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Would Removing Downward Attribution Retroactively Be a Gift?

Posted on Dec. 2, 2019

On the wish list of many multinational corporations is some sort of legislative solution to the difficulties resulting from the Tax Cuts and Jobs Act‘s repeal of the no-downward attribution rule in former section 958(b)(4). This gift is unlikely to arrive with a red bow on top in the next month, but when Congress gets around to dealing with the consequences of repeal, it must determine whether to make those changes retroactive.

In the current proposals, reinstating section 958(b)(4) is coupled with the addition of new section 951B, which would impose downward attribution when a U.S. shareholder owns more than 50 percent of a foreign corporation. The addition of section 951B is written as retroactive in the technical corrections bill introduced by Texas Republican Rep. Kevin Brady when he was chair of the House Ways and Means Committee, and Rep. John Lewis, D-Ga., and Sen. Johnny Isakson, R-Ga., also picked it up in their bills (H.R. 4509 and S. 2589). But retroactive application, while it might be welcomed by many taxpayers, might not pass constitutional muster.

The difficulty in relying on the legislative history to reinstate section 958(b)(4) retroactively through a technical correction is that the statutory language is unambiguous. Congress must be assumed to have said what it meant in the statute, even if it did say a little more about what it intended to do in the legislative history.

Constitutional Questions

In a December 20, 2018, letter to congressional taxwriters, tax practitioners Jeffrey M. O’Donnell, Robert H. Dilworth, and Matthew A. Lykken argued that the proposed technical correction to reinsert the limitation on downward attribution and the proposed enactment of a new section 951B “are examples of amendments to carry out a revised Congressional intent nowhere contemplated in the Committee Reports accompanying the TCJA.” The letter objected to the proposed section 951B as a potentially unconstitutional taking under the Fifth Amendment, because it would “retroactively subject to tax income that was never described as income to be taxed in connection with the repeal of section 958(b)(4).”

The practitioners explained that taxpayers have relied on the clear language of the removal of section 958(b)(4), as well as the Treasury guidance that implements the change, which assumed that the repeal would not be revoked retroactively, in planning their 2018 (and now 2019) transactions. They gave examples of how taxpayers might have changed their structures in order to address the new rule and how a retroactive reversal would harm that planning. Taxpayers “will be harmed through an increased U.S. federal tax liability if the proposed re-adoption of section 958(b)(4) is made retroactive to the same date as its repeal as part of TCJA,” they argued.

One of the problems with reinstating section 958(b)(4) and adding section 951B via technical correction is that the amendments are likely to raise revenue, according to O’Donnell, Dilworth, and Lykken. They also noted that changing the law in a way that overrides a treaty in a technical correction is “peculiarly inappropriate.” They wrote that if the proposed changes are enacted, they should be prospective only.

The arguments espoused by O’Donnell, Dilworth, and Lykken were disputed by lawyers at Miller & Chevalier Chtd., who argued that the change could be enacted as a technical correction without violating the Fifth Amendment. They argued that the legislative history showed that Congress intended the repeal of section 958(b)(4) to apply only to transactions designed to avoid the rules of subpart F. The letter notes that the explanation of the Senate amendment in the conference report (H.R. Rep. No. 115-466) says that the Senate Finance Committee did not intend to cause a foreign corporation to be treated as a controlled foreign corporation for a U.S. shareholder as a result of attribution of ownership to a U.S. person that is not a related person. And the practitioners argued that “it is not conceivable that Congress intended to modify a bedrock principle of the subpart F rules since their original enactment in 1962 — that a U.S. Shareholder should not be taxed on earnings of a foreign corporation it neither controls or is related to — without a detailed and explicit rationale for doing so.”

Controversy continues about the legislative history of the section 958(b)(4) repeal. (Prior coverage: Tax Notes Int’l, Nov. 11, 2019, p. 495.) The conference report says the point is to “render ineffective certain transactions that are used as a means of avoiding the subpart F provisions,” and it identifies transactions that result in “de-control” of a foreign subsidiary as one example. But Congress didn’t change the legislative language to reflect the apparent intent to reach only transactions that are meant to avoid subpart F, and the House bill says only that the provision provides downward attribution from a foreign person to a related U.S. person in circumstances in which present law does not. The House Ways and Means Committee explained that it believed the provision was necessary to render decontrolling transactions ineffective as a means of avoiding the subpart F provisions, but it doesn’t suggest that the provision should be limited to only those types of transactions.

The Fifth Amendment Framework

The notion that the takings clause and its due process requirements in the Fifth Amendment apply at all to tax statutes wasn’t generally accepted until the Supreme Court decided Brushaber v. Union Pacific Railroad Co., 240 U.S. 1 (1916). In Brushaber, the Court explained that the Fifth Amendment’s due process requirement “is not a limitation upon the taxing power conferred upon Congress by the Constitution,” but suggested that a putative tax statute might be “so arbitrary as to constrain to the conclusion that it was not the exertion of taxation, but a confiscation of property, . . . or, what is equivalent thereto, was so wanting in basis for classification as to produce such a gross and patent inequality as to inevitably lead to the same conclusion.” In Nichols v. Coolidge, 274 U.S. 531 (1927), the Court applied the arbitrariness standard to hold that a tax statute that applied to property transferred before the passage of the statute “is arbitrary, capricious and amounts to confiscation.”

O’Donnell, Dilworth, and Lykken argued that the courts distinguish between legislation that retroactively changes the rate of tax from legislation that changes whether a transaction is taxable. They pointed to Judge Learned Hand’s opinion in Cohan v. Commissioner, 39 F.2d 540, 545 (2d Cir. 1930), as evidence that there is a constitutional difference — as yet undefined in 1930 — between a taxpayer whose transaction would have been taxable under the prior statute, but in a different way or degree, and a taxpayer whose transaction was not previously taxable. Hand’s explanation of the distinction is dicta because the transaction at issue was one that had been taxable before the legislative change, which effectively increased the rates to the taxpayer’s disadvantage. Congress must follow “custom” in order to avoid a constitutional problem, but it need not be “consistent,” in Hand’s opinion. Individuals “cannot hope to fit their doings in advance to a pattern which will be sure to endure. The most they can expect is that courts will intervene when the defeat of their expectations passes any measure that reasonable persons could think tolerable, and even then their grievance must be fairly outside the zone of possible debate,” Hand explained.

How Late Is Too Late?

The TCJA was signed into law December 22, 2017. Almost two years later, technical corrections that would reinstate section 958(b)(4) subject to the limitations of new section 9951B haven’t yet been adopted. In United States v. Carlton, 512 U.S. 26 (1994), the Supreme Court held that a retroactive application of an amendment to the tax code did not violate the due process clause of the Fifth Amendment when the provision was retroactively applied to a statute passed a little over a year before. The Court explained that the amendment was “adopted as a curative measure” because without it, an estate could buy stock after the death of the testator and immediately resell it to an employee stock ownership plan for the sole purpose of generating a loss and reducing the estate tax. What Congress apparently had in mind when enacting the provision was to encourage the estates of decedents who were already stockholders to sell stock in companies that they owned to their employees.

The Supreme Court also explained that “we do not consider respondent Carlton’s lack of notice regarding the 1987 amendment to be dispositive.” And the Court discounted the authority of cases like Nichols v. Coolidge, on the grounds that they “were decided during an era characterized by exacting review of economic legislation under an approach that ‘has long since been discarded.’”

Justices Antonin Scalia and Clarence Thomas concurred in the judgment in Carlton but objected to the majority opinion on the grounds that the Court’s reasoning means that “all retroactive tax laws will henceforth be valid.” To support the majority’s reasoning is to say that the only requirement for constitutionality is that the retroactive aspects of the statute are rationally related to a legitimate legislative purpose, they suggested. The concurrence explained that “I welcome this recognition that the Due Process Clause does not prevent retroactive taxes, since I believe that the Due Process Clause guarantees no substantive rights, but only (as it says) process.”

The Miller & Chevalier letter contended that a taxpayer who relied on “the technical results of Section 14213 [repeal of subsection 958(b)(4)] to enter into a transaction or arrangement that resulted in an unintended windfall would have a much weaker case in challenging a technical correction to Section 14213 under the Due Process Clause than the taxpayer in Carlton,” because the congressional intent was clear. While a taxpayer who aggressively used the repeal of section 958(b)(4) in planning might not be sympathetic, it shouldn’t be the case that standard tax minimization techniques using the plain language of the tax code should effectively be punished simply because a taxpayer relied on the unambiguous statutory language and not the prospect of a technical correction based on the legislative history. This is materially different than  Carlton, in which the estate executor had taken advantage of a poorly drafted provision. To be sure, in both cases, Congress seems to have made a significant drafting misstep insofar as achieving its legislative goals, but the post-death acquisition and sale scenario has an air of unclean hands that is absent in the situation of a taxpayer relying on downward attribution to restructure.

A Solution

There is no perfectly clear line between what’s within the scope of a technical correction and what should be in a separate amendment, but a tidy legislative fix may be possible to avoid the problem of retroactive application. Congress could make the provision retroactive only on an elective basis, or only prospectively. Taxpayers might prefer the election because it would preserve the benefits of any tax planning already implemented for 2018 and 2019, and that’s probably the most equitable solution. Administratively, it could be more of a nuisance on audit to deal with a temporarily elective provision, but that shouldn’t be a large obstacle to making the retroactivity elective. A prospective-only approach has the drawback of leaving the same taxpayers who hoped for a reversal of repeal with several years’ worth of problems.

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