Tax Directors Criticize Effect of FTC Regs on Tech Companies

February 5, 2019

CC:PA:LPD:PR (REG-105600-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments on proposed §§ 78, 861, 904, and 960 regulations in REG-105600-18

Dear Sirs or Madams,

The Silicon Valley Tax Directors Group (“SVTDG”) hereby submits these comments on the above-referenced proposed regulations issued under § 78, 861, 904, & 960 of the Internal Revenue Code of 1986, as amended, in REG-105600-18, 83 Fed. Reg. 63200 (December 7, 2018) (the “Proposed Regs”). SVTDG members are listed in Appendix A of this letter. Sincerely,

Robert F. Johnson
Co-Chair, Silicon Valley Tax Directors Group
Capitola, CA

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I. Introduction and summary

A. Background on the Silicon Valley Tax Directors Group

The SVTDG represents U.S. high technology companies with a significant presence in Silicon Valley, that are dependent on R&D and worldwide sales to remain competitive. The SVTDG promotes sound, long-term tax policies that allow the U.S. high tech technology industry to continue to be innovative and successful in the global marketplace.

B. Summary of recommendations — changes that should be made to the Proposed Regs

We recommend that Treasury and the IRS make certain specific changes to, and reconsider certain aspects, of the Proposed Regs. Here we summarize our main recommendations.

[A] Prop. § 1.904-4(f) should be narrowed to cover a more limited set of transactions

Prop. § 1.904-4(f) provides retroactive rules for determining the new separate foreign branch category income introduced in §§ 904(d)(1)(B) and 904(d)(2)(J). Prop. § 1.904-4(f)(2)(i) provides generally that foreign branch category income is gross income reflected on the separate set of books and records of a foreign branch, as adjusted to conform to Federal income tax principles (so that book effects of transactions disregarded under such principles are generally erased). But Prop. § 1.904-4(f)(2)(vi) provides rules for adjusting gross income attributable to a foreign branch to reflect certain transactions disregarded for Federal income tax principles.

In particular, a rule in Prop. § 1.904-4(f)(2)(vi)(D) adjusts gross income attributable to a foreign branch or its owner to reflect disregarded branch-owner transactions involving § 367(d)(4) intangible property. We believe this rule — particularly the retroactive effective date — is unduly harsh. In response to the TCJA, many U.S. multinationals restructured their foreign operations, for example to take advantage of incentives of owning and exploiting intangible property in the U.S. The rule is a retroactive “gotcha” for such multinationals, surprisingly “redetermining” general basket gross income of a foreign branch owner to be foreign branch category income, or vice versa, depending on disregarded transactions undertaken during restructuring but before the issuance of any guidance on determining foreign branch income. Taxpayers had no advance guidance on how foreign branch income would be determined.

We make three recommendations. First, Treasury and the IRS should delay application of any final rule adopting Prop. § 1.904-4(f)(2)(vi)(D) such that the final rule would only apply to intangibles transfers made after promulgation of such final rule. In any event, any such final rule shouldn’t apply to intangible transfers before December 7, 2018 (when the Proposed Regs were published in the Federal Register). Second, foreign branch category income should be determined simply using foreign branch books and records. Third, foreign branch category income should be determined ignoring transitory ownership of property by a foreign branch.

[B] Prop. § 1.960-2(b)(l) should be modified to permit deemed paid foreign income taxes under § 960(a) with respect to § 956 inclusions under § 951(a)(1)(B)

A rule in Prop, § 1.960-2(b)(l) says that no foreign income taxes are deemed paid under § 960(a) with respect to an inclusion under § 951(a)(1)(B) (i.e., relating to § 956 amounts based on a CFC’s investment in U.S. property). To justify this rule, the Preamble to the Proposed Regs asserts that § 960(a) treats foreign income taxes of a CFC as deemed paid by a U.S. shareholder only with respect to an “item of income” of a CFC that’s included in the gross income of a U.S. shareholder under § 951(a)(1). We believe this assertion is wrong, and is based on a strained reading of § 960(a) that in essence rearranges the language of the subsection. A natural reading is that “item of income” in § 960(a) simply refers to the two amounts included in a U.S. shareholder’s gross income under § 960(a)(1) — both the amount under § 951(a)(1)(A) (subpart F inclusion) and under § 951(a)(1)(B) (§ 956 inclusion).

This natural reading of “item of income” to refer to both amounts in § 951(a)(1) is consistent with the legislative history. The conference agreement followed the House Bill on § 960(a), which it described by stating that “[a] deemed-paid credit is provided with respect to any income inclusion under subpart F,” An argument that “any income inclusion under subpart F” must refer to subpart F as envisioned with the repeal of § 956 proposed in another section of the House Bill (but rejected in the conference agreement) fails: the conference committee’s reference to “income inclusion under subpart F” must be to subpart F as envisioned by the committee — i.e., with § 956 intact.

We recommend Prop. § 1.960-2(b)(1) be revised to make clear that foreign income taxes are deemed paid under § 960(a) with respect to subpart F inclusions under §§ 951(a)(1)(A) and 951(a)(1)(B).

[C] Treasury and the IRS should issue proposed regulations dealing with allocation and apportionment of R&E expenses

We recommend Treasury and the IRS issue proposed regulations dealing with allocation and apportionment of R&D expenses. In particular, to maintain consistency with the TCJA Conference Report assertion that no residual U.S. tax should be paid on GILTI that’s effectively taxed at or above 13% percent, we recommend R&E expenses not be allocated to gross income in the § 951A category, so as to not impose further limitations on foreign tax credits available to high-taxed GILTI.

Prop. § 1.861-17(e)(3) gives a one-time exception to the binding five-year election by allowing a taxpayer to change its apportionment method for the first taxable year beginning after December 31, 2017. We recommend that instead of a one-time exception under Prop. § 1.861-17(e)(3), Treasury and the IRS allow elections under § 1.861-17(e) to be made annually.

We recommend Treasury and the IRS make three changes to the gross income method under § 1.861-17 to make it less restrictive. First, we recommend that under § 1.861-17(b)(1), the exclusive apportionment percentage under the gross income method (currently 25 percent) should, if a taxpayer so elects, match the percentage under the sales method (50 percent). Second, “option one” of the gross income method currently can only be used if the amount of R&E expense apportioned to the statutory grouping and the residual grouping are each not less than 50 percent of the amount that would’ve been apportioned under the sales method. We recommend this 50 percent floor be eliminated. Third, under the current sales method rules, sales in a product category are taken into account if the taxpayer is reasonably expected to benefit from the R&E expense associated with those product categories. Subparagraph 1.861-17(c)(3)(iv) provides that a corporation in a cost sharing arrangement with the taxpayer isn’t reasonably expected to benefit from the taxpayer’s share of the research expense. We recommend a similar rule be provided for the gross income method.

For the sales method under § 1.861-17, we recommend Treasury and the IRS provide a rule allocating R&E expense to the § 904(d) category to which the sales receipts generated by the R&E are assigned under the sales method. This would ensure the expenses are properly reflected in the same income baskets in which income generated by the R&E is assigned.

[D] Prop. § 1.904-6(a)(iv) should be modified to cross reference § 904(d)(1)(D)

The TCJA added two new foreign tax credit baskets in § 904(d)(1) — one for § 951A GILTI (§ 904(d)(1)(A)) and one for foreign branch income (§ 904(d)(1)(B)) — thereby renumbering the prior baskets for passive category income and general category to §§ 904(d)(1)(C) & (D), respectively. The TCJA, however, failed to make a conforming adjustment to the reference to § 904(d)(1)(B) in § 904(d)(2)(H)(i), so this last clause now inadvertently treats foreign taxes imposed on an amount not constituting income under U.S. tax principles (a base difference) as imposed on foreign branch income, rather than on general category income as it did pre-TCJA. We recommend Prop. § 1.904-6(a)(iv) — which currently tracks § 904(d)(2)(H)(i) with no conforming adjustment — be modified to directly cross reference general category income (i.e., income described in § 904(d)(1)(D)).

[E] Treasury and the IRS should clarify that § 1.965-2(f)(2)(ii)(B)(2) applies to limit basis reductions under Prop. § 1.861-12(c)(2)(i)(B)(1)(/i)

Prop. § 1.861-12(c)(2)(i)(B)(7)(ii) provides that, for purposes of apportioning expenses based on assets, a taxpayer’s stock basis in a specified foreign corporation is determined as if the taxpayer had made an election under § 1.965-2(f)(2)(i) (whether or not an actual election has been made), but excluding any adjustment for basis increases under § 1.965-2(f)(2)(ii)(A) (the " deemed election”).

An election under § l,965-2(f)(2)(i) allows a U.S. shareholder to "shift” its stock basis from E&P deficit foreign corporations to DFICs. The final § 965 regulations also allow taxpayers to elect, in the alternative, for limited basis increases, and reductions, under § 1.965-2(f)(2)(ii)(A)(2) and § 1.965-2(f)(2)(ii)(B)(2), respectively. Subclause 1.965-2(f)(2)(ii)(B)(2) provides that if a U.S. shareholder applies § 1.965-2(f)(2)(ii)(A)(2) to limit increases to its basis in DFICs, reductions to the taxpayer’s stock basis in a deficit corporation may not exceed the stock basis. We recommend Treasury clarify that § 1.965-2(f)(2)(ii)(B)(2) would apply to limit basis reductions in a deemed election under Prop. § 1.861-12(c)(2)(i)(B)(7)(ii).

[F] Prop. §§ 1.960-2(b)(2) and 1.960-2(c)(4) should be modified to account for potential timing distortions in crediting current-year taxes

Prop. § 1.960-2(b)(1) generally provides that a U.S. shareholder is deemed to have paid its CFC’s foreign income taxes to the extent those taxes are properly attributable to subpart F income of the CFC included by the U.S. shareholder. Prop. § 1,960-2(b)(2) provides that only current-year foreign taxes of the CFC are considered properly attributable to an item of income of the CFC (the “ current-year taxes rule”). Prop. § 1.960-2(c)(4) gives a similar rule attributing only current-year foreign taxes to tested income.

The current-year taxes rule could create timing distortions that prevent crediting of foreign taxes arising in a tax year different from an income inclusion year. We recommend Treasury and the IRS introduce rules to mitigate timing distortions caused by the current-year taxes rule. For example, a rule could allow for a one-year carryforward or carryback of foreign taxes so that they can be properly attributed to CFC income included by a U.S. shareholder in its gross income in a prior or subsequent tax year.

[G] Part of Prop. § 1.78-1 is contrary to the TCJA and should be withdrawn

The plain language of § 14301(d) of Public Law 115-97 (the "TCJA”) is clear that the amendment to § 78 made in § 14301(c) of the TCJA — i.e,, providing that a § 78 deemed dividend is treated as a dividend for all purposes of the Code other than §§ 245 and 245A — applies to taxable years of foreign corporations beginning after December 31,2017. Fiscal year taxpayers thus have a period from January 1, 2018 until their taxable year end during which old § 78 (which refers only to § 245 but not § 245A) and new § 245A apply.

Prop. § 1.78-1(a) tracks TCJA-modified § 78 by providing in part that "[a] section 78 dividend is treated as a dividend for all purposes of the Code, except that it is not treated as a dividend for purposes of section 245 or 245A, . . . .” But regarding applicability, Prop. § 1.78-1(c) states that — although in general Prop. § 1.78-1 applies to taxable years of foreign corporations beginning after December 31, 2017 — the quoted provision from Prop. § 1.78-l(a) “also applies to section 78 dividends that are received after December 31, 2017, by reason of taxes deemed paid under [§ 960(a)] with respect to a taxable year of a foreign corporation beginning before January 1, 2018.” Prop. § 1.78-1(c) thus rolls back application of TCJA-modified § 78 to deny taxpayers the benefit of a § 245A deduction for a § 78 dividend received during the gap period. This is contrary to the plain language of the TCJA.

We accordingly recommend the rule in Prop. § 1.78-1 denying application of the § 245A deduction to the § 78 deemed dividend in the gap period be withdrawn. This can be done simply by removing the above-quoted timing language from Prop. § 1.78-1(c).

II. SVTDG CONCERNS WITH, AND RECOMMENDATIONS FOR CHANGES TO, THE PROPOSED REGS

A. Prop. § 1.904-4(f) should be narrowed to cover a more limited set of transactions

1. Background

The TCJA introduced a new separate foreign tax credit category “foreign branch income” in §§ 904(d)(1)(B) and 904(d)(2)(J). Whether a domestic corporation owning a foreign branch earns foreign-source general category (basket) income or foreign branch income can drastically affect taxation of the domestic corporation. Foreign-source general basket income is subject to its own § 904 foreign tax credit limitation, and such income may increase the domestic corporation’s deduction under § 250 if it’s “foreign-derived deduction eligible income” described in § 250(b)(4). Foreign branch income is also subject to its own foreign tax credit limitation, and under § 250(b)(3)(A)(i)(VI) it’s carved out from qualifying as foreign-derived deduction eligible income. Other than the § 904(d)(2)(J)(i) directive that Treasury would establish rules for determining the amount of foreign branch income, taxpayers had no advance guidance on how foreign branch income would be determined. The Proposed Regs were issued almost a year after the TCJA was enacted, when most U.S. multinational corporations were most of the way through their first taxable year in which foreign branch income had to be determined.

Prop. § 1.904-4(f) provides rules for determining the new separate foreign branch category income. Prop. § 1.904-4(f)(2) focuses on the determination of gross income attributable to a foreign branch. Prop. § 1.904-4(f)(2)(vi) provides rules for adjusting gross income attributable to a foreign branch (income that is not passive category income) to reflect certain transactions disregarded for Federal income tax purposes.

2. The rule in Prop. § 1.904-4(f)(2)(vi)(D), relating to intangible property transfers, is unduly harsh

Prop. § 1.904-4(f)(2)(vi)(D) — entitled “Certain transfers of intangible property” — provides that for purposes of applying Prop. § 1.904-4(f)(2)(vi):

the amount of gross income attributable to a foreign branch (and the amount of gross income attributable to its foreign branch owner) that is not passive category income must be adjusted under the principles of [Prop. § 1.904-4(f)(2)(vi)(B)] to reflect all transactions that are disregarded for Federal income tax purposes in which property described in i § 367(d)(4)! is transferred to or from a foreign branch, whether or not a disregarded payment is made in connection with the transfer. In determining the amount of gross income that is attributable to a foreign branch that must be adjusted by reason of this [Prop. § 1.904-4(f)(2)(vi)(D)], the principles of [§§ 367(d) and 482] apply. [Emphasis added]

Prop. § 1.904-4(f)(2)(vi)(D), if finalized as is, would apply for taxable years that both begin after December 31, 2017 and end on or after December 4, 2018.¹ It would, for example, for calendar year taxpayers, apply to any 2018 foreign branch ↔ owner disregarded transactions involving § 367(d)(4) intangibles — for example, any such disregarded transactions occurring on January 1, 2018, only 10 days after TCJA was enacted.

The Preamble contrasts foreign branch ↔ owner disregarded transactions involving § 367(d)(4) intangible property with general remittances and contributions — which, under the rule in Prop. § 1.904-4(f)(2)(vi)(C), don’t give rise to redeterminations of gross income of the foreign branch or its owner — as follows:

However, the different treatment of contributions and remittances, on the one hand, and other disregarded transactions, on the other, could allow for noneconomic reallocations of the amount of gross income attributable to the foreign branch category. To prevent this in connection with certain transactions, the proposed regulations require the amount of gross income attributable to a foreign branch (and the amount attributable to the foreign branch owner) to be adjusted to account for consideration that would be due in any disregarded transactions in which property described in [§ 367(d)(4)] is transferred to or from a foreign branch if the transactions were regarded, whether or not a disregarded payment is made in connection with the transfer.

We believe Prop. § 1.904-4(f)(2(vi)(D) targets far more than “non-economic reallocations” of gross income attributable to the foreign branch category.

To see this, consider two alternative disregarded transactions pursuant to which a foreign branch, newly converted from a CFC under a check-the-box election, transfers § 367(d)(4) intangible property (“IP”) to its U.S. owner. In both alternatives suppose immediately following the IP transfer the foreign branch owner earns general category gross income that isn’t reflected on the foreign branch’s separate books and records.

In alternative [A], the foreign branch nominally sells the IP to its U.S. owner in exchange for contingent payments. In alternative [A], the foreign branch records the contingent payments as income on its books and records for local country purposes. As adjusted to conform to Federal income tax purposes, however, the recorded income is ignored because the IP sale is disregarded, so there’s no gross income attributable to the foreign branch as a consequence of the IP sale. But Prop. § 1.904-4(f)(2)(vi)(D) results in the redetermination of non-passive-category gross income attributable to the foreign branch.² This is consistent with the foreign branch’s recording of gross income on its separate local country books and records.

In alternative [B], the foreign branch transfers the IP in a transaction treated as a distribution for local country purposes. The foreign branch records no income associated with the IP on its separate books and records for local country purposes.³ Adjusting the local country books and records to conform to Federal income tax principles leaves them unchanged — disregarding the IP distribution doesn’t change the fact that no income is reflected on such books and records. But Prop. § 1.904-4(f)(2)(vi)(D) again results in the redetermination of nonpassive-category gross income attributable to the foreign branch. This is inconsistent with the foreign branch’s recording of no gross income on its separate local country books and records. It’s also inconsistent with the local country view that the foreign branch isn’t entitled to income from IP it doesn’t own. Application of Prop. § 1.904-4(f)(2)(vi)(D) doesn’t, in this case, prevent “non-economic reallocation” of gross income attributable to the foreign branch — rather, it causes non-economic reallocation of gross income to the foreign branch.

We believe the rule in Prop. § 1.904-4(f)(2)(vi)(D) — particularly the retroactive effective date — is unduly harsh. In response to the TCJA, many U.S. multinationals restructured their foreign operations, for example to take advantage of incentives of owning and exploiting intangible property in the U.S. Prop. § 1.904-4(f)(2)(vi)(D) is a retroactive “gotcha” for such multinationals, surprisingly “redetermining” general basket gross income of a foreign branch owner to be foreign branch income, or vice versa, depending on disregarded transactions undertaken during restructuring but before issuance of any guidance on determining foreign branch income. As noted, taxpayers had no advance guidance on how foreign branch income would be determined, and in particular had no inkling of the extent to which Treasury would, for purposes of this determination, override application of existing check-the-box regulations under § 301.7701-3 or foreign law treatment of transactions. As one example, to avoid harmful effects of Prop. § 1.904-4(f)(2)(vi)(D) in a check-the-box conversion of a CFC to a foreign branch, the CFC would have had to (presciently) distribute all its intangibles before the effective date of a check-the-box election. This is inordinately harsh.

Equally harsh would be enforcement of the rule in Prop. § 1.904-4(f)(2)(vi)(D) with respect to disregarded transactions undertaken before the first year foreign branch income is determined — i.e., making redeterminations under such rule with respect to deemed annual §§ 367(d)/482 income streams associated with disregarded foreign branch ↔ owner intangibles transfers occurring before such first year. Although neither the Preamble not the rule itself explicitly permit such enforcement, we understand such enforcement is perhaps being contemplated. Enforcing such rule with respect to transactions in pre-foreign-branch-income years is, we believe, unprincipled and unduly harsh.

3. Recommendations

Because of the concerns raised above, we recommend —

B. Prop. § 1.960-2(b)(1) should be modified to permit deemed paid foreign income taxes under § 960(a) with respect to § 956 inclusions under § 951(a)(1)(B)

Subsection 960(a) provides in relevant part —

if there is included in the gross income of a domestic corporation any item of income under [§ 951(a)(1)] with respect to any [CFC] with respect to which such domestic corporation is a [U.S.] shareholder, such domestic corporation shall be deemed to have paid so much of such foreign corporation’s foreign income taxes as are properly attributable to such item of income. [Emphasis added]

The twice-referenced "item of income” is evidently included in the gross income of a domestic corporation under § 951(a)(1). Paragraph 951(a)(1) provides —

If a foreign corporation is a [CFC] at any time during any taxable year, every person who is a [U.S.] shareholder (as defined in [§ 951(b)]) of such corporation and who owns (within the meaning of [§ 958(a)]) stock in such corporation on the last day, in such year, on which such corporation is a [CFC] shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends —

(A) his pro rata share (determined under [§ 951(a)(2)]) of the corporation’s subpart F income for such year, and

(B) the amount determined under section 956 with respect to such shareholder for such year (but only to the extent not excluded from gross income under [§ 959(a)(2)]). [emphasis added]

Paragraph 951(a)(1) thus requires two amounts be included in a U.S. shareholder’s gross income — an amount under § 951(a)(1)(A) (subpart F income of a CFC), and an amount under § 951(a)(1)(B) (§ 956 inclusion).

Prop. § 1.960-2(b)(l) provides that “[n]o foreign income taxes are deemed paid under [§ 960(a)] with respect to an inclusion under [§ 951(a)(1)(B)].” In trying to justify this rule, the Preamble to the Proposed Regs asserts —

[§ 960(a)] treats foreign income taxes of a CFC as deemed paid by a [U.S.] shareholder only with respect to an item of income of a CFC that is included in the gross income of the [U.S.] shareholder under [§ 951(a)(1)], Proposed § 1.960-2(b)(1) treats taxes as deemed paid under [§ 960(a)] specifically with respect to subpart F inclusions because the inclusions are with respect to items of income of the CFC. In contrast, an inclusion under [§ 951(a)(1)(B)] is not an inclusion of an “item of income" of the CFC but instead is an inclusion equal to an amount that is determined under the formula in [§ 956(a)].⁴

The assertion that “item of income” used in § 960(a) necessarily means “an item of income of a CFC” is wrong. This assertion in effect takes the first clause of § 960(a), i.e., —

if there is included in the gross income of a domestic corporation any item of income under [§ 951(a)(1)] with respect to any [CFC] with respect to which such domestic corporation is a [U.S.] shareholder,

and rearranges it as:

if there is included in the gross income of a domestic corporation under [§ 951(a)(1)(A)] any item of income with respect to any [CFC] with respect to which such domestic corporation is a [U.S.] shareholder.

Another reading of § 960(a) — one that doesn’t strain or in effect rearrange the language — is that “item of income” simply refers to either (or both) of the two amounts included in the U.S. shareholder’s gross income under § 951(a)(1): the amount under § 951(a)(1)(A) and the amount under § 951(a)(1)(B).

This latter reading of § 960(a) means the justification in the Preamble of the Proposed Regs for the rule in Prop. § 1.904-2(b)(1) is wrong: it’s not the case that § 960(a) treats foreign income taxes of a CFC as deemed paid by a U.S. shareholder only with respect to certain items of income of the CFC. Rather, § 960(a) treats foreign income taxes of a CFC as deemed paid by a U.S. shareholder with respect to any U.S. shareholder gross income inclusion under § 951(a)(1) — whether arising under §§ 951(a)(1)(A) (arising from the CFC’s subpart F income) or 951(a)(1)(B) (arising from the CFC’s investment in U.S. property under § 956).

This latter reading of § 960(a) is consistent with the TCJA legislative history. As relevant, the conference agreement followed the House Bill,⁵ which explained: “A deemed-paid credit is provided with respect to any income inclusion under subpart F. The deemed-paid credit is limited to the amount of foreign income taxes properly attributable to the subpart F inclusion.”⁶ Income inclusions under subpart F, of course, mean income inclusions under both §§ 951(a)(1)(A) and (B). Prop. § 1.960-2(b)(1) ignores the second inclusion, flouting the directive in the House Bill requiring provision of credit for any subpart F inclusion.

It might be argued that reference to “any income inclusion under subpart F” in the House Report could only refer to income inclusions under § 951(a)(1)(A), because the House and Senate proposed repealing § 956, which — had it been enacted — would result, in effect, in no U.S. shareholder gross income inclusion under § 951(a)(1)(B). The conference agreement rejected repeal of § 956.⁷ Thus — the argument might run — by stating that “[t]he conference agreement follows the House Bill . . .,"⁸ the conference agreement must have meant it was following the House bill with respect to § 960(a) assuming that § 956 was repealed.

This argument fails. The conference agreement described the House Bill on § 960(a) by stating that “[a] deemed-paid credit is provided with respect to any income inclusion under subpart F?’⁹ The conference agreement used this language without qualification. The conference agreement didn’t, for example, describe the House Bill by saying “[a] deemed-paid credit is provided with respect to any income inclusion under subpart F as modified by the House Bill [i.e., with § 956 repealed]?’ The Committee of Conference must be assumed to have understood the language it chose and — by describing the House Bill as providing a deemed-paid credit “with respect to any income inclusion under subpart F” — it meant subpart F as the Committee understood it: without § 956 repealed. Income inclusions under subpart F thus come from §§ 951(a)(1)(A) and (B).

The Preamble to the Proposed Regs is thus wrong to assert that § 960(a) treats foreign income taxes of a CFC as deemed paid by a U.S. shareholder only with respect to an item of income of a CFC. The language of § 960(a) is readily interpreted to treat foreign income taxes of a CFC as deemed paid by a U.S. shareholder with respect to any subpart F inclusion — whether arising from an item of income of a CFC or from earnings of a CFC invested in U.S. property. This interpretation requires no rearrangement of the language of § 960(a), and if s consistent with the legislative history.

The mandate in Prop. § 1.960-2(b)(l) that “(n]o foreign income taxes are deemed paid under [§ 960(a)] with respect to an inclusion under § 951(a)(1)(B)” is thus contrary to § 960(a) and its legislative history. We believe there’s no sound policy reason for denying crediting of foreign taxes deemed paid under § 960(a) with respect to subpart F inclusions under § 951(a)(1)(B). We recommend this provision in Prop. § 1.960-2(b)(l) be withdrawn, and that the paragraph be clarified to explain that foreign income taxes are deemed paid under § 960(a) with respect to subpart F inclusions under §§ 951(a)(1)(A) and 951(a)(1)(B).

Mechanically, such crediting can be done by keeping, for each CFC, annual foreign tax credit income categories (baskets), and associated foreign taxes, and then determining foreign taxes associated with § 951(a)(1)(B) inclusions (which inclusions come only from § 959(c)(3) E&P accounts) using a last-in, first-out basis and proportionately from the annual foreign tax amounts associated with each CFC’s general, passive, and treaty-resourced income baskets.

C. Recommendations for proposed regulations dealing with allocation and apportionment of R&E expenses

1. Background and request for comments

The preamble to the Proposed Regs says Treasury intends to reexamine existing approaches for allocating and apportioning research and experimentation (“R&E”) expenses, and requests comments on whether aspects of § 1.861-17 should be revised in light of changes to § 904(d), in particular the addition of the § 951A category in § 904(d)(1)(A).¹⁰ Undercurrent § 1.861-17, R&E expenses are apportioned, at the taxpayer’s election, between groupings within product categories using either a sales or gross income method of apportionment. The following comments provide recommendations for revisions to § 1.861-17, both generally in light of changes to the tax laws over the past two decades and specifically with respect to certain provisions in the TCJA, such as § 951 A. We recommend Treasury and the IRS issue proposed regulations updating § 1,861-17.

2. Don’t allocate R&E expense to gross income in the § 951A category

The Conference Report says that taxpayers subject to a foreign tax rate on tested income at or above 13.125 percent won’t be subject to GILTI:

[A]s foreign tax rates on GILTI range between zero percent and 13.125 percent, the total combined foreign and U.S. tax rate on GILTI ranges between 10.5 percent and 13,125 percent. At foreign tax rates greater than or equal to 13.125 percent, there is no residual U.S. tax owed on GILTI. so that the combined foreign and U.S. tax rate on GILTI equals the foreign tax rate.¹¹

The statutory scheme implements this outcome by providing a 50 percent deduction for GILTI — lowering the effective tax rate to 10.5 percent — and a foreign tax credit for 80 percent of foreign taxes paid on GILTI. Thus, if the GILTI is subject to 13.125 percent or greater foreign tax, the U.S. tax on GILTI should be fully offset by foreign tax credits.

The allocation of R&E expenses to the § 951A category would reduce a taxpayer’s foreign source income and therefore reduce its foreign tax credit limitation in the § 951A category.¹² This can result in high-taxed GILTI¹³ being subject to residual U.S. tax on a GILTI inclusion due to insufficient foreign tax credits being available under the reduced limitation, i.e., the limitation falls below 80 percent of the foreign taxes paid. This is contrary to the statement in Conference Report that no residual U.S. tax should be paid on GILTI that is effectively taxed at or above 13.125 percent. In the preamble to the proposed regulations, Treasury appears to reject this suggestion with respect to the allocation and apportionment of other expenses.¹⁴ The preamble, however, doesn’t address the plain language, quoted above, of the Conference Report. We believe this language and the statutory scheme as a whole indicate that R&E expenses shouldn’t be allocable to the § 951A category.

We therefore recommend that R&E expense not be allocated to gross income in the § 951A category, so as to not impose further limitations on foreign tax credits available to high-taxed GILTI.

3. Allow taxpayers to elect annually the sales or gross income methods

Under current § 1.861-17(e), taxpayers can elect between the sales or gross income methods of apportioning R&E expenses. Such election is generally binding for a five-year period. Prop. § 1.861-17(e)(3) gives a one-time exception to the five-year period by allowing a taxpayer to change its apportionment method for the first taxable year beginning after December 31,2017.

We recommend that instead of a one-time exception under Prop. § 1.861-17(e)(3), Treasury and the IRS allow elections under § 1.861-17(e) to be made annually. A five-year binding period is overly restrictive for taxpayers in research-intensive industries, in which product and service offerings change rapidly. A five-year period isn’t required by statute, so moving to an annual election by regulation to give taxpayers more flexibility can be done. An annual election of R&D expense allocation and apportionment is also consistent with (a) the determination of creditable foreign taxes on an annual basis; and (b) the annual election to choose a credit, rather than a deduction, for foreign taxes (this is the main context in which R&E expense allocation and apportionment is relevant).

4. Gross income method

We recommend Treasury and the IRS make several changes to the gross income method to make it less restrictive. We note that enactment of § 951A has resulted in large involuntary increases (compared to pre-TCJA) of foreign-source gross income inclusions of U.S. shareholders, who previously had more control — through structuring business operations — over such income inclusions. This sea change, we believe, warrants revisiting the gross income method.

First, we recommend that under § 1.861-17(b)(1), the exclusive apportionment percentage under the gross income method (currently 25 percent) should, if a taxpayer so elects, match the percentage under the sales method (50 percent).

Second, “option one” of the gross income method currently can only be used if the amount of R&E expense apportioned to the statutory grouping and the residual grouping are each not less than 50 percent of the amount that would’ve been apportioned under the sales method.¹⁵ We recommend this 50 percent floor be eliminated.

Third, under the current sales method rules, sales in a product category are taken into account if the taxpayer is reasonably expected to benefit from the R&E expense associated with those product categories. Subparagraph 1.861-17(c)(3)(iv) provides that a corporation in a cost sharing arrangement with the taxpayer isn’t reasonably expected to benefit from the taxpayer’s share of the research expense. We recommend a similar rule be provided for the gross income method.

These changes should be made because the current R&E allocation rules were more appropriate to the pre-TCJA landscape, in which foreign earnings were generally deferred and not reflected on a U.S. return — the current R&E allocation and apportionment rules were designed to reflect such deferral. After the introduction of GILTI, however, the vast majority of foreign income will be subject to current U.S. taxation. In addition, income recognized when intangible property is transferred to a CFC has generally increased due to changes to §§ 367(d) and 482 since § 1.861-17 was issued in 1995, including changes introduced by the TCJA. Multinationals therefore generally have more foreign source income under current law than they had in the past, and excessive allocations of R&E expense to foreign source income can now lead to harsh results. The preamble to the 1995 proposed § 1.861-17 regulations notes the changes to R&E allocation methods introduced there were in part based on an economic study of the relationships between taxpayer-performed R&E expenses and foreign source income.¹⁶ The 1995 regulations were consistent with evidence at the time, and resulted in lower expense allocations and apportionments to foreign source income than was previously the case.¹⁷ These allocations and apportionments should now be updated to reflect TCJA changes in the tax law that have increased currently taxed foreign source income.

5. Sales method

We recommend Treasury and the IRS provide a rule allocating R&E expense (after exclusive apportionment) to the § 904(d) category to which the sales receipts generated by the R&E are assigned under the sales method. This allocation and apportionment would ensure the expenses are properly reflected in the same income baskets in which income generated by the R&E is assigned.

D. Treasury should modify § Prop. § 1.904-6(a)(iv) to cross reference § 904(d)(1)(D)

Prop. § 1.904-6(a)(iv) says that foreign taxes imposed on items that aren’t income under U.S. tax principles (a base difference) are to be treated as imposed with respect to income “described in [§ 904(d)(2)(H)(i)].” Clause 904(d)(2)(H)(i) cross-references “income described in [§ 904(d)(1)(B)],” and § 904(d)(1)(B) describes “foreign branch income.” Prop. § 1.904-6(a)(iv) thus assigns base differences to foreign branch income under § 904(d)(1)(B).

This assignment is the result of a drafting oversight in the TCJA. Before enactment of the TCJA, § 904(d)(2)(H)(i) had, by reference to § 904(d)(1)(B), assigned base differences to general category income.¹⁸ Subparagraph 14201(b)(2)(A) and subsection 14302(a) of the TCJA cumulatively redesignated § 904(d)(1)(B) as § 904(d)(1)(D), and inserted “foreign branch income” as a new category of income under § 904(d)(1)(B). No conforming amendments, however, were made to § 904(d)(2)(H)(i), which continues to cross-reference § 904(d)(1)(B). The legislative history of the TCJA is silent on re-assigning base differences from passive category income to foreign branch income. The non-updated reference to § 904(d)(1)(B) appears to be a simple clerical error in failing to making a conforming amendment.¹⁹

Accordingly, we recommend Treasury modify Prop. § 1.904-6(a)(iv) to directly cross-reference “income described in § 904(d)(1)(D).”

E. Treasury and the IRS should clarify that § 1.965-2(f)(2)(ii)(B)(2) applies to limit basis reductions under Prop. § 1.861-12(c)(2)(i)(B)(7)(ZZ)

Prop. § 1.861-12(c)(2)(i)(B)(7)(//) provides that, for purposes of apportioning expenses based on assets, a taxpayer’s stock basis in a specified foreign corporation is determined as if the taxpayer had made a deemed election under § 1.965-2(f)(2)(i) (whether or not an actual election has been made), but excluding any adjustment for basis increases under § 1.965-2(f)(2)(ii)(A).

An election under § 1.965-2(f)(2)(i) allows a U.S. shareholder to “shift” its stock basis from E&P deficit foreign corporations to DFICs. That “shifting” occurs by increasing the shareholder’s stock basis in a DFIC by the DFIC’s § 965(b) PTI,²⁰ and reducing the shareholder’s stock basis in an E&P deficit foreign corporation by the deficit foreign corporation’s specified E&P deficit.²¹ The final § 965 regulations also allow taxpayers to elect, in the alternative, for limited basis increases, and reductions, under § 1.965-2(f)(2)(ii)(A)(2) and § 1.965-2(f)(2)(ii)(B)(2), respectively. Subclause 1.965-2(f)(2)(ii)(B)(2) provides that if a U.S. shareholder applies § 1.965-2(f)(2)(ii)(A)(2) to limit increases to its basis in DFICs, reductions to the taxpayer’s stock basis in a deficit corporation may not exceed the stock basis. The preamble to the final § 965 regulations explains that “it is appropriate to not require downward basis adjustments in excess of basis (in order to avoid gain recognition under § 1.965-2(h)(3) to the extent of such excess) if the corresponding upward basis adjustments are correspondingly limited.”²²

We recommend Treasury clarify that § 1.965-2(f)(2)(ii)(B)(2) would apply to limit basis reductions in a deemed election under Prop. § 1.861-12(c)(2)(i)(B)(7)(ii). Because Prop. § 1.861-12(c)(2)(i)(B)(1)(ii) excludes basis increases under § 1.965-2(f)(2)(ii)(A), it would appear that § 1.965-2(f)(2)(ii)(B)(2) technically doesn’t apply in a deemed election because the taxpayer hasn’t applied (or can’t apply) § 1,965-2(f)(2)(ii)(A)(2). We believe, however, that the exclusion of basis increases under Prop. § 1.861-12(c)(2)(i)(B)(1)(ii), in effect, is a limitation on basis increases within § 1.965-2(f)(2)(ii)(A)(2), and therefore § 1.965-2(f)(2)(ii)(B)(2) should apply to a deemed election.

We also believe that without a limitation on basis reductions, there could be situations in a deemed election in which a deficit foreign corporation’s stock basis could be reduced below zero — e.g., if the deficit foreign corporation’s specified E&P deficit exceeds its stock basis. It’s unclear how such a reduction in excess of stock basis would affect expense apportionment rules,²³ other than it would preclude apportionment of expenses to stock whose basis has been reduced to zero. It’s therefore sensible that basis reductions under a deemed election shouldn’t exceed stock basis.

F. Prop. §§ 1.960-2(b)(2) and 1.960-2(c)(4) should be modified to account for potential timing distortions in crediting current-year taxes

Prop. § 1.960-2(b)(l) generally provides that a U.S. shareholder is deemed to have paid its CFC’s foreign income taxes to the extent those taxes are properly attributable to subpart F income of the CFC included by the U.S. shareholder. The current-year taxes rule in Prop. § 1.960-2(b)(2) provides that only current-year foreign taxes of the CFC are considered properly attributable to an item of income of the CFC. Prop. § 1.960-2(c)(4) gives a similar rule attributing only current-year foreign taxes to tested income.

The current-year taxes rule could create timing distortions that prevent crediting of foreign taxes arising in a tax year different from an income inclusion year. Consider, for example, a U.S. shareholder with a June 30 taxable year-end, and a CFC with a December 31 year-end. The CFC earns subpart F income on June 30, 2018, and accrues foreign income taxes on the income on December 31, 2018. The CFC has no other subpart F income. The subpart F income is included in the U.S. shareholder’s FY2018 gross income, but the foreign taxes are considered paid in FY2019. Under the current-year taxes rule, the U.S. shareholder wouldn’t be able to credit the foreign taxes against its FY2018 taxes because the foreign taxes aren’t current-year taxes — they’re paid in FY2019. The U.S. shareholder also wouldn’t be able to credit the foreign taxes against its FY2019 taxes because it has no subpart F income inclusions in FY2019.

We recommend Treasury introduce rules to mitigate timing distortions caused by the current-year taxes rule. For example, a rule could allow for a one-year carryforward or carryback of foreign taxes so that they can be properly attributed to CFC income included by a U.S. shareholder in its gross income in a prior or subsequent tax year,

G. The rule in Prop. § 1.78-1 denying application of the § 245A DRD to the § 78 gross-up deemed dividend for tax years of fiscal taxpayers beginning before January 1,2018 is contrary to the TCJA and should be withdrawn

Prop. § 1.78-1 (a) provides in part that “[a] section 78 dividend is treated as a dividend for all purposes of the Code, except that it is not treated as a dividend for purposes of section 245 or 245A,. . . .” Regarding applicability, Prop. § 1.78-1

(c) states that — although in general Prop. § 1.78-1 applies to taxable years of foreign corporations beginning after December 31,2017 — the quoted provision from Prop. § 1.78-l(a) “also applies to section 78 dividends that are received after December 31,2017, by reason of taxes deemed paid under [§ 960(a)] with respect to a taxable year of a foreign corporation beginning before January 1, 2018.”

The Prop. § 1.78-1(a) rollback — to § 78 dividends received after December 31, 2017 — of non-treatment of a § 78 dividend as a dividend for purposes of § 245A is, of course, contrary to the plain language of the TJCA. Subsection 14301(c) of the TCJA amended § 78 so that, if its requirements are met, a § 78 dividend “shall be treated for all purposes of [the Code] (other than sections 245 and 245A) as a dividend received by such domestic corporation from the domestic corporation.” But § 14301(d) is quite clear that the. . . . amendment to § 78 “shall apply to taxable years of foreign corporations beginning after December 31, 2017 . . .” Fiscal year taxpayers thus have a period from January 1, 2018 until the end of the taxable year during which TCJA-modified § 78 doesn’t apply, but the old § 78 does, and so does new § 245A. Old § 78 provided that a deemed § 78 dividend would be treated for all purposes of the Code (other than § 245) as a dividend. The plain language of the TCJA is thus clear that a § 78 dividend received during such period is treated as a dividend under old § 78, and thus is eligible for the § 245A DRD. Courts aren’t free, nor are Treasury or the IRS, to ignore unambiguous statutory language.²⁴

Congress can of course enact new legislation and rollback the carve-out from § 245A dividend treatment for the § 78 deemed dividend. That Congressional action would be needed to accomplish this is signaled in the Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18), December 2018.²⁵ And in the House Ways and Means Committee Chairman’s discussion draft Tax Technical and Clerical Corrections Act Chairman Brady proposed just such rollback action.²⁶

We accordingly recommend the rule in Prop. § 1.78-1 denying application of the § 245A deduction to the § 78 deemed dividend in the gap period be withdrawn. This can be done simply by removing the above-quoted timing language from Prop. § 1.78-1 (c).

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Appendix — SVTDG Membership

Accenture

Activision Blizzard

Adobe

Agilent

Airbnb

Amazon

AMD

Ancestry.com

Apple

Applied Materials

Aptiv

Arista

Atlassian

Autodesk

Bio-Rad Laboratories

BMC Software

Broadcom Limited

Cadence

CDK Global

Chegg, Inc,

Cisco Systems Inc.

Crowdstrike, Inc.

Dell

DocuSign

Dolby Laboratories, Inc.

Dropbox Inc.

eBay

Electronic Arts

Expedia, Inc.

Facebook

FireEye

Fitbit, Inc.

Flex

Fortinet

Genentech

Genesys

Genomic Health

Gilead Sciences, Inc.

GitHub

GLOBALFOUNDRIES

GlobalLogic

Google Inc.

GoPro

Grail, Inc.

Guidewire

Hewlett-Packard Enterprise

HP Inc.

Indeed.com

Informatica

Ingram Micro, Inc.

Integrated Device Technology

Intel

Intuit Inc.

Intuitive Surgical

Keysight Technologies

KLA-Tencor Corporation

Lam Research

LiveRamp

Marvell

Maxim Integrated

MaxLinear

Mentor Graphics

Microsoft

NetApp, Inc.

Netflix

NVIDIA

Oracle Corporation

Palo Alto Networks

PayPal

Pivotal Software, Inc.

Pure Storage

Qualcomm

Red Hat Inc.

Ripple Labs, Inc.

Rubrik

salesforce.com

Sanmina-SCI Corporation

Seagate Technology

ServiceNow

Snap, Inc.

Stripe

SurveyMonkey

Symantec Corporation

Synopsys, Inc.

The Cooper Companies

The Walt Disney Company

TiVo Corporation

Trimble, Inc.

Über Technologies

Velodyne LiDAR

Veritas

Verizon Media

Visa

VMware

Western Digital

Workday, Inc.

Xilinx, Inc.

Yelp