SIFMA Seeks Changes to 3 Topics Under FTC Regs

February 18, 2020

Internal Revenue Service
CC:PA:LPD:PR (REG-105495-19)
Room 5203, Post Office Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Foreign tax credit regulations

Ladies and Gentlemen:

The Securities Industry and Financial Markets Association¹ appreciates this opportunity to submit comments on proposed foreign tax credit regulations issued by the Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) on November 28, 2019.² Final regulations issued on the same day address many of the concerns that taxpayers had raised regarding the prior proposed regulations.³ We commend the drafters for their efforts to take account of taxpayer comments.

This letter focuses on three topics: (i) the proposed changes to the definition of “financial services entity” (“FSE”) and “financial services group” (“FSG”) for purposes of section 904(d)(2)(D); (ii) the proposed rule that would disallow credits for certain foreign taxes on disregarded income, by allocating those taxes to the residual category; and (iii) redeterminations of foreign taxes relating to periods prior to the entry into force of the Tax Cuts and Jobs Act of 2017 (the “TCJA”).

SIFMA has submitted separate comments regarding provisions of the proposed regulations relating to the computation of foreign branch category income.⁴ These provisions are particularly important to our industry, because regulated financial services companies conduct a significant proportion of their activities through foreign branches, and many of those branches are located in high-tax countries. As noted in our comment letter, it is imperative that the methodology for calculating net income in this category be designed to minimize the potential for distortions, and to produce results that correspond as nearly as possible to the actual net income of our foreign branches from an economic, regulatory and foreign tax perspective.

I. Summary of Recommendations.

A. Financial services.

• The proposed regulations would narrow the definition of an FSE to encompass only finance companies that meet specified requirements, and U.S.-licensed banks and securities dealers. This restrictive definition would exclude a significant number of substantial and genuinely active financial services businesses, including banks and securities dealers that are licensed outside the United States, asset managers, and entities that provide custody, trust and agency services.

• In determining whether an FSG exists, the proposed regulations would require that at least 70% of the group’s income be derived from a lending or financing business. This restrictive definition would exclude a significant number of substantial and genuinely active FSGs, including some groups headed by large banks.

• Appendix 1 provides examples of cases in which the proposed regulations would inappropriately exclude groups that qualify under the current regulations, and would attribute the same income to different categories depending on which member of the group derived the income.

• The list should be based on the one provided in the legislative history to 954(h),⁵ with additions and modifications to the extent necessary to bring it up to date.

• Appendix 2 provides suggested language for the definitions of financial services income, FSE and FSG that would address our concerns.

B. Taxes on disregarded income.

Treasury and the IRS should reconsider, and reverse, the proposed rule under which credits for foreign taxes paid by a controlled foreign corporation (a “CFC”) in respect of certain disregarded transactions would be allocated to the residual category.⁶

This rule, which would disallow credits for a potentially significant class of foreign tax payments, is unnecessary and inappropriate. This outcome is inconsistent with the allocation of taxing authority under OECD transfer pricing principles and U.S. tax treaty obligations.

C. Redeterminations of foreign taxes.

A simplified alternative methodology should be provided under which redeterminations of foreign taxes paid by foreign corporations in respect of years prior to the entry into force of the TCJA may be taken into account as if the relevant adjustments had been made in the foreign corporation’s last taxable year beginning before January 1, 2018.

II. Financial services income.

A. Overview: why it matters.

For more than 30 years, the Internal Revenue Code (the ‘'Code”) and regulations have provided that income derived in the active conduct of a financial services business is not considered passive for foreign tax credit purposes. This rule is necessary because financial services businesses typically derive a significant proportion of their income from financial assets (e.g., securities and derivatives) that give rise to passive income in the hands of other taxpayers.

Congress recognized that, if a taxpayer clearly is predominantly engaged in the active conduct of a financial services business, then it is unnecessary, and would be unreasonable, to require the taxpayer to conduct a granular analysis of every single activity and item of income to determine whether it should be classified as active or passive. Thus, once it has been determined that a company is an FSE, income that otherwise would have been treated as passive category income (such as interest and dividends) is allocated to a non-passive foreign tax credit category.⁷

In the preamble to the 2018 proposed regulations. Treasury and the IRS indicated that they were considering changes to the longstanding gross income test for determining whether a corporation qualifies as an FSE. Treasury and the IRS asked for comments with respect to issues including the treatment of related-party payments. SIFMA encouraged Treasury and the IRS to ensure that the changes did not affect genuinely active FSGs. Treasury and the IRS acknowledged and agreed with this comment, stating in the preamble to the 2019 proposed regulations: “The Treasury Department and IRS agree that a substantial and genuinely active financial services group should be included in the definition of an FSE.”

The proposed regulations do not accomplish this objective, and instead would have the effect of excluding a significant number of genuinely active financial services businesses. The preamble language quoted above suggests that this result may have been unintended. We encourage Treasury and the IRS to modify the proposed definitions of “financial services entity” and “financial services group” to ensure that they do not affect the treatment of genuinely active financial services businesses.

The preamble says that the proposed changes are intended to promote simplification and consistency. These are important objectives. We understand that the drafters chose to use section 954(h) as a starting point because they believed that this provision represents the state of the art. We agree that the legislative history to section 954(h) provides the most recent list of financial services activities. Regulations under that section have not been proposed or adopted. Thus, Treasury and the IRS should adopt regulations that provide an updated list of qualifying activities.⁸

Section 954(h) does not use or define the terms “financial services entity” or “financial services group” because those concepts generally are irrelevant for subpart F purposes. Section 954(h) was not designed to encompass the full range of financial services income. Instead, it is one of several provisions that prescribe exceptions to the subpart F anti-deferral rules for specified kinds of income derived in the active conduct of a financial services business.⁹ The provisions are targeted at income that otherwise would constitute subpart F income (in the case of section 954(h), principally interest income). There wasn’t any reason to provide exceptions for income that would not have been subject to subpart F in any event, such as fees for the performance of financial services. The definitions used for foreign tax credit purposes must encompass all of the income derived in the conduct of an active financial services business, and not merely income that otherwise would have been subject to subpart F. Narrowly-drafted criteria developed in the context of an anti-deferral rule should not be used without modification as a template for foreign tax credit classification rules.

Notwithstanding our concerns, we believe that comparatively small modifications to the definitions included in the proposed regulations should be sufficient to reduce unintended consequences for real financial services businesses, without compromising Treasury and the IRS’s objectives of fostering consistency and uniformity, and addressing concerns about the scope of the prior rules.¹⁰

B. Mechanics of the rules.

The current and proposed regulations make use of the same conceptual framework. Financial services income includes income derived by a financial services entity from the active conduct of specified activities.¹¹ A company can qualify as an FSE either in its own right (because it is predominantly engaged in the conduct of an active financial business), or by reason of its status as a member of o. financial services group. Once a company has qualified as an FSE, none of its income is considered passive.

1. Qualifying activities.

Treasury and the IRS correctly understood that the legislative history to section 954(h) provides the most recent list of qualifying activities and qualifying income. That list should be included or incorporated by reference in the regulations, and should be updated to the extent necessary to take account of developments in the financial markets since 1998, when section 954(h) was enacted.

2. Financial services entities.

Under the current regulations, a company will be an FSE on a standalone basis (i.e., without regard to whether it is a member of an FSG) if at least 80% of its gross income consists of qualifying income.¹² Thus, a bank, broker-dealer, asset manager or custodian can qualify as an FSE as long as it derives a sufficiently high proportion of the right kind of income, without regard to where it is organized or how it is regulated.

Under the proposed regulations, in order in order to qualify as an FSE on a standalone basis, a company would need to: (i) derive more than 70% of its gross income directly from the active and regular conduct of a lending or finance business from transactions with unrelated customers; (ii) be engaged in the active conduct of a banking business; or (iii) be engaged in the active conduct of a securities business. In the latter two cases, the proposed regulations would require that entities be licensed or registered in the United States. Limiting the definition to regulated banks and securities dealers, and further limiting it to entities that are licensed or regulated in the United States, is unnecessary and inappropriate.¹³

As illustrated by the examples in Appendix 1. this proposed standard would exclude a significant number of active financial services businesses that unquestionably would qualify under the current regulations, and ought to qualify under the new regulations.

3. Financial services groups.

Under the current regulations, a group of companies will qualify as an FSG. and all of the members of the group will qualify as FSEs, if at least 80% of the group’s gross income consists of qualifying income.¹⁴

In order to qualify as an FSG under the proposed regulations, a group would need to derive more than 70% of its gross income directly from the active and regular conduct of a lending or finance business from transactions with unrelated customers (i.e., the first of the three tests for FSE classification under the proposed regulations).

Under this standard, a group headed by a broker-dealer or an asset manager typically would be out of luck. Even a global bank — the paradigmatic example of a lending or finance business — may find it difficult to qualify if it conducts diversified financial businesses.

The examples in Appendix 1 show how the proposed regulations could produce inappropriately disparate results for companies and groups that clearly are engaged in the conduct of a global financial services business.

4. Recommended changes.

We commend Treasury and the IRS for recognizing the need to ensure that the proposed changes do not affect the treatment of genuinely active FSGs. We recommend the following modifications and clarifications to accomplish this objective consistently with the drafters' desire to foster consistency and uniformity:

• Treasury and the IRS should revise the definition of "financial services entity” to take better account of the diverse range of activities conducted by U.S.-owned financial services companies in global markets.

  • Thus, the definition should include asset managers and entities that provide custody, trust and agency services, as well as banks and broker-dealers.

  • The definition should not be limited to entities that are subject to any particular regulatory scheme. The proposed regulations would treat unregulated commercial finance companies as FSEs. It wouldn’t make sense to permit such companies to qualify, but to exclude regulated financial services companies because they are not subject to a specified regulatory scheme (e.g., U.S.-regulated asset managers, and U.K.-regulated securities dealers).

  • If the definition assigns significance to whether an entity is subject to regulation, it should refer to a broader range of financial or prudential regulatory authorities within and outside the United States, and should include, for example, entities that are registered as investment advisers under the Investment Advisers Act of 1940 (15 U.S.C. 80b-1 el seq.) and comparable provisions of state or foreign law.¹⁵

• In determining whether an FSG exists, the regulations should take account not only of income derived by lending or finance businesses, but also of income derived by FSEs from other qualified activities involving unrelated customers and counterparties.

• The regulations should provide an updated list of qualifying activities.

We believe that our suggested modifications would accomplish the objectives that Treasury and the IRS identified in the preamble to the proposed regulations, while significantly reducing the risk of unintended consequences for genuinely active financial services businesses. Our suggestions are intended to respect and to further the drafters’ objectives as we understand them: to bring the rules up to date, to foster consistency and uniformity, and to reduce the potential for overbroad interpretations. After taking account of our suggestions, the rules would continue to rely on the definition of qualifying activities and income for purposes of section 954(h), and to condition eligibility for FSE status on the active conduct of a third-party business.

We note that our proposal is consistent with the legislative history under section 954(h). In delineating qualifying activities for purposes of section 954(h), Congress recognized that active banking, financing and similar businesses can encompass a diverse range of activities involving unrelated customers and counterparties. The list provided in the legislative history includes lending money; underwriting, dealing and acting as a broker in securities and derivatives; securitization; leasing; performing investment management or advisory services; and acting as a fiduciary, agent, custodian or trustee. Many of these activities are subject to prudential regulation, often by multiple regulators within and outside the United States, but they are not necessarily conducted by banks or broker-dealers. There are many examples of diversified global FSGs that are unquestionably active, but are not predominantly engaged in a lending business. In the absence of the modifications described above, companies with these characteristics will not qualify as FSEs, and groups with these characteristics will not qualify as FSGs.

III. Foreign taxes on disregarded income.

The proposed regulations include a rule under which foreign tax on income derived from a foreign branch or disregarded entity (“DRE”) from its CFC owner would be assigned to the residual category. This rule would disallow credits for such taxes.¹⁶ The preamble notes that Treasury and the IRS are continuing to study this proposed rule.¹⁷

We strongly urge Treasury and the IRS to reconsider, and reverse, this proposed rule. Though payments between a CFC and its branches or DREs generally are disregarded for U.S. federal income tax purposes, they represent real economic flows that are regarded for foreign tax purposes, and can represent a significant category of foreign tax costs for a CFC that conducts a multinational business through a network of branches or DREs. A rule that would automatically disallow credits for this category of foreign taxes is unnecessary, inappropriate, and inconsistent with U.S. treaty obligations.

It has been suggested that the disallowance of foreign tax credits in this context does not present significant policy issues, because taxpayers effectively brought the problem on themselves, and can eliminate it by electing to treat disregarded entities as corporations for U.S. tax purposes. This suggestion is shortsighted and incorrect. First, it will not always be possible to exercise self-help to cause income to be regarded for U.S. tax purposes: the proposed regulations would disallow credits for taxes paid by true branches as well as by disregarded entities. Taxpayers cannot make an entity classification election in respect of a true branch. Second, there is nothing inherently suspect about transactions that are regarded for foreign tax purposes and disregarded for U.S. tax purposes. In many cases, the measure of income for foreign tax purposes will be more consistent with the actual economic income of a branch or DRE. A rule that would automatically disallow credits for such taxes is inappropriate. Taxpayers should not be required to restructure their foreign operations to preserve the creditability of foreign taxes.¹⁸

IV. Foreign tax redeterminations.

The proposed regulations include a transition rule for foreign tax redeterminations relating to taxable periods beginning prior to the entry into force of the TCJA. Under this proposed rule, such redeterminations generally must be accounted for by adjusting the relevant foreign corporation’s post-1986 undistributed earnings, post-1986 foreign income taxes and other related items in the pre-TCJA tax year to which the foreign taxes relate (the "relation-back year”).

Treasury and the IRS requested comments regarding “whether an alternative adjustment to account for post-2017 foreign tax redeterminations with respect to pre-2018 taxable years of foreign corporations, such as an adjustment to the foreign corporation’s taxable income and earnings and profits, post-1986 undistributed earnings, and post-1986 foreign income taxes as of the foreign corporation’s last taxable year beginning before January 1,201 8, may provide for a simplified and reasonably accurate alternative.”

We strongly support the provision of such an alternative method, with the modification discussed below'. Such a method would foster simplicity and ease of administration, to the benefit of taxpayers and tax administrators. We commend Treasury and the IRS for taking these considerations into account in crafting transition rules. The generally applicable rules, under which adjustments would be attributed to the relation-back year, should continue to apply to taxpayers that do not choose to take advantage of the alternative method.

In the vast majority of cases, a foreign corporation’s last taxable year beginning before January 1, 2018 will be the last year in which an adjustment could have been made to the pools of post-1986 earnings and foreign taxes maintained by the corporation under prior law. In those cases, the required adjustments would be made immediately prior to the deemed distribution of the corporation’s earnings pursuant to section 965, and would be taken into account in determining the tax treatment of that distribution.

In a limited number of cases, a redetermination may be made in respect of a foreign corporation that has ceased to be subject to pooling prior to the entry into force of the TCJA. This circumstance could arise, for example, if a redetermination affects a U.S. shareholder’s interest in a foreign corporation that was liquidated, or sold to a foreign acquiror, prior to the entry into force of the TCJA. The regulations should confirm that, in such a case, the required adjustments would be made in respect of the last year in which the foreign corporation was subject to the pooling rules (the “last relevant year”). The redetermination then would be taken into account in determining the tax treatment of the U.S. shareholder in the year of disposition (for example, under section 1248).

Separately, we encourage the drafters to consider providing a de minimis rule under which foreign tax redeterminations that fall below a specified threshold may be taken into account in the year of payment, rather than being attributed to a prior year and reported on an amended return.

* * * * *

We very much appreciate the opportunity to comment on the proposed regulations. Let me know if you have questions, or would like to discuss our comments in more detail.

Respectfully submitted,

Sincerely,

Jamie Wall
Executive Vice President, Advocacy
Securities Industry and Financial Markets Association

cc:
David J. Kautter
Assistant Secretary for Tax Policy

L.G. “Chip” Harter
Deputy Assistant Secretary (International Tax Affairs)

Doug Poms
International Tax Counsel

Jason Yen
Attorney Advisor (Office of Tax Policy)

Peter Blessing
Associate Chief Counsel (International)

Barbara Felker
Chief, Branch 3. Office of Associate Chief Counsel (International)