Correction to TCJA Provision Doesn’t Violate Due Process, Firm Says

December 31, 2018

The Honorable Orrin Hatch
Chairman
Committee on Finance
United States Senate
219 Dirksen Senate Office Building
Washington, D.C. 20510

The Honorable Kevin Brady
Chairman
Committee on Ways and Means
United States House of Representatives
1102 Longworth House Office Building
Washington, D.C. 20515

The Honorable Ron Wyden
Ranking Member
Committee on Finance
United States Senate
219 Dirksen Senate Office Building
Washington, D.C. 20510

The Honorable Richard Neal
Ranking Member
Committee on Ways and Means
United States House of Representatives
1139E Longworth House Office Building
Washington, D.C. 20515

Re: Pending Technical Correction to Section 14213 of P.L. 115-97 (Modification of Stock Attribution Rules for Determining Status as a Controlled Foreign Corporation)

Dear Chairman Hatch, Ranking Member Wyden, Chairman Brady, and Ranking Member Neal:

Miller & Chevalier Chartered respectfully submits this letter to provide information regarding the pending technical correction to Section 14213 of P.L. 115-97 (Dec. 22, 2017) (commonly referred to as the Tax Cuts and Jobs Act or TCJA), which modified the stock attribution rules for determining status as a controlled foreign corporation.

Based on the legislative history to the TCJA, Congress intended the modification of the stock attribution rules to render ineffective certain so-called “de-control” transactions as a means of avoiding the subpart F provisions applicable to U.S. shareholders of controlled foreign corporations. Based on that same legislative history, Congress did not intend for this provision to tax a U.S. taxpayer on subpart F income earned by a foreign corporation that it does not control and to which it is not related.

In light of this legislative history, numerous taxpayers and their representatives, including Miller & Chevalier Chartered, have requested that the Treasury Department (“Treasury”) and the Internal Revenue Service (the “IRS”) issue administrative guidance implementing the modification of the stock attribution rules consistent with Congressional intent and the overall purpose of the subpart F rules.¹ We continue to encourage Treasury and the IRS to issue such guidance, which we believe is well within their regulatory authority.

In addition to consideration of administrative guidance, Congress has also sought to address this issue through a pending technical correction to Section 14213 of the TCJA. On December 20, 2018, the House of Representatives passed H.R. 88. Section 501(f) of Division A of that bill (the Retirement, Savings, and Other Tax Relief Act of 2018) contains a technical change to the statute to clarify the application of the attribution rules under subpart F based on the legislative history. This technical change to the statute has been determined to be a “technical correction,” as that term is commonly understood, by the nonpartisan staff of the Joint Committee on Taxation after a deliberative and consultative process and, as such, can properly be enacted retroactive to the effective date of the TCJA without violating the Due Process Clause of the Fifth Amendment of the Constitution or any other rule of law. We believe this conclusion to be self-evident and not controversial. However, we understand that one group of unaffiliated individual commentators has taken a contrary view, based on a selective and misleading analysis of the legislative history.² Thus, the purpose of this letter is to provide additional support for the technical correction as contained in H.R. 88 and as determined by the nonpartisan staff of the Joint Committee on Taxation.

Congress Intended Section 14213 of the TCJA to Address Only Transactions Designed to Avoid the Subpart F Rules

Section 14213 of the TCJA modifies the technical ownership attribution rules for determining whether foreign corporations are U.S. controlled foreign corporations. Prior to the TCJA, the applicable rules prevented the “downward attribution” of stock ownership from a foreign person to a U.S. subsidiary for purposes of determining the status of a corporation as a controlled foreign corporation.³ Section 14213 modified these rules to require such downward attribution under certain circumstances.

The legislative history notes two elements of Congressional intent with respect to Section 14213. As explicitly provided in the Conference Report to the TCJA (the “Conference Report”), the primary intent of this provision was “to render ineffective certain transactions that are used to as means of avoiding” the subpart F rules, including so-called “de-control” transactions following inversion or similar transactions.⁴

Congress recognized, however, that this change could also be interpreted more broadly to cause a foreign corporation, which is part of an affiliated group that includes a domestic corporation, to be treated as a controlled foreign corporation with respect to a minority U.S. shareholder not otherwise related to the foreign corporation or affiliated group. Congress did not intend for this provision to tax a U.S. taxpayer on subpart F income earned by a foreign corporation that it does not control and to which it is not related, and Section 14213 need not be interpreted to require such result.⁵ Such a broad interpretation was neither intended, nor was it is necessary to address the de-control transactions targeted by Congress. Accordingly, the Senate Budget Committee Report and the Conference Report both note a second element of Congressional intent, explaining that the provision:

Congress' intent was further reinforced by a colloquy between Senate Committee on Finance Chairman Hatch and Senator Perdue on the Senate floor, during which Chairman Hatch confirmed that the above statement reflected the intent of the Senate Committee on Finance and the conferees.⁷

Even absent the specific expression of Congressional intent in the Senate Budget Committee Report and the Conference Report, 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.⁸

A Technical Correction to Section 14213 of the TCJA To Clarify Its Application Consistent with the Two Elements of Congressional Intent Is Appropriate

Technical corrections to an act of Congress are appropriate when necessary to align the technical statutory text with the intent of Congress.⁹ As explained above, the legislative history notes two elements of Congressional intent with respect to Section 14213 of the TCJA:

With reference to the second element of Congressional intent, the nonpartisan staff of the Joint Committee on Taxation has concluded that “[a] technical correction may be necessary to reflect the intent expressed by Congress.”¹⁰ It is important to note that this conclusion was the result of a deliberative and consultative process among the Congressional and Administration tax staffs.¹¹

The legislative change proposed in Section 501(f) of the Retirement, Savings, and Other Tax Relief Act of 2018 clarifies Section 14213 to be consistent with both elements of Congressional intent, as articulated by the Senate Budget Committee Report and the Conference Report. Under Section 501(f), the downward attribution rules would apply as necessary to ensure that de-control and similar transactions cannot be used to avoid the subpart F rules. Moreover, under Section 501(f), the subpart F rules would not extend to a U.S. taxpayer with a minority interest in a foreign corporation solely as a result of the downward attribution of ownership to an unrelated U.S. person. Accordingly, Section 501(f) implements both elements of Congressional intent and, therefore, qualifies as a technical correction as has been determined to be necessary and appropriate by the nonpartisan staff of the Joint Committee on Taxation.¹²

A Technical Correction to Section 14213 of the TCJA Does Not Raise Due Process Concerns

By its nature, a technical correction has the same effective date as the underlying provision to which it relates (i.e., retroactive as if included in the original legislation to which the correction relates). This is sensible because a technical correction implements the intent of Congress in enacting the original provision. Thus, Section 501(f) of the Retirement, Savings, and Other Tax Relief Act of 2018 contains the same effective date as that of Section 14213 of the TCJA: the last taxable year of a foreign corporation beginning before January 1, 2018.¹³ This proposed effective date does not raise concerns with the Due Process Clause of the Fifth Amendment to the U.S. Constitution because a technical correction to Section 14213 would be supported by a legitimate legislative purpose furthered by rational means.

In the leading case in this area, United States v. Carlton,¹⁴ the U.S. Supreme Court considered whether a technical correction enacted more than a year after the enactment of the provision at issue violated the Due Process Clause. The provision at issue, which was enacted in October 1986, granted an estate tax deduction equal to 50 percent of the proceeds of the sale of employer stock to an employee stock ownership plan (an “ESOP”). Based on the legislative history, the purpose of the rule was to provide an incentive for stockholders to sell their companies to their employees who helped them build the company rather than to sell to outsiders. The taxpayer in the case, an executor of an estate of an individual who had died prior to the enactment of the provision, purchased $11 million of MCI stock in December 1986 and immediately sold that stock at a loss to an MCI ESOP. The technical correction limited the benefit of the estate tax deduction to the stock of the decedent held prior to her death, in accordance with the Congressional intent underlying the original provision. The Court concluded that the technical correction was supported by a legitimate legislative purpose furthered by rational means based on the following factors: (1) the amendment was intended to implement the original provision as intended; (2) Congress did not act with an improper motive; (3) Congress acted promptly in proposing the amendment; and (4) the retroactivity period was relatively modest. The Court upheld the retroactive amendment even though the taxpayer detrimentally relied on the technical language of the original provision and even though the taxpayer did not have notice that an amendment with retroactive effect would be enacted.

As with the provision at issue in Carlton, a technical correction to Section 14213 would be supported by a legitimate legislative purpose furthered by rational means. The technical correction better aligns the statutory text with the stated and contemporaneous intent of Congress in enacting Section 14213; i.e., it more clearly implements the original provision based on the legislative history explaining the original provision. Congress would not be acting with an improper motive, as Congress has made its intent in enacting Section 14213 very clear in the Senate Budget Committee Report and the Conference Report. The technical correction to Section 14213 was proposed less than a year following the enactment of the TCJA, and assuming the technical correction is enacted within a reasonable period of time, the retroactivity period will be relatively modest.¹⁵ It is not surprising that a technical correction to Section 14213 would withstand a Due Process challenge given that it has been determined to be necessary and appropriate by the nonpartisan staff of the Joint Committee on Taxation, that the technical correction clarifies Section 14213 to align it more closely to clearly expressed Congressional intent, and that the Supreme Court “has repeatedly upheld retroactive tax legislation against a due process challenge.”¹⁶

Indeed, a taxpayer that relied on the technical results of Section 14213 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. Congress's intent in enacting Section 14213 was clearly stated and contemporaneous with the enactment of the TCJA: Congress intended to render ineffective certain de-control transactions as a means of avoiding the subpart F provisions, and Congress did not intend the provision to have incidental effects that were not necessary to the achievement of this purpose, including the taxation of U.S. taxpayers on subpart F income earned by foreign corporations that the taxpayers do not control and to which the taxpayers are not related. The technical deficiencies in Section 14213 have the potential to lead to unintended windfalls because Section 14213 could be interpreted to create, for the first time, a class of controlled foreign corporations with no direct or indirect U.S. shareholders — that is, a class of faux controlled foreign corporations that earn subpart F income that is not taxed in the hands of any U.S. person. The subpart F rules, and the many other rules of the Internal Revenue Code that refer to controlled foreign corporations as defined by the subpart F rules, were not drafted with such faux controlled foreign corporations in mind. Treasury and the IRS have issued guidance since the enactment of the TCJA that excludes such faux controlled foreign corporations from certain otherwise applicable rules, consistent with the intent of Congress and with the agencies' perceptions of their regulatory authority, and have signaled that more guidance is being considered.¹⁷ A taxpayer that has ignored stated Congressional intent and relied on an inappropriately broad interpretation of Section 14213 to achieve an unintended windfall would have no recourse under the Due Process Clause to preserve such windfall.¹⁸

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We hope that you find this letter helpful and would be happy to answer any questions that you may have.

Respectfully submitted,

Rocco V. Femia

Marc J. Gerson

Miller & Chevalier Chartered
Washington, DC

cc:
David Kautter
Lafayette Harter III
Douglas Poms
Charles Rettig 
William Paul
Marjorie Rollinson
Thomas Barthold
Jennifer Acuna
Tiffany Smith
Barbara Angus
Kara Getz