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Tax Group Urges Retention of Safe Harbor in Loss Limitation Regs

NOV. 11, 2019

Tax Group Urges Retention of Safe Harbor in Loss Limitation Regs

DATED NOV. 11, 2019
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November 11, 2019

Internal Revenue Service
CC:PA:LPD:PR (REG-125710-18)
Room 5203
Post Office Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments on proposed regulations under section 382(h) (NPRM REG-125710-18)

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 the proposed regulations under section 382(h) of the Internal Revenue Code (“Code”), as amended by the Tax Cuts and Jobs Act (“TCJA”). ACT recognizes and commends the extraordinary efforts of Treasury and IRS staff 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:
The Honorable David J. Kautter, Assistant Secretary for Tax Policy, Department of the Treasury

The Honorable Charles P. Rettig, Commissioner, Internal Revenue Service

Mr. Michael J. Desmond, Chief Counsel, Internal Revenue Service

Mr. Krishna Vallabhaneni, Tax Legislative Counsel, Office of Tax Policy, Department of the Treasury

Mr. Christopher W. Call, Attorney-Advisor (Tax Legislation), Office of Tax Policy, Department of the Treasury

Mr. Colin Campbell, Attorney-Advisor, Office of Tax Policy, Department of the Treasury

Mr. Kevin Jacobs, Office of the Associate Chief Counsel (Corporate), Internal Revenue Service

Ms. Marie C. Milnes-Vasquez, Special Counsel to the Associate Chief Counsel (Corporate), Internal Revenue Service


COMMENTS BY ALLIANCE FOR COMPETITIVE TAXATION ON
PROPOSED REGULATIONS UNDER SECTION 382(h)

I. INTRODUCTION

This document sets forth the comments of the Alliance for Competitive Taxation (ACT) on the proposed regulations regarding section 382(h), related to the identification of items of recognized built-in gain and loss (NPRM REG-125710-18) (the “Proposed Regulations”).

In Notice 2003-65 (the “Notice”), the Internal Revenue Service (the “IRS”) and the Department of the Treasury (“Treasury”) provided two alternative safe harbor approaches for the identification of built-in items for purposes of section 382(h): the 1374 approach and the 338 approach.1 As explained in the Notice:

The 338 approach identifies items of RBIG and RBIL generally by comparing the loss corporation's actual items of income, gain, deduction, and loss with those that would have resulted if a section 338 election had been made with respect to a hypothetical purchase of all of the outstanding stock of the loss corporation on the change date (the “hypothetical purchase”). As a result, unlike under the 1374 approach, under the 338 approach, built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period, and deductions for liabilities, in particular contingent liabilities, that exist on the change date may be treated as RBIL.2

The 338 approach is based upon the “wasting asset” theory, which assumes that the “wasting” of a depreciable, amortizable, or depletable asset approximates the income produced by such asset over the course of its useful life. Accordingly, the difference between the “FMV wasting” of an asset (based upon the asset's fair market value as of a change date) and such asset's “tax wasting” (based upon the loss corporation's tax basis in such asset as of the change date) was intended to approximate the amount of built-in gain or loss recognized with respect to such asset during a relevant period of time.

I. PROPOSED ELIMINATION OF THE 338 APPROACH

Proposed Regulations

The Proposed Regulations would eliminate the ability of taxpayers to use the 338 approach to identify items of recognized built-in gain (“RBIG”) and recognized built-in loss (“RBIL”).

Treasury Explanation

The Preamble to the Proposed Regulations provides the following explanation regarding the proposed elimination of the 338 approach:

After study, and based on taxpayer input, the Treasury Department and the IRS have decided not to incorporate the 338 approach into these proposed regulations. As described in part I.B.1. of this Explanation of Provisions, the Treasury Department and the IRS have concluded that the 338 approach lacks sufficient grounding in the statutory text of section 382(h). Further, the Treasury Department and the IRS have determined that the mechanics underlying the 338 approach (i) are inherently more complex than the accrual-based 1374 approach, (ii) can result in overstatements of RBIG and RBIL, and (iii) as a result of the TCJA, would require substantial modifications to eliminate increased uncertainty and ensure appropriate results. By eliminating the 338 approach, the Treasury Department and the IRS have determined that these proposed regulations would significantly reduce current and future complexity of section 382(h) computations for taxpayers and the IRS alike.

ACT Recommendation

ACT recommends the final regulations retain the 338 approach as a safe harbor that taxpayers may rely upon in identifying items of RBIG and RBIL for purposes of section 382(h).

Reasons for ACT Recommendation

ACT believes the 338 approach is consistent with both the statutory text and purpose of section 382(h). Not only is the 338 approach consistent with the purpose of section 382 but, as discussed below, we believe it promotes such purpose to a greater degree than the 1374 approach, by producing results that more closely align with the neutrality principle, which is the foundation for section 382.

1. Legislative History

The Preamble concludes the 338 approach “lacks sufficient grounding in the statutory text of section 382(h).”3 We disagree; we believe ample support for the 338 approach can be found in the statutory text. Section 382(h)(6)(A) currently provides that RBIG includes “[a]ny item of income which is properly taken into account during the recognition period but which is attributable to periods before the change date.”4 As we will discuss in greater detail below, it is our belief that this language implies that RBIG and RBIL should include items of income and deduction that arise in modalities other than through the disposition of an asset (upon which gain or loss is generally realized and/or recognized).

While the Preamble does not clearly articulate the reasons why the 338 approach is believed to lack grounding in the statutory text, this view may be based on a narrow reading of an isolated part of section 382(h)(6)(A). As discussed above, that provision provides, in part, that an item of income is included in RBIG where it is “properly taken into account” during the recognition period. Because the 338 approach is based on a deemed sale of the assets and liabilities of the loss corporation, “no actual recognition of gain or income has occurred,”5 and, therefore, the item of income resulting from the deemed sale arguably is not “properly taken into account.” However, we believe section 382(h)(6)(A) should be read as a whole with regard to the policies and objectives of section 382(h).6

When section 382(h)(6) was originally enacted in 1986, it stated: “[t]he Secretary may by regulation treat amounts which accrue on or before the change date but which are allowable as a deduction after such date as recognized built-in losses.”7 As a result, section 382(h)(6)'s original emphasis, with respect to built-in deductions, was on when the item accrued. Congress permitted Treasury to “issue regulations under which amounts that accrue before the change date, but are allowable as a deduction on or after such date, will be treated as built-in losses.”8 However, Congress made clear that such regulations were not permitted to include depreciation deductions as built-in deductions.9

In contrast to section 382(h)(6), both sections 382(h)(2)(A) and (B) required the disposition of an asset before a loss corporation took into account an item of RBIG or RBIL. Thus, given the absence of regulatory authority with respect to items of built-in income, no relief was provided for “built-in income other than gain on disposition of an asset.”10

The following year, Congress amended section 382(h)(2)(B) to expand the definition of RBIL to include amounts allowable as depreciation, amortization or depletion.11 Underlying this change was Congress's belief that “the benefit of built-in depreciation with respect to an asset that is retained is economically indistinguishable from the benefit of a built-in loss if the same asset is sold.”12 We believe this statement is important for two reasons. First, it makes clear that Congress was focused on the economic relationship between the retention of an asset and the disposition of such asset. Second, it implies that Congress believed the “wasting” (i.e., depreciation) of a retained, depreciable asset is economically indistinguishable from the disposition of such asset.13 Because the 338 approach employs the “wasting asset” theory to approximate the recognition of built-in items with respect to a retained asset, we believe the 338 approach is consistent with Congress's implied belief.14 Moreover, we believe the 338 approach attempts to provide economic “neutrality” between the retention of an income-producing asset and the disposition of such asset — a policy that aligns with Congress's determination that the depreciation of a retained asset should be “economically indistinguishable” vis-à-vis the disposition of such asset.

In addition, the Conference Report to the Omnibus Reconciliation Act of 1987 states that items of depreciation, amortization, and depletion constitute RBIL because they had “economically accrued prior to the acquisition.”15 Again, Congress made clear that economic principles should control the identification of recognized built-in deductions — not the sale or disposition of the asset. We believe such economic principles should be equally controlling in the context of identifying recognized built-in income, as we do not see a compelling rationale for distinguishing items of built-in income and deduction. Given that the 338 approach approximates the recognition of income and deduction with respect to a retained asset that economically accrued prior to an acquisition (rather than requiring the sale or disposition such asset), it more closely aligns with the legislative history of the 1987 Act.

The following year (i.e., 1988), Congress again amended section 382(h), this time clarifying section 382(h)(6).16 In this clarification, Congress enacted section 382(h)(6)(A) to include items of built-in income that were recognized during the post-change recognition period but that were attributable to the pre-change period. Although the legislative history behind this clarification is sparse, it is our belief that use of the word “clarifies” in describing the enactment of section 382(h)(6)(A) indicates Congressional intent to retain the economic principles guiding the 1987 amendments. Accordingly, we view section 382(h)(6) as requiring the determination of whether an item of built-in income or deduction is economically attributable to pre-change periods — a requirement we view the 338 approach as satisfying.

2. Neutrality Principle

The Preamble states that the purpose of section 382(h) is to implement the “neutrality principle,” under which “the built-in gains and losses of a loss corporation, if recognized during the recognition period, generally are to be treated in the same manner as if they had been recognized before the ownership change.”17

In explaining the 338 approach, the Preamble states:

[T]he most notable feature of the 338 approach is that assets with built-in gains can generate RBIG even without a realization event. . . . This treatment follows from the logic that such built-in gain assets would have generated income in subsequent years; in the absence of an acquisition, such income could have been offset freely by the old loss corporation's NOLs. The 338 approach prescribes a proxy for that excess income amount: the extent to which cost recovery deductions . . . under a hypothetical purchase of each asset at its current fair market value exceed actual allowable cost recovery deductions.

Consistent with the Preamble, the 338 approach allows recognition of items of RBIG (and RBIL) without disposition of an asset. By contrast, elimination of the 338 approach would require a built-in gain asset to be disposed of before such asset could produce an item of RBIG (or RBIL). In the modern, post-industrial economy, such elimination would unduly restrict the ability to utilize pre-change losses where the predominant portion of built-in gains are due to intellectual property (e.g., patents, trademarks, etc.). Loss corporations generally view the disposition of their intangible assets as impractical or economically imprudent if they desire to continue their business. Thus, absent the 338 approach, pre-change losses would be utilizable solely to the extent of the “base” section 382 limitation. This result would greatly impair the ability to use pre-change losses notwithstanding the majority of post-change income is due to retained built-in gain assets. We believe such a result would violate the “neutrality principle.”

In 1986, Congress recognized that “special rules” related to RBIG needed to be enacted, otherwise the temporal dissociation of an asset's deductions from income (generally caused by statutory provisions that accelerate deductions or defer income) would result in net operating loss (“NOL”) carryforwards being too limited in their ability to offset built-in gains that were recognized subsequent to an ownership change.18 We believe the elimination of the 338 approach would violate this policy goal, because the 1374 approach effectively would require the disposition of an asset before an item of RBIG could be produced, without regard to the non-tax business considerations that prevent the disposition of certain income-producing, built-in gain assets.

Where the target's NOLs are principally driven by deductions on intangible property, to the extent the target generates income in later years, it would have been able to offset such income with NOLs. The elimination of the 338 approach would impede the ability of an acquiring company to offset income with NOLs generated during the period (which may be largely attributable to depreciation and amortization deductions taken on such property), despite the direct relationship between the NOLs and the income.

3. Overstatements of RBIG and RBIL

The Preamble identifies two reasons why the 338 approach overstates items of RBIG:19

1. [T]he schedules for cost recovery deductions were never intended to match the production of income from each asset; rather, they were intended to accelerate cost recovery to stimulate investment. Thus, this proxy is likely to, on average, overstate income created by those assets, further increasing NOL usage beyond the neutral baseline.

2. [S]uch an adjustment for income created by built-in gain assets is unnecessary, as it is already taken into account by section 382. Section 382 provides that the NOLs of the old loss corporation can be used by the new loss corporation up to the annual limit. This annual limit is equal to a prescribed interest rate multiplied by the value of the stock of the old loss corporation, and serves as a proxy for the income created by the assets of the old loss corporation. Thus, to the extent that the appreciated value of a built-in gain asset is reflected in the value of the stock, the general rule of section 382 allows for the NOLs of the old loss corporation to offset the flow of income created by that asset. Therefore, the treatment created by the 338 approach creates a double benefit.

With respect to the use of recovery rates as a proxy for income, it is our experience that a loss corporation's built-in gain assets generally are predominantly comprised of intangible assets, not depreciable assets. With respect to intangible assets, the legislative history underlying section 197 is clear that “investment stimulus” was not at the forefront of Congress' decision-making process.20 Rather, Congress chose a 15-year recovery period as an attempt to eliminate controversy between taxpayers and the IRS.21 Moreover, when choosing the 15-year recovery period, Congress made clear that useful lives of certain intangible assets may be shorter or longer than the prescribed recovery period.22 Thus, it is arguable that the 338 approach's income proxy is some cases may actually understate the income to be generated by built-in gain intangible assets.

More broadly, we note that to substantiate an asset's fair market value, the asset should produce an amount of income greater than its fair market value (as such income must be discounted to present value). Thus, it is arguable that the use of fair market value as the 338 approach's proxy of a built-in gain asset's aggregate income actually may understate the income to be generated by such asset.

In addition, we disagree with Treasury and the IRS's assertion that the section 338 approach provides a double benefit because the annual limit serves as a proxy for the income created by the assets of the old loss corporation. First, the “base” section 382 limitation was never intended to approximate the economic (or taxable) income generated by built-in gain assets. Rather, it was intended to approximate a “reasonable risk-free rate of return a loss corporation could obtain in the absence of a change in ownership” if it had sold all of its assets, satisfied all of its liabilities, and invested the remaining proceeds in long-term marketable obligations of the U.S. government.23 Congress's goal in using this rate was to ensure that the loss corporation's pre-change NOL carryforwards were not more valuable to a potential acquirer than they were to the going concern that produced them.24 It was never intended to provide a proxy of economic (or taxable) income produced by the loss corporation's built-in gain assets.

Moreover, it is not clear that section 382(h) is intended to relate to determinations of the “base” section 382 limitation. For example, assume a loss corporation with $50 of NOLs has an asset with a fair market value of $100 and a tax basis of $40. The loss corporation also has a liability of $30, the payment of which would give rise to a deduction. Under the “neutrality principle,” the loss corporation is deemed to sell the asset for a gain of $60 and pay the liability for a deduction of $30, resulting in a net unrealized built-in gain (“NUBIG”) of $30. Thus, $30 of the $50 of NOL should be available as the gain is pre-change, with $20 of the remaining NOL now subject to the section 382 limitation each year, which is equal to the equity value on the ownership change date ($70) multiplied by long-term tax-exempt rate (assumed to be 1%), which would result in $0.70 of section 382 limitation each year. As a result, the use of the long-term tax-exempt interest rate does not interact with the recognition of built-in gains through the wasting of the built-in gain assets; instead, the gains and losses are separately considered.

Even if the annual limit were intended to function in the manner described in the Preamble, built-in gain assets are not exclusively funded with equity. Thus, focusing on the “duplication” of income produced by equity-funded, built-in gain assets ignores the fact that a similar proxy is not provided with respect to debt-funded, built-in gain assets.25 Thus, debt-funded, built-in gain assets are given no income-generation proxy by the “base” section 382 limitation. Because of this omission and because we believe debt-to-equity capitalizations generally do not skew towards majority equity funding, we believe that such statement should hold little weight in determining whether the 338 approach overstates items of RBIG.

II. CONCLUSION

Based upon the foregoing discussion, we urge Treasury and the IRS to withdraw their proposed elimination of the 338 approach. The issues presented by Treasury and the IRS in the Preamble, including items not discussed herein, are complex in nature and provide few simple answers. However, we do not believe that the outright elimination of the 338 approach is an appropriate response. ACT representatives would welcome the opportunity to meet with Treasury and the IRS to discuss the above recommendation. 

FOOTNOTES

1Notice 2003-65, 2003-2 C.B. 747.

2Id. at 12.

3REG-125710-18, 84 F.R. 47455, at 47457 (Sept. 10, 2019).

4(Emphasis added). Section 382(h)(6)(B) provides similar language with respect to RBIL.

5REG-125710-18, 84 F.R. 47455, at 47458 (Sept. 10, 2019).

6Kelly v. Robinson, 479 U.S. 36, 43 (1986) (“In expounding a statute, we must not be guided by a single sentence or member of a sentence, but look to the provisions of the whole law, and to its object and policy.”) (quoting United States v. Heirs of Boisdoré, 49 U.S. (8 How.) 113, 122 (1850)).

7Tax Reform Act of 1986, Pub. L. N. 99-514, § 621(a) (emphasis added).

8JCS-10-87, General Explanation of the Tax Reform Act of 1986, at 320.

9H.R. Conf. Rep. No. 99-841, at II-191.

In connection with the enactment of section 382(h), Congress required Treasury to “conduct a study of whether built-in depreciation deductions should be subject to section 382.” See JCS-10-87, General Explanation of the Tax Reform Act of 1986, at 320-321.

10JCS-10-87, General Explanation of the Tax Reform Act of 1986, at 320 n.36.

11P.L. 100-203, Omnibus Reconciliation Act of 1987, § 10225(b) (1987).

12H.R. Rep. No. 100-391(II), at 997 (emphasis added).

13Said differently, the “wasting” of a retained asset economically mimics the continuous disposition (or consumption) of such asset.

14With respect to items of RBIG, the 338 approach identifies amounts of “foregone” — rather than actual — depreciation, amortization, and depletion to estimate the “wasting” of an asset.

15H.R. Conf. Rep. No. 100-495, at 974.

16S. Rep. No. 100-445, at 48. We note that the original explanation of the Senate's proposed amendment to section 382(h)(6) stated that “[t]he amendment clarifies that under regulations . . . [RBIG would include] any item of income . . . that is attributable to periods before the change date . . . ”(emphasis added). See JCS-10-88, Description of the Technical Corrections Act of 1988 (H.R. 4333 and S. 2238), at 47 (March 31, 1988) (providing background on the technical correction bills introduced by the House and Senate on March 31, 1988). Although the phrase “under regulations” did not appear in the Senate's official report, such phraseology in the Joint Committee on Taxation's (the “JCT”) explanation of the Senate's bill could be read to indicate a Congressional mandate for Treasury and the IRS to determine the scope of amended section 382(h)(6)(A).

17REG-125710-18, 84 F.R. 47455 (Sept. 10, 2019).

18JCS-10-87, General Explanation of the Tax Reform Act of 1986, at 298.

19REG-125710-18, 84 F.R. 47455, at 47464 (Sept. 10, 2019). The Preamble does not appear to state how the 338 approach overstates items of RBIL. Therefore, this portion of our letter will solely focus on items of RBIG.

20H.R. Rep. No. 103-111, 103rd Cong., 1st Sess., at 256 (1993).

21Id.

22Id.

23JCS-10-87, General Explanation of the Tax Reform Act of 1986, at 296 and 317.

24Id., at 317.

25The Preamble's assertion understands that the “base” section 382 limitation generally is calculated by multiplying the loss corporation's equity value by the prescribed long-term tax-exempt rate for the month in which the ownership change occurred. Presumably, all built-in gains are inherent in such equity value because (i) equity value generally equals the aggregate fair market value of a loss corporation's assets less its aggregate liabilities and (ii) technically, all built-in gains are reflected in the aggregate fair market value of a loss corporation's assets. However, because the “base” section 382 limitation only utilizes equity value (and not the aggregate fair market value of a loss corporation's assets), we do not believe it properly accounts for any assets (or the built-in gains associated with such assets) that are funded with debt. Rather, we believe it only accounts for the portion of the assets (and their associated built-in gains) that are funded with equity.

END FOOTNOTES

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