Law Firm Seeks Guidance on Loss Rules for GILTI, FTC Purposes

February 5, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable William M. Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Lafayette G. “Chip” Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Douglas L. Poms
International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Re: Request for Guidance on Loss Issues Related to Global Intangible Low-Taxed Income (REG-105600-18)

Dear Sirs:

We offer the following comments and requests for guidance related to the Notice of Proposed Rulemaking on the Guidance Related to the Foreign Tax Credit, Including Guidance Implementing Changes Made by the Tax Cuts and Jobs Act by the Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “IRS”) (the “Proposed Regulations”). Specifically, we request guidance with respect to two issues related to the overall foreign loss (“OFL”) and Separate Limitation Loss (“SLL”) rules in light of the new global intangible low-taxed income (“GILTI”) provision. Neither of these issues was explicitly addressed in the Proposed Regulations, and we believe it is important that these issues be addressed when the regulations are promulgated in final form:

Recapture of OFLs in Other Baskets Should Not Be Calculated by Taking GILTI Inclusions into Account Under the 50% Test

An OFL is created when the allocation and apportionment of U.S. level expenses results in a foreign source loss that reduces U.S. source income. In such a case, the OFL recapture rules require recharacterization of a portion of the taxpayer's FSI, in subsequent years, as U.S. source income to the extent of the prior foreign losses. This reduction in FSI results in a reduced capacity to use FTCs (i.e., a reduced FTC limitation) in the year of recharacterization. The OFL rules were added to the Code in 1976 to prevent taxpayers from obtaining what was perceived to be a double benefit from a foreign loss, from first reducing tax on U.S. source income in the year of the loss and then using FTCs to offset the U.S. tax on positive FSI earned in a later year.¹ OFL recapture, by recharacterizing FSI in the later year as U.S. source income to the extent of the prior year loss, prevents the use of FTCs to offset the tax on that amount of income, thereby recapturing the benefit obtained in the prior year. Consistent with the basket-by-basket framework for determining the FTC limitation, Treas. Reg. § 1.904(f)-2(c)(1)² provides that for a particular year recapture of an OFL in a separate basket of FSI is limited to the amount of FSI in that basket for the year.

The OFL recapture rule is set out in the Code in section 904(f)(1), which provides:

For purposes of this subpart, in the case of any taxpayer who sustains an overall foreign loss for any taxable year, that portion of the taxpayer's taxable income from sources without the United States for each succeeding taxable year which is equal to the lesser of —

(A) the amount of such loss (to the extent not used under this paragraph in prior taxable years), or

(B) 50 percent (or such larger percent as the taxpayer may choose) of the taxpayer's taxable income from sources without the United States for such succeeding taxable year,

shall be treated as income from sources within the United States (and not as income from sources without the United States).

(Emphasis added. The lower limit for OFL recapture imposed by section 904(f)(1)(B) is referred to herein as the “50% Test.”)

Since 2007, the regulations have interpreted this provision to mean that FSI in a particular basket will be recharacterized as U.S. source income up to an amount equal to the lesser of (A) the OFL in that basket or (B) 50% of the taxpayer's total FSI (i.e., in all baskets).³ If that approach were applied going forward without carving out GILTI inclusions, foreign source GILTI inclusions would be taken into account for purposes of the 50% Test for recapturing OFLs in each of the other baskets. For most relevant taxpayers, this would effectively write the 50% Test out of the Code, because for most companies with OFLs the foreign source GILTI inclusion will significantly exceed other FSI. For such taxpayers, 50% of FSI will always be greater than the FSI in any particular basket other than the GILTI basket, so all of such a taxpayer's FSI in a basket with an OFL will always be subject to full OFL recapture up to the amount of the OFL. There is no suggestion Congress intended to alter the typical historic operation of the OFL recapture rules in this way.

The harshness of this result is compounded considering that, as a result of the mandatory GILTI inclusion, multinationals with CFCs are generally compelled to elect FTCs going forward as opposed to deducting foreign taxes in years in which they do not have a current OFL, in order to minimize tax on the GILTI inclusion. Because FTCs cannot be selectively elected, this means that OFL taxpayers will generally be obliged to elect not to deduct foreign taxes (and to include a taxable section 78 gross-up with respect to subpart F inclusions). If the 50% Test takes into account the GILTI inclusion, such taxpayers will therefore pay current U.S. tax on a section 78 gross-up for FTCs that they may never have the ability to use. For example, in light of new section 245A, it may be difficult for a taxpayer with a historic general basket OFL to generate sufficient net general basket FSI in the United States to overcome its OFL and therefore be in a position to utilize general basket FTCs. It is thus likely that taxpayers with significant historic general basket OFLs will not be able to overcome those OFLs within the ten-year period for FTC carryforwards, and so will never be made whole for the double tax imposed on their general basket earnings (including the tax on the section 78 gross-up).

Fortunately, the Treasury and the IRS have the authority to write regulations that carve out GILTI inclusions from the 50% Test for purposes of recapturing historic OFLs, in order to avoid these unintended and unreasonable results. As an initial matter, it is important to note that application of the 50% Test to all FSI is not mandated by statute. In fact, the approach of the current regulations is strained in that it requires reading “the taxpayer's taxable income from sources without the United States” to have two different meanings the two times it is used in section 904(f)(1) (both underlined above). Under the approach of the regulations, in the flush language of the Code provision the phrase is limited to income in the same basket as the overall foreign loss, consistent with the separate basket approach of section 904(d), but in section 904(f)(1)(B) (the 50% Test) the phrase includes all FSI. A more natural reading of the Code section would be to read the two instances of the phrase consistently and, pursuant to the principles of section 904(d), both as applying only to FSI in the basket with the OFL.

The Treasury and the IRS initially issued regulations that adopted just such a reading of the statute, applying the 50% Test only to the FSI in the basket with the relevant OFL being recaptured.⁴ However, Treasury and the IRS subsequently modified the 50% Test to take into account all FSI, based on a comment in the Conference Report to the Tax Reform Act of 1986.⁵ The 1986 Act added the SLL rules, but did not otherwise modify section 904(f).⁶ Importantly, a comment in legislative history 10 years after the enactment of section 904(f), in connection with a bill that did not modify the provision at issue, is entitled to limited deference and in no way constrains the authority of the Treasury and the IRS.⁷

Moreover, the comment in the 1986 legislative history obviously was made without the GILTI provisions in mind and gives no indication of how OFL recapture should interact with the GILTI provisions. GILTI was imposed to address concerns related to the introduction of a dividend participation exemption system and to a large extent operates as an independent quasi-minimum tax.⁸ As such, it is clearly distinguishable from income attributable to (including movable from) the US, which was the FSI contemplated when the OFL rules were instituted (and when Congress made its comment on the 50% Test in 1986). It therefore would be appropriate to treat GILTI differently for purposes of OFL recapture and exclude it from the 50% Test (if the Treasury and the IRS do not elect to revert to the initial interpretation of section 904(f)(1)).

In light of the above, the Treasury and the IRS should not feel constrained to take GILTI inclusions into account under the 50% Test, which would effectively write the 50% Test out of the Code for most relevant taxpayers. Instead, guidance should be issued that either reverts to the rule of the 1987 regulations or carves GILTI out of the 50% Test and thereby, at least as relates to GILTI, applies the more natural reading of the statute. Such guidance is clearly authorized, just as it was the first time the Treasury and the IRS issued regulations applying a similar interpretation in 1987, under the authority granted by section 7805. In fact, in light of the language of section 904(f)(1) and the purposes of the GILTI provisions, it is not clear that an interpretation that considered GILTI inclusions under the 50% Test would be valid. Notably, the requested guidance would not disadvantage any taxpayers who might prefer to recapture more than 50% of their FSI in the relevant basket, because the statute itself provides an election for any preferred greater recapture percentage. Potential language for such guidance is included as Appendix 1.

SLLs from Other Baskets Should Not Reduce GILTI Basket Earnings for Purposes of Calculating the FTC Limitation

The SLL rules under section 904(f)(5) require that a current loss in one basket of FSI (the “loss basket”) be allocated against positive FSI in other baskets (the “offset baskets”), thereby reducing the FTC limitation with respect to the offset baskets for the year. A corresponding recapture rule provides that if the taxpayer has positive FSI in the loss basket in a subsequent year, such FSI is recharacterized as FSI in the offset baskets, up to the amount of the original loss, thereby increasing the FTC limitation with respect to the offset baskets for such subsequent year. The incremental effect of adding the SLL rules on top of the OFL regime was to restrict FTCs in the offset baskets, resulting in excess FTCs. As the legislative history of the provision indicates, the SLL recapture rule combined with the FTC carryforward rule was intended to mitigate the impact of this restriction on FTCs in the offset baskets by allowing additional FTCs to be claimed in the year of recapture as a result of the increased FTC limitation in the offset baskets.⁹

GILTI does not fit into this regime as a result of the fact that GILTI basket FTCs may not be carried forward.¹⁰ If a SLL in a loss basket is allocated to the GILTI basket and produces excess GILTI basket FTCs, those FTCs are permanently lost. SLL recapture in a later year that increases the GILTI basket limitation will not make the taxpayer whole, as intended by Congress, unless the taxpayer happens to have current-year excess FTCs in the GILTI basket in the year of the SLL recapture.

In light of the above, the Treasury and the IRS should issue guidance under the authority granted by section 7805 to harmonize the GILTI provisions and the SLL rules consistent with Congress's intent by providing that SLLs should not be allocated to GILTI basket FSI. Notably, such guidance would not generally be expected to disadvantage any taxpayers, because the guidance would prevent a restriction on the use of FTCs that might otherwise result. It is possible that on a particular set of facts a taxpayer might prefer to create a GILTI basket SLL, for instance if the taxpayer had excess limitation in the GILTI basket in the year of the SLL but expected to have excess FTCs in the GILTI basket in later years. In order to address such concern, the guidance might provide an election for taxpayers to allocate an SLL to GILTI basket FSI. Potential language for such guidance is included as Appendix 2.

If you have any questions, please feel free to contact me.

Sincerely,

Aaron Payne
Eversheds Sutherland (US) LLP
Washington, DC

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Appendix 1 — Proposed Language Providing GILTI Inclusions Are Not Taken into Account Under the 50% Test

Revised 1.904(f)-2(c)(1) In general. In a taxable year in which a taxpayer elects the benefits of section 901 or section 30A, the section 904(f)(1) recapture amount is the amount of foreign source taxable income subject to recharacterization in a taxable year in which recapture of an overall foreign loss is required under paragraph (a) of this section. The section 904(f)(1) recapture amount equals the lesser of the balance in the applicable overall foreign loss account (after reduction of such account in accordance with §1.904(f)-1(e)) or fifty percent of the taxpayer's foreign source taxable income of the same limitation as the loss that resulted in the overall foreign loss account (as determined under paragraph (b) of this section). If, in any taxable year, in accordance with sections 164(a) and 275(a)(4)(A), . . .

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Appendix 2 — Proposed Language Providing SLLs from Other Baskets Do Not Reduce GILTI Basket Earnings for Purposes of Calculating the FTC Limitation

Revised 1.904(g)-3(d) Step Three: Allocation of separate limitation losses. The taxpayer shall allocate separate limitation losses sustained during the taxable year (increased, if appropriate, by any losses carried over under paragraph (b) of this section), in the following manner —

(1) The taxpayer shall allocate its separate limitation losses for the taxable year to reduce its separate limitation income in other separate categories, other than the GILTI category described in section 904(d)(1)(A), on a proportionate basis, and increase its separate limitation loss accounts appropriately. To the extent a separate limitation loss in one separate category is allocated to reduce separate limitation income in a second separate category, and the second category has a separate limitation loss account from a prior taxable year with respect to the first category, the two separate limitation loss accounts shall be netted against each other.

(2) If the taxpayer's separate limitation losses for the taxable year in categories other than the GILTI category described in section 904(d)(1)(A) exceed the taxpayer's separate limitation income for the year in categories other than the GILTI category described in section 904(d)(1)(A), or if the taxpayer has a separate limitation loss for the taxable year in the GILTI category described in section 904(d)(1)(A) and the taxpayer's total separate limitation losses for the taxable year exceed the taxpayer's separate limitation income for the year, so that the taxpayer has separate limitation losses remaining after the application of paragraph (d)(1) of this section, the taxpayer shall allocate those losses to its U.S. source income for the taxable year, to the extent thereof, and shall increase its overall foreign loss accounts to that extent in accordance with Sec. 1.904(f)-1.

Revised 1.904(g)-3(e) Step Four: Allocation of U.S. source losses. The taxpayer shall allocate U.S. source losses sustained during the taxable year (increased, if appropriate, by any losses carried over under paragraph (b) of this section) first to separate limitation income in categories other than the GILTI category described in section 904(d)(1)(A) on a proportionate basis, and then to separate limitation income in the GILTI category described in section 904(d)(1)(A) to the extent of any excess and shall increase its overall domestic loss accounts to the extent of such allocation in accordance with Sec. 1.904(g)-1.

Revised 1.904(g)-3(f) Step Five: Recapture of overall foreign loss accounts. If the taxpayer's separate limitation income for the taxable year (reduced by any losses carried over under paragraph (b) of this section) exceeds the sum of the taxpayer's U.S. source loss and separate limitation losses for the year, or if the taxpayer's separate limitation income for the taxable year in the GILTI category described in section 904(d)(1)(A) exceeds the taxpayer's U.S. source loss allocated to such category under paragraph (e) of this section, so that the taxpayer has separate limitation income remaining after the application of paragraphs (d)(1) and (e) of this section, then the taxpayer shall recapture prior year overall foreign losses, if any, and reduce overall foreign loss accounts in accordance with Sec. 1.904(f)-2.

1.904(g)-3(g) Step Six: Recapture of separate limitation loss accounts. To the extent the taxpayer has remaining separate limitation income for the year after the application of paragraph (f) of this section, then the taxpayer shall recapture prior year separate limitation losses, if any, in accordance with Sec. 1.904(f)-8 and reduce separate limitation loss accounts in accordance with Sec. 1.904(f)-7.

Revised 1.904(g)-3(h) Step Seven: Recapture of overall domestic loss accounts. If the taxpayer's U.S. source income for the year (reduced by any losses carried over under paragraph (b) of this section or allocated under paragraph (d) of this section, but not increased by any recapture of overall foreign loss accounts under paragraph (f) of this section) exceeds the taxpayer's separate limitation losses for the year allocated to such U.S. source income under paragraph (d)(2) of this section, so that the taxpayer has U.S. source income remaining after the application of paragraph (d)(2) of this section, then the taxpayer shall recapture its prior year overall domestic losses, if any, and reduce overall domestic loss accounts in accordance with Sec. 1.904(g)-2.