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NYSBA Tax Section Submits Report on Proposed Transition Tax Regs

OCT. 5, 2018

NYSBA Tax Section Submits Report on Proposed Transition Tax Regs

DATED OCT. 5, 2018
DOCUMENT ATTRIBUTES

October 5, 2018

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable William M. Paul
Principal Deputy Chief Counsel and
Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Report No. 1401 on Proposed Section 965 Regulations

Dear Messrs. Kautter, Rettig, and Paul:

I am pleased to submit Report No. 1401, commenting on proposed regulations under sections 962, 965 and 986 (the “Proposed Regulations”). This Report also addresses guidance provided by the Internal Revenue Service relating to refund claims of taxpayers that elect under section 965(h) to pay their tax liability resulting from the application of section 965 in installments.

In a prior report submitted on February 6, 2018, we made recommendations for guidance under section 965, and addressed certain issues arising under the rules set forth in Notice 2018-07 and Notice 2018-13 (the “Prior Report”). In this Report, we make a number of new recommendations regarding issues raised by the Proposed Regulations, and we also restate certain of our recommendations from the Prior Report that were not adopted by the Department of Treasury and the Internal Revenue Service in the Proposed Regulations.

We commend Treasury and the Service for making substantial progress in providing extensive guidance under section 965 in a short timeframe. We appreciate your consideration of our recommendations. If you have any questions or comments regarding this Report, please feel free to contact us and we will be glad to assist in any way.

Respectfully submitted,

Karen G. Sowell
Chair
Tax Section
New York State Bar Association

Enclosure

Cc:
Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Brian Jenn
Deputy International Tax Counsel
Department of the Treasury

Marjorie A. Rollinson
Associate Chief Counsel (International)
Internal Revenue Service

Daniel M. McCall
Deputy Associate Chief Counsel (International)
Internal Revenue Service

Raymond J. Stahl
Special Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service

John J. Merrick
Special Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service


Report No. 1401

NEW YORK STATE BAR ASSOCIATION TAX SECTION

REPORT ON PROPOSED SECTION 965 REGULATIONS

October 5, 2018


Table of Contents

I. Introduction

II. Comments on Proposed Regulation Section 1.965-4

A. Double Counting Rule

B. Coordination of Proposed Regulations 1.965-4(b) and (c) with other Provisions in the Code

III. Comments on Availability of Refunds for Taxpayers that Make Section 965(h) Election

IV. Clarification of the Definition of “Domestic Pass-Through Entity” as Applied to Grantor Trusts that are Shareholders of an S Corporation for Purposes of Making Deferral Elections under Section 965(i)

V. Specified Foreign Corporations' Cash Positions Should be Reduced for Previously Taxed Income

VI. Comments on Proposed Regulation Section 1.965-2(d)

VII. Comments on Proposed Regulation Section 1.965-5

VIII. Comments on Proposed Regulation Section 1.965-7

A. Exceptions from Acceleration Events

B. Triggering Events with Respect to Deferral Elections under Section 965(i)

IX. Comments Related to Recommendations in Prior Report

A. Need for Additional Guidance Providing for Simplifying Conventions

B. Clarification of the “Gain-Reduction Rule”

C. Application of the “Gain-Reduction Rule” to CFC to CFC Distributions

D. Basis Reallocation Election

E. Need for Additional Guidance Regarding Measurement of Post-1986 Earnings and Profits and Deficits

1. Sales, Redemptions and Distributions During the Transition Year

2. Application of E&P Deficit Rules to SFCs with PTI and E&P Deficits

3. Potential Double Counting of Earnings and Profits of SFCs With Inclusion Years Ending November 30, 2018

F. Need for Additional Guidance Regarding Measurement of Cash Position

G. Need for Additional Guidance Regarding Elections Under Section 962

H. Need for Guidance Regarding Treatment of Section 965(a) Inclusions by Regulated Investment Companies


I. Introduction

This Report1 (“Report”) comments on proposed regulations (the “Proposed Regulations”)2 under sections 962, 965 and 986.3 This Report also addresses guidance provided by the Internal Revenue Service (the “Service”) relating to refund claims of taxpayers that elect under section 965(h) to pay their tax liability resulting from the application of section 965 in installments.

In a prior report submitted on February 6, 2018, we made recommendations for guidance under section 965, and addressed certain issues arising under the rules set forth in Notice 2018-07 (issued December 29, 2017) and Notice 2018-13 (issued January 19, 2018).4 In this Report, we make a number of new recommendations regarding issues raised by the Proposed Regulations, and we also restate certain of our recommendations from the Prior Report that were not adopted by the Department of Treasury (the “Treasury”) and the Service.

We commend Treasury and the Service for making substantial progress in providing extensive guidance under section 965 in a short timeframe. We understand that Treasury and the Service intend to issue final regulations under section 965 within the period described in section 7805(b)(2) of the Code. This Report does not include a general overview of the Proposed Regulations or the statute; instead, it focuses on significant unresolved issues that we have identified thus far and that we believe should be addressed in future guidance.

II. Comments on Proposed Regulation Section 1.965-4

A. Double Counting Rule

Under Proposed Regulation section 1.965-4(f)(1) (the “Double Counting Rule”), “specified payments” made by a specified foreign corporation (the “payor SFC”) to another SFC (the “payee SFC”) are disregarded for purposes of determining the post-1986 earnings and profits (“E&P”) of both the payor SFC and the payee SFC as of the December 31 measurement date.

A payment between SFCs will not be a specified payment unless the payor SFC and the payee SFC have different “tentative E&P measurement dates.”5 For this purpose, an SFC's tentative E&P measurement date is generally the measurement date (i.e., November 2, 2017 or December 31, 2017) on which the SFC's deferred E&P is greater (determined without regard to Proposed Regulation section 1.965-4(f)(1)). In the case of an SFC that, without regard to Proposed Regulation section 1.965-4(f)(1), would be an E&P deficit foreign corporation, the tentative measurement date is November 2, 2017.

The Proposed Regulations do not specify how the tentative E&P measurement date is to be determined in the case of an SFC that does not have positive deferred E&P on either of the measurement dates, but is also not an E&P deficit foreign corporation (e.g., an SFC that has previously taxed income (“PTI”) in excess of its aggregate post-1986 E&P). As a result, it is unclear whether intra-SFC payments made to, or received by, such an SFC can be “specified payments” that must be disregarded pursuant to Proposed Regulation section 1.965-4(f)(1). We recommend that Treasury and the Service clarify this issue.

Furthermore, the application of the Double Counting Rule can result in an artificial reduction in the creditable foreign taxes available to U.S. shareholders as a result of a section 965(a) inclusion. This can occur because the Double Counting Rule disregards an SFC to SFC payment solely for purposes of calculating the post-1986 E&P of the SFCs, but not for purposes of computing the section 960 fraction.

Example.

USP, a domestic corporation, owns two controlled foreign corporations (“CFCs”), CFC1 and CFC2. On November 2, 2017, each of CFC1 and CFC 2 has $200 of E&P and $20 of creditable foreign taxes. On November 15, 2017, CFC1 makes a deductible payment of $20 to CFC2, which is disregarded under Proposed Regulation section 1.965-4(f). As a result, USP has a $200 section 965(a) inclusion with respect to each of CFC1 and CFC2. CFC1's section 960 fraction is 1 ($200 of section 965(a) inclusion divided by $180 of E&P, but capped at 1). However, CFC2's section 960 fraction is 0.91 ($200 of section 965(a) inclusion divided by $220 of E&P). As a result, $1.8 of CFC2's creditable foreign taxes are unavailable to USP.

We recommend that the final regulations provide that a payment that is disregarded under the Double Counting Rule for purposes of determining post-1986 E&P is also disregarded for purposes of determining the foreign taxes deemed paid by a U.S. shareholder under section 960 with respect to a section 965(a) inclusion.

B. Coordination of Proposed Regulations 1.965-4(b) and (c) with other Provisions in the Code

Proposed Regulation section 1.965-4(b) provides that certain transactions are disregarded for purposes of determining the “section 965 elements” of a U.S. shareholder if (i) they occur in whole or in part after November 2, 2017, (ii) were undertaken with a principal purpose of changing the amount of a section 965 element of the U.S. shareholder, and (iii) if given effect, would change the amount of a section 965 element. Certain types of transactions are presumed to have been undertaken with a principal purpose of changing the amount of a section 965 element. A “section 965 element” is a U.S. shareholder's section 965(a) inclusion, aggregate foreign cash position, or foreign taxes deemed paid by a U.S. shareholder under section 960 with respect to a section 965(a) inclusion.6 Proposed Regulation section 1.965-4(c)(2) further provides that an entity classification election under Treasury Regulation section 301-7701-3 (a “Check-the-Box Election”) that is filed after November 2, 2017 is disregarded for purposes of determining the section 965 elements of a U.S. shareholder if giving it effect would in fact change any section 965 element.

It is unclear how far the fictions of Proposed Regulation section 1.965-4(b) and (c) are to be extended.

Example.

USP, a domestic corporation, owns all the stock of CFC1, which in turn owns all the stock of CFC2. As of November 3, CFC1 had $100 of E&P and no creditable foreign taxes and CFC2 has no E&P and $50 of creditable foreign taxes. On November 15, 2017, CFC2 files a Check-the-Box Election to be treated as an entity disregarded as separate from CFC1 for U.S. federal income tax purposes. On November 25, CFC2, now a disregarded entity, distributes built-in gain property to CFC1. On December 31, 2017, CFC1's E&P is $110 (it earned $10 of unrelated E&P between measurement dates) and its creditable foreign taxes are $50.

As a result of the Check-the-Box Election, CFC1 succeeds to CFC2's $50 of creditable foreign taxes under Treasury Regulation section 1.367(b)-7. Accordingly, if the Check-the-Box election were given effect for purposes of section 965, it would result in an increase of the foreign taxes deemed paid by USP under section 960 with respect to the $110 section 965(a) inclusion from CFC1. In the absence of the election, the foreign taxes would have remained at CFC2 and would have been unavailable because USP would have had no section 965(a) inclusion with respect to CFC2. Therefore, the Check-the-Box election is disregarded for purposes of determining USP's section 965 elements.

It is uncertain whether the distribution of appreciated property by CFC2 to CFC1 is also disregarded, or whether it must be given effect for purposes of section 965. It would not appear that the distribution would be disregarded under Proposed Regulation section 1.965-4(b) because this step was not engaged in with a principal purpose of changing a section 965 element. If the distribution were given effect, and the Check-the-Box election were not, then CFC2 would recognize gain under section 311(b), which would increase its post-1986 E&P for purposes of the December 31, 2017 measurement date.

We do not believe that result is appropriate. It is a retroactive recharacterization of a transaction in a manner that artificially increases USP's section 965(a) inclusion. USP engaged in the distribution expecting that it would be disregarded for U.S. federal income tax purposes. We recommend that Treasury address in the final section 965 regulations the extent to, and manner in which, transactions that follow a transaction that is disregarded under Proposed Regulation section 1.965-4(b) or (f) are themselves taken into account for purposes of determining section 965 elements. We recognize that this is a difficult issue to address because of the myriad of different transactions that a taxpayer could have engaged in between measurement dates. One possibility is that the final regulations could provide that if a transaction or Check-the Box Election is disregarded for purposes of determining the section 965 elements of a U.S. shareholder under Proposed Regulation section 1.965-4(b) or (f), but subsequent related transactions are not, that the effect of the subsequent transactions on a U.S. shareholder's section 965 elements is determined as if Proposed Regulation section 1.965-4(b) or (f) did not apply to the earlier step. This may allow Treasury and the Service to target more narrowly the transactions it intends to disallow while reducing unanticipated collateral effects of the recharacterization on other section 965 elements.

III. Comments on Availability of Refunds for Taxpayers that Make Section 965(h) Election

In question 14 in the FAQs about section 965 reporting posted on the Service's website, the Service first announced that a taxpayer with a valid section 965(h) election that made 2017 tax payments (including estimated payments) in excess of the taxpayer's “regular tax liability”7 plus the first installment of its transition tax liability would not receive a refund.8 Rather, the overpayment would be applied to the next successive annual installment under section 965(h) and, to the extent that this exceeds the amount due at the next installment, it is applied to the following successive annual installment.

For example, assume the taxpayer had a regular 2017 tax liability of $200, and a total liability under section 965 of $100, which it validly elected to pay in installments under section 965(h). The taxpayer must pay $8 installments for each of 2017 through 2021 by the terms of section 965(h)(1). If such taxpayer made estimated tax payments of $220 with respect to the 2017 tax year, then the taxpayer would not receive a refund of $12 ($220 minus $208). Instead, $8 would be applied to the 2018 section 965(h) installment (otherwise not due until 2019), and $4 would be applied to the 2019 section 965(h) installment (otherwise not due until 2020).

The Service explained its reasoning in a memorandum dated August 2, 2018.9 The memorandum argues that section 6403 and Estate of Bell v. Commissioner10 precludes the Service from issuing a refund and mandates that the overpayment be applied to future section 965(h) installments. As we explain below, we believe that these authorities should not apply to all overpayments, and the memorandum cuts against the policy behind section 965(h).

Section 6403 provides that where there is a tax payable in installments, and the taxpayer has “paid as an installment” more than the correct amount of such installment, then “the overpayment shall be credited against the unpaid installments, if any.” In Estate of Bell, the estate had made a valid election under section 6166 to defer a portion of its estate tax attributable to stock in a closely-held corporation. The executor had overvalued the stock and, as a result, had overpaid its initial installments. The Tax Court held that this overpayment should be applied to subsequent installments and should not be refundable, and the 9th Circuit affirmed. The Service argued that this applies here, as well. Any overpayment must be applied to subsequent installments.

Section 6403 applies, by its terms, to a taxpayer that made an overpayment of a tax payable in installments “as an installment of the tax.”11 In the memorandum and FAQ, the Service does not appear to differentiate between estimated tax payments made “as an installment” under 965(h) and overpayments of regular tax liabilities. At the very least, section 6403 should not apply if the taxpayer made estimated tax payments of its regular tax liability that turned out to be in excess of that liability. In the example above, the $220 payment of estimated taxes was not “paid as an installment” towards the taxpayer's section 965 liability and therefore section 6403 should not apply to the payment. The taxpayer should be entitled to a refund of the $20 over-payment of its regular tax liability rather than having that amount automatically applied towards its section 965 liability.

As a policy matter, applying section 6403 to a taxpayer who made a section 965(h) election seems inconsistent with the overall scheme established by Congress in section 965(h).12 Congress decided to allow taxpayers to defer the transition tax interest-free. Moreover, the installments are backloaded, with the taxpayer paying 8% of the liability for the first few installments, which rises progressively to 25% of the liability in the last installment. The back-loading appears to evidence a Congressional intent to provide taxpayers with a deferral. Neither of these characteristics existed, for example, in section 6166, the subject of Estate of Bell.

Finally, the fact that this guidance was released on April 13, 2018 creates harsh results for taxpayers who made estimated payments for the first quarter of 2018 and the last quarter of 2017, each of which had a due date that preceded the release of the applicable FAQs. Taxpayers who took a cautious approach are now penalized by not getting refunds.

In light of these considerations, we recommend that Treasury and the Service consider revising their guidance on this issue to exclude section 965(h) installment payments from the application of section 6403 altogether. If Treasury and the Service decline to adopt this approach, we recommend the following:

1. First, we recommend that Treasury and the Service issue administrative guidance that distinguishes between overpayments made in respect of a section 965(h) installment (e.g., due to a revised E&P or foreign cash calculation) and overpayments made in respect of estimated taxes or regular income taxes. The guidance would clarify that the Service will issue refunds in respect of the latter type of overpayment. Accordingly, in the example above, the taxpayer would receive a refund of the $20 overpayment of its regular tax liability.

2. Second, we recommend that Treasury and the Service allow for relief for over-payments made in respect of a section 965(h) installment that are attributable to systemic uncertainty, such as payments made before guidance was released.

Finally, to the extent that Treasury and the Service cannot resolve the issue, we encourage Congress to consider a statutory amendment to the extent that the administrative guidance is inconsistent with the original intent of section 965(h).

IV. Clarification of the Definition of “Domestic Pass-Through Entity” as Applied to Grantor Trusts that are Shareholders of an S Corporation for Purposes of Making Deferral Elections under Section 965(i)

Section 965(i) provides that a shareholder of an S corporation that is a United States shareholder of a deferred foreign income corporation (a “DFIC”) may elect to defer payment of its net tax liability under section 965 with respect to such S corporation until the shareholder's taxable year that includes a triggering event with respect to such liability.13 Any shareholder of an S corporation that is a United States shareholder of a DFIC, whether it owns section 958(a) stock of such DFIC or not, may make the election.14 The Proposed Regulations further provide that a domestic pass-through entity of an S corporation is not permitted to elect under section 965(i) to defer the payment of the shareholder's section 965(i) net tax liability with respect to the S corporation.15 The Proposed Regulations define a “domestic pass-through entity” to mean a pass-through entity that is a United States person (as defined in section 7701(a)(30)), and define “pass-through entity” to mean a partnership, S corporation, or any other person to the extent that the income or deductions of such person are included in the income of one or more direct or indirect owners or beneficiaries of the person.16 The Proposed Regulations state that if a domestic trust is subject to U.S. federal income tax on a portion of its section 965(a) inclusion amount and its domestic pass-through owners are subject to tax on the remaining portion, then the domestic trust is treated as a domestic pass-through entity with respect to such remaining portion.

There is some uncertainty regarding whether a grantor trust that is a shareholder of an S corporation is treated as a United States person for purposes of section 7701(a)(30), and therefore as a “domestic pass-through entity” ineligible to make the section 965(i) election under Proposed Regulation section 1.965-7(c)(1). The Service has in the past concluded that a grantor trust is treated as a disregarded entity for all U.S. federal income tax purposes. In Example 5 of Treasury Regulation section 1.1001-2(c), “C,” an individual, is the sole owner of “T,” a grantor trust. T purchases an interest in “P,” a partnership, in 1975. In 1978, C renounces certain powers which cause T to lose its status as a grantor trust. The example states that “prior to the renunciation . . . C was considered the owner of all the trust property for Federal income tax purposes, including the partnership interest.”17 In contrast, the Tax Court has held that a grantor trust, and not its grantor, is treated as a United States shareholder of a CFC for purposes of determining subpart F inclusions.18 The Tax Court's decision has been criticized for being inconsistent with the authorities outside of subpart F regarding the treatment of grantor trusts.19

In the context of section 965, we cannot articulate any policy rationale why the sole grantor of a grantor trust that is treated as a disregarded entity should be prevented from making a section 965(i) election.20 Given the Service's long-standing position that an owner of a grantor trust is treated as the owner of the trust's assets,21 we recommend that the final section 965 regulations confirm that a grantor trust with a single grantor that is a shareholder of an S corporation should not be treated as a “domestic pass-through entity” for purposes of determining whether a section 965(i) election is available. More generally, we recommend that Treasury and the Service consider clarifying in the final regulations that a grantor trust with a single owner should be excluded from the definition of “domestic pass-through entity” for all purposes of section 965.

V. Specified Foreign Corporations' Cash Positions Should be Reduced for Previously Taxed Income

As described in the preamble to the Proposed Regulations, Treasury and the Service declined to adopt a rule that would reduce an SFC's cash position by PTI as of each relevant measurement date. In our view, such a rule would be consistent with the principles underlying the tiered tax rate implemented by section 965(c) and the general treatment of PTI. Taxpayers who chose not to repatriate cash that was matched by PTI prior to enactment of the TCJA should not be penalized. U.S. tax considerations likely played little or no role in the decision to cause SFCs to retain this cash. There are at least two alternative approaches that could be adopted in reducing SFCs' cash position by PTI. Under the first, the cash position of an SFC would be reduced dollar-for-dollar for PTI. The rationale for this approach is that, to the extent cash and other liquid assets were matched by PTI, they generally could have been repatriated without incurring any additional U.S. federal income tax. Under the second approach, an SFC's PTI would be allocated between the SFC's cash position and its other assets pro rata (based on tax basis), and the cash position would be offset only by its allocable share of PTI. The rationale for this approach is that some PTI might have been reinvested in assets, which is why it was not repatriated.

If Treasury and the Service believe they lack the authority to adopt a rule that adjusts SFCs' cash positions to account for PTI, we encourage Congress to consider a statutory amendment.

VI. Comments on Proposed Regulation Section 1.965-2(d)

Proposed Regulation section 1.965-2(d)(1) provides that the previously taxed earnings of a DFIC under section 959(c)(2) are increased by an amount equal to the reduction of the U.S. shareholder's section 965(a) amount with respect to the DFIC under section 965(b), “provided the section 958(a) U.S. shareholder includes the section 965(a) inclusion amount with respect to the [DFIC] in income.” Read literally, the proposed regulation appears to say that if the U.S. shareholder has no section 965(a) inclusion with respect to a DFIC (for example, because the deficit allocated to the DFIC under section 965(b) is in excess of the DFIC's post-1986 E&P), then none of the DFIC's E&P becomes section 965(b) PTI. If instead the U.S. shareholder has at least one cent of section 965(a) inclusion with respect to the same DFIC, then the DFIC's E&P offset by the allocated deficit does become section 965(b) PTI.

This rule creates a cliff effect that can lead to dramatically different consequences. If the E&P of the DFIC does not become section 965(b) PTI, then presumably the E&P would be eligible for the section 245A deduction once distributed to the U.S. shareholder. If instead the E&P becomes section 965(b) PTI, then a distribution to the U.S. shareholder could result in gain recognition under section 965(b)(2) if it exceeds the shareholder's basis in the top-tier CFC's stock. This result is inconsistent with section 965(b), which does not require a U.S. shareholder to have a section 965(a) inclusion with respect to a DFIC in order for the DFIC's E&P offset by an allocated deficit to become section 965(b) PTI. We recommend that the final regulations conform to the statute and eliminate this requirement in the Proposed Regulations.

VII. Comments on Proposed Regulation Section 1.965-5

Under Proposed Regulation section 1.965-5(b), neither a deduction nor a credit under section 901 is allowed for the “applicable percentage” (as defined in Proposed Regulation section 1.965-5(d)) of any foreign income taxes attributable to a distribution of section 965(a) PTI or section 965(b) PTI. Similarly, under Proposed Regulation section 1.965-5(c), a credit under section 901 is not allowed for the applicable percentage of any foreign income taxes treated as paid or accrued with respect to which a section 965(c) deduction is allowed, including, inter alia, foreign income taxes paid under section 960(a)(3) with respect to distributions of section 965(a) PTI or section 965(b) PTI. We believe that applying the applicable percentage to disallow credits with respect to such foreign income taxes with respect to distributions of section 965(b) PTI may be inconsistent with the plain language of the statute. Furthermore, as a policy matter, the Proposed Regulations' approach seems problematic for at least two reasons. First, in contrast to section 965(a) PTI, which generally will have been matched by a corresponding basis increase in the stock of the distributing SFC (resulting from the initial gross income inclusion) that is re-versed by the distribution (leaving the U.S. shareholder in a neutral position), a distribution of section 965(b) PTI results in a dollar-for-dollar reduction to basis (to the extent thereof) followed by gain recognition. Second, the Proposed Regulations' approach could treat similarly situated taxpayers disparately based on very small differences in their SFCs' amount of deferred E&P.

In the case of a U.S. shareholder that owns DFICs but does not have a section 965(a) inclusion pursuant to the application of section 965(b) because its allocable share of deficits equals or exceeds its allocable share of deferred E&P, the definition of “applicable percentage” in Proposed Regulation section 1.965-5(d) results in a “divided by zero” percentage, given that the U.S. shareholder does not have a section 965(a) inclusion. Therefore, it appears that the Proposed Regulations would not disallow any portion of the foreign income taxes paid or deemed paid by these U.S. shareholders with respect to distributions of section 965(b) PTI. This result seems consistent with section 965(g), which ties the foreign tax credit “haircut” to amounts for which a deduction is allowed under section 965(c). A U.S. shareholder that has a section 965(a) inclusion of zero due to the application of section 965(b) is not entitled to any deduction under section 965(c). If Treasury and the Service agree that a U.S. shareholder that does not have a section 965(a) inclusion pursuant to the application of section 965(b) is not impacted by the foreign tax credit haircut rule, we recommend they confirm this result in the final section 965 regulations.

In the case of a U.S. shareholder that has a section 965(a) inclusion that is reduced (but not to zero) pursuant to the application of section 965(b), it appears that the Proposed Regulations disallow the same applicable percentage of foreign taxes paid with respect to distributions of section 965(a) PTI and section 965(b) PTI. It is not clear that foreign taxes paid with respect to distributions of section 965(b) PTI should be viewed as foreign taxes paid “with respect to any amount for which a section 965(c) deduction is allowed,” given that section 965(b) PTI represents amounts by which a U.S. shareholder reduced its section 965(a) inclusion, rather than amounts for which it claimed a deduction. This treatment also seems inconsistent with section 965(g), which ties the foreign tax credit “haircut” to amounts for which a deduction is allowed under section 965. Furthermore, assuming Treasury and the Service determine that a U.S. share-holder described in the preceding paragraph (i.e., one that has no section 965(a) inclusion pursuant to the application of section 965(b)) is not subject to the foreign tax credit haircut rule, then the approach of Proposed Regulation section 1.965-5 would treat a taxpayer dramatically differently depending on whether its allocable share of its SFCs' deferred E&P was completely offset by its allocable share of deficits, or exceeded such deficits by even a de minimis amount. A U.S. shareholder with a section 965(a) inclusion of $1 could be subject to the haircut rule on billions of dollars of section 965(b) PTI distributions.

In light of these considerations, we recommend that Treasury and the Service reconsider the approach of Proposed Regulation Section 1.965-5 with respect to section 965(b) PTI.

VIII. Comments on Proposed Regulation Section 1.965-7

A. Exceptions from Acceleration Events

We agree with the relief provided in Proposed Regulation section 1.965-7(b)(3) regarding exceptions from acceleration events. We have limited observations on the operation of the exception because actual experience with the application of the exceptions will be necessary to access the procedures. Our two limited observations are the following:

Proposed Regulation section 1.965-7(b)(3)(ii)(F) appears to accelerate the section 965 tax liability if a consolidated group terminates without a successor. This could occur simply because the common parent liquidates all of its subsidiaries and ceases to file consolidated returns (e.g., all of the consolidated subsidiaries convert into disregarded LLCs wholly owned, directly or indirectly, by the common parent). In such case, there seems no incremental risk of collection to the Treasury. Accordingly, it is not clear why there should be an acceleration of remaining installments.

The procedures in Proposed Regulation section 1.965-7(b)(3)(iii)(A)(2) appear to require that in the case of the purchase of substantially all of the assets of the Seller, both the Purchaser and the Seller enter into a transfer agreement under which the transferor assumes the section 965 liability but under which the Seller remains jointly and severally liable if it continues to exist. It is not clear to us why the Seller should remain liable when it is likely that the purchase price that it has received has been reduced by the section 965 liability. We appreciate, and believe that it is appropriate, that relief has been provided to a Seller that liquidates because the liquidation of the Seller is fairly common in the case of a sale of substantially all of the assets. Nevertheless, a Seller that continues in existence may have much reduced assets unless it reinvests the cash from the sale in new assets. It is not clear why a Seller that continues in existence should be in a worse position than one that liquidates.22 The Purchaser has agreed to assume a liability and it now has the assets from which that liability would otherwise have been satisfied.

B. Triggering Events with Respect to Deferral Elections under Section 965(i)

For purposes of the election that is available to S corporation shareholders pursuant to section 965(i), Section 965(i)(2)(A)(ii) provides that triggering events include “a liquidation or sale of all the assets of [the] S corporation . . . or any similar circumstance.”23 Under the Proposed Regulations, the related prong of the list of triggering events includes “a liquidation, sale, exchange or other disposition of substantially all of the assets of the S corporation . . .” (emphasis added)24 We recommend that Treasury and the Service clarify the meaning of “exchange or other disposition” in this regard. For instance, Treasury and the Service should consider whether a non-recognition exchange governed by sections 351 or 721 in which the S corporation retains an indirect equity interest in its transferred assets should constitute a triggering event.

IX. Comments Related to Recommendations in Prior Report

Certain recommendations included in the Prior Report were not addressed in the Proposed Regulations. The preamble to the Proposed Regulations addresses some of these recommendations and explains why Treasury and the Service concluded it was unnecessary or not appropriate to adopt the recommendations discussed in the Prior Report. In other cases, Treasury and the Service have requested additional comments on the subject. In this section, we restate and give brief explanations of our prior recommendations. We encourage Treasury and the Service to further consider these recommendations that we believe continue to merit consideration. If Treasury and the Service believe that they lack the authority to adopt these rules, we urge Congress to consider statutory amendments.

A. Need for Additional Guidance Providing for Simplifying Conventions

In the Prior Report, we recommended that Treasury and the Service issue guidance providing for simplifying conventions that taxpayers can apply for purposes of determining SFCs' deferred E&P and cash positions as of the various measurement dates. We noted that such conventions are of particular importance for U.S. shareholders holding minority interests in foreign corporations that under pre-TCJA law may not have been tracking E&P under U.S. tax principles or otherwise furnishing any information to such shareholders in connection with U.S. tax requirements.

In the preamble to the Proposed Regulations, Treasury and the Service considered this recommendation but declined to adopt regulations addressing the issue, stating that the administrative burdens imposed under section 965 are not unique or novel. In this regard, the preamble asserts, under longstanding provisions of the Code, minority shareholders of foreign corporations must determine E&P consistent with section 312 if they own stock in a passive foreign investment company (a “PFIC”) and elect to treat the PFIC as a qualifying electing fund (a “QEF”) under section 1293, or if they are U.S. shareholders of a CFC.

In our view, these comparisons are inapposite. Generally, a QEF election may be made only if the QEF agrees in advance to report annually to its shareholders their share of the corporation's ordinary income and net capital gain, based on E&P as determined for U.S. federal income tax purposes.25 Foreign corporations will typically disclose to prospective investors whether or not they will provide the necessary information so that investors can make informed investment decisions. Similarly, a U.S. investor considering a 10% or greater investment in a foreign corporation can generally conduct due diligence and negotiate to ensure that it will be able to obtain the necessary information to comply with the PFIC and subpart F regime, if necessary. By contrast, in the case of section 965, many U.S. shareholders are being required for the first time to obtain substantial information within a short time period from foreign corporations in which they already own stock and which would not have known to maintain the requisite records. It is our experience that many foreign corporations decline to provide QEF information because of the difficulties involved in maintaining records under U.S. federal income tax principles.26

Because section 965 imposes new and in many cases unanticipated administrative bur-dens on minority U.S. shareholders of SFCs, we encourage Treasury and the Service to reconsider their position and issue further guidance permitting shareholders to apply simplifying conventions in determining SFCs' E&P and cash positions.

B. Clarification of the “Gain-Reduction Rule”

Notice 2018-7 and Notice 2018-13 described a “gain-reduction rule” which provided that if a U.S. shareholder receives distributions from a DFIC during the inclusion year that are attributable to section 965(a) PTI, the amount of gain recognized by the U.S. shareholder with respect to the stock of the DFIC under section 961(b)(2) will be reduced (but not below zero) by the “section 965(a) inclusion amount.” Proposed Regulation section 1.965-2(g) implements this rule and extends it to include PTI created under section 965(b)(4) by reason of the allocation of a deficit in E&P from a deficit foreign corporation to a related DFIC (referred to as “section 965(b) PTI” in the Proposed Regulations).

In Section V.A of the Prior Report, we described the uncertainty under current law regarding whether basis decreases under section 961(b) are taken into account before basis increases under section 961(a) that occur in the same taxable year. This is because Treasury Regulation section 1.961-1(a)(1) currently provides that basis increases occur “as of the last day in the taxable year” of the CFC while Treasury Regulation section 1.961-2(a)(1) states that basis decreases occur “as of the time [the United States shareholder] receives [the PTI distribution].”

The limited “gain-reduction rule” in Notice 2018-7 and the Proposed Regulations implementing the rule do not address this issue expressly; however, they seem to be based on the premise that section 961(b) basis reductions (and gain) occur prior to basis increases pursuant to section 961(a).27 As we highlighted in the Prior Report, this approach is inconsistent with analogous basis adjustment rules in the S corporation and partnership context, which generally provide that basis increases are taken into account before basis decreases caused by distributions.28 The gain-reduction rule does not, moreover, include an ordering rule for determining what portion of a distribution is attributable to section 965 PTI when a distributing DFIC has different categories of PTI. This could lead to the double taxation of the same earnings — first when the earnings are included in the United States shareholder's income under section 965 and then again when they are distributed as PTI to the United States shareholder if the distribution is made before the last day of the taxable year. This is a result that sections 959 and 961 were intended to prevent.

Example 1 of Proposed Regulation section 1.965-2(j), which is substantially identical to the example included in Notice 2018-7, raises but does not resolve this issue. In the example, USP, a domestic corporation owns all the stock of CFC1, which owns all the stock of CFC2. Both CFC1 and CFC2 have taxable years that end December 31, 2017. As of the beginning of 2017, CFC1 has no E&P and CFC 2 has 100u of E&P described in section 959(c)(3). In 2017, CFC 1 earns 30u of subpart F income and CFC2 earns 20u of subpart F income, CFC2 distributes 40u to CFC1, and CFC1 distributes 60u to USP. The example illustrates that USP must first calculate its subpart F income without regard to section 965, then take into account the effect of the CFC2 to CFC1 distribution during 2017, then calculate its section 965(a) inclusion amount, and finally determine the effect of the distribution by CFC1 to USP. Based on the example, at the time of the distribution to USP, CFC1 has 50u of PTI attributable to subpart F income (30u of its own subpart F income and 20u of CFC2's subpart F income from the 40u distribution it received from CFC2) and 20u of section 965(a) PTI (attributable to the portion of the 40u distribution from CFC2 that was section 959(c)(3) E&P). Therefore, there are multiple possible results to USP depending on whether section 965(a) PTI is deemed distributed first, subpart F PTI is deemed distributed first, or the distribution is prorated between the categories of PTI. The example concludes that “some portion” of the 60u distribution made by CFC1 to USP is attributable to section 965 PTI, but it does not explain what portion. Example 2 also raises but does not resolve this issue.

We reiterate our recommendation in the Prior Report that Treasury and the Service amend the section 961 regulations to clarify that basis decreases under section 961(b) and gain recognition under section 961(b)(2) do not occur prior to giving effect to basis increases under section 961(a) during the same taxable year. As discussed in a forthcoming NYSBA report on previously taxed earnings, this issue is not unique to section 965, but has received increased attention due to the significant amount of PTI created by section 965. Amending the section 961 regulations would solve the issue at a systemic level for all types of previously taxed earnings, whether created by sections 965, 951A, or 951(a). Alternatively, if Treasury and the Service do not adopt this recommendation, then we suggest that they provide in the final section 965 regulations an ordering rule that specifies that distributions made by a DFIC are sourced first from section 965 PTI before other types of PTI and amend Examples 1 and 2 in Proposed Regulation section 1.965-2(j) to state that the distributions to USP in those examples are first sourced from section 965 PTI.

C. Application of the “Gain-Reduction Rule” to CFC to CFC Distributions

Section 961(c) provides that, “under regulations,” “adjustments” will be made to the basis of stock in certain lower-tier CFCs held by an upper-tier CFC that are similar to the adjustments made under sections 961(a) and (b) to the stock of a CFC held directly by a U.S. shareholder. Treasury has never issued final regulations under section 961(c) and it is not clear that the statute is self-executing in the absence of regulations, although in our experience it is common for taxpayers to make these adjustments. Notice 2018-13 announced that a version of the gain-reduction rule would be adopted in the section 965 regulations that would reduce the amount of gain that would “otherwise be recognized under section 961(c)” when a lower-tier CFC distributes section 965 PTI to an upper-tier CFC in excess of basis.

The Proposed Regulations do not include this CFC to CFC gain-reduction rule, and the preamble to the Proposed Regulations does not explain its absence. The absence of this previously announced rule leaves taxpayers in an uncertain position trying to guess Treasury's reasoning. Treasury may have ultimately determined that a CFC to CFC gain-reduction rule is unnecessary. Section 961(c) requires “adjustments” to be made to the basis of the stock of a lower-tier CFC similar to those in sections 961(a) and (b) and arguably recognition of gain is not an “adjustment.” Consistent with that interpretation, the proposed regulations issued in 2006 under section 961(c) make no mention of gain recognition when a lower-tier CFC makes a distribution of PTI in excess of basis.29 If this is the case, then we recommend that Treasury explain in the preamble to the final section 965 regulations its reasoning for excluding the rule.30

If Treasury and the Service believe that section 961(c) does require gain recognition, and do not adopt our principal recommendation that the section 961 regulations be amended to clarify the timing of section 961(a) adjustments as described above, then we recommend including the CFC to CFC gain-reduction rule in the final section 965 regulations.

D. Basis Reallocation Election

Under section 965(b)(4)(A), the amount by which a shareholder reduces its section 951(a)(1) inclusion with respect to a DFIC as a result of the allocation of a deficit is treated as PTI (referred to as “section 965(b) PTI” in the Proposed Regulations). Nevertheless, section 965(b)(4)(A) does not provide for a corresponding increase in basis under section 961(a). As a result, taxpayers may not be able to distribute section 965(b) PTI without recognizing section 961(b)(2) gain, and as a result post-transition year E&P can become “trapped” by this PTI. In Section V.B. of the Prior Report we recommended that Treasury consider allowing taxpayers to utilize the basis in the stock of E&P deficit corporations to allow a DFIC to which a deficit has been allocated pursuant to section 965(b) to distribute section 965(b) PTI without recognizing section 965(b)(2) gain. This would be consistent with the result if the deficit CFC and DFIC were one foreign corporation.

We generally agree with the approach in the Proposed Regulations, which provides an election to reallocate basis from a deficit CFC to a DFIC (the “Basis Reallocation Election”), as a result of which gain can be reduced under section 961(b)(2) on the distribution of section 965(b) PTI. We note, however, that if the amount of the E&P deficit allocated from the deficit CFC to the DFIC to reduce the DFIC's E&P under section 965(b) exceeds the amount of the stock basis in the deficit CFC allocated to the DFIC under the basis reallocation election, then the U.S. shareholder is required to recognize gain equal to the excess. We see no policy reason why a U.S. shareholder should be required to recognize gain in such a case. Eliminating the gain recognition requirement would create closer parity with the results if there were only one CFC. We recommend that Treasury revise the Basis Reallocation Election to limit the amount of the basis reallocation to the lesser of the existing basis in the stock of the deficit CFC (or applicable section 961 property) or the amount of the E&P deficit allocated to the DFIC, so as to not result in immediate gain recognition with respect to the deficit CFC stock (or applicable section 961 property). We have considered whether the basis reallocation rule, if so revised, should be mandatory instead of elective. Given that the rule would be retroactive, we believe taxpayers should still be given the option of whether or not to elect its application. We believe that this would be consistent with Notice 2018-78.31

E. Need for Additional Guidance Regarding Measurement of Post-1986 Earnings and Profits and Deficits

1. Sales, Redemptions and Distributions During the Transition Year

The Prior Report included a discussion concerning how the rule in section 965(d)(3) providing that the deferred E&P of an SFC is determined “. . . without diminution by reason of dividends distributed during the taxable year . . . other than dividends distributed to another specified corporation” (the “no-diminution” rule) can lead to incongruous results in transactions in which stock in an SFC is sold or redeemed during the transition year. We suggested several possible solutions to the over-inclusion of E&P that can result in these situations. The Proposed Regulations do not address these issues.

In addition, Proposed Regulation section 1.965-2(b), which sets forth an ordering rule for adjustments to the E&P of an SFC in respect of its transition year, does not expressly address adjustments to E&P that result from amounts that are included in a taxpayer's gross income as a dividend pursuant to section 1248. For example, assume a domestic corporation (S) sold 100% of the stock of calendar year CFC1 to another domestic corporation (B) in 2017 and, as a result, was required to include $100 of CFC1's E&P in income as a dividend pursuant to section 1248. Under section 959(e), this $100 is generally treated as an amount included in the gross income of S under section 951(a)(1)(A) (i.e., as PTI resulting from an inclusion of subpart F income). Nevertheless, because such amount is not in fact technically subpart F income, there may be some uncertainty as to whether this transaction is taken into account in the first step in the Proposed Regulations' ordering rule, which generally provides that an SFC's subpart F income is determined without regard to section 965(a) and the SFC's PTI described in section 959(c)(2) is correspondingly increased.32 Omitting the section 1248 amount from this first step could result in the same $100 of CFC1's E&P being included in income by both S and B. Accordingly, we believe it is appropriate to treat a gross income inclusion pursuant to section 1248 in the same manner as subpart F income for purposes of applying this ordering rule, and recommend that Treasury and the Service clarify this result in the final regulations.

2. Application of E&P Deficit Rules to SFCs with PTI and E&P Deficits

In the Prior Report, we recommended that a rule be adopted providing that PTI is to be disregarded in determining the existence and amount of a “specified E&P deficit.”33 The Proposed Regulations did not adopt this recommendation. The preamble to the Proposed Regulations explains that in the view of Treasury and the Service, such a rule would conflict with the plain language of sections 965(b)(3)(B) and 965(d)(3). As described in the Prior Report, we believe this rule is consistent with Congressional intent and necessary to avoid arbitrary results for taxpayers based on the existence and location of PTI among affiliated SFCs.

3. Potential Double Counting of Earnings and Profits of SFCs With Inclusion Years Ending November 30, 2018

The Prior Report identified distributions by first-tier November 30 SFCs to their U.S. shareholders occurring between November 2 and December 1, 2017 as transactions that could result in double counting of E&P. This is because such distributions occur after the November 2 measurement date, and thus may not reduce the section 965 inclusion, but prior to the SFC's inclusion year, and thus would seem not to be PTI. The Prior Report recommended that Treasury and the Service consider issuing guidance regarding the proper treatment of such distributions, either by treating such distributions as PTI, or by providing that the deferred E&P as of November 2, 2017 is reduced by such distributions, to the extent necessary to prevent double counting.

In the preamble to the Proposed Regulations, Treasury and the Service stated that they had determined not to adopt any recommendations in this regard, because such payments only affect the E&P of a single SFC, and thus do not result in double counting in determining a U.S. shareholder's section 965(a) inclusion amount. Moreover, the preamble notes, such payments can have attendant U.S. tax effects that would have to be considered, including the indirect foreign tax credits that a U.S. shareholder might have been eligible to claim in respect of a distribution from its November 30 SFC that occurred November 2 and December 1, 2017 and was treated as a dividend. We do not think Treasury's and the Service's rationale is convincing, because this is a case where there quite clearly is a potential for taxpayers to be subject to taxation on the same earnings twice, and the double taxation results from the application of section 965.

F. Need for Additional Guidance Regarding Measurement of Cash Position

The Prior Report recommended that Treasury and the Service consider expanding the definition of “accounts payable” for purposes of determining an SFC's cash position beyond the narrow definition set forth in Notice 2018-13. Under that narrow definition, for example, payables incurred by a manufacturer (i) to acquire equipment, (ii) to license intellectual property rights or (iii) to pay employees would all fail to qualify as “accounts payable.” The Prior Report's recommendation was not adopted. The Proposed Regulations, like Notice 2018-13, limit the term to include only payables arising from the purchase of property described in section 1221(a)(1) or 1221(a)(8) or the receipt of services from vendors or suppliers.34 The preamble to the Proposed Regulations states that this definition is consistent with the “ordinary meaning” of accounts payable. In our experience, the term often has a broader meaning. Revenue Procedure 99-32,35 for example, permits a U.S. taxpayer to establish an account receivable from, or payable to, an affiliate in order to conform its accounts to reflect a transfer pricing adjustment pursuant to section 482. As many section 482 adjustments relate to royalties with respect to intangibles, this is an example of the Service itself treating accrued but unpaid royalties as creating an account payable. Moreover, if the SFC had paid the relevant expense with cash rather than credit, its cash position would have been reduced, and we do not believe that should affect the outcome. In our experience, it is common for companies to handle payments through their controller's group with intercompany payables.

G. Need for Additional Guidance Regarding Elections Under Section 962

In the Prior Report, we recommended that Treasury and the Service consider what relief can be provided for individuals so that the taxes paid on the section 965(a) inclusion amount (after taking into account the participation exemption under section 965(c)) are no greater than those of a corporation. The Prior Report noted that the desired result would be that individual taxpayers would be entitled to treat the full amount of the their section 965(a) inclusions as PTI (notwithstanding section 962(d)), and to make adjustments to their basis in their stock in the relevant DFICs in an amount equal to such inclusions (notwithstanding the special rule in section 961(a) that generally limits basis adjustments for U.S. shareholders who make section 962 elections).

The Proposed Regulations provide that in the case of a taxpayer making an election under section 962, the section 965(c) deduction is taken into account with respect to the tax imposed under section 11 rather than under section 1.36 This rule will result in individuals who make an election under section 962 being subject to the same effective tax rates as corporations on their section 965(a) inclusion amounts.

The Proposed Regulations do not, however, provide any relief for electing individuals who subsequently receive a distribution of section 965 PTI from a DFIC. The Prior Report acknowledged the challenges that may be involved in applying section 962 solely to create parity in the effective tax rates of individuals and corporations. Notwithstanding these challenges, we continue to believe that an effort should be made to provide such parity.

H. Need for Guidance Regarding Treatment of Section 965(a) Inclusions by Regulated Investment Companies

The Prior Report recommended that Treasury and the Service issue guidance providing that a section 951(a)(1) inclusion pursuant to section 965 is a dividend or other income with respect to a regulated investment company's (a “RIC's”) investment business within the meaning of section 851(b)(2)(A) for purposes of applying the gross income test in section 851(b)(2). In the absence of such a rule, an entity's status as a RIC may be jeopardized if it has section 951(a)(1) inclusions but does not receive a corresponding distribution from the SFCs in which it owns stock in the same tax year. The preamble to the Proposed Regulations does not address this recommendation.

On September 6, 2018, the Service issued Revenue Procedure 2018-47 (the “Revenue Procedure”) which provides certain excise tax relief for RICs that had section 965 inclusions for the tax year ending December 31, 2017 (“2017 Inclusions”). The Revenue Procedure does not address the RIC qualification issue described above. In effect, it generally permits a RIC to defer making a distribution in respect of a 2017 Inclusion until 2018 without being subject to the excise tax that would otherwise be imposed. Consideration should be given to affirming that section 965 inclusions do not affect RIC qualification. In addition, there should be some recognition that a RIC may not have a ready source of cash to make a distribution. A RIC that is a minority shareholder may have little ability to force an SFC to make a distribution and may have trouble selling the position if it is illiquid.

FOOTNOTES

1The principal drafters of this Report were Edward Gonzalez, Brian Krause, Jay Cosel, and Lee Allison, with contributions from Kimberly Blanchard, Andy Braiterman, Daniel Dunn, Larry M. Garrett, Thomas Giegerich, Bradford LaBonte, Michael Mollerus, Joshua Ruland, Michael Schler, Karen Gilbreath Sowell, and Gordon E. Warnke. This Report reflects solely the views of the Tax Section of the New York State Bar Association (“NYSBA”) and not those of the NYSBA Executive Committee or the House of Delegates.

2REG-104226-18, 83 Fed. Reg. 39514 (Aug. 9, 2018).

3Unless otherwise indicated all section references are to the Internal Revenue Code of 1986, as amended (the “Code”) and the Treasury Regulations issued thereunder.

4See NYSBA Tax Section Report No.1388, Report on Section 965 (February 6, 2018) (the “Prior Report”), which is attached as an exhibit to this Report.

5Prop. Reg. § 1.965-4(f)(2)(ii).

6Prop. Reg. § 1.965-4(d).

7The FAQ defines a taxpayer's regular tax liability as its tax liability described in section 965(h)(6)(A)(ii) (its net income tax determined without regard to section 965).

8https://www.irs.gov/newsroom/questions-and-answers-about-reporting-related-to-section-965-on-2017-tax-returns (last accessed September 5, 2018).

9PMTA 2018-016.

10928 F.2d 901 (9th Cir. 1991).

11Section 6403 does not define the term “installments” or elaborate on what constitutes a “tax payable in installments.” Although section 965(h) also refers to “installments,” it should be emphasized that the same terms often have different meanings under different provisions of the Code. In this regard, some of us believe that section 6403 is intended to apply in cases where taxpayers have entered into closing agreements with the Service in which a liability is paid in installments, or where a tax liability is required to be pre-paid in installments, but not in cases where the Code entitles taxpayers to elect to defer payments of a portion of their tax liabilities without incurring any penalties or interest, such as section 965(h).

12The National Taxpayer Advocate, Nina E. Olson, has also questioned whether application of section 6403 in this manner is inconsistent with Congressional intent in enacting section 965(h). See “NTA Blog: IRS Administration of the Section 965 Transition Tax Contravenes Congressional Intent and Imposes Unintended Burden on Taxpayers,” available at https://taxpayeradvocate.irs.gov/news/nta-blog-irs-administration-of-the-section-965-transition-tax-contravenes-congressional-intent-and-imposes-unintended-burden-on-taxpayers (last accessed September 5, 2018).

14See Prop. Reg. § 1.965-7(c)(1).

15Id.

16See Prop. Reg. §§ 1.965-1(f)(19) and 1.965-1(f)(28).

17See, e.g., CCA 201343021.

18See Textron Inc., et al. v. Commissioner, 117 TC 67 (2001).

19See, e.g., Glicklich & Levine, “Textron Makes for Mischief: Tax Court Opens Pandora's Box by Viewing a Voting Trust as a Separate Entity,” 1 J. Tax'n Global Transactions 5 (Winter 2002); Stevens, “A Grantor Trust Visits Subpart F: Ruminations on Textron v. Commissioner and Other Anomalies,” 21 Va. Tax Rev. 507 (2002).

20We note that in promulgating recent Treasury Regulations in connection with the new centralized partnership audit regime, Treasury and the Service considered adopting a rule that would have disregarded grantor trusts for purposes of identifying the partners in a partnership and their tax classifications, but declined to adopt such a rule. See T.D. 9829 (December 29, 2017). However, as indicated in the preamble to those regulations, that position was motivated by policy considerations — principally, limiting the number of partnerships eligible to elect out of the new audit regime — not present here.

21See also CCA 201343021 citing Rev. Rul. 85-13. The Service has stated that “it would be anomalous to suggest that Congress, in enacting the grantor trust provisions, intended that the existence of a trust would be ignored for purposes of attribution of income, deduction, and credit, and yet retain its vitality as a separate entity capable of entering into a sales transaction with the grantor.” Id.

22In addition, in many cases an entity that sells substantially all of its assets will remain in existence to dispose of any remaining assets and potentially to settle liabilities (e.g., there could be a limited survival period for representations given in connection with selling the assets).

24Prop. Reg. § 1.965-7(c)(3)(ii)(B).

25Section 1295(a)(2). Treasury Regulations require the QEF to provide an annual information statement, which must include a statement of the U.S. shareholder's pro rata shares of the QEF's ordinary earnings and net capital gain, as well as a statement that the QEF has permitted the shareholder to examine its books and records in order to verify that those calculations are made in accordance with U.S. tax principles. Treas. Reg. § 1.1295-1(g)(1). In “rare and unusual circumstances,” the Service may issue a private ruling providing for alternative documentation. Treas. Reg. § 1.1295-1(g)(2).

As an alternative to actually reporting the shareholder's shares of ordinary earnings and capital gain, the annual information statement may include information sufficient to allow the shareholder to compute those amounts or a statement that the QEF has allowed the shareholder to examine its books and records in order to make those calculations.

26For example, every restructuring of the foreign corporation would have to be tested under U.S. federal income tax principles to determine whether it was tax-free (e.g., eligible for section 368 or 355 treatment).

27For instance, Example 4 of Proposed Regulation section 1.965-2(j) illustrates a situation where the gain-reduction rule is applied, but would be wholly unnecessary if the U.S. shareholder were permitted to take into account positive section 961(a) adjustments in respect of section 965(a) PTI prior to applying section 961(b) with respect to the distribution of such PTI.

28Section 1368(d)(1) and Treasury Regulation section 1.1368-1(e)(2) provide that a shareholder of an S corporation increases its basis in its S corporation stock for its share of income before taking distributions into account. Treasury Regulation section 1.731-1(a)(1)(ii) provides that advances or drawings of money or property against a partner's distributive share of income are treated as current distributions made on the last day of the partnership taxable year with respect to such partner.

29Prop. Reg. § 1.961-3(a).

30Notably, both Examples 4 and 5 of Proposed Regulation section 1.965-2(j) involve a mid-year distribution of section 965(a) PTI from a second-tier CFC (“CFC2”) to a first-tier CFC (“CFC1”) that initially has zero basis in its CFC2 stock, but say nothing about CFC1 recognizing gain in connection with the distribution. Thus, the examples imply that either (1) no gain is recognized on PTI distributions between CFCs generally or (2) the gain-reduction rule applies.

31Notice 2018-78 (October 1, 2018).

32See Prop. Reg. § 1.965-2(b)(1).

33As used in the Proposed Regulations, the term "specified E&P deficit" means, with respect to an E&P deficit foreign corporation, the amount of the E&P deficit foreign corporation's deficit in post-1986 earnings and profits as of November 2, 2017.

34See Prop. Reg. § 1.965-1(f)(5).

351999-2 CB 296.

36See Prop. Reg. § 1.962-2(b).

END FOOTNOTES

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