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Individual Seeks Clarification Under FDII, GILTI Regs  

MAY 6, 2019

Individual Seeks Clarification Under FDII, GILTI Regs  

DATED MAY 6, 2019
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May 6, 2019

CC:PA:LPD:PR (REG-104464-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Comments on Proposed Regulations under Section 250

Dear Sir or Madam:

I appreciate the opportunity to comment on the proposed regulations entitled “Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income” (REG-104464-18) (the “Proposed Regulations”), 84 F.R. 8188 (March 6, 2019), which was issued under section 250,1 as enacted by the tax reform and simplification law formerly known as the Tax Cuts and Jobs Act of 2017 (P.L. 115-97).

These comments are provided in my capacity as an individual and cover the interaction of section 250 with other tax provisions that contain similar taxable-income-based limitations, such as section 163(j) and section 172.

As I had noted in a prior comment to the section 163(j) proposed regulations, 83 F.R. 67490 (Dec. 28, 2018),2 some commentators have stated that the simultaneous application of multiple taxable-income-based limitations would result in an infinite number of computational steps, which cannot have a finite solution. A comparable comment was made around the 5th century B.C.E by Zeno of Elea; he claimed “that which is in locomotion must arrive at the half-way stage before it arrives at the goal,” such that it was impossible to complete the infinite number of steps of crossing increasingly smaller distances.3 Similar to how Diogenes supposedly disproved Zeno's Paradox by getting up and walking, this comment attempts to show how to give proper and definite effect to all of the taxable-income-based limitations, in a manner that is simpler and more accurate than the method in the Proposed Regulations.4

Introduction

Section 250(a)(1) allows a domestic C corporation to claim a deduction equal to 37.5% of its foreign-derived intangible income (“FDII”), which is reduced to a 21.875% deduction in 2026 and later. Section 250(a)(2) further provides that the FDII-related section 250 deduction is limited to 37.5% (or 21.875%) of the corporation's taxable income determined without regard to section 250.

Section 163(j)(1) generally provides that a taxpayer's deductible net business interest expense is limited to 30% of “adjusted taxable income” (“ATI”), which is generally the taxpayer's taxable income computed under section 163(j)(8)(A) without regard to interest expense, the section 172 net operating loss (NOL) deduction, the section 199A pass-through business income deduction, and (in 2018 through 2021) any depreciation, amortization, or depletion.

Section 172(a) provides that a taxpayer's NOL deduction is limited to 80% of the taxpayer's taxable income, computed without regard to the section 172 NOL deduction, for taxable years beginning in 2018 and later.

In considering the interactions of the different taxable income limitations in section 250(a)(2), section 163(j), and section 172(a)(2), the preamble to the Proposed Regulations states that:5

The Code does not otherwise define “taxable income” for purposes of applying the taxable income limitation of section 250(a)(2).

In general, a taxpayer's taxable income is based, in part, upon the availability, and proper calculation, of deductions. However, multiple Code provisions simultaneously limit the availability of a deduction based, directly or indirectly, upon a taxpayer's taxable income, including sections 163(j)(1) (limiting a deduction for business interest) and 172(a)(2) (limiting a net operating loss deduction). Sections 163(j)(2) and 172(b) also provide that any deduction not allowed to a taxpayer for a taxable year by reason of the limitation in section 163(j)(1) or 172(a)(2), respectively, may be allowed to the taxpayer, subject to the same limitation, in its succeeding taxable year. A taxpayer's net operating loss for a taxable year is determined without regard to the section 250 deduction (see section 172(d)(9)), and a taxpayer's adjusted taxable income is determined without regard to section 172. See section 163(j)(8)(A)(iii). However, neither section 163(j) nor section 250 prescribes an ordering rule with respect to the other provision.

The Treasury Department and the IRS considered proposing computations requiring the use of simultaneous equations in lieu of an ordering rule but determined that an approach that requires such computations would result in undue administrative and compliance burdens. Therefore, the proposed regulations provide an ordering rule for applying sections 163(j) and 172 in conjunction with section 250 that the Treasury Department and the IRS have determined is consistent with the statutory language for each provision.

The Proposed Regulations then describes an iterative and complex 5-step solution to the simultaneous application of section 250, section 163(j), and section 172:6

1. First, the domestic corporation computes its tentative FDII and FDII-related section 250 deduction, without regard to any section 163(j) limitations, any section 172 NOL deduction, or the section 250(a)(2) taxable income limitation,

2. Second, the domestic corporation computes its allowed business interest deduction under section 163(j), taking into account the tentative section 250 deduction but not any section 172 NOL deduction,

3. Third, the domestic corporation computes its section 172 NOL deduction, taking into account the allowed business interest deduction under section 163(j) and the section 172(a)(2) taxable income limitation, but without regard to the section 250 deduction (or tentative section 250 deduction),

4. Fourth, the domestic corporation computes its FDII, taking into account the allowed business interest deduction under section 163(j) and the section 172 NOL deduction, and

5. Fifth, the domestic corporation computes its section 250 deduction, after the application of the section 250(a)(2) taxable income limitation, the allowed business interest deduction under section 163(j), and the section 172 NOL deduction.

The 5-step process is not explicitly stated in the Proposed Regulations but can be extrapolated from a 1,200-word example in Treas. Reg. § 1.250-1(f)(2) Ex. 2.

The Proposed Regulations appear to disregard the section 250 deduction in determining the section 172(a)(2) NOL taxable income limitation, which is contrary to the statutory language in section 172(a)(2) that adds back the NOL deduction to its taxable income but does not add back any section 250 deduction. The Proposed Regulations should indicate whether the change was intentional and the policy and statutory basis for the change. Treasury may be exercising its regulatory authority to incorporate a future technical correction to section 172; U.S. House Ways and Means Committee Chairman Kevin Brady released a Tax Technical and Clerical Corrections Act (Discussion Draft) on January 2, 2019, which in section 4(p) provide that the section 172(a)(2) NOL taxable income limitation should be applied to taxable income without regard to any deduction allowable under sections 172, 199A, and 250 (not just section 172).

In either event, the 5-step process is inconsistent with the statutory language and can significantly increase costs, burden, and administrative complexity. One statutory justification for the 5-step process, according to the preamble, seems to be that “[t]he Code does not otherwise define “taxable income” for purposes of applying the taxable income limitation of section 250(a)(2).”7 In fact, section 64(a) appears to define “taxable income,” for purposes of subtitle A of the Code, as equal to gross income minus the deductions allowed by chapter 1 (other than the standard deduction).8 Subtitle A of the Code consists of sections 1 through 1563, which includes section 250.

A single and consistent definition of “taxable income” throughout subtitle A of the Code is important because sections 1 and 11 generally impose the U.S. federal income tax on a taxpayer's “taxable income.” The Proposed Regulations' 5-step process is inconsistent with other Code sections and regulations that refers to “taxable income” as defined in section 64(a), sometimes with explicit modifications, such as Prop. Treas. Reg. § 1.250-1(c)(4), which provides that “a domestic corporation's taxable income under the previous sentence [for section 250(a)(2) purposes] is determined taking into account the application of sections 163(j) and 172(a).”

For comparison, the section 163(j)(8)(A) definition of ATI adds back both the section 172 NOL deduction and the section 199A deduction, with the result that section 163(j) is applied before either of those provisions. Congress clearly knew how to provide for ordering rules in the many instances when it chose to do so, yet the section 163(j) definition of ATI does not add back the section 250 deduction.

Simultaneous Equation Solution

According to the statutory language, ATI for section 163(j) purposes is reduced by the taxpayer's section 250 deduction, while “taxable income” for section 250(a)(2) purposes is reduced by the taxpayer's business interest expense. When multiple income-based limitations apply to a taxpayer at the same time, without specified ordering rules, the IRS has solved simultaneous equations in order to give proper effect to all the limitations.

Specifically, the IRS officially used algebra to resolve concurrent income-based deduction limitations in Rev. Rul. 79-347, 1979-2 C.B. 122. The ruling's domestic corporation taxpayer was entitled to a dividends received deduction (“DRD”) under section 243, equal at the time to 85% of its dividends from other domestic corporations. The taxpayer was also entitled to a section 613A percentage depletion deduction (“PD”) for certain income from oil and gas wells. The DRD was limited under section 246(b) to 85% of pre-DRD taxable income, which was reduced by any allowed PD. The PD was limited by section 613A(d) to 65% of pre-PD taxable income, which was reduced by any allowed DPD. The taxpayer therefore could not know its maximum DRD under the 85% limitation without knowing its PD, but it also could not know its maximum PD under the 65% limitation without knowing its DRD.

The IRS recognized the problem as two simultaneous equations with two unknowns, DRD and PD, based on a constant (TI) that is the taxpayer's taxable income before both deductions:

formula

The ruling applied some algebra to determine that the maximum allowed DRD was 66.5% of TI, and the maximum allowed PD was 21.8% of TI. For example, a taxpayer has $1,000 of taxable income before any DRD or PD. The maximum DRD is $665 and the maximum PD is $218, which results in net taxable income of $117. The results can be checked to confirm that the $665 maximum DRD is 85% of the taxpayer's $782 pre-DRD taxable income ($117 net taxable income plus $665 DRD addback). Similarly, the $218 maximum PD is 65% of the taxpayer's $335 pre-PD taxable income ($117 net taxable income plus $218 PD addback). See Appendix A for two computational methods.

Simultaneous equations appeared more recently in CCA 201226021 (June 29, 2012), which involved a corporate taxpayer that had both charitable contribution deductions and an alternative minimum tax net operating loss (AMTNOL) deduction. The charitable contribution deduction was limited by section 170(b)(2) to 10% of a corporation's pre-contribution taxable income, while the AMTNOL deduction was limited by section 56(d) to 90% of pre-AMTNOL taxable income. The IRS solved the simultaneous equations to conclude, with more precision than in Rev. Rul. 79-347, that the taxpayer's two deductions were limited to 1.0989010989011% and 89.010989010989%, respectively, of taxable income before both deductions.9

Sections 163(j), 250, 172

Simultaneous equations can similarly resolve the statutory interaction between section 163(j), section 172, and the FDII-related section 250. Algebraically, the taxpayer has taxable income before all three deductions of TI. Its maximum FDII-related section 250 deduction D is equal to 37.5% of its TI reduced by the interest deduction I and the NOL deduction N. Its maximum interest deduction I is equal to 30% of its ATI, which is TI reduced by the section 250 deduction D and increased by depreciation addback (and other ATI adjustments). Its maximum NOL deduction N is equal to 80% of TI reduced by the interest deduction I and the section 250 deduction D.

formula

The three equations and three unknowns (D, I, and N) can be solved to arrive at:

formula

The simultaneous equations approach is also more robust in the event that there are changes to the relevant Code sections due to future legislation. For a corporate taxpayer, the enactment of the technical correction described above to section 172(a)(2), adding back the section 250 deduction, would change the formula for the NOL deduction N to be based on TI minus only the interest deduction I:

formula

The resulting three equations with the same three unknowns can be promptly solved as:

formula

For example, a domestic corporation has $800 of FDII, $500 of interest expense (of which $400 relates to FDII), and $1,000 of taxable income before any deductions for interest, section 250, or NOL deductions. The domestic corporation has $1,000 of NOL carryovers subject to the section 172(a)(2) taxable income limitation. It has $200 of ATI addbacks.

Plugging in just the $1,000 of TI and $200 of ATI addback to the simultaneous equation solutions, the taxpayer has a maximum $49 section 250 deduction, a maximum $345 of business interest deductions under section 163(j), and a maximum NOL deduction of $524. The taxpayer's taxable income is $82.

In contrast, under the Proposed Regulations' approach, the calculations appear to be:

1. Compute tentative section 250 deduction of $150, equal to 37.5% of $400 net FDII ($800 FDII less $400 allocated interest),

2. Compute section 163(j) business interest limitation of $315, equal to 30% of $1,050 ATI ($1,000 TI minus $150 tentative section 250 deduction plus $200 ATI addback),

3. Compute NOL deduction of $548, equal to 80% of section 172(a)(2) taxable income ($1,000 TI reduced only by $315 business interest deduction), Steps 4/5. Compute the maximum section 250 deduction of $51, equal to 37.5% of $137 section 250(a)(2) taxable income ($1,000 TI reduced by $315 business interest deduction and $548 NOL deduction).

The end result is $86 of taxable income, which is a worse result than under the simultaneous equations approach.

In addition to the simultaneous equations approach being more consistent with the statutory language and giving rise to lower and more accurate taxable income amounts for some taxpayers, the simultaneous equations approach has the following additional benefits when compared to the Proposed Regulations' 5-step approach:

1. Easier to administratively confirm the correct deduction amounts.

Similar to NP complete problems, it is easy to check whether the simultaneous equation results agree with the statutory language. In the above example, the $49 section 250 deduction is equal to 37.5% of $131 pre-section-250 taxable income ($82 taxable income plus $49 section 250 deduction), the $345 business interest deduction is equal to 30% of $1,151 ATI ($82 taxable income plus $345 business interest deduction, $524 NOL deduction, and $200 ATI addback), and the $524 NOL deduction is equal to 80% of $655 section 172(a)(2) taxable income ($82 taxable income plus $524 NOL deduction and $49 section 250 deduction with technical correction).

In contrast, the Proposed Regulations' 5-step process produces a $315 business interest deduction that is only 27.4% of the taxpayer's $1,149 ATI ($86 taxable income plus $315 business interest deduction, $548 NOL deduction, and $200 ATI addback). It is not apparent whether the deduction is consistent with the statutory requirement that the business interest deduction is limited to 30% of ATI. The difficulty of verifying the final deductions may give rise to additional costs, burden, and administrative complexity for both taxpayers and the IRS.

2. Simpler calculations for taxpayers not subject to all limits.

For a taxpayer who is in fact not subject numerically to a taxable income limitation, the simultaneous equations approach allows the taxpayer to first compute that deduction in the normal fashion, and then apply any remaining simultaneous equations solutions. For example, if a taxpayer has only a small amount of post-2017 NOL carryovers such that it is not subject to the section 172(a)(2) taxable income limitation, the simultaneous equations approach would allow the taxpayer to first compute and claim its NOL deduction under generally applicable rules, and then apply the remaining taxable income limitations and any simultaneous effects with other deductions. In contrast, the Proposed Regulations effectively requires all taxpayers to use the 5-step process, even for taxpayers who are not in fact subject to the taxable income limitations, which may give rise to additional costs, burden, and administrative complexity.

3. Increased flexibility following a change in statute.

As shown above, the simultaneous equations approach allows taxpayers to independently and quickly determine the new solutions in the event of later changes to the relevant Code sections. In contrast, it is unclear how the Proposed Regulations' 5-step approach should be modified after future legislation, in which case the taxpayers may have to wait over another 400 days for Treasury to issue regulations and prescribe new ordering rules. Such a delay may give rise to additional costs, burden, and administrative complexity and increase the chances that similarly situated taxpayers would interpret the statute differently.

4. Easier to generalize to other taxable income limitations, such as section 246(b).

The Proposed Regulations' 5-step approach takes into account only the taxable income limitations under section 163(j), section 172, and section 250. It is unclear how taxpayers should apply any ordering rules when additional taxable income limitations are applicable, such as under section 170(b)(2) for corporate charitable contributions. Appendix B is an article that contains the following chart of the various limitations:

table for section 172 and section 250

The simultaneous equations approach would allow taxpayers to determine the proper steps and results when four or more taxable income limitations apply at the same time, which may reduce costs, burden, and administrative complexity and minimize the chances that similarly situated taxpayers would interpret the statute differently.

Appendix B, at page 577, also discusses the simultaneous equations that may apply to a U.S. individual who is subject to the section 199A(a)(2) taxable income limitation and the section 250(a)(2) taxable income limitation at the same time, due to the individual making a section 962 election and being allowed the GILTI-related section 250 deduction under Prop. Treas. Reg. § 1.962-1(b)(1)(i)(B)(3). In order to reduce costs, burden, and administrative complexity, and to minimize the chances that similarly situated taxpayers would interpret the statute differently, the final regulations should confirm the interaction of the different individual-level taxable income limitations with a few examples.

The Tax Technical and Clerical Corrections Act (Discussion Draft) would change two of the above simultaneous interactions and create new ordering rules for (i) the section 172(a)(2) NOL deduction limitation and the section 199A pass-through business income deduction limitation, and (ii) the section 172(a)(2) NOL deduction limitation and the section 250 deduction. No similar technical correction is made for the section 163(j), which continues to not add back the section 250 deduction and confirms that the existing statute's simultaneous approach is the proper one.

The preamble to the Proposed Regulations summarily dismissed the simultaneous equations approach as “resulting in undue administrative and compliance burdens.”10 The Proposed Regulations did not fully explain the actual simultaneous equations approaches considered by the Treasury and the merits of each one. For example, Treasury may have tried to use Lagrange multipliers in order to provide more optimal solutions, or Treasury may have made the more elementary mistake of falling for Zeno's Paradox. Given that Executive Orders 13563 and 12866 direct Treasury to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits (including potential economic, environmental, public health and safety effects, distributive impacts, and equity), it would be helpful for the final regulations to provide a more detailed explanation of the different approaches considered by Treasury and the costs and benefits of each one.

Since the above simultaneous equation computations may be complicated for less sophisticated taxpayers or result in higher taxable income for other taxpayers, the final regulations can make them elective. For comparison, the interest expense allocation rules of Treas. Reg. § 1.861-10T(e)(1)(iv)(B) has an elective quadratic formula, which is illustrated by Treas. Reg. § 1.861-12T(j) Ex. 2:11

formula

The final regulations may similarly provide a simplified elective computation for the FDII-related section 250 deduction.

I would be pleased to discuss these comments if you believe it would be helpful.

Respectfully submitted,

Libin Zhang


Appendix A

In Rev. Rul. 79-347, 1979-2 C.B. 122, a domestic corporation taxpayer was entitled to a dividends received deduction (y) under section 243, equal at the time to 85% of its dividends from other domestic corporations. The taxpayer was also entitled to a section 613A percentage depletion deduction (x) for certain income from oil and gas wells. The y amount was limited under section 246(b) to 85% of pre-y taxable income, which was reduced by x. The x amount was limited by section 613A(d) to 65% of pre-x taxable income, which was reduced by y. The IRS recognized the problem as two simultaneous equations with two unknowns, x and y, based on a constant (G) that is the taxpayer's taxable income before both deductions:

formula

The ruling applied variable substitutions to determine that the maximum allowed y was 66.5% of G, and the maximum allowed x was 21.8% of G. Specifically, the ruling stated:

formula

Another way to solve the system of simultaneous equations is to use linear algebra and matrix multiplication. Specifically, the above system of equations can be rearranged as:

formula

Which is recognizable as a matrix equation:

formula

Both sides can be multiplied by the inverse of the left matrix:

formula

formula

The general formula for the inverse of a 2x2 matrix is given by (i) swapping the diagonal entries a and d, (ii) negating the off-diagonal entries b and c, and (iii) dividing by the determinant:

formula

Accordingly, the inverse of the left matrix is:

formula

The inverse of the left matrix can be applied to determine the DRD-PD solution:

formula

The maximum allowed DRD is therefore 2975/4475th, or 66.5%, of TI, while the maximum allowed PD is 975/4475th, or 21.8%, of TI.

FOOTNOTES

1Unless otherwise noted, section references are to the Internal Revenue Code of 1986, as amended (the “Code”).

2Libin Zhang, Comments on Proposed Regulations under Section 163(j), February 25, 2019, available at https://www.regulations.gov/document?D=IRS-2019-0004-0059.

3See Aristotle, Physics, Volume 6 Part 9.

4See generally Emily L. Foster, Regs Merit Simpler Option for Computing TCJA Deduction Limits, 163 Tax Notes 451 (April 15, 2019).

584 F.R. 8189 (March 6, 2019).

684 F.R. 8190 (March 6, 2019).

7Id.

8For an individual who does not itemize deductions, “taxable income” instead means adjusted gross income minus the standard deduction, the section 151 deduction for personal exemptions (suspended in 2018 through 2025), and the section 199A deduction.

9Simultaneous equations were mentioned, but not solved, by the IRS in AM 2009-009 (Sept. 18, 2009), for a taxpayer entitled to both the section 199 domestic production activities deduction and the section 114 exclusion for extraterritorial trading income.

1084 F.R. 8189 (March 6, 2019).

11T.D. 8228, 53 F.R. 35501 (Sept. 14, 1988).

END FOOTNOTES

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