EY Requests Amendments to Proposed FTC Regs

February 17, 2020

Internal Revenue Service
Attn: CC:PA:LPD:PR (REG-105495-19)
Courier's Desk
1111 Constitution Avenue, N.W.
Washington, DC 20224

Re: REG-105495-19 (Proposed Regulations Related to Foreign Tax Credit)

Dear Sir or Madam:

We appreciate the opportunity to comment and respectfully submit this letter on behalf of Tokio Marine HCC, the common parent of an affiliated group of corporations filing a consolidated US corporate income tax return.

On November 28, 2018, the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (2018 FTC proposed regulations)¹ that provide guidance relating to the determination of the foreign tax credit under the Internal Revenue Code (the Code).² The preamble to the 2018 FTC proposed regulations stated that portions of the temporary regulations under sections 861 through 865 are being reproposed under the 2018 FTC proposed regulations (including Temp. Reg. § 1.861-8T(d)(2)) and “the Treasury Department and the IRS will remove the corresponding temporary regulations upon finalization of the proposed regulations.”

On December 17, 2019, Treasury and the IRS issued additional proposed regulations (2019 Proposed Regulations)³ that provide guidance relating to, inter alia, the allocation and apportionment of deductions and creditable foreign taxes under the Code. While the 2019 Proposed Regulations provide for many new rules aimed at implementing the statutory changes made by the Tax Cuts and Jobs Act (TCJA),⁴ they adopt the rules in Temp. Reg. §1.861-8T(d)(2) (the 1988 Temporary Regulations), promulgated in 1988, without modifying those temporary regulations to reflect the statutory change made to section 864(e) by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) — namely, the enactment of section 864(e)(7)(E).

Although the preamble to the 2019 Proposed Regulations (the Preamble) notes that one comment to the 2018 FTC proposed regulations⁵ “suggested that insurance companies reduce exempt income and assets to reflect prorated amounts of dividends and tax-exempt interest,” the Preamble does not acknowledge that the comment letter's suggestion mirrors that of the legislative record surrounding the enactment of section 864(e)(7)(E)(the Comment Letter).

Further, the Preamble states that “the current regulations already provide the appropriate rules in this area” and suggests that the adoption of Temp. Reg. §1.861-8T(d)(2) by Treasury and the IRS is based on a simplified application of the matching principle,⁶ without addressing the fact that section 864(e)(7)(E) was enacted after Temp. Reg. §1.861-8T(d)(2) had already been promulgated and was intended to accomplish a policy objective different from the matching principle addressed by the 1988 Temporary Regulations.⁷ Specifically while Temp. Reg. §1.861-8T(d)(2) addresses the treatment of certain tax exempt assets/income as it relates to life insurance companies, the 1988 Temporary regulations do not address the mandate provided by section 864(e)(7)(E) which aimed at providing a certain amount of relief from section 864(e)(3) to the insurance industry in light of the significant amount of tax-exempt assets such companies are required to hold and in recognition of the changes made to Subchapter L as part the Tax Reform Act of 1986 (1986 TRA).

The Preamble language suggests that Treasury and the IRS may have concluded that “no further modification to the generally applicable rules is required to ensure that the appropriate amount of expenses are apportioned to U.S. source income”.⁸ As explained below, finalizing the temporary regulation that was in place prior to the enactment of section 867(e)(7)(E), without addressing section 864(e)(7)(E), would make section 864(e)(7)(E) a nullity.⁹

The Comment Letter highlighted the statutory language of section 864(e)(7)(E) and the congressional intent surrounding its enactment. Section 864(e)(7)(E) was originally proposed as part of the Technical Corrections Act of 1987 (1987 TCA) and identified the specific adjustments Congress intended to be made by an insurance company when applying section 864(e)(3). Treasury and the IRS should address section 864(e)(7)(E) and, more specifically, should address Congress's intent behind section 864(e)(7)(E) and its expectation that regulations would be promulgated to provide for the “appropriate adjustment in the application of [section 864(e)(3)] in the case of an insurance company.”

Section 864(e)(7)(E) was aimed at providing relief to the insurance industry to remedy a double detriment arising from the reduction of certain deductions deemed related to tax-exempt assets/income and the exclusion of these same tax-exempt assets/income for purposes of allocating and apportioning any other deductible expenses for foreign tax credit determination purposes.¹⁰ While the reduction of the amount of deductions relating to the tax-exempt assets/income provides for a matching of the tax-exempt income with a disallowed deduction, the effect of also removing the entire amount of tax-exempt assets/income from the expense apportionment computation creates a disproportionate effect on insurance companies (which generally hold large amounts of US tax-exempt assets due to regulatory or commercial requirements) by apportioning more expenses to foreign source income. This disproportionate apportionment is the detrimental effect that section 864(e)(7)(E) was intended to address and remedy, and the issue that was not addressed by Temp. Reg. §1.861-8T(d)(2). The legislative history to section 864(e)(7)(E) indicates the amount of relief to be granted to the insurance industry is to be measured by reference to the reductions made to reserves and allowable deductions by the 1986 TRA with respect to tax exempt assets/income. However, because this referenced amount is simply the “measuring stick” by which the mechanical rule determines the relief granted, it should not be confused as to re-invite the application of a matching principle to amount of tax-exempt assets/income that should be included for expense apportionment purposes.

Accordingly, we respectfully request that Treasury and the IRS reconsider modifying Temp. Reg. §1.861-8T(d)(2) to provide for the adjustments that an insurance company should make when applying section 864(e)(3). In particular, we respectfully request, consistent with the legislative history of section 864(e)(7)(E), that when apportioning deductions that are definitely related either to a class of gross income consisting of multiple groupings of income (whether statutory or residual) or to all gross income, the amount of exempt income and exempt assets that are not taken into account would be reduced by:

i. in the case of an insurance company taxable under section 801, the policyholders' share (as defined in section 812(b)) of tax-exempt interest that reduces the closing balance of section 807(c) items, as provided in section 807(b)(1)(B), the amount of the policyholders' share of the dividends (other than 100 percent dividends) received by the company, as provided in section 805(a)(4)(A)(ii), and any amounts excluded or reduced from 100 percent dividends under section 805(a)(4)(C) (or the amount of tax-exempt assets for which such income is attributable to); and

ii. in the case of an insurance company taxable under section 831, the applicable percentage, as defined in section 832(b)(5)(B), of the sum of the tax-exempt interest received or accrued during such taxable year, as provided in section 832(b)(5)(B)(i), and the aggregate amount of deductions for dividends (other than 100 percent dividends) received during the taxable year, and 100 percent dividends received during the taxable year to the extent attributable (directly or indirectly) to prorated amounts, as provided in section 832(b)(5)(B)(ii) (or the amount of tax-exempt assets for which such income is attributable to).

Please see the example included at the end of this letter for an illustration of the resulting apportionment where such adjustments are made.

Legislative History of Section 864(e)(7)(E)

The legislative history surrounding the enactment of current section 864(e)(7)(E) is instructive in determining the true intent underlying that provision. The statutory language of section 864(e)(7)(E) states that “[t]he Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section, including regulations providing . . . for appropriate adjustments in the application of paragraph (3) in the case of an insurance company” (emphasis added). Indeed, the legislative record regarding the passage of technical corrections to the 1986 TRA prescribes the adjustments that Congress wanted the regulations to provide when applying section 864(e)(3) to insurance companies.

As proposed in the June 10, 1987, draft of the 1987 TCA, section 864(e)(7)(E) provided that, in the case of an insurance company, the following adjustments should be made:¹¹

(i) the first sentence of paragraph (3) shall not apply to the policyholders' share of (or, in the case of an insurance company taxable under section 831, 15 percent of) any tax-exempt asset (or income from such an asset), and

(ii) a similar rule shall apply to any stock (or dividend thereon) which would otherwise be subject to the second sentence of paragraph (3).

Although the language of the original draft of section 864(e)(7)(E) is unambiguous, the House report, dated October 25, 1987, explains this proposed technical correction to section 864(e) as follows:¹²

Under the bill, the Secretary is also to prescribe regulations providing that, in the case of a life insurance company, the Act's rule requiring that tax-exempt assets and income therefrom be disregarded will not apply to the policyholders' share of any tax-exempt asset or income from such an asset. That is, the policyholders' share of assets that produce tax-exempt income will attract expenses notwithstanding their tax-exempt character. The same treatment applies to tax-exempt assets of property and casualty insurance companies, to the extent that the income from such assets reduces that company's loss deduction (under section 832(b)(4)).

In general, similar treatment is to apply with respect to the policyholder's share of stock that insurance companies hold to the extent that dividends it pays would be eligible for the 80-percent dividends received deduction. Thus, that stock will attract expenses notwithstanding the deduction for the dividends it would pay.

As of December 3, 1987, the Senate's Budget Committee Bill on the Proposed Omnibus Budget Reconciliation Act (the 1987 ORA) continued to include the detailed version of section 864(e)(7)(E) as part of the proposed technical corrections to the 1986 TRA.¹³ A week later the following discussion took place on the Senate floor regarding the removal of the 1987 TCA provisions from the 1987 ORA:

Mr. CRANSTON. Mr. Chairman, as you know, the financial community has widely anticipated the passage of the Technical Corrections Act of 1987. However, because of the importance of passing the reconciliation bill as soon as possible, technical corrections apparently will not be part of the reconciliation package this year.

Mr. BENSTEN. The Senator from California is correct. As a result of the budget summit with the White House, the technical corrections have been taken out of the reconciliation bill.

Mr. CRANSTON. No doubt you have heard from a number of individuals who are concerned about how to conform to the Tax Reform Act of 1986 in the absence of technical corrections . . .

Mr. BENTSEN. I have heard from a number of constituents who are concerned about how to conform to the Tax Reform Act without technical corrections. I assure the Senator that efforts will be made to provide retroactive protection for those who are relying on the original Technical Corrections Act of 1987 which I introduced with Congressman Rostenkowski earlier this year. I will also urge the Treasury Department to provide guidelines for those taxpayers who file their 1987 returns in reliance on those technical corrections. [emphasis added]

Following the passage of the 1987 ORA, Congress introduced a draft of the Technical Corrections Act of 1988 as early as March 31, 1988. Although the new draft version of section 864(e)(7)(E) was simplified to the current language of that provision, Congress still wanted Treasury to provide a rule in regulations that would exclude the policyholders' share of tax-exempt interest and dividends eligible for dividends received deduction from such amounts that generally must be disregarded when allocating and apportioning certain expenses. See the March 31, 1988, explanation of the section 864(e)(7)(E):¹⁴

The bill also provides that the Secretary is to prescribe regulations that make appropriate adjustments in the application of the rule that disregards tax-exempt assets and income derived therefrom in the case of an insurance company. [emphasis added]

This explanation of section 864(e)(7)(E) remained consistent until the enactment of the Technical Corrections Act of 1988 on November 10, 1988.

Conclusion

Section 864(e)(7)(E) and its legislative history should be considered because they reflect the congressional intent to make certain adjustments to application of section 864(e)(3) in the case of insurance companies. As the legislative record demonstrates, section 864(e)(7)(E) was enacted as a technical correction — i.e., Congress intended to change the way section 864(e), as enacted by the 1986 TRA, applied to insurance companies. The 1987 TCA version of section 864(e)(7)(E) unambiguously directed the IRS and Treasury to issue regulations that would have excepted the policyholders' share of any tax-exempt asset or income from such an asset as being treated as tax-exempt assets and income when applying the rules of section 864(e)(3) to insurance companies. This Congressional directive was not driven by a matching principle policy (as that was already largely affected by the reductions of allowable deductions provided by the 1986 TRA) but was instead driven by a policy decision to grant insurance companies a measured relief in recognition of the unique position insurance companies find themselves when subject to the rules of section 864(e)(3). Legislative history instructs that the amount of the relief granted is to be specifically determined by allowing a portion of the insurance company's tax-exempt assets/income to attract expenses.

Although the statutory language provides the IRS and Treasury with some discretion in determining the exact adjustments an insurance company should make when applying section 864(e)(3), through the enactment of section 864(e)(7(E) (directing the Secretary to promulgate regulations necessary to make the appropriate adjustment in the application of section 864(e)(3) in the case of insurance companies), Congress intended to change the rules regarding the treatment of specific exempt amounts and their corresponding exempt assets in the apportionment formula in allocating expenses. Otherwise, if the pre-section 864(e)(7)(E) regulatory rules provided sufficient guidance addressing the purposes of section 864(e)(7)(E), then Congress would not have needed to enact section 864(e)(7)(E) to change the prior rules.

Accordingly, we respectfully request that the Treasury and IRS reconsider modifying Temp. Reg. §1.861-8T(d)(2) to provide for the adjustments that an insurance company should make when applying section 864(e)(3), taking into account section 864(e)(7)(E) and its legislative history.

In particular, we respectfully request, consistent with the legislative history of section 864(e)(7)(E), that when apportioning deductions that are definitely related either to a class of gross income consisting of multiple grouping of income (whether statutory or residual) or to all gross income, the amount of exempt income and exempt assets that are not taken into account would be reduced by:

(i) in the case of an insurance company taxable under section 801, the policyholders' share (as defined in section 812(b)) of tax-exempt interest that reduces the closing balance of section 807(c) items, as provided in section 807(b)(1)(B), the amount of the policyholders' share of the dividends (other than 100 percent dividends) received by the company, as provided in section 805(a)(4)(A)(ii), and any amounts excluded or reduced from 100 percent dividends under section 805(a)(4)(C) (or the amount of tax-exempt assets for which such income is attributable to); and

(ii) in the case of an insurance company taxable under section 831, the applicable percentage, as defined in section 832(b)(5)(B), of the sum of the tax-exempt interest received or accrued during such taxable year, as provided in section 832(b)(5)(B)(i), and the aggregate amount of deductions for dividends (other than 100 percent dividends) received during the taxable year, and 100 percent dividends received during the taxable year to the extent attributable (directly or indirectly) to prorated amounts, as provided in section 832(b)(5)(B)(ii) (or the amount of tax-exempt assets for which such income is attributable to).

We appreciate the opportunity to provide comments on the Proposed Regulations. If you would like to discuss further, please contact Chris Ocasal at chris.ocasal@ey.com, (202) 327-6868 or Revital Gallen at revital.gallen@ey.com, (949) 437-0302.

Respectfully submitted,

Chris Ocasal
Principal, Ernst & Young, LLP
Washington, DC

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Example Illustrating Proposed Rule under Section 864(e)(7)(E)

An example reflecting the results of the requested adjustments, per the recommendation, is provided below.

Example 1 from Proposed Regulations modified to reflect the requested revision: