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Firm Addresses NOL Issue under Proposed FDII Regs

FEB. 10, 2020

Firm Addresses NOL Issue under Proposed FDII Regs

DATED FEB. 10, 2020
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February 10, 2020

Courier's Desk
Commissioner of Internal Revenue
Internal Revenue Service
Attn: CC:PA:LPD:PR (REG-104464-18)
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Comments with respect to Proposed Regulations under Section 250 REG-104464-18

Dear Sir:

On March 6, 2019, the Treasury and internal Revenue Service issued proposed regulations under section 250 of the Internal Revenue Code, dealing with the deduction with respect to foreign-derived intangible income (“FDII”) and global intangible low-taxed income (“GILTI”). 84 Fed. Reg. 8188. Our focus in this letter is on the portion of the proposed regulations dealing with FDII.

The deadline for written comments for these proposed regulations was May 6, 2019. Numerous comments were filed with respect to the proposed regulations. While at least one of these comment letters briefly addressed the general issue discussed in this comment letter relating to the allocation and apportionment of pre-TCJA NOLs, none of these prior comments addressed an important point relating to the existence of relevant prior authority that is covered in this letter.

We understand from news reports that final, and possibly additional proposed regulations, may be issued shortly. However, since these regulations have not yet been sent to the Office of Management and Budget's OIRA for review, it is our hope that there is still time to take the comments in this letter into account in any regulations that may soon be issued.

The particular issue that is addressed in this letter is the treatment for purposes of allocating and apportioning deductions under section 1.861-8 with respect to a net operating loss (“NOL”) carryforward to post-Tax Cuts and Jobs Act (“TCJA”) taxable years, where the NOL arose in a pre-TCJA taxable year. At least one of the comments that were submitted on the proposed regulation addressed this issue, but only in a fairly cursory way. However, as far as we can tell, none of the previously submitted comments focused on the existence of certain legal authorities that have a direct bearing on the resolution of this issue.

We also note that the issue on which we are commenting also has a bearing on a related question concerning the treatment of pre-TCJA NOLs for purposes of the taxable income limitation under FD1I for post-TCJA taxable years. Several comment letters recommended that pre-TCJA NOLs should be entirely disregarded for purposes of determining the taxable income limitation. However, the authorities that we address herein do not have a direct application to that aspect of the issue. Nevertheless, we will comment briefly below on the relationship between these two issues.

The broader issue that we address herein may be framed in terms of whether gross income that is earned prior to the effective date of a statute (TCJA, in this case), may be treated as a class of income that is assigned to a statutory grouping under section 1.861-8 that did not exist when the income was earned. In other words, may gross income that was earned prior to the effective date of section 250 be assigned to the statutory grouping of gross income that is gross foreign-derived deduction eligible income (“gross FDDEI”) for purposes of section 1.861-8, in light of the fact that at the time the income was earned this manner of classifying gross income had no relevance for federal income tax purposes?

We submit that in connection with a similar issue under former section 199, the IRS concluded that pre-effective date gross income cannot be assigned to the category of gross income referred to under section 199 as domestic production gross receipts (“DPGR"), in light of the fact that this way of classifying income had no relevance for federal income tax purposes prior to the enactment of section 199. The IRS concluded in the section 199 context that it was irrelevant that the same type of gross income that was earned subsequent to the enactment of section 199 was treated as part of the statutory grouping, DPGR.

We think it is particularly notable that the preamble to the proposed regulations relies on authorities under section 199 on a separate issue in supporting the treatment of similar items under section 250. We will discuss this other context below.

Background

As background to understanding the relevance of the authorities with respect to former section 199 to the issue we are commenting on under section 250, some background is helpful. As the starting point for this background, it should be noted that Prop. Treas. Reg. § 1.250(b)-1(d)(2)(i) provides as follows:

For purposes of determining a domestic corporation's deductions that are properly allocable to gross DEI and gross FDDEI, the corporation's deductions are allocated and apportioned to gross DEI and gross FDDEI under the rules of §§ 1.861-8 through 1.861-14T and 1.861-17 by treating section 250(b) as an operative section described in § 1.861-8(f). In allocating and apportioning deductions under §§ 1.861-8 through 1.861-14T and 1.861-17, gross FDDEI and gross non-FDDEI are treated as separate statutory groupings.

Turning to the section 861 regulations as they apply to determine the allocation and apportionment of an NOL deduction, Treas. Reg. § 1.861-8(e)(8) provides:

A net operating loss deduction allowed under section 172 shall be allocated and apportioned in the same manner as the deductions giving rise to the net operating loss deduction.

Thus, in the case of a carryforward of an NOL that arose in a different taxable year than the taxable year to which the NOL is carried and used, the NOL carryforward is allocated and apportioned to gross income under section 861 based on the factual relationship between the deductions that make up the NOL and the gross income that was earned in the taxable year in which the NOL arose. This treatment is based on case law emanating from Motors Insurance Corp. v. United States, 530 F.2d 864 (Ct. Cl. 1976). In this case, the Court of Claims held the deductions reflected in a net operating loss carryback that was used in a prior taxable year are allocated to gross income based on the facts relating to the taxable year the deductions giving rise to the NOL were claimed, rather than based on the facts in the taxable year in which the NOL carryback is used.

Moreover, applying this analysis to the present situation, it is irrelevant that the category of gross income to which the NOL is allocated (gross non-FDDEI) may have no income in that class in the taxable year that the NOL carryforward is used. In this regard, Treas. Reg. § 1.861-8(d)(1) provides that deductions may be allocated to a class of gross income even if there is no gross income from that class in the taxable year in which the deduction is taken. Treas. Reg. § 1.861-8(e)(8) and Treas. Reg. § 1.861-8(d)(1), in combination, have been interpreted to mean that deductions may be allocated to a class of gross income that was earned, or will be earned, in a different taxable year than the taxable year in which the deduction is taken. Thus, for purposes of section 250, an NOL carryover that is deductible and is used in a particular taxable year may be allocated to gross non-FDDEI where the deductions giving rise to the NOL were originally allocable to gross non-FDDEI in the taxable year in which the deductions were claimed, regardless of whether there is any gross non-FDDEI in the taxable year in which the NOL is used.

However, what the foregoing authorities do not address is whether the gross income earned by a taxpayer in a pre-TCJA taxable year, which would be gross FDDEI if earned in a post-TCJA taxable year, is necessarily treated as gross FDDEI in the prior taxable year when the gross income was earned simply because the income in the earlier year is the same type of income as income that would be classified as gross FDDEI in the later year. In other words, is the classification of income as either gross FDDEI or gross non-FDEEI in a taxable year before those classifications became relevant for federal income tax purposes affected by the similarity of the income that would be classified as gross FDDEI or gross non-FDDEI in a later taxable year after the effective date of the statutory provision making these income classifications relevant for federal income tax purposes. This question was addressed by at least one commenter, but those comments were very brief and did not consider the relevant section 199 authorities. This is where the Treasury's and IRS's prior legal analysis of this issue in the context of former section 199 comes into play.

Analysis under Section 199

1. In general

When section 199 was enacted, it provided taxpayers with a substantial deduction based on the amount of a taxpayer's qualified production activities income (“QPAI”). A taxpayer's QPAI was computed by first determining the amount of a taxpayer's domestic production gross receipts (“DPGR”) and reducing that DPGR by cost of goods sold and any deductions allocated and apportioned to the class of income referred to as DPGR. The regulations under former section 199 provided that, except for certain small business taxpayers, the principles in section 1.861-8 would apply in determining the extent to which deductions are allocated and apportioned to DPGR, the statutory grouping in this case, using the terminology in section 1.861-8.

As a result of the enactment of section 199, taxpayers began to search for ways to increase the portion of their taxable income that was classified as QPAI. One way to accomplish that result was to reduce the amount of expenses that were allocated to DPGR under section 1.861-8. With that goal in mind, taxpayers began to explore whether any of the expenses that were deducted in taxable years to which section 199 applied could be allocated to non-DPGR by treating the expenses as allocable under section 1.861-8 to income earned prior to the effective date of section 199. Taxpayers believed that if expenses could be allocated to pre-effective date gross income, that income would be classified as non-DPGR, since DPGR did not exist until the effective of section 199.

Given the widespread adoption of this practice by taxpayers, the issue immediately came to the attention of the IRS. The taxpayers' position posed two potential issues for the IRS to consider: (1) what types of expenses that are deductible in a particular taxable year are allocable to income earned in a different taxable year, either earlier or later than the taxable year in which the income was earned; and (2) if an expense was deductible in a taxable year to which section 199 was effective, but the expense was allocable under section 1.861-8 to an earlier taxable year that pre-dated the effective date of section 199, would that expense be apportioned to the statutory grouping, DPGR, or the residual grouping, non-DPGR.

These issues were referred to the International Branch of the IRS National Office and, after studying the issues, the IRS issued AM 2009-001 (“the AM") as general guidance to Internal Revenue agents. The AM addressed both of the issues referred to in the preceding paragraph. First, the AM addressed a number of different types of situations, including situations where the particular type of expense was allocable to income earned in a taxable year prior to the taxable year in which the expense was deducted and situations where the particular type of expense was allocable to income earned either in, or subsequent to, the taxable year in which the expense was deductible. In either of those cases, the IRS concluded that the grouping of the class of income for purposes of section 1.861-8 was based on the statutory rules that were in effect in the taxable year in which the income was earned, rather than the taxable year in which the expense was deducted.

Second, the AM addressed the issue of whether an expense that was allocable to gross income earned in a taxable year prior to the effective date of section 199 should be apportioned to the statutory grouping of DPGR or to the residual grouping of non-DPGR. On this point, the IRS ruled that if the expense was allocated to income that was earned prior to the effective date of section 199, that deduction reduced the residual class of income, non-DPGR. In reaching this conclusion, it didn't matter whether the income earned in the prior year was of a type that would have been treated as DPGR if the income had been earned after the effective date of section 199.

This same issue arose in connection with a different type of expense CCA 201714029. In this CCA, a taxpayer incurred legal expenses in defense of lawsuits against alleging that the taxpayer's customers were harmed reason of the defective nature of the taxpayer's products. The CCA notes that the products in question were sold to customers in taxable years prior to the effective date of section 199. On its original tax returns, the taxpayer allocated the legal expenses that were deducted in taxable years to which section 199 applied against DPGR for purposes of section 1.861-8, thus reducing the taxpayer's QPAI. However, upon reconsideration, the taxpayer filed refund claims asserting that the legal expenses were allocable to pre-effective date sales income and, therefore, the legal expenses should have been apportioned to the residual class of income, non-DPGR.

The IRS exam team referred the case to the Associate Chief Counsel, International, IRS National Office, for assistance. In response, the National Office issued CCA 201714029. Consistent with the position that it took some eight years earlier in the AM, the National Office concluded that the product liability expenses were allocable to the class of income resulting from sales of the taxpayer's products that occurred in taxable years prior to the effective date of section 199. Accordingly, the National Office concluded that the legal expenses were apportioned to the residual class of income under section 199, non-DPGR.

2. Application to cost of goods sold

The holdings in the AM and the CCA attracted widespread attention. Taxpayers began to look for ways to expand the holdings in the AM and the CCA and one obvious way to do that was to apply the conclusion in those pronouncements to a taxpayer's cost of goods sold.

However, the IRS adamantly rejected the expansion of the holdings and insisted that since cost of goods sold was not a deduction subject to the allocation and apportionment rules in section 1.861-8, the principles in section 1.861-8 could not be applied to a taxpayer's deduction of cost of goods sold. Instead, under allocation principles separate from section 1.861-8, the IRS concluded that the deduction of cost of goods sold could not be allocated to gross income that was earned in a taxable year prior to the taxable year in which the cost of goods sold was deducted. That is the reason why both the AM and the CCA noted that they did not apply to expenses that were includible in cost of goods sold.

Notwithstanding the IRS's position, taxpayers continued to challenge the IRS on the allocation of cost of goods sold deductions. To bolster its position, in 2015 the IRS issued proposed regulations that unequivocally confirmed its position that deductions for cost of goods sold could not be allocated to sales income earned in a different taxable year than the taxpayer year in which the cost of goods sold was deducted by the taxpayer. Prop. Treas. Reg. 1.199-4(b)(2)(iii)(A). The preamble to these proposed regulations discusses some of this history and the IRS reasoning.

While the proposed regulations under section 199 were never finalized because section 199 was repealed in the TCJA, its principles were carried over in the section 250 proposed regulations and are discussed in the preamble to those regulations

What is most important to this discourse is that while the pronouncements cited herein — the AM, the CCA, and the proposed regulations — are not normally regarded as official precedents in the tax law, the IRS has never wavered from the conclusion that in the case of ordinary expenses that are allocable under section 1.861-8 to a class of income that was earned prior to the effective date of a statute those expenses may not be allocated to the statutory grouping established by that statute in a subsequent taxable year. This conclusion received substantial consideration at the highest levels of the IRS and Treasury, far beyond what occurs in the case of pronouncements such as the AM and CCA. Accordingly, we submit that the position asserted herein is established law and beyond reproach.

As a result, we submit that the regulations under section 250 should clearly provide that deductions comprising an NOL that arose in a taxable year prior to the effective date of section 250 are always apportioned to the residual class of gross income, gross non-FDDEI.

If you have any questions about our suggestions or would like to discuss them further with us, please contact either of the undersigned at (202) 393-7600.

Sincerely yours,

Leslie J. Schneider

Patrick J. Smith

Ivins Phillips Barker
Washington, DC

Cc:
L. G. “Chip” Harter, Deputy Assistant Secretary (International Tax Affairs), Treasury Department
Mr. Jeffrey Van Hove, Senior Advisor, Regulatory Affairs, Treasury Department
Douglas Poms, International Tax Counsel, Treasury Department
Brigid Kelly, Attorney-Advisor, Office of International Tax Counsel, Treasury Department
Jason Yen, Attorney-Advisor, Office of International Tax Counsel, Treasury Department
Peter Blessing, Associate Chief Counsel (International), Internal Revenue Service
Kenneth Jeruchim, Office of Associate Chief Counsel (International), Internal Revenue Service
Joseph P. Dewaid, Office of Associate Chief Counsel (International), Internal Revenue Service
Michelle Monroy, Office of Associate Chief Counsel (Corporate), Internal Revenue Service
Austin M. Diamond-Jones, Office of Associate Chief Counsel (Corporate), Internal Revenue Service
Marissa K. Rensen, Office of Associate Chief Counsel (International), Internal Revenue Service
Melinda E. Harvey, Office of Associate Chief Counsel (International), Internal Revenue Service

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