Silicon Valley Group Finds Room for Improvement in FTC Regs

February 18, 2020

CC:PA:LPD:PR (REG–105495–19)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments on proposed regulations in REG–105495–19

Dear Sirs or Madams,

The Silicon Valley Tax Directors Group (“SVTDG”) hereby submits these comments on the above-referenced proposed regulations issued under §§ 861, 905, and 960 of the Internal Revenue Code of 1986, as amended, in REG–105495–19, 84 Fed. Reg. 69124 (December 17, 2019) (the “Proposed Regs”). SVTDG members are listed in the Appendix to this letter.

Sincerely,

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

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SVTDG comment letter on proposed regs in REG–105495–19

I. INTRODUCTION AND SUMMARY

A. Background on the Silicon Valley Tax Directors Group

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

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

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

[A] Prop. § 1.861-17, dealing with allocation and apportionment of R&E expenditures, should be modified

We make five recommendations relating to Prop. § 1.861-17. First, we recommend that Treasury and the IRS keep the existing optional gross income method for apportioning R&E expenditures. Second, we recommend that the “exclusive apportionment” rule in Prop. 1.861-17(c) should apply when § 250 is the operative section (i.e., not just when § 904 is the operative section). Third, we recommend that the sales-method exception in Prop. § 1.861-17(d)(4)(iv) for taking into account sales and services gross receipts of corporations in a CSA with the taxpayer should be modified in one of two alternative ways to address situations following termination of a CSA. Fourth, we recommend removal of the sales-method “presumption” that prior history of licensing or transferring intangibles to a controlled corporation means intention to license or transfer all similar intangible property created in future. Fifth, we recommend that the exclusive apportionment rule in Prop. § 1.861-17(c) be modified so that if U.S.-performed research and experimentation accounts for at least 50 percent of a taxpayer's R&E expenditures in a SIC code category, the taxpayer is allowed to elect out of the exclusive apportionment. Sixth, we recommend that the definition of “gross intangible income” in Prop. § 1.861-17(b)(2) be modified to exclude blanket inclusion of PCT Payments.

[B] Prop. §§ 1.861-20(d)(3)(ii)(B) and 1.960-1(d)(3)(ii)

We have two recommendations. First, we recommend that foreign gross income resulting from disregarded payments made between different foreign branches of the same foreign branch owner shouldn't be assigned to the residual income grouping under §§ 1.861-20(d)(2)(ii)(B) or 1.861-20(d)(3)(ii)(B) (resulting in loss of associated foreign tax credits). We propose a modification of the language in Prop. § 1.960-1(d)(3)(ii)(A) to accomplish this. Second, we recommend Prop. § 1.861-20(d)(3)(ii)(B) be changed to clarify that (1) it only applies to disregarded payments made to a foreign branch by a foreign branch owner acting in its capacity as an equity owner in the foreign branch, and (2) it doesn't apply in connection with disregarded payments reflected as deductions on the (possibly deemed) books and records of a home-office foreign branch.

[C] Prop. § 1.861-8(e)(4)(ii), relating to allocation and apportionment of stewardship expenses, should be modified to provide that stewardship expenses should be allocated and apportioned based on income

We recommend a two part allocation methodology for stewardship expenses. First, stewardship expenses that factually relate to a specific income producing subsidiary should be allocated to relevant income of such subsidiary. Second, if there's no direct factual relationship between the incurrence of the stewardship expense and underlying assets or income, such expenses should be allocated based on income of all subsidiaries. We also recommend that stewardship expenses be allocated based on income, not tax basis (as adjusted) of subsidiary stock.

For subsidiaries that are members of a consolidated group, we recommend clarifying that such subsidiaries be regarded as separate entities for purposes of allocating and apportioning stewardship expenses — such expenses can in fact be incurred with respect to such subsidiaries and should be respected.

[D] Prop. § 1.905-4(b), relating to notification in the event of a foreign tax redetermination, should be modified to provide more time for refiling, a filing alternative for certain taxpayers, and in certain cases no refiling should be required

We recommend that the due date for notifying the Secretary be extended by at least one year such that notification be required by the due date (with extensions) of the original return for the tax year immediately following the taxable year in which the foreign tax redetermination occurs. We recommended that redeterminations of foreign tax below an established threshold amount — we recommend $20 million (determined at the U.S. consolidated group level) — not require the refiling of a return, and that such adjustment be taken into account on the current return.

We recommend that redeterminations of foreign taxes that relate to taxable years of foreign corporations beginning before January 1, 2018 below an established threshold amount — we recommend $20 million — not require a redetermination or adjustment of § 965 liabilities.

We recommend that Prop. § 1.905-4(b)(1)(ii) (governing notification procedure in the event of an increase in the amount of U.S. tax liability as a result of a foreign tax redetermination) be modified to allow taxpayers that can avail themselves of Rev. Proc. 94-69 to appropriately notify the IRS when they make a Rev. Proc. 94-69 disclosure during an LB&I audit of the taxable year for which U.S. tax liability is so increased.

[E] Rules regarding effective dates should be modified to be effective on or after publication of the final regulations

We recommend the final regulations have an effective date for taxable years beginning on or after the date the final regulations are published in the Federal Register. In addition, we recommend that taxpayers be allowed to rely on the Proposed Regs for taxable years ending on or after December 17, 2019 (and before the effective date of the final regulations).

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

A. Recommendations relating to Prop. § 1.861-17, dealing with allocation and apportionment of R&E expenditures

1. The optional gross income method for apportioning residual R&E expenditures should be kept

a. The Proposed Regs eliminate the optional gross income method

The Proposed Regs eliminate the optional gross income methods in existing § 1.861-17(d) and require R&E expenditures in excess of the amount exclusively apportioned under Prop. § 1.861-17(b) to be apportioned among the statutory and residual groupings within the class of “gross intangible income” (“GII”) on the basis of the relative amounts of gross receipts from sales and services in each grouping.

The cited rationale in the preamble for eliminating the optional gross income method begins with an example assuming a taxpayer selling, in the U.S., products incorporating its intangible property, but earning royalties from licensing its intangible property used by others to make sales abroad.¹ The preamble states that comparing gross income from sales — which includes value attributable to other factors in addition to intangible property — to gross royalty income “will generally distort the extent to which the R&E expenditures produce U.S. and foreign source income from intangible property.”² The preamble asserts that use of the gross income method in situations like those in the example is inconsistent with the general principle under § 1.861-8T(c) that the method of apportionment “reflect to a reasonably close extent the factual relationship between the deduction and the grouping of gross income.”

b. The optional gross income method should be kept

The crux of the displeasure with use of the gross income method in the preamble example is that gross income from sales “includes value attributable to other factors in addition to intangible property.”³ The tacit assumption in the example is that all the intangible property at issue is created solely from the taxpayer's R&E expenditures. So the preamble is asserting that for R&E apportionment purposes treating sales and royalty gross incomes the same way doesn't give an apples-to-apples comparison of amounts reflecting the fruits of the taxpayer's R&E expenditures (i.e., intangibles created by the R&E expenditures).

But one can readily envision a realistic example in which the sales method similarly results in a distorted allocation. This will happen in any situation in which a taxpayer's CFC derives sales and services gross receipts using both intangibles licensed from the taxpayer and intangibles the CFC has itself developed or acquired. This situation is not uncommon. On such facts, using all of the CFC's gross receipts to apportion the taxpayer's R&E expenditures can result in a distortion no less egregious than that in the preamble example. Yet the preamble makes no mention of possible sales-method distortions, but rather levels criticism only at the gross income method. That is unfair.

The preamble recites the two constraints imposed on use of the gross income method⁴ — constraints that lessen the sort of distortion arising in the preamble example. Existing § 1.861-17 imposes no constraints addressing potential distortion under the sales method.⁵

We recommend that Treasury and the IRS keep the optional gross income method, with its two constraints. Neither method functions in all situations to produce a perfect factual relationship between R&E expenditures and the grouping of gross income to which the R&E expenditures are apportioned. But having two methods gives taxpayers some flexibility — on their facts — to avoid the greater distortion in R&E allocation. Having two methods also accommodates a wider range of intangible property deployment in the wake of restructuring as a consequence of the TCJA.

2. The exclusive apportionment rule in Prop. § 1.861-17(c) should also apply to situations in which § 250 is the operative section

a. The Proposed Regs restrict the exclusive apportionment rule to situations in which only § 904 is the operative section

Prop. § 1.861-17(c) clarifies that the “exclusive apportionment” rule applies only if § 904 is the operative section:

Solely for purposes of applying [Prop. § 1.861-17] to section 904 as the operative section, an amount equal to 50 percent of a taxpayer's R&E expenditures in a SIC code category (or categories) is apportioned exclusively to the residual grouping of U.S. source gross intangible income if research and experimentation that accounts for at least fifty percent of such R&E expenditures was performed in the United States.

The proposed subsection's next sentence gives a corresponding 50 percent exclusive apportionment to the statutory grouping of foreign source gross income if most R&E was done outside the U.S.

The preamble to the Proposed Regs notes that Treasury and the IRS got comments on § 1.861-17 in connection with proposed regulations under § 250, issued in REG–104464–18, published on March 6, 2019 (the “Proposed § 250 Regs”).⁶ The preamble further states that “[f]urther changes to the rules for allocating and apportioning R&E expenditures will be considered as part of addressing comments in finalizing those regulations.”⁷ Subparagraph 1.250(b)-1(d)(2)(i) of the Proposed § 250 Regulations gave rules for allocating and apportioning a taxpayer's deductions to its gross “deduction eligible income” (“DEI”) and “foreign-derived deduction eligible income” (“FDDEI”) under § 250. The last sentence of Prop. § 1.250-1(d)(2)(i) provides that “[f]or purposes of [Prop. § 1.250(b)-1(d)(2)(i)], research and experimental expenditures are allocated and apportioned in accordance with § 1.861-17 without taking into account the exclusive apportionment rule of § 1.861-17(b).” (Emphasis added). The preamble of the Proposed § 250 Regs gives no explanation for this.

b. The exclusive apportionment rule should also apply if § 250 is the operative section

We recommend that the exclusive apportionment rule in Prop. § 1.861-17(c) should also apply to situations in which § 250 is the operative section — i.e., exclusive apportionment shouldn't only apply if § 904 is the operative section. We correlatively recommend that the final sentence in Prop. § 1.250-1(d)(2)(i) — denying application of exclusive apportionment when determining allocation and apportionment of R&E expenditures to DEI and FDDEI — be removed.

We believe no rational basis can be given for allowing exclusive apportionment when § 904 is the operative section, but disallowing it when § 250 is the operative section. In any event, neither the Proposed Regs nor the Proposed § 250 Regs articulate any such basis. The exclusive apportionment of 50 percent of a taxpayer's R&E expenditures required under Prop. § 1.861-17(c) was based on Treasury analysis indicating that 50 percent reflects the fact that U.S. research and experimentation typically disproportionately benefits products and services sold into the U.S. over those sold foreign.⁸ These conclusions reached in prior Treasury analysis of the relationship between U.S. R&E and foreign income are equally relevant to § 250, because of the overlap between a domestic corporation's foreign source gross income and its gross FDDEI (as defined in Prop. § 1.250(b)-1(b)(15)). Denial of the exclusive apportionment when § 250 is the operative section, on the basis of no stated analysis, is unlikely to constitute reasoned decisionmaking. Congress enacted § 250 to try to reach its TCJA goal of “remov[ing] the tax incentive to locate intangible income abroad and encourage U.S. taxpayers to locate intangible income, and potentially valuable economic activity, in the United States.”⁹ Many U.S. multinational corporate taxpayers — including SVTDG members — undertook or intend to undertake global restructurings in part to avail themselves of the Congressional incentive in § 250. Allowing exclusive apportionment for § 904 purposes, but not for § 250 purposes, stymies that incentive.

3. The proposed rule addressing sales or services of controlled corporations should be modified in two ways

a. Background on apportionment of R&D expenditures under the Proposed Regs

Under Prop. § 1.861-17(b)(1), a taxpayer's R&E expenditures are first allocated to GII as a class related to relevant SIC code categories. This is followed by a two-stage apportionment. In the first stage, 50 percent of any R&E expenditures in any SIC code category are, under Prop. § 1.861-17(b)(1), exclusively apportioned to the residual grouping of U.S. source income if certain conditions are met. In the second stage, any R&E expenditures remaining after possible first-stage 50-percent exclusive apportionment are apportioned between the statutory grouping(s) within the class of GII and the residual grouping within such class of GII according to rules in Prop. §§ 1.861-17(d)(1)(i)–(iv).

In the second stage of apportionment, the remaining R&E expenditures are apportioned in the same proportion that (A) the taxpayer's gross receipts from sales and leases of products or services that are related to GII within the statutory grouping(s) bear, respectively, to (B) the total amount of such gross receipts in the class.¹⁰ For purposes of this second-stage apportionment, the amount of the gross receipts used to apportion R&E expenditures also includes gross receipts from sales and leases of products or services of any controlled or uncontrolled party to the extent described in Prop. §§ 1.861-17(d)(3) and (4).

For purposes of the second-stage apportionment, the Proposed Regs explain what gross receipts of a controlled corporation are taken into account:

the gross receipts from sales, leases, or services of a controlled corporation are taken into account if the taxpayer can reasonably be expected to license, sell, or transfer to that controlled corporation, directly or indirectly, intangible property that would arise from the taxpayer's current R&D expenditures. Except to the extent provided in [Prop. § 1.861-17(d)(4)(iv)], if the taxpayer has previously licensed, sold, or transferred intangible property related to a SIC code category to a controlled corporation, the taxpayer is presumed to expect to license, sell, or transfer to that controlled corporation all future intangible property related to the same SIC code category [the “Presumption”]. [Prop. § 1.861-17(d)(4)(i) (emphasis added)]

The cited exception, in Prop. § 1.861-17(d)(4)(iv), applies in the case of a cost sharing arrangement (“CSA”) (the “CSA Exception”):

If the controlled corporation has entered into a [CSA], in accordance with the provisions of §1.482-7, with the taxpayer for the purpose of developing intangible property, then the taxpayer is not reasonably expected to license, sell, or transfer to that controlled corporation . . . intangible property that would arise from the taxpayer's share of the R&E expenditures with respect to the cost shared intangibles as defined in § 1.482-7(j)(1)(i). Therefore, solely for purposes of apportioning a taxpayer's R&E expenditures . . . that are intangible development costs . . . with respect to a [CSA], the controlled corporation's gross receipts are not taken into account for purposes of [Prop. §§ 1.861-17(d)(1) and (d)(4)(i)]. [Emphasis added]

b. The proposed rule addressing sales or services of controlled corporations should be modified in two ways

i. Dealing with allocation and apportionment of R&E expenditures following termination of a CSA

We make two alternative recommendations for modifications to Prop. § 1.861-17 to address allocation and apportionment of R&E expenditures following termination of a CSA.

(A) The CSA Exception should be broadened to address post-CSA termination

The CSA Exception provides that sales or services gross receipts of a controlled corporation that's in a CSA with a taxpayer are “excluded from the apportionment formula because the controlled [corporation] is not expected to benefit from the taxpayer's remaining R&D expenditures.”¹¹ This policy principle underlying the CSA Exception (and its two clarifications) is rational. With respect to R&E expenditures that are intangible development costs (“IDCs”) under the CSA, the cost sharing participants split those costs in proportion to their separate reasonably anticipated benefits from cost-shared intangibles that may be developed.¹² Each participant bears a share of IDCs corresponding to its share of anticipated benefits from exploiting its interests in cost-shared intangibles. The SVTDG welcomes inclusion of the CSA Exception in the Proposed Regs, but recommends that the CSA Exception be broadened, consistent with its policy principle and with a goal of the TCJA.

Terminating a CSA so that all post-termination R&E expenditures are borne, and all post-termination developed intangibles are owned, solely by the former U.S. controlled participant is consistent with an important goal of the TCJA.¹³ While a CSA is in effect, the CSA Exception provides that sales or services gross receipts of the foreign controlled participant are excluded from the apportionment formula. Post-termination of a CSA, the foreign corporation (former controlled participant) may keep its pre-termination interests in cost-shared intangibles. To provide up-to-date products and services, however, the foreign corporation would need to augment its pre-termination rights in cost-shared intangibles — such frozen-in-time intangibles would generally be expected to obsolesce. The foreign corporation may license newly developed intangibles from the U.S. corporation (former U.S. controlled participant). In that case, the foreign corporation's post-termination products and services would for some period use a blend of intangibles — pre-termination cost-shared intangibles owned and co-developed by the foreign corporation, and post-termination intangibles licensed from the U.S. corporation. The situation is shown.

Unless the CSA Exception is broadened, post-termination the foreign corporation's gross receipts would be included in the apportionment formula used to apportion the U.S. corporation's R&E expenditures. The result would be a skewing of the allocation of the U.S. corporation's post-termination R&E expenditures to foreign-source income (including the royalty it gets from the foreign corporation). The skewing arises because — absent a modification of the CSA Exception — all of the foreign corporation's sales and services gross receipts would be included in the apportionment formula, even though only a portion of such gross receipts would be attributable to intangibles created by the U.S. corporation's post-termination R&E expenditures. In the immediate post-termination period the relative contribution of pre-termination cost-shared intangibles and post-termination licensed intangibles would be lopsided, making the distortion egregious. Although the foreign corporation benefits (through the license) from the U.S. corporation's post-termination R&E expenditures, it does so only in part — for some post-termination period the foreign corporation benefits more from intangibles created by its own R&E expenditures incurred under the CSA.

The cliff-effect result of the CSA Exception may have administrative appeal, but it lacks any other policy basis, and administrative simplicity should — we believe — yield to the reasonable view that only part of the foreign corporation's sales and services gross receipts should be included in the apportionment formula. In the situation outlined above, under § 482, the U.S. and foreign corporations are required to determine an arm's length royalty under

§1.482-4, and — to avoid imposition of penalties under § 6662 — will almost invariably have transfer pricing documentation detailing how the foreign corporation uses licensed intangibles in conjunction with intangibles it owns. The U.S. and foreign corporations will, for § 482 purposes, have information relevant to determining how much of the foreign corporation's sales and services gross receipts are attributable to intangible property it licenses from the U.S. corporation.

We recommend accordingly that the CSA Exception be modified to deal with situations in which a foreign corporation exits a CSA. The underlined text below shows added language that accommodates this situation.

(iv) Effect of cost sharing arrangements.

(A) Entering a CSA. If the controlled corporation has entered into a cost sharing arrangement, in accordance with the provisions of §1.482-7, with the taxpayer for the purpose of developing intangible property, then the taxpayer is not reasonably expected to license, sell, or transfer to that controlled corporation, directly or indirectly, intangible property that would arise from the taxpayer's share of the R&D expenditures with respect to the cost shared intangibles as defined in §1.482-7(j)(1)(i). Therefore, solely for purposes of apportioning a taxpayer's R&E expenditures (which does not include the amount of CST Payments received by the taxpayer; see paragraph (a) of this section) that are intangible development costs (as defined in §1.482-7(d)) with respect to a cost sharing arrangement, the controlled corporation's gross receipts are not taken into account for purposes of paragraphs (d)(1) and (d)(4)(i) of this section.

(B) Exiting a CSA. If the controlled corporation has ceased being a controlled participant in a cost sharing arrangement with the taxpayer for the purpose of developing intangible property, then the taxpayer is reasonably expected to license, sell, or transfer to that controlled corporation, directly or indirectly, intangible property that would arise from the taxpayer's R&E expenditures only to the extent the controlled corporation exploits such intangible property. Therefore, solely for purposes of apportioning a taxpayer's R&E expenditures, the controlled corporation's gross receipts are taken into account for purposes of paragraphs (d)(1) and (d)(4)(i) of this section only to the extent such gross receipts are attributable to such intangible property.

(B) Alternatively, taxpayers should be allowed to use the optional gross income method for five years post-CSA termination

In the event Treasury and the IRS don't accept the above recommendation to broaden the CSA exception to address post-CSA termination, and don't otherwise accept our recommendation (in § II.A.1.b, above) to keep the optional gross income method, we recommend that Treasury modify Prop. § 1.861-17(d) — governing the sales method — to allow taxpayers post-CSA-termination, in situations in which cost-shared intangibles remain held offshore, to use the optional gross income method for a period of five years following the termination. Allowing temporary use of the gross income method in this situation would reduce the drastic distortion caused by the sales method (described immediately above) in the post-CSA-termination period.

ii. The Presumption should be removed

The Presumption is that — unless the CSA Exception applies — if a taxpayer has previously licensed, sold, or transferred intangible property to a controlled corporation, the taxpayer is presumed to expect to license, sell, or transfer to the controlled corporation all similar¹⁴ future intangible property.

Prop. § 1.861-17(d)(4)(i) says nothing about how a taxpayer might rebut the Presumption. The Presumption is in any case set up to be difficult to rebut: how might a taxpayer demonstrate lack of intent (lack of reasonable expectation) to license, sell, or transfer intangible property in future? The Presumption may be administratively convenient for the IRS and Treasury, but its effect can materially distort the apportionment of a taxpayer's R&D expenditures. If a taxpayer can't rebut the Presumption, sales or services gross receipts of a controlled corporation can skew apportionment of a taxpayer's R&E expenditures to foreign source gross income even absent any factual relationship between the R&E expenditures and the controlled corporation's sales or services.

We recommend the Presumption be removed, while keeping the CSA Exception (broadened, as recommended above). The first sentence of Prop. § 1.861-17(d)(4)(i) conditions use of a controlled corporation's sales or services gross receipts “if the taxpayer can reasonably be expected” to license, sell, or transfer to the controlled corporation the relevant intangible property. Determination of “reasonable expectations” should be sufficient to trigger use of the controlled corporation's sales or services gross receipts.

4. Taxpayers should be permitted to elect out of exclusive apportionment

The exclusive apportionment of 50 percent of a taxpayer's R&E expenditures required under Prop. § 1.861-17(c) was based on Treasury analysis indicating that 50 percent was, in some sense, a middle ground amount, reflecting the fact that U.S. research and experimentation typically disproportionately benefits products and services sold into the U.S. over those sold foreign.¹⁵ For many U.S. corporations performing the majority of their R&D in the U.S., the 50 percent exclusive apportionment is beneficial because their foreign tax credit limitation is larger than it would otherwise be.

Some such U.S. corporations may, however, be harmed by the exclusive-apportionment rule. This could be the case if the corporation has insufficient domestic-source gross income to absorb allocated R&E expenditures. This results in a domestic-source loss, and that loss is allocated under § 904(f) to the § 951A GILTI, foreign branch income, passive, and general income baskets in §§ 904(d)(1)(A)–(D) on a proportionate basis. The reallocation mechanism under § 904(f) may result in such corporation's R&E expenditures being allocated to § 904(d)(1) income baskets entirely unrelated to the income generated from the intangibles developed by the taxpayer's R&E expenditures.

We accordingly recommend that Treasury and the IRS modify the exclusive apportionment rule in Prop. § 1.861-17(c) so that — if U.S.-performed research and experimentation accounts for at least 50 percent of a taxpayer's R&E expenditures in a SIC code category — the taxpayer is allowed to elect out of the exclusive apportionment otherwise mandated in Prop. § 1.861-17(c).

5. The definition of gross intangible income in Prop. § 1.861-17(b)(2) should be modified

a. Background on allocation of R&E expenditures under Prop. § 1.861-17(b)

Prop. § 1.861-17(b)(1) gives a rule for allocating “R&E expenditures.”¹⁶ Before stating the rule, two sentences explain its rationale:

The method of allocation and apportionment of R&E expenditures set forth in this section recognizes that research and experimentation is an inherently speculative activity, that findings may contribute unexpected benefits, and that the gross income derived from successful research and experimentation must bear the cost of unsuccessful research and experimentation. In addition, the method set forth in this section recognizes that successful R&E expenditures ultimately result in the creation of intangible property that will be used to generate income.

The allocation rule is that —

R&E expenditures ordinarily are considered deductions that are definitely related to gross intangible income (as defined in [Prop. § 1.861-17(b)(2)]) reasonably connected with the relevant SIC code category (or categories) of the taxpayer and therefore allocable to gross intangible income as a class related to the SIC code category (or categories). . . . [Emphasis added]

“Gross intangible income” (“GII”) is defined in Prop. § 1.861-17(b)(2) to mean —

all gross income earned by a taxpayer that is attributable (in whole or in part) to intangible property and includes [a] gross income from sales or leases of products or services derived (in whole or in part) from intangible property, [b] income from sales of intangible property, [c] income from platform contribution transactions described in § 1.482-7(b)(1)(ii), [d] royalty income from the licensing of intangible property, and [e] amounts taken into account under section 367(d) by reason of a transfer of intangible property. Gross intangible income also includes a distributive share of any amounts described in the previous sentence, but does not include dividends or any amounts included in income under sections 951, 951A, or 1293.

b. The definition of gross intangible income should be modified

We agree with the statement in the asserted rationale in Prop. § 1.861-17(b)(1) that a taxpayer's successful R&E expenditures ultimately result in the creation of intangible property that will be used to generate income for the taxpayer. The other statement in the asserted rationale — that gross income derived from successful research and experimentation must bear the cost of unsuccessful research and experimentation — is also reasonable. Neither statement, however, provides a basis for allocating a taxpayer's R&E expenditures to gross income other than gross income derived from intangible property the taxpayer has developed. No basis exists for allocating a taxpayer's R&E expenditures to gross income derived from intangible property the taxpayer acquires, for example. The general provision for allocation of deductions states that “[t]he rules emphasize the factual relationship between the deduction and a class of gross income,” requiring a determination of “the class of gross income to which the deduction is definitely related.”¹⁷ The definition of GII in Prop. § 1.861-17(b)(2) can result in an irrational allocation of a taxpayer's R&E expenditures, in the sense that such expenditures get allocated to income entirely unrelated to the R&E expenditure deductions. The definition of GII should be modified to prevent such an allocation.

In particular, the definition of GII should be modified so it doesn't automatically include all income from platform contribution transactions described in § 1.482-7(b)(1)(ii). The reference to “income from platform contribution transactions” presumably means income comprising PCT Payments defined in § 1.482-7(b)(1)(ii):

In a PCT, each other controlled participant (PCT Payor) is obligated to, and must in fact, make arm's length payments (PCT Payments) to each controlled participant (PCT Payee) that provides a platform contribution.

A “platform contribution” is “any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost shared intangibles.”¹⁸

There may be no factual relationship between a PCT Payee's R&E expenditure deductions and PCT Payments the PCT Payee gets. For example, in an existing CSA between a U.S. corporation and its controlled foreign corporation, the U.S. controlled participant may, using U.S. corporation stock, acquire a target corporation that owns intangible property constituting a platform contribution.¹⁹ The foreign controlled participant (PCT Payor) would owe the U.S. controlled participant (PCT Payee) a PCT Payment as a result of the target corporation acquisition. But there's no factual relationship between the U.S controlled participant's R&E expenditures and the PCT Payment it gets. In no rational sense are the taxpayer's R&E expenditures “definitely related” to the PCT Payee's PCT Payment income. The U.S. controlled participant's R&E expenditures didn't create the acquired platform contribution intangibles. The PCT Payment may depend on the foreign controlled participant's interest in cost shared intangibles,²⁰ but the existing and the Proposed Regs both treat that interest in cost-shared intangibles as independent of the U.S. controlled participant's R&E expenditures.²¹ There's accordingly — in this situation²² — no factual basis to allocate any of the U.S. participant's R&E expenditures to its income from PCT Payment.

The assertion that GII should be defined broadly for administrative convenience, to avoid having to trace a taxpayer's R&E expenditures to particular types of income from intangibles, is in this case clearly unjustified. Taxpayers in CSAs are administratively required to track acquired platform contributions and associated PCT Payments, detailing the nature of any acquired platform contribution and the methodology used to determine PCT Payments.²³ Taxpayer already identify gross income comprising PCT Payments.

We accordingly recommend that Treasury and the IRS modify the definition of GII to exclude blanket inclusion of PCT Payments.

B. Recommendations relating to allocation of foreign gross income in connection with disregarded payments involving a foreign branch

1. Foreign gross income resulting from a branch-to-branch disregarded payments shouldn't be assigned to the residual income grouping

We recommend that foreign gross income resulting from disregarded payments made between different foreign branches of the same foreign branch owner shouldn't be assigned to the residual income grouping under §§ 1.861-20(d)(2)(ii)(B) or 1.861-20(d)(3)(ii)(B). To accomplish this, language can be added to the last sentence of Prop. § 1.960-1(d)(3)(ii)(A) so it reads:

Foreign gross income attributable to a base difference, or resulting from the receipt of a disregarded payment made to a foreign branch by a foreign branch owner, is assigned to the residual income grouping under §§ 1.861-20(d)(2)(ii)(B) and 1.861-20(d)(3)(ii)(B).

2. Foreign gross income included by reason of receipt of a disregarded payment made to a foreign branch by a foreign branch owner should only include certain types of disregarded payments

Prop. § 1.861-20(d)(3)(ii)(B) — entitled “Disregarded payments made by an owner” — provides —

Except as provided in [Prop. § 1.861-20(d)(3)(C) — relating to disregarded payments in connection with disregarded sales or exchanges of property] an item of foreign gross income that a taxpayer includes by reason of the receipt of a disregarded payment made to a foreign branch by a foreign branch owner is assigned to the residual grouping. [Emphasis added]

The consequence of assigning such disregarded payments to the residual grouping is that foreign tax credits associated with the payment can't be claimed. The policy of this blanket rule may be to deny of foreign tax credits associated with disregarded payments that are akin to capital contribution equity infusions from an owner to a subsidiary: such capital contributions give rise neither to a deduction for the contributor nor an income inclusion for the recipient. But a problem with the blanket rule in this clause is that ignores the capacity in which the foreign branch owner makes a disregarded payment to a foreign branch.

Suppose, for example, that the foreign branch owner is a CFC conducting, in its country of incorporation, home office business activities. Prop. § 1.861-20(d)(3)(ii) uses the terms “disregarded entity,” “disregarded payment,” “foreign branch,” and “foreign branch owner” defined under the foreign branch category income rules in § 1.904-4(f), and provides that — for purposes of Prop. § 1.861-20(d)(3)(ii) — a foreign branch owner can include a foreign corporation. The foreign branch category income rules deem the activities of a foreign corporation conducting a trade or business to constitute a foreign branch,²⁴ and deem the (deemed) foreign branch to maintain a separate set of books and records with respect to such activities.²⁵ So the CFC's home office business activities constitute a foreign branch (“home-office foreign branch”) whose foreign branch owner is the CFC.

If such CFC makes a disregarded payment to another foreign branch of the CFC, and such disregarded payment is allowed as a deduction against foreign branch gross income of the home-office foreign branch, such disregarded payment isn't akin to a capital contribution. We believe no valid policy reason exists for assigning the corresponding item of foreign gross income of the CFC (the taxpayer) to the residual grouping. Yet Prop. § 1.861-20(d)(3)(ii)(B) may be interpreted to yield this result.

Accordingly, we recommend Prop. § 1.861-20(d)(3)(ii)(B) be changed to clarify that (1) it only applies to disregarded payments made to a foreign branch by a foreign branch owner acting in its capacity as an equity owner in the foreign branch, and (2) it doesn't apply in connection with disregarded payments reflected as deductions on the (possibly deemed) books and records of a home-office foreign branch.

3. Problems with allocating and apportioning foreign income taxes in accordance with tax book values of assets held by foreign branches or disregarded entities

Under Prop. § 1.861-20(c), any foreign income tax is allocated and apportioned, under a three-step process, to the statutory and residual groupings that include items of foreign gross income included in the base on which the foreign income tax is imposed. Prop. § 1.861-20(d) gives rules for assigning foreign gross income to statutory and residual groupings. Prop. § 1.861-20(d)(3)(ii)(A) assigns foreign gross income that a taxpayer (e.g., a CFC) includes by reason of receipt of a disregarded payment made by a disregarded entity or other foreign branch. The proposed clause provides that such foreign gross income received is assigned to the statutory or residual grouping to which the income out of which the payment is made is assigned. A disregarded payment is considered to be made ratably out of all of the accumulated after-tax income of the foreign branch, as computed for Federal income tax purposes. For this purpose, the accumulated after-tax income of the foreign branch generally is deemed to have arisen in the statutory and residual groupings in the same ratio as the tax book value of the assets of the branch in the groupings, determined in accordance with § 1.987-6(b)(2). Thus foreign income taxes associated with disregarded payments from a branch or disregarded entity of a foreign corporation generally are allocated and apportioned to the statutory and residual groupings based on the tax book value of assets held by the branch or disregarded entity.

This approach has shortcomings. Asset-based allocation may function rationally for interest payments, because of the fungibility of cash, but it's unclear such allocation works well outside that application. Such asset-based allocation would be onerous, and overly burdensome, for many taxpayers to perform. The allocation would change based on movement of assets between branches or disregarded entities, thereby potentially drastically changing the basketing of foreign income taxes as a consequence of normal movement of assets between foreign branches.

C. Recommendations relating to Prop. § 1.861-8(e)(4)(ii), relating to allocation and apportionment of stewardship expenses

1. Stewardship expenses should be allocated based on the factual relationship of such to the income to which they relate

a. Background on allocation of stewardship expenses

Under both the current and Proposed Regs two categories of stewardship expenses are referenced — duplicative activities and shareholder activities. Prop. § 1.861-8(e)(4)(ii) provides that “[s]tewardship expenses . . . shall be considered definitely related and allocable to dividends received from [a] related corporation.” The preamble to the Proposed Regs says this reflects the proposition that stewardship expenses are generally intended to protect the shareholder's investment in subsidiaries and thus are factually related to the income that arises from such subsidiaries.²⁶

The Proposed Regs expand the classes of income considered to arise from such subsidiaries and to which stewardship expenses are allocated. Prop. § 1.861-8(e)(4)(ii)(B) states:

Stewardship expenses are considered definitely related and allocable to dividends and inclusions received or accrued, or to be received or accrued, under [§§ 78, 951 and 951A], as well as amounts included under [§§ 1291, 1293, and 1296], from the related corporation. [Emphasis added].

By adding inclusions under § 951A, the Proposed Regs have gone beyond allocating expenses solely to dividends, but only for foreign corporations. Inclusions under § 951A are generally attributable to operating income of controlled foreign corporations. Such operating income will in many cases constitute most of the income described in Prop. § 1.861-8(e)(4)(ii)(B) for a taxpayer.

Under Prop § 1.861-14(e)(4), stewardship expenses incurred within a consolidated group are allocated and apportioned as if all members of an affiliated groups were treated as single corporation. It's unclear how this single corporation construct applies with respect to stewardship expenses incurred with respect to another member of a consolidated group. The sole example provided in the Proposed Regs sidesteps the issue.²⁷

Treasury requests comments as to the appropriateness of the allocation and apportionment of certain factually related stewardship expenses:

The Treasury Department and the IRS are aware that stewardship expenses that are incurred to facilitate compliance with reporting, legal, or regulatory requirements may be more appropriately treated as definitely related to the gross income produced by the particular asset, or assets, whose ownership required the stewardship expenditure. For example, the owner of an entity in a particular jurisdiction might have unique reporting requirements not triggered by the ownership of a similar entity in a different jurisdiction. The Treasury Department and the IRS request comments regarding exceptions to the general rule for the allocation and apportionment of stewardship expenses where it is more appropriate to treat stewardship expenses as definitely related to a more limited class of gross income.²⁸

b. Stewardship expenses should be allocated to the income to which they relate

We recommend a two part allocation methodology for stewardship expenses. First, stewardship expenses that factually relate to a specific income producing subsidiary should be allocated to relevant income of such subsidiary. Second, if there's no direct factual relationship between the incurrence of the stewardship expense and underlying assets or income, such expenses should be allocated (and apportioned, as discussed below) based on income of all subsidiaries. This two-part methodology is consistent with § 1.862-8(a)(2), which provides that “allocations and apportionments are made on the basis of the factual relationship of deductions to gross income.”

Stewardship expenses can relate to oversight of both domestic and foreign subsidiaries, including domestic subsidiaries that are members of the same consolidated group. To the extent stewardship expenses are directly factually related to a foreign subsidiary or domestic subsidiary, such expenses should be allocated taking in account the income from such subsidiary — including, for subsidiaries that are part of the same consolidated group, items of income taken into account in determining consolidated taxable income.²⁹ To this end we also recommend that Treasury and the IRS clarify the treatment of stewardship expenses incurred with respect to another member of a consolidated group. Treating consolidated group members as a single corporation for all purposes of allocating and apportioning stewardship expenses (i) is incongruent with the notion that stewardship expenses can in fact be incurred with respect to members of a consolidated group and (ii) could lead to over allocation of expenses to foreign source income, especially if § 951A inclusions are taken into account. Stewardship expenses incurred for a consolidated subsidiary should be respected and the consolidated subsidiary regarded as a separate entity for purposes of allocating and apportioning such expenses.

If there's no direct factual relationship between the incurrence of the stewardship expense and underlying assets or income, we recommend such expenses be allocated (and apportioned) based on gross income of all related subsidiaries of the taxpayer (including all members of the consolidated group and their items that contribute to consolidated taxable income).

2. Stewardship expenses should be apportioned to the income to which they relate

a. Background on apportionment of stewardship expenses under Prop. § 1.861-8(e)(4)(ii)

Current § 1.861-8(e)(4)(ii) doesn't give a specific methodology for apportioning stewardship expenses aside from stating that basing apportionment on dividends may not be appropriate. See § 1.861-8(g) Example 18 (noting that dividend policies bear no relationship to income earned by the subsidiary or the stewardship expenses). Under Prop. § 1.861-8(e)(4)(ii)(C), once the allocation of stewardship expenses has been determined, stewardship expenses are apportioned among statutory groupings based on the relative values of stock in the same manner as interest expenses are apportioned. The relative value is the tax book value (i.e., stock basis as modified).³⁰ This tax book value approach requires adjustments to stock basis to take into account earnings and profits of the subsidiary (and deficits in earnings and profits) as required by § 1.861-12(c)(2).

Under the relative-stock-value approach to apportionment, stewardship expenses factually related to domestic consolidated affiliates apparently could be apportioned solely to foreign income (if the consolidated affiliate owns CFCs) as a result of treatment of members of a consolidated groups under Prop § 1.861-14 discussed above.

b. Stewardship expenses should be apportioned based on income

Pursuant to § 1.861-8(a)(2), allocation and apportionment is done on the basis of the factual relationship of deductions to gross income. As noted, the rationale in the current regulations for not using dividends as a basis for the apportionment methodology (at least in one example) is that the dividends bore no relationship to the income earned by the subsidiary. The Proposed Regs aren't limited to allocations based on dividend income. Stewardship expenses are also allocated to § 951A inclusions, which are generally attributable to operating income of CFCs. The concerns in the current regulations are no longer relevant given the application of § 951A.

In many cases § 951A inclusions may be the bulk of the income associated with CFCs. Inclusions under § 951A aren't dependent on earnings and profits. There could be a significant § 951A inclusion associated with a CFC that has no accumulated earnings a profits (or even has an accumulated deficit) potentially resulting in no apportionment to the CFC under the Proposed Regs. Apportionment based on stock basis (that also takes into account historic earnings/deficits that could result in the stock basis being zero) could result in no apportionment of expenses to income-generating CFCs to which the underlying expenses factually relate. For this reason such apportionment isn't appropriate.

Stewardship expenses are expenses relating to the oversight and protection of the taxpayer's investment in and income generated by subsidiaries. Because tax basis may not be an appropriate apportionment methodology due to the expanded classes of relevant income used in allocating stewardship expenses, we recommend that the allocation of stewardship expenses be made based on current income.

3. Regulations should provide more details on determining stewardship expenses

Both the current and Proposed Regs describe two categories of stewardship expenses — duplicative activities and shareholder activities — which are further defined by reference to § 1.482-9(l)(3). Notwithstanding this, there's still significant uncertainty in determining which expenses constitute stewardship expenses. Given the distortions under the approach in Proposed Regs as described above (over allocation to CFCs' income), identifying stewardship expenses takes on greater importance. We recommend that more detailed descriptions and examples be added to help taxpayers identify those expenses that constitute stewardship expenses.

D. Recommendations relating to Prop. § 1.905-4(b), relating to notification in the event of a foreign tax redetermination

1. Background relating to notification and filing in the event of a foreign tax redetermination

Subsection 905(c) generally provides that in connection with a redetermination of the amount of a credited foreign tax, the taxpayer must notify the Secretary and, to the extent relevant, pay the additional amount of U.S. tax liability due. Under Prop. § 1.905-4(b)(1), if a redetermination results in an increase in U.S. tax liability, the requirement to notify the Secretary is satisfied by filing an amended return “by the due date (with extensions) of the original return for the taxpayer's taxable year in which the foreign tax redetermination occurs.” For taxpayers under examination of the LB&I Division for the relevant tax year, the due date under Prop. § 1.905-4(b)(4)(i)(E) is “not before the later of the opening conference or the hand-delivery or postmark date of the opening letter concerning the examination of the return.”

Prop § 1.905-5 gives additional rules and informational reporting requirements for redeterminations that relate to taxable years of foreign corporations beginning before January 1, 2018. These additional requirements relate to maintenance of pre-2018 earnings and profits and foreign tax credit pools — concepts generally no longer relevant post-2018 due to the enactment of § 965 and the repeal of § 902. The due dates for notifying the Secretary are the same as the post-January 1, 2018 periods under Prop § 1.905-4, which is the due date of the return for the year the redetermination was made.

Redeterminations relating to taxable years of foreign corporations beginning before January 1, 2018 are subject to additional complexity due to § 965. As part of the TCJA Congress re-enacted § 965, which generally required net untaxed earnings of certain foreign corporations be included in a U.S. shareholder's income at significantly reduced tax rates, while also allowing credits for foreign taxes. The determination of the liability resulting from application of § 965 (the “§ 965 liability”) was time consuming and complex.

The penalty for failure to timely file under Prop. § 301.6689-1(b) is 5 percent of the deficiency if the failure isn't for more than a month, and, in cases lasting longer than month, an additional 5 percent for each additional month, not to exceed 25 percent.

2. Increasing complexity of the U.S. and international tax rules

The U.S. tax system rules, and those of other jurisdictions, continue to change with increasing frequency and complexity. The adoption of the TCJA and regulations interpreting the TCJA have compounded the complexity. There remain areas of uncertainty that lack adequate guidance and for which guidance continues to be modified and/or published. This isn't limited to the U.S. Foreign jurisdictions continue to change their tax systems (including in some cases with retroactive effect), including in response to changes made by the TCJA. This is only expected to continue to increase, especially if the aspirational goals of the OECD working groups are achieved.

3. Recommendations

For the above reasons, and given the significant penalties at stake, we make the following recommendations.

a. Thresholds for required refiling should be established

Given the increased complexity of U.S. tax rules, we recommend that redeterminations of foreign tax below an established threshold amount — we recommend $20 million — not require the refiling of a return. This threshold amount should be determined at the level of a U.S. consolidated group. Below this threshold, the taxpayer could apply the redetermination to the current year, so long as the taxpayer has a reasonable basis to conclude that applying the redetermination to the current year won't result in a better after-tax result as compared to the year of adjustment.

b. Extend the due date for notifying the Secretary

Due to concerns of complexity of the U.S. tax rules, we recommend that the due date for notifying the Secretary be extended by at least one year such that notification be required by the due date (with extensions) of the original return for the tax year immediately following the taxable year in which the foreign tax redetermination occurs.

c. Thresholds for adjustments to § 965 liabilities

Based on concerns of complexity already noted, we recommend that redeterminations of foreign taxes that relate to taxable years of foreign corporations beginning before January 1, 2018 below an established threshold amount — we recommend $20 million — not require a redetermination or adjustment of § 965 liabilities. Given the limited effective creditability of such foreign taxes under the § 965 regime, it isn't expected that such a recommendation would result significant harm to the Treasury, especially when taking into account the cost to taxpayers of refiling and recalculating the § 965 liability.

d. Notification to the IRS in the event of a foreign tax redetermination increasing U.S. tax liability should be permitted on a Rev. Proc. 94-69 disclosure

Rev. Proc. 94-69,³¹ gives special procedures — for certain taxpayers examined by LB&I — to disclose additional tax due or make adequate disclosure with respect to an item or a position to avoid imposition of penalties under § 6662(b).³² The Rev. Proc. 94-69 disclosure constitutes a “qualified amended return.”³³ We recommend that Prop. § 1.905-4(b)(1)(ii) (governing notification procedure in the event of an increase in the amount of U.S. tax liability as a result of a foreign tax redetermination) be modified to allow relevant taxpayers — i.e., those that can avail themselves of Rev. Proc. 94-69 — to appropriately notify the IRS when they make a Rev. Proc. 94-69 disclosure during an LB&I audit of the taxable year for which U.S. tax liability is so increased. Such a modification would decrease taxpayer compliance burdens by taking advantage of an existing disclosure mechanism.

E. Recommendations relating to effective dates

1. Background

Although the Proposed Regs have varying effective dates, most are proposed to apply to taxable years that end on or after December 17, 2019. Given the complex nature of these rules, the timing of their issuance, and the number of expected interested party comments requesting changes, taxpayers will have limited time to digest the rules and adopt appropriate changes to their internal compliance functions and processes.

2. The Proposed Regs should only apply on or after publishing the final regulations

We recommend, for the reasons noted above, that the final regulations have an effective date for taxable years beginning on or after the date the final regulations are published in the Federal Register. In addition, we recommend that taxpayers be allowed to rely on the Proposed Regs for taxable years ending on or after December 17, 2019 (and before the effective date of the final regulations).

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Appendix — SVTDG Membership

10x Genomics, Inc.

Accenture

Activision Blizzard

Adobe

Adobe

Agilent

Airbnb

Amazon

AMD

Alphabet Inc.

Analog Devices

Ancestry.com

Apple

Applied Materials

Aptiv

Arista

Atlassian

Autodesk

Bio-Rad Laboratories

BMC Software

Broadcom Limited

Cadence

Chegg

Cirrus Logic

Cisco Systems Inc.

Crowdstrike, Inc.

Cypress Semiconductor

Dell

Dolby Laboratories, Inc.

Dropbox Inc.

eBay

Expedia, Inc.

Facebook

FireEye

Fitbit, Inc.

Flex

Fortinet

Genentech

Genesys

Genomic Health

Getaround

Gigamon, Inc.

Gilead Sciences, Inc.

GLOBALFOUNDRIES

GlobalLogic

GoPro

Hewlett-Packard Enterprise

HP Inc.

Indeed.com

Informatica

Ingram Micro, Inc.

Intel

Intuit Inc.

Intuitive Surgical

Jazz Pharmaceuticals

Keysight Technologies

KLA Corporation

Lam Research

LiveRamp

Marvell

Maxim Integrated

MaxLinear

Mentor Graphics

Microsoft

NetApp

Netflix

NortonLifeLock

NVIDIA

Oracle Corporation

Palo Alto Networks

PayPal

Pure Storage

Qualcomm

Ripple Labs, Inc.

Robinhood

Rubrik

salesforce.com

Sanmina Corporation

Seagate Technology

Snap, Inc.

Snowflake

Stripe

SurveyMonkey

Synopsys, Inc.

The Cooper Companies

The Walt Disney Company

TiVo Corporation

Trimble, Inc.

Uber Technologies

Velodyne LiDAR

Verifone

Veritas

Visa

VMware

Western Digital

Workday, Inc.

Xilinx, Inc.

Yelp