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Gaps in the TCJA Guidance

Posted on Aug. 5, 2019

In meeting its demanding agenda for publishing guidance interpreting the Tax Cuts and Jobs Act, Treasury followed the 80/20 rule: It met taxpayer needs for guidance by publishing rules that covered 80 percent of the questions, leaving 20 percent unanswered. Complying with the 80/20 rule generally means the most challenging topics are left open for future guidance, and it’s no different in this case.

Part I of this series surveyed the guidance released on international provisions of the TCJA to date. The second in the series, this article considers the biggest questions that Treasury left unresolved. Some are matters the government simply didn’t have time to work through; others involve areas it has struggled to answer, including how to reconcile seemingly irreconcilable code provisions. Some of the most challenging subjects arise when the international code sections overlap and intersect with other regimes — most notably, subchapters C and K. Long-standing problems were made worse by the TCJA, thus heightening the need for taxpayer guidance.

PTEP

Ensuring that earnings taxed under the subpart F rules aren’t taxed again when repatriated — but also that taxpayers can’t avoid any tax on those earnings and are able to claim the proper amount of foreign tax credits — is a topic that both taxpayers and Treasury very much want to be worked out. But the government has struggled to write rules, with its attempts necessitating a change in terminology from previously taxed income to previously taxed earnings and profits (PTEP).

The government last issued comprehensive guidance in 2006. Those proposed regulations (REG-121509-00) were meant to update the PTI rules for changes to subpart F rules over the prior four decades and resolve questions that had vexed taxpayers, but Treasury hasn’t been able to finalize them because of the complexities involved. (Prior analysis: Tax Notes, May 25, 2015, p. 860.) (A 2015 New York State Bar Association report highlights the many questions raised by the proposed regulations.) Any direction the government takes could leave room for taxpayer planning or subject taxpayers to double tax — and would invariably be wildly complex.

However hard it was to develop rules to avoid doubly taxing PTI before the TCJA, the new law compounded the challenges exponentially. For one, any technical questions about how to account for PTI have multiplied in importance — although previously taxed earnings used to represent only a small subset of the earnings of controlled foreign corporations, the bulk of foreign earnings now belongs in this category. The general category of previously taxed earnings is now divided into three buckets taxed at different rates: earnings taxed by section 965 (taxed at two different rates), earnings taxed under the global intangible low-taxed income rules (at half the statutory rate), and subpart F income (a category that for some shareholders includes both subpart F income and section 956 investments). Those different rates, new complexities in FTC basketing that become relevant on PTEP distribution, and the GILTI calculation’s varying from that of subpart F (such as by allowing an offset for positive earnings by losses from deficit companies) make writing rules inordinately more difficult.

Drafting workable PTI rules is also hard because the policies behind international tax rules don’t necessarily coincide with those in subchapter C. As a result, some unreconciled issues involve basic questions about how the policies behind subchapter C should interact with those for the taxation of foreign earnings, such as whether a company that has an earnings and profit deficit but a PTI account can have a distribution of previously taxed earnings taxable under section 959. The GILTI regime introduces even more complexities.

Government officials have repeatedly emphasized the importance of issuing regulations and originally said they planned to do so in 2018. That year came and went, with Treasury instead issuing Notice 2019-1, 2019-2 IRB 275, announcing its intent to issue proposed regulations to address PTEP of foreign corporations as affected by the TCJA. The notice outlines a complex system of 16 categories of PTEP derived from different types of foreign earnings inclusions mandated by various code sections, and it says regulations will prescribe ordering rules for distributing those earnings. But officials have acknowledged that the envisioned rules would present compliance and record-keeping challenges for taxpayers and have said they’re open to a simpler regime — should someone propose one. So far, no one has.

PTEP guidance is surely a priority, but the challenges raise the question whether a PTEP regime is still needed. In an international tax system in which all earnings are taxable under subpart F or GILTI, or are tax exempt under section 245A, having to account for PTEP seems unnecessary — even though PTEP-related credits remain important for taxpayers.

Stock Basis Adjustments

Also unclear is how to adjust stock basis to ensure it properly reflects that earnings were previously subject to tax. Section 961(c), enacted in 1997, provides that Treasury will issue rules for adjusting lower-tier CFC stock basis after subpart F inclusions, but only for determining gain on the sale of stock. Treasury has never issued regulations, leaving open whether taxpayers can still make those kinds of basis adjustments. That’s now much more problematic: Section 951A has made more common the questions of whether, when, and how to adjust stock basis for lower-tier CFCs whose earnings have been included in a U.S. shareholder’s income.

References to the need to write rules for section 961 basis adjustments, as well as taxpayer suggestions for how to do so, are sprinkled throughout the proposed and final TCJA regs issued to date. In the preamble to the final GILTI regulations (T.D. 9866), the IRS said it would further consider the interaction of basis adjustments under sections 961(c) and 951A in connection with the PTEP guidance project. In response to questions whether basis adjustments under section 961(c) should be taken into account in determining a CFC’s gross tested income on the CFC’s disposition of another CFC’s stock, and recommendations that those basis adjustments apply for determining both subpart F income and section 951A tested income, the government said that taking into account section 961(c) basis adjustments in determining gross tested income could inappropriately reduce the amount of stock gain subject to tax in some cases. It requested comments on that topic, including the extent to which adjustments should be made to minimize the potential for double taxation and inappropriate reduction of gain in CFC stock.

In the final section 965 regulations (T.D. 9846), the IRS tried to answer many taxpayer questions on how to make CFC stock basis adjustments to reflect section 965 inclusions — with one notable exception. Taxpayers had asked that regulations clarify the basis adjustments to be made for a domestic passthrough owner that made a section 962 election for its share of a section 965 inclusion. The government said that raised a long-standing issue of general applicability in subpart F that was outside the scope of the section 965 project, so the final section 965 regs address basis adjustments for section 958(a) shareholders only.

While the government has been unable to figure out how to write rules telling taxpayers how to make basis adjustments for section 962 elections, avoiding the problem (which has become more prevalent) doesn’t make it go away.

Reconciling foreign currency rules with new provisions is another challenge, and the IRS punted again in the final section 965 regulations. It merely said it was considering proposing rules under section 961 to ensure that taxpayers aren’t required to recognize gain because of fluctuations in exchange rates on distributions of section 965 PTEP and that it intended to study the proper amount of gain or loss, including foreign currency gain or loss, to be recognized on distributions of PTEP.

The DRD

The IRS has released two limited sets of guidance on the interpretation of section 245A. Temporary regs issued in June (REG-106282-18) deny the dividends received deduction (DRD) for transactions that could limit taxpayers’ GILTI or subpart F inclusions while maximizing dividends from earnings potentially subject to section 245A in a manner the IRS views as abusive. Proposed hybrid regs (REG-104352-18) address section 245A(e), which denies the DRD for hybrid dividends. General guidance interpreting section 245A remains to be released.

A 2018 NYSBA report outlines some remaining questions for section 245A dividends, and many of them are basic and common. They include whether deemed dividends that aren’t specifically referenced in the legislative history can qualify for the DRD, whether domestic corporations that are partners in a partnership can claim the DRD, how to identify a dividend paid for a particular share of stock when taxpayers hold multiple blocks of stock, how to tack holding periods for a dividend-equivalent redemption or reorganization, and how a taxpayer that hasn’t satisfied the holding period requirement when it files its tax return can provisionally claim the deduction. Taxpayers also want guidance on the qualification of a section 245A dividend as tax-exempt income under the consolidated return regulations, the application of section 961(d) by a consolidated group, and the computation of the foreign-source portion of a dividend received.

The government is wrestling with whether the section 245A deduction should apply to a dividend received by one CFC from another. The statute says that deduction applies to dividends received by domestic corporations, but section 964(a) says the rules for calculating the E&P of foreign corporations generally follow the rules for domestic corporations. In the preamble to the GILTI regulations, the government said future guidance would clarify that generally, any provision limited in its application to domestic corporations doesn’t apply to CFCs because of reg. section 1.952-2 (which provides that income of foreign corporations is generally determined by treating them as domestic). It said it will continue to study whether proposed regulations should provide that dividends received by a CFC are eligible for a section 245A deduction.

FTC Calculation: Expense Apportionment

In the proposed FTC regulations (REG-105600-18) issued last November, the government addressed many of taxpayers’ most urgent questions about how to allocate and apportion interest expense to the GILTI basket and how to reflect other types of income (such as the section 78 gross-up) and deductions (such as the section 250 deduction) in calculating the FTC under the new regime. But it left big holes regarding how to allocate other types of expenses — most obviously absent is any guidance on allocating research and development expenses, stewardship, and general and administrative expenses. Treasury noted in the preamble to the proposed regs that it expects to examine the apportionment and allocation rules for those expenses and requested comments on whether and how existing rules should be changed to account for TCJA changes. As an example of a rule that might need revision, the preamble notes that royalties paid by a CFC to its U.S. shareholder would generally be treated as general category income even though the CFC sales the royalties relate to may be tested income, which would create a mismatch between the R&D expense apportioned to the GILTI basket and the royalty income allocated to the general basket.

The government is slowly coming to appreciate how important new rules for expense allocation are for taxpayers. Because the consequences of having expenses allocated to the GILTI basket can be severe, all questions regarding allocation of expenses have heightened importance. In March government officials said a rethink of those rules would be given a higher priority and that they might try to publish something this year. Treasury has also said it’s looking at how to allocate stewardship expenses and general and administrative expenses, both in general and for the foreign branch category specifically.

Interest Expense Limitation

Although extensive proposed regulations (REG-106089-18) have been issued on the new interest expense limitation in revised section 163(j), the rules touch only lightly on how the limitation applies in cross-border scenarios. The preamble states that Treasury and the IRS are still studying whether additional modifications to the application of section 163(j) to CFCs are needed and whether it might sometimes be appropriate to exempt a CFC from the application of section 163(j).

Unanswered questions about how new limitations and exclusions that apply in calculating domestic corporations’ taxable income should apply to CFCs is a prevalent theme in the TCJA guidance. The government has said it intends to address questions regarding the application of reg. section 1.952-2 in a future guidance project.

Partnership Withholding Regs

The government still must address some questions about the mechanics of complying with the partnership withholding required for enforcement of section 864(c)(8). For example, it has requested comments about how refunds for excess amounts withheld should work; under the proposed regulations, if the tax withheld from the transferee exceeds its section 1446(f) liability, only the partnership can claim the refund on behalf of the transferee.

The government also requested comments on what additional guidance is necessary regarding the source of gain or loss under section 864(c)(8), and how that section should apply to nonrecognition transactions; the preamble notes that some nonrecognition transactions could reduce the gain or loss that would be taken into account.

BEAT

Treasury mostly declined to address the interaction of foreign currency questions and the calculation of the base erosion and antiabuse tax. It has requested comments on the treatment of section 988 losses under the BEAT and on the aggregate approach to partnerships in the proposed BEAT regulations.

Hybrids

Because Treasury was able to draw on the extensive OECD recommendations on hybrid transactions, the proposed regulations under sections 267A and 245A are more complete than most TCJA guidance. Even so, the government remains concerned that they’re not comprehensive enough. The preamble says that while the proposed rules address deduction/no inclusion results from actual and deemed payments of interest and royalties that are recognized for U.S. tax purposes but disregarded for foreign tax purposes, they don’t address the consequences of similar structures involving payments to domestic corporations that are recognized for foreign tax purposes but disregarded for U.S. tax purposes.

Also reflecting the challenge in coordinating new international guidelines with the rules for determining E&P, the preamble asks for comments on whether hybrid deductions attributable to amounts included in income as subpart F or GILTI shouldn’t increase a company’s hybrid deduction account, or, alternatively, whether a hybrid deduction account should be reduced by distributions of PTEP. It also asks whether the effect of any deemed paid FTCs associated with those inclusions or distributions should be considered. Finally, in another recurrent theme, it requests comments on foreign currency rules for the sections 245A and 267A proposed regulations, including any rules regarding the translation of amounts between currencies.

Partnerships

The difficulties inherent in reconciling subchapter K and the international aspects of the TCJA are evident in the design of the GILTI calculation for foreign stock held by a U.S. partnership.

In the proposed GILTI regs (REG-104390-18) issued last October, Treasury adopted an unwieldy hybrid approach that treated a partnership as an aggregate for some partners but an entity for others. Numerous comments pointed out the unworkability of that approach, so the government reversed course and decided instead to simply treat the partnership as an aggregate.

While the resolution made sense, it opened the door to other questions about how preexisting law can be reconciled with TCJA guidance. To address some of those questions, proposed regulations issued in June (REG-101828-19) would extend the aggregate approach to subpart F as well, thereby overturning long-settled law. However, it's not easy to make just one change without the house of cards tumbling down. Treasury’s solution to the GILTI partnership conundrum and application of the same principle to subpart F income raises new questions — for example, about the interaction of the CFC/passive foreign investment corporation overlap rule.

Conclusion

Treasury and the IRS have performed a herculean task in issuing guidance on most of the challenging questions posed by the complex and hastily written TCJA, but the ones that remain won’t be easy to answer. Many involve topics the government has wrestled with for years. Treasury’s struggle to write rules that reliably prevent double tax on the distribution of previously taxed earnings or disposition of the stock of CFCs whose earnings were previously included in U.S. taxable income also belies its claim, as articulated in the preamble to the temporary section 245A regulations, that the international tax regime enacted by the TCJA forms a cohesive interlocking regime for taxing cross-border earnings as envisioned by Congress. (Prior analysis: Tax Notes Federal, July 8, 2019, p. 153.)

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker Chtd., and a contributor to Tax Notes International.

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