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Individual Addresses Intersection of Transition Tax and NIIT

OCT. 2, 2018

Individual Addresses Intersection of Transition Tax and NIIT

DATED OCT. 2, 2018
DOCUMENT ATTRIBUTES

October 2, 2018

CC:PA:LPD:PR (REG-104226-18)
Internal Revenue Service, Room 5203
P.O. Box 7604, Ben Franklin Station
Washington, DC 20044

Re: Comment on proposed regulation § 1.965-3(f)(3)

To whom it may concern,

This comment letter relates solely to proposed regulation § 1.965-3(f)(3), which provides that the “section 965(c) deduction” is not allowed in the computation of Net Investment Income (NII) under § 1411 (the Net Investment Income Tax, or NIIT).1 This comment letter recommends that the section 965(c) deduction be allowed as a deduction in computing NII. Further, this letter will also show that the section 965(c) deduction is already allowed as a deduction by reason of regulation § 1.1411-4(f)(3)(ii), and thus the proposed regulation § 1.965-3(f)(3) is contrary to an existing regulation. As a result, proposed regulation § 1.965-3(f)(3) should be amended or stricken altogether.

1. Overview

Proposed regulation § 1.965-3(f)(3) provides that for purposes of § 1411 and regulation § 1.1411-4(f)(6), a section 965(c) deduction is not treated as a deduction properly allocable to a corresponding “section 965(a) inclusion.”

The preamble to the proposed regulations under § 965 notes that the section 965(c) deduction is intended to reduce the rate of income tax applicable to the section 965(a) inclusion and goes on to cite H.R. Rep. No. 115-466, at 620 (2017) (Conf. Rep.). The Treasury Department and the IRS have determined that the section 965(c) deduction was not intended to reduce the rate of tax imposed by non-income tax provisions outside of chapter 1.2

2. Section 1411

Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010, Public Law 111-152, (HCERA) added § 1411 to a new chapter 2A of subtitle A (Income Taxes) of the Code effective for taxable years beginning after December 31, 2012.

Because § 1411 is within subtitle A, and subtitle A covers income taxes, the statement in the preamble to the proposed regulations under § 965 concluding that § 1411 is a “tax imposed by non-income tax provisions outside of chapter 1” is factually incorrect. Section 1411 is an income tax. Thus, to the extent that the decision to deny the section 965(c) deduction was based on this premise, it should be reconsidered.

a. Calculation of NIIT

In the case of an individual, § 1411(a)(1) imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to 3.8 percent of the lesser of: (A) the individual's net investment income for such taxable year, or (B) the excess (if any) of: (i) the individual's modified adjusted gross income (MAGI) for such taxable year, over (ii) the threshold amount. Section 1411(b) provides that the threshold amount is: (1) in the case of a taxpayer making a joint return under § 6013 or a surviving spouse (as defined in § 2(a)), $250,000; (2) in the case of a married taxpayer (as defined in § 7703) filing a separate return, $125,000; and (3) in the case of any other individual, $200,000.

Consistent with section 3.06 of Notice 2018-26, proposed regulation § 1.965-3(f)(1) provides that the section 965(c) deduction will not be treated as an itemized deduction for any purpose of the Code.

Because the section 965(c) deduction is taken into account in computing a taxpayer's AGI, it is already taken into account in computing the tax base on which the 3.8% rate is imposed. To the extent that the section 965(c) deduction causes the taxpayer's MAGI to be less than his NII, the taxpayer gets the benefit of the deduction for NIIT purposes. But in the case of taxpayers with NII that is less than MAGI, even with the section 965(c) deduction, these taxpayers are harmed by proposed regulation § 1.965-3(f)(3)'s disallowance of the deduction. In effect, some taxpayers are getting the benefit of the deduction and others are not. By allowing the section 965(c) deduction to reduce NII, you will treat all taxpayers with section 965 inclusions equally.

b. Section 1411 regulations that permit the section 965(c) deduction

Regulation § 1.1411-1(f)(1)(i) provides that “unless provided elsewhere in §§ 1.1411-1 through 1.1411-10, only properly allocable deductions described in this paragraph (f) may be taken into account in determining net investment income.”

Regulation § 1.1411-4(f)(3) provides that in determining net investment income, “the following itemized deductions are taken into account . . . (ii) Investment expenses (as defined in section 163(d)(4)(C)).”

In order to determine which deductions are allowed in computing NII, one must determine which deductions are included in § 163(d)(4)(C). As demonstrated below, the section 965(c) deduction is included by § 163(d)(4)(C). As a result, proposed regulation § 1.965-3(f)(3) is in conflict with regulation § 1.1411-4(f)(3)(ii).

c. Section 163(d)

Section 163(a) provides that, in general, a deduction is allowed for all interest paid or accrued within the taxable year on indebtedness. Section 163(h)(1) provides that a noncorporate taxpayer is not entitled to a deduction for personal interest paid or accrued during the taxable year. Section 163(h)(2) provides that personal interest does not include interest paid or accrued on indebtedness properly allocable to a trade or business (other than the trade or business of performing services as an employee) or investment interest, as defined in § 163(d).

Section 163(d)(1) provides that the amount allowed as a deduction for investment interest for any taxable year by a noncorporate taxpayer shall not exceed the amount of the taxpayer's net investment income for the taxable year.

Section 163(d)(4)(C) provides that the term “investment expenses” means the deductions allowed under this chapter (other than for interest) which are directly connected with the production of investment income.

Section 163(d)(5)(A) provides that the term “property held for investment” shall include:

(i) any property which produces income of a type described in § 469(e)(1), and

(ii) any interest held by a taxpayer in an activity involving the conduct of a trade or business that is not a passive activity and with respect to which the taxpayer does not materially participate.

Section 163(d)(5)(B) provides that “in the case of property described in subparagraph (A)(i), expenses shall be allocated to such property in the same manner as under section 469.” The relevancy of § 163(d)(5)(B) is to link § 469 to § 163(d).

As I explain in the next part, a specified foreign corporation, as defined in § 965(e)(1), is “property which produces income of a type described in § 469(e)(1).” As a result, the § 469 rules will allocate the section 965(c) deduction to that “property held for investment.” By reason of § 163(d)(5)(B), the section 965(c) deduction becomes a deduction described in § 163(d)(4)(C). The result is, as initially stated, that the section 965(c) deduction is already properly allocable and deductible to net investment income by reason of regulation § 1.1411-4(f)(3)(ii).

d. Section 469

i. Treatment of section 965(a) amounts

Section 469(e)(1)(A)(i)(I) provides that income from interest, dividends, royalties, and annuities is classified as portfolio income unless such income is derived in the ordinary course of a trade or business.

Regulation § 1.469-2T(c)(3) provides that passive activity gross income does not include portfolio income, which is defined as gross income that is derived from specified sources (including interest, dividends, annuities, and royalties) and is not derived in the ordinary course of a trade or business. Regulation § 1.469-2T(c)(3)(i)(A) specifically states:

Passive activity gross income does not include portfolio income. For purposes of the preceding sentence, portfolio income includes all gross income, other than income derived in the ordinary course of a trade or business (within the meaning of paragraph (c)(3)(ii) of this section), that is attributable to —

(A) Interest (including amounts treated as interest under paragraph (e)(2)(ii) of this section, relating to certain payments to partners for the use of capital); annuities; royalties (including fees and other payments for the use of intangible property); dividends on C corporation stock; and income (including dividends) from a real estate investment trust (within the meaning of section 856), regulated investment company (within the meaning of section 851), real estate mortgage investment conduit (within the meaning of section 860D), common trust fund (within the meaning of section 584), controlled foreign corporation (within the meaning of section 957), qualified electing fund (within the meaning of section 1295(a)), or cooperative (within the meaning of section 1381(a));

Regulation § 1.469-2T(c)(3)(ii)(A) through (c)(3)(ii)(G), which implements § 469(e)(1), identifies several situations where income, such as interest, dividends, royalties, or annuities, are derived in the ordinary course of a trade or business and therefore are not portfolio income. If the income items do not fall into one of these situations, they are not derived in the ordinary course of a trade or business and, therefore, are treated as portfolio income.

Generally, if property is held for investment purposes pursuant to § 163(d), it is not held in the ordinary course of a trade or business. There are a series of cases and rulings that stand for the proposition that property does not need to currently produce portfolio income (such as interest or dividends) in order to be classified as investment property. Thus, stock of a corporation is treated as held for investment purposes even if the corporation never pays a dividend.3

The section 965(a) inclusion is treated as subpart F income, regardless of whether it is from a CFC or a foreign corporation with at least one 10% domestic corporation shareholder. While regulation § 1.469-1T(c)(3)(i)(A) does not state that “subpart F income” is portfolio income, the reference to income from a CFC includes subpart F income. Therefore, the section 965(a) inclusion from a CFC is treated as portfolio income (provided stock of the CFC is not held in the ordinary course of a trade or business).

Furthermore, stock of a foreign corporation with at least one 10% domestic corporate shareholder is treated as held for investment regardless of whether or not a dividend is paid (unless it is attributable to an activity listed in regulation § 1.469-1T(c)(3)(ii) such as income or gain derived in the ordinary course of the trade or business of trading or dealing in any property). Therefore, the section 965(a) inclusion from a specified foreign corporation that is a foreign corporation with at least one 10% domestic corporate shareholder is treated as portfolio income under § 469(e)(1). As a result, such stock is considered property held for investment under § 163(d)(5)(A)(i).

ii. Treatment of section 965(c) amounts

Section 469(e)(1)(A)(i)(II) provides that expenses (other than interest) that are clearly and directly allocable to such income described in § 469(e)(1)(A)(i)(I) are portfolio deductions.

Regulation § 1.469-2T(d)(4) provides that, for purposes of § 469 and the regulations thereunder, an expense (other than interest expense) is clearly and directly allocable to portfolio income (within the meaning of paragraph (c)(3)(i) of this section) if and only if such expense is incurred as a result of, or incident to, an activity in which such gross income is derived or in connection with property from which such gross income is derived.

In order for the section 965(c) deduction to not be deductible against § 1411's NII, the government must determine that it is not an investment expense under § 163(d)(4)(C). In order to conclude it is not an expense under § 163(d)(4)(C), it must conclude under § 163(d)(5)(B) that it is not allocable to property held for investment under § 469. In order to conclude that the expense is not allocable to portfolio income under regulation § 1.469-2T(d)(4), it must conclude that the section 965(c) deduction is not incurred as a result of, or incident to, an activity in which such gross income is derived or in connection with property from which such gross income is derived. Only when that occurs will the section 965(c) deduction not be deductible against § 1411's NII.

It is my view that the section 965(c) deduction is clearly and directly allocable to the section 965(a) inclusion. A taxpayer cannot have section 965(c) deduction without a section 965(a) inclusion. In my opinion, it is hard to construct an argument where the section 965(c) deduction is not incurred in connection with property (the stock of a specified foreign corporation) from which such gross income is derived (the section 965(a) inclusion).

Therefore, because the section 965(c) deduction is allocable to the specified foreign corporation under regulation § 1.469-2T(d)(4), it is allocable to property held for investment under § 163(d). As a result, it becomes a deduction described in § 163(d)(4)(C), and therefore is deductible in computing NII by reason of regulation § 1.1411-4(f)(3)(ii).

3. The purpose of section 1.1411-4(f)(6)

Regulation § 1.1411-4(f)(6) provides that any other deduction allowed by subtitle A that is identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter) is properly allocable to gross income or net gain under this section. Proposed regulation § 1.965-3(f)(3) refers to this provision of the NIIT regulations. However, regulation § 1.1411-4(f)(6) is not relevant in the context it was used in proposed regulation § 1.965-3(f)(3). To understand why this provision is not relevant, the government should consider the context of why it was created. The preamble to the final NIIT regulations (TD 9644) provides, in relevant part, an explanation:

D. Properly allocable deductions described in section 1411(c)(1)(B)

Section 1411(c)(1)(B) provides that net investment income includes deductions allowed by subtitle A that are properly allocable to gross income or net gain described in section 1411(c)(1)(A). Section 1.1411-4(f)(1)(i) of the proposed regulations provided that “[u]nless specifically stated otherwise, only properly allocable deductions described in this paragraph (f) may be taken into account in determining net investment income.” Specifically, proposed § 1.1411-4(f)(3) provided that properly allocable deductions include: (A) investment interest expense, (B) investment expenses described in section 163(d)(4)(C), and (C) state, local, and foreign income taxes described in section 164(a)(3). The Treasury Department and the IRS intend this rule to limit the deductions against net investment income to those specifically enumerated in paragraph (f).

One commentator recommended that the final regulations provide that the phrase “properly allocable deductions” comprise all of the chapter 1 deductions that are allowed against chapter 1 gross income from rent, dividends, royalties, annuities and interest, other gross income derived from a trade or business, and net gains attributable to the disposition of property other than property held in a trade or business.

The Treasury Department and the IRS believe the recommended language would permit taxpayers to argue that they can take deductions that have no direct relation to net investment income, and it would lead to uncertainty and to disputes between taxpayers and the IRS over what constitutes properly allocable deductions. However, the Treasury Department and the IRS acknowledge that flexibility is needed within § 1.1411-4(f) so that future changes in law or circumstances can be more easily integrated into the regulations. Although the cross-references in § 1.1411-4(f)(2) to deductions described in section 62(a) provide section 1411(c)(1)(B) flexibility to automatically take into account additions or changes to chapter 1 deductions attributable to trades or businesses, rents, and royalties, these regulations would have to be amended to expand properly allocable deductions in the event of such changes not captured by section 62(a)(1) or 62(a)(4). To strike a balance between the intent of the proposed rule (to provide a specific list of deductions to limit uncertainty and controversy) and the recognized value of future flexibility inherent in the commentators' recommendation, § 1.1411-4(f)(6) of the final regulations allows the Treasury Department and the IRS to publish additional guidance in the Internal Revenue Bulletin that expands the list of properly allocable deductions.

To rephrase the preamble, regulation § 1.1411-4(f)(6) allows the Treasury Department and the IRS to expand the definition of what are considered properly allocable deductions under § 1411(c)(1)(B), but it does not allow taxpayers to do it themselves. Therefore, this provision can only be activated by the Treasury Department and the IRS by express reference to a new deduction. As a result, the only time that regulation § 1.1411-4(f)(6) could have relevance with respect to the section 965(c) deduction is if (a) the section 965(c) deduction is expressly allowed in computing NII in the section 965 final regulations, and (b) it is not already deductible by reason of another provision in § 1.1411-4(f). For example, it should be used in this manner:

To the extent the taxpayer has an election under regulation § 1.1411-10(g) in place with regard to a specified foreign corporation (as defined in § 965(e)(1)), then pursuant to regulation § 1.1411-4(f)(6) and § 1411(c)(1)(B), a section 965(c) deduction shall be treated as properly allocable to any section 965(a) inclusion that is taken into account in computing net investment income with respect to that specified foreign corporation.

If you have any questions, I can be reached at 703-966-0852.

Sincerely,

David Kirk4
McLean, VA

This letter represents my personal views on the subject and do not represent the views of any taxpayer other than myself.

Cc:
Adrienne Mikolashek, Branch Chief, CC:PSI:B03 

FOOTNOTES

1All section references are to the Internal Revenue Code of 1986, as amended, or the Treasury
regulations promulgated thereunder.

2If Congress intended that §965(c) not be a deduction allowed outside of chapter 1, it knows how
to do that. See §199A(f)(3). Therefore, given that absence of legislative history, the conclusion provided in the
preamble cannot be free from doubt.

3See Russon v. Comm'r, 107 T.C. 263 (1996).

4Former attorney, CC:PSI:B02 (2008-2014); Co-author, Net Investment Income Tax (NIIT) regulations.

END FOOTNOTES

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