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Law Firm Addresses NOL Deduction Election Under FTC Regs

FEB. 5, 2019

Law Firm Addresses NOL Deduction Election Under FTC Regs

DATED FEB. 5, 2019
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February 5, 2019

Mr. David Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

Mr. Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Mr. L.G. “Chip” Harter
Deputy Assistant Secretary
International Tax Affairs
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

Mr. William M. Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Proposed Regulations on Section 904 Aspects of Section 965(n) Election (REG-105600-18)

Dear Sirs,

On December 7, 2018, the Treasury Department (“Treasury”) issued proposed regulations that provide guidance relating to the determination of the foreign tax credit under the Internal Revenue Code (the “Code”) (the “Proposed Regulations”).1 The guidance relates to changes made to the applicable law by the Tax Cuts and Jobs Act (the “Act”), which was enacted on December 22, 2017, and includes rules on the determination of foreign tax credits in the case of a section 965(n) election. Treasury requested comments on the proposed regulations by February 5, 2019. We commend Treasury and the Internal Revenue Service (the “Service”) for their continuing efforts to issue guidance under the Act and appreciate the opportunity to provide comments to you. We comment here on certain aspects of the application of the section 904 limitation on foreign tax credits in the case of a taxpayer which elects under section 965(n) to forgo taking certain deductions against its income inclusion arising under section 965. We respectfully request a public hearing on the Proposed Regulations and would appreciate the opportunity to testify at the hearing.

I. The Proposed Regulations Are Unfair to Taxpayers

Section 965(n) provides an election that permits a taxpayer to forgo taking deductions arising from or contributing to net operating losses (“NOLs”) against its income inclusion arising under section 965, as discussed in more detail below. Forgoing the use of NOLs under section 965(n) could allow the use of foreign tax credits against the tax liability arising from the section 965 income inclusion, subject to the usual limitations on foreign tax credits, including those provided under section 904. Section 965(n)(3) provides that the Secretary has the authority to prescribe how the election is made, and is silent regarding whether the election may be revoked.

Throughout 2018, Treasury and the IRS released Notices,2 a Revenue Procedure,3 and proposed regulations (the “Earlier Proposed Regulations”),4 some of which provided taxpayers with guidance related to making the section 965(n) election. The Earlier Proposed Regulations contain Treas. Reg. section 1.965-7(e), which describes the scope and timing of a section 965(n) election. Those regulations provide that the election must be made “no later than the due date (taking into account extensions, if any) for the person's return for the taxable year to which the election applies”5 and state that the election is irrevocable.6

The Earlier Proposed Regulations gave no indication of the approach taken in the new proposed rules (the “Proposed Regulations”) and did not directly address the determination of a taxpayer's section 904 limitation in the case of a section 965(n) election. Rather, to the extent that the Earlier Proposed Regulations addressed the section 904 limitation at all, they suggested a very different approach than the one proposed in the new Proposed Regulations. The Preamble to the Earlier Proposed Regulations stated that the existing rules for allocation and apportionment of expenses would generally apply.7

Taxpayers that relied on the Earlier Proposed Regulations and made an irrevocable section 965(n) election learned that they had relied on the Earlier Proposed Regulations to their detriment when the Proposed Regulations were released. To taxpayers' surprise, the Proposed Regulations took a different approach than the Earlier Proposed Regulations regarding the determination of a taxpayer's section 904 limitation. Had taxpayers been aware of the possibility that the Proposed Regulations would propose this approach, they would have considered different factors when deciding whether to make a section 965(n) election. In hindsight, some taxpayers may not have made a section 965(n) election at all. However, because the election is irrevocable and the Proposed Regulations were not issued until after taxpayers were required to file their tax returns, taxpayers are unable to go back and amend their returns now that they understand the full consequences of making a section 965(n) election. This is unfair to taxpayers, who justifiably based their decisions regarding whether to make a section 965(n) election based on the guidance that Treasury and the IRS had released by the time their returns were due — namely, the Earlier Proposed Regulations.

The most straightforward way for Treasury and the IRS to correct this unfair result is by not finalizing the Proposed Regulations. Below, we describe the approach that we recommend Treasury and the IRS take in the final regulations, which we believe is consistent with the statute, furthers good tax policy, and protects taxpayers from the potentially unfair consequences of the Proposed Regulations.

II. The Proposed Regulations Are Inconsistent with Section 965, Section 904, and Existing Rules on the Allocation and Apportionment of Expenses Under Section 904

The Proposed Regulations on the determination of the section 904 limitation in the case of a section 965(n) election should not be finalized as proposed because they are inconsistent with the statutory language in section 965(n) and with existing rules on the allocation and apportionment of expenses under section 904, to the extent they defer deductions that would be taken against income other than the section 965 inclusion. They also should not be finalized as proposed because they are inconsistent with the operation of section 965 and section 904 to the extent they treat the net section 965 inclusion, rather than the gross section 965 inclusion, as the gross income arising under section 965 for section 904 purposes.

A. The Proposed Regulations Would Inappropriately Defer Deductions that Would Be Taken Against Income Other than the Section 965 Inclusion

1. Inconsistency with the Statute

Section 965(n) provides taxpayers the opportunity to forgo taking certain deductions against their net inclusion under section 965 and any section 78 gross-up arising from that inclusion. More specifically, if a taxpayer makes the section 965(n) election, the taxpayer's section 965 inclusion, and the related section 78 gross-up, are not taken into account in determining the amount of the taxpayer's NOL for the year or the amount of taxable income for that year which may be reduced by its NOL carrybacks or carryovers to that year from other years.8 The taxpayer's section 965 inclusion therefore should not be offset by otherwise applicable deductions if the taxpayer elects section 965(n) because the use of the deductions to offset the inclusion would reduce the taxpayer's NOL in violation of section 965(n). The taxpayer's deductions in excess of its income other than its section 965 inclusion (and related section 78 gross-up) should instead flow into and constitute the taxpayer's NOL for the year. To provide a very simple example to illustrate, assume a taxpayer has 100 of section 965 inclusion, net of the section 965(c) deduction (and, for simplicity, no section 78 gross-up arising from that inclusion), and 900 of other gross income for the year. Assume the taxpayer has 1,000 of other deductible expenses for the year. If the taxpayer does not elect section 965(n), it has no taxable income and no NOL for the year. If the taxpayer elects section 965(n), it has 100 of taxable income and 100 of NOL for the year.

Congress recognized that permitting taxpayers to forgo the use of NOLs under section 965(n) could allow taxpayers to use foreign tax credits against the tax liability arising from the section 965 income inclusion.9 The tax liability arising from the taxable income created by a section 965(n) election is subject to possible reduction by foreign tax credits just like any other taxable income, subject to the usual limitations on the use of foreign tax credits, including the foreign source income and basketing limitations of section 904. Under section 904(a), in simplified terms, foreign tax credits can be used only to reduce tax on foreign source income. To determine foreign source net income under section 904, taxpayers must allocate and apportion expenses against foreign source gross income and US source gross income under allocation and apportionment rules discussed in more detail below. Under section 904(d), in simplified terms, foreign tax credits can be used only to reduce tax on income within a particular specified category of income. The basketing of income into these categories limits a taxpayer's ability to take a credit for foreign taxes imposed on one type of income against US tax imposed on another type of income. As with the sourcing limitation, taxpayers must allocate and apportion expenses against gross income from different baskets to determine the net income from different baskets. The section 904 limitation rules are understandably complex given the wide variety of factual circumstances that can arise, but the Proposed Regulations are inconsistent with some fundamental aspects of the section 904 limitation and section 965(n) for the reasons discussed below.

The Proposed Regulations are inconsistent with the statutory language in section 965(n) to the extent they defer deductions that would be taken against income other than the section 965 inclusion. Section 965(n) makes clear that the income that is not offset by deductions, and thus ends up as taxable income, by reason of a section 965(n) election is the taxpayer's section 965 inclusion, along with any section 78 gross-up arising from such inclusion.10 Consistent with the statute, the Earlier Proposed Regulations recognize that the taxable income resulting from a section 965(n) election is the section 965 inclusion when they provide that a taxpayer may elect to not take into account “the amount described in paragraph (e)(1)(ii)” in determining its net operating loss under section 172 for the taxable year, which amount is the sum of the taxpayer's net section 965 inclusion and any section 78 gross-up arising from such inclusion.11 The Proposed Regulations are also consistent with the statute on this point. They seem to recognize that the taxable income resulting from a section 965(n) election is the section 965 inclusion when they state that the taxable income for a taxpayer whose section 965(n) election creates or increases an NOL for the current year “cannot be less than the amount described in paragraph (e)(1)(ii).”12

Given that the deductions that are disallowed under section 965(n) are those deductions that would otherwise be taken against the section 965 inclusion, the deductions that are considered to give rise to the current year NOL should be the deductions that would have been taken against the section 965 inclusion. The Proposed Regulations are not consistent with those statutory terms of section 965(n), however, to the extent they provide that the deductions that are deferred as a current year NOL as a result of a section 965(n) election do not consist solely of deductions allocated and apportioned against the section 965 inclusion. Instead, these deferred deductions consist of deductions drawn proportionately from across all income for the year. The Proposed Regulations seem to provide for such a result when they provide that the amount of deductions equal to the amount by which an NOL is created or increased for the taxable year by reason of the section 965(n) election (the “deferred amount”) “comprises a ratable portion of the deductions . . . allocated and apportioned to each statutory and residual grouping” for purposes of determining sourcing and basketing under section 904.13 Such a rule would in many cases significantly impact a taxpayer's section 904 limitation income. For example, in many cases a taxpayer's section 965 inclusion would be solely foreign source income while the taxpayer's entire income would be a combination of foreign source income and US source income. To the extent the Proposed Regulations defer deductions that are allocated and apportioned against income other than the section 965 inclusion (and related section 78 gross-up) for section 904 sourcing and basketing purposes, they should be removed or revised to be consistent with the statute.

2. Inconsistency with Existing Rules for Allocating and Apportioning Expenses Under Section 904

The Proposed Regulations also are inconsistent with the existing rules on the allocation and apportionment of expenses to gross income (the “A&A rules”) to the extent they defer deductions allocated and apportioned against income other than the section 965 inclusion (and related section 78 gross-up).

The A&A rules provide that “the net operating loss deduction allowed under section 172 shall be allocated and apportioned in the same manner as the deductions giving rise to the net operating loss deduction.”14 Under the A&A rules, current year deductions that give rise to an NOL thus should not be taken as a deduction against gross income for section 904 purposes in the current year, in which the deduction gives rise to an NOL rather than reduces taxable income, and instead should be taken as a deduction against gross income for section 904 purposes in the later (or earlier) year to which they are carried forward (or back) and in which they are used as an NOL deduction that reduces taxable income. Moreover, that later-year (or earlier-year) NOL deduction should be allocated and apportioned against gross income for section 904 purposes in that year in the same way the deduction that gave rise to the NOL would have been allocated and apportioned against gross income in the year in which that deduction gave rise to the NOL. For example, to the extent an NOL carryover is attributable to a deduction that would have reduced foreign source gross income under the allocation and apportionment rules in the year in which it was incurred and gave rise to an NOL, the NOL deduction taken in the later year to which the NOL is carried should also be allocated and apportioned against foreign source gross income.

The Proposed Regulations correctly provide, on an overall basis, that deductions which do not reduce taxable income for the current year should not reduce gross income for purposes of determining the section 904 limitation income for the current year.15

The Proposed Regulations are inconsistent with the A&A rules, however, when they seem to provide, as discussed above, that the deductions that are deferred as a current year NOL as a result of a section 965(n) election do not consist solely of deductions that would have been allocated and apportioned against the section 965 inclusion (and related section 78 gross-up), and instead consist of deductions drawn proportionately from deductions allocated and apportioned against all income for the year.16 The statute indicates that the deductions that are considered to give rise to the NOL should be the deductions that would have been allocated and apportioned against the section 965 inclusion for the reasons discussed above. That treatment also provides the appropriate result under the A&A rules because, under the A&A rules, the allocation and apportionment of the deductions giving rise to the NOL in the current year governs the allocation and apportionment of the deductions in the later (or earlier) year in which they are taken as an NOL deduction. To the extent that the Proposed Regulations do not provide for that result, they should be removed or revised to be consistent with the A&A rules.

B. The Proposed Regulations Would Inappropriately Treat the Net Section 965 Inclusion Rather than the Gross Section 965 Inclusion as Gross Income

The Proposed Regulations also are inconsistent with section 965 and section 904 to the extent they treat the net section 965 inclusion, rather than the gross section 965 inclusion, as the gross income arising under section 965 for section 904 purposes.

Section 965(a) provides for an amount to be included in subpart F income, which is included in the income of a United States shareholder under section 951(a)(1). The section 965(a) inclusion gives rise to a deduction under section 965(c) for the United States shareholder. Section 965(c) expressly refers to the amount included under section 965(a) as “an amount [which] is included in the gross income of such United States shareholder under section 951(a)(1) by reason of this section.” Section 965(n) understandably provides, upon election, for deferral of deductions that would otherwise be taken against the section 965 inclusion only to the extent of the section 965 inclusion remaining after the section 965(c) deduction. However, that provision does not alter that the gross income under section 965 is the section 965(a) amount and that the section 965(c) deduction allowed to effectively tax such income at a lower rate is a deduction against such gross income. At the same time, section 904, as discussed above, operates by dividing gross income between or among relevant statutory and residual groupings (such as between foreign and US source income) and then allocating and apportioning deductions against such groupings of gross income to arrive at net section 904 limitation income.

The Proposed Regulations seem to treat the net section 965 inclusion as the item of gross income for section 904 purposes when they exclude the “deduction allowed under section 965(c)” from the pool of deductions from which the “deferred amount” of deductions (discussed above) is proportionately comprised.17 Such a rule would in many cases significantly impact a taxpayer's section 904 limitation income by skewing the deductions that are considered to be deferred through the current year NOL toward more US source deductions and fewer foreign source deductions, which in turn skews the remaining pool of non-deferred current year deductions that are allocated and apportioned against gross income for section 904 purposes toward more foreign source deductions and fewer US source deductions. To the extent the Proposed Regulations exclude the portion of section 965(a) gross income that is offset by a section 965(c) deduction from the pool of gross income that is divided into relevant groupings under section 904, rather than including such amount in gross income and allowing the section 965(c) deduction to be allocated and apportioned against it, they are inconsistent with the operation of both section 965 and section 904.

III. If Finalized, the Proposed Regulations Should Allow Taxpayers to Revoke Section 965(n) Elections

If Treasury and the IRS disagree with our recommendation and finalize the Proposed Regulations as they are currently drafted, we recommend that Treasury and the IRS provide taxpayers who made a section 965(n) election an opportunity to revoke that election. Treasury and the IRS have previously permitted taxpayers to revoke otherwise irrevocable elections in limited circumstances. For example, members of the clergy who have a religious or conscientious objection to receiving Social Security benefits may file Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners, to seek an exemption from Social Security taxes. As described in the instructions to Form 4361, this election is irrevocable. Notwithstanding the irrevocable nature of filing Form 4361, the IRS has, in limited circumstances, permitted members of the clergy to revoke their otherwise irrevocable election by filing Form 2031, Waiver Certificate for Use By Ministers, Members of Religious Orders and Christian Science Practitioners Electing Coverage Under the Social Security Act.18 Similarly, in Notice 2008-106, the IRS provided that an otherwise irrevocable election made by a taxpayer under section 42 was effectively superseded by subsequently-enacted legislation, and the taxpayer's irrevocable election was disregarded. Here, because taxpayers who made an irrevocable section 965(n) election prior to the issuance of the Proposed Regulations made that election without full knowledge of the consequences of that election, principles of equity and fairness support Treasury and the IRS issuing guidance that permits taxpayers to revoke their section 965(n) elections.

IV. If Finalized, The Proposed Regulations Should More
Precisely Refer to Certain Deductions

The Proposed Regulations also could be revised to more precisely refer to certain deductions. Specifically, proposed Treas. Reg. section 1.965-7(e)(1)(iv)(B) currently refers to only the deductions that would have been allowed for the year but for the section 965(n) election in some places where the intent seems to have been to refer to those deductions plus the other deductions for the year.

V. Recommendations

As noted above, we believe that Treasury should remove or revise the Proposed Regulations to the extent they provide that the deductions that are deferred as a current year NOL as a result of a section 965(n) election do not consist solely of deductions that would have been allocated and apportioned against the section 965 inclusion (and related section 78 gross-up), and instead consist of deductions drawn proportionately from deductions allocated and apportioned against all income for the year. The Proposed Regulations otherwise would be inconsistent with the statutory language in section 965(n) and existing guidance on the allocation and apportionment of deductions for section 904 purposes.

We also believe that Treasury should remove or revise the Proposed Regulations to the extent they treat the net section 965 inclusion, rather than the gross section 965 inclusion, as the gross income arising under section 965 for section 904 purposes. The Proposed Regulations otherwise would be inconsistent with the operation of section 965 and section 904.

Our comments in this letter are limited to the section 904 aspects of the section 965(n) election discussed above. Comments on other rules in the Proposed Regulations are beyond the scope of this comment letter.

We appreciate your consideration of our request and attention to these important matters and would be pleased to continue a dialogue with you. If you would like to discuss these matters further, please contact Alexandra Minkovich at (202) 452-7015 or Lance Martin at (650) 856-5594.

Respectfully submitted,

Lance Martin
Baker & McKenzie LLP

cc:
Doug Poms
International Tax Counsel
Department of the Treasury

Brian Jenn
Deputy International Tax Counsel
Department of the Treasury

Jason Yen
Attorney-Advisor
Department of the Treasury

Lindsay Kitzinger
Attorney-Advisor
Department of the Treasury

Peg O'Connor
Acting Associate Chief Counsel (International)
Internal Revenue Service

FOOTNOTES

1Fed. Reg. Vol. 83, No. 235 p. 63200 (REG-105600-18) (Dec. 7, 2018).

2See Notices 2018-7, 2018-13, and 2018-26. Notice 2018-26 described the guidance relating to the section 965(n) election that Treasury and the IRS subsequently released in the Earlier Proposed Regulations.

3See Rev. Proc. 2018-17.

483 Fed. Reg. 39514 (Aug. 9, 2018).

5Treas. Reg. § 1.965-7(e)(2)(ii).

6Treas. Reg. § 1.965-7(e)(1)(i).

783 Fed. Reg. at 39531.

8Section 965(n)(1); 83 F. R. 39514, 39518, 39535.

9See Senate Budget Committee, S. Prt. 115-20, at 365 (2017); Conference Report, at 615; Joint Committee on Taxation General Explanation of Public Law 115-97 (Blue Book), 362-363 (Dec. 2018). See also NYSBA Tax Section, “Report No. 1388 on Section 965,” at 27 (Feb. 6, 2018); American Petroleum Institute (API) letter to Treasury Secretary Steven Mnuchin, at 2 (Mar. 1, 2018).

10Section 965(n)(1) (referring to “the amount described in paragraph (2)”, which is the sum of “the amount required to be taken into account under section 951(a)(1) by reason of [section 965]” plus the section 78 gross-up, as the amount that shall not be taken into account in determining the amount of the year's NOL deduction).

11Prop. Treas. Reg. § 1.965-7(e)(1)(i) (first paragraph).

12Prop. Treas. Reg. § 1.965-7(e)(1)(i) (second paragraph).

13Prop. Treas. Reg. § 1.965-7(e)(1)(iv)(B)(2).

14Treas. Reg. § 1.861-8(e)(8).

15Prop. Treas. Reg. § 1.965-7(e)(1)(i) (“The amount of deductions equal to the amount by which a net operating loss is created or increased for the taxable year by reason of the section 965(n) election (the 'deferred amount') is not taken into account in computing taxable income or the separate foreign tax credit limitations under section 904 for that year.”).

16Prop. Treas. Reg. § 1.965-7(e)(1)(iv)(B)(2).

17Prop. Treas. Reg. § 1.965-7(e)(1)(iv)(B)(2).

18See Announcement 87-19.

END FOOTNOTES

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