases followed media reports regarding a Department of Justice investigation into the pricing and marketing of certain processed egg products. On December 2, 2008, the cases were consolidated into a single matter in the U.S. District Court in the Eastern District of Pennsylvania, titled In re Processed Egg Products Antitrust Litigation.

The complaints allege violations of Section 1 of Sherman Act; specifically, that defendant egg producers and alleged co-conspirators engaged in a continuing combination and conspiracy in unreasonable restraint of trade. The alleged anticompetitive conduct falls into two primary categories: (1) that UEP and its members engaged in pretextual animal husbandry guidelines; and (2) that UEP, its affiliates, and their respective members reduced supply by selective exportation of eggs at a loss in order to increase domestic egg prices.

On June 8, 2009, one of the egg producing defendants, Sparboe Farms, Inc. (“Sparboe”), settled with the direct purchaser plaintiffs in exchange for cooperation, but no monetary damages. Based on information provided by Sparboe, the direct purchaser plaintiffs filed a second amended class action complaint on December 14, 2009. Although the indirect purchaser plaintiffs did not settle with Sparboe, the Court ordered that they too be given access to the information provided by Sparboe, which enabled them to file their own second amended class action complaint on April 8, 2010.

In response, six defendants filed individual 12(b)(6) motions to dismiss the amended complaints. These motions were not based on the Capper-Volstead Act; rather, they argued that the Complaints did not contain sufficient allegations to be plausible as to the relevant defendants. Collectively, defendants also filed joint motions to dismiss portions of both amended complaints on statute of limitations grounds, and the indirect purchaser amended complaint for failure to 68

state legally sufficient claims under various state antitrust and unfair competition laws. Eight defendants answered the amended complaints.

On September 26, 2011, the Court issued its opinion setting forth its ruling on the six individual motions to dismiss. The Court denied the motions as to four of the defendants (Michael Foods Inc., Daybreak Foods Inc., Rose Acre Farms Inc., and Ohio Fresh Eggs LLC), and granted the motions as to two defendants, the Hillandale Farms entities and United Egg Association.

One of the primary issues involved in the Court’s opinion was the selection and application of the legal standard of review for a motion to dismiss. The Court referenced the old Conley v. Gibson decision, seen as more favorable to plaintiffs, as well as the more recent Bell Atlantic Corp. v Twombly decision in its treatment of the standard for review for Rule 12 motions. The opinion thus has significance based on where it falls in the ongoing course of cases since the Twombly decision by the Supreme Court.

Summarizing the Court’s denial of four of the individual motions to dismiss (Michael Foods, Daybreak Foods, Rose Acre Farms, and Ohio Fresh Eggs), the Court did not rule in favor of motions that sought to identify allegations in the Complaint (or lack thereof) with regard to those entities either specifically or generally, and then dispense with them under the Twombly standard. As to the two motions to dismiss the Court granted: (1) the Court stated that for the Hillandale entities, the plaintiffs listed three Hillandale entities, and that by lumping the three entities together, the plaintiffs failed to allege specific facts to connect any individual entity to the alleged conspiracy; and (2) regarding the United Egg Association, the Court found that the Complaint failed to allege any freestanding conduct by UEA (as opposed to United Egg Producers, another defendant in the case) that could suggest participation in the alleged conspiracy.

On November 30, 2011, the district court granted a motion to dismiss direct purchasers’ complaint on statute of limitations grounds to the extent that these plaintiffs sought damages for a period more than four years before they filed their complaint. The court granted leave for these plaintiffs to file an amended complaint (including leave to plead “fraudulent concealment” if they believed they had a good-faith basis for such pleading). Additional motions to dismiss are still pending with the Court, including joint motions to dismiss portions of both amended complaints on statute of limitations grounds, and the indirect purchaser amended complaint for failure to state legally sufficient claims under various state antitrust and unfair competition laws.

Several large commercial purchasers have opted out of the class proceedings and have filed separate actions.

3. In re Fresh and Process Potato Antitrust Litigation, No. 4:10-MD-2186-BLW (D. Idaho) (Michael Lindsay)

In June 2010 the first of several complaints was filed against United Potato Growers of America and several other parties. The suit arose when retail purchasers of potatoes brought suit claiming that the members of federated cooperative United Potato Growers of America illegally agreed to reduce the supply of potatoes through supply management in order to raise prices. The

plaintiffs claim that the growers limited planting acreage and paid farmers to either destroy existing stocks or refrain from growing additional potatoes. The plaintiffs further allege that the members of United Potato Growers of America include numerous vertically integrated growers who perform packing and processing functions, and that the vertically integrated growers do not qualify for Capper-Volstead protections. The litigation was consolidated for pretrial purposes in the District of Idaho.

On December 2, 2011, the district court denied the defense motion to dismiss.3 The court held that the United States District Court for the Capper-Volstead Act’s protections do not apply to pre-production supply control activities such as acreage reduction and production restrictions. The court reasoned that because the key phrase of the Act (processing, preparing for market, handling, and marketing) applies to post-production activity, “coordinating and reducing acreage for planting is not allowed.”

With regard to vertical integration, the court stated that the majority opinions in Case- Swayne Co. v. Sunkist Growers, Inc., 389 U.S. 384 (1967) and National Broiler Marketing Ass’n v. United States, 436 U.S. 816 (1978), “do not provide a clear indication whether such integrated agribusiness would be a disqualified participant in an association otherwise protected by Capper- Volstead.” He noted that the defendants urged the court to adopt the view presented by the dissent in National Broiler that a fully integrated farm operation is eligible for Capper-Volstead protection. The judge rejected that view, concluding that “adopting the [National Broiler] dissent’s expansive reading of the statute would read ‘the farmer’ requirement out of the statute, ignore congressional intent, and create the potential for abuse.” The court declined to offer a bright line rule on vertical integration, but instead said a “factually-intense inquiry is necessary – one which focuses on the economics and history of potato marketing, the actual functions of the associations, and the degree of integration of the participants.”

The court also ruled that Capper-Volstead protections apply to agreements between domestic and foreign cooperatives, as well as to cooperatives with foreign grower members. This ruling is consistent with the ruling in Northern Cranberries Inc., v. Ocean Spray, Inc., 382 F. Supp. 2d 221 (D. Mass. 2004), which held that the Capper-Volstead Act did not preclude membership of foreign producers.

4. United States v. Dean Foods Co., Case No. 10-CV-59 (E.D. Wis.) (Foremost Foods Acquisition) (Michael Lindsay)

On April 1, 2009, Dean Foods Company acquired two dairy processing plants (along with two consumer brands) from Foremost Farms USA. Foremost is a dairy cooperative owned by approximately 2,300 dairy farmers located in seven states. At the time, Foremost stated that the dairy industry had been “transformed through large waves of consolidations,” and that selling the two plants to Dean Foods was the best way of ensuring their long-term survival: “As food retailers consolidate to gain market share and operating efficiencies, Foremost Farms has been challenged to efficiently supply customers who have a significant regional or national presence

3 The court did dismiss claims against several defendants: United Potato Growers of Canada, United II (a cooperative made up of growers participating in a dehydration joint venture), and Dole Food Company, Inc. (and a Dole affiliate). 70

and prefer to have a sole supplier.... “[T]hese plants have a better chance for success by being part of Dean Foods, the largest processor and distributor of milk and other dairy products in the country.”4

On January 22, 2010 – eight months after the deal closed – the U.S. Department of Justice (along with the states of Illinois, Michigan, and Wisconsin) filed suit challenging the acquisition. The Complaint alleged anticompetitive effect in two markets: the market for the sale of school milk to individual school districts located throughout the State of Wisconsin and the Upper Peninsula of Michigan, and the market for the sale of fluid milk to purchasers located in Wisconsin, the UP, and northeastern Illinois.5 The complaint was filed in the Eastern District of Wisconsin.

On April 7, 2010, the court denied Dean’s motion to dismiss the complaint and its motion for a more definite statement. The parties agreed that the relevant product market was fluid milk, but Dean contested the adequacy of the Complaint’s allegations of a relevant geographic marker. Although the court described the Justice Department’s allegations as less than what one might expect from an experienced litigator, the court also rejected Dean’s “highly specific pleading standard.” The core of the ruling was this: “plaintiffs alleged that the presence of Foremost as an aggressive price competitor constrained defendant [Dean]’s ability to raise its prices. The Acquisition of Foremost by defendant [Dean] will obviously remove that constraint. Thus, the effect of the merger will be direct and immediate in the geographic area where the previous price constraint existed, but no longer does – i.e., areas where defendant [Dean] previously had to compete with Foremost, but no longer has to do so.”

On March 29, 2011, the U.S. Department of Justice announced a settlement of the case. Dean had acquired two plants (one in Waukesha, and one in DePere), and the settlement required Dean to divest the Waukesha plant, along with certain related assets. The divestiture included “all tangible assets that comprise the Waukesha Plant milk business and all intangible assets used in the development, production, servicing, and sale of fluid milk and other dairy products for the Waukesha Plant.” According to the Justice Departments memorandum supporting entry of final judgment, the divested assets “will give the buyer of the Waukesha Plant a distribution network, an established customer base, and a brand with strong equity — Golden Guernsey.” Moreover, the Waukesha plant would “enable the buyer to effectively compete for the business of the vast majority of the population in the relevant geographic market pleaded in the Complaint,” and the plant’s excess capacity would enable a buyer “to serve additional customers of all sizes in the relevant geographic market and will give the buyer of the Waukesha Plant the incentive to compete aggressively for new business.”6

Final judgment was entered on July 29, 2011. OpenGate Capital (which describes itself as “an international private equity firm,” with offices in Paris and Los Angeles) bought the assets. The acquisition was announced on August 15, 2011 and closed on September 12, 2011.

4 Foremost Farms Sells Milk Bottling Plants To Dean Foods, available at http://www.tradingmarkets.com/.site/news/Stock%20News/2255221/ (posted 02 Apr 2009 14:24:00 EDT) 5 United States v. Dean Foods Co., Order, Case No. 10-CV-59 (E.D. Wis. Apr. 7, 2010). 6 Motion And Memorandum of the United States in Support of Entry of the Proposed Final Judgment, United States v. Dean Foods Co., Order, Case No. 10-CV-59 (E.D. Wis. July 20, 2011). 71

5. Dairy Antitrust Litigation (Allen v. Dairy Farmers of America, Inc., No. 2:09-CV- 230 (D. VT.); In re Southeastern Milk Antitrust Litigation, No. 08-1000 (E.D. Tenn.) (MDL No. 1899); Andrews v. Dairy Farmers of America, Inc., No. 2:11cv97KS-NTP (S.D. Miss.) (Don Barnes)

At present, eleven (11) antitrust class action lawsuits are pending against Dairy Farmers of America, Inc. (“DFA”), Dean Foods Company (“Dean”) and various alleged co-conspirators in federal courts in Vermont and Tennessee.

a) The Vermont lawsuit, Allen et al. v. Dairy Farmers of America, Inc. et al., was filed on October 8, 2009. There, a class consisting of all dairy farmers (including DFA members) who produced Grade A milk in the Northeast (Order 1) and sold it through DFA’s affiliate, Dairy Marketing Services (“DMS”) from October 9, 2005 to present allege a conspiracy among DFA, Dean Foods, DMS and H.P. Hood which reduced the mailbox price to the dairy farmer members of the class. The producers are seeking damages, injunctive relief and divestiture of dairy plants for alleged violations of the Sherman Act § 1 and § 2 (conspiracy to monopolize and monopsonize attempt to monopolize and monopolization) and the Agricultural Fair Practices Act (coercion of dairy farmers to join DFA/DMS). An amended complaint was filed on January 21, 2010, followed by motions to dismiss filed by HP Hood, Dairy Farmers of America and Dairy Marketing Services, and Dean Foods on February 8, 2010. On August 30, 2010, the court issued an opinion granting in part and denying in part the defendants’ motions to dismiss. Most significantly, the court granted Hood’s motion, which argued that the plaintiffs failed to state antitrust conspiracy claims against Hood and did not plead facts with the adequate specificity as outlined in Twombly. It also granted DFA’s and DMS’ motion seeking dismissal of the price fixing conspiracy claims against them holding that because DFA and DMS had such a unity of interest and acted as a single entity, they were legally incapable of conspiring with each other. All of the other claims were unaffected. The court, however, denied DFA’s motion to dismiss a price fixing claim on the basis of Capper Volstead immunity. DFA argued that the activities of the Greater New England Milk Marketing Agency (“GNEMMA”), an over-order pricing federation consisting of DFA and six other cooperatives, were exempt Capper-Volstead conduct. The court denied the motion as premature at this early pre-discovery stage in the litigation.

A Revised Consolidated Amended Class Action Complaint was filed November 12, 2010. On May 4, 2011, the court issued an opinion granting preliminary approval of a settlement agreement between the plaintiffs and defendant Dean. Pursuant to this agreement, all members of the settlement class, dairy farmers that produced raw Grade A milk in Order 1 from January 1, 2002 to the notice date, agreed to release their claims against Dean in exchange for a cash settlement of $30,000,000. Dean admitted no wrongdoing, and an earlier provision that would have required Dean to purchase certain quantities of milk from suppliers other than DFA or DMS was stripped out. In addition the court denied a motion to intervene from interveners in the state of Maine. The interveners argued the settlement class should include farmers that produce milk for Order 1 even if not located in Order 1, but the court reasoned it would be unduly burdensome to add additional parties at this late date. The court also denied additional motions to intervene by parties objecting to the injunctive portion of the settlement agreement, which, having been stripped from the final agreement, rendered the objections moot. The court subsequently on August 3, 2011, entered a final opinion granting approval in part and denying in part final approval of the Dean settlement. The court granted final approval of the settlement 72

agreement but reduced attorneys fees and denied plaintiff’s request for an award of accrued interest. Pursuant to the final approved settlement agreement, the court dismissed the claims against Dean on August 15, except with respect to four individuals within the settlement class that requested to be excluded.

b) In addition, nine previously filed antitrust lawsuits have all been consolidated under the caption: In re Southeastern Milk Antitrust Litigation, No. 08- 1000 (E.D. Tenn.) in the Eastern District of Tennessee. In July of 2007, two antitrust class action lawsuits were filed against Dean Foods, Dairy Farmers of America, National Dairy Holdings, and others in federal court in Tennessee. Shortly thereafter, five additional “tag along” dairy farmer class actions were filed along with two direct purchaser suits, including one by the Food Lion supermarket chain. More recently, in June of 2009 yet another class action antitrust lawsuit was filed on behalf of “indirect purchasers” (i.e., milk consumers) residing in thirteen (13) states. This lawsuit seeks injunctive relief and damages for the alleged overcharges paid by the indirect purchasers as a result of the alleged antitrust violations. All of the cases have been consolidated before Judge Ronnie Greer in the Greeneville Division, Eastern District of Tennessee. In a consolidated amended complaint the Dairy Farmer Classes alleged that the Defendants conspired and refused to compete for raw Grade A milk, thereby causing reduced pay prices to members of the Class. In addition, a sub-class of DFA members had additional claims for “breach of contract,” i.e., the duty of DFA management to use corporate resources for the benefit of the members. Various preliminary motions to dismiss the complaint pursuant to Rule 12(b)(6) have been denied, including one motion based upon alleged Capper-Volstead Act immunity. On July 29, 2008 the court entered an Order directing the parties to participate in a mediation effort. The mediation was not successful and discovery in the litigation has continued. Class certification motions were filed and on September 7, 2010 the court entered an order certifying two classes of dairy farmers. One class includes independent dairy farmers and independent cooperative members who produced Grade A milk within Orders 5 and 7 during the period from January 1, 2001 to the present. The other includes all DFA members fitting the same description. The court also declined to certify another sub-class of DFA members who sought to pursue breach of contract claims against the cooperative. All of the class certification briefs, including virtually everything else filed to date in the case, remain under seal. On September 18, 2009, defendants DFA, DMS, Dean Foods, National Dairy Holdings (“NDH”), and Southern Marketing Agency (“SMA”), filed motions for summary judgment in the Food Lion direct purchaser action. On August 4, 2010, the court ruled on those motions, granting them in part, and denying them in part. The court refused to dismiss Counts I and V—which remain in the case—and which alleged, respectively, that:

(1) Dean, DFA, and NDH entered into a horizontal agreement to lessen competition for sales of processed milk to retailers in the Southeast and not to compete for such sales in violation of § 1 of the Sherman Act; and (2) conspired to monopolize the market for processed milk in violation of § 2 of the Sherman Act. The court dismissed Counts II, III, and IV, which alleged, respectively, that: (1) Dean, DFA, NDH, SMA, and DMS entered into exclusive supply agreements for raw milk which the plaintiffs argued constituted a conspiracy to unreasonably restrain trade in violation of § 1 of the Sherman Act and § 3 of the Clayton Act; (2) Dean possesses monopoly power in the market for processed milk and has willfully and unlawfully used exclusionary and predatory conduct to obtain and/or illegally maintain that power in violation of § 2 of the Sherman Act; and (3) Dean has the specific intent to achieve monopoly 73

power in the market for processed milk and could likely achieve that goal, in violation of § 2 of the Sherman Act.

On July 24, 2010, defendants James Baird, Gerald Bos, DFA, DMS, Dean Foods Company, Gary Hanman, Mid-Am Capital, LLC, NDH, SMA filed motions for summary judgment in the suit by Sweetwater Valley Farms, including both a joint motion and several motions by individual defendants. For the joint motion, the court entered a May 12, 2011 order granting the motion to dismiss counts II, III & IV, which alleged: (II) attempt by the defendants to monopolize and monopsonize, (III) unlawful monopolization, and (IV) unlawful monopoly. The order denied summary judgment as to Count I, conspiracy to monopolize and monopsonize. With respect to Count V, the court granted in part and denied in part, dismissing the claim to per se violations of § 1 of the Sherman Act because the alleged conspiracy is in essence a vertical restraint and does not involve the category of “naked restraints” typically subject to the per se analysis. However, the court denies summary judgment with respect to Count V as to conspiracy under the rule of reason. In a July 27, 2011 memorandum opinion and order the court affirmed its earlier order on the joint motion and, additionally, granted or denied several individual motions for summary judgment. The order granted the motion for summary judgment of Gerald L. Bos, dismissing a claim to conspiracy because it could not be shown he actively and knowingly participated in such conspiracy. The order denied motions for summary judgments of James Baird, Gary Hanman, and SMA, rejecting various claimed individual defenses.

There have been two major settlement attempts. One is a settlement between Sweet Water Farms, et. al and the defendant Dean, which was preliminarily approved on July 14, 2011. Pursuant to such settlement Dean agreed to pay approximately $140,000,000 in exchange for a full release of claims from the class. However, on July 28, 2011, the court granted defendants’ motion to decertify the DFA subclass, finding a conflict of interest among class members in that DFA member dairy farmers benefited from the wrongdoing allegedly committed in the complaint. In light of this, the court on August 31, 2011 granted Dean’s motion to vacate the preliminary approval. Nevertheless, the court notes that it may still be possible to certify the DFA subclass for settlement purposes and proceed with settlement approval after all parties have had an opportunity to be heard and register further objections.

The other settlement, preliminarily approved on July 28, 2011, regards a proposed settlement between plaintiffs Sweetwater Valley Farms et. al and defendants SMA and James Baird according to the following terms: (1) settling defendants pay $5,000,000, (2) SMA agrees to annual audits by an independent auditor, (3) SMA will use best efforts to increase Class I utilization percentages by reducing milk supply commitments to manufacturing plants currently operating in Orders 5 and/or 7, (4) settling defendants agree to work through SMA’s member cooperatives to create an incentive program to run for a minimum of three years aimed at increasing milk production in the southeast, (5) SMA will agree to certain changes to its management structure aimed at increased transparency, (6) the parties will establish a dispute resolution committee, and (7) SMA will no longer be involved with Dairy Marketing Services, LLC.

(c) A lawsuit was filed in the Southern District of Mississippi on April 26, 2011, captioned Andrews v. Dairy Farmers of America, Inc. There, the plaintiffs represent a proposed class including all dairy farmers who produced Grade A milk within Federal Milk Order 7 and 74

were forced to join DFA and/or sold Grade A milk through SMA or DMS in Order 7 from October 9, 2005 to present. They allege that defendants DFA, Dean, NDH, SMA, DMS, Greg L. Engles, James Baird, Gary Hanman and others engaged in an illegal racketeering conspiracy to corner the market on milk processing and distribution, thereby maximizing the defendants’ profits at the expense of the plaintiffs. The plaintiffs are seeking money damages in an amount plaintiffs would have received for Sales of Grade A milk in the absence of the alleged violations together with compensatory, incidental, and consequential damages, injunctive relief proscribing further violations of the Sherman Act, nullification of full-supply agreements between Dean, NDH and DFA, enjoining further such full supply agreements, and ordering divestiture of defendants’ Grade A milk bottling plants to the extent necessary to restore competition. Alleged violations include: conspiracy to monopolize or monopsonize, attempt to monopolize and monopsonize, unlawful monopolization, and unlawful monopsony, each in violation of Section § 2 of the Sherman Act; unlawful conspiracy to foreclose competition and fix prices in violation of Section § 1 of the Sherman Act; violations of Civil Rico 18 U.S.C. § 1962(b) (“Rico”); common law fraud, and breach of contract. The Rico claim is that in addition to pursuing monopoly the defendants engaged in a pattern of acts intended to steal, convert and/or extort money out of farmers that had no choice but to buy into their alleged scheme for fear of being cut out of the milk market. The plaintiffs filed a Rico Case Statement on May 11, 2011, further elaborating on their Rico claims. The plaintiffs filed an amended complaint August 10, 2011, which, among other things, added a claim for compensatory, incidental, consequential and punitive damages for tortious interference. This litigation is in its preliminary stages and there has been no major substantive rulings to date.

6. Cheese Antitrust Litigation (In re: Dairy Farmers of America Inc. Cheese Antitrust Litigation, No. 1:09-cv03690 (N.D. Ill.) (Don Barnes, David Faith, Michael Lindsay)

In re: Dairy Farmers of America Inc. Cheese Antitrust Litigation is a multi-district consolidation of suits by multiple plaintiffs filed June 15, 2009 that allege various anti-trust and other violations by defendants including DFA, Keller’s Creamery LP, Keller’s Creamery LLC, Keller’s Creamery Management LLC, and the individuals Hanman, Box, Otis & Miller. As set out in a Corrected Consolidated Class Action Complaint filed April 9, 2010, one set of plaintiffs consists of persons who purchased CME III milk futures contracts, CME spot cheese contracts, cheese and milk influenced by the government minimum price formula, or wholesale cheese or raw milk. These plaintiffs allege that they suffered harm as a result of defendants’ alleged conspiracy to buy up available long positions in Class III milk futures contracts on the Chicago Mercantile Exchange, and to purchase cheese at inflated prices on the CME spot cheese market, all in order to inflate Class III milk prices and thereby profit from the inflated futures market created thereby. The plaintiffs requested damages, costs, interest and injunctive relief based on violations of Section § 1 & 2 of the Sherman Act, Section § 9 of the Commodities Exchange Act (the “CEA”), Rico, and unjust enrichment.

In a memorandum Opinion and Order dated February 4, 2011, the court granted a number of motions to dismiss as follows:

1) By Keller’s Creamery Company LLC and Keller’s Creamery management based on the fact such entities no longer exist and any recourse is against their successor, DFA.

2) By all defendants for claims to damages stemming from the purchases of products priced on the basis of the government minimum milk prices. The court cited the filed rate doctrine as precluding damage claims linked directly to rates set by the government. This dismissal does not affect claims based on prices indirectly influenced by products so priced.

3) By all defendants for dismissal of monopolization claims where the alleged injuries stemmed from inflated price of cheese since such plaintiffs were not in the relevant market and therefore lacked standing.

4) By the individual defendants to dismiss counts 2 and 3, which alleged monopolization and attempted monopolization. The plaintiffs failed to plead facts sufficient, with respect to individual defendants, to establish monopoly power and willful acquisition or maintenance of that power.

5) By all defendants to dismiss count 6, the Rico claim, due to plaintiffs failure to state facts sufficient to show the duration and repetition of allegedly criminal activity required to sustain such claim.

Motions to dismiss the remaining claims were denied. Except to the extent particular plaintiffs and defendants were dismissed as set forth above, remaining claims include: count 1 for contract, combination or conspiracy in constraint of trade in violation of Sherman Act § 1; Count 2 and 3 for monopolization and attempted monopolization in violation of Sherman Act § 2; count 4 for violations of the CEA, and count 5 for unjust enrichment.

Another set of plaintiffs in this case filed a Second Amended Class Action Complaint March 14, 2011. These plaintiffs consist of consumers that purchased dairy products for themselves and not for resale in a number of states allegedly affected by the defendants’ futures manipulation. Their allegations are quite similar to the other plaintiffs and they seek injunctive relief as well as compensatory, punitive, exemplary, statutory and full consideration damages pursuant to Sections § 1 & 2 of the Sherman Act, state consumer protection laws, and unjust enrichment. Several motions to dismiss have been filed, which the court has not ruled on. s

7. United States v. George’s Foods, LLC, Civil Action No. 5:11-cv-00043 (W.D. Va.) (Michael Lindsay)

For the second year in a row, the U.S. Department of Justice brought a post-closing challenge to the acquisition of an agricultural production facility – Dean Foods in 2010, and George’s in 2011. George’s Foods proposed to buy the Harrisonburg, Virginia chicken processing complex from Tyson Foods for $3.1 million.7 Because of the deal size, the parties were not required to notify the antitrust agencies under the HSR premerger notification rules, but the transaction was publicly announced on March 18, 2011. The Justice Department’s Antitrust Division then opened an investigation of the potential competitive effects of the proposed acquisition. On May 7, 2011, George’s closed the acquisition – while the investigation was still pending. Three days after the closing, DOJ filed a complaint challenging the acquisition. (The DOJ’s Competitive Impact Statement includes the interesting observation that “After notifying

7 Names of the multiple affiliated corporate entities are omitted for convenience. 76

the parties of the Antitrust Division’s concerns regarding the Transaction, the parties failed to provide the Division the information it requested to fully examine the Transaction.”)

The government’s theory was that the transaction reduced competition in a local market for the purchase of farmers’ services – “purchase of broiler grower services from chicken farmers in the Shenandoah Valley and nearby areas.”8 Both George’s and Tyson are chicken processors that produce, process, and distribute “broilers” (chickens raised for meat products). George’s and Tyson both use farmers to raise and care for chicks until they are ready for slaughter. The processor typically retains title to the birds throughout the process.

According to the complaint, processors rarely contract with growers who are located more than fifty to seventy-five miles from the processor’s feed mill and processing plant. Within the Shenandoah Valley “draw area” for the George’s and Tyson facilities, there was only one other processor (Pilgrim’s Pride), and the complaint alleged that growers in that area would not be able to defeat a small but significant, non-transitory price decrease9 by processors (e.g., by switching to processors outside the Shenandoah Valley region, switching to providing any other service, or ceasing to grow chickens). Interestingly, even after the transaction’s completion, George’s had only a 40% share of the Shenandoah Valley processing capacity.10

An interesting aspect of the case is that a relatively large number of growers evidently were prepared to state that they favored the transaction. We draw this inference from a statement in the government’s opposition to turning over reports of its interviews of growers. The government stated that “Defendants have already obtained 225 declarations from growers, more than four times the number of growers the United States has interviewed,” and 75 of these had been filed with the court (suggesting that they were favorable to the defense position. (The government’s memorandum indicated that it had conducted a total of 60 interviews.)

The parties reached a settlement in June 2011. The settlement requires George to “acquire and install certain assets and improvements for its Shenandoah Valley poultry processing facilities.” This is intended to “enhance George’s ability and financial incentive to operate the Harrisonburg facility acquired from Tyson at a greater scale than occurred pre-Transaction” and thus give “George’s . . . an increased demand for chickens and, consequently, an increased demand for grower services that will benefit growers in the Shenandoah Valley region.”

The settlement was approved on November 4, 2011.

8 Complaint ¶ 20, United States v. George’s Foods, LLC, Civil Action No. 5:11-cv-00043 (W.D. Va.). 9 More typically, antitrust cases refer to the ability of buyers or other customers to defeat a small but significant price increase, but the complaint here alleged buyer concentration, not seller concentration. 10 Competitive Impact Statement at 6.

8. Matthew Edwards, et al. v. National Milk Producers Federation, et al., Dkt. No. 3:11- cv-04766-JSW (N.D. Cal.)

In late September 2011, a class action lawsuit was filed at the behest of an animal rights group against the Cooperatives Working Together (CWT) program. CWT is a voluntary, producer-funded national program developed by the National Milk Producers Federation (NMPF) to strengthen and stabilize milk prices.

NMPF, Dairy Farmers of America, Inc., Land O’Lakes, Inc., Dairylea Cooperative, and Agri-Mark, Inc. are named in the suit, which was filed in the United States District Court for the Northern District of California. The plaintiffs allege that the CWT program caused increased prices for indirect purchasers of milk and that the defendants are not eligible for Capper-Volstead protections. The defendants have filed motions to dismiss on several grounds, including asserting that the court lacks subject matter jurisdiction because the Capper-Volstead Act vested the Secretary of Agriculture with exclusive and primary jurisdiction over the issues in dispute.

National Council of Farmer Cooperatives Legal, Tax and Accounting Committee

Report of the Committee on Securities January 2012

Todd R. Eskelsen, Chair

1. SEC Review of Capital Raising

The U.S. Securities Exchange Commission has recently undertaken a review of U.S. legal requirements for the raising of capital. The initiative was announced on April 6, 2011, by Mary L. Schapiro, Chairwoman of the SEC, in a 26-page response to a March 22, 2011 letter from Representative Darrell Issa (R. Calif.), House Oversight Committee Chairman. http://www.sec.gov/news/press/schapiro-issa- letter-040611.pdf In her letter, Chairwoman Schapiro disclosed that she has ordered SEC staff to undertake a review of all the rules that affect share issues by privately held companies to develop ideas for ways to reduce the regulatory burdens on small business capital formation. The review was undertaken in response to the limited number of U.S. IPOs in the last three years, the withdrawal by Goldman Sachs Group in January 2011 of the U.S. component of an offer of shares in Facebook, the cancelling of The Go Daddy Group, Inc. public offering and other perceived difficulties by companies in connection with raising capital in the United States. http://www.nytimes.com/2011/04/09/business/09sec.html.

On September 13, 2011, the SEC announced the formation of an Advisory Committee on Small and Emerging Companies to focus on the interests and priorities of small businesses and smaller public companies. http://www.sec.gov/news/press/2011/2011-182.htm. The Advisory Committee is to advise and consult with the SEC on such issues as capital raising through private placements and public securities offerings, trading in the securities of small and emerging and small publicly traded companies and public reporting requirements of such companies. On January 6, 2012, the Advisory Committee submitted the “first of what will be an ongoing series of recommendations to be provided by the Advisory Committee in fulfillment of its mandate” (quoting from the letter from the Advisory Committee to Chairman Shapiro). The recommendation was limited and will not likely impact cooperatives significantly -- that “the Commission take immediate action to relax or modify the restrictions on general solicitation and general advertising to permit general solicitation and general advertising in private offerings of securities under [Regulation D] Rule 506 where securities are sold only to accredited investors.” The Advisory Committee will also hold a public hearing at SEC headquarters in Washington, DC at 10:00 a.m. on Wednesday, February 1, 2012. Further details can be found at http://www.sec.gov/rules/other/2012/33-9293.pdf. The agenda indicates that the discussion will be a general “consideration of recommendations and other matters relating to the rules and regulations affecting small and emerging companies under the federal securities laws.

A. On September 15, 2011, Meredith B. Cross, Director of the SEC’s Division of Corporation Finance, testified on Crowdfunding and Capital Formation before the Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the House Committee on Oversight and Government Reform. http://www.sec.gov/news/testimony/2011/ts091511mbc.htm. and on September 21, 2011, Ms. Cross testified on Legislative Proposals to Facilitate Small Business Capital Formation and Job Creation before the House Subcommittee on Capital Markets and Government Sponsored Enterprises. http://www.sec.gov/news/testimony/2011/ts092111mbc-ln.htm. Ms. Cross 79

repeated much of that testimony before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, at a hearing on December 1, 2011.

2. SEC No-Action Letter – National Consumer Cooperative Bank, January 3, 2011 (incoming letter from Goodwin Procter, dated December 14, 2010).

The SEC Division of Corporation Finance Staff stated it would not recommend enforcement action in reliance on the opinion of counsel that Class C stock of the National Consumer Cooperative Bank (NCB) was not a “security” if NCB offers and sells Class C Stock without compliance with registration requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934 and stopped filing periodic and current reports under the 1934 Act. In the PLR, the Staff noted that:

(a) NCB is a Congressionally-chartered, member-owned cooperative to provide financial and technical assistance to its members;

(b) NCB will issue the Class C stock only as part of its patronage refund and for no other purpose;

(d) Only holders of Class C are and will be cooperative borrowers, organizations eligible to borrow or organizations controlled by such borrowers;

(e) Class C stock can only be transferred to another borrower, eligible borrower or organization controlled by such borrower, and then only with the approval of NCB;

(f) Class C stock can be transferred only for an amount equal to its par value, thereby precluding a profit on its sale;

(g) NCB is subject to an alternative regulatory scheme; and

(h) NCB provides information to its shareholders through means other than 1934 Act reporting and will continue to do so.

Prior to 1986, the Class C stock had not been registered in reliance on a 1982 SEC no-action letter that noted that the Class C stock was not a “security” (for reasons similar to those cited above and because the Class C Stock was not entitled to receive dividends). In 1986, NCB filed a registration statement under the 1933 Act for Class C (and became subject to 1934 Act reporting requirements) stock because of the perception that “being subject to SEC regulation would be favorably viewed by NCB’s actual and potential sources of debt financing . . “ Disappointed with the lack of interest, NCB ceased registering Class C stock in 1994 and only used Class C stock as part of the annual patronage refund. Less than 200 current holders of Class C stock hold stock that was issued during the period when the stock was registered and there are only 498 holders total.

Class C stock is currently issued only to patrons who hold more than 12.5% of the outstanding balance of its aggregate loan amount with NCB in Class B shares and then Class C shares are issued in lieu of additional Class B shares to such holders. Such holders are long-term customers who have multiple loans with NCB. Thus, the holdings of Class C shares are generally indirectly related to patronage.

Class C shares may pay cash dividends, but such dividends are subject to two enumerated limits: (1) dividend may not be greater than the interest rate on Class A notes (held by the U.S. Treasury as the remaining part of the initial $184 million funding of NCB by Congress being paid off through 2020); and (2) dividend is not required and is only paid upon declaration by the Board (which did pay annual dividends averaging $1.30/share until 2007, but did not declare any dividends in 2008 or 2009 and has no plans to pay dividends for 2010 or in the foreseeable future).

Counsel argued that the Class C stock was not a security under the five-part test of Howey (no dividends, non-negotiable, no right to pledge, not voting in proportion to number of securities owned, and no ability to appreciate) and the Forman test (didn’t involve “an investment of money in a common enterprise with profits to come solely from the efforts of others”). The only difference between the current Class C stock and the prior Class C stock on which the 1982 no-action letter was issued was the eligibility for dividends. However, because the “dividends are closely tied to patronage refunds and cooperative principles,” counsel argued that the dividends were actually “best characterized as a deferred patronage refund,” citing the Associated Grocers Co-op Inc. (June 8, 1984) and Affiliated of Florida (August 25, 1987) no-action letters. Counsel also noted that the vast majority of purchased Class C stock (which is less than 10% of the entire outstanding Class C stock) was purchased before the stock was eligible for dividends and that most of such purchasers were borrowers or customers of NCB at the time and thus their primary motivation in purchase Class C stock was “other than the possibility of earning a share of NCB’s profits through a dividend.” Thus, Class C stock is not an investment instrument.

As to the removal of the 1934 Act reporting requirements, counsel noted that the purposes of Exchange Act Section 15(d) (to provide investors and the public with current information on companies issuing securities to assure a stream of current information about an issues) were not furthered by continued reporting by NCB for the following reasons: First, there is no market for Class C stock (and only 12 known transfers, with all being done at par value of $100 per share). Second, six years have now passed since NCB issued any registered security. Third, NCB is subject to OTS, FCA and GAO oversight, in addition to its annual report to Congress. Fourth, because of NCB’s 100% ownership of NCB, FSB, a federal savings bank (which represents 80% of NCB’s consolidated assets), NCB provides information to its shareholders and the public through Bank Act-required public annual meetings, open Board meetings, publicly-available quarterly Thrift Financial Reports filed by NCB, FSB, and annual reports made available on NCB’s website. Such disclosure was evidently sufficient for SEC Staff, which allowed FSB to cease periodic reporting.

3. 2011 Assembly Bill 228 in the Wisconsin Legislature – An act to repeal and recreate 551.201(8) of the statutes relating to exemptions from securities registration requirements.

The existing Wisconsin statute exempts “A member’s or owner’s interest in, or a retention certificate or like security given in lieu of a cash patronage dividend issued by, a cooperative organized and operated as a nonprofit membership cooperative under the cooperatives laws of a state, but not a member’s or owner’s interest, retention certificate, or like security sold to persons other than bona fide members of the cooperative.” Bill 228 proposes to replace such language with “Any securities of a cooperative corporation organized under ch. 185 or an unincorporated cooperative association organized under ch. 193.” The analysis by the Wisconsin Legislative Reference Bureau and the Fiscal Estimate notes that the proposed language of the bill is “similar to the language applicable prior to the 2007 recodification of the WUSL” (Wisconsin Uniform Securities Law) that was passed in 2008.

The bill has been passed by the Assembly 96-0 and approved by the Senate Committee on Financial Institutions and Rural Issues and is set to be considered by the whole Senate in the current session in January 2012. The Cooperative Network Association, Wisconsin Credit Union League, Wisconsin

Farmers Union and Wisconsin State Telecommunications Association have all reported lobbying on the bill, with the first three being in favor and the fourth taking no position.

4. Overview of Trading Services

The Committee is also monitoring issues arising in connection with trading services for buying and selling membership interests in cooperatives (both corporate and LLCs). Such services currently exist and seem to be getting more prevalent, especially in the upper Midwest in connection with ethanol companies. For example, our research to-date has identified Alerus Securities Corporation as a prime mover in this space and their website (http://www.alerusagcoopstock.com/webagcoop.nsf/?Open) currently lists 31 agricultural companies for which Alerus will provide buyers and sellers with trading and clearing house services related to the “securities, from ethanol stock to sugar beet shares.”

In her letter to Rep. Issa (discussed above), SEC Chairwoman Schapiro stated that SEC “staff is currently monitoring the secondary trading activity on a variety of online trading platforms, many of which are facilitating the trading of securities of private companies.” She also stated that benefits from such trading have to be balanced with investor protection, especially regarding availability of information on the issuers. Thus, the SEC is clearly aware of such trading platforms and there may be future regulatory activity.

NATIONAL COUNCIL OF FARMER COOPERATIVES

Report of the Standing Subcommittee On Environmental Laws and Regulations for 2011

Legal, Tax and Accounting Committee

Vice Chairman: Chairman: Daniel S. Hall B. Andrew Brown Growmark DORSEY & WHITNEY LLP 1701 Towanda Avenue 50 South Sixth Street, Suite 1500 Bloomington, IL 61701 Minneapolis, MN 55402 [email protected] [email protected] Tel: 309-557-6294 Tel: 612-340-5612

National Council of Farmer Cooperatives 2011 Update on Environmental Laws

BIOTECHNOLOGY...... 84

1. Alfalfa ...... 84 2. Sugar Beets ...... 86 3. Eucalyptus ...... 87

CLIMATE CHANGE ...... 88

1. EPA Regulation ...... 88 2. 2011 Changes ...... 89 3. Nuisance Cases ...... 90

ETHANOL AND BIOFUELS ...... 92

2012 FARM BILL ...... 92

SUPERFUND AND ANIMAL WASTE ...... 93

EPA NATIONAL ENFORCEMENT PRIORITIES ...... 93

Biotechnology

Complex litigation has continued regarding the deregulation decisions made by the United States Department of Agriculture (“USDA”)’s Animal and Plant Health Inspection Service (“APHIS”) regarding genetically engineered (“GE”) products, including GE alfalfa, sugar beets and eucalyptus. Under the Plant Protection Act, GE products are considered “potential plant pests” and “regulated articles” (requiring notifications or permits from APHIS) until they are deregulated by APHIS. 7 C.F.R. Part 340.

1. Alfalfa

In 2007, the District Court for the Northern District of California held that APHIS’ environmental assessment, prepared in connection with the petition for deregulation of Roundup Ready (“RR”) alfalfa, was inadequate because it failed to explain why the possibility of cross- pollination of conventional and organic alfalfa with RR alfalfa was not a potential “significant harmful impact” on the environment. Geertson Seed Farms v. Johanns, No. 06-01075, WL 518624 (N.D. Cal. Feb. 13, 2007). The Court ordered APHIS to prepare a full Environmental Impact Statement (“EIS”). The decision to require an EIS was not challenged on appeal, but APHIS, Monsanto (who owns the intellectual property rights to RR alfalfa), Forage Genetics (the

exclusive developer of RR alfalfa) and three alfalfa growers appealed the court’s order, which prohibited the commercial use of RR alfalfa until the EIS was prepared. The appellants argued that the injunction was too broad, the court had effectively exempted the National Environmental Policy Act (“NEPA”) plaintiffs from showing irreparable harm to obtain the injunctive relief (only requiring the “possibility” of harm), and that the injunctive relief had been granted without an evidentiary hearing although there were genuinely disputed issues of fact and an evidentiary hearing had been requested.

On June 24, 2009, the Ninth Circuit Court of Appeals affirmed the district court decision. The appellants petitioned the Supreme Court to hear the case, and certiorari was granted on January 15, 2010. Oral arguments were held on April 27, 2010. On June 21, 2010, the United States Supreme Court issued its decision. Monsanto v. Geertson Seed Farms, 130 S.Ct. 2743 (2010). The Court affirmed that the four-factor injunction standard applies in NEPA litigation and held that the district court abused its discretion in enjoining APHIS from effecting a partial deregulation and in prohibiting the planting of GE alfalfa pending the agency’s completion of a final EIS. The Supreme Court rejected a nationwide ban on GE alfalfa and found that USDA has authority to set the terms under which the crop can be grown while full environmental review takes place.

On December 23, 2010, USDA published the final EIS for RR alfalfa. In the final EIS, USDA considered three alternatives: (1) to maintain RR alfalfa’s status as a regulated article; (2) to deregulate RR alfalfa; or (3) to deregulate RR alfalfa with geographic restrictions and isolation distances for the production of RR alfalfa. USDA News Release, USDA Announces Final EIS for GE Alfalfa (Dec. 16, 2010). After considering comments from the public, USDA published its final decision to deregulate RR alfalfa (following alternative 2) on January 27, 2011.

The decision to deregulate RR alfalfa means that APHIS no longer holds “any regulatory control” over the planting and distribution of RR alfalfa. In the January 27 record, USDA determined not only that RR alfalfa does not pose a greater plant pest risk than other conventional alfalfa varieties, but also that “there is no evidence of plant pest risk” associated with RR alfalfa. Record of Decision: Glyphosate —Tolerant Alfalfa Events J101 and J163: Request for Nonregulated Status. This means that farmers can freely move and plant RR alfalfa seed without further oversight from APHIS. APHIS Factsheet, Questions and Answers: Roundup Ready Alfalfa Deregulation (January 2011). However, farmers planting RR alfalfa will still be subject to contract restrictions imposed by Monsanto’s technology use agreement, and farmers raising RR alfalfa will still be required by Forage Genetics’ license agreement to follow certain Best Practices.

The Center for Food Safety (“CFS”) and several other plaintiffs commenced an action on March 18, 2011 in the U.S. District Court for Northern District of California requesting the reversal of USDA’s deregulation decision. Plaintiffs claim APHIS violated the Endangered Species Act by failing to formally consult with the U.S. Fish & Wildlife Service regarding the impact of the deregulation of RR alfalfa on threatened and endangered species. They also claim the EIS was not adequate because, among other things, it failed to adequately assess the impacts associated with the increased use of glyphosate (the herbicide used with RR alfalfa) that was likely to result from the deregulation decision. Oral arguments on the cross motions for

summary judgment made by the parties were heard on December 9, 2011, and a decision is pending.

2. Sugar Beets On August 13, 2010, the District Court for the Northern District of California became the first district court to apply the recent alfalfa Supreme Court decision. In Center for Food Safety v. Vilsack, 734 F. Supp. 2d 948 (N.D. Cal. Aug. 13, 2010), the court analyzed another APHIS decision to deregulate a GE crop: sugar beets. In November 2003, Monsanto Company submitted to APHIS a petition for deregulation of RR sugar beets. APHIS prepared a draft Environmental Assessment (“EA”) and solicited public comments. APHIS then determined that the introduction of RR sugar beets would not have any significant adverse impact on the environment and, in 2005, granted the deregulation petition without preparing an EIS.

In January 2008, plaintiffs filed suit challenging APHIS’ deregulation determination, claiming that the EA was inadequate and that the deregulation decision violated the Plant Protection Act (“PPA”) and Administrative Procedure Act. Plaintiffs sought to vacate APHIS’ deregulation decision and to permanently enjoin the deregulation of RR sugar beets until APHIS completed an EIS.

On August 13, 2010, the district court partially granted plaintiffs’ request for vacatur and denied their motion for a permanent injunction. The vacatur was limited to only those plantings after the date of the order. This meant any RR sugar beet root and seed crops already planted were permitted to remain in the ground, and to be harvested and processed into sugar without restriction. The district court declined to issue any form of permanent injunctive relief, finding that the extraordinary relief of an injunction is not warranted if a less drastic remedy, such as a vacatur of APHIS’ deregulation decision, is sufficient to redress plaintiff’s injury. The court held plaintiffs had not established that the remedy of vacatur would be insufficient to remedy their injury, so a partial vacatur was appropriate. Plaintiffs have appealed. APHIS anticipates that the final EIS will be published by the end of May 2012.

Although the district court’s ruling returned RR sugar beets to regulated status, it did not preclude APHIS from taking interim action pending completion of the EIS. In a news release issued on September 1, 2010, APHIS indicated that it had received applications for permits to authorize “steckling” (i.e., seedlings) production, as well as a request for partial deregulation of RR sugar beets. APHIS also stated its intent to exercise its authority to take interim action consistent with the court’s decision and statutory requirements. On September 3, 2010, APHIS began issuing permits for the limited release of RR sugar beets as a regulated article pursuant to its regulatory authority. Soon after this decision, plaintiffs filed suit challenging four of the issued steckling permits. On November 30, 2010, the District Court for the Northern District of California issued an injunction that ordered the destruction of approximately 250 acres of planted GE sugar beet stecklings intended to produce seeds for the 2012 crop. After initially staying the injunction, the Ninth Circuit Court of Appeals overturned it on February 25, 2011, holding that plaintiffs failed to show that the stecklings “present a possibility, much less a likelihood, of genetic contamination or other irreparable harm.” The court also indicated that it would address plaintiffs’ appeal regarding the August 13, 2010 order vacating the deregulation of RR sugar beets in a later, separate decision.

On February 4, 2011, APHIS issued a decision which partially deregulated RR sugar beets, provided that the root crops were grown under mandatory conditions and under compliance agreements. The decision included a final EA and Finding of No Significant Impact (“FONSI”) regarding RR sugar beets. This partial deregulation is an interim measure until APHIS is able to complete a full EIS for RR sugar beets by May 2012. Under the partial deregulation, RR sugar beet growers are required to enter into a compliance agreement with APHIS that outlines mandatory conditions for how the crop can be grown.

On February 7, 2011, representatives of the sugar beet industry, who were defendants in the first two cases, filed a lawsuit in the District of Columbia as plaintiffs. Grant v. Vilsack, 1:11-cv-00308-JDB ((February 7, 2011). The suit challenges some of the conditions imposed by APHIS’ partial deregulation decision, such as planting distances, and also asks for a declaratory judgment affirming APHIS’ February 4 partial deregulation, EA, and FONSI. On February 23, 2011, the Center for Food Safety filed a motion in the District of Northern California, challenging APHIS’ February 4 partial deregulation, EA, and FONSI. On March 17, 2011, the court granted the sugar beet defendants’ motion to transfer venue to the District of Columbia to be heard along with Grant v. Vilsack. Center for Food Safety v. Vilsack, 3:11-cv-00831-JSW (March 17, 2011). Briefs for the case are due January 6, 2012. Mateusz Perkowski, Judge sets date for biotech arguments, capitalpress.com (Aug. 25, 2011).

3. Eucalyptus On October 6, 2011, a coalition of environmental groups lost a Florida court case regarding field trials of GE eucalyptus trees. The case pitted APHIS, ArborGen (the trees’ developer), and the Biotechnology Industry Organization (“BIO”) against many environmental groups, including the Center for Biological Diversity, the Center for Food Safety, the Dogwood Alliance, the Global Justice Ecology Project, the International Center for Technology Assessment, and the Sierra Club. According to these groups, APHIS did not adequately prepare an environmental review before issuing permits allowing ArborGen’s field trials of GE eucalyptus trees to proceed.

The permits in question authorized ArborGen to plant their GE strain of freeze-tolerant eucalyptus trees on 28 sites in seven southeastern states. The trees are designed to be used primarily as timber. Before granting the permits, APHIS prepared an EA and opened it to public comment, then issued a FONSI and determined that an EIS was not necessary. The environmental groups oppose testing the trees because they fear the GE eucalyptus could become an invasive species, harming other native wildlife and plants. On July 1, 2010, the environmental groups filed a case in the U.S. District Court for the Southern District of Florida, alleging that APHIS did not comply with NEPA in issuing the permits for field trials of GE eucalyptus trees. After full briefing by the parties, the Court denied plaintiffs’ motion for summary judgment and instead granted APHIS, ArborGen, and BIO’s motion for summary judgment on October 6, 2011.

Climate Change

1. EPA Regulation

Although major climate change legislation appears unlikely in the near future, the Environmental Protection Agency (“EPA”) is proceeding to promulgate regulations to cover Greenhouse Gas (“GHG”) emissions under the Clean Air Act (“CAA”). In 2007, the United States Supreme Court decided the landmark decision Massachusetts v. EPA, 549 U.S. 497 (2007), where the Court held that GHGs are “air pollutants” for purposes of the CAA and that EPA has authority to regulate GHG emissions.

The New Source Review (“NSR”) program of the CAA applies to major stationary sources and major modifications of stationary sources. Under NSR, a major source must install control technology for each pollutant “subject to regulation” under the CAA. See CAA § 165(a). A “major source” is defined as any source with potential emissions greater than 250 tons per year of any pollutant subject to regulation under the CAA, or, if the source is in certain listed source categories, 100 tons per year. Prevention of Significant Deterioration (“PSD”) provisions of the CAA require existing, new and modified stationary sources to control air pollution emissions and obtain permits for those emissions. For the traditional pollutants regulated by the CAA, this effectively limits the NSR permitting requirements to fairly large stationary sources. However, for GHGs, these thresholds are extremely low. EPA estimated that if the current 100 and 250 ton thresholds were applied to GHG emissions, tens of thousands of small sources would be brought into NSR permitting each year. As a result, EPA issued the GHG “Tailoring Rule” on June 3, 2010, limiting NSR and PSD requirements to the largest emission sources, including existing, new or modified industrial facilities that have emissions over 25,000 tons per year. 75 Fed. Reg. 31,514. Under the Tailoring Rule, PSD provisions began applying to GHG emissions on January 2, 2011. These provisions require new and modified sources to control emissions using best available control technology (“BACT”), determined individually for each facility. The BACT requirements apply to new sources with emissions above 100,000 tons per year of carbon dioxide-equivalent (“CO2e”) and modified sources with emissions above 75,000 tons of CO2e. 75 Fed. Reg. 31,514. Existing sources are subject to new PSD permit requirements for GHGs. This includes the nation’s largest GHG emitters, such as power plants, refineries and cement production facilities.

On November 10, 2010, EPA announced guidelines for state regulators to reduce GHG emissions under the CAA. The guidelines give states considerable discretion in regulating CO2e emissions from large industrial facilities. They require states to develop and implement plans for controlling carbon emissions, but allow states to determine on a case-by-case basis the BACT that industrial facilities can use. EPA’s November 10th guidance does not define BACT, but does say that EPA anticipates that the most cost effective way for industry to reduce GHG emissions will generally be through energy efficiency. Id. EPA advises states to use the same five-step process to determine BACT as is currently used for traditional air pollutants. Under this process, agencies first identify all available control technologies. Second, they eliminate technically infeasible options. Third, they evaluate and rank remaining control technologies

based on their effectiveness of controlling emissions. Fourth, they evaluate the cost- effectiveness of the controls and other environmental impacts. Fifth, they select BACT. Id.

On December 30, 2010, the Texas Attorney General filed suit in the U.S. Court of Appeals for the District of Columbia Circuit asking for an emergency stay, pending a full court review, of EPA’s guidelines to the states regarding GHG emissions from new and modified sources. Texas v. EPA, D.C. Cir., No. 10-1425; Steven Cook, Texas Files Challenge to Rule Allowing EPA to Take over GHG Permitting in State, BNA (Dec. 30, 2010). Almost immediately, the D.C. Circuit ordered the emergency stay. Texas refused to implement GHG emissions permitting as all other states have done. On December 1, 2011, the U.S. Court of Appeals for the District of Columbia Circuit held that the lawsuit challenging EPA’s takeover of GHG permitting in Texas can proceed. One issue was whether another lawsuit, one that challenges EPA’s rule requiring states to modify their state implementation plans to include GHGs in the permitting, must be resolved first. In its order, the D.C. Circuit held that the lawsuit filed by Texas does not have to wait for separate cases challenging EPA’s underlying regulatory program for GHGs to be resolved. Andrew Childers, Lawsuits Challenging EPA’s Permit Takeover in Texas Can Proceed, Appellate Court Says, BNA 233 DEC A-2 (Dec. 5, 2011). The parties must submit their proposals for briefing the case by Jan. 27, 2012. Because of Texas’ refusal, the EPA has since took over GHG permitting authority in Texas. On November 10, 2011, EPA issued its first GHG permit which covers a new 590-megawatt combined cycle natural gas-fired unit.

2. 2011 Changes

EPA has issued regulatory actions under the CAA and in some cases other statutory authorities to address issues related to climate change. See http://epa.gov/climatechange/initiatives/index.html. In addition to earlier regulatory initiatives, such as the Tailoring Rule, EPA has recently done the following:

x On Dec. 23, 2010, EPA issued a proposed schedule for establishing GHG standards under the CAA for fossil fuel fired power plants and petroleum refineries. These two sectors generate approximately 40 percent of GHG emissions in the United States. EPA’s plan was in response to a lawsuit initiated by several states, local governments and environmental organizations who sued EPA over the agency’s failure to update the pollution standards for power plants and refineries. Plaintiffs sued after EPA issued revised new source performance standards (“NSPS”) for utilities in 2006 and refineries in 2008 without GHG emissions controls. As of December 2011, EPA is still negotiating with states and environmental groups on a new deadline to propose GHG emission limits on power plants. Originally, the deadline was July 26, 2011 which was extended to Sept. 30, 2011. The final power plant rule is due May 26, 2012. EPA sent a proposed power plant rule to the White House Office of Management and Budget for review on Nov. 7, 2011. x On Aug. 9, 2011, EPA and the Department of Transportation's National Highway Traffic Safety Administration (“NHTSA”) announced standards to reduce GHG emissions and improve the fuel efficiency of heavy-duty trucks and buses. 89

x On July 29, 2011, EPA and NHTSA announced plans to propose stringent federal GHG and fuel economy standards for model year 2017-2025 passenger cars and light-duty trucks. EPA and NHTSA published proposed rules on December 1 and are holding three public hearings in January 2012. The proposed rules set a CO2 emissions limit of 163 grams per mile by 2025, an average fuel economy of 56 mpg for passenger cars by 2025, and an average fuel economy of 40.3 mpg for light-duty trucks by 2025. x On December 21, 2011, EPA announced a final rule for mercury and air toxics standards for power plants. The rule sets national emissions standards for hazardous air pollutants from power plants and requires the use of maximum achievable control technology (“MACT”). MACT standards are the emissions levels achieved by the best-performing 12 percent of power plants. EPA has stated that utilities can receive an additional year beyond the standard three-year compliance period to install pollution controls.

Although EPA is moving forward to address climate change, Congress has not altogether agreed to EPA’s oversight. On December 16, 2011, the House of Representatives approved a $1.043 trillion, nine-bill omnibus package to fund the federal government for 2012 (passed by a vote of 296-121). On December 17th, the omnibus bill cleared the Senate. The bill includes a number of environmental riders, including provisions that place restrictions on environmental and energy regulations and prevents the White House from using funds to hire a presidential assistant for energy and climate change. Amena Saiyid, House Approves Omnibus Spending Bill with Environmental, Energy Policy Riders, BNA 243 DEN A-5 (Dec. 19, 2011). The bill also blocks EPA from regulating GHGs from livestock operations and from requiring GHG reporting from manure management systems. President Obama signed the omnibus bill into law on December 23, 2011.

3. Nuisance Cases There are notable legal decisions involving GHG claims against power companies, petroleum companies and car manufacturers. In each case, plaintiffs have claimed the defendants are contributing to a public nuisance due to their GHG emissions. The key issues in these cases have been standing and the political question doctrine. For standing, plaintiffs must show that (1) they have suffered an injury that is concrete and particularized, (2) the injury must be fairly traceable to the challenged action of the defendant, and (3) it must be likely, as opposed to merely speculative, that the injury will be redressed by a favorable decision. In these cases, one area of debate is whether plaintiffs’ alleged injuries can be fairly traced to the defendant’s individual GHG emissions, as opposed to society’s emissions as a whole. For the political question doctrine, these courts have examined whether there is constitutional or statutory authority committing the issue of climate change to Congress or the President so as to remove it from the purview of the courts and whether climate change falls into any of the traditionally recognized categories for nonjusticiable political questions.

After granting cert in December 2010, the U.S. Supreme Court decided American Electric Power Co., Inc. v. Connecticut, 131 S.Ct. 2527, on June 20, 2011. In its first climate change-related tort case, the Court held that the CAA and the EPA activity it authorizes displaces a common law nuisance action. In this case, a group of eight states, New York City, and three land trusts sued six power companies, seeking to abate the public nuisance of climate change.

Plaintiffs were seeking injunctive relief in the form of emission caps on stationary sources of GHG emitters. The Second Circuit found that the states had both parens patriae standing to sue on behalf of their quasi-sovereign interest in protecting citizens and proprietary standing to sue in regard to their property interests. The court also found that the action did not present nonjusticiable political questions. Connecticut v. American Electric Power Co., 582 F.3d 309 (2d Cir. 2009). Plaintiffs brought the action to force the utility companies to cap and then reduce their CO2 emissions. The appellate court’s ruling allowed states to sue utility companies based on charges that their GHG emissions are a public nuisance.

In its June 20th decision, the Supreme Court dealt with two main issues: displacement and standing. On displacement, the Supreme Court held that the CAA and the EPA actions it authorizes categorically displace any federal common law right to seek abatement of CO2 emissions from coal-fired power plants. The Court held that Supreme Court precedents clearly hold that the relevant question for purposes of displacement is “whether the field has been occupied, not whether it has been occupied in a particular manner.” 131 S.Ct. at 2538. It is irrelevant whether the CAA permits emissions until EPA acts. “The critical point is that Congress delegated to EPA the decision whether and how to regulate CO2 emissions from power plants; the delegation is what displaces federal common law.” Id. On standing, the Court was equally divided on whether plaintiffs had standing to bring their claims. 131 S.Ct. at 2535. This means the Second Circuit’s finding that plaintiffs did have standing is affirmed, although the ruling is not binding on other circuits.

In Comer v. Murphy Oil USA, plaintiffs are residents along the Mississippi coast and lost property due to Hurricane Katrina. 585 F.3d 855 (5th Cir. 2009); appeal dismissed by 607 F.3d 1049 (5th Cir. 2010). Plaintiffs sued oil companies for contributing to the cause of the hurricane via global warming. The Fifth Circuit found that the political question doctrine did not bar trial of the case as there was no constitutional or statutory authority committing the issues of global warming to Congress or the President so as to remove it from the purview of the courts. The court found that the individual plaintiffs had satisfied the threshold requirement for injury, redressability and traceability in order to have standing by claiming a causal chain between defendant’s GHG emission and the harm to plaintiffs. The Fifth Circuit opinion was vacated pending review en banc, which then did not occur due to a lack of a quorum, resulting in dismissal of the appeal to the 5th Circuit. Plaintiffs sought review by the Supreme Court, but the petition for writ of mandamus was denied. In re Comer, 131 S. Ct. 902 (2011). On May 27, 2011, plaintiffs refiled their climate change tort action in the U.S. District Court for the Southern District of Mississippi. Comer v. Murphy Oil USA, S.D. Miss., No. 11-220. This new action alleges public and private nuisance, trespass and negligence causes of action under Mississippi law.

There is also a notable district court decision regarding political questions and an upcoming appellate court decision that will impact future climate change cases. In Kivalina v. Exxonmobil Corp., an Inupiat Eskimo village brought suit against 24 oil, energy and utility companies seeking damages under a claim of nuisance for erosion and destruction of village land caused by global warming, forcing the village to move. 663 F. Supp. 2d 863 (N.D. Cal. 2009). The district court dismissed the claim on the basis that the issue of GHGs and global warming presents a “nonjusticiable political question.” The case is now before the Ninth Circuit Court of

Appeals which heard oral arguments on November 28, 2011 and should render a decision sometime in 2012. Plaintiffs in Kivalina argue their case is distinguishable from American Electric Power because AEP focused exclusively on injunctive relief and did not address claims for damages under federal common law.

Ethanol and Biofuels

The Energy Independence and Security Act (“EISA”)’s Renewable Fuel Standard (“RFS”) requires the country’s motor fuel supply to include 36 billion gallons of ethanol or other biofuels by 2022, including 15 billion gallons of conventional ethanol grown from corn. Pub. L. No. 110-140, §§ 201-202, 121 SStat. 1492, 1519-1524 (2007). The remaining 21 billion gallons must be “advanced biofuel,” which the statute defines as “renewable fuel other than ethanol derived from corn starch” that achieves a minimum GHG emissions reduction of 50 percent relative to gasoline. This category includes biofuels made from cellulose, hemi-cellulose, or lignin, as well as those made from sugar or other non-corn starches, crop residue, biodiesel, and biogas. For 2012, the law requires the use of 15.2 gallons of ethanol or other biofuels. Though it currently supports both forms of biofuel, the RFS is designed to phase out conventional corn ethanol and phase in advanced biofuel made from other crops.

The Farm Bill’s Volumetric Ethanol Excise Tax Credit (“VEETC”) currently provides a tax credit for blending ethanol with conventional gasoline at $0.45 per gallon of ethanol. I.R.C. §6426 (b)(2)(A) (2010). This subsidy is set to expire at the end of this year on December 31, 2011, and there are no indications that Congress intends to extend it. The loss of the tax credit is expected to increase gasoline prices for retailers and pump prices for consumers. Carol Donoghue, Refiners Warn Marketers of Imminent End of Ethanol Tax Break, http://www.nacsonline.com/NACS/News/Daily/Pages/ND120511_2.aspx (December 5, 2011).

Additionally, the Remove Incentives for Producing Ethanol Act of 2011 (“RIPE Act”) was introduced in the House of Representatives on January 25, 2011. The proposed bill repeals the EISA’s RFS, ends the VEETC and other tax credits for ethanol, and removes tariffs on foreign ethanol imports. H.R. 426, 112th Cong. (2011). The bill was referred to the Subcommittee on Energy and Power on February 9, 2011, and no further action has been taken at this time.

2012 Farm Bill

The United States’ Farm Bill is the primary agricultural and food policy tool of the federal government. Every five years or so, Congress passes a comprehensive omnibus Farm Bill addressing agricultural issues such as farm commodity programs, trade, rural development, farm credits and subsidies, conservation, agricultural research, and food and nutrition programs. The current Farm Bill, known as the Food, Conservation, and Energy Act of 2008, is set to expire in September 2012, and work has already begun on the new Farm Bill.

With attention in the federal government focused on budget cuts, a combined committee of the House and Senate Agriculture committees developed a bipartisan, bicameral Farm Bill proposal for the Joint Select Committee on Deficit Reduction (also known as the 92

supercommittee) that would save $23 billion. This proposal was drafted behind closed doors, and many of its details remain undisclosed. One of its primary goals was the elimination of so- called direct payment subsidies to farmers, which accounted for roughly $15 billion in cuts. The proposal replaced these programs with a new “shallow-loss protection” program that pays farmers only for planted acres when prices drop below certain thresholds.

However, the supercommittee’s failure to reach a deal on overall deficit reduction effectively ended this effort. The combined Agriculture committees will continue the process of reauthorizing the Farm Bill in the coming months, but will be starting from the beginning. According to some lobbyists, however, the “new starting point” for spending cuts to agricultural programs will be $23 billion. One of the largest changes on the horizon remains a likely replacement of the current direct payment program subsidies with “shallow-loss protection,” which acts as an insurance policy to cover commodity farmers against small drops in revenue.

Many interest groups, including many farmers and their representative organizations, view the supercommittee Farm Bill proposal’s failure as extremely positive. The proposal was drafted quickly, behind closed doors, and without opportunity for the public to comment on any of its provisions. These groups see the proposal’s failure as an opportunity to restructure the current federal agricultural system in a way that works better for both small farmers and large agricultural interests.

Superfund and Animal Waste

Title III of the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA” or “Superfund”) regulates hazardous substances. Under CERCLA, farms must report the quantity of hazardous substances released from animal waste if it meets or exceeds a reportable quantity set by EPA. In December 2008, EPA issued a final rule that exempted from CERCLA reporting requirements all farms that release hazardous substances to the air from animal waste, even if the they meet or exceed the reportable limits. Amena Saiyid, Senate Bill Would Exempt Manure from Regulation Under Superfund Law, BNA 205-DEN a-10 (Oct. 24, 2011). On October 18th, Senators Roy Blunt (R-Mo.) and Mike Crapo (R-Idaho) introduced legislation that would permanently exempt animal manure and poultry litter from EPA’s regulations of hazardous substances. Titled the “Superfund Commonsense Act of 2011,” the legislation would exempt livestock manure and associated wastewater and emissions from being regulated or held liable as a hazardous substance under CERCLA. The legislation is an attempt to “head off” reported efforts at EPA to remove the reporting exemption granted to farms in 2008. Id.

EPA National Enforcement Priorities

EPA sets national enforcement priorities every three years in order to focus the department’s resources on high priority environmental and human health problems. During the 2011 – 2013 fiscal years, EPA will focus on the following issues:

x Keeping raw sewage and contaminated stormwater out of the nation’s waters 93

x Preventing animal waste from contaminating surface and ground waters

x Cutting toxic air pollution that affects communities’ health

x Reducing widespread air pollution from the largest sources, especially the coal-fired utility, cement, glass, and acid sectors

x Reducing pollution from mineral processing operations

x Assuring energy extraction sector compliance with environmental laws

Additional information about each of these issues is available at EPA’s website, http://www.epa.gov/compliance/data/planning/initiatives/initiatives.html.

NCFC LTA COMMITTEE

DIGEST OF CURRENT COOPERATIVE TAX DEVELOPMENTS 1/1/2011 – 12/31/2011

George W. Benson McDermott Will & Emery LLP Chicago, Illinois

This digest outlines the significant cooperative tax developments since January 1, 2011. The focus of this annual digest is upon federal income taxes and upon issues of taxation that are peculiar to Subchapter T cooperatives. In addition, developments affecting the taxation of other kinds of cooperative or mutual organizations are included where those developments may have some interest to Subchapter T cooperatives. Also, some state tax developments of interest to cooperatives are included.

Index and Capsule Summary

Section 199 rulings

During the past year, a number of letter rulings were issued confirming that grain payments made by cooperatives to members and other participating patrons are per-unit retain allocations paid in money which may be disregarded (i.e., added back) in the cooperatives’ Section 199 computations. The rulings are listed below:

1. Ltr. 201105015 (October 13, 2010) (grain payments).

2. Ltr. 201115009 (January 10, 2011) (grain payments). In a year where a cooperative incurs a net operating loss without regard to its Section 199 deduction and the cooperative passes through its Section 199 deduction to patrons, Section 172(d)(7) does not apply to limit the cooperative’s net operating loss carryover.

3. Ltr. 201115010 (January 3, 2011) (grain payments).

4. Ltr. 201118009 (January 28, 2011) (grain payments).

5. Ltr. 201120008 (February 15, 2011) (grain payments).

6. Ltr. 201126012 (March 23, 2011) (grain payments).

7. Ltr. 201138002 (June 9, 2011) (grain payments).

8. Ltr. 201138029 (June 9, 2011) (unidentified crop payments). 95

None of the cooperatives making grain payments pooled. While there are a few nuances, with the one exception noted below, these rulings do not break any new ground.

9. Instructions to Form 8903 (Rev. December 2010).

In addition, the Internal Revenue Service released revised instructions to Form 8903 (Domestic Production Activities Deduction) taking the position that cooperatives should compute the Section 199 deduction on a two-company basis with separate computations for the patronage and nonpatronage portions of their business. This instruction has doubtful legal basis and was released without allowing cooperatives to comment. The NCFC questioned this instruction in a letter to the IRS. See item 16 below.

Many grain cooperatives have filed amended returns claiming an enhanced Section 199 deduction resulting from treating grain payments made to members in prior years as per-unit retain allocations paid in money. The IRS has issued a number of proposed notices of disallowance of these claims, and many cooperatives have protested. The cases have been coordinated, and a team of four Appeals Officers headed by the Appeals Technical Guidance Coordinator for Cooperatives is considering a handful of cases with the objective of developing Appeals guidelines to apply to all cases.

Miscellaneous – directly related to Subchapter T cooperatives

10. Ltr. 201103007 (October 5, 2010). Gain realized by a fruit and vegetable marketing cooperative from sale of an interest in a processor that historically had been a significant customer for its crops is patronage-sourced.

11. Ltr. 201103060 (October 22, 2010). A retailer-owned cooperative was granted a waiver of minimum funding standards for multi-employer plans.

12. Ltr. 201105008 (October 5, 2010). Gain realized from the sale of a tobacco auction facility by a cooperative in the process of liquidation is patronage-sourced. The cooperative’s proposed method of allocating the gain among members was approved.

13. Ltr. 201141007 (July 13, 2011). Entity formed to provide treasury services to member firms located around the world qualifies as a nonexempt Subchapter T cooperative.

14. CCA 201144023 (July 28, 2011). Limited transfer of fishing rights created and administered by cooperatives under federal law is not a sale or exchange of a capital asset and therefore does not give rise to capital gain.

15. T.D. 9547 (August 22, 2011) and Treas. Reg. §1.179C-1 (election to expense certain refineries). These regulations contain directions as to how a cooperative refinery can elect to allocate its Section 179C deduction for qualified refinery property to its “cooperative owners.”

16. NCFC and NSAC letters to R. Joseph Durbala, Internal Revenue Service, dated August 29 and August 30, 2011. Comments were made regarding (i) the absence of a line for

per-unit retain allocations on the draft Form 1120-C for 2011 (and new Form 1125-A), (ii) the new instructions to Form 8903 taking the position that cooperatives must compute their domestic production activities deduction on a two-company basis, and (iii) problems with respect to the coding of federal tax deposits by cooperatives.

17. Notice 2010-82, I.R.B. 2010-51 and IRS frequently asked questions regarding the small business healthcare tax credit (Section 45R), http://www.healthcare.gov/news/blog/smallbusiness09072011.html. These confirm that “a section 521 farmers cooperative that is subject to tax under section 1381 is eligible to claim the small business health care tax credit as a taxable employer, if it otherwise meets the definition of an eligible small employer.”

18. “Federal Tax Treatment of Individuals,” prepared by the Staff of the Joint Committee on Taxation, JCX-43-11 (September 12, 2011). This report observes in passing that the reduced rate of tax on dividends enjoyed by individuals does not apply to dividends paid by Section 521 cooperatives (which is the case because those dividends are deductible by Section 521 cooperatives so the income is not subject to corporate tax).

19. Letter from TryghedsGruppen smba to the Treasury dated October 17, 2011 (2011 TNT 207-29). This letter presents the case as to why a Danish mutual company should be exempted from the reporting requirements of the Foreign Account Tax Compliance Act.

Rural electric/rural telephone and other kinds of cooperative issues

20. TAM 201105045 (November 10, 2010). A telephone cooperative may exclude payments from Universal Service Funds for purposes of the 85% member income test.

21. Ltr. 201110013 (December 13, 2010). Payment of a rebate to member credit unions does not affect the Section 501(c)(6) status of an organization organized to provide supplemental deposit insurance to credit unions and their members.

22. Ltr. 201114003 (December 7, 2010). Forbearance to exercise certain termination rights with respect to a wholesale electricity requirements contract will not affect a prior tax- exempt bond financing by an exempt rural electric cooperative.

23. Ltrs. 201123035 (March 18, 2011) and 201123037 (March 18, 2011). These rulings describe how a Section 501(c)(12) cooperative that wants to give up its exempt status should do so.

24. Ltr. 201123038 (March 18, 2011). Gain realized by a rural telephone cooperative on the sale of stock in a cellular telephone company is patronage-sourced.

25. Ltr. 201136027 (June 14, 2011). This ruling approves the proposed manner of distributing the assets to another exempt organization as part of the dissolution of a Section 501(c)(5) organization originally formed to help finish equity drives for farmer- owned agricultural processing facilities by investing in the facilities and then selling the shares back to producers.

26. Ltr. 201143021 (August 1, 2011). This ruling concludes that a program for redeeming capital credits at a discount established by a Section 501(c)(12) rural electric cooperative does not present tax issues.

27. Ltr. 201145012 (August 9, 2011). This ruling confirms that an internal reorganization simplifying the corporate structure of a corporate group whose parent is a rural electric cooperative will be tax free. If the parent later meets the 85% member income test and regains its Section 501(c)(12) status, an exception in Treas. Reg. §1.337(d)-4 will apply (and an anti-avoidance exception to that exception will not).

28. Annual Report of the IRS Tax Exempt and Government Entities Division (December 2010). Among other things, this report describes an initiative underway to check on compliance by Section 501(c)(12) organizations as to their compliance with the 85% member income test.

29. Christina A. Alphonso, 136 T.C. 247 (2011). A shareholder of a housing cooperative is not entitled to a casualty loss deduction for damages sustained when a retaining wall on the cooperative’s property collapsed.

30. INFO 2011-0006 (December 22, 2010), INFO 2011-0016 (March 1, 2011) and INFO 2011-0048 (June 24, 2011). Information to members of housing cooperatives with respect to the application of the tax credit for nonbusiness property under Section 25C to housing cooperatives and their members.

31. Letter from Credit Union National Organization to the IRS dated September 15, 2011, and memorandum dated October 11, 2001 from the General Counsel of CUNA, https://www.cuany.org/access_files/compliance/RevocationLtrUpdateOct112011.pdf. This letter and memorandum describe how many credit unions are having their exempt status revoked for various reasons and what they should do in response.

State tax matters

32. Illinois Schedule INL (Illinois Net Loss Adjustment for Cooperatives). This new form is to be used by cooperatives desiring to elect to net patronage losses against nonpatronage income in accordance with legislation passed by Illinois last year. According to the form, the election must be made for the first taxable year ending on or after December 31, 2010.

33. Indiana Department of State Revenue Letter of Finding No. 08-0374 (December 1, 2009). A captive cooperative organized by and serving a group of corporations under common control should be included as part of the group’s combined return for Indiana purposes.

34. Minnesota Revenue Notice No. 11-02 (April 11, 2011). Patrons of cooperatives organized under Minnesota’s traditional cooperative statute can not treat patronage dividends paid out of income from “qualified business” of a cooperative as exempt business income under the Minnesota job opportunity building zone exemption. In

contrast, patrons of cooperatives organized under Minnesota’s new cooperative statute can do so since those entities are treated as pass-through entities for state tax purposes.

Detailed Analysis

Section 199 rulings

1. Ltr. 201105015 (October 13, 2010) (grain payments).

3. Ltr. 201115010 (January 3, 2011) (grain payments).

4. Ltr. 201118009 (January 28, 2011) (grain payments).

5. Ltr. 201120008 (February 15, 2011) (grain payments).

6. Ltr. 201126012 (March 23, 2011) (grain payments).

7. Ltr. 201138002 (June 9, 2011) (grain payments).

8. Ltr. 201138029 (June 9, 2011) (unidentified crop payments).

While there are a few nuances, with the one exception noted below, these rulings do not break any new ground.

9. Instructions to Form 8903 (Rev. December 2010).

Miscellaneous – directly related to Subchapter T cooperatives

10. Ltr. 201103007 (October 5, 2010).

The cooperative involved in this ruling is a marketing cooperative formed to market vegetables and fruit of its members. Over the years, the cooperative’s principal customer was a corporation (referred to in the ruling as “Corp A”).

The ruling describes in detail the evolving relationship between the cooperative and Corp A.

Originally, Corp A was a public corporation, controlled by a cooperative (“Coop X”). Coop X was not the same cooperative as the cooperative asking for the ruling, but for many years supported the formation and activities of the cooperative asking for the ruling. The cooperative asking for the ruling supplied crops to Corp A pursuant to a “unique” contractual arrangement.

This arrangement was placed in jeopardy by the decision of Coop X to sell its controlling interest in Corp A. It appeared that all potential new owners would likely terminate the unique arrangement. In self-defense, the cooperative purchased all of the stock of Corp A. The ruling notes:

“As a general rule, the crops provided to Taxpayer by its members are not the types of crops planted, cultivated, and harvested unless the member has an established market to which its crop will be sold. As such, the termination of the contractual relationship between Taxpayer and Corp [A] would have left Taxpayer’s members with no stable, reliable market for their crops and would have ended the purpose for Taxpayer to exist, leading to its liquidation and dissolution. Confronted by this prospect, Taxpayer’s Board of Directors, and subsequently its members, determined that they had no choice except to pursue ownership and control of Corp [A] if Taxpayer were to maintain a market for its members’ crops.”

After acquiring Corp A, the cooperative operated the business much as the business had operated in the past. Then, the opportunity arose to acquire a national branded frozen vegetable business and to combine it with Corp A, improving the market for the cooperative’s crops and improving the profitability of Corp A. However, this acquisition left Corp A highly leveraged.

100

It became apparent that additional capital was needed, and that it could not be raised from existing members or by adding new members.

This led to a transaction with a private equity firm, which infused the necessary additional capital. An LLC was established. The LLC ended up owning Corp A. The private equity firm was the principal member of the LLC, and it had control. The cooperative ended up with a non-controlling interest in the LLC. Management of Corp A also had an ownership interest in the LLC. A new supply agreement was put into place between Corp A and the cooperative. It was much like the prior agreement, but it also required Corp A “to use reasonable commercial efforts to have the supply agreement, or appropriate portions of the supply agreement, assumed by a buyer of the business of Corp [A], or by a buyer of any part of the business, if it were sold during the new agreement’s ten-year term.”

The ruling states:

“… through the **** refinancing transaction, Taxpayer was able to avoid the potential financial failure which seemed imminent in **** and the first half of **** while also obtaining a long-term, stable supply arrangement for the benefit of the members of Taxpayer through the **** growing season.”

Corp A was operated under this new arrangement, and “the supply agreement … served to maintain the markets for the crops of Taxpayer’s members.” Eventually, the private equity firm decided that the time was right to sell Corp A, and did so. Because the cooperative controlled the LLC, the cooperative was not in a position to prevent the sale of Corp A.

As a result of the sale, the LLC recognized a gain, and a portion of that gain passed through to the cooperative. The cooperative also received a distribution of its share of the sale proceeds . The ruling concludes that all of the cooperative’s distributive share of the gain was patronage-sourced. The analysis in the ruling follows that of prior letter rulings concluding gains can be patronage-sourced. In reaching this conclusion, the ruling emphasized the supply relationship that existed between the cooperative and Corp A throughout the relationship. The ruling states:

“The sale of Corp A in **** marked the end of Taxpayer’s ownership of the assets originally acquired in ****. But at all times from **** through the sale of Corp A, Taxpayer’s ownership of Corp A (and its predecessors) served to provide a market for the crops of Taxpayer’s members. Even with the sale of Corp A, the supply agreement terms obtained in **** have resulted in a continuing market for the crops of Taxpayer’s members, not only to Corp A but also to various other customers obtained by Taxpayer through the workings of the supply agreement.”

The ruling also concludes that the entire gain should be treated as patronage-sourced. It appears that Corp A sourced crops not only from the cooperative, but also from others. However, this did not cause the IRS to conclude that a portion of the gain should be treated as nonmember/nonpatronage. Rather, the ruling states: 101

“Taxpayer has represented that its members supplied over **** percent of the raw product purchases made by Corp A for processing. As that percentage exceeds Taxpayer’s ownership interest, we can assume that the gain on the sale received by Taxpayer was attributable to its members’ business conducted with Corp A and, accordingly, all patronage sourced.”

11. Ltr. 201103060 (October 22, 2010).

Companies that maintain defined benefit pension plans or that are part of multi-employer plans are required to meet certain minimum funding standards.

Section 412(c)(1)(A) of the Code provides that waivers may be granted under certain circumstances where an employer is “unable to satisfy the minimum funding standard for a plan year without temporary substantial business hardship … and application of the standard would be adverse to the interests of plan participants in the aggregate.”

Section 412(c)(2) provides that:

“… the factors taken into account in determining temporary substantial business hardship … shall include (but shall not be limited to) whether or not –

(A) the employer is operating at an economic loss,

(B) there is substantial unemployment or underemployment in the trade or business and in the industry concerned,

(D) it is reasonable to expect that the plan will be continued only if the waiver is granted.”

In this ruling, a retailer-owned grocery cooperative serving supermarkets in the northeastern United States was the principal participant in a multi-employer pension plan that was severely underfunded. The plan was a “spin-off of assets and liabilities from a predecessor multi-employer plan that itself had a large funding shortfall, some of which was transferred to the Plan.” The cooperative sought a waiver of “the contribution that otherwise would have been required to reduce the balance in the funding standard account to zero as of August 31, 2009.”

The IRS granted the waiver. In so doing, it took into account the cooperative status of the taxpayer. The IRS stated:

“The Company does not maintain a large cash position since it is a cooperative and distributes almost all of its profits to its members. The financial submissions illustrate that the Company is financially healthy, but it would experience a

102

substantial financial hardship if it were to use any additional cash flows for contributions to the Plan.”

The ruling provides that the amount waived will be amortized over a period of 15 years. The cooperative represented that “it will aggressively fund the Plan over the next five years to create a credit balance equal to the outstanding amortization base associated with this waiver.” However, that was not made a specific condition of the waiver. The ruling is conditioned on not amending the plan to increase benefits and/or plan liabilities while any portion of the waived funding deficiency remains unamortized.

12. Ltr. 201105008 (October 5, 2010).

Over the last ten years, there have been dramatic changes in how tobacco is grown and marketed in the United States. For years the federal government supported tobacco prices and imposed production controls. Many thousands of farmers raised tobacco, often on relatively small plots of land. When it came time to market tobacco, they took their tobacco to tobacco warehouses where auctions were regularly conducted. Tobacco that did not receive a bid over the support price was purchased by the Government. Cooperatives operated warehouses and helped the Government administer the price support program on behalf of their members, helping to store and eventually sell the Government tobacco.

This system began to change when the large tobacco companies started contracting directly with large producers for production of tobacco. Tobacco produced under contract was not marketed through the auction warehouses. Then, in 2004 the Fair and Equitable Tobacco Reform Act (“FETRA”) (which was enacted as part of the American Jobs Creation Act of 2004) ended the federal price support and production control programs for tobacco. FETRA contained generous buy-out provisions that resulted in many tobacco producers, particularly smaller ones, agreeing to stop producing tobacco.

These changes ended the role that cooperatives had in administering the Government price support program. Moreover, they largely have led to the end of the system of marketing tobacco through auction warehouses.

Ltr. 201105008 deals with issues arising from the liquidation of a cooperative that had for many years operated a tobacco auction facility and played a role in the Government price support program. According to the ruling:

“Faced with these market conditions [after passage of FETRA], Coop’s board of directors decided to suspend further auctions unless and until market conditions changed. …

Coop’s board of directors did not immediately decide to sell Coop’s facilities because at the time there was uncertainty as to whether the changes in government’s role in regulating the Crop production and marketing business would work as intended and whether government policy might change again resulting in renewed need for the Coop’s auction services.” 103

Rather, the cooperative leased its facilities to another cooperative that planned to continue auctions at the site. After two years and:

… after the board had determined there was no longer sufficient current or projected future market need or economic basis upon which to justify continuation of the cooperative or retaining the ownership of its facilities within the purposes for which Coop had been formed, the membership voted to sell Coop’s property and begin liquidation proceedings.”

However, finding a buyer proved difficult. The cooperative leased the property to a tobacco product manufacturer for use as a delivery point and storage facility for tobacco grown under contracts. The cooperative hoped that company would eventually be interested in purchasing the facility. However, that did not happen, and further efforts were made to sell the facility.

Eventually, the facility was offered for sale to the cooperative that had leased and operated it for several years after the passage of FETRA. That cooperative agreed to purchase it, but for substantially less than the appraised value of the facility at the time the cooperative started the process of trying to sell it.

In a lengthy ruling, the IRS considered several issues.

First, the IRS concluded that the cooperative retained its status as a Subchapter T cooperative even though several years passed between the time it stopped conducting tobacco auctions for its members and the time it sold its facilities and liquidated. The IRS concluded that the period time was “a reasonable liquidation period under the circumstances.”

Second, the IRS concluded that the entire gain from the sale of the facilities was patronage-sourced income. The cooperative had operated as a Section 521 cooperative, paying patronage dividends to members and nonmembers alike, so no allocation between patronage and nonmember/nonpatronage was required. In addition, the evidence indicated that “the value of Coop’s land and buildings substantially deteriorated in the liquidation period to the point they were sold…” Thus, none of the gain was attributed to the period when the cooperative was no longer using the facilities to conduct auctions. More interesting, the ruling indicated that the cooperative’s business was seasonal and that it had rented the warehouse facility out to others during the off-season each year for many years. This did not affect the characterization of all of the gain as patronage-sourced:

“The rental income generated from the facilities during the off season did not change the character of the assets sold. The rental income itself would constitute nonpatronage income…; however, the facilities were always used to provide services to the member patrons directly and indirectly during the Crop harvest season and no part of the facilities were built or used solely for the purpose of generating income to enhance the overall profits of Coop. The seasonality of Coop’s purpose created a situation where off season rental of the facilities was a logical and reasonable incidental financial benefit to members requiring no 104

additional investment or annual expenses that did not change Coop’s fundamental cooperative operations. Operation as a section 521 cooperative assured that patrons individually shared in the economic benefit of allowing the facilities to be used in the off season through better assurance that the facilities will continue to be available in good condition to meet their marketing needs and enhancement of their patronage dividends representing net farming proceeds from marketing their Crop through Coop.”

Third, the IRS approved the manner in which the cooperative planned to allocate the sales proceeds.

For a variety of reasons, the cooperative planned to allocate the proceeds based on patron business for a period of fiscal years ending with the year that the cooperative last conducted an auction. Records were not available for earlier periods because of a fire and resultant water damage. The cooperative indicated that (if earlier records were available) it expected that basing the allocation on a longer period would result in allocating a significant amount to former patrons who could not be located so that “a substantial portion of the asset sale proceeds would go unclaimed … and be transferred to the State A as abandoned property, defeating the objective of proportionally sharing Coop’s remaining funds with patrons who used the facilities…” The cooperative also indicated that it believed that the period chosen “generally represent[ed] a cross section of Coop’s patrons over a longer period of time.”

The ruling noted that the cooperative’s Bylaws provided that upon liquidation residual assets “shall be distributed to the patrons on an equitable patronage basis as determined by the board of directors.” The board of directors and the members formally voted to approve the method the cooperative proposed to use.

Based upon these considerations, the IRS concluded that the period the cooperative planned to use “is an acceptable representation of proportional use of the facilities by its members, in so far as practicable, such that it will not jeopardize Coop’s ability to continue to be recognized as operating on a cooperative basis and the distribution will be deductible as a patronage dividend in computing Coop’s taxable income for the year of the distribution.”

Readers interested in learning more about this ruling are referred to Mike McIntyre’s article entitled “Gain from Sale of Cooperative’s Facilities Classified as Patronage Sourced Despite Passage of Time Between Last Business Conducted on a Cooperative Basis and the Sale,” appearing in the Spring, 2011 issue of The Cooperative Accountant.

According to that article, the last auctions were conducted by the cooperative during its fiscal year ended June 30, 2005, and the sale occurred on December 18, 2009. The cooperative based the allocation on patronage during the last six fiscal years of its operation of the auction, namely the fiscal years ending June 30, 2000 through June 30, 2005. The fire that destroyed a significant portion of the cooperative’s patronage records occurred in January, 1999.

105

13. Ltr. 201141007 (July 13, 2011).

This is another ruling confirming that a newly formed company will be a “corporation operating on a cooperative basis” within the meaning of Section 1381(a)(2) and thus will be eligible to be treated as a nonexempt Subchapter T cooperative.

The cooperative was being organized to serve a number of independently-owned member firms located around the world. The member firms provides services of some sort to clients. The ruling states:

“Each Member Firm is a separate legal entity and remains solely responsible for its own work for clients, but all Members Firms are part of a highly integrated organization to enable the delivery of seamless, consistent, high-quality service worldwide.”

The ruling states that the cooperative is to be a “global finance and treasury services company owned by Member Firms and operating on a cooperative basis…”

“The purpose of Finco will be to provide Member Firms with a variety of treasury services. Finco will also serve as a source of credit on a structured and strategic basis for Member Firms needing to borrow funds and as a place where Member Firms with temporarily unused working capital can loan funds and earn a market rate of return. Each Member Firm will ultimately continue to remain responsible for its own treasury function, but Finco will coordinate and implement a global treasury strategy in order to achieve operational efficiencies which will allow each of the Member Firms to operate its local treasury function more efficiently.”

The ruling contains a detailed description of how the cooperative will be organized and how it plans to operate. In concluding that the organization will qualify as a nonexempt Subchapter T cooperative, the IRS went through its standard analysis, focusing on subordination of capital, democratic control and operation at cost.

There are a few things to note about this ruling.

First, in the course of its analysis, the IRS confirms that United States cooperatives can have foreign members:

“There is nothing in subchapter T of the Code limiting the membership of a nonexempt subchapter T cooperative to United States citizens, residents or businesses. It is not unusual for United States cooperatives to have foreign members. Some United States cooperatives are wholly-owned and controlled by members located outside the United States.”

Second, the ruling states that the cooperative plans to allow its members to grant proxies to vote their stock. It confirms that this is not inconsistent with the democratic control requirement of operating on a cooperative basis. 106

Finally, the IRS approves a dissolution provision that provides for residual assets to be shared “based upon patronage for the seven years immediately preceding dissolution (or the period of existence of Finco, if shorter).” The ruling states:

“This seven-year period was chosen to assure a cooperative sharing of earnings consistent with practicalities and the nature of the business. Seven years was felt to be long enough to assure sharing on a patronage basis, but without placing an undue record-keeping burden on Finco.”

It is not unusual for rulings to involve situations where residual assets upon liquidation are to be shared based upon patronage over a fixed period of time. However, most rulings do not disclose the number of years the cooperative proposes to use.

14. CCA 201144023 (July 28, 2011).

This chief counsel advice (“CCA”) was written by an attorney in the IRS National Office and addressed to an IRS attorney in the field to provide the field attorney with guidance as to whether income realized by a taxpayer upon the transfer of fishing rights should be treated as capital gain or ordinary income. It concludes that the income is ordinary.

The facts are rather complicated. Taxpayer is a limited partnership. At one time it owned and operated a fishing Vessel. Taxpayer later sold the Vessel to Transferee, a corporation, which immediately transferred it to a wholly-owned subsidiary. Both Taxpayer and Transferee were owned by the same group of persons.

According to the ruling:

“Under the terms and conditions of the sale of Vessel, Taxpayer retained ownership of Vessel’s catch history and license limitation permit. Taxpayer and Transferee recognized that one or more of the fisheries that Vessel participated in might become subject to a limited entry system in the future. Limited entry systems divide current fishing rights based on catch history. Retention of catch history by Taxpayer meant that Taxpayer would take credit for all fish harvested by the vessel prior to the sale, in the event that a new limited entry system were put into effect in a fishery in which Vessel had participated prior to the sale of the vessel.”

As anticipated, a limited entry system went into effect after the passage of a law referred to in the ruling as the Act.

As a result of the manner in which the Act was administered, Taxpayer ended up with all of the fishing rights. According to the ruling:

107

“NMFS [the National Marine Fisheries Services] refused to recognize a divided catch history for purposes of the Act. Ultimately it was determined that Taxpayer would claim the fishing rights associated with Vessel under the Act.”

The Act permitted owners of vessels with fishing allowances to join together in a fishing cooperative, which enabled members to divide the allowances among the vessels in any mutually agreeable way. This made the fishing rights transferable among members of the cooperative. Two cooperatives were formed, one among catcher vessels and another among catcher/processors, and the two cooperatives agreed upon a joint harvest schedule and an apportionment of the total amount of fish that could be harvested under the Act.11

Taxpayer assigned its fishing rights to Transferee for one year:

“The terms of the agreement were that Taxpayer assigned all of its allocated fishing rights for year 4 under Act to Transferee, and in turn Transferee agreed to pay $x per metric ton during the first fishing season of Year 4 and $y per metric ton during the second season of Year 4. The amounts due were paid in cash at the close of each season, and the agreement related only to the Year 4 Fish seasons.

Taxpayer and Transferee understood that Taxpayer would own any future fishing rights awarded based on Fish harvested under the Year 4 allocation. … Since the creation of the Act Taxpayer and Transferee had entered into similar arrangements on a yearly basis.”

The issue in the CCA was whether amounts Taxpayer was paid in Year 4 for use of the fishing rights could be treated as capital gain.

The CCA observes:

“In order from the proceeds from the disposition of an asset to qualify as long- term capital gain, the asset must be a capital asset as defined by §1221, the disposition must be a ‘sale or exchange,’ and the asset must have been held for more than one year. Section 1222.”

The CCA concludes that two of these requirements were not met, and thus the gain was ordinary.

The CCA views the agreement between Taxpayer and Transferee as a “lease or license” of the fishing right, not as a “sale or exchange.” The Taxpayer did not transfer “all substantial rights and obligations” in the fishing rights to Transferee; rather it granted Transferee a limited right to use the fishing rights for two fishing seasons in the year.

11 The names and other identifying details have, of course, been redacted from the CCA. However, it appears that the cooperatives involved may be the High Seas Catchers’ Cooperative (the catcher-vessel cooperative) and the Pollock Conservation Cooperative (the catcher-processor cooperative) which operate in the Bering Sea pollock fishery. 108

In addition, the CCA concludes that if there were a “sale or exchange,” the “income from the transaction would still be ordinary income, because the transferred rights were not ‘property,’ as that term is used in defining a capital asset under §1221.” The CCA does not address whether the fishing rights were themselves property, though it would probably have conceded that they were, but rather focuses on whether what was in fact transferred was property. The CCA observes:

“As discussed above, Taxpayer only transferred the right to fish in the Area on a yearly basis. What was transferred was a time-limited interest carved out from Taxpayer’s allocation rights, the remainder of which it retained. … What Taxpayer transferred was less than the whole directed allocation right stemming from the Act, Vessel’s catch history, and the cooperative agreements.”

15. T.D. 9547 (August 22, 2011) and Treas. Reg. §1.179C-1 (election to expense certain refineries).

Section 179C of the Code was enacted in 2005 and later amended and extended to encourage the construction of new refineries and the expansion of existing refineries to enhance the nation’s refinery capacity. In general, the provision allows taxpayers to elect to deduct as an expense 50 percent of the cost of any qualified refinery property. The remaining 50% is recovered under Section 168.

There are a number of technical rules defining what constitutes a “qualified refinery” and “qualified refinery property” and what investments qualify.

Section 179C(g) allows Subchapter T cooperative refiners, whose members are in turn Subchapter T cooperatives, to elect to pass through all, some or none of its Section 179C deductions to cooperative members. The final Section 179C regulations provide guidance as to how this election must be made and the effect of the election. See, Treas. Reg. §1.179C-1(e).

The Section 179C pass-through is unlike most special cooperative pass-through provisions in that it deals with an item that is not a permanent book/tax difference like a credit or the Section 199 deduction. The one similar pass-through is that of Section 179B (which provides a similar election to expense 75% of the costs incurred by a small business refiner with the EPA sulfur regulations). Because the pass-through involves a temporary difference, it presents interesting issues if the cooperative refiner bases its patronage dividends on book income.

The Section 179C pass-through is also different than, for instance, the pass-through for small ethanol producers in that it only allows pass-throughs to persons who are themselves Subchapter T cooperatives. Also, the passthrough is based upon respective ownership interests in the refiner, not on a patronage basis. In contrast, the small ethanol credit passthrough is made to patrons on a patronage basis. Section 40(g)(6).

Treas. Reg. §1.179C-1(e) describes when and how an election is made and what notice must be given to the owners. The election must be made by the due date (including extensions) for the tax year, and a notice must be provided to members on or before the same date. Most 109

cooperative pass-through provisions (see, e.g., Section 40(g)(6)(A)(ii)) require that the pass- through be accomplished before the end of the payment period for the year – this pass-through is different. The amount passed-through must also be reported on a Form 1099-PATR.

The regulations provide that once an election is made to pass-through all or any part of the Section 179C deductions for a year, the election is irrevocable.

The statute provides (and the regulations repeat) that “[t]he taxable income of the taxpayer shall not be reduced under section 1382 by reason of any amount [which is passed through to members].” Section 179C(g)(1). The meaning of this sentence is not clear. Section 1382 provides for the exclusion or deduction of per-unit retain allocation, patronage dividends, etc. One would not normally deduct depreciation under that section. One might wonder whether the draftsmen intended to have the reporting like the reporting for Section 199 deductions that are passed through to patrons, where the cooperative still claims the deduction on its return, but is required to reduce per-unit retain allocations or patronage dividends by an amount equal to the amount passed through. See, Section 199(d)(3)(B). This approach to reporting leaves the audit risk on the cooperative if there is a problem with the amount of the deduction claimed and passed through. However, if that is what is meant here, one must read between the lines to get to that result.

16. NCFC and NSAC letters to R. Joseph Durbala, Internal Revenue Service, dated August 29 and August 30, 2011.

Both the NCFC and the NSAC submitted comments on the draft of the 2011 Form 1120- C (Income Tax Return for Cooperative Associations) that was posted on the IRS website on July 21, 2011.

The letters identified three areas of concern.

First, the draft eliminates Schedule A (Cost of Goods Sold) and replaces it with a new Form 1125-A (Cost of Goods Sold). This follows a similar change that is being proposed for the Form 1120 used by regular corporations. However, in the process of making the change for cooperatives, the lines for per-unit retain allocations that were included on Schedule A were not added to the Form 1125-A.

The letters pointed out this error and suggested that the lines be restored. Alternatively, they suggested that a separate line be created on the face of the Form 1120-C for per-unit retain allocations, comparable to the line for cost of goods sold. This would be truer to the language of Subchapter T, which provides that per-unit retain allocations are not deductible as cost of goods sold (which historically has been how the form treats them), but rather as an other deduction in arriving at gross income. See, Sections 1382(a) and (b).

As of the time of preparation of this report, the jury is still out as to what, if anything, the IRS is going to do to respond to this comment. A revised draft form 1120-C was posted on the

110

IRS website on December 15, and it does not appear to address the issue. The NCFC is considering following up with the IRS.

Second, the letters pointed out a problem that has occurred with processing tax deposits made by cooperatives filing Form 1120-C. There is no special form for cooperative tax deposits, and the IRS computers do not appear to recognize the extended due date for cooperative tax returns. The result is that cooperative tax deposits are often applied to the wrong periods. After the letter was sent, the NCFC had further discussions with the IRS with respect to this problem. Curtis Freeman, Senior Technical Advisor, Tax Forms & Publications, e-mailed Marlis Carson with the following comment:

“I’m sorry that in fixing one problem by converting to 1120-C from 990-C that another was created. We’re working on following up with the EFTPS [Electronic Federal Tax Payment System]. Just because all the other 1120 series forms were lumped together as 1120 doesn’t mean that the 1120-C should have automatically been thrown in as well, but that’s what happened.”

Third, the letters criticized the change in the instructions to the Form 8903 (Domestic Production Activities Deduction), as revised December 2010, which were released early in 2011 without first having been released in draft form for public comment. These instructions require cooperatives to perform two separate computations to determine their domestic production activities deduction – one for patronage activities and a second for nonpatronage activities – and then to merge the results on line 25 of a single Form 8903. This is a change from prior instructions, which contained no requirement for two separate computations, and can reduce the amount of a cooperative’s Section 199 deduction in many cases.

The letters criticized this change, noting that there is no basis for it in Section 199 or in the regulations under Section 199.

Finally, the letters asked that the IRS share with cooperatives the instructions to the 2011 Form 1120-C while they are still in draft form so that cooperatives will have an opportunity to comment on them before they are finalized. As of the time this report is being prepared, the IRS has not responded to this request, and draft instructions have not been posted on the IRS web site.

17. Notice 2010-82, I.R.B. 2010-51 and IRS frequently asked questions regarding the small business healthcare tax credit (Section 45R), http://www.healthcare.gov/news/blog/smallbusiness09072011.html.

As part of the Patient Protection and Affordable Care Act and Health Care and Education Reconciliation Act of 2010, Congress enacted a tax credit for small employers who provide health insurance for their employees. See, Section 45R.

The rules for this credit are complicated, but, in general, for taxable years beginning in 2010, 2011, 2012 and 2013, the credit is equal to 35 percent (25 percent in the case of a tax- 111

exempt employer) of the eligible payments made by the employer on behalf of its employees for health insurance. Sections 45R(b) and (g)(2)(A). The amount of the credit reduces the deduction the employer may claim for the health insurance premium. Section 280C(g). However, this does produce a good tax result. For an employer in the 35% tax bracket, every $1,000 of qualifying costs will result in up to $350 of tax credit and $650 of deduction (saving taxes of $227.50).

The credit is limited to small employers. A small employer is defined as an employer that has no more than 25 full-time employees and the average compensation of the employees is not greater than $50,000. Section 45R(d). However, the credit is reduced by 6.667 percent for each full-time employee in excess of 10 employees and by 4 percent for each $1,000 that average annual compensation paid to the employees exceeds $25,000. Section 45R(c).

In order for payments to qualify, they must be made pursuant to an arrangement that “requires an eligible small employer to make a nonelective contribution on behalf of each employee who enrolls in a qualified health plan offered to employees by the employer through an exchange in an amount equal to a uniform percentage (not less than 50 percent) of the premium cost of the qualified health plan.” Section 45R(d)(4). To keep employers from offering “Cadillac” plans, for the years 2010, 2011, 2012 and 2013, the payments that can be counted for credit purposes can not exceed those that would have been made if the plan had a premium equal to “the average premium for the small group market in the State in which the employer is offering health insurance coverage.” Section 45R(g)(2)(C).

The credit is a component of the general business credit and can be used against regular and alternative minimum tax. Sections 38(b)(36) and (c)(4)(B)(vi). Exempt organizations can use the credit against tax on unrelated business income (even if it relates to employees in the exempt portion of the business). The tax is not refundable for taxable employers. It may be carried back and over as a component of the general business credit (but note that the carryback may not be to years the health insurance credit did not exist). Any portion of the credit that is not usable by the expiration of the 20-year carryforward period may be claimed as a deduction for the first tax year after the expiration of the carryover period. Section 196(c)(14). The credit is refundable for tax exempt employers (so long as it does not exceed the employer’s income tax withholding and Medicare tax liability). Section 45R(f)(3)(B).

There are many more details that need to be considered in determining the amount of an employer’s credit under this section. Anyone actually trying to claim the credit needs to look beyond this simple description in order to make certain the credit is computed correctly. One might wonder whether it could have been possible for Congress to come up with a simpler statutory arrangement, particularly since the credit is targeted for small employers. One also might wonder how much it encourages employers to offer health insurance for their employees given the complexity of the credit. As with many credits, it probably benefits taxpayers for doing something they would have done otherwise. Perhaps it may encourage some employers that are already helping pay for health insurance for their employees to continue to do so in the future.

112

The IRS has engaged in an effort to make small employers aware of the existence of this credit. However, illustrating the complexity of this provision, the IRS has had to release several lengthy notices filling in some of the gaps necessary to implement this section. See Notice 2010- 44, I.R.B. 2012-22, and Notice 2010-82, I.R.B. 2010-51, amplifying the prior notice.

Notice 2010-82 notes that the credit is not generally available to exempt organizations unless they are described in Section 501(c) and exempt from taxation under Section 501(a). Section 45R(f). This presents an issue for Section 521 cooperatives, since Treas. Reg. §1.1381- 2(a) provides that “[f]or the purpose of any law which refers to organizations exempt from income taxes such an association shall, however, be considered as an organization exempt under section 501.” This has led to numerous “fixes” in the tax statute and regulations that provide that Section 521 cooperatives will not be treated as “exempt” in many situations. Notice 2010-82 contains another “fix”:

“Tax-exempt organizations that are not both described in §501(c) and exempt from taxation under §501(a) are not eligible to claim the credit. However, a §521 farmers cooperative that is subject to tax under §1381 is eligible to claim the credit as a taxable employer, if it otherwise meets the definition of an eligible small employer.” (Section II(A)).

Thus, both exempt and nonexempt farmers’ cooperatives are eligible to claim this credit, provided they meet the definition of eligible small employer.

This conclusion is repeated in an FAQ at the IRS website. See, http://www.healthcare.gov/news/blog/smallbusiness09072011.html. Q&A 2 confirms that “a section 521 farmers cooperative that is subject to tax under section 1381 is eligible to claim the small business health care tax credit as a taxable employer, if it otherwise meets the definition of an eligible small employer.”

18. “Federal Tax Treatment of Individuals,” prepared by the Staff of the Joint Committee on Taxation, JCX-43-11 (September 12, 2011).

In a document entitled “Federal Income Tax of Individuals” prepared by the Staff of the Joint Committee of Taxation, JCX-43-11 (September 12, 2011), the Joint Committee Staff included a description of the reduced tax regime for qualified dividend income received by individuals. That explanation contains the reminder that “[t]he reduced rates do not apply to dividends received from an organization that was exempt from tax under section 501 or was a tax-exempt farmers’ cooperative in either the taxable year of the distribution or the preceding taxable year…”

113

19. Letter from TryghedsGruppen smba to the Treasury dated October 17, 2011 (2011 TNT 207-29).

In 2010, Congress enacted the Foreign Account Tax Compliance Act (“FATCA”) as part of the Hiring Incentives to Restore Employment Act. The purpose of FATCA is to help the United States efforts to combat tax evasion by U.S. persons holding investments in offshore accounts.

FATCA imposes reporting requirements on U.S. taxpayers holding foreign financial assets with an aggregate value exceeding $50,000. Section 6038D. Failure to report will result in penalties. Section 6038D(d). Underpayments of tax attributable to non-disclosed foreign financial assets will be subject to an additional substantial understatement penalty of 40%. Section 6662(j).

FATCA also imposes reporting and withholding requirements on certain foreign financial institutions (“FFI”). Sections 1471 to 1474. According to the IRS website:

“To properly comply with these new reporting requirements, an FFI will have to enter into a special agreement with the IRS by June 30, 2013. Under this agreement a ‘participating’ FFI will be obligated to:

(1) undertake certain identification and due diligence procedures with respect to its accountholders.

(2) report annually to the IRS on its accountholders who are U.S. persons or foreign entities with substantial U.S. ownership, and

(3) withhold and pay over to the IRS 30-percent of any payments of U.S. source income, as well as gross proceeds from the sale of securities that generate U.S. source income, made to (a) nonparticipating FFIs, (b) individual accountholders failing to provide sufficient information to determine whether or not they are a U.S. person, or (c) foreign entity accountholders failing to provide sufficient information about the identity of its substantial U.S. owners.”

By a letter dated October 17, 2011 to the Treasury (and reported in Tax Notes Today at 2011 TNT 207-29), TryghedsGruppen smba (“TG”) asked that it be exempted from the FATCA requirements under Section 1471(f)(4), which provides that the provisions shall not apply to “any other class of persons identified by the Secretary [of the Treasury] for purposes of this subsection as posing a low risk of tax evasion.” The letter provides an interesting insight as to how at least one European cooperative entity is organized and operated (and problems presented to it by the increasingly broad reach of the U.S. tax rules).

TG is a Danish mutual company that acts as a holding company for a general insurance company. According to the letter, standing alone TG would not be subject to the reporting requirements, but is swept into the requirements by reason of being a holding company for a financial institution. The letter goes on to describe the unique “mutual” nature of TG: 114

“[TG] uses the investment income from the investment in the general insurance company to invest in other businesses within health, rescue and safety and non- profitable activities such as donations to research in the same areas including various donations. Free excess funds are invested in ordinary securities including US securities.

In this context, being mutual implies that the company is governed by a Committee of Representatives elected by and among Danish policy-holders in a Danish general insurance company as well as Danish policy-holders in a Danish life insurance company, and that it is the policy of the Company that the funds in the Company are to benefit not just one generation but also future generations. There is accordingly no access to distribution of funds and the policyholders have no right to receive funds when ceasing to be a policy-holder.”

The view that unallocated earnings of mutual companies represent funds held to benefit future generations appears to be one that is more broadly accepted in Europe than in the U.S.

The letter lists reasons why a mutual company such as TG should be exempted from FATCA. TG has no shareholders “and can best be described as a private foundation with no owner interest.” It has members, not shareholders. TG is not permitted to distribute funds to members, and members have no right to receive anything from TG when they cease being members of TG. “… any payment of funds to the members requires the Company to be liquidated which requires a drastic change in the present business philosophy/strategy as well as it will be very difficult based on the quorum requirements in the Articles of the Company.”

It will be interesting to see whether the Treasury will carve out an exception from FATCA for mutual companies that might otherwise fall under its broad reach.

Rural electric/rural telephone and other kinds of cooperative issues

20. TAM 201105045 (November 10, 2010).

In order to qualify as exempt under Section 501(c)(12) of the Code, 85% or more of the income of a mutual or cooperative telephone company must consist of “amounts collected from members for the sole purpose of meeting losses and expenses.” Section 501(c)(12)(B)(i) provides that this test “shall be applied without taking into account any income received or accrued … from a nonmember telephone company for the performance of communication services which involve members of the mutual or cooperative telephone company.”

TAM 201105045 (November 10, 2011) considers how mutual or cooperative telephone companies should treat payments received from the Federal Universal Service Fund (“FUSF”) and from a State Universal Service Fund (“SUSF”).

The TAM begins with a lengthy description of the history of the arrangements that have been in place over the past seventy years for compensating local exchange carriers like the cooperative for long distance calls that use the services of their system. These arrangements 115

have all involved some degree of subsidization of the higher costs incurred by local exchange carriers providing services to customers in rural areas. In Rev. Rul. 74-362, 1974-2 C.B. 170, the IRS took the position that settlement payments to rural telephone cooperatives for long distance calls were not member income for purposes of the 85% member income test. This ruling was reversed by Congress in 1978 when Section 501(c)(12)(B)(i) was added to the Code (and the reversal was made retroactive).

According to the TAM:

“In the more than 30 years since Rev. Rul. 74-362 and the enactment of section 501(c)(12)(B)(i), telecommunications policy in the United States has slowly evolved from the provision of most telecommunications services by a government-sanctioned monopoly to the competitive provision of most telecommunications services. This evolution has gradually change the way that most local exchange companies in rural or other high-cost areas recover their joint and common costs and, more generally, the methods that the FCC and state regulators employ to achieve universal service.”

The TAM then details this evolution, describing a variety of federal and state programs that have been developed to support the concept of universal telephone service, both in high cost areas (e.g., rural areas) and for low income and other classes of users.

Currently, FUSF supports a number of programs whose goal is universal telephone service. The federal “High Cost Support Program aims to enable carriers to provide service in high cost areas through a number of mechanisms, including interstate common line support, local switching support, and high-cost loop support.” The general objective is to ensure that consumers in all regions of the country have access to and pay rates for telecommunication services that are reasonably comparable to those in urban areas. The federal “Low Income Support Program is designed to ensure that quality telecommunications services are available to low-income customers at affordable rates.” The general objective of this and several similar programs is to provide discounted or reduced rates to low income consumers, schools and libraries and rural health care providers.

States offer similar support programs on a state-wide basis supported through SUSFs.

Funds for these programs are collected from all telecommunications providers and pooled in federal and state funds administered by third-parties. The federal program is administered by the Universal Service Administrative Company. The administrator is responsible for billing contributors, collecting contributions to the universal service support mechanisms, and disbursing universal service support funds. Telecommunications carriers are permitted to pass the costs through to end users (so telephone bills frequently have surcharges for federal and state universal service charges).

Periodically, carriers in high-cost areas or serving low income persons receive FUSF and SUSF payments from the funds, which can be significant for rural telephone companies. For the

116

year in question, the local telephone cooperative that was the subject of the TAM had $16.8 million of gross receipts, about 55% of which constituted FUSF and SUSF revenues.

The TAM addressed two questions.

First, it addressed whether the cooperative could treat the payments as non-shareholder contributions to capital and exclude them from income under Section 118 of the Code. It is the IRS’s position that universal service support payments are not contributions to capital, but rather are consideration for goods or services rendered. Rev. Rul. 2007-31, 2007-1 C.B. 1275. This position has been sustained by both the Fifth and Eleventh Circuit Courts of Appeal. See, United States v. Coastal Utilities, Inc., 514 F.3d 1184 (11th Cir. 2008), and AT&T, Inc. v. United States, 629 F.3d 505 (5th Cir. 2011), cert. den. Thus, the TAM concluded that they must be included in income.

Second, the TAM addressed whether the FUSF and SUSF payments could be excluded by the cooperative from its 85% member income computation pursuant to Section 501(c)(12)(B)(i).

Two requirements must be met for this section to apply.

The first requirement is that the payments must come from a nonmember telephone company. The TAM concluded that they did. The funds were not regarded as the source of the payments, but rather the telephone companies contributing to the funds were treated as the source. The fund administrators were viewed as acting simply as intermediaries. However, it is interesting to note that the ruling contains no discussion of the status of the FUSF or the SUSF for federal income tax purposes.

The second requirement is that the payments must be “for the performance of communication services that involve members of the cooperative telephone company.” Here, the TAM simply states:

“Taxpayer also benefits each contributing nonmember telephone company by increasing the total number of subscribers that can connect to their networks and thereby increasing the value of such networks. The FUSF also benefits contributing nonmember, interexchange carriers by lowering access charges and, therefore, long distance charges.

Finally, FUSF and SUSF revenues represent the functional equivalent of the portion of the AT&T/BOC settlements in effect during the 1970s that implicitly subsidized universal service and that Congress intended section 501(c)(12)(B)(i) to exclude from the 85 percent member income test. Therefore, we conclude that the FUSF and SUSF revenue received by Taxpayer is properly categorized as excluded income under section 501(c)(12)(B)(i) of the Code.”

The TAM concludes that, while the payments may not simply be excluded from income as nonshareholder contributions to capital, they nevertheless may be excluded for purposes of the 117

85% member income test pursuant to Section 501(c)(12)(B)(i).

21. Ltr. 201110013 (December 13, 2010).

The recent financial difficulties have had some interesting repercussions on business organizations, most negative, but some positive. The situation addressed by Ltr. 201110013 (December 13, 2010) is an example of a situation where the consequences were positive.

This private letter ruling involves an organization established in the 1960s by a state legislature to create and maintain a fund to insure shares and deposits of state and federal credit unions doing business in the state. According to the ruling, the organization has over 100 members. Besides maintaining the fund, the organization reviews “the financial condition of each member credit union and may take remedial action, such as making capital infusions to member credit unions, to strengthen financial condition or enhance liquidity in order to protect the credit union’s depositors.”

Soon after it was formed, the organization obtained a determination letter from the Service recognizing its status as an exempt Section 501(c)(6) business league. One of the requirements for exempt status under that section is that “no part of the net earnings of [the organization] inures to the benefit of any private shareholder or individual.” That “no private inurement” requirement was the focus of the ruling.

The deposit insurance provided by the organization supplements the federal deposit insurance provided by the National Credit Union Administration. Thus, the insurance is on deposits in excess of the federal deposit insurance limit in effect at any time (“excess deposits”). The limit of federal deposit insurance has increased over the years. It was $20,000 in 1970, increased to $40,000 in 1974, increased again to $100,000 in 1980, and, as a result of the Emergency Economic Stabilization Act of 2008, increased to $250,000 in 2008. While the 2008 increase was originally temporary, it has been extended to the end of 2013, and apparently the organization believes the increase will effectively be permanent.

As a result of the increase in the federal deposit insurance limit, the aggregate amount of the excess deposits that the organization insures has dramatically decreased. As of June 30, 2006, the excess deposits (those over the $250,000 limit) totaled approximately $400 million. If the old $100,000 limit had been in place, the excess deposits would have been approximately $1.5 billion.

This decrease in excess deposits has left the organization in what it believes is an overfunded position.

Historically, the organization assessed members to build up the fund an amount equal to 1.25% of their maximum excess deposits (the assessment practice is described in detail in the ruling). The ruling indicated that, because of the increase in the federal deposit insurance limit, and the resultant drop in excess deposits, the organization has “received assessments that are approximately over $10 million in excess of the amount that your member credit unions would

118

have been required to contribute if they had all calculated their Aggregate Excess Deposits using the $250,000 federal deposit insurance limit.”

The organization indicated that it had obtained approval of the State Commissioner of Banks to pay a “rebate” to member credit unions to return the overfunding. The question was whether the rebates might amount to private inurement, leading to a loss of exempt status.

The Service ruled that it would not, observing:

“It is well settled that a nondiscriminatory pro rata refund of dues is not inurement to members of a tax exempt business league. The Service has ruled that an exempt business league may generally make cash distributions to its members without loss of exemption where such distributions represent no more that a reduction in dues or contributions previously paid to the league to support its activities. …

Here the rise in the federal insurance deposit limit from $100,000 to $250,000 creates a substantial surplus in your Reserve Fund and results in a substantial overpayment to the Reserve Fund by most member credit unions. Moreover, each of your current members has paid assessments that exceed the amount that you propose to rebate to that member. The rebate of Surplus Assessments can be paid entirely out of each recipient’s net assessments. As such, these payments represent a permissible nondiscriminatory, pro rata refund of prior contributions, and will not adversely affect your Section 501(c)(6) exemption.”

Besides structuring the rebate so that each member will receive less than it originally contributed, the ruling states that the rebate will be structured so that the total amount rebated will be less than total assessments over the years. Thus, the rebate will not require “distribution of amounts that could be considered income earned with respect to such assessments.” In addition, the rebate will be structured so that in “no case will a current member’s rebate be funded by contributions of a former member (except to the extent that the current member is a former member’s successor in interest).” With these limitations, the Service found that the distribution would not amount to inurement.

22. Ltr. 201114003 (December 7, 2010).

This ruling was issued to a public power company, which owns and operates a fully integrated electric utility system consisting of facilities for the generation, transmission, and distribution of electric power at wholesale and retail. A portion of the output of the public power company is sold to a rural electric cooperative pursuant to the terms of a long-term contract, which appears to have required the cooperative to buy all of its electricity requirements from the public power company.

The cooperative added new members (who likely were themselves electric distribution cooperatives). The new members initially were brought under the long-term contract. However,

119

the cooperative wanted to purchase electricity for those members from another source, an investor-owned public utility.

The cooperative and the public power company entered into negotiations, which culminated in an agreement to transition the new members over time from electricity obtained from the public power company to electricity from the investor-owned public utility. The cooperative agreed to a modification of the long-term contract. The long-term contract originally had a term of 35 years, and renewed automatically for successive 35-year periods, subject to the right of either party to terminate the agreement after the first term upon 10 years’ notice. The cooperative agreed to defer the date of any elective termination by 6.5 years.

The issue in the ruling related to whether the public power company could issue tax exempt bonds to finance a portion of the costs of the acquisition and construction of an ownership interest in a new electric power generating facility. Generally, tax exempt financing is not available for private activity bonds. Apparently, a contract like the one with the cooperative would today result in bonds for the new facility being considered private activity bonds, but there is an exception for output contracts entered into before September 19, 2002. The long-term contract between the public power company and the cooperative was entered into before that date and would be grandfathered, provided the modification did not cause the contract to be treated as a new contract:

“An output contract is treated as entered into on or after [September 19, 2002] if it is amended on or after that date, but only if the amendment results in a change in the parties to the contract or increases the amount of requirements covered by the contract by reason of an extension of the contract term or a change in the method for determining such requirements.”

The amendment did not change the parties to the contract. Thus, according to the ruling:

“The issue is whether the parties’ deferral of any elective termination of the Agreement for 6.5 years is an amendment that increases the amount of requirements covered by the contract by reason of an extension of the contract term… We conclude it is not. … The right to terminate or not was provided in the Agreement, a contract before September 19, 2002, and thus, the deferral is not an amendment.”

23. Ltrs. 201123035 (March 18, 2011) and 201123037 (March 18, 2011).

These two private letter rulings address how an exempt Section 501(c)(12) cooperative can surrender its tax-exempt status and operate as a for-profit cooperative (taxable under pre- Subchapter T law).

Both rulings involve electric cooperatives engaged in the distribution business in rural areas. The rulings state that the areas served by the cooperatives had experienced significant economic growth. The cooperatives had expanded their physical plant to allow them to serve 120

new and existing customers, looking to outside lenders and others to help finance that expansion. Both anticipated the need for additional expansion and had concluded “that further financings will be necessary to fund additional capital expenditures.”

Both rulings state that the cooperatives had concluded that it was necessary to surrender tax-exempt status because they were concerned that their “continued operations [as a tax-exempt cooperative] will limit your ability to seek and obtain additional financing to fund your capital improvements.” The rulings do not describe the cooperatives’ concerns further, but they likely related to limitations on accelerated depreciation and other tax benefits available to entities which lease facilities to tax exempt organizations. Presumably, tax benefits were important to whatever financing arrangements the cooperatives were contemplating, and all parties wanted to know with certainty that the cooperatives would no longer be considered to be considered tax exempt.

Section 501(c)(12) sets a variety of requirements that must be met for a rural electric or telephone cooperative to enjoy exempt status under that section. When an organization does not meet the 85% member income test for a year, the Internal Revenue Service has ruled that the entity loses its Section 501(c)(12) status for that year, but if it satisfies the requirements the next year, it automatically is exempt in that year. It does not have to reapply to obtain tax-exempt status. The letter rulings both state:

“Rev. Rul. 65-99, 1965-1 C.B. 252, provides that the 85 percent member income test is applied on the basis of an annual accounting period. Failure to meet the requirement in a particular year precludes exemption for that year, but has no effect upon exemption for years in which the 85 percent test is satisfied.”

What probably prompted the cooperatives to seek a ruling was the concern that, even though they might violate the requirements of Section 501(c)(12) for a year and become taxable for the year, and that they might do so for every year the financing was in place, they would still be regarded as tax-exempt organizations since, if they ever once again met the requirements of Section 501(c)(12), they would automatically again be tax-exempt. Perhaps something else is required to surrender tax-exempt status.

If this was the concern of the cooperatives, the rulings confirm that it was shared by the Internal Revenue Service:

“Even though an organization described under section 501(c)(12) of the Code is required to file Form 1120 for the years it does not satisfy the 85 percent member income test, it is still recognized as an exempt organization until it wants to surrender its exempt status. See, Rev. Rul. 65-99.”

Rev. Rul. 65-99 does not say this precisely, so there likely is room for reasonable minds to differ as to precisely what the status of an organization is that has lost its tax-exempt status for a year by reason of violating one or more of the requirements under Section 501(c)(12). Compare, for instance, the treatment of Section 501(c)(12) organizations that regain tax-exempt status after 121

having temporarily lost it under Treas. Reg. §1.337(d)-4 (which generally provides that when a taxable organization becomes tax-exempt there is a taxable event – the taxable organization is treated as if it had disposed of all of its assets were sold at their fair market values).

In any event, according to the two private letter rulings, the way to give up Section 501(c)(12) status is to file a final cooperative return:

“An organization that no longer wants to be exempt under section 501(a) of the Code will need to file a final return as described in section 6043(b). Once the final return is filed, the organization will no longer be described under section 501(a).”

Section 501(c)(12) cooperatives seeking to permanently surrender Section 501(c)(12) status should be careful to take this formal step.

24. Ltr. 201123038 (March 18, 2011).

This is yet another ruling issued to a rural telephone cooperative concluding that a gain realized upon the sale of an interest in a cellular telephone company is patronage-sourced.

The cooperative initially invested along with other investors (including other rural telephone cooperatives) in two corporations, Corp X and Corp Y, “in order to access cellular telephone technology for [its] members.” Corp X and Corp Y later formed a Limited Partnership. Collectively, Corp X, Corp Y and the Limited Partnership are referred to in the ruling as the Enterprise.

A third party, Corp Z, gradually acquired a significant interest in the Enterprise. This presented an operational problem, since the Enterprise and Corp Z were in competition with each other, trying to sell cellular services to the same customers. At the same time, “alternative cellular phone services were becoming available from other sources to provide to [the cooperative’s] members.”

The cooperative decided to sell its interest in the Enterprise to Corp Z. The ruling states:

“Your board of directors determined it would be in your best interest to sell your interest in Enterprise, use proceeds from the sale for capital investments in plant and equipment to provide services to members, and potentially obtain cellular service from a different source after a required two-year continuing contractual commitment to obtain cellular service from Corp Z.”

In concluding that the gain on the sale of the interest was patronage-sourced, the ruling focused on why the cooperative originally become involved in the Enterprise and why it sold its interest. With respect to the decision to become involved, the ruling states:

122

“You actively participated in the formation and funding of Corp X and Limited Partnership to insure that cellular service would be available on reasonable terms to your customers and to ensure that they would not be adversely affected by other customers’ migration to cellular. You have submitted affidavits from three current board members who state that the purpose of your participation was to provide cellular service to your members and to protect against losing your core business to cellular services offered by others. You represent that your investment was not made primarily for the purpose of receiving earnings, although the ultimate return on the investment is substantial….

Your investment in Corp X and Enterprise was directly related to its cooperative business. Investing in a company in order to provide wireless telephone service is directly related to the business of a cooperative whose foundation is to provide telephone service to its patrons.”

With respect to the decision to sell the interest in the Enterprise, the ruling observes:

“Your sale of Enterprise is also directly related to your cooperative business purpose. The sale of Enterprise to Corp Z is the natural conclusion of an enterprise calculated to build the cellular network and guarantee service to rural customers.”

The ruling does not contain a description of the role that the cooperative played in the activities of the Enterprise and whether the cooperative’s cellular activities (as opposed to its land-line activities) were conducted on a patronage basis.

The ruling observed that the cooperative could treat the entire gain as patronage sourced because “you do 100 percent of your telephone business with patrons on a cooperative basis.”

25. Ltr. 201136027 (June 14, 2011).

Ltr. 201136027 (June 14, 2011) addresses the dissolution of an exempt Section 501(c)(5) agricultural organization. It concludes that the organization can transfer all or substantially all of its assets to another section 501(c)(5) organization pursuing similar objectives without jeopardizing its exempt status.

The ruling states that the agricultural organization was formed in 1999 as a nonprofit corporation:

“… to invest in certain agricultural processing facilities and allied enterprises. Specifically, you were organized to help finish equity drives for farmer-owned agricultural processing facilities, and then sell the shares back to producers.”

The organization received a determination letter confirming its status as an exempt Section 501(c)(5) agricultural organization in 2004.

123

According to the ruling, the organization desires to dissolve because:

“Due to a variety of market and economic reasons, the construction of such farmer-owned processing plants has stopped. Because these plants are no longer being built, you are no longer able to carry out your exempt purpose.”

As part of the dissolution, the organization wants to distribute its assets (including interests in some of the businesses it helped to foster) to another Section 501(c)(5) organization that is engaged in research and technology that will assist the agricultural community.

Generally, Section 501(c)(5) agricultural organizations must “have as their objects the betterment of the conditions of those engaged in [agricultural] pursuits, the improvement of the grade of their products, and the development of a higher degree of efficiency…” Treas. Reg. §1.501(c)(5)-1(a)(2). In addition, none of their earnings may inure to any member. Treas. Reg. §1.501(c)(5)-1(a)(1).

The focus of the ruling was on the inurement requirement. Based on the following representations, the ruling concluded that the proposed liquidating distribution was permissible:

“You have represented that your officers and directors, and the officers and directors of M, the recipient organization exempt under section 501(c)(5) of the Code, will receive no compensation connected with the dissolution and distribution of your assets. Although officers of both companies own some stock or other investment units in the assets being transferred, you have represented that all of such investments were purchased or subscribed to prior to the acquisition or subscription of you to the investment, and that it is not contemplated that the value of such assets will increase as a result of the transfer.”

26. Ltr. 201143021 (August 1, 2011).

This is yet another ruling issued to a Section 501(c)(12) rural electric cooperative confirming that a program involving redeeming capital credits at a discount will not create tax issues.

The cooperative proposed to establish a voluntary plan which would offer holders of allocated patronage capital the option of tendering the capital for redemption at a discount. It appears that the redemption price for each year’s allocated equity would be determined based upon an assumed twenty-year revolving period and a discount rate equal to the 20-year Treasury risk-free bond rate plus a risk factor to be determined by the cooperative’s board. All holders of allocated patronage capital would be eligible to participate, and, at the board’s discretion, holders would be able to tender for redemption all or part of their allocated capital. According to the ruling, “the difference between the face amount of the equity capital credit and the amount paid will be reserved as permanent equity, to be distributed only at your dissolution or liquidation.”

124

The ruling describes the reason the cooperative proposed adopting the plan:

“You have stated that your sources of electric generation will change in the next decade. You also expect fossil fuels will become more difficult to use, and additional financial resources will be required to acquire or upgrade electric transmission assets. Seeking to strengthen your equity resources, you have proposed to retire the current patronage allocations to current, former and deceased patrons on an accelerated basis.”

The IRS ruled on three matters.

First, it concluded that the proposed redemption program was consistent with operating on a cooperative basis and would not jeopardize the cooperative’s Section 501(c)(12) status. Second, it concluded that the proposed discounting would not result in an impermissible forfeiture of patronage capital. Third, it concluded that “the proposed methodology for determining the discount rate is consistent with the precepts of cooperative tax law, and is within the board of trustees’ discretion.”

The ruling contains somewhat more analysis than is found in many of the other similar rulings.

In concluding that the program is consistent with “operating on a cooperative basis,” the ruling analyzes the impact of the program on governance, operation at cost and subordination of capital. The redemption program will not affect voting rights. The ruling indicates that the “cooperative principle of operating at cost is satisfied because the members’ right to receive the excess (i.e., capital credits) over the cost of electricity is also not adversely affected.” With respect to subordination of capital, the ruling observes:

“The cooperative principle of subordination of capital is satisfied because the proposed redemption program does not adversely affect the members’ control and ownership of the cooperative assets.”

In concluding that the program does not result in an impermissible forfeiture of rights of former members, the ruling observes:

“The cooperative requirement that there is no forfeiture of former members’ rights to assets of the cooperative is not violated. Specifically, the redemption program permits members and former members to receive the present value of their capital credit accounts (i.e., patronage savings) at a date earlier than a 20- year holding period or cycle. The discount rate is in accordance with the prevailing market rate. Thus redeeming the capital credits at a discount rate would not violate cooperative principles, and your tax-exempt status under section 501(c)(12)(A) would not be jeopardized, assuming you meet the 85 percent member income test.”

125

This ruling is different from prior rulings in that it discusses whether there are any issues arising from adding the amount of discount to unallocated equity. The ruling states:

“You have said that the difference between the face amount of the equity capital credit and the amount paid would be reserved as permanent equity, to be distributed only at your dissolution or liquidation. The issue is whether this proposal violates cooperative principles.

This proposal does not violate the cooperative requirements of democratic control by members and non-forfeiture of a member’s right to your assets because your trustees are subject to and responsive to the control of the members. We note that the members of the cooperative elect the trustees, and any members may submit resolutions to change the cooperative operations, subject to approval of the majority of members. Consequently, the transfer of the difference between the face amount of the equity capital credit and the amount paid to permanent equity, or net savings, under these circumstances does not violate any cooperative requirements and, therefore, your exempt status under section 501(c)(12) is not adversely affected, assuming you satisfy the 85 percent member income test for the particular tax year.”

27. Ltr. 201145012 (August 9, 2011).

This ruling addresses an internal reorganization involving a cooperative exempt under Section 501(c)(12) and four subsidiaries. Three of the subsidiaries were disregarded entities for tax purposes. The one regarded entity was a wholly-owned subsidiary of the cooperative treated as a corporation for tax purposes.

In the reorganization, all of the disregarded subsidiaries were merged into the corporate subsidiary, the corporate subsidiary elected to be treated as a disregarded entity, and it distributed two utility businesses that the subsidiaries had been conducting to the parent (which also had been conducting a utility business).

After the reorganization, the parent had one subsidiary, which was a disregarded entity. That subsidiary appears to have the purpose of acting as a holding company for various interests in large partnerships also providing utility services.

The ruling describes the reasons for the reorganization as follows:

“Parent and its subsidiaries provide Utility 5 related services to the rural State area. As currently structured, Parent provides service (local Utility 1 services) that are different from those provided by the subsidiaries (Utility 2 and Utility 3 services). Consolidating these services at the Parent level will allow Parent to provide such services to customers from a single source on a cooperative basis. The strategic marketing from such bundled services will be valuable to Parent. A 126

simpler structure also will streamline management and accounting functions of Parent. Further, moving Utility 2 and Utility 3 activities to Parent will minimize state franchise and sales taxes.”

Not surprisingly, the ruling concludes that the reorganization is tax free.

The real issue was probably not whether the proposed reorganization was tax exempt, but whether it would trigger gain under Section 337 if it resulted in the conversion of the utility businesses conducted by the subsidiaries from taxable to tax exempt. Treas. Reg. §1.337(d)-4(a) provides, as a general rule:

“…if a taxable corporation transfers all or substantially all of its assets to one or more tax-exempt entities, the taxable corporation must recognize gain or loss immediately before the transfer as if the assets were sold at their fair market values.”

One of the representations made by the cooperative and recited in the ruling is that, “[a]fter the conversion of Sub 1 … Parent expects that it will not be an organization that is exempt from federal income tax under §501 or any other provision of the Code.” Presumably this is because the Utility 2 and Utility 3 activities (which are not being conducted on a cooperative basis) would cause it to violate the 85% member income test. Thus, on the surface, the general rule would not be applicable.

But what if those activities are converted to cooperative activities, and the cooperative parent later regains its Section 501(c)(12) status?

There is a special exception from the Treas. Reg. §1.337(d)-4 rules for Section 501(c)(12) entities that lose their exemption solely because of a violation of the 85% member test and then later regain it. Treas. Reg. §1.337(d)-4(a)(3)(i)(E). But there is an exception to the exception where a corporation “with a principal purpose of avoiding the application” of the general rule “acquires all of the assets of another taxable corporation and then changes its status to that of a tax-exempt entity.” Treas. Reg. §1.337(d)-4(a)(3)(iii).

Would the exception to the exception apply? Interestingly, the IRS was willing to rule that it would not:

“If Parent’s status changes to be a tax exempt cooperative under §501(c)(12) by meeting the 85% member income test after the conversion of Sub 1, the deemed liquidation of Sub 1 will not be considered to have had a principal purpose of avoiding the application of the change in status rules under the anti-abuse rule in §1.337(d)-4(a)(3)(iii), and the parent’s return to tax-exempt status will qualify for the exception from the Change in Status Rule under §1.337(d)-4(a)(3)(i)(E).”

127

28. Annual Report of the IRS Tax Exempt and Government Entities Division (December 2010).

At the end of 2010, the IRS Tax Exempt and Government Entities division issued a report describing some if its future projects and initiatives.

In a section entitled “EO Invests,” the report included the following description of a project targeting Section 501(c)(12) cooperatives:

“‘Mutual’ Organizations – The IRC §501(c)(12) Project. Organizations exempt under section 501(c)12) include benevolent life insurance associations of a purely local character, mutual ditch or irrigation companies, or cooperative telephone companies. An organization that performs any comparable service can also qualify.

These organizations must use their income solely to cover losses and expenses, with any excess being returned to members or retained for future losses and expenses. They must collect at least 85 percent of their income from members for the sole purpose of meeting losses and expenses. The results of the member- income ‘test’ determine the organization’s yearly filing requirement. An organization should file Form 990 for the years in which it meets the 85 percent member-income test, and it should file Form 1120 for the years it fails to meet the test.

The Forms 990 filed by some section 501(c)(12) organizations indicate that these organizations are not meeting the 85 percent member-income test every year. To address this issue, questionnaires were mailed to affected organizations in early FY 2010, and 40 percent of the questionnaire respondents were selected for examination. In FY 2011, we will begin conducting these examinations.”

29. Christina A. Alphonso, 136 T.C. 247 (2011).

A shareholder of a housing cooperative is not entitled to a casualty loss deduction for damages sustained when a retaining wall on the cooperative’s property collapsed.

30. INFO 2011-0006 (December 22, 2010), INFO 2011-0016 (March 1, 2011) and INFO 2011-0048 (June 24, 2011).

The Internal Revenue Code contains various credits designed to encourage homeowners to make energy efficient improvements to their homes. Section 25D provides a tax credit for residential alternative energy equipment equal to 30 percent of the cost of eligible solar water heaters, solar electricity equipment and fuel cell plants, subject to various limitations. Section 25C provides a credit for certain residential improvements equal (in 2011) to 10 percent of the cost of qualified energy efficiency improvements (windows, doors, insulation, certain roofs) plus

128

the cost of qualified property (heat pumps, water heaters, furnaces, central air units) up to a $500 lifetime maximum.

For housing cooperatives and their tenant-stockholders (i.e., their members who typically own stock in proportion to their unit size), a special rule applies. Section 25D(e)(5) provides:

“(5) Tenant-Stockholder in Cooperative Housing Corporation. – In the case of an individual who is a tenant-stockholder (as defined in section 216) in a cooperative housing corporation (as defined in such section), such individual shall be treated as having made his tenant-stockholder’s proportionate share (as defined in section 216(b)(3)) of any expenditures of such corporation.”

The Internal Revenue Service has not gotten around to issuing regulations under either Section 25C or Section 25D. It has issued notices under Section 25C (Notice 2009-53, 2009-25 I.R.B. 1095) and Section 25D (Notice 2009-41, 2009-19 I.R.B. 933) containing information about what qualifies and how to claim the credits. These notices contained no guidance with respect to the special rule for cooperative housing corporations and their tenant-stockholders.

Several IRS Information Letters were recently released clarifying how the Internal Revenue Service views the special rule as operating. See Information Letters 2011-0006 (December 22, 2010), 2011-0016 (March 1, 2011) and 2011-0048 (June 24, 2011).

Most special provisions drafted to allow Subchapter T cooperatives and their members to benefit from tax credits provide that, in the first instance, the cooperative earns the credit and then it is up to the cooperative to determine whether to pass all, none or part of the credit through to patrons. A few provisions applicable to Subchapter T cooperatives provide that cooperatives earn the credit, but require cooperatives to pass through any credits they can not use. There are no provisions that provide that the credit is earned by the members themselves, not the cooperative.

The housing cooperative provision is different. The housing cooperative is not entitled to the credits, and it does not pass them through. Rather, the tenant-stockholders are entitled to the credits. The Information Letters confirm that difference:

“A cooperative housing corporation is not eligible for these tax credits for new fenestration or other products that benefit all of the individual tenant- stockholders. This credit is a personal, individual credit for individual taxpayers, and the law specifically allows tenant-stockholders in their individual and personal capacity to claim these tax credits. The Congress would have to amend the law to allow a cooperative to claim the credit.” (See, Information Letter 2011- 0048, emphasis in original.)

This is a different legislative approach to credits and probably is not practical or desirable for Subchapter T cooperatives and their members. But it is worth noting for possible future

129

reference when cooperatives are considering what kinds of pass-through provisions to request from Congress.

The Information Letters make it clear that each tenant-stockholder’s proportionate share of expenditures is determined based on “the proportion that the stock of the cooperative housing corporation owned by the particular tenant-stockholder is of the total outstanding stock of the corporation (including any stock held by the corporation.” The letter states that the proportionate share of tenant-stockholders is not adjusted to take into account the share of expenditures attributable to tenant-stockholders who cannot take the credit because they do not meet the principal residence requirement.

Finally, the Information Letters emphasize that each tenant-stockholder gets a proportionate share of any and all qualifying expenditures. If an expenditure is made to install qualified property in a tenant-stockholder’s unit, the tenant-stockholder does not get to claim a credit based upon the entire expenditure. Rather, the tenant-stockholder is limited to a proportionate share of the expenditure. By the same token, a tenant-stockholder is entitled to claim a credit for a proportionate share of expenditures related to improvements to other tenant- stockholders’ units or to common areas.

31. Letter from Credit Union National Organization to the IRS dated September 15, 2011, Tax Notes Doc. 2011-19731, and memorandum dated October 11, 2001 from the General Counsel of CUNA, https://www.cuany.org/access_files/compliance/RevocationLtrUpdateOct112011.pdf

The Pension Protection Act of 2006 added a section to the Code that provides that a tax- exempt organization automatically loses its exempt status if it fails for three consecutive years to file an annual return or notice. Section 6033(j). This provision first became effective this past year, and in May the IRS notified a number of organizations that their exempt status was revoked.

Many credit unions received notice of revocation.

By letter dated September 15, 2011, Bill Cheney, the President of the Credit Union National Association (“CUNA”), wrote to the Commissioner of the IRS and the Director of the Exempt Organizations Division asking that the IRS “take immediate action to correct a very serious error that has resulted in the purported revocation of the tax-exempt status of over one hundred credit unions that have been diligently filing Form 990 information returns for years.”

This letter appears to have led to discussions with the IRS which have clarified the situation.

Credit unions fall into two general categories – state-chartered credit unions, which are exempt under section 501(c)(14) and are required to file a Form 990, and federally-chartered credit unions, which are exempt under Section 501(c)(1) and are not generally required to file a Form 990.

130

Apparently, several different problems let to the erroneous revocations. These problems and how they are being addressed are described in a memorandum dated October 11, 2011, prepared by the General Counsel of CUNA.

Some of the affected state-chartered credit unions were originally affiliated with central organizations that received a group exempt letters from the IRS, but are no longer affiliated with those organizations and have been filing their own returns for years. Many of these credit unions were notified of revocation because of the failure of the former parent entity to file a return. The General Counsel of CUNA advised these organizations not to do anything.

“The IRS is researching and untangling the credit union group parent issue (which apparently stretches back to WWII when viewed through IRS records), and will eventually be issuing letters to each of the affected credit unions telling them that they are in good standing.”

Some of the affected state-chartered credit unions were notified of the revocation as a result of their own alleged failure to file (not the failure to file by a former parent). According to CUNA’s General Counsel, those entities, if they did in fact file returns, should provide the Ogden Service Center with proof of filing.

Some federally-chartered credit unions got notices because they used to be state- chartered and required to file tax returns. The IRS has placed an FAQ on its website as to how such organizations should straighten out their status.

Some federally-chartered credit unions have received letters, similar to letters received by some state-chartered credit unions, that their exempt status has been lost because of an alleged failure by a parent organization to file. Here, CUNA’s General Counsel advises doing nothing:

“As stated above, the IRS is researching and untangling the credit union parent organization issue, and will eventually be issuing letters to each of the affected credit unions telling them that they are in good standing.”

Finally, in a seemingly unrelated area, some federally-chartered credit unions (which are exempt under Section 501(c)(1) of the Code) have been attempting to file Form 990-Ts to claim the health insurance premium credit and have encountered problems. The CUNA General Counsel advises that the IRS system needs to be overridden to allow this to be done since it is programmed not to expect tax forms from federally chartered credit unions. He provides instructions as to how to contact the IRS to accomplish this.

State tax matters

32. Illinois Schedule INL (Illinois Net Loss Adjustment for Cooperatives).

131

Last year’s Digest of Current Cooperative Tax Developments reported on an Illinois administrative law decision denying a cooperative a net operating loss carryover for nonpatronage losses the cooperative chose not to net against patronage income for federal income tax purposes. That decision led to a change in Illinois law that allows cooperatives the option for Illinois income tax purposes of netting patronage losses against nonpatronage income.

During the past year, Illinois released a new form – Schedule INL (Illinois Net Loss Adjustment for Cooperatives) – to implement the statute. The form allows cooperatives to elect whether or not to net patronage losses against nonpatronage income. The statute contemplates that this is a one-time election, and that a cooperative must ask for permission to later change. The instructions to the form provide:

“This election must be made with your Illinois income tax return for the first taxable year ending on or after December 31, 2010, and once made, is irrevocable and must be followed for all taxable years, including any earlier taxable years that are still open (e.g., within statute of limitations for refunds, nonfiled periods, etc.).” (emphasis in original).

There is no comparable election for nonpatronage losses. The Schedule INL does have a box to be checked if a cooperative chooses to net nonpatronage losses against patronage income for a year for federal income tax purposes to inform the state of how it reports.

Note that under current Illinois law, net operating losses may not be carried back, but they may be carried over for 12 years. However, early in 2011, in response to severe budget problems, Illinois dramatically increased its income tax rates for corporations and individuals. As part of that change, Illinois suspended net operating loss deductions for C corporations for taxable years ending after December 31, 2010 and prior to December 31, 2014 (i.e., calendar years 2011, 2012 and 2013). That suspension was modified slightly in December to allow C corporations to deduct $100,000 of loss carryovers for taxable years ending on or after December 31, 2012 and prior to December 31, 2014 (i.e., calendar year 2013). Any year for which losses are suspended is not counted for purposes of the 12 year carryover period.

33. Indiana Department of State Revenue Letter of Finding No. 08-0374 (December 1, 2009).

Large corporations have sometimes established cooperatives which are wholly-owned by the corporation and its subsidiaries (“captive cooperatives”) to serve their many subsidiaries, by, for instance, conducting purchasing activities or providing services of some sort on a consolidated basis for the group. Conceptually, captive cooperatives are similar to captive insurance companies that serve corporate parents and their subsidiaries. If structured properly, captive insurance companies generally are respected today for federal and state tax purposes. However, as prior articles in the TAXFAX Column have reported, captive cooperatives have not been well received by the Internal Revenue Service, who has often looked at them as motivated solely or principally by tax avoidance motivations.

132

In Letter of Finding No. 08-0374 (December 1, 2009), the Indiana Department of Revenue addressed, among other things, use of a captive cooperative by a group of corporations under common control and concluded that the captive cooperative should be part of the group’s combined return for Indiana purposes.

This letter of finding involves the case of an unidentified corporation with over forty subsidiaries, both domestic and foreign. Indiana was concerned because several of the subsidiaries appeared to be designed to move income from Indiana to low tax jurisdictions. One of the subsidiaries was an intellectual property leasing company. Another loaned funds generated by royalty payments back to members of the group. Another was a captive cooperative, formed to manufacture products which other subsidiaries in the group sold. The letter of finding describes the captive cooperative as follows:

“The manufacturing corporation (hereafter ‘Mfg. Corp.’), which is owned by affiliate-subsidiaries that are also Mfg. Corp’s customers, manufactures products for the affiliate-subsidiaries to sell. Mfg. Corp. makes wholesale sales to the other subsidiaries and then pays ‘patronage dividends’ back to the subsidiaries according to the volume of purchases that the subsidiaries make. Taxpayer did not include Mfg. Corp. in its Indiana corporate income tax returns for the years in question. However, the subsidiaries that Taxpayer included in its Indiana corporate income tax returns were all affiliate-subsidiaries of Mfg. Corp. that made purchases and received ‘patronage dividends’ back from Mfg. Corp.”

Indiana described why the group’s failure to include the captive cooperative in the combined return did not fairly reflect the income of its Indiana business:

“Mfg. Corp. made wholesale sales to the other subsidiaries and then paid ‘patronage dividends’ back to the subsidiaries according to the volume of purchases that the subsidiaries made. While nothing changed with respect to the Taxpayer’s overall business after entering into the … manufacturing transactions, Taxpayer received a substantial profit from its sales of products only to have it greatly reduced by these intercompany transactions.”

From a state tax perspective, the answer was relatively simple. Indiana did not attempt to sham the captive cooperative and other entities which caused it concern. Rather, it concluded that those entities should be included in the group’s combined Indiana return, effectively restoring a portion of the earnings to the Indiana tax bases. The letter of finding observed:

“Here based on numerous intercompany transactions and excluding certain entities from the return, Taxpayer sought to shield virtually all of the income of its Indiana operations from Indiana’s taxation. Taxpayer’s method of reporting the transactions can only be described as not fairly representing Taxpayer’s Indiana income. Taxpayer received a substantial profit from its sales of products, only to have the profit greatly reduced by several intercompany transactions, including … taking ‘cost of goods sold’ deductions for goods that were ‘bought’ from a related 133

entity that in turn paid those subsidiaries purchasing the goods tax-exempt dividends [presumably for Indiana purposes] in relation to the amounts that were purchased. These businesses, if respected as businesses, constituted an integrated enterprise. Thus, to state that only a portion of the income due to Taxpayer’s primary products sales was taxable, without recognizing the whole of the enterprise to overall profitability, was to not fairly represent Taxpayer’s income in Indiana.”

Other issues were involved in this case, and interested readers should look at the letter of finding to get the full story.

In additional to requiring that the group file a combined return that included both the intellectual property company and the cooperative, the letter of finding concluded that the auditors properly imposed the Indiana underpayment of estimated tax and negligence penalties.

34. Minnesota Revenue Notice No. 11-02 (April 11, 2011).

Minnesota exempts the net income from certain “qualified businesses” from the individual income and corporate franchise taxes. For this purpose, a “qualified business” is a person that operates a trade or business in a job opportunity building zone and has executed a business subsidy agreement with the appropriate local unit of government.

In Minnesota Revenue Notice No. 11-02 (April 11, 2011), the Minnesota Department of Revenue considered whether patrons of a cooperative that is itself engaged in a “qualified business” can claim that all or a portion of the patronage dividends that they receive are exempt business income. The Department concluded that the answer depended upon whether the cooperative was incorporated under Minnesota’s traditional cooperative statute (a “308A Cooperative”) or under Minnesota’s new cooperative association statute (a “308B Cooperative”). For Minnesota tax purposes, 308A Cooperatives are generally treated as corporations (which are entitled to a patronage dividend deduction), while 308B entities are generally treated as pass- through entities.

The Department concluded that patronage dividends paid by a 308A Cooperative do not maintain their character, and thus patrons can not claim that they are exempt income. In the Department’s view, the income of a 308A Cooperative loses its character when distributed as a patronage dividend. It observed: “…the character of patronage dividends is determined under the general tax rules that dictate the character of a C-corporation’s distributions … [and such income] does not retain its character after distribution…”

For patrons of 308B Cooperatives, it is a different story. Since those entities are treated as pass-through entities for state tax purposes, the Department concluded that for individuals, trusts or estates that are members, the patronage dividends retain their character after distribution and thus if attributable to a qualified business carried on by the cooperative is exempt business income to the patron. However, corporate members of a 308B Cooperative still are not eligible to claim that the income is exempt because a “corporation must itself be a qualified business before it can exempt income from the franchise tax” under the provision. Finally, the 134

Department concluded that nonmember patrons of a 308B Cooperative also were not eligible to treat patronage dividends as exempt since, in its view, “non-member patrons are like the cooperative’s other trade creditors; thus, the cooperative’s net income does not flow-through to them with its retained character.”

135

2011 Report of LTA Subcommittee on the IRS Industry Specialist

Marla Aspinwall, Chair Loeb & Loeb LLP 10100 Santa Monica Boulevard, Suite 2200 Los Angeles, California 90067-4164 Telephone: (310) 282-2377 Fax: (310) 282-2200 E-Mail: [email protected]

Our Industry Specialist, Tracy Holtslag is located in Dallas Texas at 4300 MSRO, 4050 Alpha Rd. Dallas, Texas 75244; phone: (972)308-1631; fax: (972)308-1545; e-mail: [email protected]. The Industry Specialist provides the Internal Revenue Service with an overview of the examinations in a particular industry and acts as a repository of knowledge and experience for auditors examining taxpayers in such industry.

Few of our members have reported any contact with Tracy this year. Tracy is known to have been involved behind the scenes in advising auditors on various cooperative audits. As always, we ask that you not contact Ms Holtslag directly without first discussing the nature of your contact with a member of this Committee. If Ms Holtslag attends your audit or otherwise makes contact with you, we would appreciate it if you notify us of such contact.

136