Firm Seeks Changes to Proposed Regs on Covered Asset Acquisitions

Baker & Hostetler LLP submits this letter on behalf of a client in response to the request for comments on the proposed regulations (REG 129128-14) under section 901(m) of the Internal Revenue Code. We respectfully request two changes to the proposed regulations. First, we request that an exemption to section 901(m) be provided for a transaction in which, for U.S. federal income tax purposes, members of the U.S.-parented group that includes the "section 901(m) payor" recognize all or substantially all of the gains and losses with respect to the "relevant foreign assets." Second, we request that the overly burdensome "aggregate basis difference carryover" rules in the proposed regulations not be included in any final regulations that ultimately are issued. These requests are discussed in turn.

Exemption for Taxable Transactions in which Section 901(m) Payor or Related Person Recognizes Gains and Losses

We request that an exemption to section 901(m) be provided for a "covered asset acquisition" in which all or substantially all of the gains and losses with respect to the relevant foreign assets are recognized by members of the U.S.-parented group that includes the section 901(m) payor. Such transactions arise commonly in internal business restructurings, and permanently denying foreign tax credits under section 901(m) in connection with such transactions is unduly harsh and results in double taxation. U.S.-parented groups are placed at a competitive disadvantage compared to foreign-parented groups which, under their countries' territorial international tax systems, can undertake such internal restructurings without adverse tax consequences. To address concerns that the requested exemption would increase compliance costs to businesses, the exemption could be made elective.

The policy behind section 901(m) is to prevent an acquirer from "hyping" its foreign tax credits by obtaining a step-up in basis in the relevant foreign assets for U.S. federal income tax purposes without recognizing a corresponding step-up in basis for foreign income tax purposes, resulting in a permanent difference in the tax bases for U.S. federal income tax purposes and foreign income tax purposes. The basis step-up reduces the taxpayer's U.S. federal income tax base through increases in cost recovery deductions (such as depreciation or amortization deductions) or reductions in gains or increases in losses recognized on dispositions of the relevant foreign assets. Because there is no corresponding reduction in the taxpayer's foreign income tax base, the effective foreign income tax rate applied to the U.S. federal income tax base can be artificially high, potentially enabling the taxpayer to "cross-credit" the foreign income taxes against the tentative U.S. federal income taxes on unrelated foreign income.

This policy is not implicated in a transaction in which members of the U.S.-parented group recognize all of the gains and losses on the relevant foreign assets. In such a transaction, the group takes into account any gains on the relevant foreign assets up front and then, in the future, recognizes offsetting cost recovery items on the relevant foreign assets. Over time, the gains are offset by these cost recovery items, so the group's U.S. federal income tax base is unchanged -- in fact, because the gains are accelerated and the offsetting cost recovery items are deferred, the timing difference typically benefits the government.¹

Applying section 901(m) to such a transaction is unnecessary and inappropriately results in double taxation. This can be illustrated with a simplified example. Assume that a domestic corporation (USP) wholly owns two other domestic corporations (USS1 and USS2) and that USP, USS1, and USS2 do not file a consolidated U.S. federal income tax return. USS1 owns a disregarded entity organized in Country X (DEX), which owns a single asset (A) that was purchased by DEX at the beginning of Year 1 for $100, has a fair market value of $100, is depreciated over five years on a straight-line basis for both U.S. federal income tax purposes and Country X income tax purposes, and generates $40 of income annually.² Country X imposes income tax at a rate of 25%.

At the beginning of Year 4, USS1 sells DEX to USS2 for $100 of cash. USS1's adjusted basis in A for U.S. federal income tax purposes is $40, and DEX's basis in A for Country X income tax purposes also is $40. Assume that there are no other relevant transactions or tax items. The transaction is shown in Diagram 1.

 

Diagram 1

 

 

 

                                    Table 1

                                    Table 2

If the sale did not occur, the group's net income for U.S. federal income tax purposes would be $160 ($200 of income minus $40 of depreciation deductions), and DEX's Country X income taxes would be $40 (25% multiplied by $160 of net income for Country X income tax purposes). Thus, the U.S. federal income taxes of the group would be $16 ($56 of tentative U.S. federal income taxes minus $40 of creditable Country X income taxes). As shown in Table 2, if the sale did occur and section 901(m) did not apply, the group's net income for U.S. federal income tax purposes similarly would be $160 ($260 of income minus $100 of depreciation deductions), DEX's Country X income taxes similarly would be $40, and the group's U.S. federal income taxes similarly would be $16 ($56 of tentative U.S. federal income taxes minus $40 of creditable Country X income taxes). In each case, the group's combined tax rate is 35%. Thus, the foreign tax credits appropriately prevent double taxation, and the policy behind section 901(m) -- disallowing hyped foreign tax credits -- is not implicated.

Applying section 901(m) to the transaction precludes the group from crediting $15 of Country X income taxes, resulting in double taxation. The group incurs $40 of Country X income taxes and $25.75 of residual U.S. federal income taxes over time (equal to $145 of net income, determined by deducting the $15 of disqualified portions of the Country X income taxes, multiplied by 35%, minus the $25 of creditable Country X income taxes). The group's combined tax rate would be over 41% ($65.75 of combined taxes, divided by $160 of net income), reflecting unjustified double taxation. In contrast, a foreign-parented group subject to a territorial international tax system would not be penalized if it undertook a similar internal restructuring transaction. Section 901(m), accordingly, should not apply to these transactions.

Although such a transaction does not present the policy concern intended to be addressed by section 901(m), it could result in the separation of foreign income taxes and the related income. This could occur, for example, if the sale transaction described in the example was between related controlled foreign corporations, rather than between domestic corporations. Such policy concerns could be addressed under section 909 if section 901(m) did not apply.⁴ A taxpayer could be permitted to elect out of applying section 901(m), and section 909 could apply if the transaction resulted in a separation of foreign income taxes and related income. The government would be adequately protected under either section 901(m) or section 909, and businesses would not be unduly burdened.⁵

Finally, we note that Congress granted the Treasury Department and the Internal Revenue Service authority to provide the requested exemption. Section 901(m)(7) states that the Secretary may issue regulations necessary or appropriate to carry out the purposes of section 901(m), including to exempt certain covered asset acquisitions. Providing the requested exemption would appropriately tailor the scope of section 901(m), giving effect to its underlying policy.⁶

Aggregate Basis Difference Carryover Rules

We request that the aggregate basis difference carryover rules in section 1.901(m)-3(c) of the proposed regulations not be included in any final regulations that ultimately are issued. The proposed carryover rules would significantly increase the costs to businesses of complying with section 901(m), which is particularly unjustifiable given that they would be contrary to the straightforward approach enacted by Congress.

Congress provided two clear rules for allocating basis differences. Section 901(m)(3)(B)(i) sets forth the general rule, allocating the basis difference relating to a relevant foreign asset to taxable years "using the applicable cost recovery method" determined for U.S. federal income tax purposes. Under the general rule, the basis difference is amortized over the useful life of the relevant foreign asset. Section 901(m)(3)(B)(ii) provides an exception to the general rule: unless regulations provide otherwise, if the relevant foreign asset is disposed of during the applicable cost recovery period, any remaining basis difference that has not already been allocated under the general rule to prior taxable years is allocated to the taxable year in which the disposition occurs, and no portion of the basis difference is allocated to subsequent taxable years under the general rule. Thus, Congress granted the Secretary authority to provide exceptions to the specific rule for dispositions but not to the general rule that the basis difference is allocated using the applicable cost recovery method.

The proposed regulations would, if finalized, provide that in some circumstances all or a portion of the aggregate basis difference allocated to a taxable year is carried over and taken into account in a subsequent taxable year, such that credits for foreign taxes would be disallowed in the subsequent taxable year. The proposed carryover rules would apply, for example, in a taxable year in which the "disqualified tax amount" is zero or the section 901(m) payor's aggregate basis difference for the year exceeds its "allocable foreign income." Aggregate basis differences could be carried forward indefinitely.

The proposed carryover rules would significantly increase the costs of compliance to businesses, allocating a basis difference to taxable years after -- in some cases, many years after -- the end of the applicable cost recovery period or the taxable year of a disposition. Businesses could even be required to account for covered asset acquisitions in perpetuity. These added compliance costs are unjustified, particularly given that Congress enacted an administrable approach in the statute and did not express any intent that carryover rules could apply.

This letter does not address whether the proposed carryover rules would, if finalized, be a valid exercise of administrative authority by the Treasury Department and the Internal Revenue Service. We note, however, that the results under the proposed carryover rules cannot be reconciled with the unambiguous provision in section 901(m)(3)(B)(i), as the proposed carryover rules would allocate basis differences to taxable years other than pursuant to the applicable cost recovery methods. This could cause the disqualified portions of foreign income taxes to differ from those determined under the straightforward provisions in section 901(m)(3)(A).

We appreciate your consideration of these requests. This letter, however, should not be construed as supporting the finalization of the proposed regulations in their current form. If you have any questions or comments regarding this letter, we would be pleased to speak with you.

Sincerely,

² For purposes of simplicity, all amounts in the example are denominated in U.S. dollars and the U.S. federal corporate income tax rate is assumed to be 35%. The foreign tax credit limitation provisions of section 904 and the consolidated group rules are not discussed in the example, as these rules are not relevant to the issue and would complicate the discussion. Also, the cost recovery period and method and basis are assumed to be the same for U.S. federal income tax purposes and Country X income tax purposes for simplicity, but the point demonstrated by the example holds true regardless of the respective cost recovery periods and methods.

³ Equal to $60 of gain recognized by USS1 on the sale and $40 of income recognized by USS2.

⁴ In T.D. 9577 (Feb. 14, 2012), which set forth temporary regulations under section 909, the Treasury Department and the Internal Revenue Service explained that they considered several approaches to coordinating section 901(m) and section 909 and decided not to apply section 909 to covered asset acquisitions for administrative reasons.

⁵ As an alternative approach, the exemption from section 901(m) could be limited to transactions that do not implicate the policy behind section 909 either, such as a transaction in which all of the gains and losses with respect to the relevant foreign assets are taken into account in determining the taxable income of domestic corporations that are members of the U.S.-parented group in the taxable year in which the transaction occurs. Under this approach, it would not be necessary to issue additional guidance under section 909.

⁶ For a discussion of this policy, see Ways and Means Committee, "The American Jobs and Closing Tax Loopholes Act of 2010, H.R. 4213," 2010 TNT 98-33 (May 20, 2010).