Baker McKenzie Seeks Clarification of Transition Tax Regs

October 5,2018

Internal Revenue Service
Attn: CC:PA:LPD:PR (REG-104226-18)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Attn: David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of the Treasury

Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
U.S. Department of the Treasury

William M. Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service

Re: Request for Comments on the Section 965 Proposed Regulations (REG-104226-18)

We write to provide comments in response to Notice of Proposed Rulemaking, 83 Fed. Reg. 39514 (Aug. 9, 2018) (the “Preamble”) with respect to the proposed regulations under section 965 (the “Proposed Regulations”) of the Internal Revenue Code (the “Code”), as enacted in P.L. 115-97 (the “Act”).¹ We commend the Treasury Department (“Treasury”) and the Internal Revenue Service (“Service”) for their efforts to address and obtain taxpayers' input into the interpretive issues that arise in connection with the calculation of a taxpayer's “cash position” under section 965(c)(3)(B).

The Proposed Regulations define “cash position” in a manner that is largely identical to that in section 965(c)(3)(B), with a few exceptions which are not relevant for the purposes of this letter. In particular, like section 965(c)(3)(B), the Proposed Regulations do not provide further guidance on how taxpayers should interpret the phrase “personal property which is of a type that is actively traded and for which there is an established financial market” in section 965(c)(3)(B)(iii)(I).

In the Preamble, Treasury and the Service responded to several comments they received from taxpayers regarding the definition of a specified foreign corporation's cash position.

Treasury and the Service declined to adopt some of these comments, including taxpayers' requests that the value of all stock in specified foreign corporations be excluded from the U.S. shareholder's aggregate foreign cash position. Treasury and the Service indicated that the list in section 965(c)(3)(B) contained assets which Congress believed were liquid assets. At the same time, Treasury and the Service also requested further comments on future guidance under Section 965(c)(3)(B) with respect to the definition of the cash position of a specified foreign corporation.

Our response to this request aims to further Treasury's and the Service's objectives of implementing the Act, enhancing fairness, reducing administrative burdens, and minimizing disputes over the proper treatment of a taxpayer's cash position. We respectfully request that Treasury provide further guidance on the meaning of “personal property which is of a type that is actively traded and for which there is an established financial market” in final regulations under section 965 as described below.

Our comments in this letter are limited to the meaning of the phrase “personal property which is of a type that is actively traded and for which there is an established financial market” as applied to certain publicly traded stock. While we may have other comments with respect to section 965, those matters are beyond the scope of this letter and may be addressed separately.

I. Executive Summary with Key Points

In certain circumstances, stock in a publicly traded company is not a liquid business asset and should not be treated as “personal property which is of a type that is actively traded and for which there is an established financial market.” Such stock's value should not be included in the cash position of a specified foreign corporation.

The scope of the phrase “personal property which is of a type that is actively traded and for which there is an established financial market” is ambiguous. The only thing that is clear is that it is not sufficient for the stock merely to be publicly traded. The use of the word “and” in the phrase plainly indicates that there are at least two conditions that must be satisfied for this rule to apply. One must define the phrase with reference to Congressional intent that the list in section 965(c)(3)(B) includes only liquid assets, and the economic characteristics of other items on that list.

Whether publicly traded stock should be treated in a manner similar to other items on the list, all of which are liquid financial assets, necessarily requires an inquiry into whether the stock has economic characteristics comparable to those other assets. At the same time, the use of the phrase “of a type” suggests that further categorization of property with bright line tests could be appropriate.

Accordingly, we recommend that the final regulations clarify that “personal property which is of a type that is actively traded and for which there is an established financial market” excludes publicly traded stock that satisfy the following criteria:

II. Definition of “Personal property which is of a type that is actively traded and for which there is an established financial market”

A. Background

Section 965 taxes a United States shareholder on its pro rata share of the deferred foreign earnings of certain foreign corporations. In particular, the section taxes a United States shareholder's “aggregate foreign cash position” at a higher effective rate of 15.5%.² Other deferred foreign earnings are taxed at an effective rate of 8%.³ For each United States shareholder, the aggregate foreign cash position is measured with reference to the cash position of its specified foreign corporations on the relevant date, also referred to as the cash measurement date.⁴

Section 965(e) defines a specified foreign corporation as any controlled foreign corporation, as well as any foreign corporation with respect to which one or more domestic corporations is a United States shareholder. A United States shareholder is defined in former section 951(b) as a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. Passive foreign investment companies, which are not controlled foreign corporations, are excluded from the definition of specified foreign corporations.⁵

Section 965(c)(3)(B) defines the “cash position” of any specified foreign corporation as the sum of the following items:

B. Policy Considerations

Section 965 imposes a one-time tax on deferred foreign earnings as the United States transitions from a worldwide taxation system to a modified territorial system. When evaluating whether to enact section 965(c)(3)(B), Congress concluded that a lower transition tax rate is more appropriate for foreign earnings invested in non-liquid business assets. Congress responded to the fact that many companies that chose to reinvest their offshore earnings in operating assets rather than liquid assets could have difficulty raising cash to pay any transition tax attributable to these offshore earnings.⁶ Congress accepted the concerns that lawmakers and industry groups had raised that certain companies would have fewer liquid assets to satisfy their liability under section 965 because they had reinvested the earnings in their businesses and, thus, the transition tax could harm their businesses and, in turn, potentially harm the competitiveness of U.S. businesses.

The same rationale for subjecting deferred foreign earnings in the form of cash to a higher effective tax rate equally applies to deferred foreign earnings in the form of cash equivalents. Accordingly, Congress provided a list of cash equivalent assets that it determined were as liquid as cash, making them, in the most important respect for purposes of section 965, economically equivalent to cash. The list includes financial assets such as accounts receivable, foreign currency, commercial paper, etc., which typically are highly liquid and do not constitute operating business assets.

The liquidity of personal property, on the other hand, varies, even if there is an established financial market for the property. Recognizing that it cannot make a blanket assumption on the liquidity of publicly traded personal property, Congress included in the list of cash equivalent assets only personal property that is “of a type” that is “actively traded.” Implicit in the wording is a recognition that numerous limitations exist that act to limit the liquidity of a U.S. shareholder's strategic investment in a company whose stock is publicly traded.

Treasury is aware of many such limitations, so we do not seek to restate them here in detail. At a high level, U.S. companies are often able to operate and make long-term strategic investments in certain foreign countries with high barriers to entry only through investments in publicly traded companies. Despite being a publicly traded company, the foreign corporation could well be treated as an integral part of the U.S. company's business operations for business and financial accounting purposes. A sale, even of a fraction of such interests, could be detrimental to the U.S. company's foreign presence and operations. Even if the U.S. company were willing to sell its investments, it could take months, if not years, to liquidate its interest on the open market because of the size of the U.S. company's shareholding compared to the stock's average daily float, and regulatory restrictions and approvals that such a seller must satisfy before it can sell on the market. A private sale, on the other hand, typically requires many months to negotiate and execute, and is subject to various legal or regulatory restrictions, including insider trading rules, tender offer requirements, anti-trust approvals, foreign investment limitations, and other contractual restrictions imposed by local stakeholders, further delaying any potential sale.

We urge Treasury to provide clarity in this context by providing guidance that advances the Congressional policy whereby strategic, long-term investments do not represent an inappropriate shift of earnings offshore. Furthermore, including the value of these investments in a specified foreign corporation's cash position, thereby subjecting foreign earnings so invested to the higher transition tax rate of 15.5%, would create undue financial burden, which Congress intended to avoid by providing for a lower transition tax rate of 8% for foreign earnings invested in non-liquid business assets.

C. Technical Analysis

Statutory interpretation principles provide that, if the meaning of the language in the statute is clear on its face, the plain meaning of the statutory language controls. In contrast, when terms within a statute are subject to varying interpretations, legislative intent and other statutory interpretation principles are crucial.

In the instant case, as noted in the Preamble, the list of assets in section 965(c)(3)(B) includes what Congress determined are liquid assets.⁷ Where the scope of an item (e.g., cash) on the list is clear, Congressional intent by itself does not justify an expansion or a limitation of the scope of the item. Where the scope of an item is open to interpretation, the item is best defined with reference to Congressional intent. In the instant case, that would mean limiting items on the list to assets that are in fact liquid.⁸ The scope of the phrase “personal property which is of a type that is actively traded and for which there is an established financial market” is ambiguous and is certainly open to interpretation. Reasonable persons could interpret “of a type” and “actively traded” differently. Thus, whether personal property should be treated as being of a type that is actively traded is best defined with reference to the liquidity of the property. What is clear from the statute is that it is not sufficient that there is an established financial market. For the phrase “actively traded” to be something other than mere surplusage, it must constitute an additional requirement.

The canon of statutory interpretation noscitur a sociis provides that a word capable of multiple meanings should be understood by the company it keeps.⁹ In other words, when a word that could have multiple meanings appears as part of a list in a statute, the word should be interpreted to have the meaning which shares characteristics similar to that of the other items on the list. All of the other items on the list are liquid, non-business assets. Cash, commercial paper, certificates of deposit, securities of any federal, state, or foreign government, and foreign currency are all assets that corporations expect to be able to quickly dispose of in exchange for cash, likely within days, if not hours or minutes, at the prevailing market price without having any material negative impact on the markets of these assets. Corporations expect to be able to immediately convert these assets to cash without having to accept lower proceeds for the convenience of doing so. These are all assets which a corporation can generally dispose of without affecting the operation of its business, other than for cash flow and other financial concerns. It follows that publicly traded stock should be treated as being “of a type” that is “actively traded” only if the stock possesses these same economic characteristics.

Although there is no single definition of liquidity either in section 965 or in other parts of the Code, courts have analyzed the concept of liquidity in the context of valuation of stock. As a general matter, liquidity is a measure of the time required to convert an asset into cash and may be influenced by marketability.¹⁰ In valuing stock in a publicly traded company, courts have found that stock owned by a particular taxpayer was not liquid because of the size of the taxpayer's shareholding relative to the average trading volume and the prevailing market conditions, which impose practical limitations on the taxpayer's ability to sell its interest within a short period of time.¹¹

Furthermore, in determining the liquidity of stock, the potential to sell the stock only to a strategic buyer should be distinguished from the potential to sell the stock on an established financial market because of the vastly different mechanics involved in the sale.

III. Recommendations in Response to Request for Comments

Under section 965(o), Congress granted Treasury regulatory authority to issue regulations or other guidance as may be necessary or appropriate to carry out the provisions of the section. Because of the lack of clarity of the scope of the phrase “personal property which is of a type that is actively traded and for which there is an established financial market,” it is appropriate for Treasury to provide further guidance.

For the reasons illustrated above, to stay within the parameters of the statute, any guidance under section 965(o) should limit the scope of “personal property which is of a type that is actively traded and for which there is an established financial market” to property which is similar to that of other items on the list. Congress' use of the phrase “of a type” suggests that it would be appropriate to further categorize property with bright line tests to define the scope of “personal property which is of a type that is actively traded and for which there is an established financial market” as long as the tests are designed to ascertain the liquidity of the relevant property.

Based on the above, we recommend that the final regulations clarify that “personal property which is of a type that is actively traded and for which there is an established financial market” excludes publicly traded stock that satisfies the following criteria:

Excluding the value of stock of a publicly traded specified foreign corporation from a taxpayer's cash position is appropriate because a 10% or more interest in a publicly traded company likely is not liquid. It is unlikely one would be able to sell 10% of the stock of a publicly traded company on an established financial market within a short period of time, due to practical and regulatory constraints. Often times, 10 percent shareholders of publicly traded companies hold the shares as a business asset and may have material influence over the operations of the underlying business.

Requiring that the specified foreign corporation not be a passive foreign investment company ensures that the stock the taxpayer owns represents an interest in an operating business, as opposed to an interest in liquid financial assets the value of which might be more appropriately included in a corporation's cash position. This rationale for excluding stock in a passive foreign investment company from the safe harbor should equally apply regardless of whether the corporation is also a controlled foreign corporation. Alternatively, Treasury and the Service could consider requiring that the specified foreign corporation conduct an active trade or business as defined, for example, in Treas. Reg. § 1.367(a)-2(d). This similarly helps ensure that the taxpayer holds the shares as an investment in an operating business, rather than in liquid financial assets.

Imposing a holding period requirement further ensures that the taxpayer does not in fact dispose of the stock within a short period of time. A holding period which could be satisfied by ownership before or after November 2, 2017 is sufficient for this purpose. Alternatively, Treasury and the Service could consider imposing a requirement that the publicly traded stock is treated as a current asset on the audited financial statements of the taxpayer, which in turn reflects the fact that the taxpayer does not expect to liquidate its stock ownership within a year.

If all of the above requirements are satisfied, the stock that the taxpayer owns constitutes an illiquid business asset despite the fact that other stock of the same company is publicly traded on an established financial market. The value of such stock should be excluded from the taxpayer's aggregate foreign cash position.

If Treasury and the Service consider the above requirements to be insufficient by themselves, Treasury and the Service could consider imposing an additional requirement that the U.S. shareholder would not have been able to dispose of the stock of the specified foreign corporation that it owns on the relevant established financial market on November 2, 2017 without being subject to applicable laws and regulations that would have delayed the sale. This ensures that the taxpayer would not have been able to dispose of the stock within a short period of time even if it had wanted to.

As mentioned above, our comments in this letter are limited to the meaning of the phrase “personal property which is of a type that is actively traded and for which there is an established financial market” as applied to certain publicly traded stock. Although other exclusions from the phrase might also be appropriate, that is outside the scope of this comment letter.

We appreciate your consideration of our request and attention to these serious issues and would be pleased to continue a dialogue with you. If you would like to discuss these matters further, please contact Jeff Maydew at (312) 861-2560 or jef£maydew@bakermckenzie.com, Stewart Lipeles at (650) 856-5502 or Stewart.lipeles@bakermckenzie.com, or Katie Fung at (312) 861-6632 or katie.fung@bakermckenzie.com.

Respectfully submitted,

Baker &McKenzie LLP
Chicago, IL

cc:

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

Brian Jenn
Deputy International Tax Counsel
U.S. Department of the Treasury

Gary Scanlon
Attorney-Advisor
U.S. Department of the Treasury

Brenda Zent
Special Advisor on International Taxation
U.S. Department of the Treasury

Marjorie A. Rollinson
Associate Chief Counsel (Indernational)
Internal Revenue Service

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

Leni C. Perkins
General Attorney (Tax)(International)
Internal Revenue Service

Karen J. Cate
Tax Law Specialist (International)
Internal Revenue Service