PwC Seeks Transition Rule for Some Excess Foreign Taxes

August 6, 2018

David J. Kautter
Assistant Secretary for Tax Policy, and Acting Commissioner of the Internal Revenue Service
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

William M. Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Re: Carryforward of Excess General Category Taxes to Foreign Branch Income Category

Dear Messrs. Kautter and Paul:

PricewaterhouseCoopers LLP respectfully submits this comment letter on behalf of DefCo Holdings, Inc. (collectively, “we”) to urge Treasury and the IRS to promulgate a transition rule that will allow U.S. taxpayers to carryforward certain excess general category foreign taxes under section 904(c) to the foreign branch income category (the “FBIC”) introduced as part of the Tax Cuts and Jobs Act 2017 (P.L. 115-97) in the first year of its existence.¹ In the absence of such a transition rule, many U.S. taxpayers that have historically conducted foreign business operations directly through foreign disregarded entities and/or foreign branches will be unjustifiably subject to double taxation, contrary to the core purpose of the foreign tax credit. As discussed herein, Treasury and the IRS have ample authority to provide a transition rule in this context and there is precedent and compelling policy support for providing such a rule.

Recommendation: Promulgate a transition rule that permits taxpayers to reconstruct the amount of their pre-effective date excess taxes in the general category that would have been attributable to the FBIC if that category had been in existence in prior taxable years, and reassign such excess taxes to the FBIC under section 904(d)(1)(B) in the first year of its existence (i.e., taxable years beginning after December 31, 2017).

We believe that such a transition rule could be promulgated as a general rule, which would apply to all taxpayers, or as an election, which would allow taxpayers to decide whether to apply the rule. In either event, a transition rule is needed to mitigate the adverse impact that the enactment of the new FBIC could have on taxpayers, and provide taxpayers the most sensible and fair transition to the new FBIC.

I. Discussion

A. Pre- and Post-TCJA Treatment of Foreign Branch Operations

Many U.S. taxpayers conduct their foreign business operations through foreign disregarded entities, foreign branches, or joint venture partnerships. In some cases, the form of the operation is required by foreign legal or regulatory requirements, and in other cases, the flow-through nature of the operations are chosen based on simplicity, administrability, foreign withholding tax, or U.S. tax considerations. In all cases, however, it is clear that the income generated by the foreign business operations are immediately subject to U.S. taxation as well as foreign income tax. To ensure that U.S. taxpayers operating in such a manner can maintain competitiveness, the Code provides U.S. taxpayers a quid pro quo by granting U.S. taxpayers a foreign tax credit under section 901, subject to the limitations of section 904. Broadly speaking, prior to the TCJA 2017, a U.S. taxpayer's active business operations conducted directly through foreign branches (including disregarded entities), as well as through CFCs (recognized by the U.S. taxpayer as a result of a dividend, Subpart F, or section 956 inclusion) were placed in the general category for purposes of the section 904 limitation. As such, U.S, taxpayers that conduct foreign business operations through foreign branches or foreign disregarded entities generated largely general category income prior to the changes made in the TCJA 2017.

Section 904(d)(1)(B) establishes the new FBIC and was enacted to preclude foreign taxes imposed on foreign branch operations, which generally are subject to relatively higher rates of foreign tax, from reducing the U.S. tax on foreign general category income that is subject to a relatively lower rate of foreign tax.² In this regard, following the enactment of the new FBIC, the same historic business operations conducted by a U.S. taxpayer through foreign branches or disregarded entities, which previously were taken into account in the U.S. taxpayer's general category under section 904, are now expected to come within the FBIC (i.e., income and foreign taxes historically assigned to the general category will now be assigned to the FBIC). As a result, excess general category foreign taxes from pre-TCJA 2017 years that are attributable to these same business operations will be stranded in the general category and may not have a realistic opportunity of ever being fully utilized even though those taxes otherwise would have been assigned to the FBIC if it had been in existence at that time. That is, U.S. taxpayers will have insufficient foreign tax credit limitation to utilize excess general category foreign taxes carried forward if income generated in a carryforward year, which is of the same type that gave rise to the excess foreign taxes in a prior year, is allocated to the FBIC rather than the general category. Absent a transition rule permitting taxpayers to reassign these excess taxes, U.S. taxpayers will be subject to double taxation, contrary to the purpose for which section 904(c) was enacted.

Further, as a result of the reduction in the U.S. corporate tax rate in the TCJA 2017,³ U.S. taxpayers will generally have less foreign tax credit limitation. Moreover, relatively high foreign tax rates, the blending of profitable and loss-making branches, and expense apportionment each negatively impact foreign tax credit limitation in the FBIC. All of these factors exacerbate the challenges associated with enactment of the new FBIC (e.g., including the increased likelihood that taxpayers will be subject to double taxation as a result of lost excess foreign tax credit carryforwards) and illustrate the importance of appropriately applying section 904(c) to U.S. taxpayers as they transition to the new FBIC.

B. Foreign Tax Credit Regime

i. Foreign tax credits and separate categories of income

Under section 901, foreign taxes paid through foreign business operations conducted through foreign disregarded entities or foreign branches are available to be claimed as a credit, subject to applicable limitations, to provide U.S. taxpayers relief from double taxation. In this context, the ability to claim a foreign tax credit is absolutely essential to allow U.S. taxpayers to compete in the global marketplace. If the credit were not available, U.S. taxpayers would suffer significant double taxation, resulting in a substantial competitive disadvantage when compared to foreign competitors whose operations are subject to only a single level of tax.

Prior to the TCJA 2017, foreign income and associated foreign income taxes were generally assigned to the section 904 category for either passive category income or general category income. A separate section 904 foreign tax credit limitation was then required to be computed for each category to ensure that the foreign taxes able to be claimed in a separate category did not exceed the U.S. tax on the net foreign source income in the category. Thus, the higher the foreign tax rate on foreign income derived, the more likely that section 904(a) would limit the ability of a U.S. taxpayer to claim foreign taxes as a credit from a category. Further, many other factors could impact whether a U.S. taxpayer was limited in its ability to claim foreign tax credits, such as timing or base differences between U.S. and foreign law, passive foreign losses or overall U.S. sourced losses of the U.S. taxpayer, net operating losses, separate limitation or overall foreign loss recapture under section 904(f), or, more generally (and more likely), expense apportionment (e.p., interest expense, R&D) under section 861.⁴ If a U.S. taxpayer is limited in its ability to claim foreign tax credits in a particular year, the excess amount is not immediately creditable. Despite this limitation, excess foreign tax credits are not forfeited, but rather, as discussed below, section 904(c) provides a mechanism through which such excess foreign taxes may be utilized in a different year.

ii. Section 904(c)

The application of the foreign tax credit regime is complex and designed to protect the U.S. tax base in certain cases, while fundamentally providing taxpayers the ability to mitigate double taxation by claiming a credit in the United States. Implicit in the overall function of the foreign tax credit regime is that U.S. tax law and the policies it furthers will not exactly align with the application of foreign tax laws and, in certain instances, may result in a delay in the ability of a U.S. taxpayer to claim a credit in the United States. Consistent with the fundamental purpose of the grant of a foreign tax credit under section 901, section 904(c) was enacted for the purpose of mitigating double taxation that could result from timing differences between the methods of reporting the same item of income for United States and foreign country tax purposes and the foreign tax credit limitations existing at that time.⁵ Section 904(c) provides that to the extent taxes paid to a foreign country for any taxable year exceed the limitation under section 904(a), the excess may be carried back to the preceding taxable year and carried forward to the 10 succeeding years under certain limitations. The taxes carried over under section 904(c) are determined separately for each category described in section 904(d) and are treated as paid or accrued in the year in which they are carried.⁶ Furthermore, such taxes may only be used as a credit, and not as a deduction, in the year to which carried. Any excess foreign taxes in a separate category that cannot be utilized by a U.S. taxpayer within the 10-year carryforward period are lost.

II. Recommendation

As demonstrated above, the enactment of the FBIC will cause many U.S. taxpayers conducting their activities directly out of the United States through foreign disregarded entities or foreign branch operations to be unjustifiably subject to double taxation, contrary to the core purpose of the foreign tax credit. For these taxpayers, the effect of this change in law is the same as if Congress had repealed the general category. In light of the purpose of the foreign tax credit regime, including section 904(c), it is imperative that Treasury and the IRS promulgate under section 904(c) a transition rule to mitigate this seemingly unintended consequence.

Specifically, we recommend promulgating a rule that permits taxpayers to reconstruct the amount of their pre-effective date excess taxes in the general category that would have been attributable to the FBIC if that category had been in existence in the prior taxable year, and reassign such excess taxes to the FBIC under section 904(d)(1)(B) in the first year of its existence (i.e., taxable years beginning after December 31, 2017).⁷ Whether provided as a general rule or as election, we believe such a rule is necessary to mitigate the adverse impact that the enactment of the new FBIC could have on taxpayers and to provide taxpayers the most sensible and fair transition to the new FBIC.

Although Congress did not include in the TCJA 2017 an explicit delegation of authority to promulgate transition rules, we believe, as discussed in more detail below, that Treasury's general authority to promulgate regulations, the historic precedent for promulgating transition rules, and the overall fundamental purpose of the grant of a foreign tax credit provide a sufficient basis. Moreover, we further believe that significant policy support exists for Treasury and the IRS to provide a transition rule in the form of an elective reassignment rule that addresses the adverse impact that the new FBIC could have on taxpayers with excess foreign taxes in the general category.

A. Section 904(c) Precedent for Transition Rules

Congress has fairly regularly modified the section 904(d) categories, and has, on occasion, explicitly provided transition rules relating to the carryback or carryforward of excess taxes under section 904(c).⁸ In 2004, as part of the American Jobs Creation Act of 2004 (P.L. 108-357), Congress repealed all but the passive and general section 904(d) categories that taxpayers had to consider when computing their section 904(a) foreign tax credit limitation.⁹ The reduction in the number of section 904(d) categories was intended to simplify the foreign tax credit limitation calculation and reduce the incidence of double taxation.¹⁰ As a result of this change, Congress enacted section 904(d)(2)(K) as part of the AJCA to provide transition rules under section 904 to address the carryback and carryforward of excess taxes under section 904(c).¹¹

Specifically, section 904(d)(2)(K)(i) provided that excess taxes carried forward from any tax year beginning before 2007 to any later taxable year, with respect to any item of income, would be treated as within the passive category or general category based on the category in which the income would be described if the taxes were paid or accrued with respect to such income in the taxable year to which the taxes were carried. Moreover, section 904(d)(2)(K)(ii) provided Treasury regulatory authority to address the allocation of any carryback of taxes with respect to income from a tax year beginning on or after 2007, to a tax year beginning before such date for purposes of allocating such income among the separate categories in effect for the tax year to which carried.

In response to the changes to section 904(d) made in the AJCA, Treasury and the IRS pursuant to their authority under section 7805 promulgated regulations that generally required taxpayers to reconstruct their earnings and tax pools for purposes of the carryback and carryforward provisions of section 904(c).¹² However, Treasury and the IRS recognized the difficulties taxpayers may have in reconstructing excess tax accounts and provided safe harbor rules related to the carryforward and carryback of excess taxes. With respect to the carry forward of excess taxes, in lieu of allocating excess taxes in any pre-2007 section 904(d) separate category to a post-2006 separate category to which such taxes would have been assigned if the taxes were paid or accrued in a tax year beginning after December 31, 2006, the regulations provide a safe harbor that permits taxpayers to allocate all excess foreign taxes (except from the passive category) to the post-2006 separate category for general category income.¹³ The addition of a safe harbor was no doubt helpful to many taxpayers who would have otherwise been unable to entirely reconstruct their historic excess credits.

With respect to the carryback of excess taxes from a post-2006 taxable year to a pre-2007 taxable year, a similar approach was taken. While Treasury and the IRS generally required excess taxes in the passive category or general category be assigned to the appropriate pre-2007 separate category or categories as if the taxes had been paid or accrued in a pre-2007 taxable year, the regulations provided that, in lieu of this reconstruction approach, taxpayers could assign excess taxes in the post-2006 separate category for passive category income to the pre-2007 separate category for passive income, and all other excess foreign taxes to the pre-2007 separate category for general limitation income.¹⁴

The technical and policy-based support for the foregoing transition rules appears clear: in situations in which a section 904(d) category is eliminated, it is necessary to provide rules that account for the carryforward of excess taxes in the eliminated category to ensure that taxpayers are at least provided the opportunity to use the excess taxes in the future. Otherwise, such excess taxes would be lost and the purpose of the foreign tax credit regime to mitigate double taxation would not be served. The same technical and policy-based support exists in situations such as that presented by the changes in the TCJA 2017 in which the number of section 904(d) categories are increased. Admittedly, the need in this context may not be readily apparent, as one might simply assume that any excess foreign taxes carried forward in a category that exists both before and after the change can be carried forward to that category. But as demonstrated, this is not the case if the income and foreign taxes that were historically assigned to such category are assigned in years after the change to a new category, as is the case following the enactment of the FBIC. Now, instead of income and foreign taxes historically assigned to the general category continuing to be assigned to that category, such items may be assigned to either the general category or the FBIC as the case may be. For U.S. taxpayers that conduct foreign operations solely through foreign disregarded entities or foreign branches, income and foreign taxes attributable to those activities will be assigned solely to the FBIC, which effectively results in the elimination of the general category.

B. Authority

Although Congress did not include in the TCJA 2017 an explicit delegation of authority to promulgate transition rules, Treasury's general authority to promulgate regulations pursuant to section 7805 provides sufficient basis for doing so — indeed, Treasury cited section 7805 as the authority for promulgating the aforementioned transition rules under section 904(c) in 2011.¹⁵ Therefore, regardless of whether or not Congress explicitly provides transition rules or directives to Treasury to promulgate transitions rules relating to the carryback or carryforward of excess taxes under section 904(c), Treasury's authority under section 7805 should suffice so long as the rules and regulations promulgated thereunder are necessary and helpful for the enforcement of the Code and further the purpose for which section 904(c) was enacted.¹⁶

Based on the legislative history discussed above, it is clear that the purpose of any transition rule under section 904(c) is to provide U.S. taxpayers with certainty in the continued application of section 904(c) and ensure that the statutory objective of relieving double taxation is furthered. Consistent with this underlying purpose, we believe Treasury and the IRS have ample authority to provide transition rules under section 904(c) after the changes made by the TCJA 2017 to ensure that U.S. taxpayers have certainty as to the application of section 904(c) and are provided the full application of the statute intended to reduce the incidence of double taxation.¹⁷

Specifically, section 7805(a) provides “[e]xcept where such authority is expressly given by this title to any person other than an officer or employee of the Treasury Department, the Secretary shall prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.” The authority provided by section 7805(a) is intended to be broad and provide Treasury the authority to provide rules that fill in gaps left in a statute, including providing for any rules that are necessary to provide a seamless transition or further the purposes of various provisions when there has been a change in the law. In this regard, there should be no question that transition rules with respect to section 904(c) are needed and would be appropriate and helpful to U.S. taxpayers, and that the recommendation we have made herein falls easily within this broad rulemaking authority.

C. Policy Support

As discussed, in the past Treasury and the IRS have exercised their explicit and implicit rulemaking authority to provide administrable and helpful transition rules for taxpayers. Recent precedent suggests that the technical and policy-based support for transition rules is clear when a section 904 category is eliminated. As previously noted, the same technical and policy-based support exists for transition rules in this case when a section 904 category has been added because the addition of the FBIC may effectively function as an elimination of the general category for U.S. taxpayers that have historically conducted their foreign operations directly through foreign branch operations or foreign disregarded entities. The income or losses and foreign taxes related to those operations are now expected to be considered in the FBIC (rather than the general category). For these U.S. taxpayers that have accumulated excess foreign taxes in the general category prior to the effective date of the new FBIC, the ability to potentially use the excess taxes has been effectively lost because these taxpayers have no effective way to generate foreign source income in the general category to enable the use of the excess general category taxes — the enactment of the FBIC is tantamount to a repeal of the general category. As a result, it is very likely that these taxpayers will be unable to use the excess general category taxes and will suffer double taxation. This result is clearly contrary to the fundamental purpose of the foreign tax credit and should be remedied,

A transition rule similar to that recommended herein would further the purpose of the foreign tax credit regime and section 904(c) to mitigate potential double taxation, consistent with the section 904(c) precedent of promulgating transition rules. Moreover, such a rule would not be contrary or inconsistent with the purpose of the FBIC and would prevent impractical ancillary effects seemingly unintended by Congress.

i. Further the purpose of the foreign tax credit regime and section 904(c) to mitigate potential double taxation

The foreign tax credit regime and section 904(c) were enacted to ensure that taxpayers were not subject to double taxation. Providing a transition rule that allows taxpayers to reassign excess taxes to the extent such taxes would have otherwise been assigned to the FBIC if it were in existence in the year to which the taxes relate is consistent with the policy of providing for a foreign tax credit and is necessary for a fair administration of the tax laws. If, however, taxpayers cannot carry forward excess taxes from the general category to the FBIC, taxpayers are very likely to be subject to double taxation, inconsistent with the grant of a foreign tax credit generally and section 904(c). Such taxpayers have done nothing inconsistent with the letter of the law and it is simply unfair to effectively penalize such taxpayers because of a change in the label given to the activities they have historically conducted.

ii. Historically consistent, but not inconsistent with purpose of FBIC

As previously mentioned, transition rules have been enacted or otherwise promulgated each time Congress modified the section 904(d) categories in order to appropriately account for the carryback or carryforward of excess taxes. Promulgating a transition rule to account for the carryforward of excess taxes in a category that theoretically no longer exists for (or is of limited applicability to) a taxpayer as a result of the enactment of the new FBIC under section 904(d) would be historically consistent. The transition rule would function similar to prior transition rules promulgated under section 904(c) to ensure that taxpayers are at least provided the opportunity to use the excess taxes in the future (i.e., by permitting taxpayers to reconstruct the amount of their pre-effective date excess taxes in the general category that would have been attributable to the FBIC if that category had been in existence in the prior taxable year, and reassign such excess taxes to the FBIC in the first year of its existence).

Moreover, a transition rule in this context would not be inconsistent with the purpose of the FBIC. The new FBIC was enacted in order to preclude foreign taxes imposed on foreign branch operations, which generally are subject to relatively higher rates of foreign tax, from reducing the U.S. tax on foreign general category income that is subject to a relatively lower rate of foreign tax.¹⁸ The recommended transition rule would not be contrary to the policy of precluding cross crediting of high tax on foreign branches with low tax on other general category income — rather, the transition rule would effectively further the policy with respect to an earlier taxable year.¹⁹

iii. Prevent impractical ancillary effects seemingly unintended by Congress

Many taxpayers conduct most, if not all, of their foreign business operations through foreign branches and disregarded entities and, as a result of the enactment of the FBIC, will have no realistic ability to generate excess limitation in the general category to utilize excess general category taxes if no transition rule is provided. Absent a transition rule, it would seem the only options available for these taxpayers involve restructuring their foreign business operations in order to access those excess taxes — but is this even a realistic option, or more importantly, is this really what Congress intended? For example, to access these excess taxes taxpayers may consider restructuring the form through which they conduct their foreign business operations, retroactively triggering general category income through the incorporation of a branch or disregarded entity in a taxable manner, or transferring their business operations out of their foreign branches and disregarded entities to their U.S. owners to generate general category income in the future. Each option, however, seems impractical and not likely to be feasible.²⁰

Further, effectively requiring taxpayers to restructure their foreign business operations in order to utilize excess foreign taxes is inconsistent with the grant of a foreign tax credit, which historically provided parity for claiming such credits whether a U.S. taxpayer operates through a foreign branch (including a disregarded entity) or a foreign subsidiary. Congress simply did not intend to require taxpayers to restructure their operations in order to claim excess general category taxes and there is no policy support to require the same. Taxpayers with excess general category taxes have not engaged in any activity or transactions that are inconsistent with the general policies of the foreign tax credit, and the ability to claim foreign tax credits should not hinge on the form through which taxpayers conduct their foreign business activity.

Moreover, given the limited restructuring options realistically available to taxpayers for accessing excess general category taxes, the practical effect of not providing relief in the form of a transition rule is that taxpayers must deduct such taxes in order to obtain partial relief from double taxation. This would require a taxpayer to change its initial choice to elect to credit foreign taxes in prior tax years and, instead, deduct such taxes. A deduction of foreign taxes, however, would not entirely mitigate double taxation. And, unless the statute of limitations is otherwise open, taxpayers will not be able to change their election to credit foreign taxes to instead deduct such taxes for any excess taxes attributable to a closed tax year.²¹ As a result, the ability for a taxpayer to even partially mitigate double taxation through a deduction may be significantly, if not entirely, unavailable.

The distinction here between a taxpayer that chose to take a credit versus a deduction with respect to foreign taxes is critical to the focus of this letter. Specifically, recent guidance suggests that a taxpayer generally has 10 years to switch from a deduction to a credit, but only three years to switch from a credit to a deduction.²² Thus, if a taxpayer claims a credit for foreign taxes that ultimately become excess foreign taxes, arguably the taxpayer only has the general three year statute of limitations to change its mind and claim a deduction for such taxes. After the expiration of the three year statute of limitations, it would appear that the taxpayer is effectively locked into claiming a credit for such taxes. Thus, if a taxpayer realizes after the three year statute of limitations period that it will not be able to utilize the excess foreign taxes as a credit within the period provided in section 904(c), the taxpayer may be out of realistic options to remedy the situation and obtain any benefit from the foreign taxes paid. That is, without a transition rule, a taxpayer that expected that it would otherwise generate sufficient income through its business operations to utilize its excess general category taxes is now effectively precluded from utilizing such excess taxes. Stated differently, had the taxpayer known that the law would change and effectively confiscate its excess foreign taxes in the general category, the taxpayer would have chosen to deduct (rather than claim a credit for) such taxes in the years incurred.

Moreover, there is no indication in the TCJA 2017 changes to the foreign tax credit provisions that Congress intended to effectively force taxpayers to deduct foreign taxes in any context. Rather, when Congress has intended that taxpayers should only be able to deduct foreign taxes, it has clearly set forth that directive in the statute.²³ Thus, requiring U.S. taxpayers in cases that are not specifically enumerated to deduct foreign taxes is contrary to the purpose of the grant of a foreign tax credit and inconsistent with Congressional intent. Based on the foregoing, we submit that logic and fairness in the administration of the tax law mandate that taxpayers who have followed the law and have not engaged in any nefarious activity should not be subject to double taxation merely as a result of a change in law that adds a category for an activity that previously did not have a separate category.

III. Conclusion

Treasury and the IRS should provide taxpayers the ability to elect to reconstruct pre-effective date excess taxes in the general category that are attributable to the activities of a U.S, taxpayer conducted directly out of the United States through a foreign disregarded entity or foreign branch and reassign such excess taxes to the extent they otherwise would have been assigned to the FBIC if it were in existence in the prior taxable year. Such an election should also apply to any foreign taxes that under section 905(c) must be accounted for in a pre-effective date relation back year as a result of a later foreign tax redetermination. Overall, an elective reassignment rule, or some other form of a transition rule, is needed to mitigate the adverse impact that the enactment of the new FBIC could have on taxpayers, and provide taxpayers the most sensible and fair transition to the new FBIC.

We appreciate the opportunity to provide input on this important issue for many taxpayers. If you have any questions or if you require any additional information, please contact David Sotos at (408) 808-2966.

Very truly yours,

PricewaterhouseCoopers LLP

Cc:
Mr. Lafayette G, “Chip” Harter III
Deputy Assistant Secretary
International Tax Affairs
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Marjorie Rollinson
Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Barbara Felker
Branch Chief, Branch 3, Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224