NAM Points to Problematic Areas in Proposed FTC Regs

February 18, 2020

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

RE: Comments on the Allocation and Apportionment of Deductions and Foreign Taxes

On behalf of the 12.8 million men and women who make things in America, the National Association of Manufacturers appreciates the opportunity to comment on the Treasury Department's proposed regulations relating to the allocation and apportionment of deductions and foreign taxes. The NAM is the largest industrial association in the United States representing manufacturers in every sector and in all 50 states, and our comments are intended to ensure that the tax reform legislation enacted in 2017 (informally known as the Tax Cuts and Jobs Act (TCJA))¹ has the intended effect of spurring economic growth and supporting innovation.

Background on Expense Allocation and Apportionment

As part of the TCJA's move toward a territorial system whereby taxpayers can repatriate foreign earnings without an additional layer of U.S. tax, Congress enacted Section 951A.² Under this anti-base erosion measure, a U.S. shareholder of a controlled foreign corporation (CFC) must include in its gross income the excess (if any) of the shareholder's net CFC tested income over the shareholder's net deemed tangible income return. Once the Global Intangible Low-Taxed Income inclusion has been calculated, it is included as part of the U.S. shareholder's taxable income and taxed at the corporate tax rate of 21 percent.

The TCJA also enacted Section 250, which provides a deduction for Foreign-Derived Intangible Income (FDII). The FDII provision allows for a deduction equal to 37.5 percent of FDII amounts plus 50 percent of the Global Intangible Low-Taxed Income amounts.³ When coupled with the ability to use 80 percent of foreign tax credits (FTCs),⁴ the result is a minimum tax of 13.125 percent on foreign income.

The legislative history of Section 951A indicates that Congress intended to limit the scope of this provision to exempt from additional U.S. taxation foreign earnings that are taxed beyond a threshold rate in the local country. As the TCJA conference committee report states, “The minimum foreign tax rate, with respect to [Global Intangible Low-Taxed Income], at which no U.S. residual tax is owed by a domestic corporation is 13.125 percent.”⁵

However, taxpayers can face an additional U.S. tax on income that is subject to a foreign rate of tax well beyond 13.125 percent. This occurs due to the interaction of Section 951A with existing rules for taxing international income. Specifically, FTCs are affected by the expense allocation rules, which were unchanged by the TCJA and require deductions to be allocated to the income to which they relate. This FTC limit is based on the ratio of foreign source income to worldwide taxable income, multiplied by a taxpayer's U.S. tax liability. This limit declines as foreign source income declines. Foreign source income declines as deductible expenses are allocated to foreign income, thus making expense allocation a concern for manufacturers operating on a global basis.

Under the current rules for the allocation of research and experimental (R&E) expenses,⁶ taxpayers must allocate deductible expenses to the product category to which the expense relates. These expenses must then be apportioned among the statutory and residual groupings of underlying income. Taxpayers can choose to use the sales method or the gross income method for this apportionment. Under the sales method, 50 percent of the R&E deduction is apportioned to the country in which more than 50 percent of deductible R&E activities were performed. The remaining amount is apportioned to each product category based on the ratio of foreign sales to total sales. Under the optional gross income method, 25 percent of the R&D deduction is apportioned to the country in which more than 50 percent of deductible R&E activities were performed. The remaining amount is apportioned ratably among the statutory and residual groupings.⁷

Manufacturers appreciate Treasury's willingness to re-examine the operation of the expense allocation rules in light of the enactment of Section 951A. To the extent the proposed regulations help limit the reach of Section 951A to instances in which foreign earnings are taxed at less than 13.125 percent in the local jurisdiction, it provides a result that is more consistent with congressional intent.⁸ The NAM respectfully submits the comments below to help achieve this intent.

Specific Issues Related to the Allocation and Apportionment of R&E Expenditures

The proposed regulations adopt as a starting point for allocation and apportionment the premise that R&E expenses are related to “gross intangible income.”⁹ This concept is broadly defined, but appropriately excludes amounts included in income under Section 951A.¹⁰ However, manufacturers urge Treasury to consider excluding amounts included in the Section 250 calculation. Section 250 provides a deduction against export income and excluding these amounts from the expense allocation rules would be consistent with the congressional intent of encouraging the location of intellectual property in the U.S. Moreover, Sections 951A and 250 include many of the same concepts with respect to their calculations and methodology and they are intended to work together to protect the U.S. tax base. Excluding Section 250 amounts would provide consistency with the approach taken for Section 951A amounts.

In addition, the proposed regulations would eliminate the ability of taxpayers to utilize the optional gross income method in apportioning R&E expenses. In the preamble, Treasury states that:

[I]f a taxpayer sells products incorporating its intangible property in the United States but earns royalties from licensing its intangible property used by others to make sales abroad, comparing the gross income from sales, which includes value attributable to other factors in addition to intangible property, to the gross royalty income will generally distort the extent to which the R&E expenditures produce U.S. and foreign source income from intangible property. In such cases, the gross income method is inconsistent with the general principle under §1.861-8T(c) that the method of apportionment “reflect to a reasonably close extent the factual relationship between the deduction and the grouping of gross income.”¹¹

As Treasury notes, it is possible that under a specific set of circumstances, the sales method may produce a more reasonable result. However, it is not clear that the gross income method would be inappropriate in all cases. Accordingly, we respectfully suggest that Treasury continue to allow taxpayers to utilize their method of choice for allocating and apportioning R&E expenses, as it has done since the initial regulations on this topic were finalized in 1995.¹² Moreover, Treasury proposes to only allow the apportionment under the sales method for FTCs. By not applying this rule for FDII, an overallocation of R&E expenses to FDII amounts can occur as taxpayers would effectively be unable to properly account for income generated by R&E activities in the U.S. We urge Treasury to consider extending the application of allocation and apportionment methods to specifically include amounts taken into account under Section 250.

Allocation and Apportionment of Stewardship Expenses

In the preamble, Treasury proposes to allocate and apportion stewardship expenses to a U.S. taxpayer's Global Intangible Low-Taxed Income on the basis that these expenses are related to the foreign income generated by the taxpayer's stock assets.¹³ More specifically, Treasury proposes to apportion these expenses based on the assets' values. In order to prevent an over-allocation of such expenses from causing a taxpayer's foreign income to be taxed beyond what Congress intended, the NAM respectfully urges Treasury to provide taxpayers with the flexibility to apportion the expenses based on a facts and circumstances method similar to Treas. Reg. sec. 1.861-8(b).¹⁴

Other Issues

Financial Services Income

The proposed regulations make a substantial change¹⁵ to the scope of “financial services income” for which FTCs must be separately computed by eliminating long-standing definitions that clearly identify types of income subject to the provision.¹⁶ Such a modification could cause uncertainty for taxpayers who have been tracking attributes related to the prior regulations' definition of “financial services income or have otherwise relied on the definition in the current regulations.” Accordingly, we respectfully urge Treasury to either abandon the modification or allow taxpayers to continue to rely on current law definitions until Treasury has promulgated detailed guidance (comparable to the existing regulations) under the relevant subpart F provisions which are cross-referenced by the proposed regulations. At a minimum, taxpayers should be permitted to rely on current-law definitions with respect to any pre-existing attributes such as qualified deficits that were generated in the years before the definition change, so that future income that could be offset with a qualified deficit under the current, long-standing regulations can continue to be offset (as if there were no definition change).

Payments between foreign disregarded entities

Although the proposed regulations are silent regarding tax payments between foreign disregarded entities (DREs) with a single CFC owner, the NAM encourages Treasury to provide certainty and creditability for any foreign taxes attributable to these payments. We note that an operating rule treating payments between DREs as per se residual basket income is problematic. An approach that sources the foreign taxes attributable to these payments based on the sourcing of the underlying payment would more accurately reflect the economic reality and character of the DRE's income.

State Income Taxes

In the preamble, Treasury requests comments regarding whether the rules governing the allocation and apportionment of state income taxes should be revised in light of conforming state law changes made by the TCJA. The NAM recommends that Treasury maintain the current approach, which provides a broad framework for allocating and apportioning the categories of income giving rise to those taxes.¹⁷ Current regulations look to state law as the basis for determining how to allocate and apportion the taxes to which underlying income relates.¹⁸ This deference to state law in determining the treatment of state taxes should be maintained.

Litigation Damages Awards, Prejudgment Interest and Settlement Payments

Treasury proposes to allocate and apportion a U.S. taxpayer's damages, prejudgment interest and settlement payments to all of the taxpayer's income.¹⁹ In doing so, Treasury is making the assumption that the expenses associated with the claims impact all of the taxpayer's income when the case may be that the claims are only related to the income from the jurisdiction where the claims originate. Accordingly, the NAM requests that Treasury narrow the scope of the allocation and apportionment to one based on the facts and circumstances of the claims so as to more accurately match the expenses to the income to which it relates.

Thank you for the opportunity to comment. If you have questions or would like to discuss this matter further, please contact me at 202-637-3077.

Sincerely,

Chris Netram
Vice President
Tax & Domestic Economic Policy
National Association of Manufacturers
Washington, DC