PwC Warns Against Sequestering Corporate AMT Credits

May 8, 2018

Thomas West, Esq.
Tax Legislative Counsel
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

Re: Application of Federal Budget Sequestration to Alternative Minimum Tax Credit Refunds

Dear Mr. West:

Thank you for agreeing to meet with us again to discuss the application of the sequestration provisions of the Budget Control Act of 2011 (“BCA”) to the taxpayer refunds of corporate alternative minimum tax (“AMT”) credits (“MTCs”) provided for under the recently enacted Tax Cuts and Jobs Act (“TCJA”). We look forward to discussing further the reasons that MTCs constitute — and Treasury should treat them as — prior tax paid that Congress clearly intended to return to taxpayers. Despite the nomenclature, such returns properly reflect a reduction in governmental receipts, not an outlay subject to BCA sequester. This conclusion is consistent with Treasury's own practice of not applying the BCA sequester to certain other refundable corporate tax credits as well as the underlying substance of the MTC refunds. This letter supplements our prior communications and provides additional background supporting this conclusion.

Budget Sequestration Background

The current congressional budget process was established by the Congressional Budget and Impoundment Control Act of 1974 (the “1974 Budget Act”).¹ The 1974 Budget Act provided controls over the budget process through annual congressional determinations of appropriate levels of federal revenues and expenditures and of national budget priorities. The 1974 Budget Act defined the terms “budget outlays” and “outlays” to mean expenditures of budget authority.² “Budget authority” means “the authority provided by Federal law to incur financial obligations,” including borrowing authority, contract authority, offsetting receipts and collections, and general “provisions of law that make funds available for obligation and expenditure . . .”³

Sequestration was first introduced as part of the “1985 Budget Act,” commonly referred to as the Gramm-Rudman law, as a means to enforce deficit targets.⁴ Though the Act was modified several times and eventually expired in 2002, in 2011, Congress revived the sequestration process through the BCA.⁵ Sequestration under the BCA separately affects discretionary spending⁶ and direct (or mandatory) spending. Direct spending is “budget authority provided by law other than appropriation Acts.”⁷ The BCA sequester reduces a broad range of non-exempt direct spending accounts, and applies to certain refundable tax credits.

The Office of Management and Budget (“OMB”) has, for several years, interpreted the BCA sequester to apply to “Payments Where Certain Tax Credits Exceed Liability for Corporate Tax.”⁸ The IRS, since the enactment of § 168(k)(4), has applied the BCA sequester to MTC refunds and intends to apply the same sequester to MTC refunds required under the TCJA. For the reasons we have discussed and set forth below, we do not believe this result is correct. Unlike tax credits enacted as an alternative way of funding spending priorities, MTCs do not provide, and were not intended to provide, financial assistance to specific activities, entities, or groups of people. Rather they are refunds of tax previously paid and, as such, should be exempt from the BCA sequester.

Budget Treatment of Refundable Tax Credits

Increasingly over the last 30 years, Congress has relied on income tax credits to incentivize certain activities or provide income support, moving large amounts of government spending from the appropriations process to the tax code. In some cases where the taxpayer has no tax liability to offset, Congress has made tax credits refundable.

While there are a number of refundable tax credits, the credits generally fall into one of two categories:

The following provides an overview of the disparate treatment of these two categories of credits for budget purposes as either direct spending or reduction of prior receipts.

Refundable tax credits as direct spending

The first refundable income tax credit — the EIC — went into effect shortly after passage of the 1974 Budget Act. Under the newly established budget process, Congress needed to determine whether to treat the refundable portion of the EIC as a budget outlay or a reduction of revenues.

In 1977, the conferees of the First Concurrent Budget Resolution for fiscal year 1979 resolved this issue in “agree[ing] to treat refundable tax credit payments in excess of the recipient's tax liabilities as outlays and budget authority, rather than as revenue reductions.”¹² This decision made sense for the EIC, which provides benefits that are not limited to the amount of prior tax payments by the recipient. There was little disagreement that the portion of the EIC reducing regular tax was properly considered a reduction in revenues.

A contemporaneous Congressional Budget Office (“CBO”) report expounds on the meaning of “refundable tax credit” as follows:

A tax expenditure taking the form of a refundable tax credit is the most similar to a direct spending program. When the amount of a refundable credit exceeds a taxpayer's income tax liability, the Treasury Department refunds the difference to him. Individuals may thus receive payments from the Treasury greater than the amount of income taxes they have paid in.¹³

A more recent CBO report provides that refundable tax credits — as well as certain income tax exclusions, deductions, and nonrefundable credits — are termed tax expenditures for budgeting purposes “because they resemble government spending programs by providing financial assistance to specific activities, entities, or groups of people.”¹⁴ Credits that reduce revenues are not tax expenditures or outlays subject to the budget sequestration rules designed to reduce spending through cancellation of budgetary resources.¹⁵

The conferees in the 1977 agreement drew a parallel between refundable tax credits and government spending because Congress intended the EIC — the only refundable credit at that time — to provide targeted financial assistance. In recognition of this intent, Gramm-Rudman exempted “[p]ayments to individuals made pursuant to § 32 of the Internal Revenue Code of 1954 [the earned income credit] . . .,” as at that time, there was only one refundable tax credit that resembled government spending — the EIC.¹⁶

As a result of the subsequent creation of other refundable tax credits, Congress expanded the statutory exemption in 2010 to include “payments to individuals made pursuant to provisions of the Internal Revenue Code of 1986 establishing refundable tax credits.”¹⁷ While Congress specifically exempted from sequestration certain individual refundable tax credits that might otherwise qualify as government spending, it did not consider all refundable credits as outlays for budget purposes as they have never been explicitly exempt from or subject to sequestration.

Refundable tax credits as reductions of receipts

Contemporaneous with the 1974 Budget Act, there were a number of tax credits technically refundable to the extent such credits exceeded regular tax liability; however, the nature of these credits differed from the EIC for the purpose of budget classification. Under the analysis adopted by the conferees to the 1977 agreement as it related to budget outlays, the term “refundable tax credits” referred to a narrow category of credits, i.e., those credits that resemble government spending by providing targeted financial assistance. Those “refundable tax credits” not providing targeted financial assistance were not considered outlays. This category of refundable credits not considered to be outlays included the IRC § 31 credit for taxes withheld on wages and the current IRC § 33 credit for taxes withheld at source on non-resident aliens and foreign corporations. In the context of these refundable tax credit payments to individuals (e.g. the § 31 refundable credit for excess tax withholding), such payments are exempt from sequestration not because of specific statutory exemptions, but because they are not outlays for budgetary purposes. The refundable tax credit under IRC § 33, similar in nature to the § 31 refundable tax credit, applies to both individuals and corporations.

Section § 33 provides for a refundable credit against corporate income tax for “the amount of tax withheld at source under subchapter A of chapter 3 (relating to withholding of tax on nonresident aliens and on foreign corporations).” U.S. withholding agents must withhold and deposit tax on certain U.S. source income of foreign persons, including foreign corporations.¹⁸ The rate at which tax is withheld is generally 30% applied to the related income amount; however, this rate may be reduced by exemption or treaty.¹⁹ In effect, § 33 allows a company to claim a refund of excess tax withheld on its behalf to the extent that excess withholding amounts exceed its income tax liability for the period. Refunds of § 33 tax credits are in many ways similar to MTC refunds under the TCJA:

• The § 33 credit resides in Subpart C, the same Subpart referenced under the MTC refund provisions enacted by the TCJA.²⁰

• Refundable tax credits under § 33 are refunds of amounts paid by corporations in excess of income tax liability.

• Both the § 33 credit and the MTC refunds represent overpayments administered by Treasury.²¹

Importantly, refunds under § 33 have not historically been subject to the BCA sequester.

Because MTCs result from prior payments of tax in excess of regular tax, they are akin to credits for withheld taxes (which are prior payments of tax) rather than refundable tax credits providing financial assistance or incentives and requiring no prior payment of tax. MTCs, like other refundable credits limited by the amount of previously paid tax, are properly treated as revenue reductions, not governmental outlays. As such, Treasury should exercise the authority by which it determined that § 33 refundable credits are not subject to sequester and conclude that MTC refunds should similarly not be subject to sequestration, regardless of the “credit” moniker used by Congress when providing for the refund mechanism.

Substance of AMT payments

In considering the structure of the AMT and its role in the income tax system, it is clear that payments of AMT represented a loan from the taxpayer to the government because it was Congress' intent to repay the AMT to the taxpayer as a credit against future income tax liability. The application of the BCA sequester to MTC refunds would mean that the government, as borrower, would be dishonoring its obligation to repay a portion of the principal. From both a legal and an equitable view, we know of no other business arrangement where this would be acceptable.

Over the years, courts have given Treasury and the Internal Revenue Service (IRS) the latitude to apply statutes consistent with substance rather than form. The judicial doctrines have taken a variety of forms, and Treasury and the IRS have used them in a wide variety of situations to achieve appropriate results. Treasury and IRS should use the authority courts have given them to look at the substance of the MTC refunds and treat them as returns of prepaid tax liability, not as outlays, which in substance they plainly are not.

In the seminal case of Gregory v. Helvering,²² the Supreme Court analyzed the substance of the taxpayer's transaction rather than the form. The court declined a literalist approach, which would have produced a clearly unintended result. In examining the overall substance of the transaction at issue, the court found that “the transaction on its face lies outside the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.”²³

Since the Gregory decision, courts have frequently applied the substance over form approach in deciding the proper tax treatment. In its recent PPL decision,²⁴ the Supreme Court addressed the substance and proper characterization of certain foreign tax payments as creditable against U.S. income tax. The IRS argued that a U.S. taxpayer's foreign tax payments were not creditable against U.S. income tax because the underlying foreign tax was based on an artificial valuation as compared to a direct measure of current income, at odds with the requirements under a literal reading of the IRC. In reaching its decision, the court evaluated the nature of the foreign tax payments by looking to the “predominant character” of the tax and noting that a foreign government's characterization of the tax is not dispositive with respect to the characterization for U.S. tax purposes.²⁵ The court stated that the IRS position could not “be squared with the black-letter principle that 'tax law deals in economic realities, not legal abstractions',”²⁶ and found unanimously, based on a substance over form analysis, that the foreign tax payments were creditable against U.S. income tax.

While MTC refunds are “credits” in name, that designation simply reflects the mechanism by which the government returns prior AMT payments. The substance of the MTC refund, not its nomenclature or the mechanism by which the tax to be repaid is determined, should govern its treatment for purposes of the BCA sequester. As illustrated in PPL, it would be appropriate for a substance over form approach to govern in determining the sequestration of payments in the tax credit context. In following this approach, the primary consideration include:

Under this approach, the BCA sequester should not apply because MTC refunds represent reductions in prior budget receipts, not outlays. This conclusion is consistent with prior Treasury reports indicating that the return of prepaid tax in the form of MTCs is neither an expenditure nor an outlay for budget purposes.

Treasury budget reports

The 1974 Budget Act requires an annual listing of “tax expenditures” defined as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability” that may be viewed as alternative policy instruments to other spending or regulatory programs.²⁷ Pursuant to this requirement, Treasury's Office of Tax Analysis (“OTA”) publishes its listing of “tax expenditures” for each fiscal year in a specific Tax Expenditure report.²⁸ The MTC, as a credit against regular tax, has not been identified as a tax expenditure per se.

Treasury's Fiscal Year 2019 report identified 167 distinct corporate and individual tax expenditures across multiple economic sectors and categories related to federal tax law provisions in effect as of July 1, 2017. Enumerated expenditures included corporate tax credits, ten of which were refundable. OTA has designated credits as “tax expenditures” to the extent they reduced tax liabilities or as “outlays” to the extent they are refundable.²⁹ In its report, Treasury does not consider the § 33 credit a “special credit” or “tax expenditure” for this purpose. Non-refundable portions of specific tax credits other than minimum tax credits have been listed as tax expenditures since the publication of these reports, and properly so: they constitute spending via the tax code. Treasury has never included non-refundable MTCs, on the other hand; nor should they because MTCs represent repayments of tax paid, not spending effectuated by means of a credit against tax or cash refund.

The absence of MTCs as expenditures is logical in that the AMT was not designed to benefit taxpayers; to the contrary, the AMT served to accelerate tax payments to the government, operating to the clear detriment of taxpayers. A CBO report contemporaneous with the deliberations following the 1974 Budget Act provides that “tax expenditures are revenue losses from the provisions of the tax law that provide special or selective tax relief to certain categories of taxpayers.”³⁰ MTC refunds do not provide special or selective tax relief to certain categories of taxpayers; rather, they serve to reimburse taxpayers for prior taxes imposed through the AMT itself.

Just as Treasury does not treat MTC offsets to regular tax as tax expenditures, consistency requires that Treasury consider a refund of MTCs as an outlay for purposes of the BCA sequester. While Treasury's Tax Expenditure report does not yet reflect a post-TCJA world, the fact that MTCs are now refundable does not change the nature of the underlying MTCs as a return of prepaid tax. Based on Treasury's historical interpretation of “tax expenditure,” it would be illogical for subsequent reports to characterize the refund of MTCs as “special credits,” identify the use of such credits as tax expenditures, or designate MTC refunds as outlays. Such a change would be in direct conflict with both the past budgetary treatment of MTCs as well as the underlying substance of the credit.

Conclusion

MTC refunds should be exempt from sequestration, just as the return of other prepaid tax amounts are exempt. Given the substance and nature of MTCs, Treasury's own application of the budget rules to similar credits, and the fact that MTC refunds are not outlays as originally contemplated under the budget rules, this conclusion is the only reasonable conclusion with respect to the application of the BCA sequester. We respectfully request that Treasury reconsider its decision to sequester the MTC refunds directed by the TCJA and use its authority to exempt such refunds from the BCA sequester.

We would be happy to discuss any questions you may have in respect of this letter or otherwise assist in your efforts with respect to this important issue. Please feel free to call me at 202 414 1401 if you have any questions. We look forward to meeting with you on May 9th.

Very truly yours,

Pamela F. Olson
Partner, PricewaterhouseCoopers LLP

cc:
Bradley Bailey, Deputy Assistant Secretary for Legislative Affairs
Krishna Vallabhaneni, Deputy Tax Legislative Counsel
Edith Brashares, Director of Business and International Taxation, Office of Tax Analysis
Christopher Call, Attorney-Advisor, Income Tax & Accounting