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Company Reiterates Foreign Branch Issue in FDII, GILTI Reg Comments

MAY 6, 2019

Company Reiterates Foreign Branch Issue in FDII, GILTI Reg Comments

DATED MAY 6, 2019
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May 6, 2019

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments Requested in Notice of Proposed Rulemaking: Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income

Dear Messrs. Kautter, Rettig, and Desmond:

We are writing to comment on the regulations recently proposed under section 250,1 as related to foreign-derived intangible income ("FDII") and enacted by P.L. 115-97 (commonly referred to as the "Tax Cuts and Jobs Act" or "TCJA"), which were published in the Federal Register on March 6, 2019, at 84 Fed. Reg. 8188 (the "FDII Regulations"). We have previously submitted comments regarding the proposed regulations addressing various issues related to the foreign tax credit under section 904 (the "Foreign Tax Credit Regulations"). Under section 904, a new separate limitation basket for foreign tax credits relating to taxable income earned via foreign branches was created.2 The FDII Regulations make clear that the treatment mandated under the Foreign Tax Credit Regulations, about which we previously commented, is neither modified, nor rescinded.3 Accordingly, we wish to reiterate our prior comments, which addressed the requirement of the Foreign Tax Credit Regulations that transfers of certain intangible property to or from foreign branches effectuated via disregarded transactions — whether or not a disregarded payment is made in connection with the transfer — will be regarded for purposes of determining the foreign tax credit limitation for the foreign branch, as well as for purposes of calculating the foreign branch owner's deduction eligible income under section 250 (the "Proposed Rule"). In our view, the Proposed Rule is an impermissible reading of the statute that is inconsistent with Congressional intent. While it is appropriate to regard certain disregarded transactions for purposes of determining the income properly attributable to the foreign branch (and therefore, the foreign tax credits attributable to the foreign branch), to extend that reallocation for purposes of calculating the FDII deduction ignores the economic reality of foreign branch activities and produces perverse results that incentivize the offshoring of certain intangible property, in contravention of the stated Congressional intent behind enacting the FDII regime.

We believe that the Proposed Rule imposes a significant economic detriment on companies such as Synopsys, who entered into transactions to repatriate intellectual property ("IP") rights to the US before the issuance of the proposed regulations, inconsistent with the desired effect of international tax reform enacted as part of the TCJA.

I. Section 904, Section 250, and the Foreign Tax Credit Regulations

Section 904 imposes a limitation on the foreign tax credit a US shareholder may apply against its US tax liability.4 To prevent cross-crediting, section 904 imposes separate limitation categories, including the foreign branch category.5 In calculating the section 904 limitation for credits against tax paid by a foreign branch, taxpayers must determine their foreign source income attributable to that foreign branch. Foreign branch income means the business profits of such United States person which are attributable to one or more qualified business units (as defined in section 989(a)6) in one or more foreign countries. In addition, foreign branch income may not include any passive income.7

Under section 250, a deduction is allowed in the amount of the applicable percentage of the taxpayer's FDII for that taxable year.8 The amount of FDII is derived by multiplying a corporation's deemed intangible income by the ratio the foreign-derived deduction eligible income bears to the deduction eligible income of such corporation.9 Deemed intangible income is the amount of deduction eligible income over the corporation's deemed tangible income return, or ten percent of the corporation's qualified business asset investment.10 Deduction eligible income is the excess (if any) of the corporation's gross income, determined without regard to —

1. Any amount included in the gross income of such corporation under section 951(a)(1),

2. The global intangible low-taxed income included in the gross income of such corporation under section 951A,

3. Any financial services income (as defined in section 904(d)(2)(D)) of such corporation

4. Any dividend received from a corporation which is a controlled foreign corporation of such domestic corporation,

5. Any domestic oil and gas extraction income of such corporation, and

6. Any foreign branch income (as defined in section 904(d)(2)(J), over

the deductions (including taxes) properly allocable to such gross income.11 Finally, foreign-derived deduction eligible income is any deduction eligible income of a taxpayer that is derived in connection with either (1) property that is sold by the taxpayer to any person who is not a United States person that is for a foreign use; or (2) services provided by the taxpayer to any person, or with respect to property, not located in the United States.12

The Foreign Tax Credit Regulations give two circumstances in which gross income will be reallocated between a foreign branch owner and its foreign branch ("General Rule"): when either

1. A foreign branch makes a disregarded payment to its foreign branch owner and the disregarded payment is allocable to non-passive category gross income of the foreign branch reflected on the foreign branch's separate set of books and records . . . the gross income of the foreign branch is adjusted downward to reflect the allocable amount of the disregarded payment and the general category gross income attributable to the foreign branch owner is adjusted upward in the same amount; or

2. A foreign branch owner makes a disregarded payment to its foreign branch and the disregarded payment is allocable to general category gross income of the foreign branch owner that was not reflected on the separate set of books and records of any foreign branch of the foreign branch owner, the gross income attributable to the foreign branch owner is adjusted downward to reflect the allocable amount of the disregarded payment, and the gross income attributable to the foreign branch is adjusted upward by the same amount.13

However, in cases where intangible property of a type described in section 367(d)(4) is transferred to or from a foreign branch in a disregarded transaction, the Proposed Rule forces the aforementioned upward and downward adjustments to gross income to be made regardless of whether a disregarded payment was made in connection with the transfer. In determining the amount of gross income that is attributable to a foreign branch that must be adjusted, the principles of sections 367(d) and 482 apply.14

The Preamble to the Foreign Tax Credit Regulations makes clear that the adjustments to the gross income of the foreign branch and the foreign branch owner are not only for the purpose of calculating the section 904 separate limitation for the foreign branch basket, but also for the purpose of determining the foreign branch owner's deduction eligible income under section 250.15 In so establishing, the Preamble states that the treatment of disregarded transactions is solely for the ". . . redetermination of whether gross income . . . is attributable to [a] foreign branch or to the foreign branch owner," and therefore, any redetermination will ". . . have no effect on the amount, character, or source of a United States person's gross income."16

II. Legislative History and Policy of Section 250 and Section 904

The legislative history to section 250 acknowledges that under the prior system of taxing worldwide corporate income at a 35% rate, companies were encouraged to locate intangible income (any by extension, the intangible property that generates such income) offshore in low- or no-tax jurisdictions.17 To encourage the onshoring of intangible income, and the potentially valuable economic activity associated therewith, Congress created the FDII deduction to effectively operate as an analogue to section 951A, the global intangible low-tax income ("GILTI") provision of TCJA. Under the FDII/GILTI regime, US multinationals are subject to the same preferential statutory tax rate on income generated by serving the foreign market, regardless of whether that income is generated through domestic operations or controlled foreign corporations ("CFC"s).18

When calculating the deduction eligible income of a corporation, the rules of section 250 force the exclusion of any of that corporation's income earned through a foreign branch. Thus, where there are foreign branches — rather than CFCs — generating intangible income by serving the foreign market, the corporation is unable to take advantage of the GILTI regime to equate the rates it pays on intangible income generated from serving the foreign market domestically and abroad, because the GILTI inclusion only applies to US shareholders of CFCs. In these cases, the value of the benefit of the FDII deduction increases for the foreign branch owner, since it is the only mechanism by which the foreign branch owner may achieve preferential rates on its intangible income earned by serving foreign markets. The amount of any potential FDII deduction is first reduced because the income attributable to foreign branches is carved out of deduction eligible income; it is further reduced when the Proposed Rule mandates downward adjustments to the foreign branch owner's gross income for purposes of section 250.

III. The Proposed Rule is Overly Broad and Inconsistent with Congressional Intent

The stated purpose of the Proposed Rule is to prevent the non-economic reallocation of gross income to the foreign branch category that might arise from differences between the treatment of remittances, contributions and interest payments on the one hand, and payments for goods and services on the other.19 However, by reclassifying disregarded transactions for purposes of both section 904 and 250, the Proposed Rule is overly broad in that it forces a result that both distorts the determination of the foreign branch owner's gross income and frustrates the Congressional intent behind the enactment of the FDII regime.

First, the General Rule in the Foreign Tax Credit Regulations notes that the adjustments to attribution of gross income required thereunder will ". . . not change the total amount, character, or source of the United States person's gross income."20 This assertion can be true only if the adjustments are made solely for purposes of section 904. If the adjustments apply for purposes of section 250, then the amount of the United States person's gross income — here, the foreign branch owner — does change. In our case, the US parent/foreign branch owner effectuated the repatriation of IP21 owned by its foreign branch via an inbound "F" reorganization,22 which was disregarded for US federal income tax purposes. Following the reorganization, the IP was sold by the foreign branch to the US parent for a note — also a disregarded transaction — with the result being that that the IP is owned by the US parent under both US law and for foreign legal and tax purposes. We repatriated our IP to reduce our risk profile and align our ownership model to better comport with DEMPE (developing, enhancing, maintaining, protecting or exploiting IP and the rights associated therewith) functions. Our foreign effective tax rate did not change post-repatriation, but the new ownership structure does offer the added benefit of simplifying our supply chain, such that our multinational customers are no longer forced to enter into separate contracts with as many as seven various Synopsys entities.

Under the Proposed Rule, regardless of whether an actual payment was made to the foreign branch in exchange for the IP, the income of the foreign branch will be adjusted upward to reflect the value of the IP transferred.23 To illustrate, assume that following the IP repatriation transaction in which we engaged, the foreign branch owner had gross general category income of 300 and the foreign branch had 0. Also, assume that the section 367(d) annual payment for the IP was 100. Per the Proposed Rule, the foreign branch owner's income will be adjusted downward to 200, and the foreign branch's income will be adjusted upward to 100. For purposes of the FDII deduction calculation, the foreign branch owner's deduction eligible income will go from 300 to 200,24 immediately reducing the potential benefit associated with repatriating its IP and generating intangible income in foreign markets from home, in clear contravention of the Congressional intent behind enacting the FDII regime.

This perverse result is compounded when one considers the inverse: when a disregarded transaction is used to outbound IP and the Proposed Rule forces adjustments to increase the foreign branch owner's general category gross income and decrease the foreign branch's gross income. Using the same figures from the example above, the foreign branch owner's general category gross income after the disregarded transaction would be adjusted upward to 400, and the foreign branch's income would be adjusted downward to (100). For FDII purposes, the foreign branch owner would benefit from a larger base of gross income, from which the deduction eligible income amount would be derived. This results in what is essentially a reward (in the form of an inflated FDII deduction) for outbounding IP, also in contravention of Congressional intent. In cases of both inbounding and outbounding IP, that the amount of the foreign branch owner's gross income does indeed change when the Proposed Rule is applied for purposes of calculating the foreign branch owner's deduction eligible income — which runs counter to the assertion in the Foreign Tax Credit Regulations that these reallocations will have no effect on a United States person's gross income — is further evidence that to apply the reallocations beyond the context of section 904 is overreach.

Moreover, the Proposed Rule fails to consider the economic reality of the foreign branch's activities, by ignoring the actual income of the foreign branch as reflected on its books and records. Because the foreign branch is defined as a qualified business unit, the concept of its books and records, and the importance of referencing those books and records to determine the foreign branch's gross income is tantamount.25 Any reallocations that might be required under the Proposed Rule should first take into account actual payments made to or from the foreign branch that are reflected in the books and records. Instead, the Proposed Rule sidesteps that analysis by mandating reallocations regardless of whether a disregarded payment is made when the IP is transferred to or from the foreign branch. Indeed, unlike the General Rule, which calls for reallocation only when the economics of the transactions are not reflected on the foreign branch's books and records, the Proposed Rule imposes a result that lacks nuance, in that it forces reallocations even in circumstances where a payment has been made or received and has been properly accounted for in the books and records by making appropriate diminutions or accretions to the foreign branch's gross income. Furthermore, the retroactive nature of the Proposed Rule compounds its unduly harsh result, as it subjects taxpayers, like Synopsys, who attempted to comply with the spirit with which the FDII regime was enacted to a diminished benefit — an outcome which they had no way of knowing when the transaction was entered into.

Finally, it must be noted that the Foreign Tax Credit Regulations' express language limits its application strictly to the context of section 904, when it clarifies the purpose behind the rule as seeking to eliminate distortions that might arise when allocating income to the foreign branch category.26 The use of "category" necessarily refers to section 904(d), the heading of which is "Separate application of section 904 with respect to certain categories of income."27 Using the limiter of "category" restricts the Proposed Rule's application to section 904 only, because if it were to apply to section 250, the stated purpose in the Preamble would have properly referenced potential distortions that might arise ". . . when allocating income to the foreign branch."

IV. Conclusion

For the foregoing reasons, we believe that the Proposed Rule is overly broad, and impermissibly applies in the context of section 250. To be consistent with the Congressional intent behind both the creation of a separate limitation category for foreign branches and the enactment of the FDII regime, the Proposed Rule's reallocation of gross income between foreign branch owners and foreign branches should be limited to the purpose of determining the foreign tax credits attributable to foreign branch activities.

We would also like to highlight the disparity in effective dates between the Foreign Tax Credit Regulations and the FDII Regulations. Under the former, the Proposed Rule would have retroactive effect to transactions that were executed before its issuance, when such a drastic reduction of the FDII benefit could not have been reasonably anticipated. Conversely, the definition of foreign branch income under the FDII Regulations is effective for tax years beginning after March 4, 2019, meaning that similarly situated taxpayers who engaged in the same type of transaction in the same taxable year as we did would not be constrained by the flawed definition, and would not have to suffer a significantly reduced FDII benefit. Such an inconsistent result underscores the need for Treasury to devote more attention to this issue and rescind the Proposed Rule altogether, as it is leads to perverse results on both administrative and substantive grounds.

Respectfully submitted,

Jill Harding
Vice President, Corporate Tax
Synopsys, Inc.
Mountain View, CA

cc:
Lafayette "Chip" Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Douglas Poms
International Tax Counsel
Department of the Treasury

Jason Yen
Attorney Advisor
Department of the Treasury

Kenneth Jeruchim
Attorney Advisor
Internal Revenue Service

Loren Ponds
Miller & Chevalier
900 16th Street, NW
Washington, DC 20006

Jorge Castro
Miller & Chevalier
900 16th Street, NW
Washington, DC 20006

FOOTNOTES

1All "section" or "§" references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.

3 See Prop. Treas. Reg. § 1.250(b)-1(c)(11) (defining foreign branch income by reference to Prop. Treas. Reg. § 1.904-4(f)). The definition of foreign branch income in the FDII Regulations is broader than that established in the Foreign Tax Credit Regulations, as it also includes "the sale, directly or indirectly, of any asset (other than stock) that produces gross income attributable to a foreign branch, including by reason of the sale or a disregarded entity or partnership interest." Id. Setting aside issues arising from having two different definitions for the same income when those definitions are purportedly to be used interchangeably between sections 250 and 904, we base our comments herein on the narrowest definition as set forth in Prop. Treas. Reg. § 1.904-4(f).

5See Committee Print, Reconciliation Recommendations Pursuant to H. Con. Res. 71, S. Prt. 115-20, (December 2017) at 393 (hereinafter "Senate Budget Committee Report") (articulating Congressional intent of creating a separate foreign branch basket ". . . to prevent excess foreign tax credits generated in high-tax branch countries to be used to reduce US tax owed on income generated in a low-tax country.").

6A qualified business unit is any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records.

7Section 904(d)(2)(J). Notably, the statute confers regulatory authority on Treasury to determine the amount of business profits attributable to a qualified business unit.

12Section 250(a)(4).

13Prop. Treas. Reg. § 1.904-4(f)(2)(vi)(A).

14Prop. Treas. Reg. § 1.904-4(f)(2)(vi)(D).

15Preamble, 83 Fed. Reg. 235, at 63210.

16Id.

17See Senate Budget Committee Report, at 375.

18Id.

19Preamble, 83 Fed. Reg. 235, at 63210.

20Prop. Treas. Reg. § 1.904-4(f)(2)(vi).

21Of a type referenced in Section 367(d)(4).

24Assume no other disregarded categories of income are taken into account to reduce the foreign branch owner's gross income. See Section 250(b)(3).

25See Preamble, 83 Fed. Reg. 235, at 63209 (establishing that the default rule is to determine the gross income attributable to a foreign branch by reference to the amounts reflected on the foreign branch's separate set of books and records).

26Id. (emphasis added).

27Id. See also Prop. Treas. Reg. § 1.904-4(a) (referencing each of the separate categories of income for which taxpayers are required to compute separate foreign tax credit limitations).

END FOOTNOTES

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