Transcript Available of IRS Hearing on Foreign Tax Credit Regs

UNITED STATES DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE

TELECONFERENCE PUBLIC HEARING ON PROPOSED REGULATIONS

"GUIDANCE RELATED TO THE FOREIGN TAX CREDIT; CLARIFICATION OF FOREIGN-DERIVED INTANGIBLE INCOME"

[REG-101657-20]

Washington, D.C.

Wednesday, April 7, 2021

PARTICIPANTS:

For IRS:

LAURA TIANLIN SHI
Attorney
Office of Associate Chief Counsel (International)

For U.S. Department of Treasury:

JASON YEN
Associate International Tax Counsel
Office of Tax Policy

Speakers:

RAFIC H. BARRAGE
Silicon Valley Tax Directors Group

GARY SPRAGUE
Software Coalition

JEFFREY L. GOULD
Frank Hirth, PLC

* * * * *

PROCEEDINGS

(10:00 a.m.)

MS. SHI: Good morning, everyone. My name is Laura Tianlin Shi. I'm an attorney in Branch 3 of the IRS Office of the Associate to Chief Counsel International. I want to welcome you to this public hearing on proposed regulations published in the Federal Register on November 12th, 2020, entitled Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income.

The government panel today consists of myself and Jason Yen, who is an Associate International Tax Counsel in the Office of Tax Policy at the Department of Treasury. We have three speakers today. First we have Rafic Barrage from the Silicon Valley Tax Directors Group. Second we have Gary Sprague from the Software Coalition, and third, we have Jeffrey Gould from Frank Hirth, PLC.

Each speaker will have 10 minutes to present after which the panel may ask the speaker questions. The operator will be keeping track of time. You'll hear a beep on the line at the one-minute mark when you have one minute remaining. With that, I think we're ready to begin, and we can turn it over to our first speaker Rafic Barrage.

MR. BARRAGE: Thank you very much. Good morning. My name is Rafic Barrage, and I'm a partner in the Washington, D.C., Office of Baker & McKenzie. I'm speaking today on behalf of the Silicon Valley Tax Directors Group regarding the proposed foreign tax credit regulations issued last November. The Silicon Valley Tax Directors Group is composed of representatives from leading and diverse high-technology companies based in the Silicon Valley.

The group was formed in 1981 and now has 105 members. Members of the SVTDG represent a significant portion of U.S. exports of digital goods and increasingly services that would be adversely impacted by the proposed regulations.

I would like to thank Treasury and the IRS for their thoughtful work on the proposed regulations and their continuing opposition to digital services taxes and other unilateral measures enacted or proposed by certain foreign governments intended to target U.S. companies. However, the proposed jurisdictional nexus requirement would undermine the principled purposed of the foreign tax credit provisions of the code to relieve double taxation, leaving many U.S. taxpayers with unrelieved double taxation with respect to many foreign taxes that have been creditable under the current regulations for decades.

The jurisdictional nexus requirement represents a significant change in U.S. international tax policy that we believe has no basis in the statutory text of Section 901 and 903 of the code and would therefore constitute an invalid exercise of regulatory authority. We strongly recommend that the jurisdictional nexus requirement be withdrawn.

I'll address the following topics.

First, I'll briefly summarize the present context in which the jurisdictional nexus requirement was proposed. Next, I'll address the statutory and regular history surrounding the jurisdictional nexus requirement, and third, I'll address certain other technical aspects of the proposed regs.

Turning to the context for the jurisdictional nexus requirement, as the preamble to the proposed regs explains, in recent years several countries have enacted or proposed a derived in new taxes that overage (phonetic) and material respects from traditional norms for international tax in jurisdiction, including digital services taxes imposed by various countries. The Indian Equalization Levy, the U.K. Divergent Profits Tax (phonetic), the U.K. Tax on Offshore Receipts and Respected Intangible Property, and the Australian Multinational Anti- (inaudible) Tax.

The U.N. Committee on Experts has also recently proposed the imposition of withholding taxes on certain income from automated digital services under a new Article 12B to the U.N. Model Tax Convention. We strongly oppose all of such taxes, but rather than punishing U.S. multinationals for the introduction of such taxes by denying them a foreign tax credit, we recommend that the U.S. take the leading role and multilateral fora including at the OECD and the U.N. Committee of Experts to oppose the adoption of such taxes.

The negotiation or renegotiation of tax treaties and trade agreements provides other opportunities for the U.S. to oppose such taxes, however the inclusion of such taxes as covered creditable taxes under any particular bilateral income tax treaties should not have a bearing on whether such taxes are creditable in the U.S.

A jurisdictional nexus requirement would also preclude foreign tax credits from any foreign taxes that SVTDG members have faced for many years. For example, many countries treat income from sales of copyrighted articles as giving rise to royalty income and therefore imposed withholding taxes on such payments. In addition, many countries imposed withholding taxes on income from the performance of certain services based on the location of the recipient of the services.

These withholding taxes have been long creditable under the current regulations, such as example 3 in the regulations under section 903, and are specifically committed under some existing U.S. income tax treaties that allow for source (phonetic) state taxation of fees for technical services.

Moving next to the statutory and regulatory history of the relevant U.S. foreign tax credit provisions, the U.S. has had a foreign tax credit system in place since the Revenue Act of 1918 and for almost all of its history with the exception of the period from 1919 to 1921, the foreign tax provisions of the code haven't imposed a jurisdictional nexus requirement. Rather, Congress has chosen to limit the availability of the foreign tax credit through alternatively a per-country and an overall limitation against foreign-source income.

The U.S. has not had a per-country limitation since 1976 and has instead allowed taxpayers to geographically cross-credit foreign taxes subject to the limitations of section 904. The preamble to the proposed regs explains that the fundamental purpose of the foreign tax credit to relieve double taxation is served most appropriately if there is substantial conformity in the principles used to calculate the base of the foreign tax and the base of the U.S. income tax.

According to the preamble, this requirement is satisfied if the foreign tax conforms with established international norms as reflected in the Internal Revenue Code and Related Guidance (phonetic). For example, rules that conform with the U.S. rules for taxing effectively connected income or that includes source of income rules that are reasonably similar to the U.S. source of income rules would pass this text.

And particular for services income, the foreign rules must source the income by reference to the place of performance and not the location of the recipient. Yet the treasury regulations, like the code, have not imposed a jurisdictional nexus requirement for most of their history.

Consistent with the code, the current regulations, which have been in effect since 1983, do not include jurisdictional nexus requirement.

Temporary regulations issued in 1980 included a similar requirement for a foreign tax to follow reasonable rules regarding the source of income residence or other bases for tax in jurisdiction, but those same regulations explained that a foreign tax may meet the requirement even if the provisions of the law of the foreign country imposing the charge differs substantially from the income tax provisions of the code.

Treasury in the IRS appropriately acknowledge that there can be substantial differences between the U.S. and foreign notions of taxing jurisdiction without jeopardizing the ability of U.S. taxpayers to claim a foreign tax credit, and this is especially true today as both developing and other countries revisit the fundamental principles of international taxation through the OECD G-20 inclusive framework.

It's important for the foreign tax credit regulations to (inaudible) obtain the flexibility to accommodate the continued evolution of international tax norms away from the U.S. view of traditional tax norms.

You have also requested comments and alternative approaches the Treasury and the IRS may consider to achieve the policy objective outlined in the preamble. While we believe that the proposed jurisdictional nexus requirement costs too wide in that and should be withdrawn and left to Congress to decide whether to impose such a requirement, if Treasury and the IRS were inclined to identify attributes or design features of taxes that do not conform to international laws then we should suggest the following criteria: The tax applies solely to a particular sector, the tax is discriminatory towards U.S. companies, the tax is structured to side step the existing framework of income tax treaties, and the tax allows undue administrative discretion to modify material elements of the tax including the rate. These attributes resemble tariffs or excise taxes more than income taxes.

Coming to the other technical aspects of the proposed regs of the first net gain requirement, the proposed regs would largely replace the flexibility in the current regulations regarding whether a foreign tax reaches net gain in the normal circumstances in which it applies by replacing their empirical analysis required under the current regs with more and flexible rules, and would make corresponding changes to the realization gross receipts and cost recovery or net income conformance (inaudible) net with gain requirement.

We recommend that the changes to the net gain requirement be withdrawn, similar to the jurisdictional nexus requirement, that proposed changes to the net regain requirement attempt to more strictly imposed U.S. standards regarding the definition of an income tax on foreign countries.

Next on the noncompulsory payments that the proposed regs purport to clarify that the requirement for a taxpayer to reduce over time its liability for a foreign income tax applies only to foreign income tax. We recommend that Treasury and the IRS should not adopt this change. The proposed rule would put taxpayers at a significant disadvantage and make it more difficult for taxpayers with respect to the settlement of foreign tax disputes.

And then finally the substitution of the "but for" test (phonetic) that the regs would introduce, this is a highly prescriptive standard that would only be satisfied in certain cases if the tax bears a close relation to the failure to impose the generally imposed net income tax and places additional burdens on taxpayers with regard to researching foreign legislative history, so we also think this is overly burdensome and unnecessary, and —

MS. SHI: All right. Thank you so much for your comments, Mr. Barrage. We appreciate your time.

MR. BARRAGE: Thank you.

MS. SHI: I don't have any questions at this time. Jason, do you?

MR. YEN: No.

MS. SHI: All right.

MR. BARRAGE: Okay.Thank you very much.

MS. SHI: Thank you. All right, let's move to our second speaker, Mr. Gary Sprague from the Software Coalition.

MR. SPRAGUE: Good morning. My name is Gary Sprague. I'm speaking on behalf of the Software Coalition, an informal group with 23 major U.S. software companies originally formed in 1990.

As major global exporters, U.S. software companies have paid foreign withholding taxes on everything from the sale of software and digital goods and services for many years. First, we do want to note our sympathy with Treasury's work to oppose those novel unilateral and extraterritorial taxes such as digital services taxes which would inspire these proposed regulations. We encourage Treasury to continue to work though multilateral engagement to have those taxes withdrawn.

That said, we do not believe that this proposed regulation is the appropriate cure, in particular the jurisdictional nexus rule.

Treasury and the Service requested comments in particular on the effect that these proposed regulations may have on taxes other than the novel unilateral and extraterritorial taxes at issue.

For the U.S. software industry, the main examples are withholding taxes on software and digital goods and services which for many years have been imposed by various countries in accordance with commonly accepted notions of source-based taxation. The jurisdictional nexus requirement apparently have caused many of those common and longstanding taxes to be uncreditable.

Accordingly, we believe the Treasury should withdraw the proposed jurisdictional nexus requirement. To that point, I will make four points in particular. The Polish (phonetic) rule will create substantial inequities for the U.S. software industry. The code does not in fact reflect international tax norms that should be the basis of the double-tax relief mechanism. The Treasury instead should address this issue through multilateral advocacy and we could suggest a more traditive (phonetic) approaches that reproposed regulation might take.

First, on the inequities for the U.S. software industry. The laws of many countries impose source-based taxation on payments for intangibles and/or services, and they classify software products as falling into those categories. Those taxes disproportionately affect the U.S. software industry as these taxes do not apply to payments for tangible property.

The U.S. has been active over the years in endeavoring to set international norms for the characterization of payments for software products and digital services. Many countries however disagree with those classification conclusions and continue to impose withholding tax on software product payments. Argentina, Brazil, Greece, India, Thailand, and even some EU countries among many others assert tax on software product payments, and proposed regulations apparently make those taxes non-creditable on the basis that the foreign source rules may not be "reasonably similar" to U.S. source rules.

The application of the U.S. source rules — the software transactions — can be quite complex, leading to different source results for different forms of software deliveries. Polish rule apparently would preclude a credit for those transactions which produce U.S. source income with no policy justification for the different treatment of similar transactions.

I will provide three examples. First is a comparison between software as a service, i.e. SaaS provided by a U.S. person, and downloaded software is supplied by a U.S. person under a limited duration license. Both transactions could be subject to foreign withholding tax. Since under U.S. source rules, the SaaS payment is sourced in the U.S., but the limited duration license payment is sourced at the user location, a credit for any withholding tax would be denied for the SaaS payment but allowed for the limited duration license payment even if the two transactions give access to similar software functionality.

Second, the proposed jurisdictional nexus test also may uniquely disadvantage software companies that produce their software products in the United States. Under new section 863B, the sale of software copies will be entirely U.S. source if the software is produced entirely in the United States without regard to where title passage occurs, precluding a credit for withholding tax imposed on those payments, and with foreign law, of course, it makes no difference whether the software is produced within the United States under 863B or not.

Third, the proposed regulations also may create different results for certain sales of software copies where the title passage rule remains relevant. If the proposed changes to Treasury of 861-18 concerning source of digital deliveries is finalized as proposed, then all digital deliveries of software will be foreign-source income while deliveries on tangible media shipped from a U.S. location typically produce U.S. source income. That difference in delivery methods then could produce a difference in foreign tax credit allowance.

If the proposed changes to (dash)18 concerning source of digital deliveries is not implemented, then anomalies will arise between digital copies delivered from U.S. servers compared to those delivered from foreign servers as deliveries from foreign servers normally produce foreign source income while deliveries from U.S. servers typically produce U.S. source income. Again, that difference in U.S. source rules would make no difference to the foreign government imposing the Golden Tax, and yet those different delivery methods would seem to result in different foreign tax credit consequences.

In all of these cases, the anomalies are created by the complex and unusual U.S. source rules when compared to the foreign counterpart. These differences in delivery methods should not result in different foreign tax credit consequences for the U.S. supplier. To my second point, what should beginner national norms be that are the foundation of these regs? The preamble states 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 code in order to qualify as an income tax in the U.S. sense."

As demonstrated by the examples I described of different delivery methods to deliver the same software functionality, we believe that the code's complex source and nexus rules are not the embodiment of traditional international norms of taxing jurisdiction. In fact, by far the most common rule around the world is that jurisdiction to tax payments for services or for intangibles is based on the location of the payor. The fact that many countries for many years have imposed withholding taxes on services and software payments on this basis shows that such taxes are firmly within the boundaries of international tax norms.

Third point, what is the alternative? Despite these concerns, we agree that the Treasury's stated purpose to address the challenges of proliferating unilateral measures that target U.S. companies. That said, we believe that the proposed regulations which after all apply only to U.S. taxpayers and only will have the effect of denying credits to the U.S. taxpayers are highly unlikely to deter foreign governments from adopting these taxes therefore we believe the regulation should be withdrawn as not likely to achieve their stated purpose. That said, Treasury should continue to advocate a bilateral and multilateral forum to allow these taxes.

We support this administration's stated commitment to multilateralism and urge Treasury to be a vocal leader in the OECD (phonetic) in the course of framework negotiations with the goal of achieving a fair result for the U.S. taxpayers in convincing countries to withdraw all relevant unilateral measures.

Treasury also should play an active role in other multilateral organizations such as the U.N. Committee of Experts to oppose the introduction of taxes to focus principally in these companies.

In a few weeks, United Nations Committee of Experts will vote on the proposed amendment to the U.S./U.N. model that would allow source-based withholding tax on all payments for software and develop a (inaudible) which would allow withholding tax on all payments for digital services.

We regret that the U.S. does not have a representative on COE at the moment. Treasury also should act to impose these taxes on all bilateral contacts both tax treaty and trade treaty.

Possible modifications. At the time that Congress adopted Sections 901 (inaudible) had a choice to adopt either an exemption or credit system. Congress chose a credit system. Once Congress chose a credit system, Treasury should allow the system to work as intended to relieve double taxation for all foreign taxes normally and historically recognized as income taxes and withholding taxes.

The foreign tax credit rule should recognize that capital importing in less economically developed countries may have different tax policy goals than the U.S. These differences are frequently collected in greater reliance on source-based taxation. Those differences in tax policy goals are very much —

MS. SHI: Thank you for that, Mr. Sprague, for your comments. I don't have any follow up questions, do you?

MR. YEN: No, nope, thank you.

MS. SHI: Thank you so much, again, for your time, your comments. All right. Our final speaker today is Mr. Jeffrey Gould. Mr. Gould, take it away.

MR. GOULD: Thank you. My name is Jeffrey Gould. I'm giving testimony on behalf of Frank Hirth, PLC, a London-based accountancy firm which provides U.S. tax consultancy and compliance services in an international setting. We are grateful for this opportunity to share our views on the proposed foreign tax credit regulation.

I will address proposed regulation sections 1.905-1(d) and 1.905-1(e)(i). As explained in our outline, neither regulation is consistent with current law and both will result in double taxation contrary to the objectives as a foreign tax credit.

Proposed regulation section 1.905-1(d) would adopt the so-called "end of the foreign tax year" rule. This rule was originally set out six years ago in revenue ruling 8193. This concerned a taxpayer liable for both U.S. and Hong Kong tax. The Hong Kong tax year ended on March 31, while the U.S. tax year ended December 31. For its 1961 U.S. tax year, the taxpayer was liable to both U.S. and Hong Kong tax on income earned in the nine-month period between April and December 31, because they only held a credit for the Hong Kong tax owner's income could not be claimed under the accrual method until 1962, when the Hong Kong tax year ended.

Revenue Ruling 61-93 reached the wrong result because it ignored code section 461, which sets out rules for the taxable year deduction.

Regulations under section 461 provide that two conditions must be met to accrue an expense, namely: (1) that all events that occurred that established the fact of a liability; and (2) that the amount of the liability needs determinable at the accrual date with reasonable accuracy.

With the fact of liability for foreign taxes income earned during U.S. tax years is established, in normal circumstances the amount of the liability should be determinable with a reasonable accuracy at the end of the U.S. Tax year because both the amount of income and applicable foreign tax rate will be known.

However, Revenue Ruling 61-93 asserted that all events must have occurred to determine not only the fact but also the amount of the liability which clearly is not what the section 461 regulations require. This led to the rulings erroneous conclusion.

The enormity of the end of the foreign tax year rule is illustrated in AM 2008-005, a 2008 letter from Associate Chief Counsel International, concerning the allowance of credits for U.K. income tax imposed on the basis of an April 5th year AM (phonetic).

Consider the case of Mr. X, a U.S. citizen with a calendar year and U.S. tax year, who has previously elected to claim the foreign tax credit under the accrual method. Mr. X becomes a U.K. resident on April 6, 2021, and commences to earn a large salary. U.K. income tax will be withheld from his salary at the rate of 45 percent.

However, according to AM 2008-005, Mr. X cannot accrue and claim any credit for that U.K. tax against U.S. tax for the 2021 U.K. salary because the relevant U.K. tax year will not have ended until April 2022. As a result, Mr. X will have an additional U.S. liability on the 2021 U.K. salary of nearly 40 percent and won't be paying 85 percent income tax on his 2021 U.K. salary.

While the U.K. tax on the 2021 income will be creditable against Mr. X's U.S. tax of 2022, in the normal case that credit will be needed to offset U.S. tax on income earned by Mr. X during 2022 because there will be no unused credit available to carryback to 2021 and the 85 percent liability will become permanent.

While AM 2008-005 asserts without any analysis that this is the correct application of the reasonable accuracy standard, no accountant would consider Mr. X's 2021 financial statements correct without an accrual for the anticipated U.K. liability.

As the following brief history illustrates, over the past 60 years the IRS has shown a consistent unwillingness to consider the validity on the end of the foreign tax year rule. First, Revenue Ruling 61-93 did not reference the code ruling section 461 regulation.

Second, in the 60 years since the ruling, the IRS has never asserted the end of foreign tax year rule in a reported case. Evidently, the IRS has been prepared to give way on the issue in individual cases rather than risk setting an adverse precedent.

Third, when the IRS issue proposed regulations under code section 960 in 2018, they incorporated the end of the foreign tax year rule. The ABA tax section commented under section 960 proposed regulations noting that the end of the foreign tax year rule was not charitably (phonetic) considered absolute.

It recommended that this part of the proposed section 960 regulations be withdrawn and made a separate regulation project so that the issue could receive proper attention. The IRS rejected the ABA's recommendation and adopted the language of the proposed section 960 regulations without material modification.

In the preamble to the final section 960 regulations, the IRS stated that the ABA's comment was clearly wrong. "By definition, net basis foreign income taxes can only be determined with reasonable accuracy after the foreign taxable year has ended."

No authority was cited for this robust statement; thus, even in the context of the notice in common procedure and the IRS avoided engagement on the end of the foreign tax year rule.

Fourth, and finally, the end of the foreign tax year rule has now been incorporated in the proposed section 905 regulations. The preambles of the proposed regulation mistakenly cites Revenue Ruling 61-93 as an authority for the proposition that the reasonable accuracy standard cannot be satisfied until the year of the foreign year. However, Revenue Ruling 61-93 didn't even acknowledge that the reasonable accuracy standard existed, much less applied.

Give this history, adoption of the end of the foreign tax year as set out in proposed regulation section 1.905-1(d) might be considered arbitrary as well as contrary to applicable law.

I now turn to proposed regulation section 1.905-1(a)(1i), which would generally invalidate section 905(a) accrual method election made on an amended tax return. Section 905(a) permits the cash of the taxpayer to elect to accrue credits of foreign tax. Section 905(a) does not specify the date by which the election to accrue foreign taxes must be made.

Congress enacted section 905(a) to permit taxpayers to achieve a more accurate matching of credits for foreign tax against U.S. tax on foreign source income. The fundamental objective of the foreign tax credit rules where, as in section 905(a), no deadline is specified for making an election permitted under the code.

It follows that the election may be made on an amended return. In particular, if the decision to make such an election can be affected by facts that could not have been known at the time the original return was filed, the courts have consistently upheld the taxpayers' right to make that election on an amended return.

The cash method taxpayer's decision to accrue foreign tax credits is inherently one which can be affected by facts not known when the original return is filed. One of many examples is a taxpayer whose foreign tax liability is increased as a result of a tax audit in its foreign country of residence.

This audit may cover a number of prior tax years. If the taxpayer originally claimed the foreign tax credit on the cash method in those years and unless able to amend this prior year returns to switch to the accrual method, increased foreign tax credits arising from the owner's (phonetic) adjustments will not be related back in the U.S. tax years in which the relevant income was reported. Matching your credits against liability will be impossible and the potential costs to the taxpayer enormous.

In the preamble with proposed regulations, the sole relevant authority cited by the IRS's refusal to permit a section 905(a) election on an amended return in a 1935 case called Strong v. Wilka, decided by U.S. District Court in Minnesota, the court in that case quite properly denied the taxpayer's accrual claim because all that's necessary to establish the fact of liability had not occurred at the end of the tax year.

The Minnesota court comments on whether an accrual method election could be made on an amended return, not being essential to its decision, were overturned dictum (phonetic) and not legal authority.

It is incumbent on the IRS to provide strong justification for the rule of proposed regulation section 1.905-1(a)(i), bearing in mind that it is inconsistent with what the courts have held in analogous cases and would lead to double taxation. That concludes my comments. Thank you.

MS. SHI: Thank you, Mr. Gould. I do have a follow-up question. You said the (inaudible) court cases?

MR. GOULD: Can you repeat?

MS. SHI: You said at the end of your comment that (inaudible) was court cases, are those court cases holding so this election can be made on an amended return?

MR. GOULD: No, I said they were analogous cases. You'll find one cited in my outline, Albert L. Dockerty, 60 Tax Court 917, which concerned another election where the issue was the statute doesn't say when you make the election. Can you make it on an amended return? And it held in favor of the taxpayer.

MS. SHI: Okay. So not specifically with respect to this election in 905(a)?

MR. GOULD: No, as far as I know, the only court that's ever mentioned is in the Wilka's case that I mentioned, which as I said, I don't think represents authority.

MS. SHI: Okay. Thank you for that clarification and for your comments. Jason, did you have any questions?

MR. YEN: No, thanks.

MS. SHI: Thanks again.

MR. GOULD: Great, thank you both.

MS. SHI: All right. I think that concludes this hearing. Once again, I really appreciate the comments from the speakers, and thank you to everyone for participating in this hearing.

(Whereupon, at 10:23 a.m., the PROCEEDINGS were adjourned.)