Individual Analyzes Allocation, Apportionment in Proposed FTC Regs

February 5, 2019

U.S. Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

Internal Revenue Service
1111 Constitution Ave., NW
Washington DC 20224

RE: “Guidance Related to the Foreign Tax Credit, Including Guidance Implementing Changes Made by the Tax Cuts and Jobs Act,” REG-105600-18

Dear Administrators:

This response pertains to the request for comments in the document entitled “Guidance Related to the Foreign Tax Credit, Including Guidance Implementing Changes Made by the Tax Cuts and Jobs Act,” REG-105600-18, provided by the Department of the Treasury and the Internal Revenue Service in proposed regulations published in the Federal Register on Dec. 7, 2018.

The observations below are specific and limited to REG-105600-18's proposed guidance on allocation and apportionment of deductions (Category I in the explanation of provisions)¹ with regard to the calculation of taxable income for the foreign tax credit (“FTC”) limitation under the Tax Cuts and Jobs Act (the “TCJA”). Unless otherwise specified or dictated by context, the comments herein generally attempt to use the term “allocation” (and respectively “allocated” and “allocating”) for both “allocation and apportionment,” except in the case when “apportionment” (and respectively “apportioned” and “apportioning”) is used with the intent of referring to certain items not definitely allocable (in which case “allocation” and related terms take on singular meaning also). Further, unless otherwise specified, “Treasury” refers to both the Department of Treasury and the Internal Revenue Service.

This response acknowledges that existing and recent proposed regulations including REG-105600-18, as well as the TCJA itself, did not originate (though the TCJA may have exacerbated) some of the fundamental issues that are cited below. It also is understood that regulators and the regulatory process have reasons for giving credence to precedent including the perspectives taken by prior regulators and regulations, the tax code as it existed prior to the TCJA, and by the statutory language of the TCJA and other legislation. More on this below in section (6), but the context for this response is that the TCJA provides an opportunity (and, in terms of making the TCJA viable for what its sponsors stated were its economic and revenue goals, a necessity) to address some long-lived issues with allocation; hence the attempt below (perhaps not common to comments of this sort) to outline the evolution and principles of allocation at the outset.

Seven topics are addressed: (1) Traditional allocation's evolution; (2) The proposed regulations' perspective; (3) Loftier aspirations for allocation; (4) Co-existence of the TCJA and allocation; (5) Economic effects of allocation under the proposed regulation; (6) Deduction-based adjustment; and (7) Other allocation changes to consider. The response finishes with (8) Conclusion and an Appendix containing two tables.²

(1) Traditional Allocation's Evolution

The determination of FTC eligibility historically has been the primary focus of cross-border attention in both tax law and bilateral tax treaties.³ Treasury regulations traditionally have treated allocation of deductions to foreign income as simply a mechanical intermediate step in the FTC calculation — this is consistent with the historical statutory language and legislative explanations (going back as far as this non-lawyer commenter could determine). As U.S. law and guidance evolved, requiring certain expenses to be allocated as part of the FTC calculation may have seemed like the perfect marriage of the accounting principle of matching expense and income with the Alpha of the IRC's international portion, the FTC concept. For this reason the traditional and still-current allocation of deductions can be described as “FTC-based” as demonstrated by the title of REG-105600-18 itself and its contents that frame the allocation process as needed to compute FTCs.

Under the pre-TCJA system of taxing foreign source income that permitted deferral of earnings and profits (“E&P”), allocation, by reducing the amount of foreign source taxable income used to determine the eligibility for FTCs, caused some delays in the crediting of foreign taxes against U.S. tax liability (and in some cases, particularly in the energy and certain other industries, some of these FTC carryforwards actually expired unused). But in these excess credit situations (i.e., the foreign tax rate (“FTR”) after allocation exceeded the U.S. rate because the FTR was relatively high and/or the allocation was relatively large), a company had recourse to elect when and what to defer or repatriate in order to optimize FTC usage (including cross-crediting if available). There was also the option to move expenses (particularly if mobile) overseas to avoid allocation altogether.

In the converse situation in which foreign income was excess limit (i.e., even after allocation the FTR was low compared to the U.S. rate), subjecting expenses to allocation had no direct tax impact on multinational enterprises (“MNEs”), though that did not mean that company decisions had been made without cognizance of both allocation and the tax benefits of expense location. The FTC-based approach did not attempt to target MNEs (i.e., did not reduce their FTCs and was not capable of directly changing the overall taxes paid by MNEs in any other way) that effectively may have engaged in tax arbitrage by paying a low FTR on deferred E&P linked to mobile allocable expenses that benefited from U.S. deductibility, though some of the expenses allocated to deferred income/assets ended up being allocated against other foreign source income as losses caused by allocation were spread around (a situation that again most MNEs could manage using the tools available so as to not incur substantial U.S. tax liability).

However, with the growth of deferred foreign earnings and profits (E&P) in the past few decades, the question arose about how well FTC-based expense/income matching was working because expenses subject to allocation often were being deducted against the U.S. tax base years before any corresponding repatriation (if repatriation was ever going to happen at all).⁴ The Obama administration anti-deferral proposals in 2009 and 2010 would have required suspension, though not any actual disallowance, of U.S. deductibility of certain expenses subject to allocation until there was repatriation of E&P linked to the expenses.⁵ Suspension of certain U.S. deductions surely would have affected the time value of those deductions, induced various behavioral responses from MNEs, and would have extended the conceptual reach of expense allocation, at least in its capacity to deal with timing, beyond just allocation's mechanical role in FTC calculation. These suspension proposals gained little political traction beyond being included in the Obama administration's budget proposals.

In the last ten years or so the international tax focus in the United States generally turned to ending deferral via a participation exemption and/or advance tax regime (though of course there were, and continue to be, holdouts favoring more aggressive worldwide taxation), raising a different set of expense-related questions (e.g., dividend haircuts and thin capitalization rules) than deferral did. In any case, as the proposed regulations state, the FTC-based allocation rules generally remained unchanged over the 30 years prior to the advent of the TCJA in 2018 (a notable exception being the worldwide method of interest allocation enacted in 2004 and now scheduled to take effect in 2021).⁶

Thus before the TCJA, MNEs potentially harmed by allocation (i.e., excess credit situations) could self-help. MNEs with excess limit situations not affected by the FTC-based approach (but that maybe in accord with certain principles should have been targeted somehow for some cases of tax-rate-based expense location arbitrage) seemed content to lay low, only surfacing to discuss allocation when the Obama administration expense suspension plan or other attempts were made to curb deferral. Policymakers and regulators, with a few exceptions including the Obama administration suspension proposals, did not pay much attention to the excess limit situations including the benefits of U.S. expense location for MNEs with low FTRs.

(2) The Proposed Regulations' Perspective

The proposed regulations appear to take as their primary task the need to adapt allocation to the TCJA. Perhaps understandably given the background and evolution of allocation, as well as the dearth of discussion of allocation in the TCJA conference report and the “bluebook” that attempt to reflect how the legislation was contemplated contemporaneously,⁷ there are no existential or other broad conceptual questions posed in REG-105600-18 about the continued use of FTC-based allocation.

While offering a (what this commenter finds credible)⁸ justification for the application of at least some kind of allocation for the purposes of implementing the TCJA, REG-105600-18's explanation expresses concern about the potential loss of FTCs caused by allocation in excess credit situations (perhaps this tone is at least partially in response to comments acknowledged in the proposed regulations) and suggests that the exemption for allocation described in the proposed regulations will provide relief for MNEs.⁹ For example, it is contended that with the TCJA MNEs will have less self-help options linked to repatriation timing: “the (TCJA's) reduction in the U.S. corporate rate, limitations on deferral, and introduction of a participation exemption regime without deemed paid credits has limited the benefits of (self-help).”¹⁰ The proposed regulations' allocation carve-out of exempt assets and income (“carve-out”) is described in REG-105600-18's economic analysis as alleviating the impact of allocation and thereby “potentially increas(ing) the competitiveness of U.S. corporations”¹¹ relative to the “no-action baseline” in which it is assumed that allocation without the carve-out would prevail.¹²

(3) Loftier Aspirations for Allocation

Unfortunately, FTC-based allocation is blunt and arbitrary, effectively aimed at only one thing, reducing FTCs. Even then the result is often overkill, that is, double taxation (though claims of double taxation are often overstated when tax benefits of the U.S. deductibility of allocable expenses is overlooked), or of little effect when MNEs find other ways to use FTCs (assuming that FTC-based allocation is not designed to encourage such behavior). Existing allocation's mechanical role in FTC determination extracts U.S. revenue from what from an MNE equity perspective seems like the “wrong” taxpayers (that is, excess credit situations in which MNEs are presumably paying a high FTR already) while looking the other way (hence underkill) in cases in which some kind of other non-FTC-driven adjustment may be needed (excess limit situations in which expense fungibility is exploited).¹³ The unwieldiness and one-sidedness of the FTC-based method should not be surprising as the approach ignores an MNE's overall tax burden including the value of U.S. deductibility.

This upside-down result for the FTC-based method may be magnified for both excess credit and limit situations, respectively, by: (a) the TCJA's broadening of foreign source income subject to U.S. taxation (with ostensibly less self-help available to MNEs paying high FTRs, though the self-help option of simply moving an expense offshore is still available); and (b) the legislation's selective use of deductions (for foreign-derived intangible income (“FDII”) global intangible low-taxed income (GILTI)) and an exemption (for net deemed tangible income return (“NDTIR”)) in combination with the end of E&P lockout and deferral.

Maybe FTC-based allocation with its impact in excess credit situations is supposed to discourage MNEs from undertaking certain activity domestically when the expenses (presumably “bad” expenses that the United States does not covet, though there could be an argument that good and bad expenses are often bundled) do not generate much U.S. residual tax. However, that justification would have been tested when deferral was available, because before the TCJA little residual U.S. tax was being paid with regard to any foreign E&P or other income, because either FTRs were high (generally resulting in FTCs even after allocation or even if FTCs were impeded, as MNEs self-helped to alleviate burden) or the low-foreign-taxed E&P was deferred. Because not much residual tax was collected at all in the past because of self-help and deferral, it is not clear what role allocation played other than serving the matching principle (but then even only with regard to FTC calculation and not intended to achieve location neutrality) and occasionally nailing the MNE that could or didn't plan.

Further, with the TCJA's new deductions/exemptions for GILTI, FDII, and (especially) NDTIR, the United States likely will still not collect much residual U.S. tax even when the corresponding FTR is relatively low compared to the U.S. 21% statutory rate. If allocation under the TCJA is simply intended as a U.S. revenue grab (which the exemption under REG-105600-18 itself undermines) in return for the U.S. deductibility of certain fungible U.S. expenses without regard to double taxation, the FTC-based allocation under the TCJA does not do a very good job even at that. Perhaps someone seeking to justify FTC-based allocation as a U.S. revenue necessity could more profitably spend time defending the BEAT.¹⁴

Compounding the Type 1/Type 2 errors of the FTC-based approach is how difficult it is to determine what are “good” and “bad” expenses. Perhaps there is consensus that interest expense may be bad because at the margin it may not add value (though debt financing for the right reason should carry no stigma). Perhaps certain expenses are “fungible” (as the proposed regulation states)¹⁵ as to timing and location, making them ideal for tax arbitrage.¹⁶

The identification of apportionable expenses in the case of interest, overhead, and research and experimental expenditures in existing regulations may be the place to start because these expenses by definition are unassignable by MNEs to particular income (and thus for which by regulation there are settled formulae for assignment). Caveats about targeting potentially bad expenses this way include problems with treating differently allocable and apportionable expenses of the same type (e.g., allocable and apportionable interest expense) because there may be ways for taxpayers to influence the assignment of an expense between the allocable and apportionable classifications, and that research expenses may not belong in this exercise (see section (7) below). In contrast to fungible bad expenses, other labor, capital, and assorted expenses may encourage U.S. production and be desirable regardless of how much foreign or domestic business income the expenses generate or how mobile (e.g., capital) the expenses are or for that matter how much U.S. entity-level tax the expenses, when they are located domestically and receive a U.S. tax deduction, generate.

In sum, perhaps the primary goal of allocation should be to at least neutralize the choice of where to locate mobile empty expenses (interest, some or all overhead) while not driving away “good” domestic expenses.

In pursuit of location neutrality for fungible expenses, perhaps there should be less concern about overtaxing (the excess credit situations) and more about undertaxing (tax location arbitrage incentives in excess limit situations), because at least in some (though not all) double tax situations taxpayers can simply relocate overseas allocable/apportionable bad indirect expenses (interest, some elements of overhead) that the United States does not value for their domestic location in any case. The best approach may be to adjust allocation to eliminate extreme issues at both ends of the excess-credit/excess-limit spectrum. In addition to sorting out expenses, pursuit of this kind of expense location neutrality requires going beyond mechanical FTC calculation to include a comparison of an MNE's tax benefits for deducting certain expenses here and abroad. This comparison is attempted in section (6) in which a “deduction-based” adjustment is presented as an alternative to FTC-based allocation.

(4) Co-existence of the TCJA and Allocation

REG-105600-18 correctly (in this commenter's opinion) concludes that the TCJA requires at least some kind of allocation (whether best achieved solely through an FTC-based approach being another matter). In addition to justifications for this conclusion cited in the proposed regulation,¹⁷ the recent explanation prepared by the staff of the Joint Committee on Taxation endorsed the necessity of allocation by, among other things, invoking the need to adhere to pre-TCJA “principles.”¹⁸ Additional indirect evidence that allocation was contemplated includes the TCJA's repeal of the fair market value method of interest expense (as well as, for whatever evidential value it may have, the JCT revenue estimate of that provision), something that likely would be relevant only if allocation was considered still to be operative and likely broadly applied across foreign income types (with the potential exception of the exemption of income and assets included in the proposed regulations).

This is not to say that some of the double-taxation complaints about allocation are not warranted (even if sometimes overstated),¹⁹ or that the justification offered for allocation (either in the existing or proposed regulations) holds up under examination.²⁰ Yet if somehow FTC-based allocation were made to disappear with nothing else happening, allocation-caused double taxation in excess credit situations would go away but at the same time the issue of expense location arbitrage in excess limit situations would remain. The continuing requirement for allocation presents the opportunity to aspire to neutrality (or at least make more neutral) for the location of “bad” allocable expenses by revisiting (and perhaps even expanding beyond) the FTC-based method to address both double taxation (the excess credit issue) and tax-rate location deduction arbitrage (the excess limit issue).

(5) Economic Effects of Allocation under the Proposed Regulation

REG-105600-18's economic analysis²¹ states that the proposed FTC-based allocation method that exempts certain income and assets would “potentially increase the competitiveness of U.S. corporations relative to the no-action baseline, which includes proposed though not yet final regulations under section 951A, by generally reducing the amount of U.S. parent expenses that are allocated to the section 951A category.”²² Further, quoting at length the economic conclusion about allocation under the proposed regulation:

“. . . the reduced expense allocation to the section 951A category resulting from these proposed regulations has the potential to reduce Federal tax revenue relative to the statute and in consideration of proposed though not final regulations related to section 951A [i.e., the statute, existing regulations, and other proposed regulations constitute the no-action baseline]. In addition, [the proposed regulations] could also provide some taxpayers with the incentive to locate more of their worldwide expenses in the United States, because U.S. expenses will have the potential to reduce U.S. taxable income, and also increase allowable [FTCs] relative to the no-action baseline. However, the post-[TCJA] U.S. interest expense limitation rules under section 163(j) make it more difficult to use excessive interest expense to reduce U.S. taxable income, and the significantly lower U.S. statutory corporate rate reduces the (previously strong) incentive to locate 'fungible' deductions such as expense in the United States. Therefore, any increase in the incentive to report interest expense in the United States resulting from the reduced expense allocation [under the proposed regulations] to the section 951 category is likely to be minor.”²³ {Commenter added bolding for emphasis; square brackets added for abbreviation, or clarification through word substitution.}

It is stipulated in REG-105600-18's economic analysis that the statements above about the arithmetic effects²⁴ of allocation apply only to the difference between the proposed regulations and the no-action baseline. With regard to allocation, the proposed regulations' economic analysis states that the proposed regulations' differ from the no-action baseline by providing that the income and assets of GILTI and FDII that qualify for a deduction under IRC section 250 would be exempt in the allocation of deductions for the purpose of determining FTCs.

Two aspects of the narrowness of the framing of this economic analysis are revealing (discussed in subsections (A) and (B) below), and this narrowness and other issues raise questions (discussed in subsection (C) below) about the qualitative statement in the economic analysis concerning the effect of the TCJA's new 21 percent corporate statutory rate and section 163(j) of the TCJA.

(A) No attention to NDTIR. The economic analysis does not seem to consider the non-allocation to another type of exempt income, the net deemed tangible income return (“NDTIR”), even though the proposed regulations in REG-105600-18 address the definition of NDTIR. Omitting consideration of a type of income and assets that is exempt from allocation and U.S. taxation overlooks a TCJA change that creates the potential for tax-rate arbitrage involving both profit and expense shifting. While the allocation carve-outs for GILTI and FDII are partial depending on the IRC section 250 deductions (deductions that are scheduled to decrease after 2025), the carve-out for NDTIR is complete.

Further, the carve-out for NDTIR under IRC section 904(b)(4), by way of IRC section 245A, seems to be more advantageous to taxpayers than the carve-out for GILTI/FDII under IRC section 864(e)(3). ²⁵ The NDTIR is carved out of allocation by disregarding deductions after they have been allocated, so there is no additional allocation to other foreign source income types as a result of the treatment of NDTIR. In contrast, the pre-allocation exemption for GILTI/FDII, by decreasing worldwide income that constitutes the denominator used for other limitations, increases the allocation of expenses to other types of foreign source income (e.g., branch income). While there may be a statutory reason for treating these types of exemptions differently, there does not appear to be an economic rationale unless it is somehow felt that it is better to encourage NDTIR than GILTI and FDII. If anything the converse, in which FDII and GILTI rather than NDTIR would be benefit from the more taxpayer-favorable exemption approach that disregards deductions after allocation, seems more intuitive.²⁶

It is not apparent why the carve-out for NDTIR appears not to have been included in the economic analysis of the proposed regulations. It could be that, because the NDTIR carve-out (unlike the GILTI/FDII carve-out) is statutory, NDTIR is regarded as part of the no-action baseline and therefore does not compel economic analysis for regulatory purposes, but that requires assuming that the portion of REG-105600-18 that addresses the definition of NDTIR by way of clarifying IRC section 245A is inconsequential. Or maybe there are other separate proposed regulations contemplated for NDTIR beyond the scope of what REG-105600-18 attempts to do? In any event, the allocation treatment of NDTIR (including the apparent lack of conformity with the exemption for GILTI/FDII) is of consequence on many levels.

(B) Relief for excess credit positions, unabated arbitrage opportunities (at least as far as REG-105600-18 is concerned) for excess limit positions. The allocation exemption provided under REG-105600-18 targets (though does not necessarily eliminate) the burden of allocation in excess credit situations. The FDII/GILTI exemption relief from allocation when FTRs are relatively high seems not unreasonable and likely involves at most modest tax-based expense shifting (because to the MNE the U.S. effective tax rate (“ETR” used for valuing deduction location is likely to be about the same or lower than the respective foreign ETR). On the other hand, the proposed exemption does nothing to restrict MNEs from funding and supporting low-foreign-taxed FDII and GILTI (as well NDTIR, if the proposed regulations are considered to affect that) via the location of allocable (including “bad” and/or fungible) expenses in the United States.

An example of the second situation is a U.S. parent that domestically locates allocable and apportionable interest and/or apportionable overhead expense, respectively, to equity-finance and support tangible assets in a controlled foreign corporation that generates low-foreign-taxed NDTIR. The proposed regulations would bless, rather than impede, this transaction by ensuring the absence of allocation and apportionment for FTC purposes or any other kind of tax-based adjustment to the expenses even though the expenses are economically linked to income and dividends not taxable in the United States. Further, the TCJA and/or the proposed regulations through IRC section 904(b)(4) would prevent any of the expenses from being allocated to other types of foreign source income (this latter protection would not be afforded expenses that are found allocable to GILTI and FDII that affect the denominator used for allocations to other types of income).

If instead the FTR in this example were close to the U.S. rate or higher (that is, an excess credit situation or close to it), the U.S. parent would have less of an incentive to domestically locate the fungible expenses. Further, if the MNE was taxed at a high foreign rate and was using domestic expenses to equity-finance and support GILTI or FDII, again there would be no particular incentive for the allocable and apportionable expenses to be located domestically, and the taxpayer in this third case would be looking to the proposed regulations to relieve potential double taxation and not, as in the first case, to enshrine the opportunity to engage in tax-rate-based expense location arbitrage.

(C) Interaction with other TJCA provisions. The economic analysis in REG-105600-18 predicts that interest expense location shifting will be “relatively minor” because of the TCJA's general interest expense limitation under IRC section 163(j) and the lower 21 percent statutory corporate rate. The proposed regulations assert that these two TCJA provisions “reduce . . . the (previously strong) incentive to locate fungible deductions such as interest expense in the United States.”²⁷ As a baseline matter, these statements are intended to pertain only to the exemption in allocation (and then apparently only to the exemption for FDII and GILITI, not NDTIR) under the proposed regulations, but citations to other TCJA provisions open the door to broader TCJA issues.

Among the reasons not to be as sanguine as REG-105600-18 about expense shifting is that shifting responds to effective and not statutory tax rates, and the TCJA's corporate base broadeners cause the U.S. corporate ETR to fall much less than the statutory rate.²⁸ In one category important for cross-border expense and income shifting, intellectual property products, the TCJA increases the marginal ETR by about 15 percentage points by the 2025-2027 period compared to pre-TCJA law.²⁹ As noted above, it is also not clear in REG-105600-18 whether the opportunity to create NDTIR is considered part of the no-action baseline or is included in the counterfactual of the proposed regulations — if NDTIR (with its taxpayer-favorable allocation exemption) is part of the “no-action” baseline, it should be considered one of the “other” TCJA provisions (and one that encourages leveraging in contrast to other TCJA changes that encourage deleveraging) when thinking about effects on expense and profit shifting.

With respect to the TCJA's general interest expense limitation, it is not clear how binding that provision will be, especially with so many companies having repatriated cash now at their disposal. Other big changes that will roil the fungibility of interest are introduction of the worldwide method of interest allocation in 2021 and the possibility that interest rates could return to their historically higher levels — both of those events could put a lot more allocable interest in play. And REG-105600-18's optimism is focused just on interest expense — the prospects for overhead and other fungible expenses should also matter.

Of course any economic analysis has its uncertainties, and for sure there is a possibility that the proposed regulations' optimism about expense shifting will be borne out, even with the non-allocation of expenses to the exempt portions of FDII and GILTI as well as the disregard of the allocation to the entire amount of NDTIR. But in the event insurance against a less rosy expense shifting outcome is deemed necessary, the next section considers an alternative to FTC-based adjustment.

(6) Deduction-based Adjustment

If the benefit of U.S. location of a “bad” expense deduction (using any deduction of a type which is apportionable³⁰ as the starting point) for an MNE with a low FTR cannot be curbed (or even addressed) by an FTC-based-only approach, an alternative is to start by focusing on and tailoring the U.S. deductibility itself instead of just seeing the particular expense solely as a potential (depending upon type of exemption) piece in the mechanical FTC calculation. The absence of deferral under the TCJA offers the information and opportunity to move beyond FTC-based allocation. A serendipitous result of the deduction-based adjustment method sketched below is that it can be adapted to address more robustly the double taxation problem that the proposed regulations only partially ameliorate. Subsection (A) describes the deduction-based adjustment under the assumption that this new approach would be a further exercise of regulatory authority intended to operate in tandem with REG-105600-18, (B) gauges the marginal incentive to relocate expenses as a way to assess expense location neutrality, and (C) discusses in detail the choice of regulatory-authority-versus-new-legislation as well as revenue.

(A) Deduction-based adjustment in conjunction with REG-105600-18. Assuming the deduction-based adjustment described here can be promulgated by regulation, allocation under REG-105600-18 would be retained though the proposed regulations could under certain circumstances be elected out of or substituted for. The deduction-based adjustment involves the following:

(i) Taxpayers would not be required to make allocations under existing allocation rules or REG-105600-18, and would not be required to proceed further in the adjustment described below, if any of the following conditions apply:

(a) The taxpayer has none of each of the following: FDII, GILTI, and NDTIR; or

(b) The taxpayer's FTR for overall foreign source income (defined to include NDTIR and any tested income offset by tested loss, before any deductions for FDII and GILTI under IRC section 250, with appropriate IRC section 78 treatment as necessary), equals or exceeds 80% of the U.S. corporate statutory rate (thus currently 16.8%); or

(c) The taxpayer's FTR for FDII and GILTI and NDTIR (calculated as in the prior step) in combination equals or exceeds 80% of the U.S. corporate statutory rate

This step would more narrowly target the FTC-based allocation, as well as the deduction-based adjustment described below, by eliminating the possibility of double taxation altogether for many taxpayers that, as shown above, do not materially gain from the U.S. location of fungible expenses.

(ii) A taxpayer not excused altogether from allocation under section (ii) would be required to determine allocable expenses using post-TCJA income and asset categories but without regard to REG-105600-18's exemption carve-out for FDII and GILTI, and before disregarding allocated deductions for NDTIR or tested income that is offset by tested loss.³¹ Any U.S deduction that falls within the class of expenses that theoretically could be apportionable (e.g., interest, overhead, and research and experimental expenditures) to FDII, GILTI, and NDTIR, regardless of whether the income is eligible for an IRC section 250 deduction or is fully exempt from U.S. taxation under the TCJA, and regardless whether the deduction itself is classified by the taxpayer as allocable or apportionable, would be prorated according to the ratio of the taxpayer's overall FTR to 80% of the U.S. statutory rate.

Consider an example for which details are shown in the tables in the Appendix.³² Assume an MNE has a 5% FTR spread evenly across its foreign operations. The taxpayer has $100 of apportionable³³ overhead expense located in the United States, $252 of U.S. source income before taking the U.S. deduction for overhead, $100 of GILTI (inclusive of foreign tax but before the IRC section 250 deduction) included in U.S. taxable income, $100 of NDTIR (the NDTIR exclusive of foreign tax is $95.24),³⁴ and $48 of FDII.

Under REG-105600-18, for FTC determination the taxpayer would allocate [$100*(50/332) = $15.06] under IRC section 864(f)(3) to the GILTI included in U.S. taxable income, [$100*(30/332) = $9.04] to FDII included in U.S. taxable income, and $0 to the general limitation (the NDTIR allocation is disregarded under IRC section (904)(b)(4)).³⁵ Assuming the MNE's U.S. tax rate is 21%, the taxpayer has $48.72 of pre-FTC U.S. tax liability, with a total FTC of $5.31, and therefore U.S. tax of $43.41, foreign tax liability of $11.92, leading to total liability of $55.33 and combined U.S. and FTR of 13.83%. Because the FTR used in the example is so low and the relative amount of apportionable overhead is not outsized, REG-105600-18 has no impact on this MNE, and the company likely could benefit from shifting expenses including overhead and interest (though the latter has a separate constraint under section 163(j)) to the United States with impunity until that shift results in a U.S. loss and/or the allocation of expenses begins to wipe out FTCs.

Under the steps in the deduction-based adjustment outlined so far, the MNE has [$100*(248/400) = $62.00] of expense allocable to foreign source income, and because overhead is a potentially apportionable expense (and under existing regulations all overhead is apportionable and not directly allocable), the overhead deduction for all U.S. tax purposes would be prorated by (.05/.168).³⁶ Therefore the U.S. deduction for overhead used in the computation of U.S. tax liability is reduced by [$62.00*(.118/.168) = $43.55.] Under the deduction-based approach, if the MNE chose to stop at this point, the MNE's U.S. tax liability would be the result under REG-105600-18 plus the simple denial caused by the prorated deduction [$43.41 + (.21*$43.55) = $52.56], which when combined foreign tax liability of $11.92 would result in a combined U.S. and foreign tax liability of $64.48.

The option for a taxpayer to combine the mandatory prorated denial of U.S. deductibility calculated by prorating the taxpayer's FTR relative to 80 percent of the U.S. corporate tax rate with the apportionment under REG-105600-18 is offered both to maintain a role for the exemption approach to apportionment created by existing regulations, law, and REG-105600-18 and also to permit taxpayers to choose not to have to make further calculations. However, in almost all cases a taxpayer will be better off proceeding to step (iii) in which any U.S. deduction denied in (ii) is permitted to be used in both the calculation of U.S. tax generally and the calculation of FTCs.

(iii) A taxpayer that experiences a denial of U.S. deduction because of FTR prorating would be permitted to elect to recalculate its U.S. tax, including FTCs, by reducing its foreign source income in a like-for-like manner up to the amount of U.S. deduction disallowed in step (iii). The taxpayer would also not have to allocate any expense the deduction for which was denied because of step (ii). The overall result of this recomputation (including the prorated deduction against U.S income calculated in step (ii) as well as the FTC result) could be substituted for the result of a combination of the prorated U.S. deduction from step (ii) combined with application of REG-105600-18.

Continuing the example from above and detailed in the Appendix, under the deduction-based approach this recomputation would result in reducing foreign source income by $43.55, spread ratably among the foreign income types. GILTI income (after taking account of the deduction afforded under IRC section 250) subject to U.S. taxation (before an FTC) would be reduced from $50 to $41.22, and NDII inclusion similarly would fall from $30 to $24.73, with the FTCs associated with those respective income flows being unaffected (the GILTI FTC) or lower (the FDII FTC) as a result of recomputation. The overall effect of this recomputation combined with U.S. deduction proration would be a U.S. tax liability of $49.87, showing the benefit of electing this recomputation (that is, simply combining prorated U.S. deduction denial with the results of REG-105600-18) compared to a U.S. tax liability without this election of $52.56. If the taxpayer elects recomputation rather than simply combining the prorated U.S. deduction with the REG-105600-18 result, the MNE's FTC would be $5.04, foreign tax liability $11.92, with combined U.S. and foreign taxes of $61.79 for a 15.45% combined foreign and U.S. tax rate.

Table 1. Tax Liability Effects and Average Tax Rate by Allocation/Adjustment Approach a/

	FTC-based allocation with REG-105600-18 method	Deduction-based adjustment method
		U.S. deduction proration, without electing recomputation (so grafts on the results under FTC-based approach)	U.S. deduction proration and election to recompute
1. U.S. deduction denial prorated by FTR	n/a	$9.15	$9.15
2. Computation of FTCs and U.S. tax liability using the denied U.S. deduction from step (1)	n/a	n/a	$52.54
3. FTC-based allocation with REG-105600-18	$55.33	$55.33	n/a
4. Combined foreign and U.S. tax liability	$55.33	$64.48	$61.79
5. Combined foreign and U.S. taxaverage tax rate	13.84%	16.12%	15.45%
a/ See Appendix Tables A-1 and A-2 for details, base case column.

Table 1 above summarizes the tax liability and average tax rates results of this example. The election under (iii) is necessary to get closer to expense location neutrality for the class of expenses that are apportionable by making sure that U.S. deductions denied in step (ii) reduce the amount of foreign source income subject to U.S. taxation in the recomputation permitted under step (iii). Taxpayers would almost always benefit from choosing to recompute in lieu of combining prorated U.S. deduction with REG-105600-18. The practical effect of this election is to moot, while still maintaining, REG-105600-18 as well as FTC-based allocation without recourse to legislation.

(B) Marginal Location Incentive. The difference in average tax rates caused by the FTC-based and deduction-based alternatives may not be enough by itself to indicate comparative effectiveness in achieving expense location neutrality. On the surface, it may be difficult to discern whether the traditional FTC-based result of a combined U.S. tax rate and FTR of 13.83% is more location-neutral than the 15.45% under the deduction-based adjustment. This information can be augmented by considering expense location decisions at the margin. This marginal relocation exercise also is a proxy for decisions about where to locate fungible expenditures to finance offshore activity.

Continuing the example used in the prior section, suppose that the taxpayer is considering shifting $1 of overhead expense back to the United States, the first two consequences of which would increase foreign taxes paid by $.05 and decrease U.S. tax liability by $.21 for a net of -$.16.

To further track the effect that this marginal relocation would have on the U.S. taxation of foreign income (foreign income in this instance defined broadly beyond just what gets included in U.S. taxable income), consider four scenarios that do not exhaust the options of foreign income consequences but are representative of the spectrum. In the first case the$1 of expense shifted back to the Unites States is assumed to cause a $1 increase in foreign income matching the MNE's existing foreign profile, so that $.81 of the income will be evenly split between GILTI and NDTIR while $.19 will be FDII. Alternatively, the shift of $1 of overhead to the U.S. could lead to more exclusive results, so that in scenario 2 the entire $1 foreign income increase is in GILTI, in scenario 3 NDTIR, and scenario 4 FDII.

Expense location neutrality is indicated by a marginal tax rate (“MTR”) of zero, meaning that shifting an expense does not have a positive or negative tax effect. The marginal results of the shift in this exercise are detailed in the Appendix³⁷ and summarized in Table 2 below. Under the FTC-based approach with REG-105600-18 (Table A-1 in the Appendix), the respective MTR effects for this exercise are all negative, with the expense transfer linked exclusively to NDTIR generating an MTR of -16%, followed respectively by the scenario in which the foreign income reflects the MNE's existing foreign income mix with an MTR of -12%, exclusively GILTI at -10%, and exclusively FDII at -6%. These MTRs mean that if there are no other economic effects of relocating the $1 of expense in the United States, the change will still offer a return (constituted entirely of tax savings) of from 6 to 16 percent.

Table 2. Marginal Tax Rates for Expense Relocation to the United States, by Foreign Income Dispersion and Allocation/Adjustment Method a/

	$1 of overhead relocated to the U.S., with different foreign income assumptions
	Spread broadly in accord with existing foreign income profile b/	Entire $1 increase to GILTI	Entire $1 increase to NDTIR	Entire $1 increase to FDII
1. FTC based allocation under REG-105600-18	-11.53%	-9.55%	-16.22%	-6.00%
2. Deduction-based approach with election made to recompute	-2.35%	-0.54%	-5.04%	-2.41%
a/ See Appendix Tables A-1 and A-2 for details, four right-most columns. b/ $1 of foreign income increased with $.81 split evenly between GILTI and NDTIR, and $.19 to FDII.

In contrast, the MTRs with the deduction-based adjustment (Appendix Table A-2), while still negative in all but the exclusive FDII scenario,³⁸ constrain the tax benefit from the marginal expense transfer to -5% in the exclusive NDTIR scenario and lesser tax benefits of -2% in the existing-foreign-income-mix and -1% in the exclusive GILTI scenarios. The choice in the deduction-based adjustment to use 16.8% as the get-out-of-allocation-for-free threshold and baseline for prorated U.S. deduction denial effectively would ensures that taxpayers paying high overall FTRs would be excused from allocation altogether but the 16.8% cliff also would prevent elimination of all of the tax benefits of expense location arbitrage. Nevertheless, the deduction-based adjustment moves the results closer to expense location neutrality than the FTC-based method.³⁹

(C) Regulation authority, potential need for legislation, revenue and other issues. The deduction-based adjustment was presented in the last section as a regulatory undertaking that could at least nominally coexist with REG-105600-18 (even though, in impact, the deduction-based approach likely would moot FTC-based allocation). The deduction based-based approach has been intentionally framed conservatively: The expenses potentially subject to prorated deduction denial for U.S. tax purposes are only interest, overhead, and research and experimental expenditures (and see below for the possibility of excluding the latter from allocation altogether), the threshold for U.S. deduction denial has been set at 80% of the U.S. statutory corporate tax rate to temper effects of the deduction-based adjustment in excess limit situations and broaden relief in excess credit situations, and the election to recompute U.S. tax liability by fully reflecting the effects of deduction denial helps soften the impact of deduction denial. The 80% choice could be tailored for equity and/or federal revenue purposes as needed.

Few issues would seem to compel the exercise of IRC section 482 authority more than FTC-based allocation which generally has its only impact in the wrong (i.e., excess credit) situations. However, there could be hesitation to rely on IRC section 482 (perhaps because it can be so powerful) or other regulatory authority. For example, this commenter's fear would be if section 482 were just used to give relief to excess credit situations (extending the relief granted those taxpayers by REG-105600-18 via exemption) but nothing is done about the potential for tax-rate driven expense location arbitrage available under the TCJA for NDTIR and GILTI. Or one could see difficulties in dealing with similar complaints about double taxation (particularly related to high FTR income) concerning the base erosion and anti-abuse tax (which may or may not have its own merits but also is different from the double taxation issue with expense allocation),⁴⁰ so natural prudence to use something like section 482 to rectify expense treatment seems justified. From a behavioral standpoint, the excess credit situations of double taxation, though sympathetic, can be addressed by self-help: if the double taxation is onerous, fungible “bad” expenses could just be moved overseas to relatively high-tax countries and the United States would be none the worse if the expenses (particularly interest and some kinds of overhead) were moved off-shore. On the other hand, excess-limit related expense location arbitrage is in an MNE's self-interest and there is no natural remedy other than exhaustion of tax benefits.

But if IRC section 482 or some other grounds for regulatory action are deemed insufficient authority, any legislation that addresses expense location should end existing FTC-based allocation altogether and replace it with something that encourages expense location neutrality for “bad” expenses. In any event, if there is concern that going to something like the deduction-based adjustment is regulatory overreach or is somehow too invasive, FTC based-allocation even with REG-105600-18 is not in any way neutral either — this is not a situation in which doing just a little is more neutral or likely to cause less economic harm.

(7) Other Changes to Consider

If there is no appetite for a big change like replacing (in fact or in effect) FTC-based allocation with something like the deduction-based adjustment, there are other changes or events to consider that fall short of that kind of meta change or affect the picture. Two issues that face the same kind of regulatory-versus-legislative track question that the deduction-based adjustment would face are the absence of conformity in the treatment of exemption and the question of what to do with research and experimental expenditures.

As noted above (and touched upon in REG-105600-18 itself), the treatment under IRC section 864(e)(3) of GILTI and FDII for allocation is less favorable overall to taxpayers than the disregard-after-allocation treatment accorded to NDTIR under IRC section 904(b)(4). What seems like an unintended effect is discrimination against other forms of foreign income. For example, for a taxpayer with foreign branch income, the exemption under the proposed regulations for GILTI and FDII not only lessens the allocation to those two forms of income but also increases the allocation to branch income (as well as to NDTIR though that allocation is disregarded after the fact). In contrast, allocation to NDTIR would have no effect on any allocation to branch income. This difference does not seem right as a matter of equity or policy unless there was some combination of a desire to overall favor NDTIR (seemingly unlikely and unwarranted, as noted above), a specific desire to favor GILTI and FDII over branch income (if this is an attempt to achieve some form of branch-subsidiary conformity beyond introduction of the branch limitation, the mechanics seem very subtle). In any case, consideration should be given to conforming the exemption treatment of FDII, GILTI, and NDTIR.

The expense allocation treatment of research and experimental (“R&E”) expenditures has raised questions for some time as demonstrated by the amount of historical effort Treasury (and especially the late Harry Grubert in the 1980s) spent on the issue. Of all the three major types of apportionable expenses, R&E seems the least bad it is bad at all, and also is of the least empirical consequence (though the latter may be partially due to the relatively favorable R&E apportionment options under existing law and regulations). Particularly if there is a sweeping change of FTC-based allocation as suggested above, consideration should be given to dropping R&E altogether out of allocation for FTC purposes or omitting it from being deemed an apportionable expense under the deduction-base adjustment.

Probably as more of a regulatory than legislative matter, the TCJA raises the stakes on the boundary between non-allocation and allocation, and within the allocable category the distinction between directly allocable and not directly allocable/apportionable. These categorizations matter more now than ever before because so much more foreign income will be subject to current inclusion or exemption (even if the overall residual U.S. tax on foreign income does not change that much). Taxpayers likely had much less reason in the past to care about these boundaries, so a check-up, as it were, is warranted.

Other legal and economic changes likely raise the stakes of getting expense location neutrality. The proposed regulations briefly mention the worldwide method of interest expense allocation that will become available in 2021. When enacted in 2004, that method was deemed to be a fairer approach (though apparently it was not fair and/or important enough to avoid its implementation being delayed in subsequent legislation) to interest allocation, though as seems to be true at many points in the evolution of allocation there was a lot of attention paid to excess limit situations and almost none paid to expense location arbitrage in excess limit situations.⁴¹ Not that dissimilar to the exemption for allocation offered in REG-105600-18, the worldwide method of interest allocation helps taxpayers in excess credit situations at the same time that it enables and/or blesses expense location arbitrage in excess limit situations, and all of this will be amplified if interest rates rise up to their historical average. An example of an economic structural change likely to raise the expense treatment stakes is the advent of remote selling, which has the potential of substantially increasing allocable expenses.

(8) Conclusion

The TCJA's ending of deferral, adoption of a participation regime, and rules requiring consideration if not entirely taxable inclusion of more foreign income than ever before on a contemporaneous basis create both an opening and an imperative to reconsider and reset allocation. REG-105600-18 represents an attempt to remedy (if only partially) one of the two big issues, double taxation in excess credit situations, but fails to address (and may actually indirectly worsen by providing exemption and a clear path) the other big issue, expense location arbitrage in excess limit situations. The proposed regulations suggest that expense location arbitrage may be lessened by other TCJA provisions, but this a qualitative statement relying on two provisions that may have limited impact while the mechanics of expense location arbitrage with the TCJA are not explored in detail in REG-105600-18.

This response endorses location neutrality which, for fungible “bad” expenses, would be furthered by adoption of a deduction-based approach either in conjunction (if there is to be a regulatory response justified by, say, IRC section 482) with, or replacement of (if there is to be a legislative response), the current FTC-based method. Other less meta changes, including conformity in the exemption for allocation purposes of FDII, GILTI, and NDTIR, as well as the possibility of taking research and experimental expenditures out of allocation altogether, may be merited if more incremental changes are considered.

The commenter apologizes in advance for any misreading of the IRC, REG-105600-18 or other regulations, or the TCJA as well as any unrecognized interactions that may affect the views above.

Regards,

Patrick Driessen
11607 Wave Lap Way
Columbia, MD 21044
(410) 730-3286
pdriesentax@hotmail.com

Attachment: AllocationREGcommentAppendixTables5Feb2019.xlsx (Excel versions of Tables A-1, A-2)