Company Presses for Broader Transitional Rules on Excess Foreign Taxes

30 August 2018

David J Kautter
Assistant Secretary for Tax Policy, and Acting Commissioner, Internal Revenue Service
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

William M Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20220

Re: 2017 Tax Cuts and Jobs Act (P.L. 115-97) (the “TCJA”)/Need for Transitional Guidance under IRC § 904(d)

Dear Messrs Kautter and Paul

We refer to the letter to you of August 6, 2018 from PricewaterhouseCoopers LLP (“PwC”) written on behalf of one of its clients, a U.S. corporation, and explaining the urgent need for transitional rules concerning the carryover of pre-TCJA foreign tax credits in the general category “basket” to offset tax on post-TCJA foreign source income falling into the new foreign tax credit “baskets” created by the TCJA.

We are writing on behalf of a significant part of our client base generally, namely U.S. citizens resident overseas. We assist more than 2,000 such individuals annually with their U.S. tax compliance. Such individuals face worldwide double taxation, namely residence-based taxation overseas and citizenship-based taxation in the U.S., and the principal mitigating factor is the foreign tax credit which the U.S grants in respect of foreign taxes paid or accrued. These individuals need urgent guidance regarding transitional rules for their foreign tax credit carryovers to 2018 and, due to their particular circumstances, a more liberal transitional rule than that proposed by PwC may be appropriate.

Background

Changes to the foreign tax credit rules enacted as part of the TCJA included the addition of two categories of income, namely (1) foreign branch income and (2) income includible under new IRC § 951A (GILTI), as categories for which the foreign tax credit limitation of IRC § 904(a) must be determined separately under § 904(d). This is commonly referred to as separate “basket” treatment.

IRC § 904(c) provides for a one-year carryback and 10-year carryover of foreign tax credits that are not utilized in the year such taxes are paid or accrued. Consistent with the other provisions of § 904, carrybacks and carryovers are made on a basket-by-basket basis.¹

On the last two occasions when Congress modified foreign tax credit baskets (in the 1986 Tax Reform Act and the 2004 American Jobs Creation Act), the amendments to § 904(d) included statutory transitional rules which specified how carryovers from the baskets maintained under prior law should be apportioned to the baskets required to be maintained under the new law, and vice versa in the case of carrybacks. Such rules were essential to allow taxpayers to know with certainty how much U.S. tax liability they would face under the amended rules and what planning would be appropriate to optimize the utilization of their foreign tax credits.

Although the need for such transitional rules is as at least as important for the TCJA changes as for the previous changes, those rules have not been specified in the statute, and there is no commentary in the Congressional Committee Reports to indicate whether this was deliberate. Without a transitional rule, it would seem that, on the one hand, carryovers from the pre-TCJA “general category’’ basket (which would have included foreign branch income) could only be utilized to offset tax on income in the post-TCJA general category basket, which will exclude foreign branch income, while, on the other hand, the one-year carryback from the post-TCJA foreign branch income basket would simply not be utilizable given that this basket did not exist in 2017. Such a result is unacceptable as a matter of sound tax policy and potentially inconsistent with the U.S.’ obligations under its double tax treaties, which contemplate that the U.S. will apply amendments to its domestic foreign tax credit provisions only to the extent they are not inconsistent with the general principle of providing relief from double taxation.

Taxpayers need assurance that the Treasury Department will promulgate transitional rules that address the change in foreign tax credit baskets and an indication of what those transitional rules will provide.

This is required urgently to permit basic planning. For reasons discussed below, we urge the Treasury Department to provide transitional rules under which taxpayers will be allowed to apply credits in the general limitation basket carried forward from 2017 and prior years to offset tax on income in either the general category or foreign branch baskets from 2018 forward.

Analysis

As reflected in Article 23 of the OECD Model Income Tax Treaty, OECD member states typically eliminate double taxation either through an exemption method, under which income permitted to be taxed by the country of source is exempted from tax in the country of residence, or a credit method, under which tax imposed by the country of source is allowed as a credit against tax imposed by the country of residence. While a credit method is more complex to apply than an exemption, it has the advantage, from the standpoint of the country of residence, of allowing that country to impose tax to the extent not offset by credit.

The U.S. follows the credit method, but rather than apply it on a source-by-source basis, as provided in the OECD Model Treaty, under U.S. rules a taxpayer’s foreign tax credits are pooled and offset against the proportion of his U.S. tax liability which is attributable to foreign source income (the foreign tax credit limitation). IRC § 904(a). To prevent loss of credit through timing differences, carrybacks and carryovers of excess foreign tax credits are allowed under § 904(c), as explained above. On the other hand, separate “basket” treatment is provided for certain categories of income in order to eliminate inappropriate cross-crediting, i.e. averaging of foreign income taxed at rates in excess of U.S. rates with foreign income taxed at lower rates so as to achieve an overall rate of foreign tax that is within the foreign tax credit limitation. The recent evolution of the foreign tax credit baskets reflects efforts by Congress to prevent cross-crediting in cases where this will significantly increase tax, while not making the rules so complicated as to hamper administration.

a. 1986 Tax Reform Act (TRA) Changes

Prior to the 1986 TRA, four comparatively narrow separate baskets were provided for. First of these was a basket for foreign source interest income. The fifth and final catch-all basket, comprising all income not included in the first four enumerated baskets, corresponds to what is now referred to as the “general category” basket.

In the 1986 TRA Congress significantly increased the number and size of the separate baskets. According to the legislative history, income targeted was of a type which (i) tended to bear little foreign tax, or an abnormally high rate of foreign tax, or (ii) which was “manipulable as to source”. One lasting contribution of the 1986 legislation was the expansion of the first basket, previously comprising only interest income, to comprise all income that would be "foreign personal holding company” in the hands of a controlled foreign corporation under IRC § 954(c), e.g. dividends, interest, passive rents and royalties and most capital gains. This is now referred to as the “passive category basket”. Additional separate baskets were created for, inter alia, financial services income and shipping income (income manipulable as to source) and high withholding tax interest. The general category basket duly became the ninth and final basket.

Transitional rules for carryovers under the 1986 TRA were provided in IRC § 904(d)(2)(I). Carryovers from the pre-2006 TRA interest basket were to be attributed to the new expanded passive basket. Carryovers from the previous general category basket were to be attributed to the new, diminished, general category basket except to the extent the taxpayer could demonstrate that such carryovers would have belonged in the financial services or shipping income baskets if the 2006 TRA rules had applied before 2007.

b. 2004 American Jobs Creation Act (AJCA) Changes

Experience in administering the nine baskets of the 1986 TRA had led to the conclusion that there were far too many baskets. The 2004 ACJA amended § 904 to reduce the number of baskets to two-the passive category basket was retained, and the remaining baskets folded into the general category basket, effective for tax years beginning after 2006.

Transitional rules for both carryovers and carrybacks were again provided. Under IRC § 904(d(2)(K)(i), taxes carried forward from pre-2007 years were to be assigned to the basket that they would have been assigned to under the post-2006 rules. The Treasury Department simplified matters in regulations, providing that a taxpayer could treat all carryovers other than from the passive basket as being general category income. Regulations were also authorized to provide for an allocation of carrybacks from post-2006 years to pre-2007 baskets.

c. 2017 Tax Cuts and Jobs Act (TCJA) Changes

As noted above, we agree with PwC that Congress’ failure to provide for transitional rules to address carryovers from pre-TCJA years to post-TCJA baskets does not eliminate the need for such rules, both as a matter of fairness and in recognition of the U.S.’s treaty commitments.

A question arises as to what degree transitional rules adopted in connection with the 1986 TRA and/or 2004 ACJA should be a guide to what is needed on this occasion.

The 1986 TRA changes are more analogous to what has occurred under the TCJA than the 2004 ACJA changes since, like the TCJA changes, the 1986 legislation involved the adding of new separate baskets. If rules analogous to the 1986 TCJA transitional rules were adopted for the TCJA changes, there would be a default rule that pre-TCJA general category carryovers would be allocated to the post-TCJA general category basket, subject to the ability of taxpayers to prove that pre-TCJA general category carryovers would have been attributed to the foreign branch basket under the application of the post-TCJA rules.

This is consistent with PwC’s proposal, but in our opinion because of the position, inter alia, of U.S. citizens resident abroad the transitional rule should be more liberal and simply allow the taxpayer to choose to which of the post-2017 foreign branch and general category baskets any pre-2018 general category carryovers should be apportioned. Under the 1986 TRA, the only taxpayers required to prove pre-1987 carryovers were attributable to post-1986 baskets were those in receipt of shipping income or financial services income, which would have been a relatively small subset of the taxpayers affected by the legislation. On the other hand, taxpayers in receipt of foreign branch income, which in the case of individuals would include self-employment income or partnership income attributable to a trade or business carried on outside the U.S., represent a far larger subset of the set of taxpayers having foreign tax credit carryovers. Moreover, individual taxpayers in receipt of foreign branch income are far more likely than domestic corporate taxpayers also to have received general limitation income outside the foreign branch basket, e.g. salaries for overseas services, income from overseas pensions, high-taxed income (§ 904(d)(2)(F)), and tax base difference income (§ 904(d)(2)(H)). In the case of U.S. citizens resident overseas, who will typically have been liable to foreign tax on their worldwide income, the task of deconstructing ten years’ worth of foreign tax credit carryovers to determine to what extent those carryovers would fall into the foreign branch or general category baskets under the post-TCJA rules would be a hugely burdensome exercise, even assuming adequate records were available. As the pre-TCJA rules did not make it necessary to maintain the records needed to perform such an exercise, it can’t be assumed most individual taxpayers would be in a position to do so.

Allowing taxpayers with pre-TCJA general category basket carryovers to allocate them freely amongst the post-TCJA foreign branch and general category baskets does not in any sense represent a windfall to those taxpayers. But for the TCJA changes, taxpayers would have had this flexibility. There is no indication that, in enacting the TCJA changes, Congress intended to make less useable those foreign tax credit carryovers that had already accrued.

Thank you for this opportunity to provide our views on this vital issue for many Americans resident overseas. If you have any questions, please contact Jeffrey Gould at +4420 7833 3500.

Yours sincerely

Frank Hirth Plc
London, UK

Cc
Mr Lafayette G. "Chip” Harter III
Deputy Assistant Secretary
International Tax Affairs
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Marjorie Rollinson
Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20220

Barbara Felker
Branch Chief, Branch 3, Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20220