Baker McKenzie Suggests Changes to Transition Tax Regs

October 9, 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

Charles P. Rettig
Commissioner
Internal Revenue Service

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)

Dear Sirs:

On August 9, 2018, the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “IRS”) issued proposed regulations (the “Proposed Regulations”)¹ under section 965 of the Code.² In the preamble to the Proposed Regulations, Treasury and the IRS (collectively, “Treasury”) requested comments “on all aspects of the proposed rules.” We appreciate the opportunity to provide comments and submit this letter to recommend that Treasury amend Prop. Treas. Reg. sec. 1.965-2(j), Example 1, to address two additional factual scenarios.

A. Overview of Example 1 and Proposed Recommendation

Example 1 of Proposed Regulation Section 1.965-2(j) states as follows:

We recommend that Treasury add two examples to further illustrate the concepts addressed by Proposed Regulation 1.965-2 when it finalizes the Proposed Regulations. Specifically, we recommend that Treasury extend the previously taxed income (“PTI”) concept in Example 1 for distributions in 2017 to cover sales covered by section 1248. We therefore propose that Treasury add an Example 1A to the final regulations that would state as follows:

We also propose that Treasury add an Example 1B to the final regulations. Example 1B is also needed in order to avoid double taxation in a similar manner to Example 1A. Example 1B would provide as follows:

B. Support for Recommendations

In support of our recommendation that Treasury add the foregoing requested examples to the final regulations, we note the following:

For Example 1A, considering the Transition Tax as PTI under section 959 and permitting a basis increase for the Nov. 1, 2017 sale is necessary to avoid double taxation of the same earnings under the Transition Tax and the section 1248 sale. Imposition of the Transition Tax, due to its intent to transition to the new “territorial” system of U.S. federal income taxation, wipes out a CFC's E&P and related FTCs those earnings would carry. Thus, all historic earnings are taxed.

The Conference Report to the Transition Tax explicitly prohibits double taxation of the same earnings under the Transition Tax and under other taxes. The Conference Report specifically provides as follows:

In order to avoid double-counting and double non-counting of earnings, the Secretary may provide guidance to adjust the amount of post-1986 earnings and profits of a specified foreign corporation to ensure that a single item of a specified foreign corporation is taken into account only once in determining the income of a United States shareholder subject to this provision. Such an adjustment may be necessary, for example, when there is a deductible payment (e.g., interest or royalties) from one specified foreign corporation to another specified foreign corporation between measurements dates.

Without the PTI and basis increase of 50u, there would result an imposition of the Transition Tax on earnings of CFC1 (i.e. 20u), other subpart F income on earnings of CFC1 (i.e. 30u) and allocation of the relevant FTC's to those income inclusions. Without the basis increase under Prop. Treas. Reg. section 1.965-2(b)(4), there would be a second tax imposed on the same earnings as part of the sale of the CFC1 stock by USP on Nov. 1, 2017. The second taxation of the same earnings in the sale would not be eligible for a FTC. As a result, there would be double taxation of the same earnings. The second taxation would be without FTC's. The PTI and basis increase of the 50u prevents double taxation from the Transition Tax. The principles of section 1001 and section 1248 would apply to this transaction (although there would be no remaining FTC's after their application to the subpart F income (of 30u) and the Transition Tax (of 20u). As the foregoing example illustrates (where there is residual gain), the section 961 basis allowance prevents double taxation of earnings. This is because it allows the Transition Tax and the other subpart F income to be allowed as a basis increase. It does not wholly cancel out the gain. Thus, gain in excess of the Transition Tax earnings and other subpart F earnings still is permitted.

Moreover, the Transition Tax under section 965 is part of subpart F. As such, the foregoing PTI and stock basis increase provisions from sections 959 and 961 are basic applications of sections 951 and the subpart F rules that prevent double taxation of subpart F inclusions. They provide a bridge between earnings and gain under the subpart F rules. It should be noted that to the extent that a taxpayer takes advantage of the PTI provisions in section 959, the stock basis of the CFC shares is reduced to prevent a double benefit.³

Because the buyer in the example is a foreign buyer, the last US shareholder of CFC1 is USP. As such, USP bears the income tax liability for all subpart F income from 2017. This includes the Transition Tax which is covered generally by section 951.

The stock sale of CFC1, absent the Transition Tax (and the other subpart F income), would have triggered section 1001 gain and 1248 dividend income. This would have brought up E&P and foreign tax credits. The E&P and foreign tax credits were utilized by the Transition Tax (and the other subpart F income).

Example 1 addresses a case where there is a Transition Tax inclusion (under section 965) and a subpart F inclusion under section 951(a). Both of these amounts are considered to be PTI for purposes of the dividend distribution that occurs on November 1, 2017. As such, the Transition Tax and the other subpart F inclusion are determined before determining the income tax consequences of the dividend. The Transition Tax and the other subpart F income result in PTI that will permit the tax-free payment of the dividend made on Nov. 1, 2017. Part of the PTI benefit from a dividend would be an increased stock basis in the shares of CFC1 to USP. Thus, the higher basis resulting from the dividend should similarly permit a higher basis for the sold shares in CFC1. The higher basis prevents the double tax on the same earnings that otherwise results. Thus, the same rationale that motivated the dividend in Nov. 1, 2017 being treated as PTI for the Transition Tax and the subpart F income applies to a section 1001 and section 1248 sale.

1. The Proposed Regulations Utilize the Existing Ordering Rules Under Subpart F and Section 1248

Under the existing framework of section 1248 and the subpart F regime in general, which Congress left unchanged when it enacted the Tax Cuts and Jobs Act,⁴ there is a well-established ordering methodology with respect to income inclusions. The detailed ordering rule under section 959, discussed above, contemplates the various permutations of subpart F, section 965, and actual distributions within the same taxable year. The Proposed Regulations apply the above described concepts in avoiding double taxation.

As discussed above, the ordering rule in section 959 specifically addresses section 1248 Inclusions. The manner in which section 1248 references the ordering rule in section 959 sheds light on how the section 1248 inclusion is to be treated under section 959:

“For provision excluding amounts previously taxed under this section from gross income when subsequently distributed, see section 959(e).”⁵

The language of this cross reference suggests that, although a section 1248 Inclusion is treated as a deemed dividend for purposes of recharacterizing the gain as ordinary income, the inclusion is not considered a “distribution” for purposes of the ordering rule. Instead, it is treated as directed under section 959(e), which provides that, for purposes of the primary ordering rules under section 959 and for purposes of section 960(c), section 1248 Inclusions are to be treated as inclusions under section 951(a)(1)(A) — i.e. subpart F inclusions.⁶ Subpart F inclusions similarly trigger immediate inclusion to the U.S. shareholder, but are not actually distributed to that shareholder. Instead, the inclusion causes those earnings to be treated as PTI, and are not subject to further U.S. tax upon subsequent distribution.

This language is mirrored in section 965, which provides that “accumulated post-1986 deferred foreign income” means post-1986 E&P, excluding earnings which:

in the case of a controlled foreign corporation, if distributed, would be excluded from the gross income of a United States shareholder under section 959. To the extent provided in regulations or other guidance prescribed by the Secretary, in the case of any controlled foreign corporation which has shareholders which are not United States shareholders, accumulated post-1986 deferred foreign income shall be appropriately reduced by amounts which would be described in subparagraph (B) if such shareholders were United States shareholders.⁷ (emphasis added)

Section 965 goes on to define “post-1986 earnings and profits,” and specifically states that such amount is determined “without diminution by reason of dividends distributed during the taxable year.”⁸ Read together, this language suggests that (1) current year distributions are not considered when computing accumulated E&P and (2) the carve out of earnings which would be excluded from income of a U.S. shareholder under section 959 (i.e. PTI) therefore only extends to the prior year's ending pool of PTI. By providing that current year distributions are not considered, section 965 would suggest that the deemed distribution under section 1248 would be excluded from E&P for purposes of the Transition Tax calculation. The earnings of CFC1 would therefore be subject to the Transition Tax. As the Transition Tax was meant to eliminate a CFC's previously untaxed E&P, those earnings would be eliminated for purposes of applying section 1248. Thus, both the dividend in 2017 and the section 1248 sale in 2017 would be eligible for PTI (under section 959) and adjusted basis step-up (under section 961).

2. Section 959(e) and Section 961 Provide That the Transition Tax Would Cause a Step Up in Basis.

As discussed above, the Transition Tax is imposed through the subpart F structure. The earnings subject to the tax are included in the income of the U.S. shareholder under section 951 as though it were an additional subpart F inclusion. Congress's choice to apply the Transition Tax in this manner — i.e. with specific reference to the inclusion mechanism under section 951(a)(1) — suggests that Congress knew of and intended the inclusion to be subject to the ordinary U.S. federal income tax consequences of an inclusion under that provision. The foregoing concepts are incorporated into the Proposed Regulations.

The Code is clear that, when there is a subpart F inclusion, the U.S. shareholder recognizing the income is permitted a step up in basis with respect to its stock in the CFC which generated the subpart F income.⁹ If the U.S. shareholder then receives a distribution of the previously taxed earnings on a tax-free basis as provided by the ordering rule in section 959, that basis step up is reversed. ¹⁰ This step up in basis aids in preventing double taxation, as it represents the fact that the U.S. shareholder has already been taxed on a portion of the CFC's E&P without actually receiving those funds. Thus, until the amounts are actually distributed, it is as though the U.S. shareholder has made a capital contribution to the CFC.

3. Application of Proposed Regulations.

USP, a domestic corporation, owns all of the stock of CFC1, a foreign corporation, which owns all of the stock of CFC2, also a foreign corporation. USP, CFC1, and CFC2 all have taxable years ending December 31, 2017. As of January 1, 2017, CFC1 has no earnings and profits, and CFC2 has 100u of earnings and profits described in section 959(c)(3) that were accumulated in taxable years beginning after December 31, 1986, while CFC2 was a specified foreign corporation. On March 1, 2017, CFC1 earns 30u of subpart F income (as defined in section 952), and CFC2 earns 20u of subpart F income. On July 1, 2017, CFC2 distributes 40u to CFC1. On November 1, 2017, CFC1 distributes 60u to USP. USP does not have an aggregate foreign E&P deficit.

The example then applies each of the five Tiers to the transaction. Importantly, the example applies the Transition Tax to the earnings of CFC 1 before it determines the taxability of the 60u distribution by CFC1 to USP. In the example, CFC1 has 30u of subpart F income that is treated as subpart F income. It also has 20u of subpart F income that results from a dividend by CFC2 to it. It also has 20u of other earnings from a dividend paid to it by CFC2. Finally, the Transition Tax applicable to CFC1 results in 20u additional earnings being recognized by CFC1 All of the foregoing amounts create PTI that exempts the 60u November 1, 2017 distribution from tax.

The facts of Example 1, when applied to the facts of this Example 1A would first apply the PTI from the Transition Tax for CFC1 to the section 1248 sale.¹³ As a direct result of the foregoing subpart F inclusion, USP would be entitled to increase the basis of CFC1 by the Transition Tax Earnings and the subpart F income.¹⁴ Under the facts of Example 1, the 60u dividend by CFC1 to USP was exempt from tax because it was PTI. If the facts were changed for USP to have sold CFC1 to a foreign buyer on November 1, 2017, the adjusted basis of the CFC1 stock would be increased by the earnings that were subject to the Transition Tax (i.e. 20u) and the subpart F income (i.e. 30u). This would happen before the application of Tier 4 in the Proposed Regulations which is the Tier where the section 1248 would be allocated (with the dividends). Thus, a sale of CFC1 by USP to a foreign buyer on November 1, 2017, would have recognized 20u less of gain from the November 1, 2017 sale as a result of the earnings that were subject to the Transition Tax and 30u less of gain from the November 1, 2017 sale as a result of the earnings that were subject to the other subpart F income.

4. Taxation of Other Transfers

Distributions and stock sales are interchangeable under the PTI rules. The basis increase and decrease rules under sections 961(a) and (b) accomplish that result.

5. Transition Tax and Section 1248 Policy Goals Satisfied

The foregoing result accomplishes no double taxation on the same earnings. This result accomplishes the following goals:

6. Treasury should include Example 1B in the final regulations.

Thank you for the opportunity to provide comments on the Proposed Regulations, and we look forward to having a dialogue with you about the Proposed Regulations. If you have questions or would like to discuss the recommendations in this comment letter further, please contact James Barrett at james.barrett@bakermckenzie.com or (305) 789-8957.

Respectfully submitted,

Baker McKenzie

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

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

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

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

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

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

Leni C. Perkins
Office of Chief Counsel (International)
Internal Revenue Service

Karen J. Cate
Office of Chief Counsel (International)
Internal Revenue Service