Law Firm Seeks Clarification in Transition Tax Regs

October 1, 2018

CC:PA:LPD:PR (REG-104226-18)
Room 5203
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: REG-104226-18

Dear Sir or Madam:

Miller & Chevalier Chartered respectfully submits this letter in response to the Notice of Proposed Rulemaking under section 965 of the Internal Revenue Code (the “Code”), as amended by the Tax Cuts and Jobs Act, P.L. 115-97 (the “Act”), published in the Federal Register on August 9, 2018 (the “Proposed Regulations”). In particular, we request that the Proposed Regulations be revised to clarify that a controlling interest in a corporation is not treated as property of a type that is actively traded and for which there is an established financial market for purposes of determining the cash position of a specified foreign corporation under section 965(c)(3). This guidance would be consistent with the ordinary meaning of the terms used in section 965(c)(3), financial accounting standards, Congressional intent as reflected in the relevant legislative history of the Act, and the interpretation of similar language in other sections of the Code.

I. EXECUTIVE SUMMARY AND REQUESTED GUIDANCE

Under section 965, U.S. shareholders are taxed on the deferred foreign earnings of their specified foreign corporations as if those earnings had been repatriated under prior law, but at reduced and bifurcated rates of tax. The rate of tax depends on the extent of the specified foreign corporations' cash position, with the higher tax rate applicable to the extent of the value of the specified foreign corporations' cash, net accounts receivable, and certain enumerated cash-equivalent assets. Section 965(c)(3)(B)(iii) provides that cash-equivalent assets include “personal property which is of a type that is actively traded and for which there is an established financial market” (referred to in the Proposed Regulations and herein as “actively traded property”).

The Proposed Regulations should be revised to clarify that that a controlling interest in a corporation, defined as a greater-than 50 percent interest in the vote and value of the stock of a corporation, is not treated as actively traded property. This guidance would be consistent with the ordinary meaning of the terms used in section 965(c)(3) because, as a practical matter, there is no established financial market into which a controlling interest in a corporation can be sold, even where the corporation's stock is listed on a stock exchange. This guidance also would be consistent with financial accounting standards because a controlling interest in a corporation is accounted for as a direct investment in that corporation's assets and liabilities, and not as a financial asset that can be sold into a financial market. Moreover, this guidance would be consistent with Congressional intent, which is to apply the higher rate of tax to earnings that were reinvested into liquid assets, and not to earnings that were reinvested into business assets. This guidance further would be consistent with the regulatory interpretation of similar language under the Code, which has often provided a different treatment of controlling interests in corporations. Finally, such a bright-line test would avoid the concerns expressed in the preamble to the Proposed Regulations that a facts-and-circumstances analysis would be difficult to administer and would be under- or over-inclusive.

The requested guidance would not constitute an “exception” to the statutory list of cash-equivalent assets; rather, it would provide a reasonable interpretation of the terms used in the statute. The guidance requested would be easy to administer for taxpayers and the Internal Revenue Service, and would not require subjective determinations regarding the liquidity of, or the motivation for holding, any particular asset.

II. BACKGROUND

A. Section 965 and Higher Rate on Cash Position

Section 965 was enacted as part of the transition to the new participation exemption system. The relevant reports of the House Ways & Means Committee and the Senate Finance Committee related to the Act are strikingly consistent as to the intent of section 965.¹ Congress was aware that many U.S.-parented multinational companies had accumulated significant untaxed and undistributed earnings under the prior-law system. Rather than permit such earnings to be distributed tax-free under the new participation exemption system, Congress believed it was appropriate to tax such earnings as if they had been repatriated under prior law, but at a reduced rate. Moreover, Congress believed that the tax rate “should take into account the liquidity of the accumulated earnings.” Accordingly, Congress established a bifurcated rate, a higher rate for “earnings held in liquid form,” and a lower rate for “accumulated foreign earnings that have been reinvested in the foreign subsidiary's business.” Finally, Congress provided procedures for the payment of the transition tax over an eight year period to mitigate the burden of the tax on taxpayers.

Section 965's statutory text embodies the Congressional intent outlined above. Section 965(a) requires any U.S. shareholder of a specified foreign corporation to include in income its pro rata share of the accumulated post-1986 deferred foreign income of that corporation. Section 965(c) provides a deduction intended to replicate the results of a bifurcated tax rate on the included amounts: (1) a 15.5% tax rate on the amounts included up to the U.S. shareholder's “aggregate foreign cash position;” and (2) an 8% tax rate on any additional amounts. The aggregate foreign cash position of a U.S. shareholder is the greater of (1) the aggregate of the U.S. shareholder's pro rata share of the cash position of each of its specified foreign corporations as of the close of the taxable year of the corporation beginning before January 1, 2018, or (2) the average of such amounts determined as of the close of the prior two years. The cash position of any specified foreign corporation is the sum of the cash held by the corporation, the net accounts receivable of the corporation, and the fair market value of several categories of cash-equivalent assets held by the corporation, including “personal property which is of a type that is actively traded and for which there is an established financial market.” Section 965(c)(3)(D) provides a rule to prevent the double counting of the same assets in determining the cash position of two specified foreign corporations with the same U.S. shareholder. Section 965(h) provides an election to pay the transition tax liability over eight annual back-loaded installments.

In sum, section 965 provides a bifurcated tax rate, with the higher rate applicable to the extent of the value of cash, net accounts receivable, and statutorily enumerated cash-equivalent assets held by a U.S. shareholder's foreign subsidiaries as of particular measurement dates. The categories of cash-equivalent assets listed by section 965(c)(3), including actively traded property, represent Congress's effort to identify “earnings held in liquid form,” which are intended to be taxed at the higher rate, as distinct from “earnings that have been reinvested in the foreign subsidiary's business,” which are not.²

B. Proposed Regulations and Actively Traded Property

The Proposed Regulations are intended to implement section 965. Prop. Reg. § 1.965-1(f)(13) provides a definition for “cash-equivalent asset” that tracks the definition in section 965(c)(3)(B)(iii), including language identical to the statutory definition of active personal property.

The preamble to the Proposed Regulations explains that comments were received requesting guidance excluding certain categories of assets from a specified foreign corporation's cash position, including, among other items, “stock of a publicly traded company in which the specified foreign corporation holds at least 10 percent of the stock.”³ The preamble describes these comments as “premised on the view that an asset that otherwise would be included in the cash position of a specified foreign corporation should be excluded to the extent that the asset cannot be otherwise employed; that is, if the asset is not sufficiently 'liquid.'” The preamble concludes that the statutory list of cash-equivalent assets provides the best indication of what Congress believed is a liquid asset for purposes of section 965. The preamble states that depending on the facts, “any particular asset may be required to be used for a specific purpose, or a taxpayer may intend to retain the asset for a lengthy period of time.” The preamble concludes that “the Treasury Department and the IRS have determined that it would not be administrable to create individual regulatory exceptions to the statute because it would require introducing a facts-and-circumstances test that analyzes the liquidity of every asset, which would be difficult to administer.” The discussion of this issue in the preamble closes by welcoming comments with respect to the definition of cash position of a specified foreign corporation.⁴

III. CONTROLLING INTERESTS IN CORPORATIONS AND “ACTIVELY TRADED” PROPERTY

Section 965(c)(3)(B)(iii) provides that a specified foreign corporation's cash position includes the fair market value of “personal property which is of a type that is actively traded and for which there is an established financial market.” These terms are not self-defining, especially as applied to stock in a corporation. Based on the ordinary meaning of these terms, the financial accounting for equity investments, Congressional intent, and regulatory interpretations of analogous statutory provisions, guidance should provide that a controlling interest in the stock of a corporation is not treated as actively traded property. This guidance would not constitute an “exception” to the statutory list of cash-equivalent assets; rather, it would provide a reasonable and administrable regulatory interpretation of the terms used in the statute. Importantly, the requested guidance would not require subjective determinations regarding the liquidity of, or the motivation for holding, any particular asset.

A. Ordinary Meaning of Terms of Section 965(c)(3)(B)(iii) Supports Treatment of Controlling Interests in Corporations as Property that is Not Actively Traded

As noted above, section 965(c)(3)(B)(iii) provides that a specified foreign corporation's cash position includes the fair market value of “personal property which is of a type that is actively traded and for which there is an established financial market.” Thus, the statute provides a two-part test: personal property must be of a type (1) that is “actively traded,” and (2) “for which there is an established securities market.” These terms are not defined in section 965, and we urge Treasury to provide guidance that interprets these statutory terms consistent with their ordinary meaning and the policies of section 965.

As an initial matter, the qualifying language “of a type” in the statute must be interpreted in the context of section 965, and the better reading of the text is that actively traded property can only include stock of a specified foreign corporation if the same class of stock of that corporation is itself actively traded and for which there is an established financial market.

With respect to stock in a particular specified foreign corporation that is listed on a stock exchange and for which some trading occurs, the question then is whether stock of the same class held by another specified foreign corporation is “actively traded” and whether an “established financial market” exists for such stock. The ordinary meaning of those terms suggests that the level of trading on a financial market must be sufficient to permit the owner of the stock at issue to dispose of its stock in an orderly manner without affecting the trading price of the stock. If an owner of stock cannot dispose of its interests in a financial market without drastically affecting the trading price, then that stock is not property of a type that is “actively traded” or property “for which an established financial market exists” in any meaningful sense. This could be the case if the volume of trading in the stock is too low to support the transaction, or the block of stock that the owner wishes to sell is too large (or a combination of the two). If the owner of such stock wishes to dispose of its interests, it would do so in a privately negotiated transaction, and not on the established financial market. In that respect, the stock is indistinguishable from stock that is not listed on a stock exchange, which is clearly not actively traded and for which no established financial market exists.

In virtually all circumstances, the owner of a controlling interest in the stock of a corporation that is listed on a stock exchange or other market could not dispose of its interests in the financial market in an orderly manner. The sale of such a large number of shares into a market in a short period of time would depress the market value of the stock, as there would not be enough potential buyers of the stock in the ordinary course to meet the supply of shares being offered for sale. In other words, there is no established financial market with respect to a controlling block of stock notwithstanding the fact that the stock may be listed on a stock exchange. Moreover, in different jurisdictions there may be legal or regulatory restrictions that could impede the ability to dispose of a controlling block of stock on a stock exchange. A controlling shareholder would instead pursue a negotiated sale of its interests to a strategic buyer, which could preserve the value of control and potentially create synergistic value between the buyer and the target, or would pursue another mechanism for transferring the stock to a large number of buyers for a set price, such as an underwritten private or public offering at a set offer price. Accordingly, the ordinary meaning of the terms defining “actively traded property” should be interpreted to exclude controlling interests in the stock of a corporation.

This ordinary meaning is reinforced by the fact that section 965(c)(3)(B) requires taxpayers to account for the “fair market value” of actively traded property. Fair market value is easy to determine for the other assets listed as cash equivalents in section 965(c)(3)(B)(iii), such as commercial paper, government securities, and foreign currency, and would be easy to determine for property that could be readily disposed of in an established financial market at the prevailing market price. For stock that is listed on a stock exchange but could not be disposed of in that financial market without drastically affecting the trading price, fair market value would be difficult to determine. Such stock would have to be independently valued, based on an income or discounted cash flow method, or based on the trading price with adjustments for lack-of-marketability, control premium, or other items.

B. Financial Accounting Standards Further Support Treatment of Controlling Interests in Corporations as Property that is Not Actively Traded

The treatment of controlling interests in corporations as property that is not “actively traded property” is also supported by the financial accounting standards for accounting for equity investments.⁵ In general, for non-financial firms, equity securities having readily determinable fair values are accounted for as available for sale securities, initially at cost and then carried at fair value on the balance sheet of the owner. These marketable securities are treated as current assets, like all of the other assets other than actively traded property listed as cash or cash equivalents in section 965(c)(3)(B).⁶ Equity securities have a readily determinable fair value if the sale price is available on a securities exchange, such as an U.S. exchange regulated by the Securities and Exchange Commission or a comparable foreign exchange.

Equity securities cannot be accounted for as current assets at fair value where the owner has significant influence over the underlying corporation or is in control of the corporation. This is the case even where the equity interests are listed on an exchange, and even where there is trading in the interests. Control is presumed at more than 50 percent ownership; a controlled subsidiary must be accounted for by consolidating its results with the results of the owner and other affiliates. In effect, the operations and financial position of a parent company and its consolidated subsidiary are accounted for as if they were a single company, with the parent company treated as directly owning its pro rata share of the assets of the subsidiary, rather than a financial interest in the subsidiary. Accordingly, the distinction made for controlling interests in the financial accounting standards further supports interpreting “actively traded property” to exclude controlling interests in the stock of a specified foreign corporation.

C. Treatment of Controlling Interests in Corporations as Property that Is Not Actively Traded Is Consistent with Congressional Intent

In addition to being consistent with the ordinary meaning of the terms used in section 965(c)(3)(B) and the financial accounting standards applicable to equity investments, the treatment of controlling interests in corporations as property that is not actively traded property is consistent with the Congressional intent underlying section 965. As described above, Congress believed it was appropriate to tax such deferred foreign earnings of U.S. shareholders as if the earnings had been repatriated under prior law, but at a reduced rate that “should take into account the liquidity of the accumulated earnings.” Accordingly, Congress established a higher rate for “earnings held in liquid form,” and a lower rate for “accumulated foreign earnings that have been reinvested in the foreign subsidiary's business.” Congress defined earnings held in liquid form to include certain categories of assets held by specified foreign corporations, notably cash, net accounts receivable, and cash-equivalent assets such as actively traded property, commercial paper, government debt, foreign currency, and short term obligations. The distinction drawn by Congress appears intended to provide taxpayers with a relatively lower rate of tax to the extent they had reinvested deferred foreign earnings in their business because Congress perceived such reinvestments as being less motivated by avoiding the prior-law U.S. tax on repatriation.

A controlling interest in a corporation represents a strategic investment in the business of that corporation, which typically is integrated with the business of the parent company and its affiliates. The acquisition of a controlling interest in a corporation that operates a business overseas is economically equivalent to the acquisition of that business: in each case, the acquirer has a controlling equity interest in the business, which provides it with an ability to direct the conduct of the business and the right to any earnings from that business. A controlling interest in a corporation is not a financial asset or a current asset that is economically similar to cash or cash equivalents as those terms are normally understood. Treating a controlling interest in a corporation as actively traded would contravene the Congressional intent to provide U.S. shareholders with a relatively lower rate of tax on earnings that had been reinvested in their business. As explained above, the statute can reasonably and legitimately be interpreted so as to give effect to Congressional intent by excluding controlling interests from the definition of actively traded property.

D. Regulatory Guidance Clarifying that Controlling Interests in Corporations Are Property that Is Not Actively Traded Would Be Consistent with Regulatory Guidance in Analogous Areas

Providing regulatory guidance clarifying that a controlling interest in a corporation is not property that is actively traded property further would be consistent with regulatory guidance in analogous areas. Section 965 does not cross-reference any other statutory standard to define actively traded property. However, many Code sections have similar language referencing “actively traded” or “regularly traded” property for a variety of purposes. The context for each of these rules is different, but in appropriate cases the regulations interpreting these rules provide that stock of an affiliate or other controlled entity is not considered actively or regularly traded. The requested guidance would be consistent with these regulatory precedents.

For example, sections 897, 884, and 883, which provide for special international tax regimes for the taxation of foreign persons investing in U.S. real property, operating through a U.S. branch, or engaged in international shipping activities, each refer to stock “regularly traded on an established securities market.” In each case, the regulations provide that the stock of a corporation that is controlled by one person, or a small group of persons, cannot be considered “regularly traded” even if such stock is traded on an established securities market and otherwise meets the general definition of “regular” trading in the regulations.⁷

Section 897 generally provides for U.S. tax on gain from the disposition by a foreign person of a U.S. real property interest, including stock of a “U.S. real property holding corporation.” In the case of a domestic corporation with a class of stock that is “regularly traded on an established securities market,” stock is treated as a U.S. real property interest only in the case of a person who has held more than five percent of such class of stock. Section 897(c)(3). Treas. Reg. § 1.897-9T(d) provides rules for determining whether a class of stock is regularly traded, generally with reference to a minimum number of days in which there are trades and a minimum volume of shares traded.⁸ However, if “100 or fewer persons own 50 percent or more of the outstanding shares of a class of interests, such class shall not be considered to be regularly traded” for purposes of section 897 and related sections of the Code. Treas. Reg. § 1.897-9T(d)(1)(ii)(B).

Section 884 provides for a branch profits tax on remittances from a U.S. branch to a foreign corporation. Section 884(e) provides rules coordinating the branch profits tax with tax treaties; in general, section 884 applies notwithstanding pre-effective date tax treaties unless the foreign corporation is a “qualified resident” of the treaty partner. A qualified resident of a foreign country includes a corporation if the stock of such corporation “is primarily and regularly traded on an established securities market” in that country. Section 884(e)(4)(B). Treas. Reg. § 1.884-5(d)(4) provides rules for determining whether a class of stock is regularly traded, generally with reference to a minimum number of days in which there are trades and a minimum volume of shares traded. However, a class of stock is not considered “regularly traded” if “one or more persons who are not qualifying shareholders and who each beneficially own 5 percent or more” of the value of the class of stock “own, in the aggregate, 50 percent or more of the outstanding shares” of the class of stock. Treas. Reg. § 1.884-5(d)(4)(iii)(A).

Section 883(a) provides for an exclusion from gross income for certain shipping income earned by foreign corporations organized in a foreign country that grants a reciprocal exemption to U.S. corporations. This exclusion does not apply to a foreign corporation if 50 percent or more of its value is owned by individuals who are not resident of that foreign country or another foreign country that provides a reciprocal exemption. This rule does not apply to a foreign corporation the stock of which “is primarily and regularly traded on an established securities market” in a foreign country that provides a reciprocal exemption. Section 883(c)(3). Treas. Reg. § 1.883-2(d) provides rules for determining whether a class of stock is regularly traded; these rules are similar to the regulations under section 884, including the exception for closely held corporations at a 50 percent or more standard.

Similarly, the tax accounting rules often treat controlling interests in a corporation differently than other equity securities. For example, section 475 provides a mark-to-market accounting method for dealers in securities. Securities “held for investment” are not subject to these rules. Under the regulations, securities that are “actively traded” on “established financial markets” generally are not treated as held for investment. Treas. Reg. § 1.475(b)-1(b)(3)(i). This rule does not apply to stock if the taxpayer and its affiliates hold more than 15 percent of the class of stock at issue. Moreover, Treas. Reg. § 1.475(b)-1(b) generally provides that stock in a corporation is per se held for investment if the corporation and the taxpayer are members of a controlled group within the meaning of 267(f) (i.e., more than 50 percent ownership).

E. Requested Regulatory Guidance Would Improve Administrability of Statute and Ease Compliance Burden of Taxpayers

Finally, providing regulatory guidance clarifying that a controlling interest in a corporation is not property that is actively traded property further would simplify compliance with and the administration of the statute. The requested guidance would not raise the sort of concerns regarding administrability noted by the preamble to the Proposed Regulations, as it is not based on a subjective determination of whether assets are liquid or illiquid in the hands of any particular specified foreign corporation. Rather, the requested guidance would be an interpretation of the statute that aligns with other tax and financial accounting principles, under which a controlling interest in a subsidiary is treated as a direct investment in the subsidiary's business assets rather than a financial interest in stock.

* * *

For the reasons set out above, the Proposed Regulations should be revised to clarify that a controlling interest in a corporation is not treated as property of a type that is actively traded and for which there is an established financial market for purposes of determining the cash position of a specified foreign corporation under section 965(c)(3). Thank you in advance for your consideration of this request.

Respectfully submitted,

Rocco V. Femia
202.626.5823
rfemia@milchev.com

George A. Hani
202.626.5953
ghani@milchev.com

Miller and Chevalier