Firm Offers R&E, Ad Expenses Proposal for Foreign Tax Credit Regs

February 24, 2020

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

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

Hon. Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Determination of Basis in Intangible Property for Purposes of Interest Expense Allocation and Apportionment

Dear Messrs Kautter, Rettig, and Desmond:

In the preamble to the recently proposed foreign credit tax regulations, REG-105495-19, December 2, 2019 (the "Proposed Regulations"), Treasury and the IRS requested comments on, among other issues:

[W]hether rules providing for the capitalization and amortization of certain expenses solely for purposes of § 1.861-9 may better reflect asset values under the tax book value method. For example, solely for purposes of § 1.861-9, research and experimental expenditures and advertising expenses could be treated as if they were capitalized and amortized.¹

This letter responds to the government's request for comments on this issue.

Treasury and the IRS already have taken important steps to coordinate the operation of preexisting interest expense allocation and apportionment principles with the statutory changes made as part of the 2017 tax reform legislation. Revising the asset valuation rules for purposes of Treas. Reg. sec. 1.861-9 to allow a taxpayer to take into account its investment in intangible property ("IP") in the form of previously deducted research and experimental ("R&E") and advertising expenditures would represent another useful measure in coordinating the preexisting allocation and apportionment principles with the post-2017 rules. This letter describes how such a proposal could work, as well as the regulatory authority to adopt the proposal.

Description of proposal

For purposes of applying the asset method of interest allocation and apportionment as required under section 864(e)(2), a U.S. group member's basis in IP could be adjusted to reflect certain costs incurred to develop the IP. In order to manage the complexity impact of the proposal, these adjustments should be elective on the taxpayer's part.

Specifically, R&E and advertising expenses that have been incurred and deducted within a certain reference period (such as the prior 15 years, using section 197 principles as a guide) could be capitalized into the adjusted basis of IP and then amortized on a straight-line basis, solely for purposes of applying the asset method of interest allocation and apportionment. This capitalized basis would be attributed to different types of U.S.-owned IP based on the sources and types of return earned by the U.S. group from the exploitation of its IP (discussed further below).

For these purposes, R&E expenditures could be defined by reference to the section 174 definition ("research or experimental expenditures which are paid or incurred by the taxpayer").

Advertising expenses could be defined as the amount reported as advertising expense on line 22 of Form 1120, or through the use of a simplified version of the definition used in section 3110 of H.R. 1 (2014) (the Camp tax reform bill), along the following lines:

[A]ny amount paid or incurred for the development, production, or placement (including any form of transmission, broadcast, publication, display, or distribution) of any communication to the general public (or portions thereof) which is intended to promote the taxpayer or a trade or business of the taxpayer (or any service, facility, or product provided pursuant to such trade or business).

The characterization of IP assets in turn should be determined based on existing principles in the regulations, under Treas. Reg. secs. 1.861-8T(c)(2) and -9T(g)(3), which characterize assets based on the source and type of income they generate, have generated, or may reasonably be expected to generate (and, if an asset generates more than one source or type of income, then the asset is dually characterized, pro rata by income yield).² This determination would focus entirely on the types of income earned by U.S. group members from their own transactions in directly exploiting or licensing out their own IP.³

The election, once made, could be binding on the taxpayer for 5 years, unless the Commissioner gives permission for an earlier change. In the event of an acquisition of one electing group by another, the acquiring group would succeed to the acquired group's capitalized basis under the proposal.

The proposal should be effective for all open taxable years of CFCs beginning after December 31, 2017, and taxable years of U.S. shareholders in which or with which such CFC taxable years end. Pre-effective-date expenditures and reference-period gross income would be taken into account for purposes of post-effective-date interest allocation and apportionment, as though the proposal had been in effect for the entire 15-year amortization period.

Authority for proposal

This proposal would be consistent with the longstanding fungibility-of-money principles on which the asset method is based, and well within Treasury's authority under sections 864(e)(7) and 7805(a).

The IRS set forth the principles underpinning the asset method several decades ago:

When the Congress mandated the use of the asset method, it referenced the principles that the IRS had under already established the regulations.⁵

R&E and advertising expenses constitute amounts of capital utilized or invested in the activity of developing IP, and in the IP itself. This use and investment of capital is supported by the taxpayer's borrowing. The fact that the cost recovery rules permit current deduction rather than capitalization of these amounts (in part to incentivize the associated business activities) does not alter this reality.

Thus, an adjustment to IP asset basis to reflect some reasonable period of IP development investments is consistent with the longstanding principles underpinning the asset method, and thus with section 864(e)(2) and (e)(7).

Elective basis adjustments of this nature for purposes of applying the asset method have some precedent, in the form of the alternative tax book value method provided under Treas. Reg. sec. 1.861-9(i) and -9T(g)(1)(ii) (allowing taxpayers to elect to determine the tax book value of certain tangible property using the alternative depreciation system under section 168(g), solely for expense apportionment purposes).

Practical effects of proposal

In the GILTI context, the proposal would have the effect of reducing allocation and apportionment of interest expense to GILTI in situations in which a company holds IP in the United States and is subject to U.S. tax on the premium return in the United States from exploiting the IP (e.g., through an intercompany license, or through product sales transactions). The proposal would not produce this effect to the extent that IP is beneficially owned by foreign affiliates.

The proposal should not be vulnerable to abuse, as the only way to "plan into" the benefits of the proposal would be to onshore IP to the United States. The use of a multi-year reference period also would make it difficult to achieve significant tax savings from year-to-year behavior changes.

* * * *

We appreciate the diligence of Treasury and the IRS in ensuring the appropriate coordination of the post-2017 tax reform rules with the relevant legacy rules of the prior-law system. We hope that you find our comments useful in that regard. Thank you very much for the opportunity to comment, and please let us know if you have any questions.

Respectfully Submitted,

David G. Noren
dnoren@mwe.com
(202) 756-8256

Damon M. Lyon
dlvon@mwe.com
(312) 984-7643

McDermott Will & Emery
Washington, DC

cc:
L.G. "Chip" Harter, Deputy Assistant Secretary (International Tax Affairs), U.S. Treasury Department
Douglas Poms, International Tax Counsel, U.S. Treasury Department
Jason Yen, Attorney-Advisor, U.S. Treasury Department
Peter Blessing, Associate Chief Counsel (International), Internal Revenue Service
Anne Devereaux, Deputy Associate Chief Counsel (International), Internal Revenue Service
Daniel McCall, Deputy Associate Chief Counsel (International-Technical), Internal Revenue Service

---

Appendix: Should a Capitalized Cost Approach Apply at the CFC Level as Well?

As discussed in the body of this letter, section 864(e)(2) now requires taxpayers to allocate and apportion interest expense based on the adjusted basis of their assets (as opposed to fair market value or gross income).

This in tum requires that the adjusted bases of all of a taxpayer's assets be (1) determined and (2) associated with the various relevant categories of U.S.-source and foreign-source income.⁶ The proposal set forth in this letter provides a method for measuring a U.S. group's investment in IP that is exploited from the United States, such that some of the U.S. group's interest expense would be treated as reducing the U.S. group's relevant income (likely to be some combination of U.S.-source income and foreign-source general-basket income, as opposed to GILTI) for section 904 purposes.

Another relevant kind of asset in the allocation and apportionment determination is CFC stock. Generally, CFC stock has been characterized (under Treas. Reg. sec. l.861-12T(c)(3)) by applying the general asset or modified gross income methods under Treas. Reg. sec. 1.861-9T(g) at the CFC level, with reference to the CFC's own assets (i.e., characterizing the CFC's assets based on the source and type of income they generate, have generated, or may reasonably be expected to generate).

In a typical case of a fairly profitable CFC generating mainly GILTI tested income, the CFC's stock should be treated as primarily a GILTI-generating asset, and thus any interest expense allocated and apportioned to such CFC stock should primarily reduce GILTI for section 904 purposes.

It could be argued that, if a capitalized cost approach makes sense to as applied the assets of U.S. members of a corporate group, a similar approach also should apply CFC at the level for purposes of determining characterization the of CFC stock for interest expense allocation and apportionment purposes.

For example, if a U.S. shareholder has an adjusted basis of $100 in the stock of CFC, and CFC has an adjusted basis of $20 in its property, plant, and equipment, then any interest expense attributed to the $100 of basis in the CFC stock reduces whatever sources and types of income those $20 of CFC assets are treated as generating noted As above, typically this would be primarily GILTI.

If CFC also would be treated as having $40 of capitalized advertising or R&E expense under the principles of this proposal, arguably the analysis should consider the sources and types of income generated at the CFC level by the CFC's $40 of IP as well, and not just its $20 of property, plant, and equipment. Again, typically this would be primarily GILTI, and thus adding this step to the analysis is unlikely to have much tax effect adding (while obviously some complexity).⁷

Adding this step to the analysis would seem to affect the tax outcome only in situations in which a CFC incurs capitalized IP expenditures under the proposal that by their nature relate disproportionately to specific categories of income (such as subpart F income), rather than being in proportion with CFC income. This could occur, for example, if heavy advertising or R&E investments are being made with a view to generating a new source or category of income that historically has been relatively minor for the CFC. In such a case, adding these capitalized IP development costs to the analysis could produce a significantly different result from that produced by looking solely at the income generated by the CFC's property, plant, and equipment. It is questionable that these situations would merit compounding the proposal's complexity for all taxpayers.