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Transcript Available of IRS Hearing on FTC Proposed Regs

MAY 20, 2020

Transcript Available of IRS Hearing on FTC Proposed Regs

DATED MAY 20, 2020
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 "GUIDANCE RELATED TO THE ALLOCATION AND APPORTIONMENT OF DEDUCTIONS AND FOREIGN TAXES, FINANCIAL SERVICES INCOME, FOREIGN TAX REDETERMINATIONS, FOREIGN TAX CREDIT DISALLOWANCE UNDER SECTION 965(G), AND CONSOLIDATED GROUPS"

UNITED STATES DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE

PUBLIC HEARING ON PROPOSED REGULATIONS

[REG-105495-19]

Washington, D.C.

Wednesday, May 20, 2020

PARTICIPANTS:

For IRS:

JEFFREY P. COWAN
Attorney Branch 3
Office of Associate Chief Counsel (International)
Office of Chief Counsel

MICHAEL I. GILMAN
Senior Technical Reviewer Branch 3
Office of Associate Chief Counsel (International)
Office of Chief Counsel

For U.S. Department of Treasury:

JASON YEN
Attorney-Advisor Office of Tax Policy

Speaker:

CATHERINE SCHULTZ
National Foreign Trade Council

LESLIE J. SCHNEIDER
Ivins, Phillips & Barker

LARISSA NEUMANN ADAM HALPERN
Fenwick & West LLP

* * * * *

PROCEEDINGS

(10:00 a.m.)

MR. COWAN: Thank you, good morning. I am Jeff Cowan of Branch 3 of the Office of the Associate Chief Counsel International of the IRS. This is first public hearing on proposed regulations we've conducted by telephone. And today our hearing involves proposed regulation issued on December 17th, 2019, entitled guidance related to the allocation and the apportionment of deductions and foreign taxes, financial services income, foreign tax redeterminations, foreign tax credit disallowance under section 965(g), and consolidated groups.

The government panel consists of myself and Jason Yen, an attorney-advisor with the Office of Tax Policy at the Department of Treasury, and Michael Gilman senior technical reviewer, also of Branch 3 Office of Associate Chief Counsel International. The speakers in order of presentation are first: Catherine Schultz of the National Foreign Trade Council, next, Leslie Schneider of the law firm Ivins, Phillips & Barker, and finally Larissa Neumann and Adam Halpern of the law firm of Fenwick & West.

Each speaker will have 10 minutes to present and the panel will reserve questions for the person who has presented. We will interject the discussion at 9 minutes to announce that one minute remains and restrict the testimony at 10 minutes. We ask that other speakers keep their phones on mute while the other speaker is presenting. Participants other than the speakers will be automatically muted for the duration of the hearing. Thank you. With that, I will turn to Ms. Schultz.

MS. SCHULTZ: Hi, thank you. Thank you for the opportunity to present the views of the National Foreign Trade Council (NFTC) on the proposed foreign tax credit regulations. The first issue of concern to NFTC members is the allocation and apportionment of R&E expenses. At issue is the proposed regulation exclude GILTI (Global Intangible Low-taxed Income) income from the definition of gross intangible income.

However, this exclusion does not apply to foreign-derived intangible income for FDII. Under the proposed regulation, R&E (Research and Experimentation) expenses would be allocated for apportioned to FDII, thereby significantly reducing FDII benefits. To mitigate the negative impact on the FDII and provide parity with GILTI, the NFTC recommends that the regulation exclude FDIIs from the definition of gross intangible income.

As a proposed and existing gross income method would be eliminated and allocating an apportioning R&E expenses. Instead, gross receipts from sales of products or services is the only available and mandatory method. The final regulation should retain the optional gross income method. This elective allocation and apportionment method may align more closely with the taxpayer's business and should continue to be a valid method going forward, so long as it is reasonable and applied consistently over time and for all cooperative code sections.

Under exclusive apportionment, as proposed, exclusive apportionment has limited application only when section 904 is the operative section. However, in calculating the FDII deduction, the proposed section 250 regulation provide, that 1.a61-17 shall apply without the exclusive apportionment rule.

This mechanical discrimination may result in an over-allocation of R&E expenses to FDII and failed to properly measure the income derived from conducting R&E activities in the U.S. in the service of foreign markets. Taxpayers should be provided with an option to apply the exclusive apportionment when section 250 is the operative section.

The second issue I would like to address is the redetermination of foreign tax credits. The proposed regulations require a redetermination of a U.S. shareholder's U.S. tax liabilities when there is redetermination of foreign taxes with respect to control foreign corporations including tax law changes in various jurisdiction.

With the increased complexity of international taxation and subsequent changes in tax law which we fully expect to see more of after COVID-19, the frequency of redetermination of foreign taxes will continue to increase. Consequently, the U.S. taxpayer's compliance and administrative burdens are even more challenging. Additionally, the penalties for failure to provide notice of the redeterminations on such a complicated process are significant. Unfortunately, the proposed regulations remove the necessary flexibility for notification requirements by taxpayers under examination within the jurisdiction of LB&I (Large Business and International Division).

Treasury should consider establishing higher threshold levels for redetermination below certain level such as 20 million foreign tax changes. Taxpayers should be relieved of the notification and refiling requirements. In addition to the threshold limitation, Treasury should consider additional simplification measures such as permitting the taxpayer to apply the redetermination to the current year taxes versus requiring a taxpayer to amend the past federal and state tax filings.

This process as it is currently proposed would result in not only numerous federal amended returns but also associated amended state tax income returns. The administration burden and cost related to the efforts are not insignificant. The proposed regulations require a redetermination of post-1986 undistributed earnings and profits any time there is a redetermination of foreign taxes with respect to a CFC (Controlled Foreign Corporation) for any taxable year before 2018.

The 2017 TCJA (Tax Cuts and Jobs Act) imposed a one-time transition tax on such earnings under section 965, according to which only partial foreign tax credits were available to offset U.S. taxpayers' section 985 liabilities. The penalties for failure to notify and incorporate the impact of many foreign tax redeterminations are severe.

Furthermore, taxpayers have already made multiple installment payments based on prior Treasury proposed and final regulations issued earlier than these foreign tax credit regulations. Given the increased complexity of the U.S. tax and global tax environment, Treasury should consider simplifying the redetermination process for the use of foreign tax credit in the 965 area.

Treasury should consider establishing a higher reporting threshold levels such that redetermination below a certain level, again, something like the $20 million foreign tax changes do not require a redetermination or adjustment of U.S. section 965 liabilities. In addition to a threshold limitation, Treasury should consider additional simplification measures such as permitting taxpayers to amend the redetermination of current year taxes versus requiring taxpayers to amend past and federal and state tax filing.

On the allocation apportionment of foreign income tax, the proposed regulation lists the distribution of property to the extent of section 301(c)2 as a base difference, and such for withholding taxes attributable to the portion would not be creditable. This is contrary to Treasury and IRS longstanding historical position that based differences are rare and unusual.

This further conflicts with the final section 904 regulation, which only includes gifts and life insurance proceeds as based differences. The NFTC recommends the distribution of property to the extent of section 301(c)(2) to be removed from the regulations list of base differences. If the foreign country imposes tax on distribution, such as a withholding tax, a portion of the distribution may be beyond the CFC E&P (Earnings and Points) under U.S. tax principles. Therefore, this portion should be a timing difference as opposed to a base difference.

On disregarded payments and transfers of appreciated property, Proposed reg 1.a61-20 sets forth complex rules with respect to disregarded payment. When a foreign disregarded entity makes a disregarded payment to a CFC owner, such as in example 9, the foreign taxes associated with such payments are allocated based on the tax book value of assets owned by the foreign disregarded entity.

In an example where the foreign disregarded entity owned another CFC stock, the tax book value of such stock was utilized to determine how much of the foreign taxes were allocable to passive income baskets. This rule contradicts the laws in U.S. tax principle that a disregarded entity should be disregarded for all U.S. tax purposes.

This proposed change would treat a disregarded entity as if it was regarded. Here, the disregarded payments should be disregarded by segregating the taxes imposed on such a disregarded payment from the property and losses already taxed in the U.S. creates unnecessary, complex, and undue burden to the taxpayer.

The disregarded payment rules do not apply to situations where the payment is made from a foreign disregarded entity to a CFC owner or to another disregarded entity under the CFC owner. This can be accomplished by removing the sentence in the proposed regulation that states that a foreign branch owner could be a foreign corporation.

Post-acquisition restructuring is often performed to better align a multinational's legal structure with its commercial operations. In many cases, this includes an invalidating of appreciated property. The proposed regulation would require a U.S. taxpayer to allocate withholding taxes imposed on the transfer of assets based on the tax book value of assets owned by a foreign, disregarded entity of a U.S. parent. Such allocation creates complexity and uncertainty in a post acquisition integration and provides a significant disincentive to move business assets back to the U.S.

The final regulation should permit companies to engage in post-acquisition restructuration to transfer appreciated assets to the U.S. following acquisition and permit taxpayers to fully credit the foreign tax payments associated with such transfers. The final section 904 regulations provide transitory ownership rules when IP (Intellectual Property) is involved. Treasury could consider adopting a similar transitory rule to business assets used in the ordinary course of business.

Our final comments are on the stewardship expenses. Comments were solicited on definitions of stewardship expense and the preamble acknowledges the difficulty of distinguishing stewardship expenses from supportive or duplicative activities. The regulations also require that a taxpayer allocate the apportionment stewardship based on the stock base of the CFC.

MR. COWAN: You're at the 9 minute mark so please continue.

MS. SCHULTZ: Okay, I'm just about done. As it is difficult for a taxpayer to readily distinguish certain expenses, greater flexibility should be provided for identifying stewardship expenses and message used to the allocation and apportionment of such. Specifically, companies should be allowed to utilize a facts and circumstance that is similar to reg section 1. a61-8. A facts and circumstance approach can better align with the underlying business and books and records. Thank you for your time. I appreciate it and I'm happy to answer any questions.

MR. COWAN: Okay, thank you, Catherine. I don't have any questions but I appreciate your testimony. Do you have anything?

MR. YEN: No, I do not.

MR. COWAN: Okay, well with that I will pass it on to Leslie Schneider of Ivins, Phillips & Barker to go over his testimony.

MR. SCHNEIDER: Thank you. My name is Les Schneider and I'm a partner in the Washington, D.C. law firm of Ivins, Phillips & Barker. My testimony is focused on the treatment of net (inaudible) loss deductions. In this regard, the present final regulations under 861 provide that a NOL is allocated to class and gross income in the same manner as the deductions that give rise to the NOL.

This principle reflects the Holding and Motors Insurance Corp where an NOL turned that was allocated to classes with gross income based on the facts with respect to that gross income in the taxable year the expense is making up the NOL were deducted. The proposed regulations under 861(a) follow that same approach.

However, the preamble to the proposed regulations goes on to explain that the present final regulations fail to address the second step in the allocation process, which is then after a taxpayer identifies the class of gross income to which particular deductions relate. That class of gross income must be assigned to particular statutory residual groupings. The preamble explains that the proposed regulations are intended to address the second step in the allocation process, that providing that the components of an NOL (Net Operating Loss) are assigned the statutory residual groupings by reference to the groupings to which the components of the NOL would be assigned in the taxable year those components were deducted. And this is reflected in the proposed 861(a), e(a)ii.

One were to expect that this clarifying rule resolving the question of whether NOL is then rose prior to the effective date of TCJA are then carried over and reduced taxable income in a post-TCJA taxable year would be assigned to the statutory and individual groupings that existed prior to the enactment of TCJA.

However, the preamble to these proposed regulations notes that because the effect of this NOL allocation and NOL carrier was pre-TCJA years, it was originally mentioned in proposed regulation under section 250, the NOL rules address — will be addressed in the final regulations under that section rather than this section.

Our firm previously submitted written comments on this subject on February 10, 2020. In those comments, we noted that the question of how to resolve the determination of the statutory residual groupings of income to which the components of an NOL carryover are allocated was previously resolved in an analogous setting involving deductions in the former IRS section 199.

That issue was resolved by the IRS concluding that an expense recognized in a post-section 199 taxable year that actually relates to a class of gross income recognized in the pre-section 199 taxable year, is assigned to the residual grouping of non BPGR because the statutory grouping of BPGR did not exist when the income was recognized.

However, we want to point out an inconsistency between that conclusion and a provision in the current proposed regulations that calls into question the foregoing determination on the statutory residual groupings to which income is assigned. In the section of these proposed regulations dealing with product liability expenses, the proposed regulations provide the damages and the expenses of settling product liability (inaudible) allocated to class and gross income produced by specific sales of products of services that gave rise to the claims to damage or injury.

However, the proposed regulations provide that the income is assigned to the statutory residual grouping to which that income would be assigned as if the income were recognized in the same taxable year that the expenses were deducted rather than in the tax year the income was actually recognized.

We do not agree with that approach. We submit that the more correct approach would be to determine the statutory and residual groupings to which the related sales income is assigned based on the statutory and residual groupings that existed in a taxable year in which related sales income was actually recognized.

In these comments, we're not so much concerned with the allocation rules required liability expenses. But we want to point out this inconsistency because we fear that it could be interpreted more broadly as recycling a general principle, that when an expense is deductible in a particular taxable year but it actually relates to a class of income that was recognized in a different taxable year. The determination that the statutory residual grouping to which the income is assigned is based on the facts in the taxable year the expense was deducted rather than the taxable year which the related income was recognized.

It's a broader principle extends its NOL carryovers we are concerned that that might give rise to the interpretation that while the classes of income to which expenses making up an NOL are allocated based on the facts in the taxable year in which the expenses within the NOL weren't deducted. The statutory and residual groupings to which that income is assigned is dependent based on the facts of the taxable year and NOL carryovers used to reduce taxable income.

As noted in our prior written comments, this issue was resolved by the IRS over 10 years ago in AM 2009 (inaudible). It is pronounced that the IRS issued general guidance to revenue agents about how to deal with taxpayers that were proposed to allocate expenses deductible in taxable years in which section 199 was effective to non-BPGR because it those expenses were factually related to manufactured income. That was recognized in the pre-section 199 years.

The IRS resolved that issue by concluding that expenses without the post-section 199 year fell factually attributable income recognized in a pre-section 199 year are assigned to the residual grouping on non-BPGR because the statutory grouping for BPGR did not exist when the income was recognized.

More recently in CCA 2017 14029, the IRS ruled that a taxpayer's legal expenses incurred in defending losses from customers claiming harm from the use of the taxpayers alleged defective products should be assigned to non-BPGR when the product at issue is sold to customers prior to the effective date of 199.

The conclusion was reached, notwithstanding that the product liability expenses were deducted in taxable years after the enacted of section 199. And that was banning that the income from sales of similar products that occurred after the enactment of section 199 would have been assigned to the statutory grouping of the BPGR.

Accordingly, we submit that the position in proposed regs 861(a)(e)5 should be revised to reflect the principle that income is assigned to a statutory residual grouping based on the facts in the taxable year the income is recognized, regardless of whether the expenses to which that income relates was deducted in the same taxable year in which the income was recognized. This would eliminate any potential inconsistency with the rule for allocating NOL carryovers.

However, you know that the IRS rejects this recommendation with this product liability expenses. That interpretation of the allocation rules should not be extended when all carryovers arising in pre-TCJA years. In that regard, there's an important distinction between the situation in the NOL carryover context of product liability expenses insofar as the expenses that make up a pre-TCJA NOL were, in fact, deducted in pre-TCJA taxable years or allocated to pre-TCJA classes of gross income under the rules of section 861 in the proposed regs.

Thus, despite the fact that a pre-TCJ NOL that it be carried over in years would effect loss income recognized in a later post-TCJA taxable year. That should not mean that the statutory residual groupings to which the components of the NOL were originally assigned in the taxable year the NOL arose should be reassigned to potentially different statutory residual groupings. Because the income that is offset by the NOL carryover is assigned to different statutory residual groupings than the groupings that existed in the taxable year the NOL arose.

In conclusion, pre-TCJA NOL should be allocated to statutory residual groupings based on the groupings that existed in the taxable year that the NOL originally arose, and not the statutory residual groupings that exist in the taxable year the NOL carryover is used to reduce the taxpayer's income. Thank you for the opportunity to testify and I welcome any questions.

MR. COWAN: Okay, thank you. Thank you for your testimony, we really appreciate it. At this point, I don't have any questions but I will ask anyone on the panel if they might have questions.

MR. GILMAN: I do not.

MR. YEN: No.

MR. COWAN: Okay. Thank you, Les, and with that we will turn over to the next speakers, Larissa Neumann and Adam Halpern of Fenwick & West.

MS. NEUMANN: Great. The first topic we will be commenting on is the allocation and apportionment of NOL deductions. The preamble to the proposed regulations requested comments on the allocation of NOL arising before the enactment of TCJA but deducted in a post-TCJA year for purposes of applying FDII under section 250.

The allocation and apportionment of NOLs should follow the proposed regulation in 861-8(B)8 which assigns NOL to the statutory or residual grouping by reference to the losses in each grouping in the taxable year of the loss. Under this rule, NOLs arising in pre-TCJA year but deducted in post-TCJA year would be allocated to — would not be allocated to FDII.

So, this is appropriate because FDDEI and non-FDDEI grouping did not exist in pre-TCJA taxable years. The contrary rule was creating the inequitable circumstance of treating identical losses in the same year differently depending on whether taxpayers had sufficient income in that year to absorb the losses.

As a result, we recommend that 861-8(B)8 be finalized as proposed and should apply to how you would define an NOL for FDII purposes. And this is a sensible rule consistent with decades of legislation, regulatory guidance, and case law that describes in detail in our written comments.

The longstanding rules and guidance have consistently provided that an NOL deduction should be allocated based on the respective groupings of the income in the year the NOL arose. The final regulation should provide a result that is consistent with the longstanding NOL allocation rule.

The second topic we will be commenting on is foreign tax redetermination, notification, and reporting. The final foreign tax redetermination regulation under 905(c) significantly broadened the scope of redetermination adjustment to include any change in U.S. tax liability, even in direct effect and not just changes in the foreign tax credit itself.

As a result, foreign tax redeterminations will be very common. One issue this creates is the notification requirements in section 905-4. The proposed regulation required amended returns to be filed whenever a foreign tax redetermination causes any change in the reported U.S. tax liability for a prior year.

And this creates significant compliance burdens for taxpayers and a substantial administrative burden for the government as well. Forced audits are becoming much more common and redeterminations are now happening all the time. If you have one CFC with a tax change, you now have to amend potentially multiple year tax returns and revise your GILTI calculations and your 965 amounts.

We're concerned that unless this proposed rule is modified, taxpayers will need to file a number of amended returns every year. When federal amended returns are required, many states also require conforming amended returns. We strongly urge you to consider streamlined alternatives to the amended return requirements.

One option would be a de minimis test. So, for example, if the FTC change is less than 10 percent the adjustment could just be in the current tax return. This rough adjustment is better than the alternative of excessive and burdensome amended returns. We also recommend that taxpayers under examination should be allowed to notify the IRS directly regardless of whether the foreign tax redetermination results in an upward or a downward adjustment.

Another issue in the regulations that needs to be addressed is in example 2. The example states that if the high tax election is made, it would decrease U.S. tax. However, the adjustment is four years out from this original year. The question is, if you make the high tax election, does the 10-year statute of limitation provision for FPC apply or does the standard 3 year statute of limitation of apply. If the government leaves the 3 year statute of limitation applies, that fully should be clarified in the final regulations and otherwise the example is misleading.

Another issue with the proposed regulations is that they generally apply to foreign tax redeterminations occurring in tax years ending on or after December 17, 2019. There are no transition rules for the gap period after the three year expiration of the 2007 temporary regulation. Thank you and with that, I'll turn it over to Adam.

MR. HALPERN: Thank you, Larissa. I will cover three topics: stewardship, legal damages, and the allocation of foreign taxes. Stewardship, the proposed rule would move us away from the traditional factual relationship test to a formulary apportionment based on stock assets. But in practice, all stock assets will generally be foreign CFCs.

So, what if stewardship expense is factually related to an affiliated U.S. subsidiary or to a combination of U.S. and foreign? The rules need to ensure, in the final regs, that they make sense in light of the facts. You can't have 100 percent allocation to foreign when factually the expense is for the U.S. group.

Legal damages, again the proposed rules would move us away from factual relationships, in this case, to certain specific rules. The preamble says that we need to create clear rules but these rules are not clear. The rules start with simple cases, product liability claims, industrial accidents but they extrapolate to every other claim imaginable in every kind of business imaginable. And simplicity and clarity breaks down as we move away from these sort of simple cases.

We would recommend sticking with the factual relationship test. Alternatively, the proposed — the final rule could simply be for product liability in industrial accident claims if these are clear cases and leave the factual relationship test in place for other claims.

A separate point on legal damages: The final rules should protect against duplication of an allocation. For example, indemnification provisions in intercompany and third-party agreements often perform the same function as an allocation rule automatically. The final regs shouldn't require a double allocation by applying a blanket rule. Yet another reason the factual relationship test, which is more flexible, ought to be considered.

Foreign income taxes, I have two points. First, the proposed rule on base and timing differences. We commend the government for setting up an exclusive list of base differences. This is helpful and provides clarity. Our concern is with two of the specific items on the list. First, 301(c)2, return of basis distributions. In concept, these are really just a secondary affect of a tiny difference that exists at the lower-tier corporation level making distribution and should be treated as a timing difference in the final regs.

Second, section 733 distributions to partners, any taxes here really results from timing differences. For example, the U.S. sees a partner whose taxed immediately on partnership income whereas the foreign country sees two separate persons and the partner is only taxed upon distribution. In both of these cases, the taxes should be assigned to the same grouping as the underlying earnings.

The second point relates to disregarded payments from an owner to a branch. We're concerned that these payments under the proposed regs will cause the taxes at the disregarded branch level to be assigned to the residual grouping for purposes of section 960 and then eliminated from any possible foreign tax credit.

As a simple example, suppose a CFC owns a disregarded entity and pays a service fee to the disregarded entity. The CFC's income and foreign tax expense will be reduced. The disregarded entities income and foreign tax expense will be increased. The taxes at the disregarded entity level ought to be creditable under section 960Thank you for the opportunity to speak at today's hearing.

MR. COWAN: Okay, thanks Larissa and Adam, we appreciate those comments. At this point, I don't have any further questions for you two. I'm going to leave it up to Jason and Mike if they do.

MR. YEN: I don't.

MR. GILMAN: I just have a quick question on your last point just in your example if you could just elaborate. What is the income to which you would recommend that the taxes be related to?

MR. HALPERN: Well, whatever the disregarded entities other income would be related to. So, if it's earning tested income then those taxes should go into tested income. Or if it's a part of income then whatever grouping it's a part of, yeah.

MR. GILMAN: At the disregarded entity. Thank you for the clarification.

MR. COWAN: Okay, thank you. Danielle, I understand that there may be the possibility of participants raising their hand virtually and asking questions too, is that correct?

OPERATOR: Yes, there is. Would you like me to give those instructions right now?

MR. COWAN: Yes.

OPERATOR: Great. Ladies and gentlemen, as we move to Q&A, please press #2 on your telephone keypad to enter the question queue. You will then hear a notification when your line is unmuted. At that time, please then state your name and question. Once again, pressing #2 will indicate that you wish to ask a question. And at this time, there are no questions in the queue.

MR. COWAN: Okay. Well, if there are no questions, I guess that will conclude the hearing and we appreciate all the testimony from the speakers. From Catherine Schultz, from Les Schneider and Larissa Neumann and Adam Halpern and thank you for your comments and participation. Thank you.

OPERATOR: Than concludes our conference. Thank you for using AT&T event conferencing. You may now disconnect.

(Whereupon, at 10:35 a.m., the PROCEEDINGS were adjourned.)

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