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Big Corporations Seek CFC Exemption in Interest Deduction Regs

FEB. 25, 2019

Big Corporations Seek CFC Exemption in Interest Deduction Regs

DATED FEB. 25, 2019
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February 25, 2019

Internal Revenue Service
CC:PA:LPD:PR (REG-106089-18)
Room 5203
Post Office Box 7604
Ben Franklin Station
Washington, DC 20044

Re: CC:PA:LPD:PR (REG-106089-18) (Proposed Regulations on section 163(j))

These comments are being submitted by the Working Group for Competitive International Taxation (the Working Group), a group of 21 U.S.-headquartered companies that include industrial companies, manufacturers, financial services companies, and service providers.1 While from a mix of industries, the companies in the Working Group share a number of characteristics: they are all subject to the new global intangible low-taxed income (GILTI) provisions created by the Tax Cut and Jobs Act (TCJA), and much of their income subject to GILTI derives from operations in higher taxed jurisdictions. The Working Group welcomes the opportunity to provide comments on proposed regulations issued by the Department of Treasury (Treasury) and the Internal Revenue Service (IRS) relating to the application of section 163(j)2 to controlled foreign corporations (CFCs), and thus the potential interaction with the GILTI provisions.3

Background to the application of section 163(j) to CFCs

Section 163(j)(1) allows taxpayers to deduct only a certain amount of business interest expense. The amount allowed as a deduction is generally the taxpayer's net business interest expense (i.e., business interest income reduced by business interest expense) plus 30 percent of the taxpayer's adjusted taxable income (ATI) for the taxable year. The limitation generally applies to all corporate taxpayers.4

The Proposed Regulations would extend the limitation to CFCs.5 Where applicable, the limitation would reduce the amount of deductions a CFC takes into account when computing, in relevant part, its tested income under section 951A. Under section 951A(c)(2)(A), tested income of a CFC is the excess of the gross income of such CFC (excluding certain types of income) over the deductions properly allocable to such gross income. If section 163(j) applies to limit a CFC's interest deduction, then its tested income will increase and the U.S. shareholder of the CFC likely will have an increase in its GILTI inclusion. However, any increase in the U.S. shareholder's GILTI inclusion likely will not produce additional U.S. tax liability where foreign tax credits (FTCs) can be used. Taxpayers that operate in higher taxed jurisdictions will have FTCs available to offset the U.S. tax on the increased GILTI inclusion. The ability to use more FTCs against GILTI can, in theory, reduce the effective tax rate on GILTI (measured as taxes paid over GILTI inclusion).

The section 163(j) limitation applies to CFCs in one of two ways. First, under the general rule, described in Prop. Reg. § 1.163(j)-7(b)(2), each CFC determines its business interest income, business interest expense, and ATI to determine whether its net business interest expense exceeds 30 percent of its ATI. If there is a limitation, the CFC's tested income is increased by the amount of the limitation on its interest expense.

Second, under the alternative method, available at the election of the taxpayer, the limitation would be determined by the CFC's allocable share of the group's applicable net business interest expense.6 The alternative method is applied separately to entities that conduct a qualifying financial services business. An entity conducts a qualifying financial services business if it is (1) an eligible CFC within the meaning of section 954(h)(2)(A) (banking and financing), (2) a qualifying insurance companies within the meaning of section 953(e)(3), or (3) a dealer within the meaning of section 954(c)(2)(C). The alternative method is at the election of the taxpayer by applying the group rules for computing the amount of a CFC group member's deduction for business interest expense and doing so for all CFCs in the group. No additional statement or formal election is required but once the method is used, the election becomes irrevocable.7

The Economic Analysis provided by the Office of Information and Regulatory Affairs (OIRA) concludes the administrative and compliance costs to taxpayers from the application of section 163(j) to CFCs should not be substantial because the additional calculations “are relatively simple and involve data that are already collected.”8 Examples of the additional calculations include aggregating CFC income, separating income under the financial services subgroup rule, and eliminating intra-group dividends. OIRA also concludes any additional compliance costs for the alternative method can be avoided by not making the election.9

Comments and recommendations on the application of section 163(j) to CFCs

The Working Group's comments below respond to Treasury's requests on whether there are particular circumstances in which it may be appropriate to exempt a CFC from the application of section 163(j) and whether it would be appropriate to provide additional modifications to the application of section 163(j) to CFCs.10

1. Circumstances in which CFCs should be exempt from the application of section 163(j)

The application of section 163(j) to CFCs is not clearly delineated in the statute, and thus was a policy choice that the Treasury and IRS made that greatly expands the application of the interest disallowance rule. As noted above, such application can have the effect of increasing the U.S. shareholder's ATI, and this in theory can produce a favorable result in regards to a taxpayer's effective tax rate. Nevertheless, we believe the application of the section 163(j) limitation to CFCs creates enormous complexity and compliance burdens for companies relative to the limited potential abuse that it is intended to prevent, and will produce little if any additional tax revenues to the Treasury.

From a tax policy standpoint, the application of the rules to CFCs seems to address a tax policy concern — not stated in the Preamble but addressed by at least one commentator — that CFCs would lever in excess of what domestic corporations could do if the limitation were not applied at the CFC level.11 We question whether this concern has much validity, mainly because it seems to suggest that taxpayers would borrow extensively outside the United States to fund foreign operations and receive some potential U.S. tax benefit in doing so. In reality, this concern seems misplaced. If taxpayers have capacity under the section 163(j) limitation, borrowing in either lower taxed jurisdictions or higher taxed jurisdictions would provide little U.S. tax benefit. In lower taxed jurisdictions, taxpayers would be more likely to borrow from third parties at the U.S. level, receive a tax deduction at the 21% U.S. corporate rate, and “push down” the debt to CFCs. In higher taxed jurisdictions, there might be a benefit from local deductions against foreign income but from a U.S. perspective, there would be no additional U.S. tax benefit gained. The local deduction might decrease the GILTI inclusion and decrease allowable FTCs but taxpayers with excess GILTI FTCs would still have FTCs available.

Instead, the focus should be on whether U.S. taxpayers have capacity under the section 163(j) limitation at the U.S. level. Section 163(j)'s target is not on leverage outside the United States, nor should it be. During the process of enacting the TCJA, Congress considered and did not enact proposed section 163(n) that would have monitored and limited U.S. interest deductions based on a U.S. taxpayer's worldwide leverage. Instead, Congress enacted section 163(j) and that reflects the intent of Congress to focus on U.S. leverage and allow interest deductions when U.S. taxpayers borrow within the 30 percent threshold. We believe the design of the statute therefore protects against excess U.S. leverage and does not require application to CFCs. Moreover, the mechanics of the GILTI rules will ensure that Treasury would receive little if any benefit from borrowing at the CFC level because any excess FTCs will offset the increase in the U.S. shareholder's GILTI inclusion.

Given the lack of incentive for taxpayers to borrow at the CFC level, and the fact that the application of section 163(j) to CFCs in many cases will not increase the tax paid on GILTI, we question whether such application merits the complexity and compliance burdens that U.S. taxpayers will suffer. OIRA's conclusion that there will not be a substantial burden is based, in part, on the assumption that the information necessary to do the additional calculations is collected by taxpayers currently. While information is collected on CFCs, the information is not captured in a manner that translates into understanding how the section 163(j) calculation will impact each CFC. Taxpayers will be required to track each CFC's separate limitation or excess into subsequent years, and additional analysis will be required each year to understand the impacts under the alternative method election. The alternative method does not avoid this burden because it too requires information be captured for each CFC before aggregating those numbers into a group interest expense item. In fact the alternative method increases the complexities in many ways that have not been addressed in the proposed regulations (e.g., accounting for different functional currencies across CFCs).

Recommendation: We recommend that the application of section 163(j) to CFCs be removed in the final regulations. If however, Treasury feels compelled to apply section 163(j) to CFCs, the final regulations, at a minimum, should apply in a more limited manner, in cases where the limitation would actually have some impact. We recommend one of two ways of limiting the rule.

  • A safe harbor approach in which taxpayers would make a determination whether the aggregate business interest expense and income recorded by all CFCs exceeds the section 163(j) limit. If not, section 163(j) would not apply to any CFC.

  • A results-based approach in which taxpayers could establish either (1) the U.S. taxpayer would not be subject to the section 163(j) limitation before taking into account the net interest income and expense of its CFCs, or (2) the application of section 163(j) at the CFC level would produce no additional U.S. tax because of available FTCs. If either is established, section 163(j) would not apply to any CFC of the group.

2. The alternative method should not be an irrevocable election

In the event the IRS and Treasury do not exclude CFCs from the application of section 163(j), the alternative method should be retained with modifications.12 In particular, the election should not be irrevocable. From a tax administration viewpoint, making an election irrevocable provides certainty and ease of administration, but from a taxpayer's perspective business operations are too uncertain and income too unstable to be able to recommend a permanent election. Modeling cannot be done on the impacts of such elections and are difficult to justify to company decision makers. The purpose of the alternative method is to reduce mismatches between deductions and income between CFCs, but, without more flexibility in the election itself, the election will not likely be available to most taxpayers. Taxpayers need both certainty and flexibility to respond to changing business needs and competitive market places. An irrevocable election undermines these business needs. At the same time, if Treasury believes that restraints on a taxpayer's flexibility are preferred, there seems to be room to modify the election. Treasury has done this in other contexts. In the consolidated return context, for example, under section 1504(a)(3), a corporation that ceases to be a member of a consolidated group may not be included in another return of that consolidated group for 60 months. Under Treas. Reg. § 301.7701-3(c)(1)(iv), an entity that is eligible to elect its classification for U.S. federal income tax purposes via the check-the-box regulations may not change that initial classification during the 60 months succeeding the effective date of the election. A similar time restraint should be added to the alternative method election.

Recommendation: We recommend the election to use the alternative method be modified to no more than a five-year election.

* * * * *

The Working Group thanks you for your consideration of these comments. Please contact Jeff Levey (Jeff.Levey@ey.com) if you have any questions regarding this submission.

Copies to:

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Douglas L. Poms
International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Margaret O'Connor
Acting Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

FOOTNOTES

1The Working Group members are American Express; American International Group, Inc.; Acushnet Company; Assurant, Inc.; BlackRock, Inc.; Citigroup Washington, Inc.; The Dow Chemical Company; ExxonMobil Corporation; General Electric Company; Kansas City Southern; Microsoft Corporation; Marsh & McLennan Companies, Inc.; Medtronic Inc.; Metropolitan Life Insurance Company; Prudential Insurance Company of America; Sempra Energy; Thermo Fischer Scientific, Inc.; Tupperware Brands Corporation; United Technologies Corporation; Valero Energy Corporation; and, The Walgreen Co.

2Unless otherwise indicated all “section” references are to the Internal Revenue Code of the 1986 Act, as amended (the Code). References to “Treas. Reg. §” are to the Treasury regulations issued thereunder and references to “Prop. Treas. Reg. §” are to particular sections of the Proposed Regulations.

3REG-106089-18, 83 Fed. Reg. 67490 (December 28, 2018) (hereinafter the Proposed Regulations).

4Exceptions are made for certain small businesses that meet the gross receipts test in section 448(c) and certain trades or businesses listed in section 163(j)(7).

5Prop. Reg. § 1.163(j)-7.

6See Prop. Reg. §1.163(j)-7(b)(3).

7Prop. Reg. § 1.163(j)-7(b)(5).

8Preamble at 67530.

9Id.

10Preamble at 67512.

11See NYSBA Report No. 1393 (March 29, 2018) at page 41 (stating “if Section 163(j) did not apply to CFCs, then it would be possible for U.S. taxpayers to conduct leveraged activities through a CFC and get the effect of a full interest deduction.”).

12Our members identified other changes with respect to the alternative method that go beyond the scope of this comment letter but are being addressed by other commentators, including whether it is appropriate to treat all qualifying financial service entities as a separate group, or to treat entities such as partnerships that are controlled by members of a single corporate group differently for purposes of section 163(j).

END FOOTNOTES

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