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So Many Ways to Lose Your Losses

Posted on May 4, 2020

The U.S. income tax — like all others — is supposed to allow for an offset of economic losses against gains so that taxpayers are taxed only on their net income. For the same reason, expenses incurred in generating revenue are supposed to reduce gross income in calculating net income.

At the same time, every tax system defines arbitrary periods for attributing losses and gains. That necessarily produces the potential for mismatch between when items of income accrue and when expenses or losses may be recognized. Another artificial component of the tax system is that it generally permits only items of income and loss that have been recognized to be allowed in computing a given tax year’s net income: Sometimes taxpayers can recognize items of income or loss earlier or later.

Those inherently arbitrary aspects of any tax regime provide a lot of room for clever planning for taxpayers who want to defer taxable income to later years and accelerate the recognition of deductible expenses and losses. As a result, tax rules to prevent taxpayers from deferring income and to limit their ability to recognize losses have proliferated. To smooth out the arbitrariness of the tax-year concept and to try to preserve the economic validity of the net income principle, Congress has enacted provisions that allow for the carryover of valuable tax attributes, such as net operating losses, from year to year. But because the ability to carry forward NOLs is itself a valuable tax attribute worth paying for, Congress has also tried to limit trafficking in those losses.

Overall then, the code attempts to strike a balance between preserving an economic concept of net income not limited by tax years, while also recognizing the planning opportunities presented by loss carryforwards and deductible expenses that can be manufactured and accelerated without true economic cost. It may be that this balance is the right one in years when most companies are generating profits. But it might be tilted too heavily against struggling businesses in a downturn, when obtaining cash for economic losses becomes an important means of survival and the preponderance of losses runs into what appear to be overly restrictive rules and processes generally meant to guard against opportunistic planning.

To address that, Congress last month passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) to loosen some of the restrictions on taxpayers’ ability to deduct expenses and claim the benefits of NOLs, some of which were enacted in 2017 as part of the Tax Cuts and Jobs Act. But the rules in the CARES Act intended to help loss-making companies might not go far enough, partly because the new law mostly doesn’t take into account the various changes enacted in the TCJA. There are still plenty of ways that taxpayers could fail to benefit from economic losses incurred in 2020, and the CARES Act makes it harder for taxpayers to benefit from changes that were likely designed to help them.

Loss rules are troublesome to navigate, even in the simplest fact patterns. They’re triply so in the cross-border context, partly because — as taxpayers are mostly just now discovering — the timing rules governing inclusions of foreign income enacted as part of the TCJA don’t mesh well with myriad other rules, including those governing NOLs and foreign tax credits.

Loss Limitations: Some Basics

Interest Expense

Among the ways to manufacture uneconomic deductions, incurring interest expense to related parties takes a lead role. For years, the United States was a sterling example of a jurisdiction where it was remarkably easy to reduce the taxable income of a foreign-owned U.S. business simply by creating interest expense attributable to a related foreign person. That allowed multinationals to reduce U.S. taxable income without incurring the economic cost of having third-party debt on the consolidated balance sheet. Interest expense payable by U.S. businesses to related parties that aren’t U.S. persons is also common among private equity portfolio companies, which are often highly leveraged and where debt financing can take elaborate forms.

For those reasons, Congress acted in 2017 to reduce the ability of U.S. taxpayers to deduct interest expense in excess of 30 percent of adjusted taxable income, closely adhering to the OECD’s 2015 action 4 guidelines in doing so. The 2017 law went far beyond concerns about excess debt in the related-party cross-border context to apply to any business over a specific size, also including third-party interest expense.

Less than three years later, recognizing that many taxpayers in a severe downturn might end up having to borrow and pay interest in excess of the limitation amount and not because of tax planning, the CARES Act increased the 30 percent interest expense limitation to 50 percent. But for taxpayers whose gross income has plummeted, 50 percent of a very low number is still a very low number. Excess section 163(j) limitation can be carried forward, but because of the way the carryforward interacts with other TCJA-enacted provisions (such as the base erosion and antiabuse tax), it might not be helpful.

Related-Party Payments

Concerns similar to those about the ease with which related parties could reduce U.S. taxable income by creating debt between related persons with different U.S. tax profiles led to the original enactment of section 163(j), as well as to the adoption of more generally applicable restrictions on claiming losses in related-party transactions. While section 267 applies broadly to disallow the deductibility of expenses and losses in transactions between related parties, a few of its rules are particularly salient in the cross-border context.

For example, section 267(a)(1) generally provides that no deduction is allowed for any loss from the sale or exchange of property between related persons (as defined in section 267(b)), and a matching rule in section 267(a)(2) defers the deduction until the tax year in which the payment is included in the payee’s gross income. But a separate rule applies in the cross-border context. Section 267(a)(3) grants Treasury the authority to write regulations to apply the matching rule for payments made to foreign persons. It also provides that a deduction for an amount paid to a controlled foreign corporation is allowable only when the U.S. shareholder of the CFC includes the amount in income.

The matching rules of section 267(a)(3) require some attention if taxpayers have to defer payments because of cash shortages and other constraints associated with a downturn, and if other countries provide tax relief to companies organized in their jurisdictions.

A special rule for related-party payments applies for controlled groups. Transactions between controlled group members aren’t disallowed, but simply deferred until the property leaves the group and there’s recognition of loss under consolidated group rules. Partnerships aren’t members of a controlled group (only corporations are), so under section 267(f), transactions in which a related-party member is a partnership could end up with a disallowed, rather than a deferred, loss.

Hybrid Losses

Not content with the situation, Congress in 2017 enacted new rules to restrict the deductibility of losses applicable to hybrid payments or payments between hybrid entities. Extensive regulations (T.D. 9896) applying and interpreting a relatively brief statute (section 267A, and as applied to dividends, section 245A(e)) came into effect April 8.

Treasury borrowed heavily from the OECD’s base erosion and profit-shifting guidance in writing those regulations, which are in some cases narrower than the OECD guidance (limited to situations in which the hybrid nature of an entity or transaction creates a mismatch in the U.S. and foreign tax treatment of a payment, resulting in a deduction/no-inclusion outcome) and in other cases broader (applying when foreign law allows a deduction for an equity instrument — a notional interest deduction — and to interest-free loans). Again, the rules will need to be reexamined if foreign jurisdictions grant special relief to taxpayers, potentially resulting in no income inclusion and thereby triggering the adverse effects described in the regulations.

NOL Carryovers

The TCJA eliminated the carryback of losses and removed the 20-year restriction on carryforwards, but limited those carryforwards to 80 percent of taxable income. The CARES Act reversed those TCJA changes and expanded the pre-TCJA loss-carryback rule to five years for NOLs incurred in the 2018, 2019, and 2020 tax years. But other TCJA changes make the loss carryover provisions less favorable than they might appear at first glance.

Transition Tax Complications

One complication associated with the new NOL carryback rules arises from their interaction with the transition tax enacted as part of the TCJA. The one-time inclusion of foreign earnings created such an unusual tax year for taxpayers — and a slug of income taxable at different rates than the regular statutory rate — that Congress enacted a special provision in the CARES Act to address the carryback of an NOL to a section 965 inclusion year.

Under the CARES Act, taxpayers can elect to skip the year in which they included the amount required under section 965 (2017 or 2018, or for some taxpayers, both) in carrying back an NOL. Waiving the carryback of an NOL to a transition tax inclusion year might be beneficial when otherwise favorable tax attributes would be limited as a result of the loss offset. For example, because there’s no provision for a refund of an overpayment of a section 965 liability, using an NOL to offset a section 965 inclusion doesn’t free up any cash that might be needed in the current crisis — the amount that would otherwise be refunded simply becomes an offset against future section 965 installment payments. Or there might be simple practical considerations: Calculating the transition tax involved so many complexities that some taxpayers might be reluctant to revisit it.

Taxpayers that don’t elect to skip the section 965 inclusion year when carrying back an NOL are deemed to have made a section 965(n) election in that year. That election provides that any section 965 inclusion (in addition to any gross-up required for FTCs being claimed on the inclusion under section 960) isn’t taken into account in computing the amount of the NOL in the transition tax year or the amount of any NOL carryback used in the transition tax year. In other words, if the election is made (or deemed made), the section 965 inclusion — which is taxed at a lower rate than ordinary income — is computed separately from the remaining taxable income that goes into calculating a section 172 NOL or the amount of an NOL carryback being used. Taxpayers that made the election may have had both taxable income includable under section 965 and an NOL in the transition tax inclusion year. The deemed section 965(n) election could be taxpayer favorable, or less so, depending on the availability of FTCs and section 250 deductions, among other things.

FTC: Beneficial or Not?

For many taxpayers, the section 965 inclusion brought with it lots of foreign taxes, creditable under section 960. Eliminating taxable income in the transition tax year would make those FTCs worth less, because most foreign-source income post-TCJA will be branch income or global intangible low-taxed income. The carryback could thus result in an otherwise valuable tax attribute becoming worthless. Skipping the section 965 inclusion year when carrying back an NOL could be beneficial if FTCs were available to offset other taxable income in that year. Or it could mean just swapping one tax attribute for another.

Consider an example from an April 8 International Fiscal Association event, moderated by Josh Odintz of Baker McKenzie. If a taxpayer had enough FTCs in the transition tax year to offset the non-section 965 taxable income, carrying back an NOL to that transition year would simply result in more of the section 965 inclusion being offset by FTCs and reducing future section 965 installments. (See Table 1.)

Table 1. CARES Act Carryback With Credits

 

2015

2016

2017

2018

2019

2020

Taxable Income

1,000

1,000

1,000

1,000

1,000

-5,000

Carryback

-1,000

-1,000

-1,000

-1,000

-1,000

 

Corporate Tax Rate

35%

35%

35%

21%

21%

21%

Non-965 Tax Liability

0

0

0

0

0

-

965 Inclusion

 

 

2,000

 

 

 

Tax at 8% After 965(c) Deduction

 

 

160

 

 

 

Tentative Tax

0

0

160

0

0

160

FTCs

20

20

20

0

0

 

Total Tax Liability

0

0

100

0

0

100

Source: International Fiscal Association — USA Branch, “The CARES Act and TCJA: An Analysis of Select International Issues” (Apr. 8, 2020).

There are other practical considerations regarding the use of FTCs and carrying back an NOL to pre-TCJA years. Any carryback that results in the use of fewer FTCs means that those credits will carry forward to future years, but there’s no simplified procedure for amending a tax return when there’s a carryforward of FTCs. That means that taxpayers with FTCs being made available in prior years because of an NOL carryback can’t use the simplified method for claiming a tax refund (through Form 1139) and instead have to file Form 1120X (see question 10 from the IRS’s April 23 frequently asked questions regarding carrybacks of NOLs for taxpayers who have had section 965 inclusions). Refunds claimed on amended returns via Form 1120-X require review by the Joint Committee on Taxation. (Further, an amended return presumably must fully reflect the law in effect on the date filed, so that taxpayers must reconsider the validity of any return positions taken at the time of the original filing if the law changed since then — for example, as a result of the issuance of final regs.)

Sourcing an NOL carryback also raises complex and essentially unanswerable questions. Treasury has released final FTC regulations (T.D. 9882) that address the transition between the two-basket pre-TCJA FTC system and the four-basket post-TCJA regime. But those regs didn’t contemplate that taxpayers might be able to carry back an NOL from a post-TCJA world into the two-basket pre-TCJA regime. Taxpayers are left to their own devices in figuring out how to compute overall foreign losses, overall domestic losses, and separate limitation losses when an NOL from 2020 is carried back to a year in which the baskets the losses were created in didn’t exist.

Losing Foreign Losses

The picture gets even more complicated when considering foreign jurisdictions’ pandemic-related relief measures. An NOL incurred in 2020 that’s carried back to earlier years under foreign law may result in additional U.S. tax because of the way different rules and relief measures interact.

Another example from the IFA webinar illustrates how measures intended to provide taxpayer relief can sometimes produce perverse results (see Table 2). In the first sets of facts, there’s no net U.S. tax in the 2019 carryback year because the U.S. tax on the GILTI inclusion is fully offset by FTCs. In the second set of facts, the foreign jurisdiction has allowed an NOL carryback, resulting in less tax paid overseas, which means additional U.S. tax on the foreign earnings.

Table 2. Section 905(c) Foreign Tax Redeterminations

Before Foreign Law Carryback

 

2019

GILTI Inclusion

850

Section 78 Gross-Up

150

Total Inclusion

1,000

Section 250 Deduction

(500)

Net GILTI After Section 250

500

Tax Rate

21%

Tax-Effected GILTI

105

GILTI FTC

(105)

Net GILTI Liability

-

After Foreign Law Carryback

 

2019

GILTI Inclusion

920

Section 78 Gross-Up

80

Total Inclusion

1,000

Section 250 Deduction

(500)

Net GILTI After Section 250

500

Tax Rate

21%

Tax-Effected GILTI

105

GILTI FTC

(64)

Net GILTI Liability

41

Source: International Fiscal Association — USA Branch, “The CARES Act and TCJA: An Analysis of Select International Issues” (Apr. 8, 2020).

Losses Can Lead to Higher BEAT

Beat and Section 163(j)

Although the CARES Act expanded the section 163(j) limitation, the interaction of different loss limitation rules means that relief may be less beneficial than perhaps intended. For example, less interest expense disallowed could result in a taxpayer paying more in BEAT, offsetting any benefit from the expansion. The fact pattern in Table 3, also taken from the IFA webinar, shows the mechanics of that result: Because section 163(j) applies to first reduce deductible third-party interest expense, and only after, related-party interest expense, additional interest expense deductible under the expanded limitation could simply mean more interest expenses added back to the BEAT modified taxable income calculation. Those results are compounded by the way the BEAT computation applies to NOLs.

Table 3. Section 163(j) Limitation — BEAT Interaction

 

50% of ATI

30% of ATI

Change

Taxable Income Before Interest

1,000

1,000

-

Interest Expense (Base Erosion Payments)

(500)

(300)

(200)

Regular Taxable Income

500

700

(200)

Tax Rate

21%

21%

 

Income Tax

105

147

(42)

FTCs

(77)

(77)

-

Regular Tax Liability

28

70

(42)

Regular Taxable Income

500

700

(200)

Base Erosion Payments

500

300

200

Modified Taxable Income

1,000

1,000

-

10% of Modified Taxable Income

100

100

-

BEAT Liability

72

30

42

Total Tax Liability

100

100

-

Source: International Fiscal Association — USA Branch, “The CARES Act and TCJA: An Analysis of Select International Issues” (Apr. 8, 2020).

Foreign Earnings in Loss Years

Several aspects of the regime devised by the TCJA to impose more tax on the foreign earnings of U.S. taxpayers (at lower rates) increase the possibility that losses generated in an economic downturn won’t be fully used, regardless of the expanded NOL carryover enacted by the CARES Act.

FTCs and NOLs

In general, the TCJA increased the possibility that U.S. taxpayers would be subject to double tax on their foreign earnings. That’s because the FTC on GILTI is limited to 80 percent of foreign taxes paid and taxpayers can’t carry FTCs attributable to GILTI basket income over to other tax years. Adhering to a rigid annual system for FTCs dilutes the benefits from any carryover of NOLs. It doesn’t help to carry over NOLs if credits can be used only to offset income in the year earned.

Section 250

A loss incurred primarily in the United States in 2020 that’s carried back to an earlier year when there were both domestic and foreign earnings can end up being offset against a taxpayer’s GILTI and foreign-derived intangible income. Both types of income are subject to lower rates, which has the perhaps unintended result of creating current-year losses (which benefit from a 21 percent rate) being used to offset income that was taxed at a lower rate. Once again, the uneconomic consequence is compounded because the GILTI inclusion is calculated based on an annual snapshot of earnings. If the carryback eliminates the taxable income in an earlier year, both the benefit of the lower rate resulting from the section 250 deduction and the use of FTCs paid on GILTI earnings are completely lost. Although an NOL can carry over, the benefit of a section 250 deduction can’t.

Lines of Business

Large multinationals often benefit from operating different lines of business: A profitable business can offset one that’s more cyclical, and profits from one business can be used to fund additional investment and innovation in a loss-making business. But that appears to work to the disadvantage of taxpayers because of some unique characteristics of TCJA provisions, such as section 250. There, the benefit of a lower rate on FDII is lost if the whole group is in a loss position — even if there’s one business with valuable U.S.-owned intellectual property. The section 250 taxable income limitation results in the FDII incentive for U.S. businesses to own valuable IP in the United States being of little value.

QBAI

The benefits (or detriments) associated with investments in tangible property can also produce counterintuitive results in a downturn. The FDII benefit is reduced to the extent of a deemed fixed return on tangible property in the United States. But it’s unclear whether in a downturn, the rate of return on that tangible property — which isn’t adjustable for economic cycles — should be lower to better reflect economic realities.

On the flip side, investment in tangible property by a CFC reduces the GILTI inclusion in the United States — part of the computation of GILTI that’s supposed to benefit taxpayers. But the calculation can also work to the detriment of taxpayers suffering losses because property that otherwise would qualify as qualified business asset income loses its tax-beneficial status if it’s in a tested loss CFC. As with other aspects of the TCJA’s international regime, there’s no carryover for that attribute either.

Conclusion

In the CARES Act, Congress acknowledged some of the TCJA’s harmful effects during a downturn and acted to reverse them, but it failed to fully correct the international tax regime enacted in the TCJA, which generally forces taxpayers into an annual inclusion system for foreign earnings. The severe downturn caused by COVID-19 gives Congress the chance to consider how to make those rules better reflect economic realities.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker Chtd., and a contributor to Tax Notes International.

Follow Mindy Herzfeld (@InternationlTax) on Twitter.

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