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Addressing an Opaque Foreign Income Subsidy With Expense Disallowance

Posted on Aug. 2, 2021
[Editor's Note:

This article originally appeared in the August 2, 2021, issue of Tax Notes Federal.

]
Stephen E. Shay
Stephen E. Shay

Stephen E. Shay is the Paulus Endowment Senior Tax Fellow at Boston College Law School. He thanks Reuven Avi-Yonah, Kimberly Clausing, Patrick Driessen, David Elkins, Cliff Fleming, Mike Kaercher, Peter Merrill, Isaac Moore, Susan Morse, Shu-Yi Oei, Paul Oosterhuis, Robert Peroni, James Repetti, Diane Ring, Michael Schler, Martin Sullivan, Wade Sutton, Clint Wallace, and participants at the Boston College Law School Tax Policy workshop for comments on earlier versions of this report.

In this report, Shay argues that the use of exemptive deductions — deductions whose object is to exempt foreign income from U.S. tax — should trigger the application of section 265 to expenses allocable to the exempted income, and he shows how the government could address the expense disallowance issue through various legal avenues, regardless of the outcome of the Biden administration’s fiscal 2022 revenue proposals.

The views expressed here are made in the author’s individual capacity and do not represent the views of any school with which he is associated, any organization for which he serves as an officer or trustee or is a member, or any client for which he acts or has acted on a compensated or pro bono basis.

Copyright 2021 Stephen E. Shay.
All rights reserved.

I. Introduction

This report considers whether income offset by deductions whose object is to exempt foreign income from U.S. tax is a class of income wholly exempt from taxes for purposes of the deduction disallowance rule of section 265(a)(1). From a normative perspective, the disallowance of deductions for expenditures to earn untaxed income is fundamental to achieving a tax on net income that measures ability to pay. Net income representing a change in taxpayer wealth will be mismeasured if expenses allocable to exempt income are allowed to offset other income instead of being disallowed. If deductions are to be allowed, the distortion of net income should be justified.

The issue arises under current law from the adoption of two deductions in the Tax Cuts and Jobs Act whose object is to exempt specific foreign income from the federal income tax.1 The deductions exempt 50 percent of a global intangible low-taxed income inclusion (subject to a taxable income limit) and 100 percent of the foreign-source portion of a dividend (the exemptive deductions).2 These deductions are not equivalent to rate reductions applied to a category of taxable income, because they apply before other deductions and do not thereby limit the benefit of those deductions to the lower tax rate.3 Unlike other business deductions, these deductions are fundamentally exemptive in nature and do not have a measurement-of-income objective.4 The better analysis of the section 265(a)(1) statutory language is that deductions (other than the exemptive deduction) allocable to income offset by an exemptive deduction are subject to disallowance under existing section 265(a)(1).

Allowing U.S. shareholder deductions allocable to exempt foreign income earned through a controlled foreign corporation would be an opaque subsidy for foreign investment. That subsidy would advantage multinational over domestic businesses, shareholders over workers, and high-income and foreign investors over other taxpayers. To disable the operation of section 265(a)(1), there should be evidence in the statute or legislative history that Congress intended that its disallowance rule not apply. That evidence is lacking, while there is clear evidence that Congress intended for the income to be untaxed.

Regulations under section 265 do not directly address the treatment of income offset by exemptive deductions. The relevant regulation adopts a meaning for “class of income wholly exempt from . . . taxes” that is narrower than the statute, presenting the interpretative question whether the meaning used in the regulation is exclusive.5 The regulation states that “a class of income wholly exempt from . . . taxes . . . includes any class of income which is (i) Wholly excluded from gross income . . . or (ii) Wholly exempt from taxes.” (Emphasis added.) While a contrary reading is possible, as explained below, the regulation’s use of the term “includes” indicates that it is intended to be nonexclusive.

The analysis in this report demonstrates that if reg. section 1.265-1(b) were interpreted by the IRS to be the exclusive meaning, and assuming the courts either agreed with or deferred to the agency interpretation, the IRS still could validly amend its regulation to adopt an interpretation that would cause section 265 to apply to income offset by an exemptive deduction.

Adopting a notice and comment regulation applying section 265 to income offset by an exemptive deduction would reasonably interpret the statute, offer stakeholders the opportunity for criticism, and mitigate the burdens of potential litigation on taxpayers and the government. Because exemptive deductions are a novel feature of the income tax law and the proper application of section 265 may be underappreciated by taxpayers, the IRS could exercise its discretion to make a regulatory amendment prospective. Such an exercise of discretion would not be required, and the interpretation could apply from the effective dates of the exemptive deductions.

The alternative of seeking legislation clarifying the application of section 265 to income offset by exemptive deductions is available but not required. Legislation would be available, if, contrary to the analysis in this report, a court were to conclude that section 265(a)(1) cannot apply and find a confirming regulation invalid. Moreover, Congress can legislate if it disagrees with an interpretation adopted by regulation.6

Treasury’s fiscal 2022 revenue proposals include amending section 265 to disallow deductions allocable to a class of foreign gross income that is exempt from tax or taxed at a preferential rate through a deduction. The proposal states that no inference should be drawn regarding current law.7 Whether the legislative proposal would have a budgetary effect would depend on how the staff of the Joint Committee on Taxation interprets the statute and the existing regulation. If the JCT agrees with the analysis in this report, revenue from expense disallowance could be included in baseline revenue subject to adjustment for taxpayer practice and whether the IRS enforces the interpretation. If the JCT disagreed, a legislative clarification would increase revenue. Under the analysis in this report, Treasury has authority to adopt a regulation incorporating a reasonable interpretation of the statute, as proposed in this report, regardless of whether the proposed legislative clarification is adopted and whether or not the legislative proposal is considered to have a budgetary effect.

This report is intended to identify the expense disallowance issue and its structural importance in an income tax. The article illuminates the revenue significance of the expense disallowance issue and shows how different legal avenues — including statutory interpretation, regulation, legislation, and their combinations — are available to address it.

II. Exemptive Deductions and Section 265

A. Objectives of an Income Tax

The primary objective of the U.S. federal income tax is to raise revenue to fund government expenditures for public goods and services appropriated by a democratically elected Congress.8 Federal expenditures include those for internal and external security, for a reasonable social safety net to achieve social welfare objectives, and for any other congressionally approved purpose. The United States relies more than its peer countries on the income tax as a principal source of federal revenue.9

The U.S. income tax is imposed on net income as an appropriate measure of a taxpayer’s ability to pay.10 Net income is determined by reducing gross income by the deductions related to that income.11 The resulting net income (or loss) reflects the taxpayer’s increased (or decreased) capacity to consume or invest.12 If deductions in relation to gross income are understated, there is excessive income taxation. If deductions are overstated, taxable income is understated, resulting in undertaxation.13

When taxable income must be determined for an advantaged subset of gross income, such as foreign-source taxable income eligible for a foreign tax credit or income exempt from tax, the usual incentives are reversed. If deductions in relation to foreign-source income or exempted income are understated, U.S. tax will be understated if more foreign taxes are allowed as a credit or if deductions are allowed to offset nonexempt income. If deductions against foreign or exempt income are overstated, U.S. tax will be overstated if credits or deductions appropriately allowed are disallowed.

This report deals with the treatment of deductions allocable to income that is not taxed, in this case because of exemptive deductions. Section 265(a)(1) addresses the issue with a general rule that deductions “allocable” to a class of income “wholly exempt from . . . taxes” shall not be allowed. The reason for the general rule of section 265 is straightforward and may be seen in Example 1.

Example 1: If Corp. A has gross income of $100 and allocable business expenses of $25, its taxable income is $75, and its tax at 21 percent is $15.75. If the taxable income is exempt, the taxpayer saves the $15.75 tax otherwise due.

If the $25 of expense is allowed as a deduction and offsets other income, the taxpayer effectively is refunded the tax on income offset by the deduction, or $5.25 (21 percent * $25 = $5.25). Instead of benefiting from the exemption by $15.75, the taxpayer’s benefit is $21 ($15.75 + $5.25 = $21).

The principle underlying section 265 is that the benefit from exempting income should not exceed the tax on the income. The tax is imposed on the gross income after it is reduced by allocable deductions (in Example 1, the tax of $15.25 on net income of $75). Under this structure, exemption of income does not affect the distribution of tax burden according to level of net income.

If deductions allocable to exempt income are allowed such that exemption applies to gross income, the benefit of exemption ($15.25 in Example 1) will be increased to $21. In a business income context, exemption of gross instead of net income will be more beneficial for businesses with more deductions and lower margins than for businesses with fewer deductions and higher margins. It is difficult to reconcile this discrimination among taxpayers with rational policy.

Another way to describe the principle of section 265 is that a deduction should not give rise to a double benefit.14 A deduction for an expenditure to generate income that is exempted should not also be allowed to offset other income. That would be using the deduction twice. If this is allowed as a general matter, a taxpayer could increase its expenditures to earn the exempted income and thereby erode the nonexempt tax base. Accordingly, a limit is necessary to protect the income tax base.15

In the TCJA, Congress adopted a form of partial territorial taxation known as foreign dividend exemption. The section 245A deduction eliminates the U.S. tax on the foreign portion of a dividend from a foreign corporation. Similarly, a GILTI deduction offsets 50 percent (declining to 37.5 percent in 2026) of a GILTI inclusion.16 Both exemptive deductions apply without regard to whether the underlying earnings have been previously taxed by the United States or, indeed, taxed — or even subject to tax — by any foreign country. The deductions are not based on an expenditure by the taxpayer and serve no separate measurement-of-income purpose. To the extent of the exemptive deduction, the United States is declining to assert its taxing jurisdiction over the foreign earnings.17

There has been little discussion whether U.S. shareholder expenses (other than the exemptive deduction) allocable to a foreign dividend or the portion of a GILTI inclusion offset by an exemptive deduction should be allowed to the shareholder as a deduction. Allowing a U.S. shareholder’s deductions allocable to the income offset by an exemptive deduction would be inconsistent with the basic principle that deductions allocable to exempted income should not be allowed.18 It has been widely accepted that deductions allocable to exempt income in an exemption regime should be disallowed (or an equivalent adjustment should be made to limit the exemption).19 While this normative conclusion is clear, this report focuses on the analysis of section 265 and the exemptive deductions under the code.

Before turning to the relevant statutory background and considering whether section 265 applies to gross income offset by exemptive deductions, to motivate analysis of the disallowance issue, the next section considers the revenue implications of not disallowing deductions allocable to a U.S. shareholder’s income offset by an exemptive deduction.

B. Scale of the Exemptive Deduction Issue

The effect of not disallowing under section 265 U.S. shareholder deductions allocable to a U.S. shareholder’s income offset by an exemptive deduction may be seen in Example 2.

Example 2: Assume that USP, a U.S. corporation, owns all the stock of CFC, its only foreign subsidiary. CFC has $500 of taxable income for the year that is not subpart F income and is not GILTI (for example, because USP’s net deemed tangible income return for the year exceeds $500, so there is no GILTI inclusion). CFC pays a dividend of $250 at the end of the year. USP has $750 of U.S.-source gross income; $250 of foreign-source dividend income eligible for a section 245A exemptive deduction; and $450 of expense, of which $50 would be stewardship expense allocable to a dividend on CFC stock.20

USP’s gross income is $1,000, and its deductions are a section 245A deduction of $250 and other deductions of $450, including $50 allocable to the foreign dividend. USP’s taxable income is $300 ($1,000 - $250 - $450 = $300), and USP pays U.S. tax of $63 (21 percent * $300 = $63).

The 245A deduction of $250 reduces U.S. tax by $52.50 ($250 * 21 percent = $52.50). But the foreign-source taxable income is $200 ($250 - $50 = $200). The U.S. tax saved by exempting the net income of $200 would be $42 ($200 * 21 percent = $42). The additional $10.50 of tax saved is attributable to allowing the deduction of $50 to reduce U.S. tax on other income, which is more than the tax that would be saved by exempting the gross income net of deductions. From a U.S. perspective, the effective marginal tax rate on the investment giving rise to the deemed tangible income return is negative.21

Some simple metrics suggest the scale of the issue from a revenue perspective. If 10 percent of CFC earnings is subpart F income22 and 25 percent of CFC earnings is equal to a 10 percent return on net deemed tangible investment return (NDTIR), the remaining 65 percent of CFC earnings and profits would be GILTI. The total earnings offset by exemptive deductions would be 57.5 percent of total earnings (half of GILTI or 32.5 percent of earnings plus 25 percent of earnings that are NDTIR). If it is assumed that expenses allocable to income from CFCs are equal to approximately 20 percent of total CFC earnings, disallowed expenses would be 10.4 percent of total CFC earnings.23 At 21 percent, the marginal tax rate benefit to taxpayers of not disallowing allocable deductions would be approximately 2.17 percent of total CFC earnings.

Table 1

Inputs

Row

Description

 

1

CFC total earnings less deficits

100%

2

Subpart F and other exceptions

-10%

3

CFC net tested earnings

90%

4

NDTIR 10% return less CFC interest expense

-25%

5

GILTI

65%

6

U.S. shareholder expenses allocable to total CFC earnings

20%

Marginal Tax Rate Benefit of Allowing Expenses Allocable to Exempted Income

7

50% * GILTI

32.5%

8

NDTIR 10% return less CFC interest expense

-25%

9

Exempt income

57.5%

10

U.S. expenses allocable to exempt income

10.4%

11

U.S. pre-credit tax rate on CFC net tested earnings without section 265

3.05%

12

U.S. pre-credit tax rate of CFC net tested earnings applying section 265

5.22%

13

Marginal tax rate benefit of not applying section 265

2.17%

This table is reproduced at Appendix A with explanatory comments.24

Under this model’s assumptions, the U.S. pre-credit effective tax rate on CFC net tested earnings without applying section 265 would be 3.05 percent. (In other words, the effective U.S. tax on the CFC net tested earnings assuming the level of exemptive deductions in the facts would be 3.05 percent absent the application of section 265.) After applying section 265, the effective tax rate on CFC net tested earnings would be 5.22 percent. The tax rate effect of applying section 265 is 2.17 percent of net tested income. This rate would approximate an average for all CFCs and would, of course, vary for each company depending on its facts. Under a range of reasonable assumptions, however, the amounts at stake would be material, possibly in the range of $5 billion to $10 billion a year, or $50 billion to $100 billion over a 10-year budget period.

The application of section 265 to income offset by exemptive deductions would prevent the overstatement of allowable deductions that would result from failing to disallow expenses allocable to income that bears no U.S. tax because of the exemptive deductions. Allowing deductions allocable to untaxed income essentially refunds U.S. tax on other income, which subsidizes the investment made to earn the exempted income. There is no indication in the TCJA’s legislative history that this subsidy (from allowing deductions allocable to exempt income) is intended.25

The next section provides relevant statutory background on the exemptive deductions before analyzing in Section III whether section 265 applies to income offset by exemptive deductions.

C. Statutory and Regulatory Background

1. The GILTI exemptive deduction.

Section 951A requires a U.S. shareholder of a CFC to currently include GILTI in income.26 A U.S. shareholder that is a domestic corporation is allowed a deduction for 50 percent of the sum of the GILTI amount and the section 78 dividend attributable to it.27 This report refers to this 50 percent deduction against GILTI as the GILTI exemptive deduction. The section 250 GILTI deduction combined with the section 250 foreign-derived intangible income deduction is subject to a taxable income limit. If the GILTI and FDII exceed the U.S. shareholder’s taxable income, GILTI and FDII deductions are reduced pro rata.28 The section 250 deduction as so limited is subject to the limitation of section 246(b).29 The section 250 deduction is not allowed in determining the amount of an NOL.30

2. The section 245A exemptive deduction.

Section 245A provides a 100 percent deduction for the foreign-source portion of a dividend (that is not a hybrid dividend) received by a 10 percent corporate U.S. shareholder on stock in a foreign corporation satisfying a holding period condition (a section 245A dividend).31 The foreign-source portion of a dividend is based on the ratio of undistributed foreign earnings to total undistributed earnings of the foreign corporation, each determined at the end of the year without reducing earnings for the dividends distributed during the year. This report refers to the 100 percent deduction as the section 245A exemptive deduction.

It is possible that a dividend from a CFC is in whole or in part from earnings effectively connected with a U.S. business or from dividends from an 80 percent owned domestic corporation (that is not a regulated investment company or a real estate investment conduit). The portion of the dividend that is attributable to those earnings would be subject to 50 percent section 245 dividends received deduction (DRD).32 The apportionment of the dividend between the foreign earnings and the rest of the earnings directs section 245A at foreign dividend income. No FTC or deduction is allowed for any foreign income taxes paid or accrued on a dividend for which the section 245A exemptive deduction is allowed.33

3. Section 265(a)(1).

Section 265(a)(1) disallows deductions allocable to “one or more classes of gross income” (other than interest to which section 265(a)(2) applies) “wholly exempt from the taxes imposed by this subtitle.” Under section 261, the disallowance of deductions under section 265 takes precedence over code provisions allowing deductions, including sections 245A and 250. Before turning to interpretation of section 265, the next subsection describes statutory provisions that intersect with the exemptive deductions to assess their potential import for the interpretation of section 265 in relation to gross income offset by the exemptive deductions.

4. Exemptive deductions and the FTC.

a. The FTC.

It may reasonably be asked, what is the relevance of the FTC to the disallowance under section 265 of deductions attributable to gross income offset by exemptive deductions:

  • First, some code provisions described in this subsection of the report prescribe rules for allocating and apportioning deductions attributable to exempt income for purposes of the FTC limitation. Consequently, they are a potentially relevant context for interpreting section 265’s disallowance rules.

  • Second, the regulatory implementation of these rules shows that the IRS appears to consider gross income offset by exemptive deductions as exempt income for purposes of sections 864(e)(3) and 904(b)(4), described below.

  • Third, the approach taken in regulations under sections 864(e)(3) and 904(b)(4), particularly in conjunction, is quite distortive if the section 265(a)(1) deduction disallowance does not apply.

Because of the technical nature of this part of the argument, a more generalist reader may prefer to skim this section and retain their focus on the section 265 discussion.

The FTC mitigates the effects of income being subjected to taxation by two countries. In this case, the two countries are the United States and the country where the CFC earns its income. The U.S. tax on the taxable portion of the CFC’s earnings may be reduced by a credit for corporate-level foreign income tax.34 As previously noted, a section 245A dividend is not allowed to be offset by an FTC.35

The FTC broadly involves two steps. The first is to determine whether the foreign tax is an income tax for purposes of the FTC, and how much tax is paid.36 In this discussion, it is assumed that the foreign taxes are income taxes and that the amount of the foreign tax is not in question. The second step is to determine the limit on the amount of the foreign tax allowed to offset the U.S. tax. The purpose of the FTC limitation is to prevent foreign taxes from being allowed as a credit against U.S. tax on U.S.-source taxable income.37

The FTC limitation is applied separately to categories of foreign-source income, including passive income,38 GILTI (that is not passive income),39 and general category income (including subpart F income that is not passive category income).40 The FTC limitation for a limitation category is determined by multiplying the U.S. taxpayer’s total U.S. taxes (before reduction by the FTC) by a fraction. The numerator is foreign-source taxable income in the relevant income category, and the denominator is the taxpayer’s worldwide taxable income.41 Accordingly, the allocation of deductions between U.S.-source and foreign-source income in a limitation category determines the relative size of the numerator of the fraction. The more deductions allocated to a category in the numerator, the smaller the numerator and the limitation for that category. As this makes clear, the allocation of deductions to or away from foreign-source income in a category is an essential part of the FTC regime.42

b. GILTI, the section 960 indirect credit, and section 864(e)(3).

The portion of GILTI that is not offset by the GILTI exemptive deduction is foreign-source income taxed by the United States. If a domestic corporate U.S. shareholder elects the FTC for a year, the shareholder is treated as paying 80 percent of its share of the foreign taxes associated with a GILTI inclusion (before reduction by the GILTI exemptive deduction).43 The U.S. shareholder also must include in income a “section 78 dividend” for 100 percent of the CFC-level foreign income taxes associated with the net tested income that is included in GILTI.44 The U.S. corporate shareholder’s deemed paid foreign taxes assigned to the GILTI FTC limitation category may be used for cross-crediting against other GILTI but may not be used against income in other limitation categories.45

The final FTC limitation regulations make it clear that U.S. shareholder deductions must be allocable to GILTI in determining the numerator of the FTC limitation.46 Section 864(e)(3), adopted in the Tax Reform Act of 1986,47 provides that a tax-exempt asset (and income from the asset) is not taken into account in the allocation and apportionment of deductions.48 This rule applies only to deductions that are allowed as expenses, and not to expenses disallowed under section 265.49

In applying section 864(e)(3), post-TCJA regulations treat GILTI offset by a GILTI exemptive deduction as exempt income, and they treat stock in the CFC as an exempt asset in proportion to the exempt income.50 Accordingly, GILTI (and stock from which it is derived) is excluded from the numerator and denominator of the FTC limitation fraction based on the ratio of the GILTI exemptive deduction to the amount of the GILTI inclusion.51 The effect of this rule is illustrated in Example 3, which is drawn from the example at reg. section 1.904(b)-3(e).

Example 3: USP, a domestic corporation, owns a domestic factory with a tax book value of $27,000x. USP owns three CFCs and has a tax book value of $10,000x in the shares of each CFC, $8,000x of which is assigned to the section 951A (GILTI) category and $2,000x of which is assigned to the general category in the section 245A subgroup. USP has U.S.-source gross income of $1,600x and a GILTI inclusion amount of $2,200x.52 USP has a GILTI exemptive deduction of $1,100x (50 percent * $2,200x) and interest expense of $1,500x.53 Half of each CFC’s stock assigned to the section 951A category, or $4,000x, is treated as exempt under section 864(e)(3), so $12,000x of stock basis is excluded from the apportionment fraction (and $12,000x stock basis remains).

The $1,500x of interest expense is apportioned based on assets after being adjusted for section 864(e)(3) as follows:

Description

Asset Basis

Allocation

Section 951A assets

$12,000x

$400x

General section 245A assets

$6,000x

$200x

Residual U.S. grouping

$27,000x

$900x

Totals

$45,000x

$1,500x

The effect of the regulation is to shift interest expense away from section 951A and to the other categories. If section 864(e)(3) did not apply, then absent any disallowance under section 265(a)(1), the allocation would be:

Description

Asset Basis

Allocation

Section 951A assets

$24,000x

$632x

General section 245A assets

$6,000x

$158x

Residual U.S. grouping

$27,000x

$711x

Totals

$57,000x

$1,500x

Specifically, the effect of the rule in Example 3 is to shift $232x of interest away from reducing the FTC limitation on foreign taxes imposed on GILTI to exempt foreign dividends and U.S. income instead. This will expand the GILTI FTC limitation and thereby allow more FTCs.54 This does not reach the correct answer. The correct answer is to disallow the interest expense allocable to half the GILTI ($315x = 50 percent * $632 (rounded)) and allocate the remaining $1,185x according to the assets after the application of section 864(e)(3):

Description

Asset Basis

Allocation

Section 951A assets

$12,000x

$315x

General section 245A assets

$6,000x

$158x

Residual U.S. grouping

$27,000x

$711x

Totals

$45,000x

$1,185x

In other words, the operation of section 863(e)(3) is more coherent when section 265 applies to disallow deductions allocable to income offset by exemptive deductions.

c. Sections 245A and 904(b)(4).

Section 904(b)(4) provides that a 245A dividend and deductions allocable to a 245A dividend (and the portion of stock giving rise to a section 245A dividend) are not taken into account for purposes of the FTC limitation (numerator and denominator).55 This rule parallels the rule of section 864(e)(3), except that it applies only for purposes of subsection (a) of section 904.

With the preceding as background, we turn to statutory interpretation of section 265 in relation to income offset by an exemptive deduction.

III. Section 265 and Exemptive Deductions

This Section III considers the following: Does section 265(a)(1) disallow deductions allocable to gross income offset by the GILTI or the section 245 exemptive deduction? The discussion in this part of the report is broken into separate elements to allow the pieces to be assembled according to the reader’s interpretative proclivities.56 The order of questions addressed is:

  • Does the statutory language support applying section 265(a)(1) to gross income offset by exemptive deductions?57

  • Does the context support applying section 265(a)(1) to gross income offset by exemptive deductions?

  • Does the legislative history support applying section 265(a)(1) to gross income offset by exemptive deductions?

A. Section 265 Statutory Language

The first clause of section 265(a)(1) identifies circumstances in which a deduction will be disallowed.58 The provision has three elements:

  • it potentially applies to “any amount otherwise allowable as a deduction”;

  • the amount must be “allocable to one or more classes of income other than interest”; and

  • the “class of income” must be “wholly exempt from the taxes imposed by this subtitle.”

From the earliest days of the income tax, it was recognized that “expenses incurred in earning income which is not subject to tax under the income tax law do not constitute allowable deductions in computing net income from other sources which are taxable under the law.”59 This is the principle adopted in 1934 in the predecessor to section 265(a)(1) in relation to income other than interest.60

The question here is whether the language of the first clause of section 265(a)(1) admits of an interpretation that would apply the disallowance rule to expenses (otherwise allowable as deductions) allocable to income that is exempted by the mechanism of an exemptive deduction. Sections 250(a)(1)(B) and 245A each describe an amount that otherwise would be deductible. The gross income that is offset by these exemptive deductions is not exempt, so section 265 does not apply to the exemptive deductions themselves. Once an exemptive deduction is applied, however, the gross income that is offset by the exemptive deduction is readily described in the words “wholly exempt from the taxes imposed by this subtitle.” In other words, for purposes of section 265, exempting gross income is equivalent to including gross income and offsetting it with an exemptive deduction. In both cases, any deductions allocable to the resulting exempt income should be disallowed.

But wait. Would that reading cause section 265(a)(1) to potentially apply whenever any deduction was allocable to gross income? This clearly is not contemplated by section 265(a)(1).61 What is it about exemptive deductions that would justify marrying the exemptive deduction to gross income so as to treat the gross income as exempt and not similarly treating all other corporate deductions?

1. Attributes of exemptive deductions.

Exemptive deductions have the following attributes that when combined, single out exemptive deductions from other deductions for corporations (found in parts VI and VIII of subchapter A):

  • the exemptive deductions are not the result of any expenditure of amounts for property or services relating to the corporation’s business;62

  • the “amount” of each exemptive deduction is determined before the allocation of other deductions (here U.S. shareholder deductions that are not taken into account in determining tested income);63

  • in contrast to other non-expenditure deductions, such as the section 243 and section 245 DRDs, the exemptive deductions do not serve a purpose to avoid double U.S. corporate taxation;64 and

  • the exemptive deductions declare that the United States declines to assert its taxing jurisdiction over the foreign portion of a dividend from a foreign corporation and the requisite percentage of GILTI (50 percent until 2026).65

Deductions that share some of the features of the exemptive deductions are the percentage depletion deduction66 and the qualified business income (QBI) deduction.67 The percentage depletion deduction, which is calculated as a percentage of gross income from the property (reduced by rents and royalties paid regarding the property and limited to 50 percent of taxable income from property), is the closest to the exemptive deductions.68 Percentage depletion, which substitutes for cost depletion when it is more generous, is best understood as a taxpayer-favorable instrument to measure income (much like accelerated depreciation) and as an incentive for resource extraction.69 The history of percentage depletion demonstrates that Congress thought it was enacting an administrable substitute for the discovery depletion deduction, which had proven incapable of being administered with any consistency or fairness but nonetheless was designed to allow recovery of costs of unsuccessful wells.70 Percentage depletion may be distinguished from the exemptive deductions, which are untethered from measurement-of-income objectives.

The QBI deduction is based on a percentage of taxable income from a business. There are no deductions allocable to pretax income offset by the QBI deduction, and consequently, application of section 265 would have no effect.71 A non-expenditure deduction calculated in relation to taxable income is a proxy for a modification of the tax rate. A non-expenditure deduction calculated in relation to gross income has an effect equivalent to a reduced tax rate only if other expenses allocable to the gross income reduce the gross income before the deduction is taken or, if not, are disallowed. Those who would argue that Congress intended for the exemptive deductions to serve as an effective rate reduction implicitly are arguing for section 265(a)(1) to apply.

There is no evidence in the statute enacting the exemptive deductions that Congress did not intend for section 265 to apply.72 As demonstrated in Section III.B below, the affected provisions operate as intended when section 265 is applied. As discussed in Section III.C below, the legislative history supports the conclusion that section 265 should apply.

2. Scope of ‘class of income.’

What is meant by the statute’s use of the term “class of income”? For example, is it limited to the items of gross income listed in section 61? Clearly, the answer is no. First, the list of income items in section 61 is by its own terms nonexclusive, because gross income is defined to be “all income from whatever source derived, including (but not limited to) the following items.”73 (Emphasis added.)

Can the term “class of income” refer to gross income that is offset by an exemptive deduction? The infamous (to tax lawyers) Gitlitz decision is instructive in interpreting “item of income” to include cancellation of debt income excluded from gross income of a corporation to the extent it remained insolvent after the forgiveness.74 If Gitlitz remains good law, despite the evident failure of its interpretative method to discern what Congress appears to have intended,75 the same interpretative approach applied here (hopefully more appropriately) supports allowing “class of income” to include income identified by its being offset by an exemptive deduction. Importantly, this reading of the term “class of income” comports with the use of the term elsewhere in the code.

Sections 652(b) and 662(b), which provide for flow-through to a trust beneficiary of character of amounts distributed by a trust, use “class of income” to refer to the possibility that the trust instrument specifically allocates income to different beneficiaries. A class of income for this purpose can be income under trust accounting rules that differ from tax accounting and can include net income amounts. Thus, the code’s use of the term “class of income” is consistent with an understanding that it refers to an inherently flexible concept and is not limited to categories of gross income. Accordingly, a class of income can include gross income identified by its being offset by an exemptive deduction.

3. Income wholly exempt from tax.

Does the class of income described in section 265(a)(1) have to be excluded “gross income,” for example, of the kind found among exclusions from gross income in Part III of subchapter B?76 The regulations under section 265(a) consider a class of income wholly exempt from taxes to include income “wholly excluded from gross income under any provision of Subtitle A.”77 (Emphasis added.) This interpretation would restrict the scope of what is considered income wholly exempt from taxes to an extent not required by the text of the statute.

Gross income offset by an exemptive deduction is in fact “wholly exempt from the taxes imposed by this subtitle.”78 As stated in Curtis, the earliest reported case applying the predecessor to section 265(a)(1), in 1944: “The language of section 24(a)(5), including therein the phrase [‘income wholly exempt from . . . taxes’], is susceptible of only one sensible interpretation, namely, that a taxpayer is allowed no deduction for expenditures which are allocable to income that is nontaxable for whatever reason.”79 (Emphasis added.)

Importantly, the section 265 regulation’s meaning for income wholly exempt from taxes is prefaced by the term “includes,” which can either be used to indicate an exclusive list or a nonexclusive list of items. The term “includes” in legal usage is more commonly used to leave open the possibility of additional items,80 although it is possible for it to describe a closed group of items. The interpretation of the regulation as providing a nonexclusive definition of exempt income encompasses a statutory interpretation that includes gross income offset by an exemptive deduction within the scope of section 265(a)(1).

The term “income” is used throughout the code and is preceded by numerous modifiers (“gross,” “adjusted gross,” “taxable,” etc.). Section 265(a)(1) uses the term “class of income” and not, as used for example in section 862(b), “class of gross income.” There is no presumption that when the word “income” is preceded by “class of,” it means “gross income,” particularly where “wholly exempt from the taxes imposed by this subtitle” can refer to taxable income and exemption can be achieved by deduction as well as exclusion. As observed in Curtis, the target of section 265 is income “that is nontaxable for any reason.”

4. Section 265 case law.

There are relatively few cases that address section 265 (or its predecessor) generally and even fewer that raise interpretative questions. There is no Supreme Court case interpreting section 265(a)(1).81

Cases interpreting section 265(a) generally involve excluded gross income, as expected in light of the regulation’s approach to defining income wholly exempt from taxes. With one arguable exception, the cases do not consider exemption situations paralleling those involving exemptive deductions. This may be because there are few precedents for deductions having the configuration of attributes of exemptive deductions. The cases do not foreclose the application of section 265(a)(1) to income offset by exemptive deductions.

Perhaps the most significant interpretative issue addressed in the section 265 case law is whether specific nonrecognition provisions should be considered to give rise to gross income “wholly exempt from the taxes imposed by this subtitle.” This line of cases has concluded that income subject to nonrecognition under sections 332 and 337 is not considered wholly exempt.82 The decisions’ rationales are largely based on the view that the carryover of tax attributes preserves future taxation so that exemption may be considered temporary. In contrast, the exemptive deductions result in permanent, not temporary, exemption from tax.83

In Petschek, the Second Circuit overruled a district court decision and held that the exclusion of a war loss recovery to the extent a prior deduction for the loss had not been used would not be treated as wholly exempt gross income, and deductions incurred to win the recovery were allowed.84 The class of income tested by the court under section 265 was the war loss recovery and not solely the excluded portion, and therefore the gross income should not be considered wholly exempt. This conclusion may raise the question whether the exempt income analysis can be based on a portion of underlying gross income. The Second Circuit placed weight on the fact that had the taxpayer not been required by the code’s war loss provision to claim a deduction for the year of the loss, the recovery likely would have constituted recovery of basis and not gross income in the first place (in which case section 265 would not apply, and deductions to win the recovery would be allowed).85

The facts and context of Petschek are distinguishable from treating as exempt gross income offset by an exemptive deduction. Petschek seeks to measure net income correctly over the affected periods. In contrast, the amount of the GILTI exemptive deduction is determined based on a fixed percentage of a category of income — GILTI as defined in section 951A — and the 245A exemptive deduction is 100 percent of the foreign-source portion of a dividend from a foreign corporation. The income offset by the exemptive deductions will be “untaxed” without regard to tax attributes of the taxpayer.

It might be argued that the taxable income limitation on the section 250 deductions in section 250(a)(2) is a taxpayer attribute. This limitation effectively restricts the income exclusion to the GILTI and FDII that would be taxed, if, for example, there were a domestic loss. It is unclear why this limit should be given significance. Gross income exclusions are subject to comparable limitations. For example, the section 104 exclusion from gross income of a recovery for damages physical injuries or sickness is not applicable to the extent of prior section 213 medical deductions (which in turn must exceed a percentage, currently 7.5 percent, of adjusted gross income). The taxable income limit is a similar mechanic to prevent the effective reduction in tax rate from applying to income not intended to be within its scope. The limit is consistent with treating the deduction as equivalent to an exclusion and does not align with a tax base measurement rationale.

Nonetheless, an argument against an interpretation applying section 265 to exemptive deductions could be that under section 265, the “class of income” should be all dividends from a foreign corporation or all GILTI, not just the portion eligible to be offset by the GILTI exemptive deduction, and that the income therefore should not be considered “wholly exempt from . . . taxes.” This would be at odds with the position recently taken by the IRS in Notice 2020-32, 2020-21 IRB 837, and Rev. Rul. 2020-27, 2020-50 IRB 1552, which would have disallowed certain expenses to the extent they give rise to forgiveness of a covered PPP loan (when forgiveness of the loan is based on the amount of those expenses).86 Although the notice was overridden by legislation, the reason was not that the analysis in the notice was incorrect, but that Congress intended to provide the double benefit.87 The interpretation in the notice also is consistent with the approach to interpreting section 265(a)(1) manifest in Curtis that section 265(a)(1) should apply to income “that is nontaxable for whatever reason.”88

What may be concluded so far is that the text of section 265(a)(1) permits an interpretation that would apply it to gross income offset by an exemptive deduction.

B. Context: Section 265, Exemptive Deductions

Section 265 prevents a double benefit from the exemption of gross income.89 Section 261 provides that deduction disallowances in Part IX of subchapter B take precedence over income tax deductions. As commonly stated, deductions are a matter of legislative grace, and the burden is on the taxpayer to establish eligibility for a deduction.90 There should be a basis in the statute or in the legislative record (discussed in the next section) to show that Congress intended that deductions be allowed against gross income offset by the exemptive deductions despite section 265.

There is nothing in the statute to indicate that section 265 does not apply to gross income offset by a section 245A exemptive deduction. As previously observed, those dividends are readily encompassed by the words class of “income other than interest . . . wholly exempt from the taxes imposed by this subtitle.” The statute is silent on the treatment of expenses allocated under section 862(b) to the untaxed foreign dividend income.91 Section 904(b)(4) operates appropriately regarding the section 245A dividend, the section 245A exemptive deduction, and any other deduction not disallowed because of section 265(a)(1).92

Section 265(a)(1) also operates coherently to disallow deductions allocable to an inclusion in gross income under section 951A that is offset by the GILTI exemptive deduction. The disallowance does not change the amount of the taxable and untaxed amount of the GILTI inclusion. The CFC earnings attributable to the taxable amount are assigned to CFCs in the same way as previously to become previously taxed E&P.

There is further statutory evidence that Congress intended for section 265(a)(1) to apply to income exempted by the GILTI exemptive deduction. The second sentence of section 864(e)(3), which addresses the treatment of income exempted by intercorporate dividend deductions under section 243 and section 245, was not amended to include section 245A, leaving it to be addressed under the first sentence as the regulations do. The regulations have applied section 864(e)(3) to treat GILTI offset by the GILTI exemptive deduction as exempt gross income for allocation purposes. Section 864(e)(3) should apply after the application of section 265.93

In summary, the statutory context of section 265 in relation to the exemptive deductions supports the application of section 265 to gross income exempted because of the exemptive deductions. Indeed, applying section 265 to this exempt income maintains the coherence of the U.S. international tax rules.

C. Extrinsic Evidence: Legislative History

1. Section 265.

The predecessor of section 265(a)(1) was section 24(a)(5) of the 1939 code, adopted in 1934.94 The legislative history refers to income “wholly exempt” from the taxes imposed by then Title I and does not otherwise refer to gross income except in relation to affected deductions from gross income.95 The discussion of the amendment by Samuel Hill in the House referred to disallowing expenses incurred in earning “nontaxable” income.96

Fifty years ago, an IRS general counsel memorandum reviewing the legislative history of section 265 found:

Although expenses incurred for the purpose of producing exempt income (interest on state securities, salaries received by state employees, and income from leases of state school lands) comprised the specific situations that Congress had before it when considering the predecessor of section 265(1), we conclude that they enacted a broader statute.97

The legislative history as understood close to the adoption of the statute and by the IRS in 1971 supports an interpretation of section 265 that restricts double tax benefits.98

2. Sections 250 and 245A.

The legislative history to section 250 makes explicit the congressional intent that the section 250 deduction be treated as exempting the offset income from tax.99 The legislative history to section 245A also makes explicit that its purpose is to exempt the foreign portion of a dividend.100

In the legislative history, Congress did not consider allocable U.S. shareholder deductions.101 Taxpayers have argued as a result that Congress did not intend to allocate any U.S. shareholder deductions to GILTI. The IRS has rejected the argument for purposes of determining the FTC, observing: “The TCJA did not provide for any changes to how the generally applicable rules for computing taxable income within each separate category should apply with respect to the new section 951A category.”102

An electronic scan of the conference report finds that there is no reference to section 265 other than those pertaining to interest, which is covered by section 265(a)(2), not section 265(a)(1). There is no discussion of section 265 in relation to section 245A or 250.

In summary, nothing in the TCJA legislative history suggests that Congress did not intend that section 265(a)(1) apply by its terms. Moreover, there is strong support for the view that Congress did understand and intended that the exemptive deductions be treated as exempting the gross income offset by the deductions.

D. Summary

The preceding analysis shows that the statute, its context, and the legislative history allow and indeed support interpreting section 265(a)(1) to apply to gross income offset by an exemptive deduction under current law. Under the U.S. self-assessment system, this interpretation of the statute would require that taxpayers forgo deductions allocable to gross income offset by an exemptive deduction.

Based on the analysis in this report, if the government asserted this position on audit before expiration of relevant statutes of limitation, it would have a material chance of success on the merits.103 This raises important practical issues regarding whether a corporation should book a reserve in financial statements for years for which the TCJA has been effective for claiming deductions allocable to income offset by an exemptive deduction on a tax return.104 As described in Section II.B, billions of dollars likely are at stake.

The next part discusses possible use of a regulation amendment to confirm and publicize the interpretation.

IV. A Regulatory Clarification

A. Reasons for an Amending Regulation

Reasons to favor adopting an amendment to reg. section 1.265-1(b) include to announce the scope of application of section 265(a)(1), to allow stakeholders an opportunity to comment on the interpretation, to mitigate the burdens of potential litigation on taxpayers and the government, and, in the discretion of the IRS, to make the interpretation prospective.105 One approach to amending the existing section 265 regulation is set out in Appendix B.106

This report has argued that the current regulation left open the interpretation of the scope of application of section 265(a)(1). Under this analysis, an amendment to the regulation is an exercise of regulatory authority under section 7805 and not a change of agency position.107 Even if construed as a change in position, an appropriately executed notice and comment regulation should support Chevron deference.108 Whichever deference results, the use of a regulation should reduce the practical scope of controversy and litigation.

In light of the novel nature and context of the exemptive deductions, a tax administration argument could be made for using a notice and comment regulation to implement the application of section 265(a)(1) to the exemptive deductions. There will be specific situations identified by taxpayers in written comments that might not be anticipated by statute and regulation writers and warrant consideration as to whether and how section 265 should apply. Ideally, this would reduce the burden on tax and generalist courts.

To the extent the application of section 265 to gross income offset by an exemptive deduction has been underappreciated as a tax exposure, there likely would be taxpayer pressure for prospective application of such a regulation. While the IRS would not be required to apply that regulatory interpretation prospectively, it would be within its discretion to do so.109

B. Prioritizing Regulatory Guidance

The Treasury tax regulatory agenda in recent years has been dominated by the demands for guidance on how to apply provisions adopted in the TCJA.110 Tax regulatory priorities and resources now should be redirected. First, resources should be used to ensure that regulatory interpretations take account of all Americans, including those of underrepresented communities, to further previously underweighted or disregarded social and racial justice objectives.111 Second, Treasury and the IRS should favor interpretations that determine taxable income in accordance with measurement-of-income and ability-to-pay principles, and reconsider interpretations that are not required by the statute and in many cases give rise to unfair and inefficient distortions. Third, resources should be devoted to improving administration of the tax law. The regulation suggested here satisfies these criteria and should be given priority for guidance.

There should be a corresponding adjustment to executive branch legislative priorities. In general, Treasury should propose a regulatory change in preference to a legislative proposal in cases in which statutory authority already exists and the goals of a proposal can be accomplished by regulation. Whether a delegation of authority is general or specific, exercising rather than disregarding existing congressional delegations under the code respects separation of powers. A preference for a notice and comment regulation also serves transparency and democratic objectives when the alternative is to pass complex legislation hurriedly, without hearings and without public input (other than from interested lobbyists).

C. Policy

Whether in the form of a dividend exclusion or a 100 percent dividends deduction, the effect is the same: The dividend income is wholly exempted from U.S. tax. It has long been understood that as a normative matter, a territorial or dividend exemption should not allow deductions allocable to the exempt income to be deducted.112 This is consistent with the apparent objective of section 265, which should be applied to reach this result for income offset by the section 245A and section 250(a)(1)(B) exemptive deductions.

The failure to disallow deductions allocable to exempt income goes beyond exempting the net income tax on the income. It provides an additional subsidy that is, irrationally, based on the ratio of allocated expenses to the exempted income. Income with a lower operating margin receives a greater subsidy than income with a higher operating margin. This can be seen in Example 4.

Example 4: Assume a U.S. corporation (USCorp) has a section 245A dividend of $100 and allocable deductions of $25. USCorp will have taxable income of $75 before section 245A, and U.S. tax at 21 percent of $15.75. The benefit of exemption should be the tax saved of $15.75. If the $25 of deductions are nonetheless allowed, the benefit will be increased by 21 percent * 25 = $5.25.

If, instead, USCorp had allocable deductions of $60, it will have taxable income of $40 before section 245A, and U.S. tax at 21 percent of $8.40. Again, the benefit of exemption should be the tax saved of $8.40. If the $60 of deductions are nonetheless allowed, the benefit will be increased by 21 percent * 60 = $12.60.

It makes no sense as a matter of tax or economic policy to design a general subsidy for foreign investment that varies according to the level of the U.S. shareholder’s allocable deductions. Section 265 is designed to limit the benefit of exemption to the income tax saved. Failure to apply section 265, particularly in the international context, results in an excessive incentive to engage in foreign rather than domestic economic activity.

As described above, the amount of deductions involved and the potential subsidy for foreign investment are material. It is reasonable to expect that the revenue impact of allowing deductions allocable to gross income offset by exemptive deductions would be billions of dollars annually. This hidden subsidy favors multinational over domestic businesses and shareholders over workers.113 The distribution of burden of the corporate tax among individuals is heavily skewed toward those within the highest income categories.114 Moreover, an increasing share of owners of U.S. corporations are foreign investors.115

There is no coherent policy reason to favor allowing deductions allocable to exempt foreign income. If it is urged that the tax burden on foreign income is too high, alternative policy instruments would be far superior.

D. Validity

The proposed amendment to reg. section 1.265-1(b) at Appendix B is a permissible interpretation of the statute.116 The preceding analysis in this report demonstrates that it is a reasonable interpretation of section 265(a)(1) to cover income that is not taxed because of an exemptive deduction. If an alternative interpretation of the statute is preferred, at a minimum the preceding analysis demonstrates that the language of the statute is susceptible to more than one interpretation, thereby satisfying an essential element of Chevron analysis.117

There is no meaningful distinction for the language or objective of section 265 between excluding the gross income and offsetting it by exemptive deductions. When, as here, the exemptive deductions eliminate tax on the income, involve no expenditure of taxpayer assets, and serve no measurement-of-income purpose — or indeed any purpose other than to exempt the income — it is reasonable to apply section 265(a)(1) to this untaxed income.

An argument might be made that section 911(d)(6), which disallows deductions (and FTCs) allocable to the portion of wages and housing allowance that is exempt under section 911, shows that Congress understood that income only partially exempt would not be subject to section 265 and knew how to disallow deductions for that income. Congress made no such disallowance for the exemptive deductions.118 However, the predecessor to section 911 including the expense disallowance was adopted in 1926, before adoption of the predecessor to section 265(a)(1) in 1934.119 The application of section 265 does not interfere with section 911(d)(6) if the usual canon applies that the more specific provision takes precedence. The presence of section 911(d)(6) is unpersuasive as a basis for arguing that the proposed regulation is an impermissible interpretation of section 265.

What about a reenactment concern that Congress has had many opportunities to modify section 265? The reenactment doctrine is inapposite in a context in which the interpretation complements and does not supplant the prior interpretation and can be readily reconciled with the prior interpretation. For some, the acknowledgment in the TCJA legislative history that the exemptive deductions are intended to exempt the income further supports application of section 265(a)(1).

It is impossible to discern from silence that Congress viewed section 265 as inapplicable. Congressional silence regarding the application of section 265 is the arena within which section 265 operates. Nothing prohibits Treasury from exercising its authority under section 7805(a) to address exemptive deductions. As the Supreme Court said, “‘It is a fundamental principle of statutory interpretation that absent provision[s] cannot be supplied by the courts.’ This principle applies not only to adding terms not found in the statute, but also to imposing limits on an agency’s discretion that are not supported by the text.”120

Another question that could be raised is why disallow deductions allocable to income exempted by section 245A and not by sections 243 and 245? The corporate income targeted by the exemptive deductions has not previously been subject to U.S. corporate tax, which distinguishes section 245A’s exemption from intercorporate tax relief under sections 243 and 245.121 There is no U.S. double corporate taxation justification for section 245A or 250.

The long-standing view is that the U.S. tax base is determined independently of the foreign base on which foreign taxes are applied.122 Under sections 245A and 960, the foreign tax base is disregarded.123 Insofar as foreign income taxes are taken into account, an FTC subject to the section 904 limitation is allowed. If U.S. income is not taxed, the fact that it may have been subject to foreign tax is not a justification for allowing a U.S. deduction allocable to the exempt income. The effect would be for the United States to make a refund to the U.S. taxpayer (with allocable deductions) to pay the foreign tax on the exempted income.

If a notice and comment regulation is executed properly, a regulation applying section 265 to the exemptive deductions would be a valid exercise of regulatory authority. If, contrary to the analysis in this report, a court concluded that existing section 265 cannot apply even by regulation, or if Congress disagrees with a regulatory interpretation, legislation would remain an available tool.

V. Legislation as an Alternative to a Regulation

Treasury’s fiscal 2022 revenue proposals would amend section 265 to disallow deductions allocable to a class of foreign gross income that is exempt from tax or taxed at a preferential rate through a deduction.124 (A possible draft is set out in Appendix C.) President Biden also has proposed significant modifications to GILTI, including eliminating the exclusion from GILTI of a deemed return on certain tangible business investment, which would reduce the scope for the section 245A exemptive deduction; and decreasing the percentage of the GILTI exemptive deduction. Under the draft revision to section 250 at Appendix C, there would be no need to apply section 265 to the GILTI exemptive deduction because, just as for the FDII section 250 deduction, there would be no deductions allocable to the exempt income.125 Because the Biden proposals do not repeal section 245A, the revision to section 265(a)(1) would remain relevant.

There are trade-offs between the use of a regulation and seeking legislation to achieve the same objective.126 When the regulation is interpreting the law and not exercising a specific grant of authority, the rationale for seeking legislation would appear to be quite weak. The objective of using legislation may be based on a concern that a different administration may change a regulatory interpretation, although even that step would be subject to reversal by Congress. Factors favoring a regulation include the ability to use the expertise of the agency outside the constraints of the legislative process; the opportunity for notice and comment; the availability of the preamble for reasoned responses to comments; and the greater flexibility to adjust regulations in the future. In a highly technical area like the one discussed in this report, the regulatory process affords greater opportunity to avoid or mitigate errors.

A reported rationale to prefer a legislative proposal is to benefit from a budgetary “score” counting the revenue to be raised from a proposal.127 This would seem to be a weak argument other than as a matter of assigning political credit for the revenue. If revenue is indeed increased materially enough to warrant a budget score (that is, it exceeds $50 million in the relevant period), it should also show up in collections if a regulation is implemented. Those revenues should be included in the budget baseline for future legislation. In a political environment hostile to tax increases, using a regulation could allow easier passage of associated or other tax legislation. Of course, in a political environment in which pay-fors are needed to meet political or procedural budgetary objectives, a positive budget score for legislation often is motivation for a legislative change in lieu of a regulatory change.

VI. Conclusion

This report considers whether gross income offset by exemptive deductions is covered by the deduction disallowance rule of section 265(a)(1). The better analysis is that section 265 should apply to income offset by exemptive deductions such that deductions (other than the exemptive deduction) allocable to that income should be disallowed.

Adopting a notice and comment regulation amendment confirming the application of section 265 to income offset by an exemptive deduction would reasonably interpret the statute, offer stakeholders the opportunity for criticism, and mitigate the burdens of potential litigation on taxpayers and the government. Support for such a regulatory amendment would advance good tax policy while not implying agreement with the TCJA’s reduced taxation of foreign dividend income or GILTI. If, contrary to the analysis in this report, a court concluded that existing section 265 cannot apply, or if Congress disagrees with the regulatory interpretation, legislation would remain an available tool.

The Biden green book proposes a legislative clarification of section 265. Whether the legislative proposal would have a budgetary effect would depend on how the JCT staff interprets the statute and existing regulation and whether the income should be considered as already in the budget baseline. Under the analysis in this report, Treasury has authority to adopt a regulation incorporating a reasonable interpretation of the statute, as proposed in this report, regardless of whether a legislative clarification were enacted and regardless of whether the legislative proposal were considered to have a budgetary effect.

Irrespective of the outcome of the immediate legislative proposals, the use of exemptive deductions should trigger the application of section 265.

VII. Appendix A: Marginal Tax Rate Benefit

Table 1

Inputs

Row

Description

 

Source

1

CFC total earnings less deficits

100%

See IRS Statistics of Income, “U.S. Corporations and Their CFCs: Tax Year 2016” Table 1, Col. 10, Row All Industries

2

Subpart F and other exceptions

-10%

Rough estimate based on 2016 data

3

CFC net tested earnings

90%

Row 1 - Row 2

4

NDTIR 10% return less CFC interest expense

-25%

Rough estimate

5

GILTI

65%

Row 3 - Row 4

6

U.S. shareholder expenses allocable to total CFC earnings

20%

Rough estimate based on 2016 data

Marginal Tax Rate Benefit of Allowing Expenses Allocable to Exempted Income

7

50% * GILTI

32.5%

50% * Row 5

8

NDTIR 10% return less CFC interest expense

-25%

Row 4

9

Exempt income

57.5%

Row 7 + Row 8

10

U.S. expenses allocable to exempt income

10.4%

Row 3 * Row 6 * Row 9

11

U.S. pre-credit tax rate on CFC net tested earnings without section 265

3.05%

21% * (Row 3 - Row 9 - (Row 3 * Row 6))

12

U.S. pre-credit tax rate of CFC net tested earnings applying section 265

5.22%

21% * (Row 3 - Row 9 - (Row 3 * Row 6 - Row 10))

13

Marginal tax rate benefit of not applying section 265

2.17%

Row 12 - Row 11 [alternatively, 21% * Row 10]

VIII. Appendix B: Regulatory Amendment

The proposal is to amend reg. section 1.265-1(b) and (c):

“(b) Exempt income and nonexempt income.

(1) As used in this section, the term class of exempt income means any class of income (whether or not any amount of such income of such class is received or accrued) wholly exempt from the taxes imposed by Subtitle A of the Code. For purposes of this section, a class of income which is considered as wholly exempt from the taxes imposed by subtitle A includes any class of gross income which is:

(i) Wholly excluded from gross income under any provision of Subtitle A, or

(ii) exempted from tax by reason of a deduction under section 245A or section 250(a)(1)(B), or

(iii) Wholly exempt from the taxes imposed by Subtitle A under the provisions of any other law.

(2) As used in this section the term nonexempt income means any income not described in paragraph 1 which is required to be included in gross income.

(3) The deductions to be disallowed under this section shall not include a deduction described in subparagraph (ii) of paragraph 1 of this subsection.

(c) Allocation of expenses to a class or classes of exempt income.

. . .For purposes of income described in subsection (b)(1)(ii), expenses shall be allocated under section 862(b).

IX. Appendix C: Legislative Amendments

Amendment to Section 250(a)(1)(B):

Section 250

(a) Allowance of deduction

(1) In general. In the case of a domestic corporation for any taxable year, there shall be allowed as a deduction an amount equal to the sum of —

(A) 37.5 percent of the foreign-derived intangible income of such domestic corporation for such taxable year, plus

(B) 50 percent of the excess of

(i) the sum of

(I) the global intangible low-taxed income amount (if any) which is included in the gross income of such domestic corporation under section 951A for such taxable year, and

(II) the amount treated as a dividend received by such corporation under section 78 which is attributable to the amount described in clause (i), over

(ii) the deductions properly allocable to such gross income.

Amendment to Section 265(a)(1):

Section 265

(a) General rule - No deduction shall be allowed for —

(1) Expenses

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle (including by reason of a deduction), or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

FOOTNOTES

1 The TCJA is formally known as “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” P.L. 115-97 (Dec. 22, 2017).

2 Sections 245A and 250(a)(1)(B). GILTI is defined in section 951A and applies to include certain income of a controlled foreign corporation in income of a United States shareholder. A United States shareholder is a U.S. person that owns, directly or indirectly, 10 percent or more by vote or value of the stock in a foreign corporation. Section 951(b). In this report, U.S. shareholder refers to a shareholder described in section 951(b). A foreign corporation is a CFC if more than 50 percent of its shares are owned, directly or indirectly, by vote or value by U.S. shareholders on any day in the CFC’s year. Section 957(a).

3 This situation arises in the cases of deductions of a domestic corporation under sections 245A and 250(a)(1)(B) because they are determined in relation to net income of a foreign corporation before or without regard to the allocation of the domestic corporation’s expenses to the income.

4 Deductions under section 250(a)(1)(B) are not taken into account in determining a net operating loss carryover. Section 172(d)(9). The section 245A 100 percent dividends received deduction (DRD) is not limited by the section 246(b) limitation on the aggregate amount of section 243, 245, and 250 deductions.

5 See reg. section 1.265-1(b).

6 Recent experience shows that Congress is quite capable of overriding administrative guidance when it disagrees with it. See, e.g., the Consolidated Appropriations Act, 2021. Section 276(a) of the act reversed guidance in Notice 2020-32, 2020-21 IRB 837, and Rev. Rul. 2020-27, 2020-50 IRB 1552 (obsoleted by Rev. Rul. 2021-2, 2021-4 IRB 495, that would have denied deductions paid for with later-forgiven Paycheck Protection Program loans). Similarly, section 265(a)(6)(B) reversed IRS guidance in Rev. Rul. 83-3, 1983-1 C.B. 72, ruling that mortgage interest paid by a minister receiving a housing allowance would be disallowed.

7 Treasury, “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals,” at 14 (May 28, 2021) (fiscal 2022 green book).

8 Raising revenue is not the sole function of the federal income tax. Its other functions include regulating behavior through providing tax incentives or disincentives and serving as a mechanism to make income transfers to the working poor and lower-middle-income taxpayers. The incentive for employer health insurance plans is the largest single tax expenditure, exceeding $1 trillion over a 10-year budget period. See Treasury Office of Tax Analysis, “Tax Expenditures,” at 4 (Feb. 26, 2020). The earned income tax credit is one of the largest components of the federal social safety net. Susannah Camic Tahk, “The Tax War on Poverty,” 56 Ariz. L. Rev. 791, 797 (2014).

9 See OECD, “Revenue Statistics 2020,” Table 3.4. Taxes on income and profits as a share of total revenues at all levels of government in the United States are 45 percent compared with an OECD average of 34.3 percent. Individual countries that have higher percentages of income taxes are Australia (60.2 percent), Canada (48.8 percent), Denmark (62.2 percent), Iceland (49.3 percent), Ireland (45.3 percent), New Zealand (56.3 percent), and Switzerland (47.7 percent). U.S. taxes on goods and services as a share of total revenues at all levels of government are lower than for any other OECD country. For a historical perspective on why the United States disfavors consumption taxes, see Ajay K. Mehrotra, Making the Modern American Fiscal State: Law, Politics and the Rise of Progressive Taxation 1877-1929 (2013); and Steven R. Weisman, The Great Tax Wars: How the Income Tax Transformed America (2004).

10 Marvin A. Chirelstein and Lawrence Zelenak, Federal Income Taxation 117 (2018); and J. Clifton Fleming Jr., Robert J. Peroni, and Stephen E. Shay, “Fairness in International Taxation: The Ability-to-Pay Case for Taxing Worldwide Income,” 5 Fla. Tax Rev. 299 (2001).

11 Section 63(a).

12 The principles governing when it is appropriate to allow a deduction arise in a variety of contexts. Underlying the deduction disallowance issue addressed in this report is the question of when an otherwise allowable deduction should be allocable to a class of income — a subject addressed at length under existing regulations but not discussed in this report. See reg. sections 1.265-1(c) and 1.861-8 et seq.

13 When deductions are overstated (or understated) as a deliberate legislative choice, the deviation from income tax principles may be designed to achieve a nontax regulatory objective. Treasury classifies as tax expenditures the “reduced rate of tax” on GILTI from the section 250 deduction and the exemption of foreign dividends from tax by reason of the section 245A 100 percent DRD. The Treasury tax expenditure estimate for “Reduced tax rate on active income of controlled foreign corporations (normal tax method)” for 2020-2029 is $480.08 billion. This includes an offset for the collection during this period of deferred payments of tax on mandatory deemed repatriations under section 965. See Treasury, “Tax Expenditures,” supra note 8. This report does not consider the propriety of that one-time offset, which is questionable. See Fleming, Peroni, and Shay, “Getting From Here to There: The Transition Tax Issue,” Tax Notes, Apr. 3, 2017, p. 69 (arguing for full-rate transition taxation of deferred earnings while acknowledging the arguments for a distribution timing discount).

14 See United States v. Skelly Oil, 394 U.S. 678 (1969) (“The Code should not be interpreted to allow respondent ‘the practical equivalent of double deduction,’ Charles Ilfeld Co. v. Hernandez, 292 U.S. 62, 68 (1934), absent a clear declaration of intent by Congress.”).

15 See Charlotte Crane, “Matching and the Income Tax Base: The Special Case of Tax Exempt Income,” 5 Am J. Tax Pol’y 161, 237-238 (1986) (“Without such a rule and in the presence of readily available sources of exempt income, any otherwise taxable income could be immediately transformed into a tax-exempt receipt. If one could deduct $10 from other income, and receive $10 tax-exempt receipt, taxable income could be avoided, without any diminution in wealth, merely by participating in the transaction. The only limit would be imposed by the availability of such transactions.” (Footnote omitted.)).

16 The section 250(a)(1)(B) deduction for GILTI is determined without any allocation of expenses of the U.S. shareholder to the GILTI inclusion before the deduction is determined. Note that the section 250 deduction for foreign-derived intangible income is after all U.S. deductions have been taken. Accordingly, the FDII section 250 deduction is in relation to a base already reduced by allocable deductions, with the result that these deductions are not allocable to the income after it is exempted by the FDII section 250 deduction.

17 See Hugh J. Ault and Brian J. Arnold, Comparative Income Taxation, A Structural Analysis 467-471 (2010) (describing different countries’ approaches to exempting foreign income).

18 Regulations under section 862(b) prescribe rules for determining deductions allocable to foreign-source gross income to reach foreign-source taxable income. Reg. section 1.861-8 et seq. This report does not address the appropriate content for these rules, but for purposes of discussion accepts the current rules as given.

19 See Martin A. Sullivan, “Should Biden Fix a Forgotten Flaw That Mismeasures Foreign Profits?” Tax Notes Federal, May 3, 2021, p. 691, at 694 (summarizing the history of exemption proposals since 2001 and recommending disallowing deductions or reducing the DRD to account for deductions); and Michael J. Graetz and Paul W. Oosterhuis, “Structuring an Exemption System for Foreign Income of U.S. Corporations,” 54 Nat. Tax J. 771, 781 (2001) (“On the other hand, expenses allocable to exempt foreign income are properly described as deductions incurred to earn exempt income, which the Code typically disallows. Such deductions should be disallowed or allowed only to the extent they exceed exempt income in any year and are subject to recapture out of exempt income in subsequent years.”). For the history and an insightful analysis of the application of section 265 generally, see Crane, “Matching and the Income Tax Base,” supra note 15, at 229-266.

20 Reg. section 1.861-8(e)(4)(ii)(B).

21 Whether a foreign tax is imposed on the exempted gross income is irrelevant. Long-standing U.S. tax policy has been to allow double taxation relief only for U.S. tax on foreign-source taxable income. The effect of disallowing deductions allocable to income offset by a section 250(a)(1)(B) deduction would be similar to that in Example 2 at low rates of foreign tax. Because the disallowed expense would have the effect of increasing U.S. tax and the FTC limitation, at higher rates of foreign tax, the effect on increasing U.S. liability would vary and depend on the facts.

22 The most recent published IRS data are for 2016. The total subpart F income ($95 billion) was 7.8 percent of the E&P of positive income CFCs ($1.221 trillion) and 8.9 percent of E&P of CFCs less deficits ($1.071 trillion).

23 There is a long history of business community lobbying success in reducing allocations of expenses to lower-taxed income. See American Bar Association Section of Taxation, “Report of the Task Force on International Tax Reform,” 59 Tax Law. 649, 769-771 (2006). If the approach to section 265 argued for in this article were adopted, or the Biden green book proposal included in legislation, it may be expected that there will be redoubled business community efforts to lobby for allocations of expenses away from foreign income to domestic income.

24 I thank Patrick Driessen for help in thinking about the issue in this way and Martin Sullivan for his comments and identifying an error in an earlier version. The assumptions described in the text and in the model at Appendix A (and any remaining errors) are mine. The assumptions can be readily adjusted when better data are available. Driessen has been the leading analyst of the effects of expense allocation on the effective tax rate incurred by U.S. multinationals on foreign income. See, e.g., Driessen, “Getting Foreign Deferral’s Epitaph Right,” Tax Notes Federal, June 15, 2020, p. 1883; and Driessen, “GILTI’s Effective Minimum Tax Rate Is Zero or Lower,” Tax Notes Federal, Aug. 5, 2019, p. 889. Sullivan has long recognized the issue as well. See Sullivan, supra note 19.

25 Indeed, the deduction for FDII at section 250(a)(1)(A) was designed to offset any incentive to shift investment to take advantage of GILTI and/or the section 245A 100 percent DRD exemption mechanism. See Tim Dowd and Paul Landefeld, “The Business Cycle and the Deduction for Foreign Derived Intangible Income: A Historical Perspective,” 71 Nat. Tax J. 729, 730 (2018).

26 GILTI is the sum of a U.S. shareholder’s share of the tested income of each positive income CFC in which it is a U.S. shareholder, reduced by the sum of the tested loss of each tested loss CFC in which it is a U.S. shareholder. A U.S. shareholder’s net tested income exceeding a 10 percent return on qualified business asset investment of its tested income CFCs measures the GILTI inclusion. Section 951A(b).

27 Section 250(a)(1)(B). A section 78 dividend equals the amount of foreign tax deemed paid under section 960 on the included GILTI.

28 Section 250(a)(2). This could occur as a result of losses from the U.S. shareholder’s sales to domestic customers. For ease of discussion, except as otherwise noted, it is assumed that the taxable income limit is not binding.

29 The section 246(b) limitation also applies to the DRDs under sections 243 and 245.

30 Section 172(d)(8).

31 Sections 245A(a) and 246(c). This report’s discussion will focus on the case of a corporate U.S. shareholder in a CFC, although the section 245A deduction also is allowed to a corporate U.S. shareholder in a specified 10 percent foreign owned corporation, which is any foreign corporation that is not a passive foreign investment company and that has a U.S. shareholder that is a domestic corporation. Section 245A(b). The issue presented is the same in both cases.

32 Sections 245(a) and 243(a). Section 245A is not subject to the limitation under section 246(b) on the aggregate amount of the section 243 and section 245 DRDs.

33 Section 245A(d).

34 Section 960.

35 Section 245A(d).

36 Section 901.

37 A corollary purpose for the limitation is to prevent foreign governments from raising tax rates at the expense of the U.S. treasury.

38 Section 904(d)(1)(C).

39 Section 904(d)(1)(A).

40 Section 904(d)(1)(D). There also is a separate limitation for income in a foreign branch limitation category. See section 904(d)(1)(B).

41 Section 904(a) and (d).

42 See H. David Rosenbloom, “The U.S. Foreign Tax Credit Limitation: How It Works, Why It Matters,” Tax Notes Federal, Mar. 9, 2020, p. 1591.

43 Section 960(d); see reg. section 1.960-1(d)(2)(ii)(C) and -2(c)(7), Example 1. Tested foreign income taxes include taxes on the portion of GILTI that is offset by the 50 percent section 250 deduction. The limit should have been based on 1 minus the GILTI deduction percentage, which would be 50 percent until 2026 and then would be 62.5 percent instead of 80 percent. Only the amount of taxes actually deemed paid should be included in income under section 78. The potentially material excess credits under the current regime may partially explain the denial of a carryover for foreign taxes in the GILTI limitation. Section 904(b).

44 Section 78. More technically, the section 78 dividend is for a CFC’s “tested income foreign taxes” deemed paid by the CFC on the GILTI included in the U.S. taxpayer’s income and attributed to the CFC. Tested income foreign taxes are the taxes associated with the tested income underlying the GILTI inclusion without reduction by the 20 percent haircut.

45 Section 904(d)(1)(A) and reg. section 1.904-4(g). The regulations appear to allow the deemed paid foreign taxes attributable to the GILTI inclusion offset by the GILTI exemptive deduction to be allowed as a credit available for cross-crediting. See reg. sections 1.960-2(c)(7), Example 1; and 1.903(b)-3(e), Example. If, as discussed below, GILTI offset by an exemptive deduction is exempt income for purposes of section 265, the foreign taxes attributable to the exempted gross income also should be disallowed. See, e.g., Heffelfinger v. Commissioner, 5 T.C. 985 (1945) (Canadian taxes on income exempt from U.S. tax under a predecessor to section 911 were not deductible).

46 See T.D. 9882, 84 F.R. 69022, at 69023-69024 (citing JCT, “General Explanation of Public Law 115-97,” JCS-1-18, at 381 n.1753 (Dec. 20, 2018)).

47 Section 864(e)(3) provides:

For purposes of allocating and apportioning any deductible expense, any tax-exempt asset (and any income from such an asset) shall not be taken into account. A similar rule shall apply in the case of the portion of any dividend (other than a qualifying dividend as defined in section 243(b)) equal to the deduction allowable under section 243 or 245(a) with respect to such dividend and in the case of a like portion of any stock the dividends on which would be so deductible and would not be qualifying dividends (as so defined).

48 The second sentence of section 864(e)(3) subjects dividend income offset by the section 243 and section 245 deductions to the same rule. The provision does not apply to deductions described in section 243(b) from a payer in the affiliated group. The deductions covered are partial DRDs mitigating double corporate taxation on specific dividends from a domestic corporation and dividends from a foreign corporation on earnings that have been subject to U.S. corporate taxation as effectively connected income. The general effect of these rules for domestic-source dividends from unaffiliated U.S. and foreign corporations is to prevent excessive allocation of deductions to domestic income that has already been subject to U.S. corporate tax.

49 See JCT, “General Explanation of the Tax Reform Act of 1986,” JCS-10-87, at 949 (May 15, 1987).

50 Reg. section 1.861-8(d)(2)(ii)(C).

51 Reg. section 1.861-8(d)(2)(ii)(C)(1) and (2)(ii).

52 The example in the regulations provides that the CFCs make no distributions, so we are not told directly whether the CFCs had any deemed tangible income return on their tangible assets (if any), but because $2,000x of the stock is assigned to the section 245A subgroup of the general category, it may be inferred that the CFC had deemed tangible income return. See reg. section 1.861-13(a).

53 The example does not mention section 265.

54 The rule also may permit foreign taxes attributable to the exempt GILTI to be used to a greater extent than otherwise.

55 Regarding whether section 904(b)(4) would be necessary if section 265 applied, the answer is yes, as indicated in the last sentence of reg. section 1.903(b)-3(b), applying the rule to the section 245A exemptive deduction itself.

56 That is, as a textualist, a purposivist, or a pragmatic. The pragmatic rejects ready classification. See, e.g., Richard A. Posner, How Judges Think, ch. 191-203 (2008).

57 See Hughes Aircraft Co. v. Jacobson, 525 U.S. 432, 438 (1999) (“As in any case of statutory construction, our analysis begins with ‘the language of the statute.’”). I forgo string cites of Supreme Court cases to the same effect.

58 Section 265(a)(1) provides: “Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.” This report does not discuss the second clause, involving section 212 deductions allocable to interest. See Crane, “Matching and the Income Tax Base,” supra note 15, at 245-246.

59 T.D. 2137, quoted in Crane, “Matching and the Income Tax Base,” supra note 15, at 243. Crane goes on to note that the principle was not followed closely until the enactment in 1917 of the predecessor of section 265(a)(2) concerning tax-exempt interest. War Revenue Act of 1917, section 1201(1).

60 See Revenue Act of 1934, adding section 24(a)(5).

61 For example, if section 265 disallowed allocable deductions whenever gross income was offset by a deduction, there would be no loss carryovers.

62 Allowing a deduction without any underlying expenditure does not achieve a measurement-of-income objective, but it is equivalent to excluding the same amount of gross income. Under an income tax, double taxation of the “same” income is avoided by allowing deductions for costs paid with after-tax dollars of producing that income. See Skelly Oil, 394 U.S. 678.

63 If the exemptive deduction is applied after all other deductions (i.e., to the gross income net of allocable deductions), section 265(a)(1) should not apply, because the other deductions all have been taken against nonexempt income. The section 250(a)(1)(A) FDII deduction is an example of such a case. The comparable legislative fix for GILTI is described in Section VI, and a possible text is in Appendix C. The fiscal 2022 green book, supra note 7, includes such a proposal, as well as other changes relevant to the exemptive deductions. The draft at Appendix C does not consider those other changes, but at their current level of specification, they would not appear to require a change to the draft.

64 Note that in the TCJA, Congress did not add section 245A to the second sentence of section 864(e)(3), showing that it did not consider section 245A to be the same as the intercorporate DRDs in sections 243 and 245. Section 246A also was not amended to add section 245A to the reduction in DRD for debt-financed stock. I thank Wade Sutton for pointing that out. See also Christopher P. Bowers, Oosterhuis, and Joshua G. Rabon, “Worldwide Interest Apportionment Has Arrived: What Do We Do Now?Tax Notes Federal, Jan. 25, 2021, p. 549, at 565 (In considering the policy underlying section 904(b)(4), they write: “Perhaps the most plausible explanation is that Congress viewed the section 245A deduction as fundamentally different from a DRD under section 243 or section 245(a), which are intended to relieve duplicative taxation on distributions of earnings that have already been subject to U.S. tax at least once.”).

65 The exemptive deductions are the mechanism by which Congress implemented partial territorial taxation in the form of a dividend exemption regime. See Bowers, Oosterhuis, and Rabon, supra note 64, at 565 (Section 245A “could be viewed as excluding a portion of a foreign corporation’s activities from the scope of the U.S. tax regime entirely, and therefore any shareholder-level expenses allocable to that income should be effectively disallowed for FTC purposes under principles similar to section 265.”).

66 Sections 613 and 613A.

67 Section 199A. See Crane, “Double or Nothing: Sorting Out the Consequences of PPP Loans,” Tax Notes Federal, June 8, 2020, p. 1705, at 1710. The domestic production activity deduction (now repealed) preceded the QBI deduction. Former section 199 (in effect until 2018).

68 Percentage depletion is taken before the QBI deduction. The depletion allowance was recognized by the Supreme Court in Skelly Oil as having the same effect as an exclusion of income such that the Court upheld denial of a deduction of customer refunds to the extent they had originally been untaxed because of the depletion allowance. Skelly Oil, 394 U.S. 678. Crane, “Double or Nothing,” supra note 67, at 1710.

69 For the history of the immediate predecessor of the percentage deletion deduction, known as “discovery depletion,” and its evolution into the percentage depletion deduction, see Joseph J. Thorndike, “When Reforms Go Bad: The Origins of Percentage Depletion,” Tax Notes Federal, Aug. 12, 2019, p. 997; and George K. Yin, “A Maritime Lawyer, Percentage Depletion, and the JCT,” Tax Notes, Sept. 19, 2016, p. 1695. The 1918 adoption of the discovery deduction was based on the value of wells and resulted in a morass of valuation complexity. In 1926 it morphed into the percentage depletion deduction based on a percentage of the operating income from the well. Thorndike, id., at 1,000.

70 Thorndike, supra note 69; and Yin, supra note 69. The Revenue Act of 1926 provided for a percentage depletion allowance equal to 27.5 percent of a well’s gross income. Adopted eight years before the predecessor to section 265(a)(1), there is no indication that Congress considered the percentage depletion deduction as a partial exemption of, or as a reduced effective tax rate on, income from oil and gas. It was a successor to the discovery depletion regime for recovering costs of unsuccessful wells. That the predecessor discovery depletion itself was flawed as a surrogate for costs of production is shown by Yin to be attributable to mistakes made in its formulation.

71 In this respect, the effect is the same as the section 250(a)(1)(A) FDII deduction. See supra note 16.

72 See the discussion of the legislative history of exemptive deductions, infra at Section III.C.2.

73 Does the use of the parenthetical words “but not limited to” in section 61 imply that use of “includes” in the regulation under section 265 without modifying language should be deemed exclusive? That goes too far. As then-Judge Brett M. Kavanaugh observed regarding the consistent usage canon, “Of course, that rigidity is inappropriate — in documents as complex and sprawling as statutes, oftentimes authors will use the same term to mean different things in different places.” Kavanaugh, “Fixing Statutory Interpretation,” 129 Harv. L. Rev. 2118, 2162 (2016). This may be going out on a limb, but regulations under the IRC arguably come within the scope of “complex and sprawling.”

74 Gitlitz v. Commissioner, 531 U.S. 206 (2001). For a cogent criticism of stupid literalism in the interpretation of tax statutes as exemplified by Gitlitz, see Jasper L. Cummings, Jr., “The Meaning of ‘Tax-Exempt Income,’” Tax Notes Federal, June 21, 2021, p. 1957. See also Calvin H. Johnson, “The Supreme Court’s Statutory Interpretation in Gitlitz: A Failed Approach to Interpretation and a Bad Decision,” 40 ABA Tax Times 1 (2020).

75 The result in Gitlitz (decided Jan. 9, 2001) was legislatively overruled by an amendment to then-section 108(d)(7) to prevent excluded cancellation of indebtedness income of an S corporation from increasing shareholder basis. Job Creation and Worker Assistance Act of 2002, section 402.

76 Part III of subchapter B encompasses sections 101-140. Relatively few of these exclusions for income other than interest have relevance to a corporation.

77 Reg. section 1.265-1 provides in part:

(b) Exempt income and nonexempt income.

(1). . . . For purposes of this section, a class of income which is considered as wholly exempt from the taxes imposed by subtitle A includes any class of income which is:

(i) Wholly excluded from gross income under any provision of Subtitle A, or

(ii) Wholly exempt from the taxes imposed by Subtitle A under the provisions of any other law.

(2) As used in this section the term nonexempt income means any income which is required to be included in gross income.

The regulation is substantially unchanged from when first adopted soon after the enactment of the predecessor to section 265(a)(1). See Heffelfinger, 5 T.C. at 991.

78 Indeed, final regulations issued in 2019 interpreting a different code provision, section 864(e)(3), treat gross income offset by the GILTI exemptive deduction as “exempt income.” Reg. section 1.861-8(d)(2)(ii)(C) (GILTI income offset by a GILTI exemptive deduction treated as exempt income for purposes of applying section 864(e)(3)). As a result, GILTI income (and stock from which it is derived) is excluded from the numerator and denominator of the FTC limitation apportionment fraction based on the ratio of the GILTI exemptive deduction to the amount of the GILTI inclusion. Reg. section 1.861-8(d)(2)(ii)(C)(1) and 2(ii). The operation of section 864(e)(3) is discussed supra, at Section II.B.4.

79 Curtis v. Commissioner, 3 T.C. 648, 651 (1944). Section 59(i) provides in part that “any amount shall not fail to be treated as wholly exempt from tax imposed by this subtitle solely by reason of being included in alternative minimum taxable income.” The reference to an “amount” without reference to “income” or “gross income” lends support to the argument in the text.

80 This corresponds to the semantic canon of interpretation to presume a nonexclusive meaning of the word “include.” See Antonin Scalia and Bryan Garner, Reading Law: The Interpretation of Legal Texts 132-133 (2012) (“That is the rule both in good English usage and in textualist decision-making.” (Footnotes omitted.)). See also Cummings, supra note 74, at 1962-1964 (listing cases supporting predominant usage of “including” to expand, not limit, the meaning of a term). The use of the term “or” in relation to the two categories listed is best understood to include the sense of “and.” Garner, The Elements of Legal Style 103 (2002).

81 Under the Supreme Court’s decision in Brand X, a notice and comment regulation would not have to follow a prior court’s interpretation unless it is a Supreme Court interpretation of the text that leaves no ambiguity. National Cable & Telecommunications Association v. Brand X Internet Services, 545 U.S. 967 (2005); and United States v. Home Concrete & Supply LLC, 566 U.S. 478 (2012). There is no such Supreme Court decision here.

82 See Commissioner v. McDonald, 320 F.2d 109 (5th Cir. 1963); and Commissioner v. Universal Leaf Tobacco Co., 318 F.2d 658 (4th Cir. 1963). The IRS has acquiesced to decisions in these cases. Rev. Rul. 63-233, 1963-2 C.B. 113. See also Hawaiian Trust Co. Ltd. v. United States, 291 F.2d 761 (1961).

83 If the income offset by the exemptive deduction is later used to acquire an asset, the asset will have a full cost basis. This is the same result as for excluded gross income. This report does not address whether or when a “backward disallowance rule” should apply under section 265. See Joseph M. Dodge, “Disallowing Deductions Paid With Excluded Income,” 32 Fla. Tax Rev. 749 (2013). See also Cummings, supra note 74, at 1967; and Crane, “Matching and the Income Tax Base,” supra note 15, at 250-254.

84 Petschek v. United States, 335 F.2d 734 (2d Cir. 1964). Viktor Petschek claimed a deduction for war losses in relation to the assets for which he later received war loss awards. The relevant income exclusion provided that war loss recoveries would be excluded to the extent attributed to prior deductions that did not give rise to a tax benefit. War loss recoveries attributed to prior deductions that had yielded a tax benefit were includable in income, and any recoveries exceeding prior deductions were treated as gain from an involuntary conversion eligible for a section 1033 rollover.

85 Petschek, 335 F.2d at 738 (“If Congress had not required him to take the deduction in 1941, his later recoveries up to his basis would not have been income exempt from taxes, to which the prohibition of section 265 alone applies they would not have been income at all.”). See Crane, “Matching and the Income Tax Base,” supra note 15, at 242 n.105.

86 Rev. Rul. 2020-27 was obsoleted by Rev. Rul. 2021-2, 2021-4 IRB 495. Notice 2020-32 explains that under section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act, a recipient of a covered loan can receive forgiveness of indebtedness on the loan without income inclusion (covered loan forgiveness) in an amount equal to specified expenses under a series of conditions and limits.

87 See Crane, “Double or Nothing,” supra note 67, at 1711; letter from Thomas Barthold to Senate Finance Committee member John Cornyn, R-Texas (July 27, 2020) (on this basis and the manner in which the Congressional Budget Office scored the CARES Act, the congressional override did not change the revenue baseline, and the JCT accordingly found no revenue effect). For criticisms of the application of section 265 to the PPP loans, see Stanley I. Langbein, “The Deductibility of PPP-Reimbursed Expenses,” Tax Notes Federal, Dec. 14, 2020, p. 1747; Matthew A. Morris, “Does the Deductibility of Qualifying PPP Loan Expenses Violate ‘Tax 101’?Tax Notes Federal, Jan. 25, 2021, p. 577 (deduction in connection with general welfare payments typically allowed); see also Cummings, supra note 74, at 1967.

88 Curtis, 3 T.C. at 651.

89 Id.; see also Skelly Oil, 394 U.S. 678.

90 New Colonial Ice v. Helvering, 292 U.S. 435, 440 (1934); INDOPCO Inc. v. Commissioner, 503 U.S. 79, 84 (1992); and Northern California Small Business Assistants Inc. v. Commissioner, 153 T.C. 65, 69 (2019).

91 Section 862(b) provides in relevant part:

From the items of gross income specified in subsection (a) there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto, and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall be treated in full as taxable income from sources without the United States.

92 This report does not address whether any deductions allocated and apportioned to the dividend income would not be described in reg. section 1.265-1(c) and disallowed.

93 I was critical of the regulations’ approach at the time of the proposed regulations because of the distortion that resulted if the expenses allocable to the exempted gross income are not disallowed. Shay, “A GILTI High-Tax Exclusion Election Would Erode the U.S. Tax Base,” Tax Notes Federal, Nov. 18, 2019, p. 1129, at 1133-1134. I had asserted that applying section 864(e)(3) to disregard the exempted GILTI income (and portion of stock) lacked a foundation in the statute, a position I reconsider based on the analysis in this report and the application of section 265 to the GILTI exemptive deduction. If the facts of Example 2 in that article, which pointed out the distortions of applying section 864(e)(3) (if expenses allocable to the exempt GILTI are not disallowed), instead provide for disallowance of the U.S. shareholder expense allocable to the exempted GILTI, the application section 864(e)(3) rules reach a coherent result.

94 Bernard D. Reams Jr., Internal Revenue Acts of the United States: The Revenue Act of 1954 With Legislative Histories and Congressional Documents a65 (1982).

95 Jacob S. Seidman, Seidman’s Legislative History of Federal Income Tax Laws — 1938-1861, 314-315 (1938).

96 Id. at 315 (“This particular amendment has reference to the question of deductions from gross income. It makes very certain the text of the bill disallowing deduction of expenses incurred in the production of non-taxable income.”). This is the same language relied on in Curtis, 3 T.C. 648. As a historical aside, Samuel Hill resigned from Congress in 1936 after being confirmed as a member of the Board of Tax Appeals, serving as a judge until 1953. See Biographical Directory of the United States Congress, “Hill, Samuel Billingsley 1875-1958.”

97 GCM 34506 (May 26,1971). Cummings correctly observes that the originally stated objects of the predecessor to section 265(a)(1) (first clause) were limited to situations involving intergovernmental tax immunity. Cummings, supra note 74, at 1966. There is no suggestion, however, that the provision’s application was intended to be limited to those cases. The memorandum’s conclusion on this point appears to be correct.

98 See Skelly Oil, 394 U.S. 678. It is unnecessary to resolve the academic question whether the rule against double tax benefits is a “substantive tax canon” or a “presumption.” Jonathan H. Choi, “The Substantive Canons of Tax Law,” 72 Stan. L. Rev. 195, 249-251 (2020). Either characterization supports the interpretation of section 265(a)(1) set forth in this report.

99 See Finance Committee explanation of the TCJA (Nov. 22, 2017), which is contained in the Senate Budget Committee explanation of the Finance Committee’s fiscal 2018 reconciliation legislation., S. Prt. No. 115-20, “Reconciliation Recommendations Pursuant to H. Con. Res. 71,” at 376 n.1210 (Dec. 2017) (“The Committee intends that the deduction allowed by new Code section 250 be treated as exempting the deducted income from tax.”); and H.R. Rep. No. 115-466, at 623 n.1517 (Dec. 15, 2017) (same) (conference report on H.R. 1).

100 Conference report on H.R. 1, supra note 99, at 598-599 (“The provision in the conference agreement . . . allows an exemption for certain foreign income by means of a 100-percent deduction for the foreign-source portion of dividends received from specified 10-percent owned foreign corporations by domestic corporations that are United States shareholders of those foreign corporations.” (Footnotes omitted.)).

101 See id. at 627 n.1527 (description of effective tax rate disregards possibility of deductions allocable to GILTI inclusions).

102 Preamble to T.D. 9882, 84 F.R. 69022, 69023-69024 (Dec. 17, 2019).

103 I leave for lawyers, tax advisers, and their clients to decide whether the taxpayer’s likelihood of success is “substantial” or “more likely than not” in opinion terms.

104 See Financial Accounting Standards Board Accounting Standards Codification 740-10. The financial disclosure question in turn raises issues regarding whether amounts should be disclosed on Schedule UTP of Form 1120, “Uncertain Tax Position Statement.” Reg. section 1.6012-2(a)(4). Disclosure can be required even if the corporation did not record a reserve for that tax position because the corporation expects to litigate it. Recent reporting on the effects of IRS underfunding suggests that there are insufficient IRS resources to pursue companies even if they do report a position on Schedule UTP. Douglas MacMillan and Kevin Schaul, “As IRS Audits Waned, Big Businesses Racked Up Unapproved Tax Breaks,” The Washington Post, July 14, 2021.

105 Despite the likely significant revenue loss from providing relief for past years (explicitly or implicitly), the U.S. tax system is asymmetric in that the IRS has broad scope to decline to enforce the tax law without serious risk of challenge by taxpayers that do not benefit from the nonenforcement. Article III standing limits effectively preclude review of IRS decisions initiated by persons who do not pay tax or are not the taxpayers, no matter how significant their interests may be in enforcement of the law. Allan v. Wright, 468 U.S. 737 (1984) (Supreme Court denies standing to NAACP plaintiffs seeking review of tax exemption for segregated private schools formed to avoid reach of public school desegregation after Brown v. Board of Education, 347 U.S. 483 (1954)).

106 The amendment at Appendix B does not attempt to identify collateral amendments to regulations affected by a change to the section 265 regulation and does not propose making the change prospective.

107 A nonexclusive reading of the existing regulation supports a conclusion that applying section 265(a)(1) as proposed in this report does not constitute a change in agency position. See Note, “Judicial Review of Agency Change,” 127 Harv. L. Rev. 2070 (2014). An agency should be permitted to change its own long-standing interpretation for good reason, including circumstances presented by novel statutory provisions and application of provisions in circumstances not anticipated in earlier regulations. See Anita S. Krishnakumar, “Longstanding Agency Interpretations,” 83 Fordham L. Rev. 1823, 1863 (2015). In any event, the interpretation proposed in this report should be subject to the same deferential review as a first-instance agency decision. Id. at 1878.

108 Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984); Skidmore v. Swift & Co., 323 U.S. 134 (1944); and Krishnakumar, supra note 107, at 1863.

109 Section 265(a)(1) was enacted before July 30, 1996, so regulations related to it are subject to the version of section 7805(b) that preceded the 1996 amendment. Taxpayer Bill of Rights 2, Title XI, section 1101(b). Before amendment, the text read: “The Secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect.” See UnionBanCal Corp. v. Commissioner, 113 T.C. 309, 327 (1999), aff’d, 305 F.3d 976 (9th Cir. 2002); and Islame Hosny, “Interpretations by Treasury and the IRS: Authoritative Weight, Judicial Deference, and the Separation of Powers,” 72 Rutgers U. L. Rev. 281, 305 (2020); but see John Bunge, “Statutory Protection From IRS Reinterpretation of Old Tax Laws,” Tax Notes, Sept. 8, 2014, p. 1177.

110 Before enactment of the TCJA, the regulatory agenda tended to be weighted toward projects that responded to requests from interested parties represented by Washington lobbyists, large law firms, and Big Four accounting firms, as well as from bar association tax sections composed principally of business-taxpayer representatives, for explicitly favorable, or as next-best clear and certain interpretations of statutory provisions.

111 See Dorothy A. Brown, The Whiteness of Wealth — How the Tax System Impoverishes Black Americans — And How We Can Fix It (2021); and Shu-Yi Oei and Leigh Osofsky, “Legislation and Comment: The Making of the Section 199A Regulations,” 69 Emory L.J. 209 (2019). The usual default to requests on behalf of interested taxpayers generally will not address social justice concerns. See Clinton G. Wallace, “Congressional Control of Tax Rulemaking,” 71 Tax L. Rev. 179, 216-224 (2017) (describing the uneven involvement of different interests in tax regulations).

112 Sullivan, supra note 19; Shay, “Ownership Neutrality and Practical Complications,” 62 Tax L. Rev. 317, 325-326 (2009); and Graetz and Oosterhuis, supra note 19, at 781.

113 Note that foreign multinationals only are allowed U.S. deductions allocable to a U.S. trade or business. Section 882(c). The incidence of corporate taxes is contested among economists. The most recent published review of the issue by the JCT staff concluded that owners of capital bear 100 percent of the corporate income tax burden in the short run and 75 percent of it in the long run, with the remainder not distributed to domestic and foreign owners of capital being borne by labor. The JCT does not use the long-run distribution for a provision until the 10th year after its adoption. See JCT, “Modeling the Distribution of Taxes on Business Income,” JCX-14-13, at 30 (Oct. 16, 2013).

114 See Urban-Brookings Tax Policy Center, “Share of Change to Corporate Income Tax Burden by Expanded Cash Income Percentile, Preliminary Results,” Table T17-0180 (June 6, 2017).

115 Steve Rosenthal and Theo Burke, “Who’s Left to Tax? U.S. Taxation of Corporations and Their Shareholders,” TPC Working Paper (2020) (estimating that 40 percent of stock in all U.S. corporations, public and private, is held by foreign investors).

116 See Chevron, 468 U.S. 1227.

117 There is extensive academic commentary on Chevron, including analyses that suggest varying numbers of Chevron analytical steps (including step zero and step one and a half, as well as step one and step two). This analysis focuses on the traditional two steps: (1) is there ambiguity in interpretation of the statute for the agency to fill, or has Congress “directly spoken to the precise question at issue”; and (2) is “the agency’s answer based on a permissible construction of the statute?” Chevron, 467 U.S. at 842-843.

118 Moreover, Congress denied any credit under section 901 or deduction under chapter A (of title 26) for foreign taxes in relation to section 245A exempt dividend income. Section 245A(d). These provisions, however, merely complete the articulation of how international double taxation will be addressed and ignore the separate and distinct issue of whether allocable deductions should be allowed under section 265.

119 See “history” in Heffelfinger, 5 T.C. 985.

120 Little Sisters of the Poor v. Pennsylvania, 140 S. Ct. 2367, 2381 (2020) (citation omitted); see also Scalia and Garner, supra note 80, at 94.

121 See Hawaiian Trust, 291 F.2d 761.

122 See section 904(a); and Biddle v. Commissioner, 302 U.S. 573 (1938) (payment of foreign tax determined under U.S. tax laws).

123 Sections 245A(d), 904(a), and 960(d)(1). The foreign tax base is taken into account in attributing foreign taxes to tested units. See reg. section 1.904-6.

124 The green book proposal states that no inference should be drawn regarding current law. Fiscal 2022 green book, supra note 7, at 14.

125 The Biden proposal would repeal the provision excluding the 10 percent return to QBAI, which would effectively limit the scope for section 245A, but the proposal does not appear to repeal section 245A.

126 See generally Daniel Jacob Hemel, “The President’s Power to Tax,” 102 Cornell L. Rev. 633 (2017). I do not discuss in detail here the concerns that notice and comment tax regulations are less democratic than fully specified legislation. That concern seems formalistic for taxation when congressional provision for regulatory guidance is ubiquitous and necessary, the statute already is detailed, and remaining issues for guidance are technical (as evidenced by this report), and there is extensive public demand for regulatory guidance. The notice and comment regulatory process allows for public input on an ex ante basis. In addition to executive branch ex ante oversight, there is ex post congressional oversight and regular tax legislation providing opportunity for congressional changes to regulatory decisions that historically has been exercised. Finally, there is judicial review. The clear democratic legitimacy of fulsome administrative guidance is a topic for another day.

127 The flip side of this consideration is that a regulation can be a stealth revenue raiser or revenue loser.

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