Portions of FTC Regs May Conflict With Repatriation Goals, SoFTEC Warns

February 1, 2019

Office of Associate Chief Counsel (International)
Attention: Jeffrey L. Parry and Larry R. Pounders
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224 s

CC:PA:LPD:PR (REG-105600-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Comments on REG-105600-18
Prop. Reg. 1.904-4(f)(2)(vi)(B)
Prop. Reg. 1.904‐4(f)(2)(vi)(D)
Guidance Related to the Foreign Tax Credit

Dear Messrs. Parry and Pounders:

The Software Finance and Tax Executives Council (“SoFTEC”) appreciates the opportunity to provide comments with respect to REG-105600-18, proposed “Guidance Related to the Foreign Tax Credit, Including Guidance Implementing Changes Made by the Tax Cuts and Jobs Act.” SoFTEC believes certain provisions of the proposed guidance conflict with the intent of the Tax Cuts and Jobs Act (“TCJA”) of promoting the repatriation to the U.S. of foreign owned intellectual property (“IP”). Specifically, Proposed Treas. Reg. §1.904‐4(f)(2)(vi)(D) would treat the repatriation of foreign-owned IP in such a way as to reduce the domestic parent's Foreign Derived Intangible Income (“FDII”) thereby reducing its deduction under Section 250. Also, SoFTEC is concerned the provisions of Prop. Reg. 1.904-4(f)(2)(vi)(B), depending on how they are interpreted, could lead to double taxation of income from repatriated IP.

We believe both of these proposed regulations would or could have the effect of reducing or eliminating the incentive for domestic corporations to repatriate their foreign-owned IP. Repatriation of foreign-owned IP results in a transfer of the taxing rights over the income from the foreign exploitation of the IP to the U.S. from the foreign country, benefiting the U.S. fisc. The U.S. has an interest in promoting such repatriations, not deterring them.

SoFTEC is a trade association providing software industry-focused public policy advocacy in the areas of tax, finance and accounting. SoFTEC is the voice of the software industry on matters of tax policy. Because all SoFTEC members distribute their products worldwide, they have an interest in the application of the U.S. tax laws to the profits they earn from foreign distribution and thus have an interest in commenting on these proposed regulations.

A. Prop. Reg. 1.904-4(f)(2)(vi)(D):

1. The Proposed Regulation:

Proposed Treas. Reg. §1.904-4(f)(2)(vi)(D) (pp. 216-17 of the proposed regulations) provides as follows:

The preamble to the proposed regulations, with regard to proposed Treas. Reg. §1.904-4(f)(2)(vi)(D), (pp. 51) provides:

2. Effect of the Proposed Regulation on Foreign Owned IP Repatriation:

Companies that wish to repatriate foreign-owned IP may do so in a number of ways. One of the simplest ways to accomplish the repatriation of IP is for the U.S. owner to make a “check the box” election to treat the foreign IP owner as a disregarded entity. Such an election has the effect of treating the foreign-owned IP as owned by the U.S. taxpayer without the need for the legal assignment of the IP or the liquidation of the foreign entity, which may take months or even years to complete.

However, the effect of the regulation would be to have the principles of Sec. 367(d), which applies to transfers of intangible property to a foreign corporation, also apply to transfers of intangible property both to or from a “check the box” foreign branch. Application of the principles of Sec. 367(d) to the case of the repatriation of foreign owned IP to the U.S., would require that an inbound transfer of the IP be treated as if the foreign branch sold the IP in exchange for payments that are contingent on the productivity, use, or disposition of the property. See Sec. 367(d)(2). This, in turn, would require that the gross income of foreign branch's owner be reduced to reflect the imputed payment to the foreign branch. This would have the effect of reducing the amount of foreign source income that would be eligible for characterization as FDII and, concomitantly, the amount eligible for the Sec. 250 deduction. See Section 250(b)(3)(A)(VI).

The language of the preamble indicates the rule is intended to prevent artificial reductions of the foreign branch basket income. The preamble further indicates the proposed regulation is there to guard against “non-economic reallocations of the amount of gross income attributable to the foreign branch category.” We do not believe repatriations of foreign-owned IP is a circumstance that would result in such reallocations. Indeed, the gross income of a foreign branch from the foreign exploitation of U.S. owned IP, in the context of software, is derived from the license of copies of the software for use by foreign customers or its use by the branch in the supply of services (such as cloud computing services) to foreign customers.

3. Proposed Solutions:

We believe the proposed regulation should be narrowed so its effect is confined to the category of abuse it is intended to guard against. The final regulation should make clear it does not apply if the gross income from the IP, but for the transfer, would otherwise be characterized as Global Intangible Low Taxed Income (“GILTI”). In its current form, the proposed regulation deters repatriation of foreign-owned IP to the U.S. To view the impact of this in context, a well-advised domestic parent would opt to maintain foreign IP rights with its CFC. From an effective tax rate perspective, the U.S. parent would benefit from the full Sec. 250 deduction for its GILTI inclusion when the income is in CFC whereas if owned by a U.S. corporation, the income would generally be excluded from obtaining the FDII Sec. 250 benefit (and therefore taxed at the full US rate of 21%). It is not in the interest of sound tax policy to provide an incentive, in the form of a higher Sec. 250 deduction, for U.S. taxpayers to keep their IP offshore.

We also believe it is imperative that the final regulation should provide transition rules clarifying that the provision does not apply to transfers between foreign branch owners and foreign disregarded entities occurring prior to the effective date of the regulations. The lack of such a transition rule would otherwise penalize taxpayers who have already repatriated foreign IP via a “check the box” election thus treating the IP owner as a foreign branch of a domestic enterprise. At a minimum, the final regulations should provide an exception for disregarded entities in the process of liquidation as part of a plan to repatriate foreign IP back to the U.S. Taxpayers that undertook such transactions prior to the effective date of the regulations should not be subject to retroactive application of such a drastic change in the law.

B. Prop. Reg. 1.904-4(f)(2)(vi)(B):

1. The Proposed Regulation:

Proposed Treas. Reg. §1.904-4(f)(2)(vi)(A) and (B) (pp. 213-5 of the proposed regulations) provides as follows:

In addition, Proposed Treas. Reg. S1.904-6(a)(1) provides, in part:

The preamble to the proposed regulations, with regard to proposed Treas. Reg. §1.904-4(f)(2)(vi)(B), (p. 64-65) provides:

2. Effect of the Proposed Regulation on Foreign Owned IP Repatriation:

The wording in the proposed regulation could lead to misinterpretation, which, improperly, could cause a portion of the gross income allocated to the foreign branch to be treated as U.S. source income. Prop. Reg. §1.904-4(f)(vi)(A) states, “An adjustment to the attribution of gross income under this paragraph (f)(2)(vi) does not change the total amount, character, or source of the United States person's gross income.” However, §1.904-4(f)(vi)(B)(1)(i) implies that if the disregarded payments are treated as U.S. source, a corresponding amount of foreign branch income is also treated as U.S. source, since the overall amount, character and source of the U.S. person is unchanged.

The effect of Proposed Treas. Reg. §1.904-4(f)(2)(vi)(B) could be to reallocate gross income of the foreign branch between foreign source and US source income, for purposes of the foreign tax credit, based on the allocation of expenses that would have applied to the foreign branch owner if the payments were regarded, rather than the following the sourcing rules for gross income. Based on the reference in the proposed regulation to Treas. Reg. Sec. 1.861-17, the rule would apply to research and development expenditures deductible under Sec. 174. This regulation creates a separate category for statutorily disregarded income for payments to a foreign branch for the performance of R & D services attributable to IP owned by the foreign branch's owner. Proposed Treas. Reg. S1.904-6(a)(1) assigns a portion of the foreign taxes incurred by the foreign branch to such separate category. The operation of these proposed rules could create an artificial limitation on the foreign tax credit by creating a new category of foreign branch income ineligible for the foreign tax credit.

To give an example, consider a U.S. parent that owns IP that has a foreign branch performing research and development for which the branch receives arms' length consideration (i.e., a disregarded payment). The payment to the foreign branch gives rise to income tax in the foreign country. If, for purposes of the foreign tax credit, the R & D expense is apportioned 50/50 between U.S. and foreign sources, the proposed regulation could be interpreted as treating 50% of the foreign branch's income and a corresponding percentage of the taxes, in the newly created U.S. source foreign branch category. As a result, the amount of foreign source income, the foreign tax limitation and ultimately the amount of foreign taxes available to be credited are all artificially reduced. This leads to double taxation.

This artificial reduction of the foreign tax credit and concomitant double taxation would not occur if the taxpayer kept its IP in a CFC which funded the foreign branch's R&D costs directly. Thus, the proposed regulations provide an incentive for the U.S. parent to keep its IP offshore in a CFC and subject itself to the GILTI regime rather than on-shoring the IP. In essence, the U.S. is ceding the right of primary taxation of the IP income by encouraging ownership and maintenance of IP offshore, rather than promoting the adoption of structures and operations intended to maximize the FDII benefit, in direct contravention of the intended purpose of the new FDII regime.

3. Proposed Solutions:

We assume the result described above is not intended as it would be contrary to the primary objective of the TCJA of increasing investment in the U.S. by providing incentives for U.S. businesses to repatriate their foreign-owned IP. On this assumption, we recommend that the language of Prop. Reg. §1.904-4(f)(vi) be clarified such that gross income from disregarded payments attributed to foreign branch income do not result in a “resourcing” of a portion of such income to U.S. source. Inclusion of an example illustrating this result also would be helpful in clarifying the result of the proposed regulation.

If our assumption is incorrect, we recommend the adoption of an allocation rule based on gross income instead of expenses. Such an allocation method would provide a reasonable proxy for overall expense allocation and relieve taxpayers of the burdensome requirement allocating every category of expense incurred by each branch.

C. Conclusion:

SoFTEC thanks you for the opportunity to provide these comments and we look forward to working with you as the proposed regulation moves towards finality. I can be reached at (202) 486-3725 or mnebergall@softwarefinance.org with any questions or requests for further information.

Respectfully submitted,

Mark E. Nebergall
President
Software Finance and Tax Executives Council