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ACLI Advises on Proposed Subpart F High-Rate Exception Regs

SEP. 21, 2020

ACLI Advises on Proposed Subpart F High-Rate Exception Regs

DATED SEP. 21, 2020
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September 21, 2020

Office of Chief Counsel
Attention: Jorge M. Oben and Larry R. Pounders
Internal Revenue Service (I.R.S.)
1111 Constitution Avenue, NW
Washington, DC 20224

CC:PA:LPD:PR (REG-127732-19)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20224

Re: Comments Regarding Section 954(b)(4) Proposed Regulations (Internal Revenue Service REG-127732-19) on Income Subject to a High Rate of Foreign Tax

Dear Messrs. Oben and Pounders:

On July 23, 2020, Treasury and the IRS published proposed regulations under Section 954(b)(4) in the Federal Register, providing unified high-tax exception guidance with respect to global intangible low-taxed income (“GILTI”) and subpart F income (the “Proposed Regulations”).1 The Proposed Regulations would modify both the existing high-tax exception under Section 954(b)(4) and Treas. Reg. § 1.954-1(d)(5) (the “Subpart F HTE”) and the high-tax exclusion under Sections 951A and 954 (the “GILTI HTE”) included in final regulations that were also published in the Federal Register on July 23, 2020 (the “Final Regulations”).2 On behalf of the American Council of Life Insurance (“ACLI”), we are writing to recommend several aspects of the Proposed Regulations implementing a unified high tax exception for subpart F and tested income (the “Unified HTE”) be modified. Our comments offer reasons for why the Unified HTE should be modified to best address concerns of the life insurance industry. Specifically, ACLI requests that Treasury and the IRS modify the Proposed Regulations so that

1) the existing Subpart F HTE is retained and final regulations enable taxpayers to make independent elections under the Subpart F HTE and the GILTI HTE;

2) tested units with losses are not treated as subject to a HTE;

3) the 24-month period to file an amended tax return and make (or revoke) the HTE election where foreign tax redeterminations have occurred is extended through appropriate procedures;

4) the foreign financial statement conformity rule is applied only with respect to the HTE; and

5) certain tested units whose income is subject to tax should not be treated as tested units.

We thank you for the continued solicitation of feedback and welcome the opportunity to discuss these items in further detail. We commend you for finalizing the GILTI HTE and recognize that the Final Regulations take an important step to reflect the legislative intent to limit tax that arises from GILTI income that is subject to an appropriate rate of foreign tax. To that end, we believe the following recommendations will assist you to issue guidance effectively and efficiently to implement the GILTI HTE and the Subpart F HTE (in lieu of a Unified HTE) for the life insurance industry.

1. GILTI — Subpart F HTE Conformity Rule

Addressing taxpayer comments that the rules implementing the GILTI HTE (as proposed in June 2019) should be conformed with the longstanding rules implementing the Subpart F HTE, the preamble to the Proposed Regulations provides that Treasury and the IRS have determined that the rules implementing the GILTI HTE better reflect the policies underlying Section 954(b)(4) in light of the changes made by the Tax Cuts and Jobs Act (the “Act”). The Proposed Regulations achieve conformity between the GILTI HTE and the Subpart F HTE by providing a Unified HTE under Section 954(b)(4) for purposes of determining both a CFC's subpart F income and tested income. Therefore, although the comments recommended that the GILTI HTE conform to the Subpart F HTE, the Proposed Regulations require instead that the Subpart F HTE conform to the GILTI HTE through a Unified HTE. Under the Unified HTE, the Proposed Regulations introduce the concept of a “tested unit” requiring that the high-tax determination be made on a tested unit-by-tested unit basis. No distinction is made between items generally included in subpart F income or tested income. Furthermore, the election must be made with respect to a CFC group rather than on a CFC-by-CFC basis.

The Unified HTE in the Proposed Regulations is a significant departure from the existing Subpart F HTE that fails to properly account for the statutory differences between the GILTI and subpart F regimes, where the latter has been left undisturbed by the Act. Congress added the subpart F regime to the Code in 1962 to address the use of so-called “tax havens” to defer U.S. taxation on specific, often-passive categories of undistributed income.3 Added to the Code alongside the participation-exemption system of Section 245A, the GILTI regime is designed to subject CFC income (other than certain enumerated types) to current U.S. taxation at reduced rates in order to mitigate possible base erosion via migration of economic activity from the United States to low- or no-tax jurisdictions.4 Although the GILTI and subpart F regimes both subject undistributed CFC income to current U.S. taxation, they do so pursuant to significantly different mechanisms. The subpart F regime currently taxes a U.S. shareholder of multiple CFCs on its pro rata share of certain, specific items of income earned by each of the CFCs. While subpart F income is generally based on the income of each CFC, GILTI is significantly different as it is based on the aggregate net tested income of all CFCs. In that regard, consistent with the statutory differences between the subpart F and GILTI regimes, any HTE should be implemented under subpart F on an item-by-item and CFC-by-CFC basis, even if Treasury and the IRS have determined it is appropriate to implement the GILTI HTE based on tested units and across CFC groups. Since GILTI is based on the aggregate net tested income of CFCs it may be appropriate for the regulations to provide a consistency rule as part of the GILTI HTE rule, while there is no such basis for adopting such a rule for purposes of the Subpart F HTE.

Although the Act made substantial revisions to the United States' international tax rules, Congress did not amend Section 954(b)(4) as part of the Act. Furthermore, in addition to the clear differences between the statutory schemes underlying the GILTI and subpart F regimes, the legislative history to the Act does not provide any indication that Congress intended for the Act to modify the manner in which the longstanding Subpart F HTE applied to a U.S. shareholder and the shareholder's CFCs. In that regard, the current Subpart F HTE is consistent with the statutory language of Section 954(b)(4), which excludes from “insurance income” and “foreign base company income” any item of income received by a CFC that was subject to an effective rate of foreign tax greater than 90 percent of the maximum rate of U.S. corporate income tax.5 We commend Treasury and the IRS's efforts to faithfully implement the policies of the GILTI regime with the GILTI HTE. However, in the absence of congressional intent to alter the existing Subpart F HTE as a result of the changes made by the Act, we recommend that the existing Subpart F HTE that is applied on an item-by-item and CFC-by-CFC basis be retained and that final regulations enable taxpayers to make the Subpart F HTE and GILTI HTE elections independent of each other.

2. Loss units with foreign taxes

The Proposed Regulations provide that, where foreign taxes and other expenses are allocated and apportioned to an item of gross income and result in a tentative net item (plus foreign taxes) that is zero or negative, the tentative net item is deemed to be high-taxed (the “Negative Effective Tax Rate Rule”).6 The preamble to the Proposed Regulations does not provide a specific rationale for the Negative Effective Tax Rate Rule, other than to state that, as a result of the rule, “the item of gross income, and the deductions allocated and apportioned to such gross income under the rules set forth in the regulations under Section 861, are assigned to the residual grouping, and no credit is allowed for the foreign taxes allocated and apportioned to such gross income.”7 The Negative Effective Tax Rate Rule thus appears to be primarily focused on the impact that foreign taxes paid at a negative foreign effective tax rate may have on foreign tax credit utilization against U.S. income tax liability. As described below, the Negative Effective Tax Rate Rule also creates a distortion in a taxpayer's ability to utilize tested losses where even a nominal amount of foreign taxes is paid by a tested unit with a loss. Accordingly, ACLI recommends that tentative net items with an undefined value or negative effective foreign tax rate should not be deemed high-taxed.

The skewed impact of the Negative Effective Tax Rate Rule may be illustrated by an example. For instance, consider a U.S. company (U.S. Co.) that wholly owns CFC1 and CFC2, each of which is a standalone tested unit under Prop. Reg. § 1.954-1(d)(2)(A) and neither of which have any qualified business asset investment. CFC1 has a tentative net item of $90 that is considered tested income, and with respect to which it paid $10 of foreign tax. CFC2, an insurance company, has a tentative net item of ($10) that would be considered a tested loss.

As a result of the Negative Effective Tax Rate Rule, the amount of U.S. Co.'s GILTI inclusion would differ in the case where CFC2 paid even $0.01 of foreign tax as opposed to $0.00 of foreign tax. If CFC2 paid $0.01 of foreign tax, because CFC2's effective tax rate would be negative, its tested loss would not be included in U.S. Co's GILTI calculation and U.S. Co. would have a GILTI inclusion of $90 (attributable to CFC1's tested income). If, on the other hand, CFC2 paid no foreign tax, U.S. Co. would have a GILTI inclusion of $80 (attributable to CFC1's tested income, reduced by CFC2's tested loss). In certain countries insurers are subject to taxes on premiums that are considered “in lieu of a tax on income” within the meaning of Section 903. Therefore, whether a CFC that is engaged in an insurance business has taxable income or a loss has no bearing on whether such a company may pay local income tax. If this rule is adopted, then it would be impossible for such a CFC engaged in insurance business to have a tested loss in the GILTI context or a qualified deficit in the subpart F context. Consequently, the Negative Effective Tax Rate Rule is expected to have a more significant impact on taxpayers in the insurance industry than taxpayers in other industries that principally pay foreign income taxes on their net foreign income. ACLI believes this result is inappropriate, particularly in light of the fact that the GILTI regime requires a U.S. shareholder to aggregate all tested items (including tested loss) of its CFCs to determine its GILTI inclusion8 and the subpart F regime explicitly provides for qualified deficits to offset future subpart F income.9 We therefore recommend that tentative net items with an undefined value or negative effective foreign tax rate should not be deemed high-taxed.

3. Redetermined taxes — 24-month rule

The Proposed Regulations provide that the high-tax election may be made (or revoked) on an amended federal income tax return only if all U.S. shareholders of the CFC file amended returns (unless an original federal income tax return has not yet been filed, in which case the original return may be filed consistently with the election (or revocation)) for the year (and for any other tax year in which their U.S. tax liabilities would be increased by reason of that election (or revocation)), within a single 6-month period within 24 months of the unextended due date of the original federal income tax return of the controlling domestic shareholder's inclusion year.

Foreign tax redeterminations may occur after the 24-month window of the unextended due date of the original federal income tax return of a U.S. shareholder's inclusion year. In that case the 24-month window could lead to an unfair result. For example, there may be situations where in the initial reporting year, the U.S. shareholders' tested units did not qualify for the HTE, but as a result of foreign tax redetermination, U.S. shareholders are now subject to a foreign tax that is sufficiently high to qualify for the HTE. If the foreign tax redeterminations occurred outside of the 24-month window, U.S. shareholders would lose the ability to elect the HTE. If Treasury and the IRS extend the 24-month window in such situations for as long as the statute of limitations under Sections 6501 and 6511 has not expired, it would equitably allow U.S. shareholders sufficient time based on the proper and applicable facts to determine if they want to make (or revoke) the election, by reason of a foreign tax redetermination.

Accordingly, ACLI requests Treasury and the IRS to implement procedures that would allow for extended periods for making or revoking the HTE election on an amended return where foreign tax redeterminations occur with respect to one or more CFCs after the 24-month window.

4. Use of Financial Statements

The preamble to the Proposed Regulations provides that the Treasury Department and the IRS have determined that the policy goal of Section 954(b)(4) is to identify income of a CFC subject to a high effective rate of foreign tax and is better served by determining the effective foreign tax rate with respect to items of income attributable to a tested unit by reference to an amount of income that approximates taxable income as computed for foreign tax purposes, rather than federal income tax purposes. The Final Regulations use items properly reflected on the separate set of books and records (within the meaning of §1.989(a)-1(d)) as the starting point for determining gross income attributable to a tested unit.10 Treasury and the IRS explained that:

[b]ooks and records are used for this purpose because they serve as a reasonable proxy for determining the amount of gross income that the foreign country of the tested unit is likely to be subject to tax and, given that this approach is consistent with the approach taken in other provisions, it should promote administrability.11

The Proposed Regulations retain this general approach but replace the reference to “books and records” with a more specific standard based on items of gross income attributable to the “applicable financial statement” of the tested unit.12 The Proposed Regulations also determines tentative net income by allocating and apportioning deductions, determined under federal income tax principles, to items of gross income to the extent the deductions are properly reflected on the applicable financial statements of the tested unit. Treasury Department and the IRS have adopted the new standard as they believe that this new standard will provide more accurate and reliable information, promote certainty in cases where there may be various forms of readily available financial information, and promote administrability because it is consistent with approaches taken under other provisions such as Section 451(b).

The Proposed Regulations allocate and apportion deductions to the extent properly reflected on the applicable financial statement only for purposes of Section 954(b)(4), and not for any other purpose. ACLI agrees that determining both the gross income and allowable deductions of a tested unit by reference to the financial statements of the tested unit results in an effective tax rate test that more closely ties to the taxable income calculated for foreign tax purposes, consistent with the stated purpose of Section 954 to identify CFC income subject to a high effective rate of foreign tax.

The preamble to the Proposed Regulations notes that the Treasury and the IRS are considering whether it would be appropriate for purposes of Sections 954(b)(5), 951A(c)(2)(A)(ii), and 960, in limited cases (for example to reduce administrative and compliance burdens), to allocate and apportion deductions incurred by a CFC based on the extent to which they are properly reflected on an applicable financial statement, and request comments in this regard. ACLI believes that the adoption of the new standard may actually increase the administrative burden because the new standard would require taxpayers to apply different apportionment rules based on the tax laws in the local jurisdiction across their CFCs each year. Under the current law, taxpayers have been applying Section 861 principles consistently across all of the CFCs. By adopting the applicable financial statement standard, taxpayers will be required to conduct analysis of each of their CFCs to determine the appropriate methods for apportioning deductions, and a new analysis has to be conducted every time there is a change in the local tax accounting rules. This analysis may require dedicating a significant amount of resources and therefore actually increases the administrative burden. Accordingly, ACLI recommends that the final regulations, consistent with the Proposed Regulations, allocate and apportion deductions to the extent properly reflected on the applicable financial statement only for purposes of Section 954(b)(4), and not for any other purpose.

5. Investment companies that are tested units

The Final Regulations provide three categories of a tested unit: (1) a CFC; (2) an interest in a pass-through entity held, directly or indirectly, by a CFC, provided that the pass-through entity is (a) a tax resident of any foreign country or (b) an entity that is not treated as fiscally transparent for purposes of the CFC's local tax law; and (3) a branch, or portion of a branch, the activities of which are carried on directly or indirectly by a CFC, provided that either (a) the branch gives rise to a taxable presence in the country in which the branch is located or (b) the branch gives rise to a taxable presence under the owner's tax law and the owner's tax law provides an exclusion, exemption, or similar relief for income attributable to the branch (a non-taxed tested unit).13 The same categories are also provided by the Proposed Regulations.14

The tested-unit standard is a departure from the QBU standard proposed in the 2019 proposed regulations. In the preamble to the Final Regulations, Treasury and the IRS explain that applying the QBU standard as a proxy for determining the type of entity, or level of activities, would likely result in items of income attributable to the QBU being subject to a different rate of foreign tax than that imposed on other income of the CFC. In response to this issue, Treasury and the IRS have concluded that a more targeted approach should be applied for identifying income that is likely to be subject to foreign tax rates different from those imposed on other income earned by the CFC, and the approach proposed is the tested-unit approach. Unlike the QBU standard that serves as a proxy for being subject to foreign tax, the tested-unit approach generally applies to the extent an entity, or the activities of an entity, are actually subject to tax, as either a tax resident or a permanent establishment (or similar taxable presence), under the tax law of a foreign country. Treasury and the IRS believe that the tested-unit approach will generally limit the scope of the factual analysis necessary to apply these rules as it does not depend on whether activities constitute a trade or business, or whether books and records are maintained. Accordingly, the QBU standard is replaced by tested-unit standard.15

The change to a tested-unit standard, with an emphasis on whether the entity is a tax resident in the jurisdiction, will adversely affect insurance CFCs that are in one jurisdiction and own interests in certain investment vehicles in another jurisdiction. It is a common practice for insurance CFCs to hold investments in different jurisdictions to support their surplus and reserves necessary to run the insurance business. These investment vehicles16 are typically structured as disregarded entities or partnerships for U.S. tax purposes, but are opaque for local tax purposes. The reason for this is so that the investment income supporting insurance company reserves is properly included within the financial services investment income of an insurance company, and not treated as separate income of a non-insurance CFC that would then be subpart F income. The investment vehicles are often organized in a manner such that there is no local tax (similar to a RIC) on its income earned; while the income is taxed at the parent level upon distribution, which may be in a later year. Under the Proposed Regulations, the investment vehicles are treated as separate tested units, and are tested individually to determine if the Unified HTE applies.

For example, assume an insurance CFC that is domiciled and subject to tax in Country X owns an interest in an investment vehicle that is domiciled in Country Y. The income of the investment vehicle is not taxed in Country Y, while Country X taxes the distribution from the investment vehicle in the year of receipt. Country X's rate of tax is above the US tax rate. If the insurance CFC receives a distribution of its share of the income from the investment vehicle in the year that the income is earned, then Country X taxes that distribution. Pursuant to Treas. Reg. sec. 1.951A-2(c)(7)(iii)(A) and (B), the current year tax expense should be allocated and apportioned under the principles of Treas. Reg. sec. 1.960-1(d)(3) by treating each tentative gross tested income item as assigned to a separate tested income group. Further, the principles of Treas. Reg. sec. 1.904-6(a)(2)(ii) and (iii) should apply to allocate and apportion foreign taxes associated with disregarded payments. In the instant case, the tested income produced by the investment vehicle and the tested income produced by the insurance CFC are each expected to constitute a separate tentative gross tested income item for purposes of Treas. Reg. sec. 1.951A-2(c)(7)(iii)(A). A distribution from the investment vehicle to the CFC is not expected to result in the application of the reattribution rules under Treas. Reg. sec. 1.951A-2(c)(7)(ii)(B)(2). Accordingly, the rules of Treas. Reg. sec. 1.904-6(a)(2)(iii)(A) are expected to apply to allocate the Country X tax on the disregarded distribution based on the income/assets of the investment vehicle tested unit under the general timing difference rules. It is therefore expected that the Country X tax will be allocated to the investment vehicle's tentative gross tested income item under Treas. Reg. sec. 1.951A-2(c)(7)(iii)(A) and (B) as the investment vehicle is only expected to produce income in such income grouping.

However, a timing mismatch occurs when the distribution from the investment vehicle occurs at a later year. Therefore the effective tax rate may be less than 90% of the U.S. rate if its measured annually, even though the income of the investment vehicle is clearly subject to tax at a rate higher than the U.S. rate (the Country X rate) upon distribution. Unlike domestic RICs, foreign investment vehicles may not have a current distribution requirement. In the circumstance where a timing mismatch arises, in that the tax on the distribution imposed by Country X is imposed in a later year than when the income is earned, ACLI requests that the Country Y entity not be treated as a tested unit or that a taxpayer be allowed to elect for the income of the Country Y entity to not be treated as that of a separate tested unit. While there may be a timing mismatch between the US and foreign tax base, such mismatches have generally not been addressed in the regulations. There is no permanent tax difference that should cause the Country Y entity to be treated as a separate tested unit. This situation is similar to a branch that is not subject to tax in Country Y but is subject to tax in Country X. In such a situation, although there may be a timing difference on recognition of income and imposition of tax, the Country Y branch would not be treated as a separate tested unit. Therefore, we ask that the pass-through entity that is not subject to tax in Country Y be treated in a similar manner as a branch in Country Y that is not subject to tax in Country Y and not be treated as a tested unit.

We thank you for considering our comments to the Proposed Regulations and welcome the opportunity to discuss our recommendations.

Sincerely,

Regina Y. Rose
Senior Vice President, Taxes & Retirement Security
(202) 624-2154 t
reginarose@acli.com

Mandana Parsazad
Vice President, Taxes & Retirement Security
(202) 624-2152 t
mandanaparsazad@acli.com

American Council of Life Insurers
Washington, DC

cc:
Angela Walitt

FOOTNOTES

1REG-127732-19, 85 Fed. Reg. 44650 (July 23, 2020).

2TD 9902, 85 Fed. Reg. 44620 (July 23, 2020).

3See H.R. Rep. No. 87-1447, at 40-45 (1962).

4See S. Prt. No. 115-20, at 370 (2017). The legislative history to the Act indicates that GILTI is intended to apply only to income subject to foreign tax at a rate below a certain threshold. See id. at 371 (“The Committee believes that certain items of income earned by CFCs should be excluded from the GILTI, either because they should be exempt from U.S. tax — as they are generally not the type of income that is the source of base erosion concerns — or are already taxed currently by the United States. Items of income excluded from GILTI because they are exempt from U.S. tax under the bill include foreign oil and gas extraction income (which is generally immobile) and income subject to high levels of foreign tax.”); H.R. Conf. Rep. No. 115-466, at 626 n.1526 (2017) (“If the foreign tax rate on GILTI is 13.125 percent, and domestic corporations are allowed a credit equal to 80 percent of foreign taxes paid, then the post-credit foreign tax rate on GILTI equals 10.5 percent . . ., which equals the effective GILTI rate of 10.5 percent. Therefore, no U.S. residual tax is owed.”)

5The existing Subpart F HTE is also consistent with the legislative history to Section 954(b)(4), which focused on items of moveable income and specific transactions rather than CFC income generally:

The committee's judgment is that because moveable income could often be as easily earned through a U.S. corporation as a foreign corporation, a U.S. taxpayer's use of a foreign corporation to earn that income may be motivated primarily by tax considerations. If, however, in a particular case no U.S. tax advantage is gained by routing income through a foreign corporation, then the basic premise of subpart F taxation is not met, and there is little reason to impose the subpart F tax. Thus, since the scope of transactions subject to subpart F will be broadened, and may sweep in a greater number of non-tax motivated transactions, the committee expects that the flexibility provided by a readily applicable exception for such transactions will become a substantially more important element of the subpart F system.

H.R. Rep. No. 99-426, at 401 (1986).

6See Prop. Reg. § 1.954-1(d)(4)(ii).

7See 85 Fed. Reg. at 44653.

8See generally Section 951A.

10Prop. Reg. § 1.951A-2(c)(7)(ii)(B)(1).

11Id.

12Prop. Reg. § 1.954-1(d)(1)(iii)(A).

14See Prop. Reg. § 1.954-1(d)(1)(i)(5)(v)(2).

16An example of such an investment vehicle would be an Irish or Luxembourg Undertakings for Collective Investment in Transferable Securities (UCITS), which are not taxed locally.

END FOOTNOTES

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