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Law Firm Seeks Different Transition Rules Under Proposed FTC Regs

FEB. 28, 2019

Law Firm Seeks Different Transition Rules Under Proposed FTC Regs

DATED FEB. 28, 2019
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February 28, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave., N.W.
Washington, D.C. 20220

The Honorable Charles Rettig
Commissioner
Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, D.C. 20224

The Honorable William Paul
Principal Deputy Chief Counsel and Deputy
Chief Counsel
Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, D.C. 20224

CC:PA:LPD:PR (REG-105600-18)
Courier's desk, Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, DC 20044

Re: Prop. Treas. Reg. § 1.904(f)-12(j)(3)

Dear Sirs:

We write to comment on Prop. Treas. Reg. § 1.904(f)-12(j)(3), which sets forth transition rules related to the carryforward of losses to years after the effective date of the Tax Cuts and Jobs Act (the “Act”) which was enacted on December 22, 2017. We believe that the transition rules do not promote the clear reflection of income: They potentially create distortions in taxpayers' foreign earnings pools that could result, depending on the facts, in either unwarranted detriments or windfalls to the taxpayer. Accordingly, we encourage Treasury and the Service to adopt a transition rule similar to the rule in Treas. Reg. § 1.904(f)-12(a)(2), which addresses the carryforward of general category overall foreign losses from pre-Tax Reform Act of 1986 (“TRA”) years to post-TRA years.

Prop. Treas. Reg. § 1.904(f)-12(j)(3)(i) provides in relevant part that to the extent a taxpayer has a balance in any pre-Act general category separate limitation loss or overall foreign loss account at the end of its last pre-Act taxable year, the amount of such balance is allocated on the first day of the taxpayer's next taxable year to general category income, or if the taxpayer applies the exception in Prop. Treas. Reg. § 1.904-2(j)(1)(iii)(A), on a pro rata basis to the taxpayer's post-Act general and foreign branch category baskets, based on the proportion in which any unused foreign taxes in the same pre-Act separate category for general category income are allocated under Treas. Reg. § 1.904-2(j)(1)(iii)(A).

Similarly, Prop. Treas. Reg. § 1.904(f)-12(j)(3)(ii) provides in relevant part that to the extent that a taxpayer's separate limitation or overall domestic loss offsets pre-Act general category income, the balance in the loss account at the end of the taxpayer's last pre-Act taxable year is recaptured in subsequent taxable years as general category income, or, if the taxpayer applies the exception in Prop. Treas. Reg. § 1.904-2(j)(1)(iii), on a pro rata basis to the taxpayer's post-Act general and foreign branch category baskets, based on the proportion in which any unused foreign taxes in the same pre-Act general category taxes are allocated under Prop. Treas. Reg. § 1.904-2(j)(1)(iii)(A).

Prop. Treas. Reg. § 1.904-2(j)(l)(iii)(A) provides in relevant part that if unused foreign taxes with respect to general category income are carried forward to a post-Act taxable year, a taxpayer may choose to allocate those taxes to the post-Act foreign branch category to the extent those taxes would have been allocated to the taxpayer's post-Act foreign branch category if the taxes were paid or accrued in a post-Act taxable year. Any remaining unused foreign taxes are allocated to the general category.

Both of the alternatives set forth in Prop. Treas. Reg. § 1.904(f)-12(j)(3)(i) and (ii) could produce severe distortions that do not clearly reflect income.

  • The general rule (allocating to, or recapturing as, general basket income alone) ignores that that some or all of the carryover amounts could have been attributable to a foreign branch, and therefore should be more properly attributable to the foreign branch category.

  • The elective alternative, which is based on foreign tax allocations, creates mismatches since a taxpayer's foreign tax is determined under foreign tax principles while a taxpayer's foreign income is determined under U.S. tax principles. Therefore, the elective alternative could result in allocations or recaptures that have no relationship to the taxpayer's income generating activity.

Accordingly, we respectfully suggest that final regulations adopt different transition rules that minimize the possibility for distortions. We believe that the transition rules in respect of the TRA (Treas. Reg. § 1.904(f)-12(a)(2)) promote the clear reflection of income and are helpful precedent.

Like the Act, the TRA created new foreign income categories. Treas. Reg. § 1.904(f)-12(a)(2)(i) addresses this by providing that that pre-1987 general limitation overall foreign losses shall be recaptured in post-1986 years from the general limitation, financial services, shipping, and noncontrolled section 902 baskets on a pro rata basis.1

Additionally, Treas. Reg. § 1.904(f)-12(a)(2)(ii) sets forth an elective alternative that promotes an even more targeted clear reflection of income. Under the elective alternative, the taxpayer could recapture the amount of losses attributable to a separate category of section 904(d)(1) if the taxpayer could demonstrate to the satisfaction of the district director that such amount of the taxpayer's general limitation overall foreign loss was attributable to losses in that separate category.

We believe that the Treas. Reg. § 1.904(f)-12(a)(2)(i) and (ii) transition rules remain an accurate reflection of Congressional intent. Congress has mandated that losses be allocated proportionately to separate income categories (and not be allocated by reference to foreign taxes). Sections 904(f)(5)(B) and (D) allocate, respectively, separate limitation losses and U.S. source losses to separate limitation income amounts on a proportionate basis.

The current final regulations reflect this Congressional intent. See Treas. Reg. § 1.904(g)-3(d)(1) (separate limitation losses are allocated against separate limitation income in other categories on a proportionate basis); Treas. Reg. § 1.904(g)-3(e) (U.S. source losses are allocated against foreign source income in separate categories on a proportionate basis); Treas. Reg. § 1.904(f)-8(a) (separate limitation losses are recaptured as separate limitation income in other categories on a proportionate basis); and Treas. Reg. § 1.904(g)-2(a) (overall domestic losses are recaptured as foreign source income in separate categories on a proportionate basis).

A simple example illustrates the potential distortion and non-clear reflection of income caused by the proposed regulations. Suppose that a taxpayer has a 20 overall domestic loss in 2017 and 100 of general basket income, 50 of which is attributable to a foreign branch and 50 of which is not attributable to a foreign branch. Suppose also that the taxpayer has 20 of general category foreign tax credit carryovers, 5 of which are attributable to a foreign branch and 15 of which are not so attributable. Under the general rule of Prop. Treas. Reg. § 1.904(f)-12(j)(3)(ii), the 20 ODL is allocated entirely to general category income even though the taxpayer has foreign economic activity that generates both general and branch category income. Under the elective alternative (which is applicable in the example only because the taxpayer has unused pre-2018 foreign taxes), 15 of the ODL is allocated to general category income and 5 is allocated to foreign branch income, which is also not an accurate reflection of the taxpayer's income-producing activity.

By contrast, a rule based on Treas. Reg. § 1.904(f)-12(a)(2)(i) and (ii) would allocate the ODL in proportion to the taxpayer's income in its post-2017 general and branch categories, or alternatively, to the categories that the taxpayer could clearly identify with its pre-2018 income-producing activity. Both of these alternatives are directly related to the taxpayer's income-producing activity and therefore are a far clearer reflection of income.

In conclusion, we would encourage that final regulations adopt transition rules similar to the TRA transition rules, which result in a clear reflection of income and are consistent with Congressional intent.

Sincerely,

David Forst
Mike Knobler
Fenwick & West LLP
Mountain View, CA

FOOTNOTES

1The regulation excludes the passive income and high withholding tax interest categories from this recapture rule because income in those two categories likely would not have been general limitation income in pre-TRA years. See T.D. 8306 (August 2, 1990). This concern is not an issue in respect of foreign branch income, which would have been general limitation income in pre-Act years.

END FOOTNOTES

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