Group Supports Carryforward of Refunds of Foreign Tax on RICs

March 12, 2021

Mark Mazur
Acting Assistant Secretary, Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

William M. Paul
Acting Chief Counsel
Internal Revenue Service 
1111 Constitution Avenue, NW
Washington, DC 20224

RE: Additional Guidance for RICs Receiving EU Reclaims

Dear Mr. Mazur and Mr. Paul:

The Investment Company Institute¹ respectfully requests that the Treasury Department and the Internal Revenue Service (IRS) issue additional guidance addressing reclaim amounts received by regulated investment companies (RICs) from European Union countries. First, we renew our request for published guidance that will permit RICs to carry forward the amount of any refunded taxes and pre-refund interest that cannot be offset in the year received under Notice 2016-10.² Second, we request published guidance that would provide clear procedures by which a RIC that cannot apply the Notice's netting procedure, ideally with carryforwards, can make a settlement payment expeditiously.

Published guidance adopting these recommendations will prevent harm to tax-exempt investors,³ reduce substantially the need for closing agreements, and accelerate payments to the IRS. The current situation, as explained below, puts the industry in an untenable situation. Both RIC investors and the IRS would benefit greatly from expanded relief and improved procedures.

The requested guidance is needed urgently for three reasons. First, France has conceded the legal issue for RICs and has begun returning several billion dollars of previously withheld tax. Substantial amounts already were recovered late in 2020. Recent favorable decisions in Spain and Sweden indicate that further recoveries may be expected soon. Successful litigation in other countries, such as Germany, would result in still larger recoveries.

Second, for many RICs, the recoveries attributable to years of inappropriately applied withholding tax, particularly in France, exceed the foreign taxes incurred in the current year. Thus, absent the carryforward relief we have requested (which eliminates any RIC-level payment), RICs must enter into closing agreements and pay a negotiated amount to the IRS. Because a RIC must calculate daily its net asset value (NAV) based upon assets and liabilities, any uncertainty regarding proper resolution of this tax issue potentially raises NAV concerns. The greater the recoveries, the greater the potential uncertainty.

Third, and critically, absent a RIC's ability to carry forward unused credit-offset amounts, tax-exempt shareholders will be harmed. Specifically, as only taxable shareholders benefited from foreign tax credits claimed when foreign tax initially was withheld, the burden of tax recoveries likewise should fall only upon them. The IRS' proposed closing agreement template, however, spreads the burden proportionately over taxable and tax-exempt shareholders, as a RIC's assets and liabilities (other than certain class-specific expenses) are shared equally by all shareholders.

Background

The Court of Justice of the European Union (CJEU) ruled in 2012 in Santander⁴ that Article 63 of the Treaty on the Functioning of the European Union (TFEU) applied to certain disparate treatment between “comparable” local and foreign funds. Specifically, the Court held that France could not impose tax on dividends paid by French companies to non-French investment funds when “comparable” French funds were exempt from the tax. Two US investment funds were among the successful litigants in this Article 63 “free movement of capital” litigation. Several subsequent decisions in both the CJEU and national courts have established further the ability of RICs to recover tax from European countries under Article 63.⁵

For the IRS to recoup tax benefits provided previously to US investors on withheld foreign taxes recovered via Article 63 litigation, the Code provides only one mechanism: section 905(c). In the context of widely held RICs, however, this mechanism has little utility. Specifically, section 905(c) effectively would require the IRS to recover tax separately from every shareholder in every RIC that receives an EU reclaim. For this to work, each RIC and each broker holding shares as a nominee would have to send amended Forms 1099 to each RIC shareholder for the years that the foreign taxes were withheld. The shareholders then would file amended tax returns to reflect the proper liability. The per-shareholder recoveries would need to be calculated separately for each year to which refunded tax related. Moreover, if recoveries were received over several years, prior-year recalculations likewise would need to be made repeatedly for every taxable shareholder. Amending millions of Forms 1099 and then relying upon taxpayers to file amended tax returns likely means that the IRS, at great expense, would recover substantially less under section 905(c) than it would have received in US tax had the European governments never imposed the impermissible taxes.

ICI approached the IRS in 2013 to discuss an administrable mechanism for reimbursing the IRS for previously claimed tax benefits, including foreign tax credits claimed by taxable RIC shareholders. Specifically, ICI urged the IRS to permit RICs to reduce amounts eligible for section 853 foreign tax credit flow-through by any foreign taxes recovered.⁶ ICI believed that this “credit-offset” method was preferable to either RICs and brokers sending millions of amended Forms 1099 (to inform shareholders and the IRS of amounts that would be subject to section 905(c)) or RICs writing checks directly to the IRS.

More specifically, ICI asserted that credit-offset would provide three benefits over the “check writing” alternative. First, the credit-offset method would eliminate any financial accounting concerns arising with determinations of expected tax liability and the inclusion of the appropriate payable in NAV calculations. Second, the credit-offset method would eliminate any need to determine the portion of taxable shareholders in any RIC for any particular year. Third, and in many ways most importantly, the credit-offset method would prevent individuals holding RIC shares through tax-deferred savings vehicles, who did not enjoy any previously claimed tax benefit, from incurring any cost of reimbursing the IRS.

Notice 2016-10 effectively adopts the ICI's credit-offset method. One important limitation in the Notice, however, is that netting is not available if the amount of reclaims recovered by a RIC exceeds the foreign tax credits available for the year.⁷

Any RIC that is not eligible to use the credit-offset approach must seek a closing agreement with the National Office of the IRS, which, in this unusual context, has been a very time-consuming and so far unsuccessful endeavor.⁸ Although fact-specific discussions with the IRS regarding closing agreements began in 2016, to date no closing agreement has been finalized. Because no other mechanism exists by which RICs may submit a payment to the IRS for these recovered amounts, post-refund interest continues to accrue in every situation in which Notice 2016-10 does not apply to the entire refund amount.

Amend Notice 2016-10 to Permit Carryforwards

The industry greatly appreciated the release of Notice 2016-10 in January 2016. ICI shortly thereafter requested that the relief be extended to permit RICs to carry forward any amounts that cannot be netted in the year received.⁹ Absent this relief, as noted above, tax-exempt shareholders will bear their allocable share of any payment made by the RIC as an alternative to the IRS pursuing individual claims under section 905(c).

Since 2016, we repeatedly have sought published guidance permitting carryforwards. Under our proposal, a time value of money “interest” component would be added to the amount carried forward to ensure that the IRS is reimbursed fully.

More recently, during discussions regarding a closing agreement “template” that would apply throughout the industry, we urged that the closing agreements permit RICs to carry forward any amounts that cannot be fully netted in the year received. We understand, however, that the IRS does not believe it has the administrative authority or capacity to accommodate this request in light of the express limitation on netting beyond the refund year in Notice 2016-10 and standard closing agreement procedures.

Consequently, the need for published guidance remains paramount. Although the industry prefers an extended carryforward period to ensure that RICs can offset fully amounts recovered without burdening tax-exempt shareholders, any carryforward period (e.g., five years) would be preferable to the current situation.

We recognize that the new Administration has many competing priorities and limited resources. Nevertheless, we urge that priority be given to this increasingly important issue. Because over half of all shares held by international equity funds across the industry are held by taxable investors,¹⁰ the industry's success in pursuing these claims will result in substantial recoveries to the IRS. Without carryforward relief, however, tax-exempt shareholders will be burdened unfairly. Moreover, the number of closing agreements for which IRS attention will be required will increase substantially as France and other countries resolve outstanding reclaims by RICs. These burdens seem unnecessary when resolution requires only a simple extension of relief previously provided.¹¹

Provide Standardized Procedures

Need for Standardized Procedures

Even if carryforward is permitted, some RICs still will need closing agreements for 2021 and future years. Given the size of the French reclaims and the potential for withholding tax relief at source in the future, some RICs may be unable to fully offset foreign tax credits before a carryforward period expires. Other RICs may not be eligible to flow through foreign tax credits in the year the reclaim is received or otherwise may be ineligible to apply Notice 2016-10.

On a going-forward basis, one closing agreement template presumably could address most situations. A draft closing agreement template that ICI has been discussing with the IRS, for example, would require RICs to include certain amounts in income during the year in which the closing agreement is signed.

For reclaims already received, however, multiple versions of the template will be required. Specifically, in the absence of guidance, RICs reached different conclusions in consultation with their outside advisers on what amounts, if any, to include in income and distribute in the year received.¹²

Providing published guidance with standardized procedures for reclaim amounts would benefit both the industry and the IRS. For RICs receiving reclaims going forward, they would know exactly how to treat the reclaim amount (including interest received) and how much is due to the IRS. RICs could apply the procedures in the guidance, determine how much is owed to the government, and make payment directly to the IRS, without requiring the involvement of the National Office. Standardized procedures also would reduce significantly the costs to the RICs (and ultimately the shareholders) of entering into closing agreements.¹³ Finally, uncertainties regarding the impact of refund amounts on the RICs' NAVs also would be reduced.

Alternatively, standardized procedures could allow RICs to enter into closing agreements with IRS field offices, rather than the National Office. This approach would avoid the substantial user fees required to enter into closing agreements with the National Office. Given the great expense that funds already have incurred to pursue the EU reclaims and repay the government for previously claimed tax benefits, avoiding payment of the user fees and professional fees would be equitable to funds and their shareholders.

Setting forth these procedures in published guidance, such as a revenue procedure, also would benefit the IRS, as it would reduce substantially the number of closing agreements that the government, or at least the National Office of the IRS, would have to execute. RICs with unusual circumstances (e.g., RICs that have liquidated) still would need to enter into fact-specific closing agreements; going forward, however, this number should be limited.

The published guidance we request would specify the procedures that RICs should follow upon receiving an EU reclaim amount when the RIC does not qualify for netting under Notice 2016-10, including situations in which the ability to utilize a carryforward has expired.

Recommended Procedures

We recommend that the Treasury Department and the IRS publish guidance setting forth the calculation described below of the amount that RICs should pay upon receipt of a reclaim amount. This calculation is based on the draft template that ICI, on behalf of the industry, has discussed with the IRS. The calculation requires a RIC to pay to the government a “compliance fee” equal to 85% of the refund and pre-refund interest received with respect to the RIC's taxable shareholders. The compliance fee is intended to compensate the government for the amount of tax not collected due to the flow-through of the foreign tax credit in the tax payment year to the RIC's shareholders, and for associated pre-refund interest, in a manner that fairly approximates the amount that the government would be expected to collect if the section 905(c) rules were applied. The template provides a 15% “haircut” in recognition of the administrative costs incurred by a RIC in pursing the reclaim amount.¹⁴

We thus propose that the guidance set forth the following calculation for determining the compliance fee due:

The guidance would specify that a RIC that pays the compliance fee (and complies with any other provisions of the guidance) would be treated as satisfying in full the liability of the RIC, third-party intermediaries, and shareholders owning the RIC shares during the relevant calendar years arising from the initial reporting and/or subsequent redetermination of the refund of the EU country tax. In addition, the RIC and any third-party intermediaries would be treated as having satisfied any reporting obligations with respect to the reclaim, including any obligations to correct Forms 1099 as a result of the reclaim.

The IRS has suggested adding to the draft template a provision requiring a RIC to include in income as a dividend the amount of the foreign tax adjustment (the refund amount and pre-refund interest in US dollars) in excess of the amount paid to the IRS as part of the compliance fee (the “excess refund”).¹⁵ ICI strongly disagrees with this provision and has not included it in our proposal. We believe that this amount should not be included in the RIC's income because the amount of the refund already was included in the gross-up amount when the tax credit was flowed through to shareholders under section 853(b)(2).¹⁶ Under the IRS' proposal, this amount effectively would be taxed twice as dividend income.¹⁷ We also note that, depending on the percentage of tax-exempt shareholders in the RIC, including the excess refund in income offsets the benefit of the 15% haircut and, in some scenarios, may result in the RIC paying more to the IRS than otherwise would be due if adjustments were made at the shareholder level under the general section 905(c) rules.

The industry and the IRS generally agree on the compliance fee calculation described above, other than the treatment of the excess refund. We believe that providing published guidance to this effect would reduce greatly the burden to RICs, their shareholders, and the IRS. For RICs receiving reclaims going forward, it would provide clear guidance as to how to treat the reclaim and how to calculate and pay an amount to the IRS. RICs that already have included reclaim amounts in income or that have other facts that fall outside the general scenario still will need to seek a closing agreement. The standardized procedures proposed here, however, should reduce greatly those numbers for 2021 and beyond.

* * *

We appreciate your timely consideration of our request. As described above, this is a significant issue for the mutual hind industry; quick resolution would benefit RICs, their shareholders, and the US government. We will contact your offices soon to schedule a meeting to discuss our request. In the meantime, please do not hesitate to contact us if we can answer any questions. Keith can be reached at 202-326-5832 or lawson@ici.org: Karen can be reached at 202-371-5432 or kgibian@ici org

Sincerely,

Keith Lawson
Deputy General Counsel, Tax Law

Karen Lau Gibian
Associate General Counsel Tax Law

 

Attachments

cc:
Jeffrey Van Hove
Tom West
Krishna Vallabhaneni
Jose Murillo
Drita Tonuzi
Peter Blessing
Helen Hubbard