Trade Group Urges Withdrawal of Temporary DRD Regs

September 16, 2019

Mr. David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave., N.W.
Washington, D.C. 20220

Mr. Lafayette G. “Chip” Harter
Deputy Assistant Secretary for International Affairs Department of Treasury
1500 Pennsylvania Ave., N.W.
Washington, D.C. 20220

Mr. Charles Rettig
Commissioner
Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, D.C. 20224

Mr. William Paul
Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, D.C. 202224

Re: Withdrawal of the Section 245A Temporary Regulations [REG. 106282-18]

Dear Sirs:

On June 14, 2019, the Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) released Temporary Regulations under Section 245A (the “Temporary Section 245A Regulations”) of the Internal Revenue Code of 1986, as amended (the “Code”) that limited 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 (specifically, for certain dividends received by upper-tier CFCs from lower-tier CFCs).

We respectfully request that Treasury and the IRS withdraw the Temporary Section 245A Regulations and re-propose the regulations so as to be more consistent with the statute and Congressional intent in enacting the territorial tax rules of Section 245A. The NFTC also strongly believes that the Temporary Section 245A Regulations were issued in violation of the Administrative Procedures Act

The NFTC, organized in 1914, is an association of approximately 200 U.S. business enterprises engaged in all aspects of international trade and investment. Our membership covers the full spectrum of industrial, commercial, financial and service activities and the NFTC therefore seeks to foster an environment in which U.S. companies can be dynamic and effective competitors in the international business arena. The NFTC's emphasis is to encourage policies that will expand U.S. exports and enhance the competitiveness of U.S. companies by eliminating major tax inequities in the treatment of U.S. companies operating abroad. To achieve this goal, American businesses must be able to participate fully in business activities throughout the world, through the export of goods, services, technology, and entertainment and through direct investment in facilities abroad. Foreign trade is fundamental to the economic growth of U.S. companies.

We urge the Treasury and the Service to withdraw the regulations as discussed below.

I. Background

Congress specifically designed the international framework of the Tax Cuts and Jobs Act (“TCJA”) to increase U.S. economic competitiveness by transitioning the U.S. international tax system into a territorial system. That is, with the exception of certain identified base-eroding earnings, the U.S. would no longer tax the off-shore earnings of controlled foreign corporations (CFCs) owned by U.S. companies. As a result, U.S. companies would be able to bring those earnings back to the U.S. without incremental U.S. tax.

Congress utilized three key components to achieve its objectives:

Instead of a territorial system with targeted anti-abuse regimes, Treasury and the IRS assert that Congress in the TCJA created a comprehensive framework with respect to a CFCs foreign earnings.

In the preamble to the Temporary Section 245A Regulations, Treasury and the IRS state the following:

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 CFCs 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.

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

In this regard, the Senate Report makes clear that the section 245A deduction was the key component of the new territorial system. The legislative history of section 245A indicates that Congress intended to have section 245A apply broadly to distributions of previously untaxed foreign earnings and profits. The Conference Report to the TCJA states:

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.²

Contrary to the Temporary Regulations, Congress clearly intended for section 245A to be broadly applied, and set no restrictions on its application for fiscal year taxpayers.

II. Temporary Regulations Issues

Issue: Extraordinary Disposition and Extraordinary Reduction

Based on the Temporary Section 245A Regulations, it appears that Treasury and the IRS perceive that there is a potential to avoid U.S. taxation on certain types of previously untaxed foreign earnings and profits derived by CFCs as a result of their reading of the TCJA statute.

There are two key types of CFC earnings that Treasury and the IRS are seeking to tax under the Temporary Section 245A Regulations: (i) “extraordinary disposition” earnings generated after the section 965 measurement date, but before the effective date of the GILTI rules, and (ii) “extraordinary reduction” earnings “generated” by virtue of a U.S. shareholder's reduction in its ownership of the CFC.

Treasury and the IRS designed and promulgated the “extraordinary disposition” and “extraordinary reduction” rules because they perceived that Congress failed to draft the TCJA international provisions in the manner that they would have preferred, particularly as it pertains to the effective dates of the different elements of the new international regime implemented by the TCJA. Instead of characterizing such extraordinary amounts as being subject to either Subpart F rules or GILTI, the Temporary Section 245A Regulations find these pools of income to be “intended” (but unmentioned) categories of “residual” income not entitled to the benefits of the section 245A deduction. It is unclear how “residual earnings and profits” can be overstated unless Treasury and the IRS are substituting their judgement for Congress' judgement on what earnings and profits should be entitled to the territorial system section 245A because of what Treasury and the IRS call the unanticipated interactions of those separate tax regimes.

Indeed, permitting distributions of previously untaxed foreign earnings and profits arising from “extraordinary dispositions” and “extraordinary reduction” transactions (as defined in the Temporary Section 245A Regulations) to qualify for the 100 percent DRD of section 245A is not some sort of “miss” by Congress, but should be instead viewed as squarely within the scope of the section 245A deduction rule in order to maintain the competitiveness of American workers and companies — that was the focus of Congress' modification to our U.S. international tax system.

The creation of an extraordinary disposition under Temp. 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 an 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.

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.

Congress 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)).

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, 2017.³

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 cannot 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. As such, income arising from extraordinary dispositions during the “disqualified period” cannot be denied the section 245A(a) deduction.

Issue: CFC's Should Be Permitted the Section 245A DRD

The preamble to the Temporary Section 245A Regulations provides that: “[t]he Treasury Department and the IRS continue to study whether, and to what extent, proposed regulations should be issued that provide that dividends received by a CFC are eligible for a section 245A deduction.” The Temporary Section 245A Regulations do not provide any guidance on this specific issue, and we understand guidance will be forthcoming in a separate regulation package. The NFTC believes that, consistent with Congressional intent, a section 245A deduction should be permitted for a dividend received by a CFC from a lower tier specified owned foreign corporation (“SFC”).

The Conference Report makes clear that the intent of Congress was to apply the section 245A DRD to dividends received by CFCs from lower-tier SFC's, it states, “a CFC receiving a dividend from a 10-percent owned foreign corporation that constitutes Subpart F income may be eligible for the DRD with respect to such income.”⁴ The Conference Report elaborates that section 245A should be “interpreted broadly,”⁵ and includes a specific example applying Section 245A in a tiered ownership structure.⁶ Further, the statutory language of section 245A relies on the definition of “United States shareholder,”⁷ a defined term including both direct and indirect ownership in foreign corporations. Use of the term “United States shareholder” is indicative of the fact that section 245A is meant to apply indirectly to lower-tier dividends. Further, applying the section 245A DRD to dividend received by CFCs from lower-tier CFCs leads to the correct policy result, and avoids differing U.S tax treatment of dividends in flat and tiered structures. Treasury can resolve any ambiguity consistent with Congressional intent by issuing regulations stating that dividends received by CFCs from lower-tier SFCs that give rise to Subpart F income are allowed the Section 245A DRD. Treasury can exercise this authority by permitting the section 245A DRD at the CFC level or the United States shareholder level.

Statutory authority for issuing regulations is enumerated in Section 245A(g), “The Secretary shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section [. . .].” Treasury is also granted authority to issue regulations clarifying the calculation of earnings and profits of a foreign corporation for purposes of Subpart F in a similar manner to a domestic corporation.⁸ These two powerful, separate grants of authority permit Treasury to issue regulations allowing the Section 245A DRD to a CFC in the calculation of the CFC's Subpart F income. In the alternative, Treasury could issue regulations applying the section 245A DRD to the Subpart F inclusion at the level of the United States shareholder. The House Bill makes it clear Treasury is empowered with authority to treat a Subpart F inclusion triggered by a dividend received by a CFC from an SFC as a “dividend received” for purposes of Section 245A.⁹ Reading this clear grant of regulatory authority in conjunction with Section 245A(g) provides Treasury with the power to treat a Subpart F inclusion that is triggered by the payment of a dividend by an SFC to a CFC as a “dividend received” by the United States shareholder, and thereby, the Subpart F inclusion qualifies for the section 245A DRD.

We respectfully request that Treasury issue regulations clarifying that the Section 245A DRD applies to dividends received by a CFC from a lower-tier SFC that would otherwise be Subpart F income.

III. The Administrative Procedures Act

The NFTC believes that the Treasury and the IRS's issuance of the temporary regulations is in violation of the Administrative Procedures Act (the “APA”) because it violated the notice and public comment requirements of that act.

Subsection (b) of section 533 of the APA requires that agencies publish a notice of proposed rulemaking, allowing comment (subsection (c)), with an effective date no earlier than 30 days after the publication of the notice (subsection d)). The Temporary Section 245A Regulations were made effective retroactively back to December 31, 2017.

In the preamble to the Temporary Section 245A Regulations, Treasury and the IRS explain that no notice or public comment period was necessary under the “public interest” prong of 5 U.S.C. 553((b)(3)(B), and stated that the “good cause” exception applies where notice-and-comment would harm, defeat or frustrate public interest rather than serving it.

“Public interest” connotes a situation in which the interest of the public would be defeated by any requirement of advance notice. For example, an agency may contemplate the issuance of financial controls under such circumstances that advance notice of such rules would tend to defeat their purpose; in such circumstances the “public interest” might well justify the omission of the notice and public rulemaking.”¹⁰

The Congressional Research Service (CRS) has provided guidance on the interpretation of the “good cause” exception. In discussing the “good cause” exception, the CRS guidance states,

However, the “mere existence” of a deadline is usually insufficient to establish good cause. Courts have generally rejected good cause exemptions where agencies argue that statutory deadlines alone justify bypassing notice and comment procedures or the 30-day publication requirement. Instead, some “exigency” is required, independent of the deadline itself, where merits dispensing with Section 533's requirements. Importantly, courts have precluded efficiency goals and concerns for agency convenience from qualifying as exigencies.¹¹

Importantly, those cases concerning the existence of a deadline relate to explicit deadlines within the statutory framework. As mentioned previously, there is no deadline in section 245A. Indeed the statute is clear as to the effective date of 245A.

The second reason given by Treasury and the IRS for finding a good cause is that “these temporary regulations, as applied retroactively, will affect taxable years of certain taxpayers ending in 2018.”¹² However, all other guidance for applying retroactively to 2018, including the regulations under section 951A GILTI, section 965 transition tax, and section 960 deemed paid foreign tax credits went through the APA required notice and comment period. Not explanation is provided why the Temporary Regulations under section 245A are sui generis in this respect.

After the enactment of the TCJA, Treasury stated that it would not publish temporary regulations, but would provide proposed regulations for notice and comment. Indeed, following the passage of the TCJA, Treasury has published numerous proposed regulations apprising taxpayers of the government's interpretation of the TCJA so that taxpayers could plan accordingly. There is no reason why Treasury could not have published a proposed regulation subject to notice and comment.

In sum, the NFTC believes the Temporary Section 245A Regulations are contrary to the TCJA statute as enacted by Congress, that APA compliance has not been met, and, as such, should be withdrawn.

Again, thank you for the opportunity to provide these comments. Please do not hesitate to contact me should you have any questions on the above.

Sincerely,

Catherine G. Schultz
Vice President for Tax Policy
National Foreign Trade Council, Inc.
Washington, DC