Transcript Is Available of IRS Transition Tax Hearing

UNITED STATES DEPARTMENT OF THE TREASURY

INTERNAL REVENUE SERVICE

PUBLIC HEARING ON PROPOSED REGULATIONS

"GUIDANCE REGARDING THE TRANSITION TAX UNDER SECTION 965 AND RELATED PROVISIONS" [REG 104266-18]

Washington, D.C.

Monday, October 22, 2018

PARTICIPANTS:

For IRS:

THOMAS CURTEMAN
Branch Chief
Office of Associate Chief Counsel
(Procedure and Administration)

ROSE JENKINS
Senior Counsel
Office of Associate Chief Counsel (International)

For U.S. Department of Treasury:

BRENDA ZENT
Special Adviser
Office of the International Tax Counsel

LINDSAY KITZINGER
Attorney-Adviser
Office of the International Tax Counsel

Speakers:

MARY LOUISE SERRATO
American Citizens Abroad, Inc.

STEVEN COMSTOCK
American Petroleum Institute

CATHERINE SCHULTZ
National Foreign Trade

BRIAN MARRON
Robert Bosch LLC

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PROCEEDINGS

(10:00 a.m.)

MS. JENKINS:Good morning.Welcome to the Hearing on the Proposed Regulations providing guidance regarding the Transition Tax under Section 965 and related provisions. I'd like to introduce our panel here. I am Rose Jenkins. I'm with the Office of Associate Chief Counsel International. This is Tom Curteman, with the Office of Associate Chief Counsel, Procedure and Administration. Then Lindsay Kitzinger with the Office of International Tax Counsel and Brenda Zent with the Office of International Tax Counsel.

We have four speakers on the agenda this morning. Each speaker has ten minutes to speak. The light here will turn red when their time is up. If I could ask the first speaker to speak, please. We have Mary Louise Serrato from the American Citizens Abroad, Inc.

MS. SERRATO: Good morning. My name is Mary Louise Serrato. I am the Executive Director of American Citizens Abroad, Inc., an exempt section 501(c)(4) organization. Its sister organization is American Citizens abroad Global Foundation, an exempt Section 501(c)(3) organization. Together they represent the interests of Americans living abroad.

It is frequently said that there are around nine million Americans living abroad. ACA believes this number to be closer to 5.1 million, after making a number of adjustments, including one for approximately 1.3 million individuals affiliated with the Federal government. Treasury Department's Office of Tax Analysis and the Joint Committee of Taxation will have their own estimates as they can access tax information and other non-public resources not available to ACA. ACA is pleased to be able to present its views today.

ACA is very familiar with the situation, including the tax treatment of Americans Abroad, having dealt with this subject for over forty years. Of interest might be the fact that over the past four years, ACA has published an on-line directory of U.S. tax return preparers servicing Americans abroad. Also last year in the run-up to tax reform, ACA Foundation produced baseline data of Americans abroad. An analysis of an approach that would replace citizenship based taxation, they approached currently in the tax code with residency based taxation.

This analysis, which was the first of its type and the most comprehensive, was funded by the Foundation and conducted by District Economics Group. Work on this study gave ACA a good feeling for the numbers, that is, how many American taxpayers there are abroad, number of returns filed by them, income profile of the overseas filers, and other key information. ACA, we believe, is uniquely positioned to make several pointed remarks about the proposed regulations. I won't belabor points made in our comments on the regulations to the effect that Section 965 is an enormous injustice because American individuals abroad don't get the benefits of the Dividends Received deduction, but nonetheless are hit with the Detriment of the Transition Tax. This was done in the context of tax reform, with no thought given to the impact of American taxpayers on tax abroad.

Moving on to today's topics, first, Treasury Department and the IRS should insert a de minimis rule into the regulations. These proposed regulations affect almost every American living abroad with direct or indirect ownership interest in certain foreign corporations. Broadly speaking, these are foreign corporations controlled by these American individuals. These corporations can be big or small. The individuals can be wealthy or middle class or relatively modest in means. Many Americans abroad own and do business through what for U.S. tax purposes are characterized as corporations. They are commonly organized under foreign law which differs in many ways from say, Delaware corporate law. The steps for organizing them are different. The people involved, often fiduciaries in civil law jurisdictions, and the documentation is different. Most importantly, the basic accounting is different.

As American accountants practicing in London, Paris, Frankfurt and elsewhere will tell you, it is not a simple trick to go from local accounting to U.S. accounting to U.S. Tax accounting. Now, with Section 965 and these regulations, taxpayers will have to make additional modifications to go to what I'll call Section 965 tax accounting. It should be obvious to everybody that a de minimis rule is necessary to take out from under the workings of the regulations small taxpayers. There can be no justification for requiring an American owning and operating a restaurant in Burgin, Norway, with very little in the way of undistributed non-previously taxed post-1986 foreign earnings of the business to calculate and pay the transition. If he doesn't comply, not only will he owe the tax, but also penalties and interest. In the true sense of the work, this result is absurd.

As suggested in our comments on the regulations, the de minimis rule can run to citizens or residents living abroad and residency rules along the lines of those in Section 911 can be utilized. The rules should apply at the level of the individual taxpayer, not the entity, so as to avoid forcing the individual to make entry level calculations which would defeat the purpose. Thresholds like those on Form 8938 can be applied to define what is small. When drafting the rule, Treasury can look over to the data available to the Office of Tax Analysts to gauge how many people will be taken out of the Section 65 regime and how much tax is involved. ACA's guess, and this is only a guess, as to without tax return data, this is available to Treasury and Joint Committee on Taxation, our guess is that all or almost all small taxpayers abroad with controlled foreign corporations can be taken out of the 965 regime and the tax costs will be little, if anything. At the end of the day, many of the small businesses in question are simply not profitable.

If the Treasury Department believes it cannot write a simple upfront de minimis rule because its hands are tied, then it can come at the problem from a different direction. Small taxpayers can be allowed to treat their foreign corporations as disregarded entities. There not being corporation in place, Section 965 would not apply. Affected taxpayers can be allowed to retroactively make this selection. Still another approach is to set forth — it was set forth in the comments of the American Chamber of Commerce of Japan, where it is suggested that the transition tax be indefinitely postponed until the occurrence of the triggering event. This would be along the lines of the rule applicable to S Corporation. ACA commends the American Chamber of Commerce in Japan for this thinking.

If none of these fallbacks are possible, then the Treasury Department and the IRS should go back to the drafting board and come up with their own solutions. No one knows the ins and outs of regulations like the drafters of the regulations. Having the regulations apply to small taxpayers is a glaring problem and everyone knows it exists. Treasury Department and IRS must fix it.

Second, skipping over the official estimated average annual burden per taxpayer which is said, we think, wrongly to be five hours, we turn to Treasury's determination that the Regulatory Flexibility Act does not apply, essentially because shareholders of foreign corporations are not small entities. The conclusion stated in the regulations that the collection of information requirements will not have a significant impact, economic impact, on a substantial number of small entities, we think is wrong. It ignores the reality that Americans abroad frequently own and operate businesses, often small businesses. As for the point that collections of information apply only to owners of specified foreign corporations and "because it takes significant resources and investment of foreign business to be operated in corporate form by U.S. persons, specified foreign corporations will infrequently be small entities. This demonstrates the problem nicely. Treasury Department is not truly in touch with the reality of Americans abroad. Foreign corporations owned by Americans abroad exist in abundance. They are a fact of everyday life. Similarly, as to the point, "the collection of information requirements in this regulation apply primarily to persons that are U.S. shareholders or specified foreign corporations. The ownership of sufficient stock in specified foreign corporations, in order to constitute a U.S. shareholder, generally entails significant resources and investment such that the business that are U.S. shareholders are generally not small corporations. This again misses the point that in the Americans abroad community, many individuals own small businesses directly or sometimes through entities. Stepping back, Treasury Department, in our view, is not well informed about the situation of Americans abroad. These regulations in the eyes of tens of thousands of individuals living overseas are maddeningly cavalier. Treasury Department should assess under the Regulatory Flexibility Act the impact of these proposed regulations on small entities as defined in the Act, including small entities abroad. To do so would need to identify the population of these entities. Among other things, Treasury should determine how many Americans abroad own CFC's, what are the size of the assets inside these CFC's, what is the inventory of relevant accumulated earnings and profits. If It is fundamentally for the Treasury Department to write regulations without knowing who was effective and to what extent. This goes against the fundamental requirements of the RFA, including the requirement of the analysis of the small entities for which the rules will allow and the estimate of their number. Treasury department cannot conclude that the regulations will not have a significant impact on a substantial number of small entities without a good idea about who is being affected. Again, thank you for this opportunity to testify today.

MS. JENKINS:Thank you.Our next speaker is Steven Comstock from API.

MR. COMSTOCK: Good morning. My name is Steven Comstock, and I am the Director of Tax and Account Policy of the American Petroleum Institute or APT. APT represents over six hundred member companies involved in all aspects of the nation's national gas and oil industry. On behalf of those members, I appreciate the opportunity to speak today regarding two issues associated with the Section 965 proposed regulations and follow up on comments already submitted to the Department of the Treasury.

The industry certainly understands that the inclusion of Section 965 and the recent tax reform legislation help address the foreign earnings lack of problem and transition the United States toward a more modern international tax system. As a transition provision, the rules around section 965 could be approached to stand along guidance, but we believe they should still be developed to maintain coherent tax policy and treat similarly situated taxpayers in a consistent manner. Our first issue focuses on what is considered cash or cash equivalent for purposes of Section 965.

As you know, Section 965(c)(2) Cap A, applies to lower 8 percent rate to the non-cash assets of a deferred foreign income corporation or DEFIC. On the other hand, Section 965(c)(2) Cap B, applies to 15.5.percent tax rate to the aggregate foreign cash position to a DEFIC. Though the bifurcation of the rates applicable to earnings of a DEFIC was driven by several legislative factors, the application of one rate for tangible assets held and another for cash creates the need for considered policy in determining how a DEFIC assets are to be categorized. Some further clarification was meant by cash is provided in Section 965(c)(3) which defines aggregated foreign cash position to include cash and the fair value of cash like assets. Section 965(c)(3)CAP B notes that among these cash like assets are personal property which is of a type that is actively traded for which there is an established financial market. The scope of cash like equivalents is something our members have been focused on and we believe the proposed regulations have potentially created significantly fusion and uneven tax policy by not clearly classifying inventories like physical crude, oil and finished product inventories held by a DEFIC that is non-cash assets.

Accordingly, our industry is seeking specific guidance of physical inventory held in a DEFIC trader business constitutes non-cash property and subject to the rate in Section 965(c) Cap A. We recognize that the preamble to the proposed regulation states that it would not be administrable to create individual regulatory exceptions to this cash definition based upon the liquidity of the asset. However, we believe the Treasury can still implement an approach that would clarify the physical crude and product inventories held by DEFIC constitutes non-cash assets.

The bifurcation in Section 965 rate was developed to recognize that re-investment into a company's business abroad should be treated differently thank cash or items easily convertible to cash such as stock. Oil refineries must operate 24 hours a day, 7 days a week, 365 days a year. Save for extreme situations, the only times that a refinery is non-operational is when repairs are being made. For this reason, large physical volumes of crude oil must be kept on hand. This is the only reason that as of the date of the Dean Repatriation, the DEFIC with refining operations would have had large crude oil and finished produce inventories. Since they are so ingrained in the operation, these inventories are much more similar to the physical plant holding them than they are to cash. But instead of focusing on the liquidity of the inventory, we believe the IRS could focus on whether to DEFIC assets are non-operational without the physical inventory and whether the going concern is compromised. We expect that this will allow for no difference between various taxpayers with physical inventories supporting DEFIC with manufacturing operations.

The second reason inventory should be subject to the non-tax rate is the manner in which these items are bought and sold is inconsistent with category in Section 965(c)(3) Cap b, of personal property that is actively traded on an established financial market. We think the crude oil and finished product inventories fail to meet this definition for two reasons. First, while crude futures are sold on various exchanges such as the New York Mercantile Exchange, the actual physical personal property itself is not sold on those markets. Rather, it is only the financial products based upon the underlying crude oil and finished products that are actively traded on those types of exchanges and essentially constitute derivative products and not the actual personal property itself. Second, the manner in which physical rude and finished properties inventories are bought and sold by refineries is by the use of forward contracts, but despite this terminologies, these contracts are not similar to options, swaps and futures, and should not be confused with the definition of derivative financial instruments in the proposed regulations. The Internal Revenue Service itself has gone so far as to declare that forward contracts are not equitable to contracts sold on the community exchange by stating that "the forward market is where oil is bought and sold between two parties and with delivery of the commodity to be consummated at a future date. This type of transaction does not take place through a commodity exchange."

Adopting the rule that physical inventories of DEFIC normally sold by that DEFIC under purchase sale of foreign contracts are not cash is consistent with the intent of Congress and will allow for similarly situated taxpayers to be treated consistently. One DEFIC with physical refits and inventory sold to be a purchase sale contracts is no different than a DEFIC with defining operations holding crude and physical inventories. Further, adopting this approach would not be open to tax optimizing as Section 965 is not applicable to future years.

Finally, it is audible by the IRS and constitutes sound tax policy. For this reason API and its member companies believe that crude oil and finished product inventories should not be considered cash like assets for purposes of Section 965 and see clarifying issues on this point.

The second issue I wish to address is the restriction imposed on taxpayers by the proposed regulations which limits the abilities of taxpayers to change their method of accounting or make entity classification elections. The proposed regulations establish a per se rule which invalidates otherwise permissible changes in accounting methods or entity classifications elections. The preamble to the proposed regulations stated that at a principal purpose test would not be applied to change in accounting method. The rationale is that the proposed rule does not affect the taxpayers' ability to change its accounting method, rather it disregards an accounting method only in the limited purposes of determining a taxpayers' Section 965 elements. A taxpayer has the obligation to report its income in the most clear and accurate way possible. It should require that the taxpayer should adopt a change in accounting method, regardless of the consequences of Section 965. The practicable impact of the IRS disregarding an otherwise permissible election is that taxpayers may utilize and otherwise impermissible method of accounting. Furthermore, API and its member companies disagree with the Department of Treasury's assertion that the legislative history of the conference report reflects the intent of Section 965(0) to allow Treasury to disregard changes in accounting method if there is the effect of a reduction of a taxpayer's tax liability under Section 965. Rather, we believe Congress intended for a principal purpose test to be applied when there remains the ostentation for a taxpayer's taxable inclusion under Section 965 to be diminished. The desire to apply a principal purpose test was not intended to be ignored, merely because the reduction of a taxpayer's tax liability under 965 could occur. The reduction was one of multiple factors to be considered. If, however, the Department of Treasury is committed to the proposed regulations language, specific language should be included that a change of method in accounting should not be disregarded if there is no decrease in the tax liability under Section 965 after considering all the other Section 965 elements. API believes a similar approach should be taken by the Department of Treasury regarding entity classification elections. For check-the-box elections, the principal purpose test should be applied with the election being regarded so long as the principal purpose of the election was not to reduce Section 965 tax liability. Alternatively, similar to the change in accounting method, a check-the-box election should be honored at a minimum if it does not reduce Section 965 tax liability.

Thank you for allowing me to speak before the panel this morning. The implementation of the recent tax reform legislation is complicated and intricate and we appreciate the opportunity to provide input to the process.

MS. JENKINS: Thank you. Our next speaker is Catherine Schultz from the National Foreign Trade Council.

MS. SCHULTZ: Hi, my name is Catherine Schultz. I am the Vice President of Tax Policy at the National Foreign Trade Counsel. We are very pleased to be able to present our testimony here today.

We have four main issues that we are concerned about from the 965 proposed regulations. The first is in the preamble to the proposed Section 965. Treasury and the IRS followed Notice 2018-3 by providing the previously taxed EMP is not excluded in determining the existence in an amount of a specified EMP deficient, but as the Treasury and the IRS are considering other rules with respect to determination of post-1986 earnings and profits, accumulated post-1986 deferred foreign income and specified EMP deficit in connection with the finalization of these proposed regulations. Consistent with the rules of calculating the deferred foreign income, Treasury and the IRS should adopt the position that the rules for calculating EMP should exclude the amount of undistributed foreign earnings that have already been subject to U.S. tax. I understand that there will be additional regs on PTI, but for right now those included in the 965 are a problem. By adopting this position, the Section 965 regulations would align with congressional intent that the transition tax apply to taxpayers net historic foreign earnings which had not been previously taxed. Further, we believe that this calculation achieves the most accurate measures of a taxpayer's EMP that should be subject to the transition tax. There is no policy reason for including PTI in the calculation of a specified EMP deficit. Indeed, including PTI in the calculation will cause the taxpayer to have its EMP that is subject to the transition tax over measured and cause the transition tax to be imposed on more than the hundred percent of the taxpayer's EMP. There is nothing in the legislative history that suggests the Congress intended to include PTI in the calculation of a specified EMP deficit. In fact, there is evidence in the legislative history that the Congress intended to exclude income that had been previously taxed from the transition tax. The statute's silence on the issue should be interpreted as a simple failure of the Congress to provide guidance one way or the other. The broad grant of regulatory authority in Section 965(0) gives Treasury the ability to implement the policy in a way that is clearly aligned with congressional intent and achieves the most reasonable measurement of a taxpayer's EMP for purposes of calculating the transition tax. The second issue that we are concerned about is the netting of short term notes receivable and notes payable. The proposed 965 regulations do not permit short term notes payable that do not arise from the purchase of goods or services to offset short-term notes receivable which count as cash. Due to the short term nature of these transactions, the inability to net related short term notes payable against notes receivable distorts the true cash positon of a company.

For example, a specified foreign corporation may borrow funds from its U.S. shareholder for operational needs and the borrowing is booked as short term intercompany not payable. The same SFC would also lend funds to its U.S. shareholder or a member of the same U.S. federal consolidate group for its need which is booked as intercompany notes receivable. Under the generally accepted accounting principles, the two accounts are netted to properly reflect the FFC's true cash picture.

However under the proposed 965 regulations, the notes receivable would be treated as short term obligations includable as cash for the SFC while the notes payable would not be allowed to be offset or netted against the notes receivable. This disallowance results in a distortive overstatement of the SFC's cash balances and is contrary to the congressional intent of measuring a true liquidity of SFC's on the measurement date.

Moreover, the note payable owed to the U.S. was provided with U.S. funds, not foreign cash that Congress intended to tax at a higher rate.

The NFTC would recommend that the gap — that basically that the gap permits the netting of accounts payable and accounts receivable for a more accurate picture of a company's financial position. Due to similar nature of short term notes, comparable notes should be applied for Section 965 purposes. Specifically the proposed 965 regulation should allow an SFC to net this short term intercompany note payable against a short term intercompany notes receivable with this U.S. shareholder or a member of the same share, U.S. Consolidated group of U.S. shareholder.

The third issue I want to address is notional cash pooling. While the proposed 965 regulations do not specifically address the treatment of notional cash pooling for purposes of determining the cash — the taxpayers aggregate cash and cash equivalent position, the preamble states the comments were received, that the proposed regulations provided notional cash pooling arrangements were treated as creating intercompany receivables, and that the regulations do not adopt the recommendation. Even though there is a lack of direct guidance on the netting of receivables and payables balance in notional cash pooling arrangements, there is ample support for a ruling permitting this approach, particularly where the use is intercompany.

Both the statement of managers and Notice 2018-07 acknowledge that intercompany relationships must be scrutinized to ensure that they do not create any type of double counting that might cause the aggregate cash position calculations to include amounts that exceed the relevant U.S. shareholder aggregate amounts of foreign cash assets. The statute allows for netting of accounts payable and accounts receivable to arrive at a true amount of liquid net assets receivable which is consistent with the manner to which notional cash pooling arrangements actually operate. Pool balances are notes for the purpose of determining the maximum amount of cash that one member participant can withdraw from its account.

In addition, under Notice 2018-7 the note, the positive and negative values of all derivative financial instruments are taken into account in order to arrive at their aggregate impact on a specified form corporation's cash position. Given the fact that some jurisdictions mandate by law the use of notational cash pooling, the rejection of a rule accommodating companies operating in those jurisdictions will be significantly disadvantaged relative to companies who do not operate in those jurisdictions and thus do not — are not required to use notational cash pooling.

Absent a favorable ruling for notional cash pooling will result in the gross overstatement of some taxpayer's cash and cash equivalent positions, treatment of EMP as cash and cash equivalent even when a taxpayer does not actually have an economic right to access such assets. A substantially higher effective tax rate on some taxpayers undistributed EMP then the underlying economic realities would otherwise dictate and disregard of the mismatches created by the check-the-box rules.

A single CFC may have several disregarded entities each of which is a participant in the cash pool. If one disregarded entity is a borrower and another is a depositor, only the net balance should be treated as cash of the CFC rather than the gross amount of the deposit. To eliminate the disparity and treatment between notional and physical cash pooling arrangements, we urge Treasury to treat notional cash pools as creating intercompany loans for purposes of 965. Absent such a rule, taxpayers using physical cash pols will have a material advantage over the taxpayers using a notional cash pool.

And our, the last issue that I would like to talk about is changes in accounting method issues. The principal purpose test, the rule disregarding certain changes in methods of accounting and entity classification election should not apply without regard to whether the change was made with the principal purpose of reducing the amount of income included pursuant to Section 965 and the 965 tax liability of the U.S. shareholder.

Such a per se rule denying a method change from the impermissible method to permissible method may exceed the IRS's authority to exercise its discretion to determine which method most clearly reflects income and may require use of an otherwise impermissible method. The legislative history shows clear legislative intent for a principal purpose test.

Alternatively the rule should be modified that allows entity classification changes and accounting method changes so long as there is no decrease to tax liability under Section 965 from such a change after taking into account all the 965 elements. Provided there is no principal purpose — provided that the principal purpose test applies to check-the-box election and accounting method changes.

In the alternative, provide that the check-the-box elections and accounting method changes will be respected so long as the 965 tax liability after taking into account changes to Section 965 elements is not decreased.

The changes in accounting method in deemed paid foreign tax is our next issue under this section. Proposed Treasury Reg Section 1.65-4B provides the transaction is disregarded for purposes of determining the amount of all the Section 965 elements of a U.S. shareholder if the transaction would change the amount of the Section 965 element of such a shareholder.

Proposed Treasury Reg 1.65-4C and D state that the change in method of accounting made for a taxable year that ends in 2018 or 2019 is disregarded for purposes of determining the amount of all Section 965 elements if it changes the deemed paid foreign tax credit as a result of the Section 965A inclusion.

For companies filing accounting method changes with positive 481 adjustment, 481A adjustments, their transition tax liability would have been increased even if the positive EMP adjustments would increase the deemed paid credit under Section 960. However, under the proposed Section 965 regulations as drafted, companies now will not pay on 25 percent of the positive section 481A adjustment. As such, a portion of the Section 481A adjustment is tax exempt permanently. This could not have been what Treasury and the IRS intended when drafting proposed Section 965 regulations.

When finalized, this drafting error should be eliminated. Our last section, I think I'm out of time, is basically on the audit position that a CFC should still continue to receive audit protection.

MS. JENKINS: Thank you. And our last speaker is Brian Marron from Robert Bosch, LLC. Since it appears that he is not here, are there any people who did not, were not on the agenda who want to speak? Okay. Well, thank you very much.

(Whereupon, at 10:30 a.m., the HEARING was adjourned.)