Firm Criticizes Per Se Rule for Check-the-Box Elections

June 13, 2018

Office of Associate Chief Counsel (International)
Attn: Leni C. Perkins
Internal Revenue Service, IR-4579
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments to Internal Revenue Code Section 965 and Notice 2018-26

Dear Ms. Perkins

This letter provides comments on Notice 2018-26¹ (the “Notice”), which announced that the U.S. Department of the Treasury (the “Treasury”) and the U.S. Internal Revenue Service (the “IRS”) intend to issue regulations addressing various issues under Sections² 962 and 965 of the United States Internal Revenue Code of 1986, as amended (the “Code”). Our comments are focused on certain anti-abuse rules that will be applicable to taxpayers under Section 965, including anti-abuse rules applicable to retroactive elections under Treasury Regulations Section 301.7701-3 (“check-the-box elections”). We believe that the rules specified in the Notice should be modified and clarified to limit their applicability to the abuse that Congress specifically intended to address. In particular, the per se rule for check-the-box elections is overly broad and prevents taxpayers from making check-the-box elections that are not only not abusive but are specifically contemplated as being consistent with legislative intent. In particular, when a check-the-box election has the practical effect of the making of an election under Section 962, such a check-the-box election should be recognized for Section 965 purposes as being consistent with Congressional intent.

I. Summary of Section 965 and other Relevant Tax Code Provisions

A. Summary of Section 965

Recently enacted tax reform³ included a one-time “transition tax” on post-1986 accumulated earnings and profits of certain foreign corporations. Effectively, Section 965 is part of the general transition to a partial territorial system of international taxation — certain U.S. shareholders of certain foreign corporations must pay an immediate one-time tax on deferred earnings & profits held by such foreign corporations (effectively a deemed repatriation of to-date deferred earnings and profits) in exchange for, amongst other benefits, a 100 percent dividends received deduction on distributions from such foreign corporations (contained in new Section 245A).⁴

The deemed repatriation under Section 965 arises by treating the earnings of a specified foreign corporation (“SFC”)⁵ as subpart F income (and thus subject to current year taxation for United States shareholders) for the SFC's last taxable year beginning before January 1, 2018.⁶ Subpart F income arising under Section 965 is subject to “transition tax” rates that are substantially lower than regular U.S. income tax rates.⁷ Foreign tax credits and the Section 78 gross-up amount in connection with income inclusion under Section 965 are limited to reflect the reduced rate of taxation.⁸

B. Summary of the Anti-Abuse Rules to be Issued

Since the signing of the Act into law, the IRS and the Treasury have issued multiple notices and revenue procedures regarding Section 965, all of which describe certain to-be-issued regulations interpreting different parts of Section 965.⁹ Most relevant to the purpose of this letter, on April 16, 2018, the IRS published the Notice. The Notice addresses a variety of issues under Section 965 and certain other provisions of the Code. This letter particularly addresses the IRS's stated intent to issue regulations that will disregard, for purposes of Section 965, any check-the-box election that is filed on or after November 2, 2017, if such election would otherwise reduce the Section 965 tax liability of any United States shareholder — regardless of the purpose for entering into the check-the-box election (the “Per Se Check-The-Box Rule”).¹⁰

The Per Se Check-The-Box Rule appears in the context of a general anti-avoidance rule that will also be included in the intended regulations under Section 965. The Notice states that the Treasury and the IRS intend to issue an “anti-avoidance rule” regulation that will disregard a transaction for the purposes of determining a United States shareholder's Section 965 tax liability if: “(i) such transaction occurs, in whole or in part, on or after November 2, 2017 . . . ; (ii) such transaction is undertaken with the principal purpose of reducing the section 965 tax liability of such United State shareholder; and (iii) such transaction would, without regard to this sentence, reduce the Section 965 tax liability of such United States shareholder. . . ."¹¹ A transaction will be treated as reducing a section 965 tax liability of a United States shareholder if the transaction, with respect to such United States shareholder: (i) reduces the Section 965(a) inclusion with respect to an SFC, (ii) reduces the aggregate foreign cash position, or (iii) increases the amount of foreign income taxes paid of an SFC under certain circumstances.¹² The presumption of tax-avoidance will be overcome, “only if facts and circumstances clearly establish that the transaction was not undertaken with a principal purpose of reducing the section 965 tax liability of a United States shareholder.”¹³ Since this general anti-avoidance rule would already disallow recognition of any abusive check-the-box election that affected taxation of a U.S taxpayer, the Per Se Check-The-Box Rule presumably intends to disallow even those check-the-box elections that do not otherwise reduce the Section 965(a) inclusion with respect to an SFC, reduce a foreign cash position, or increase the amount of foreign income taxes paid of an SFC, as well as where there is no primary purpose of tax avoidance.

C. Summary of Treatment of Pass-throughs and the Section 962 Election

The Notice states that the IRS and Treasury intend to issue regulations under which the Section 965 income inclusion and deduction of a domestic pass-through entity that is a United States shareholder of a DFIC under the rules of Section 958(a) will be determined at the pass-through entity level.¹⁴ As a result, the regulations will provide that each owner of a domestic pass-through entity will take into account its share of Section 965 income inclusion with respect to the Section 958(a) stock of a DFIC regardless of whether such domestic pass-through entity owner is also a United States shareholder with respect to such DFIC.¹⁵ The practical effect of this regulation would be that a U.S. person that holds interests in a domestic partnership that holds stock in a DFIC will be liable for such U.S. person's proportionate share of such domestic partnership's Section 965 tax liability, irrespective of whether such U.S. person would be treated as a United States shareholder if they directly held the same such interests of the DFIC.

According to the Notice, the IRS intends that the regulations will state that for purposes of the anti-avoidance regulation, a domestic member of a domestic pass-through entity that is a United States shareholder will also be treated as a United States shareholder. As a result, certain pass-through owners that would not otherwise be treated as United States shareholders because they would not meet the minimum ownership requirements to qualify as United States shareholders on their own will nevertheless be treated as United States shareholders for purposes of the anti-avoidance rules.¹⁶ The anti-avoidance portion of the regulations will therefore apply to a much larger population than is otherwise subject to the rules that apply to United States shareholders, or, in certain cases described more below, then is otherwise able to take advantage of certain elections to be taxed as corporations.

The Notice also states that the regulations will provide details about the Section 962 election and how it will interact with Section 965.¹⁷ Congress enacted Section 965 with Section 962 — which section permits an individual U.S. shareholder to elect to be treated as a domestic corporation for many purposes of subpart F — specifically and expressly in mind. In particular, Congress specified that individuals were expected to be able to opt-in to corporate tax rates through the Section 962 election — even individuals who were indirect owners of a DFIC by virtue of ownership in a U.S. shareholder that was a pass-through entity (such as a partnership).¹⁸ Section 962 has existed as part of subpart F since 1962, and was intended to ensure that individual U.S. shareholders could avoid disadvantages from the subpart F regime by allowing them to be treated as a domestic corporation in part for U.S. federal income tax purposes. In particular, Section 962 is meant to allow individuals to elect corporate tax rates and the ability to receive deemed-paid foreign tax credits under Section 960 — although such individuals must effectively pay a double tax by including as income amounts actually distributed to them in excess of the amount of U.S. income tax paid at the time of the Section 962 election. The ability to elect corporate-rate taxation is expressly not abusive and has been recognized and endorsed by Congress and the IRS through Section 962.

At the same time that the Notice provides that holders of interests in pass-through entities will be treated as “United States shareholders” for purposes of the anti-abuse rule, the Notice disallows the treatment of those persons as United States shareholders for purposes of Section 962 and the election to be taxed at corporate rates. The regulations will provide, inter alia, that the 965(c) deductions will be available to any individual making a Section 962 election.¹⁹ Further, the regulations will specify that if a U.S. individual is an owner of an interest in a passthrough entity where the pass-through entity is a United States shareholder of a DFIC, the individual can only make a Section 962 election if the individual is also a United States shareholder of the DFIC.²⁰

II. Anti-Abuse Concerns and “Check-the-Box” Elections

In drafting Section 965, Congress was clearly concerned with the possibility of abusive transactions that were intended to reduce the income inclusion and tax under Section 965 of taxpayers, as evidenced by their specific inclusion of language referencing anti-abuse rules to be enacted by the IRS. Section 965 contains an express provision authorizing the IRS and Treasury to enact “regulations or other guidance to prevent the avoidance of the purposes of this section, including through a reduction in earnings and profits, through changes in entity classification or accounting methods, or otherwise.”²¹ Section 965 also states that a transaction, the principal purpose of which is to reduce the aggregate foreign cash position of an SFC, will be disregarded.²² The intent of both of these provisions, and the scope of the anti-abuse regulations that Congress contemplated, is set forth in several sections of the legislative history.

First, Congress wanted to ensure that the date of the introduction of the tax bill in the House of Representatives is a “measurement date,” such that a “floor for determining the post-1986 deferred foreign earnings and profits” is established as of the date of introduction.²³ In other words, Congress intended that deferred foreign earnings and profits be included based on a calculation made as of November 2, 2017.

Second, Congress expressed a specific concern that “certain taxpayers may have engaged in tax strategies designed to reduce the amount of post-1986 earnings and profits in order to decrease the amount of the inclusion required under this provision."²⁴ As such, Congress “expect[s] the Secretary to prescribe rules to adjust the amount of post-1986 earnings and profits in such cases in order to prevent the avoidance of the purposes of this section.”²⁵ Congress was therefore concerned both about general anti-avoidance transactions and about certain specific abuses that could manipulate the amount of deferred earnings subject to tax in the United States, where the result was to decrease the inclusion of income under Section 965.

A check-the-box election — which allows an entity that is not a per se corporation to electively change its default U.S. federal income tax classification — is an obvious avenue whereby the inclusion of deferred earnings could be manipulated, especially given that the election can be retroactive for up to 75 days by the filing of the election form itself, and potentially retroactive for an even longer period under certain IRS procedures.²⁶ It is therefore also not unexpected that Congress specifically flagged retroactive check-the-box elections as an area of particular concern when discussing anticipated anti-abuse regulations.²⁷ However, no legislative history indicates any intent by Congress to disallow check-the-box elections entirely in the context of Section 965. Rather, the concern was clearly with preventing check-the-box elections that were abusive and that sidestepped the application of Section 965 to offshore earnings and profits.

We agree with the IRS and the Treasury that certain anti-abuse rules are necessary to prevent taxpayers from manipulating the check-the-box election option to inappropriately lower their subpart F income inclusion under Section 965 where there is a primary purpose of tax-avoidance. Below are examples of circumstances in which a taxpayer could reduce their Section 965 income inclusion through use of a check-the-box election that could, under certain circumstances, also be an inappropriate technique to evade or avoid U.S. federal income tax. But, as explained below, a per se rule is not appropriate because, even in these examples, there may be other factors, including payment of tax, that outweigh any reduction in Section 965 liability and therefore make such check-the-box elections not abusive.

These examples highlight how check-the-box elections can potentially be motivated by tax avoidance or evasion. In these examples, the check-the-box election allows taxpayers to reduce or eliminate the total amount of deferred foreign earnings and profits included in income under Section 965, with no corresponding increase in inclusion under Section 965 by another United States shareholder. Assuming that these elections were made with the primary intent of tax avoidance, they would be subverting Congressional intent, and we agree that future antiabuse regulations should make it clear that the Section 965 inclusion cannot be inappropriately reduced where there are tax-avoidance intentions by using check-the-box elections with similar effects and as set forth in the examples above.

Even with respect to these examples, however, a per se rule is not necessarily appropriate, depending on other tax attributes and consequences with respect to the individuals, entities and transactions discussed above. For instance, in Example 1, the check-the-box election would trigger a liquidation of DC which would likely be taxable under Section 367(e)(2) and the regulations promulgated thereunder. If the gain recognized is sufficiently large, it would effectively cause DC to recognize gain (and including gain recharacterized under Section 1248) equal to or in excess of any income that would be recognized if all deferred foreign earnings were included in DC's income under Section 965. It is difficult to conclude that such a scenario results in tax avoidance or evasion, and thus a per se rule rejecting the effectiveness of such a check-the-box election would seem to go beyond the purposes of reasonable antiabuse regulations.

III. Need for Modification of the Per Se Check-The-Box Rule

A. Background

The IRS and Treasury have announced through the Notice their intention to issue general anti-abuse regulations, as well as anti-abuse regulations applicable to a variety of transactions, including check-the-box elections, as described above. However, despite having a general anti-avoidance rule, the Notice contemplates as well the Per Se Check-The-Box Rule that disregards any check-the-box election that reduces a United States taxpayer's tax liability under Section 965. This rule extends well beyond Congress's specific intent regarding potential anti-abuse transactions and catches certain transactions that are specifically intended to be allowed by Congress, as further discussed below. A general anti-avoidance rule, such as one described in the Notice, would already serve to void any abusive check-the-box election without the need for a per se rule.

Specifically, the Per Se Check-The-Box Rule's overly broad prohibition would prevent taxpayers that are individuals from effectively choosing to be taxed as corporations, which election was specifically endorsed by Congress in the legislative history of Section 965. The availability of such an election to individuals predates the new Section 965 and was specifically referenced in the legislative history. In other words, the ability for an individual to be taxed as a corporation has been explicitly contemplated by Congress and the IRS and neither implies, nor is treated as, a tax-avoidance mechanism. As such, the per se rule should be modified so as to remain consistent with Congressional intent to allow individual taxpayers to elect to be taxed as corporations

B. Congressional Intent with Respect to Sections 962 and 965

As we have noted above in Section I of this letter. Congress enacted Section 965 with the existence of the election provided by Section 962 specifically in mind. The tax rates applicable to the subpart F inclusion created by Section 965 are calculated by reference to the “rate equivalent percentage” first appearing in the initial tax bill passed in the House.²⁹ “The calculation is based on the highest rate of tax applicable to corporations in the taxable year of inclusion, even if the U.S. shareholder is an individual.”³⁰ Even though the tax rates applicable to corporations and individuals differ — and for foreign corporations where the relevant tax year for the Section 965 inclusion is a fiscal year ending in 2018, the rates can differ substantially — Congress expected individuals generally to be able to affirmatively elect corporate tax rates.

Specifically, Congress stated that “[i]ndividual U.S. shareholders, and the investors in U.S. shareholders that are pass-through entities generally can elect application of corporate rates for the year of inclusion.”³¹ As support for this statement, Congress cited Section 962.³² Therefore, Congress decidedly intended for an individual U.S. taxpayer to be treated as a domestic corporation for purposes of calculating such individual's Section 965 liability, whether or not such individual was a direct or indirect equity holder in the relevant DFIC or DFICs. Notably, Congress did not seem to limit their expectation with respect to U.S. individuals that owned less than 10 percent of a domestic pass-through entity that was itself a 10 percent shareholder of an SFC, and there is no other legislative history that suggests that Congress intended for U.S. individuals that owned less than 10 percent of a domestic pass-through entity to be disadvantaged compared to individuals that owned 10 percent or more of the same entity with relation to electing corporate tax treatment.

The Congressional intent to allow individuals to elect to be taxed as corporations could have been effectuated by the issuance of regulations specifying that any U.S. individual subject to a subpart F inclusion was eligible to make an election under Section 962, regardless of whether such U.S. individual directly or indirectly owned more than 10 percent of an SFC, or whether the U.S. individual only was subject to a subpart F inclusion because of his or her ownership of a U.S. pass-through entity that itself was subject to a subpart F inclusion. However, the IRS and Treasury specifically adopt a different approach in the Notice, without explanation. The Notice states that the Treasury and the IRS intend to issue regulations that clarify that a Section 962 election is only eligible for individuals who are themselves 10 percent (or greater) holders (directly or indirectly) of a CFC or SFC.³³ An individual that is not a United States shareholder itself of a DFIC will not have the opportunity to make a Section 962 election with respect to such individual's share of Section 965(a) inclusion. Thus, as a technical matter, many U.S. individuals would be ineligible to be treated as a domestic corporation for subpart F purposes even though such individuals are subject to subpart F inclusions, including because of Section 965. Further, such individuals would not be eligible to make a Section 962 election despite the fact that they are subject to the anti-avoidance rules described above in Section I of this letter. The problem posed by the regulations as proposed in the Notice is evidenced in the following example.

The result in Example 6 is in tension with the clear Congressional intent of Section 965. The Notice cites Section 962(b) as its support for its conclusion that only those owners of passthrough entities that are themselves 10 percent (or greater) holders (directly or indirectly) of an SFC are eligible for a Section 962 election. Section 962(b) states that a “United States shareholder” is eligible to make the election, but the IRS and Treasury appear to have concluded that the specific terms of Section 962 itself tie their hands — and that the statute does not allow a non-United States shareholder, or a person other than an individual, to make a Section 962 election.

Now consider the below examples:

Contrast Example 8 to the following, with similar facts as Example 8 except that DI A does not make a Section 962 election but DP makes a check-the-box election:

Under Example 7, it is true that DI no longer will have a subpart F inclusion pursuant to Section 965 on account of the check-the-box election of DP. But the tax consequences to DI are essentially equivalent to those as if DI had been entitled to, and had made, a Section 962 election. The deferred foreign earnings are all subject to corporate tax rates (and entitled to the use of foreign tax credits), just as if DI had made a Section 962 election. Similarly, a second level of tax would be imposed (and is thus preserved) upon an actual distribution from DP to DI, not dissimilar to the rule under Section 962(d) imposing taxes on an electing individual to the extent actual distributions are made in excess of the tax paid.

Furthermore, under the facts of Example 7, the check-the-box election has actually increased, rather than decreased, the total amount of foreign deferred earnings and profits subject to U.S. tax pursuant to Section 965. Whereas, absent the check-the-box election, the vast majority of the repatriated foreign earnings and profits are untaxed due to the subpart F income being allocated to a foreign individual not subject to tax on such amounts; with the check-the-box election, all of the subpart F income is subject to U.S. federal income taxation. Consequently, the Congressional concerns motivating the statutory provision authorizing antiabuse regulations — namely, fears that taxpayers are engaging in transactions that reduce the amount of the subpart F inclusions under Section 965 — are not present in the scenario described in Example 7. Rather, the transaction has effectively increased the amount of deferred foreign earnings and profits subject to U.S. tax. This result is a direct contrast to the examples described in Section II of this letter, in which the transaction resulted in a total elimination or net decrease of a DFIC's earnings and profits in the income inclusion under Section 965 of the United States shareholders of the DFIC, which would have been abusive. There is no such decrease of the DFIC's earnings and profits being included in the income of DP under Section 965 in Example 7.

Under Example 9, similar to Example 7, it is true that DI A and DI B no longer will have a subpart F inclusion pursuant to Section 965 as a result of DP's check-the-box election, but DP will now have a subpart F income inclusion of exactly the same combined amount of DI A and DI B's subpart F income inclusion instead. In other words, the historic earnings and profits of DFIC will be subject to U.S. federal income taxation regardless of the check-the-box election. This result is a direct contrast to the scenarios described in Examples 1-5, in which the elimination or reduction of a United States shareholder's subpart F income inclusion under Section 965 was not met with a corresponding increase in inclusion by a different United States shareholder.

Further, the check-the-box election in Example 9 clearly is not intended to be an antiavoidance mechanism for DI A, as evidenced by the fact that the result for 95% of the income of DP is substantially equivalent under the check-the-box scenario of as it would be under the facts of Example 8, where DI A makes a Section 962 election to be taxed as a corporation for U.S. federal income tax purposes. The check-the-box election in Example 9 is also non-abusive with respect to DI B, because the check-the-box election was not done with the intent to avoid including amounts in subpart F income under Section 962, but instead allows DI B to be taxed in the same manner as DI A; i.e., it allows DI B to benefit in a similar manner had he been able to make a Section 962 election. Thus, the check-the-box election in Example 9 allows for parity between similarly situated taxpayers DI A and DI B, fulfills the Congressional intent of allowing individual taxpayers to elect to be treated as corporate entities for U.S. federal income tax purposes, and does not reduce the amount of the DFIC's historic earnings and profits that is included in income under Section 962.

The check-the-box elections in Examples 7 and 9 are substantially different from the potentially abusive check-the-box elections described in Examples 1-5 and are manifestly non-abusive. Electing to change the taxation of a domestic pass-through entity to that of a corporation is not abusive where the same amount (in the case of Example 9) or more (in the case of Example 7) of deferred foreign earnings and profits are subject to U.S. tax under Section 965 as a result of such an election. Nevertheless, these elections would still be disallowed under the regulations proposed by the Notice because of the Per Se Check-The-Box Rule.

C. Our Proposal

When the regulations described by the Notice are issued, the IRS and Treasury should ensure that the Per Se Check-The-Box Rule is modified from the description currently in the Notice. The Notice describes the intended regulations under Section 965 as disregarding any check-the-box election made on or after November 2, 2017 that could reduce the Section 965 tax liability of any United States shareholder. As per our discussions above analyzing our examples, the Per Se Check-The-Box rule should be removed and the disallowance of abusive check-the-box elections should be folded into the general anti-avoidance rule.

Regardless, and at the very least, a specific exception to both the Per Se Check-The-Box Rule and any other anti-abuse rule to be contained in the proposed regulations should be included which would carve out check-the-box elections in situations similar to Examples 7 and 9. Specifically, a check-the-box election in which a domestic pass-through entity is treated as a domestic corporation should be respected (under the Per Se Check-The-Box Rule, under the general anti-abuse rule, or under any other anti-abuse rule to be included in regulations) if the election does not decrease the total amount of deferred foreign earnings and profits included as subpart F income under Section 965 by all U.S. taxpayers considered in the aggregate. In other words, the regulations should be explicit that the use of a check-the-box election to change the tax treatment of a domestic pass-through entity to that of a domestic corporation, which has an effect equivalent to a Section 962 election for the pass-through entity and its U.S. interest holders, is not abusive.

Under this specific exception, the check-the-box elections described under Examples 7 and 9 would be respected. Consistent with Congressional intent, this exception would allow small U.S. individual owners of domestic pass-through entities to effectively elect domestic corporate tax treatment. Additionally, this exception in the anti-abuse rules would not allow any of the abuses identified by Congress, as check-the-box elections would only be allowed to the extent that subpart F inclusions are increased or unchanged (with the resultant U.S. tax increased or unchanged) by virtue of the election and would only be allowed to effectively create an economically equivalent result to a Section 962 election. Finally, the addition of this exception would represent a relatively minor modification to the anti-abuse rules proposed in the Notice.

We believe that failing to adopt our proposal or a proposal with similar effects would be starkly inconsistent with Congressional intent under Section 965. As such, we strongly urge the IRS and Treasury to include such an exception, or an equivalent or broader exception, when the regulations are issued, so as to minimize any risk that the regulations would be determined to be beyond the regulatory authority granted to the IRS and Treasury.

We appreciate your consideration of our recommendation. If you have any questions or comments regarding this comment letter, please feel free to contact us and we will be glad to discuss or assist in any way.

Stuart L. Rosow
Partner

Richard M. Corn
Partner

Proskauer Rose LLP
New York, NY

CC:
David J. Kautter
Assistant Secretary, Office of Tax Policy
U.S. Department of the Treasury

William M. Paul
Chief Counsel and Deputy Chief Counsel (Technical) (Acting), Office of the Chief Counsel
Internal Revenue Service, U.S. Department of the Treasury

Lafayette "Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Brian Jenn
Deputy International Tax Counsel
Department of the Treasury

Marjorie A. Rollinson
Associate Chief Counsel (International)
Internal Revenue Service

Daniel M. McCall,
Deputy Associate Chief Counsel (International)
Internal Revenue Service

Raymond J. Stahl
Senior Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service

John J. Merrick
Special Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service

Brenda Zent
Special Advisor to the International Tax Council, Office of Tax Policy
Department of the Treasury