Firm Criticizes Aspects of Proposed FTC Regs

February 19, 2020

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

Re: Proposed Foreign Tax Credit Regulations; REG-105495-19

Dear Sirs and Mmes.,

On December 17, 2019, the Treasury Department published in the Federal Register proposed regulations titled "Guidance Related to the Allocation and Apportionment of Deductions and Foreign Taxes, Financial Services Income, Foreign Tax Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), and Consolidated Groups," REG-105495-19. Enclosed are comments to these proposed regulations. These comments are not intended to provide comprehensive comments on the proposed rules, but rather seek only to address certain issues described below.

We appreciate your consideration of these comments. We also request the opportunity to speak at a public hearing on these regulations.

Sincerely,

Adam S. Halpern, Larissa Neumann, Julia Ushakova-Stein, Sean P. McElroy, and Einav Axler
Fenwick & West LLP
Mountain View, CA

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A. Allocation of Stewardship Expenses

Proposed § 1.861-8(e)(4) would provide that stewardship expenses are allocated to dividends and inclusions received or accrued from related corporations, and proposed § 1.861-14(e)(4) would apply this rule to consolidated groups as if all members of the group were a single corporation. As under the existing final regulations, the only example illustrating stewardship expenses would be Example 18, involving a U.S. parent and U.S. subsidiary that file separate returns.

Because related U.S. corporations typically file consolidated returns, the dividends and inclusions a U.S. corporation will receive or accrue from related corporations will usually be Subpart F and GILTI inclusions. The final regulations should make clear that the filing of consolidated returns does not mean that all stewardship expenses will be allocated and apportioned to Subpart F and GILTI income.

For example, the final rules could provide that expenses incurred by a U.S. corporation for overseeing other members of its consolidated group are not treated as stewardship expenses. Since the consolidated group is considered a single taxpayer, these "overseeing" expenses are really expenses incurred by the single taxpayer to oversee itself. Thus, these expenses should be properly allocated under the "supportive" rule or another rule, rather than the stewardship rule.

B. Allocation of Lawsuit-Related Expenses

Proposed § 1.861-8(e)(5) would introduce specific rules for allocating and apportioning litigation damages, settlement payments, and similar deductions. The current final regulations do not include any specific rules in this area. Under the current rules, deductions for litigation related amounts are allocated and apportioned based on the factual relationship between the deduction and the activity or property from which they arose.

We have two concerns with the proposed rules. First, the specific rules proposed do not have a clearly articulated rationale, making them difficult to apply. For example, the existing R&D expense allocation rules are based on the principle that successful research must bear the costs of unsuccessful research. The interest expense allocation rules are based on the principle that money is fungible. What is the guiding principle for proposed § 1.861-8(e)(5)?

Nothing in the preamble explains why these particular rules have been chosen, or offers any meaningful guidance in applying them. The preamble states that clear rules are needed, but the proposed rules are not clear. For example, what does it mean for a claim to be "similar or related" to a product liability claim in the context of a services business? Before abandoning the general "factual relationship" test in favor of specific rules, Treasury and the IRS should articulate a clear, organizing principle for the specific rules, and explain how the rules are meant to be applied in various factual situations.

Second, the proposed rules could be interpreted to require an effective "double allocation" of deductions to foreign income — FDII, for example, or foreign source income — if the taxpayer is already addressing foreign-related deductions in another manner.

Consider, for example, a U.S. company that conducts R&D, develops intellectual property, and uses its IP to manufacture products for distribution in the United States. The U.S. company also licenses its IP to related CFCs for manufacturing and distribution abroad. Under the license agreements, the U.S. company agrees to defend any lawsuits related to infringement, and to indemnify the CFCs for any damages they may sustain. Any indemnifiable damages incurred by the CFCs reduces the royalties otherwise due to the U.S. company.

In this scenario, by reducing the foreign source royalty income, the U.S. company has effectively allocated all of its foreign lawsuit damages to foreign source, FDII income. If the U.S. company also had to allocate and apportion its U.S. lawsuit damages to foreign source, FDII income under § 1.861-8(e)(5), the result would be a double allocation to foreign income.

C. Allocation of Net Operating Loss Deductions

1. Overview

Proposed § 1.861-8(e)(8) would assign NOLs to statutory or residual grouping components by reference to the losses in each grouping in the taxable year of the loss. This is a sensible rule, consistent with decades of legislation, regulatory guidance, subregulatory guidance, and caselaw. Section 1.861-8(e)(8) should be finalized as proposed.

In addition, the preamble to the proposed regulations discusses taxpayers having provided comments on the application of § 1.861-8(e)(8) to NOLs arising before the enactment of the TCJA, but deducted in a post-TCJA year, for purposes of applying § 250 (relating to FDII) as the operative section. Although the preamble provides that these comments will be addressed as part of finalizing the § 250 regulations, proposed § 1.861-8(e)(8) should also specify that NOLs arising in pre-TCJA years, but deducted in a post-TCJA year, should follow the general rule in proposed § 1.861-8(e)(8) and should not be allocated or apportioned to foreign derived deduction eligible income (FDDEI) for purposes of § 250. If Treasury and the IRS prefer to address this issue solely in the § 250 regulations, the § 250 regulations should follow proposed § 1.861-8(e)(8), and NOLs arising in pre-TCJA years should not be allocated or apportioned to FDDEI.

2. Proposed Section 1.861-8(e)(8) Embodies a Longstanding Rule

When Congress restored the NOL provisions to the tax law in the Revenue Act of 1938, it imposed certain restrictions that made the NOL deduction more complicated, and less valuable. For example, § 26(c) of the 1938 Act provided that the amount of a NOL was computed as the excess of deductions over gross income, but with certain adjustments limiting the deduction for depletion and adding back certain tax-exempt interest to gross income. These adjustments to the amount of the NOL tended to discriminate against companies with fluctuating income. For that reason, Congress ultimately repealed them. In the decades since, a corporation's NOL deduction has been the same as the excess of its deductions over gross income in the original loss year. There is no need to recompute the amount of the NOL in the year in which it is absorbed.

More recently, when Congress in the TCJA limited the NOL deduction to 80% of taxable income, it did so only on a prospective basis, for post-TCJA NOLs, and not for pre-TCJA NOLs. Similarly, § 965(n) evidences Congress's intention to allow taxpayers with pre-TCJA NOLs to utilize them fully to offset taxable income in post-TCJA years. These TCJA provisions again illustrate a legislative intent to provide parity between taxpayers with consistent income and those with fluctuating income.

Since the issuance of Treasury Decision 7456 in January 1977, regulatory guidance has offered similar parity with respect to the allocation of the NOL deduction, consistently providing that the deduction is allocated based on the respective groupings of income in the year the NOL arose. This approach is also consistent with the approach taken by courts before the regulations were issued. For example, in Motors Ins. Corp. v. United States, 530 F.2d 864 (Ct. Cl. 1976), the U.S. Court of Claims concluded that for purposes of adjusting a foreign tax credit limitation to take account of a NOL, the inquiry is whether the NOL is allocable to income from specific, geographical sources based on the year the NOL arose.

IRS subregulatory guidance has consistently applied the same principle. In TAM 9805003 (Oct. 15, 1997), the IRS considered whether a NOL incurred in one taxable year could, in a later taxable year, be used to offset combined taxable income (CTI) under then § 936. The IRS held that the NOL could not offset CTI in another taxable year if the expenses giving rise to the NOL in the year in which it arose did not relate to the computation of CTI for that year. The principle behind the ruling is that expenses giving rise to a NOL must be allocated and apportioned to classes of gross income in the year of the loss, the same rule now found in proposed § 1.861-8(e)(8). In PLR 8911022 (Dec. 15, 1988), the IRS applied the same principle and reached the same conclusion.

3. Applying Section 1.861-8(e)(8) to FDII

Proposed § 1.861-8(e)(8) provides a straightforward and logical approach for allocating NOLs arising before the enactment of the TCJA, but deducted in a post-TCJA year, for purposes of applying § 250. Under proposed § 1.861-8(e)(8), pre-TCJA NOLs would be allocated by reference to the statutory or residual grouping components of the loss in the taxable year in which it arose. Because the FDDEI and non-FDDEI groupings of § 250 did not exist in the taxable year of the loss for pre-TCJA years, NOLs arising in those years, but utilized in a post-TCJA year, should not be allocated or apportioned to FDDEI.

A contrary rule would create the inequitable circumstance of treating identical losses in the same year differently, depending on whether taxpayers had sufficient income in that year to absorb the losses. Consider the following example:

If a new rule required taxpayers to reassign their pre-TCJA 2015 NOLs based on the year in which they are absorbed rather than incurred, A and B would have incurred identical losses, in the same tax year, but those losses would have disparate effects on their taxable incomes. That is precisely the inequitable result that Congress, Treasury, the IRS, and courts have sought to avoid for decades.

D. Allocation of Foreign Income Taxes

Proposed § 1.861-20 would provide detailed rules for assigning foreign income taxes to groupings. We have two comments on the proposed rules. Both relate to situations where the proposed rules would assign foreign taxes to the "residual" grouping, with the result that the taxes could never be credited.

First, the proposed "base difference" rule in § 1.861-20(d)(2)(ii)(B) is overly broad. We are particularly concerned with items (6) and (7). Item (6) is a § 301(c)(2) return-of-capital distribution. Item (7) is a § 733 distribution to a partner. The proposed rule would treat taxes imposed on these distributions as base difference taxes. These foreign taxes should be treated as timing difference taxes associated with the underlying earnings that are distributed (or that would be distributed if the entity had earnings for U.S. tax purposes). The foreign taxes would more naturally be assigned to groupings under proposed § 1.861-20(d)(3)(ii)(A), just like foreign taxes on a distribution/remittance from a disregarded entity.

In the case of a § 301(c)(2) distribution, it shouldn't matter that the distributing CFC has no earnings as measured under U.S. tax principles. That's the point of the timing difference rule — U.S. and foreign law sometimes measure amounts differently, or take them into account at different times.

A primary purpose of TCJA's international tax changes was to allow U.S. parent companies to repatriate foreign earnings without incurring residual U.S. tax. In light of that purpose, it seems inappropriate for Treasury and the IRS to create additional obstacles to repatriation. Many U.S. corporations have multi-tiered CFC structures. By assigning foreign taxes on distributions to the residual basket and eliminating them from the foreign tax credit base for purposes of § 960, the proposed rules would impose an obstacle to repatriation.

Second, proposed § 1.861-20(d)(3)(ii)(B), assigning disregarded payments by an owner to the residual grouping, is inappropriate. If a CFC makes disregarded payments of taxable income to its foreign disregarded entity (FOE), the taxes imposed on the FDE should be associated with the FDE's earnings and creditable under § 960 in that grouping. The proposed rule makes no sense.

E. Foreign Tax Redeterminations

Proposed § 1.905-4 would require amended returns to be filed whenever a foreign tax redetermination causes any change in the reported U.S. tax liability for a prior year. Between TCJA and recent OECD developments, foreign tax redeterminations will be very common. We are concerned that unless this proposed rule is modified, every year taxpayers will end up filing not only their current year tax return, but also amended returns for many open tax years. The compliance burden on taxpayers after TCJA is already quite high. The revised Forms 5471, 1118, 8992, and others make U.S. international tax compliance extremely challenging. The IRS will not find auditing post-TCJA returns to be an easy task, either. Layering on top of the already-complex compliance landscape a requirement that taxpayers file (and that the IRS process) multiple amended returns every year seems unwise. We would strongly urge Treasury and the IRS to consider streamlined alternatives to the amended return requirement.

One possible approach could be a percentage de minimis test. If the change in foreign tax liability is less than 15% (for example) of the originally reported liability, the change would be reported in some way on the current year's return. We recognize that without foreign tax pooling, the mapping from the prior year's return to the current year's return won't be perfect.

Still, it seems a better alternative than having taxpayers file multiple, highly complex amended returns every single year.

We also recommend that taxpayers under examination be allowed to notify the IRS by providing the IRS exam team with the statement described in proposed § 1.905-4(b)(4)(iii), whether the foreign tax redetermination results in an upward or downward adjustment in the amount of foreign taxes paid or accrued. The condition in proposed § 1.905-4(b)(4)(i)(B) should be eliminated. The final regulations should also make clear that notifying the exam team of a reduction in U.S. tax liability in accordance with the regulations constitutes a valid refund claim if it is made within the period prescribed by § 6511.

Finally, proposed § 1.905-3(b)(2)(v), Example 2, involves a U.S. corporation (USP) that owns a Country X corporation (CFC). The example concludes that USP is eligible to elect to exclude an item of CFC's Subpart F income under the Subpart F high-tax exception following an increase in CFC's Year 1 foreign taxes pursuant to a Country X audit of CFC that concludes in Year 5. The example states that if USP makes a timely refund claim within the time period allowed by § 6511, USP will be entitled to a refund of any overpayment. In light of the government's litigating position in Schaeffler v. United States, 889 F.3d 238 (5th Cir. 2018), and Trusted Media Brands v. United States, 899 F.3d 175 (2d Cir. 2018), we ask that Treasury and the IRS clarify how they believe § 6511 would apply in this example, if USP wished to elect the high-tax exception.