Rules on Dividends Received Deduction Don’t Pass Muster, Attorneys Say

June 25, 2019

Mr. David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220

Mr. Charles P. Rettig
Commissioner of Internal Revenue
1111 Constitution Avenue, N.W.
Washington, DC 20224

Mr. Lafayette G. “Chip” Harter III
Deputy Assistant Secretary International Tax Affairs
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220

Mr. William M. Paul
Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224

Mr. Douglas Poms
International Tax Counsel
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220

Ms. Kirsten Wielobob
Deputy Commissioner for Services and Enforcement.
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224

Re: Withdrawal of the Section 245A Temporary Regulations

Dear Sirs and Madam:

On June 14, 2019, Treasury and the Internal Revenue Service (the “IRS”) released temporary regulations under section 245A of the Internal Revenue Code of 1986, as amended, (the “Code”) that limit the dividend received deduction (“DRD”) available for certain dividends received from current or former controlled foreign corporations (“CFCs”), and also apply certain additional limitations on the applicability of the exception under section 954(c)(6) to foreign personal holding company income for certain dividends received by upper-tier CFCs from lower-tier CFCs, collectively referred to herein as the “Temporary Regulations.”¹ We respectfully request that Treasury and the IRS withdraw the Temporary Regulations in order to be more consistent with both the language of the statute and Congressional intent in enacting the territorial tax rules of section 245A. Furthermore, the Temporary Regulations have been issued in violation of the Administrative Procedures Act and/or will not be entitled to deference under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), even as recently applied by the Ninth Circuit in Altera Corporation v. Commissioner, No. 16-70496, No. 16-70497 (9^th Cir. 2019), given that the Temporary Regulations are not filling the interstices of the law, but rather are manifestly contrary to the statute as enacted by Congress.²

And when the last law was down, and the Devil turned 'round on you, where would you hide, Roper, the laws all being flat? . . . Yes, I'd give the Devil benefit of law, for my own safety's sake!³

Summary of Primary Arguments

In Public Law No. 115-97, Congress enacted a territorial system of taxation for foreign earnings and profits derived by specified 10 percent-owned foreign corporations, subject to two targeted anti-base erosion regimes of Subpart F (applicable to mobile types of passive income) and GILTI (applicable to low-taxed intangible income). If foreign earnings and profits are not subject to current taxation under either the Subpart F or GILTI regimes, a distribution of those foreign earnings and profits are entitled to the territorial regime of section 245A, except as specifically limited in section 245A. In the Temporary Regulations, however, Treasury and the IRS simply ignore the territorial tax system as enacted in Public Law No. 115-97 and appear, instead, to believe that the default rule should be full federal taxation (whether under Subpart F, GILTI or under the two newly created categories of “extraordinary” income) unless specifically exempt from federal taxation in situations provided for by Treasury and the IRS, not Congress. In addition, the Temporary Regulations were issued in violation of the notice and comment requirements of the Administrative Procedures Act.

Discussion

I. Background

At issue is the appropriate application of section 245A(a) to distributions received from “specified foreign corporations” (“SFCs”).⁴ Section 245A, as added to the Code by Public Law No. 115-97 (the so-called “Tax Cut and Jobs Act of 2017” or “TCJA”) and as described in the preamble to TD 9865, generally allows a domestic corporation a 100 percent DRD (the “section 245A deduction”) for the foreign-source portion of a dividend received after December 31, 2017, from a SFC, defined as a 10 percent-owned foreign corporation.⁵ The purpose of section 245A was to enact a “territorial” system of taxation in the United States, and to replace the foreign tax credit regime then provided by section 902.⁶ The House Report accompanying H.R. 1, explains that the reason to change the law to provide for a territorial tax system to the Code was as follows:

The Committee believes that the current tax system puts American workers and companies at a severe disadvantage to foreign workers and companies. This is primarily because the United States is one of the few industrialized countries with a worldwide system of taxation and has the highest corporate tax rate among OECD member countries. The worldwide system of taxation with deferral provides perverse incentives to keep funds offshore because dividends from foreign subsidiaries are not taxed until repatriated to the United States. The Committee believes that a territorial system with appropriate anti-base erosion safeguards, combined with a lower corporate tax rate, will make American workers and companies competitive again, and also will remove tax-driven incentives to keep funds offshore.⁷

In addition to competitiveness, the Senate Report accompanying H.R. 1, explains that the adoption of the territorial tax system was needed in order to “eliminate the 'lock-out' effect under current law, which means U.S. businesses avoid bringing their foreign earnings back into the United States to avoid the U.S. residual tax on those earnings.”⁸

In this regard, the Senate Report makes clear that the section 245A deduction was the key component of the new territorial system.⁹ Further, the legislative history to the enactment of section 245A indicates that Congress intends to have section 245A apply broadly to distributions of previously untaxed foreign earnings and profits. Specifically, the history states as follows:

The term “dividend received” is intended to be interpreted broadly, consistently with the meaning of the phrases “amount received as dividends” and “dividends received” under sections 243 and 245, respectively. For example, if a domestic corporation indirectly owns stock of a foreign corporation through a partnership and the domestic corporation would qualify for the participation DRD with respect to dividends from the foreign corporation if the domestic corporation owned such stock directly, the domestic corporation would be allowed a participation DRD with respect to its distributive share of the partnership's dividend from the foreign corporation.¹⁰

Simultaneously, and to limit the potential for base erosion in the new territorial system, Congress enacted one new anti-deferral regime for so-called global intangible low-tax income (or “GILTI”) under section 951A and expanded the then-existing Subpart F regime by modifying the definition of a “United States shareholder” under section 951(b) and by broadening the constructive attribution rules for establishing CFC status through the repeal of the limitation on downward attribution under section 958(b)(4). In addition, in order to partially pay for the new territorial or participation exemption system, Congress enacted as part of TCJA a one-time tax on the previously untaxed earnings and profits of CFCs as of no later than December 2017.

As noted above, the link between dividends formerly entitled to the indirect deemed paid foreign tax credit under section 902 and the exemption for like dividends from SFCs is inherent in what the Congress stated it intended to do in enacting the “territorial” alternative to full inclusion of worldwide income with foreign credit credits. The TCJA replaced a regime of worldwide taxation of a U.S. corporation, and an associated credit for foreign taxes on foreign source income of such U.S. corporation, that had governed U.S. business since 1918. The prior regime was replaced with a “territorial” regime whose fundamental characteristic is the exemption of foreign source income. As expressed by the tax writing committees of the 115^th Congress, section 245A was intended to level the playing field with the tax systems of our competitor trading partners that had adopted or planned to adopt a territorial exemption system for direct investment income. The rules were not an unprecedented paradigm for full worldwide taxation, under GILTI and Subpart F, with a limited role for territorial exclusion. Congress did not dream up a new unique exemption system without considering its prior knowledge and understanding of how exemption systems operate as an alternative to inclusion/credit systems. Congress has been regularly informed of that progression in this century by OECD¹¹ members from inclusion/credit to exemption.¹² It is disingenuous to disregard that history, the statutory text and the entire point of adopting a territorial system in order to justify creating a new paradigm (see Part III below) under which the United States will impose comprehensive current worldwide taxation, without a credit for deemed paid foreign taxes, and to provide only narrowly limited territorial exemptions for income (if) in excess of GILTI and subpart F income. To find such a paradigm structure, the Treasury and IRS must deliberately ignore what the members of Congress stated they intended in enacting section 245A and GILTI and in retaining and modifying Subpart F in 2017.

II. The “Literal” Problem

Notwithstanding its enactment by Congress in TCJA, and as signed into law by the President, in Treasury and the IRS's view that the application of the section 245A deduction in accordance with the statute results in income generated by SFCs that is not subject to appropriate levels of federal taxation.¹³ Instead of a territorial system with targeted anti-abuse regimes, in the Preamble to TD 9865, Treasury and the IRS assert that Congress in the TCJA created a comprehensive framework with respect to a CFC's foreign earnings. Specifically, on page 7 of the Preamble to TD 9865, Treasury and the IRS state as follows:

The statutory text of the participation exemption system under section 245A, the GILTI regime, the subpart F regime, and the PTEP rules collectively operate as a comprehensive framework with respect to a CFC's foreign earnings after the application of the transition tax under section 965. A central feature of this regime is that income derived by CFCs is eligible for the section 245A deduction only if the earnings being distributed have not been first subject to the subpart F or GILTI regimes.

And, again, on page 9 of the Preamble to TD 9865, Treasury and the IRS state as follows:

Section 245A is designed to operate residually, such that the section 245A deduction generally applies to any earnings of a CFC to the extent that they are not first subject to the subpart F regime, the GILTI regime, or the exclusions provided in section 245A(c)(3) (and were not subject to section 965). That is, the text of the subpart F and GILTI rules explicitly defines the types of income to which they apply, and section 245A applies to any remaining previously untaxed foreign earnings. Under ordinary circumstances, this formulation [of the comprehensive framework] works appropriately, as earnings are first subject to the subpart F or GILTI regimes before the determination of dividends to which section 245A could potentially apply. However, in certain atypical circumstances, a literal application of section 245A (read in isolation) could result in the section 245A deduction applying to earnings and profits of a CFC attributable to the types of income addressed by the subpart F or GILTI regimes — the specific types of earnings that Congress described as presenting base erosion concerns. These circumstances arise when a CFC's fiscal year results in a mismatch between the effective date for GILTI and the final measurement date under section 965 or involve unanticipated interactions between section 245A and the rules for allocating subpart F income and GILTI when there is a change in ownership of a CFC. Moreover, the Treasury Department and the IRS are aware that some taxpayers are undertaking transactions with a view to eliminating current or future taxation of all foreign earnings of a CFC, including earnings attributable to base erosion-type income, by structuring into these situations. These transactions have the potential to substantially undermine the anti-base erosion framework for post-2017 foreign earnings. (Emphasis added.)

Thus, Treasury and the IRS perceive that there is a potential to avoid federal taxation on certain types of previously untaxed foreign earnings and profits derived by CFCs as a result of the literal, i.e., the plain reading of the statute as enacted into law. In their view, this perceived “comprehensive framework” is akin to a triangle made up on one side by the section 245A deduction, and two anti-base erosion sides, one an expanded Subpart F regime and another the GILTI regime. The Treasury and the IRS then appear to use the Temporary Regulations to apply a muddled Pythagorean principle to the effect that the purposes of the two anti-base erosions sides should inform the application of the section 245A deduction side of the triangle. But this is not supported by the separate statutory regimes enacted in TCJA or by their legislative histories.

Even if, contrary to their legislative histories, an enactment of a unique sui generis comprehensive framework is assumed, the 'solution' put forth by the Temporary Regulations is not to provide appropriate or reasonable interpretations of the base erosion regimes of Subpart F and GILTI to reach their perceived categories of undertaxed foreign earnings, but an interpretation of section 245A that results in the cutback in previously untaxed foreign earnings and profits that are entitled to the territorial rules of section 245A. It is patently unclear how 'residual' earnings and profits can be overstated, unless Treasury and the IRS are substituting their judgement for Congress' judgment on what earnings and profits should be entitled to the territorial system of section 245A because of what Treasury and the IRS call the unanticipated interactions of those separate tax regimes.¹⁴

In this regard, Treasury and the IRS admit that they lack authority to interpret or otherwise modify the base erosion regimes of Subpart F and GILTI¹⁵ and, therefore, utilize their limited authority under section 245A(g) to split 'residual' earnings and profits in order to create two new categories of previously untaxed foreign earnings and profits.¹⁶ Section 245A(g) provides as follows:

Regulations. — The Secretary shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section, including regulations for the treatment of United States shareholders owning stock of a specified 10 percent owned foreign corporation through a partnership.

It is clear that this grant of authority is not broad enough to create new categories of previously untaxed foreign earnings and profits that will be subject to full federal taxation (without the benefit of deemed paid foreign tax credits as further described below) or even to redefine previously untaxed foreign earnings and profits as the 'residual' earnings of a SFC. Instead, such authority was merely to be used to clarify what would or would not constitute the “receipt” of a dividend¹⁷ in respect to distributions of previously untaxed foreign earnings and profits of a SFC. Thus, this use of the limited authority under section 245A(g) to support the Temporary Regulations was clearly not anticipated by Congress when it established the new territorial system of section 245A.

Moreover, even if Congress had intended to grant effective authority to override the statute itself, such a grant would have been invalid. There is also no hint that Congress intended Treasury and the IRS to find in section 245A(g) the capacity to redefine the paradigm that it seems to think Congress tried, but failed, achieve. Nevertheless, in the Temporary Regulations (as further discussed in Part III below) an imaginary new overarching structure is invoked to find an unwritten statutory mandate to achieve maximum taxation of income from cross border trade and investment. Again, this new paradigm may be just what the country needs in these perilous times, but such fundamental changes in tax law are reserved for the Congress and not the Executive Branch (however well-intentioned its staff may be).

III. Creation of New Categories of Residual Foreign Earnings and Profits

The Temporary Regulations create two new categories of previously untaxed foreign earnings and profits that are not entitled to the section 245A deduction when distributed. These earnings and profits are either derived in “extraordinary disposition” transactions or “extraordinary reduction” transactions, as follows:

In general, the ineligible amount is the sum of (i) 50 percent of the portion of a dividend attributable to certain earnings and profits resulting from transactions between related parties during a period after the measurement date under section 965(a)(2) and in which the SFC was a CFC but during which section 951A did not apply to it (referred to as the “extraordinary disposition amount”) and (ii) the portion of a dividend attributable to certain earnings and profits generated during any taxable year ending after December 31, 2017, in which the domestic corporation reduces its ownership of the CFC (referred to as the “extraordinary reduction amount”).¹⁸

Again, instead of interpreting such extraordinary amounts as being subject to either the Subpart F rules or GILTI, the Temporary Regulations find these pools to be 'intended' (but unmentioned) categories of 'residual' income not entitled to the section 245A deduction.

As discussed in Part I above, section 245A is the centerpiece (“key”) of the territorial system enacted by Congress to make American workers and companies competitive with foreign workers and companies based in jurisdictions with territorial or participation exemption systems. Further, as enacted, Congress intended a broad territorial tax system with appropriate anti-base erosion provisions. However, as interpreted by Treasury and the IRS, the apparent intent was the enactment of a comprehensive framework to provide for full inclusion, with only limited pockets of exempt foreign earnings — i.e., an end to deferral for practically all earnings derived by a CFC. This is exactly opposite to what Congress actually enacted. The Temporary Regulations are simply enacting by regulation the occasionally proposed and invariably-rejected end-of-deferral and full-inclusion regimes from prior Congresses, including when the Subpart F regime was enacted in 1962,¹⁹ as well as more recently by the 115^th Congress itself,²⁰ and from prior presidential administrations.²¹

In addition, permitting distributions of previously untaxed foreign earnings and profits arising from “extraordinary dispositions” and “extraordinary reduction” transactions as defined in the Temporary Regulations to qualify for the 100 percent DRD of section 245A(a) is not some sort of “miss” by Congress, but should be instead viewed as squarely within the intended scope of the section 245A(a) deduction rule in order to maintain the competitiveness of American workers and companies that was the focus of Congress. In this regard, it should be noted that the territorial or participation exemption of our “competitor” countries (such as the United Kingdom, Netherlands, and Luxembourg) are specifically designed to provide a full participation exemption from taxation for distributions and gains arising on asset dispositions and stock sales, which are essentially equivalent to the “extraordinary dispositions” and “extraordinary reduction” transactions of the Temporary Regulations. For those “competitor” countries (such as the France and Germany) that only provide a partial participation exemption from taxation for distributions and gains arising on asset dispositions and stock sales (e.g., 88 percent deduction in France and 95 percent deduction in Germany), the residual taxation is a matter of the statutory regimes themselves, rather than a regulatory interpretation that residual taxation should override a full participation exemption regime. Finally, even in Canada, which has a CFC regime applicable to foreign accrual property income (“FAPI”) that is comparable to the U.S. Subpart F regime, distributions of income arising from “extraordinary dispositions” and stock gains in “extraordinary reduction” transactions that are attributable to the so-called exempt surplus (i.e., non-FAPI earnings) of the CFCs are exempt from residual Canadian tax; in this regard it is noted that Canada's exempting from taxation those gains arising on stock sales to the extent of underlying exempt surplus is comparable to Congress' specific treatment of gains recast as dividends under section 964(e)(4) and section 1248(a) (as further discussed below) as being entitled to the section 245A deduction.

In addition to the competitive concerns, Treasury and the IRS's treatment of distributions of certain previously untaxed foreign earnings and profits as subject to full federal tax will result in those earnings remaining offshore in the hands of the CFCs. This will cause the Treasury Regulations to have a lock-out effect, negating one of the primary stated reasons for the adoption of the territorial tax system in 2017.²²

Thus, because the regulatory regime contemplated by Treasury and the IRS is so unlike any territorial or participation exemption regime of any competitor country and will have a lock-out effect, the onus must be on Treasury and the IRS to show that the intended scope of the territorial system created by TCJA was not what Congress specifically stated, and that Treasury and the IRS's regulatory rewrite of the statute will still enable American workers and companies to compete in the international marketplace, while removing the lock-out effect of foreign earnings of CFCs.

The new paradigm of the Treasury Regulations may be a crowning intellectual achievement that will ensure fairness and better wealth distribution in the 21^st century, but it is a paradigm that must be first vetted and accepted by the Congress. It is entirely inappropriate to spring it on the public as a done deal without any opportunity for comment or correction, with 18 months retroactive effect that precludes compliance by the public during the period December 29, 2017 to June 2019. Pious recitals of consideration of authority to make the new paradigm work seem now to have been designed to entrap the unwary.

It is even more of a distortion to invoke this newly minted paradigm as justification to correct the perceived shortcomings of the statutory text. But that is indeed what the temporary regulations explicitly purport to do. The Preamble to TD 9865 specifically states:

Under ordinary circumstances, this formulation works appropriately, as earnings are first subject to the subpart F or GILTI regimes before the determination of dividends to which section 245A could potentially apply. However, in certain atypical circumstances, a literal application of section 245A (read in isolation) could result in the section 245A deduction applying to earnings and profits of a CFC attributable to the types of income addressed by the subpart F or GILTI regimes — the specific types of earnings that Congress described as presenting base erosion concerns.²³

Section 245A is clear. It does not require upending the entire framework of the exemption from tax for foreign source income derived by United States shareholders who own 10 percent or more of the stock of a foreign corporation. It does not require the creation of a whole new paradigm for the imposition of U.S. federal income tax on income from cross border trade and investment. Section 245A is the general rule in the TCJA amendments to the Code.

The Subpart F and GILTI regimes are exceptions to the general territoriality rule that Congress adopted to achieve solutions to problems that the Congress actually identified in its explanations of what it was enacting. Treasury and the IRS now assert that section 245A is not the general rule, but instead that the Subpart F and GILTI regimes are the general rule. It does so by inventing a whole new fundamental architecture to rationalize the need for emergency anti-abuse measures using words never before appearing in any materials produced by Congress. Under that newly created paradigm, the failure of Congress to adopt legislation to carry out that heretofore unidentified purpose, must be rectified by making the Subpart F and GILTI regimes the general rules and relegating section 245A to the narrow function of exempting dividends out of a CFC's QBAI from federal taxation.²⁴

The creation of new categories of income (or, in this case, earnings and profits) is not a new conceit of the Treasury and IRS in trying to find a remedy for some unanticipated consequence of applying the Code to facts. It is worth remembering, and learning from, the unfortunate history of Notice 98-11,²⁵ and its withdrawal by Notice 98-35²⁶ to enable Congress the opportunity to agree to the “fix” of the “problem” identified by the 1998 class of the tax policy staff of the Executive Branch. The problem then, and the problem now, is that the supposedly unanticipated application of the Code as enacted by Congress may well be acceptable to Congress when it makes the policy choices to balance competing considerations in international tax policy. The Treasury and the IRS at that time decided that the elective check-the-box regime had unanticipated consequences and settled upon creating an extra-statutory analog in foreign personal holding company income to the certain branch income provisions in section 954. Notice 98-11 stated:

As this arrangement creates income intended to be subpart F income which is not subject to subpart F in this case, the result of the arrangement is inconsistent with the policies and rules of subpart F.²⁷

The parallel is striking: Then as now staff of Treasury and the IRS decided that the words of the statute did not quite accomplish the policies and rules of Subpart F as they would wish. Now Subpart F has been joined by GILTI, so the class of 2019 has decided that the words of the statute (“a literal application”) will not carry out the policies that the staff have decided must have been driving the Congress to enact TCJA's international provisions.

The authority of the 1998 staff of Treasury and the IRS to amend the statute by regulations to deal with “hybrid branches” was not agreed by many members of the tax policy community, particularly those members of that community who were members of Congress,²⁸ and a consensus emerged that this sort of legislative problem solving should be performed, or at least overseen, by the body tasked with that function under the Constitution: the Congress.²⁹ Notice 98-35 was issued within approximately 6 months. It withdrew Notice 98-11 and issued proposed regulations, which were never finalized.

The Treasury and the IRS should again give the Congress the opportunity to agree or disagree with the paradigm of international taxation floated by the class of 2019 in Temp. Treas. Reg. § 1.245A-5T before subjecting taxpayers to it retroactively. The “problem” presented by hybrid branches was never addressed by making Treas. Reg. § 1.954-9 effective. Instead, Congress 19 years later, in the TCJA, enacted section 267A to address what Congress determined to be the relevant problem.

IV. The Creation of the Extraordinary Disposition Amount Category of Temp. Treas. Reg. § 1.245A-5T(c) Exceeds the Grant of Authority under Section 245A(g) and Section 965(o)

The creation of an extraordinary disposition amount under Temp. Treas. Reg. § 1.245A-5T(c) exceeds the grant of authority under section 245A(g) and section 965(o) because this category of 'residual' income has been created by Treasury and the IRS simply as a veiled attempt either to extend the statutorily fixed measurement date for the transition tax under section 965 or to accelerate the statutorily fixed effective date for the GILTI regime of section 951A.

The extraordinary disposition rules apply only to earnings and profits arising on certain dispositions of specified property (i.e., property that would give rise to “tested income” under section 951A) by an SFC to a related person during the disqualified period.³⁰ The term “disqualified period,” in turn, means, with respect to a SFC that is a CFC on any day during the taxable year that includes January 1, 2018, the period beginning on January 1, 2018 (i.e., the day immediately after the latest measurement date for earnings and profits subject to the transition tax of section 965), and ending as of the close of the taxable year of the SFC, if any, that begins before January 1, 2018, and ends after December 31, 2017 (i.e., the period ending immediately before the effective date of the GILTI regime).³¹ This special rule is further linked to this “gap” period between the application of section 965 and the effective date of section 951A through Treasury and the IRS's determination (dare we say interpretation) that this new category of previously untaxed foreign earnings and profits is to be subject to federal tax at 50 percent of the regular corporate tax rate. Specifically, on pages 14-15 of the Preamble to TD 9865, Treasury and the IRS state as follows:

The section 245A deduction is limited to 50 percent of the extraordinary disposition amount to reflect the fact that taxpayers generally would have been eligible for a deduction under either (i) section 250(a)(1)(B) had section 951A applied to the SFC during the disqualified period or (ii) section 965(c) had the net gain been subject to the transition tax under section 965.³²

It is hardly an interpretation of section 245A or the application of the limited authority of section 245A and section 965(o) for the Treasury and the IRS to impose a special tax rate applicable to a GILTI regime that is not yet applicable/effective to taxpayers subject to the extraordinary disposition rules or to view the 50 percent reduction as appropriate for a 'third' deemed measurement date for earnings and profits subject to the transition tax of section 965.³³ Congress could not have had the special extraordinary disposition rules of the Temporary Regulations in mind when it specifically made section 245A effective for all distributions made after December 31, 2017.³⁴ As the relevant measurement dates for the transition tax regime of section 965 and the effective date for the application of the GILTI regime were both parts of the statutory framework enacted by Congress in the TCJA (even as recognized by Treasury and the IRS), Congress could not be viewed as having misunderstood the relevant effective dates of the various pieces of the statutory rules. Thus, Treasury and the IRS have no authority under section 245A(g) to alter the statutory effective dates of provisions that are outside of section 245A. Thus, income arising from extraordinary dispositions during the “disqualified period” cannot be denied the section 245A(a) deduction.

V. The Creation of the Extraordinary Reduction Amount Category of Temp. Treas. Reg. § 1.245A-5T(e) Exceeds the Grant of Authority under Section 245A(g)

As defined in Temp. Treas. Reg. § 1.245A-5T(e)(2)(i)(A), in general, an extraordinary reduction occurs during a taxable year ending after December 31, 2017,³⁵ if either —

(1) a controlling section 245A shareholder transfers directly or indirectly more than 10 percent (by value) of the stock of the CFC that the controlling section 245A shareholder owned directly or indirectly as of the beginning of the taxable year, provided the change in ownership was at least 5 percent (by value) of the outstanding stock of the CFC as of the beginning of the taxable year; or

(2) the percentage of stock (by value) of the CFC that a controlling section 245A shareholder owns directly or indirectly as of the close of the last day of the taxable year is less than 90 percent of the percentage of stock (by value) that the controlling section 245A shareholder owned directly or indirectly as measured by reference to either the highest ownership interest during the taxable year or the ownership interest immediately prior to a transfer in the immediately preceding taxable year, provided the change in ownership was at least five percentage points.³⁶

Although self-evident from the language of the Temporary Regulations, the Preamble to TD 9865 shows that Treasury and the IRS apparently intend the extraordinary reduction rules to apply to both transfers and dilution of ownership interests by the controlling section 245A shareholder, including through transactions with both related persons and unrelated persons.³⁷

The creation of an extraordinary reduction amount under Temp. Treas. Reg. § 1.245A-5T(e) exceeds the grant of authority under section 245A(g) because (i) this type of income has been specifically addressed by Congress as being within the purview of section 245A, and (ii) the creation of this category of 'residual' income will lead to double taxation.

A. Congress has Specifically Addressed Extraordinary Reduction Transactions

Although the statutory rules enacted by Congress as part of TCJA are clear, Treasury and the IRS offer up their insight that those rules lead to unintended results. Specifically, on page 10 of the Preamble to TD 9865, it is stated as follows:

The Treasury Department and the IRS do not believe Congress intended section 245A to defeat the purposes of subpart F and GILTI regimes in these instances.

Once again, if Treasury and the IRS view the issue as an avoidance of the Subpart F and GILTI regimes, recourse should be to interpreting those anti-base erosion regimes, rather than cutting back what was intended to be the territorial regime of section 245A to provide a 100 percent DRD broadly to dividends of previously untaxed foreign earnings and profits distributed by SFCs. More importantly, as discussed in Parts I-III above, Treasury and the IRS have it backwards. TCJA created a territorial system of tax for foreign earnings and profits that was subject to targeted anti-abuse regimes applicable to mobile passive income (Subpart F) and low-tax intangible income (section 951A). The default rule is simple: a section 245A deduction for previously untaxed foreign earnings and profits distributed by a SFC.

Congress has specifically addressed income arising on “extraordinary reduction” transactions and concluded that such income “shall be” entitled to the deduction under section 245A(a). In this regard, it is important to recognize that the transactions that Treasury and the IRS have defined as giving rise to a “extraordinary reduction” are, in fact, the only ways in which a controlling section 245A shareholder can reduce its ownership in a CFC. Thus, these transactions are the “norm” and not some unusual, tax-motivated means for reducing ownership. Moreover, the normal means for reducing share ownership in a CFC are those transactions that are subject to gain recognition subject to the concurrently revised rules of section 964(e) and section 1248(j).

As part of TCJA, and to coordinate the stock gain recognition rules for CFCs with the territorial regime of section 245A, Congress enacted section 964(e)(4)(A) to provide as follows:

In general. — If, for any taxable year of a controlled foreign corporation beginning after December 31, 2017, any amount is treated as a dividend under paragraph (1) by reason of a sale or exchange by the controlled foreign corporation of stock in another foreign corporation held for 1 year or more, then, notwithstanding any other provision of this title —

(i) the foreign-source portion of such dividend shall be treated for purposes of section 951(a)(1)(A) as subpart F income of the selling controlled foreign corporation for such taxable year,

(ii) a United States shareholder with respect to the selling controlled foreign corporation shall include in gross income for the taxable year of the shareholder with or within which such taxable year of the controlled foreign corporation ends an amount equal to the shareholder's pro rata share (determined in the same manner as under section 951(a)(2)) of the amount treated as subpart F income under clause (i), and

(iii) the deduction under section 245A(a) shall be allowable to the United States shareholder with respect to the subpart F income included in gross income under clause (ii) in the same manner as if such subpart F income were a dividend received by the shareholder from the selling controlled foreign corporation.³⁸

Thus, the gain arising from the “extraordinary reduction” described in section 964(e)(4)(A) was not errantly excluded from the Subpart F regime as asserted by Treasury and the IRS, but was expressly made an item of subpart F income for which “the deduction under section 245A(a) shall be allowable.”³⁹ There is simply no room for Treasury and the IRS to apply its authority under section 245A(g) to exclude normal gains from the statutorily required 100 percent DRD of section 245A(a) as required by Congress and the Code.

Notwithstanding the clear intent of Congress, in the Preamble to TD 9865, Treasury and the IRS state as follows:

Thus, section 964(e)(4) presents the same concerns as direct dividends; absent a rule to the contrary, taxpayers might use section 964(e)(4) to avoid the results applicable to actual distributions from an upper-tier CFC to a U.S. shareholder or to constructive dividends under section 1248 that are addressed elsewhere by these temporary regulations. Therefore, the rules in these temporary regulations for determining eligibility for the section 245A deduction also apply to deemed dividends arising by reason of section 964(e)(4).⁴⁰

Once again, Treasury and the IRS attempt to revise history in order to revise the application of the anti-base erosion regimes, while ignoring not only the statutory treatment of such section 964(e)(4) gains as items of subpart F income but also the statutorily mandated treatment of those items of subpart F income as dividends for which the section 245A deduction shall apply.

This required application of section 245A(a) to gains described in section 964(e)(4)(A)(iii) is fully in accord with the legislative history to section 964(e)(4). The Conference Report to TCJA reflects that, if amounts are included under section 964(e)(4), “the deduction under section 245A(a) is allowable to the United States shareholder . . . in the same manner as if the subpart F income were a dividend received by the shareholder from the selling CFC,”⁴¹ which is in accordance with Congress' intent that the term “dividend received” for purposes of section 245A is to be broadly interpreted.⁴²

In addition to income arising on “extraordinary reduction” transactions subject to section 964(e)(4), Congress has similarly concluded that income arising on “extraordinary reduction” transactions that are subject to section 1248 “shall be” entitled to the section 245A deduction. As part of TCJA, and to coordinate the stock gain recognition rules of section 1248 with the territorial regime of section 245A, Congress enacted section 1248(j) to provide as follows:

Coordination with dividends received deduction. — In the case of the sale or exchange by a domestic corporation of stock in a foreign corporation held for 1 year or more, any amount received by the domestic corporation which is treated as a dividend by reason of this section shall be treated as a dividend for purposes of applying section 245A.⁴³

As all income arising on sales of CFC stock (other than a de minimis sale) by a controlling section 245A shareholder would be an “extraordinary reduction” transaction (as defined in the Temporary Regulations) that are subject to section 1248(a), the enactment of section 1248(j) that statutorily requires the section 1248(a) amount be treated as a dividend for purposes of section 245A cannot be viewed as an 'oversight' or an unintended application of section 245A. Instead, it is clear that Congress intended that section 1248 earnings and profits subject to section 1248(a), which by definition are determined only after application of the Subpart F and GILTI regimes for the taxable year,⁴⁴ shall be entitled to the section 245A deduction and provided no authority to Treasury or the IRS to legislate otherwise.⁴⁵

It should be noted that Treasury and the IRS failed to even refer to section 1248(j) in the Preamble to TD 9865 or the regulatory text of Temp. Treas. Reg. § 1.245A-5T.

B. Creation of the Extraordinary Reduction Amount Category Will Give Rise to Excess Federal Taxation

Treasury and the IRS should not exercise its limited authority under section 245A(g) to create categories of previously untaxed foreign earnings and profits subject to double tax. Nowhere in the legislative history to TCJA is there any indication that Congress intended a category of previously untaxed foreign earnings and profits that would be subject to full federal tax without the availability of a foreign tax credit. Instead, the territorial system as enacted by Congress provides for subpart F income subject to full federal tax rates but with deemed paid foreign tax credits under section 960, GILTI income subject to half federal tax rates and with applicable deemed paid foreign tax credits under section 960 as reduced by section 960(d), and previously untaxed foreign earnings and profits entitled to the 100 percent DRD of section 245A. Congress has spoken on how taxpayers are to be taxed under this statutory framework.

Notwithstanding the apparent intent of Congress, Treasury and the IRS have created two new categories of 'residual' income applicable to an extraordinary disposition or an extraordinary reduction that are subject to full federal income tax. If it only stopped there, Treasury and the IRS would have overstepped its section 245A(g) authority, but they did not. Under the Temporary Regulations the new two new categories of 'residual' income can be subject to double tax, federal tax on double income, and federal tax on income economically derived by third persons as further explained below.

1. Federal Taxation of Income Economically Derived by Third Persons

As noted above, the definition of an extraordinary reduction transaction includes a transaction in which a controlling section 245A shareholder's stock interest in a CFC is diluted by more than 10 percent, regardless of whether the new investor is a related or unrelated person. It seems likely that no example of such a dilution transaction is provided in Temp. Treas. Reg. § 1.245A-5T(j) because the arbitrary nature of the rule to create fully taxable income would then become self-evident.

The application of the Temporary Regulations to a generic example of a “dilution” transaction may help to make this clear. Assume a calendar year CFC for which a controlling section 245A shareholder directly owns 100 percent of the CFC on January 1^st. On January 2^nd, a foreign, third-party, joint venture partner contributes its assets to the CFC in exchange for a 30 percent interest in the CFC. Pursuant to Temp. Treas. Reg. § 1.245A-5T(e)(2)(i) this dilution would result in an extraordinary reduction, and the controlling section 245A shareholder's pre-reduction pro rata share of subpart F income and GILTI for the taxable year would, in essence, be 30 percent of the CFC's subpart F income and GILTI for such year (i.e., inclusions at the end of year based on 100 percent pre-dilution ownership versus only 70 percent of post-dilution, actual ownership).⁴⁶ However, the incremental 30 percent of the CFC's subpart F income and GILTI for the taxable year is not the result of some nefarious avoidance of economic income by the controlling section 245A shareholder or even a change in the character or nature of earnings and profits of the CFC that are properly attributable to that shareholder. Instead, this 30 percent portion of the CFC's subpart F income and GILTI is directly attributable to the joint venture partner's contribution of income producing assets to the CFC in exchange for its 30 percent ownership interest. Thus, the extraordinary reduction rules result in converting an amount of the CFC's non-subpart F income and/or non-tested income into “tainted” earnings and profits; and, again, this converted amount will be equal to the 30 percent of the CFC's subpart F income and GILTI directly attributable to the joint venture partner. Upon a distribution of this “tainted” amount (in essence, the earnings and profits of attributable to the QBAI of the CFC would carry this taint) in the taxable year in which the extraordinary reduction occurs, the existing controlling section 245A shareholder will be subject to full federal tax, rather than being entitled to the 100 percent DRD of section 245A(a) as intended by Congress.

It is hard to imagine a more anti-competitive result. U. S. multinationals with CFCs will not be able to joint venture or combine their CFCs with foreign based multinationals without becoming subject to full federal tax on earnings and profits attributable to their joint venture partners. This disregards the Congressional intent behind the enactment of the territorial system in 2017.⁴⁷

2. Federal Taxation on Double Income

The interaction of the extraordinary reduction rules with the new section 954(c)(6) exclusion rules will lead to federal taxation on the same amount of income twice.⁴⁸ Specifically, the inclusion of subpart F income in the “extraordinary reduction amount” of Temp. Treas. Reg. § 1.245A-5T(f) effectively increases the denial of section 954(c)(6) treatment for amounts that would not qualify for section 954(c)(6) in any event (i.e., dividends paid out of subpart F earnings and profits), which will effectively double count the denial of section 954(c)(6) relief from subpart F income.

The Temp. Treas. Reg. § 1.245A-5T(j) examples fail to provide a scenario where the CFC has subpart F income. However, let us assume that CFC1 owns CFC2, both calendar year taxpayers, and that CFC2 has $100 of subpart F income during the year and $50 of non-subpart F/non-tested income. CFC2 makes a $150 distribution to CFC1 in March, and CFC2 is sold by CFC1 to an unrelated U.S. buyer at no gain or loss mid-way through the taxable year. The $100 and $50 are the only income items of CFC2. In this situation, the U.S. buyer will have a $50 subpart F inclusion (i.e., $100 less $50 under section 951(a)(2)(B) (which is the lesser of $150 of dividends and the amount of subpart F income ($100) multiplied by the number of days that U.S. buyer did not own the stock over the number of days in the year (50 percent)). CFC1 will also have $100 of subpart F income from the dividend, because the $100 of the $150 dividend is paid out of E&P from subpart F income. The $50 that might have qualified for section 954(c)(6) will be reduced by $50 under Temp. Treas. Reg. § 1.245A-5T(f) because CFC1's extraordinary reduction amount includes subpart F income of $100, multiplied by the pre-reduction ownership ratio of 100 percent, less the inclusion by U.S. buyer of $50. As a result, the Temporary Regulations will effectively result in double inclusion of the $100 of subpart F income.

3. Double Taxation of Income

The interaction of the Temporary Regulations with the repeal of the section 902 deemed paid foreign tax regime will lead to double taxation of the same income. In this regard, it is noted that Congress aligned the effective date for the section 245A deduction (i.e., effective for distributions after December 31, 2017)⁴⁹ with the repeal of the section 902 deemed paid foreign tax regime (i.e., effective for distributions after December 31, 2017), and (as discussed in Part I above) the shareholder entitled to a section 245A deduction upon receipt of a distribution is defined the same as a shareholder that would have been entitled to a deemed paid foreign tax credit prior to the repeal of section 902.⁵⁰ The legislative history to TCJA makes clear that once distributions of previously untaxed foreign earnings and profits were entitled to the 100 percent DRD, the policy basis and need for the deemed paid foreign tax credit regime of section 902 were no longer needed.

Uninterrupted since 1918, a deemed paid or indirect foreign tax credit regime has been a basic feature of the United States world-wide taxation system.⁵¹ Given this long standing policy of avoiding double taxation, as enshrined in our network of tax treaties, it is imperative that Treasury and the IRS show that Congress in enacting TCJA clearly intended that categories of previously untaxed foreign earnings and profits arising from “extraordinary disposition” or “extraordinary reduction” transactions (as defined in the Temporary Regulations) were intended to be subject to full federal taxation, without the benefit of a section 902 or 960 deemed paid foreign tax credit, before issuing “interpretive” regulations that have that result. In the case of “hybrid dividends”, Congressional intent is clearly reflected in the enactment of section 245A(e), which denies credit for even section 901 direct foreign taxes.⁵² No such intent to exclude from both deemed paid foreign tax credits and the 100 percent DRD of section 245A(a) for “extraordinary” income, including income described in section 964(e)(4) and section 1248(j), can be found in the legislative history to TCJA.

Instead, the legislative history to TCJA fully reflects Congress' understanding that the section 902 deemed paid foreign tax credit regime was no longer needed because the distribution of the pool of previously untaxed foreign earnings and profits were to be exempt from federal taxation as a result of the 100 percent DRD of new section 245A. The House Report accompanying H.R. 1, explains that the reason for the change in law to repeal section 902 as follows:

The Committee believes that a section 902 credit is not appropriate in a participation exemption system under which 100 percent of dividends received by certain domestic corporate shareholders of specified foreign corporations are exempt from U.S. taxation. To continue to offer section 902 credits for taxes deemed paid would result in a double benefit to the U.S. shareholder, by first allowing a dividend to be recognized in income with no U.S. tax liability associated therewith, and by further reducing existing U.S. tax liability with a credit for taxes paid on foreign source income. Rather, offering deemed paid foreign tax credits on a current year basis solely under section 960 reflects what the Committee believes to be a simpler and more appropriate application of the foreign tax credit regime in a 100 percent participation exemption system.⁵³

It is noted that the House's explanation for the repeal of section 902 was not modified by either the Senate version of the bill or in the Conference Report.⁵⁴

C. The Special Election of Temp. Treas. Reg. § 1.245A-5T(e)(3)

The plain finding is that Treasury and the IRS's concern is with respect to the scope of the anti-base erosion regimes of Subpart F and GILTI, which they have no authority to modify as they desire, rather than with respect to applying the 100 percent DRD of section 245A(a) as statutorily required, including by section 964(e)(4) and section 1248(j). This is reflected by the special election provided in Temp. Treas. Reg. § 1.245A-5T(e)(3). In lieu of being subject to the extraordinary reduction rules of Temp. Treas. Reg. § 1.245A-5T(e), a controlling section 245A shareholder can elect “to close the CFC's taxable year for all purposes of the Internal Revenue Code (and, therefore, as to all shareholders of the CFC) as of the end of the date on which the extraordinary reduction occurs.”⁵⁵ This election has the effect of accelerating the inclusion event for subpart F income and tested income and loss under section 951A to the date of the extraordinary reduction transaction, rather than on the last day of the taxable year in which the foreign corporation is a CFC as specified by section 951(a)(1) (with respect to subpart F income) and section 951A(e) (with respect to tested income and loss). The 'carrots' provided in exchange for making this extra-statutory special election include the following:

1. The special election will permit the electing shareholders to benefit from the deemed paid foreign tax credit regime of section 960,⁵⁶ and thereby avoid the double taxation otherwise imposed on extraordinary reduction amounts under the Temporary Regulations as discussed in Part V.B.3 above.

2. The special election will allow foreign taxes for the foreign taxable year of the CFC in which the extraordinary reduction transaction occurs to be allocated between the elected shorten taxable year and the remaining taxable year of the CFC,⁵⁷ even though the ability of a taxpayer to allocate foreign taxes across taxable years (as determined for U.S. federal tax purposes) of a foreign corporation has historically been denied by Treasury and the IRS.⁵⁸

3. The special election will enable taxpayers to claim the 50 percent deduction of section 250 for the portion of the extraordinary income treated as section 951A GILTI arising as a result the elected closing of the taxable year.

This special election demonstrates that the real concern of Treasury and the IRS is the statutorily mandated inclusions dates of section 951(a)(1) (with respect to subpart F income) and section 951A(e) (with respect to tested income and loss), rather than the scope for previously untaxed foreign earnings and profits otherwise entitled to the section 245A deduction. Treasury and the IRS's recourse, however, should be to request appropriate statutory changes from Congress, rather than to legislate and misuse their limited authority under section 245A(g).

It should be further noted that Treasury and the IRS have failed to cite any authority, under section 898 or otherwise, to permit a taxpayer to close by election the taxable year of a CFC and/or to allocate foreign taxes for purposes of section 960 between taxable years.

VI. Issuance of the Temporary Regulations is in Violation of the Administrative Procedures Act

Treasury and the IRS's issuance of the Temporary Regulations is in violation of the Administrative Procedures Act (the “APA”) because it has violated the notice and public comment requirements of the APA.

The Preamble to TD 9865 provides a summary explanation for why Treasury and the IRS believe that issuance of the Temporary Regulations satisfies, or otherwise qualifies for an exception from, the notice and public comment requirements of the APA. Specifically, pages 32-26 of the Preamble to the TD 9865 state in relevant part as follows:

The Treasury Department and the IRS are issuing these temporary regulations without prior notice and the opportunity for public comment pursuant to section 553(b)(3)(B) of the Administrative Procedure Act (the “APA”), which provides that advance notice and the opportunity for public comment are not required with respect to a rulemaking when an “agency for good cause finds (and incorporates the finding and a brief statement of reasons therefor in the rules issued) that notice and public procedure thereon are impracticable, unnecessary, or contrary to the public interest.” Under the “public interest” prong of 5 U.S.C. 553(b)(3)(B), the good cause exception appropriately applies where notice-and-comment would harm, defeat, or frustrate the public interest, rather than serving it. The Treasury Department and the IRS are similarly utilizing the good cause exception in section 553(d)(3) of the APA to issue these temporary regulations with an immediate effective date, rather than an effective date no earlier than 30 days after the date of publication.

. . . .

First, good cause exists with respect to these temporary regulations because any period for notice and comment, as well as a delayed effective date, would provide taxpayers with the opportunity to engage in the transactions to which these rules relate with confidence that they achieve the intended tax avoidance results absent the applicability of the regulations. The Treasury Department and the IRS are aware that taxpayers have considered engaging in the transactions described in these temporary regulations, but some may have been deterred from doing so because of uncertainty about the operation and interaction of the various provisions of the Act. By limiting the deduction under section 245A for these transactions, these temporary regulations remove that uncertainty and — if subjected to notice-and-comment and a delayed effective date — could embolden some taxpayers to engage in aggressive tax planning to take advantage of the unintended interactions among the Act's provisions, with the comfort that their actions were not subject to the rules of the temporary regulations during the period of notice and comment and before the regulations' effective date. . . .

The second reason for a finding of good cause arises from the fact that these temporary regulations, as applied retroactively, will affect taxable years of certain taxpayers ending in 2018. As a result, these regulations can apply to taxable years for which tax returns have been or may be due during a period of comment and delayed effectiveness. Deferring the effectiveness of the temporary regulations until after such a period could increase taxpayer compliance costs because certain taxpayers would only be able to come into compliance with the regulations by amending and refiling returns and paying additional taxes owed with interest.

Third, good cause is supported where a regulation is temporary, with public comment permitted and meaningfully considered before finalization of the temporary rule. . . . Comments are requested on all aspects of these rules, and specific comment requests contained in this preamble are incorporated by reference into the cross-referenced notice of proposed rulemaking. The Treasury Department and the IRS will consider all written comments properly and timely submitted when finalizing these temporary regulations.

Finally, these temporary regulations are part of an effort to implement the provisions of the Act, which effected sweeping and complex statutory changes to the international tax regime. In conjunction with developing and issuing these temporary regulations, the Treasury Department and the IRS have also been tasked with issuing regulations implementing the numerous provisions enacted or modified by the Act, along with attendant changes to forms and other sub-regulatory guidance and attention to the orderly administration of the U.S. tax system.

Good cause exists for the issuance of temporary regulations relating to the transactions affected by these temporary regulations partially because of the statutory deadline in section 7805(b)(2), which provides (among other rules) that a regulation may be applied retroactively if it is issued within 18 months of the date of enactment of the statutory provision to which it relates. The rules in these temporary regulations relate to sections 245A, 951A, and 965, which were enacted as part of the Act on December 22, 2017. Thus, to qualify for retroactivity under section 7805(b)(2), a regulation retroactive to the enactment of these provisions must be effective no later than June 22, 2019. These temporary regulations need to apply retroactively from the date of the underlying statutory provisions to ensure that the international tax regime enacted by Congress in the Act, and its interaction with existing tax rules, functions correctly for all affected periods. Retroactivity is also required to prevent treating taxpayers comparatively advantageously if they have engaged in the types of transactions described in these temporary regulations prior to the issuance date of these temporary regulations.

Each of these four reasons and explanations are addressed below.

In addition, it is important to keep in mind the actual language of this good cause exception to the notice-and-comment requirement of the APA, which is as follows:

Except when notice or hearing is required by statute, this subsection does not apply —. . . .

(B) when the agency for good cause finds (and incorporates the finding and a brief statement of reasons therefor in the rules issued) that notice and public procedure thereon are impracticable, unnecessary, or contrary to the public interest.⁵⁹

A. A Notice and Comment Period Would Not Facilitate Tax Planning

Treasury and the IRS's purported first reason is that “any period for notice and comment, as well as a delayed effective date, would provide taxpayers with the opportunity to engage in the transactions to which these rules relate with confidence that they achieve the intended tax avoidance results absent the applicability of the regulations.”⁶⁰ This explanation is shocking. Treasury and the IRS regularly issue Notices announcing that future regulations will include specific anti-abuse rules to address perceived tax planning by taxpayers. In fact, Treasury and the IRS have issued several Notices during 2018 and 2019 to address perceived tax planning arising from statutory changes of TCJA, with the effective dates of those announced rules being retroactive to the relevant effective dates of the underlying provisions of TCJA.⁶¹ No such Notice was issued to provide taxpayers with notice of the “extraordinary disposition” and “extraordinary reduction” transaction rules of the Temporary Regulations.

Moreover, Treasury and the IRS are not working from a clean slate on this issue. In Notice 2018-26, the Treasury and the IRS addressed the fact pattern of an “extraordinary reduction” transaction and appeared in fact to support the “literal” application of the statutory rules established in TCJA to that transaction, even though they now wish to dramatically alter that result through the Temporary Regulations. Specifically, in Section 3.04(a)(iv) of Notice 2018-26, Treasury and the IRS announced future regulations to be issued under the broad regulatory authority of section 965(o) to address certain perceived abuse transactions, including so-called pro-rata share transactions, as follows:

Application of the Anti-Avoidance Rule to Pro Rata Share Transactions

For purposes of applying the anti-avoidance rule, a pro rata share transaction is presumed to be undertaken with a principal purpose of reducing the section 965 liability of a United States shareholder. For this purpose, the term “pro rata share transaction” means a transfer of the stock of a specified foreign corporation to a United States shareholder of the specified foreign corporation or a person related to a United States shareholder of such specified foreign corporation if such transfer would, without regard to the anti-avoidance rule, (i) reduce such United States shareholder's pro rata share of the section 965(a) earnings amount of such specified foreign corporation if it is a DFIC; (ii) increase such United States shareholder's pro rata share of the specified E&P deficit of such specified foreign corporation if it is an E&P deficit foreign corporation; or (iii) reduce such United States shareholder's pro rata share of the cash position of such specified foreign corporation.

Notwithstanding the presumption described in the preceding paragraph, an internal group transaction will be treated per se as being undertaken with a principal purpose of reducing the section 965 tax liability of a United States shareholder for purposes of the anti-avoidance rule. For purposes of the preceding sentence, the term “internal group transaction” means a pro rata share transaction if, immediately before or after the transfer, the transferor of the stock of the specified foreign corporation and the transferee of such stock are members of an affiliated group in which the United States shareholder is a member. For this purpose, the term “affiliated group” has the meaning set forth in section 1504(a), determined without regard to paragraphs (1) through (8) of section 1504(b), and the term “members of an affiliated group” means entities included in the same affiliated group. For purposes of identifying an affiliated group and the members of such group, (i) each partner in a partnership, as determined without regard to clause (ii) of this sentence, is treated as holding its proportionate share of the stock held by the partnership, as determined under the rules and principles of sections 701 through 777, and (ii) if one or more members of an affiliated group own, in the aggregate, at least 80 percent of the interests in a partnership's capital or profits, the partnership will be treated as a corporation that is a member of the affiliated group.

Example. (i) Facts. FP, a foreign corporation, owns all of the stock of USP, a domestic corporation. USP owns all of the stock of FS, a foreign corporation. USP has held the stock of FS for more than one year. USP has a calendar year taxable year; FS's taxable year ends November 30. On January 2, 2018, USP transfers all of the stock of FS to FP in exchange for cash. On January 3, 2018, FS makes a distribution with respect to the stock transferred to FP. USP treats the transaction as a taxable sale of the FS stock and claims a dividend received deduction under section 245A with respect to its deemed dividend under section 1248(j) as a result of the sale. FS has post-1986 earnings and profits as of December 31, 2017, and no previously taxed income or effectively connected income for any previous taxable year.

(ii) Analysis. The transfer of the stock of FS is a pro rata share transaction because such transfer is to a person related to USP, and the transfer would, without regard to the anti-avoidance rule, reduce USP's pro rata share of FS's section 965(a) earnings amount. Because USP and FP are also members of an affiliated group within the meaning of this section 3.04(a)(iv), the transfer of the stock of FS is also an internal group transaction and is treated per se as being undertaken with a principal purpose of reducing the section 965 tax liability of USP. Accordingly, the transfer will be disregarded for purposes of determining USP's section 965 tax liability with the result that, among other things, USP's pro rata share of FS's section 965(a) earnings amount is determined as if USP owned (within the meaning of section 958(a) 100 percent of the stock of FS on the last day of FS's inclusion year and no other person received a distribution with respect to such stock during such year. See section 951(a)(2)(A) and (B).⁶²

The above quoted example describes an “extraordinary reduction” transaction now subject to Temp. Treas. Reg. § 1.245A-5T(e). Further, the “Facts” of the example clearly reflect the taxpayer's intent to claim the section 245A(a) deduction for the section 1248 amount in accordance with section 1248(j). If Treasury and the IRS thought that taxpayer's intended treatment was contrary to Congress' intent, they should have put taxpayers on notice in Notice 2018-26, rather than to imply that Treasury and the IRS's only recourse was limited to a special anti-avoidance rule under section 965 based on the broad grant of authority under section 965(o).⁶³

It should be further noted that Treasury and the IRS's guidance and exercise of proposed rulemaking under section 956 supports the “literal” scope for the application of section 245A to the distribution of previously untaxed foreign earnings and profits. Specifically, proposed regulations have been issued under section 956 to call-off the application of those rules when a distribution of the section 956 “applicable earnings” would otherwise qualify for the 100 percent DRD of section 245A (the “Section 956 Proposed Regulations”).⁶⁴ The Preamble to the Section 956 Proposed Regulations provides as follows:

Accordingly, the proposed regulations continue the Treasury Department and the IRS's longstanding practice of conforming the application of section 956 to its purpose. The proposed regulations exclude corporate U.S. shareholders from the application of section 956 to the extent necessary to maintain symmetry between the taxation of actual repatriations and the taxation of effective repatriations. In general, under section 245A and the proposed regulations, respectively, neither an actual dividend to a corporate U.S. shareholder, nor such a shareholder's amount determined under section 956, will result in additional U.S. tax.

No warnings or other guidance were provided in the Section 956 Proposed Regulations that taxpayers should expect to treat certain categories of “applicable earnings” as not entitled to the benefit of section 245A under future regulations for purposes of section 956.

B. Retroactivity of Temporary Regulations is Not Sufficient to Justify Failure of Notice and Comment

The Treasury and the IRS's purported second reason for a finding of good cause is that “these temporary regulations, as applied retroactively, will affect taxable years of certain taxpayers ending in 2018.”⁶⁵ However, all other guidance for applying retroactively to 2018 the remaining pieces of Treasury and the IRS's “comprehensive framework” under section 951A GILTI,⁶⁶ section 965 transition tax,⁶⁷ and section 960 deemed paid foreign tax credits⁶⁸ (as well as other guidance applicable to new regimes created by TCJA) have been able to go through the APA required notice and comment period. No explanation is provided why the Temporary Regulations are sui generis in this respect. Moreover, as discussed above, the relevant issue was well-known to Treasury and the IRS, at the latest, at the time of the issuance of Notice 2018-26 in April 2018.

It is conceivable that Treasury and the IRS might wish to introduce evidence in litigation to the effect that Treasury and IRS personnel had unofficially communicated to taxpayers their personal concerns with respect to the scope of previously untaxed foreign earnings and profits entitled to section 245A(a).⁶⁹ However, unofficial rumor-mill communications are not an accepted cure for the lack of authoritative notice as required under the APA.⁷⁰

C. Public Comment Would Potentially Not Be Meaningfully Considered Before Finalization

Treasury and the IRS's purported third reason for a finding of good cause is that the Temporary Regulations are “temporary” and that public comment is permitted and will be meaningfully considered before finalization of those temporary rules.⁷¹ However, as a practical matter it is highly likely there will not be an opportunity for taxpayers to make effective public comment for the meaningful consideration by Treasury and the IRS prior to finalization. Because the Temporary Regulations have been made retroactively effective for distributions after December 31, 2017, and the Temporary Regulations will not sunset until June 14, 2022,⁷² for many taxpayers it is quite possible that the statute of limitations will have run for distributions received after December 31, 2017 and during their taxable years ending in 2018 prior to the time Treasury and the IRS actually finalize the Temporary Regulations.⁷³ If Treasury and the IRS wish to rely on the ability that public comment will be meaningfully considered prior to finalization to avoid the notice-and-comment requirement of the APA, the Temporary Regulations must be withdrawn and reissued to be effective only on a prospective basis.

D. The Authority of Section 7805(b)(2) is Not Sufficient to Justify Failure of Notice and Comment

Treasury and the IRS's purported fourth reason for a finding of good cause is that the Temporary Regulations are, in part, issued under the authority of section 7805(b)(2), which provides that an interpretative regulation may be applied retroactively if it is issued within 18 months of the date of enactment of the statutory provision to which it relates.⁷⁴ However, as discussed in more detail in Parts I-V above, the Temporary Regulations are not merely interpretive rules for the applicable statutory territorial system enacted in TCJA. Instead, the Temporary Regulations create two new categories of previously untaxed foreign earnings and profits that are not entitled to the section 245A deduction. The Temporary Regulations are “legislative” and should be, at a minimum, made effective on a prospective basis if they are to be retained.

E. Conclusion — APA

Based on the above, and notwithstanding Treasury and the IRS's statements to the contrary, the Preamble to TD 9865 does not provide adequate analysis to determine that compliance with the notice-and-comment requirement of the APA would have been or will be impracticable, unnecessary, or contrary to the public interest. Thus, the Temporary Regulations must be withdrawn and Treasury and the IRS should, at a minimum, issue a Notice or proposed regulations describing future guidance under section 245A that will be prospective effectively in order to comply with the requirements of the APA.

VII. The Temporary Regulations Not Entitled to Deference Under Chevron

The Temporary Regulations are not entitled to deference under the Chevron standard as established by the Supreme Court and as recently applied by the Ninth Circuit.⁷⁵

In accordance with the Supreme Court's decision in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc.,⁷⁶ to give deference to the Treasury's regulatory interpretation, a court must first determine if “Congress has directly spoken to the precise question at issue” based on the plain statutory text, the legislative history, the statutory structure, and other traditional aids of statutory interpretation. Second, if a statute is silent or ambiguous, then a court will defer to the Treasury's regulatory interpretation provided it “is based on a permissible construction of the statute” and is not “arbitrary, capricious, or manifestly contrary to the statute.”⁷⁷ The Temporary Regulations fail under each of these requirements.

A. The Temporary Regulations are Contrary to the Plain Statutory Framework Established by Congress in TCJA

As discussed in detail in Parts I-V above, the Temporary Regulations are directly contrary to Congress' intent based on the plain statutory text, the legislative history, the statutory structure, and other traditional aids of statutory interpretation of the new section 245A 100 percent DRD rules. Specifically, as recognized by Treasury and the IRS, section 245A is part of the statutory rules that “literally” applies to distributions of previously untaxed earnings and profits of SFCs after December 31, 2017, inclusive of earnings and profits derived in “extraordinary” transactions. The earnings that are subject to the section 245A deduction are the previously untaxed foreign earnings and profits of SFCs. There is no indication in the legislative history to section 245A that Congress intended that Treasury and the IRS could create categories of such earnings and profits that would be subject to full federal taxation. This is confirmed by Congress' concurrent (i) repeal of the section 902 deemed paid foreign tax credit regime for distributions after December 31, 2017 and (ii) enactment of section 964(e)(4) and section 1248(j) to state that section 245A “shall” apply to the income defined to be “extraordinary” by Treasury and the IRS in the Temporary Regulations. Thus, because the Temporary Regulations are contrary to Congress' intent, the Temporary Regulations fail to satisfy the first requirement for deference under the Chevron standard.

B. The Temporary Regulations are Manifestly Contrary to the Statute

As discussed in detail in Parts I-V above, the Temporary Regulations are also manifestly contrary to the statute. As is self-evident by the “special election” of Temp. Treas. Reg. § 1.245A-5T(e)(3), Treasury and the IRS are actually concerned that the anti-base erosion regimes of Subpart F and GILTI are not sufficiently broad enough to subject defined pockets of foreign earnings and profits to federal tax, but that they have no authority to alter those statutory rules for extraordinary transactions.

Treasury and the IRS's attempt to substitute its determination for Congress' with respect to the determination of the type of previously untaxed foreign earnings and profits that are entitled to the 100 percent DRD, rather than to provide interpretative guidance under the Subpart F and GILTI regimes, is prima facie manifestly contrary to the statute as enacted by Congress. If the concern is that the statutory anti-base erosion regimes should be expanded, the remedy is to seek changes from Congress in the relevant statutory base erosion regimes or to issue regulatory guidance under those regimes, not to distort the limited regulatory authority of section 245A(g) to legislate through temporary regulations. Alternatively, Treasury and the IRS should convince Congress to amend the Code to create additional categories of foreign earnings based on their percepts of appropriate amounts that will be subject to full federal tax on a prospective basis, and even then Congress would be required to re-enact the section 902 deemed paid foreign tax credit rules for the new categories of previously untaxed foreign earnings and profits as requested by Treasury and the IRS.

In the guise of interpreting statutory provisions, Treasury and the IRS should not be permitted to legislate rules that are “literally” contrary to the Code. Based on the above discussion, for even believers in a multiverse, there is not a world in which the Temporary Regulations are not manifestly contrary to the statute as enacted by Congress. Thus, the Temporary Regulations fail to satisfy the second requirement for deference under the Chevron standard.

VIII. Overall Conclusion

Based on the above, in order to comply with the APA and recognizing that deference will not be accorded, the Temporary Regulations must be withdrawn by Treasury and the IRS in that the Temporary Regulations violate the APA and are manifestly contrary to the statute as enacted by Congress.

We appreciate your consideration of our comments.⁷⁸ We would be happy to discuss any questions you may have.

Sincerely,

Jeffrey M. O'Donnell

Robert H. Dilworth

Matthew A. Lykken

Washington, DC

CC:
Mr. Brent McIntosh
General Counsel
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220

Mr. Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224