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Deciphering the Nebulous NOL Waive-Off Election

Posted on June 18, 2018
[Editor's Note:

This article originally appeared in the June 18, 2018, issue of Tax Notes.

]
Ron Dabrowski
Ron Dabrowski
Douglas Holland
Douglas Holland

Douglas Holland is a managing director in the international tax group and Ron Dabrowski is a principal and deputy to the principal in charge of KPMG LLP’s Washington National Tax office.

In this report, Holland and Dabrowski consider interpretive and policy questions raised by new section 965(n), which allows taxpayers to forgo use of their losses against the mandatory repatriation income inclusion required by new section 965(a).

This report represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG.

I. Introduction

The election offered by section 965(n)(1) has been among the most heavily debated provisions in the Tax Cuts and Jobs Act (P.L. 115-97). The statutory language is confusing and thus has prompted requests for clarification from the U.S. Chamber of Commerce, the American Institute of CPAs, the New York State Bar Association Tax Section, and the American Petroleum Institute.1 The immediate focus of those requests is confirmation that the section 965(n)(1) election allows taxpayers to forgo or waive absorption of current-year losses, as well as carryover or carryback losses, against the mandatory repatriation income inclusion required by new section 965(a). Notice 2018-26, 2018-16 IRB 480 (the third notice on section 9652) confirmed that Treasury and the IRS agree with that reading of the statute and will issue regulations consistent with that result.3

Once it is determined that the election applies to current-year losses as well as carryover or carryback losses, the next matter to consider is the election’s effect on the taxpayer’s broader foreign tax credit limitation under section 904. Although section 965(n)(1) is not expressly described in these terms, the election appears to have been intended to allow taxpayers to use their FTC attributes, in lieu of their loss attributes, to the fullest extent possible to offset the U.S. tax liability arising from section 965(a).4 This report considers the intersection of section 965(n)(1) and the section 904 FTC limitation rules. It also addresses procedural matters concerning the election.

II. Overview

A. Section 965 Generally

As revised by the TCJA, section 965 requires a U.S. shareholder of a deferred foreign income corporation (DFIC) to include, as an increase to the U.S. shareholder’s subpart F income for the DFIC, the U.S. shareholder’s pro rata share of the DFIC’s post-1986 accumulated deferred foreign income.5 The deferred foreign income is generally based on the DFIC’s post-1986 earnings and profits, excluding amounts that were previously taxed under section 951 or as effectively connected income.6 The inclusion applies to the DFIC’s last U.S. tax year that begins before 2018 (the DFIC inclusion year).7 For example, for a calendar-year DFIC, section 965 would apply to its U.S. tax year ended December 31, 2017, while a calendar-year DFIC that had made a one-month deferral election under section 898 would use its U.S. tax year that began December 1, 2017, and ends November 30, 2018. In those cases, a calendar-year U.S. shareholder would include the section 965 amounts in its tax year with or within which the DFIC inclusion year ends (the U.S. shareholder inclusion year), meaning December 31, 2017, and December 31, 2018, respectively.

The increased subpart F amount is subject to an 8 percent or 15.5 percent targeted tax rate based on the extent to which the deferred income is deemed to have been invested in cash or cash equivalents (higher rate) versus other assets. The targeted rate is achieved through a scaled deemed deduction equal to an amount to produce the targeted tax rate for a domestic corporation for the tax year at issue, taking into account the reduction and blending of effective tax rates provided in the TCJA and through section 15.8

Corporate U.S. shareholders subject to section 965 are eligible to claim a deemed-paid FTC under section 960 for the DFIC’s foreign income taxes attributable to the section 965(a) inclusion, but the deemed-paid FTC is subject to a haircut corresponding to the deemed deduction percentages for a 35 percent rate inclusion.9

Thus, a U.S. shareholder owning DFIC stock on the last day of the DFIC’s inclusion year ordinarily includes the section 965(a) amount for the DFIC in the U.S. shareholder inclusion year, including the section 965(c) targeted rate percentage deduction. If the U.S. shareholder is a domestic corporation, it may be eligible to claim a deemed-paid FTC for the net inclusion.10 Unlike the former (2004) version of section 965, discussed later, there are no restrictions on the use of other tax attributes — such as current, carryover, or carryback net operating losses, unrelated FTCs, or other available tax credits — to offset (even in full) the tax liability resulting from the new section 965 amounts.

B. Section 965(n)

Against the backdrop of section 965 generally not restricting the use of tax attributes to offset the section 965 inclusion and resulting liability, section 965(n) gives taxpayers the opportunity to forgo use of their NOLs against the net section 965 inclusion (defined below). By forgoing use of the NOLs, the taxpayer preserves them for a future date and can use other tax attributes, including FTCs, against the tax liability resulting from section 965.

A careful review of the legislative text and associated provisions is useful to understand the impetus for the many requests for clarification of section 965(n).11

Section 965(n) contains three paragraphs. The first and most relevant contains the operative election; the second prescribes the amount of income to which the election relates (the net section 965 inclusion); and the third contains procedural rules for taxpayers making the election.12

The first paragraph (section 965(n)(1)) provides:

(1) In General — If a United States shareholder of a deferred foreign income corporation elects the application of this subsection for the taxable year described in subsection (a), then the amount described in paragraph (2) shall not be taken into account —

 

(A) in determining the amount of the net operating loss deduction under section 172 of such shareholder for such taxable year, or

(B) in determining the amount of taxable income for such taxable year which may be reduced by net operating loss carryovers or carrybacks to such taxable year under section 172.

 

As noted above, the tax year described in section 965(a) is the last tax year of a DFIC that begins before 2018. This point is considered further in Section V.A.

Section 965(n) was not included in the version of the tax reform bill (H.R. 1) the House passed November 16, 2017, or in the “conceptual mark” of proposed legislation that was released by Senate Finance Committee Chair Orrin G. Hatch, R-Utah, November 9, 2017.13 Instead, section 965(n) was first included in the chair’s modified mark, which was released November 15, 2017. The Finance Committee approved a bill with the section 965(n) provision from the modified mark November 16, and the text of that bill was released November 20. The conference agreement for H.R. 1 ultimately adopted section 965(n), as approved by the Finance Committee, and passed by the Senate without change. Thus, the language of section 965(n) in the new law is the same as the version that was in the modified mark and the Finance Committee bill.

The Joint Committee on Taxation described the provision in the modified mark as follows:

The Chairman’s modification allows taxpayers to elect to preserve net operating losses and opt out of utilizing such net operating losses against the mandatory inclusion required of a U.S. shareholder under the transition proposal. The modification also provides rules to coordinate the interaction of existing net operating losses, overall domestic losses, and foreign tax credit carry-forward rules with the income inclusions required under section 965.14

Both the Senate Budget Committee’s explanation of the bill approved by the Finance Committee and the conference report for the TCJA explain the section 965(n) provision as follows:

A U.S. shareholder may elect, no later than with a timely filed return for the taxable year, not to apply its net operating loss deduction to the deemed repatriation. If so, neither the section 951 inclusion nor any related deemed paid foreign tax credits may be taken into account in computing the net operating loss deduction for that year.15

The conference report does not elaborate on the section 965(n)(1) election, treating it as among the items from the Senate proposal for section 965 that were enacted without further modification.16

C. NOL Deduction

Given the use of NOL deduction and NOL carryover and carryback in section 965(n)(1), it is helpful to understand how section 172, the code provision authorizing the use of NOLs, defines those significant terms. Although the TCJA enacted changes to section 172 (see below), the NOLs that would be taken into account by a taxpayer for purposes of its section 965 inclusion generally would be pre-TCJA NOLs that are not subject to the new rules, and indeed, section 965(n) appears to have been drafted with “old” section 172 in mind.

Before enactment of the TCJA, the first sentence of section 172(a) allowed taxpayers a deduction for an amount equal to the aggregate of (1) the NOL carryovers to that year, plus (2) the NOL carrybacks to that year. Under section 172(a) as amended by the TCJA, for losses arising in tax years beginning after 2017, NOL carryovers may be absorbed only to the extent of 80 percent of the taxpayer’s taxable income, and NOL carrybacks are significantly curtailed or eliminated.17 However, the amount allowed as a deduction under section 172(a) remains defined as the NOL deduction, with that definition applicable for purposes of subtitle A of the code.

Separately, section 172(c) (pre- and post-TCJA) defines an NOL as the excess of the deductions allowed to the taxpayer over the taxpayer’s gross income, with some modifications set forth in section 172(d). In relevant part, the current-year NOL determination does not take into account the NOL deduction for the year (resulting from the carryover or carryback of NOLs arising in other years).18 For example, if a taxpayer has positive income of $15,000 for a tax year and an NOL deduction of $75,000 for the tax year, the taxpayer does not have an NOL for that year. Instead, the taxpayer’s positive taxable income is reduced to zero (assuming the new 80 percent limit does not apply), and there is a $60,000 NOL carryforward to the next tax year, which then can yield a $60,000 NOL deduction in that succeeding year.19

As a final point, in trying to reconcile the modifications made in the TCJA to section 172 with the language in section 965(n)(1), note that the rule in section 965(n)(1)(B) preventing an NOL carryback to the U.S. shareholder inclusion year will be a nullity in essentially all cases. This is because a U.S. shareholder inclusion year can end no earlier than December 31, 2017, but TCJA section 13302 generally eliminated carrybacks of NOLs arising in years ending after December 31, 2017. Thus, any NOL arising in a year ending after the earliest date in which a U.S. shareholder inclusion year could end is no longer eligible to be carried back to a U.S. shareholder inclusion year.20 This point supports the argument made later that section 965(n)(1) is modeled on former section 965(e)(2) because Congress included in section 965(n)(1) the carryback language used in former section 965(e)(2) — language that was relevant in 2004 but is no longer relevant in light of the new restrictions on NOL carrybacks.

III. Application to Current-Year Losses

A core question presented by section 965(n) is whether the provision applies to current-year losses, as opposed to only carryover or carryback losses. It appears that the provision was intended to apply to all those losses, but the provision’s drafting was not ideal in reaching that result.

Section 965(n)(1) contains two distinct subparagraphs: (A) and (B). Subparagraph (A) provides that the net section 965 inclusion is not taken into account in determining the taxpayer’s NOL deduction under section 172 for the tax year. Subparagraph (B) provides that the net section 965 inclusion is not taken into account in determining how much of the U.S. shareholder’s income can be reduced by NOL carryovers or carrybacks to the tax year.

A literal reading of the section 172(a) definition of the NOL deduction is that it equals the amount of NOL carryovers and carrybacks to a tax year, regardless of the amount of gross income (or taxable income without regard to section 172(a)) in that year.21 So read, section 965(n)(1)(A) would be inapposite and would have no apparent legal effect. That is, the amount of income or loss otherwise arising in the U.S. shareholder inclusion year would not be an input into the U.S. shareholder’s NOL deduction for that year. Rather, the section 172(a) NOL deduction for the U.S. shareholder inclusion year would consist solely of NOL carrybacks and carryforwards from other tax years that are carried into the U.S. shareholder inclusion year. Thus, the net section 965 inclusion would never be taken into account in computing the NOL deduction for the U.S. shareholder inclusion year. Under that interpretation, section 965(n)(1)(A) was a nullity upon enactment.

An alternative would be to consider section 965(n)(1)(A) as providing that the U.S. shareholder’s net section 965 inclusion would not be absorbed by NOL carryovers or carrybacks from other years — namely, that the net section 965 inclusion would not be taken into account in determining the amount of section 172 NOL deduction used by the U.S. shareholder in the U.S. shareholder inclusion year. For example, if a U.S. shareholder had a net section 965 inclusion of $50 and $60 of other taxable income in the U.S. shareholder inclusion year, and a $100 NOL carryforward into that year, the $100 NOL carryforward would offset only the $60 of other income and not the $50 of net section 965 inclusion. In isolation, this interpretation is plausible and would suggest that what Congress meant to limit was the amount of deduction used under section 172 ($60 instead of $100).

However, that interpretation becomes implausible when section 965(n)(1) is read in full, because that is precisely what section 965(n)(1)(B) provides: that the net section 965 inclusion is not taken into account in determining the actual reduction in taxable income resulting from the “net operating loss carryovers or carrybacks to such taxable year under section 172.” Thus, interpreting section 965(n)(1)(A) in the manner suggested in the prior paragraph would render subparagraph (A) wholly superfluous instead of irrelevant — compounding the confusion about what the statutory language means.

In drafting section 965(n)(1)(B), Congress may not have appreciated that the sum of the taxpayer’s NOL carryovers and carrybacks to a tax year is the taxpayer’s NOL deduction for that tax year.22 This definition is clearly set forth in section 172(a). If the drafters had applied that definition, they presumably would have written section 965(n)(1)(B) to apply “in determining the amount of taxable income for such taxable year which may be reduced by the net operating loss deduction under section 172 for such taxable year.” That Congress did not draft section 965(n)(1)(B) in the foregoing manner suggests that when the words “net operating loss deduction under section 172” were used in section 965(n)(1)(A), the drafters must have meant something other than the sum of the electing U.S. shareholder’s NOL carryovers and carrybacks to the U.S. shareholder inclusion year.

A. Comparison With Former Section 965(e)(2)

The first version of section 965, as enacted in the American Jobs Creation Act of 2004,23 gave taxpayers the opportunity to claim an 85 percent dividends received deduction (DRD) under former section 965(a) for the qualifying dividends received by the shareholder during the election year. Former section 965 also imposed several limitations on taxpayers’ ability to use other tax attributes to offset the tax cost associated with the post-DRD portion of the qualifying dividends (the nondeductible dividends).24

Former section 965(e)(2) imposed the following special limitations on the taxpayer’s ability to use losses to offset the nondeductible dividends:

(2) Limitation on reduction in taxable income, etc.

 

(A) In general

The taxable income of any United States shareholder for any taxable year shall in no event be less than the amount of nondeductible CFC dividends received during such year.

(B) Coordination with section 172. The nondeductible CFC dividends for any taxable year shall not be taken into account —

 

 

(i) in determining under section 172 the amount of any net operating loss for such taxable year, and

(ii) in determining taxable income for such taxable year for purposes of the 2nd sentence of section 172(b)(2).

 

Thus, there were three specific operative rules within former section 965(e)(2):

  1. a general “minimum taxable income” rule in section 965(e)(2)(A) providing that the taxpayer’s taxable income (meaning gross income minus deductions allowed) could not be less than the nondeductible dividends;

  2. a “carried from” rule in section 965(e)(2)(B)(i) providing that the nondeductible dividends were not taken into account under section 172(c) in computing the NOL for that year and thus would not reduce the NOL deduction allowed in other tax years through the carryover or carryback of the NOL otherwise arising in the year; and

  3. a “carried to” rule in section 965(e)(2)(B)(ii) providing that the nondeductible dividends would not be considered part of the taxable income base that reduces the NOL carryovers and carryforwards that were carried to the former section 965(a) election year and, from there, to later tax years.

Together, these three rules provided that the nondeductible dividends would in all cases be taxed once by preventing any losses or deductions (including the NOL deduction available through carryover or carryback NOLs) from offsetting the nondeductible dividends. And then they also prevented possible double taxation of the nondeductible dividends by ensuring that the nondeductible dividends did not reduce an NOL arising in, carried back to, or carried forward to the tax year including the nondeductible dividends. The rules thereby implemented the policy underlying section 965(e)(2), which was to ensure that the taxpayer’s expenses, losses, and deductions could not offset the nondeductible portion of the qualifying dividends, but that those expenses, losses, and deductions could offset other income of the taxpayer.25

So understood, the “carried from” rule in former section 965(e)(2)(B)(i) and the “carried to” rule in former section 965(e)(2)(B)(ii) were both taxpayer-favorable rules. They were drafted to prevent a double-disallowance result that would otherwise occur because of the nondeductible dividends having to be taken into account as “taxable income” and the collateral effects of importing that “taxable income” measurement into section 172(c) (carried from) and former section 172(b)(2) (carried to).

However, that double-disallowance result arose only because of the existence of the minimum taxable income rule in former section 965(e)(2)(A). Absent the minimum taxable income rule, neither former section 965(e)(2)(B)(i) nor (ii) was necessary for the U.S. tax system to properly operate.

A simple example demonstrates the point. Assume a U.S. shareholder received $100 of former section 965(a) qualifying dividends and otherwise earned $900 of gross income and was allowed $915 of expenses for that year. The U.S. shareholder had $1,000 of gross income and $1,000 of deductions (including the $85 section 965(a) DRD). Absent section 965(e)(2), the U.S. shareholder’s taxable income ordinarily would have been zero. Under section 965(e)(2)(A), however, its taxable income could not be less than $15. The U.S. shareholder thus had $15 of income in the former section 965(a) election year, ensuring the single instance of taxation on the nondeductible dividends, which was then balanced out by a $15 NOL for that year that could be carried forward or back to other years and could offset other taxable income of the U.S. shareholder in those other years.26

Consider, however, that if former section 965(e)(2)(B)(i)’s “carried from” rule were in effect without section 965(e)(2)(A)’s minimum taxable income rule, it would yield a presumably unintended benefit. The U.S. shareholder in the example would have zero net taxable income for the year of the section 965 election ($1,000 taxable income - $1,000 deductions) and would owe no regular tax liability. But because of section 965(e)(2)(B)(i), the U.S. shareholder would then also have a $15 NOL that could be carried to other years. Note that the nondeductible dividend amount (the $15) was defined in former section 965(e)(3) as the qualifying dividends over the 85 percent DRD allowed by former section 965(a). That definition did not depend on or cross-reference the minimum taxable income rule.

Congress surely did not intend that the U.S. shareholder electing the benefit of former section 965(a)’s 85 percent DRD be allowed to fully offset its taxable income in the section 965(a) election year and then also have a $15 NOL arising from that year. The net effect of that result — $1,000 of deductions allowed plus the $15 NOL — would have been to provide a 100 percent DRD, rather than the 85 percent DRD, for the qualifying dividends. This illustrates that former section 965(e)(2)(B)’s “carried from” and “carried to” rules were not and could not have been intended to operate without the minimum taxable income rule. This point is further proven by the separate headings for section 965(e)(2)(A) (“In General”) and section 965(e)(2)(B) (“Coordination With Section 172”). Absent the general rule, there would be nothing to, and no need to, coordinate with section 172.

B. Treasury and IRS Analysis

In Notice 2018-26, Treasury and the IRS acknowledge the concerns presented by section 965(n)’s drafting and favorably address them. The notice states that interpreting section 965(n)(1)(A) to apply to the NOL “deduction” in its ordinary sense, as opposed to the NOL arising in the year, would render section 965(n)(1)(A) “duplicative of section 965(n)(1)(B), which already provides that amounts described in section 965(n)(2) are disregarded for purposes of applying net operating loss carryovers or carrybacks to such taxable year under section 172.”27 The notice then announces that Treasury and the IRS “have determined that section 965(n)(1)(A) was intended to apply to a different set of losses than those to which section 965(n)(1)(B) applies.” The notice does not further elaborate on the basis for that determination — for example, on the extent to which it was based on principles of statutory construction that augur against finding a redundancy in the statute28 versus knowledge of congressional intent exceeding what can be gleaned from the limited legislative history statements noted earlier.

Nevertheless, the helpful consequence of this interpretation is that Treasury and the IRS have stated that future regulations will provide that if a section 965(n)(1) election is made for a U.S. shareholder inclusion year, the NOL arising in that year is determined without taking into account the net section 965 inclusion. Notice 2018-26 also confirms that the election applies for purposes of both section 965(n)(1)(A) and (B). Therefore, a taxpayer cannot, for example, take into account its current-year loss while still forgoing the use of NOL carryforwards into the U.S. shareholder inclusion year. Those conclusions resolve several of the key ambiguities presented by the election. Importantly, the notice allows taxpayers to rely on these rules before the issuance of the regulations.29

The IRS’s earlier release of procedural guidance on section 965 through a series of frequently asked questions foreshadowed this interpretation. In the FAQs, the IRS provides a sample election form for taxpayers to use in making the section 965(n)(1) election. The sample form includes language indicating that the taxpayer intends to not take the net section 965 inclusion into account in determining:

the amount of the net operating loss deduction under section 172 for the [insert tax year, for example, 2017] taxable year or in determining the amount of the taxable income for the [insert tax year, for example, 2017] taxable year which may be reduced by net operating loss carryovers or carrybacks to the [insert tax year, for example, 2017] taxable year under section 172.

By distinguishing “the net operating loss deduction under section 172” for the year as an item separate from the NOL carryovers and carrybacks to the year, the sample form supports the interpretation that paragraphs (A) and (B) of section 965(n)(1) are referring to separate items and are not a duplicative reference to the same thing.

C. Discussion

Treasury and the IRS’s determination in Notice 2018-26 gives effect to each of the distinct subparagraphs in section 965(n)(1) and allows the election to exclude the net section 965 inclusion for two distinct purposes: (A) in determining the amount of NOL in the current year that is carried back or carried forward to other years and gives rise to an NOL deduction in those other years; and (B) in determining the amount of income that can be reduced by NOL carrybacks or carryovers to the U.S. shareholder inclusion year. As a result, taxpayers making the election would report a minimum taxable income result equal to the net section 965 inclusion and would preserve their NOL attributes for use to carry over or carry back to other years.

For example, consider a calendar-year U.S. shareholder that but for section 965 would have had an $80x NOL arising in its tax year ending December 31, 2017. Assume the U.S. shareholder has no NOL carryover or carrybacks from other years and has a net section 965 inclusion of $100x for 2017. If the U.S. shareholder makes the section 965(n)(1) election, it would be taxed on the $100x of net section 965 inclusion, and then it would carry the $80x NOL otherwise arising in 2017 back to the prior two years and then forward under the former section 172 rules.30

That result is consistent with the JCT’s initial description of section 965(n), which stated that the election was intended to allow taxpayers to both preserve the use of the NOL and opt out of using it against the net section 965 inclusion.31 A close comparison of section 965(n)(1) with former section 965(e)(2) further supports the argument that Congress intended the election to provide those results. As noted earlier, the language used in section 965(n)(1) is similar to, and presumably was based on, the language in former section 965(e)(2), and appears intended to allow taxpayers to opt into both the minimum taxable income result as well as the “carried from” and “carried to” rules, which prevent a hypertechnical disallowance of the NOL in other years.

IV. Interaction With Section 904 Limitation

A. Overview

Now that Treasury and the IRS have issued the notice, the next issue to consider is how applying the section 965(n)(1) election to current-year losses as well as to carryover and carryback losses affects the taxpayer’s FTC limitation under section 904.

Ordinarily, taxpayers must determine their U.S.-source versus foreign-source income for section 904 purposes by first determining the gross income in each category32 and then allocating and apportioning deductions to each of the categories based on the rules in section 861 et seq. and the regulations thereunder. That process results in taxpayers first netting within each category, which then determines if the taxpayer has limitation allowing an FTC or otherwise has a separate limitation loss, overall foreign loss (OFL), or overall domestic loss. When NOL carryforwards or carrybacks are absorbed in whole or in part during the tax year, under the rules of reg. section 1.904(g)-3, the taxpayer essentially re-deducts the U.S.-versus-foreign basket portion of the NOL deductions.33 Thus, to the extent an NOL is composed of U.S.-source losses, those amounts first offset U.S.-source income in the NOL deduction year.34

The issue presented by the section 965(n)(1) election is whether, in implementing the requirement that the net section 965 inclusion not be taken into account in determining the current-year loss or in the amount of taxable income reduced by NOL carryovers or carrybacks into the year, (1) is the net section 965 inclusion itself the specific income that is left standing and undisturbed by the other losses (the section 904 wall-off approach); or (2) does the election only limit in a general sense the amount of income that cannot be reduced by current, carryover, or carryback losses, regardless of the source and character of that income (the section 172 wall-off approach)?

For section 904 purposes, this question is highly relevant because the taxpayer’s section 904 limitation for the U.S. shareholder inclusion year will depend on how much of the net section 965 inclusion is taken into account in the numerator of the section 904 calculations. Unfortunately, the section 965 statutory language and legislative history do not specifically address this issue and offer only scant guidance on it.

In last year’s tax reform process, the House version of section 965 contained a provision that would have treated the net section 965 inclusion as not being subject to section 904(f)(1) OFL recapture.35 Section 904 was not otherwise specifically addressed and was intended to apply as it otherwise would, as demonstrated by the House provision offering a special 20-year carryforward window for FTCs deemed paid for the net section 965 inclusion.36 The House’s OFL protection rule, however, was not in the Senate bill or in the conference agreement that became law. In describing the interaction of sections 904 and 965, the conference agreement states that “the separate foreign tax credit limitation rules of present law section 904 apply, with coordinating rules.”37 However, apart from the section 965(n)(1) election and new section 904(g)(5)’s election to allow for greater than 50 percent recapture of pre-2018 overall domestic losses in post-2017 years, it is unclear what these “coordinating rules” are or what they refer to. It therefore seems likely that Congress intended that the results of the election be coordinated in some manner with the section 904 rules through Treasury regulations.

B. The Section 904 Wall-Off Approach

The section 904 wall-off approach appears to be the better interpretation of the intersection of sections 965(n) and 904 and to better implement the policy objectives of the section 965(n)(1) election.

The statutory language of the election (as interpreted by Notice 2018-26) prescribes that the net section 965 inclusion be ignored in computing the taxpayer’s current-year NOL or the amount subject to offset by the section 172 NOL deduction. Ignoring the net section 965 inclusion for those purposes strongly suggests that no other deductions or losses should be considered to offset the net section 965 inclusion as a general matter, including for purposes of section 904.

The section 904 wall-off approach also fulfills Congress’s apparent intent for the election by allowing taxpayers to waive use of the current and carryover losses to the fullest extent possible and to instead use current or carryover FTCs to offset their tax liability resulting from the net section 965 inclusion.38 The need for this approach is particularly acute because taxpayers’ FTCs up through and including the 965 inclusion year would primarily be in the general basket, while for later years, the new global intangible low-taxed income provision in section 951A and the new DRD in section 245A may severely restrict access to U.S. taxpayers’ heretofore primary source of general basket income — CFC earnings that were actually distributed as dividends or deemed distributed under subpart F. The section 965(n)(1) election thus offers a last best chance for electing taxpayers to use the foreign-source income from their net section 965 inclusion in their section 904 computations before transitioning to the new system.

In addition to this favorable policy gloss, the section 904 wall-off approach is also supported by the IRS’s historical treatment of current-year losses under former section 965, as set forth in Notice 2005-64.39

1. Notice 2005-64.

In generally describing the interaction of former sections 965 and 904, section 8.01 of Notice 2005-64 offers the following:

Section 965 does not modify the operation of the overall foreign loss and separate limitation loss allocation and recapture rules or the U.S. loss allocation rules of section 904(f). Accordingly, except in situations where the taxable income limitation of section 965(e)(2)(A)40 applies, as provided in paragraph .02 of this section, section 904(f) may operate to reduce amounts of foreign source income, which may include nondeductible CFC dividends in a separate category, or recharacterize such amount as U.S. source income or foreign source income in a different separate category for purposes of applying the limitations on the allowable foreign tax credit under sections 904(d) and 965(e)(1).

Thus, section 8.01 of Notice 2005-64 confirmed that ordinarily, the section 904 limitation rules would apply in their regular manner to the taxpayer’s year that included the nondeductible dividends. However, section 8.02 of the notice promulgated a section 904 wall-off approach for the question of which income would be left standing when the minimum taxable income rule applied and the taxpayer otherwise would have had a loss for the tax year that included the nondeductible dividends:

Because separate limitation losses and U.S. losses in the aggregate may not reduce the sum of separate limitation income and U.S. source income below the amount of nondeductible CFC dividends in the election year, the excess of such losses over the amount of such income exclusive of the amount of nondeductible CFC dividends will constitute a net operating loss for the election year. For purposes of determining which losses are absorbed in the election year and which losses make up the net operating loss in the election year if the taxable income limitation of section 965(e)(2) applies, separate limitation losses and U.S. losses are allocated under section 904(f)(5)(B) and (D) without regard to nondeductible CFC dividends. See Examples 3 and 4 in section 8.05 of this notice.

Example 3 under section 8.05 of the notice addressed a fact pattern in which the taxpayer (USP41) had $750 of foreign-source general limitation income, which included $500 of nondeductible CFC dividends and a U.S.-source loss of $750. The example illustrated that applying the loss allocation rules “without regard to the nondeductible CFC dividend” meant that the amount of nondeductible dividends is ignored in the section 904 allocations, with the effect that no losses or expenses were allocated against that income, and thus the section 904 categorization of the nondeductible dividends did not change. Example 3 therefore concluded that the taxpayer had $500 of foreign-source general limitation income, equal to the amount of the nondeductible dividends; and $250 of foreign-source general limitation income that was offset by $250 of the U.S.-source loss allocated to it (establishing an overall domestic loss account); and that the remaining $500 of U.S.-source loss then became an NOL that could be carried back or forward into other years.

Example 4 illustrated a similar result in a scenario in which the taxpayer otherwise would not even have had net positive income in the category including the nondeductible dividends. USP had $100 of general limitation income attributable to nondeductible dividends, $100 of general limitation loss, $100 of passive income, and $100 of U.S.-source loss. Because USP’s overall income was zero but its taxable income must be at least the $100 of nondeductible dividends, the minimum taxable income rule applied, and the “without regard to” rule from section 8.02 of the notice thus applied. Example 4 therefore concluded that the $100 general limitation loss reduced the passive income instead of the nondeductible dividend amounts in the (same) general limitation basket and that the $100 U.S.-source loss became an NOL that could be carried back or forward into other years. The results of this example were highly relevant for taxpayers that had no significant general limitation income without section 965 in the inclusion year but were still required to allocate and apportion material expenses (for example, interest expense) to the general limitation category under the sourcing rules of section 861 et. seq.

By linking the applicability of the section 904 wall-off approach to the taxpayer being in a position in which the loss limitation rule applied, but otherwise providing that the section 904 rules applied according to their regular terms, Notice 2005-64 created a significant cliff effect for taxpayers that would have been in loss positions, versus those that would not have been, absent the nondeductible dividends. Taxpayers that would not have been in loss positions were required to still take into account allocated and apportioned expenses against foreign-source income in the categories that included the nondeductible dividends. That allocation process could result in the income that was reported on the return, of which the nondeductible dividends were a component, being considered U.S.-source or a different foreign category, such that the FTCs attributable to the nondeductible dividends would be limited under section 904. Examples 1 and 2 of section 8.05 illustrated that cliff effect and made clear that the disparate result of taxpayers that would have been in loss positions and those that would not was a foreseen consequence.

In Example 1, USP has $100 of general limitation income, all attributable to nondeductible dividends; $100 of passive limitation loss; and $200 of U.S.-source income. Because USP’s overall taxable income of $200 exceeds the amount of nondeductible dividends ($100), the loss limitation rule did not apply and the section 904 wall-off approach was inapplicable. Thus, USP’s passive limitation loss of $100 was allocated against the $100 of general limitation income under section 904(f) and Notice 89-3 (now reg. section 1.904(g)-3, step 3); USP’s $200 of income reported for the year was entirely U.S.-source; and USP had a $100 passive basket separate limitation loss account in the general basket that could be recharacterized in future years. Although not explicitly stated, on the example’s facts, any FTCs deemed paid for the nondeductible dividends would not have been allowed in the year at issue because all of USP’s net taxable income for the year was from U.S. sources.

Example 2 is similar to Example 1, except that USP had only $40 of U.S.-source income. Thus, the section 965(e)(2)(A) loss limitation rule applied (because USP’s taxable income would be negative $60 without the nondeductible dividends), and under section 8.02 of Notice 2005-64, USP had to allocate its passive limitation loss without regard to the nondeductible dividend amount. Thus, $40 of USP’s passive limitation loss was allocated to reduce the $40 of U.S.-source income, creating a $40 OFL account in the passive basket; the remaining $60 of passive loss constituted an NOL for the year; and USP reported $100 of taxable income that was entirely attributable to the nondeductible dividends.

2. Discussion — Current-year loss.

A taxpayer with a current-year loss that makes the section 965(n)(1) election should be entitled to wall off the net section 965 inclusion and leave that inclusion, according to the component separate category amounts of which it is composed, as a minimum taxable income amount for the 965 inclusion year. That minimum taxable income amount, by category, should then form the denominator of the taxpayer’s section 904 limitation fraction for each category for the year. Absent an OFL account that must be recaptured, the net section 965 inclusion within each category also would form the numerator of the section 904 limitation fraction, such that potentially all the regular U.S. tax liability arising in the 965 inclusion year could be offset with FTCs. The following example illustrates this process.

a. Example.

Assume USP owns CFC1, which is USP’s only specified foreign corporation under section 965(e). After determining CFC1’s accumulated post-1986 E&P under section 965(d)(2) and aggregate cash position under section 965(c), USP includes a $100x net section 965 inclusion (that is, the gross section 965(a) inclusion minus the section 965(c) deemed deduction, and adding the section 78 gross-up inclusion as determined under the partial disallowance rule in section 965(g)(4)). All of the net section 965 inclusion is general basket income, and USP also is deemed to pay $25x of general basket FTCs after computing the section 965(g) disallowance percentages.

USP also has $20x of other foreign-source general limitation income, $5x of foreign-source passive income, and a $75x U.S.-source loss. USP has $5x of other general basket FTCs. Further, USP has an OFL account of $30x in the general basket.

b. Result — No section 965(n)(1) election.

USP has $120x of foreign-source general basket income, $5x of foreign-source passive income, and a $75x U.S.-source loss. Under the reg. section 1.904(g)-3 ordering rules, the first relevant step is step 4, the proportionate allocation of USP’s U.S.-source loss. Thus, 24/25ths [$120x/($120x + 5x)], or $72x, of the U.S.-source loss is allocated to the general basket and the remaining $3x of the U.S.-source loss is allocated to the passive basket, reducing those income categories and creating overall domestic loss accounts to that extent. USP has $48x of general basket income and $2x of passive basket income remaining.

The next step, step 5, is the recapture of USP’s OFL account in the general basket. This requires recapturing the OFL account to the extent of 50 percent of the income in the corresponding basket, unless a higher percentage is elected. Assuming USP does not make that election, the lesser-of calculation is $24x (50 percent of $48x) versus $30x of the OFL account, resulting in $24x of OFL recapture from general basket income to U.S.-source income. After this step, USP has $24x of general basket income, $24x of U.S.-source income, and $2x of passive income.

USP has no FTCs associated with the passive basket and has $30x of credits associated with the general basket. Its section 904 limitation in the general basket, using a flat 35 percent rate, is $8.4x ($24x * 0.35). USP can use $8.4x of its general basket FTCs, and it carries the remaining $21.6x back or forward under section 904(c). USP must pay $9.1x of regular tax liability on its other $26x of combined U.S.-source and passive basket income, subject to reduction by any other (non-FTC) available tax credit.

c. Result — USP makes section 965(n)(1) election.

By making the section 965(n)(1) election, USP walls off the net section 965 inclusion from reduction by its U.S.-source loss. USP therefore reports $100x of general basket income for the 965 inclusion year, for which USP has a pre-credit U.S. tax liability of $35x.

Under step 4 of reg. section 1.904(g)-3, applied by ignoring the $100x net section 965 inclusion, USP’s U.S.-source loss would be fully allocated against the non-section-965 $20x of general basket income and $5x of passive basket income. This would fully reduce those income categories and create overall domestic loss accounts to an equal extent. The remaining $50x of U.S.-source loss becomes a section 172 NOL that may be carried back or forward to other tax years.

Under step 5, USP must recapture its $30x general basket OFL account to the extent of 50 percent of its general basket income of $100x (that is, $50x) of the net section 965 inclusion. The $30x OFL account is fully recaptured. USP has $30x of U.S.-source income and $70x of general basket income.

After step 5, USP’s section 904 limitation for its general basket FTCs is $24.5x ($70x * 0.35). After using $24.5x of the general basket FTCs, USP has $5.5x of excess FTCs that may be carried back or forward under section 904(c). USP also must pay $10.5x of regular tax liability on its other $30x of income, all U.S.-source, subject to reduction by any other (non-FTC) available tax credit.

d. Conclusion.

The tax liability and attribute results as between USP making and not making the section 965(n)(1) election are:

 

No Section 965(n)(1) Election

With Section 965(n)(1) Election

Tax liability

$9.1x

$10.5x

General basket excess FTC

$21.6x

$5.5x

NOL

$0

$50x

The preferable option for USP depends on several factors, including the rate against which the NOL attribute would be absorbed (for example, at a 35 percent rate, if possible, to carry back to 2016 versus at a 21 percent rate if carried forward after 2017) and how likely it is that USP would be able to absorb the general basket FTC attribute as a carryback to 2016 or forward in post-2017 years. In considering the latter, the coming GILTI regime42 will make it more difficult (significantly so, most likely) for USP to earn general basket income from its investment in CFC1.

3. Discussion — NOL carryovers or carrybacks.

The minimum taxable income rule in former section 965(e)(2)(A) rendered it impossible for the nondeductible dividends to be offset by any other deduction, whether arising in the current year or as an NOL carryover or carryback into the former section 965 year. Thus, one might expect that the rule from sections 8.01 and 8.02 of Notice 2005-64 — that section 904(f) would apply normally unless the minimum taxable income rule applied, in which case the nondeductible dividends would be ignored in performing the section 904 allocation — would apply when the taxpayer had an available NOL deduction for the year exceeding its other net income.

Yet, in Notice 2005-64 Treasury instead treated taxpayers facing the minimum taxable income rule because of NOL carryovers and carrybacks differently than taxpayers with current-year losses — and less favorably from a section 904 perspective. Under section 7.01 of Notice 2005-64, the minimum taxable income rule was relevant only in determining the amount of the NOL deduction for the year that could reduce the taxpayer’s net income other than its nondeductible dividends. Once that quantum of the partial NOL deduction was established, however, the section 904 and NOL ordering rules in paragraph (1) of Notice 89-3 (now step 1 in reg. section 1.904(g)-343) applied according to their regular terms. There was no “without regard to” rule that ignored the nondeductible dividends in each separate category from being offset by losses allocated to that category after deeming the relevant amount and category of NOL deduction to have been effectively re-deducted in the current year.

The effect of this treatment was that for section 904 purposes, the category of income that included the nondeductible dividends could be reduced to zero — that is, no wall-off result — if the sum of the current-year and NOL-sourced portion of the deductions allocable to that category, or through the allocation of a separate limitation loss or U.S.-source loss to that category, produced that result.

The result was illustrated in Example 5 under section 7.02 of Notice 2005-64, which addressed a USP that had $2,000 of current-year income consisting of $1,000 of U.S-source income, $500 of general category income (including $15 of nondeductible dividends), and $500 of passive category income. USP also had a $2,000 NOL carryover into the year, consisting of a $1,000 U.S. loss, a $600 general category loss, and a $400 passive category loss. In applying the step 1 rules, USP first allocated the $1,000 U.S. loss against the U.S. income, then allocated $500 of the general category loss against the $500 of general category income and the $400 of the passive category loss against $400 of the $500 of passive category income. That left $100 of passive category income and $85 of NOL still to be absorbed, after excluding the $15 of nondeductible dividends. The result of the allocation process was that the $15 of income included by USP was passive category income even though the $15 of nondeductible dividends arose as general category income and USP had a $15 general basket NOL attribute and an $85 separate limitation loss account attribute that could re-source passive income into general category income in later years.

That result seems neither necessary nor appropriate in the context of the section 965(n)(1) election. Congress appears to have enacted the election specifically to help qualifying taxpayers best use their section 904 limitation arising from the net section 965 inclusion. That posture is distinguishable from former section 965(e)(2)’s minimum taxable income rule, which sought to ensure that taxpayers paid a specified threshold amount of tax on the nondeductible dividends as the cost for the privilege of electing former section 965’s 85 percent DRD. Further, USP in Example 5 would have 10 years to carry forward any residual taxes attributable to the nondeductible dividends and 10 years to earn additional general category income for its investment in its CFCs, including through recapture of the separate limitation loss account.

Taxpayers considering the section 965(n)(1) election will have less ability to use the carryover attributes once they have transitioned into the post-TCJA regime. Most relevant, future deemed or actual distributions from CFCs will most likely be categorized as GILTI basket income and not general basket income.

As applied to the example in Section IV.B.2.a above, if USP had a $75x NOL carryforward into its U.S. shareholder inclusion year instead of a $75x current-year loss, the section 965(n)(1) election should result in USP taking into account only $25x of NOL deduction in the year and maintaining the residual $50x NOL as a carryforward into the next year. In determining the allocation of the $25x of NOL, the approach that better implements section 965(n) is that the NOL deduction should be allocated only against the $25x of non-net section 965 inclusion. Thus, for example, even if USP’s $25 of non-section-965 income were U.S.-source and the $75x NOL were entirely attributable to the general basket, USP should allocate the absorbed $25x general basket NOL deduction against the U.S.-source income and create a general basket OFL account of $25x, with the $100x net section 965 inclusion ignored and unaltered through that process.

C. Other Approaches and Counterarguments

The section 904 wall-off approach seems to best implement Congress’s intent in enacting the section 965(n)(1) election. The apparent — and indeed, only conceivable — benefit for taxpayers that would arise from waiving the use of current and carryover losses against the net section 965 inclusion would be to use FTCs and other available tax credits to instead offset the associated tax liability. The benefit scheme is incomplete and self-defeating if it does not result in the taxpayer being able to use those tax credits to the fullest extent possible.

It could be argued, however, that the legislative language and other authorities in the section 904 context do not support this approach, and that the more natural result would be to simply consider the net section 965 inclusion as a minimum amount of taxable income in the abstract to which taxpayers must apply the regular rules for allocating expenses under section 861 and losses under section 904 (the section 172 wall-off approach). That was the Treasury’s approach to NOL carryovers and carrybacks under former section 965, and it was also the approach taken by the IRS in a heavily redacted field service advice memorandum regarding a similar minimum taxable income rule in section 860E, which addresses the taxation of real estate mortgage investment conduit residual interests.44

The facts of the field service advice appear to be that the taxpayer had both U.S.-source income, including a U.S.-source REMIC residual interest inclusion, as well as foreign-source income and FTCs, for the tax year at issue. The taxpayer later had an entirely U.S.-sourced NOL carryback to that year that exceeded the combined taxable income, thereby triggering the minimum taxable income rule in 860E(a).

The IRS field agent identified the issue and argued for a section 904 wall-off approach, which would have been unfavorable to the taxpayer in that case. That is because if the (U.S.-source) REMIC inclusion was the amount that could not be deducted under section 860E but the rest of the taxpayer’s income (including the foreign-source income) was offset by the NOL carryback, the numerator in the taxpayer’s section 904 limitation fraction would afterward have been zero, and no FTCs would have been allowed.

The taxpayer, however, argued that while the NOL carryback amount should be determined by including the foreign-source income, the deduction only should be allocated for purposes of sections 861 and 904 according to its component deductions under reg. section 1.861-8(e)(8),45 such that the NOL first would offset all the U.S.-source income for the year and could only then offset foreign-source income to the extent that the foreign-source income exceeded the excess inclusion — that is, a section 172 wall-off approach. The net effect would be that the taxpayer’s minimum taxable income amount for the year, the gross amount of which was determined by reference to the U.S.-source REMIC inclusion, was treated as entirely foreign-source income, and FTCs would be available to offset the U.S. tax liability on what was initially a U.S.-source amount. The taxpayer appeared to rely primarily on the Davies decision for this position.46

The Tax Court in Davies held that in determining the section 861 allocation of capital losses, a foreign-source capital loss would be allocated against foreign-source income for section 904 purposes even though the capital loss, from a capital gain and loss limitation perspective, was “in fact” deducted against only U.S.-source capital gains in that same year. The decision was consistent with an earlier IRS ruling, Rev. Rul. 73-572, 1973-2 C.B. 289, addressing the converse situation of a U.S. taxpayer with foreign-source capital gains and U.S.-source capital losses. The ruling concluded that the “in fact” use of U.S.-source losses against the capital gains did not prevent the foreign-source capital gains from being taken into account in the numerator of the taxpayer’s section 904 limitation fraction.

The IRS Office of Chief Counsel found the taxpayer’s Davies-based argument more persuasive. In doing so, the field service advice memorandum noted the absence of a specific provision addressing or dictating that the minimum taxable income rule in section 860E should control the section 904 allocation. It also cited the REMIC rules’ legislative history to support the absence of a prohibition on tax credits offsetting the tax liability arising from the REMIC minimum taxable income amount. Thus, the end result that FTCs were available to offset what at first seemed to be U.S.-source income was not considered problematic. The memorandum also noted that Congress had explicitly overruled the “mismatch” created by the result in Rev. Rul. 73-572 in section 904(b)(2)(a); however, it then distinguished that overruling as limited to the capital gain result and observed that no similar specific provision overruled reg. section 1.861-8(e)(8) in the context of section 860E(a).

The field service advice does not consider in any detail the point that the reg. section 1.861-8(e)(8) and section 904(f) loss allocation regime are rules of general application that do not address or contemplate the interaction of section 904 with other special provisions limiting the absorption of deductions against specific items of income. The general rules can fairly be viewed as assuming that the allocated deductions or losses would and could reduce the taxable income in the category to which they were allocated (to the extent thereof) and are silent on whether the same rule should apply when that premise is absent. This difference supports not viewing those general rules as automatically applicable in those special cases and that a different approach may be more appropriate, as the context may require. Congress’s overruling of the Rev. Rul. 73-572 result through a statutory change also could be read as disfavoring the mismatch created in one special case — capital gains and losses — and thus as inferentially supporting a non-generalized approach to other special cases.47

Further, section 860E(a) and former section 965(e)(2), as well as the net capital gain and loss regime, have fundamentally different purposes than section 965(n). Each of those other provisions seeks to impose greater taxable income on taxpayers by restricting the amount of otherwise incurred expenses and losses against specific types of income. The section 965(n)(1) election, however, appears to have been intended to provide qualifying taxpayers a benefit that would become available through taxpayers electing into a minimum taxable income result — not to impose a specific amount of minimum tax liability by mandating recognition of a minimum taxable income amount. Thus, the IRS’s analysis in the field service advice memorandum, and its treatment of NOL deductions in Notice 2005-64, address scenarios distinguishable from section 965(n), and the results reached in those cases are not mandated or persuasive in the context of section 965(n).

Another potential counterargument against a section 904 wall-off approach is the disparate treatment that arises between taxpayers that have current-year or carryover losses versus taxpayers that do not, the latter category of which receive no protection from expense and separate limitation loss allocation against the net section 965 inclusion. Although that is technically true, Congress nevertheless chose to offer the section 965(n)(1) election to taxpayers that otherwise would use losses in the 965 inclusion year against the net section 965 inclusion. That only some taxpayers may qualify for the election and wall off other expenses and losses from their net section 965 inclusion for 904 purposes may be unfortunate for some of the taxpayers that are ineligible for the election, but that fact should not undermine the result for the taxpayers that are eligible.

The same type of disparate treatment also is reflected in the election under new section 965(i). That election permits S corporation shareholders to defer (perhaps indefinitely) payment of the tax liability arising from the net section 965 inclusion. The section 965(i) election is irrefutably available only to investors in S corporations and not to investors in other, otherwise similarly situated U.S. shareholder passthrough vehicles such as domestic partnerships. Thus, an argument that the section 965(n)(1) election should be limited or ineffective on policy grounds because the election would be overly generous compared with the treatment of election-ineligible taxpayers does not seem persuasive.

V. Other Procedural Issues

A. Tax Year for Which the Election Is Made

The section 965(n)(1) election applies if the U.S. shareholder of a DFIC makes the election for the tax year described in section 965(a), which is the last tax year of a DFIC that begins before 2018. Thus, there is an arguable inconsistency between the section 965(n)(1) election being made by the U.S. shareholder for the tax year of the DFIC but not for its own tax year.

Still, the provision should not be read as self-defeating or ineffective on the hypertechnical basis that a U.S. shareholder cannot make an election for a tax year that is not its own. The discussion of the section 965(n)(1) election in the conference report clearly indicates that the election is made by the U.S. shareholder for the income included because of section 965(a) (that is, the net section 965 inclusion). The best construction of this issue therefore is that the U.S. shareholder makes the election for its tax year for which it includes the net section 965 inclusion — that is, the U.S. shareholder inclusion year.

The sample section 965(n)(1) election statement released by the IRS as part of the section 965 FAQs confirms this approach by requesting that the electing taxpayer reference its own tax year in making the election. Notice 2018-26 also indicates that a U.S. shareholder may make a section 965(n)(1) election for the U.S. shareholder inclusion year.

B. Who Makes the Election?

Another procedural question presented by the section 965(n)(1) election is who may or should make the election when the U.S. shareholder is not itself a taxpayer (for example, a domestic partnership or S corporation) but instead passes through a section 965(a) inclusion and deduction amount to a partner or investor that could have current or carryover losses and would be eligible to make the election.

Q&A 5 confirms that a taxpayer must be eligible to have an NOL to make a section 965(n)(1) election, thereby foreclosing the ability of a domestic partnership or S corporation U.S. shareholder to make any of the elections. Section 3.05(b) of Notice 2018-26 also confirms that investors in domestic passthrough U.S. shareholders, such as domestic partnerships and S corporations, are themselves deemed to be U.S. shareholders for purposes of the section 965(n)(1) election and can make the election on their own behalf for the passed-through share of net section 965 inclusion.48

VI. Conclusion

Section 965(n) provides an important election that taxpayers with losses that exceed their non-net section 965 inclusion income in the U.S. shareholder inclusion year should carefully consider. Despite the confusing language of section 965(n)(1)(A),49 the IRS and Treasury have confirmed that the section 965(n)(1) election allows taxpayers to include the net section 965 inclusion as a minimum taxable income amount that cannot be offset by current-year losses or NOL carryovers or carrybacks into the U.S. shareholder inclusion year. Section 965(n) appears to be the first instance in which this result would be provided through an optional election. It was intended as a benefit to eligible taxpayers, not as a revenue-raising measure seeking to ensure a minimum threshold of tax liability from taxpayers, like section 860E(a) and former section 965(e)(2).50 That difference justifies an interpretation of the intersecting application of section 965 with the section 904 loss allocation rules that permits electing taxpayers to use FTCs to the fullest extent possible — that is, the section 904 wall-off approach. Treasury should consider the novel and special circumstances presented by the section 965(n)(1) election as it develops guidance for taxpayers making the election.

FOOTNOTES

1 See, e.g., U.S. Chamber of Commerce, “Comments on Notice 2018-13” (Feb. 20, 2018); AICPA, “Request for Immediate Guidance Regarding Pub. L. No. 115-97” (Jan. 29, 2018); NYSBA tax section, “Report No. 1388 on Section 965” (Feb. 6, 2018); and American Petroleum Institute (API) letter to Treasury Secretary Steven Mnuchin (Mar. 1, 2018).

2 The two earlier notices were Notice 2018-7, 2018-4 IRB 1, and Notice 2018-13, 2018-6 IRB 341.

3 Notice 2018-26, section 3.05(d). This report later details the issues presented by the statutory language.

4 See, e.g., API letter, supra note 1, at 2, stating: “The clear legislative intent of the election was to provide taxpayers the option to forego using their losses in the year of repatriation (i.e., “ring-fence” the losses with such being available for carryover or carryback) and instead apply foreign tax credits to offset the tax related to the repatriated amount.”

5 Section 965(a).

6 Section 965(d).

7 Section 965(a).

8 See generally section 965(c). Section 15 provides special rules for determining how rate changes apply to taxpayers whose tax years straddle relevant effective dates (e.g., fiscal-year filers for law changes that are effective as of the beginning or end of the calendar year).

9 See generally sections 960, 902, and 965(g).

10 This report does not consider in detail the myriad inputs and issues relevant to determining a U.S. taxpayer’s overall section 965 computation and tax liability.

11 See supra note 1.

12 The net 965 inclusion equals the sum of (1) the section 965(a) gross subpart F inclusion minus the dividends received deduction allowed under section 965(c) (collectively, the net section 965(a) amount), plus (2) for domestic corporations electing to claim FTCs, the amount of deemed-paid taxes for the net section 965(a) amount, as limited under section 965(g)(4).

13 See Joint Committee on Taxation, “Description of the Chairman’s Mark of the ‘Tax Cuts and Jobs Act,’” JCX-51-17, at 221-226 (Nov. 9, 2017) (no discussion of the section 965(n)(1) election).

14 See id. at 8. The “rules to coordinate” the different attributes appears to be a reference to the new election in section 904(g)(5) to increase (up to 100 percent) the percentage of a taxpayer’s U.S.-source income that is eligible to be resourced into foreign-source income under the overall domestic loss regime for pre-2018 unused overall domestic losses.

15 See S. Prt. 115-20, at 365 (2017); and H.R. Rep. No. 115-466, at 615 (Conf. Rep.).

16 H.R. Rep. No. 115-466, at 618-621.

17 TCJA section 13302.

18 Section 172(d)(1).

19 See reg. section 1.172-6(a)-(b) (before updating for new section 172(b)(2)); see also section 172(b)(2) (the NOL carryover to each succeeding year is the amount of the origination-year NOL that exceeds the amount of that loss over the sum of the taxable income for each of the prior tax years to which the loss may be carried, but now taking into account the 80 percent limitation for post-2017 NOL carryforwards).

20 New section 172 still allows two-year NOL carrybacks for some farming and insurance company losses, but it seems unlikely that that limited subset is what the reference to carrybacks in section 965(n)(1)(B) was intended to address.

21 Because the U.S. shareholder inclusion year for section 965 will necessarily end in 2017 or 2018, and those years generally would have only NOL carryovers arising in 2017 or earlier years (and thus before the effective date of the 80 percent limitation in new section 172), the potential for this 80 percent limitation is not considered further.

22 Or more precisely, the sum of the taxpayer’s NOL carryovers and carrybacks to a tax year was the NOL deduction in the prior version of section 172.

23 P.L. 108-357, section 422.

24 See former section 965(e)(3).

25 See H.R. Rep. No. 108-755, at 316 (“The income attributable to the nondeductible portion of a qualifying dividend may not be offset by expenses, losses, or deductions.”) and n.113 (“These expenses, losses, and deductions may, however, have the effect of reducing other income of the taxpayer.”).

26 See Notice 2005-64, 2005-2 C.B. 471, section 7.02, Example 1. The same year, Treasury and the IRS issued a revenue ruling interpreting in a similar manner section 860A(e), which implements a rule comparable to former section 965(e)(2) that is imposed on real estate mortgage investment conduit “excess inclusion” interests. See Rev. Rul. 2005-68, 2005-2 C.B. 853.

27 Notice 2018-26, section 3.05(d).

28 See, e.g., 15 West 17th Street LLC v. Commissioner, 147 T.C. No. 19 (2016) (“When construing a statute, ‘[i]t is our duty to give effect, if possible, to every clause and word’ so as to avoid rendering any part of the statute meaningless surplusage.” United States v. Menasche, 348 U.S. 528, 538 (1955) (quoting Montclair v. Ramsdell, 107 U.S. 147, 152 (1883)); Market Co. v. Hoffman, 101 U.S. 112, 115 (1879) (construing a statute so that “no clause, sentence, or word shall be superfluous, void, or insignificant”); Marbury v. Madison, 5 U.S. (1 Cranch) 137, 171 (1803) (enunciating “anti-surplusage” canon of construction).”

29 Notice 2018-26, section 7.

30 The NYSBA tax section reached a similar conclusion: “We believe that the purpose of section 965(n) is to permit a taxpayer to elect to have taxable income in the inclusion year at least equal to its aggregate section 965(a) inclusion amount (plus the section 78 gross-up amount with respect thereto and after taking into account the participation exemption deduction under section 965(c)), the tax on which could then be reduced by allowable foreign tax credits.” NYSBA report, supra note 1, at 27.

31 See supra note 14.

32 “Category” refers to the foreign-source category of income in section 904 and is used synonymously with “basket.”

33 See also reg. section 1.861-8(e)(8) (An NOL “deduction allowed under section 172 shall be allocated and apportioned in the same manner as the deductions giving rise to the [NOL] deduction.”).

34 Reg. section 1.904(g)-3(b)(2) and (3).

35 See section 965(k), as included in H.R. 1, as passed by the House on November 16, 2017.

36 See H.R. Rep. No. 115-466, at 611 (reciting House explanatory language that the special carryforward period applied for foreign taxes deemed paid “with respect to the inclusion required by the provision and for which no credit is allowed in the year of inclusion by reason of section 904 limitations (e.g., because part or all of the inclusion by the provision is offset by a net operating loss deduction)”).

37 Id. at 613.

38 See API letter, supra note 1, at 2; and NYSBA report, supra note 1, at 27.

39 The only meaningful change to the section 904 rules that occurred between the issuance of Notice 2005-64 and the enactment of H.R. 1 was that the rules addressing the section 904 treatment of NOL carryover and carryback deductions, as first announced in Notice 89-3, 1989-1 C.B. 623, were finalized (with modifications not relevant here) into the multistep framework in reg. section 1.904(g)-3.

40 Defined above as the minimum taxable income rule.

41 All of the following examples reference USP as the applicable taxpayer.

42 See new section 951A. Nearly all CFC income in future years will be treated as tested income and included under section 951A, with the income inclusion placed into a separate FTC category (section 904(d)(1)(A)), which will supersede the pre-TCJA treatment of deemed or actual dividends from CFCs E&P (general or passive basket based on look-through).

43 Under step 1, different results apply depending on whether the NOL carryover and carrybacks are fully or only partially absorbed. If they are fully absorbed, the taxpayer is deemed to re-deduct the U.S. and separate foreign category portions of the NOL deduction for the year and to add those deemed re-deducted deduction amounts to the net income or loss results for each of the different baskets. If they are only partially absorbed, the taxpayer is deemed to first deduct the U.S.-source portion of the NOL deduction to the extent of the taxpayer’s U.S.-source income for the year. If the absorbed NOL amount exceeds the U.S. income, the remainder is treated as proportionately coming from the other component foreign-category-allocated deductions within the NOL.

44 See FSA 19970313. Although field service advice is not binding on the IRS and may not be cited as precedent (section 6110(k)(3)), it can be useful in demonstrating the explicit or implicit reasoned views of the IRS on the issues discussed therein.

45 The result would be the same under reg. section 1.904(g)-3 and Notice 89-3.

46 Theo. H. Davies & Co. Ltd. v. Commissioner, 75 T.C. 443 (1980), aff’d, 678 F.2d 1367 (9th Cir. 1982).

47 See, e.g., JCT, “General Explanation of the Tax Reform Act of 1976,” JCS-33-76, at 244-247 (Dec. 29, 1976) (describing changes to capital gain rules, including enactment of the predecessor of section 904(b)(2)(A)).

48 See supra note 4.

49 Other commentators that have addressed section 965(n)(1)(A) thus far have referred to it as “unclear” (see NYSBA report, supra note 1) and its language as “garbled” (see Jasper L. Cummings, Jr., “The Territorial Transition Tax,” Tax Notes, Feb. 12, 2018, p. 857).

50 The section 7874 inversion regime uses a similar minimum taxable income rule, by cross-reference to section 860E, for “inversion gain” recognized by surrogate foreign corporations within the 60 to 80 percent prior ownership category. See section 7874(e)(3).

END FOOTNOTES

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