Oil Company Seeks Exclusions Under Proposed Transition Tax Regs

To Whom It May Concern:

Phillips 66 is pleased to offer comments on the proposed regulations under section 965, enacted as part of the Tax Cuts and Jobs Act 2017. Specifically, Treasury and the IRS seek additional comments with respect to the definition of the cash position of a specified foreign corporation in section 965(c)(3)(B).

Phillips 66 (“Phillips”) is a multinational, diversified energy manufacturing and logistics company, headquartered in the USA. Our refining business processes crude oil and other feedstocks into petroleum products (such as gasoline, distillates and aviation fuels) at 13 refineries in the United States and Europe. Phillips employs approximately 14,000 employees globally, predominately in the United States. Phillips appreciates the opportunity to comment on this issue.

I. Summary

Phillips seeks further clarification of the section 965 meaning of “which is of a type that is actively traded and for which there is an established financial market”. Phillips believes for energy commodities, “which is of a type that is actively traded and for which there is an established financial market” includes only certain CFTC regulated financial futures, options and swaps that are traded on an established financial market. Phillips also believes that the section 965 aggregate foreign cash position should exclude forward contracts and commodities inventory that are not traded on an established financial market and are excluded from the CFTC's regulation.

II. Section 965 Aggregate Foreign Cash Position

Congress enacted section 965 as a transition tax to account for accumulated foreign earnings, that had not yet been subject to U.S. tax under the old deferral system, and that would not be subject to tax under the new hybrid system. These accumulated earnings are subject to tax at two different effective tax rates, with the higher rate of tax applicable to the “aggregate foreign cash position” of the taxpayer, and the lower rate applicable to the remaining earnings. The “aggregate foreign cash position” of a United States shareholder under Section 965(c)(3)(B) is determined by calculating the term “cash position” which includes three buckets of assets held by specified foreign corporations: (i) cash; (ii) net accounts receivables; and

Section 965(B)(iii)(I) includes within the cash position “personal property which is of a type that is actively traded and for which there is an established financial market.” The issue is whether a specified foreign corporation² that holds commodity inventories of raw material inputs or finished products outputs as part of its manufacturing trade or business should treat such assets as “which is of a type that is actively traded and for which there is an established financial market” for purposes of section 965. Phillips seeks further clarification of the meaning “which is of a type that is actively traded and for which there is an established financial market”. Phillips seeks this clarification with three objectives. One, optimal tax administration for the government is sought. Two, optimal tax compliance for manufacturing industry taxpayers, similarly-situated to Phillips, as described above is sought. Three, guidance that best distinguishes inventory from investment vehicles or other cash equivalents, is sought.

III. Refining Background

a. Crude Oil and the Refining Process

The refining of crude oil is best understood as a manufacturing process. The required input of any refinery is crude oil which is a mixture of hydrocarbons that exists in a natural liquid phase.³ After crude oil is removed from the ground, it is sent to a refinery where different parts of the crude oil are separated and refined into useable petroleum products. Petroleum refineries are complex and expensive industrial facilities. A refinery runs 24 hours a day, 365 days a year and requires a large number of employees. The process of refining breaks crude oil down into its various components, which are then selectively reconfigured into new products.⁴ These petroleum products include gasoline, distillates such as diesel fuel and heating oil, jet fuel, petrochemical feedstocks, waxes, lubricating oils, and asphalt. For every 42-gallon barrel the refining process produces 44-45 gallons of finished products.⁵

For its manufacturing process, each refinery must be able to store vast quantities of crude oil to be used for the refinery inputs and store vast quantities the refinery output of finished product to be distributed. To illustrate the quantities which are refined each day consider that the top 10 U.S. refineries as of January 1, 2017 refined anywhere from 336,000 – 603,000 barrels of crude per day.⁶ Ships, pipelines, trains, and trucks are used to distribute the finished products across the country and to other countries.

b. Purchasing Crude Oil and Selling Finished Product

All crude oil, held for manufacturing purposes, and finished products, the result of the manufacturing process, are treated as inventory tangible property. To secure the supply of crude oil for refinery inputs and to sell refinery finished products outputs, the refining industry utilizes purchase and sale contracts of “physical” barrels. These inventory purchase and sales contracts are known as forward contracts. The inventory purchase and sales contracts are privately negotiated contracts with other commercial entities, including producers, processors, refiners, and merchandisers of petroleum products as well as other entities that buy and sell petroleum products. For a description of the crude oil forward contract process, please see the CFTC's Statutory Interpretation Concerning Forward Transactions,⁷ (herein referred to as “CFTC's Brent Crude Oil Interpretation”). The process of negotiating forward contract inventory purchases of crude oil and sales of inventory finished products does not occur in an actively traded financial market like the NYMEX. While the NYMEX is an actively traded financial market, the contracts traded on the NYMEX are futures contracts which are typically financially settled, but are different than forward contracts which are typically physically settled and results in the delivery of inventory. The futures contracts are the intangible financial instruments, sometimes referred to as “paper” barrels in the industry.

IV. Cash and Cash Equivalents under Section 965(c)(3)(B)(iii)(I)

Section 965's definition of cash and cash equivalents in Section 965(c)(3)(B)(iii)(I), includes 1) personal property 2) which is of a type that is actively traded and 3) for which there is an established financial market, is ambiguous and could be misinterpreted to include forward contracts and crude oil and refined products inventory which are not sold on an established financial market.⁸

1) Personal property

Inventory is a type of personal property.

2) Which is of a Type that is Actively Traded

The term “which is of a type that is actively traded” is not defined in section 965 of the Code. Forward contracts are privately negotiated contracts to buy and sell physical inventory. Crude and refined products inventory are actively traded utilizing privately negotiated forward contracts.

3) For Which is There is an Established Financial Market

The Code does not define the phrase “for which there is an established financial market” and this phrase is used only in section 965. A definition for an “established financial market” can be found in the straddle regulations, Treas. Reg. 1.1092(d)-1(b), to include: (1) a domestic board of trade designated as a contract market by the CFTC or (2) a foreign board of trade that satisfies analogous regulatory requirements under local law. Assuming the 1092 straddle regulation definition of an “established financial market” is applicable to section 965, the CFTC has designated the NYMEX as a designated contract market, so the NYMEX could be interpreted as an example of an established financial market for futures contracts and options.

The Commodity Exchange Act (CEA), passed in 1936, established the framework for the CFTC, which regulates the trading of commodity futures and options in the United States. As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, the CFTC expanded its regulations to swaps. The CFTC regulates only certain financial contracts, more specifically, contracts that are futures, options, and swaps. The CFTC's jurisdiction does not include a contract for sale of a commodity for a “deferred shipment or delivery”, which is a forward contract. Please see the CFTC's Brent Crude Oil Interpretation,⁹ which discusses the forward contract exclusion from the CFTC's regulations. The forward contract exclusion from futures contracts is contained in the CEA section 2(a) (1)(A) definition of “future delivery” for which CEA Section 1a(27) defines that "future delivery" does not include "any sale of any cash commodity for deferred shipment or delivery." The CEA section 1a(47)(B)(ii) contains a similar forward contract exception for swaps that excludes any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.

In the CFTC's Brent Crude Oil Interpretation, the CFTC analyzes contract features to draw the distinction between regulated futures contracts, which are “paper” barrels as compared to non-regulated forward contracts, which are contracts to buy and sell inventory “physical” barrels. The CFTC also has a statutory interpretation distinguishing regulated option contracts as compared to non-regulated forward contracts¹⁰ (herein referred to as “CFTC's Commodity Options Interpretation”).

As explained in both the CFTC's Brent Crude Oil Interpretation and the CFTC's Commodity Options Interpretation, the CFTC regulates futures and option contracts, traded on an established financial market, like the NYMEX. Privately negotiated forward “physical” contracts to buy and sell inventory are not traded on an established financial market and are also excluded from being regulated by the CFTC.

4) Forward Contracts and Physical Inventory are Not “of a Type”

Since futures contracts are a type of contract that is included in section 965 aggregate cash position, for energy commodities, in comparing between a forward contract and a futures contract, there is little in common between the two types of contracts. Since a forward contract is completely different than futures contract, Phillips believes that forward contracts are not of a type which is of a type that is actively traded and for which there is an established financial market. Physical commodity inventories are also very different from futures contracts. Phillips also believes that physical commodity inventories are not of a type which is of a type that is actively traded and for which there is an established financial market.

Below is a summary comparison between futures contracts, forward contracts, and physical inventory:

	Commodity Future Contracts	Commodities Forward Contracts	Crude & Refined Products Physical Inventory
Market	Exchange Traded	Privately Negotiated	Refineries have crude inventory on-hand for processing inputs. Some of the inventory is purchased or sold using private forward contracts.11
Regulatory Framework	CFTC	None, private contracts	None
Margin	Margin with Broker and Exchange, daily margin settlement	None	None
Quality	Contract quality specifications as set by the exchange	Any specification, including off-spec products	Any specification, some of which are further inputs into additional manufacturing processes
Product	Certain types of commodities — crude, heating oil, gasoline, distillates	Any type of crude or or refined product, many types of which are not quoted on an exchange	Any type of crude or or refined product, many types of which are not quoted on an exchange
Quantity	Standard contract size	Flexible volumes	Volumes held for refinery inputs or as the result of refinery output
Maturity Dates	Fixed maturity contract dates	Flexible physical delivery dates, including long-term delivery contracts	None
Pricing	Market transparency	No market transparency	No market transparency
Liquidity	Market liquidity based upon all exchange participants	Not liquid	Not liquid
Secondary Market	Fully transferable	Not transferable without counterparty consent	-
Risk	No credit risk, cleared on the exchange	Buyer has risk that the Seller may not delivery. Seller has credit risk that the Buyer may default.	-
Settlement	Virtually all market participants close out their futures position with an offsetting futures position and typically delivery does not occur12	Physical delivery and cash settlement	Physical delivery and cash settlement for volumes purchased or sold in forward contracts.
Delivery	If physical settlement is made, fixed delivery location as set out by the contract specification	Flexible delivery location that is privately negotiated	-
Contract Usage	Speculative or hedge physical position	Hedge physical position	-
Fees	Broker fees and exchange market fees	No 3rd party fees	-

5) Regulations Should Exclude Contracts Not Traded on an Established Financial Market

As it pertains to the oil and gas industry, Phillips believes that the appropriate policy is for Treasury and the IRS to clarify that “of a type that is actively traded and for which there is an established financial market” includes only certain CFTC regulated financial futures, options and swaps that are traded on an established financial market like the NYMEX. Phillips also believes that the section 965 aggregate foreign cash position should exclude forward contracts and commodities inventory that are not traded on an established financial market and are excluded from the CFTC's regulation. This position would avoid the application of a facts-and circumstances test that analyzes the liquidity of every asset, and would be difficult to administer.

The need for this kind of distinction has been noted in tax policy discussions of other kinds of proposals, including a prior Treasury Department's financial products reform package. In its analysis of the financial products package, the Joint Committee on Taxation discussed the application of the mark-to-market regime to derivatives actively traded on an established financial market. The Joint Committee on Taxation stated: “The President's proposal only applies to derivatives on actively traded property. Although the proposal does not define that term, the intent may have been to rely on the same term that is defined by regulations under section 1092.¹³ Major Congressional financial products reform proposals used similar definitions to exclude physical delivery contracts.¹⁴

V. Proposed Regulations, Cash Equivalents Assets should exclude Forward Contracts

In the section 965 proposed regulations, in 1.965-1(f)(13)(v), the category of derivative financial instruments was added as a separate category of 965(c)(3)(B)(iii)(V) cash-equivalent assets.

The section 965 proposed regulations in 1.965-1(f)(18), further defines derivatives financial instruments.

Phillips 66 believes that the addition of a “forward contract” in the proposed section 965 regulation, 1.965-1(f)(18), as a derivative financial instrument that is a cash equivalent under section 965 has expanded the cash equivalent definition beyond the original scope of Section 965. Given that forward contracts are privately negotiated contracts to buy, sell, and deliver inventory, forward contracts are not traded on an established financial market. Consistent with our viewpoint on seeking clarification from Treasury and the IRS, that the section 965 aggregate foreign cash position should exclude forward contracts and commodities inventory that are not traded on an established financial market and are excluded from the CFTC's regulation, Phillips believes that forward contracts should be excluded from the cash equivalent definition in the proposed 965 regulations.

Thank you for the opportunity to comment on the proposed regulations and your consideration of this matter. If you have any questions or comments, please do not hesitate to contact me at Phillips 66.

Respectfully,

Heather Crowder
General Tax Officer
Phillips 66