Proposed Transition Tax Regs Need Many Revisions, NFTC Says

October 4, 2018

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave., N.W.
Washington, D.C. 20220

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

The Honorable William Paul
Principal Deputy Chief Counsel and Deputy Chief Counsel
Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, D.C. 202224

Ms. Kirsten Wielobob
Deputy Commissioner for Services and Enforcement
Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, D.C. 20224

Re: Proposed Regulations under Section 965 [REG 104226‐18]

Dear Sirs and Madame:

On behalf of the National Foreign Trade Council (“NFTC”), I would like to express our appreciation to the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (“Service”) for your efforts in developing the recently issued proposed section 965 regulations (the “Proposed Section 965 Regulations”).

The NFTC, organized in 1914, is an association of approximately 250 U.S. business enterprises engaged in all aspects of international trade and investment. Our membership covers the full spectrum of industrial, commercial, financial and service activities and the NFTC therefore seeks to foster an environment in which U.S. companies can be dynamic and effective competitors in the international business arena. The NFTC's emphasis is to encourage policies that will expand U.S. exports and enhance the competitiveness of U.S. companies by eliminating major tax inequities in the treatment of U.S. companies operating abroad. To achieve this goal, American businesses must be able to participate fully in business activities throughout the world, through the export of goods, services, technology, and entertainment and through direct investment in facilities abroad. Foreign trade is fundamental to the economic growth of U.S. companies.

The Proposed Section 965 Regulations are highly complex and would have a very significant impact on U.S. income tax administration and compliance. In light of that complexity, and the significant number of issues we have with the Proposed Section 965 Regulations, we urge the Treasury and the IRS to revise the regulations as discussed below.

Exclude PTI in Determining the Existence and Amount of a Specified E&P Deficit

• PTI and Specified E&P Deficits: In the preamble to the Proposed Section 965 Regulations, Treasury and the IRS follows Notice 2018‐13 by providing that “previously taxed E&P is not excluded in determining the existence and amount of a specified E&P deficit . . .”, but adds that “the Treasury Department and the IRS are considering other rules with respect to the definitions of post‐1986 earnings and profits, accumulated post‐1986 deferred foreign income, and specified E&P deficit in connection with the finalization of these proposed regulations.” Section 965(o) is cited as providing the necessary authority to consider a different interpretation.

  • Recommendation: Treasury and the IRS should adopt the position that, consistent with the rules for calculating deferred foreign income, the rules for calculating E&P deficits should exclude the amount of undistributed foreign earnings that have already been subject to U.S. tax (“PTI”). By adopting this position, the section 965 regulations would align with Congressional intent that the transition tax apply to a taxpayer's net, historic foreign earnings “which had not been previously taxed.” Ways and Means Committee Report at page 375. Further, we believe that this calculation achieves the most accurate measure of a taxpayer's E&P that should be subject to the transition tax.

  • There is no policy reason for including PTI in the calculation of a specified E&P deficit. Indeed, including PTI in the calculation will cause a taxpayer to have its E&P (that is subject to the transition tax) “over‐measured” and cause the transition tax to be imposed on more than 100% of the taxpayer's E&P. There is nothing in the legislative history that suggested that Congress intended to include PTI in the calculation of a specified E&P deficit. In fact, there is evidence in the legislative history that Congress intended to exclude income that had been previously taxed from the transition tax (as noted above). At most, the statute's silence on the issue should be interpreted as a simple failure of Congress to provide guidance one way or the other. In this case, the broad grant of regulatory authority in section 965(o) gives Treasury and the IRS the ability to implement the policy in a way that is clearly aligned with Congressional intent and achieves the most reasonable measurement of a taxpayer's E&P for purposes of calculating the transition tax.

Cash Position — Short‐term Notes Payable

• Netting Short‐term Notes Receivables and Notes Payables: The Proposed Section 965 Regulations do not permit short‐term notes payable (i.e., generally debt with a term of less than one year), that do not arise from the purchase of goods or services to offset short‐term notes receivable, which count as cash. Due to the short‐term nature of these transactions, the inability to net the related short‐term note payables against the notes receivable distorts the true cash position of a company. For an example, a specified foreign corporation (“SFC”) may borrow funds from its U.S. shareholder for operational needs, and the borrowing is booked as short term intercompany (“IC”) note payable (“NP”). The same SFC could also lend funds (previously taxed in the U.S.) to its U.S. shareholder or a member of the same U.S. federal consolidated group, for its needs, which is booked as IC note receivables (“NR”). Under Generally Accepted Accounting Principles (“GAAP”) the two accounts are netted to properly reflect the SFC's true cash picture. Under the Proposed Section 965 Regulations, the NR would be treated as short term obligations, includable as cash for the SFC, while the NP would not be allowed to offset or be netted against the NR. This disallowance results in a distortive overstatement of the SFC's cash balances, and is contrary to the Congressional intent of measuring the true liquidity of SFCs on the measurement dates. Moreover, the NP owed to the U.S. was provided with U.S. funds — not foreign cash that Congress intended to tax at the higher rate.

  • Recommendation: As noted above, GAAP permits the netting of account receivables and account payables for a more accurate picture of a company's financial position. Due to the similar nature of short‐term notes, comparable rules should also be applied for Section 965 purposes. Specifically, the Proposed Section 965 Regulations should allow an SFC to net its short‐term intercompany notes payable against its short‐term intercompany notes receivable with its U.S. shareholder or a member of the same U.S. consolidated group of its U.S. shareholder.

Foreign Cash Position and U.S. Obligations

• U.S. Loans: The Proposed Section 965 Regulations do not exclude from a SFC's cash position short‐term obligations that constitute U.S. property as defined in section 956(c) (“U.S. Loans”). This overstates the amount of deferred foreign income that is considered to have been reinvested in cash and therefore subject to tax at the higher rate provided for under section 965. U.S. Loans represent assets that were funded or acquired with earnings that have already been subject to U.S. tax, either as subpart F income (thereby creating PTI) or under section 956 upon the acquisition of the loan. Treating U.S. Loans as part of a SFC's cash position therefore is inconsistent with the purpose of the bifurcated rate provided by section 965(c), which is intended to apply a higher rate of tax to deferred foreign earnings to the extent they were reinvested in cash‐equivalent assets. U.S. Loans should not be treated as a reinvestment of deferred foreign income in cash‐equivalent assets because they are funded by earnings that have already been subject to U.S. tax. Put another way, if a CFC with deferred foreign income had acquired a U.S. Loan, that income would have been included in the income of its U.S. shareholders under section 956 by reason of the U.S. Loan itself. The preamble to the proposed regulations explains that liquidity‐based regulatory exceptions to the list of cash‐equivalent assets were not adopted because such exceptions would require a facts‐and‐circumstances determination of whether an asset is sufficiently liquid and therefore would not be administrable. The existence and amounts of U.S. Loans outstanding during the cash measurement dates are simple to determine and can be clearly shown on routine tax filings. Moreover, the liquidity of U.S. Loans is not relevant; rather, U.S. Loans should not be treated as cash‐equivalent assets because they do not represent a reinvestment of deferred foreign income.

  • Recommendation: Short‐term obligations that constitute U.S. property as defined in section 956(c) should be excluded from an SFC's cash position. This best coordinates the cash position rules of section 965 with the other subpart F rules to ensure that the higher rate of tax under section 965 is imposed only to the extent that deferred foreign income has been reinvested in cash‐equivalent assets.

Consolidated Groups — Double Counting of Cash and the Section 965(c) Deduction

• We believe there may be a drafting error in the Proposed Section 965 regulations. Prop. Treas. Reg. Sec. 1.965‐3(b)(1) prevents double counting of cash only with respect to SFCs owned by the same U.S. shareholder.

• Further, Prop. Treas. Reg. Sec. 1.965‐8(e)(3) disallows U.S. shareholders of the same US group to be treated as one U.S. shareholder for purposes of computing the Section 965(c) deduction.

  • The final regulations should adopt a rule that treats a consolidated group as one U.S. shareholder for purposes of applying Prop. Treas. Reg. Sec.1.965‐3(b)(1). This would eliminate the double counting of cash issue.

  • Further, the final regulations should adopt a rule that treats a consolidated group as one U.S. shareholder for purposes of applying Prop. Treas. Reg. Sec. 1.965‐3(b)(1).

Cash Position — Notional Cash Pooling

• Notional cash pooling: While the Proposed Section 965 Regulations do not specifically address the treatment of cash pools for the purposes of determining a taxpayer's aggregate cash and cash equivalents position, the Preamble states as follows:

  Comments requested that the proposed regulations provide that notional cash pooling arrangements are treated as creating intercompany receivables for purposes of Section 965. The proposed regulations do not adopt this recommendation. The determination of whether transactions in a notional cash pooling arrangement are treated as occurring among participants in the arrangement, or between the participants and a third party, depends on the application of federal income tax principles.

  Even though there is a lack of direct guidance on the netting of receivable and payable balances in notional cash pooling arrangements, there is ample support for a rule permitting this approach — particularly where the use is intra‐company.

  Both the Statement of the Managers and Notice 2018‐07 acknowledge that intercompany relationships must be scrutinized to ensure that they do not create any type of double counting that might cause the aggregate cash position calculation to include amounts that exceed the relevant U.S. shareholder's aggregate amount of foreign‐held cash assets.

  The statute allows for the netting of accounts payable and accounts receivable to arrive at the true amount of liquid net accounts receivable, which is consistent with the manner in which notional cash pooling arrangements actually operates — pool balances are notes for the purposes of determining the maximum amount of cash that any one member participant can withdraw from its account.

  In addition, under Notice 2018‐7, the positive and negative values of all derivative financial instruments are taken into account in order to arrive at their aggregate impact on a specified foreign corporation's cash position (and related party derivatives are generally disregarded in their entirely).

  Given the fact that some jurisdictions mandate (by law) the use of notional cash pooling, the rejection of a rule accommodating companies operating in those jurisdictions will be significant disadvantaged relative to companies do not operate in those jurisdictions and, thus, not required to use notional cash pooling.

  Absent a favorable rule for notional cash pooling, will result in: (i) the gross overstatement of some taxpayers' cash and cash equivalent positions; (ii) treatment of E&P as cash and cash equivalent even when a taxpayer does not actually have an economic right to access such assets; (iii) a substantially higher effective tax rates on some taxpayer's undistributed E&P than the underlying economic realities would otherwise dictate; and (iv) the disregard of the mismatches created by the check‐the‐box rules (a single CFC may have several disregarded entities, each of which is a participant in the cash pool. If one disregarded entity is a borrower and another is a depositor, only the net balance should be treated as cash of the CFC, rather than the gross amount of the deposit).

  • Recommendation: To eliminate the disparity in treatment between notional and physical cash pooling arrangements, we urge Treasury to treat notional cash pools as creating intercompany loans for purposes of Section 965. Absent that rule, taxpayers using a physical cash pool will have a material advantage over the taxpayer using a notional cash pool. As noted above, treating notional and physical cash pools the same for Section 965 purposes is completely consistent with Congress' clear and stated objective of preventing the double‐counting of assets relative to an accurate application of the transition tax.

Foreign Tax Credit Haircut

• Withholding Tax Haircut: Under the Proposed Section 965 Regulations, there is a haircut on any foreign withheld taxes (paid or accrued) on the foreign cash (already subject to U.S. tax under Section 965) when it is actually distributed to the United States. In general, the FTC haircut of Section 965 is designed to reflect the reduced tax rate enjoyed under the deemed repatriation. However, foreign withheld taxes on the distributions of foreign earnings (that have already been taxed under Section 965) will be in addition to the foreign income taxes deemed paid and the U.S. transition tax liability on those earnings. Therefore, the foreign tax credits generated from the withholding taxes should not be subject to a haircut in the same way that deemed paid foreign tax credits are subject to a haircut.

  • Recommendation: Companies should not lose credits for foreign withholding taxes imposed on distributions of earnings that have been subjected to the transition tax. This discourages foreign cash that has been taxed under Section 965 from actually being distributed back to the United States for investment, which perpetuates the “lockout effect” that Congress was seeking to solve. As such, the FTC haircut of Section 965 (that applies to deemed paid foreign taxes) should not apply to foreign withholding taxes.

Loss of Foreign Tax Credits for Less Than 10% U.S. Shareholders

• Members of a Consolidated Group/Less than 10% Shareholder: Under the Proposed Section 965 Regulations, all members of a consolidated group are not treated as a single U.S. shareholder for the purposes of determining foreign taxes deemed paid with respect to a Section 965(a) inclusion. Where ownership of a foreign corporation is split between and amongst several more than one member of the consolidated group (with one or more members owning less than 10% of the foreign corporation), a portion of the otherwise allowable FTC is denied.

  In that regard, it should be noted that in Notice 2018‐07, the IRS announced its intention to issue regulations that would treat all members of a consolidated group as a single U.S. shareholder for the purposes of Section 965, including a single aggregate foreign cash position for the entire group.

  • Recommendation: When finalized, the section 965 regulations should treat all the members of a consolidated group as a single taxpayer for all purposes of Section 965.

Foreign Taxes Relating to Hovering Deficits

• The preamble to the Proposed Section 965 Regulations states:

  Comments also recommended that, to the extent that a hovering deficit is treated as reducing the post‐1986 earnings and profits of a DFIC, those taxes should be added to the DFIC's post‐1986 foreign income taxes in the inclusion year with respect to the DFIC. The Treasury Department and the IRS have determined that the existing rules adequately address this issue and decline to adopt this comment. The proposed regulations do not provide special rules for foreign income taxes that are related to hovering deficits; as a result, the rules in Treas. Reg. Sec. 1.367(b)‐7 continue to apply with respect to such foreign income taxes.

  For section 965 purposes, Congress suspended the usual restrictions on the use of hovering deficits — allowing them to offset position E&P regardless of whether the deficit and E&P are in the same limitation category, regardless of whether distributed before year‐end or accumulated, without regard to whether “earned‐out” with post‐section 381 event profits, and without regard to the “first day of the next year” requirement. That said, Congress did not intend to suspend the rule of Treas. Reg. Sec. 1.367(b)‐7(d)(2)(iii) with respect to hovering taxes.

  • Recommendation: The Treasury and the IRS should clarify that, while the deficit offset rules of Treas. Reg. Sec. 1.367(b)‐7(d)(2)(ii) have been suspended for section 965 purposes with respect to hovering deficits, the rule in Treas. Reg. Sec. 1.367(b)‐7(d)(2)(iii) with respect to hovering taxes continues to apply.

    The regulations should clarify that, in order to release foreign taxes along with a hovering deficit, the requirements of Treas. Reg. Sec. 1.367(b)‐7(d)(2)(iii) need to be met, i.e., that the foreign taxes must be in the same separate limitation category as the hovering deficit, and that the taxes become available on a pro rata basis to the extent that the hovering deficit was absorbed by post‐section 381 event earnings. As provided for in the existing regulations for foreign taxes, “pro rata” means in the same proportion as the portion of the hovering deficit that offsets post‐transaction earnings in the separate category.

    In other words, to the extent a hovering deficit is treated as reducing the post‐1986 earnings and profits of a DFIC, the taxes should be treated as released on a pro rata basis under Treas. Reg. Sec. 1.367(b)‐7(d)(2)(iii) in the same taxable year and, as such, available to reduce the section 965 Transition Tax.

Disregard Of Certain Changes In Method Of Accounting And Entity Classification Elections

• Principal Purpose Test: The rule disregarding certain changes in method of accounting and entity classification elections should not apply without regard to whether the change was made with a principal purpose of reducing the amount of income included pursuant to Section 965 and the Section 965 tax liability of a U.S. shareholder. Such a per se rule denying a method change from an impermissible method to a permissible method may exceed the IRS's authority to exercise its discretion to determine which method most clearly reflects income and may require use of an otherwise impermissible method. The legislative history (Conference Report, p. 619) shows clear legislative intent for a principal purpose test. Alternatively, the rule should be modified that allows entity classification changes and accounting method changes so long as there is no decrease to tax liability under 965 from such a change after taking into account all of the 965 elements.

  • Recommendation: Provide that the/a principal purpose test applies to CTB elections and accounting method changes. In the alternative, provide that CTB elections and accounting method changes will be respected so long as section 965 tax liability, after taking into account changes to section 965 elements, is not decreased.

  • Additionally, we recommend that Treasury and the IRS reconsider their position re impermissible to permissible method changes. We continue to believe that those method changes should not be disregarded.

Changes in Accounting Methods and Deemed Paid Foreign Taxes

• Prop. Treas. Reg. Sec. 1.965‐4(b) provides that a transaction is disregarded for purposes of determining the amounts of all of the Section 965 elements of a U.S. shareholder if the transaction would change the amount of the Section 965 element of such U.S. shareholder. A change in a Section 965 element includes: (i) a reduction in a U.S. shareholder's Section 965(a) inclusion amount with respect to an SFC; (ii) a reduction in the aggregate foreign cash position of the U.S. shareholder; and (iii) an increase in the amount of foreign income taxes of a SFC deemed paid by the U.S. shareholder under Section 960 as a result of a Section 965(a) inclusion.

  Prop. Treas. Reg. Sec. 1.965‐4(c) and (d) state that any change in method of accounting made for a taxable year that ends in 2018 or 2019 is disregarded for purpose of determining the amounts of all Section 965 elements if it changes the deemed paid FTC as a result of a Section 965(a) inclusion.

  For companies filing accounting method changes with positive 481(a) adjustments, their transition tax liability would have been increased even if the positive E&P adjustments would increase the deemed paid credit under Section 960. However, under the Proposed Section 965 Regulations as drafted, companies now will not pay tax on 25% of the positive Section 481(a) adjustment. As such, a portion of the Section 481(a) adjustment is tax‐exempt permanently. This could not have been what Treasury and the IRS intended when drafting the Proposed Section 965 Regulations.

  • Recommendation: When finalized, this drafting error should be eliminated.

Changes in Accounting Methods — Audit Protection

• Audit Protection: A taxpayer that voluntarily changes its accounting method with IRS consent receives audit protection for that method if the proper procedures are followed. However, a CFC does not receive audit protection if any of the CFC's domestic corporate shareholders computed an amount of foreign taxes deemed paid under Sections 902 and 960 that exceeds 150% of the average amount of foreign taxes deemed paid under Sections 902 and 960 in the shareholder's three prior tax years. The policy behind this provision is to prevent a taxpayer from utilizing accounting method changes in a way that inappropriately increases the taxpayer's foreign tax credits. However, as a result of the imposition of the transition tax under Section 965, it is likely that a taxpayer's deemed taxes paid in 2017, or 2018 (as applicable), will exceed 150% of the deemed taxes paid in the prior three tax years as a result of the transition tax. Thus, CFCs would not receive audit protection in connection with accounting method changes made in either 2017 or 2018 (as applicable), for reasons totally unrelated to the purpose of the denial of audit protection.

  • Recommendation: Treasury and the IRS should issue immediate guidance amending the automatic method change procedures to disregard deemed paid foreign tax credits resulting from the application of Section 965 in applying those procedures to accounting method changes in the 2017 or 2018 tax year(s), as applicable.

E&P Shifting — Basis — Election for Calculating Gain

• The Proposed Section 965 Regulations, in providing for an elective solution to the basis and PTI issues created by the E&P shifting of section 965(b), require taxpayers to recognize gain to the extent the “specified basis adjustment(s)” exceeds a U.S. shareholder's basis in such stock.

  The share‐by‐share rule in the Proposed Section 965 Regulations makes it difficult for taxpayers to avail themselves of the intended relief from the corollary impacts of section 965(b) and lacks a compelling policy justification to cause gain recognition where none exists economically, in particular for CFCs with highly concentrated ownership. The share‐by‐share rule also imposes undue administrative burdens, particularly with respect to large U.S. multinationals, and significantly increases audit complexity.

  Specifically, Prop. Treas. Reg. Sec. 1.965‐2(h)(3) treats basis reductions in excess of a deficit CFC's pre‐adjustment stock basis as gains from the sale or exchange of property. Prop. Treas. Reg. Sec. 1.965‐2(h)(4) specifies that basis is reduced on a share‐by‐share basis. As a result, taxpayers with non‐uniform basis in stock of a CFC may recognize gain without exhausting the basis in all shares held in the relevant CFC.

  In addition to the non‐economic gain created by share‐by‐share calculations in Prop. Treas. Reg. Sec. 1.965‐2(h)(4), tracking CFC stock basis over years of funding transactions imposes substantial burdens on taxpayers and the IRS. Moreover, reconstructing the U.S. tax consequences of past funding transactions is cumbersome.

  The Proposed Section 965 Regulations thus offer taxpayers a very difficult choice: either make the election and bear significant administrative costs to reconstruct basis tranches across many CFCs in a limited time period, or refrain from making the election, and face the burden of tracking PTI/basis mismatches indefinitely.

  • Recommendation: The final regulations should allow U.S. shareholders of CFCs to determine such gain on an aggregate, rather than share‐by‐share, basis. The share‐by‐share rule in the Proposed Section 965 Regulations may (in many cases) trigger gains (on a share‐by‐share calculation), where there is ample basis (when calculated in the aggregate) to support the deficit E&P that has been allocated to any DFIC.

The Section 965(h) Election to Pay the Transition Tax in Eight Installments

• Overpayment of the Transition Tax: In building cash positions for the payment of the transition tax, businesses include anticipated federal tax overpayments to determine the net impact to free cash flow for each respective taxable year. Taxpayers who elected to pay their deferred foreign income tax liability over eight years included 8% of the anticipated transition tax in their respective net cash tax forecasts for 2018, thereby properly applying the statutory of Section 965(h) and the clear Congressional intent. However, IRS guidance (FAQs 13 and 14 published April 13, 2018), indicate that any overpayment by a taxpayer to the IRS will be applied in full against the taxpayer's total (eight‐year) transition tax liability. This means that instead of applying the 2017 overpayment as a refund or credit against their 2018 tax liability, such taxpayers are forced to have paid a large portion — or all — of their transition tax in the first year, effectively forfeiting the taxpayer's election to pay the tax over eight years — as planned.

  • Recommendation: The guidance provided by the IRS directly conflicts with Congressional intent to permits taxpayers, who elect, to pay their deferred foreign income tax liability over eight installments. This guidance not only puts companies who overpaid at a competitive disadvantage, it also creates volatility and distortion in their ability to forecast and meet their anticipated financial commitments. The IRS should issue guidance and regulations should be align with the statute and clear Congressional intent that allows taxpayer to elect to pay their transition tax over eight years under IRC Sec. 965(h).

• The Proposed Section 965 Regulations acknowledge that a taxpayer can have section 965 inclusions is two successive years because of their CFCs having different year‐ends. This leads to the unanswered question of whether taxpayers are free to: (i) make a section 965(h) election with respect to the Year 1 inclusion, but not the Year 2 inclusion; (ii) make a section 965 election with respect to the Year 2 inclusion, but not the Year 1 inclusion.

  • Recommendation: Allow taxpayers the flexibility to: (i) make a section 965(h) election with respect to the Year 1 inclusion, but not the Year 2 inclusion; (ii) make a section 965 election with respect to the Year 2 inclusion, but not the Year 1 inclusion.

* * * * * * *

Again, thank you very much for the opportunity to provide these comments. Please do not hesitate to contact me should you have any questions on the above. We would be glad to meet with you to discuss these comments more fully and hereby formally request a public hearing to present our oral comments on the Proposed Section 965 Regulations.

Sincerely,

Catherine G. Schultz
Vice President for Tax Policy
cschultz@nftc.org
202‐887‐0278 ext. 104
National Foreign Trade Council, Inc.
Washington, DC