Firm’s Comments Focus on Specified Foreign Corp’s Cash Position

October 2, 2018

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

The Honorable Charles P. Rettig
Commissioner of Internal Revenue
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

The Honorable William M. Paul
Deputy Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Re: Comments on Cash Position under Section 965 Proposed Regulations

Dear Messrs. Kautter, Rettig, and Paul:

McDermott Will & Emery LLP appreciates the opportunity to comment on the proposed section 965 regulations published in the Federal Register on August 9, 2018, 83 Fed. Reg. 39514 (the Proposed Regulations). We respectfully submit this letter requesting the Department of Treasury and the Internal Revenue Service to add clarifying language to the Proposed Regulations providing that shares of stock in a corporation that are not reported in the current assets section of a specified foreign corporation’s (SFC’s) balance sheet should not be included in that SFC’s cash position. This treatment clearly comports with Congressional intent as set forth in the legislative history and is consistent with the statutory language of section 965.

I. Background

A. General

Section 965 generally requires a U.S. shareholder in a specified foreign corporation (SFC) to include in its gross income under Subpart F its pro rata share of the SFC’s post-1986 earnings and profits for the last taxable year of the SFC beginning before January 1, 2018.¹ The total amount of the section 965 inclusions from all SFCs is effectively subject to a 15.5% tax rate to the extent of the U.S. shareholder’s “aggregate foreign cash position.” Any remaining amount is subject to tax at an effective rate of 8%.²

A U.S. shareholder’s aggregate foreign cash position is the sum of its pro rata shares of the cash positions of SFCs in which it is a U.S. shareholder, and is the greater of two amounts determined on different dates. The first amount is the U.S. shareholder’s aggregate foreign cash position determined as of the close of the last taxable year of each SFC which begins before January 1, 2018. The second amount is the average of two amounts: (1) the U.S. shareholder’s aggregate foreign cash position determined as of the close of the last taxable year of each SFC which begins before November 2, 2017, and (2) the U.S. shareholder’s aggregate foreign cash position determined as of the close of the last taxable year of each SFC which precedes such taxable year.³

B. SFC’s Cash Position

Section 965(c)(3)(B) defines the “cash position” of an SFC as including cash and foreign currency held by the SFC. Cash position also includes net accounts receivable of an SFC, and the Proposed Regulations provide that only accounts receivable with a term of less than one year are included in an SFC’s cash position.⁴ An SFC’s cash position further includes commercial paper, certificates of deposit, the securities of the Federal government and of any State or foreign government, as well as obligations with a term of less than one year. Finally, the term cash position includes “personal property [held by an SFC] which is of a type that is actively traded and for which there is an established financial market.” The Proposed Regulations label all listed items other than cash and accounts receivable as “cash-equivalent assets.”⁵

The Code provides that additional assets that the Secretary identifies as being economically equivalent to any listed asset may be included as a cash position asset. The Proposed Regulations add certain derivative financial instruments to the list of cash position assets.⁶

Congress described the assets intended to be included in an SFC’s cash position as the SFC’s “liquid” assets and “cash and cash equivalents.”⁷ The term “liquid” assets generally refers to assets held for less than one year and readily convertible into cash without significant change to their value. The reference to “cash equivalents” refers to very liquid short-term instruments, generally with a maturity of no more than three months, and readily convertible into a known amount of cash.

Congress further described the assets intended to be excluded from the definition of cash position as an SFC’s “illiquid” assets and earnings reinvested in the corporation’s business. The term “illiquid” generally refers to assets held for more than one year. Congress expressed a clear intent that earnings not invested by an SFC in liquid assets be subject to the lower 8% rate to “moderate the tax burden on illiquid accumulated E&P that has been reinvested in the foreign subsidiary’s business.”

C. Shares of Stock in a Corporation

As noted above, cash position assets include “personal property which is of a type that is actively traded and for which there is an established financial market.” Shares of stock in some corporations are actively traded on established financial markets. Thus, shares of stock in a corporation can be included in the cash position of an SFC.

Nevertheless, it is clear that not all shares of stock in a corporation held by an SFC would be considered as personal property which is “of a type” that is actively traded and for which there is an established financial market. For example, shares of stock held by an SFC in a wholly-owned subsidiary would not be considered as a cash position asset.⁸ The fact that shares in some corporations are actively traded on established financial markets does not cause shares in a corporation whose shares are not traded at all to be considered of a type of personal property that is actively traded.

It is equally clear that shares held by an SFC in a corporation whose shares are traded on an exchange but not “actively” traded also would not be considered as personal property of a type that is actively traded on an established financial market. When none of a corporation’s shares are actively traded, then just like with shares in a wholly-owned subsidiary, such shares held by an SFC cannot be of a type of actively traded shares based on the fact that shares in other corporations are actively traded.⁹

An SFC may hold stock in a public company and not itself actively trade the stock, but the stock in the public company may be considered as actively traded on an established financial market. The SFC may hold the shares as a short-term investment or as a long-term strategic investment. A facts and circumstances inquiry is required to determine whether the stock held by the SFC is “of a type” of stock that is actively traded on an established financial market.

II. Illustration: Long-Term Strategic Investment

Consider the following example which is representative of a common situation involving corporations holding strategic investments in stock of public corporations. A domestic public corporation owns a CFC, which in turn owns 65% of the outstanding stock in a foreign public company. The stock was acquired in 2010 as a strategic investment to gain a business presence in a particular country outside the United States.

There are material business transactions between the domestic corporation and the foreign corporation. These include sales of products, provision of services, and the development of new products and services. The domestic corporation also is involved with providing strategic direction to the business of the foreign corporation. The foreign public company is the sole presence of the domestic corporation’s group in the particular country, which plays a strategic role in the group’s global expansion objectives.

The taxpayer has never traded the stock in the public company since the stock was acquired in 2010. In addition, certain restrictions and limitations apply to any sale of the stock by the taxpayer, and business exigencies necessitate holding the stock on a long-term basis. Moreover, any attempt by the taxpayer to sell even a fraction of the stock in the market (much less the taxpayer’s entire holding) would disrupt the market, making it unrealistic to expect that the taxpayer could quickly convert its entire holding into cash at the prevailing market price. Nevertheless, the trading activity carried on by other shareholders may cause the stock in the corporation to be considered as actively traded on an established financial exchange, even though that activity does not represent any opportunity for the taxpayer to convert its holding quickly into a predictable amount of cash like the corporation’s other shareholders could do.

The investment in the stock of the foreign public corporation has been reported on the domestic corporation’s audited financial statements by reporting the assets of the foreign corporation on a consolidated basis as an affiliate, and the value of the non-controlling interest in the entity is listed on the balance sheet as equity not owned by the parent. At no time was the stock in the foreign public company reported as a current asset.

It is indisputable that the investment of earnings by the SFC in the stock of the foreign public company would not be considered as a “cash position” of the SFC under any common definition of that term. In addition, it is clear that such stock would not be considered as within any of the descriptive terms used in the legislative history. The SFC’s investment in the public foreign corporation is not a liquid asset, nor would it be considered as cash or a cash equivalent (or within the ordinary meaning of a “cash-equivalent asset” as used in the Proposed Regulations to describe this category of cash position). Indeed, the stock in the public company is clearly an illiquid asset with very little similarity to cash as an economic and practical matter. Such stock represents a long-term investment of the SFC’s earnings in its business, which Congress states is not a cash position subject to the higher tax rate.

Thus, it is necessary to interpret the phrase “of a type” as not including the above SFC’s investment in stock in the public foreign corporation. A 65% interest in a public company’s stock truly is not “of’ the same “type” of property as a 0.01% interest in that company’s stock. The latter can be quickly converted to cash at a knowable price; the former cannot. The existence of active trading on an established market renders the latter holding cash-like, whereas it has no such effect with respect to the former holding. Any interpretation that would treat these two situations the same would conflict with both the language of the Code and Congressional intent.

Moreover, such an interpretation would spawn a series of messy valuation disputes between taxpayers and the IRS, as section 965(c)(3)(B)(iii) would require a determination of the “fair market value” of the holding, which could not be reliably determined as simply the number of shares multiplied by the general stock price quoted on a public exchange. Taxpayers would seek blockage or lack-of-marketability discounts, the IRS might seek control premiums, and battles of expert economists would be fought to determine the correct values. The fact that it would be so fraught to put a reliable number on a strategic stock holding of this nature of course itself reinforces that the holding is in no way cash-like and was never meant to be treated as such for purposes of section 965.

Due to the uncertainty concerning how to determine whether stock in a publicly traded company held by an SFC is “of a type” of property that is actively traded — which is a common situation — it is important that the Treasury and IRS provide guidance.

III. Proposed Clarification Language

We request that clarifying language be added to the regulations as follows:

“Shares of stock in a corporation will not be treated as personal property which is of a type that is actively traded and for which there is an established financial market if such stock properly was not reported as a current asset on the audited financial statements of the taxpayer or a specified foreign corporation in which the taxpayer is a U.S. shareholder on the determination dates specified in Reg. § 1.965-1(f)(8) and -3(c).”¹⁰

Under financial accounting rules, stock in a corporation is included in the current assets section of its balance sheet if the stock is a liquid asset. Stock generally is reported as a current asset if it is expected to be converted to cash within one year. Long-term strategic investments in stock of a corporation are not permitted to be reported in the current assets section of a corporation’s balance sheet because such stock is not a liquid asset.

The requested clarifying sentence is consistent with the descriptive terms used to describe the assets that are taken into account for purposes of applying the higher 15.5% tax rate. Such assets are labeled generally “cash position,” a term that is also used for financial accounting purposes, and would include only assets reported in the current assets section of the balance sheet. In addition, the Proposed Regulations describe stock included within an SFC’s cash position as a “cash-equivalent asset,” which again is a concept applied for financial accounting purposes and would only include an asset that is considered a current asset. Such descriptive terms would not include assets reported on the long-term assets section of a balance sheet.

This clarification would precisely carry out Congressional intent. Any asset not reported in the current assets section of the balance sheet would not be a liquid asset. Any significant investment in a corporation that is reported in the long-term section of the balance sheet generally would be a strategic business investment, just like the reporting company’s other trade or business assets. Congress made it clear that the higher rate of tax is not intended to apply to illiquid investments and in particular to earnings reinvested in the business of the foreign corporation.

This approach ensures that the “of a type” requirement is interpreted consistent with the other cash position assets listed in the Code. Cash, foreign currency, obligations with a term of less than one year, commercial paper, certificates of deposit, and government obligations all generally would be reported as current assets, in that they represent liquid assets of the corporation.

Importantly, the requested clarification is quite similar to what was already added in the Proposed Regulations for accounts receivable. The Code includes within the definition of cash position net accounts receivable regardless of the term. Consistent with Congressional intent, the Proposed Regulations provide that only accounts receivable with a term of less than one year are a cash position asset (such assets would be reported as current assets on the SFC’s financial statements). On the other hand, accounts receivable with a term of one year or more are not a cash position asset under the Proposed Regulations (such assets generally would be reported in the long-term assets section of a corporation’s balance sheet). Consistency requires that the regulations provide that shares of stock in a corporation that are not reported as current assets for financial statement purposes — which generally means the shares are illiquid assets that will not be converted to cash within one year — should likewise be excluded from the definition of cash position.

The above proposed clarification would be easy to administer. The financial statements of the taxpayer and an SFC will be the primary reference for identifying the assets held by an SFC for purposes of determining its cash position. Any shares of stock in corporations held by an SFC that are not reported as current assets would be excluded from the SFC’s cash position.

The proposal ensures reliability by making the cash position determination with reference to the current asset section of a corporation’s financial statements. Specific accounting rules and standards must be followed in classifying assets as current assets or as long-term assets (which distinguish between liquid and illiquid assets).¹¹ Furthermore, since the relevant balance sheets would have already been prepared by the time of the issuance of final regulations, there would be no ability to affect the result.¹² Indeed, corporations if anything may be motivated to maximize the amount of current assets to present the best liquidity picture of a public company.

In summary, we respectfully request that a sentence be added to the Proposed Regulations clarifying that stock in a corporation will not be included in an SFC’s cash position if such stock properly was not reported as a current asset on the audited financial statements of the taxpayer or a specified foreign corporation in which the taxpayer is a U.S. shareholder. We appreciate the opportunity to comment on the Proposed Regulations, and welcome the opportunity for a meeting. We appreciate your time in considering this proposal. Please feel free to contact Lowell Yoder at (312) 984-7523 or lyoder@mwe.com, or Dave Noren at (202) 756-8256 or dnoren@mwe.com.

Respectfully Submitted,

McDermott Will & Emery LLP

cc:
Mr. L.G. “Chip” Harter, Deputy Assistant Secretary (International Tax
U.S. Department of the Treasury

Mr. Douglas L. Poms, International Tax Counsel
U.S. Department of the Treasury

Ms. Marjorie A. Robinson, Associate Chief Counsel (International)
Internal Revenue Service

Ms. Brenda Zent, Special Advisor on International Taxation
Office of Tax Policy, U.S. Department of the Treasury

Mr. Gary Scanlon, Attorney Advisor
Office of International Tax Counsel, U.S. Department of the Treasury

Mr. Daniel McCall, Deputy Associate Chief Counsel (International — Technical)
Internal Revenue Service

---

Appendix One

Cash Position: Congressional Intent

Congress describes its intended meaning of the term “cash position” in the reports explaining section 965. The discussion in the reports states that the 15.5% rate is intended to apply to cash and cash equivalents, as well as other liquid assets. The term cash position is not intended to include earnings reinvested in the business of an SFC or other illiquid assets.

The House Ways and Means Committee report on the House bill, H.R.1, provided, “[t]he Committee believes the tax on accumulated foreign earnings should apply without requiring an actual distribution of earnings, and further believes that the tax rate should take into account the liquidity of the accumulated earnings. Accordingly, the provision establishes a bifurcated rate, i.e., 14 percent for earnings held in liquid form and 7 percent for accumulated foreign earnings that have been reinvested in the foreign subsidiary’s business.”¹³

The Committee described how the bifurcated rate was implemented: “[a] portion of that pro rata share of deferred foreign income is deductible; the amount deductible varies depending upon whether the deferred foreign income is held in the form of liquid or illiquid assets. The deduction results in a reduced rate of tax of 14 percent for the included deferred foreign income held in liquid form and 7 percent for the remaining deferred foreign income.”¹⁴

The Committee then defined cash position: “[t]he cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market, government securities, certificates of deposit, commercial paper, foreign currency, and short-term obligations. In addition, the Secretary may identify other assets that are economically equivalent to the enumerated assets that are treated as cash.”¹⁵

The Ways and Means Committee also provided a section-by-section summary of the House bill. The section-by-section summary noted that, “[t]he E&P would be classified as either E&P that has been retained in the form of cash or cash equivalents, or E&P that has been reinvested in the foreign subsidiary’s business (e.g, property, plant, and equipment). The portion of the E&P comprising cash or cash equivalents would be taxed at a reduced rate of 12 percent, while any remaining E&P would be taxed at a reduced rate of 5 percent.”¹⁶ The section-by-section summary also provided that “[t]he provision would moderate the tax burden on illiquid accumulated E&P that has been reinvested in the foreign subsidiary’s business.”¹⁷

The Senate Budget Committee issued a report describing the Senate amendments to the House bill. This report provided, “[t]he Committee believes the tax on accumulated foreign earnings should apply without requiring an actual distribution of earnings, and further believes that the tax rate should take into account the liquidity of the accumulated earnings. Accordingly, the provision establishes a bifurcated rate, i.e., 10 percent for earnings held in liquid form and 5 percent for accumulated foreign earnings that have been reinvested in the foreign subsidiary’s business.”¹⁸

The report also described the definition of cash position in the Senate amendment: “[t]he cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market (other than stock in the specified foreign corporation) government securities, certificates of deposit, commercial paper, and short-term obligations.”¹⁹

The language in the conference report describing the legislation actually enacted was very similar to the language in the House and Senate committee reports. The conference report provided, “[a] portion of that pro rata share of deferred foreign income is deductible; the amount deductible varies depending upon whether the deferred foreign income is held in the form of liquid or illiquid assets. The deduction results in a reduced rate of tax of 14 percent for the included deferred foreign income held in liquid form and 7 percent for remaining deferred foreign income.”²⁰

The conference report further provided, “[t]he cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market, government securities, certificates of deposit, commercial paper, foreign currency, and short-term obligations. In addition, the Secretary may identify other assets that are economically equivalent to the enumerated assets that are included.²¹

The Joint Committee descriptions of the House bill, Senate amendment, and enacted legislation were consistent with the committee reports. The Joint Committee’s description of the House bill provided, “[a] portion of that pro rata share of deferred foreign income is deductible; the amount deductible varies depending upon whether the deferred foreign income is held in the form of liquid or illiquid assets.”²² In parts, the Joint Committee language is almost identical to the House committee language: “[t]he cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market, government securities, certificates of deposit, commercial paper, foreign currency, and short-term obligations. In addition, the Secretary may identify other assets that are economically equivalent to the enumerated assets that are included.”²³

The Joint Committee described the Senate amendment by saying, “[a] portion of that pro rata share of foreign earnings is deductible; the amount of the deductible portion depends upon whether the deferred earnings are held in cash or other assets.”²⁴ It also provides that “U.S. shareholders with accumulated deferred foreign income may deduct a portion of the mandatory inclusion in an amount that depends upon the proportion of aggregate earnings and profits attributable to cash assets rather than noncash assets.”²⁵

After both the House bill and the Senate amendment had been passed in their respective chambers, the Joint Committee published a report comparing the two versions. The Joint Committee noted that in the House bill, “[a] deduction from the amount of the section 951 inclusion is based on equivalent percentages required to achieve a 14-percent rate of tax on accumulated post-1986 foreign earnings held in the form of cash or cash equivalents, and 7-percent rate of tax on all other earnings.” It stated that the House bill also, “[d]isallows a portion of foreign tax credits attributable to the nontaxable portion of the income inclusion, in the fixed percentages of 80 percent of foreign taxes paid with respect to noncash earnings, and 60 percent of the credits paid with respect to earnings held in cash.”²⁶ The Joint Committee noted that the Senate amendment, “authorizes a 78,6-percent deduction of deferred foreign income [not] held in cash or cash equivalents, and a 58.6-percent deduction of deferred foreign income held in cash assets.”²⁷

The Joint Committee report notes both similarities and differences in how the House bill and Senate amendment determined cash position: “[b]oth the House and Senate amendments differentiate between earnings held in the form of cash or cash equivalents, and those held in illiquid assets, including authority for the Secretary to disregard transactions that lack economic substance, with the following differences.”²⁸ The report notes that in the House bill, “[p]ublicly traded stock of a specified foreign corporation is excluded from cash position to the extent of the U.S. shareholder['s] pro rata share of cash.”²⁹ It notes that in the Senate amendment, by contrast, “[p]ersonal property actively traded on an established market is excepted from the cash position of a specified foreign corporation if the property is stock in the specified foreign corporation.³⁰

In summary, in describing its intended meaning of the term “cash position,” Congress in the various reports states that the 15.5% rate is intended to apply to cash and cash equivalents, as well as other liquid assets. Congress did not intend to include within the meaning of cash position earnings reinvested in the business of an SFC or other illiquid assets.

---

 Appendix Two

Financial Accounting Standards

The Accounting Standard Codification published by the Financial Accounting Standards Board (the “FASB ASC”), the official source of nongovernmental U.S. GAAP, provides that most entities display separate classifications of their current and noncurrent assets and liabilities.³¹

The FASB ASC defines the term “current assets” as “cash and other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.”³² The term “operating cycle” means “[t]he average time intervening between the acquisition of materials or services and the final cash realization . . .,”³³ An entity’s operating cycle is presumed to be twelve months unless the entity has a clearly defined operating cycle longer than twelve months.³⁴

The FASB ASC further provides that, “[c]urrent assets generally include . . . [m]arketable securities representing the investment of cash available for current operations, including investments in debt and equity securities classified as trading securities under Subtopic 320-10.”³⁵ FASB ASC 320-10 defines the term “trading securities” as:

“[securities] that are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period of time. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.”

The FASB ASC specifically excludes from current assets “investments in securities (whether marketable or not) or advances that have been made for the purposes of control, affiliation, or other continuing business advantage.”³⁶

The international financial accounting standards published by the International Financial Reporting Standards Foundation (the “IFRS”) explicitly require that current assets and current liabilities be reported as separate classifications.³⁷ Under the IFRS, an entity is required to classify an asset as current in any of the following situations:

All assets that do not fall within any of the four listed categories are classified as noncurrent assets.³⁹ The IFRS use the term “non-current assets” to describe tangible, intangible, and financial assets of a long-term nature.⁴⁰

The term “operating cycle” is defined in the IFRS as “the time between the acquisition of assets for processing and their realisation in cash or cash equivalents” and is presumed to be twelve months unless the entity identifies a different operating cycle.⁴¹ A financial asset or liability is treated as held for trading if the asset: