Tax Group Proposes Changes to Third Round of FTC Regs

February 10, 2021

CC:PA:LPD:PR (REG-101657-20)
Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments on proposed foreign tax credit regulations (NPRM REG-101657-20)

Dear Sir or Madam:

The Alliance for Competitive Taxation (“ACT”) is a coalition of leading American companies from a wide range of industries that supports a globally competitive corporate tax system that aligns the United States with other advanced economies.

Attached are ACT's comments on proposed regulations providing guidance related to the foreign tax credit (“FTC”), including guidance implementing changes made by the Tax Cuts and Jobs Act (“TCJA”). We recognize and commend the extraordinary efforts of the Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) staffs in issuing TCJA guidance in a timely and comprehensive manner.

We appreciate your consideration of these comments. ACT representatives welcome future discussion of these comments with your staff.

Yours sincerely,

Alliance for Competitive Taxation

cc:
Charles P. Rettig, Commissioner, Internal Revenue Service
Wade Sutton, Deputy International Tax Counsel, U.S. Treasury Department
John J. Merrick, Senior Level Counsel to Associate Chief Counsel (International), Internal Revenue Service
Barbara Felker, Branch Chief, Office of Associate Chief Counsel (International), Internal Revenue Service
Jason Yen, Associate International Tax Counsel, U.S. Treasury Department
Tianlin (Laura) Shi, Attorney, Office of the Chief Counsel (International), Internal Revenue Service

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COMMENTS BY THE ALLIANCE FOR COMPETITIVE TAXATION

I. INTRODUCTION

This document sets forth ACT's comments on the third round of proposed regulations relating to the FTC (NPRM REG-101657-20) (the “Proposed Regulations”).

II. COMMENTS RELATING TO CERTAIN ASPECTS OF THE PROPOSED REGULATIONS

1. Definition of a Creditable Foreign Tax

Proposed Regulations

The Proposed Regulations fundamentally alter the determination of whether a foreign tax is a creditable tax for U.S. purposes. The Proposed Regulations would add a new “jurisdictional nexus” requirement providing that a foreign tax is only creditable to the extent that there is sufficient nexus for the imposition of the tax. Further, the Proposed Regulations would provide additional rules for the existing “net gain” requirement, address soak-up taxes, modify the treatment of refundable credits, alter the noncompulsory tax rules, and narrow the definition of an “in lieu of” tax.

Treasury Explanation

The preamble to the Proposed Regulations provides that Treasury and the IRS have determined that it is “necessary and appropriate to require that a foreign tax conform to traditional international norms of taxing jurisdiction as reflected in the Internal Revenue Code in order to qualify as an income tax in the U.S. sense, or as a tax in lieu of an income tax.” Further, the preamble states “[i]n recent years, several foreign countries have adopted or are considering adopting a variety of novel extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction as reflected in the Internal Revenue Code.”

ACT Recommendation

As discussed further below, ACT recommends that the definition of a creditable foreign tax be addressed by Congress through the legislative process and remain unchanged until such process is undertaken.

Reasons for ACT Recommendation

The Proposed Regulations would make sweeping changes to the definition of a creditable foreign tax, introducing wholly new concepts such as “jurisdictional nexus” and jettisoning other concepts that, notwithstanding the discussion in the preamble, generally have been well understood by taxpayers and applied consistently for decades. Further, where controversies or ambiguities regarding the meaning of the concepts in the existing regulations have arisen, the government has issued guidance, or courts have addressed the uncertainty. As a result, there exists today a well-developed body of law interpreting the meaning of key terms in sections 901 and 903.

The Proposed Regulations would introduce significant uncertainty where it does not exist today and would do so barely three years after Congress, while making the most significant changes to the U.S. international tax regime in more than 50 years, chose not to make any substantive changes to either of the related sections of the Code.¹ ACT also notes that most of the changes proposed in the Proposed Regulations, including those said to “improve or clarify the rules,” would have the effect of restricting the availability of an FTC where it would be available under current law. Accordingly, although we address some of the specific aspects of the Proposed Regulations below, ACT respectfully requests that, if Treasury wishes to make fundamental, primarily taxpayer-unfavorable changes to well-settled rules that have proven to be administrable by taxpayers and the IRS, it should do so in consultation with Congress and through the legislative process.

The most sweeping change of the Proposed Regulations would introduce a new requirement — “jurisdictional nexus” — to the definition of a creditable income tax under section 901 (and, by extension, an “in lieu of” tax under section 903). The preamble to the Proposed Regulations notes that this proposed change is in response to the adoption by other countries of “a variety of novel extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction. . . .” ACT members, like many globally engaged companies, also have noted these developments and broadly share Treasury's and IRS's concerns that the introduction of novel extraterritorial taxes is a destabilizing development that threatens to undermine the benefits of global trade and investment to the United States as well as other countries.

ACT respectfully submits, however, that denying a credit for such taxes merely shifts the taxation burden to the companies (which are legally obligated to pay such taxes) and has no direct effect on the foreign country that has introduced the tax. In effect, globally engaged companies are caught in the middle of a policy dispute among nations regarding the allocation of taxing rights and are forced to bear the economic burden. This approach would harm the competitiveness of U.S. companies as they are disproportionately affected by these extraterritorial taxes.

In addition, because the jurisdictional nexus standard is novel, it would introduce enormous uncertainty into the determination of whether a tax is creditable, which is directly at odds with Treasury's stated goal to “improve or clarify” the rules in this area. For example, to determine creditability, taxpayers will be forced to determine whether: another country's transfer pricing rules are sufficiently close to traditional arm's-length principles; tax has been imposed on the basis of functions, assets, and risks in a country (as opposed to other additional criteria); and a country's source rules are sufficiently similar to U.S. concepts.

Further, the broad application of the jurisdictional nexus requirement to section 903 taxes goes beyond the stated goal of responding to novel extraterritorial taxes that diverge from international norms. Due to international differences in sourcing rules, the extension of the jurisdictional nexus requirement to section 903 would have the effect of disallowing FTCs for certain withholding taxes on services provided by taxpayers outside the taxing jurisdiction. While attempting to capture taxes directed toward business to consumer transactions performed through an intermediary (e.g., digital services taxes on advertising revenue), the broad application of the rule may capture long-standing taxes imposed upon services (e.g., withholding taxes with respect to business-to-business transactions performed for customers outside the taxing authority's jurisdiction). Withholding taxes on services, while an evolving area of law internationally, are neither novel nor recently emerging. In fact, Treasury, in promulgating the existing section 903 regulations in 1983, specifically identified withholding taxes on technical services performed outside the country of incorporation as creditable taxes.²

ACT respectfully submits that there is a better approach. As the preamble notes, Treasury is currently engaged in negotiations with other countries as part of the OECD/G20 Inclusive Framework. If agreement is reached through that process, Treasury, together with Congress, will determine what changes would need to be made to U.S. law to reflect the terms of such agreement. Conversely, if agreement is not reached, the U.S. government has policy tools at its disposal to engage constructively with other countries to resolve disagreements regarding the appropriate exercise of a country's taxing sovereignty.³

Unlike the U.S. government, however, ACT members have no such policy tools and will be forced to bear the increased economic burden resulting from the imposition of tax if the FTC were not available. Further, because the jurisdictional nexus standard would have such broad and uncertain parameters (well beyond the taxes on digital business models that are the current focus of the Inclusive Framework's efforts), applying it to all foreign taxes potentially in its scope could encroach upon or undermine other policy priorities of the U.S. government in areas that are unrelated to the current discussions at the Inclusive Framework.⁴

Beyond introduction of the novel jurisdictional nexus standard, the Proposed Regulations would make significant revisions to other definitions relating to the creditability of a foreign tax, including changes to the “net gain,” “gross receipts,” and “cost recovery” requirements. These changes would replace the more flexible standard in the existing regulations that is aligned with the statutory language and case law with more rigid definitions subject to new ambiguities, causing globally engaged U.S. companies to face economic double taxation. Of particular note, in determining whether a tax is an “income tax,” the Proposed Regulations no longer would allow a taxpayer to look at the normal circumstances in which the tax applies, but rather require taxpayers to look solely to the statutory framework in which the foreign tax law is promulgated. This elevates the form of the tax over the substance.

ACT believes that the current regulatory standard is well-suited to address the variability of the taxes that may be imposed by the many government bodies that have the right to impose tax on globally engaged taxpayers. Further, as noted above, the experience of ACT members (who are among the most globally engaged of all U.S. companies) is that the existing regulations and accompanying IRS guidance and relevant cases represent a well-developed body of law that taxpayers and practitioners can apply, and IRS agents can examine, in a straightforward manner.

In addition, unlike the Proposed Regulations, the existing regulations are flexible enough to permit taxpayers and the IRS to assess whether new foreign taxes sufficiently resemble an income tax in the U.S. sense to be considered creditable. That is, the current regulations provide necessary flexibility to identify creditable net income taxes calculated with variations from U.S. tax principles, while also rendering non-creditable other types of foreign levies (e.g., property taxes and value added taxes). Accordingly, ACT respectfully requests that the current regulatory standard be retained unless and until Congress determines it should be reconsidered.

ACT further believes any revisions to the existing standard should retain sufficient flexibility to accommodate the fact that income tax law in other countries reflects different policy decisions and is frequently amended (as in the United States). The existing regulations allow creditability of a tax on gross receipts that estimates gross receipts using a method that is likely to produce an amount that is not greater than fair market value. This rule protects the tax base from artificially inflated measures of gross receipts while allowing sufficient flexibility for credits where foreign tax regimes make minor deviations from the U.S. measurement of tax base to reflect the foreign country's administrative or policy preferences. As the U.S. standards themselves are a product of decades of administrative and policy decisions, Treasury should not subject U.S. taxpayers to significant double taxation risk over a formalistic difference between standards of measuring gross receipts.

Similarly, Treasury should retain the flexibility of the existing regulations with respect to the net income requirement. Deductions in the United States are allowed as a matter of legislative grace, and the Code contains many deductions, alternative allowances, and restrictions on those allowances which reflect decades of U.S. tax policy and experience. Foreign governments differ in their policy aims and administrative concerns resulting in different allowances. For example, it would not be per-se unreasonable for a government to more closely align the treatment of equity and debt by heavily restricting deductions for related-party debt. In other cases, governments may have similar aims but implement restrictions on different timelines. For example, some countries may adopt limitations as part of the BEPS initiative which are later copied by the United States. In still other cases, governments may rely on alternative allowances for certain deductions because their tax authorities find those deductions more difficult to administer than the IRS does. None of these situations indicate that a tax is not an income tax. Treasury's proposed rule, unlike the existing regulations, lacks the flexibility needed to assess the variety and changing nature of tax regimes in the world.⁵

The Proposed Regulations also would make significant changes to the determination of the amount of tax considered to be paid when a taxpayer is eligible for certain government incentives (for example, research or investment incentives) that may, as a matter of administrative convenience, be in the form of an offset for an income tax that otherwise is due. The preamble describes the current state of the law as “inconsistent,” “ambiguous,” and “administratively challenging.” ACT members respectfully disagree. The current regulatory standard and accompanying guidance,⁶ in the experience of ACT members, is relatively straightforward to apply and, importantly, sufficiently flexible to address a wide variety of potential fact patterns.

Further, as the preamble suggests, the new proposed standard would introduce discontinuity between government grants that are administered in the first instance through the tax system and those that are not. Attempting to address this discontinuity — by forcing taxpayers to consider whether government grants administered outside of the tax system should affect the amount of the credit — would introduce new uncertainty into the determination of the amount of tax that has been paid and would be difficult for tax departments and the IRS to administer.

Accordingly, ACT respectfully requests that the proposed changes to the creditability of foreign taxes be reconsidered jointly by Treasury and the Congress, taking notice of the ongoing OECD/G20 Inclusive Framework discussions regarding potential changes to income tax jurisdiction. ACT would welcome the opportunity to discuss the many policy issues raised by this area of the law with the IRS, Treasury, and Congressional staff.

Regulatory Authority for Recommendation

No regulatory authority is needed as ACT's recommendation requires no change to the current regulatory standard.

2. CFC Netting Rule Under Prop. Reg. § 1.861-10(e)(4)(v)

Proposed Regulations

The Proposed Regulations revise the treatment of certain controlled foreign corporation (“CFC”) debt under Treas. Reg. § 1.861-10(e)(8)(v) to provide that CFC-to-CFC debt is not treated as related group indebtedness (“RGI”) for purposes of the CFC netting rules contained in Treas. Reg. § 1.861-10(e).

Existing Treas. Reg. § 1.861-10(e)(4)(v) provides that for purposes of applying the rules of Treas. Reg. § 1.861-10(e) (the “CFC Netting Rule”), certain loans made by one CFC to another CFC are treated as loans made by a U.S. shareholder to the borrower CFC, to the extent the U.S. shareholder makes capital contributions directly or indirectly to the lender CFC, and are treated as RGI. No income derived from the U.S. shareholder's ownership of the lender CFC stock is treated as interest income derived from RGI, including subpart F inclusions related to the interest income earned by the lender CFC.

Under existing rules, no interest expense is generally allocated to income related to CFC-to-CFC debt, but the debt nevertheless may increase the amount of allocable RGI for which a reduction in assets is required under Treas. Reg. § 1.861-10(e)(7).

Treasury Explanation

Treasury and the IRS have determined that the failure to account for income related to CFC-to-CFC debt can distort the general allocation and apportionment of other interest expense under Treas. Reg. § 1.861-9.

ACT Recommendation

ACT recommends that the CFC Netting Rule be revised to provide that interest expense be allocated and apportioned to the separate limitation category to which RGI income is allocated and apportioned, rather than the separate limitation category to which stock of the obligor of the RGI is allocated.

Reasons for ACT Recommendation

Due to the significance of the proposed changes to the CFC Netting Rule, ACT believes it is appropriate for Treasury and the IRS to reexamine the existing mechanics of the CFC Netting Rule to account for changes made to the FTC regime by the TCJA.

The existing rules under Treas. Reg. § 1.861-10(e) provide that taxpayers subject to the CFC Netting Rule must specifically allocate interest expense to a separate limitation category (hereinafter each separate limitation category is referred to as a “basket”) in proportion to the relative average amounts of RGI held by the taxpayer in each basket during the year. Specifically, Treas. Reg. § 1.861-10(e)(4)(v) provides that RGI is allocated to a basket based on how the stock of the obligor is allocated under Treas. Reg. § 1.861-12T(c)(3), whether the stock is directly or indirectly held by the U.S. shareholder.

Because RGI is allocated to a basket based on how the stock of the obligor is allocated, and interest expense is allocated based on proportionate RGI allocated to each basket, the interest income and interest expense may be allocated to different baskets. For example, and as discussed in more detail below, in many fact patterns a majority of the obligor's stock will be attributable to the GILTI basket. Accordingly, under Treas. Reg. § 1.861-10(e)(4)(iv) and (v) interest expense subject to the CFC Netting Rule will be allocated to the GILTI basket. However, the rule does not take into account how the interest income received by the obligee is basketed. In many fact patterns, the interest income will be attributable to the general or passive basket, thus creating a mismatch between where the income and expense are basketed for FTC purposes. ACT believes the interest income and expense should be attributed to the same basket.

Under the rules of section 904, including the section 904(d)(3) “look-thru” rules, interest income received or accrued by a U.S. shareholder from a CFC will be treated as passive basket income to the extent the amounts are allocable to the CFC's passive income. Amounts received by the U.S. shareholder that are not allocable to the CFC's passive income generally are treated as general basket income. Thus, under the look-thru rules, interest income on RGI generally will be allocated to either the passive or general basket.

Because the TCJA introduced the new section 904(d)(1)(A) GILTI basket, stock of the obligor on RGI is likely to be allocated to the GILTI basket (in whole or in part) under Treas. Reg. § 1.861-12T(c)(3) to the extent not passive, rather than being allocated to the general basket. As a result, interest expense allocated under the CFC Netting Rule, as compared to the RGI interest income, may be over-allocated to the GILTI basket and under-allocated to the general basket.

Given this potential mismatch, ACT believes it would be more appropriate for Treas. Reg. § 1.861-10(e) to allocate interest expense to the basket(s) associated with the income generated by the RGI, rather than the basket(s) associated with the stock of the obligor. This modification would provide better parity between the basketing of RGI interest income and interest expense allocated under the CFC Netting Rule, thus neutralizing the FTC limitation impact of such interest expense and interest income.

Regulatory Authority for Recommendation

The recommendation above is within Treasury's authority under section 7805(a) to prescribe all needful regulations for the enforcement of the Code.

3. Applicability Date and General Application of Prop. Reg. § 1.861-10(g)

Proposed Regulations

Prop. Reg. § 1.861-10(g) provides special rules for allocating and apportioning interest expense to foreign branch category income for certain financial institutions. Specifically, the Proposed Regulations provide that interest expense reflected on a foreign banking branch's books and records is directly allocated to the branch's foreign branch category income to the extent of such income. The Proposed Regulations also provide a corresponding reduction in the value of the assets of the foreign branch for purposes of allocating other interest expense of the foreign branch owner.

Prop. Reg. § 1.861-10(g) applies to taxable years beginning on or after the date the final regulations are filed with the Federal Register. The Proposed Regulations do not provide any reliance language that would allow taxpayers to early adopt the rules of Prop. Reg. § 1.861-10(g).

Treasury Explanation

The preamble to the Proposed Regulations states that the rules under Prop. Reg. § 1.861-10(g) were provided in response to taxpayer comments that the general interest expense allocation and apportionment approach under Treas. Reg. §§ 1.861-8 through 1.861-13 did not appropriately take into account the fact that interest rates related to assets and liabilities of foreign branches of financial institutions are different from interest rates related to assets and liabilities of the U.S. home office, which may result in an over- or under-allocation of interest expense to the branch basket.

ACT Recommendations

Reasons for ACT Recommendations

As noted above, Prop. Reg. § 1.861-10(g) is effective for taxable years beginning on or after the date the regulations are filed as final in the Federal Register, and the Proposed Regulations do not contain any reliance language that would allow taxpayers to early adopt the rules of Prop. Reg. § 1.861-10(g). ACT generally agrees with a prospective applicability date with respect to the Proposed Regulations because it allows taxpayers additional time to analyze the rules and update existing compliance processes, particularly where changes are made prior to finalization.

However, ACT believes that when the merits of a rule are clear in proposed form, and a significant deviation from the rule seems unlikely to occur upon finalization, taxpayers should be given the option to rely on the proposed rule before it is finalized. This is particularly true where Treasury and the IRS have indicated that the proposed rule is intended to correct potential issues and inconsistencies in prior regulations, like the “potential distortions” noted in the preamble. Therefore, ACT believes that, consistent with the approach applied to many of the other recent TCJA-related proposed regulations, taxpayers should be able to rely on Prop. Reg. § 1.861-10(g) before the regulations are finalized.

Additionally, ACT believes that all branch liabilities, whether interest-bearing or not, should be netted against branch assets for purposes of Prop. Reg. § 1.861-10(g). To the extent a branch liability exists, that liability supports the branch assets, regardless of whether the liability bears interest. As a result, ACT believes that the general principles of Prop. Reg. § 1.861-10(g) should apply to all branch liabilities, whether or not interest is incurred.

Regulatory Authority for Recommendations

The recommendation above is within Treasury's authority under section 7805(a) to prescribe all needful regulations for the enforcement of the Code.

4. Adjustments to the Amount of Foreign Branch Liabilities Under Prop. Reg. § 1.861-10(g)(2)

Proposed Regulations

The Proposed Regulations provide that interest expense reflected on a foreign banking branch's books and records is directly allocated against the foreign branch category income of that foreign branch, to the extent it has foreign branch category income. The Proposed Regulations further provide for a reduction in the value of the assets of the foreign branch for purposes of allocating other interest expense of the foreign branch owner.

Treasury and the IRS have requested comments as to whether adjustments to the amount of foreign branch liabilities subject to this rule are necessary to account for differing asset-to-liability ratios in a foreign branch and its owner.

Treasury Explanation

N/A

ACT Recommendation

ACT recommends, in order to take into account differing asset-to-liability ratios in a foreign branch and its owner, that a rule similar to Treas. Reg. § 1.882-5 should apply to adjust the amount of foreign branch liabilities subject to Prop. Reg. § 1.861-10(g)(2).

Reasons for ACT Recommendation

For U.S. branches of foreign corporations, the baseline for apportioning interest expense under the Adjusted U.S. Booked Liability (“AUSBL”) method of Treas. Reg. § 1.882-5 is the interest expense paid or accrued on its third-party liabilities that are reflected on the books of the branch and incurred in connection with its U.S. businesses. This amount is adjusted to reflect interest expense on an amount of the foreign corporation's “U.S. connected liabilities,” that is equal to its U.S. assets multiplied by a fixed liability to asset ratio or to the ratio of liabilities to the assets of the entire legal entity. The purpose of this rule is to prevent possible abuses (e.g., leveraging a U.S. branch more than its home office to reduce the branch's taxable income in the United States via increased interest expense deductions).

If U.S.-booked liabilities exceed U.S.-connected liabilities, the foreign corporation's U.S. interest expense deduction will be equal to the interest expense it incurs on its U.S.-booked liabilities, multiplied by the ratio of its U.S.-connected liabilities to its U.S.-booked liabilities. However, if its U.S.-booked liabilities are less than its U.S.-connected liabilities, the interest expense on the former is increased by an amount equal to the average interest rate on the USD-denominated liabilities that are not U.S.-booked liabilities, multiplied by that excess. Thus, while the AUSBL method of Treas. Reg. § 1.882-5 takes into account the interest expense on third-party liabilities of U.S. branches that are reflected on their books, the foreign corporation adjusts that interest expense under the assumption that the leverage of its U.S. branches should be equal to either a fixed prescribed ratio or reflect the leverage of the entire legal entity.

ACT believes a similar adjustment is appropriate in Prop. Reg. § 1.861-10(g)(2). To be clear, ACT does not believe that Treas. Reg. § 1.882-5 should take the place of Prop. Reg. § 1.861-10(g)(2); rather, ACT believes the relative-leverage concept of Treas. Reg. § 1.882-5 (discussed above) should be used to adjust foreign branch liabilities in order to achieve an equitable allocation of interest expense to foreign branch basket income in the case of foreign banking branches.

Regulatory Authority for Recommendation

The recommendation above is within Treasury's authority under section 7805(a) to prescribe all needful regulations for the enforcement of the Code.

5. Election to Capitalize Certain Expenses in Determining Tax Book Value of Assets — Prop. Reg. § 1.861-9(k)

Proposed Regulations

For purposes of allocating and apportioning interest expense, the Proposed Regulations allow taxpayers to elect, in determining the tax book value of its assets, to capitalize and amortize all research and experimentation (“R&E”) expenses and 50% of advertising expenses. The cost recovery periods for R&E and advertising expenses are 15 and 10 years, respectively.

Treasury Explanation

The preamble to the Proposed Regulations states that Treasury and the IRS are aware that internally developed intangible assets may have no tax book value because the associated R&E and advertising expenses are immediately deductible but, nevertheless, may have significant economic value. Accordingly, to better reflect the economic value of these assets in the allocation and apportionment of interest expense, the Proposed Regulations allow taxpayers, solely for purposes of allocating and apportioning interest expense, to capitalize R&E and advertising expenses over a prescribed period of time.

ACT Recommendations

ACT recommends the following with respect to the election in Prop. Reg. § 1.861-9(k):

Reasons for ACT Recommendations

ACT applauds Treasury and the IRS in promulgating Prop. Reg. § 1.861-9(k) which, to the benefit of the taxpayer, aligns the economic reality of asset values with the rules for allocating and apportioning interest expense in Treas. Reg. § 1.861-9. However, the Proposed Regulations are proposed to be effective for taxable years beginning on or after the date the Proposed Regulations are finalized, unnecessarily delaying their effect. For calendar-year taxpayers, the earliest date the Proposed Regulations can be effective is January 1, 2022, at which point section 174 as contained in Pub. L. 115-97, title I, § 13206(a) will be effective, requiring amortization of R&E expenditures over a period of five years.⁷ For these taxpayers, the Proposed Regulations will only affect the capitalization and amortization of advertising expenses. ACT believes that the discrepancy in asset values for purposes of allocating and apportioning interest expense exists in all prior years, not just years following the finalization of the Proposed Regulations.

The Proposed Regulations limit capitalization and amortization to 50% of a taxpayer's “specified advertising expenses.” Specified advertising expenses are defined to include:

. . . any amount paid or incurred in a taxable year (but only to the extent otherwise deductible in such taxable year), for the development, production, or placement (including any form of transmission, broadcast, publication, display, or distribution) of any communication to the general public (or portions thereof) which is intended to promote the taxpayer (or any related person under §1.861-8(c)(4)) or a trade or business of the taxpayer (or any related person), or any service, facility, or product provided pursuant to such trade or business.

ACT believes that the entirety of these expenses should be eligible to be capitalized and amortized by electing taxpayers. The R&E undertaken to create a product, and the advertising undertaken to promote the product, often are closely linked and in many cases occur with little time lag. As R&E expenses of a product can be fully capitalized and amortized, so should the advertising expenses used to promote the product.

The Proposed Regulations require electing taxpayers to capitalize and amortize both R&E and advertising expenses. ACT believes that requiring electing taxpayers to capitalize and amortize both expenses would unduly burden both taxpayers and the IRS. Determining the amount of R&E and advertising expenses that are subject to the rules of Prop. Reg. § 1.861-9(k) will be a substantial undertaking for some taxpayers.

In many cases, an immaterial amount of either R&E or advertising expenses will not justify the undertaking required in determining the amount that may be capitalized and amortized. For example, some taxpayers have well-established products that do not require extensive R&E expense; however, these products are highly marketed to consumers and thus incur material amounts of advertising expense. Conversely, some taxpayers produce products that require extensive R&E to refine and develop the product; however, these products are not heavily marketed to consumers and thus incur an immaterial amount of advertising expenses. Requiring either group of taxpayers to calculate an immaterial amount of either R&E or advertising expenses is, in ACT's opinion, unwarranted. Accordingly, ACT recommends that the capitalization and amortization of R&E and advertising expenses be elected independently of one another.

Finally, after making the election a taxpayer must determine the tax book value of its assets as if it had capitalized its R&E and advertising expenses in every prior year. ACT believes the character of the asset should be apportioned based on the proportion of the taxpayer's sales in each statutory and residual grouping based on the application of Treas. Reg. § 1.861-17 as in effect in the year in which the taxpayer makes the election to capitalize the expenses.

Characterizing the asset based on Treas. Reg. § 1.861-17 as in effect in the year in which the taxpayer makes the election to capitalize the expenses, rather than the year in which the expenses were incurred (if different), provides an administrative convenience to both taxpayers and the IRS. Further, as the statutory and residual groupings of Treas. Reg. § 1.861-17 have recently been amended, ACT's recommendation would prevent unnecessary complexity that could arise by apportioning the asset to prior-year statutory and residual groupings.⁸

Regulatory Authority for Recommendations

The recommendations above are within Treasury's authority under section 7805(a) to prescribe all needful regulations for the enforcement of the Code. Regarding Treasury's authority for effective dates, Treasury has the authority under section 7805(b)(1)(B) to issue regulations retroactive to the date on which the Proposed Regulations were filed with the Federal Register, and authority under section 7805(b)(7) to allow taxpayers to apply the regulations retroactively.

6. Financial Services Entities

Proposed Regulations

The Proposed Regulations retain the general approach of existing Treas. Reg. § 1.904-4(e) by providing a numerical test which provides that an entity is a financial services entity if more than a threshold percentage of its gross income is derived directly from active financing income. However, the Proposed Regulations lower the threshold percentage from 80% to 70%, and further provide that active financing income generally must be earned from customers or other counterparties that are not related parties.

Treasury and the IRS request comments on the treatment of related-party payments in the numerator and denominator of the 70% gross income test and on whether related-party payments should in some cases constitute active financing income.

Treasury Explanation

Treasury and the IRS believe these changes will promote simplification and greater consistency between Code provisions that have complementary policy objectives, while still taking into account the differences between sections 954 and 904.

ACT Recommendations

ACT recommends that Treasury and the IRS retain existing-law definitions with respect to financial services entities, including the definition of financial services income.

If Treasury and the IRS do not retain the existing-law definitions, ACT recommends that:

Reasons for ACT Recommendations

Similar to the proposed regulations issued in 2019, the Proposed Regulations would change the definition of “financial services income” resulting in potentially detrimental effects with respect to both the basketing of income and taxes for purposes of section 904 and the definition of a qualified deficit for purposes of section 952. While ACT appreciates Treasury's endeavor to make less substantial changes to the existing, long-standing regulatory regime as compared to the changes proposed in the 2019 proposed regulations, ACT remains concerned that the proposed changes could create unexpectedly adverse and inequitable results in common fact patterns.

As described above, the Proposed Regulations would relax the threshold to qualify as a financial services entity from 80% to 70% of income derived from active financing income, but also would introduce a new requirement that income be earned only from unrelated customers in order to be treated as qualifying income. ACT believes that a consequence of these revised definitions is that treasury centers of companies that lend to related parties and enter into hedging transactions with related and unrelated parties to manage foreign exchange or interest rate risk on an overall group basis would fail to qualify as a financial services entities in most instances.

As a result, although the income of these entities is from legitimate, bona-fide risk management activities on behalf of the overall group, the income would be treated as passive basket income. In addition, taxpayers could not use the statutorily granted qualified deficit rules to reduce current-year treasury center income by prior-year treasury center losses. Such a result would introduce volatility into a taxpayer's annual tax computations without an apparent tax policy justification and without any indication that Congress intended this outcome.

Accordingly, ACT respectfully urges Treasury to reconsider the proposed changes and either retain current-law definitions or revise the definitions to provide that entities such as those that operate as treasury centers for a group of related companies be permitted to treat related-party income (i.e., from lending or hedging activities) as qualifying financial services income to the extent that the income would have been qualifying financial services income but for the relatedness of the companies.

Further, should Treasury and the IRS not adopt ACT's above-mentioned recommendations, ACT respectfully requests Treasury permit taxpayers to rely on current-law definitions with respect to any pre-existing attributes such as qualified deficits that were generated in the years before the definitional changes. Such an allowance would ensure that future income that could be offset with a qualified deficit under existing regulations can continue to be offset (as if there were no definitional change) and would prevent the revised regulatory definition from negating the ability to utilize the pre-existing attribute.

Regulatory Authority for Recommendations

The recommendations would either withdraw the proposed changes with respect to financial services entities entirely or modify the rules with respect to financial services entities and financial services income. Thus, to the extent that the proposed rules are within the scope of Treasury's regulatory authority, the recommendations would be as well.

III. COMMENT RELATING TO THE NOTIFICATION REQUIREMENTS OF FOREIGN TAX REDETERMINATIONS

Request for Comments

On February 2, 2021, the IRS issued a request for comments related to foreign tax redeterminations.

IRS Explanation

The request for comments is part of the IRS's effort to reduce paperwork and taxpayer burden related to foreign tax redeterminations.

ACT Recommendation

ACT commends Treasury and the IRS for continuing the dialogue with taxpayers related to foreign tax redeterminations and expects to submit detailed comments in response to this request.⁹ In the interim, ACT recommends taxpayers be allowed additional time to make the election under Treas. Reg. § 1.905-5(e).

Reasons for ACT Recommendation

The election under Treas. Reg. § 1.905-5(e) is intended to provide a “simplified and reasonably accurate” alternative method to account for post-2017 foreign tax redeterminations with respect to pre-2018 taxable years of foreign corporations. The election applies only with respect to foreign tax redeterminations that occur in the foreign corporation's taxable years ending with or within a taxable year of a United States shareholder of the foreign corporation ending on or after November 2, 2020. Taxpayers must file a statement with a timely filed original tax return for the taxable year of each controlling domestic shareholder of the foreign corporation in which or with which the foreign corporation's first redetermination year ends.¹⁰

For example, if a calendar-year taxpayer has a foreign tax redetermination (that relates to a pre-2018 taxable year) that occurs on December 1, 2020, the taxpayer must decide whether to make the election by the extended due date of its 2020 tax return. As the election currently is irrevocable, a substantial amount of analysis is required to determine whether the simplicity the election provides outweighs the burden of filing multiple amended tax returns. In light of the request for comments and the irrevocable nature of the election, ACT believes it is reasonable to provide taxpayers with additional time to make the election (e.g., to allow taxpayers to make the election on an amended return).

ACT plans to submit detailed comments on foreign tax redeterminations in response to the IRS request at a later date.

Regulatory Authority for Recommendation

The recommendation above is within Treasury's authority under section 7805(a) to prescribe all needful regulations for the enforcement of the Code.

IV. CONCLUSION

We understand that a number of details would need to be addressed if Treasury and the IRS accept the recommendations set forth above. ACT member companies have identified a number of these detailed drafting issues and have carefully considered how they might be addressed. ACT representatives would welcome the opportunity to meet with Treasury and the IRS to discuss any of the above recommendations.